Risk Transfer


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Weathering The Storm

Retirees need to be able to weather the upcoming storm in their retirement horizon.  I’m not talking about a luxurious retirement, simply one that can keep a retiree self-sustaining for such items as health and long-term care needs, senior housing and all the other expenses that crop up, often deep into the retirement years.

The economy is a delicate and temperamental beast. The critical point is that the mere fact that America’s retirees risk falling into the economic quicksand.  If you’re rapidly approaching retirement, you need to start seriously thinking about how you’ll secure an income.

Securing a decent retirement income will be key to ensuring you’re able to live your post-work years in comfort, but unfortunately, it can sometimes be easier said than done.  The assets from which you expect to create a vital stream of income during your retirement face risk from economic turmoil, interest rate uncertainty and market volatility.

As you move from asset accumulation (saving money for retirement) to income distribution (spending money in retirement), positioning your investments to provide a primary income that lasts as long as you need becomes more complex and difficult to manage.

Not only are the logistics of planning hard enough—when to collect Social Security, how to budget for expenses, what to do with savings, now that individuals are fully responsible for their own retirement security, part of that responsibility must certainly include the possibility that time may leave you less rather than more equipped to make the right decisions. As the saying goes: hope for the best but plan for the worst.

You can’t predict your life span, your total retirement spending or your future investment returns. But you can predict with relative certainty your basic retirement expenses, such as utilities, food and clothing, as well as the amount of income you’ll receive from guaranteed sources, such as Social Security, pensions and annuities.

Old-fashioned company pensions, which guarantees a certain amount of retirement income each month, has all but vanished in private-sector employment. Defined benefit pensions – often known as final salary schemes – remain the most deluxe of arrangements outside of the public sector.  The pension paid at retirement is based on two prime factors – length of service and the salary at retirement.

Participants in defined benefit plans do not have to worry that their pension could be decimated by a stock market correction prior to retirement. In nearly all circumstances, the pension promised is the pension paid. However, today the vast majority of us do not have pensions to replace our income at retirement.

People’s need to build savings during their working lives has grown more urgent in recent decades as pensions have been partially replaced by defined contribution plans (401k)s, which rely on savings set aside by employees, employers or both. Pre Retirees should set targets for their retirement – looking at how much income they will need to retire on, whether their investments are set up to deliver the returns they need, and whether their hotchpotch of pensions and investments need to be consolidated to deliver better value for money.

The challenge today is taking a lifetime of savings into plans such as a 401(k), other investments and other sources of your own personal net worth, and coordinating that with making the right decisions for receiving social security, and turning your 401(k) savins into reliable lifetime income.

Don’t assume that you’ll be able to live on the earnings generated by your investment portfolio and retirement accounts for the rest of your life. At some point, you’ll probably have to start drawing on the principal.  Traditional wisdom holds that retirees should value the safety of their principal above all else.

Most defined benefit pension plans pay benefits in the form of an annuity. If you’re married you generally must choose between a higher retirement benefit paid over your lifetime, or a smaller benefit that continues to your spouse after your death.  Other employer retirement plans like 401(k)s typically don’t pay benefits as annuities; the distribution (and investment) options available to you may be limited.

Don’t forget tax! No matter in what form they withdraw money – in one lump sum, through the purchase of an annuity or by drawing down income as and when they choose – it will be taxed.

Keep in mind that you must generally begin taking minimum distributions from employer retirement plans and traditional IRAs when you reach age 70 and one-half, whether you need them or not. By way of review, the distribution rules are in place to force plan participants to withdraw at least a minimum taxable income from the tax-deferred retirement plan rather than allowing it to just remain tax-deferred throughout retirement.

It is calculated to spread the withdrawals across the participant’s life expectancy or the joint life expectancies of the participant and chosen beneficiary. For most people the start deadline for the required minimum distribution is April 15 of the year following the year that the participant turns age 701/2.

