Nahum Daniels, Author at Integrated Retirement Advisors

Yes, You Can Lose It All, Even If You’re Wealthy

by M. Nahum Daniels

If you’ve been wondering about the book I wrote, RETIRE RESET!, we are publishing some excerpts right here on our blog so that you can learn more. Along the way, you will learn why our firm, Integrated Retirement Advisors, was founded: we’re on a mission to help people with retirement!

 

Here are some excerpts from Chapter 6.

Chapter 6: WALL STREET INSECURITIES

       “Unless you have millions and millions and millions … you cannot retire on the investment return on your savings … because there is no return on it.”

       Jeff Gundlach, Bond King & Modern Art Collector, Founder and CIO, DoubleLine Capital

 

I first conferred with Mauricio in 1995, overlooking New York’s Central Park from a Fifth Avenue penthouse filled with modern art. Studying his experience as a do-it-yourself retiree has taught me an invaluable lesson: Even if you enter retirement with many millions, you are always subject to the risks, rules and ratios embedded in modern retirement planning. Should they go misunderstood or ignored, the result can be depletion and austerity—no matter how wealthy you may be starting out. Retirement success, on the other hand, especially if you have only modest wealth, depends on an informed approach to managing your nest egg that properly balances your capital and spending over an open-ended time horizon.

Do you find it hard to believe that even the very rich can run out of money? (Do you find it even harder to be sympathetic?) Allow me to demonstrate the vital lessons worth learning.

Deciding to enter retirement as he turned 65, Mauricio had just completed the sale of a Parisian fashion company he founded, clearing a nest egg of $100 million. Our purpose in meeting that day was to discuss his legacy planning. He faced a 50% estate tax upon his death and was looking for ideas that could mitigate the impact of those levies on his children and grandchildren. As for Mauricio’s income planning, he wasn’t looking for help from me or anyone else. He made it clear that he would consider only US Government bills, notes and bonds.

Mauricio, as it turns out, had serious trust issues. A Holocaust survivor, he spent some of his formative years in Buchenwald, the Nazi slave-labor camp near Weimar, Germany. At age 15, he was one of the prisoners liberated by American troops in April 1945. While maintaining his European connections and building a post-war business there, Mauricio became a proud and grateful American citizen, trusting in the inherent goodness and reliability of US government promises. It was simply unthinkable that the United States of America could ever default. In his mind, government paper was as safe as safe could be, and he viewed it as the key to a “risk-free” retirement that would let him sleep soundly at night while enabling him to live a fulfilling life by day.

And he wasn’t one to fuss. A saver at heart, he’d be happy to buy and hold US notes for their ten-year duration and simply roll them over to new issues when they matured. He would hear of nothing else. Risk was anathema. Professional advice was gratuitous. He would manage his own money by lending it (safely) to the US Treasury.

Besides, in January 1995 savers like Mauricio could still thrive. The risk-free 10-year Treasury note was yielding 7.69%. In theory, it would pay him annual interest of $7,690,000 for ten years without having to dip into principal. What’s more, that yield was tax-advantaged: Interest income on US Government obligations was then (and is still) given preferential tax treatment. He would have to pay about 40% in federal income taxes but would avoid New York state and city taxes that together could have easily added another 10% or so to the burden.

Mauricio estimated that around $4.6 million spendable dollars would enable him to fund his family needs and essential living requirements, his discretionary globetrotting, his passion for modern art and his generous philanthropy. So, he matched his lifestyle to the income his capital would generate. “Living off the interest,” he began his retirement by effectively withdrawing 7.97% from his nest egg. As for his estate-tax obligation, he would simply set up a life insurance trust and be done with it.

Later on, I learned that Mauricio had failed to factor in inflation, which averaged around 3% a year during the decade that followed (and even more in the prices bid for modern art). To keep up with his increasing cost of living he would have to up his annual withdrawal. To avoid dipping into principal, Mauricio faced the sacrifice of reducing his art-buying and charitable giving. He decided to give his lifestyle priority. Luckily, falling Fed interest rates during this period mitigated any capital depletion as he sold some of his bonds into a rising-price market. Still, after ten years, he found that he was left with only $85 million of the $100 million with which he began (Table 2).

When he rolled his portfolio over in 2005, however, 10-year rates on government notes had fallen to 4.16%. Reinvesting his capital at age 75, he would be earning $3.54 million in interest, less than half of what he had started with ten years earlier, and after federal income tax, it would leave just $2 million spendable dollars. Meanwhile, his annual expenses had inflated to over $10 million. Withdrawing $10 million a year from an $85 million nest egg would equate to a 12% annual withdrawal rate. Now 75, he wanted that money to last him another 25 years, just to be safe, and a 12% withdrawal rate would put him at great risk of premature depletion.

Facing the same challenge that can confront every retiree, Mauricio recognized that something had to give—despite the abundance with which he was blessed. He would either have to cut back his lifestyle or tap into principal and risk running out of money. He decided to reduce his annual withdrawal to $6.5 million. His art collecting slowed; his travels became less frequent; his charitable contributions less charitable. Bottom line: He started to feel pinched.

Despite the belt-tightening, at age 85 Mauricio found he only had $42.5 million remaining when the time came to replenish his matured portfolio with newly issued bonds. His luck couldn’t have been worse. It was January 2015 when the ten -year rate hit 1.81% and Mauricio had to face the reality that his remaining principal would generate taxable interest of just $766,000 each year! Still healthy and active, he found himself a victim of his own loss-aversion, severely set back by the Fed’s Zero Interest Rate Policy (ZIRP). His was an almost unbearable dilemma: Accept more austerity by further shrinking his lifestyle, family and charitable giving (and start to sell off his beloved art collection) and still face possible depletion at age 95—and/or chase higher yields by taking on more risk.

TABLE 2. MAURICIO’S SURPRISING RETIREMENT OUTCOME

A Shadow Banking Crisis

Mauricio’s dilemma is the same one that has faced all savers since the Great Recession of 2008 [and we are seeing it again now, during the current 2020 crisis]. Low yields pressure you to turn to a subset of “shadow banks” for greater returns.

Like the big commercial banks, the shadow banks are financial intermediaries. Unlike their commercial counterparts, they are not “cash depository” institutions; they are neither able to borrow from the Fed’s discount window in a crisis nor insure your account for up to $250,000. Some of the shadow banks—the ones of interest to us as investors—specialize in the issuance, custody and trading of non-cash financial instruments known as stocks and bonds. These institutions include the investment banks, broker dealers, money management firms, mutual fund companies and hedge funds that comprise the Wall Street community.

The Wall Street subset of the shadow-banking universe provides no guarantees. On the contrary, like commercial banks they commerce in risk—offering returns arguably great enough to compensate for the possibility of “capital impairment,” i.e., financial losses, temporary or otherwise. The Wall Street shadow banks earn money by exposing your cash to risk and trading their own.

