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Huebner School SeriesHS 353 STUDY OUTLINERetirement Income Process, Strategies, and SolutionsDavid A. LittellKenn Beam TacchinoSG353-1
Section 1: Approaches used to convert retirement assets into retirement income .............. 6.1Section 2: <strong>The</strong> systematic withdrawal approach.................................................................. 6.8Section 3: <strong>The</strong> bucket approach ........................................................................................ 6.15Section 4: <strong>The</strong> essential versus discretionary (flooring) approach .................................... 6.21Section 5: How the approaches mitigate risks ................................................................... 6.23 7 Integrating approaches, risks, products, and strategies to create an effectiveretirement income plan.................................................................................................. 7.1Section 1: Retirement Income Products .............................................................................. 7.1Section 2: Applying Products ............................................................................................. 7.18Section 3: Practical Application.......................................................................................... 7.23Section 4: Monitoring and Adjusting the Plan .................................................................... 7.28Section 5: Case Studies..................................................................................................... 7.33Resources for Competency 7: Integrating approaches, risks, products, and strategies tocreate an effective retirement income plan .......................................................... 7.36v
THEAMERICANCOLLEGE.EDUThrough <strong>The</strong> <strong>American</strong> <strong>College</strong>'s web site, theamericancollege.edu, students can accessinformation on a variety of topics including:• General Information on Courses: Course descriptions, chapter or assignmenttopics, and required study materials for all Solomon S. Huebner School,Richard D. Irwin Graduate School, and the <strong>Center</strong> for Financial AdvisorEducation courses are listed. For quick reference, visit the designation guide athttp://www.<strong>The</strong><strong>American</strong><strong>College</strong>.edu/DesignationGuide.• <strong>The</strong> <strong>American</strong> <strong>College</strong> <strong>Online</strong> <strong>Learning</strong> <strong>Center</strong>: <strong>The</strong> <strong>College</strong> provides online studymaterials for this course, including an interactive version of the sample exam, designedto be used in conjunction with the printed study materials to enhance the learningexperience. This material is provided only through password access to studentsregistered for this course. To obtain a password, students should complete the e-mailaddress <strong>section</strong> of the course registration form; <strong>The</strong> <strong>College</strong> will send the student apassword and instructions on how to access these materials.• Course Pages/Updates: New developments in the subject area, important study points,links to other useful governmental and organizational web sites, and errata in coursematerials are included. All information is accessible on <strong>The</strong> <strong>American</strong> <strong>College</strong> <strong>Online</strong><strong>Learning</strong> <strong>Center</strong> with a password at blackboard.theamericancollege.edu.• Course Registration Procedures: Secure online registration plus registration forms thatcan be printed and faxed/mailed to <strong>The</strong> <strong>College</strong> are available.• Examinations on Demand (EOD) Testing Procedures: <strong>The</strong> policies and requirementsfor EOD testing, as well as links to lists of our more than 3,000 test centers, are provided.• Educational Policies and Procedures: <strong>The</strong> education, experience, ethics, continuingeducation, and transfer of credit requirements for <strong>The</strong> <strong>College</strong>'s designation and graduateprograms are explained.vi
c. Planning for saving is an intuitive goal, planning for decumulation is not.(1) Decumulation involves more difficult decisions than accumulation.(2) Psychological issues—for example, some clients may see their financialadvisor in a parental role (e.g. “my advisor won’t let me buy a new car”).8. <strong>The</strong>re are a variety of strategies and products.a. Some portion of retirement income must come from a stable source.(1) Some will want to lock in income to meet their basic expenses (necessities).(2) Guaranteed income could be from Social Security, company sponsoredpension plan, or a commercial annuity.(3) Those without a sufficient base are good candidates to buy annuities.(a) Immediate life annuity—• One benefit of the life annuity is the mortality credit.• <strong>The</strong> cost of creating income may be lower with animmediate life annuity than with any other approachbecause of the mortality credits.(b) Deferred annuity with guaranteed minimum withdrawal benefitsmay also help to lock in a base income.b. Retirement income planning means dealing with one important fact — there isalways a trade-off between guaranteed income and the potential for additionalwealth.c. Investment strategies for stable income include:(1) Bond ladders(2) TIPs(3) Safety stock plan (set aside several years of cash so that investments donot need to be sold in a down market)d. Advisors must have a full range of strategies for their clients in order to properlyprepare a retirement income plan.(1) Must have annuity solutions(2) Must have nonannuity investment solutions(3) Must know how to maximize Social Security benefits(4) Must know how to maximize pension benefits(5) Must have long-term care needs solutions(6) Must know the most tax-efficient strategy for accessing cashe. Planners must be constantly learning and evolving in the retirement income field.(1) Products are constantly changing.(2) Retirement income planning starts much earlier than 65, as strategiesare put in place over time.9. Definition of retirement income planninga. Helping a client ensure that income needs will be met throughout retirementb. Involves figuring out ways to generate income from financial assets that havebeen accumulated for retirement1.3
c. But it is more comprehensive because it requires evaluating all assets andsources of income(1) Example: Take a couple; both are teachers and are both entitled tosignificant pensions and Social Security. <strong>The</strong>ir challenge is that they havelimited financial resources to address inflation and other unexpectedexpenses. How their assets are invested and used in retirement may bemuch different than the single person that only has Social Security andneeds to generate current income from his or her financial assets.d. Helping a client identify retirement income needs(1) Involves budgeting (identifying both essential needs and discretionaryexpenses)(2) Identifying retirement goals and objectives(3) Identify legacy goals which can include leaving money and values tofamily, or having some charitable intente. Planning for different time frames and uncertain time framesf. Planning has to consider contingencies (risks) and risk management techniques.(1) Example: You calculate a client’s expenses, but due to a disability, theclient needs nursing care, which could suddenly triple income needs.(2) Example: A client’s parents die young. <strong>The</strong> clients only expect to live to 82and instead they are still alive at age 92.g. Planning also has to consider tax and legal issues that can undermine the plan.h. Planning has to consider tax strategies that can make the plan more successful.i. <strong>The</strong> plan has to be successful for the entire lifetime.10. Characteristics of Retirement Income Planning Practicea. It requires comprehensive planning—solutions are dependent on the client’ssituation.b. It requires knowledge across a wide spectrum of issues—solutions arecomplicated.(1) Example: A withdrawal strategy requires inclusion of Social Securityclaiming decisions as some research has shown that deferring SocialSecurity and withdrawing other assets in the interim can be a successfulstrategy.c. It requires customization—no one approach works for everyone, as every client isdifferent. Examples of differences among clients include:(1) Income and resources vary—One client has a significant pension benefitwhile another has Social Security benefits, a 401(k) balance, and asignificant inheritance. A third client has a business to sell that is a criticalto having a secure retirement.(2) Circumstances vary—clients can be married, single, nonmarried couples,same sex couples married according to a State but not Federal law. <strong>The</strong>remay be dependent children or grandchildren—or even a living parent whoneeds care.(3) Views of retirement vary—clients can plan to work until they drop, playgolf every day, commit themselves to a nonprofit organization, or carefor family members.1.4
d. It’s about helping clients construct and enjoy a new life phase. Examples ofsimilarities among clients include:(1) Clients need help figuring out where they are going.(2) Clients have to create and fund this stage on their own.e. It’s hard to recover from mistakes(1) A retiree may not have the option of returning to work.(2) <strong>The</strong>re is little time to recover from investment losses.f. Errors could result in liability for the planner.(1) A client may have no other option than to blame the advisor.(2) Competency issues complicate decision making.g. Retirement income planning requires constant review and revision.h. Retirement income planning is a field still in the developmental stage.(1) Processes, systems, software, products are still developing.(2) Best practices are still being identified.(3) Advisors and other professionals are just at the beginning of the learningcurve.11. Is retirement income planning different from saving for retirement?a. Maybe yes:b. Maybe no:(1) Sequence of returns affects the portfolio performance when there areperiodic withdrawals.(2) Figuring out how to convert assets into income is a new task.(3) Mistakes are harder to recover from.(4) Client has the opportunity to undermine the plan by spending too much.(5) Change is a constant.(1) Comprehensive planning is better.(2) Help clients define a new life-phase.(3) Begin to prepare early for retirement risks.(4) <strong>The</strong> client has the opportunity to undermine the plan by saving too little.(5) Isn’t it really income planning even for the young?LO 1-1-2: Understand the decisions that clients face in retirement1. Many in the middle market have much of their wealth tied up in their home and havefew additional financial assets. (Video: What are the retirement decisions facing mostclients? Tacchino, Woerheide, Rappaport)a. For this group the key decisions are when to retire and when to claim SocialSecurity benefits.b. Options for those with limited assets include:(1) Work as long as possible and save as much as possible in the periodprior to retirement.(2) Be realistic about a reduction in standard of living during retirement.1.5
(3) Work part-time during retirement.(4) Consider deferring Social Security benefits to maximize benefits.(a) This is a critical source of income—for example, for 40% of olderwomen living alone Social Security is their only incomec. Critical housing decisions for middle-income clients include:(1) Can I afford to live in this house?(2) What is the best way to tap home equity?(a) Reverse mortgage(b) Downsizing(c) Renting out space2. Financial asset decisions for middle-income clients include:a. To what extent is it appropriate to annuitize?b. What is the proper withdrawal rate from a portfolio?c. What is the appropriate asset allocation of the retirement portfolio?(1) <strong>The</strong> asset allocation structure will be determined in part by the amount ofrequired and discretionary expenses the client has.(2) <strong>The</strong> greater the amount of discretionary expenses, the greater the amountof risk that can be taken in the asset allocation model.(3) <strong>The</strong> greater the amount of fixed expenses, the lower the amount of riskthat can be in the asset allocation model.3. Is it appropriate to fund long-term care needs with long-term care insurance (LTCI)?a. When should LTCI be purchased?b. Is LTCI appropriate for those with few financial assets?c. Is LTCI appropriate for the wealthy client?4. How do these various retirement decisions interrelate?a. Decisions must be part of a long-term planning process.b. For example, if home equity is tapped early in retirement, then no chance for areverse mortgage to pay for long-term care needs.c. For example, an annuity purchase reduces liquidity, making it more difficult to payfor long-term care expenses in later years.d. Planners and clients need to balance the trade-offs of these decisions.5. What irrevocable elections do I have to make under the employer’s employee benefitplans?a. Participants in a defined benefit plan make an irrevocable decision about the formof benefit payment (about ½ of retirees today still have defined benefit pensions).b. Some face an irrevocable decision about staying in the employer’s retiree medicalprogram.c. Even 401(k) plans may have a fixed window for deciding on the form ofwithdrawals.6. Should I get advice to make these decisions?a. One decision is whether to make decisions on your own or get professional advice.b. <strong>The</strong> well-to-do will get advice; it is the middle market where this gets tougher.c. For the middle market, just finding an affordable advisor will be tough.1.6
(1) <strong>The</strong> best chance may be advisors working on commission.(2) This may well be the traditional life agent or other commissioned advisor.d. Some of the major decisions including what has already been discussed include:(1) When to retire?(2) Whether to work part-time during retirement?(3) At what age to claim Social Security benefits?(4) Whether to purchase long-term care insurance?(5) Whether to purchase an immediate annuity and when to buy it?(6) How to decide on portfolio investment and portfolio withdrawal decisions?(7) Which Medicare and other health insurance decisions should be made?(8) Whether to make an election to participate in the employer’s retiree healthcare program?(9) Whether to maintain a life insurance policy or increase coverage?(10)Whether to tap home equity and if so, whether to choose home equityloans, reverse mortgages, or downsizing?(11)Choosing appropriate housing (considering a relocation or moving into acontinuing care retirement community (CCRC))?(12)Choosing a form of distribution from a pension plan?e. Many of these retirement decisions require expert knowledge, so a good generalistmay not be the best person work with on all decisions, and a specialist shouldnot advise on broader issues.f. As the market of people needing help on retirement decisions, the number ofpeople becoming qualified to do this may also grow.(1) <strong>The</strong>re is always concern that how a person is compensated will influencethe nature of their advice.(2) It is really important to understand how an advisor is paid, and if theadvisor is acting in the client’s interest.(3) <strong>The</strong>re is research that indicates how a person is compensated influencestheir recommendations.7. Additional retirement income decisions facing more affluent clientsa. Nonqualified executive benefits including deferred compensation and stock optionsb. Selling business interests to have a secure retirementc. As financial assets increase, decisions around addressing legacy becomes morecentral to the plan.d. Tax planning, both income and estate tax planning become more important tomeeting goals and objectives1.7
SECTION 2: UNDERSTANDING RETIREMENT PREPAREDNESSDATALO 1-2-1: Identify the costs of retirement1. <strong>The</strong> present value (at age 65) of out of pocket medical costs including health insurancepremiums (not including long-term custodial care) (Video: What are some of the basiccosts of retirement? Littell, Tacchino, VanDerhei)a. Male age 65(1) Median cost is $71,000 (cost for someone at the 50% percentile)(2) Cost for someone at the 90% level of expenses is $136,000b. Female age 65(1) Median cost is $95,000(2) Cost at 90% level is $156,000c. Range for the present value needed at age 65 to cover the medical costs for acouple is $166,000 to approximately $290,0002. Cost of long-term care in a nursing homea. Average annual cost in 2011 for a private nursing home is $87,000 (<strong>The</strong> 2011MetLife Market Survey of Nursing Home, Assisted Living, Adult Day Services,and Home Care Costs)b. Costs range significantly by state.3. Expenses using a replacement ratio approacha. Classic replacement ratio studies looking at reduction in taxes and other expensesshow a required replacement ratio to maintain a pre-retirement standard of livingof approximately 70–85%.b. Classic approach does not consider possibility of catastrophic events (such aslanding in a nursing home).c. EBRI study looking at sufficient funds to meet basic expenses shows a rangebased on the probability of success of meeting necessary expenses and uninsuredmedical costs(1) High income male at 65—50% sure, then 52% replacement; 90% sure,then 119% replacement rate(2) High income female at 65—50% sure, then 59% replacement rate; and90% sure, 129% replacement rated. Planning Point: <strong>The</strong> income needed by clients who end up in a nursing home willbe significantly higher than for clients who do not end up in a nursing home.LO 1-2-2: Understand whether <strong>American</strong>s are prepared financially forretirement1. Overall data (Video: What is the retirement readiness of those nearing retirement age?Littell, Tacchino, VanDerhei)a. If baby boomers and those in generation X retire at age 65, there is currently a4.5 trillion dollar retirement shortfall.b. This only looks at meeting basic expenses and uninsured medical expenses (theshortfall would be even more if the standard was maintaining the current lifestyle).1.8
c. As a whole group, 47% are at risk of a retirement shortfall.2. Retirement plan coveragea. Percentage of those generation X clients at risk drops from 60% (no retirementplan coverage) to 20% (with retirement plan coverage)b. 61% of full-time employees are covered and 54.5% participate in a retirement planc. Only 19% of those working for small employers (10 or fewer employees)participate in a pland. A much larger 65.7% of employees working for large employers (1,000 or moreemployees) participate in a plane. 82% of employees working for public employers participate in a retirement planf. <strong>The</strong> number one reason that small employers do not sponsor a retirement plan isbecause of volatility of earnings.3. Retirement readiness risk based on incomea. 70% of the lowest income individuals (the bottom third) are at risk not to havebasic necessities in retirement.b. Only 22% of the highest income individuals (the top third) are at risk.4. Employer-provided plan solutions for low-income individualsa. Companies can increase 401(k) participation by allowing automatic enrollment ofthose eligible employees who do not affirmatively elect out of the plan.b. Unfortunately, the default deferral percentage tends to be quite low (typically 3%).c. Planning Point: Financial planners should recommend a default deferredpercentage that is higher than 3 percent. Five and six percent are more in linewith creating adequate retirement income while at the same time not scaringemployees away from the plan.d. Plan participants could benefit from automatic escalation—which provides forincreases in contribution rates over time.e. Auto escalation should bring contributions up to 10 percent or more.f. Default deferrals and auto escalation underestimate the “number” needed forretirement.5. Role of Social Security and Medicarea. <strong>The</strong>se programs are insufficient for covering the expenses of retirement for all butthe lowest income individuals.b. This assumes the current system remains the same—reductions in benefits willhave a significant impact on lower-income workers.6. Solutions for individualsa. Work longer.b. Save raises.c. Get company match.d. Calculate how much they need to have—before making the decision to retirement.e. Get a financial professional to sign off on whether the client has enough resources.7. Retirement readiness for high net worth individuals (Video: What is the retirementreadiness of high net worth individuals nearing retirement? Littell, Tacchino, VanDerhei)a. 22% of the top quartile are at risk of having insufficient assets in retirement tomeet basic expensesb. 80% of the top quartile of earners are able to replace 80% of their income inretirement (inflation adjusted)c. Why are so many wealthy individuals at risk?1.9
d. Solutions(1) <strong>The</strong> model considers a wide range of possible life trajectories.(2) Some will live longer than expected.(3) <strong>The</strong> most compelling reason for the shortfall is the contingency of requiringlong-term care for a significant amount of time.(1) Long-term care insurance(2) Understand and maximize employer provided benefits(3) Like others, need a savings plan—especially for business owners(4) Deferring Social Security8. Retirement readiness for the middle class (Video: How well is the middle class preparedfor retirement? Littell, Tacchino, VanDerhei)a. Only 50% chance of having sufficient assets to meet retirement needs (basicexpenses plus reimbursed medical costs)b. Middle income solutions(1) Participate in the employer plan.(2) Save early.(3) Save retirement plan distributions when changing jobs.(a) Low income and small distributions are most likely to be spent—andnot rolled over.(b) Be concerned about those who are automatically enrolled whohave the option to receive retirement benefits.c. What portion of the shortfall represents costs from unexpected health care andlong-term care costs?(1) About 50% of the retirement income shortfall is a result of some individualsincurring a catastrophic event affecting health care costs and long-termcare needs.(2) Insuring against these catastrophic events significantly improves the oddsfor income adequacy.LO 1-2-3: Know consumer attitudes about preparedness for retirement1. Retirement Confidence Survey by EBRI and Mathew Greenwald (Video: What Doesthe EBRI Retirement Confidence Survey Tell Us about Retirement? Littell, Tacchino,VanDerhei)a. Annual survey ongoing for 21 yearsb. Interview 1,000 workers and 250 retirees2. Overall confidence of workersa. A 2011 survey showed more pessimism about retirement readiness today thenany time in the last two decades.b. 27% of workers are not at all confident that they are prepared for retirement.c. Drop of confidence has not translated into a higher savings rate or additionalplanning.d. High percentage of workers simply guess whether they are prepared for retirement.3. Workers expect to retire later.1.10
(1) It will identify:(a) Long-term debts which may not be paid off prior to retirement(b) Assets that may be available to meet retirement needsc. Qualitative fact finding process(1) Fact finders and conversations can reveal information about the client’scurrent financial challenges and concerns2. Identify and prioritize retirement goals(a) Ask appropriate questions about their experiences with financialprofessionals(b) Learn personal information about family, activities, andorganizations they supporta. Many clients need help envisioning what their future retirement might look likeb. Many new tools can help clients begin to think through:(1) What they want to do in retirement(2) What legacy they want to leave after they are gonec. Help clients consider issues in the later years of retirement(1) Needing long-term care(2) Providing for a spouse after death(3) Living longer than expectedd. Discuss contingencies or risks faced in retirement to help the client picture whatthey might have to cope with later in life3. Estimate retirement income needsa. Divide expenses based on whether they are essential or discretionary(1) Discretionary could mean items you could do without — or can purchaseless expensive options(2) Income solutions for basic expenses may be different than discretionaryonesb. Expenses do not stay constant over retirement(1) Identifying expenses and then increasing them throughout retirement forinflation can provide an inaccurate picture an overstate need.(2) For many, expenses in later years of retirement actually decrease(3) Sophisticated retirement software can address categories of expenses(a) Allow periodic increases or decreases over time(b) Allow for specific inflation rates appropriate for that type of expense4. Identify sources of income and assets available to generate retirement income.a. Obvious sources of retirement income:(1) Social Security benefits(2) Employer-sponsored defined-benefit plans(3) <strong>The</strong>se benefits depend upon when work stops, benefits begin, and theform of payment selected.1.12
. Other sources of retirement income(1) Supplemental nonqualified employer sponsored benefits(2) Income from rental property or renting out part of their home(3) Income from selling a business(4) Being paid commission may create a stream of income into retirement(5) Part-time employment(6) A good software program can consider the duration and amount of eachstream of incomec. Identify less obvious assets(1) Cash value life insurance(2) Home equity(a) Can be difficult to deal with, but it can provide emergency funds.(3) Collectibles(4) Move into vacation home and sell primary residence(5) Limit the list to those items that are likely to be used to generate retirementincome5. Make a preliminary calculation of the client’s preparedness for retirementa. Software outputs depend upon:(1) What the software is modeling(a) Monte Carlo probability analysis has become common(b) But the client or advisor may not fully understand what the resultsmean and how they were derived.(2) Assumptions used about rate or return, longevity, inflation, etc.(a) Assumptions need to be reasonable and appropriate for eachspecific client.6. Develop strategies for addressing a retirement income shortfalla. Strategies that may eliminate shortfall(1) Saving more(2) Getting better performance out of the portfolio(3) Working full-time longer(4) Working part-time in retirement(5) Deciding to live on lessb. Telling the client that they are not prepared to meet their goals is a difficultconversation.(1) Solving the problems before or in early retirement is much less painfulthan discovering the problem later.(2) It is almost impossible to solve financial problems at age 90, but there arestill options at age 60 or 657. Consider legal and tax issues that can derail the plan.a. Tax strategies to improve a client’s financial situation1.13
(1) Use appropriate tax-advantaged vehicles for saving for retirement.(2) Choose the appropriate order of withdrawals once the client is in thedecumulation phase.b. Tax issues can undermine the plan.(1) Example: Failing to satisfy the required minimum distribution rules fromqualified plans and IRAs can result in a 50% excise tax.c. Legal issues to address:(1) Incompetency — Planning for the possibility that a client will not be able tomake financial or health care decisions.(2) Estate planning — Putting the appropriate estate planning tools (trusts,wills, gifts, etc.) to use to meet legacy objectives, such as:(a) Protecting a spouse(b) Leaving assets to other heirs(c) Meeting charitable goals8. Consider retirement contingencies (risks) in developing alternative solutions or“stress-test” the plan.a. <strong>The</strong> plan must address the various risks and contingencies that will be facedin retirement, such as:(1) <strong>The</strong> possibility that the client will live longer than expected(2) <strong>The</strong> market will have a sustained down period in the first few years ofretirement(3) A spouse dies at an early ageb. Before offering retirement income solutions, it is critical to think through how thesolutions will address these and many other retirement risks.c. Other planning areas to be addressed in the plan(1) Health insurance planning, including Medicare choices and purchasingsupplemental insurance can limit costs in later retirement years.(2) Long-term care planning — long-term care costs can undermine a planeven for a wealthier client. LTC is the number one reason why a wealthierclient might run out of assets in retirement.9. Determine an appropriate strategy for converting assets into income.a. A successful plan requires a comprehensive analysis to come up with appropriatestrategies for a particular client.(1) Example: Converting a 401(k) account into a life annuity can be anexcellent solution for someone with little other guaranteed lifetime incomeand is not a good solution for someone with a significant pension benefitb. Increasing lifetime income is not only about converting assets to income. It canalso be about:(1) Figuring ways to maximize Social Security benefits(2) Using a reverse mortgage to tap home equity(3) Making better tax decisions to increase after-tax income1.14
c. Another option for solving cash flow needs is reducing expenses instead ofincreasing income.d. Converting assets to income begins with choosing the appropriate way of framingthis issue(1) Some advisors create an income floor for essential expenses(2) Other advisors start with the question “How much can I afford to withdrawfrom the portfolio each year and still make the money last?”(3) An advisor working in this area should be familiar with the different ways offraming the issue and be able to pick solutions appropriate for the specificclient.10. Integrate all considerations, present alternatives, and agree upon a plan.a. <strong>The</strong>re are trade-offs and clients will have to make some difficult choices.(1) Example: Strategies that improve income security in retirement may havea negative affect on wealth accumulation for legacy goals.b. It will be a back and forth process with the client.c. Clients may not fully understand the issues until they see several alternatives.d. Software can help by illustrating a plan and projecting results.e. Planning may go through a number of rounds before a final plan is agreed upon.11. Conclusiona. Time line and action steps that the eight steps of the financial planning processprovides a logical way of proceeding, starting with clarifying the scope of theengagement with the client all the way to developing an implementation programand monitoring the planb. Implementation may involve a team of professionals, including an estate planninglawyer, tax advisor, and others.c. Once a plan has been proposed, approved, and implemented, it is almost time tocircle around to the beginning and start the process all over again to address roadbumps along the way.(1) Big dip in the market(2) Client spends too much(3) Inflation suddenly increases(4) Grandparent takes on financial responsibility for adult children orgrandchildrend. Regular contact is required to evaluate and revise the plan.e. Retirement income planning can be rewarding work(1) You are helping your client invent and navigate a new life stage.(2) It can also be challenging, as it requires a wide range of knowledge andthe tools to help design and implement the plan.LO 1-3-2: Understand how the eight steps of the financial planning processapply to retirement planning1. Step 1: Establish and define the client-planner relationship. (Video: Steps of theretirement planning process: Lemoine)a. When does a prospect become a client?1.15
(1) One issue is when does the client make that transition from viewing theadvisor as “someone trying to get their business” to their “trusted advisor”(2) Is the event that creates the relationship(a) Letter of engagement signed and sent back(b) Planning fee received(c) Establishing of the accountsb. <strong>The</strong> best practice is a signed engagement letter which addresses(1) What is the relationship about(2) Who is responsible for what activities(3) When does the relationship beginc. Defining the relationship(1) Begins with identifying the product being offered(2) Identify responsibilities(a) Advisor responsibilities may include• Processing forms• Discretionary authority over accounts(b) Client’s responsibilities may include• Filling out paperwork• Providing actual information• Providing tax documentsd. Disclosing compensation should be part of the agreement(1) Fee relationship is straight forward as the client is paying a specified feefor a specified product(2) Commission relationship disclosures vary(a) May provide general description such as “I will receive acommission if you buy a product.”(b) May provide specific commission received by the broker and agent.e. Setting expectations as to what will happen(1) Establish boundaries and rules(2) Regarding communications, for example, identify how quickly you intend torespond, how you will respond to text messages and e-mails, etc.(3) Use texts and e-mails to set up meetings and not to conduct them.2. Step 2: Gather information necessary to fulfill that engagement.a. What data do you need to perform the specific task?b. General information that should be reviewed for meeting the appropriate standardof care:(1) Tax returns from the last 3 to 5 years(2) Brokerage statements(3) Retirement plan benefit statements(4) Financial statements including(a) Cash flow statements to identify current income and expenses1.16
(b) Net worth statements that identify assets and liabilities(5) Planning Point: Gather enough information to competently advise theclient. Suitability requires the planner to dig deeper and get all thenecessary information to give informed advice.(6) Use fact-finders(a) Quantitative—to gather financial information(b) Qualitative—to determine goals and objectives3. Step 3: Analyze and evaluate the financial status.a. Retirement planning is not a standalone discipline. It requires knowledge aboutthe client’s:(1) Tax situation(2) Insurance situation(3) Spending, cash flow, savings(4) Education planning for their kids(5) Housing and job situations(6) Estate plansb. Can the client meet their financial goals?c. Performing an adequate analysis based on information provided by the client.(1) Trust but verify.(a) Trust what is on the financial statements.(b) But verify with the client that the balances are accurate and upto date.(2) If using a financial planning software tool, make sure to start with accuratedata and appropriate assumptions. Without good data in the tool, theprojections will be meaningless.(3) Challenges(a) May not know answers to tax questions(b) May be a distinct feature of the pension plan of the client that youdo not know how to handle(4) May bring in outside experts when analyzing data(a) Attorney(b) Accountant(c) Confidentiality rules require the permission of the client to disclosedata to a third party. Meetings with other advisors should includethe client if possible.(5) Be respectful of a client’s time4. Step 4: Develop recommendations.a. After going through the analysis process, this may lead back to reevaluating thegoals and objectives. Clients cannot always meet their initially stated goals.b. Develop recommendations(1) End result of the analysis you have done1.17
(2) Develop recommendations based on:(a) Software outputs(b) Conversations with the client(c) <strong>The</strong> client’s risk tolerance(3) Recommendations must be clear and concise.(4) Address recommendations that client may not like.5. Step 5: Communicate the recommendations.a. Crux of the entire plan relies on your plan being communicated accurately,efficiently, and carefully to the client.b. Consider socio-economic or demographic market of the client when youcommunicate with them.c. Use different media formats to meet the learning style of the client.(1) Text(2) Verbal(3) Visual—such as charts, graphs, tablesd. Clients need to retain the information.(1) When they leave the meeting, they have to remain clear about what wassaid and decisions that were made.(2) <strong>The</strong> best way for retention involves constant feedback from client—keepchecking in with them and encourage their involvement. More participation= more retention.6. Step 6: Implement the recommendations.a. <strong>The</strong> process begins with an implementation schedule.(1) Assigns specific activities to the planner, client, or third party(a) For example, the planner sets up accounts and gets account formsready(b) For example, the client signs rollover formsb. Implementation phase needs to be very detailed.c. This phase also involves reiterating the potential consequences—includingnegative ones.(1) No guarantees(2) Surrender charges7. Step 7: Monitor the plan.a. Monitor the recommendations. Monitoring the plan is crucial for retirement incomeplanning.b. For example, monitor:(1) Performance of investment vehicles(2) Changing income needs of a client(3) Changes in risk tolerance as the client ages(4) Health concernsc. Monitor recommendations regularly.1.18
