With a massive chunk of the 77 million baby boom generation reaching age 65 this year, much of the financial planning industry's energy and focus has shifted from the best ways to accrue assets, to discovering how best to convert a lifetime of accumulated savings into a lifelong retirement income stream. And while the market volatility of the past decade has been painful, it has also provided an excellent opportunity to test some of the more established income distribution methods and develop new solutions for the next generation of retirees. So what are the factors to consider in constructing a retirement portfolio and what are the standard methods of doing so?

"One of the things we need to watch out for is what behavioral economists call 'recency bias'," says Jonathan Guyton, a retirement planning expert and principal of Cornerstone Wealth Advisors in Minneapolis. "Recency bias occurs when considering the worst-case scenario, you become more concerned about the bad things that happened most recently." For investors and advisors who have just survived the Great Recession, that most recent threat is short-term volatility.

"I think it would be a mistake to base either your money management or distribution strategy on what's happened in the last 10 years," says Chuck Prather, a financial consultant with Bellco Credit Union in Denver. He says that while clients are likely to see the market decline of 2008-2009 as a "black swan" event, it shouldn't be one for advisors. "Of course we can't ignore them, but these are not unheard of events," he says. "Historically, the volatility we've experienced are once-in-every-25-years events. We just happened to have had two of them in 10 years. Inflation is still my biggest concern."

FOUR FACTORS
Guyton agrees. "We can't single out one characteristic like short-term volatility and manage strictly around that. We need to examine all the characteristics that a client is looking for from an income stream." Guyton believes there are four main factors to consider when constructing a portfolio designed to produce income.

The first characteristic is sustainability, which means that the client will not outlive their income over a potential 40-year payout period. "We're looking for strategies that have between a 99% and 100% chance of success," says Guyton. Second is inflation protection, especially the need to account for rising healthcare costs. Third, is the need to build in flexibility so that clients can make additional, irregular withdrawals from the portfolio because "life happens." Finally, retirement portfolios have to accommodate clients' wishes to leave a legacy.

"Everything that's involved in accumulating assets is magnified and becomes more complex when we now need to both continue to manage those assets to keep pace with inflation and turn on the faucet to generate an income stream," says Guyton.

Harold Evensky, president of Evensky & Katz, a fee-only financial advisory firm based in Coral Gables, Fla., believes there are two additional factors to consider when constructing a retirement portfolio: volatility risk and behavioral risk. "Most investors have little understanding of the concept of volatility drain on portfolio returns," he says. "But it is a critical factor to be addressed in any successful cash flow strategy."

Volatility often leads clients to become their own worst enemies by enticing them to make decisions that aren't in their long-term best interest. "One thing we've learned from the recent market volatility is that clients are not always rational," says Prather. "People's emotions become one of the biggest risks we have to manage in retirement."

So how do you construct a portfolio that takes all these factors into consideration? Our experts agree that there are four main strategies, each with its own advantages and disadvantages.

INTEREST ONLY
"The most traditional solution is to create an income portfolio of dividend-paying stocks and bonds," says Evensky. Also known as the "interest-only" approach, the idea is to avoid tapping the client's principal by investing in a mix of high-dividend-paying stocks and bonds. With interest rates so low, many advisors look to boost the income potential of this strategy by adding covered call writing to the mix.

Covered call writing involves selling call options against stocks already owned in the portfolio. Preferably the option won't be exercised, the investor pockets the proceeds from the sale, and when it expires, a new call option can be sold against the stock for ongoing income.

However, the income portfolio solution is highly subject to interest rate risk, purchasing power (inflation) risk and asset allocation risk, says Evensky. "The main problem is that the asset allocation is based on current interest rates and may have nothing to do with the allocation that's truly appropriate for the client."

Prather notes that income portfolios may have worked well when there were double-digit interest rates in the 1980s. "But over the past 25 years, as interest rates have steadily declined, a retiree's income would have eroded to almost nothing using this approach," he says. "At the same time, the cost of living has more than doubled. If the portfolio wasn't allocated to grow with inflation, that would have been a double hit against the investor."

Michael Kitces, director of research for Pinnacle Advisory Group in Columbia, Md., warns that the effects of inflation and interest rate risk can negate one of the supposed benefits of the income portfolio, which is to avoid tapping into the original principal amount.

"Finance theory tells us it's problematic, but most people can't simply stop spending when inflation and interest rates begin to pinch their budget," he says. "Often they end up dipping into principal, which leaves them less to earn income on and it quickly spirals out of control."

THE 4% SOLUTION
Another option-also common for producing income from an investment portfolio—is to take systematic withdrawals from the account. The question with this strategy becomes, how much is a safe withdrawal rate?