For most people it is difficult to know how much to safely take out of the fund beyond the required minimum distribution. You want to enjoy your retirement and spend the money that you have saved for that purpose. But you do not know how long you will live and thus how much to hold back for your later years.

For many years, annuities have been the main way for people to turn lifetime savings into retirement income.  The advantage to having an annuity is that it offers someone a guaranteed income, usually for the rest of their life. This means that you have a safety net preventing you from outliving your savings.

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Tuesday, March 31st, 2015 Wealth Management Comments Off on Weathering The Storm

Baby Boomer Retirement Anxiety

Concerns over the stock market volatility, low rates of returns on savings, and loss of company-funded pension plans in favor of worker-funded 401(k) pension plans certainly are fueling baby boomers anxiety about having enough money to retire in comfort.  A 401K is the typical retirement plan offered to employees by most companies and is funded by employee contributions that are deducted from your paycheck.

In a defined contribution plan, all risk rests with the participants who have no say in the design of the plan or the economic arrangements entered into with and among providers of services to the plan.  Generally participants pay most, if not all, the costs associated with the plan and their investment results depend upon the performance of service providers chosen for them.

The optimal time for change would have been long ago—before the collapse of thousands of corporate pensions, severe public pension underfunding and the failure of 401(k)s to deliver retirement security as promised. For sure, paradigm shift in retirement planning is long overdue.

The 401K plan has many advantages but it does have a couple of disadvantages as well. One disadvantage is that it is not easy to withdraw money prior to age 59 ½. There is a large penalty unless it is for education or emergency. Another disadvantage is that they are not insured by the Pension Benefit Guaranty Corp.

There is a federal government agency, the Pension Benefit Guaranty Corp (PBGC) that is an insurer of corporate pension plans, i.e. companies pay a premium to PBGC to insure their pension plans — the more risky the company, the higher the premium. The 401K is not insured by the PBGC (Pension Benefit Guaranty Corp).

When they existed, pensions provided guaranteed income during a person’s golden years.  Individual Retirement Accounts (IRA), 401(k)s, and 403(b)s were meant to provide income for the retiree, but too many people see them as a means to passing wealth to the next generation.  This is not the intention of these qualified plans, they were designed to generate income for the holder during their retirement years.

Longevity risk is the risk of populations living longer than expected. One half of Baby Boomers will likely live beyond age 90, while the trailing edge probably can add 10 years or more to that life expectancy if biotechnology and gene therapies fulfill even a fraction of their promises.  Overwhelmingly, the biggest risk is the risk of outliving your money.

We have been conditioned our entire lives to build that nest egg, and now baby boomers need to scramble it. If you end up living well into your 80s (a real possibility if you’re 65), the benefits of never running out of money, and never having to worry about running out of money, can be enormous.

Stock market losses can seriously reduce one’s retirement savings.  Stockmarket risk is the scenario in which you’ve amassed a healthy portfolio of stocks and bonds only to see it plummet in value because of a market crash or other disruption to the global financial system.

For example, U.S. stocks fell, wiping out gains for the year this week.  The S&P 500 retreated 1.3 percent to 2,051.75 at 12:00 p.m. in New York, falling below its average price for the past 50 days for the first time since Feb. 9. The Dow Jones Industrial Average lost 264.45 points, or 1.5 percent, to 17,731.27.

Because shares of stock don’t have a fixed value but reflect changing investor demand, one of the greatest risks you face when you invest in stock is volatility, or significant price changes in relatively rapid succession.

Sequence Risk is the risk of receiving lower or negative returns early in a period when withdrawals are made from the underlying investments. The order or the sequence of investment returns is a primary concern for those individuals who are retired and living off the income and capital of their investments.  Poor returns early in retirement are much more harmful to one’s retirement prospects than poor returns later in retirement.

However, most investors feel that the bull market in stocks is not over. The current bull market is not going to end simply because ‘stocks have gone up too much’ . We head into 2015 bullish for the 3rd straight year.  The S&P 500 has risen 200% since the bull market began in March 2009 — not unprecedented by historical standards.