d. Be ready to reengage with the client. Goals, assumptions, or plans could change.You need to be prepared to start back at square one.8. Step 8: Practice within the professional and regulatory standards of your occupation.a. This aspect is present through every step.b. Act ethically throughout the planning process.c. Do to your clients only actions you would do to yourself.d. Make a list of what regulatory standards you need to meet, both state and federal.e. Be aware of changing rules, procedures, and industry standards.SECTION 4: THE BUSINESS OF RETIREMENT INCOMEPLANNINGLO 1-4-1: Building a retirement planning practice1. <strong>The</strong> first step in prospecting clients is defining the product that you have to offer. (Video:<strong>The</strong> prospecting process: Lemoine)a. What exactly is it that you will be doing for the client?(1) Guiding them through the accumulation phase(2) Helping them calculate a savings need(3) Taking a rollover amount and helping them invest it wisely(4) Counseling them through the decumulation phase(5) Etc.b. Define yourself.(1) Work as a broker.(2) Manage investments as a registered investment advisor.(3) Use insurance products to supplement retirement planning.(4) May be a mix of all three.c. Identify 3–5 specific tools, resources, strategies that you will bring your clientsthat defines you.d. When we define the retirement planning product, we can break it into one of twocategories.(1) Helping the client accumulate assets for retirement(a) Going over software tools with the client(b) Selling products to the client(c) Giving advice to the client(2) Helping the client distribute what they have accumulated(a) Insurance solutions(b) Brokerage solutions(c) Fee-based solutions2. <strong>The</strong> second step is to create an ideal client profile.a. Who is it that you want to apply your skill set to?(1) What target market has the potential for long-term profit and gain?1.19
(2) Altruistically, who do you believe needs your help the most?b. When we create the ideal client profile, we need to consider the business modelthat we have already defined.c. How do we go about creating an ideal client profile?(1) Identify the socio-economic characteristics(2) Identify the personality characteristics(3) Identify whether the firm has an ideal client profile(a) Example: Age 50-65 with $2 million net worth(4) Can you get these individuals to work with you as a professional?3. <strong>The</strong> third step is to identify the actual target market.a. Where can you find those people that match your profile?(1) Start local:(a) Family unit(b) Friends(c) Coworkers(d) Existing clients(2) Third parties(a) Friend of a friendb. If you have a client that fits the client profile, identify where you can find otherslike that client.4. <strong>The</strong> fourth step is to position your practicea. What can you do that makes yourself stand out as distinguished?b. What can you do that will make yourself attractive to the target market?(1) Put thought into the design and layout of your office.(2) What does the client see when they walk in?(3) Is this something that the target market will enjoy?(4) Is it professional?c. How do you brand yourself?(1) How do you put yourself out there?(a) Advertisement in a phone book(b) Advertisement in a newspaper(c) Going door to doord. How do you position the practice?(1) 20–30-year-olds may be intrigued by technology(2) Older clients may look for professionalism.5. <strong>The</strong> fifth step is to build prestige and create awareness.a. How to build prestige and create awareness(1) Advanced level certifications(a) In retirement planning1.20
(b) In financial planning(c) In investments(2) Ethical business practices(a) Be diligent(b) Be ethical(c) Have integrity(3) Build technical competence(4) Planning Point: Writing articles in professional journals, or writing blogs ornewsletters for clients, may help a planner to build prestige.(5) Planning Point: Planners should join groups that allow them to network inthe community.LO 1-4-2: Identify technical tools used in retirement planning1. Tools that advisors can use when working with retirees (Video: Retirement PlanningTechnology: Woerheide, Lemoine)a. Portable devices that we can take with us to the client (e.g., iPhone, iPad,Blackberry) that can be used for arithmetic, time-value-of-money functions,calculatorb. Prepackaged programs(1) Financial planning software(2) Contact management systemsc. Customized programs for answering particular questions2. Financial planning softwarea. Goal-based software(1) Addresses a specific segmented goal (retirement, estate planning,risk-management need)(2) Put in assumptions and inputs and it will generate calculations towardsmeeting a goalb. Cash flow–based software(1) Looks at all inflows and outflows providing a fluid, comprehensive plan(2) It is time sensitive and harder to explain to the client but provides a slightlymore accurate picture of the ability to meet goals.(3) Example: Goal-based software determines that you need to save $500 amonth for retirement and cash flow software would help you understandwhether you could meet that goal.3. How advisors should use software with retireesa. Regardless of the software program, it is critical that the client understands theoutput—this can be a weakness of some software programs.b. Uses with preretirees(1) Choosing the appropriate accumulation vehicle(2) Choosing appropriate asset allocationc. Uses with retirees1.21
4. Client communications(1) Model an appropriate withdrawal rate—illustrating the probability ofsuccessa. Try to communicate the results efficiently and effectively.b. Advisor has to fully understand the output of the software program.5. Should financial professionals learn software programs or is their time better spentworking with clients and leaving the number crunching to the “back room?”a. This depends in part on the business model—in some situations advisors are notrunning any calculations, while in others the advisor is deeply involved.b. Regardless of the role, the advisor should understand what he or she is presentingand understand at least theoretically the math behind the calculations.(1) Planning Point: A plan should draw the important pieces into an executivesummary or else the client will receive an overwhelming amount ofinformation.6. Monte Carlo simulation software(a) Discuss the major planning areas.(b) For each goal, address recommendations, assumptions made, andhow this will be implemented.a. Type of mathematical process that allows us to make predications of successfuland unsuccessful outcomes for a retirement funding scenariob. Can be used with both retirement accumulation and retirement income planning(decumulation)c. Planning Point: Monte Carlo modeling allows a planner to calculate probabilitiesof success using historical market returns. <strong>The</strong> simulation relies on inputs of theamount of money the client currently has, the asset allocation model currentlybeing used, and a target goal for the client.d. In the retirement income context, you may choose a withdrawal rate; then thesoftware runs thousands of simulated trials, typically based on historical returns.<strong>The</strong> percentage of successful results offers a probability of success for the client’scurrent situation. It shows how many trials met the goal and how many did not.e. <strong>The</strong> strength of this approach can be that it can simplify a situation by providingprobabilities of success for two or more different alternative courses of action. Forexample, what is the probability of success if the withdrawal rate is 3 percentversus 5 percent.f. A Monte Carlo model boils down a complex idea to give the client an estimation ofthe probability of their success. For example, continuing as is, you have X percentchance of success. If you alter this, you have Y percent chance of success.g. One limitation is that the definition of success (having one dollar left at the end oflife) may not feel like success, and being one dollar shy may not feel like a failure.h. Monte Carlo can use a stagnant life expectancy (e.g., age 95) or the planner canuse Monte Carlo with age as well. In other words, it can simulate the randomnessof death or assume everyone dies at an anticipated age.i. Another limitation may be that if simulations generally use historical data onreturns. Historical returns may not reflect future behavior.(1) However, historical returns have varied significantly and taken randomlymay still be an appropriate approach.(2) Historical returns may provide some protection.1.22
j. Planning Point: Planners can use either historical returns or project future returns.Historical data provides safety for the planner because it is a well acceptedtechnique and requires no guessing.k. Planning Point: When using historical Monte Carlo analysis, planners may wantto consider using a higher inflation assumption than the historical rate in orderto be more cautious in their analysis.7. What techniques can planners take to ensure clients understand what they are presented?a. Have the client repeat back what you have said and, more generally, activelyparticipate in the meeting.b. To keep the client focused, have them participate in the meeting with feedbackquestions.c. Follow-up phone call to make sure they are still comfortable with the plan.d. Communication is critical to success!8. Is proprietary software as good as the commercially available software?a. In many cases, proprietary software is a rebranded commercially available tool.b. Some companies have unique proprietary software systems that are quite good.c. Other large broker-dealers use branded software like eMoney and NaviPlan—andlimit the range of assumptions that can be usedd. Branded software has more controls than proprietary software and often does notallow the planner or client to change assumptions as freely.e. Software tools are critical to the advisor and it’s in a company’s best interest tohave excellent current tools that meet the advisor’s needs.LO 1-4-3: Learn how behavioral finance affects client communications1. What is most important to people: money, medicine, meaning or place where the clientlives (Video: How behavioral finance affects client communications: Littell, Jordan)a. No matter what age, meaning was ranked most important.b. As we age, meaning becomes more important and money less important.c. Advisors, when asked what is important to their clients, often get the answerwrong (they perceive money or medicine as the key issue).d. Clients care about how the financial issues fit into their lives.2. How do people actually make financial decisionsa. This is the foundational piece of behavioral finance.b. Two parts of the brain(1) Left side – analytical(2) Right side – behavioral and emotionalc. Those in financial services spend more time on the left side - focusing on facts,charts, and graphs.d. People make decisions that go beyond what they factually know - beyond knowingis believing and feeling.e. Our culture in the “information age” has altogether focused too much on theanalytical side.f. Relationships matter—as illustrated by research showing that patients who havemore time with their doctors are less likely to sue.g. <strong>The</strong> financial services point of view has been ‘how do you take emotion out of thedecision making’ – that is the wrong question - the right question is ‘how do youaccommodate emotion and behavior.’1.23
h. Also, it is very difficult to sustain a practice solely around investment and productperformance - since much of this is outside the control of the advisor (e.g. marketforces).i. What is in the control of the advisor is managing behavior through building arelationship, and taking into consideration the client’s emotions and behavioralinfluences.j. Changing mix of analytic skills and experiential capital(1) At younger ages, analytical capabilities are very high and over time thatanalytic capacity goes down.(2) This is replaced with knowledge based on experience.(3) Retirement income planning is with older clients - so working with chartsand graphs is unlikely to be successful.(4) Older clients have not amassed any experience with the distribution side ofplanning, as this is quite different from the accumulation process.3. Three major challenges in retirement income planninga. Longevityb. Inflation(1) Human beings have never lived as long as they do today.(2) Life expectancy for a 65-year-old couple is 30 years.(3) Longevity is the magnifier of many of the retirement risks - live a long lifeand there can be more health issues, need for long-term care, the impactof market forces on a portfolio. All lead to an increasing possibility of lossof financial independence.(1) A better way to frame this as “purchasing power” – how much your moneybuys.(2) People think the biggest investment risk is loss of principal or capital -instead of focusing on a bigger retirement risk – inflation.(3) To address this risk, the answer is having an equity position throughoutretirement - and now they have to contend with market volatility.c. Market volatility(1) A way to frame this is the “price you pay for outstanding performance.”(2) Volatility is the main catalyst behind bad behavior - people buying highand selling low.(3) <strong>The</strong> distribution phase adds a new risk - sequence of returns risk - once aportfolio is in the withdrawal stage.4. Do people really understand these issues in retirement incomea. Survey showed that 40% of clients said that they had an idea of what it would taketo provide income for them (60% did not understand).b. Also found that about 55% of clients felt that their advisors did a good job ofcounseling them on accumulation.c. About 40% of clients said that their advisors did a decent job of counseling themon income - so we are beginning to see a change in the market place.d. <strong>The</strong>re is still a long way to go - we need to keep educating clients about thechanging risks in retirement.1.24
e. We also need them to have a better understanding of the value (cost) of providingincome from assets. One way to help them understand is to appreciate the valueof deferring Social Security benefits.f. Three research findings:(1) <strong>The</strong> way people make financial decisions has never changed. <strong>The</strong> waythat we perceive how they make financial decisions has changed - as weare getting a better understanding of behavioral finance considerations.(2) <strong>The</strong>y do not understand how an asset works, but they understand income.(3) Manage expectations and not performance as you cannot controlperformance - the reality is that most people will have a downturn in theirlifestyles.g. How does this information translate to advisors working with their clients(1) Emotion and behavior have a lot to do with how people make financialdecisions and it is critical to establish the relationship.(2) Discuss income - not assets - with your clients.(3) This is critical work that can help clients maintain independence and dignity- and the possibility of a legacy.1.25
RESOURCES FOR COMPETENCY 1: CREATE AN EFFECTIVERETIREMENT INCOME PLANSection 1: Introduction to Retirement Income Planning• In addition to the video discussing the Retirement Income Summit, here is an articlesummarizing the results.• Click here to go to the Society of Actuaries issue briefs on Managing RetirementDecisions that Anna Rappaport discusses in the video.Section 2: Understand Retirement Preparedness Data• EBRI publishes a lot of important data concerning retirement planning. In this <strong>section</strong>,Jack VanDerhei discussed the 2011 Retirement Confidence Survey and the 2010Retirement Readiness Rating.Section 4: <strong>The</strong> Business of Retirement Income Planning• Here is the MetLife whitepaper “Engaging Clients in a New Way” that Joe Jordandiscussed in the video.1.26
Assignment 2IDENTIFY RETIREMENT INCOME NEEDS ANDOBJECTIVES AND EVALUATE THE CLIENT’S CURRENT SITUATION2Assignment 2SECTION 1: IDENTIFY RETIREMENT BUDGETLO 2-1-1: Evaluate the client’s current situation1. Fact finders (Video: Evaluate the client’s current situation: Littell, Lemoine)a. A fact finder is a data gathering instrument that is generally provided by theemployer/broker.b. Given to the client to take with them—but it is critical to go over the answerstogetherc. Demographic information—begin to learn about the client by learning about theirfamily(1) Current/former marriages(2) Children and grandchildren(3) Parents(4) Relationships with family members(a) Do adult children or parents live at home?(b) Are you providing financial support for family members?(c) Are you providing caregiving for family members?(5) Other advisors that the client is using2. Qualitative questions—to understand what is important to your client. Qualitativequestions teach us a lot about the client.a. Types of questions(1) What recreational activities do you enjoy (hobbies)?(2) Would you like to leave money to someone or some organization after youare gone (legacy planning)?(3) You would be happiest if your plan...(4) <strong>The</strong>se types of questions help us understand the client’s personality andgoals.b. <strong>The</strong> way they answer questions can provide some insight into their personalities(1) Are they “drivers” (e.g., quick, to-the-point answers)(2) Are they philosophers (e.g., long answers about the meaning of success)(3) Are they analytic (e.g., use a lot of numeric data)c. Getting to understand the client’s personality helps you learn how to work with theclient; other helpful questions may be:(1) What keeps you up at night?(2) What was your best/worst experience with a financial advisor?2.1
3. Quantitative questions(3) What is one thing I can help you with today?(4) This can help you determine how to work with the client — other waysto learn howa. Gather data about assets and liabilities to form a balance sheet (statement offinancial position)b. Have a supporting document for each asset/liability (bank/brokeragestatements/property title documents). Trust but verify!c. Assetsd. Liabilities(1) Where is the asset located?(2) How is it titled?(3) What is the cost basis?(4) Is there any additional funding to the asset?(5) Is there any cost to maintain the asset?(1) Mortgages and other secured debts (home mortgages, home equity loans,car loans). A secured debt is a debt that is tied to an asset.(2) Unsecured debts (credit card balances)(3) Identify when installment debts (those with specified end-dates) will be paidoff as well as whether there is any revolving debt (no specified end date)e. Categorizing assets (to determine what is available to meet retirement and otherneeds)(1) <strong>The</strong>re is no standard mechanism that financial planners use to categorizeassets; for retirement planning, you may want to divide into cash/otherfinancial assets/personal property(2) Cash position — cash or assets that can be turned into cash in severaldays (can be used for meeting emergencies)(a) Checking(b) Savings(c) Money market accounts(d) Cash on hand(3) Financial assets — generally used to support retirement needs(4) Personal assets (auto, personal property) — are typically not used to meetretirement needs(a) With the exception of home-equity which may be used but oftenlater in retirement(5) Planning Point: Breaking assets into cash assets, financial assets, andpersonal assets is an important way to break down an asset sheet used forretirement planning.f. Cash flow statements(1) Pull information from the fact finder and gather supporting documentssuch as tax returns2.2
(2) Income4. Determining risk tolerance(a) Taxable — wages, bonuses, commissions, investment earnings(b) Not taxable — gifts, refunds from previous years, Roth distributions(c) Identify taxable income and tax-free income(3) Expenses — can be either fixed or variable.(a) Fixed expenses — meaning they come up no matter what, such asfood, shelter, transportation, income taxes, insurance premiums(b) Required (fixed) but the amounts are uncertain such as health careexpenses or replacing a roof on the client’s home(c) Variable expenses — those items that you have control over andcan modify, such as the cable bill(d) <strong>The</strong> expense statement should be as detailed as possible becauseit can provide a tremendous amount of information necessary todevelop a retirement income plan.(e) Planning Point: <strong>The</strong> cash flow statement can give us great insightinto the client.(f) Suggestions to make this task easier for clients:• Keep detailed track of every expense for one month.• Use credit cards that provide reporting services.• Charge all expenses on a credit card to make it easier totrack expenses.(g) Cash flow statement is for an annual period and is used to get aclear sense of income and expenses(h) Budgeting is a different process• Goal is to help a client stay within spending limits• General categories of expenses may be better suited tokeep on tracka. Risk should be measured when the client is not stressed.b. It can be useful to measure risk tolerance several times.c. Until the market drops, we do not know the risk tolerance of a client. Risktolerance is a function of loss aversion.d. Separate spouses when measuring their risk tolerance because one spouse mayinfluence the other.e. Planning Point: <strong>The</strong> education process stemming from an advisor working with aclient may help to change the client’s risk tolerance.LO 2-1-2: Determine the client’s retirement goals and objectives1. Objective (Video: Advising in a digital age: Littell, Freitag, Henry)a. Retirement income planning is about having the financial means to support alifestyle in retirement.b. In the previous objective, we began to understand the client better by learningabout the client’s current situation.c. Now it is time to consider what might be different about the client’s vision ofretirement. <strong>The</strong>re is clearly a point when it is time to step away from money and2.3
think about lifestyle. To help with this process are traditional fact finders, but betteryet are some new tools to help client’s visualize retirement.d. New tools are available — such as Ready-2-Retire2. Tool for identifying goals and objectivesa. What is Ready-2-Retire?(1) Web-based application(2) Marries technology and behavioral science(3) From advisor perspective, it can help improve productivity in terms ofprospecting for new clients(4) Cements relationships with existing clients(5) Helps clients visualize the type of lifestyle that they want in retirement(6) Not about numbers; more about figuring out what retirement will look likeb. How did this project get started?(1) LIMRA is one of the preeminent research organizations serving thefinancial services community(2) LIMRA noted some very marked trends(a) Increasing number of people who are transitioning to retirementand withdrawing assets from an accumulation vehicle such as a401(k) account and redeploying those assets into IRA rollover(b) <strong>The</strong>y have many questions about making the right choices.(c) Great opportunity to create a new tool that would help addressthose challengesc. What were some of the big design challenges while building this tool?(1) Not falling into the old track of calculator thinking(2) How is this going to be able to engage, become fun, and work in an iPadenvironment?(3) How to get it more focused on goals (when to retire, where to retire) andlet the numbers come much laterd. How has LIMRA handled the compliance issues with FINRA or other concerns?(1) Do not talk about numbers or record personal demographic data.(2) Ensure that the product solutions being recommended to a client aresuitable for their particular situation.e. How can advisors learn more about Ready-2-Retire?3. Knowing the client(1) Log on to www.LIMRA.com and go to the Advisor Tools <strong>section</strong>(2) Log on to www.Impact-tech.coma. Besides learning the client’s retirement objectives, it is important to educate themabout the risks that they face in retirement.b. This is required — in part — to help them prioritize the risks.c. Planning Point: Ready-2–Retire allows the clients to drive the interview and thismakes them more comfortable. A tool like Ready-2–Retire allows for a more2.4
collaborative experience which focuses on the client’s feelings more than itfocuses on numbers.d. Planning Point: Knowing what is of critical importance to the client can leadto a better retirement income plan. Planners need to use tools to get beyondthe “noise” of multiple and contravening objectives and goals and key them inon what really matters.e. In the next learning objective we discuss another important part to understand— risk tolerance.f. After that, we begin to make an estimate of income needs to be able to meet thedesired lifestyle.4. Key client questions to identify retirement goals and objectivesa. What am I going to do?b. Where am I going to do it?c. When will retirement begin?d. What risks of retirement am I most concerned about?e. Income or wealth accumulation?f. How much money do I need?LO 2-1-3: Evaluate how the client’s risk tolerance impacts the retirementincome plan1. What is risk tolerance?a. Risk tolerance is how much uncertainty an investor can manage regardingdeclining portfolio balances and/or lower than expected investment returns.b. How risk tolerance differs in accumulation portfolios versus retirement incomeportfolios(1) In accumulation portfolios, the investor is concerned about the trade-offbetween risk and return concerning the portfolio’s return, looking to eitheravoid risk or capture a premium for taking on risk in the investment portfolio.(2) In retirement income portfolios, the client is concerned about meetingretirement income needs without running out of assets in the portfolio. It isan outcome based model.(3) <strong>The</strong> lack of human capital (no more earnings from employment) meansthat building wealth comes from earning a higher investment return thanthe yield required for income needs.(4) Risk tolerance can change in retirement.2. Risk tolerance changes with timea. As clients age, they may become less willing to take on risk in their investmentportfolios.b. Health issues can cause changes in the client’s risk tolerance.(1) Needing to go into an assisted living facility or nursing home(2) Health scare that requires a withdrawal from the portfolioc. Periodic testing of risk tolerance to capture changing client risk tolerance isnecessary to accurately test risk tolerance.3. Subjective risk tolerance2.5
a. Most investors are at least somewhat risk averse. That means that they are willingto pay a price, in the form of lower expected returns, to avoid risk when investing.(1) <strong>The</strong> more risk averse the investor, the more conservative they are withtheir investments.b. Risk Tolerance Surveys4. Risk capacity(a) That can work out okay during their careers because they canchoose to increase their savings rate to compensate for the lowerexpected return on their investments.(b) It can be a much bigger issue in retirement income portfoliosbecause they are no longer contributing to the portfolio - theyare counting on the portfolio to distribute the income they needin retirement.(1) Financial advisors will typically adopt a risk tolerance survey with a seriesof questions designed to establish the client’s risk tolerance. In the nextcourse in the RICP designation you will complete an exercise in evaluatinga client’s subjective risk tolerance.(2) It is important that the survey is a valid measure of a client’s risk tolerance.Firms consider validity when adopting a survey.a. In the accumulation years, the client has the ability to earn a return off of theirhuman capital, make consumption investment decisions with their income fromtheir human capital, and use part of that money to invest in financial capital tobuild their wealth.b. In the distribution years, human capital is depleted or virtually depleted, so it willbe the financial capital that drives the client’s retirement income.c. Risk capacity means that the client has enough income from guaranteed and othersources to meet his or her retirement income needs, so he or she can take onadditional risk in asset allocation in the retirement portfolio.d. <strong>The</strong>re can be a disconnect between risk capacity and risk tolerance where theclient has the capacity, but not the stomach, for taking on additional risk.e. Guaranteed income in retirement can increase the client’s risk capacity in assetallocation.5. Risk tolerance (Video: Risk tolerance: Nanigian, Hanna)a. It is useful to think about risk tolerance in terms of the way economists whodevelop these prescriptive models for portfolio allocation use it.(1) Related to how one values increases in consumption compared todecreases in consumptionb. Subjective risk tolerance(1) Really related to the idea of how much you value higher consumptionversus lower consumption(2) Average, low, and high subjective risk tolerance(3) Risk capacity in a typical lifetime would vary because of human capital.(a) End up with patterns that look like target date mutual funds(b) Aggressive target date mutual funds might be appropriate forsomebody with fairly high subjective risk tolerance (90%-100%).2.6
6. Asset allocation and risk tolerancea. Risk to principal(c) Someone with low subjective risk tolerance would start off with asomewhat lower, but still pretty high, stock percentage (80%).(1) Considers the decline in the investment portfolio’s value due to investmentlosses(2) Clients that are unwilling to accept any potential risk to principal areextremely risk averse.(3) During their career, they can adjust for this aversion by increasing the levelof contributions to their retirement portfolio.(4) As the portfolio goals change from asset accumulation to retirementincome, the ability to achieve income goals in investments that areguaranteed to protect principal are limited.b. Purchasing power risk7. What does it mean?(1) Clients invest with the expectation that their investments will earn a positivereal return. In other words, they expect the purchasing power of theirinvested wealth to increase over time. For that to happen, the investmenthas to earn a return higher than the rate of inflation.(2) Adding tax considerations to the mix increases the problem. <strong>The</strong> client hasto expect to earn a positive real return after taxes for the purchasing powerof a dollar invested to increase over time.a. A key difference in risk tolerance in retirement versus accumulation years is inthe risk that the retirement income goals cannot be met because of portfolioperformance.b. Outcome based performance influences risk tolerance in retirement incomeportfolios.c. Validity of the survey instrument is important.d. Repeat measures of risk tolerance over time to capture changing risk tolerance.LO 2-1-4: Estimate the income needs required to support the desiredlifestyle in retirement1. People in the pre-retirement stage should start taking stock of their lives as they enter intothe new life stage of retirement (Video: Why assessing budgeting is such a critical part ofthe retirement planning process? Littell, Tacchino, Basu)a. Clients are generally not good at identifying how much they are spending currently.b. <strong>The</strong>y are going to enter a stage that is new and that they do not understand.c. Planners cannot do a detailed retirement plan unless they can figure out the client’sfuture expenses, which they cannot do until they figure out their current expenses.d. Planners should approach budgeting as giving the client control over theirspending choices. Instead of sleepwalking through purchasing decisions, wouldn’tthe client prefer to make conscious choices?e. Building a retirement income plan starts with taking stock of the current lifestyleso that we can begin to look forward into the future(1) What are the spending habits now?(2) What is important in the client’s current lifestyle?2.7
(3) Is the client willing to make changes to his or her lifestyle in the future?(4) Can the client make adjustments to his or her current lifestyle to improvehis or her retirement lifestyle?2. Bridging the period of saving for retirement to the retirement income phasea. Saving is simply postponing consumption. But people value consumption todayover consumption later and this creates one of the central paradoxes of retirementincome planning, especially if the client cannot visualize the future.b. <strong>The</strong> planner and client must work together. Together they can improve futureconsumption by reducing current consumption.c. If the planner can bring about the spending vs. saving decision in a way that theclient can visualize it, then those clients are much more likely to listen and abideby the plan.3. Planning Point: Planners should ask clients to identify categories for different typesof expenses.a. Are the expenses for essential needs, conveniences, or for luxuries?b. Necessities are expenses that are important to sustain good health.(1) Health care(2) Nutrition(3) Exercise(4) Good shelter(5) <strong>The</strong>se expenses are self-identified.c. Another way to frame necessities is what expenditures allow us to live and die indignity. For some clients, covering essential expenses means that they will nothave to rely on others.d. Separately identify convenience items and luxury expenditures that would benice to have. It is also helpful to have a priority plan for which of these expensesare most importante. Depending upon the retirement income approach taken, outside macroeconomicfactors (such as the variability of returns on the stock market) can result in somevariability of income. It is important for the client to understand this and also “buyinto” this possibility or choose an approach that has more income certainty.f. <strong>The</strong> reality of retirement income planning is that adding more structure anddiscipline around expenses creates a more stable financial future(1) Which can translate to happiness and contentment in retirement(2) Financial security is another way to take care of your health as worry aboutfinances are a factor that can lead to depression and illness.SECTION 2: SOURCES OF INCOMELO 2-2-1: Identify sources of income currently available to meet retirementincome needs1. Inventory income sources2. Planners need to consider the following questions about a source of income:a. What sources of income are available?b. How much will be paid?2.8
c. How long will the income last?d. Is the income source reliable?e. Does the income source have cost-of-living protection?f. Is there flexibility in payout options or other features relevant to the retirementincome plan?3. Social Securitya. Amountb. Durationc. Reliabilityd. Other(1) 86.3 percent of those age 65 or older receive Social Security benefits. 1(2) An individual may be eligible for several types of benefits over his or herlifetime including a worker's benefit, and if married or divorced, a spousalbenefit or a widow's benefit.(3) Planners should note that the general rule for Social Security benefits isthat clients eligible for multiple benefits get the larger benefits but do notget both sets of benefits.(4) In some cases, retirement benefits are also available for dependentchildren and survivor benefits may be paid to other family members.(5) Determining the amount of a client's Social Security benefit is not quiteas easy today as before because Social Security has stopped sendingout benefit estimates. Social Security has a detailed calculator which ismuch better at getting a more accurate estimate based on the client'sunique situation.(6) A client can quite easily obtain the same information that was on theestimate, by going to the Social Security website, using the estimatorcalculator and entering his/her Social Security number.(7) However, this calculator does not take into consideration the governmentoffset provisions for those who have worked outside of the Social Securitysystem for part of their working careers.(8) Social Security also has a detailed calculator which is much better atgetting a more accurate estimate based on the client's unique situation.(1) Social Security retirement benefits are payable for life.(2) Both spouses in a couple can receive Social Security benefits. At thedeath of the first spouse, the survivor can receive the deceased spouse’sbenefit if it is higher. This is one reason to encourage the higher wageearner to defer benefits since this is the benefit that is paid over the jointlives of the couple.(1) Reliability is definitely a concern with Social Security. <strong>The</strong> 2011 TrusteesReport indicated that according to current estimates, in about 2036, SocialSecurity would not have sufficient assets to pay all promised benefits.At that time, Social Security will then only have the income to pay aboutthree-fourths of promised benefits.1. Income of the Population 55 or Older, 2010, Social Security Administration, March 2012.2.9
