Building a retirement plan is far different from creating a standard financial plan. Not only do you have to extrapolate your client's needs for the next 20 to 30 years, but you also have to convert assets, allocate income, and optimize taxes. Here's a six-step guide to systematically building retirement plans for middle-income clients.

Because retirement income requires a process, not just products. There is no single product that will meet all of a retiree's income needs. There is no "magic bullet" that can be applied to every situation.

This is where the retirement income management (RIM) process comes into play. Built on the six-step financial planning process, the RIM process identifies a client's goals, resources, unique retirement risks, tax and estate-planning opportunities, and options for closing income gaps prior to and during retirement. It then drives those variables through a series of income conversion considerations to optimize income streams through retirement vehicles like Social Security, IRAs, mutual funds, employer retirement plans, and immediate annuities. This optimization involves many trade-offs and timing considerations that must be identified and agreed upon by the advisor and client.

The following six steps provide a systematic method for tackling these issues and producing a customized plan to generate and manage sufficient retirement income for middle-market clients:

Step 1: Estimate duration of retirement assets

Step 2: Identify and manage retirement risks

Step 3: Identify distribution, tax and estate issues, and opportunities

Step 4: Identify options for addressing gaps

Step 5: Convert resources into income

Step 6: Maintain and update the plan

When all the steps are put together sequentially, they form the "Retirement Income Management Process" shown below.

Step 1: Estimate duration of retirement assets

Until clients define retirement on a holistic basis, it will be hard to determine what their total spending needs will be. So even though planning for retirement may not be just about the money, it all ties back to what will be needed in terms of financial resources to live a desired lifestyle.

Success or happiness in retirement for today's retirees requires integration of three major life areas: wealth, engagement, and health (see Figure 2, below).

1. Wealth (the geo-financial sphere) means not only the sufficiency of the savings accumulated, but also the cost of living and the access to health care, activities, etc., in the area of the country where the retiree lives.
2. Engagement (the psychosocial sphere) includes participation in activities that increase a personal sense of engagement and fulfillment. Such activities could include spending time with family and friends, providing volunteer labor for a favorite charity or nonprofit organization, or working part time, for the social benefits.
3. Health (the biomedical sphere) includes an awareness of inherited biological characteristics and managing health and long-term care risks during retirement.The first step in the retirement income management process, then, is to obtain an understanding of a retiree's retirement expense needs and income resources from a retirement readiness perspective, and then evaluate how long those resources might last based on the retiree's expected longevity.

When planning for retiree income needs, divide the client's spending needs into two elements: (1) essential expenses, or needs, and (2) discretionary spending, or wants.The first goal when planning for retirement income for middle-income clients is to ensure that essential expenses (such as food, clothing, and housing) are covered by income from lifetime sources. As a general rule, help clients match essential expenses to lifetime income sources, which include resources such as Social Security, pensions from defined-benefit plans, immediate annuities, and other lifetime income sources.

Discretionary spending needs (such as travel and entertainment) can be matched to income from managed sources. These resources could include taxable accounts, personal retirement accounts, employment income, or other managed sources.

As a retirement professional, you need to recognize that a key difference between lifetime and managed-income resources is that the managed-income resources are not guaranteed for life. Retirement income management is not just about managing investment assets, although this is a key component. In retirement, income allocation now becomes a critical part of the process to make sure that a retiree does not outlive his or her assets, and that a retiree's lifestyle is financially feasible. Income allocation provides a base for managing retirement-specific risks and income.

To make a quick estimate in an initial meeting of how long a middle-income client's resources may last, an advisor can take the sum of the essential and discretionary income gaps (A + B) and divide that total into the retiree's managed sources. For instance, assume a retiree has $200,000 in managed sources and a $20,000 total annual income gap; $200,000/$20,000 means the retiree's resources might last roughly 10 years using simplistic assumptions. The ability to make a quick estimate like this allows an advisor to quickly size up a client's situation and determine whether it is worth the advisor's time to invest more time with the client or suggest he or she delay retirement a few more years.

