WV Executive

Increasing longevity is an important factor to consider when planning for retirement these days. Prudent retirees, in good health now need to prepare to finance their post-employment lives for 30 years and, quite possibly, longer.

It has not always been so. In 1900, the average American male was expected to live only to age 45. By 1935, the year that social security came into being, science had extended an American male’s life expectancy to age 65. In other words, when social security was created, the average male was not expected to ever need it.

Contrast that with the current situation. American men aged 65 are expected to make it to 79, American women to attain age 84 and a married couple, both aged 65, has more than a 50 percent chance of one of the two reaching age 95.

The blessing of increased longevity, along with several related factors are causing concern among financial planners, retirees and those nearing retirement. Some of these related issues include the impact that increasing numbers of retirees, compared to those still working, may have on the social security system; a lower interest rate environment; a relatively poor stock market performance the past five years; the age-weighted savings rate; the level of 401(k) and other elective retirement plan values and the much publicized implosions of Defined Benefit Pension Plans nationwide.

Defined Benefit Plans

Defined Benefit Plans, long a fixture of the nation’s major employers, are now facing mass defections from corporate America. In 1980, there were 114,396 such plans. By 2003, the last year for which statistics were released, the number had diminished to 31,135. Employers have been rushing to transfer the obligation to pay for retirement to their employees by closing Defined Benefit Plans and replacing them with employee directed 401(k) and similar plans, known as Defined Contribution Plans.

To make matters worse, Defined Benefit Plans are facing an unprecedented funding gap. The amount by which pension obligations are short has ballooned from less than $20 billion in 2000, to about $350 billion currently. Meanwhile, the Pension Benefit Guaranty Corporation (PBGC), the entity created by Congress to bail out pensions that fail, is itself facing a shortfall. It currently stands at around $23.3 billion shy of its needs at the most recent reckoning, and the number is sure to go higher. The situation leads advisors to wonder if such plans will disappear entirely.

As individuals take increasing responsibility for the direction of their retirement investments, financial professionals are encouraging the full funding of optional retirement plans at work. They also consider an increase in individual retirement savings outside the workplace more important than ever.

Assuming a successful accumulation of funds for retirement has occurred, there is an equally important task facing professional advisors assisting with retirement planning today. Creative strategies must be devised that are most likely to assure that retirees have a sufficient income and that it will last as long as they do. This topic has been receiving attention routinely of late in the professional literature. However, there has been little mention of the subject in the general media, thus the review that follows.

The first part of the retirement income formula is simply a realization that the art of distribution is unlike the art of accumulation. In accumulation, the well known acronym ROI means “return on investment.” But in distribution during retirement, ROI’s meaning must become “reliability of income.” That change in meaning requires an important modification of viewpoint.

During retirement, advisors are seeking investments and savings performance that can deliver something known in advisor-speak as “absolute return.” An absolute return is a return that must be attained to reach the long or short term goals involved and that has a high probability of being retained, rather than being erased casually by market down-drift.

Absolute Return

Absolute return is considered in isolation, too, rather than in the context of index benchmarks or other measures. The performance result that is material in absolute returns is the attainment of the goal set for the savings vehicle or investment itself; what it is to attain in order to meet its owner’s objective. If an investment meets its absolute return goal, then it has succeeded.

Absolute return has gained prominence of late in the need to improve retirement planning methodology because of two significant developments; the failure of the stock and bond markets to provide adequate absolute returns for retirees in the last few years, and the approaching retirement of large numbers of people who were part of the baby boom. In that indexes can decline rapidly and stay depressed for long periods, absolute return becomes much more important to a retiree than beating the indexes.

Many factors come into play when examining retirement needs. One is the inflation rate which reduces the purchasing power of nominal dollars over time. A retiree who purchased a movie ticket in 1975 for $2.50 will find today that same amount will not purchase the popcorn and soft drink to go with the film, let alone the admission. If the movie were at the local drive-in theater, a common film venue then, our retiree could have driven over in a new 1975 Buick, purchased that year for about $6,700. Inflation is a gradual thief, but it is easy to see the damage it does when such examples are considered in longer segments of time.

In recognition of the risk of inflation, a system to increase distributions along the way has to be in place or the retiree’s standard of living is likely to decline due to the falling purchasing power of nominal dollars. Financial planners refer to this ability to keep up with inflation as “inflation hedging” and it can only happen in a well crafted portfolio containing assets that have a history of keeping pace with, or outpacing, inflation. Accordingly, planners generally agree that equities (stocks) need to be in the mix in a more significant way than in the past, but in as safe a way as is appropriate for the situation.

The timing of distributions as well as the source of them is another aspect one must weigh carefully. Studies have shown that systematic withdrawals from assets that can easily fluctuate in value and that commence at the early stage of a significant market decline can have a disastrous effect on the staying power of those withdrawals.

