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Retirement Investing

 

Retirement Investing

Although we’ve been led to believe otherwise, retirement investing should not be defined in terms of the “total return” approach embodied in Wall Street’s “balanced portfolio” of stocks and bonds.

While suitable for institutional investors with very long time-horizons that can eventually absorb and recover losses, the retirement “nest egg” should be constructed to generate income to last a lifetime rather than to out-smart the market by out-performing its averages. That’s a very different design goal that requires a very different approach to portfolio construction—even in the best of times.

Market volatility and losses undermine a retirement portfolio’s yield or, in the lingo of the industry, its sustainable withdrawal rate. Earlier studies posited 4% as a “safe” rate of withdrawal (adjusted annually for inflation) that limited to 10% the odds of running out of money after thirty years. With the growing  prospect of outliving a 30-year retirement and with markets priced at historically high valuations on a dozen of metrics, retirement academics have tested the norms and have concluded that today  the prospect of future losses limits a “prudent” withdrawal rate to 2.8% if you want to minimize (but still not completely eliminate) the risk of premature depletion. That means you will need 43% more capital at inception to get the same result.

Ouch.

Of course, retirees may choose to withdraw what they need from their nest eggs (most do) and only tighten their belts later when market trends make it necessary. Or they may simply risk premature depletion (every retiree’s worst nightmare) figuring they’ll end up depending on the state or their children in later years or, if they’re lucky, dying before the piper must be paid.

So whether in the short term or the long term, retirement-portfolio losses that are unlikely to ever be recovered will require sacrifice in the form of lifestyle compromises. Hence the first rule of nest-egg construction is to avoid them. The challenge is to devise an efficient nest-egg portfolio with zero downside risk that doesn’t also abandon the potential for needed growth.

In our practice, we often overweight the fixed index annuity (FIA) to serve as the anchor of a “stable-core” strategy. Leveraging actuarial science, the FIA can yield considerably more from the outset than a balanced portfolio, especially weighed against a “prudent” 2.8% “safe” withdrawal rate, and its cash flow can be guaranteed to last a lifetime or two, no matter how long, eliminating the ever-present dread of depletion often endured by even affluent retirees. In addition, the annuity’s investment methodology protects principal against market declines while still participating to capture a reduced share of upside potential.  The latest academic research in retirement portfolio construction favors this integration of longevity insurance with investment expertise.  That’s why this relatively new hybrid is trending today and worth a careful evaluation.

If you have any questions about your own retirement plan, please reach out to us for a no-obligation consultation. You can reach Nahum Daniels, Integrated Retirement Advisors in Stamford, CT at (203) 322-9122. We look forward to working with you.

Black Swan Portfolio Construction

What Is a Black Swan Event?

Financial professional-turned-writer, Naseem Nicholas Taleb, wrote the book The Black Swan after the 2008 stock market crash. He pointed out an interesting problem with statistical modeling in financial planning.

For most of history, swans were large birds known for their striking, white color. In fact, swans were considered nearly synonymous with the color white for centuries. Referring to a “black swan” meant something completely impossible or presumed not to exist. That is, until 1697, when seafaring explorers discovered black swans in the southern hemisphere of the New World.

Thinking about the discovery of black swans lead Taleb to think of an interesting logic problem—how many white swans would you have to see in order to predict the next one would be black? His answer: You wouldn’t. You didn’t even know they existed, so you would never predict one, no matter how many swans you saw.

Essentially, you don’t know what you don’t know, and so your statistical model may be missing a critical factor in calculating financial projections. You must account for unforeseen black swan events in the construction of the retirement portfolio.

The Ten Principles of Retirement Portfolio Design:

