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Retirement Risk to the Unknown

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The scariest thing in the world is to run out of money. To enjoy your retirement years to the fullest — and to help prevent the possibility of outliving your financial resources — you will need to invest for income and growth throughout your retirement years. Social Security will probably make up a significant part of your retirement income.  However, many consumers don’t appreciate the risks they are facing in keeping other kinds of long-term retirement income.

The number of defined benefit plans has dramatically declined as 401(k) plans have taken the lead.  New mortality tables showing retirees are expected to live longer raised pension plans’ liabilities, forcing companies to set aside more money to meet them.  In a defined benefit plan, the employer has only an idea of what may be provided upon an employee’s retirement, based on years of service, age and income.

Low interest rates hurt pension funds two ways. First, they lower the returns on safe, fixed income investments like Treasury bonds. But they also drive up the current cost of providing a fixed monthly payment to retirees well into the future. That means companies have to set aside more money in their pension plans to cover the increased liability created by lower rates.

Defined contribution plans move more of the “risk of the unknown” to the employees’ plate. Mutual funds remain the investment of choice for many investors.  There is a greater recognition of the notion that stock investments are still risky even after long holding periods, and so efforts to ‘amortize the upside’ through higher spending may backfire on the retiree.

Workers with access to employer 401(k) plans must pick their own mutual funds or other investments, but typically it’s from a fairly narrow menu of perhaps a dozen pre-selected choices. Mutual funds come with significant risk as you will be subject to swings in the stock market.  Leaving money in a bank has (almost) zero risk but gives you a return of just 1%-2% at the moment.

Mutual funds are by their nature a collection of various individual stocks or bonds and other underlying investments. Essentially many mutual funds are invested in similar stocks and have the same investment objective. While you may have a number of different mutual funds however you certainly may not be diversified.

You should always understand all ways in which your financial advisor is compensated including compensation directly from mutual funds he or she might suggest.  Does the advisor receive an up-front load or sales charge or perhaps trailing compensation from the mutual funds in terms of 12b-1 fees?

Generally the funds are not the cheapest in terms of expenses and often include revenue sharing arrangements featuring the 12b-1 fees from the underlying mutual funds in addition to the wrap fee being charged by the brokerage firm.

Is it time for small investors to rediscover certificates of deposit? The idea is not as preposterously old fashioned as it seems.  Good financial advisers generally recommend keeping part of a portfolio in low-risk investments, and increasing that fraction as retirement age approaches. The idea is to cushion against crashing stock markets and keep cash handy, hopefully while still earning some income.

Stop worrying about the dreaded “running out of money”  This is the best time to buy income annuities, due to their combination of bond and mortality credits. For the retiree, those products are proportionately a much better deal than many other products.  This is likely a better strategy than going fully into drawdown and hoping to find a fund to replicate what an annuity will provide – you won’t.

There is nothing else that is going to provide you with the certainty and security of an annuity, so retirees should stick with annuities or, depending on the size of their pension pots, consider a combination of an annuity purchase to secure a basic guaranteed income for life and a portfolio of funds where they are prepared to take a greater level of risk.

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Monday, April 20th, 2015 Wealth Management

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