Investing During Retirement
FORECASTS & TRENDS E-LETTER
Investing During Retirement
IN THIS ISSUE:
1. Risk Considerations In A Retirement Portfolio
2. No Shortage Of Investment Options
3. Immediate Annuities
4. Fixed-Income Alternatives
We’re now in the home stretch in this series of Retirement Focus E-Letters dedicated to converting your nest egg into a retirement income stream. Over the past year or so, I have written about how to determine how much might be enough to fund your retirement, as well as how to determine the best way to convert your nest egg into an income stream during your golden years.
As I promised in my March 18 Retirement Focus E-Letter, this week I’m going to address the issue of how to invest your money after retirement. We’ll cover the importance of risk management during retirement as well as various ways to invest to produce the income you need. In the end, we’ll discover that post-retirement investing is a delicate balance of risk and reward that must be achieved in order to reach your goal of a secure retirement.
Before launching into this week’s topic, I want to be sure to remind you that any investment information provided in this E-Letter is general in nature, and should not be construed as investment advice. You should always evaluate investment options in light of your personal financial situation, retirement goals and any special circumstances you may have. Ideally, you should consult a qualified investment professional who can take the time to review your situation and tailor an investment approach to meet your needs.
Revisiting Gary’s Risk Discussion
Gary did a great job in his April 22 E-Letter that highlighted both common and lesser-known risks associated with investing. His risk analysis discussion is especially important for those who are investing during retirement, since the negative consequences of taking on too much investment risk can be far greater during retirement than while accumulating a nest egg.
Just one example of a retirement portfolio’s heightened sensitivity to risk is the issue of investment losses in the early years of retirement. To illustrate, let’s use real-life historical market data to show the effects of early market losses. An investor retires on December 31, 1999 with a nest egg of $500,000, and decides to take 6% annual withdrawals. To keep it simple, we’ll assume he decides to invest it in an S&P 500 Index fund, lured by that Index’s phenomenal returns (33.36% in 1997, 28.58% in 1998 and 21.04% in 1999) just prior to retirement. The following table tells the story of this investor’s first three years in retirement:
Note that with the December 31, 2002 balance of $259,109, the January 2003 distribution would be only $15,547, or roughly half of the original amount of income at the beginning of retirement – all in the space of just three years.
Recalling Gary’s discussion about the amount of return required to break even, we find that it will take a total return of 93% just for this investor to get back to even, which will be especially hard to do considering an automatic 6% withdrawal each year.
The moral of this story is that the combination of steady withdrawals and portfolio losses can send a retirement portfolio’s value into a downward spiral from which it might never recover, resulting in you possibly running out of money later in life, or reducing the level of income below what is needed for a comfortable retirement. Granted, the above example chooses three of the worst years on record for the stock markets, but how do we know that the next three years won’t be a repeat of 2000 – 2002 in the stock market? The answer is that we don’t, so retirees must invest with an eye on risk management.
The remainder of this article will address the various ways to invest during retirement. Over the course of this discussion, the guiding principle will be to balance the various investment risks such that you will have both a meaningful level of income, but also avoid running out of money in retirement.
Retirement Investing – No Shortage Of Options
With the oldest of the Baby Boomers now eligible for Social Security early retirement, mutual funds, brokerage firms, insurance companies and the like have all come out with a variety of products designed to fill the need for retirement income. Accompanying this deluge of products are reams of articles dedicated to advising both investors and investment professionals on how to position their retirement portfolios for optimum income and longevity. As if this glut of frequently conflicting advice isn’t bad enough, add in a generous helping of warnings from regulatory agencies regarding scams and bogus investments aimed at seniors, and you get what Gary likes to call “information overload.”
My goal in this and subsequent E-Letters in this series will be to acquaint you with a variety of alternatives for post-retirement investing. Be aware, however, that there is no possible way that I can provide information about every conceivable way to invest for retirement. Nor can I launch into very detailed explanations of the products and investment strategies I do cover, since I am restricted as to space in these E-Letters. Even so, my hope is that I can provide you with a basic knowledge of how each of these options works.
With those caveats aside, it’s time to delve into ways you might want to invest during the course of your retirement. As a general rule, I categorize the various post-retirement investment strategies into the following six broad categories:
Due to space limitations, I’ll only be able to cover a couple of the above categories this week, with the remainder being covered in future Retirement Focus issues. As I discuss these various options, I will include some links to additional information on these investment options.
One of the major risks that retirees face is the possibility of outliving their money. With fewer and fewer people being covered by defined benefit plans that can provide an income for life, the onus is being placed upon the individual retirees to make sure post-retirement investments are such that their money will not run out.
The immediate annuity contract addresses the risk of outliving your money by providing a periodic retirement check as long as you live. There are even options available that provide an income for as long as you live, plus provide the same or a lesser amount to a surviving spouse as long as they live. Most immediate annuity contracts are “fixed,” in that they provide an assumed level of return, but there are also variable immediate annuities, as I will discuss later on.
In fixed immediate annuity contracts, once the annuity is purchased, the amount of periodic income is set and will not vary in the future. However, there are some fixed contracts being introduced that will provide for an increasing payment over time, as well as variable immediate annuities where the periodic payment varies with the investment performance.
The biggest advantage of these contracts is that the payments continue for life, even if your premium plus earnings would have otherwise been exhausted. The insurance company takes on the risk that you will live longer than your actuarial life expectancy, while you take on the risks of dying early and your heirs losing access to the premium paid.
I wrote about the basics of an annuity payout in my July 24, 2007 E-Letter, along with the major advantages and disadvantages. Rather than trying to summarize all of that material in this E-Letter, I encourage you to go back and read the Annuity Payout E-Letter to get up to speed on this investment option.
