In the face of volatile investment markets, rising medical costs, increased taxes, and uncertain social security benefits, many retirees are looking for solutions.
This article is designed to assist retirees in planning for retirement while taking a critical look at the financial services industry’s packaged solutions.
What’s your number?
How much in retirement capital is required to provide a secure retirement? The amount you have in direct income sources (pensions, Social Security, etc.), along with a number of other planning assumptions that include:
- life expectancy,
- investment rate of return, and
- expenses (including medical costs), can make a significant impact on this “number” question.
Advertisements in the financial services industry seem to indicate that this is an easily definable number to calculate and save for. But given the uncertainty of the assumptions, the calculation is not easy at all.
Lee Eisenberg explores many of the financial and psychological dimensions of this planning in his book The Number. Many financial planners recommend no more than a 4% inflation adjusted withdrawal rate from a retirement portfolio if the portfolio needs to survive 30 years or longer. This means a retiree would require a $1,000,000 portfolio to generate $40,000 per year in the first year – with increases annually at the rate of inflation.
This simple “rule of thumb” could be quite conservative or aggressive depending on the structure of the investment portfolio or other factors.
Caveat emptor (buyer beware)
With fewer and fewer retirees covered by pensions, many are turning to annuity products. An annuity is an insurance product that converts a lump sum investment into a guaranteed (by the insurance company) stream of payments.
These products have appeal to the retiree who is looking for a “guaranteed” source of income that cannot be outlived. As such, these income solutions may be appropriate for some portion of a retiree’s funding needs.
As in most cases, there is “no free lunch.” These guarantees come at a price. They may:
- have expensive internal costs;
- have surrender penalties;
- provide no benefits after death; and
- be issued by companies that are not financially secure to fulfill the promise of long payment streams.
Unfortunately, some annuities pay high sales commissions and may be promoted with aggressive sales tactics.
The inflation risk
While these products are designed to insure against the risk of living too long (longevity risk), they many expose the investor to other equally damaging risks.
The most damaging is the risk of loss of purchasing power dues to inflation.
According to the Bureau of Labor Statistics, $100,000 in 2008 will only purchase what $53,781 would purchase in 1988. In just twenty years it costs twice as much to live.
The rising cost of healthcare and the funding of Medicare raise additional concerns for products that provide an income stream that does not grow with inflation.
Many experts believe that future inflation may be somewhat higher than recent history. Alan Greenspan, former chairman of the Federal Reserve, wrote in his book, The Age of Turbulence, that an inflation rate of 4 to 5 percent is not to be taken lightly.
Variable income annuity products offer the opportunity to receive a monthly payment that participates in equity market returns and thus, over long periods of time, may keep pace with rising prices.
While this may provide some protection for increasing inflation, these products tend to be somewhat more expensive and expose the retiree to market risks.
New managed income products
Many of the large mutual fund companies are rolling out new “managed income” products.
These are mutual funds whose primary objective is to maximize income to the investor. Each offering has its own unique characteristics and advantages and disadvantages.
As with income annuities, investors are cautioned to investigate these products adequately before investing in order to understand their risks and costs.
Certain is not the same as safe
In today’s uncertain market, many retirees are choosing to invest in Fixed Income securities such as bonds and bank deposit accounts (CDs, money markets, etc.) for the illusion of a safe place to invest.
It is purchasing power that ensures security and dignity in retirement. While these investments may be certain – you get your original investment back – they may not be safe, if safety is defined as the maintenance of purchasing power. According to Morningstar, bonds provided little after inflation and cash fared even worse.
From 1988 through 2008 inflation as measured by the Consumer Price Index increased 3.05%.
At the same time, the dividends of large company stocks as measured by the S&P 500 grew at 5.91%.
In addition, the principal of the investment, compounded at 8.9%.
Therefore, if safety is defined as the maintenance of real purchasing power over time, it could be argued that being a shareholder in the world’s great companies is a safer long-term investment for today’s retiree than bonds or cash.
Families face many challenges in planning for retirement. It is important to keep in mind that there is no such thing as a “one-size-fits-all” solution.
While there are many options to provide retirement income, today’s investors are encouraged to evaluate the options adequately to understand the risks and costs before implementing any solutions.
By Jeff Bernier, CFP, ChFC, CFS
TandemGrowth Financial Advisors, LLC