9 key retirement-income questions: with the life industry's latest generation of products, advisers and buyers have new retirement-planning issues to consider.

Key Points

* The recent generation of annuity products has introduced more options in retirement-income planning.

* Properly used, these new options can reduce retirement risk and guarantee some growth.

* Advisers, however, now face new decisions about which annuity features and benefits to use, if any.

* Tax considerations will affect how to construct and draw down a retirement portfolio.

If you are a financial adviser today, you will likely be faced with some tough questions about retirement planning. Or, you may need to raise issues that clients don't think of themselves.

Today's annuity products offer more benefits and choices than ever before. Advisers who don't consider them may be doing an incomplete job. With those thoughts in mind, Best's Review asked four experienced advisers for their insights about retirement planning in general and use of annuities in particular. We chose this group for their experience, objectivity and independence, and asked them to discuss nine important questions about retirement planning that may not always be addressed. Of course, all advisers need to exercise due diligence and fact-finding to uncover a client's or prospect's Financial situation, goals, attitudes and feelings, and design a plan accordingly.

1. Which is better: an immediate annuity or a guaranteed minimum withdrawal benefit?

Advisers seem more enthusiastic about the GMWB available with deferred variable annuities than they are about annuitization. That should not be surprising, given that annuitization rates have hovered in the low single digits for decades. The main objection is that buying a payout annuity is usually an irrevocable decision, while GMWBs can be halted at any time, and their underlying assets remain available. "Very few people will spend their entire lives amassing $700,000 and then turn it over to ABC Insurance Co. for a series of checks," said John Huggard of payout annuities. "It's a great idea, but as a practical matter, very few people do that." Huggard is senior member of the Huggard Obiol & Blake law firm in Raleigh, N.C., and a professor at North Carolina State University.

Advisers dislike fixed payout annuities because inflation erodes their value. Their clients fear variable payout annuities because the payment amounts vary. The 2000-2003 bear market didn't help. Some insurers have had success in addressing those concerns by adding liquidity, increasing payouts on fixed products and installing floors on variable payouts--all at an extra cost--but with only pockets of success.

Richard A. Dulisse, assistant professor of financial planning at The American College, said that only about 5% of annuities sold are immediate annuities, and of them, only about 5% are immediate variable annuities. People don't like variable annuitizations because the assumed interest rate (which sets the amount of the first payment and helps determine the size of future payments) is best set low to allow for the monthly payments to grow. Depending on an annuitant's age, fixed annuities might pay 7% a year, while the assumed interest rate on a payout variable annuity might start at 3%. If the underlying investments perform better than that, the payments rise. Over time, they should exceed fixed annuity payouts. "But if you retired in 1970 and bought one of these, you might have committed suicide by 1978, when the stock market started turning around," said Dulisse. "It depends on when you get in."

Dulisse said fixed annuitization offers a couple of advantages over other fixed-income investments: higher monthly payments and a tax-favored status. Why? Each payment includes a return of principal, which increases the payment and is not taxable. But he said he wouldn't put more than a third of somebody's retirement assets into an immediate annuity because of the irreversibility. "Keep in mind that for most people, the segment of their portfolio that will keep pace with inflation is called Social Security," he said. "The rest can be designed to attempt to replicate increases in the [consumer price index], but it takes a financial engineer to be on top of it on a regular basis."

Some may find the "split-annuity" concept attractive, Dulisse said. This involves using money from a taxable account to buy both a period-certain immediate annuity and a deferred annuity, thus removing most of the current-year income tax liability. The immediate annuity pays for a stipulated time--nine years, for example. Since it pays out over limited time, the payments are higher than in lifetime annuitizations. Over that time, the principal is returned plus interest. Meanwhile, the deferred annuity will have grown, perhaps doubled, and the owner uses part of that annuity to buy a new immediate annuity. "So you have the best of both worlds," said Dulisse. "You always have a stream of income, but you always have some money in the deferred annuity for lump-sum purposes. Depending on the rates of return, you can actually design it so it would increase in increments every nine years to keep up with inflation."

