The advice crisis is alive and well. There is a very sobering, but globally relevant fact that more than 50% of American investors today don’t have a plan to save for or live in retirement. The clients that are receiving that kind of retirement advice are usually quite wealthy, and therefore generating income isn’t a large concern of theirs. Hence financial advisors that spend time with these clients continue to focus on the growth of assets. This creates a significant gap as more and more clients are entering retirement and needing retirement income advice.
How in an industry that has been focused on retirement income for the better part of two decades, did we get here? We think it is a confluence of three items. The first is compensation advisors are compensated to accumulate and gather assets. The second is the client situation. The vast majority of clients that are retired today have some sort of pension and government support system, hence they are not needing to generate income out of their investable assets. The final factor is the markets. Over the last 10 years, depending on which global indices you look at, clients have enjoyed anywhere from high single digits to mid-teens in performance. These three things combined may help explain why retirement income advice is still in its infancy.
Retirement income advice today is very much focused on the growth of assets, asset allocation and investment selection, and it lacks focus on product allocation. Product allocation is the critical pivot that needs to happen as clients move from saving for, to living in, retirement.
Many of the risks to a successful retirement are similar to that of asset accumulation. However, a significant number are different – longevity, sequence of returns, spending rate and cognitive decline to name a few. One of the challenges is that financial advisers aren’t comfortable talking to these new risks, never mind solving for them. They don’t want to talk about mental health, cognitive decline and are not comfortable coaching their clients on reducing their spending.
On the other hand, one role they are comfortable with relates to market declines. In market declines, the sound advice during asset accumulation is to stay the course as markets will rebound. But in return, the timing and duration of these market declines can ruin even the best laid retirement plan. The conversation therefore needs to shift to focus on flexible spending habits and sources of income that can withstand market downturns.
This leads us to another challenge we’ve seen – sources of income like guaranteed income have had a bad reputation, and financial advisers have had a tough time positioning investment solutions that will weather downturns like lower volatility. Part of the reason is because the client looks at their quarterly statement and compare it to market returns and wonders why they’re trailing. Financial advisers haven’t talked enough to clients about the benefits of downside protection. That said, we are beginning to see the advice model shift. Over the recent market volatility, we’ve seen advisors talk to clients about lower volatility solutions and advice has started to include discussions about needs versus wants. However, this may not be enough and it definitely is not fast enough, as the landscape that advisors and clients are dealing with continues to change rapidly.
One of the blooming factors for advisors is longevity. Longevity adds complexity both to the investment solutions an advisor might propose to a client and also to the discussions around spending rate and portfolio sustainability. As people around the world are living longer, how do you put a plan together when you don’t know the end point? Do you advise a client to spend less money, and maybe not enjoy retirement as much as they could? How do you accommodate spending patterns that are unknown? They may be consistent if the client remains in good health but they are likely to be variable, if there are complications. This is another challenge that we face, both from a solutions perspective but also from a client behaviour perspective. It is nearly impossible to accurately predict health and longevity, and it is difficult to talk about. The conversation needs to include solutions that have lifetime guarantees.
Insights and learnings in the retirement income arena
That said, I believe we actually are in a better position. One key lesson we have learnt is that guaranteed income is critical, whether coming from government support programs or supplemented by annuities. Positioning has been challenging in the US, where 50% of people surveyed say they want guaranteed income but much less than 50% say they would buy an annuity. Hence positioning is something we need to focus on going forward, as access to those annuities is critical. In comparison, we see that in Asia, annuities are more accepted.
Clients avoid buying annuities because of that bias of trading liquidity for a guarantee. However, if they have access to them in a retirement plan, they will use them. Plan sponsors have their own challenges in determining whether to add annuities to their plans but there are changes happening in the US regulatorily that are helping with those decisions. We think that investable assets are going to play a bigger role in generating income for clients as we move forward. With less and less people retiring with a pension, product development needs to continue in the area of solutions for investable assets.
Currently, products like managed payouts funds have had mixed results. This may be attributed to a mismatch between product development and client expectations. At Capital Group we did a survey of near retirees and asked them what they wanted out of retirement income solutions. Interestingly, it was very similar to some of the feedback we’ve seen in some of the Asian countries. Those surveyed want sustainable withdrawals; they want to feel comfortable to be able to take income and appreciation off their portfolio. However, they wish and expect to see their principal returned intact over a reasonable period of time. In the US, clients mentioned a timeframe of about 20 years. That is not the way managed payout funds are currently constructed. Currently, they dip into both principal and appreciation to give the client income. This is a sign that product development needs to continue.
We know advice is critical. In particular, advice that is tailored to the individual client situation. For example the well-known 4% withdrawal rate is a great benchmark, but it is not relevant to every client. For some, that will not suffice and for others, that is more income than they need. We have seen in the early stages, that clients are very willing to be flexible in their lifestyle, to make sure that their portfolio is sustainable.
In a low-rate environment, or a lower for longer environment, some of the traditional asset allocation approaches are going to be challenged. Traditionally, advisors will move clients towards more fixed income in their portfolio to help with capital preservation and to generate yield. But in a low-rate environment where yield is going to be challenged in fixed income, we need to think about the role fixed income is playing in the portfolio, and we need to look to equities to generate additional yield. What this all adds up to is that there is no one size fits all, from a product solution. That also means advice is going to be central to how we solve this.
Framework to address this retirement income opportunity going forward
It is key for advisors to be able to deliver scalable, simple, but tailored advice. At Capital Group we look at this through the bucket approach, identifying the four key areas of need or want for most clients – living (essential expenses), lifestyle (optional expenses), emergency (the unknowns that can destroy the best laid plans) and legacy (leaving something for the next generation).
By focusing on these four areas with clients, both product allocation and asset allocation decisions become much clearer. You can review the sources of income, focusing on lower volatility and guaranteed sources to deliver your living needs. You can look for a total return or a growth in income strategy to support your lifestyle. You would want stable and secure, almost cash like solutions for emergencies. For legacy, you would look to longer-term growth, perhaps tax-advantaged strategies. So how might this work in practice? We can think about the four buckets as preferences in retirement. Not every client is going to have the capacity for preference, their situation may not allow for legacy as a priority, for example. The elegance in Capital Group’s approach is that it is configurable to meet the client specifics, without having to start from scratch or customising it to the point of it not being feasible or cost effective to execute.
This structure can be aligned to the client type, with the primary and secondary focus changing based on the client’s net worth and income needs. As you think about a product spectrum, you could align products to each of these categories, allowing advisors to align product decisions to each one of the client priorities, based on the client’s specific situation and capacity for preference. That said, we understand that no plan is static, and the structure allows flexibility between these buckets. If lifestyle expenses are lower than the client and the advisor expected, they could look enhancing the emergency or legacy bucket with the excess. Likewise if issues arise, whether market related or health related, the legacy and lifestyle buckets could be used to shore up the living and emergency buckets.
By employing a robust, but flexible advice model, the current challenges become easier to address.