Transforming Savers into Investors: [Stocks and Bonds] 

When buying a bond, you’re lending money to a government or business in return for an interest payment over a given period of time, at the end of which you expect to be fully repaid. Like lending to a bank when you make a deposit, you are giving the borrower the use of your money for a price. Bonds come in a myriad of forms, offering claims against the borrower’s assets in the event of default based on the specific terms of the loan set forth in their respective indentures. If a secured borrower defaults, you may claim against its assets for repayment and you may come before other types of creditors. The less risk incurred in making the loan—i.e., the more credit-worthy the borrower—the lower the interest offered. When held to maturity, the interest payments over time comprise your yield. Their steady cash flow stabilizes their value, so in terms of price, bonds tend to be less volatile than stocks.

Buying a share of stock represents an incident of ownership, or equity, in a business. Stocks have no maturity date; you own them until you decide to sell them. Their payouts come in the form of dividends made at the discretion of management—both in terms of magnitude and periodicity. Some years you may get more, some less, and some none depending on the company’s operating profitability and other financial circumstances.

Among larger, mature dividend-paying US companies, dividends reflect about 50% of annual earnings. Dividend flow as a percent of the share price you paid is a critical component of stock ownership, sometimes amounting to 40% of the total return earned over time. But as an owner, you are taking the risk of total loss in the event of business failure because you are at the bottom of the capital stack, and lenders get paid first. Risk of total loss is balanced by the potential for greater reward in the form of price appreciation.

Company growth tends to be reflected in a rising share price, offering the potential for a gain on the capital you invested in addition to the dividend yield. These two components—dividends and gains—make up the “total return” potential of your invested capital.

Importantly, stocks tend to be much more volatile than bonds in terms of price.

The Wall Street brokerages buy, sell, hold and trade securities (including stocks and bonds) for their customers’ accounts. Wall Street dealers also own stock and bond inventories to facilitate customer transactions and earn proprietary trading returns.

Broker/dealers do both. The money center commercial banks, like Bank of America, have wealth management arms that are their broker/dealer affiliates, like Merrill Lynch.

Like the global economy, the investment business too is always evolving. Traditional stockbrokers can execute customer orders or make recommendations considered suitable based on their knowledge of the client’s risk tolerance, investment objectives and time horizon. Fee-based portfolio managers at mutual fund companies, money management firms, and hedge funds usually require a free hand to buy and sell securities on a client’s behalf, so handing over discretion to the portfolio manager is often mandatory. Commission-based brokers at the big bank “wire houses” and other execution-based brokerage firms typically require a client’s consent to a trade before its execution.

Trading for Trading’s Sake

With or without discretion and whether commission- or fee-based, the buying and selling of securities encapsulates the raison d’être of the Wall Street shadow banks, and securities trading is their lifeblood. But trading for trading’s sake tends to invite speculation and receives criticism from buy-and-hold investors who tend to be more analytical and systematic.

Beginning in the late 1990s, stockbrokers took on the title “financial advisor” when the big wire houses shifted from a commission- to a fee-based revenue model and wanted to exude a more knowledgeable, caring and comprehensive approach to customer service. Fees are a steady income source that levels out brokerage-firm cash flow, so most firms prefer them to the less consistent flow derived from broker commissions.

Trading is a win/lose proposition that pits buyers and sellers against each other, with both sides seeking an advantage. Buyers want to spend less and sellers want to get more for their securities. Traditionally, investment securities are valued—or priced—based on specific free -market fundamentals. For bonds, the key metric is “yield,” or the cash flow they generate. Yield translates into price: the lower the yield an investor is willing to accept, the higher the price that investor is willing to pay for a bond—the standard of “fixed income” investments.

Bonds reflect the forces of supply and demand in capital markets. If borrowing demand is high and money supply is low, the cost of money naturally rises and borrowers offer higher yields in the form of interest on the debt they issue. If money supply is plentiful and loan demand soft, lenders are likely to accept a lower rate for putting their surplus cash to work. In a free market, the forces of supply and demand naturally find equilibrium.

An important concept that retirement investors need to understand is that underlying Wall Street’s advice is a narrative that can give rise to exaggerated expectations and a methodology that can ultimately cause your undoing. Rather than buttressing the retirement process, the conventional principles of diversified investing, applied to retirement portfolios, may actually reduce portfolio reliability. Investing in securities at the wrong times and under adverse conditions can increase the odds that you run out of money; if you do make poorly timed decisions, then protecting yourself and improving your probability of success require you to self-impose austerity from the moment you start spending down.

The Wall Street Retirement Portfolio

The “balanced portfolio,” which can sometimes over-weight stocks and at others over-weight bonds, has become Wall Street’s signature retirement planning product. Applying Modern Portfolio Theory (MPT), it diversifies among stocks and bonds along an efficient frontier of return per unit of acceptable risk. A 60-40 stock/bond mix is deemed suitable by regulatory authorities for most individuals with median risk tolerance, so an advisor or firm can rarely be faulted for recommending it, even if an outcome falls into the rare extreme of return distribution. If the S&P 500 Index historically averages 10% growth per year and the UST 10-Year averages 5%, then a 60%/40% stock-bond portfolio can be expected to average 8% going forward, goes the oft-repeated incantation.

While the exact composition of each asset class may differ somewhat from firm to firm, most Wall Street customers end up with remarkably similar “investment policy” portfolios in terms of allocation, downside risk exposure and upside potential.

Projecting future returns based on historical averages is known as “deterministic” modeling. It is a form of linear forecasting wherein expected returns do not vary over time—and that’s its key flaw: the average return is most likely the one return an investor will never receive. Thanks to the increasing availability of computer power, “stochastic” modeling has grown in popularity. Applied to statistical sampling, stochastic modeling incorporates randomness. It has been tailored to retirement planning in the form of Monte Carlo simulations, named by one of its original developers after his favorite pastime—calculating the odds of winning at the casino.

In Monte Carlo computer software, returns and inflation are treated as random variables. Monte Carlo “engines” generate thousands, tens of thousands or even hundreds of thousands of possible combinations that produce a probability analysis, i.e., a statistical range of outcomes reflecting the financial impact of various return sequences. Now the standard retirement “modeling” tool, it perfectly captures the Wall Street approach to securities-based retirement planning by surrendering to uncertainty and accepting the necessity of playing the odds.

Changing the input assumptions and the type of mathematics used in a given Monte Carlo engine can materially alter the results. Critics focus on this subjectivity, which they claim introduces bias into the design. Mathematician and financial advisor James Otar, CFPTM, argues that the methodology tends to overstate the probability of favorable outcomes, giving clients a dangerously ex-aggerated sense of security.

Leading researchers in retirement-income planning have recently published seminal studies that address these issues, with some surprising conclusions. Working together, professors Wade Pfau, PhD and Michael Finke, PhD, of the American College of Financial Planning, along with David Blanchett, CFA, CFP, head of retirement research at Morningstar Investment Management, tested the 4% Rule under historic return assumptions and then under forward-looking assumptions, illustrating the possibility of Shiller CAPE-based lower returns.