  1. The future is always uncertain and bad things—like fat tails and burst asset bubbles—happen when least expected, so retirees and those nearing retirement should plan to withstand the worst possible economic outcomes while positioned to participate in the hoped-for best. Retirees are therefore well-advised to focus on risk mitigation in addition to asset class diversification, choosing investment vehicles that hedge and minimize risk, especially tail risk.
  2. In an unfortunate turn for current retirees and those nearing retirement, our economy faces serious demographic headwinds. At the same time, tax increases and government-benefit decreases seem inevitable while life expectancy improvements mean a retirement that may last for 30 years or more.
  3. Markets may be extremely volatile during this period and, as in Japan over the past thirty years, entire decades may be “lost.” Between October 2007 and February 2009, for example, the S&P 500 stock index fell over 50% then almost doubled from its low through February 2011. The historical prices tracked by Yahoo Finance reveal that from 2000 through 2009 the broad market index fell over 25% (from 1,469 to 1,074), dealing buy-and-hold investors a loss of capital, time and opportunity. Buying-and-holding in roller coaster-like equity markets can result in entire decades of lost potential growth. Nor is capitulating and moving to the sidelines an adequate response: Most retirees cannot afford to miss snapback opportunities. They need to make money even in bad economic times and, especially, in secular bear markets.
  4. The Federal Reserve can intervene specifically to drive interest rates paid on savings as low as possible and keep them there for as long as needed. This means very low returns on bank deposits, Treasuries and investment-grade corporate bonds for the foreseeable future, driving investors to take on greater and greater risk even in fixed income instruments. But bond markets, including those for government and municipal paper, can be volatile and are not immune to significant losses. In fact, all asset prices may end dramatically lower when Fed intervention ends.
  5. Reflecting adverse demographic trends, slow growth and heavily indebted consumers, a “new normal” of below-average investment returns may have already set in to reduce the weighted average return on a portfolio of 60% stocks/40% bonds to levels below historical averages over the coming decade despite the potential volatility risk which, in effect, will have to be endured uncompensated. A more conservative portfolio consisting of 40% stocks/60% bonds will likely deliver even lower annual returns. In the new normal, the risk/return ratio is not likely to favor the investor, while low returns may necessitate dipping into principal.
  6. Research confirms that the primary risk that must be managed by retirees as they take withdrawals from their accumulated savings is “sequence” risk. Ignored at one’s peril, it reflects not the average return over a period of years, but the sequence of those returns. Some generations are lucky: they retire when share prices are low and cash out as shares rise into a market boom, so their savings can sustain a dream retirement with wealth left over. Negative returns in early withdrawal years can result in shockingly rapid asset depletion: unlucky generations cash out in such declining markets and their savings can be quickly depleted resulting in a nightmarish retirement characterized by insufficient cash flow and painful belt tightening.
  7. Retirement savings by definition are intended to be spent down over one’s life expectancy. They should be distinguished from legacy assets that are intended for wealth transfer to future generations. Historical studies of the past century conducted by Jim Otar have shown that from age 65, a sustainable withdrawal rate offering the highest likelihood of success in lifetime portfolio survival cannot exceed 3.6% per annum. Thus, if you are 65 and need income of $36,000 per year, adjusted for inflation to maintain purchasing power, you should have $1 million set aside to rest assured that you and your spouse won’t run out of money. Taking a higher percentage each year risks premature depletion even in good times; it can be a recipe for retirement disaster in bad.
  8. As advocated by Warren Buffet and other classic value investors, risk-management to achieve capital preservation is the first order of business when it comes to long-term investment success. As a corollary, Buffet-like investors deem it well worthwhile to forego some upside potential (even half or more) to increase stability of principal. This truism is even more fundamental to retirement asset management: Principal protection, stability and liquidity trump maximizing upside performance for core holdings dedicated to providing lifelong income that can grow to keep up with inflation.
  9. Since even bear markets rally and the most astute prognosticator may be wrong, an optimal core portfolio protects against market declines while participating in positive price movements even in extended down markets. Insulating the investor from loss obviates the need for market timing and circumvents the behavioral tendency to buy high, sell low and miss market snapbacks.
  10. In assembling a “core” retirement portfolio, ongoing counterparty risk must be continually evaluated and managed at the lowest possible cost to the investor. The Standard & Poor’s 500 Index (“S&P 500”) is an unmanaged, market capitalization weighted index of 500 widely held stocks, with dividends reinvested, and is often used as a proxy for the stock market and cannot be invested in directly. The term “black swan” refers to very low probability events that are major market shocks able to wreak investment havoc.

Equity Indexed Annuities (EIAs) are not suitable for all investors, but may provide part of the core retirement portfolio designed to help protect retirees from black swan events. EIAs permit investors to participate in only a stated percentage of an increase in an index (participation rate) and may impose a maximum annual account value percentage increase. EIAs typically do not allow for participation in dividends accumulated on the securities represented by the index. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to age 59-1/2 may result in an IRS penalty; surrender charges may apply. Guarantees based on the claims-paying ability of the issuing insurance company.

In all cases, the retirement portfolio should be monitored and adjusted based on market conditions. Alpha measures the difference between a portfolio’s actual returns and its expected performance, given its level of risk as measured by Beta. A positive (negative) Alpha indicates the portfolio has performed better (worse) than its Beta would predict.

Going Where the Research Leads

 

By Nahum Daniels, CFP®, RICP®

 

As a client-facing financial advisor (FA), I view myself as an intermediary whose job it is to communicate in the form of sound, actionable advice the latest findings in academic research and retirement theory unearthed at the institutes and centers of retirement studies. As for my pedigree, I’m a product of The American College of Financial Planning located in Bryn Mar, PA, where I earned its Retirement Income Certified Professional (RICP) designation. Amidst the hundreds of thousands of FA’s in the USA today, there are only 6,000 graduates of this relatively new program, with another 4,000 or so currently enrolled.