(1) Most sources of retirement income are not eligible for inflation protection.Social Security, however, receives a cost-of-living adjustment (COLA) tocorrespond with increases in the consumer price index.(2) This valuable COLA benefit is enhanced by deferring and maximizingbenefits to increase the income receiving inflation protection.4. Qualified defined-benefit plansa. Amountb. Durationc. Reliabilityd. Other(1) Planners should begin by reviewing benefit statements to determine thebenefits that will be payable to the client at normal retirement age.(2) If the client is planning to retire early or defer beyond full retirement age,then the planner needs to identify from the summary plan description orthe plan administrator what the impact of early or deferred retirement willbe on benefit amounts.(1) Benefits from a defined-benefit plan are generally stated as a single lifeannuity in the plan document.(2) However, the participant can elect optional forms of annuity paymentsusually including joint-and-survivor annuities, and life with guaranteedpayments for a specified period of time.(3) Optional forms are the actuarial equivalent of the basic form of payment.(1) Benefit payments from plans of private employers are quite secure asassets used to pay benefits are held in trust — and if the plan has ashortfall (except for certain small employers), benefits are guaranteed bythe Pension Benefit Guarantee Corporation (PBGC) insurance programwhich guarantees benefits up to approximately $4,500 a month. Publicpensions do not have the PBGC guarantee.(2) If a sponsor chooses to terminate the plan, the participants only receivethe accrued benefit that has been earned to date, and not the projectedbenefit at retirement.(3) <strong>The</strong> other question in determining whether the projected retirement benefitwill be paid is whether the employee continues employment.(1) Generally, defined-benefit plans do not offer automatic inflation protection,although many plans do provide for ad hoc increases. Note that morepublic pensions will have built-in inflation protection.(2) Some defined-benefit plans offer a lump-sum option for benefit payments.Lump sums are also the actuarial equivalent of the life annuity — the lumpsum value will change over time based on the applicable interest rates.5. Nonqualified employer benefitsa. Amount(1) Unlike qualified plans, benefit statements and plan descriptions maybe harder to come by with nonqualified benefits. It may require morecommunications with the human resources department to get adequate2.10
. Durationc. Reliabilityd. Other6. Part-time workinformation about the plan. <strong>The</strong>re may also be information about the planin the client’s employment contract.(2) When estimating benefit amounts, consider the same issues discussedwith qualified plans.(3) Nonqualified plans, like qualified plans, are designed to defer taxes untilbenefits are paid out. However, taxes cannot be deferred by rolling benefitsinto an IRA. In other words, taxes are due when benefits are paid.(1) Nonqualified plans are likely to offer salary continuation only for a statednumber of years. However, some nonqualified plans offer life annuities.(2) If nonqualified benefits are in payout status, benefits may or may notcontinue after the death of a participant depending upon the terms of theplan. In other words, there may not be a survivor benefit if the client withthe nonqualified plan pre-deceases his or her spouse.(3) If the participant dies while still employed, the nonqualified plan mayinclude either lump-sum payments or salary continuation to a beneficiaryfor a period of time.(1) Benefits in nonqualified plans are not as secure as with qualified plans.<strong>The</strong> participant is treated as a general creditor of the company, and ifthe company has financial problems it is possible that some or all of thebenefits will not be paid. As recent history has shown us, companies ofany size can fail.(2) Plans can have vesting provisions that require many years of servicebefore benefits will be paid. A plan can also include a do-not-competeclause or a post-retirement consulting clause, meaning that benefits willstop if these agreements are not complied with.(3) <strong>The</strong> plan can also require that in order to receive benefits, otherperformance goals have to be satisfied as well.(1) Unlike qualified plans, nonqualified plans may not allow any alternativeforms of distribution.(2) Even if they are available, elections must be made well in advance ofthe distribution of benefits.a. Part-time work may involve staying at the same job; doing some consulting, ortaking another part-time job. Part-time work can be an important part of the planfor income as well as for life satisfaction.b. Amount(1) Planning Point: Planners may find it difficult to estimate income frompart-time work, especially if the future employment is ill-defined.(2) Future part-time employment prospects seem clearer when the client hasa position lined up, or consulting clients already identified.(3) Consulting or other self-employment income may vary widely, and if theperson is new to consulting it may take a number of years to get situated.2.11
c. Duration — identifying the duration of work income also is difficult. A best estimaterequires understanding the following:(1) <strong>The</strong> client's reason for working(2) Whether the work is difficult to perform for an older person(3) <strong>The</strong> available market for the type of work involvedd. Reliability — a lot can go wrong with relying on part-time work as a source ofretirement income:(1) <strong>The</strong> client may encounter a lack of employment opportunities.(2) <strong>The</strong> client may have health problems.(3) <strong>The</strong> client may encounter health problems of family members, which canrequire the client to quit work to provide caregiving.e. <strong>The</strong>re are some other quite positive aspects of part-time work in retirement.7. Business interests(1) For some clients, there may be some considerable flexibility in how muchis earned.(2) Part-time employment income provides a measure of inflation protection.(3) Part-time work can provide purpose, social interaction, and other benefitsthat improve life satisfaction.a. Small business owners often sell business interests in installment sales.(1) If the sale has already taken place, the terms as to how much and for howlong will be clear — although whether the new owners will be financiallyviable and able to meet the terms of the agreement might be in question.(2) Stretching out payments stretches out the payment of income taxes andthe tax treatment of each installment payment can include nontaxable costbasis, capital gains, and interest income.b. Clients may have residential rental income as a steady source of income inretirement.(1) A client may have a separate apartment in their home, a second homeor vacation home for rent or even an apartment building that providesretirement income.(2) Be sure when considering rental income in the retirement plan to considerthe costs associated with the income and the potential for capital gains forselling appreciated real estate at a later time.c. Residual sales commissions—can be another source of retirement income. Withlife insurance, for example, residual commissions are often paid if the policyremains in force. With life insurance commissions and other types of commissions,it can be hard to estimate the future stream of income and each company payingcommissions has its own rules for how much and how long payments will continue.8. Other sourcesa. Be sure to inventory benefits from previous employers.b. Annuity income — clients may have fixed annuity income from annuities thatthey have purchased, or other sources, such as legal settlements or even lotterypayments.2.12
c. Supplemental Security Income (SSI) — those with limited income and resourcesaged 65 and older may be eligible for additional supplemental security income.Only those with the lowest income qualify — but for those in need, the benefit issignificant, as singles can receive about $700 a month and couples approximately$1,000.d. Charitable gift annuities (CRTs) and similar type charitable gifts — can createa current or future income stream for a client or family member. <strong>The</strong> paymentoptions are quite flexible and with a CRT there is even the opportunity tocustomize the underlying investment portfolio supporting the income stream. Wewill discuss these later in the course.e. Ask if there are any other income sources that will be available in retirement.LO 2-2-2: Identify assets that can be used to generate retirement income1. Inventory assetsa. First, help the client create a balance sheet, and then get a complete list of assetsfrom the client’s balance sheet.b. Determine whether the asset is actually available to meet retirement incomeneeds.c. Valuation(1) Most personal property such as home furnishings, autos, and evencollectibles are generally not used to meet retirement income needs.(2) Home equity is a bit trickier. It can be used to create income, but it mustbe used with proper planning and knowlegde.(3) Most financial assets will be available to meet retirement income needs;however, some may be earmarked to meet other financial objectives suchas funding college education expenses for a child or grandchild.(1) Current market value is generally easy for the client and planner to assess.(2) <strong>The</strong> market value at retirement is more difficult for the client and theplanner to assess.(a) How much more will the client and his or her employer contribute?(b) What is the return assumption used to value the assets?(a) Simple retirement calculators will apply a statedrate-of-return assumption on all assets.(b) More complex tools allow different assumptions for differentassets, as not all assets will appreciate in value at the samerate.d. Does the asset have any special provisions for converting the asset into income?(1) Example: A qualified defined-contribution plan allows distributions as alump sum or an annuity. Annuities may have favorable institutional pricingthrough the plan.e. Account for assets that the client may have in the future, such as inheritances.2. Retirement plan review:(1) For many, these amounts are too speculative to incorporate into the plan.(2) For a few, the situation may be so clear that considering the asset as partof the retirement plan is appropriate.2.13
a. Employer sponsored tax-advantaged retirement plans, either funded fully bythe employer, like a defined-benefit plan or profit-sharing plan, or funded asa partnership with employees such as a 401(k) plan, require the followingconsiderations:(1) Determining the value of the plan at retirement is difficult because knowinghow much the employer and employee will continue to contribute from nowuntil retirement and the investment returns on plan assets are uncertain.(2) Benefits in a qualified plan are quite secure as assets are held in anirrevocable trust and are outside the claims of the employer's creditors.(3) Even though benefits are stated as a single sum, annuity options areusually available, and institutional pricing may provide for favorable annuityrates if the annuity is purchased inside the plan.b. Supplemental executive benefit plans provided to offer highly compensatedemployees additional retirement benefits may also be available as a sourceof retirement income.(1) Caveat: Participant is only a general creditor and benefits are notcompletely secure.(2) Warning: Benefits cannot be rolled into an IRA.(3) Participant will have limited distribution options.c. Self-employed individuals are allowed to establish their own tax-advantagedretirement plans, including defined-contribution plans, defined-benefit plans and401(k) plans allowing Roth contributions.d. Individuals can also establish nonqualified annuities which provide for tax-deferralon earnings.(1) Benefits are stated as an account balance.(2) Deferred annuities offer favorable annuitization terms or guaranteedlifetime or death benefits.e. Individuals may also be eligible to establish IRAs and Roth IRAs to accept newcontributions or use these vehicles to rollover benefits from employer-sponsoredretirement plans.3. Other investments can also be used to fund retirement needs.a. Savings in taxable investment accountsb. Bank products such as checking accounts, savings accounts and CDsc. Brokerage accounts including money market accounts, mutual funds, stocks andbonds(1) Traditionally available to meet retirement needs, but some may beearmarked for other purposes and will not be available.d. Real estate holdings and other business interests may be available to sell tosupport retirement needs. With these types of assets, valuation may be difficultand it may not always be easy to find a buyer.4. <strong>The</strong>re are a number of other vehicles for saving that can be used to meet multiple needs.a. Owning a home can have the secondary purpose of building home equity thatcan be tapped in retirement through downsizing, moving into senior housing, orthrough a traditional or reverse mortgage.2.14
. An unused emergency fund can support retirement needs. However, anemergency fund is useful in retirement as well to provide funds for unexpectedrisks and expenditures.c. Cash value life insurance is a way to provide for death benefits that can support aspouse or dependent’s retirement needs, and cash-value can also be borrowed orwithdrawn to support retirement needs.d. Unused amounts in health savings accounts (HSAs) can be withdrawn tax-free inretirement to meet qualified medical expenses.e. Vacation homes may not be available to meet retirement needs, but somepurchase vacation homes to enjoy now, with the intent of later supportingretirement needs through selling the vacation home or principal residence.Vacation homes can also be rented to provide some retirement income.f. Even though collectibles are not typically intended for use to fund retirement, itis important to inventory valuable personal property as it provides informationabout what the client may value — and could possibly be used to fund needsif necessary.5. Protecting wealth can be as important as building wealth for retirement.a. Clients need to have regular insurance reviews to ensure that homeowners, auto,liability, and disability insurance are sufficient so that retirement assets do nothave to be tapped if contingencies occur.b. Besides liability insurance, other strategies for protecting assets from the claimsof creditors and in the case of legal liability is an important part of planning,especially for professionals who may be exposed to high levels of liability. Rulesvary state by state, but vehicles such as qualified retirement plans and IRAs offerfairly broad protection from creditors. Homestead rules, and asset protection forlife insurance and annuities may also be available.c. Long-term care insurance is more like an asset, as policy proceeds provide fundsto cover the catastrophic costs of long-term custodial care.SECTION 3: PRELIMINARY CALCULATIONSLO 2-3-1: Choosing assumptions used in calculating retirement incomeneeds1. Advisors use retirement software programs to calculate need in retirement (Video: Whatassumptions should be used when calculating retirement needs? Littell, Tacchino)a. Retirement projection results are based on assumptions and these need tobe considered carefully so the results are more accurate and can be properlyexplained.b. In some cases, failing to include an assumption means relying on the software’sdefault assumptions, which may or may not be correct for your client.c. <strong>The</strong> more accurate the assumptions used in the retirement calculator software,the more accurate the client’s retirement income plan will be.2. Retirement agea. Average retirement age is 62b. Programs that are available for retirement influence (or frame) the decision:(1) Social Security full retirement age(2) Social Security benefits available at age 622.15
(3) Medicare available at age 65(4) Provisions of the employer’s retirement plan(s)(5) Lifestyle considerations (e.g., get rid of the mortgage)(6) Family responsibilities (e.g., need to be a caregiver for a spouse or parent)c. Plan for the possibility that retirement occurs earlier than planned because manypeople retire earlier than planned.d. Many people retire early for the following reasons:(1) <strong>The</strong>y have met their financial goals and can retire early.(2) <strong>The</strong>y value retirement so much that they are willing to reduce theirstandard of living to retire early.(3) <strong>The</strong>y have received financial encouragement (e.g. golden handshakebenefits, such as additional retirement benefits for retiring early) or simplyhave been laid off.(4) <strong>The</strong>y have health issues or family members have health concerns or theyfear bad health in the future.(5) <strong>The</strong>y have lost a spouse.(6) <strong>The</strong>y have a spouse that retires.e. Choosing early retirement has pitfalls3. Life expectancy(1) Social Security benefits are reduced before full retirement age.(2) Medicare does not become available until age 65 and purchasing healthinsurance after retirement and prior to age 65 is quite expensive.(3) Increased exposure to inflation, as early retirement means a longerretirementa. It is always an estimate - and some will live long lives while others will die shortlyafter retirement.b. 28 percent of those who live to 65 make it to age 90.c. <strong>The</strong> starting point should be life expectancy tables for those who live to age 65and not life expectancy at birth for retirement planning.d. Accommodate the possibility of living longer than an average life expectancybecause half of the people live longer than average.e. Consider the individual’s health status and the health status of family members.f. Perceptions of longevity matter. However, bring the client to a more realisticestimate.4. How much is needed in retirement?a. Replacement ratio is appropriate for estimating needs for younger clients.(1) What percentage of final average salary will you need to meet yourretirement goals?(2) 100 percent may not be necessary (there are no more FICA taxes, peopleare no longer saving for retirement, and work-related expenses are gone).(3) 60–80 percent is typically needed as a replacement ratio.b. Use an expense (budget) method for those closer to retirement.(1) Use today’s dollars (calculators will inflate this amount).2.16
5. Inflation(2) <strong>The</strong> expense method becomes more viable after age 50.(3) Budget method provides slightly more accurate assumption.a. Look to determine a long-term inflation rate (3.5–4 percent can be used).b. Think about it as a “raise” each year of retirement that is needed to coverretirement costs.c. Some software programs allow for different inflation rates for different typesof expenses.6. How does a retirement calculator work?a. Conduct a financial inventory.(1) Social Security estimates(2) Retirement plan summary plan descriptions(3) Other sources of income (personal savings, etc.)b. Compare what the client has to what they need.(1) Identify retirement income shortfall(2) Find the retirement needc. Figure out what assets are not inflation protected. For example, Social Security isinflation protected, but defined-benefit plan retirement benefits are not inflationprotected.d. We need to pick a retirement age and figure out how much we need to save eachyear until retirement to meet all of our retirement income needs.e. Living on interest only in retirement and not spending down assets is veryexpensive, requiring the individual to save a tremendous amount more to fundthe same type of retirement lifestyle.LO 2-3-2: Identify tools and approaches to making an evaluation offinancial preparedness for retirement1. After evaluating a client’s retirement income needs and evaluating retirement resources,the next step is to make a preliminary determination of whether they will be able to meettheir goals. (Video: Identify tools and approaches to making an evaluation of financialpreparedness for retirement: Littell, McLellan, Lemoine)a. <strong>The</strong> first step may be simply using past experience to eyeball the client’s situationand “back of the envelope” simple calculations to identify whether the client willhave a chance of meeting his/her goals.(1) <strong>The</strong> advisor can begin to get a feel for what types of software tools will benecessary and appropriate for this specific situation.(2) However, many clients have never done an actual calculation to determinetheir retirement preparedness.b. Do-it-yourself tools(1) <strong>Online</strong> calculators are one way to get a ballpark estimate, but they arelimited tools that do not allow much customizing for unique situations.(2) Very few clients are capable of using these tools to calculate theirretirement readiness.2.17
(3) Clients need to know these calculations are just estimates based onassumptions that will change over time.c. Software tools that are appropriate in 90 percent of the cases(1) With sophisticated planning, the cost, time, and effort can limit advisors tothe high net worth clients. But there are going to be millions of middle-class<strong>American</strong>s that need guidance.(2) <strong>The</strong>re are calculators and financial planning software programs that arenot at the high end of cost and sophistication, but are excellent for mostpeople because they are sufficiently complex, flexible, and reliable to varythe inputs into the program to meet the client’s unique situation.(3) A good program allows you control individual categories of expenses (e.g.health care, travel), allowing you to change the expenses over time andapply different inflation rates to different types of expenses.(4) A plan should be revised, updated, and monitored as events occur or theclient’s goals change – this creates a valuable, long-lasting relationshipbetween the client and advisor.(5) In a good retirement income planning software program, you should beable to:2. Communicating the results to the client(a) Change expenses over time as some expenses decrease (travel)and other expenses increase (health care)(b) Change the inflation rate for individual expense categories(c) Identify individual streams of income, controlling duration andamount(d) Model a spike because of long-term care needs or other“unexpected” costs later in retirementa. Spreadsheets may not be the most effective communication mechanism – clientswant to visualize the results.b. <strong>The</strong>re is something about the software programs that can model visually thatgoes a really long way towards success.c. Complexity is not always better because the client may not understand the results.d. <strong>The</strong> other issue is that more complex tools are still making estimates basedon assumptions that are simply educated guesses (e.g. future inflation rate,investment returns) - so it is not clear that they are more accurate.2.18
Assignment 3CHOOSE APPROPRIATE STRATEGIES TOADDRESS GAPS IN INCOME3Assignment 3SECTION 1: CASH FLOW PLANNINGLO 3-1-1: Understand the impact of saving more now and spending lessin retirement1. Objectivea. If a client has a shortfall of funds needed for retirement, the planner should reviewthe impact of saving more on a retirement income deficit.b. If a client has a shortfall of funds needed for retirement, the planner should reviewthe impact of spending less on a retirement income deficit.2. Saving more can have a limited impact on bridging the gap for those clients who areclose to retirement.a. Example: 58-year-old single individual with $100,000 of income, assets of$500,000, saving 20 percent of pay each year, and needing 85 percent of incomeb. Calculations use the Smart Money Retirement Planner calculator assuming a 19%effective tax rate, a 7% preretirement return, 6% post-retirement return and a2.7% inflation ratec. Under this scenario, retirement occurs at age 65 and the client has an incomeshortfall at age 81.d. If the planner changes the savings rate from 20% to 25%. then the incomeshortfall occurs at age 82. (Not much help!)3. Saving more is still an important strategya. <strong>The</strong> more years to retirement, the more effective the strategy will be. However, forolder clients, saving more is not likely to solve the problem.b. Some clients may have the ability to save a lot more in the years prior to retirement.(1) No longer have a mortgage(2) Finished paying for children’s college education(3) Expenses may be lower as the home is fully furnished4. <strong>The</strong> strategy of saving more is more effective in combination with other strategiesa. Saving with appropriate tax-advantaged vehicles can maximize the impact of thesaving program.b. Add years of saving by working longerc. Saving more means getting used to spending less — allowing the client theoption to “test-drive” a lower spending solution, helping to determine if the lowerspending strategy will work.5. Behavioral finance considerations affecting saving more for retirement (Video: What canwe learn from behavioral finance research about retirement savings? Littell, Tacchino,Basu)a. Clients are not aware of their own behavioral biases.3.1
(1) Advisors generally do not understand these issues either.(2) Good retirement income plans can fail because behavioral issues get inthe way.(3) One example of common self-defeating behavior is selling equities whenthe market is down.b. Current versus future consumption (saving vs. spending)(1) Desire for current consumption overrides the need for future consumption.Reason: We equate consumption with happiness.(2) Rational behavior under an economic model would predict leveling ofconsumption by saving for retirement.(3) Ambivalence about giving up current consumption for future consumptionresults in procrastination — avoiding the conflictc. Getting the client to take action(1) One answer is visualizing the future: What will life look like in the future ifyou take one path versus another?(2) Should the vision of the future focus on the positive (retirement is a timeyou can spend more time with your grandchildren) or should the focusbe on the fear of failing to plan (a life of financial dependence on familymembers)? Some clients are motivated by each approach. Differentpeople have different personalities, some respond to fear, some respondto positive reinforcement.(3) Some newer financial services practices are including a psychologist orcounselor in their practices.(4) Group sessions featuring current retirees can be helpful.(5) An approach to framing the issue and gaining a better understanding ofwhat it is like to live on much less money is to ask the client to live on halfor two-thirds of current income to better understand what that feels like.(6) Another approach is to get those in a client’s “center of influence” toreinforce the messages of saving and planning.(7) Another option can be groups of people sharing experiences about theirown planning or lack of planning.(8) Do not let automatic enrollment influence a client to save at the defaultamount. Planners should warn that the default amount is not a good wayto solve the problem.(9) Use increases in salary for retirement savings.6. Psychological issues — reviewa. Visualize the future to help value savings.b. Change the way of discussing saving: it is not spending or saving - it is spendingnow or spending later.c. For those making self-defeating decisions, psychological support may be helpful.7. Practical tips that help to motivate a client to save more:a. Saving with payroll deduction or other automated methods (the money is savedbefore we have a chance to think about spending it)3.2
. Save as a percentage of income and not a specified amount so that savingsincrease as income increases.c. Even better — save all raises in the years prior to retirementd. Do not forget to look at options for earning more which can result in additionalsavings.(1) Change jobs(2) Supplemental consulting(3) Second job8. Spending less in retirement can have a significant impact on the retirement income plan.a. Example: Using the same facts as above: 58-year-old single individual with$100,000 of income, assets of $500,000 and currently saving 20% of pay andneeding 85% of income. Remember that if this individual retired at age 65 theincome shortfall occurred at age 81.b. Change spending from 85% to 75% and the income shortfall occurs at age 86.c. In addition, increase the savings rate to 25% and the shortfall is at age 87.d. Retire at age 66 and the shortfall is eliminated — income is achieved to the age90 life expectancy9. Spend less in retirementa. Plan begins with determining how much is needed to meet the client’s desiredlifestyleb. Spending less means a reduced standard of living.c. <strong>The</strong> more care taken in preparing the spending plan, the more difficult to adjustdownward.d. However, a well prioritized spending plan may make it easier to identify reductions.10. Other options to create significant long-lasting spending reductionsa. Relocating to a location with lower housing and other living expensesb. Downsize to a smaller home or other living arrangement to reduce ongoinghomeowner expenses such as taxes, utilities, and home maintenancec. Sell assets that cost money to maintain (e.g., vacation home, boat, recreationalvehicle) that generate little or no income and have little possibility of investmentgrowth11. Making better spending decisionsa. In some cases, clients who are not careful spenders can maintain a similarlifestyle at a lower cost by finding discounts, bargains or alternative lower-costproducts and services.b. Planning Point: Financial advisors may find clients receptive to tips for helpingthem find bargains and live on less.12. Temporary spending cutsa. Depending upon the withdrawal strategy, temporary reductions in spending canbe meaningfulb. For example, a sustainable withdrawal rate can be increased somewhat if the clientis willing to reduce spending in years of poor or negative investment performance.3.3
SECTION 2: ADDITIONAL WORKLO 3-2-1: Understand the impact of working longer on retirement security1. <strong>The</strong> impact of deferring retirement age on income adequacy 2 (Video: What is the impactof deferring retirement age on retirement income adequacy? Littell, Tacchino, VanDerhei)a. Recent research has indicated that many people at age 65 do not have a decentchance at having adequate retirement income.(1) Objective of the research is to try to identify what would be the impact ofdeferring retirement(2) Deferring retirement improves the retirement income plan(a) <strong>The</strong> retirement period is shortened.(b) Social Security benefits increase.(c) Defined-benefit payments may increase.(d) <strong>The</strong> defined-contribution account increases with additionalemployee and employer contributions.b. What does the research show about how much one year of deferring retirementwould improve retirement adequacy?(1) Deferral has a tremendously positive effect on low-income workers.(2) Those with high income already have a high probability of adequateretirement income that another year or two in most cases does not matterthat much.(3) Planning Point: Use the retirement savings calculator to demonstrate howmuch needs to be saved. Extending the retirement date a few years willhelp to make the savings goal more manageable.c. Deferring retirement is important to consider as part of the planning process.(1) When doing retirement modeling, besides manipulating the savings rateand rate of investment returns, also consider looking at the impact ofdeferring retirement age.(2) <strong>The</strong> study validates that the best tool for low-income and middle-incomeclients is often deferring retirement a little bit longer.(3) Be aware that deferral of retirement may not always be a viable option —about 40% report that they retire earlier than planned.(a) Usually because of a health situation(b) Individual may no longer have marketable skillsd. Improving retirement income adequacyIncome Adequate at 65 Defer to 67 Defer to 69Lowest quartile 29.6% 34.6% 46.5%Second quartile 60.6% 67.0% 75.6%Third quartile 79.0% 82.0% 89.0%Highest quartile 89.1% 91.0% 94.5%2. EBRI Issue Brief #388 “<strong>The</strong> Impact of Deferring Retirement Age on Retirement Adequacy.” June, 2011.3.4
(1) Note that 38% of second income quartile that did not have adequateincome at age 65 have sufficient income at 69.(2) Note that 44% of third income quartile that did not have adequate incomeat age 65 have sufficient income if retirement is deferred to age 69. 3(3) Planning Point: Delaying retirement has a positive impact for all groupsbased on income adequacy.2. Retirement readiness indexa. In a 2009 report by McKinsey called “Restoring <strong>American</strong>s’ Retirement Security,”they identified what they called the retirement readiness index (RRI).(1) In their model, an RRI of 100 is required to maintain the same lifestyle.(2) An RRI of 80 requires a reduction in the standard of living — reducingdiscretionary spending.(3) <strong>The</strong> average <strong>American</strong> has an RRI of 63.b. <strong>The</strong> report recommended four ways to improve retirement readiness, includingretiring later.c. <strong>The</strong> report indicated that the impact of retiring four years later on the average<strong>American</strong> improves the RRI by 23 points!3. Impact of working longer on an individual’s retirement securitya. Additional full-time work shortens the retirement period.b. Additional full-time work allows for increases in Social Security (at least up toage 70).c. Additional full-time work lowers health costs. Health insurance coverage can bequite expensive between retirement and eligibility for Medicare at age 65.d. Additional full-time work increases defined-benefit plan benefits(1) Additional benefit accruals — higher wages(2) Actuarial increases for deferrale. Additional full-time work increases defined-contribution plan benefits4. Sample calculations(1) Additional contributions(2) Deferring withdrawal means additional earningsa. Using the Smart Money Retirement Calculator (available at smartmoney.com),review the following example using these assumptions:(1) Return on investments: 7 percent preretirement, 6 percent postretirement(2) 2.7 percent inflation rate(3) 19 percent effective tax rate(4) Assume life expectancy is age 90.b. Take a 58 year old single individual with $100,000 of income, assets of $500,000,saving 20% of earnings each year, and needing 85 percent of preretirementincome in retirement.(1) Retire at age 65 and calculator identifies an income shortfall at age 81.(2) Retire at age 66 and calculator identifies an income shortfall at age 86.3. EBRI Issue Brief #338 “<strong>The</strong> Impact of Deferring Retirement Age on Retirement Income Adequacy.” June, 2011.3.5