I do want to address several issues in regard to this method of providing retirement income. First, it is important to remember that in most immediate annuity contracts, you cannot change your mind several years later and receive a distribution of the remaining value. This is why most Advisors counsel retirees to not put their entire nest eggs into immediate annuities, since doing so could leave them without resources in case of an emergency expense.
The insurance industry is developing new immediate annuity products that address this illiquidity, but any flexibility comes at a cost. Some immediate annuity contracts do allow limited withdrawals, but periodic payments may be reduced to compensate for this extra benefit. Others allow withdrawals only during the early years of the contract, but charge a surrender fee if this option is exercised.
A second risk when purchasing an immediate annuity is dying prior to reaching life expectancy, and especially during the early years of the contract. In a life-only payout, all payments would cease and any windfall would go to the insurance company. For this reason, annuity companies provide optional forms of payments such as period-certain, joint-and-survivor and installment refund options that can extend beyond the annuitant’s life span should an early death occur. These alternative forms of payment, however, do come at the cost of lower periodic payments.
Since the payout from a fixed immediate annuity is set over the lifetime of the annuitant, another possible disadvantage is the loss of purchasing power. According to the actuaries, a retiree at age 65 can expect to live around 18 more years. However, it is not uncommon to see people live far beyond that point. While the insurance company guarantees to pay an income for the life of the individual, they cannot guarantee that its buying power will remain the same.
In other words, inflation is the natural enemy of the fixed immediate annuity. Using the Department of Labor’s inflation calculator, we can see that a $1,000 payout in 1988 would have the purchasing power of only about $550 today, while the same payout beginning in 1978 would have the buying power of only $303 after 30 years of inflation had taken its toll. If future inflation trends are similar to those of the past 30 years, an annuitant could see his or her buying power halved in 20 years, and cut to a third in 30 years.
The insurance industry has also addressed this disadvantage by providing a variable immediate annuity. Like the fixed immediate annuity, the variable contract provides an income for life. However, unlike its fixed counterpart, payments from the variable immediate annuity can rise or fall based on the performance of a portfolio of investments.
It works like this – the annuitant buys a variable immediate annuity from an insurance company and the initial monthly payment is calculated using an assumed rate of investment return. After that, the monthly payment will be based on the performance of the investment portfolio chosen by the annuitant.
If the investments do well, then payments can rise over time and possibly overcome the effects of inflation. However, the annuitant also takes on market risk so that if the selected investments do poorly, the income payments will fall, possibly below what a fixed contract would have paid. Some companies do provide a guarantee that payments cannot fall below 80% to 85% of the initial payout, but this comes at the cost of higher expense charges.
Just as with any other investment alternatives, fixed and variable immediate annuities are just one tool that can be used to provide retirement income. The important thing to remember is that the guarantee of an income for life depends upon the strength of the company issuing the annuity contract. Therefore, you should only place your money with an insurance company that you feel is safe, solid and will be around 30 years from now.
To assist you in your evaluation process, I recommend that you check out a prospective insurance company’s ratings with at least one of the five major insurance company rating services (Moody’s, A.M. Best Company, Weiss Research, Standard & Poor’s and Duff & Phelps). A link to all of these ratings services can be found at the Insbuyer.com website at the following web address: http://www.insbuyer.com/insurancenrating.htm.
You can also obtain quotes on how much monthly income your nest egg will purchase under various annuity options on many Internet websites. You can find these websites by typing “immediate annuity quote” into an Internet search engine. One I have found to be helpful is at http://www.immediateannuities.com. Note that these guides are useful to get a general idea of what annuity income may be available, but you should always consult a qualified insurance professional before buying any annuity contract.
Fixed Income Alternatives
As noted above, the fixed income category covers a lot of different types of investments, and is characterized by paying a fixed or stated rate of return for a specific period of time. In some fixed income investments, the fixed rate of return may span from several months to many years. In others, such as a fixed deferred annuity contract, the interest rate may be revised annually.
Fixed income investments can also be subject to a wide range of tax treatment on the income produced by the investment, such as municipal bonds where interest is generally income tax free, to fixed deferred annuity contracts where taxation is deferred until withdrawn from the contract. For a more detailed discussion of tax considerations, see my November 13, 2007 E-Letter.
Because the category of fixed income includes CDs and fixed annuities, many investors think that only low-return investments are included. While it’s true that some fixed income investments do have low returns, there are others that have the potential for very attractive returns, even to investors that primarily invest in equities. Of course, with this increased return potential comes a generous helping of increased risks as well.
A major advantage of fixed income investments is that they are generally not highly correlated with equity investments. As a result, including certain types of fixed income investments in a diversified retirement portfolio can lower a portfolio’s volatility, and sometimes even offset losses in the equity portion of the portfolio. While the major thrust of this article is the production of income from fixed income investments, this non-correlation can be just as beneficial after retirement as it is in the accumulation phase. As a general rule, the category of fixed income investments usually includes the following types of investments:
There are other types of fixed income investments not covered above such as US savings bonds, money market mutual funds, convertible bonds, zero-coupon bonds, and the now infamous mortgage-backed securities, among others. There are also bond mutual funds for virtually all types of debt instruments that provide many of the same advantages of buying individual bonds, but relieve the investor of having to decide which bonds to buy. The key to including any fixed income investment in a post-retirement portfolio is usually the ability to have a safe, stable amount of income with at least some measure of principal protection.
That’s it for this week. In my next Retirement Focus issue, I’ll continue discussing the various ways to invest for retirement. Until then, if you have any questions about the options given above, or would like me to cover a specific investment option, please feel free to contact me at firstname.lastname@example.org.
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.