The group confirmed that based on historical data (stocks returning 12%, bonds returning 5% and a CAPE ratio of 16), a portfolio allocation to stocks of roughly 15% or more would have likely achieved a 90% probability or better that a portfolio would survive thirty years paying out 4% adjusted for inflation.

But if future expectations are lowered based on current interest rates (bonds at 2.5%) and the reduced stock returns predicted by today’s above-average CAPE ratio—even if lowered only modestly—the odds of success plummet, barely exceeding 50% no matter how high the stock allocation!

This industry-standard Monte Carlo probability analysis conveys a stunning implication: Using forward-looking assumptions, Bengen’s “the more stock the better” equity recommendation for portfolio reliability may be overstated. Given reduced future returns, it may even court disaster, driving the odds of 60/40 portfolio success down to 56%—or little better than a coin toss.

Figure 34. Projected Success Rates

Looking ahead based on lowered return expectations, Blanchett, Finke and Pfau questioned how a 90% (or higher) probability of portfolio success can be sustained. The answer: Only by reducing the [retrirement] withdrawal percentage in inverse ratio to the equity allocation; in other words, the higher the ratio of stock held in a portfolio, the lower the safe withdrawal rate you should use and the less income you should take.

Chapter 6 Takeaways

  1. Investing involves risk, including, in the worst case, a total and permanent loss of your principal. Past performance is no guarantee of future results. Neither asset allocation nor portfolio diversification guarantee profit or protect against loss in a declining market. Bonds are subject to interest rate risks. Bond prices generally fall when interest rates rise.
  2. The projections or other information generated by Monte Carlo analysis tools regarding the likelihood of various investment outcomes are hypothetical in nature. They are based on assumptions that individuals provide, which could prove to be inaccurate over time. Probabilities do not reflect actual investment results and are by no means guarantees of future results. In fact, results may vary with each use and over time.
  3. It is advisable to understand the risks, rules and ratios embedded in the financial dynamics of modern retirement if you want to avoid failure—regardless of how much money you have at the start.
  4. Former Fed Chairman Ben Bernanke’s “new normal” of very low interest rates has turned many yield-starved savers into return-chasing speculators.
  5. Given current market valuations, the Shiller CAPE and other historical market metrics caution that equity returns over the next ten years or more may be lower than long-term averages might lead us to expect.

Questions for your financial advisor

  1. Do you rely on a Monte Carlo “tool” to project the probability of my (our) retirement success, and does that mean you can manipulate its mathematical assumptions to reflect better or worse outcomes?
  2. Do you counsel your clients to trust that the future is going to be rosy, or do you recommend they plan to withstand the worst while hoping for (and positioned to participate in) the best?
  3. If I’m nearing or in retirement, what initial withdrawal percentage would you recommend to set a floor for distributions from my nest egg?
  4. How did the balanced portfolio you’re recommending perform peak to trough, i.e., from October 2007 to March 2009?
  5. If we get a repeat of that performance at any time over the next ten years, what will it mean for my (our) withdrawals and standard of living thereafter?

 

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If you would like to discuss your personal retirement situation with author Nahum Daniels, please don’t hesitate to call our firm, Integrated Retirement Advisors, at (203) 322-9122.

If you would like to read RETIRE RESET!, it is available on Amazon at this link: https://amzn.to/2FtIxuM

Banks Making Money—For Banks

by M. Nahum Daniels

If you’ve been wondering about the book I wrote, RETIRE RESET!, we are publishing some excerpts right here on our blog so that you can learn more. Along the way, you will learn why our firm, Integrated Retirement Advisors, was founded: we’re on a mission to help people with retirement!

Here are some excerpts from Chapter 5.

Chapter 5: THE MONEY MAKERS

In the aftermath of the Global Financial Crisis (GFC), governments and regulators have recognized that banking practices were not incidental to the global crisis that almost crashed the world into an economic depression; the failings of a fragile global banking system were at its heart. Indeed, a more accurate account of events might depict a “Global Banking Crisis.” So, after 2008, managing “systemic” banking risk became the focus, containing it became the goal, and internal compliance departments burgeoned, while equity, fixed income and commodities trading desks shrank. Banking processes and culture came under the spotlight and the picture that emerged wasn’t pretty. Many observers were shocked to learn that high-powered bankers were rigging global financial markets.

Protected and Privileged 

Criticized for brazen self-dealing, elitist privilege and even criminal misconduct, banking culture has come under increasing scrutiny since the Great Financial Crisis. For malfeasance ranging from manipulating the London Interbank Offered Rate (LIBOR) at which banks lend to each other and to which $800 trillion in global assets are pegged, to price-fixing Credit Default Swaps (CDS), to precious metals and energy trading, dozens of the biggest American and European banks have been fined for restraining competition via secret meetings held by traders to benefit themselves and their institutions.

Years of scandal and allegations of misconduct have taken a serious toll. Battered by an unending barrage of revelations, Americans’ confidence in banks stood at 27% in a June 2016 Gallup Poll, well below the 40% historical average. Whether liberal or conservative, only one in four Americans were willing to say they had “a great deal or quite a lot” of confidence in banks, a level that is unchanged since 2013.

Nevertheless, it’s no exaggeration to say that big banking remains a protected industry and high-powered bankers comprise a privileged elite. Why are we, the people, so forgiving? What exactly do banks contribute to our economy that renders them so essential?

Banks Make Money 

Large banks serve as the repository for the money that greases the wheels of commerce—the wellspring of our prosperity and standard of living—while they manage the global payment system that enables willing buyers and sellers around the world to transact business.

At its core, modern banking is the business of lending. Banks fill the role of financial intermediary between borrowers and savers. From its inception in the Middle Ages to serve the gold trade— storing, lending and issuing banknotes representing deposits held of the precious metal—bank lending was ingeniously built around other people’s money (OPM).

Sound banking practices would have dictated that a banker kept a 100% reserve against demand deposits, holding an ounce of gold in the vault for every one-ounce banknote issued. But bankers realized that they could lend a multiple of all the gold money deposited by their lenders by creating a multiple of banknotes against the same reserves, then keeping 100% of the interest charged on the overage.

US financial history is littered with banks that failed due to a mismatch of fractional reserves to depositor claims when poor judgment and/or bad business conditions caused losses from nonperforming loans. This is what happened during the great banking panics of 1893, 1899 and 1907. And it’s exactly what happened during the Great Depression. The stock bubble collapse in 1929 and ensuing margin calls led to the liquidation of $20 billion of bad bank loans extended during the previous debt bubble, about half of which ($9 billion) was stock market margin loans. This liquidation was followed from 1931 to 1933 by four waves of bank runs.

The Federal Reserve System: America’s Central Bank 

The Federal Reserve System had a far more modest purpose than it does today when it was first launched in 1913. It was originally designed to serve the public interest and maintain financial stability by heading off the recurrent financial panics that a less unified banking system had suffered previously.