(3) Retire at age 67 and assets are sufficient through life expectancy (age 90).c. Take the same fact pattern and add $35,000 a year of part-time employmentincome after retirement.(1) In this example, if the individual retires at 65 and earns $35,000 a yearthrough age 70, the income shortfall does not occur until age 86 (withoutthe part-time income the shortfall occurred at age 81).(2) If retirement is deferred to age 66 and the individual earns $35,000 a yearthrough age 70, assets are sufficient through life expectancy (age 90).d. Part-time employment allows the client to(1) Spend down assets more slowly(2) Defer Social Security benefits(3) Protect the client from having to sell assets when market values are down5. <strong>The</strong> practical side of working at an older age (Video: Working During Retirement: Littell,Rappaport)a. Some older workers are downsized or otherwise forced to retire.(1) <strong>The</strong>y may have planned on working longer before retirement.(2) Studies show that at least 4 in 10 people end up retiring earlier thanexpected. Reasons may include:(a) Loss of job(b) Health issues(c) Having to care for a family memberb. Some people consider themselves retired, but want to work part-time.c. Those wanting to work longer must think about the things that make thememployable.(1) Keep skills up to date.(2) Stay culturally up to date to better fit into the work environment.(3) Maintain professional networks.d. What are the different options for working during retirement?(1) Find part-time work.(2) Be a contractor and work as a consultant for your former employer orsomeone in the industry.(a) Planning Point: Planners should help advise clients about contractsinvolved when working as a part-time independent contractor.e. <strong>The</strong>re are specific organizations that deal with the issue of opportunities for peoplethat want to work in retirement.(1) Organization called retirementjobs.com provides information about jobopportunities for those over age 50(2) Organization in the Midwest called Your Encore (www.yourencore.com)helps engineers, scientific people, pharmacists, etc. (generally retirees)get opportunities to do projects or consulting for big companies.(3) Organization called Encore Careers (www.encore.org) focuses on jobs inphilanthropy and social purpose jobs.3.6
(4) <strong>The</strong> AARP website has a national employer team that lists companiesthat have specific opportunities for older workers. <strong>The</strong>y not only list thecompanies, but provide links and information about them.f. When someone loses their job, he or she can have a hard time framing skills astransferable.6. Conclusions(1) An outplacement service can help identify those skills and how that cantranslate to other employment.(2) For a client without access to an outplacement service, look for resourcesin the community.(3) <strong>The</strong>transitionnetwork.org is a nationwide women’s network to help thinkabout how to deal with issues facing them at that stage.(4) It is important not to wait until unemployment to think about stayingemployable.a. Deferring retirement is one of the most effective strategies for improving theretirement income plan for an older worker.b. Part-time work can improve the plan as well.c. Make sure that clients are able to work.(1) Maintain job skills and professional network.(2) Maintain healthy lifestyles and develop strategies for reducing stress.(3) Avoid burnout — take time off, extended vacations and other strategiesto make continued employment more palatable.SECTION 3: SAVING MORE WITH TAX-ADVANTAGED PLANSLO 3-3-1: Identify options for saving on a tax-advantaged basis1. Key Conceptsa. Extend the client’s retirement assets by maximizing tax-deductible and tax-exempt(Roth) contributionsb. Maximizing contributions should be part of the annual planning process.c. Consider all types of savings options:(1) Employer plans(2) IRAs and Roth IRAs(3) Plans for self-employment income2. Ways that individuals can access tax-advantaged plansa. Before-tax (or tax-deductible) contributions(1) If eligible, planners recommend that clients make deductible contributionsto an IRA.(2) Clients should also consider contributing salary deferrals toemployer-sponsored 401(k) plans, 403(b) plans, SIMPLE plans(3) Self-employed persons can establish their own employer sponsoredretirement plan.b. Tax-exempt “Roth” contributions3.7
(1) If eligible, planners should recommend that clients make contributions toa Roth IRA.(2) Make a Roth election with regard to salary deferrals in anemployer-sponsored savings plan.(3) Self-employed person can establish their own 401(k) plan that has a Rothelection.(4) Convert IRAs (or qualified plan benefits) into a Roth IRA.c. Plans that provide for tax-deferred earnings3. Tax advantages(1) Make nondeductible contributions to an IRA.(2) Purchase a nonqualified annuity.(3) Make after-tax contributions to qualified plans.a. Compare saving on a pretax (tax deductible) basis versus saving on an after-tax(taxable) basis(1) Example: Jennifer is age 30; she wants to save $3,000 a year (pretax)until she retires at age 65, she will earn an 8% return, and she will betaxed at a 25% rate. Compare saving $3,000 each year to saving $2,250on an after-tax basis.(2) Jennifer accumulates approximately $86,000 4 more saving pretaxassuming that at age 65 all tax-deferred amounts are distributed and taxedat a 25 percent rate. In the calculation there is also the assumption thatafter-tax earnings are subject to income tax each year as ordinary income(as would be the case with bond investments).(3) <strong>The</strong> value of saving on a pretax basis increases as the individual’s taxrate increases.(4) Example: Take the Jennifer example, but now assume a 35% tax rate.Now the difference between pretax and post-tax saving is approximately$97,000.(5) If tax rates increase in the future, saving on a pretax basis has somewhatless value. <strong>The</strong> result will depend upon the number of years of tax deferral,the future tax rate and the rate of return.(6) Example: Assume that in Jennifer’s example the 25% tax rate changes atage 65 to 35%. Now the difference between pretax and post-tax saving isa lower amount, approximately $52,000.(7) Example: Change the example again and assume that Jennifer only savesfrom age 60 to age 65—and the tax rate changes at age 65. Here, withthe short deferral period, Jennifer would actually be better off saving on apost-tax basis.(8) Planning Point: <strong>The</strong> decision about where to save takes on greaterimportance if tax rates shift dramatically.(9) Planning Point: <strong>The</strong> decision about where to save takes on greaterimportance with regard to the amount of time the savings remain in theaccount.4. Calculated using the “IRA Savings Calculator for Tax Deferral Comparison” at the website “Free-<strong>Online</strong>-Calculator-Use.com”.3.8
4. Contributions to IRAs and Roth IRAsa. Contribution rules and limits that apply to IRAs and Roth IRAs(1) Total contributions to all accounts cannot exceed the lesser of 100% ofemployment earnings or $5,000 ($6,000 if attained age 50).(2) To make a contribution to any IRA or Roth IRA the individual must haveearnings from employment.(a) This does not include investment or pension income, so studentsand retirees with no employment income cannot contribute.(b) <strong>The</strong>re is an exception for nonworking spouses (spousal IRAs); acontribution can be made for a nonworking spouse if the couple ismarried filing jointly and has joint earnings sufficient to supportthe contributions.(3) Contributions to IRAs must be made in cash during the year or up until theApril 15 th of the following year; no extensions are allowed.b. Eligibility to make traditional nondeductible IRA contributions(1) <strong>The</strong> clients needs earnings from employment to support the contributionand the client must not have attained age 70½.(2) Exception: Spousal IRA contributions allowed for nonworking spouse ifmarried filing jointlyc. Additional requirements for eligibility for a deductible contribution (2012 indexedlimits)(1) Single taxpayers(a) If an individual is not an active participant in an employer sponsoredretirement plan, the contribution is always deductible no matterhow much the client earns.(b) If an individual is an active participant, the deduction is phased outon a pro-rata basis for AGI between $58,000 and $68,000 (2012).(2) Married filing jointly(a) If neither spouse is an active participant, the contribution for bothspouses is always deductible no matter how much the client earns.(b) If the individual is an active participant, then the deduction isphased out on a pro-rata basis for AGI between $92,000 and$112,000 (2012).(c) If the individual is not an active participant but the spouse is, thededuction is phased out for AGI between $173,000 and $183,000(2012).d. Eligibility for a Roth IRA contribution (2012 indexed limits)(1) <strong>The</strong> client must have earnings from employment to support the contribution(no age limit). In other words, as long as there are earnings fromemployment, a person over age 70½ is eligible to make a Roth IRAcontribution if they meet the requirements specified below.(2) Spousal IRA contributions are allowed for non-working spouse if marriedfiling jointly.3.9
(3) <strong>The</strong> single taxpayer contribution is phased out on a pro rata basis with AGIbetween $110,000 to $125,000 (2012)(4) <strong>The</strong> married filing jointly contribution is phased out with AGI between$173,000 and $183,000.e. Eligibility for a Roth Conversion(1) All taxpayers are eligible for Roth IRA conversions regardless of earnings.(a) A participant can convert any portion of a traditional IRA or a SEPIRA/SIMPLE IRA to a Roth IRA (after two years).(b) A participant or beneficiary can convert any portion of a qualifiedplan (if plan allows distributions), a 403(b) plan or a governmentsponsored 457(b) plan into a Roth IRA.(c) Planning Point: Death beneficiaries have the ability to do Rothconversions from a qualified plan, 403(b), or 457 plan, but not froman IRA, SEP, or SIMPLE.(2) Participants of any age can convert to a Roth IRA(a) If conversions occur prior to age 59½, withdrawals from the RothIRA within 5 years and before attainment of age 59½ will be subjectto the early withdrawal penalty tax (exceptions may still apply).(b) If conversions occur after attainment of 70½, the participant cannotconvert the amount subject to the required minimum distributionfor the year.(3) Conversion rules(a) Partial Roth IRA conversions are allowed.(b) Conversions for a tax year must occur by December 31 of that year.(4) Tax treatment of a conversion(a) A conversion requires the payment of income tax, treating theconversion as a withdrawal from the traditional IRA, except thatthe 10% early withdrawal penalty tax does not apply at the timeof the conversion.(b) <strong>The</strong> value that is taxed is based on fair market value on the date ofconversion. If an annuity is involved there are some complicatedrules regarding the valuation of certain annuity benefits. <strong>The</strong> carrierwill be required to provide a valuation for tax purposes.(c) If there is no cost basis in any IRAs, the entire value is includibleas taxable income.(d) If there is a cost basis (nondeductible contributions or after-taxcontributions that were rolled over) in any IRA, the client will needto add all IRAs together and determine the tax using a pro rata rule.(e) Example: Cheryl has a $23,000 IRA that includes $18,000 ofnondeductible contributions that she wants to convert. She also hasfully taxable $100,000 rollover IRA. Tax-free portion of conversion:$23,000 x $18,000/$123,000 = $3,366 Cheryl pays tax on $19,634!(f) Planning Point: <strong>The</strong> pro rata rule has an impact on any partialconversion or if there are multiple IRAs—effectively you cannot3.10
carve out the nondeductible contributions to avoid tax. You could,however, eliminate other IRAs by rolling them to a qualified plan.(g) Planning Point: A client who makes a $5,000 nondeductiblecontribution to an IRA and wants to convert it shortly thereaftermay believe there are no tax consequences. However, this is notthe case when other IRAs exist.5. Employer provided plan options for a Roth IRA conversiona. 401(k) plans (same issues apply to 403(b) plans and government 457(b) plans)(1) Salary deferral limit(a) $17,000 (2012) maximum salary deferral(b) $5,500 catch-up if the plan allows for those who have attainedage 50(c) <strong>The</strong> plan can provided for lower salary deferral limits.(2) Matching contributions(a) Matching contributions are generally a stated amount, oftenexpressed as a percentage of the participant’s contribution (e.g.,50% of employee salary deferrals)(b) <strong>The</strong> match is often limited to a specified percentage of salarydeferred (e.g., the company only matches 6 percent of salarydeferred).(c) <strong>The</strong>re are other ways that the match can be stated and somematching contributions are entirely discretionary.(d) Note that a participant making salary deferrals may not meet therequirements for eligibility for a matching contribution(e) Note that a participant may not be fully vested in a matchingcontribution when they terminate employment.(3) A plan can allow for a Roth election.(a) This is a tax-election that treats salary deferrals as after-tax andqualified earnings are distributed tax-free.(b) <strong>The</strong> Roth election is not allowed on employer contributions. It isonly allowed on salary deferrals.(4) Investment direction(a) Most plans give participants investment direction over the account.(b) Participants choose from among a number of specified investmentalternatives.(c) Participants should pay attention to fees associated with investingin 401(k) plans.(5) Other considerations when making 401(k) contributions(a) Contribute at least the amount necessary to receive the companymatching contribution.(b) Be aware that access to the account is limited during employment.However, withdrawals for a financial hardship or loans may beavailable.3.11
. Nonqualified deferred compensationc. SIMPLEs(1) Generally there are no limits on salary deferrals in deferred compensationplans (except for 457 plans).(2) <strong>The</strong> plan may offer a matching contribution.(3) Income tax treatment from the participant’s perspective is similar to atax-deferred plan as benefits are not taxed until distributions are made.(4) Plans may offer participants investment options.(5) Benefit security is definitely a consideration as the participant is considereda general creditor of the corporation and benefits may not be paid in full ifthe company has financial problems.(6) Check the plan to see when benefits may be available.(7) Planning Point: Nonqualified plan benefits cannot be rolled over to anotherplan.(1) Have lower salary deferral contributions than 401(k) plans(2) <strong>The</strong> employer can only make a limited matching or nonelective contributionbut cannot make both.(3) IRA accounts are established for each participant and participants cantransfer assets at any time.(4) Planning Point: In a SIMPLE, the participant has a lot of investment andwithdrawal flexibility.(5) Plans cannot allow participant loans or provide for Roth elections.(6) Participants have withdrawal flexibility; however, withdrawals are taxableincome and may be subject to the early withdrawal penalty tax.6. Plan options for the self-employed (with no employees) (Video: What types of plansshould a small business owner consider for retirement savings? Littell, Tacchino)a. <strong>The</strong> rules are generally the same for incorporated and unincorporated entitiesexcept for the calculation of the maximum contribution for the businessowner of anunincorporated entity. As most sole proprietors operate as unincorporated entities,let’s focus on the limits in that situation.b. SEP—easy to establish and maintain(1) Funded with IRA accounts (not a comingled trust)(2) Less documentation than with qualified plans(3) Easy to establish and terminate the plan(4) Maximum contribution for an unincorporated businessowner is the lesser of(a) 20 percent of Schedule C earnings reduced by the Social Securitydeduction or(b) the 415 limit—which is the lesser of earnings or $50,000 (indexedlimit in 2012)c. A 401(k) plan offers the sole proprietor with limited income the ability to make alarger contribution to the plan.(1) Just like a SEP, the owner can contribute 20 percent of Schedule Cearnings reduced by the Social Security deduction.3.12
(2) Plus salary deferrals (for an individual over age 50 that is $22,500 in 2012).However, since it is a 401(k), the contribution can exceed 20 percentbecause the salary deferrals do not count.(3) Total contributions cannot exceed the 415 limit ($50,000 in 2012); however,under 415 limits the $5,500 catch-up contribution is not included socontributions can be up to $55,500 in 2012.(4) Another valuable option is that the plan can allow a Roth election so thatsalary deferrals are after-tax and qualified earnings are received tax-free.d. Defined-benefit plans7. Supplemental income(1) Only option that allows contributions in excess of the current 415(c) limiton defined contribution plans ($50,000 in 2012)(2) Contribution limit is tied to the cost of funding an annual benefit that cannotexceed the maximum 415(b) limit which is the lesser of 100 percent ofcompensation or $200,000 a year (indexed limit in 2012)(3) Good choice for the older (50 plus) sole proprietor looking for largedeductible contributions to fund a significant benefit in a short period of time(4) Planning Point: A defined-benefit plan allows the client to far exceed the$50,000 defined-contribution limit. In some cases, the plan can be fundedwith well over $100,000.(5) Higher administrative costs more complicated to administera. General rule(1) An individual working for two unrelated employers can have benefits inboth plans.(2) With self-employment (schedule C) income for an activity unrelated toone’s job, the law allows a retirement plan that can shelter a portion ofthe self-employment income.(3) Example: Corporate executive is on the board of directors of anotherbusiness. A plan can be established for the director’s fees (assuming thatthe Board member is treated as an independent contractor)(4) Example: A college professor has a consulting practice and receives feesdirectly from companies for her consulting work.b. Exceptions for supplemental income(1) Exception for salary deferrals(a) Salary deferrals to 401(k), 403(b), and SIMPLEs are aggregatedacross unrelated employers meaning that salary deferrals cannotexceed $17,000 ($22,500 if over age 50) when adding up salarydeferrals to all plans.(b) Example: A 55–year-old doctor contributes $22,500 to a hospital’s403(b) plan—the doctor also has consulting income from being anexpert witness. <strong>The</strong> doctor cannot set up a solo 401(k) plan andmake salary deferral contributions because he has already maxedout the salary deferral contributions. <strong>The</strong> doctor could set up a SEPand contribution 20% of earnings—with the warning that you haveto consider the next exception as well.3.13
(2) Exception for 403(b) plan participants(a) Contributions to a 403(b) plan must be combined with contributionsto all other tax-advantaged plans sponsored by an entity that anindividual owns at least 50% under Code Sec. 415(c). This includesself-employment income. This means that 403(b) contributions pluscontributions to a SEP or other plan for self-employment incomecannot exceed $50,000 (2012)(3) Related employers(a) <strong>The</strong> controlled group and affiliated service group rules requirerelated employers to be treated as one employer for purposes ofthe maximum contribution to the plan.(b) Example: Individual owns one business and has self-employmentincome from another source or a close family member owns abusiness.8. Plan options for the small businessowners (with employees)a. <strong>The</strong> primary issue is that with many plan designs if a large contribution is made forthe owner, large contributions are required for eligible employees as well.(1) Example: Contribute 20 percent for the businessowner in a SEP and theemployer generally has to contribute 20 percent for other employees.b. A solution can be a cross-tested profit-sharing plan as larger contributions canbe made for an older businessowner as long as the other employees are ingeneral somewhat younger.(1) Example: Contribute 20 percent for the businessowner who is 55 andcontribute 5 percent for other employees who have an average age of 35.c. Another approach is a 401(k) plan that does still allow larger contributions than forother employees.(1) Example: <strong>The</strong> 60-year-old owner contributes $22,500 as a salary deferraland makes a 3 percent safe-harbor contribution for other employees.d. A similar option is a SIMPLE plan; however, this plan has lower contribution limitsCalculated using the “IRA Savings Calculator for Tax Deferral Comparison” at the website“Free-<strong>Online</strong>-Calculator-Use.com”.LO 3-3-2: Choose between a tax deductible and tax-exempt retirementaccount1. Planners must help a client choose between tax deductible and tax-exempt plans.a. Should I make a Roth election in my 401(k) plan?b. Should I contribute more to my 401(k) plan or contribute to a Roth IRA?c. Should I convert my traditional IRA into a Roth IRA?d. <strong>The</strong> answer depends on:(1) Current vs. future tax rates(2) <strong>The</strong> required minimum distribution rules(3) <strong>The</strong> desire for tax diversification(4) <strong>The</strong> tax treatment desired for heirs2. <strong>The</strong> way you compare makes a difference3.14
a. Example:(1) Save $10,000 in 25% tax bracket(2) Pretax save $10,000, pay taxes on earnings(3) Tax-exempt save $7,500, earnings tax exempt3. How tax rates affect the decision to elect Roth vs. before-tax saving (Video: Howcurrent and future tax rates affect the choice of retirement vehicles? Littell, Nanigian,Reichenstein)a. <strong>The</strong>re are a number of ways to access both types of tax treatment.b. Example: Assume a 35% tax bracket now and 25% tax bracket in retirement. Let’scompare a $10,000 401(k) salary deferral to a $6,500 Roth 401(k) election—bothreduce the amount you can spend this year by $6,500. Assume 100% rate ofreturn with either choice. <strong>The</strong> $10,000 401(k) grows to $20,000 and becomes$15,000 after-tax (25% rate in retirement). This is essentially growth from $6,500to $15,000. If $6,500 went to the Roth, it grows to $13,000 in retirement.c. Choose tax deferral if the tax rate is lower in retirement.d. If higher tax rate in retirement then choose the Roth.e. If tax rates currently and in the future remain the same—accumulation is thesame, but other factors below, may lean toward the Roth4. Estimating tax rates in the futurea. Young people are often in a low tax bracket and should strongly consider the Roth401(k) rather than the tax-deferred 401(k).b. If a client is temporarily in a low tax bracket, they should strongly consider theRoth 401(k) rather than the tax-deferred 401(k).c. Those in the top tax bracket may expect future rates to be higher.d. Middle income are likely to be in the same or lower bracket(1) With elimination of deductions for qualified plans and mortgage interest,this may not be true.(2) Beneficiaries (widow, adult children, trust) may be in a higher tax bracket.5. Other reasons a client should consider a Roth vehiclea. A Roth allows the client to save more. For an individual in the 35% tax bracket, a$22,500 Roth 401(k) contribution is effectively a larger contribution than a $22,500pretax salary deferral (which only reduces current income by $14,625 and onlyresults in $14,625 of after-tax retirement income).b. Can be saved for use later in retirement (no required distributions) and/or efficientasset to leave to heirsc. Roth vehicles have no required minimum distribution so they can be saved as ahedge against longevity.d. Roth IRAs are more tax efficient for heirs.e. Tax diversification(1) Can do income tax bracket planning(2) Roth distributions are not counted for Social Security taxation.(3) Roth distributions are not counted for determining Medicare premiums(Medicare premiums are based on income).6. Roth Conversion issues (Video: How do you execute a Roth IRA Recharacterizationand/or Reconversion? Littell, Schneider)a. Convert when tax rates are low.3.15
. Look for opportunities to convert.c. Planning Point: Conversion means the client is pre-paying a future tax obligation.It is a different way to save for retirement.d. State and Federal inheritance taxes(1) Converting means lowering the value of estate by the amount of taxespaid. This lowers estate taxes and reduces the effective tax rate on theconversion.e. Convert when the asset value is depressed.(1) Tax is assessed on the value of the account at the time of conversion, sothe lower the value, the less tax that must be paid.(2) <strong>The</strong> ability to recharacterize up to due date of the tax return takes awaysome of the risk of converting at the wrong time.f. Do not need plan funds to meet income needs(1) Convert prior to 70½ at lower tax rates(2) Avoid minimum distributions which increase taxable incomeg. Impact of Roth conversion on AGIh. Increase in Medicare premiums (age 65 or older)(1) Social Security subject to income tax(2) Itemized deductions tied to AGI(3) Medical expenses exceeding 7.5% of AGI(4) Unreimbursed employee business expenses(5) Passive activity loss associated with rental real estate (begin to lose afterAGI $100,000)(6) Loss of other tax creditsi. Planning Point: A client considering a Roth conversion in the current year maylook for ways to lower AGI by moving deductions, taking losses, increasingcharitable contributions.j. Problems with conversions(1) If value goes down (after recharacterization period), client will be veryunhappy.k. Not a good idea for a middle income client struggling to make ends meet inretirement (unless amount can be converted at a very low tax rate)LO 3-3-3: Strategies for maximizing tax-advantaged savings1. Maximizing contributionsa. Planners must understand the client’s specific situation:(1) What, if any, savings plans are clients eligible for at work?(2) Is the client self-employed and if so do they have employees?(3) If the client has a job, do they also have any supplemental self-employmentincome?(4) Is the client eligible to make deductible IRA contributions and/or Roth IRAcontributions?3.16
(a) This requires knowing four factors: 1) marital status, 2) tax filingstatus, 3) adjusted gross income, and 4) the active participantstatus of the client and the spouse(5) What are the client’s expectations about future tax rates?(6) What other types of plans do the participants already participate in andhow much have they accumulated?b. Consider all types of plans when looking to maximize contributions for a client.c. Determine whether other after-tax assets could be used to fund contributions orused to support income needs if additional salary is deferredd. Take advantage of age 50 catch-up(1) $5,500 (2012) in a 401(k), 403(b), 457 plan(2) $2,500 (2012) in a SIMPLE(3) $1,000 (2012) to a traditional IRA or Roth IRAe. Look to develop tax diversification for clients, which for many means contributingmore to Roth accounts.f. Look to convert tax-advantaged plans to Roth accounts when tax rates are low2. Inheritance case studya. Factsb. Solution3. Roth election case studya. Facts(1) Sam, age 55, married to Sally, age 52, inherits $80,000 (income tax-free)from Aunt Martha in March.(2) Sam wants to save much of this for retirement and is comfortable titlingsome in Sally’s name.(3) <strong>The</strong>y each earn $70,000 from work, each contribute 6% to their company’s401(k) plans and Sam earns $20,000 from consulting.(4) AGI is approximately $160,000.(1) Sam and Sally open Roth IRAs April 1 and each contribute $12,000($6,000 for last year and this year).(2) Sam and Sally currently contribute 6% of salary ($4,200). <strong>The</strong>y can eachincrease to $22,500 ($18,300 more for each).(3) Sam opens a SEP and contributes 20% of consulting income reduced bythe SS deduction (approximately $3,700).(4) Contributions to Roth IRAs and SEP total $27,700. <strong>The</strong> remaining $52,300of inheritance makes up for the loss of income due to $36,600 of additionaldeductible 401(k) contributions.(5) Next January they still have about $25,000 remaining, since the additionaldeductible contributions only reduced their after-tax income by $27,450(assuming a 25 percent tax rate).(6) <strong>The</strong>y can contribute $6,000 more to each Roth IRA, and have enoughremaining for a terrific vacation!3.17
. Solution(1) Achmed is single, age 58, with $150,000 of AGI, and his companysponsors a 401(k) plan with a Roth election.(2) Achmed wants to maximize contributions.(3) He expects that tax rates now and at the time of withdrawal will be thesame.(4) Currently he only has tax-deferred accounts.(1) If Achmed contributes $22,500 (2012 limit) on a pretax basis, it costshim less in current income because of the tax deduction but he only has$22,500 less taxes to live on in retirement.(2) If he makes the Roth election, he has all $22,500 to spend in retirement andhas prepaid the tax liability. He also has created more tax diversification,allowing him to react to changes in the tax structure in retirement.4. Repositioning assets case studya. Factsb. Solution(1) Diego and Dominga in their mid-50s each work and are contributing asmuch as they can to their employers 401(k) plans. <strong>The</strong>ir AGI is $95,000.<strong>The</strong>y do have a $20,000 CD maturing that they are saving for retirement.How can they improve their situation?(1) Each spouse can contribute $6,000 to a Roth IRA (from the proceeds ofthe CD). If it’s before April 15 th it may be possible to contribute for theprevious and current year.5. Temporary low income case studya. Factsb. Solution(a) Invest in another CD (but in a tax-exempt environment)(b) Contributions available for withdrawal without income taxconsequences(1) Francisca, age 45, leaves her well-paying job and starts a consultingbusiness. Her prospects look good in the future, but her first year’sself-employment earnings are only $40,000. She can live on this amount,but can’t see saving more for retirement. She has a $160,000 rollover IRAand $110,000 of after-tax savings and investments. What opportunitiesmight be available to Francisca in this year of lower-than-averageearnings?(1) This year poses some interesting opportunities. One, Francisca can setup a 401(k) plan and use her savings to contribute almost $21,000 on atax-deductible basis ($17,000 in salary deferrals and 20% of earnings afterthe deduction for Social Security taxes (approximately $3,700 more).(2) This reduces her taxable income even more, and makes it a good year toconsider converting some of her IRA to a Roth IRA.6. Nondeductible IRA case studya. Facts3.18
. Solution(1) Li and Lin Lin are both age 58, married and have AGI of $300,000. Bothare employed and maximize contributions to their companies’ 401(k) plans.<strong>The</strong>y do not currently have any IRA accounts. <strong>The</strong>y want to know if theycan contribute more to tax-advantaged retirement plans?(1) <strong>The</strong>y are good candidates to establish nondeductible IRA accounts,contribute the maximum amount and then immediately convert thoseamounts into a Roth IRA.(2) Since they do not have other IRAs, the conversion will be tax-free(assuming no earnings accrue before the conversion occurs). <strong>The</strong> situationis more complicated with other IRA accounts because if this is the case,there are tax consequences to doing the conversion.7. Self-employed plans case studya. Factsb. Solution(1) Sandra Sanders, age 63, is married and files a joint tax return. <strong>The</strong>couple’s AGI is $300,000 for the year.(2) She has started a training business operating as an unincorporated entityand she has no employees.(3) Her schedule C earnings are $65,000 and her deduction for 1/2 ofself-employment taxes is $5,000. She is in the position of being able tosave as much of her income as possible for retirement. What are heroptions in 2012?(1) Sandra should establish a retirement plan for her business—afterdetermining first that her company is not required to be aggregated withany business owned by her husband.(2) With a SEP she could contribute $12,000 (20 percent of $60,000).(3) With a 401(k) she could contribute $34,500 ($12,000 (the 20 percent limit)+ $17,000 (in salary deferrals) + $5,500 (in catch-up contributions)). Shecould also make salary deferrals on a Roth basis.(4) With a defined benefit plan she could shelter most of her income but it’scomplicated!(5) She could make $6,000 of nondeductible IRA contributions as well andthen convert to a Roth IRA.(6) Note that at age 70½ she can no longer contribute to an IRA but cancontinue contributions to the retirement plan.8. Roth conversion case studya. Facts(1) Alex and Alicia are married, each age 63, and retired. <strong>The</strong>y are taking$80,000 of withdrawals from their taxable investment account to pay forliving expenses.(2) <strong>The</strong>y have made some good choices, deferring Social Security and holdingonto their substantial 401(k) accounts until later. <strong>The</strong>y do not have anyRoth IRAs at this point.3.19
. Solution(3) Because of their current strategy, they have a very low taxable incomefor the year.(4) Is there any other option to improve their situation?(1) <strong>The</strong>y are great candidates for converting a portion of either of their 401(k)plan benefits. Together, with their accountant they should determine howmuch they should convert—the objective may be converting as muchas possible and still have a 15 percent effective tax rate. In the futuretheir taxable income is going way up—as they start taking qualified planwithdrawals and receive taxable Social Security benefits.SECTION 4: DEFERRING SOCIAL SECURITYLO 3-4-1: Understand how deferring Social Security can improve a client’ssituation1. Objective for this <strong>section</strong>:a. Identify the impact of deferring Social Security benefits.b. Discuss framing the Social Security deferral decision as a way to increase annuityincome as well as the more traditional approach of a “break even analysis.”c. Discuss some practical ways that can help a client afford to defer benefits byidentifying other sources of income.d. Social Security claiming decisions are complicated and will be covered in moredepth in HS 354 Sources of Retirement Income2. Deferring Social Security can improve a client’s situation because it provides for anincrease in guaranteed income in retirement.a. Most clients would benefit from additional guaranteed income. Social Securityprovides an inflation-adjusted annuity guarantee by the government.b. Benefits are payable for life—and for married couples, the higher of the two SocialSecurity benefits is paid after the death of the first spouse to the surviving spouse.c. Many retirees today do not have other guaranteed lifetime income—and researchhas shown that retirees with greater amounts of guaranteed income show moresatisfaction, worry less, and show fewer signs of depressiond. Deferring Social Security means more guaranteed income. It also means a higherproportion of the client’s income is subject to inflation protection because SocialSecurity benefits receive CPI increases.e. Commercial annuities generally do not offer full inflation protection. Someproducts have a cap on annual CPI increases. Others provide an increasingbenefit that is not directly tied to CPI, but increase benefits at a stated percentage.For example, benefits increase 3 percent each year.3. Deferring Social Securitya. Deferring benefits is an easily implemented strategy that can improve a client’ssituation.b. For each year of deferral from age 62 to 70, there’s about a 7% increase inbenefits.c. When talking with clients, discuss both3.20
(1) <strong>The</strong> increase in dollar amounts received because of a deferred claimingage(2) <strong>The</strong> increase in percentage of preretirement earnings that is replaced by adeferred Social Security claiming aged. Replacement rate example(1) Couple—both earn $60,000 using Social Security’s “Quick Calculator”(2) At age 62, Social Security replaces 23% of pre-retirement earnings.(3) At age 66, Social Security replaces 32%.(4) At age 70, Social Security replaces 45%.(5) This example was calculated assuming in each case that the individualwould continue working full-time until benefits begin.e. Benefit amount example(1) <strong>The</strong> maximum benefit is approximately $2,500 a month ($30,000 year) fora 66-year-old (currently the full retirement age) in 2012.(2) Taking at age 62 means the benefit is $1,875 a month ($22,500 a year)(3) Taking at age 70 means the benefit is $3,300 a month ($39,600 a year)4. Everyone wants a good deal from Social Securitya. Many take early to try and get their money’s worth. Under the traditionalbreak-even analysis, die early (under approximately age 80) and you would havereceived more benefits by beginning at age 62.(1) However, betting on dying young is a bad gamble—since losing meansliving a long life with too little income.(2) Wealthier individuals with more resources may be in a better position touse the break-even analysis to determine a starting age. However, at leaston average those with higher socio-economic status are more likely to livelonger—which leads to a decision to defer benefits under the break-evenanalysis(3) <strong>The</strong> break-even analysis does lead to the conclusion that a singleindividual who is in bad health and has a shorter life expectancy shouldbegin benefits early. For a married person, however, this may not be true.b. Spousal survivor benefits complicate the break-even claiming decision(1) A simple way to look at this is that the surviving spouse receives the higherof the couple’s two Social Security retirement benefits.(2) So when the spouse with the higher Social Security life-time benefit hasa short life expectancy, the surviving spouse will inherit the benefit. So ifbenefits were claimed early, the surviving spouse is saddled with the lowerbenefit for the rest of his or her lifetime.(3) Let’s consider someone who lives an average life expectancy. Forsingles receiving benefits at different starting ages, benefits are actuarialequivalent in this case. However, because of the spousal survivorbenefit (called the widow(er) benefit), married men living the averagelife expectancy who retire and begin benefits early will receive a smallerpresent value than if they defer. This means that for the average couplein this case, deferral results in the better “deal.”3.21
