Annual Returns over Next 5 years? 10 years?

Wade Pfau in a Journal of Financial Planning article (October 2011) highlights the fact that even 5 years before retirement a pre-retiree cannot know if they are on track to retire. Why?

Although "...the average compounded annual real return [from a 60/40 portfolio] was 5.26 percent, the variations of returns over five-year intervals is still dramatic, ranging from as low as -8.5 percent for the five years starting in 1916 to as high as 19 percent for the five years starting in 1924..."

Between 1989 and 2009 - a 20-year period - there were 5 five-year periods of near zero or negative returns for a 60/40 portfolio. That is 25% of the time though those negative 5-year periods (less than -3%) never approached the worst periods from 1910 - 1940 (some were greater than -5%).

Some companies refer to the 5 year period before and after retirement as the Red Zone. Out of 135 periods that Wade Pfau reviewed, 21 were negative - that is about 15% of the time. So the experience of the last 20 years is higher than the average since 1870.

It is difficult to get investors to think long-term as even one-year time frames seems long. Yet advisors often discuss long-term time horizons.

In reality, as Pfau states "...a progress report from 10 years before retirement would provide almost no information about the final wealth accumulation. Only 5 percent of the variation in the final wealth accumulation could be explained by the wealth accumulation 10 years earlier. The remaining 95 percent is explained by subsequent market events..."

The key is not to rely on your portfolio of investments (even with only 60% in stocks as in this example) alone to provide you the returns needed to meet your goals. It is important to have a few years (especially prior to retirement) of needed spending in cash.

More on the 4% Rule

 An April 2008 study by Jason Scott, William Sharpe and John Watson entitled The 4% Rule - At What Price? states that the "...4% rule wastes money..." The reason is that this withdrawal rate was based on the worst-case scenario over many 30-year periods studied where some times the portfolio generated substantial surpluses.

The rule-of-thumb is not a bad place to start but, depending on the sequence of returns you personally experience in retirement, there may be no need to be too stringent in following this rule. If your first withdrawal year is 4% of your nest egg, then in subsequent years (regardless of the returns you experience) you can increase that first year's dollar amount by inflation and not run out of money.

Good news if during your retirement you experience a 1966-1982 flat stock market and a late 1970's and early 1980's double-digit inflation after some bad returns. 1973-1974 saw a 50% decline in the markets, too. Lots of bad news for those retirees, but a 4% withdrawal rate worked.

What if you have a better retirement economically speaking? Then sticking to the 4% rule can waste money.

The authors of this paper argue that "...the major flaw of the 4% rule is its attempt to support non-volatile spending with volatile investing..." Even worse, is the situation where glide-paths are used and the retiree starts at about a 60% stock position and reduces that exposure during retirement. This strategy may tend to lock in early poor returns. So it is essential to understand retirement planning in its entirety if you want to reach your goals.

Use a NAPFA Fee-Only planner to help you.

Making Retirement Decisions

I read an interesting article in the Journal of Financial Planning by Betty Meredith, CFP®, CFA, CRC® about how the Mid-Market makes retirement decisions. Since I serve the middle-class market I thought I would share some of her thoughts with you.

The research report was sponsored by the Society of Actuaries and is entitled The Decision to Retire and Post-Retirement Financial Strategies.

Do you find yourself thinking and acting this way?

"...most of the study's participants didn't follow a decision-making process for several reasons: the uncertainty implicit in planning what life might bring, the difficulty planning for an unknown length of time..."

Many "...decided to retire due to health of self or spouse, changes in the workplace..."

When in retirement, they "...reduce spending when needed..." and "...most do not have a plan for taking systematic withdrawals from their retirement savings..."

NAPFA financial planners, like myself, certainly can help you through these issues and help you to make more informed decisions.  

Reverse Mortgages HECM

There are recent (late 2013 for 2014) changes to the HECM (Home Equity Conversion Mortgage) that can be found at the U.S. Department of Housing and Urban Development site:

http://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/sfh/hecm/hecmhome

If you are 62 years old or over and want to stay in your home, rather than sell it (which may be the better alternative depending on your unique circumstances), then a "reverse mortgage" may provide another option. Usually, this is a rather expensive solution.

There are now lower limits on how much you can borrow from your equity. You never could access it all but more likely around half the equity is what you would get. Now, only 60% of the approved amount can be taken in a lump-sum. The rest would be taken on a monthly schedule.