Starting in the 1980s, the Fed began to grow into its much larger, current role as accommodating buyer of government debt and comanager of the nation’s economy. It was at this time that deficit spending took off. The Federal Reserve System has since become a principal agent of government; by buying federal debt, it has enabled politicians to spend without taxing. Unlike all other central banks, however, and despite appearances, the Fed is not an agency of government. It is privately owned and operated by its member banks.

The complex product the central banking system offers is credit. Credit is first a measure of worthiness. It is also a byproduct of leverage because it is derived as a multiple of other people’s savings. Above all, credit can be monetized; like currency, it is a form of money that has its own financial reality. Banks turn credit into money by issuing debt. The reality is that banking does not “print” money into being, it “lends” money into being. In an ingenious feat of financial engineering, banks create money when they lend wealth that they themselves have borrowed!

Debt 

For lenders, sound debt is good and the more of it that is outstanding, the better. The good news for lenders is that these are boom times for debt.

Dr. Ben Bernanke was Fed chairman in 2008. His response to the Great Financial Crisis / Great Recession of 2008-09 was three rounds of Quantitative Easing (QE), creating money to buy government and federal housing agency securities for the Fed’s balance sheet, while releasing reserves to member banks at little to no cost. Bernanke admitted that while Quantitative Easing was consistent with Monetarist theory, it was still only “an experiment,” but central banks around the world still followed headlong and did the same.

 

     “Central banks launched the huge social experiment of quantitative easing (QE) with carelessly little thought about the side effects.”

     ~William White, PhD Ex-Chief Economist,

                        Bank for International Settlements

 

Integral to loosening the money supply and making loans cheap, Bernanke initiated ZIRP, the Zero Interest Rate Policy. ZIRP set the interest rates over which the Federal Reserve had control at close to zero.

Unfortunately, these rates also set benchmarks for interest paid on customer deposits, driving rates down to a pittance and crushing your savings’ earning power. The financial fortunes of risk-averse retirees would have to be sacrificed—and their tolerance for risk challenged—for the good of big-time economic actors who could continue to borrow and spend.

The Unintended Consequences for Retirees

It’s critically important to understand how bank policies and actions can adversely affect retirees. Under an economic system fueled by credit, the US and its citizens are indebted like never before. As of 2016, total government and personal debt stood at $33 trillion, most of which was accumulated over the last forty years. In 1980 the debt aggregate was about $3 trillion, of which government debt stood at less than $1 trillion. Today, the US national debt stands at [$22 trillion at the time of this posting] after almost doubling over the last eight years alone. According to the US Department of the Treasury, at the current rate, federal debt could double to $40 trillion by 2030—assuming that trillions in private and government pensions don’t implode and need to be bailed out by the federal government, thereby taking on even more debt in the process.

According to MarketWatch, by the end of 2016 Americans carried more debt (including consumer debt, mortgages, auto loans and student loans) than before the financial crisis. As US incomes have remained stagnant for decades, we’ve substituted debt for earnings in what some have come to call “debt-serfdom.”

How might all this debt affect you? First, you may carry mortgage or educational debt (your children’s or grandchildren’s) and/or consumer obligations into retirement. Second, you may have to contend with a significant rise in the real cost of living during your retirement years, an inevitable byproduct of the Federal Reserve’s tireless money creation. Third, as a saver, the Fed’s zero-rate policy will challenge you to earn a safe return on your cash. Finally, as an investor, you may face decades of low returns—nominal and real— driven by slow growth in the underlying economy and exacerbated by a little-understood process known as “financial repression.”

The bottom line? Investors need to recognize the potential risks imposed by a banking culture that serves its own purposes, but that is not particularly focused on the needs or future wellbeing of America’s retirees.

Chapter 5 Takeaways 

  1. In today’s financial world, bankers serve government borrowers, with both borrower and lender believing that national economic wellbeing depends on their collaborative market interventions.
  2. As credit-issuers, the banks serve as intermediaries that leverage fractional reserves to stimulate economic activity by literally creating money through the lending process itself.
  3. The Federal Reserve System, our “central bank,” was established in 1913 to mitigate liquidity pressure on banks. After 10,000 banks still failed during the early phase of the Great Depression, the Federal Deposit Insurance Corporation (FDIC) was introduced to serve as an additional layer of depositor protection to tamp down the public’s tendency to panic.
  4. Some of the unintended consequences of modern banking practices include wealth inequality, monetary inflation, excessive debt burdens on households and governments and manipulated rates that favor borrowers at the expense of savers.
  5. While the Fed sees its mandate today as protecting the international strength of the US dollar and interacting with our economy to help it achieve full employment and broad-based prosperity, our banking system does not shoulder a specific mandate to provide financial security to America’s retirees and, in fact, some of its actions may actually prove inimical.

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If you would like to discuss your personal retirement situation with author Nahum Daniels, please don’t hesitate to call our firm, Integrated Retirement Advisors, at (203) 322-9122.

If you would like to read RETIRE RESET!, it is available on Amazon at this link: https://amzn.to/2FtIxuM

 

The Perils of a Volatile Stock Market

 

                      The emotions of investing have destroyed far more potential investment return than the economics of investing have ever dreamed of destroying.

                          ~John Bogle Founder, Vanguard Group

 

If you’ve been wondering about the book I wrote, RETIRE RESET!, we are publishing some excerpts right here on our blog so that you can learn more. Along the way, you will learn why our firm, Integrated Retirement Advisors, was founded: we’re on a mission to help people with retirement!

Here are some excerpts from Chapter 4.

Chapter 4: MINDING YOUR BEHAVIOR

My first stock market crash began at the opening bell. Recently minted, I was a “financial advisor” for just over a year when Black Monday unfolded. What a day October 19, 1987 proved to be. Starting in Hong Kong and blowing through Europe, a chain reaction of market distress sent world stock exchanges plummeting in a matter of hours. As described by Donald Bernhardt and Marshall Eckblad in their report to the Federal Reserve Bank of Chicago, there was no sanctuary. In the United States, the DJIA dropped 22.6% in one day’s trading, and over three consecutive trading days back then, the S&P 500 lost a combined 28.5% of its value.

I took calls that day from panicked investors who were in the process of moving their pension assets to my supervision. Unable to get through to their brokers with sell orders, they were seeking my assurance that all would not be lost forever. Of course, even if their brokers had taken their calls, the sheer number of sell orders that day vastly outnumbered buy offers anywhere near previous prices. That lack of liquidity—i.e., the absence of buyers—in the face of panic selling is what gave rise to the downward cascade in stock markets in the first place.

This crash was different because it was truly a global event. For the first time, it brought home to American investors—including many baby boomers entering their prime earning years and just starting to invest—the interconnected nature of markets around the world. Donald Marron, chairman of Paine Webber, a prominent investment firm at the time, underscored the new reality: “Nowhere is that (inter-relatedness) exemplified more than people staying up all night to watch the Japanese market to get a feeling for what might happen in the next session of the New York market.”