Given the combination of improving economic conditions and rebounding earnings growth, everyone believes 2015 will represent another year of solid gains for US stocks. Yet, Investors have become “sick of giving back all of their gains every time the market goes down.  With the current market instability, “investors need more to be able to navigate the volatility.

Since the early 1980’s, interest rates have been steadily declining. Using the US 10-year Treasury note as a general proxy, interest rates have been declining to the present day rate of 1.68% at the time of this article. This has been detrimental to savers, whose paradigm was to invest in bonds for income.

The bottom line is if you need to make your money last longer, you’ll need the extra growth potential that continuing to invest in a mix of stocks and bonds can provide. Although that may seem to contradict the apparent logic of not taking risks with your money once you hit a certain age, relying on certificates of deposit, money-market accounts and cash could be far riskier, and may mean your retirement income won’t keep pace with inflation.

Many people with a retirement plan are asked to choose between receiving lifetime income (also called an annuity) and a lump-sum payment to pay for their day-to-day life after they stop working. An annuity provides a lifetime steady stream of income while a lump sum is a one-time payment.

A Deferred Income Annuity (DIA) 55/65 might be used to reduce investment risk in the years leading up to retirement. You put money in a DIA at 55 and you know what your income will be at 65 instead of taking the risk that what’s you’ll have at 65 depends on the stock market. With an annuity you will receive a steady income for the rest of your life, like keeping a part of your paycheck for life.  In addition, you may be able to provide a lifetime income to your spouse or to another beneficiary.

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Tuesday, March 10th, 2015 Wealth Preservation Comments Off on Baby Boomer Retirement Anxiety

Funding Retirement Income

Retirement income today should not be measured by one’s net worth; it’s about the predictable, spendable income in the bank account every single month.  Chances are, your monthly Social Security payments will not be enough, so you will likely need a 401(k), work-sponsored pension, some sort of IRA or a combination of all three options to be truly financially prepared.  Keep in mind that even if you’re retiring today, your money may need to last for 30 years throughout your retirement.

The reality is, if you’re retired or nearing retirement, you need to find a way to pay the bills for many years to come. Your Social Security income will help, but you need to supplement that with additional income, and you may need to fund your retirement for 30 years or more. You need to have enough money to cover health care during retirement in addition to the expenses of daily life.  Good health and longevity are great – as long as you can pay the freight.

Investors often spend decades working and saving to build a nest egg for retirement. During that time, their primary investment goal is to see their assets grow. When retirement finally arrives, the primary investment goal often changes from seeking to grow assets to using those assets to generate income. The investments used to pursue this new goal need to change accordingly.

Others have experienced investment or other financial struggles from the recession and had to use funds previously allocated to retirement for daily necessities.  It’s important to adjust the allocation of your retirement savings as you get older. In general, the closer you get to retirement, the less risky you want to be with your investments.

We’ve all seen the statistics that stocks have consistently outperformed bonds and cash over long periods of time. However, the older you get, the less time you have to recover from market downturns and the more your asset mix needs to be weighted toward low-risk vehicles that deliver asset preservation.  In short, the more aggressively you invest in stocks vs. bonds and other conservative investments, the more your retirement nest egg is likely to grow over time, unless there is a market downturn.

Now, there is an important caveat to this. To invest aggressively, you need a high risk tolerance. In other words, you must be able and willing to tolerate fluctuations in the value of your account. For example, in the worst year (during the 2008 financial crisis), the more conservative portfolio would have declined in value about 17.5% while the more aggressive portfolio would have declined in value by nearly 29%.

If you panic at such a time and move your money out of stocks, you’ll turn a temporary loss into a permanent one. Not getting sleep in tough times is the price you pay for higher returns. As they say, there’s no such thing as a free lunch, and that applies to investing as well.

Many people have difficulty understanding common retirement investment products such as target date mutual funds: fixed income securities (bonds): annuities: mutual funds other than target date funds: dividend stocks etc.  But the complexity of certain products isn’t the only challenge facing consumers here. In some cases, having more investment options may lead to simply bow out of the investment process because of the work required to sort through their choices.  Too many choices leads to lower participation in certain plans.