Retirement Crisis

Jeff Schlegel wrote an interesting article in the August 2011 Financial Advisor magazine entitled "What is a Retirement Crisis?" and mentioned that, regardless of income, pre-retirees need to consider the lifestyle changes that may be needed.

The retirement crisis is often presented as households not saving enough but, more than that, is the author's "crisis of expectations". He succinctly states "...lots of people...will be disappointed when they...understand what they can actually afford to spend out of their accumulated portfolio...."

Here is an example that I would like to provide: if you have saved $150,000 then that may generate $500 per month in retirement but even that will depend on your life expectancy, how you allocate those funds and a variety of other factors. That may be sufficient for some if you have a nice pension and you have a modest lifestyle but there still may be a crisis of expectations.

If you have saved $1,200,000 then you may be able to "squeeze" out $4,000 per month. That, however, may not even be close to your current lifestyle spending needs resulting in another type of crisis of expectations.
  

To Pensionize or Not to Pensionize

One final comment on Moshe Milevsky's and Alexandra Macqueen's book Pensionize Your Nest Egg is that it is not for everyone. The use of "should lean" is important:

The authors clearly state on page 121: "...those who have no concern for leaving a financial legacy should lean towards pensionization, while those who have a very strong preference for creating a financial legacy and little fear of outliving their assets should not pensionize their nest egg..."

Social security is an annuity and should be considered when evaluating how much, if any, of your investments may be considered for an annuity (and there are plenty of riders and varieties of annuities as well and you can read about those elsewhere on this site).

Pensionize Your Nest Egg (Part 2 of 2) by Moshe Milevsky and Alexandra Macqueen

Pensionizing (that is, purchasing an annuity to guarantee some monthly income) has benefits and costs (risks). They need to be weighed. For some examples, an:

• Annuity has no legacy value (either you want the money for you or for your heirs)
• Annuity is quite illiquid (you can't get at the money without substantial surrender charges/penalties)
• Annuity does not have the potential to grow like your stock investments over long periods (due to participation limits, caps, and the like)...compare them to bonds not stocks

But an annuity can protect against:

• Longevity risk
• Inflation risk (possibly, if you ladder annuities over a period of years rather than index them to the CPI)
• Sequence of return risk

There is something to be said for planning your retirement spending based on the probability that you will be alive to spend it. In other words, spend more early and worry less about how much you have left as the chances of dying increase over the years. This assumes that you are more interested in spending your hard-earned money rather than leaving it to your survivors. The problem of-course is knowing when you can run out of money.

If you have an annuity (if you pensionized a portion of your income), then you will always be able to rely on that much at least.

The authors bring up an interesting point and the book is very good and easy to read.

Pensionize Your Nest Egg (Part 1 of 2) by Moshe Milevsky and Alexandra Macqueen

Excellent book and I highly recommend you read this if within 10 years of retirement or in retirement now.

The key phrase that continues to pop up in this book is the reminder that "...in retirement, the key is having enough income as opposed to enough money..."

Three major risks can affect you and your money in retirement:

• The randomness of longevity (no one knows how long or short we are going to live)
• The randomness of stock, cash and bond investments (the sequence of those returns can damage a portfolio even though you started out with enough money - or so it seems)
• Inflation (it really does eat away at your purchasing power even in small doses and it is your personal inflation spending that matters more than the government's reported CPI)

The answer is in yet another type of diversification: product allocation. We have discussed stock versus fixed income diversification and tax location diversification and sector/size/growth/value diversification. Those are important, too. Now...

Product allocation. Maybe a portion (note: a portion, most likely no more than about 25%) of your investments should be in an annuity (social security and other monthly resources you might have count towards that 25%) which this author calls "pensionizing your nest egg".

It depends on how much your fixed expenses are in retirement and what income is guaranteed to come in to cover these needed expenses.

ROTH Conversions

Before you decide to convert a 401k, 403b or TSP from your previous employer or any Traditional IRA's you might have to a ROTH...stop and consider a few things. This is not a "no-brainer" for most investors.

Read Ric Edelman's downloadable report entitled "the ROTH Conversion Conundrum" from his website at: http://www.ricedelman.com/ (you have to provide your name and e-mail addres to get it but it is worth it).