Step 2: Identify and manage retirement risks

One of the keys to successfully creating a retirement income plan for the middle market is to be able to "identify and manage retirement risks," which is Step 2 in the retirement income process. There are many risks that clients face that may not have been as critical during their working/accumulation years. Some of these risks apply to all retirees, and some others may be unique to the individual. The goal of this step is to help the client identify primary risks, prioritize them, and then engage in a discussion to determine practical methods for managing those risks when implementing the retirement income plan. The issues listed below are the main post-retirement risks that could impact retirement income. Most retirees in the middle market will face one or more of these risks:

1. Longevity risk. The likelihood a retiree will outlive his or her financial resources.
2. Inflation risk. The likelihood a retiree's standard of living will decline due to inflation.
3. Health care and long-term care risk. The likelihood that medical expenses will consume an ever-growing percentage of a retiree's budget.
4. Investing risk. The likelihood that investment performance will not occur as expected.

As retirement professionals, we argue that the heart of retirement income planning centers around helping a retiree identify and manage his or her unique personal retirement risks, whether real or perceived, and understanding the trade-offs associated with managing those risks.

Step 3: Identify distribution, tax and estate issues, and opportunities

Deferring and reducing taxes over time can have a substantial impact on the duration of a retiree's assets, or in other words, how long retirees' assets last and how much might be available to their heirs. At the same time, there are many tax-related issues to consider when creating income from retirement plans and other assets.

For example, there are various types of retirement plan distributions, such as direct and indirect rollovers, lump-sum distributions, and Roth and annuity distributions. Each form of distribution carries its own set of potential penalties and income tax treatments. To avoid a penalty for underpayment of federal income taxes, retirees may need to pay estimated taxes each year while drawing various forms of retirement income. The tax code recognizes capital gain income, qualified dividend income, and ordinary income. Different types of assets produce different types of these incomes, so where an asset is located (in a taxable account or a tax-deferred account) can further complicate the retiree's tax picture.

Retirees must also consider asset liquidation order. Conventional wisdom says to liquidate taxable assets first, then tax-sheltered, and finally Roth money. But it is important to look at the assumptions involved in conventional wisdom and examine the tax treatment of the particular assets that are sheltered compared with those that are not sheltered. When distributing retirement assets, the whole process is often not as simple as conventional wisdom makes it out to be.

In addition to the usual estate planning needed for retirees, be sure the client confirms that the beneficiaries on all retirement accounts are current. Rather than take a client's word that the beneficiaries are correct, ask to see copies of all beneficiary documents. As mergers happen and custodian ownerships change, plan data can sometimes get dropped.

Step 4: Identify options for addressing gaps

By now, any income gaps will have become apparent. There are eight major options middle-market clients can use to fill those gaps and extend the number of years their money may last. Most clients will need your help prioritizing their options, and a combination approach will likely be necessary. A sampling of these options includes:

        Postpone Social Security and pensions. If people wait until after full retirement age (FRA) to begin collecting, their Social Security benefit can be increased in two ways: (1) waiting to take benefits until up to age 70; and/or (2) working and continuing to contribute Social Security payroll taxes. The Social Security system provides an increased benefit for those clients who choose to wait.

Called delayed retirement credits, the monthly increase starts at FRA, whatever age that is for the retiree. The benefit amount is increased by a certain percentage for each month the individual is beyond FRA but does not receive benefits. The increases are automatically added to the benefit from the time the individual reaches FRA until the individual begins taking benefits or reaches age 70. A person born before 1938 could get up to five full years of increased benefits, from age 65 to 70. A person born after 1960 would get only up to three full years of increased benefits, from age 67 to 70, depending on when exactly benefits begin. The increased benefit amount received is for life.

        Work part time. According to a Vanguard study on work in retirement, 45% of respondents said they were fully retired, not looking for work; 23% were working part time, perhaps fitting the definition of "phased retirement"; 17% were working full time; and 12% were self-employed.

Working full or part time in retirement, however, can affect a retiree's Social Security benefits if the retiree continues working after beginning benefits. Beyond income taxation, Social Security benefits may also be reduced based on a retiree's earnings between age 62 and their FRA. Once retirees reach their FRA, they can earn as much as they want without any reduction in benefits. To determine the reduction, an excess earnings test is used.