If you’re feeling paralyzed by your choices or confused by financial jargon, the best thing may be to block out all the “noise.” What I tell people, regardless of their age or wealth, is to focus on things they can control, when asked how to combat information overload.

For example, stock market prices and interest rate trends tend to impact retirement choices, but they can’t be controlled by investors. Instead of fixating on that type of investment news and information, workers should pay more attention to the following. How much they spend/save (cash flow), the timing of their retirement age and their level of investment risk (asset allocation.

With the markets hitting all-time highs recently, it’s hard to believe that just five years ago, the Dow was in the four-digit range.  If you are thinking about retirement back then, you probably had second thoughts — and rightfully so. But just because things appear to be on the up-and-up doesn’t guarantee that future years will follow suit.  But if the market starts to tank, you can then decide to switch over to safety-first before they lose so much assets.

Of course, there’s never been any certainty when it comes to financial markets, but it seems that today’s times are more uncertain than ever. That makes retirement — a time that should be a carefree period full of reward for your decades of hard work and saving — curiously cumbersome.

Retirement income affects how do-it-yourself investors design their portfolios, even if they don’t consciously realize it.  Most people face a likely shortfall in their ability to cover their expenses through a retirement that could last more than 30 years.  The safety-first method matches assets to liabilities. That is, it takes a look at the money (assets) available to pay the bills (liabilities) in retirement.

To try to bridge the gap between assets and liabilities, safety-first proponents advocate using guaranteed income, such as annuities or bonds. These products turn a lump-sum investment into an income stream that either lasts for life, as with most annuities, or for a fixed number of years, as with an individual bond. With an annuity, planners don’t have to worry about predicting the duration of a client’s retirement, since the income stream will last for life.

Combined with Social Security, monthly income from an annuity or bond could help ensure that a retiree meets his necessary expenses, such as food, utilities and housing. Anything left over would go toward discretionary expenses such as entertainment and travel.

Annuities: A Life-Long Income Stream – At one point in time, many retirees could count on life-long payments in the form of pension checks. With pensions disappearing at an alarming rate, investors seeking a predictable life-long income stream can purchase an annuity in exchange for a lump-sum payment. An annuity can be purchased as the primary vehicle designed to deliver all the income a retiree needs, or it can be one component of a larger portfolio.

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Saturday, November 22nd, 2014 Wealth Management Comments Off on Funding Retirement Income

“Sustainable Withdrawals” Retirement Income

Retirement income is a major concern for the middle class and the challenge of providing lifetime income has never been greater.  Many Americans are struggling to make ends meet in their golden years. Retirees are not only competing against the higher incomes of their younger counterparts, but they are also battling higher costs for housing, gas, food and other necessities.

Although retirement is often seen as a time to take your foot off the pedal there are often life changes that occur that could lead to financial upheaval. It is therefore essential that retirees have a degree of flexibility around their finances so they can adapt to a change in their needs, as people are living longer, it is inevitable that retirees will see their circumstances change at least once. Research points to the need for “flexibility” to cope with changing circumstances.

For most of our adult lives, we sustain our standard of living by working and generating income from the fruits of our labor. As we receive a paycheck from our employer–or draw payments from a business we own–we report the income we generate to Uncle Sam, who takes a portion in the form of taxes, and the rest is used for some combination of consumption for our current needs, and saving to fund our spending in the future.

At the point of transition into retirement (or at least, “financial independence” from work), the basic goal is relatively straightforward: to replace the income we had during our working years, with income from the assets we have saved for retirement. Simply put, we aim to replace one income stream with another, thereby allowing us to maintain our lifestyle.

The problem, however, is that the word “income” does not mean the same thing in retirement that it does while we work.  One of the most confusing problems in the world of investing is that sometimes payments are a combination of principal and income.  While some may wish to leave  a generous inheritance to their heirs, for many retirees, the reality is that they can’t afford to not use their principal at some point in their retirement.