The concept also helps people fight off what Dulisse calls the "post-retirement mentality syndrome," which he defines as the "irrational fear" of running out of money. This fear causes people to deprive themselves of little indulgences and frivolities, such as not turning on the air conditioner on a hot day.

2. So what about using the living benefits of variable annuities for income?

Huggard is a big fan of the guaranteed minimum withdrawal benefit. He says it provides inflation protection and downside market protection--100% of the risk is on the insurer--and the contract owner still owns the assets. Most insurers will pay 5% of the protected amount annually for life, but some pay as much as 8%, depending on age, he says. Owners also can lock in gains in the protected value both before and after starting withdrawals. Some insurers guarantee the growth of the protected amount before the owner activates the withdrawals.

3. Experts advise to keep withdrawals in retirement to 4%, especially in the first few years. So 5% sounds pretty good, doesn't it?

Huggard said a lot of Monte Carlo simulations still use 5%, and articles in financial journals illustrate as much as 7% or 8%. "But one thing is critical," he said. "In the first five years of retirement, if people get caught in the sequence-of-return spiral, which is where they are withdrawing money when the market is moving down, they'll realize three or five years from now that in order for them to get back to the point they won't outlive their money, even at a 5% withdrawal, the stock market has to come in with something outrageous. We're talking 25% gains for five or six years in a row, which the market is never going to do."

With the GMWB, people can take their 5% knowing that if the market goes down, it's someone else's problem, he said.

4. So if an owner has activated a guaranteed minimum withdrawal benefit, should that person invest aggressively in the account?

Huggard says yes. Some companies require the investor to choose among several mandatory allocation models ranging from conservative to aggressive. Some have optional models. Some will require that a certain percentage, perhaps 20%, has to go into their models. And some have no requirements. "That is one of the real, honest-to-goodness benefits of these living-benefit annuities," Huggard said. In the long run, although there's going to be a lot of vacillation in the market, the guy who invests in aggressive stocks and mutual funds is going to have a lot more 15 years from now than the guy who invests conservatively, he added. "The reason people invest conservatively is that they fear the risk, but if the annuity negates the risk, there'd be no reason not to do it," he said.

5. The guaranteed minimum withdrawal benefit costs an extra 60 to 75 basis points a year on top of a variable annuity with total costs up near 2.4% That's more than 3% a year. Is the feature still worth it?

Mutual funds in taxable accounts cost more than people think, especially those with up-front commissions of 5% or more, according to Huggard. Fund managers have to be paid, and they pass on trading costs. Tax experts estimate fund owners may lose about two percentage points of their gains each year in taxes. Actual costs annualized over the first five years could be as much as 5%, or as little as 2.5% if held in an IRA, he said. "So which is a better buy: something that costs 2.5% with all the risk, or 3.1% with no risk and a ratcheting upside?" he asked. "It's portfolio insurance, and I'm willing to pay it. If I were 25, I'd look at stocks and mutual funds, but I'm 60, so that makes a big difference."

6. What are the alternatives to guaranteed minimum withdrawal benefits or annuitization?

A diversified and managed portfolio of stocks and stock funds, bonds and bond funds and certificates of deposit provide better internal rates of return than annuities, particularly payout annuities, said Ted Bovard, principal with Fort Pitt Capital Group, Pittsburgh. He said that some clients can't deal with the daily, monthly or quarterly change in price, "but if you look at 10-year rolling periods of time, people would always be substantially better off to do that," he said. "The reality is, an insurance company is doing the same thing." He estimated an insurer earns perhaps 2% to 4% more on a policyholder's assets than it pays out.

7. But how does an adviser help clients deal with market risk and other risks?

Bovard said his job is to get clients a check every month or every quarter. To cull the winners in the portfolio, and to keep the asset allocation in balance, Bovard said he sells from whatever is the best-performing part of the portfolio. He also keeps on hand enough cash or short-term bonds to cover two to three years of expenses.

"The reality is that the markets go down two or three years out of every 10, and they go up in the other seven or eight," he said. "Part of my job is to reduce the risk as much as I can within a portfolio," Bovard said, but he doesn't want the portfolio to give up the long-term opportunity to beat inflation. Inflation, he said, is a much bigger deal for retirees than they initially perceive. "So if my time horizon is 10 years, would I use something to prevent me from losing anything and give me a 4% or 5% guarantee, or am I better off to balance the portfolio and have a little more of a roller coaster ride in the stock and bond markets? There isn't a 10-year period out there during which the markets have lost money; you could pick a 10-year period that hasn't done as well as 5% a year, but there aren't many."