5. Framing the issue as an annuity purchase decision (as opposed to a break-even analysis)a. With this approach, the value of deferring benefits is the amount of increasedmonthly benefits due to benefit deferral.b. <strong>The</strong> cost of deferral is the lost payments as result of deferralc. It is possible to determine if the cost is worth the increased benefits by comparingit to the actual price of purchasing an inflation adjusted annuity in that amount.d. In most cases, the “Social Security Annuity” is the cheapest and most effectiveannuity a client can purchase.6. Practical ways to support the loss of Social Security benefits in the retirement budget asa result of deferrala. Workb. Using other assetsc. Eligibility for other Social Security benefitsd. Strategies for those who have already begun benefits7. Social Security and worka. Continuing to work provides income to allow the deferral of Social Security benefitsb. Full-time work can also increase benefits.(1) <strong>The</strong> increase can be substantial if the worker has fewer than 35 years ofearnings under the Social Security system.(2) Even if thirty-five years of employment, years of higher earnings replacelower ones even for earnings after the full-retirement age.c. Part-time work can also support deferral of benefits(1) <strong>The</strong>re is an uncertain impact on benefits when comparing part-time work tofull-time employment.(2) Planning Point: Use the Social Security calculators available at the SocialSecurity website to determine the impact of additional work on benefits.<strong>The</strong> detailed calculator that can be downloaded is the most accurate andallows modeling of a number of scenarios.8. Using other assets to bridge the gap until delayed Social Security beginsa. Client retires at age 62 and either elects Social Security benefits or chooses touse other assets for a period of time and defers Social Security benefits.b. One way to look at this issue is the annuity purchase price comparison.c. Another approach is offered by Bill Reichenstein who looks at how long theportfolio will last under each scenario—claiming benefits early and takingwithdrawals steadily from the portfolio or deferring benefits and drawing downmore from the portfolio in the early years and less once Social Security benefitsbegin. (Video: Is it better to defer Social Security and withdraw other financialassets? Littell, Nanigian, Reichenstein)d. Example from article, “Social Security: When to Start Benefits and How toMinimize Longevity Risk,” Reichenstein and Meyer, March 2010 Journal ofFinancial Planning,: Single individual with $700,000 of assets in 401(k) retiring atage 62. A combination of Social Security benefits at age 62 and withdrawals fromthe 401(k) generates $41,700 of after-tax income for 30 years.(1) Deferring Social Security to age 64—now the portfolio lasts to age 91.5(2) Deferring Social Security to age 66—now the portfolio lasts to age 93(3) Deferring Social Security to age 70—the portfolio lasts the longest3.22
9. In some circumstances, an individual can take one Social Security benefit and laterswitch to a higher benefit—this may allow an individual the ability to support deferringthe higher benefit.a. One example is that a divorced spouse eligible for a divorced spousal benefitbegins that benefit at full retirement age and at age 70 switches to the maximumworker’s benefit.b. Married couples have several strategies10. Involuntary retirement11. Planning(1) <strong>The</strong> spousal benefit cannot begin until the worker claims benefits. At fullretirement age a worker can claim benefits to start the spousal benefit andthen suspend the worker’s benefit until age 70 to maximize the worker’sbenefit.(2) If both spouses are entitled to a worker’s benefit, the worker with the lowerbenefit claims worker’s benefits, at full retirement age the spouse electsthe spousal benefit, and at age 70 switches to the higher worker’s benefit.a. Client may have to begin Social Security benefits early due to involuntarytermination of employment but if circumstances change he may want to changethat decision to increase benefits.b. An individual who begins benefits and a short time later goes back to work, theindividual can pay back benefits (without interest) within one year of when benefitsbegan and Social Security will recalculate their benefits.c. Suspension of benefits(1) <strong>The</strong> “earnings test” is a forced suspension of benefits. It is not a permanentreduction in benefits as benefits are recalculated at full retirement agetaking into consideration the number of months benefits were not paid dueto the earnings test.(2) Voluntary suspension of benefits is allowed after attainment of fullretirement age.a. For many it’s the most important retirement income decision they will makebecause for approximately two-thirds of retirees more than half of their incomecomes from Social Security.b. Unfortunately, more than 50% take benefits as early as possible at age 62.c. <strong>The</strong> Social Security decision needs to be part of a comprehensive retirementincome plan.12. Planning Checklista. Determine the client’s eligibility for various retirement benefits (e.g., workersbenefit and/or spousal benefit) and the amount of benefitsb. Obtain benefit information from Social Security statements or have the clientuse Social Security’s retirement estimator online calculator. This pulls up theindividual’s wage history but requires the client’s Social Security number.c. With this information, begin to consider viable options, and use the SocialSecurity’s detailed calculator to calculate actual benefits under different scenarios.d. Part of the plan is clearly identifying a source of income for bridge period.e. Finally, it can be helpful to evaluate the impact of the plan using one of thecommercially available software tools.3.23
SECTION 5: TAP HOME EQUITYLO 3-5-1: Choosing an appropriate strategy for tapping home equity inretirement1. Options for tapping home equity (Video: What are the different ways to access homeequity to fund retirement needs? Littell, Stucki)a. Conventional home equity loans(1) Because the reverse mortgage has high up-front costs, it is a better optionfor a client when costs can be amortized over a longer period—meaningwhen the individual is planning to stay in the home for a long time.(2) A conventional home equity loan or line of credit has lower up-front costswhich makes it a better option to tap home equity for people who do notplan to stay in the house for a long time.(3) Limitations of a conventional loan:(a) If the borrower cannot make required loan payments, he can endup in a foreclosure situation.(b) <strong>The</strong> participant has to have sufficient income to qualify for aconventional loan.b. Planning Point: <strong>The</strong> home is a finite resource. Planners need to help clientsconsider how the house fits into their long-term retirement planning goals.c. Single purpose loansd. Downsize(1) State and local governments may offer single purpose loans (property taxdeferral, for example) to those of modest income.(2) Similar to reverse mortgage in that repayment is not required until theborrower leaves the home.(3) <strong>The</strong> advantage of a single-purpose is that they are lower cost loans and insome cases the loan may be forgiven.(4) A disadvantage is that once one of these loans has been taken you maynot be able to tap additional equity.(5) <strong>The</strong>se loans may not be available everywhere and may only be availablefor those whose income is lower.(1) Is one popular approach to tapping home equity(2) One challenge is that many clients wait to sell until there is a crisis.(3) Another challenge is that there may be no appropriate cheaper housingin the desired geographical area.e. Reverse mortgage(1) This is a good approach if the homeowner will live in the house for manyyears.(2) Reverse mortgages are nonrecourse loans. Homeowners are neverresponsible for any amount more than the value of the house.(3) A range of distribution options are available and an individual can switchoptions3.24
2. Reverse mortgage basicsa. Almost all loans today are made under the Home Equity Conversion Mortgage(HECM) program. <strong>The</strong> HECM encourages lenders to make loans by providingFHA insurance to the lenders.b. To qualify, all owners must be age 62 or older and the loan can only apply toa principal residence.c. <strong>The</strong> amount of loan payments made to the client depends on the client's age, thevalue of the home, and the interest rate and fees that are being charged.d. Repayment is required only when the last surviving borrower dies, sells the home,or permanently moves.e. <strong>The</strong> outstanding balance on the loan grows with interest until it is repaid—andif repayment does not occur for many years much of the home’s equity will beused up.f. Reverse mortgage loans are nonrecourse, meaning the maximum amount thathas to be repaid is the value of the home.g. If property values have eroded, and the outstanding balance on the loan exceedsthe value of the home, the homeowner or the heirs are not responsible for thedifference. This is the situation in which the FHA would make up the difference.h. If the home’s value exceeds the loan amount, the owner or heirs would receive thewindfall when the home is sold.i. Since the transaction is a loan, there are no income tax consequences when thehomeowner receives payments or the loan is repaid.j. Payment options available:(1) Options include a lump sum, line of credit and tenure option—meaning thatmonthly payments for as long as the borrower remains in the home(2) Since the loan balance grows with interest, the homeowner will use upless equity in the long run by withdrawing amounts only as the income isneeded—meaning that the line of credit or monthly payments are oftenthe best options.3. What retirees are likely to need to tap home equity in retirement (Video: What are somestrategies for using home equity in the decumulation phase of retirement? Littell, Stucki)a. Traditional thinking is that reverse mortgages are for those who are house richand cash poor.b. Only a small percentage of older homeowners fall into this “house rich and cashpoor” category (5%) and these are generally elderly widows.c. Majority are in the middle income group with less than $40,000 in income andapproximately $200,000 in home equity.(1) Because their resources are modest, this group is most likely to be tappingtheir home equity.(2) Opportunities4. Different strategies for using equitya. To increase income(a) This middle market group is traditionally not the target of financialadvisors.(b) Large number of homeowners who will be looking for advice as tohow to use home equity in retirement3.25
(1) A conventional strategy is to take out a reverse mortgage to increasemonthly income.(a) If this is the objective, an individual may elect what are calledtenure payments—in which a monthly benefit is paid as long as theindividual is living in the home.(b) Another strategy that may use less equity but could increaselong-term income would be to take a reverse mortgage beforeSocial Security benefits are paid as a bridge to defer (and increase)Social Security benefits.b. To pay for long-term care costs(1) It is generally not appropriate to take out a reverse mortgage to pay forlong-term care insurance premiums.(a) Expensive—as this requires payment of the premiums whileinterest charges accrue on the loan(b) Risky—because the individual may run out of available equity andbe unable to continue paying the premiums(c) Purchase insurance too late—a reverse mortgage is not availableuntil the individual attains age 62, rather late for purchasinglong-term care-insurance (LTCI)(2) Home equity can be an appropriate part of the long-term care plan.c. To manage debt(a) A client can purchase an affordable policy with a limited daily limitand retain home equity as a way to supplement the insurancepayments.(b) A client can purchase an LTCI policy that only pays for care in anursing facility (which lowers the cost of the policy) and uses areverse mortgage to fund care that is provided in the home.(1) A newer trend is homeowners transferring unsecured debt into a reversemortgage.(2) Way to defer a home mortgage or other debt payment(a) Someone with existing debt on the house may not be able to makethe monthly payments, so they take out a reverse mortgage.(b) Take the proceeds of that loan to pay off the existing debt on thehouse and roll that over into the reverse mortgage and then defer(c) Taking a lump sum benefit can use up the equity in a home quicklyas the interest charges on the loan will accumulate rapidly.(d) Using up home equity in this way means that it is not availablefor other purposes.d. As an emergency fund (financial buffer)(1) It may be an advantage to use the home “asset” in a more proactive,preventive way.(2) Take out a reverse mortgage line of credit(a) Have those resources available so you do not have to wait untilan emergency.3.26
5. Planning considerations(b) Keep up with needs and expenses.a. <strong>The</strong> first step in planning is simply bringing home equity into the retirement incomeconversation. For the client that has an income shortfall, home equity may bepart of the answer.b. If the goal is using home equity to create a regular income stream, there are anumber of options:(1) One option is to downsize—that is, sell the home and buy a less expensiveone or rent to create additional assets that can be used to generateadditional current or future income. This may be the simplest way to freeup equity but may not meet the client’s retirement objectives or there maynot be adequate cheaper housing in the desired neighborhood. On theother hand, for some clients this may be a great way to free up equity,possibly lowering living expenses and finding more appropriate housing forlater in life as well. This also may be part of a relocation plan—choosingan area with lower housing and living expenses.(2) For the client wanting to stay in the home, another option is to take areverse mortgage and elect a tenure option to generate a steady stream ofadditional income over the time that the individual stays in the home. <strong>The</strong>advantage of this approach is that it allows the client to stay in the home,uses up the home equity more slowly as the amount borrowed buildsslowly. <strong>The</strong> limitation is that the income will stop when the client leaves thehome, and the outstanding loan amount may use up a significant portion ofthe equity if income payments continue for many years.(3) A third option is to take a reverse mortgage with a line of credit distributionoption and take withdrawals for a limited period of time to defer SocialSecurity benefits. This strategy requires borrowing at a young age andinterest may accrue for many years, but it gives the client the ability toincrease income as deferring Social Security from 62 to 70 increasesbenefits by 76 percent.c. Another way to use home equity is to reduce expenditures by retiring outstandingdebts.(1) Some debt can be removed by downsizing—especially for those whochoose to rent instead of purchasing another home.(2) Another option is to use a reverse mortgage to retire a conventional loan.This can reduce current expenses—which is clearly one way to improve aretirement income plan. <strong>The</strong> limitation of this approach is that it requiresreceipt of a lump sum payment—which if the client is going to stay in thehome for many years may wipe out most—or all—home equity.d. Long-term care planning(1) For the individual who wants to stay at home and receive care, a reversemortgage can clearly be used to pay for care. <strong>The</strong> primary limitation is thatequity may be used up, if later institutional care is required.(2) Maybe a better approach is to use the reverse mortgage in combinationwith a less expensive LTCI insurance policy or other funding approachesto long-term care planning.e. Emergency fund3.27
(1) Using home equity as an emergency fund has the advantage of holdingon to equity longer—which will minimize the loss of home equity in thelong run.(2) For it to be effective, however, the homeowner needs to be willing to takedistributions to make sure that basic needs are met—which can clearlyprolong good health.SECTION 6: IMPROVING PORTFOLIO PERFORMANCELO 3-6-1: Learn strategies for improving the performance of a retirementportfolio1. Ways advisors add value: (Video: What investment strategies can improve portfolioperformance without adding risk? Littell, Nanigian)a. Making sure that assets are at work. For example, regularly reinvesting thedividends in the client’s account so that all assets are earning a rate of return thatis greater than the rate of return on cashb. Rebalancing the client’s portfolio assets to ensure that the level of risk of theportfolio stays appropriate for the client’s risk tolerancec. Using modern portfolio theory to make sure that the client has the portfolio thatis generating the highest rate of return per unit of risk. Clients could do this ontheir own using applications, but it is quite complex.d. Selecting specific assets (e.g., stocks or stock mutual funds) within asset classes.This is not typically done by modern portfolio theory optimization.2. How an advisor can increase a portfolio’s performance without increasing the portfolio’srisk (focusing on mutual funds)a. Planning Point: Invest in mutual funds with low expense ratios(1) Carhart (1997) 5 found that in the cross-<strong>section</strong> of mutual funds, eachpercentage point increase in expense ratio decreases returns by 1.5percentage points per year (on average).(2) Similar results have been obtained in numerous subsequent academicstudies.(3) However, there are many more criteria to consider than just expense ratiosin the mutual fund selection process.b. Planning Point: Invest in funds that have a low level of overlap with theirbenchmark index in terms of their portfolio holdings.(1) Cremers and Petajisto (2009) 6 constructed a novel measure called “activeshare” which denotes the percentage of the holdings of a fund that do notoverlap with its benchmark index. <strong>The</strong>y find that funds with the highestactive share outperform their benchmarks by 1.1 to 1.2 percent a year.In contrast, those with low active share underperform the index by 1.4to 1.8 percent a year. Active share means investing differently than thebenchmark.5. Carhart, M. M. (1997). On persistence in mutual fund performance. <strong>The</strong> Journal of Finance, 52(1), 57-82.6. Cremers, K. J. M., & Petajisto, A. (2009). How active is your fund manager? a new measure that predicts performance. Workingpaper.3.28
(2) Some funds that are promoted as actively managed funds even though arereally “closeted index funds.” In other words, they have almost the sameinvestment mix as the indexed fund.(3) Planning Point: If the client chooses an actively managed fund, make surethat the fund manager is exerting effort by looking at the active share dataavailable through some data bases and acting accordingly.(4) If the actively managed fund is performing like the index, it is likely that theportfolio manager has created a “closeted index fund.”(5) Closeted index funds may be more prevalent in Europe.c. Planning Point: Invest in newly launched funds.(1) Karoui and Meier (2009) 7 find that newly launched mutual funds outperformmore established funds. Such funds also have more concentratedportfolios and invest in less liquid stocks, which suggests that theiroutperformance stems from greater autonomy in portfolio choice they areafforded by having a small base of investor capital.(a) More concentration means they hold fewer stocks. This means themanager is investing more heavily in their best ideas.(b) Newly launched funds invest more in less liquid stocks. Recentresearch has shown that these stocks receive a higher rate ofreturn. In other words, there is compensation for the illiquidity.d. Planning Point: Invest in funds with managers and directors who have “skin inthe game.”(1) Khorana, Servaes, and Wedge (2007) 8 examine the relationship betweena portfolio manager’s investment in their mutual funds and the futureperformance of those funds. <strong>The</strong> authors find that per every basis pointincrease in the proportion of a fund that is owned by a portfolio manager,risk-adjusted performance increases by 2.4 to 5.0 basis points per year,depending on model specification.(2) <strong>The</strong> authors conclude that portfolio manager ownership is indicative offuture performance and espouse two possible explanations for this.(a) First, fund managers with high ownership have superior informationabout the future performance of their fund(b) Second, such managers have a stronger incentive to exert effort.(<strong>The</strong>y try harder!)(3) Similarly, Cremers, Driessen, Maenhout, and Weinbaum (2009) 9 findthat funds with low ownership by members of their board of directorsunderperform by at least 2% a year on average.(4) <strong>The</strong> “skin-in-the-game” data can be hard to come by. Morningstar Directand SEC filings are ways in which it may be found.e. Planning Point: Invest in institutional class shares, if you qualify7. Meier, I., & Karoui, A. (2009). Mutual fund tournaments. Working paper.8. Khorana, A., Servaes, H., & Wedge, L. (2006). Portfolio manager ownership and fund performance. Working paper.9. Cremers, M., Driessen, J., Maenhout, P., & Weinbaum, D. (2009). Does skin in the game matter? director incentives andgovernance in the mutual fund industry. Journal of Financial and Quantitative Analysis, 44(6), 1345-1373.3.29
(1) Institutional class shares typically require a large investment of assets.(2) Institutional shares pass along the lower expenses to the client.(3) People approaching retirement may have enough assets to take advantageof this.(4) Planning Point: <strong>The</strong> advisor should get the client out of the retail funds andinto institutional funds as their portfolio increases.f. Planning Point: Invest in funds with a short-term redemption fee(1) Short-term redemption fees may prevent investors from frequently tradingin and out of mutual funds, which results in an implicit wealth transfer fromlong- to short-term fund investors.(2) In a working paper by Finke, Waller, and Nanigian, they find that in thecross-<strong>section</strong> of mutual funds, those with redemption fees outperform theircounterparts by 1.0 to 1.4 percent a year. This is not driven by managerialquality. Instead, it is driven by changes in portfolio characteristics, mostnotably a reduction in cash holdings.3. Planning Point: Warnings and caveatsa. Do not invest in funds that are the worst performers.(1) It is often stated in fund prospectus “past performance is not indicativeof future results.” This “past performance statements” is true for all butperhaps funds in the bottom decile (10%) of funds when ranked byperformance. Carhart (1997) 10 found that there is considerable persistencein bad performance among these poor performers.(2) <strong>The</strong>re are many ratings agencies that provide gauges such as stars thatproxy for performance. Based on the research, it would be advisable toavoid the funds with the lowest ratings.b. Planning Point: Advisors should be aware that investment bank-affiliated fundstend to underperform their peers.(1) Advisors should be aware that investment bank-affiliated funds tend tounderperform their peers. Hao and Yan (2007) 11 find that investment bankaffiliated mutual funds underperform those of their counterparts by 0.96%to 1.68% per year, depending on the method of performance evaluation.(2) This is because such funds having higher allocations to the shares ofstocks underwritten by the investment banking arm of the investmentcompany that operates the fund, which are often overvalued.(3) <strong>The</strong> authors believe that the purchases of shares of such stocks are notmotivated by valuation reasons but rather by a desire to support the pricesof the shares in hopes of winning future business for the investmentcompany (conflict of interest!).c. Planning Point: Advisors should be aware that broker-sold funds tend tounderperform their peers.10. Carhart, M. M. (1997). On persistence in mutual fund performance. <strong>The</strong> Journal of Finance, 52(1), 57-82.11. Hao, Q., & Yan, X. (2007). Conflicts of interest and mutual fund performance: Evidence from investment banking relationships.Forthcoming in Journal of Financial and Quantitative Analysis.3.30
(1) Berstresser, Chalmers, and Tufano (2009) 12 show that broker-sold fundsunderperform direct sold funds, even before subtracting 12b-1 marketingfees. <strong>The</strong> broker-sold funds also do not have lower nondistributionexpenses to make up for their higher distribution expenses. However,there is greater money flow into funds with higher distribution expenses,which suggests that funds are “sold, not bought.”(2) Similarly, Morey (2003) 13 finds that load funds significantly underperformno-load funds on a load-adjusted basis.(3) To minimize this, the planner must require communication with the clientabout how the advisor is being paid. This ties back into the beginning of thelearning objective about what value advisors bring to the client relationship.LO 3-6-2: Choosing appropriate asset location to improve after-taxinvestment performance1. What is asset location? (Video: In a tax-deferred account what percent of principal iseffectively owned by the individual investor? Littell, Nanigian, Reichenstein)a. Asset location is not asset allocation. Asset allocation is the percentage of fundsinvested in stocks, bonds, and cash.b. Asset location is the type of account in which the asset is locatedc. For example, a stock mutual fund can be held in a taxable brokerage account, atax-deferred 401(k) plan, or a tax-exempt Roth IRA.2. What is the portion of the principal owned in a tax-deferred account owned by an investor?a. <strong>The</strong> answer is based on the investor’s tax rate.b. To determine the investor’s portion take one minus the tax rate to determine theinvestor’s portion.c. <strong>The</strong> government’s share in the account is the tax rate.d. Example: Individual has a 25 percent tax rate, the investor owns 75 percent of theaccount principal and the government owns 25 percent.3. What percentage of the returns in a tax-deferred account are received by an investor?a. In a tax-deferred account the after-tax return does not grow tax-deferred, it growstax-free.b. Example: <strong>The</strong> investor has a $10,000 tax-deferred account and is in the 25percent tax bracket. <strong>The</strong> account earns 100 percent return. <strong>The</strong> account growsto $20,000 and after-tax the investor receives $15,000. Since the pretax returnis 100 percent (account grows from $10,000 to $20,000) and the after-tax returngrows 100 percent (after-tax account grows from $7,500 to $15,000) the effectivetax rate on the return is zero.c. <strong>The</strong> pre-tax return is equal to the after-tax return. <strong>The</strong> collective tax rate is zero.4. What percentage of the risk is borne by the investor in a tax-advantaged account?a. <strong>The</strong> investor gets 100 percent of the returns and bears 100 percent of the risk.12. Bergstresser, D., Chalmers, J. M. R., & Tufano, P. (2009). Assessing the costs and benefits of brokers in the mutual fund industry.<strong>The</strong> Review of Financial Studies, 22(10), 4129-415613. Morey, M. (2003). Should you carry the load? a comprehensive analysis of load and no-load mutual fund out-of-sampleperformance. Journal of Banking & Finance, 27(7), 1245-1271.3.31
. This is the same as the Roth account—a $10,000 tax-deferred account isequivalent to a $7,500 tax-exempt Roth account—if the tax exempt account earnsa 100 percent return, the after-tax account grows to $15,000.5. How does this tax treatment affect asset location?a. With a taxable account the government receives a portion of the return, while theinvestor receives 100 percent with both tax-deferred and tax-exempt accounts.b. Example: If an investor holds bonds in a taxable account earning 4 percent,the taxpayer in the 25 percent bracket only keeps 3 percent of the return. In atax-deferred or tax-exempt account the taxpayer earns the full 4 percent.c. Also with a taxable account the government shares in both the return and the risk.d. Example: <strong>The</strong> taxpayer owns stock earning on average 10 percent over threeyears with a 20 percent standard deviation. In year one, the stock earns 10percent. In years two, the stock loses 10 percent. <strong>The</strong> stock earns 30 percent inyear three. <strong>The</strong> tax rate for most stock investors is 15 percent. So in year one, theafter-tax gain is 8.5 percent, the loss is 8.5 percent and the gain in year three is25.5 percent the average return is 8.5 percent and the standard deviation is 17percent (reducing the risk to the investor).e. As stocks are taxed at 15 percent and bonds are taxed as ordinary income—whichwill generally be taxed at a higher rate—for example 25 percent, the taxpayerwould prefer to pay the 15 percent tax rate instead of the 25 percent rate. Also, byinvesting stocks in the taxable account, the investor reduces the risk somewhat.f. Planning Point: Hold stocks in the taxable account and bonds in the tax preferredaccount.g. Planning Point: If stocks are held in the taxable account, it allows the investor toincrease the asset allocation to stocks since the “government” is taking some ofthe risk (57½ vs. 50 percent).6. General rules as a result of the tax differencesa. Hold stocks in the taxable account and bonds in the tax-advantaged retirementaccounts to the fullest extent possible (recognizing the individual’s appropriateasset allocation).b. Hold other investments that are subject to tax as ordinary income (e.g., real estatetrusts) in tax-advantaged retirement plans.c. Consider the tax aspects of different accounts in making asset allocationdecisions—asset allocation should be made on an after-tax basis.d. <strong>The</strong> impact of trading stocks frequently is that some of the gains will be taxed atordinary income rates and not long-term capital gains rates. This will reduce thevalue of holding stocks in the taxable account.7. Bringing value to the clienta. Hard to outperform the market or other advisorsb. Planning Point: All advisors can use the tax code to improve after-tax performanceand add value for their clients.3.32
RESOURCES FOR COMPETENCY 3: CHOOSE APPROPRIATESTRATEGIES TO ADDRESS GAPS IN INCOMESection 1: Saving More and/or Spending Less in Retirement• Calculations made using Smart Money’s Retirement Planner software, freely availablehere.Section 2: Additional Work• <strong>The</strong> study discussed by Jack VanDerhei in this <strong>section</strong> is EBRI’s Issue Brief #388, “<strong>The</strong>Impact of Deferring Retirement Age on Retirement Income Adequacy”, June 2011.• <strong>The</strong> 2009 report mentioned in this <strong>section</strong> by McKinsey and Company called “Restoring<strong>American</strong>’s Retirement Security” identified working longer as one of the key solutions toAmerica’s retirement savings shortfall. Available at McKinsey and Company’s website.• Employment Resources for Older Workers:– www.RetirementJob.com provides job information for those over age 50.– Your Encore provides retirees opportunities in the scientific community.– Encore Careers focuses on jobs in philanthropy.– AARP work and retirement resources and the AARP Foundation Worksearch jobplacement assistance.• A list of Community <strong>College</strong>s offering the "Plus 50" program which offers job training andlifelong learning for older adults.• A number of tools for those choosing a new career.• Resources and discussion boards concerning a wide range of issues affecting olderadults including work-related concerns.• A long list of public/private resources helpful with job-hunting.Section 3: Saving More Efficiently with Tax-Advantaged Plans• To compare savings on a pre-tax basis (such as in a 401(k) plan) versus saving on anafter-tax basis, try the “IRA Savings Calculator for Tax Deferral Comparison” at thewebsite “Free-<strong>Online</strong>-Calculator-Use.Com” found here.Section 4: Deferring Social Security• <strong>The</strong> example that Professor Reichenstein is discussing is from the article “Social Security:When to Start Benefits and How to Minimize Longevity Risk” William Meyer and WilliamReichenstein, Ph.D., CFA Journal of Financial Planning, Dec. 2010.• All of the Social Security Administration Calculators that can be used to estimate benefitscan be found here.Section 5: Tapping Home Equity• Key Findings: 2009 Risks and Process of Planning Report, Society of Actuaries. (2011Retirement Risk Survey – Full Report PDF) Among other subjects includes data abouthome.• <strong>The</strong> MetLife Mature Market Institute and NCOA study discussed in the video is called“Tapping Home Equity in Retirement”3.33
Assignment 4EVALUATE THE INCOME TAX, ESTATE ISSUES, ANDOTHER THREATS TO THE RETIREMENT INCOME PLAN4Assignment 4SECTION 1: INCOME TAX CONSIDERATIONSLO 4-1-1: Choose an appropriate distribution option from an employersponsored tax-advantaged retirement plan1. Framing the issuea. Choosing an appropriate distribution option from an employer-sponsoredtax-advantaged retirement plan affects almost everyone.(1) All clients with employer-sponsored tax-advantaged retirement benefitsface distribution decisions.(2) Because this is an issue facing most clients, it is appropriate for the advisorto fully understand the rules.(3) Distribution elections are a complex transaction with lots of paperwork.ERISA requires that clients be given distribution election forms, noticesand release forms for the qualified joint and survivor rules, a right to makea direct rollover, and information about the tax treatment of distributions.Clients want, need and appreciate help understanding their options.(4) Helping with the distribution choice transaction can really help solidify arelationship with a client, which may lead to referrals of other new clients.Some advisors who become familiar with a particular employer’s retirementbenefit plans can generate a lot of business with other retirees from thissame employer (e.g., school district, a large local private employer).b. Choosing an appropriate distribution option for an employer-sponsoredtax-advantaged retirement plan is important for the following reasons:(1) In most cases the benefit election decision is irrevocable (e.g., electing alife annuity versus a joint and survivor annuity).(2) Distribution decisions involve one of the client’s larger assets, making it acritical part of the retirement income plan.(3) Mistakes with retirement distributions can be costly. For example, fail torollover a benefit to an IRA in a timely manner and all of the distribution istaxable income.(4) Mistakes in choosing the right distribution option can mean running outof money too soon.(5) Mistakes by advisors that result in bad consequences for the client canmean legal liability to the advisor.2. Context—when do distribution decisions occur?a. Retirees must choose how to receive their retirement distributions(1) From the current employer’s plan(s)4.1