Achieving sustainable withdrawals from your “retirement pot” becomes extremely important.  While it’s obviously dangerous to spend too much principal too soon, it’s an unnecessary constraint on lifestyle to avoid spending it ever. The end result: At some point, retirement spending needs to include principal, too. Especially in low-yield environments where relying solely on “income” alone can severely (and potentially unnecessarily) constrain retirement spending.

This is all about retirement and yet people are having their pockets picked and they don’t realize it.  There has been a fundamental shift in employer-sponsored retirement plans: In 1979, of employees with a company-based retirement plan, 84 percent had a defined benefit like a traditional pension and 38 percent had a defined contribution plan like a 401(k). By 2010 that flipped: 93 percent of workers with a retirement benefit had a 401(k) or the like, and 31 percent a pension.

With pensions and other employer-provided retirement plans disappearing from the retirement landscape, it is placing more responsibility than ever on the average American to provide a steady income stream for themselves during their golden years.

In the context of retirement accounts, the matter is even more confusing. As an accumulated asset, the account balance of an IRA, 401(k) or 403(b) is “principal” in any normal accounting of investment results, yet it is treated as “income” for tax purposes–because the principal is actually a deferral of income back when it was wages during the working years!

These confusing overlaps in what constitutes retirement “income” can lead to serious problems. Retirees may purchase “income” guarantees that are actually just a return of principal, or spend principal thinking that it’s income, or rely too heavily on income and unnecessarily constrain their spending by not tapping principal when it is appropriate to do so.

A company offering a 401(k) does have a fiduciary duty to run it in the best interest of beneficiaries. But the Wall Street guys — typically hired for advice on how to set up the plans, run them and decide the menu of investments options — don’t have the same obligation. They are also retail brokers who sell financial advice on myriad mutual funds, IRAs and other investments, including many that could be potential 401(k) offerings.

And servicers have an incentive to steer employees to higher-cost investments — especially those offered by the servicers themselves —Small differences in fees can add up. Take an employee with 35 years until retirement and $25,000 in a 401(k). If yearly returns average 7 percent and expenses 0.5 percent, and assuming no additional contributions, the balance will be $227,000 by retirement. But raise fees to 1.5 percent and the balance will be $163,000, a reduction of 28 percent.

It may be hard to swallow, but the truth is that some people are delusional about their nest eggs – not because they’re worried they’ll break, mind you, but because they’re overly confident in their impenetrability. Why? Because they’ve been listening to a financial planner who has helped them prepare for what they want in retirement, not what they need.

Wouldn’t it be nice if we all had a trinket that made us instantly feel more secure, especially when it comes to our own eggs – our nest eggs?  Lifetime income is very important for retirement security. Look, people are living longer, and that’s a good thing. But longer lifespans make lifetime income more expensive and difficult for self-investors to achieve.

In retirement planning, an individual’s ability to customize a portfolio that best suits their needs is important. However, when shifting from lifetime annuities, we should not lose sight of the benefits of longevity insurance.  The life insurance industry is the one industry designed from the ground up to manage longevity risk. The life insurance industry is reliably solvent because state insurance regulations are strict, with stringent reserve requirements and conservative investment standards.

Annuities that pay a fixed income for life provide a unique longevity hedge that is not available from non-insurance products. Much like flood or fire insurance, lifetime annuities share risk over a large pool of people, allowing individuals to hedge the risk of outliving one’s savings. Without a large starting amount, it is difficult to self-insure with capital markets alone.

Fixed Indexed Annuities (FIA) are unique in that they offer the possibility of competitive interest crediting, if the markets are doing well. “Having an FIA is a smart way to balance your financial portfolio. It allows you to lock in your principal so it never declines in value due to market downturns, while also enjoying potential upside through market-linked growth. That allows you to enjoy moderate rewards without taking on too much financial risk.

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Wednesday, November 5th, 2014 Wealth Management Comments Off on “Sustainable Withdrawals” Retirement Income

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