For example,

(1) If you have children near college age, the conversion will increase your reportable income on the FAFSA form for college aid and may require additional hoops to go through to explain the unusual income spike (not in the Ric Edelman report but yet another consideration)

(2) If you are older, and maybe near retirement or in retirement, then that conversion increases your income and with the 2-year delay may increase your premiums for Medicare which are income-based (this is in the report by Ric)

(3) Do not assume that you will be in a higher tax bracket when you are ready to withdraw this IRA money. For starters, today, income tax brackets are indexed to inflation so for a married couple almost $20,000 of income is not taxed. With 3.5% inflation, in 20 years that amount may be nearer to $40,000. If, in retirement, you only had to withdraw $40,000 per year from your Traditional IRA or 401k or 403b or TSP, then that amount would come out tax-free anyway.

The answer to the question of whether to convert depends on:

(1) Your age
(2) Years to retirement and actually needing the money
(3) Whether you can pay the taxes on the conversion from other funds (but remember that you must calculate the future value of what those funds used to pay taxes could grow to also)
(4) Whether you plan to use the money or allow it to remain as an inheritance for your heirs
(5) Your tax bracket now and in the future (don't assume it will be higher)

This is one of the value-added propositions of good financial planners who are not selling you products or assets under management and can and will be independent and objective.

The $100,000 income limit to convert has been removed as of January 1, 2010 and it is not scheduled to return so there is plenty of time to consider your alternatives. The option to pay the tax over a 2-year period, however, only exists for 2010 conversions but that still does not mean you should do this in one lump-sum now.

Saving Too Much?

There are a few planners that think many of us are saving too much and that it is OK to have debt as you approach retirement. The reasoning is that it is OK to hold liabilities (debt) as long as the assets (your investments) are growing faster (as Ken Shapiro, a planner in NJ, was quoted in the April 2007 Financial Advisor magazine).

What is forgotten is risk-adjusting the return. If your mortgage is at 5.5% but your investments are growing on the average of 7%, then you should be fine. In retirement? Unlikely.

While working and accumulating? Maybe so.

The sequence of those 7% returns are important. If in the first few years of retirement, you experience losses, then those withdrawals to pay the mortgage quickly drain your portfolio and make it difficult to recover. The mortgage rate is guaranteed but the investment rate is not guaranteed so you have to adjust for that "risk".

Since 1925, large-cap and small-cap stocks have lost money 31% of the time over "one-year" (note: 1-year please) rolling periods. They have gone up 69% of the time. Those are not great odds in your favor that holding a mortgage in retirement is a good idea unless you have a "Buckets of Money" (see Ray Lucia's book and strategy) and have enough money to fund it properly (In other words, 7-15 years worth of the mortgage payments in safe money and also enough for your other income needs in retirement).

Spending of Older Consumers

The spending habits in retirement are different than in your working years. The CPI-E is an experimental measure of inflation on older consumers (age 62 and over). According to the Journal of Financial Planning (November 2008 issue), "... in general, older consumers spend a greater share on housing and medical care where prices rise faster than in other categories..."

Your personal inflation rate in retirement may be higher than you think.

Cost of Living Adjustments for 2009

Cost of living adjustments were announced last week and plan limits for 2009 are now available.

401k and 403b plans:

Employee deferrals will be $16,500, up from $15,500 in 2008.

The catch-up limit for 2009 has increased from $5,000 to $5,500. So, if you are 50 or older in 2009, then you can defer up to $22,000, not including the employer match.

The highly compensated employee limit increased from $105,000 to $110,000. This limit may affect those whose employer's plan is not a safe-harbor plan.

TAXES: The social security taxable wage base for 2009 is $106,800. You can expect to pay 6.2% of your income up to this limit. And another 1.45% on top of that for Medicare and there is no income limit on that.

If you are self-employed, then you have to pay the employer portion ,too.

SOCIAL SECURITY: The cost of living percentage increases for this have been announced, too. A 5.8% increase in social security benefits and no change in Medicare premium schedules previously put in place with stepped-up modifications for higher income retirees. Go to: http://www.ssa.gov/ for details.

The Resizing of America

Today, Tuesday, August 19, 2008 marks another down day for the DOW JONES Industrial Average and, if you are keeping track, it is more than 500 points down from its intraday high of only half-a-month ago. My advice: remain diversified and continue to stay invested in stocks in the same proportion that made sense for your time horizon when it was at 14,000 last October. The markets will recover.