        Create additional lifetime income. This income source could take one or more forms, such as interest from laddering intermediate to long-term corporate, Treasury, or TIPS bonds; dividend income from stocks; rental income; REITs (real estate income trusts), which historically pay high dividend amounts; and fixed and variable immediate annuities. The retiree may have to reposition existing assets (such as equities or mutual funds) if there is insufficient cash available for investment in additional lifetime income options. Historically, some of these options provided 4% or more income over long periods of time, but still allowed the client to have full access to the underlying assets.

Step 5: Convert resources into income

The goal of an income allocation plan is to create spending power out of a retiree's potential income resources by determining an optimal mix between lifetime income resources and managed-income resources. Simultaneous to this process is the identification and management of risks, minimization of taxes, and the implementation of legacy plans.

Source: InFRE Retirement Resource Center

There are four ways to convert assets into retirement income that may apply to middle-income clients. One method is to combine a systematic withdrawal plan (SWP) with annuitization of a portion of the assets.

For many clients, a mixed approach using both SWP and annuitization may provide the lifetime income needed to meet essential needs as well as protect against longevity risk. The SWP income component offers the flexibility and control needed to meet discretionary spending needs and potentially protects the retiree's income from inflation. The annuitized income component provides more income per dollar invested than the systematic withdrawal plan due to mortality credits. This approach combines the advantages of both strategies: the guaranteed lifetime income of an immediate annuity—and the security and peace of mind it brings—plus the flexibility and control of a SWP.

By purchasing an immediate annuity with a portion of a retiree's initial portfolio when additional lifetime income is needed, you not only create an additional lifetime income stream to meet all or a portion of essential needs, but you also have a significant impact on the duration of the remaining non-annuitized assets. In other words, annuitizing a portion of retirement assets can dramatically impact the remaining portfolio's longevity, particularly for more conservative portfolios. Even growth portfolios may benefit, though often not as greatly as conservatively managed portfolios.

Since a greater portion of the retiree's overall income need is met by annuitized income, the remaining portfolio can benefit from a lower withdrawal rate, potentially resulting in longer portfolio longevity. For clients who need income that keeps pace with inflation and also want to maintain a base of guaranteed income that can never run out, this combined approach again supports the concept of using both an asset allocation and income allocation approach for creating retirement income.

Another point worth mentioning is that the use of an immediate annuity creates a guaranteed income floor that might make the middle-income retiree more amenable to assuming more risk with a portion of his or her managed retirement assets—especially when the retiree understands that managed investments can be used to better manage inflation, health, longevity, and investing risks.

Step 6: Maintain and update the plan

As a general rule, the retirement income plan should be reviewed at least annually. Advisors will want to determine if the retiree's income goals are being met. Life expectancies will change with the passing of time and changes in health status. The retiree's circumstances may change, as well as his or her risk tolerance. Income sources (portfolio assets) will also likely need to be rebalanced. Additionally, there are several events that can trigger a revision to the retiree's income plan, such as:

       Death of a spouse

       Actual spending exceeding planned spending

       Change in health

       New retirement products

       Returning to work

Summary

The retirement income management process is much more complex than most middle-market clients and advisors realize. A host of dynamic, client-specific variables can affect the income management outcome, including different types of risk (such as longevity, health, investment), different types of products (annuities, IRAs, long-term care), and different timing decisions (when to start Social Security, when to annuitize, when to quit working).

Because each retiree is in a unique situation, a successful income plan calls for a customized approach to creating lifetime income. By understanding all you can about the multitude of variables that can impact a retiree's lifestyle, you increase the probability that the lifetime income plan you develop will meet a retiree's needs throughout the person's golden years.

This article is an excerpt from "The Professional's Guide to Managing Retirement Income." A portion of this material is also included in Book 4 of the self-study materials for InFRE's Certified Retirement Counselor (CRC) certification. If you are interested in a retirement-specific, accredited certification that covers both the accumulation and distribution phases of retirement, and also offers state insurance, CFP, and CPA continuing-education credits, find out more by visiting InFRE.