Bovard admits that keeping individual clients on course is tough. "It was very hard in 1998 and 1999 to get people to stay more conservative," he said. "The tendency was for people to want a lot more in stocks because the stock market was doing so well. In 2001 and 2002, it was difficult to keep them from selling the stocks they had. Today, it's kind of back and forth."

For Frank Congemi, the essence of retirement planning is earning more for clients than they withdraw. He is a registered financial gerontologist in Forest Hills, N.Y., and Deerfield Beach, Fla. When he achieves that goal for them, it is by combining a continuously managed asset-allocation process in each client's portfolio and dealing only with asset managers with 30 to 70 years of excellent performance. "If a client needs 4% to 5% a year, and inflation is running at 3%, you really need to earn 7% to 8%," he said. But Congemi said some of his clients have earned an average of 10% to 12%. They have been pulling down their investments for 15 to 17 years, and they have more money invested now than when they began their retirement planning. "You need to be making in excess of what you're pulling out, even if it's not every year," he said.

Some people don't want 100% of their portfolio at risk in the market, and they can become worried quickly, Congemi said. "Stuff is going to happen: war, terrorism, high oil prices, inflation," he said. Like an artist painting a picture, Congemi might add annuities to the portfolios of such clients.

Congemi is more likely to use annuities when people have "too much money to leave open to taxation for four or five years" or when people own annuities that are inappropriate for them and need to be "rescued" through tax-free exchanges as permitted under Section 1035 of the tax code.

8. Should withdrawals in retirement come first from tax-free accounts, tax-sheltered accounts or taxable accounts?

If you need income, a no-brainer is to take from taxable accounts the interest, annual dividends and capital gains in cash, since they are taxed even if you reinvest them. After that, choices can be murky.

Dulisse says tax-free assets should be withdrawn first, such as Roth IRAs, life insurance cash values or annuities issued before 1982, where principal can be drawn first."

Bovard favors preserving tax-deferred assets in qualified plans; owners must begin withdrawals on these at age 70 1/2. "But where you have to put a limit on withdrawing other assets is so you cover unexpected emergencies," he said. "You hate to have someone at 63 with only IRA assets because if something comes up ... you've got to withdraw not only the money you need, but the tax on top of it"

Many people have little choice, said Congemi. "If you only have a half million dollars in assets, your two largest assets are your home and your retirement account," he said. "You probably don't have much in savings." Such people might make use of a reverse mortgage, both Huggard and Dulisse suggested. For people with more savings, Huggard advises to first spend down assets on which there is no tax.

Huggard said a disadvantage to pulling out taxable money first is that it puts people in the position of bequeathing tax-deferred accounts, which leaves beneficiaries a big tax bill. A good idea may be to withdraw equal amounts from different kinds of accounts in order to preserve options, he said.

9. Is it necessary to diversify beyond stocks, bonds and cash?

Not many retirees need to diversify beyond these three major asset classes, said Dulisse. "If you're diversifying properly, you would have the right dissimilarity of investment objectives and historical performances sufficient to offset market volatility," he said. At some point, diversification becomes an exercise in absurdity, he said. But when using portfolio optimization strategy, some people may want and benefit from other asset classes such as gold, precious metals, commodities or real estate. "In theory, anything should be considered," he said.

Retirement Income By the Numbers

78%

Retirees with no income plan. Of those that have one, half established it before they retired. (2003)

41%

Retirees unfamiliar with the idea of retirement-income planning. (2003)

39%

Retirees concerned about outliving money. (2004)

32%

Retirees concerned about outliving money. (2001)

64%

Americans who think they will spend all of their savings in retirement. (2006)

2.2 trillion

Estimated rollover flows from 2004 to 2010.

$14 trillion

Investable assets controlled by retirees and near-retirees, about 60% of total U.S. investable assets. (2006)

Source: MassMutual Financial Group