Retirement: Goal-Based Investing Gains Traction

As defined benefit plans fade into history, more American workers are confronting the fact that they will need to be much more active in deciding how to marshal their retirement savings than their parents had to be. But how best to line up what you have now with what you'll need later?

That's where goal-based investing, or what some people call liability-driven investing, comes in. This increasingly popular approach is yet another example of the retail investing world borrowing a page from institutional investors' playbook—trying to manage people's assets so they better match their liabilities, which has long been a focus of pension funds.

The idea expands on a change in thinking about retirement portfolios that target-date funds pioneered: keeping a larger portion of the assets of people approaching retirement age—or who have already retired—invested in higher-return asset classes such as stocks in order to ensure they have ample income for the rest of their lives. (Target-date funds do shift to an ever more conservative asset mix as an investor's retirement date approaches.)

Some of the more aggressive target-date funds that incurred big losses during the 2008-09 market crash have come under attack for being too heavily weighted toward equities—as much as 40% of the portfolio in some funds with target dates as early as 2010. That, and the potential conflicts of interest that arise when mutual fund companies offer target-date retirement plans and make asset allocation calls, has spurred talk of possible regulation of target-date funds' investments.

How Much Will You Need?Most baby boomers preparing for retirement in the next few years will still receive a pension under their employers' defined benefit plan, which makes the hard call of determining a retiree's annual payout. But as pension plans are increasingly replaced by 401(k)s and other defined contribution plans, the thorny decisions about how to draw down wealth will be left to individual investors. That's why more and more financial advisers see a need to develop financial life plans centered on goals that can determine the annual income streams people need. Some 401(k) plans are just starting to display investors' account balances in the form of annual income streams rather than as lump sums.

"A common roadblock [for self-directed investors] is their relationship to money," says Michael Kay, president of advisory firm Financial Focus in Livingston, N.J. "What is their money history? Are they spenders or savers? Will their behavior be consistent with what their stated goals are?"

It's easier to motivate investors' behavior by emphasizing goals than by focusing on their portfolios' overall performance, says Thomas P. Holland, a partner at Global Vision Advisors outside of Boston. "When you communicate with clients [with specific goals in mind], they're more concerned about being on pace. The conversation is more around what needs to be done to create additional savings and rethinking asset [allocation]," he says.

An investor's stated high tolerance for risk shouldn't be confused with his actual capacity for risk based on his financial circumstances, says Kay at Financial Focus. It's not appropriate for someone who doesn't have an adequate emergency fund of cash to invest in the stock market before they have a safe reserve set aside, he adds.

safe investments for the short term"In any good financial plan, one starts with a baseline of risk management, [such as] emergency funds and insurance to obviate risk as much as is appropriate, and then starts working up the pyramid to other places that might enhance returns over time," Kay says. "Any investment needs to be linked to a specific time frame."

In other words, money earmarked for a goal that's just one to two years away should be safely stowed in a money market account or high-quality short-term bond fund. Knowing you have enough to cover your essential living expenses— shelter, food, clothing, and health care—for a certain period of time should allow retirees to feel secure in being more aggressive with how they invest the remainder of their wealth, says Global Vision's Holland.

Some advisers liken goal-based investing to the so-called bucket approach where retirees split up their wealth into distinct portfolios according to the time frame of various financial goals and needs. There's debate as to how practical this may be for people with smaller nest eggs, less than $500,000, for example.

The size of your assets matters less than the size of your liabilities, says Jean Setzfand, director of financial security at the American Association of Retired Persons (AARP). Given that health care and mortgage payments tend to be the largest expenses, "if someone is healthy and has paid off their mortgage, [the amount needed to make such a plan work] could very well be under $500,000 in assets", she says.

The healthier you are, the longer you'll be able to work, putting off Social Security payouts. Deferring payouts from age 62 until you're 66 can boost your eventual payout by as much as 30%, says Mauricio Soto, research associate at the Urban Institute, a Washington policy think tank.

more thoughtful planningKay says that some advisers in his firm are willing to work with clients with as little as $100,000 in savings, while others require net worth of at least $750,000 to $1 million. "What's most important is to work with clients we have a meeting of the minds with, clients who are really oriented toward achieving their goals," he says.