(2) From the previous employer(s) plan(s)(3) Planning Point: Planners should inquire not only about the opportunitiesfor distributions from the current employer’s plan, but they should also askwhether there are plans with previous employers.b. Clients may need to deal with distributions when changing jobs.(1) Clients may have a distribution option(2) Clients may choose to defer or rollover to an IRA or other employer plan3. Distributions from the many types of employer-sponsored tax-advantaged plans candiffer on the type of plan involved.a. More complex requirements exist — qualified plans, 403(b) plans and 457 plansthan for IRAs, SEPs, and SIMPLEs (e.g., ability to make a direct rollover, subjectto the qualified joint and survivor requirements)b. Simplified distribution or hardship withdrawal requirements (roll any distributionother than a required minimum distribution)(1) IRA(2) SEP(3) SIMPLE4. Qualified plan distributionsa. Limited distribution options(1) Plan will have clearly defined optional forms of distribution and methods todetermine the amount paid under each option.(2) Discretionary withdrawals that can be taken as needed (which is thecommon approach in an IRA) are not typically allowed in a qualified plan.b. Timing of payments(1) <strong>The</strong> plan can require that benefits are deferred to a specified retirementage.(2) Almost all defined contribution plans, and even some defined benefit plans,do allow a distribution at termination of employment.(3) Some plans may even allow in-service withdrawals.c. Ability to defer benefits(1) Even if the plan allows an immediate distribution, participants can generallyelect to defer the receipt of the distribution to normal retirement age.(2) Unless plan has involuntary cash-outs for small benefits.d. Defined-benefit plan benefits(1) In most cases, the basic benefit value is tied to a life annuity.(2) A participant electing any other form of benefit will receive the actuarialequivalent of the basic benefit form.(3) Example: Cedric is eligible for a retirement benefit of $2,000 a monthpayable beginning at age 65 in the form of a single life annuity. If hereceives instead a 100% joint and survivor annuity with his wife as thebeneficiary, the monthly benefits will be $1,600, the actuarial equivalent ofthe life annuity. <strong>The</strong> reduction reflects the longer payout period and theamount is derived under the terms of the plan.4.2
e. Defined-contribution plans(1) Value of the benefit is tied to the account balance, which is a single lumpsum.(2) If an individual elects an annuity, the amount is based on how much thelump sum will purchase.5. Checklist of qualified plan paperworka. Benefit election form—describes the amount of benefit payable under each of theoptional forms of distributionb. A qualified joint and survivor annuity notice and waiver form—required for mostqualified plans and many 403(b) plans. If the participant wants to elect a formother that a joint and survivor annuity, then both the participant and the spousemust sign a waiver in front of the plan administrator or notary.c. Right to a direct rollover—the right to have the benefit transferred directly to anIRA custodian or other tax-advantaged retirement plan. This option is meant tosimplify and thus encourage rollovers.d. Notice of tax treatment—explains the tax treatment of the distribution from the plan.e. 1099R—a tax form provided to the participant and the IRS when there is a lumpsum distribution.6. Optional forms of distribution in a tax-advantaged plan include:a. A life annuity—a stream of payments for the life of the participant with nopayments after death.b. A life annuity with a guaranteed term certain—a stream of payments for the longerof life expectancy or the term certain. If the participant dies before the end of theterm certain (for example, 10 years) benefits will continue to a chosen beneficiary.c. A joint and survivor annuity—a payment for the life of the participant, that willcontinue payments if the beneficiary lives longer than the participant.d. An annuity certain—provides payments of a specified amount for a specifiednumber of years or months.e. A single sum—the participant receives the entire benefit at one time.f. Installment payments—provide a way to liquidate an account balance over time,providing a specified payment for a specified period or until funds are depleted.7. Optional forms of distribution generally not available from qualified plansa. Discretionary withdrawals—the ability for a client to take as much as is needed atany timeb. Variable deferred annuities with lifetime benefit riders—deferred annuities thatallow for investment flexibility and the benefit rider offers some downside protectionc. Variable immediate annuities—similar to life annuities in that benefits are payablefor life, but the amount of each payment varies depending upon the underlyinginvestment performanced. Immediate annuities with inflation protection—offer increasing payments based ona fixed percentage each or based in the CPI indexe. Longevity insurance—an annuity that pays a fixed monthly benefit, but only at anadvanced age such as age 80 or 85f. Planning note: Expect employers to offer more options over time. <strong>The</strong> IRS andDOL are interested in participants having choices, and we are starting to seeregulatory changes to accommodate more options. For example, proposedregulations provide that longevity insurance could be purchased without violatingthe required minimum distribution rules.4.3
8. IRA funded plans (IRAs, SEPs, SIMPLEs) have the following characteristics:a. Allow for discretionary withdrawalsb. Allow for a wide range of investment choicesc. Allow for a wide range of annuity productsd. Allow the participant to purchase an immediate annuity at any time9. Choosing the right distribution option from a defined-benefit plana. <strong>The</strong> distribution decision should be made as part of a comprehensive retirementincome plan—but too often, it is not.b. What plan distribution options are available and how much will be paid undereach option?c. If an annuity is desired and the plan has a lump sum option, then more planning isrequired because the client can elect the lump sum and roll it to an IRA withouttax consequences. Consider:(1) Is the right annuity available inside of the plan?(2) When is the annuity going to be annuitized?(3) If the option is available both inside and outside of the plan, whichapproach pays the largest amount?(4) Is there a difference in the security of benefit payments?(5) Is there an impact on potential ad-hoc employer-provided COLAs or otherbenefits (e.g., retiree’s health) by taking the money out of the plan?d. Pension maximization concept—elect a life annuity and use the differencebetween the life annuity payments and joint and survivor payments to purchaselife insurance.e. If a lump sum is the desired form of payment, note that timing matters!(1) Value tied to outside index which changes over time(2) When interest rates are lower, the lump sum values are higher.(3) In an increasing interest rate environment, the lump sum value will belower.(4) <strong>The</strong> index used has changed from one based on treasuries to one basedon corporate bonds. (Today’s lump sum values are lower than in the past.)10. Choosing the right distribution option from a defined contribution plana. What is the best distribution option for the retirement income plan?b. What plan distribution options are available?c. When is the annuity purchase desired?d. Is the best annuity price available inside or outside of the plan?11. Qualified plan rollovers(1) Plan may have institutional pricing which might be advantageous for theclient.(2) Plan sponsor may offer institutional pricing through IRA rollovers to thesame carrier.a. Most participants elect lump-sum distributions.b. It is critical for the client to defer taxes until benefits are needed (except ifwithdrawals will be taxed at a very low rate).c. Elect a direct rollover of “eligible distributions” to tax-advantaged plans or an IRA.4.4
d. Roth Accounts in 401(k)/403(b)/government sponsored 457(b) are rolled to a RothIRA (not into a regular IRA).12. Qualified plans (403(b) plans and government sponsored 457(b)) have some technicalrequirementsa. Eligible rollover amounts include all distributions except:(1) Required minimum distributions(2) 401(k) hardship withdrawals(3) Life annuities and periodic payments for 10 years or more (e.g., termcertain annuities)b. Rules for rollovers(1) Payment directly to the participant(2) Subject to 20% mandatory withholding. So the participant gets only 80% ofthe benefit.(3) Rolling over 100% of the benefit would require contributing additional cash.(4) Rollovers must occur within 60 days of the distribution or all of thedistribution will be subject to taxes.c. Rules for direct rollovers(1) All participants must receive the opportunity for a direct rollover.(2) A direct rollover is a payment from the plan to custodian of an IRA or thetrustee of another qualified plan.(3) A direct rollover election avoids the 20% withholding requirement.(4) Planning Point: A direct rollover is clearly the better option for an individualwanting to roll over the benefit.13. Why roll over plan distributions?a. Participant wants control over the timing and amount of withdrawals.b. Participant wants control over investment options.c. Participant wants an annuity option that is not available in the plan.d. Participant wants to defer the decision to annuitize.14. Why not roll over plan distributions?a. If the best distribution option for a client is an annuity, and the “best deal” (largestannuity payment) is inside the plan.b. Rolling employer stock into an IRA means losing the opportunity to take advantageof the net unrealized appreciation (NUA) favorable tax treatment.c. Rolling after-tax contributions over to an IRA results in a less favorable costrecovery method.(1) Example: Client does a direct rollover of a $100,000 401(k) benefit intoan IRA that includes $10,000 of after-tax contributions. If the next day theclient withdrew $10,000 from the IRA, only $1,000 would be tax free asyou use a pro rata recovery rule. If the client only rolled over $90,000, the$10,000 would be recovered tax-free.15. Checklist of considerationsa. Does the client understand the information provided and the impact of theirchoices?4.5
. Does the distribution election fit into the client’s retirement income plan?c. Are the technical requirements of the rollover rules satisfied?d. Consider reasons to take into income instead of rolling over.LO 4-1-2: Understand and advise clients on the tax treatment oftax-advantaged retirement distributions1. Framing the Issuea. <strong>The</strong> tax treatment of withdrawals affects almost everyone, as almost all clientshave some type of tax-advantaged retirement plan.b. It comes up a lot; the tax treatment of a withdrawal occurs each time there is adistribution from a qualified plan, IRA or other tax-advantaged plan.c. It is an integral part of the plan; clients live on after-tax income, so minimizingtaxes can have a significant effect on the retirement income plan.d. It can set the advisor apart; your introduction to the client may be around adecision they have to make around a distribution from a retirement plan. Being anexpert in this area gives the advisor a competitive edge.2. Key take-aways:a. Describe the general rules that apply to the tax treatment of a distribution.b. Identify the various complicating factors.c. Provide a checklist to use to help identify tax issues with each distribution.d. Note that this is a complex area and will be covered in more detail later in theRICP designation.3. Tax-deductible plansa. Qualified plans(1) Defined-benefit plans(2) Profit sharing plans(3) 401(k) plansb. Traditional IRAs(1) Deductible contribution account(2) Nondeductible contribution account(3) Rollover amountsc. 403(b) and government 457(b) plansd. Roth accounts (401(k), 403(b), government 457(b))4. General tax treatment from tax-deductible plans:a. Distributions from a qualified plan, deductible IRA, rollover IRA, non-Roth 403(b)and non-Roth 457 plan are taxed as ordinary income.b. Other after-tax amounts (cost basis) can be recovered tax-free.c. Lump sum distributions from qualified plans that include distributions of theemployer’s stock will be eligible for special tax treatment called “net unrealizedappreciation.”d. A death beneficiary may get a deduction for estate taxes paid.(1) This is the case only if federal estate taxes are paid based on the pensionbenefits.4.6
(2) Under this rule, the distribution is taxable income; however, the deathbeneficiary is eligible for a deduction for estate taxes paid.(3) Example: A $1 million IRA is distributed to a death beneficiary. In thiscase, the decedent’s estate paid $300,000 of estate taxes. <strong>The</strong> beneficiaryis entitled to a deduction of $300,000 and only pays income taxes on$700,000.(4) Deduction is pro rata for partial distributions.e. Pre-59½ withdrawals are subject to a 10% penalty unless an exception applies.5. Cost recovery of amounts that were already taxeda. Types of cost basis(1) After-tax contributions in a qualified plan (only common today in largecompany 401(k) plans)(2) Nondeductible contributions to IRA(3) Table 2001 amounts that are subject to income tax each year because theplan includes a life insurance policy on the life of the participantb. Cost recovery methods(1) Clients may be able to roll over all of the distribution to anothertax-advantaged plan except for the cost basis. When this is the case, therewill be no tax consequences. This is an effective way to get the after-taxamount outside of the plan without paying taxes.(a) Example: A client takes a distribution from a qualified plan of$100,000 that includes $10,000 of after-tax contributions. She rolls$90,000 into an IRA. <strong>The</strong> $10,000 withheld is considered the costbasis and there are no tax consequences.(2) Withdrawals prior to retirement to a client that has after-tax contributionsin a qualified plan are taxed on a prorated basis—but only looking at theafter-tax account.(a) Example: A client has $200,000 in a 401(k) plan and has anafter-tax account with $20,000. Only $10,000 is from contributionsand $10,000 is earnings. If prior to retirement the client withdraws$10,000 from the after-tax account, $5,000 is taxed and $5,000 istax-free. This is determined by multiplying the $10,000 withdrawalby a fraction; $10,000 (the cost basis) divided by $20,000 (thevalue of the after-tax account).(3) Annuity payments from qualified plans are subject to a special recoveryrule. This is not a very common situation since there are so few after-taxcontributions in tax-advantaged plans.(4) <strong>The</strong> IRA cost recovery method is the most common situation that will occuras some clients will make nondeductible IRA contributions(a) To determine how much of each distribution is recovered tax free,use a prorated recovery method based on ratio of nontaxableamounts to value of all IRAs.(b) Example: Client has an IRA worth $50,000 with $20,000 ofnondeductible contributions. <strong>The</strong> client withdraws $10,000. If thisis the client’s only IRA, the portion that is not taxed is $10,0004.7
6. Net unrealized appreciation rules apply when:multiplied by the fraction $20,000 divided by $50,000 which equals$4,000. However, If the client has an additional $950,000 rolloverIRA, then multiply $10,000 by the fraction $20,000 divided by$1,000,000, the value of both IRAs and now only $200 withdrawn isexempt from income tax.a. <strong>The</strong> client receives a lump-sum distribution (defined as an entire distribution withinone year) from a qualified plan which includes a distribution in-kind of employersecurities.(1) Example: Jimmy, age 62, receives a distribution of company stockcurrently worth $200,000 that was only $50,000 when allocated to hisaccount. He is in the top 35% marginal tax bracket.b. <strong>The</strong> value of the stock when it was allocated to the participant’s account is treatedas ordinary income.(1) So in Jimmy’s case, $50,000 is taxed at time of distribution as ordinaryincome (at the 35% rate).c. <strong>The</strong> difference between that value and the current market value is the NUA(1) In Jimmy’s case, $200,000 – $50,000 = $150,000 of NUAd. <strong>The</strong> NUA is taxed at long-term capital gains rates when the stock issold—regardless of when that occurs, meaning that there is no holding periodrequirement.(1) In Jimmy’s case, $150,000 of NUA will be taxed at the current toplong-term capital gains rate of 15% regardless of when it is sold.e. If there is any additional gain from when the stock is distributed to when it is sold,the gain is taxed as short- or-long-term gain depending upon the holding period.(1) In Jimmy’s case assume that the stock is sold 5 years later for $250,000.$50,000 is not taxed (as it was already taxed), $150,000 is taxed as NUA,the additional $50,000 is also taxed as long-term capital gains because thestock has been held for more than 12 months.f. NUA planning(1) <strong>The</strong> decision whether or not to take advantage of the NUA rule must bemade at the time of the distribution. If the distribution is rolled into anIRA or the distribution is taken in cash (instead of employer stock), theopportunity is lost.(2) Planners should discuss the NUA issue with the client.(3) <strong>The</strong>re is no easy answer as to whether it is appropriate to elect NUA taxtreatment.(4) <strong>The</strong> NUA rule is only valuable when there is a significant differencebetween the value of the stock when it was allocated to the client’s accountand the market value at the time of the distribution.(5) <strong>The</strong> participant who has not attained age 59½ will have to pay the earlywithdrawal 10% penalty tax, but only on the portion of the distribution thatis subject to ordinary income tax.(6) It is appropriate to make the election if the client needs current cashbecause the capital gains tax rate will be less than the ordinary income4.8
7. Pre-59½ penalty taxtax rate in most cases. Otherwise, it’s tricky to know when to elect NUAtreatment as factors such as how long the individual expects to hold thestock, portfolio diversification considerations, and expectations aboutfuture tax rates are all factors in the decision.a. <strong>The</strong> 10% penalty on the taxable portion of a distribution prior to age 59½b. Applies to distributions from qualified plans, 403(b), 457, SEPs, SIMPLES, IRAs,and in some cases Roth IRAs (distributing income from a Roth and the distributionis not a qualified tax-free distribution)c. <strong>The</strong>re are many exceptions to the penalty tax.(1) <strong>The</strong> exceptions that apply to all plans include:(a) Distributions after the death of participant (no 10% penalty)(b) Distributions due to the participant’s disability (no 10% penalty)(c) Distributions for deductible medical expenses (no 10% penalty)(d) A distribution that is part of a stream of “substantially equal periodicpayments” (no 10% penalty)(2) <strong>The</strong> exceptions that apply to qualified plans include:(a) Withdrawals upon separation from service after attaining age 55are not subject to the penalty tax (no 10% penalty)(b) Applies to qualified plans and 403(b) plans(c) This exception does not apply once a distribution is rolled overto an IRA.(3) <strong>The</strong> exceptions that apply to IRAs (including SEPs and SIMPLEs) include:(a) Higher education expenses (college) for the participant or familymember (no 10% penalty)(b) Up to $10,000 of first-time home buying expense for the participantor family member—this is a one time exception looking at all IRAs(no 10% penalty)(c) Heath insurance premiums paid for those unemployed receivingunemployment insurance (no 10% penalty)8. Tax deductible plan checklist. <strong>The</strong> general rule is for distributions to be taxed as ordinaryincome. However, ask these questions:a. Is a portion of the distribution attributable to a 401(k) Roth account? – <strong>The</strong>distribution may be tax-free.b. Has the recipient attained age 59½? – <strong>The</strong> distribution may be subject to a10% penalty tax.c. Is there any cost basis in the plan? – <strong>The</strong> basis will be recovered tax-freeaccording to a pro-rated formula.d. Is there a distribution of employer stock or does the participant have the optionto receive employer stock? – <strong>The</strong> distribution may be taxed at capital gains rateif it qualifies as NUA.e. Is the recipient a death beneficiary and not the participant? – If there were estatetaxes paid because of the pension, then the client may be entitled to a deduction.9. <strong>The</strong> rules for the tax treatment of a tax-exempt plan are different.4.9
a. Tax-exempt plans include Roth IRAs and Roth accounts in a 401(k), 403(b)or 457(b) planb. Qualifying distributions are always tax-free.c. Nonqualifying withdrawals are taxed differently depending upon whether thewithdrawal is from a Roth IRA or Roth account.10. Qualifying Roth Distributions which are tax exempt must satisfy both the 5-year and thetrigger event rulesa. <strong>The</strong> five-year rule requires that the distribution occurs after the 5-year tax periodbeginning with the first tax year for which a contribution was made andb. A triggering event includes(1) Attainment of age 59½(2) Death or disability of the participant(3) Up to $10,000 of qualified first-time homebuyer expensesc. <strong>The</strong> 5-year rule applies differently depending upon whether the plan is a Roth IRAor Roth account11. Nonqualifying withdrawals12. Examples:(1) Roth IRAs—the 5-year period begins for all Roth IRAs based on theestablishment of the first Roth IRA(2) Roth 401(k) accounts—each plan must meet 5-year rule; however, whena distribution is rolled into a Roth IRA, the 5-year period starts over andthe favorable Roth IRA taxing rule now applies.a. Roth IRAs receive favorable tax treatment.(1) Contributions are considered withdrawn first and are not taxed.(2) Once contributions have been withdrawn, additional distributions ofearnings are taxed as ordinary income and possibly the 10% earlywithdrawal penalty.b. Roth accounts do not have the same favorable tax treatment.(1) Withdrawals are subject to a pro-rated recovery rule, so a portion of eachdistribution is treated in part as a return of contributions and a part istreated as earnings.(2) This unfortunate tax issue can be easily resolved by rolling the distributionfirst to a Roth IRA and then taking the distribution from the Roth IRA.a. Facts: Alex, currently age 55, set up a Roth IRA in 2003. <strong>The</strong> current value is$40,000. Alex contributed $22,000 and has taken no distributions.b. Question: What happens if he withdraws $15,000?c. Answer: This is a nonqualifying withdrawal—but there are no income taxconsequences as this is considered a return of contributions.d. Question: What if he withdraws all $40,000 to pay his son’s college educationexpenses?e. Answer: This is still a nonqualifying withdrawal—and $18,000 of earnings will besubject to income tax and the 10% early withdrawal penalty; however there will beno 10% penalty as the college education exception applies to this fact-pattern.13. <strong>The</strong> Roth tax checklist. <strong>The</strong> general rule is that distributions which qualify are tax-exempt.However, ask these questions:4.10
a. Is the distribution from a Roth IRA or Roth Account? – Roth accounts have lessfavorable tax treatment.b. Is the distribution a qualifying withdrawal? – <strong>The</strong> distribution is tax-exempt!c. Is it best to roll Roth Accounts to a Roth IRA?d. If a nonqualifying Roth IRA withdrawal:(1) What is being withdrawn?(2) Have contributions been fully recovered?(3) If earnings are being withdrawn, does the 10% penalty apply?LO 4-1-3: Understand and advise clients on the required minimumdistribution rules1. Framing the issuea. Any client with a qualified plan, 403(b), 457(b), SEP, SIMPLE or IRA has toaddress the required minimum distribution rules (RMD).b. Withdrawals have to be made each year once a client has attained age 70½ andgenerally must continue through the life of the chosen beneficiary.c. Distributions also have to be made to the beneficiary if the participant dies prior tothe required beginning date. <strong>The</strong>se rules also apply to Roth IRAs.d. Roth IRAs are not subject to RMDs while the participant is alive. However, afterthe participant dies, the RMD rules apply.e. Failure to satisfy the RMD rules results in a 50% penalty tax. <strong>The</strong> tax is on theshortfall between the amount that should have been withdrawn and the amountactually withdrawn.2. Retirement income plan considerationsa. Consider RMDs when building the retirement income plan.b. If a client has multiple plans, consider whether plan consolidation hascost/administrative benefits while still satisfying the client’s goals and objectives.c. Carefully evaluate beneficiary forms. Gather all of the client’s current forms toensure that they are consistent with the client’s goals, and possibly modify theforms to add contingent beneficiaries.d. For the most part, deferring withdrawals from a retirement plan as long aspossible results in the largest accrual of tax deferred earnings. So waiting untilwithdrawals are required and then only withdrawing the minimum required or ifgreater the amount needed is the best strategy. However, an exception to the ruleis that if withdrawals can be made at a lower tax rate, it may be appropriate totake withdrawals earlier. <strong>The</strong>se can be used to cover expenses or if not neededconverted to a Roth IRA and saved for later. A common situation where this mayoccur is when a client early in retirement prior to age 70½ has low income.3. Steps to take to ensure the client avoids the 50 percent RMD penalty taxa. Inventory all plans subject to the RMD requirements.b. Identify who is responsible for calculating the appropriate withdrawal.c. Consider the rules for aggregating multiple IRAs and 403(b) plans to satisfy theRMD rules.d. Identify who is responsible to ensure that the client takes the withdrawals ina timely manner.4. Three compliance concerns must be addressed:a. RMDs during participant’s lifetime4.11
8. Calculating required distributions is different for benefits that are currently annuitizedand those that are not currently annuitized.a. Account plansb. Annuities(1) Any benefit that has not been annuitized by the RBD (required beginningdate)(2) Includes deferred annuities (that have not been annuitized)(1) Elect an annuity form of payment.(2) Purchase an immediate annuity.9. RMD account calculation rule10. Example:a. Divide the account balance from the previous year by the life expectancy usingthe uniform lifetime table, which is a table established by the IRS.b. <strong>The</strong> distribution is based on participant’s age at end of distribution year.c. During the lifetime, the choice of beneficiary does not affect the calculation.(Planners should use the uniform table.)d. A spousal exception applies to the case of the uniform table:(1) When the spouse is more than 10 years younger…(2) Use the actual joint life expectancy to determine the amount that needs tobe withdrawn. This will result in a smaller required distribution.a. Sally, an IRA participant, is aged 71 on the last day of the first distribution year.Her 30-year-old niece is the beneficiary. <strong>The</strong> IRA balance end of preceding yearis $200,000.(1) First year RMD is $200,000/26.5 = $7,547(2) Second year RMD is calculated with 25.6 life expectancy (72-year-oldparticipant)b. Sally’s beneficiary was her 51-year-old spouse(1) RMD is $200,000/34.2 = $5,848(2) RMD for second year use 33.2 life expectancy (joint life expectancycalculated at the end of that distribution year)11. RMD Annuity calculation rulea. Compliance only has to be demonstrated once!b. Life, joint and survivor, and even variable annuities typically satisfy the rules.c. Rules if the annuity is purchased after the required beginning date (RBD):(1) <strong>The</strong> annuity purchased after the RBD must satisfy the account rules inthe year of the purchase. For example, if the annuity payment is smallerthan the amount required under the account rules, the client must makeup the difference.(2) Annuities are not aggregated with account plans. For example, an annuitypayment from one IRA does not reduce the RMD requirements for otheraccount plans.12. Common errors that occur under the RMD rules during the life of the participant4.13
a. During lifetime, the calculation is straightforward, looking to the uniform table forlife expectancy except with a younger spousal beneficiary.b. Remember: <strong>The</strong> account balance may have to be adjusted for withdrawals andadditional contributions.c. Getting started at 70½ can be an issue because the client is not yet in the routineof taking distributions.d. Plans that go unnoticed when the client has multiple plans may become a problem.e. Improper application of the aggregation rules may become a problem.13. Rules for account plans – distributions after the participant’s death:a. In the year of death, use the same methodology as before death.b. In the following year, the RMD depends on who the beneficiary is as of thefollowing Sept. 30th.(1) If it is the spouse(a) Typically roll into the spouse’s own IRA (then the spouse is treatedas the owner).(b) Can leave in name of decedent(2) If it is a nonperson(a) <strong>The</strong> remaining RMDs must be made over the remaining lifeexpectancy of participant.(3) If it is a nonspouse14. Nonspousal beneficiary example:(a) Use the single life expectancy (fixed) of the beneficiary. (Forexample, if the child has a 25-year life expectancy, take 1/25, then1/24, then 1/23, etc.)a. John dies at 82 with $800,000 IRA at end of previous year(1) RMD for year of death is $800,000/17.1 = $46,783.b. Assuming $840,000 value at end of the year of death and September 30 solebeneficiary is John’s 54-year-old daughter, Sarah15. Other important rules(1) RMD is $840,000/30.5 = $27,540(2) For following years distribution period is fixeda. Beneficiary rules(a) Year 2 the applicable distribution period is 29.5 (30.5 – 1), and soon in future years(b) Distributions can continue for 31 years even if Sarah dies beforethe end of the period(1) <strong>The</strong> beneficiary, for purposes of calculating the RMD, is the beneficiary asof September 30th following year of death.(2) Nonperson beneficiaries include charity, estate, or nonconforming trust.(3) Conforming trust—use life expectancy of beneficiaries of the trust whencalculating RMDs.b. If there are multiple beneficiaries:(1) Use the oldest or “shortest life” beneficiary to determine RMDs4.14
(2) Exception: If there are separate accounts for each beneficiary, then theRMD can use the beneficiaries’ specific age to determine the amount thatmust be withdrawn.16. Common errors in the RMD rules as they apply to beneficiariesa. Most glaring: beneficiary withdraws the whole account to buy a boat insteadof maximizing tax-deferred growth by stretching out distributions over thebeneficiary’s life expectancy.b. Do not fail to make RMD in year of death and remember to continue RMDs tobeneficiaries as the penalty will apply.c. Beneficiary designations: fail to consider RMD, tax and legacy goalsd. Postmortem planning is available. Clients should not fail to take advantage ofopportunities to maximize the “stretch period.”17. Postmortem planning review:18. Example:a. <strong>The</strong> beneficiary used under the RMD rules is the beneficiary as of September 30thof the year following the participant’s death.b. A beneficiary cannot be added after the death of the participant.c. Planning tools include:(1) Use a qualified disclaimer in favor of a contingent beneficiary.(2) Make distributions prior to the following September 30th so the beneficiaryis not counted.(3) With multiple beneficiaries, divide into separate accounts to stretch outpayments.a. Helen has four primary beneficiaries(1) Son Bud(2) Daughter Betty(3) <strong>The</strong> <strong>American</strong> <strong>College</strong>(4) Second husband Saul19. Rules for when a participant dies prior to the required beginning date:a. With a nonperson beneficiary(1) All distributions must be made within 5 years.b. With a spousal beneficiary(1) <strong>The</strong> spouse should roll over the account balance to their own IRA.(2) Alternatively: Leave the account balance in name of decedent; beginbenefits by December 31st of year decedent would have attained age 70½.c. With a nonspousal beneficiary(1) Lifetime exception – distribute benefits over the beneficiaries lifetime.(2) Benefits begin by end of the year following the year of participant’s death.20. Common errors that apply when a participant dies prior to the required beginning date:a. Most glaring error: beneficiary still buys a boat instead of stretching out payments,which would result in a significant amount of additional tax-deferred growth.4.15
. Failure to read the plan to see if an election is required for the lifetime exception.This may require distributions over 5 years instead of stretching out paymentsover the lifetime.c. Roth IRAs: the RMD rules that apply to Roth IRAs, regardless of the age of theparticipant at deathd. <strong>The</strong> planning and beneficiary considerations are the same as when the participantdies at an older age, but there is more likelihood that when the participantdies young that the participant had not given as much thought to the planningconsiderations.21. Planning checklista. Identify responsibilities to ensure compliance.b. Inventory all plans subject to RMD rules.c. Consider whether plan consolidation has cost/administrative benefits while stillsatisfying goals/objectives.d. Carefully evaluate beneficiary forms.e. Look to maximize “stretch” except look for years in which withdrawals or Roth IRAconversions can occur at low tax rates.LO 4-1-4: Choosing tax efficient withdrawal strategies1. Types of retirement accountsa. Taxable accounts—direct investments that are not held within a tax-advantagedretirement plan, such as stocks and bonds in a brokerage accountb. Tax deferred (or tax-deductible accounts)—401(k) plans, deductible IRAs andother tax-advantaged plans in which taxes are deferred on the entire value of theaccount (contributions and earnings) until distributions are madec. Tax exempt accounts—Roth IRAs and Roth accounts in 401(k), 403(b) and 457(b)plans in which contributions are made on an after-tax basis and earnings areexempt from tax as long as certain requirements are satisfied2. Traditional withdrawal sequencing advice (Video: What is the appropriate order ofwithdrawals from different types of retirement accounts? Littell, Nanigian, Reichenstein)a. First withdraw taxable accountsb. <strong>The</strong>n withdraw tax deferredc. Finally withdraw tax exempt accounts3. Reichenstein variation4. Rationalea. First, take a combination of taxable and tax deferred distributions.b. Second, once the taxable account is depleted, take a combination of tax-deferredand tax-exempt.a. <strong>The</strong> government owns a portion of the principal of the account—the portionrepresenting the tax rate on withdrawals.b. Example: Joe has a significant 403(b) balance. If he waits until 70½ to takerequired minimum distributions, he will be taxed at a 25% rate. After retirementbut before 70½ based on his income needs he can take a withdrawal of some ofhis tax deferred account and still be subject to a 15% tax rate. He can eithertake withdrawals to meet living expenses or if not needed, the withdrawals canbe converted to a Roth IRA.4.16
5. Impactc. Tax rates are low in early retirement in part due to the fact that withdrawals oftaxable accounts are not treated as taxable income—increasing the opportunity todo a Roth conversion.d. A key objective is to minimize the tax rate on tax-deferred accounts.e. A married couple filing jointly can have approximately $80,000 of taxable incomeand still be taxed at the 15% rate.a. Appropriate withdrawal strategies can extend the life of a retirement portfolio.b. <strong>The</strong> impact can be significant for those with modest accumulations.c. <strong>The</strong> impact is less profound for those with several million dollars or more.d. Planning requires having at least 2 different types of account (taxable andtax-deferred, for example)6. Planning—look for opportunities to take advantage of withdrawals at a low tax ratea. A year of significant medical expenses (large deductions)b. First few years in a new business with low incomec. Large charitable deductions7. Review tax principalsa. Tax-exempt and tax-deferred both enjoy tax-free growth(1) Example: An individual in the 25% tax bracket has a $750 Roth IRAand $1,000 IRA. Both grow by 100%. <strong>The</strong> individual receives the sameafter-tax distribution ($1,500) from both accounts.b. Taxable accounts have lower after-tax returns. So these should generally bewithdrawn first.c. Withdrawing taxable accounts first can have the most impact on how long theportfolio will last.d. Countervailing consideration is that the government owns a portion of the principalof tax-deferred accounts based on the individual’s tax rate.(1) Try to minimize the government’s share by taking withdrawals at a lowtax rate.(2) Opportunities for taking withdrawals at a low tax rate:(a) Taxable withdrawals are a return of principal.(b) <strong>The</strong> period before Social Security benefits begin may have a lowerincome and lower taxes.(c) <strong>The</strong> period before required minimum distributions begin may havelower income and a lower tax rate.(3) Taxpayers can have significant income and still be taxed at a 15% effectivetax rate.(a) Taxable income for a married couple filing jointly can exceed$80,000 of income that is actually taxed and still have an effectivetax rate of 15%.(b) Considering that in 2012, $19,500 is taxed at a zero rate countingpersonal exemptions and the standard deduction, a couple canactually have more than $120,000 of taxable income and still havea 15% effective tax rate.4.17