This blog entry is about a different kind of resizing rather than stock markets. I recently compared a roll of toilet paper bought last week with a roll purchased months ago and it is about a quarter-of-an-inch smaller in width. That is about 5% less paper. Companies continue to do this as effective cost cutting measures with many products, resize them, and the consumer rarely notices.

A variety of granola bars are also getting smaller (but still packaged in the same size wrapper). Cereal boxes have been getting smaller, too. Soda cans have been "necking down" the tops for years in an attempt to reduce the coatings used on the inside tops of soda cans because it is an expensive method. At least this is not delivering less product to the consumer but it is another type of resizing of America to reduce costs and maintain company profit margins without reducing employees or wages.

Have you noticed packages getting smaller or their contents?

Another area of the "Resizing of America" is going the other way. Houses in the 1950's were not much more than 1,200 square feet but the average house today is over 2,400 square feet. Yet another, automobiles. They have so many new features (air bags, automatic braking systems, separate heating and air-conditioning, etc.) that it is very difficult to just compare the cost of a car in 1950 with one today and attribute it to inflation. No, there is a positive side to this resizing of America, too. Better quality. The average cost of a car increases about 7% per year - way more than inflation of 3.2% - to make up for these additions to quality.

Keep this in mind as you prepare your retirement portfolio. Inflation is only part of the picture, the resizing of products (in some cases requiring you to buy more often) and the resizing by adding quality (replacing cars for example) have to be factored in to your future purchasing power.

Can you live on 70% of your income?

Something to think about …

If you cannot live on 70% of your income as you approach retirement by minimizing debt and reducing expenses (like mortgages) then you may want to consider changes to your personal savings and/or contribution rate. In retirement, you will not have the 7.65% (your personal net effective percentage may be less than this if your earned income exceeds $102,000 for 2008) for Medicare and Social Security deducted from your pay (unless you continue to have earnings) and you will, most likely, stop investing in your retirement (the % that is being deducted from your pay now). That may get you back down to 80-85% of your income or less.

On the other hand, in retirement, you may not have a mortgage but you may have some property taxes and home insurance premiums to consider. You will have to pay for your own healthcare, in most cases, and maybe long-term care insurance and those premiums and co-pays could be as much as 15-20% of your retirement income depending on the coverage desired.

That is why many financial planners now say you may need to replace 100% of your income unless you are able to reduce your spending plans. If you make an appointment with me, we will do a detailed analysis and you may find that the answer is 40-50% of your income needs to be replaced. One thing for sure is that you should know where you are headed.

Are you up to the challenge?

ROTH IRA CONVERSIONS

In 2007, rollovers from an employer plan can not go straight to a Roth IRA. Instead, you'll first have to rollover funds into a traditional IRA. Once in the IRA you can immediately do a Roth conversion.

But thanks to the Pension Protection Act of 2006, it will soon be easier to convert your retirement savings to a Roth IRA. Beginning in 2008, funds from your employer sponsored plan can be directly rolled over into a Roth IRA.

Income limit (AGI) is $100,000 though until 2010 when the income restriction is lifted.

Should you convert? It depends. If you are young and have lots of time and can pay the taxes with "other" money and not the ROTH money then these circumstances do favor a conversion.

Remember: If Congress revamps the tax system and goes to a flat consumption tax, then all income from retirement plans will be taxed when spent. Another tax advantage out the window. Likely? Doubtful but keep your eyes and ears wide open. Nothing is guaranteed except the known tax deductions you get today and with ROTH's your contributions are not deductible. Still it is better to have both tax-free potential growth and tax-deferred so you have options in the future.

Worst case is that if Congress switched to a flat consumption tax there would be a transition period or maybe a grand-fathering of these wonderful savings vehicles but how it would all work and how to keep track is too hard for my brain to contemplate right now.

IRAs and NUA (Net Unrealized Appreciation)

A smarter strategy for those with company stock position in the retirement accounts:

Split the rollover.

Mutual funds and cash from your 401(k) should go into an IRA, and the company stock should go into a taxable brokerage account. You will pay ordinary income taxes on the shares' original cost when you transfer them into the brokerage account, but when you sell the shares, the appreciation will only be taxed at capital-gains rates, currently just 15%.