I can humbly report that, developed and taught by some of America’s most respected retirement experts, the RICP curriculum is non-trivial. As a CFP practitioner who has specialized in retirement planning for going on two decades, I felt I needed to earn and maintain the designation if only to make sure I wasn’t missing anything. I certainly owed that to my clients and any members of the public who could fall within hearing distance or reading range.

In August 2015, Wade Pfau, PhD/CFA, professor of retirement income in the PhD program at The American College, published the results of a quantitative analysis he painstakingly performed comparing immediate annuities to bond funds in retiree nest eggs. It was entitled: Why Bond Funds Don’t Belong in Retirement Portfolios. Pfau’s findings challenge one of Wall Street’s most fundamental dicta: that bonds provide ballast to a balanced portfolio and should therefore comprise 40% to 60% of a retirement portfolio. Instead, Pfau announced that a classic insurance product, the immediate annuity, is a more efficient, higher yielding and far more reliable alternative. Therefore, he concluded, the retirement nest egg should be invested in a combination of income annuities and stocks!

Building on those findings in a paper presented at the 2018 Actuarial Research Conference, Michael Finke PhD, Dean of The American College, presented the results of a study he conducted with David Blanchett PhD, Head of Retirement Research at Morningstar Investment Management, that calculated the increased stock exposure rendered “prudent” in a retirement portfolio thanks to the guaranteed income provided by insurance in the form of an immediate annuity.

Preconceived investment notions were further challenged in January 2018 when Roger Ibbotson PhD, Yale Professor Emeritus of Finance and the world’s leading authority on asset class performance from 1926 to present, announced the results of a study he conducted on the Fixed Index Annuity (FIA), a relatively new insurance product that helps preserve retirement assets from market losses while linking them to those same markets to capture a share of their upside potential. The FIA, Ibbotson reported, could out-perform bonds, especially in rising-rate environments like the one we’re in, and should be considered, he recommended, as an alternative for bonds in de-risking retirement portfolios.

If you’ve read my book, you know I recommend the FIA serve as the anchor of your nest egg’s “stable core” and that balancing a retirement portfolio today means combining insurance and securities—and not just stocks and bonds—in suitable proportion. Now you know the identity of some of my intellectual antecedents and why I’m proud to bring their message to you. I urge you to heed it.

Retirement Planning in a Nutshell

 

 

Retirement is a unique stage of our lives that at this writing can last a third or more of the years we strut about on this earth. It has its own financial dynamics, different from earlier stages primarily focused on accumulating wealth. Retirement planning is primarily about spending down the wealth we’ve accumulated. That’s why how we manage our retirement wealth, referred to colloquially as our “nest egg,” differs diametrically from investment approaches we may have applied earlier when achieving our other financial goals.

In a nutshell, retirement planning is about generating replacement cash flow. When you stop earning income, those missing paychecks need to be replaced by regular payments from other sources if you want to continue to sustain the lifestyle to which you aspire and/or have grown accustomed.

Thus, in retirement, cash flow is king, but it’s not just any cash flow. To win at the game, retirement cash flow has to meet seven challenging requirements:

1. It must last a lifetime—or two lifetimes if you have a spouse or significant other you care about. But longevity increases with each passing year, so the duration of your retirement income must be open-ended. You simply don’t know how many years you may have.

2. Running out can mean literal ruin, so If you can get it, you want that life-long income to be guaranteed. Say what? What does a “guarantee” even mean in today’s financial world?

3. Retirement income must be impervious to market volatility and losses. The vagaries of global financial markets—including bond markets— must not be allowed to reduce it, because once reduced it’s hard to recover prior levels.

4. Somehow, your retirement income needs to increase to keep up with inflation averaging at least 2% to 4% a year. Without compensating for that erosive force, your purchasing power will lose ground, i.e. you will grow poorer. A fixed income—the same amount paid year in and year out like a pension—simply won’t cut it.

5. Your core income should be at least enough to sustain your desired consumption, i.e., your lifestyle. In our economy, you don’t want to stop consuming. While you can, you need to keep doing so for your own sense of pride; the economy needs you to consume because consumption is its life spring.

6. Ideally, your growing income floor should be reliably under your personal control, pouring out of your properly invested nest egg. This makes you self-reliant. Facing an age of acute uncertainty, you want to be self-reliant.

7. Your core income floor can then be supplemented with cash flow from other sources, like Social Security and a Pension, to create a surplus. If you can see to it, your guaranteed lifetime income should be more than you (think you) need so you can feel free to be generous to yourself and others—without living in constant dread of depletion.