(c) Single taxpayer can exceed $60,000 of taxable income and still betaxed at a 15% effective tax ratee. Phase 1 (the individual has both taxable and tax-deferred accounts): Start withwithdrawals from the taxable account and from the tax-deferred account to theextent that withdrawals can be made at a lower than normal tax rate(1) Tax-deferred withdrawals can be part of the withdrawals required to meetexpenses.(a) This has a slight positive impact on how long the portfolio lasts—inpart because early withdrawals also mean loss of some taxdeferred growth.(b) Having the opportunity to mix tax-deferred with taxable distributionsgives the participant more flexibility as they may not want toliquidate the after-tax account for a number of reasons.(2) Tax deferred withdrawals that are converted to a Roth IRA are alsoappropriate to the extent that the converted amounts are taxed at a lowerthan normal rate.(a) Looking to convert now if the current rate is lower than expectedrate on future withdrawals(b) Converting will clearly have a positive impact on the portfolioduration.f. Phase 2 (taxable accounts are depleted): <strong>The</strong> order of withdrawals betweentax-deferred and tax-exempt ties to the tax rates at the time of the withdrawalversus the tax rates on withdrawals taken later.(1) If the tax rates are higher in the future, take tax-deferred accountwithdrawals to the extent that the effective tax rate is low (e.g., 15% )(2) Withdrawals above and beyond will be taxed at the next marginal rate. Forsome future tax rates will go down as either they will have lower incomeavailable or lower income needs. In this case additional withdrawalsshould come from the Roth account.(3) Many taxpayers at this stage will expect to have the same the marginaltax rate in the future. In this case, the order of withdrawals doesn’t matterfrom a tax perspective (between tax-deferred and tax-exempt accounts).Now you would look to other reasons for maintaining one type of accountover the other.g. Planning checklist(1) Order of withdrawal decisions should become part of annual tax planning.(2) Be sure to have an inventory of the various types of accounts.(3) Identify any required minimum distributions—as there is no discretion inthis case.(4) Review past tax returns to understand the client’s tax situation.(5) Discuss with the client whether there are any income changes or changesin deductions for the current year that offer opportunities in the current year.(6) Look for special issues around selling investments—such as the step up inbasis rules.4.18
(7) Based on ordering rules, identify which accounts to withdrawal from forthe current year.LO 4-1-5: Understand the tax treatment of annuities1. Qualified annuities (are annuities held inside a qualified plan, IRA, or 403(b) plan) (Video:What is the tax treatment of a nonqualified annuity? Littell, Tacchino, Ivers)a. Qualified annuities receive the same tax treatment as other assets held intax-deferred plans.b. Generally this means that distributions are taxed as ordinary income.c. Withdrawals prior to age 59½ are subject to the 10% early withdrawal penaltyunless an exception applies.2. Nonqualified annuitiesa. General rule—nonqualified annuities are funded with after-tax dollars, sopremiums become the policyowner’s cost basis and growth will be taxed only atthe time of withdrawal.b. During the accumulation period, income tax is deferred.(1) Accumulation period implies that there are no withdrawals.(2) To qualify for deferral of taxation, the annuity must generally be held by anatural person (several exceptions apply).c. <strong>The</strong> tax treatment of withdrawals made during the pre-annuitization phase:(1) Assuming there have been earnings (gain in the value of the contract), thefirst withdrawals from the annuity are considered earnings.(2) Example: An annuity has a current value of $15,000 and premiumpayments (cost basis) is only $10,000. <strong>The</strong> owner wants to withdraw$2,000. Since there has been a gain of $5,000, the first $2,000 withdrawnis treated as gain and is fully includable as ordinary income subject toincome tax.(3) Withdrawals are also subject to the 10% early withdrawal penalty.(a) <strong>The</strong> tax only applies to the taxable portion of the withdrawal priorto attainment of age 59½ at the time of the distribution (not at theend of the tax year).(b) <strong>The</strong> penalty does not apply to• A stream of annuity payments• Payments as a result of disability• Distributions after the death of policyowner• Distributions that are part of a stream of substantially equalperiodic payments(c) <strong>The</strong> exceptions for medical expenses, education expenses, andseparation from service at age 55 do not apply to a nonqualifiedannuity, so the 10 percent penalty will apply under thesecircumstances.d. Tax treatment upon policy surrender(1) Difference between the cash surrender value and cost basis is subject toincome tax.(2) 10% early withdrawal penalty may apply as well4.19
e. Annuitization(1) <strong>The</strong> tax treatment is different if a contract is annuitized, now a portionof each payment (based on the exclusion ratio) is treated as a return ofprincipal and the remaining distribution is treated as taxable income.(2) <strong>The</strong> exclusion ratio is the cost basis (premiums reduced by any return ofcontributions) divided by the expected return (based on the type of annuity).(3) This fraction (exclusion ratio) is multiplied by the amount of the distributionto determine the portion of each distribution that is excluded from income.(4) Once the cost basis has been recovered all future payments are taxable.(5) Calculating the exclusion ratio depends on the following factors(a) Single or joint life annuity(b) Refund feature(c) Inflation rider(6) Death of participant(a) If payments cease at death, remaining cost basis is deducted in theyear of death(b) If payments continue to a beneficiary, continue recovering costbasis using the exclusion ratio.(7) Variable annuities(a) Calculate exclusion ratio by simply dividing cost basis by the lifeexpectancy.(b) If the variable annuity performs badly, the excludable amount mayexceed actual payments in which case the remaining amount notexcluded is prorated over the remaining life expectancy (payment of$10,000 and basis of $12,000 means $2,000 that can be recoveredover the remaining life expectancy).LO 4-1-6: Identify how Social Security benefits are taxed1. A portion of Social Security benefits are included in taxable income if a client’s provisionalincome exceeds thresholds provided in Code Sec. 86. In order to determine the taxableamount of Social Security, we must first calculate a client’s provisional income. (Video:How are Social Security benefits taxed? Littell, Tacchino)2. Provisional income is equal to AGI plus ½ of the Social Security income, plus othernontaxable interest (such as interest on tax-exempt bonds).3. Example: Virginia has an AGI of $50,000, plus $10,000 in municipal bond income, plusSocial Security income of $20,000. Her provisional income is $70,000. ($50,000 AGI +$10,000 bond income + ½ x $20,000 in Social Security ($10,000)).4. A single person with $25,000 or less in provisional income will pay no taxes on his or herSocial Security income.5. A married couple who files jointly with $32,000 or less in provisional income will payno taxes on their Social Security income.6. A single person whose provisional income is $25,000 to $34,000 may have up to 50percent of his or her Social Security income taxed.4.20
7. A married couple who file jointly whose provisional income is $32,000 to $44,000 mayhave up to 50 percent of their Social Security income taxed.8. If a single individual has a provisional income of $34,000 or greater, up to 85 percent oftheir Social Security is taxed, leaving at least the remaining 15 percent tax-exempt.9. If a married couple who file jointly has a provisional income of $44,000 or greater, up to85 percent of their Social Security is taxed, leaving at least the remaining 15 percenttax-exempt.10.Percentage of Social SecurityBenefits TaxedSingle ThresholdMarried Filing Jointly Threshold0% $25,000 $32,000Up to 50% $34,000 $44,000Up to 85% Above $34,000 Above $44,000A few dollars over a threshold willnot trigger all SS to be taxed atthe higher rate.<strong>The</strong> closer to the floor, the less thepercentage of SS that is taxed.<strong>The</strong> closer to the ceiling, themore the percentage of SS thatis taxed.11. Planning Point: Municipal bonds are not tax-advantaged when it comes to determiningthe percentage of Social Security benefits taxed.12. Planning Point: Roth IRA distributions are tax-exempt and will not increase provisionalincome.13. Planning Point: Use an IRS worksheet to run the numbers. A few dollars over a thresholdwill not trigger all Social Security benefits to be taxed at the higher rate. <strong>The</strong> closer theclient is to the floor, the less the percentage of Social Security that is taxed. <strong>The</strong> closerthe client is to the ceiling, the more the percentage of Social Security that is taxed.14. Example: John is 66 and single. During the current year, he has an AGI of $24,000.He has no tax-exempt interest and has received $8,500 of Social Security benefits.<strong>The</strong>refore, his provisional income is $28,250 ($24,000 plus $4,250). Code Sec. 86 saysto calculate his taxable benefit as the lesser of A or B:a. One half of the benefit received = $8,500/2 or $4,250, ORb. One half of the excess of provisional income over the first tier base amount($25,000); $3,250/2 or $1,625. <strong>The</strong>refore, $1,625 of John’s benefits is taxable.SECTION 2: ESTATE PLANNING CONSIDERATIONSLO 4-2-1: Meeting legacy objectives with wills, trusts, and beneficiarydesignations1. Estate planning involves the process of answering three questions:a. Who will receive the client’s property?(1) <strong>The</strong> vast majority of clients will have a preconceived notion of who shouldreceive the property.b. How will the property be distributed to the selected beneficiaries?(1) It is often professional advisors who must provide information and guidanceregarding how the property will be distributed.4.21
c. When will the beneficiaries receive the client’s bounty?2. Fact-finding(1) <strong>The</strong> advisor, for example, may point out that it is advisable to delaydistributions to beneficiaries who are minors.a. Follow organized methodology.b. Ascertain correct property ownership.(1) For example, is the property individually owned and could be transferredthrough a will, or is it joint property that passes automatically to a survivorat death? Are all of the client assets readily marketable?c. Recognize valuation issues — are assets readily marketable or will they createvaluation and liquidity problems for an estate?d. Determine current transfer mechanisms — ask for copies of wills, trusts, or anybeneficiary designations already in place.e. Evaluate and question competency of a client to determine if expedited actionmay be required (e.g. signing a will before capacity diminishes) as well as thecompetency of potential inheritors to determine if it is appropriate to leave themoutright gifts.3. Key estate planning stepsa. Accurate fact-findingb. Listen to goals and objectivesc. Organize client’s goals and objectivesd. Present client with current snapshot(1) Is this what you would want to happen if you weren’t here tomorrow?e. Formulate planf. Present and revise plan with clientg. Implement final planh. Periodic reviews4. Impact of going through the planning processa. Fact-finding allows the advisor to point out the potential flaws in the current plan,including:(1) Current mechanisms create unintended, unequal transfers(2) Significant transfers to minors or adults who are ill prepared to handlethe property(3) Unnecessary estate taxes or other transfer costs associated with thecurrent planb. <strong>The</strong> team of advisors should be able to create a plan that more efficiently andaccurately meets the client’s objectives.5. Potential members of the estate-planning teama. Attorney(1) Needed if legal documents must be drafted and legal advice will be requiredb. CPA (Certified Public Accountant)(1) Needed to perform tax compliancec. Life underwriter4.22
(1) Needed to provide the appropriate product advice and placementd. Financial planner(1) Needed to work with the retirement income plan and coordinate assetmanagemente. Investment advisor(1) Needed if investment decisions will be delegatedf. Trust officer(1) Needed if a corporate fiduciary is going to be usedg. Agent under durable power of attorneyh. Guardian(1) Needed to handle the problem of loss of capacity of the client(1) Needs to be appointed if the client is legally disabled6. Advisor coordination and cooperation in keeping the plan on the tracksa. Advisory team should work together to design, implement, and review the plan.b. Action steps(1) Determine if a plan is already in place.(2) Determine who has control of the plan.(3) Identify whether all the documents were actually executed. Unfortunately,this is often not the case, making an otherwise good plan ineffective.(4) Have intervening events been inconsistent with the intent of the originalplan?7. Basic estate planning techniquesa. Lifetime gifts(a) Have new accounts been established?(b) Have beneficiary designations for those accounts been inconsistentwith the plan?(1) To the extent possible, the client can reduce his or her tax base by makinglifetime gifts.b. Exemption amount(1) <strong>The</strong>re is a significant exemption available to everyone against taxabletransfers during lifetime or at death.c. Marital insurance(1) Married individuals can make gifts or bequests to their spouses throughthe unlimited gift or estate tax marital deduction.d. Life insurance8. When to make transfers(1) Life insurance is generally viewed as the most efficient inheritancebecause, unlike retirement accounts, the death benefits from a lifeinsurance policy are received income tax free by the heirs.a. Lifetime gifts are often indicated for individuals with substantial wealth.4.23
(1) Outright(2) In trustb. Much or all of the average client’s wealth will be transferred at death.9. Advantages of lifetime giftsa. Gifts which completely remove property from the estate(1) Annual exclusion gifts(2) Medical and educational expenses paid directly to a providerb. Applicable credit exempts the equivalent of $5,120,000 (in 2012) of taxabletransfers from gift tax.c. Subsequent appreciation on gifted property escapes wealth transfer taxes.10. <strong>The</strong> annual exclusiona. IRC Section 2503(b)b. Permits donor to give $13,000 per year per donee free of gift taxc. Gift splitting with the donor’s spouse is permitted allowing a married couple to giveany number of donees $26,000 a year.(1) Annual gifts generally do not require a gift tax return, however, one isrequired with gift splitting.d. To qualify for the annual exclusion, the gifts must be gifts of a present interest.11. Gifts for educational and medical expenses [IRC Sec. 2503(e)]a. Tuition expenses are limited to tuition payments and payments for books, meals,and lodging may be taxable gifts.b. Medical expenses including those expenses deductible under Code Sec. 213,including expenses for the prevention, diagnosis, and cure of illness, includinghealth insurance premiums, are eligible for the exclusion.c. Independent of and available in addition to the annual exclusiond. Payments must be made to service provider.e. No family relationship is required.f. Planning Point: <strong>The</strong>se gifts are not subject to gift tax, making this technique aneffective way to remove property from the gross estate.12. Considerations for making giftsa. Can you afford it?(1) <strong>The</strong> client should never transfer assets that might be needed for his or herretirement lifestyle, with appropriate consideration given to emergencies.b. Can the donee manage the transfer?(1) Giving too much to a beneficiary could reduce his or her incentive toachieve independently.c. What property should be given away?(1) Some assets cannot and should not be transferred.(2) For example, assets in a retirement plan or IRA are not assignable.d. What are the income tax issues?(1) Consider tax issues. For example, taking money out of the retirement planto make a gift is inadvisable because the distribution would cause theaccount owner or participant to be subject to income taxes.4.24
13. Transfers at deatha. Wills(2) A good option is to transfer income-producing property to shift income toyounger family members in a lower bracket.(3) Property with built-in loss potential should not be gifted since the capitalloss would be wasted.(4) It is important to get tax advice and determine the gift tax compliance ruleswhenever the client is considering lifetime gifts.(1) <strong>The</strong> client’s will transfers property to the selected beneficiaries.b. Jointly titled property with rights of survivorship.c. Trusts(1) If the joint property has survivorship provisions, it passes automatically tothe surviving joint owner or owners.(1) Terms of the trust determine how the assets are distributed.d. Beneficiary designations(1) Many types of retirement accounts, financial accounts, employee benefits,and life insurance products will be payable to a designated beneficiary.14. Understanding wills — some terminologya. Testator: <strong>The</strong> person writing the willb. Executor: Personal representative who will be in charge of settling the estatec. Witnesses: Must witness the signature and date at the end of the will.d. Self-proving: For the will to be made self-proving, there must be an attachment ofan affidavit of the testator and witnesses to a notary that will is being executed.15. Advantages of a valid willa. Designate guardian for minor childrenb. Choice of executor/personal representativec. Waive executor requirement to post bondd. Distribution of property to chosen beneficiariese. Transfer of property to charityf. Take maximum advantage of marital deductiong. Direct source of property to pay estate’s expenses16. Intestate distribution if there is no valid will17. Trustsa. Applies to probate property if there is no valid will (or to specific property if will isinvalid with respect to such property)b. State law imposes its “will” to provide a plan of dispositionc. Planning Point: <strong>The</strong>re are often surprising, unexpected, and unwanted resultsfrom intestacy, so it should be avoided if at all possible.a. <strong>The</strong> client may have (or may need) trusts for a number of reasons(1) Certainly, any possibility that a minor would receive property would indicatethe use of a trust rather than a guardianship.4.25
(2) If beneficiaries would need to be protected through the use of the trustbeyond reaching the age of majority, the trust is extremely important forasset protection purposes.(3) Generally speaking, the higher the net worth of the client, the greater thelikelihood he or she is the beneficiary or grantor of a trust.b. Types of trusts18. Living trusts(1) Living revocable trusts are used to hold the grantor’s assets to avoidprobate at death.(2) Living irrevocable trusts will generally be complex and must be funded,implemented, and administered carefully.a. Have trusts been funded as planned?b. If irrevocable, have gift tax returns been filed?c. Where advisable, have beneficiary designations been made to the trustee(s)of the trusts?19. Testamentary trustsa. Created under the client’s willb. Can be revised as long as the client has the capacity to rewrite his or her willc. Will be funded by a portion of the client’s probate estate at deathd. Will be administered by its terms following the client’s death20. Beneficiary designation audita. Action plan(1) Make sure that beneficiary designations are correct with respect to:(a) Life insurance policies(b) Qualified retirement plans(c) IRAs—traditional and Roth(d) Nonqualified deferred compensation plans(e) Annuity products(f) Financial accounts made payable at death21. Estate planning for retirement income vehiclesa. Review beneficiary designations for all qualified plans, traditional or Roth IRAs,simplified employee pensions or other types of self-employed accounts.b. Coordinate with estate planning goals.c. Provide copies to other members of the estate planning team.d. Educate the client not to fill out beneficiary designation forms without guidance.22. Tax implications for leaving retirement plan assets to heirsa. Distributions are fully taxable to the beneficiary; the step-up rule is not available.b. If the participant only took required minimum distributions, assets will be availableat death for heirs.c. Minimum distribution requirements after death depend upon the type and ageof the beneficiary.23. Selecting designated beneficiaries of retirement income accountsa. <strong>The</strong> spouse4.26
(1) <strong>The</strong> Retirement Equity Act mandates that a surviving spouse receive aqualified annuity from a decedent’s qualified plan unless the survivingspouse had affirmatively elected out of this mandate.(2) Only a surviving spouse can roll over the inherited IRA and deferdistributions until the surviving spouse reaches age 70½.(3) <strong>The</strong> federal estate tax marital deduction prevents estate tax on the accountbalance when inherited by the surviving spouse.(4) <strong>The</strong> surviving spouse is able to take distributions as quickly as he or shewants and will control the beneficiary designation on the account for thebalance left at the time of the surviving spouse’s death.b. Other individualsc. Trusts(1) <strong>The</strong> payments to the beneficiary must begin in the year following thedecedent’s death for the inherited IRA and can generally be distributedover the beneficiary’s lifetime.(2) Beneficiaries can take the money as fast as they choose and there is noguarantee that they will make appropriate decisions.(1) It is possible to use a trust that meets the rules provided by retirementdistribution regulations as the designated beneficiary of qualified plansor IRAs.(2) With a qualifying trust, the distributions must be taken over the lifeexpectancy of the oldest beneficiary.24. Using a trust as beneficiary of qualified retirement benefits of IRAsa. A trust increases complexity and compliance and often results in shorter minimumdistribution periods.(1) Trust must provide for identifiable beneficiaries.(2) Trust must be a valid trust as defined in the regulations.(3) Trust beneficiaries must be provided to plan administrator or custodian by10/31 of the year following the year of the participant or account owner’sdeath.b. A trust should be used as beneficiary only when there is some asset preservationobjective.(1) <strong>The</strong> participant or account owner is concerned about the beneficiary’scapability of managing the account.(2) <strong>The</strong> participant or account owner would like to prevent the beneficiary fromtaking distributions faster than required under the minimum distributionrules.(3) A marital trust is appropriate if the participant or account owner did notwant the surviving spouse to be able to designate the beneficiary of thefunds left in the account at the second death. This is often the case whenthe participant or account owner has had more than one marriage andhas children from prior marriages.4.27
LO 4-2-2: Strategies for meeting charitable legacy objectives1. Objective of assignmenta. Explain the fundamental techniques for leaving a charitable legacy with emphasison improving retirement cash flow through life-income gifts.b. Key goals(1) Be able to initiate a discussion about a charitable legacy.(2) Be able to present options for testamentary and lifetime giving.(3) Be able to discuss the advantages and disadvantages of the primary formsof life income giving.2. Identifying charitable intenta. Discussion about retirement goals for many leads to examination of the client’sgoals around “the greater good.”b. Philanthropic goals may be simple or complex, specific or general.c. Support could be in the form of time, talent, or treasure during the client’s lifetimeand/or at their death.3. Questions for helping a client identify charitable intenta. If your family had a crest, what would be its motto?b. What would you like to change or preserve in the world?c. Where do you want to have an impact? (What charities are important to the client?)d. What gifts have given you the most satisfaction?e. Would you give more if you knew you could afford it?4. Lifetime vs. testamentary giving is an important issue. Should the client meetphilanthropic goals now or at death?a. Testamentary giving(1) Reduces exposure of the client’s estate to federal and state transfer taxes(2) <strong>The</strong> income tax deduction is not available year after year for gifts at death.(3) Retention of income and principal of asset during lifetimeb. Lifetime giving(1) Reduces exposure to federal and state transfer taxes(a) Balancing act: <strong>The</strong> client must weigh the appeal of retention ofassets at the cost of denying him/herself the pleasure of seeingphilanthropy in action.(b) Clients should always make sure they have not gifted too much andjeopardized their retirement security.(2) <strong>The</strong> income tax deduction will be available (deduction for life-income giftswill be smaller than outright gifts)(3) Requires an assessment of how much income and principal from assetsare needed for anticipated lifetime5. Charitable legacy at deatha. Common techniques include a gift payable at death from:(1) Will or testamentary trust4.28
(2) Beneficiary designation of benefits from a qualified retirement plan orIRA make for a smart way to give charitable contributions because thosedistributions would have been taxable to the client’s heirs.b. Advantages(1) <strong>The</strong> client who gives testamentary gifts will have full use of funds to meetlifetime expenses (both planned and unplanned).(2) Gifts at death are simple to establish and can be established at minimalcost.c. Disadvantages6. Improving cash flow(1) Enjoyment of seeing charitable goals fulfilled during lifetime not possible(2) No federal income tax deduction(3) Missed opportunity of improving cash flow through life-income giftsa. Assume donor seeks to improve cash flow during the retirement yearsb. By making an irrevocable life-time gift benefiting charity(ies) at deathc. Remainder of presentation assumes donor seeks retention of income from a“gifted” asset to meet need for greater cash flow obtained in a tax-efficient manner7. Financial challenge driving consideration of life-income givinga. Highly appreciated asset paying a relatively small dividendb. Incurring capital gains tax would leave less principal for reinvestmentc. Estate tax reduction less a considerationd. Client also has been philanthropic in the past and would like to continue8. Charitable legacy during lifetimea. Life-income gifts for philanthropic support9. CRTs, CGAs, and PIFs(1) Charitable gift annuity (CGA)(a) Immediate payment option(b) Deferred payment option(c) Flexible payment option(2) Charitable remainder trust options (CRT)(a) Annuity trust(b) Unitrust including NICRUT, NIMCRUT, FLIP(3) Pooled-income fund (PIF)a. Common elements to each technique(1) Requires donor to make an irrevocable transfer to either a trust or acharitable entity(2) Generates an income stream to the donor or an individual or individualsnamed by the donor(3) Contribution receives part charitable and part noncharitable treatment(4) Generates an income tax charitable deduction for the charitable portion ofthe gift4.29
10. Timing of funding(5) Gifted asset will not generate estate tax if structured correctlya. Testamentary funding of CRT, CGA or PIF is possible but lifetime funding ispreferable because of donor’s desire for lifetime income and an income taxdeductible charitable contribution.b. Remaining discussion emphasizes lifetime funding of these giving vehicles11. Common questions for each techniquea. Income: How are payments determined? Fixed or variable? For how long?Guaranteed or not guaranteed?b. Taxation of payments: How is that income taxed and at what rates? Ability tocustom-design income stream for tax minimization and investment goals?c. Reduction of income taxes: What is the income tax deduction?d. Financial risks: What is the donor’s exposure to inflation? What is the donor’sinvestment risk?e. Transactional costs: How is the gift documented and implemented?12. Profile of donors: Which technique makes sense for which individual?a. Charitable remainder trust(1) CRAT (charitable remainder annuity trust)(a) Generally older (65+) than donors to CRUTs(b) Likely more interested in higher payout and fixed income(c) Almost always funded with liquid appreciated assets(2) CRUT (Charitable remainder unitrust)(a) Generally younger (55+) than donors to CRATs and desiresvariable income(b) Desire considerable flexibility for fiduciary in investment ofportfolio to manage the tax character of distributions to the incomebeneficiary(c) Often funded with illiquid assets(3) For both CRTsb. Charitable gift annuity(a) Funding amounts of $500,000 (and often $1 million) typical(b) Seldom initially funded with less than $250,000(1) Usually single (though 2 measuring lives permitted).(2) Age 77(3) Median Amount is $57K(a) Minimum at most charities is $10K(4) Attractive alternative to certificates of deposit and treasury instruments(5) Immediate payment is the most popular option(6) Deferred and flexible payment also availablec. Pooled-income fund(1) <strong>The</strong> donor seeks immediate variable income4.30
13. Overview14. Types(2) <strong>The</strong> donor seeks to avoid the startup and ongoing administration expenseof a charitable remainder unitrust(3) <strong>The</strong> donor lacks investment acumen to manage a charitable remainderunitrust and desires the professional investment management of thepooled-income funda. Charitable remainder trust(1) Donor gifts cash or assets(2) Do deduction for present value of remainder interest(3) Income (fixed for CRAT; variable for CRUT) paid back to donor(4) Remainder to charity at end of the trust termb. Charitable gift annuity(1) Donor gifts cash or assets(2) Often used for gifts of $50,000 or even less(3) Charity itself is the payer; no trust involved(4) Deduction is for remainder interest(5) Income paid to donor is first treated as ordinary income or capital gain;balance is tax-free return of principal during donor’s life expectancyc. Pooled-income fund(1) Donor gifts cash or assets into commingled fund with assets from otherdonors(2) Donor paid her pro rata share of income like a mutual fund owner(3) Receives deduction for the present value of remainder interest(4) Income retains its character as dividends or interest(5) Income may never be tax-free; may not accept tax-exempt bonds(6) Remainder of fund passes to charity sponsoring the PIFa. Charitable remainder trust(1) Charitable remainder annuity trust (CRAT)(2) Standard charitable remainder unitrust (STAN-CRUT)(3) Variations of the standard charitable unitrust (STAN-CRUT)b. Charitable gift annuity(a) Net income charitable remainder unitrust (NICRUT)(b) Net income with makeup charitable remainder unitrust (NIMCRUT)(c) Flip unitrust (FLIP-CRUT)(1) Immediate payment(2) Deferred — for at least one year or a deferral period certain(3) Flexible — deferral for at least year with an election period permittingdetermination of commencement of paymentsc. Pooled-income fund4.31
15. Taxation of payments(1) High income fund for income-oriented donors less interested in maximizingthe tax deduction(2) Balanced fund aims more for preservation of principal of gift; larger taxdeduction than high income fund(3) Growth fund for younger donors seeking largest deduction with theprospect of more income paid over timea. Charitable remainder trust(1) Reported as income as trust per “tier accounting” rules(2) Sequencing of the tier accounting rulesb. Charitable gift annuity(a) Ordinary income (first)(b) Capital gains income (second)(c) “Other income” (tax-exempt income) (third)(d) Any tax-free distribution of principal (fourth)(1) Portion reportable as ordinary income or capital gain by beneficiary(2) Balance is tax-free return of principal during life expectancy(3) Fully taxable as ordinary income if annuitant exceeds life expectancy atfunding of the charitable gift annuityc. Pooled-income fund(1) Distributions entirely ordinary income16. Amount of income deductiona. Never the full fair market value of the gift since donor will be receiving an incomestreamb. Deduction is the present value of the charitable remainder interest(1) FMV gift less present value of income stream to recipient(2) Software (PG Calc, Crescendo) exist17. Who bears the investment risk?a. CRAT shifts investment risk to remainder beneficiary, which may receive nothingb. Income beneficiary sues trustee for breach of fiduciary duty if insufficient trustassetsc. Unitrusts distribute market risk more evenly between income and remainderbeneficiaries though both have riskd. By limiting income payout to DNI in the NICRUT or NIMCRUT, net incomeunitrusts, especially NICRUTs, shift market growth to charitable remainderbeneficiarye. Charitable gift annuity(1) Charity must fulfill promise even if contributed asset has become worthless(2) Reinsurance can mitigate charity’s risk, but still must repay if reinsurer isunable to so do(3) Donor recourse is lawsuit against charityf. Pooled-income fund4.32
(1) Charity needs only to payout income pursuant to terms of pooled incomefund(2) Donor recourse is lawsuit against charity18. Who bears the inflation risk?a. Charitable remainder annuity trust(1) Fixed payments expose noncharitable beneficiary to inflationb. Charitable remainder unitrust(1) Noncharitable beneficiary not exposed since potential in sharing in anyfuture appreciationc. Charitable gift annuity(1) Fixed payments expose noncharitable beneficiary to inflationd. Pooled-income fund19. Transactional costs(1) Noncharitable beneficiary not exposed since potential for receiving higherincome during inflationary periodsa. CRT — many complexities(1) Trust instrument with opportunity for customization(2) Selection of professional fiduciary as trustee(3) Investment counsel(4) Expense of legal, accounting counselb. CGA — many fewer complexities than CRT(1) Simple multipage contract(2) Lawyers, accountants, financial advisor expense rarely incurredc. PIF — many fewer complexities than CRT(1) Relatively simple paperwork20. Excellent assets for funding life income giftsa. Appreciated publicly traded securitiesb. Unencumbered real estatec. Appreciated publicly traded mutual fundsd. Cash, though appreciated assets are more tax-efficiente. Business interests possible with high level of legal and tax expertise21. Funding the life income gift among assets to avoida. Debt encumbered property(1) Bargain sale issues; UBIT (Unrelated Business Taxable Income) issuesand can disqualify CRTs if donor continues payment of debt.b. Assets donor is obligated to sell(1) Will be treated, under the assignment of income doctrine, as if the donorhad sold it prior to gift; taxable gain to donor, even though asset is in thetrustc. S Corp Stock4.33