Pension Protection Act

The Pension Protection Act of 2006 (passed August 17, 2006 and mentioned in a 10/25/06 Wall Street Journal article) has quite a few parts to it that I will address. It not only dealt with pension plans but also 401k and IRA plans and charitable contributions.

CASH REQUIREMENTS

1) Starting in 2008, the corporate bond interest rate can be used rather than the 30-year Treasury bond interest rate. This may result in a slightly higher discount rate (if the rate ends up being higher than what was used for 2006) for use in the present value calculations of the lump-sum benefit but, my understanding is that plans with less than 100 employees are not required to make this change.

2) The maximum cash contribution has been calculated differently now. The maximum contribution is much higher than as calculated under the old rules for 2005. In 2005, you could only fund to the maximum of 100% of the liability but now the employer can fund up to 150%. This, by the way, is the RPA (Retirement Protection Act) liability which is the projected benefit not the liability as of today.

3) Under-funded plans still are required to continue to make cash contributions and will be required to bring the funding amount to 90-100% over a 7-year period.

PAYOUT BENEFIT TO RETIREES

4) The maximum benefit from the Pension Plan as a payout to retirees has always existed but has continually been indexed for inflation. It is now in 2006 $175,000. The rate used to calculate this maximum is 5.5%.

NET PERIODIC PENSION COST (Expense on the Income Statement and the Pension Liability amount on the Balance Sheet)

5) The discount rate used for the cash requirements is different than the rate used to calculate the financial statement values. The discount rates to calculate the pension expense (the FASB-87 requirement on the financial statements) can be different. The PPA'06 act may affect this in the future but if under 100 employees then the company may not be affected.

SERVICE PROVIDER REQUIREMENTS

6) Pension providers and 401k providers are required, if they do give advice, to provide "computer generated" analysis of mutual funds and other investments used for plans and show no bias toward what they recommend (effective January 1st). As has been the case for some time, when the provider puts on their "advisor/planner hat" they do not have to act in the client's best interest (a fiduciary standard) rather than their own company's interest (selling funds that provide them with commissions). The "objective computer model" the provider uses is suppose to be audited by an independent third-party annually. This will be interesting to see how Merrill Lynch and other big broker/dealers implement this or steer away from providing advice.

7) Employers can automatically enroll employees who do not enroll in the 401k (the employee then would have to opt-out rather than the current opt-in process) and the employer must offer a "life-style" or "balanced fund" to put employees in if they do not elect their own mutual funds. They could be automatically enrolled at 3% in year one, 4% in year 2, 5% in year 3 and then the maximum rate of 6% for years following three. Effective January 1, 2008, the participant must be placed into a balanced fund and/or a lifestyle fund of some sort. Again, they are not required to accept the change but they are required to then "opt-out" and consciously choose the money market reserve account which is now the default fund if no choice is made.

OTHER BENEFITS OF PPA'06 ACT

8) This PPA'06 Act has made permanent the EGTRRA provisions that were set to expire. The limits are indexed to inflation. 401k limits are $15,500 (under 50) and $20,500 (50 or over) for 2007; the act indexes IRA and ROTH IRA compensation/income limits; makes permanent the $1,000-$2,000 non-refundable tax credit for low-income individuals who contribute to a retirement plan and other items.

9) Non-spouse beneficiaries of retirement plans now have the same benefits as spousal beneficiaries and can roll over 401k's and IRA's to an inherited IRA (if done properly) and take distributions over their life expectancy rather than a lump-sum or maximum 5 year payout.

10) 529 college plans have been made permanent. They were set to expire in 2010. (As a side note, but not part of this act, the Prepaid 529 plans were counted as the child's assets (at 35%) in college financial aid but will no longer be counted as the child's but the parent's (at 5.6%) and that is good news for those affected); changes were also made to portability of funds between states and contribution limits.

11) Those aged 70 and 1/2 or older can donate to charity directly from their IRA and not have to pay tax on the IRA distribution up to $100,000 for 2006 and 2007 years only.

12) This act also eliminates deductions for clothing, furnishings, appliances and the like unless they are in good condition. You must have a receipt from the charity. If the item is over $500 and verified then the $500+ donation is an acceptable, deductible donation. Checks and money gifts are not deductible unless you have a report from the charity/church of the amount donated.

13) Long-term Care policies can be combined with special annuities paid for long-term care and afforded special tax treatment and allowing the cash-value of a life insurance policy to pay the LTC benefit.