In retrospect, there was no need for panic. In fact, according to the follow-up Brady Presidential Task Force report, panic selling was estimated to have needlessly cost investors $1 trillion. But in the moment, facing a financial loss of unknown magnitude, fear overtook rational thought, statistical analysis, and probability modeling. Under severe stress, many investors tend to react irrationally—often to their own detriment.

Our Financial Ticks 

Classical economic theory developed in the 18th Century proposed that human beings are rational, marginal-utility-seeking creatures who make financial decisions based on ice-cold calculation. But starting in the 1970s, a more contemporary school of economics emerged, focused on the study of measurable behavior when real people make real financial decisions. Working separately at Chicago, Princeton and UCLA, professors of psychology Richard Thaler, Daniel Kahneman and Shlomo Benarzi inaugurated the field of behavioral finance. Combining finance and behavioral science, its goal was to identify the emotional, psychological, and cognitive factors that shape real-time human financial choices in an effort to improve outcomes.

Kahneman recognized the roles emotion and intuition play in people’s decision making. He proposed a framework of “two minds” to describe the way people make choices: the intuitive mind forms rapid judgments without conscious inputs, and the “reflective mind” is slow, analytical and requires conscious effort. Aware or not of our cognitive biases, we are their prisoners. They’re like ticks. We have no conscious control over them. In fact, they control us.

When it comes to our finances, fear of loss—loss aversion—is said to be at the core of our biases, dominating our decision-making and behavior. Scientific studies have shown that people display a hyper-negative response to potential loss in all its forms. Research conducted at Harvard found that for the average person, losses hurt twice as much as equivalent gains yield pleasure. Researchers at Columbia concluded that retirees are up to five times more sensitive to losses than the average person, so for the people reading this book, losses hurt ten times more than equivalent gains give pleasure!

At the other end of the impulse-spectrum lies greed, the human desire for “more.” In his 2004 Chairman’s Letter, Warren Buffett, considered an investment oracle, advised that “the fact that people will be full of greed, fear or folly is predictable” so if investors insist on trying to time their participation in equities, they “should try to be fearful when others are greedy and greedy only when others are fearful.”

This was Buffett’s acknowledgment that individual investors tend to buy high and sell low precisely because they follow the herd instead of taking a contrarian position. After loss aversion, herding is acknowledged to be the key bias at the root of average investor under-performance. Investors following the herd have historically bought high (out of greed) and sold low (out of fear).

FIGURE 17. THE UPS AND DOWNS OF INVESTOR PSYCHOLOGY HAVE REAL-TIME EFFECTS

Some academics argue that better financial education can enhance investor savvy and strengthen investor resolve to stay invested through market downturns rather than rush for the exits.

Personally, I suffer from a version of what I call “DM Syndrome’—of the magnification variety—and try as I might, I can’t shake it. Black Monday left an indelible mark on me. Knowing that the circuit breakers installed into the stock market’s trading rules after the 1987 crash only limit a one-day index drop to 20%, I ask myself every morning if this might be the day the unforeseeable bears down on us.

Apparently, I am not alone. Writing in the New York Times on Black Monday’s 30th anniversary, Nobel Prize-winning Yale economist Robert Shiller opined that “we are still at risk (of a repeat of the worst day in stock market history)…because fundamentally that market crash was a mass stampede set off through viral contagion…(reflecting) a powerful narrative of impending market decline already embedded in many minds.” In other words, the primary cause of Black Monday, according to Professor Shiller’s research, was not financial or economic in nature. It was a shift in mass psychology fed by rumors gone viral (and that was before we had the Internet to instantly transmit them around the world).

[Recent events in March 2020 have borne this out with the stock market downturn. The coronavirus outbreak is a prime example of a Black Swan—unforeseeable—event that should be mitigated by the retirement portfolio’s design.]

Unlike in 1987, today I am prepared. And I believe my clients are also better prepared to weather market uncertainty, extreme volatility and even a sudden shift in mass psychology. Because the FIA anchoring the stable-core portfolio helps insulate investors from market losses, it can obviate panic, mitigate fear, prevent needless selling, and thankfully, help avoid recriminations. Investors in the FIA-anchored stable-core portfolio can stay calm and clear-sighted, their reflective minds in better control over their intuitive urges.

Chapter 4 Takeaways

  1. The school of behavioral finance illuminates the complex inner workings of our minds when it comes to managing our money under both normal and stressful conditions.
  2. Individuals’ decision-making is influenced by built-in behavioral biases that often overwhelm rationality and thereby undermine investment success.
  3. When markets turn back, fear-driven loss aversion can distort rational thinking and test our resolve.
  4. The need for confirmation leads the average investor to buy high, while the dread of bottomless losses induces the average investor to sell low.
  5. According to research firm Dalbar, buying high and selling low is believed to account for the 50% return shortfall suffered by average mutual fund investors when compared to the long-term average performance of the funds themselves.

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If you would like to discuss your personal retirement situation with author Nahum Daniels, please don’t hesitate to call our firm, Integrated Retirement Advisors, at (203) 322-9122.

If you would like to read RETIRE RESET!, it is available on Amazon at this link: https://amzn.to/2FtIxuM

What I Wrote In Chapter 3 of Retire Reset!

 

by M. Nahum Daniels

 

If you’ve been wondering about the book I wrote, RETIRE RESET!, we are publishing some excerpts right here on our blog so that you can learn more. Along the way, you will learn why our firm, Integrated Retirement Advisors, was founded: we’re on a mission to help people with retirement!

Here are some excerpts from Chapter 3.

 

Chapter 3: TIME IS MONEY

Retirement clock management begins with the very first questions posed in the planning process: “When can I (afford to) retire? Can it be sooner, does it have to wait until later or will it be never? And by the way, how long should I expect my retirement to last?”

When a husband and wife aged 65 first visit with me and they’re in reasonably good health, I have to inform them that, statistically, one member of the pair (usually the female) has a 50% chance of making it to age 94 and a 25% chance of making it all the way to age 98. And if she makes it to 98, she has a 50% chance of making it all the way to triple digits, because actuarial science informs us that the longer we live, the better our odds of further survival.

When urging clients to get proactive about their long-term financial planning, I often relate the remarkable story of Dr. Ingeborg Rapoport. It brings home not only the indomitable power of the human spirit, but also the truly amazing advances in human life expectancy that have been achieved over the last century—and continue to be made with increasing velocity.

Dr. Rapoport had already been retired for thirty years when Hamburg University authorities finally gave her a chance to complete her doctoral degree—but only after following all the rules. She would have to stand for an oral exam, questioned face to face by a panel of academics, to defend her original dissertation on diphtheria. The dissertation had been well received when she first submitted it at the tender age of 25, but she was blocked by the Nazi regime from completing the process because her mother was Jewish. Although she went on to enjoy a professional career in neonatal medicine she always felt unfairly deprived and, after 77 years, wanted to right what she felt was an injustice.