Sounds like a tall order, doesn’t it? That’s because generating “free cash flow” in retirement in the form of guaranteed surpluses is just that. If you think you can do it yourself, good luck. If you’re working with an advisor, make sure he or she knows the real objective and can show you how to achieve it. The good news is that thanks to some of today’s most ingenious financial innovations, it can be done.

8 Things to Do After Retiring Early

 

Keep an emergency fund. Unexpected events can happen at any time, and having a stash you can draw from during a crisis will bring peace of mind. “If you face an emergency without [an emergency fund], you’ll need to tap into your nest egg,” says Nahum Daniels, a financial planner and author of “Retire Reset!: What You Need to Know and Your Financial Advisor May Not Be Telling You.” This could drain your retirement funds much faster than planned. However, if you do have to dip into your long-term savings, talk to your financial advisor to evaluate your options. “Start by withdrawing from the account that has the lowest growth and that will have the least tax impact,” Daniels says.

The Winning Formula

Winning at retirement means playing the long game, the very long game.  Planning ahead, through saving and investing, is essential to fund a “nest egg;” positioning your nest egg to protect it against untimely losses while compounding adequate returns secures it; eventually  converting your nest egg into a personal pension focused on maximizing lifetime income gets you to the finish line.

As true as the foregoing formula may be for males, it’s even truer for females. As a rule, women outlive men.  That’s why when we dig deep we discover that retirement planning is really about providing for spouses and significant others.  That was certainly the original intent of the Social Security program when it was initiated in 1934; its purpose was to protect survivors from destitution rather than to sustain workers on a decades-long golf outing.  Alas, improvements in life expectancy and the unbridled generosity of politicians building a welfare state have transformed the Federal government into a huge insurance company—with taxing power and a standing  army.

Which brings us to one of today’s greatest headwinds facing contemporary baby boomers.

I’m referring to our national debt and its service.  Both the debt itself and the cost of maintaining it are unprecedentedly high and persistently growing.  What’s often  missed in their exposition are the threats they pose specifically to retiree security.

So allow me a few words on the subject (for more cf. Chapter 5, “The Money Makers,” in my new best seller, Retire Reset!).  At this writing, our national debt stands at $21 Trillion and according to the Congressional Budget Office long-term outlook released in July 2018, the GOP tax cuts and bipartisan spending increases enacted in Fall 2017 will add at least $2.3 Trillion in the next ten years, and possibly as much as $5.1 Trillion (not counting extraordinary expenses that might be imposed by new wars, financial crises, an economic downturn, municipal pension failures or natural calamities).   What will be the impact on retirees over the next 15 years?  The Medicare Hospital Insurance Trust Fund is projected to run out in 2026 followed by the Social Security Trust Fund in 2032.  Those effects mean materially reduced benefits—unless of course the federal government comes to the rescue with emergency funding.

But here’s the rub.  Reduced government revenue combined with increased government spending also means growing annual deficits. In fact, the deficit could reach $1 Trillion as soon as next year and certainly not long thereafter. The big question is with short-term rates still just around 2%, what happens when they reach the mid-3% range, which the Federal Reserve is preparing us to expect?  Interest payable at 3.5% on debt of $25 Trillion will amount to $1 Trillion in and of itself. Interest payments as a percentage of the federal budget will grow, crowding out other expenditures including federal assistance to states and funding for social safety net programs. Where are the Social Security Rescue Funds supposed to come from especially if Washington will also be called upon to bail out failed municipal and state pensions?

To be counted among retirement’s last winners, you’re going to need to be self-reliant, confidently invested in a properly diversified nest egg prudently balanced between insurance and securities.

Learning how to shift your focus on portfolio balance is your indispensable first step.  Take it now.  Time is of the essence.

How to Deal With a Financial Emergency in Retirement, US News & World Report

Make smart, careful moves to cover unexpected expenses in retirement.

LIFE EVENTS LIKE A natural disaster, health crisis or expensive home repair have one factor in common: They come when you least expect them. Most Americans (55 percent) worry about what they would do when faced with a financial emergency, according to the 2018 Northwestern Mutual Planning & Progress Study. And stress levels only increase if you are on a fixed income. “Unexpected and uncovered emergencies can literally ruin a retirement plan,” says Nahum Daniels, a wealth advisor in Stamford, Connecticut.

If you’re retired and facing a financial emergency, here are some of the best approaches to gather funds, cover the costs and move forward without going into debt.

Tap easy-to-access funds. If you have an emergency fund, now is the time to use it. When gathering additional sources of cash, check for accounts that are simple to access and won’t have a hefty tax impact. “If you have money in a savings account at the bank, start withdrawing from that before you tap your IRA,” Daniels says.

 

Visit the full story link here: https://money.usnews.com/money/retirement/articles/2018-07-11/how-to-deal-with-a-financial-emergency-in-retirement