"Unfortunately there is no one single, safe, withdrawal rate number," says Guyton. He has found through his own research and study that a safe withdrawal rate starts at a base of 4.5%. "This assumes you have a portfolio of around 60% equities," he says. "If you have less than 60% in equities, your safe withdrawal rate will be less."

Assuming one has a portfolio of 60% equities, Guyton believes the withdrawal amount should always increase by inflation, but the actual rate may vary based on market performance. "When the market does well and is overvalued, we might reduce the actual withdrawal rate, while keeping the actual dollar amount very close to what it was before," he says. "If the markets are undervalued-meaning they've gone down in value-we might actually increase the withdrawal rate to maintain the previous income level.

Say, for instance, a client needed to draw 5% ($50,000) annually from a $1 million portfolio; if the portfolio goes up to $1.1 million, the effective withdrawal rate to produce the inflation-adjusted goal of $51,750 now drops to 4.7%. The next year, if the portfolio declines to $900,000, it may require a 6% withdrawal to produce the new income goal of $53,560. "It's counterintuitive," says Guyton. "But it works."

He also believes that clients need some flexibility to adjust their income needs in down markets. "If the client has the ability to reduce their income needs by as little as 10%, that can add 100 basis points to the safe withdrawal rate."

In the above example, a 10% reduction in the client's income would decrease the withdrawal rate by over 50 basis points, lessening the cumulative decline should the markets erode further, he says.

Experts agree that the key to an effective systematic withdrawal strategy is getting the assets in the portfolio allocated just right. "The portfolios have to be constructed with an appropriate amount of alternative investments," says Prather. "People are saying modern portfolio theory is dead because everything went down during this past recession. But I don't think it's dead because not everything went down the same amount. It just didn't work as well because a lot of folks didn't have enough negatively correlated assets in their portfolios. There was typically very little oil, gold or commodities in most portfolios. Even some type of long/short strategy would have helped to soften the blow."

A systematic withdrawal strategy must be actively managed, says Guyton. "This is not a set-it-and-forget-it strategy. You have to manage the withdrawal amount with systematic triggers that will determine when and how much we change." Those triggers may include upper and lower portfolio values or corresponding withdrawal rates.

If, for example, the portfolio dropped to the point where the monthly withdrawal amount now equals 7% (annualized) or more of the portfolio value, that would be a trigger to reduce the withdrawal amount. But if the investments were to grow to the point where the withdrawal represented less than 3.5% of the portfolio, it might be a good time to increase the withdrawal rate to build up more liquid cash reserves. Guyton uses the analogy of driving a car in the mountains. "You can't just set it on cruise control," he says. "There are lots of twists and turns on the road that you need to make adjustments for. The triggers are like guardrails. If you hit them you may get a scratch, but it's not devastating to your life."

THE BUCKET LIST
Perhaps the latest of the four basic strategies to gain popularity, the bucket strategy, seems to be the topic du jour of discussion at many financial planning events. And while a new strategy to many, Evensky says his firm has been using buckets to produce retirement income for clients since the mid-1980s.

"We basically use a two-bucket approach," he says. "The first is what we call our cash flow reserve portfolio, which contains two years' worth of the client's living expenses that are primarily kept in very safe, money market-type accounts. The second becomes our investment portfolio, which is allocated for long-term growth."

Again, the asset allocation of the portfolio is critical, says Evensky. "We keep a portion of the investment portfolio in short-term assets as part of our normal asset allocation. That provides second-tier liquidity should we have an extended market downturn."

Evensky strictly adheres to a five-year limit. He believes money should not be invested in the stock market unless the client has at least five years to let it sit. He keeps his cash flow reserve bucket at two years, however, because the opportunity cost of keeping five years' worth of cash flow in potentially low-yielding money market-type accounts is too great.

He then uses the bond portion of his investment portfolio to serve as a backup cash flow reserve should it be needed. "The two-year bucket strategy has been very effective," he says. "We went through the crash of 1987, the tech bust of 2000 and now the Great Recession, and it has worked well every time."

Other variations on the bucket strategy include creating a third, intermediate-term bucket to hold the bond portion of the portfolio. According to Kitces, regardless of the number of buckets used, the approach is simply a different way to label a total return portfolio. "One of the biggest differences of the bucket strategy is in how it's framed to the client," Kitces says. "It helps the client understand where the money is coming from."

The bucket strategy can be very helpful in calming clients and preventing them from making irrational decisions during periods of market volatility, he says. "They'll look at the bucket that is supposed to be generating their income for the next three years and see that nothing has happened to it. Then they'll look at the bucket that's supposed to generate their income in three to five years and see that very little has happened to it. Finally they'll look at the bucket that is supposed to generate their income in five to 10 years and see that maybe a lot has happened to it, but that's okay, because they won't need that money for 10 years."

