We are excited to share this excerpt from renowned industry thought leader Wade Pfau’s latest book, Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success. Find a link to our latest co-authored white paper with Mr. Pfau at the end of this post.

There are competing viable approaches for building a retirement income strategy. Traditionally, Registered Investment Advisors have tended to emphasize investment-centric approaches that rely on earning the risk premium from the stock market as the most effective way to support a retired client’s financial goals. With this retirement strategy, stocks are expected to outperform bonds over sufficiently long periods, and this investment outperformance will provide retirees with the opportunity to fund a higher lifestyle. Should decent market returns materialize and sufficiently outpace inflation, investment solutions can be sustained indefinitely to support retirement goals.

Those favoring investments rely on the notion that while the stock market is volatile, it will eventually provide favorable returns and will outperform bonds. The upside potential from an investment portfolio is viewed as so significant that insurance products are not needed. Advocates for this strategy are generally more optimistic about the long-run potential of stocks to outperform bonds, so retirees are generally advised to take on as much risk as they can tolerate to minimize the probability of plan failure. Answers about asset allocation for retirees generally point to holding around 50 to 80 percent of the retirement portfolio in stocks.

In recent research highlighted in Michael Kitces’ Nerd’s Eye View blog, Alex Murguia and I determined that this investments-centric approach will resonate best with about one-third of the population aged 50-80 in the United States.

There are other viable options that favor incorporating contractual protections and commitment to a strategy which are more appealing to two-thirds of the population when seeking to meet essential spending needs in retirement.

Investments-centric financial advisors may respond differently to this finding. Some will dismiss it, arguing that aggressive and diversified portfolios are the best way to fund retirement and so the advisor’s job is to encourage retirees to invest as aggressively as possible to be exposed to the most possible stock market gains. Other advisors will recognize that there is more than one way to create sustainable retirement income, and it is important to also be open to a role for insurance-based tools such as annuities that use risk pooling to support retirement expenses. A personalized plan can be tailored for each individual client using the appropriate combination investment and insurance tools to make the client comfortable with their chosen approach. Some clients will be okay with only using investments, some may already have enough traditional pension income that annuities are not needed, but some may have a gap between reliable income and core spending needs that they would feel most comfortable closing with an annuity.

Advisors wishing to use a broader range of tools, such as annuities, with their clients have faced constraints over the years. Historically, annuities have mostly been sold through financial advisors who serve as intermediaries and receive a commission on the sale, rather than being sold directly by the insurance company to the consumer. Having insurance companies compensate the advisor through a commission has created problems for financial advisors who only accept fees from their clients rather than commissions for selling financial products.

In recent years, the fee-only model for financial advice has grown in popularity. It is often designed to charge a percentage of assets under management or charge hourly fees or fixed fees for providing planning services. Fee-only advisors have effectively won the public debate about this type of compensation model being more aligned with serving consumer interests. Commissions were argued to create a conflict of interest, as a commission-based advisor need only to sell suitable financial products that are not necessarily putting the client’s needs first.

While fee-only advisors can be aligned with client interests during the accumulation phase by seeking to accumulate more assets and grow the investment portfolio, the fee-only model does not necessarily align with managing retirement risks during the distribution phase that focuses on lifetime income rather than portfolio growth. It is concerning that fee-only financial advisors have been particularly slow to adopt the use of annuities. Caution about annuities relates to their complexity and the confusion this complexity can create among consumers, their built-in fees and surrender charges for early distributions, and their commission-based compensation model. This has left their clients more exposed to market volatility and longevity risk when seeking to build retirement income plans than they may truly be comfortable with taking.

This is changing. Insurance companies are now creating annuities that can fit into the toolbox of fee-only financial advisors in a much more effective manner. It is now increasingly possible to treat the annuity assets in the same manner as other investment options are treated on the platforms used by fee-only advisors to consolidate and manage client assets. For deferred variable and index annuities, the contract value is known, and income annuities can be managed by accounting for the present value of their remaining payments. This makes it possible for advisors to charge their fees on the assets held inside the annuity in the same way as for other investment assets.

For fee-only annuities, internal costs can be reduced because advisors can charge their fees from outside the annuity. The insurance company no longer needs to charge more from within the annuity to collect fees to compensate the advisor. This can result in lower mortality and expense charges on the annuity, and surrender charges can be reduced or even eliminated. For variable annuities, lower internal expenses can allow for more step-up opportunities and upside potential. A fee-only index annuity can provide more for the options budget, since advisor fees do not have to be supported internally. This can allow the owner to enjoy greater participation in the market upside. Allowing fee-only advisors to also incorporate annuities in their planning should help to increase their exposure to the public in the coming years.

I believe that financial advisors who can draw from multiple strategies and tools are best positioned to win in the long-term quest for serving and delighting the most clients. It behooves advisors to beef up their tool kits and have as much comfort with using annuities as they do investments. I hope this article provides an understanding of the value of risk pooling and mortality credits, an explanation for how different types of annuities work, and an explanation for how shifting from bonds to annuities has the potential to improve retirement planning outcomes in terms of better meeting spending needs and supporting legacy.

We’re excited to offer a deeper dive into this topic.

If you would like to hear more about the Envestnet Insurance Exchange and capabilities, please set-up time with the Wealth Solutions team.

Neither Envestnet, nor the Envestnet Insurance Exchange, powered by the Fiduciary Exchange (FIDx), are licensed insurance agencies and as such, do not sell or make any recommendations related to the purchase of the annuity or insurance products referred to in this presentation. Insurance products are only sold or recommended by insurance licensed financial professionals or through a third-party intermediary licensed as an insurance agency. Please refer to your insurance agreement or contact your financial professional, insurance agent or insurance company for more information.

The information, analysis, and opinions expressed herein are for general information only. Nothing contained in this document is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Past performance is not indicative of future results. Annuities can be an important part of your overall portfolio, but may not be appropriate for everyone. Before purchasing an annuity, it is important to understand details of the product.

Envestnet is not affiliated, associated, authorized, endorsed by, or in any way officially connected with Wade Pfau, Ph.D., CFA, RICP®. This blog should not be construed as a recommendation or endorsement of any particular product, service, or firm.

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