Many retirees got caught in this trap in the most recent big drop in the stock market. Withdrawals had to be cutback and the degree depended on how assets were positioned. A significant number of recent retirees has concluded to go back to work in an attempt at nest egg recovery, an unhappy development indeed.

The math here is simple, but is not well recognized by the public. Say one has a 30 percent drop in the value of a mutual fund it would require a 42.8 percent gain (not a 30 percent gain) on that same fund to get back to the beginning value; and that is if distributions are not being taken. If cash is being systematically withdrawn from the fund, an even larger gain is needed to get back to the beginning value. A stock portfolio being subjected to withdrawals while dropping significantly in value can have the opposite of the intended effect of hedging inflation. It can even be reduced to the point of an inability to sustain the desired distributions over time.

The financial services industry is responding to these challenges in retirement distribution by retooling existing products and introducing new ones for the planning community. In addition to utilizing new and modified investment and savings vehicles, many planners are diversifying more broadly to include an allocation to alternative investments such as real estate, managed futures funds and equipment leasing.

Such assets have little correlation to the three traditional classes of portfolio components: stocks, bonds and cash. Analysts theorize that if done correctly, the addition of such assets will heighten a portfolio’s overall returns for a given amount of risk, thereby helping with stability and inflation problems. However, there is relatively limited experience with the broad utilization of alternative investments. While back testing in theory looks encouraging, risk is not eliminated so caution is in order. In any case, the past cannot predict the future.

Blocks of Time

There is growing sentiment among professionals that retirement should be looked on as a series of periods or blocks of time for which gradually increasing income is sought. For the first 10 or so years of retirement, having dependable sources for income with as nearly no principal risk as possible is suggested. Sure, such assets are boring, but the key here is discipline and reliability of income; retirement’s ROI. Most of the money being distributed using such investment methods is a return of the invested principal so there is very little tax liability involved. Spending money in the early years of retirement should not come through withdrawals from assets with higher market risk unless the retiree happens to be quite rich and can sustain extended periods of market decline.

For the income needed during the 10th to 15th retirement years, many planners now feel that investments with a variable return should be held for the 10 years leading up to their use. Those planners also often prefer only investments with controls on loss to the degree possible in this period. There are a number of options available, but investors must watch expenses because there is a wide range in costs and features among the various vehicles and methods involved. Whatever asset(s) are used for this block, they should be acquired in the portfolio at the start of retirement with the intention of growing safely for later use. Then, at the right time, the asset(s) would be converted to the same type of drawdown assets as were described above; fixed income with as nearly no principal risk as is possible.

About 15 years from the commencement of retirement, one could begin withdrawals from stock portfolios, such as individually managed accounts and mutual funds, invested just for this purpose from the beginning. One could convert portions of stock holdings in the right amount to provide targeted income for five years at a time. Funds withdrawn would once more be re-allocated to the sort of fixed income assets described for the drawdown periods; those that keep principal risk contained as tightly as possible and generate fixed income.

If the economy and markets operate as they have generally over their recorded history, there should be an appreciation in these diversified stock portfolios that has kept up nicely with, or outpaced, inflation.

Assets held outside of a tax protected environment such as a qualified retirement plan will require the payment of taxes on dividends and realized capital gains as the years go by. Thus, money to satisfy these taxes must be incorporated into the planning and be available each year.

Annuities

Some planners advocate the use of variable annuities for accumulation for this period of retirement, in part because there is no tax on the appreciation until funds are withdrawn. They can certainly be appropriate vehicles, but be aware that there is a tax catch down the line. Withdrawals of funds beyond the invested sums from such annuities are not taxed at the lower capital gains rate. These are taxed as ordinary income until the original investment begins to be withdrawn unless the value that has accumulated in the annuity is traded for a systematic series of payments guaranteed by the insurance company involved.

On the other hand, if stock mutual funds or individually managed stock accounts are used, as the years go by the investment incomes and gains will be taxed annually, but they should receive more favorable tax treatment. Lesser taxes will be due on withdrawal, partly because taxes were paid along the way and partly because the sale of appreciated shares will get lower capital gains tax treatment. Of course, all of this relates to current tax law and is subject to change at the will of Congress and the President.

Many variable annuities offer a guarantee of the return of their accumulated values through withdrawals during one’s lifetime. Any remaining balance would go to a named beneficiary in case of one’s early death. As a result, these annuities are often preferred by those who want to take no chances with retirement monies whatsoever. “Why risk my retirement?” they reason. While there is comfort in such guarantees, such assurance comes at a higher price. The costs involved are charged back to the owners of variable annuities and are higher than the costs involved with comparable mutual funds and individually managed portfolios without such protection.

As with all aspects of investing, a fair amount of philosophy and personal opinion is involved. Nevertheless, one thing planners agree on is that the years of retirement should be a time to enjoy, not a time for worry about finances. With careful planning and a well structured program in place, chances are far greater that the money will last to make the enjoyment of retirement a reality.