Asset allocation is critical in both the systematic withdrawal option and the bucket strategy, but one key difference is the source of the income. In a systematic withdrawal strategy, the income is often drawn proportionally from each of the various investments in the portfolio.

Evensky believes this has several disadvantages that the bucket strategy solves. When you take a systematic withdrawal proportionally from all the investments in the portfolio, "all of a sudden all the benefits of dollar cost averaging are working against you," he says. "When the market goes down, you have to sell more shares at lower prices. It's exactly the opposite of what you're trying to do when you rebalance." Systematically withdrawing proportional shares from each investment can also create excessive transaction costs and tax consequences.

ANNUITIZATION
The final and perhaps oldest of the four basic retirement income strategies is annuitization. According to Kitces, the lack of pension annuities represents one of the biggest challenges for the baby boomers. "For their parents' generation, retirement income was primarily Social Security, an employer's pension and some minimal savings," he says. "Today's baby boomers are not pension driven, they're personal-asset driven. Today's retirement income is now more do-it-yourself."

That do-it-yourself attitude, along with the fear that they would leave no legacy for their loved ones should they die prematurely, has led many new retirees to reject the annuitized pension option offered by many employers in favor of taking their pension as a lump-sum rollover. But often, due to group underwriting, the employer's pension exceeds what an investor can get on their own. "I see a fair number of clients who are about to retire who have access to both a pension and a 401(k)," says Prather. "It scares me when I hear advisors recommending the lump sum instead of the monthly annuity. In most of the cases I've seen, the monthly payments from the pension are significantly higher than anything we can reasonably offer." He recommends taking the pension to provide a guaranteed income floor and investing the 401(k) for inflation protection growth.

For clients who do not receive a monthly employer pension, the benefits of immediate annuities-for specific portions or buckets of a client's portfolio-are regaining popularity. "I don't see them as separate strategies," says Evensky. "The bucket strategy is complemented by annuitization."

Kitces agrees. "Many types of annuities offer no different strategy than other products- it's just another type of bucket, not a different strategy," he says. "But immediate annuities are materially different for two reasons." It provides an income stream that an individual is guaranteed not to outlive, which effectively negates longevity risk. When coupled with a growth investment portfolio, this strategy can effectively manage inflation risk as well. The second reason is that since immediate annuities don't provide for a legacy, the advisor needs to engage the client in a different conversation that extends beyond just producing retirement income.

Some experts believe that individual annuities will play an increasingly larger role in retirement income strategies going forward. When interest rates finally do return to the historical norm, "immediate annuities will become critical to the product mix," says Evensky. He's already exploring deferred immediate annuities, where a client invests a lump sum today to lock in an income stream that will begin at some point in the future. "What's attractive about the deferred immediate annuity is that the amount you invest today is significantly less than the amount of the promised income at some later age," he says.

This product is particularly useful for clients who are retiring from their primary career, but plan on earning some smaller income, while working at an "encore" career. When the client wants to leave the encore career, the deferred immediate annuity kicks in to replace that income.

Kitces believes, however, that the investing public is less sure about just where an annuity fits in-especially with inflation-adjusted annuities. "From an academic perspective the inflation-adjusted annuity seems to be the perfect solution," he says. "It provides a guaranteed lifetime income that promises to keep pace with inflation. And yet, in practice, no one buys it." While the reasons for this varies, Kitces suggests that the lack of flexibility and liquidity as well as the loss of upside potential characteristic of all annuities are major hindrances. "We have complex goals," he says. "People want a chance at something better and often don't want to settle. We're not rational all the time."

THE UNRETIRED
New retirees continue to challenge advisors in new ways. "The baby boomers are approaching retirement completely differently than their parents," says Kitces. "A lot of clients are coming in with undefined goals, dreams of exotic vacations and the desire to do whatever they want. Sometimes they'll ask for a retirement income that-both you and they agree-is completely unsustainable, but they still want it for 'just a few years,' until health or other factors cause them to cut back. It makes the planning messy and provides another degree of uncertainty and another variable to try to plan for."

And then there are the unretired- those who want to return to the land of the working. "We work with a fairly affluent client base who sometimes get close to retirement, or even get six months into retirement, only to realize they would like to do something that keeps them meaningfully engaged," says Kitces. "It takes them some time to figure this out for themselves. We've all been trained into this image of what we think retirement is supposed to be, and it's often not all that we imagined and we don't find it all that fulfilling."

Advisors need to be careful not to assume that they know what retirement means to all their clients, or even assume that the clients know what retirement means for them," says Kitces. "Most of us have not spent that much time thinking about it, so trying to figure out a way to fund it can be a challenge."

Keith J. Weber founded the Weber Consulting Group, an advisor training, coaching and practice management firm in Fort Collins, Colo. He is the author of Rethinking Retirement.