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Safety First Crystal Ball Annuities

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Millions of Baby Boomers are in search of the same thing—a monthly income. If you’re fortunate enough to be ready for retirement, you should plan your income needs very carefully.  Some rely on government pensions alone. Others have private pensions. But when your primary source of retirement income is your investments, you’re tasked with creating your own pension.

Retirees do not have a crystal ball. They don’t know what the return on their assets might be. They don’t know how the value of those assets will fluctuate. And most importantly, they don’t know how long they are going to live.

Managing your finances and planning for your future do not end when you retire. If anything, you need to be more active in managing your money, because mistakes made in retirement can be far more damaging than pre-retirement slip-ups.

Baby boomers now in or approaching retirement, investing is just one part of a more complex challenge: getting to the point of being financially ready to retire and then managing several facets of your financial life—including spending, tax planning and Social Security strategy, as well as investing—to minimize the risk of running short and to get the most benefit for you and your family

The single most important factor that determines when one can retire comfortably, is the size of the investment corpus. You can estimate the corpus you may need. But this estimation is not just some math, but also a set of assumptions. You have to make assumptions about the rate of inflation and the rate of return on investments.  Even after retirement, income needs will increase with inflation.

The safety-first school relies more on matching assets to liabilities. Spending needs are differentiated between essential and discretionary, with the idea that essential needs should be covered by assets that are safe and secure. A proper strategy will most likely involve laddering purchases of bonds or annuities over time. This will help reduce any exposure to interest rates at one particular date. This means holding individual bonds to maturity or using income annuities.

Only after covering essential needs with dedicated assets should a retiree think about investing in the stock market. Stocks should be targeted to discretionary expenses.  The reality for today’s retirees is that interest rates are very low and stock market valuations are high.

It is very important you consider your stomach for risk and that your goals—in terms of when you plan to retire or need the money—align with the target date. Then you can determine whether you should invest in the market with more aggressive characteristics, or if you’re better off in annuity that, while it may lag in up markets, will better protect capital in down markets.

Sustainable withdrawal rates are intricately related to the returns provided by the underlying investment portfolio. The returns experienced in early retirement will weigh disproportionately on the final outcome.  The essence of insurance is to protect individuals by pooling resources. An individual does not know how long he or she might live, but the law of large numbers means we can be more confident estimating the life expectancy of a group.

Part of this trend toward fixed annuity products may be explained by shifting demographics—baby boomer clients are aging, and the oldest members of this group are now entering (or just a few years away from) retirement. Logically, a client who is just a few years from retirement begins to look for products that will guarantee a certain fixed level of retirement income, thus explaining the shift toward fixed annuity products.

The bottom line is that the 401(k) pension saver only really knows how much wage replacement the 401(k) pension fund can generate until the last minute, the point of switching on the income.  Until then, they are vulnerable to shocks from volatile financial markets that can knock the best-laid plans off course, as many experienced in the aftermath of the last market downturn.

This uncertainty is compounded by the fact that unless they buy a guaranteed income solution, perhaps up to the level of their personal ‘minimum income requirement’ – the income they really can’t afford to lose – then they are likely to carry this vulnerability into retirement.

As people are saving for the future through automatic enrollment into workplace pension savings, such as 401(k)s (403(b)s and IRAs, they can look into a crystal ball and guarantee their income, along with Social Security checks to help protect against longevity and market risks.  When it comes to choosing how to spend their pension pot, annuities are one of the best income-generating solutions.

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Wednesday, September 3rd, 2014 Wealth Distribution, Wealth Management

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