Now nearly blind, it was only with the help of friends that she was able to catch up on developments in diphtheria studies during the intervening decades. Dr. Rapoport passed her exams with no age-based indulgences and was finally awarded her degree in 2015, becoming the oldest person ever to be awarded a doctorate, according to Guinness World Records. She was 102.

And that’s the point: Underlying successful retirement planning at any age today is an appreciation of contemporary developments in longevity. No matter your starting point, if you’re in reasonably good health you’re advised to play the long game.

 

Most retirees are naively complacent about longevity risk

The wealthier and better educated the individual, the more life expectancy improves. If, as frequently happens, one spouse turns out to be 10 years younger when the primary earner reaches full retirement, then to be prudent we should be planning for a 45-year joint cash flow—ideally adjusted for inflation to preserve its purchasing power.

Portfolio design follows on from that core purpose. Thus, our first objective is to figure out how to guarantee a lifelong cash flow to replace previously earned income in amounts sufficient to match your expenses.

In an inflationary environment, time reduces money’s worth and therefore accelerates its use. In a deflationary environment, time enhances money’s worth and defers its use to another day when it will buy more. The longer the time horizon in which these forces play out, the more pronounced the antagonistic outcomes. Thirty years of inflation at 3% results in a 60% loss of buying power; three decades of compounding 3% interest can produce a 140% increase in buying power. That’s a 200% spread, making this a battle that is absolutely worth fighting.

 

Sequence of returns risk

If you think that an “average return rate” tells you anything about retirement investing, you haven’t seen the effect that sequence of returns can have on a portfolio.

 

Figure 10 illustrates S&P 500 total returns generated over the 20-year period from 1989-2008. The average return over the period was 8.43%. The first thing to notice is that no single year actually produced a return equal to the average; returns ranged from losses as great as -37% to gains as high as +38%. If we reverse the sequence, the average annual return remains the same.

Figure 11 shows what happens when a retiree starts pulling money out of their portfolio at a rate of 5% per year for retirement income. The clockwise sequence (based on S&P 500 from 1989-2008 from Figure 10) left a theoretical retiree with a $3.1 million asset pool at the end of twenty years available for spend-down over the next 20; the counter-clockwise sequence would have left the same retiree with a miniscule $235,000 that would have to be stretched over a decade or two!

 

Chapter 3 Takeaways

  1. Retirement planning starts with assuring that your nest egg (with or without inputs from other income sources) serves as a personal pension guaranteeing you the paychecks you’ll need for 30-40 years after you stop working.
  2. As an investor, you need to understand that time is of the essence and that playing the long game means hedging against numerous long-term cyclical risks decades in advance of their possible impact.
  3. Once you begin to spend down, retirement success depends more upon the sequence of returns you earn than the annual magnitude of those returns.
  4. To make your nest egg last for the long run, best practice is to focus on avoiding sharp losses rather than seeking high returns.
  5. True compounding will yield a more predictable outcome than the generation of random market returns that can offset each other, reduce the net result to zero (or less) and waste your precious time.

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If you would like to discuss your personal retirement situation, please don’t hesitate to call our firm, Integrated Retirement Advisors, at (203) 322-9122.

 

If you would like to read RETIRE RESET!, it is available on Amazon at this link: https://amzn.to/2FtIxuM

 

 

Nahum Daniels Joins Jon Dwoskin On His “Think Business” Podcast

 

Nahum Daniels was interviewed recently by Jon Dwoskin on his THINK BUSINESS* podcast. You can listen to the entire podcast here: https://jondwoskin.com/2019/11/jon-dwoskin-interviews-nahum-daniels-certified-financial-planner-integrated-retirement-advisors/  THINK BUSINESS* is Jon Dowskin’s 1:1 in-depth and soulful conversations with executives, managers and sales people who are making a difference in their companies, communities and in themselves.

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Here are a few of the points made during the interview:

“I’ve been an entrepreneur all my life,” says Nahum Daniels. “I was originally in the publishing business. Early on in my career, I spent seven or eight years living in Japan. That was back in the 1970s, and I published a book which was at that time considered to be “alternative lifestyle” focused. The book was called The Book of Tofu, and it ended up changing everything in the American food retail industry. Today, you’ll find multiple types of tofu sold in every grocery store; you can’t escape it. But back then, prior to the book, no one even knew what tofu was.”

“That’s the power of the written word,” Nahum continues; “It can change an entire culture.”

Nahum spent more than a year writing his book, Retire Reset! What you need to know and your retirement advisor might not be telling you.

In the early 1980s, Nahum met Bill Gates through one of his Japanese business contacts. He ended up working for Microsoft, before it was a public company, back when it was a small start-up. At that time, PCs were just being launched, and computer books were extremely technical, complex and filled with jargon. It was Nahum’s task to revamp the books’ content and design to appeal to consumers as Microsoft set out to lead the way in the personal computing industry.

As a business mentor, Nahum found Bill Gates to be a very focused leader. “He totally concentrated on the people he was working with, and was highly-attuned to both their needs and his business objectives. He was at the leading edge of innovation and had a view of what the future looked like,” Nahum explains.

“Bill is a very unique individual. By the time he reached high school, he was spending the majority of his time programming and coding. At a very early age, he had a sense of the tremendous power of the personal computer. He wanted to make sure the future happened; he was out to reshape the world and he wasn’t afraid to be an entrepreneur or leader,” says Nahum.

Later on, Nahum Daniels moved from book publishing and personal computing into financial world, specifically retirement planning. But he found himself writing and publishing again [the book, Retire Reset!] when he realized how much complacency there was in the financial industry around the subject of retirement.

“Since the 1990s we’ve been taught by the financial industry that retirement planning involves investing in a mix of stocks and bonds comprising a “balanced portfolio” and expecting the best. Standard performance expectations for securities or stocks range from 9-12% returns per year, while bonds are expected to return 4-5% per year.”

“I make the case in my book that we may be facing a span of a decade or more of extremely low returns, much lower than these projections,” says Nahum.

“People need to spend more time focusing on this. We need to learn to see the alternative scenarios that might unfold, and adapt and hedge against them, achieving financial objectives even if lesser returns materialize going forward. This is essential to retirement planning and portfolio construction specifically for retirement.”

“We need to reorient. People are living much longer, but Americans think short term—only to the next month or quarter,” Nahum continues.

“Retirement planning is all about thinking 50 years down the road.”

“Even most financial advisors have not really made a scientific study out of how to create a portfolio that works this long, which puts us at a disadvantage. With interest rates dropping lower—getting close to zero, or even negative like Germany or Japan—we can’t get yield or income from our assets. How will we have enough cash flow without spending down our capital?”

“Writing my book allowed me to study the industry icons who have analyzed markets and done in-depth research on returns. They have uncovered options and they’ve run the calculations to show that some alternatives to the stocks/bonds scenario may perform better for retirees through time. That’s what I help people with.”

