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Black Swan Events – Annuities with a Twist

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Clearly, Americans are anxious about their retirements — it’s almost like many see the handwriting on the wall and they don’t like the message it’s sending.  Low interest rates mean that fixed-income investments generate little return, while many investors are wary of volatility in equity markets. Will Rogers was quoted as saying, “The best way to double your money is to fold it over and put it back in your pocket.”

There is a term in the financial planning industry known as a “Black Swan”.  It refers to an unforeseen event, which causes instability, or lack of confidence in the market.  It could come in the form of a terrorist threat, the bankruptcy of a large company, an industry, or even an entire country.  Regardless, we try as an industry to foresee these events.  Try as we might, they can blindside us and set a well-planned retirement back on its heels.

As millions of baby boomers approach retirement, having a stable and secure retirement income will be a key issue for them.  Years ago, back when your folks were retiring (say, early 1990’s), we in the financial planning industry liked to do calculations that assumed you could reasonably plan on about an 8% rate of return.  We would plan on withdrawing no more than about 4%, and you would be fine!

The moment you begin to withdraw principal, you run the risk of outliving your money.  You can minimize this risk with your withdrawal and investment strategies, but there is always be a risk that your money will expire before you do.

The principle of “buyer beware” is a smart one to follow when seeking financial advice.  Successful investing has more to do with avoiding inappropriate investments and building a diversified, low-cost portfolio than trying to identify the next “hot” investment.  Traditional securities portfolios in retirement work well only if you receive positive returns during the first full 1/3 of retirement WITH NO SIGNIFICANT SETBACKS.

You may encounter financial advisors, experts, and analysts who may sound very convincing about their “save” withdrawal strategy.  They don’t really know for sure that it will work, however, and they can’t absolutely guarantee your money will last as long as you do.

The problems of high fees and conflicts of interest with which go hand in hand are rampant throughout the investment industry. The unfortunate reality is that these firms in the brokerage, banking and insurance industries have no legal fiduciary obligation to their clients that would require them to place the interests of those clients ahead of all others, including their own.

This is the same system that allows their representatives to sell high-commission, high-margin and inappropriate investments to unsuspecting and trusting investors. It is the responsibility of the investor to understand the distinction between the two and select the one who will better serve them.

The complexity of financial planning makes people look at simple strategies for investing and money management as lifesavers.  An overall financial strategy to help you avoid going broke in your retirement years: Don’t spend your retirement savings! Instead, you should think of your savings as “retirement income generators,” or RIGs, that deliver a monthly paycheck that lasts for the rest of your life. The goal then becomes to spend no more than the amount of your monthly paycheck.

There are essentially only three ways to generate a monthly paycheck from your retirement savings: These RIGS each have their advantages and disadvantages; there’s not one magic bullet that works best for everybody. Most important, each type of RIG generates a different amount of retirement income:

RIG #1 – Invest your savings and spend just the investment earnings, which typically consist of interest and dividends. You never touch the principal. Interest and dividends, typically pays an annual income ranging from 2 percent to 3.5 percent of your savings, depending on the specific investments you select and the allocation between stocks, bonds, cash and real estate investments.

RIG #2 – Invest your savings, and draw down the principal cautiously so you don’t outlive your assets. We call this method “systematic withdrawals.” The well-used “Four Percent Rule” is based on the assumption you’ll need income for 30 years and that you have substantial investments in stocks with an investment goal of outpacing inflation. Systematic withdrawals, typically pays an annual income from 3.5 percent to 5 percent of your savings, depending on your investments and how worried you are about exhausting your savings before you die.

Any withdrawal strategy is based on making assumptions about how long you will live and the investment returns you’ll experience during your retirement.

1. If your retirement investments are actively managed and incur investment expenses of more than 50 basis points (0.50 percent), over the long run you may fall short of the net rates of return that justify the 4 percent rule.  Today, extremely low bond yields and interests rates near “zero” are being problematic for new retirees.

2. If you’re married, both you and your spouse are healthy and you retire in your mid-60s, there’s a good chance that one of you will live for more than 30 years.

If you fall into one of the following two categories, you may want to consider withdrawing amounts of less than 4 percent: The clearest solution, though usually the hardest, is to reduce your withdrawal rate during bad markets. If either of these statements applies to you, you may want to consider payout rates on your retirement income of 2.8% or 3%. On the other hand, you may want to consider a higher withdrawal rate if you’re willing to accept the chance of running out of money before you die, or if you’re willing to curb your withdrawals down the road should your investments sour.

You would do well to recognize that systematic withdrawals require the most ongoing attention of the three different ways to generate retirement income.

RIG #3 – Buy an “immediate annuity” from an insurance company and live off the monthly benefit the insurance company pays you. Immediate annuities, can range from 4 percent to 6.5 percent of your savings, depending on the type of annuity you buy and your age, sex and whether you continue income to a beneficiary after your death.  Annuities function similarly to defined-benefit plans by paying set amounts in regular installments. The accumulation of annuity contracts would even out interest rate fluctuations.

New hybrid annuity products “annuities with a twist” combine the best features of systematic withdrawals with the guarantee of a lifetime retirement income.  With this type of annuity you have the guarantee of a fixed lifetime income with the upside potential for growth in both your retirement savings and your retirement income if the stock market does well.   You also have the guarantee that your savings or income will not decrease if the stock market crashes.

Unlike conventional immediate annuities, however, you can cancel the annuity and withdraw the remaining part of your retirement savings at any time after you’ve invested in the products, even after your retirement income starts.  Finally, any unused funds at your death can provide a financial legacy.

These features come with a cost, as there is approx ¾% charge, however, that is equal to or less than the fees in mutual funds and the stock market.  You get something with this feature in that it guarantees that you will never run out of money.  A big difference that can make all the difference!

We recommend dividing your retirement savings between RIG #2 (systematic withdrawals) and RIG #3 (annuities), you’ll realize the advantages of each while mitigating the disadvantages of both.  The annuity will provide you with a paycheck that’s guaranteed to last the rest of your life, and the systematic withdrawals method offer flexibility and access to a portion of your retirement savings.

These methods are all designed to generate a lifetime retirement income, no matter how long you live. Achieving this goal will help you relax and enjoy your retirement. These methods might also provide protection against inflation, another important goal for many people.

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Tuesday, July 9th, 2013 Wealth Distribution, Wealth Management

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