Getting investors to tie their wealth to specific purposes rather than just investing for a performance target can lead clients to more thoughtful life planning, says Holland. Showing them what it would take to reach a goal of saving 10% of their income each year could lead to important decisions about how they're accumulating wealth, and cause them to consider alternatives to traditional investments such as owning a business or taking an equity stake in a company in lieu of salary or commissions.

"I've seen clients go from a job that pays them to one that gives them equity, and over time they're able to both increase their income and build an equity position in a company," he says. "That wouldn't be done in a traditional investment conversation."

High-Tech AdviceWhile some advisers doubt this holistic approach can be approximated by technology, algorithms are being developed for financial advisers to determine the best asset mix to suit a client's circumstances. Citigroup's (C) one-year-old discount platform for financial advice, myFi, which is now being folded into Citi's Personal Wealth Management division, uses a wealth management and investment planning platform created by Advisor Software of Lafayette, Calif.

The software enables advisers to model discussions with clients about their household goals and needs and "determine the impact of potential decisions on their investment mix," says Neal Ringquist, president of Advisor Software. Knowing the extent of a client's liabilities helps direct their portfolios toward more suitable allocations than what's typically provided when someone who lacks an adviser is placed by default into an age-appropriate target-date fund, he says.

Despite their hefty fees, annuities are recommended by Soto at the Urban Institute as a way to lock in lifetime income. Annuities tend to be overpriced because they attract people more likely to live very long lives, while there's a shortage of enrollment among people of average life expectancy who would subsidize the later payouts of those living longer. "So, if you're the average household, you're not going to get a good deal," says Soto.

The Fidelity Freedom Lifetime Income Annuity guarantees a certain minimum income stream, but its payments vary with the performance of the underlying mutual funds that an investor chooses. As with all variable annuity products, although the fluctuating payment can protect against inflation, your payments can decrease if your annuity funds don't perform well.

"My sense is today those products are too early and might be too expensive," says Soto. "They're offering flexibility, so they have to be expensive."

annuity optionsDon Ezra, Bob Collie, and Matthew X. Smith, in their new book The Retirement Plan Solution, suggest delaying buying an annuity as long as you can. How long you can delay depends on your tolerance for risk. The authors suggest thinking about what your total wealth enables you to do and defining four wealth zones according to your ability to cover essential expenses: a desired lifestyle, bequests to others, and for the super-wealthy who can live on investment returns alone, endowments.

If you're concerned only with your longevity, you might buy a conventional lifetime annuity to cover essentials and invest the remainder in traditionally risky assets or a variable lifetime annuity, with the hope that the assets perform well enough to fully fund your desired lifestyle. Those who think they may be able to afford a bequest should stay away from variable lifetime annuities, "because no matter how well the risky asset does, there is nothing that outlives you," the authors write.

In response to one of the biggest retirement risks—longevity—insurance firms such as MetLife (MET) and Hartford Financial Services Group (HIG) have begun to offer Advanced Life Deferred Annuities (ALDAs) that are purchased at retirement but don't start to pay until the owner turns 80 or 85.

Policymakers now recognize the need to provide incentives so people can plan for predictable streams of retirement income. In June, Representative Earl Pomeroy (D-N.D.) proposed the Retirement Security Needs Lifetime Pay Act (H.R. 2748) to encourage workers to annuitize some of their retirement savings by providing a 50% percent tax break for up to $10,000 of lifetime annuity payments each year. The bill would also exempt from taxes 25% of lifetime income payments from Individual Retirement Accounts (IRAs), qualified plans, and similar employer-sponsored retirement plans other than defined benefit plans.

Many advisers still have to be convinced about the value of goal-based investment plans because there are incentives built into the way they're used to managing clients' assets. "They are acting as fiduciaries and trying to serve clients to the best of their ability, but this is still a new area for a lot of advisers to think about," says Setzfand at AARP.

Still, as the company pension goes the way of the dodo, financial pros will be paying attention as they try to help their clients make the smartest choices for financing their retirement.

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