 

Rethinking Your Retirement Investing To Hedge Against A Market Downturn

 

Rethinking Your Retirement Investing To Hedge Against A Market Downturn

Studies show most Americans aren’t saving enough for retirement. A recently-released World Economic Forum report warned that most retirees risk running out of money as much as a decade before death. And the anxiety of being ill-prepared for the golden years can grow when portfolios do not, leading some advisors to recommend over-weighting stocks to provide the impetus for long-term growth.

Retirement planner Nahum Daniels thinks the risk-reward trade-off of investing a retirement nest egg in stocks and bonds can result in even more worry. And, given a bad sequence of returns -coupled with the fact that people are living longer than in previous generations -many retirees could run out of money faster.

“Psychologically, we’ve grown confused about the financial dynamics of retirement,” says Daniels (www.integratedretirementadvisors.com), author of Retire Reset!: What You Need to Know and Your Financial Advisor May Not Be Telling You. “Since the early 1990s, when the 401 (k) replaced the defined benefit plan in corporate America, there’s been a fundamental shift in perception. When retirement was pension-based, planning was about guaranteed income and the employer had to keep the promises it made. Today, participants in 401 (k) plans have to know about stocks, bonds and ‘Balanced Portfolio’ management because they’re responsible for their own unpredictable outcomes.

“Ironically, centering a retirement portfolio on Wall Street’s securities-driven risk/return tradeoff may actually be a formula for an even more insecure retirement. The reason is the cyclical volatility inescapable in equity markets. Nor are bonds immune from losses: The Fed’s rate manipulations, coupled with our nation’s current $75 trillion debt overhang, introduces an abnormally high level of volatility to bond prices. The real crisis in retirement planning is not just our savings shortfall but our misguided mindset; we need a perceptual shift about what our real goals are and a tactical reset to reach them.”

 

Daniels offers four principles to reset a retirement portfolio and hedge against a market downturn:

  • De-risk. Whether in the accumulation or spend-down phase, the retirement nest egg cannot afford market losses without eventually paying out less. “Insulate your nest egg from them and guarantee the outcome when you can,” Daniels says. “It’s unnecessary to resign yourself to self-imposed austerity to accommodate market volatility.”
  • “Size your nest egg as efficiently as possible by optimizing the sustainable yield it can generate,” Daniels says. “Work it back from your income need. For example, if your nest egg supports a withdrawal rate of 5 % rather than 3%, you can achieve your goal with 67% less capital.”
  • Daniels says the latest academic research favors the integration of actuarial science with investment expertise in the construction of a “stable-core” retirement portfolio. “Longevity insurance has a heightened economic value in an era of open-ended life expectancy,” Daniels says, “while historically no asset class beats equities for long-term growth potential. Balancing the two is key to getting the best result and hard-boiling the nest egg.”
  • “Today’s fixed index annuity (FIA) lends itself well as the actuarial component of a retirement nest egg,” Daniels says. “Anchoring a stable-core portfolio to it can protect against market declines while still participating in a needed share of upside potential.”

 

“Buying and selling securities at all the wrong times can increase the odds that you run out of money,” Daniels says. “Retirement investors need a form of protection that can keep them invested without costing so much that it devours their return in the process.”

 

About Nahum Daniels

Nahum Daniels (www.integratedretirementadvisors.com) is the founder and chief  investment officer of Integrated Retirement Advisors, LLC. He is the author of Retire Reset!: What You Need to Know and Your Financial Advisor May Not Be Telling You. A Certified Financial Planner and Retirement Income Certified Professional, Daniels has served mature investors for over 30 years.

How An FIA Can Replace Bonds As Your Hedge Against Volatile Rates

 

How An FIA Can Replace Bonds As Your Hedge Against Volatile Rates

Interest rates heading to zero or below in the United States, following the pattern set in Europe and Japan, will only make it harder for most nest eggs to do their job. They could also foreshadow low returns across most major asset classes, making both wealth accumulation and retirement-income generation harder to achieve. With the bellwether 10-year Treasury note bouncing around 1.5% and the 30-year Treasury bond hitting all-time lows under 2%, all fixed income yields are expected to trend lower. If governments and high-grade corporates start paying little if any interest, they will contribute less and less cash flow to a “balanced” retirement portfolio.

On the other hand, were rates ever to normalize, longer-dated bonds would suffer a capital loss, undermining the other role in Wall Street’s policy portfolio played by bonds as a counterbalance to the volatility of stocks.

Keep in mind that the shrinking 10-year rate is also the key metric for appraising asset value and risk. Zero and/or negative rates may initially boost asset values, but longer term, the next round(s) of rate reductions may trigger a major reset in equity, bond, and real estate values, already considered on some measures to be inflated.

A strong argument can be made that retirement investors are living through a systemic paradigm shift and that the resulting uncertainty should focus them on the potential utility of hedging. Recent academic research agrees that investors in or near retirement can benefit from reallocating their nest eggs not between stocks and bonds but by integrating equities with longevity insurance.

Today, the Fixed Index Annuity (FIA) stands out as a rapidly evolving form of longevity insurance designed to anchor a retirement portfolio. Independent research, most notably under the auspices of Yale School of Management Professor of Finance Emeritus Roger lbboston, makes the case that the right FIAs can complement or even replace bonds in the nest egg, adding as much as 1 % to 2% of excess annual return – or even more in a low-rate environment. Add to that excess return the 1 % to 2% a year that actuarial science can contribute in the form of “mortality credits” and we can start to breathe a little easier.

 

Long-term pros may outweigh the cons

It’s important to note that the FIA is complex and has been characterized as such by the Securities and Exchange Commission, the National Association of Insurance Commissioners, and the Financial Industry Regulatory Association. Any guarantees are backed solely by the financial strength and claims-paying ability of the issuing company and the instrument offers varying levels of access during a gated surrender-charge period. Thus FINRA rightly stresses that investors do their due diligence when choosing among advisors before deciding whether a certain FIA is right for you.

The effort may well be worth it. Emphasizing downside protection, the FIA aspires to deliver steady mid-single-digit returns -without exposing the policy’s accumulated value to market volatility.

Because FIA performance is linked to a market index stripped of its downside risk, Wall Street’s risk-return formula trades off some of the index’s upside potential.

Those trade-offs take the form of caps and participation rates quantified by the investment banks serving as an insurer’s counter-parties. Accepting less upside to avoid market losses and stabilize returns is the price investors have always paid to hedge, and it’s up to each of us to judge whether it’s a price worth paying in the FIA.

 

Nahum Daniels is the founder and chief investment officer of Integrated Retirement Advisors, LLC., a Registered Investment Advisor in the State of Connecticut. He is the author of Retire Reset!: What You Need to Know and Your Financial Advisor May Not Be Telling You. A Certified Financial Planner and Retirement Income Certified Professional, Daniels has served mature investors for over 30 years.

Retirement Guidelines for Millennials

Millennials looking to retire at age 65 have thirty to forty years to prepare and another thirty to forty years to provide for.  Here are some guidelines we use in our practice:

 

Acquire discipline: set aside 10% of disposable income to the retirement nest egg.

Open your eyes:  Retirement investing is intended to ultimately generate decades of income in the distant future to sustain unprecedented longevity.

Learn patience: the nest egg should be “put to work” by compounding consistent gains; aim strategically for singles and doubles rather than swinging for the bleachers.

De-risk:  Market volatility and realized losses, especially early in the accumulation or spend-down phase, can undermine the best-laid plan and the ability of the nest egg to achieve its long-term income objectives, so avoid them.

Seek shelter: The retirement portfolio should be insulated from rising taxation, the most consistent drag on growth especially for Millennials who may face higher taxes than their forebears.   It should therefore be “nested” in IRAs, Employer qualified plans, deferred annuities and cash value life insurance to provide the needed tax shelter.

Hedge:   Invest the nest egg for the long term insulated from downside risk but positioned to share in the market’s upside potential.

Diversify:  Another key to long term investment success, diversify across asset classes in terms both of tactics and strategy.

Think outside the box:  Explore the economic advantages offered exclusively by actuarial science rather than limit yourself to conventional stock-and-bond investing.

Integrate:  learn how next-gen longevity insurance can complement securities in a retirement portfolio to achieve more predictable results.

Consider the alternative:  Evaluate the multi-faceted fixed index annuity (FIA) and the role it might uniquely play as a retirement portfolio’s stable core.

 

The Solo 401k

 

  1. The solo 401k is ideally suited for successful Millennials setting themselves up as single-employee businesses making enough money in the “gig” economy to start thinking seriously about tax-advantaged saving for retirement. The 2019 maximum deductible contribution of $56,000, possibly doubled by a contribution for an eligible spouse working in the business—no matter the ages of the plan participants—can be a powerful incentive to get serious about the long-term future.    Of course, the solo 401k can be useful for older GenXers too and even for Baby Boomers who have become consultants to the corporations and/or industries that have laid them off as full-time W2 employees.

 

  1. Whenever the right fact pattern presents, Integrated Retirement Advisors quick to recommend this plan. The key is for the business owner to be making enough money to take advantage of the plan’s generous capacity and low-cost simplicity. Another determinant is the expectation of doing so in future without the need to hire employees.  Once employees (other than a spouse) enter the picture, the solo 401k plan must be converted to a standard employer plan that gets more complicated (due to non-discrimination testing) and more expensive (due to additional operating and administrative costs).  Of course, every contribution to a solo plan can incent and boost a retirement investing effort, so even setting one up for a few years while a business scales up can be very advantageous.

 

  1. Limited access to the plan’s accumulating account is probably the greatest drawback to this arrangement.  Like any tax-qualified plan, once a contribution is made access to the funds is limited by IRS regulations.   Withdrawals before age 59-1/2 are subject to income tax plus a 10% premature withdrawal penalty.  Solo plan loans of up to $50,000 can be taken, but they’re tax-inefficient and must be repaid with interest over five years.  If they default, they too can generate early withdrawal penalties.

 

  1. In terms of investment, the more diversified and flexible the platform, the better. Providers come in a variety of shapes and sizes.  The big brokerages offer prototype plans that may limit their offerings to stocks, bonds, funds and ETFs.  Some securities boutiques offer self-directed plans that provide access to real estate, precious metals and other alternatives, including bitcoin!

 

  1. We make it a point to inform clients that 401k plans, including the Solo variety, permit insurance contracts as investments. Today’s fixed index annuity (FIA) can provide market-linked growth potential together with downside protection, a combination that lends itself well to long-term compounding. Integrated with securities, these contracts can help de-risk a retirement portfolio without necessarily imposing an unbearable opportunity cost.  Roger Ibbotson’s recent research suggests they’re worth considering as a bond alternative.

 

  1. Life insurance is also a permissible alternative in a Solo 401k plan. When permanent coverage may be needed for personal and/or business reasons, funding it pre-tax in a 401k plan can prove very cost-efficient.  Given enough time, index-linked life contracts can provide temporary protection together with investment growth. Once the protection feature is no longer needed, the contract can be surrendered for its cash value that is then added to the account’s aggregate holdings.

What Is An Annuity?

An annuity is first and foremost a stream of payments.  For most retirees, the payor is an insurance company.  Properly regulated, an insurer can “guarantee” the payments it promises; in fact, if an insurer gets into trouble, annuitants in payout status are considered senior creditors, i.e., they get paid first—even before the rent.

Annuities can pay for a specified number of years or for a lifetime or two, which given today’s extended life expectancies, can be open-ended.  Today’s extended life expectancies gives actuarial science enhanced economic value when it comes to providing a return on investment:  an annuity can yield more from the get-go if average life expectancy is assumed while the longer an annuitant lives, the more payments received, the greater the IRR.  So annuities are best purchased by people expecting to live into their nineties– or even beyond—who don’t want to worry about running out of money no matter how long they survive.

In a traditional fixed annuity, the insurer invests in mostly investment-grade fixed income instruments to match its assets to its liabilities.  Based on its projected earnings (usually reflecting the yield on the US ten-year Treasury) and its projected expenses, it shares the blended yield on its portfolio holdings with the annuitant, paying a fixed return for the guaranteed duration.  The purchasing power of that fixed return will be eroded over time by inflation, which is a key drawback to this structure.  The payout, however, remains unvarying, unless you buy an inflation “rider” which increases it year to year based on some measure, but inflation riders tend to be expensive and depress the initial payout level.

A variable annuity also offers an income that will never run out, but the insurer invests the policy-owner’s premium in equities.  The objective is to generate a higher level of income over time, but the income payout is subject to market risk and can either increase or decrease from year to year.  The potential to decrease—possibly requiring “belt-tightening” and a reduced lifestyle that can end up being permanent—is the biggest drawback to this structure.  A poor sequence of market returns can end up undermining the income floor most annuities are intended to provide.

The fixed index annuity is a relatively new hybrid.  Like a fixed annuity, it guarantees an income floor from inception.  But unlike a traditional fixed, its earnings are linked to one or more market indices and those earnings can be applied to the annual income payout to establish a higher floor from year to year.  If markets are favorable, the annuity income can increase and those increases are rendered permanent; unlike a variable annuity, the income yield doesn’t suffer even if markets have a bad year or two.

The older an annuitant, the higher the initial payout of any income annuity.  So the traditional fixed can be very advantageous for retirees in their 80s.  They should shop for the highest payouts being offered by the better-rated companies and consider a portfolio approach.  The deferred fixed index annuity lends itself well to investors approaching or just entering retirement, say between ages 55 and 75, aspiring to give inflation a run for its money over the long term without taking a hit on the initial payout once begun and risking income reductions if markets decline.