22. Final thoughts(1) S election is revoked(a) Tax-exempt bonds (may not be contributed to or be invested by PIF)a. Advisor has valuable role in raising the topic of philanthropyb. Philanthropic giving during lifetime can be a wonderful way for your client to dogood and do well for himself/herself.SECTION 3: INCOMPETENCYLO 4-3-1: Choosing the appropriate strategy for delegating medicaldecisions1. Why is this important?a. <strong>The</strong> personal impact of losing capacity(1) Failing to plan ahead generally leads to only one solution—having a courtappoint a guardian, which is a slow and painful process.(2) It may not lead to the same decisions that the client would have made,causing unnecessary trauma to the family.b. <strong>The</strong> financial impact of unnecessary health care expenditures can have a negativeimpact(1) On surviving spouse and/or dependents(2) Thwart other legacy goals2. Planning considerations regarding future health care decisionsa. Choosing the right documents to executeb. Capacity to execute documents is an important consideration and if capacity isdiminishing, decisions may have to be expedited.c. One type of document identifies the client’s statement of the type of care desired.d. Another type allows the client to choose a selected agent to make health caredecisions.e. Sharing the documents with family members, doctors, and hospitals is criticalto help ensure enforcement.3. Determining objectivesa. What level of care would the client prefer if facing a terminal illness based onfactors including religious belief, comfort, and the costs of long-term care?b. Does the client want to be the sole declarant of his or her wishes?c. Does the client wish to involve other family members as agents in the decisionmaking process?4. Health informationa. HIPAA restricts rights to protected health information for covered entities.b. <strong>The</strong> patient must grant access for others to receive health information.5. Granting access to protected health informationa. Access should be granted to a family members with a direct role in the decisionmaking process.b. Access should be granted to a trustee under a living trust to manage assets.4.34
c. Access should be granted to an agent under a power of attorney.d. Requirements for granting access to health information:(1) <strong>The</strong> authorization should be in writing and it should indicate the informationthat should, or should not, be discussed.(2) <strong>The</strong> authorization should identify the appropriate medical providers.(3) <strong>The</strong> authorization should indicate the time period involved.6. Documents for health care choicesa. Each state has its own terms and rules about the documents used in planning forhealth care decisions. <strong>The</strong> few major documents include:(1) Living will—wishes about care in terminal situations(2) Do-not-resuscitate—limited to CPR(3) Health care power of attorney—name an agent to make health caredecisions(4) Statement of guardian preference7. Living will/advance medical directivea. Client states intention for medical treatment when they can no longer makedecisions in the case of terminal illness.(1) Issues in a living will8. Do not resuscitate (DNR) order(a) Food and hydration to be provided(b) Pain management to be provided(c) Resuscitation and other heroic measures (e.g. feeding tubes) tobe provided(d) Quality-of-life statementa. Required to be provided to patients in hospitalsb. Part of medical directive choicesc. Relates to cardiopulmonary resuscitation and the patient’s desire not to beresuscitated if a terminal condition exists9. Durable power of attorney health care (DPOAHC)a. Definitionb. Some form valid in all statesc. Scope(1) Generally provides for a health care proxy whenever the individual isincapable of making informed consent(2) Can be written to address only limited contingencies identified in thedocument(3) Always springing—if a patient can speak for themselves, they will lookto the patient for directiond. Select the agent carefully to ensure that the client’s desires are satisfied. Somedo not want to choose their children as they are concerned that they will makeemotional decisions to sustain life unnecessarily.e. Do not name committees as this could create gridlock if all are not available tomake decisions.4.35
f. It is appropriate to elect a successor agent (in case the first agent is unwilling orunable to act quickly).10. Enforcing the documentsa. Planning Point: <strong>The</strong> famous court cases involving prolonging life either involveno documentation to make appropriate health care decisions or a health careprovider that refused to remove life support.b. Share a copy of documents with primary care physician and discuss it with thedoctor.c. Share a copy of document with a close relative and discuss it with them.d. Retain the original that is accessible to the agent or other family member.e. A bank safe deposit box is only appropriate if the agent is a permissible signatoryand can access the safe deposit box.11. Other considerationsa. Can revoke or change at any time(1) Clients reluctant to provide advance medical directions or grant a powerof attorney can rest assured that they can be revoked or amended at anytime the client has capacity.(2) If the client has lost capacity, that is exactly the time the documents areessential.b. Advance planning is better than relying on guardianship(1) Guardian makes decisions under a principle called “substituted judgment”and the decisions of Guardian of the person can make will be interpretedby state law as applied by the court system.(2) This will provide a costly circumstance and an uncertain result.c. A statement of guardian preference perhaps should be incorporated.(1) Depending upon state law, it may not be binding in a court.(2) <strong>The</strong> court generally will give deference to a choice stated by the clientin advance.LO 4-3-2: Choosing the appropriate strategy for delegating financialdecisions1. Problems associated with diminished capacitya. Lack of planning with respect to financial decision-making could result in theproblem referred to as “living probate.”b. Formal guardianship requires that the individual who has lost capacity, known asthe “Ward,” will have to be proven to be incompetent in a court proceeding.c. This involves representation of the individual to protect his or her interest and is aprocedure most families would prefer to avoid.d. If something needs to be done more quickly, this will be difficult, but there areprocedures for emergency guardianship.e. In either event, significant cost could be incurred for legal and medical advice.f. Planning Point: Financial decisions often need to be made quickly and thismay not be the case since guardianship is court supervised and allows for littleflexibility. For example, the Guardian may not continue a gifting pattern that waspart of the Ward’s estate plan. If the appropriate prior planning had been done, the4.36
nightmare of living probate might have been avoided and these decisions couldhave been made more efficiently through other vehicles.2. Planning for incapacitya. Planning for retirement income is a challenge for someone with full capacity.b. Not planning for incapacity can jeopardize a retirement income plan.c. Informally placing decision-making in a family member can have limitations.3. Planning considerations(1) No formal supervision of decision makers(2) <strong>The</strong> potential for financial abuse exists.(3) Even well-meaning family members can make bad decisions.a. <strong>The</strong> planning approach depends on client specific considerations.(1) What is the size and composition of the client’s wealth?(2) What type of financial, retirement, and estate planning objectives haveto be met?(3) What is the client’s level of comfort with respect to turning over the reinsto others as capacity diminishes?(4) Are there family members that are concerned about the client’sdecision-making capacity?b. Common client objectives include:(1) <strong>The</strong> client’s objective for simplicity to limit costs for professional advice(2) <strong>The</strong> client’s concern over retaining personal control for as long as possibleor willingness to delegate some responsibilities earlier to gain a level ofcomfort(3) <strong>The</strong> client may want his or her agents or trustees to have a great deal offlexibility with respect to making decisions or may want the decisions tofollow a fairly rigid or limited structure.c. Other related planning considerations4. Planning process(1) Are there current steps being taken to implement the estate plan to meetthe client’s legacy goals?(2) Will the loss of capacity be associated with long-term care issues thatwill require steps taken to qualify for public assistance programs suchas Medicaid?a. Identify existing plans (documents)b. Determine need for additional planningc. Consider available asset management documentsd. Identify appropriate professionals to implement the plan5. Asset management tools for delegating decisions:a. Durable power of attorney(1) Essential for continuing the asset management and decision-making for aclient that has lost capacityb. Revocable living trust4.37
(1) Often employed as a vehicle to hold and manage assets and makedistributions to the client and his or her family membersc. Irrevocable living trust(1) Might be used to make substantial gifts or provide for asset protection ifnecessary for the client who funds the trust and for future beneficiariesd. Special needs trust(1) Used in the circumstances where the client or another disabled familymember will need to remove assets to qualify for Medicaide. Guardian/conservator(1) Preferred that the actions of the guardian be limited and that most assetmanagement decisions be made through a more efficient mechanism6. Power of attorney for asset managementa. <strong>The</strong> “principal” delegates certain authorities to an agent (also known as attorney infact)b. Special power of attorney can be limited in scope to one or a few tasks.(1) For example, we may grant the power of attorney to an agent who can signan agreement of sale for a parcel of real estate.(2) Once the task and the time-frame have passed, the limited power ofattorney will terminate.c. A springing power of attorney is a document and process where the agent hasno current power but the power will spring into existence upon a specific event orcontingency.(1) Typically, the springing power of attorney will grant the power at the timethe principal loses capacity.(2) <strong>The</strong> problem with this type of document is how the loss of capacity isdetermined.d. <strong>The</strong> durable power of attorney currently grants an agent broad powers withrespect to the asset management and decision-making.7. Power of attorney(1) This power is defined in the document to affirmatively survive the principal’sloss of capacity.(2) This power will generally continue until the power is revoked, terminated,or at the principal’s death.(3) <strong>The</strong> durable power of attorney is typically viewed as the most effectiveform of power of attorney.a. Documents are construed narrowly by the courts under modern protective statutesto prevent financial elder abuse.b. Powers should be clearly specified, especially for special issues such as:(1) Powers to make Medicaid spend-downs(2) Powers to make gifts(3) Powers to fund, defund, create or revoke living trusts(4) Powers to make elections for tax or retirement plan purposes(5) Powers to deal with insurance contracts4.38
(6) Powers to represent their principal with government agencies(7) Powers to hire a caregiver and negotiate caregiver contracts8. Issues with a power of attorneya. Capacity is necessary for a power of attorney to be effective.(1) <strong>The</strong> client must be competent to sign a power of attorney.(2) Planners should document an individual’s competency when document issigned.b. Limitations of power of attorney include:(1) Third parties may not honor the agreement.(a) <strong>The</strong> attorney can draft instructions into the power of attorneydocument that will make it easier for the financial institution tocomply.(b) <strong>The</strong> best assurance for compliance is to have the agent use thepower of attorney with the principal’s financial institutions as soonas possible to determine if any problems will arise.(2) A power of attorney is revocable as long as the principal has capacity. It isimportant to periodically review the power of attorney and execute a newdocument if circumstances change.9. Solutions to the “living probate” problema. Durable power of attorney alone is sometimes not sufficient(1) Actions of the agent will be construed strictly and narrowly(2) Financial institutions may be reluctant to deal with the agentb. Laws with respect to living revocable trusts are more flexible and well developed.c. A trust is a private contract and trustee can be given full asset management anddisposition power while the grantor is alive.d. A trustee is governed by fiduciary responsibility. <strong>The</strong> trustee must act solely inthe best interest of all beneficiaries of the trust. <strong>The</strong> trustee must follow thedirections of the trust.10. Living revocable trust with a durable power of attorneya. <strong>The</strong> trust is a much more flexible vehicle with respect to investing assets andmaking distributions as necessary.b. <strong>The</strong> trustee can also be given the power to distribute to other family members ofthe grantor under the beneficial terms of the trust.c. <strong>The</strong> trustee can only manage assets which have been titled in the name of thetrustee or have been made payable to the trustee.d. <strong>The</strong> agent under the durable power of attorney can serve the function to fund thetrust or withdraw assets from the trust as necessary.e. If circumstances change, the agent under the power of attorney can beempowered to change the terms of the trust or revoke the trust if necessary.f. Both the trust and the durable power of attorney can be relatively inexpensivearrangements to set up and administer.g. Preferable to guardianship unless there are no trusted family members orfriends, or if the client is totally uncomfortable with delegating authority, it may benecessary to rely on a formal guardianship if the client loses capacity.11. Structure for the living revocable trust4.39
a. Propertyb. Trustees(1) Trust identifies grantor’s instructions for the property(2) Typically retitle most/all personal and financial assets to trust soon afterestablished(3) Funding trust later may be a problem unless power of attorney exists(1) Common for the grantor to be trustee at first(2) Family member or professional can be identified as contingent trusteesc. Transfer of control12. Special needs trust (SNT)(1) Grantor can simply step down and appoint contingent trustee or transfercontrol at incompetency(2) Clarify independent determination (two named physicians) of incompetencya. <strong>The</strong> special needs trust is a statutorily created vehicle to hold the countable assetsof an individual to enable the individual to otherwise qualify for Medicaid.b. <strong>The</strong> special needs trust normally provides for distributions for items other than thesupport, food, and shelter of the beneficiary.c. Because the government might otherwise be providing benefits, the specialneeds trust must provide for reimbursement of the government at the death of thebeneficiary for its expenditures during the beneficiary’s lifetime.d. A special needs trust cannot be created by somebody over age 65. Some otherform of Medicaid planning must be used for older individuals.e. <strong>The</strong> client can transfer his or her otherwise countable assets to a special needstrust for the disabled heir without creating a disqualifying transfer for Medicaidpurposes. Hence, the senior client that has transferred enough assets to theyounger family member’s special needs trust can qualify for Medicaid immediately.13. Retirement vehicles and the disableda. Federal law mandates that the distribution check only be payable to the participantor a named beneficiary after the participant’s death.b. This provides some difficulty with respect to a participant who has lost capacity.c. In some cases, a guardianship has to be created to handle this circumstance if thetrustee has refused to provide distributions to a representative payee.d. An agent under the durable power of attorney who has specific powers to dealwith the retirement plan assets might be able to receive a check.e. <strong>The</strong> IRS has also ruled that the living trust can be named beneficiary of the IRAand the plan’s trustee may pay the benefit to the trustee of a living trust.f. If capacity is a concern, take pro-active steps with respect to this issue such asmoving an IRA to a more flexible institution.14. Managing insurance policies of a disabled persona. Life insuranceb. Disabilityc. Long-term care15. Life insurance and a disabled insureda. Exercise of living benefits may be availableb. Provisions often provide a waiver of premium option.4.40
c. If the policy is term coverage with the conversion option, a disability wouldcertainly be a circumstance where the conversion privilege ought to be used.16. Disability income or long-term care policiesa. Identify a representative payee(1) Agent under power of attorney(2) Guardian17. Implementing a plan (checklist of tasks)a. Statement of objectives should be reviewed with the clientb. Identify and ask others who will take on trustee/power of attorney role and givethem the opportunity to receive advice about their responsibilities.c. Identify professionals and discuss their roles.(1) Attorneys(2) Professional trustees/investment advisors(3) Daily money managersd. Execute documentse. Transfer assets as required to facilitate the use of durable power of attorney, livingtrust or guardianship.4.41
Assignment 5EVALUATE RETIREMENT RISKS AND OFFERALTERNATIVE SOLUTIONS TO ADDRESS THESE RISKS5Assignment 5SECTION 1: THE RISK OF RUNNING OUT OF MONEY AT THEEND OF RETIREMENTLO 5-1-1: Analyze the risks associated with running out of money at theend of retirement1. Overview: <strong>The</strong>re are four risks embedded in every retirement income plan that couldlead to the disastrous result of a client lacking the income needed in the later years ofretirement. <strong>The</strong>se risks apply to both married and single clients and also apply to everyclient for which you need to plan regardless of his/her financial status. <strong>The</strong>se include:a. Longevity riskb. Excess withdrawal risk (also called portfolio failure risk)c. Inflation risk (also called purchasing power risk)d. Timing risk (also called point-in-time risk)2. Longevity risk is the possibility of outliving resources by living longer than planned. Yourclients should be concerned about living too long for a variety of reasons:a. Since no client can predict how long they will live with certainty, the retirementincome stream must last for an unpredictable length of time. This complicatesplanning since the client has to secure an adequate stream of income for anunpredictable length of time.b. Planning Point: <strong>The</strong> planning horizon for retirement income is indefinite andunknowable. Planners, however, need to create a proxy for longevity when theyput together a retirement income plan.c. According to some mortality tables the average life expectancy for a 65 year old is18 years. However, this is an unacceptable proxy since planning for the averagelife expectancy will be wrong for 50 percent of clients!d. Probabilities of living to a certain age are another possible predictor of a lifeexpectancy proxy.(1) <strong>The</strong> probability of living from age 65 to a specific age:(2)Age Male Female70 94% 95%75 85% 88%80 73% 79%85 54% 64%90 33% 34%5.1
e. Factoring personal and family health history can be another predictor of lifeexpectancy and another way of determining a proxy for the end of life. Seewww.livingto100.com for a life expectancy calculator that factors personal health,family history, and other factors.f. Planning Point: When planning for a couple, planners should focus on thelongevity of the second spouse to die.g. <strong>The</strong> problem with longevity risk is that an educated guess, however, is still a guess!h. Longevity risk only exists if the planner has not planned for the client to live to theadvanced age. <strong>The</strong> natural reaction of planners may be to assume the clientwill live to 100 or 105 to counteract any longevity risk complications. However,planning for a client to live to 100 or later will put an undue burden on the client’slifestyle unless they are super-affluent and will be an unworkable solution to thelongevity risk problem for most clients.i. Planning Point: Longevity has increased over time and new medical advancescould bring additional improvement to life expectancies in the future.j. Planning Point: Longevity compounds a number of other retirement risks. Forexample, it increases the need for long-term care and health care.3. Excess withdrawal risk (also known as portfolio failure risk) is the depletion of retirementassets through poorly planned systematic withdrawals that lead to the prematureexhaustion of retirement resources. Your clients should be concerned about spendingtoo much too quickly for several reasons:a. In retirement, income for monthly expenses is provided in part from withdrawals ofaccumulated assets as opposed to salary from an employer.b. If the client consumes assets too quickly, he or she will run out of resources toconvert into a stream of needed income in the later years of retirement.c. Planning Point: Clients often perceive the asset pool at retirement as an invitationto overspend early in retirement because they are dealing with more money thanthey have ever controlled at any time in their life. However, clients must resist thetemptation to overspend early in retirement. Planners must instruct the clientabout the percentage that can be drawn down each year that will preserve assetsuntil the client’s death.d. Example: Greg decides to draw down 15 percent of his portfolio each year ofretirement. He will soon find out that he is consuming assets needed for thelater years of retirement to support an overgenerous lifestyle in the early yearsof retirement.e. Planning Point: At most, the annual drawdown rate could equal the rate of returnon the investment portfolio. Any higher, and the portfolio is assured of beingdissolved. However, because of sequence risk (to be discussed later), it ispossible to have a withdrawal rate that is less than the average investment yield,and still have the portfolio disintegrate. <strong>The</strong> historical rate of return on equitiesdepends on what time period one analyzes. But over really long time periods,the rate of return on equities would appear to be about 9 – 10 percent. Giventhat most portfolios of retirees generously incorporate substantial amounts ofbonds whose rates of return are less than that of equities, the rate of return onthe retiree’s assets will be well below the 9 – 10 percent mark. Hence, withdrawalrates of 6 – 7 percent are about as high as one would want to go.f. Planning Point: Clients who own an annuity or who have otherwise securedincome to pay for their basic expenses are in a different position to take systematicwithdrawals than clients who have not locked in payment of their basic expenses.5.2
g. Most planners believe the safe harbor systematic withdrawal number is 4 percent.However, newer research allows for greater than 4 percent withdrawal rate if theclient is willing to adjust withdrawals to accommodate changing market conditions(sometimes as high as 5.5 percent). (This will be studied in more detail later).4. Inflation risk (also known as purchasing power risk) is the possibility that increases inthe price of goods and services may impede the client’s ability to maintain the desiredstandard of living. Your clients should be concerned about rising prices of goods andservices for a variety of reasons:a. When the client is working, inflation is often offset by an increase in salary. Inretirement, however, clients will need to take larger withdrawals each year tokeep up with inflation.b. Clients may be exposed to high inflation during their retirement. For example,double-digit inflation existed from 1979–1981.c. Compounding inflation works against a client the same way compounding interestworks for the client.d. Example: In the first year of retirement Annetta expects to need $60,000 per year.With 4 percent inflation, after 10 years she would need almost $89,000 per yearto maintain the same standard of living if her expenses rise at the same rateof inflation and she continues to buy the same mix of goods and services. It iscertainly possible that her own personal inflation rate might be higher, or that shemay end up buying more expensive goods and services than she currently does,in which case she might well have to spend more than $89,000 in ten years tomaintain the same standard of living.e. Some economists worry that the Federal deficit may lead to high inflation.f. Even low inflation can significantly erode purchasing power over time.g. Example: 3 percent annual inflation will mean that costs double for a client whoretired at 62 and is now 86.h. Medical inflation—something that will definitely affect retired clients—hashistorically been higher than regular inflation.i. Planning Point: Planners should use the Department of Labor inflation calculator(www.bls.gov/data/inflation_calculator.htm) to illustrate to clients the erosiveimpact of inflation.j. Example: Juan and Maria needed $5,000 a month to live when they retired atage 62 in 1981. <strong>The</strong>y will need $12,373 per month in 2011 to maintain the samepurchasing power.5. Timing risk, also known as point-in-time risk, considers the variations in sequences ofactual events beginning with different time periods. Your clients should be concernedabout retiring at the wrong time for a variety of reasons:a. Example: Patty retires in 1974. For every $1,000 per month she needs she willhave to have $3,379 per month in 1999 (25 years into retirement). Mary Lou,however, retires in 1986. For every $1,000 per month she needs, she will haveto have only $2,064 per month in 2011 (25 years into retirement). For Mary Lou,prices increased 206%. For Patty, prices over the same length of retirementincreased 337%! This is because of the different historical inflation rates.b. Planning Point: What if the client retires at the worst possible time, right beforemany years of high inflation or right before a market crash? <strong>The</strong> planner mustquickly adapt the plan or encourage the client to go back to work if possible.c. In many cases clients are not in a position to exert control over point-in-time risk.<strong>The</strong> impact of high inflation and black swan market events is a “luck of the draw”5.3
problem. On the other hand, we can hope for clients to get lucky and retire justprior to a prolonged bull market with low inflation.LO 5-1-2: Evaluate the solutions a planner can use to help his client addressthe risks associated with running out of money at the end of retirement(longevity risk, excess withdrawal risk, inflation risk, and timing risk)1. Ask the client to defer claiming Social Security.a. Clients can claim Social Security benefits as early as age 62 and should claimno later than age 70 (there is no benefit to postponing after age 70). For a clientretiring today, claiming at 62 means the client will receive 75 percent of his/herprimary insurance amount. Claiming at full retirement age (66 for current retirees)means the client will receive 100 percent of his/her primary insurance amount.Claiming at 70 means the client will receive 132 percent of his/her primaryinsurance amount.b. Example: Julie is scheduled to receive $1,500 per month at her full retirement ageof 66. If Julie claims Social Security at age 62, she will receive $1,125 per monthevery month she is alive (75% x $1,500). If Julie claims Social Security at age70, she will receive $1,980 (132% x $1,500). <strong>The</strong> difference of $855 per monthwill be paid as long as she is alive and it represents a significant hedge againstlongevity risk and excess withdrawal risk.c. Married clients who defer claiming Social Security may protect against extralongevity risk, excess withdrawal risk, and inflation risk protection for theirsurviving spouse. <strong>The</strong> survivor benefit rules allow the surviving spouse to receivethe actuarial increases associated with a delayed claiming for a deceased worker.d. Example: Joe and Betty are married. Joe worked all his life and would receive$2,000 per month at his full retirement age. Betty was a stay at home mom andnever worked and will receive a spousal benefit equal to 50% of Joe’s benefitswhile Joe is alive, and when Joe dies, an amount equal to his benefit. If Joeclaims at 62, he will receive $1,500 per month. When he dies, Betty will receive$1,500 per month. If Joe waits until age 70 to claim, he will receive $2,640 permonth. When he dies, Betty will receive $2,640 per month. Because Joe delayedclaiming, Betty will have $1,140 ($2,640 – $1,500) more per month after Joe’sdeath. This differential can be the difference between a widow suffering poverty inher old age or continuing to live with financial security.e. Delaying Social Security is in effect an annuity purchase date choice, andpurchasing a larger annuity at an advanced age will lead to greater insuranceprotection against the risks associated with running out of money in retirement.Another way to look at this is that a delayed Social Security claiming will helpthe client escape from excess withdrawal risk because the funds used to fundthe bridge period (from retirement until the start of Social Security) can not beprematurely spent since they are being used to buy a “larger Social Securityannuity.”f. From a risk protection perspective, the Social Security money that clients needto focus on is not the dollars of low marginal utility at 62, but the dollars of highmarginal utility at advanced ages.g. We have previously reviewed the implications of choosing an age 70 SocialSecurity claiming age versus choosing an age 62 Social Security claiming age forpurposes of longevity risk and excess withdrawal risk. However, the compoundingimpact of delayed Social Security can be an important weapon in the defenseagainst inflation risk.5.4
h. Example: Rick will have a primary insurance amount of $3,000 at age 67 (his fullretirement age). If Rick claims at 62, his benefit will be $2,100 per month ($25,200per year). If Rick waits until 70 to claim, his benefit will be $3,720 per month($44,640). Assuming a 4 percent COLA is granted, the yearly increase at 70 is$1,785. <strong>The</strong> yearly increase at age 62 is only $1,008.(1) <strong>The</strong> compounding effect of delay on claiming will be very significant.(2) Clients who delay do not lose COLA increases that occur prior to the timethey delayed claiming.(3) COLAs use the CPI-W.i. <strong>The</strong>re are several disadvantages or trade-offs to delaying Social Security.(1) <strong>The</strong>re is a loss of liquidity because in most cases the retiree will need toconsume retirement assets early leaving fewer retirement assets later.(2) <strong>The</strong> desire of leaving assets to heirs is jeopardized because in most casesthe retiree will need to consume retirement assets early.(3) <strong>The</strong> rate of return net of taxes and expenses that could be earned oninvested retirement savings may outperform the higher Social Securityannuity, thus making depletion of other assets while waiting for SocialSecurity to start a poor choice.2. Recommend that the client use an immediate annuity product.a. Immediate annuities pay income for a lifetime and are an insurance solution tothe insurance problem of longevity risk (just like life insurance is an insurancesolution to dying prematurely).b. Immediate annuities work as a hedge against longevity risk in part because theinsurance company pools mortality risk and distributes principal and investmentearnings not paid to early decedents to the surviving annuitants. In other words,long-lived people are subsidized by those who die early.(1) <strong>The</strong> subsidy is called mortality gain. Conversely, those who die earlyhave mortality loss.(2) <strong>The</strong> subsidy from people dying early effectively gives the client who is asurviving annuitant the ability to earn a “rate of return” in excess of whatis commercially available.(3) Example: Walt buys a single premium annuity contract by giving $100,000to an insurer at age 65. Walt will receive $526 per month ($6,312 peryear). (https://www.newretirement.com/services/annuity_calculator.aspx) IfWalt dies at 70, he will have received in cash payments $31,560, which isa loss in principal of $68,440, even before consideration of time value ofmoney. When the time value of money is considered, his internal rate ofreturn is –32.47 percent. If Walt dies at 99, he will have received $214,608in cash payments, and his internal rate of return would be 5.38 percent. Inother words, the client who survives long enough to enjoy the insuranceelement of the contract will receive a higher annual return based on thepooling/mortality gain of a certain percent each year.c. Annuities also act as an effective deterrent to excess withdrawal risk because theclient is “locked out” of spending the money too quickly because of the nature ofthe product. In other words, by using a lump sum to “buy” a stream of income ora “paycheck for life” the client is forced not to overspend the lump-sum amountearly in retirement.5.5
d. Adding a cost of living adjustment (COLA) rider with an immediate annuity willalso provide a hedge against inflation risk (assuming the pricing of the COLAis cost effective).e. Laddering immediate annuity purchases can be made to average the interestrates embedded in the purchase price. This will help to circumvent the timing riskthat comes with an immediate annuity. When interest rates are low, the annuitywill provide less monthly income than when interest rates are high. <strong>The</strong> problemfor the client is that they cannot be certain about the future direction of interestrates. In order to guard against the risk of locking in the monthly payout at a givenpoint in time they may purchase the annuity over predetermined intervals so thatthey enjoy the effect of different interest rates.(1) Annuity inflation riders typically escalate the benefits paid on a yearly basis.(2) Disadvantages:(a) Annuity inflation riders cost more.(b) <strong>The</strong>re may be other more cost-effective ways to protect againstinflation risk.f. Immediate annuities may be chosen as an option from an employer plan or maybe purchased commercially.g. Planning Point: Female clients may be able to maximize benefits by choosinga qualified plan annuity because the employer plan uses unisex tables whilecommercial annuities base payments on the sex of the annuitant.h. Planning Point: Immediate annuities from an employer plan may have lowerexpense loads and may be cheaper than commercial annuities and they mayuse institutional pricing.i. Disadvantages or trade-offs of using an immediate annuity:(1) <strong>The</strong> possibility of mortality loss(2) Consumer aversion to giving up assets to purchase an income stream withwhat is perceived to be a modest rate of return(3) Consumer aversion to giving up control of assets(4) <strong>The</strong> cost of purchase may be too expensive (in part based on adverseselection)(5) Loss of liquidity(6) Loss of bequest opportunity(7) Loss of investment control; consumers often make the “I can do bettermyself” argument.(8) (Video: How does the fixed payment immediate annuity strategy workand what are its advantages and disadvantages? Tacchino, Warshawsky,Bernard)3. Recommend an advanced life delayed annuity (ALDA) (Video: What is an Advanced LifeDelayed Annuity (ALDA) and how can it help my client? Tacchino, Lemoine, Milevsky)a. ALDAs (sometimes called longevity insurance) guarantee a lifetime income butdo not start paying benefits until an advanced age. ALDAs are a tax-deferredannuity, which is used specifically to provide protection against longevity riskand portfolio failure risk.b. ALDAs provide the greatest amount of longevity insurance per dollars spent(they are the most effective way to purchase longevity insurance) because5.6
it is analogous to having a very high deductible which would lower insurancepremiums.c. Outliving retirement resources by living longer than expected is a risk (longevityrisk) which is the opposite of the risk of premature death.(1) Premature death — term life insurance(2) Extreme longevity — ALDAd. Three factors make an ALDA cost effective:(1) Bought at a younger age and pays at an advanced age(2) No liquidity value or cash value—pure protection(3) No adverse selectione. <strong>The</strong> ALDA provides a leverage affect of 30 to 1 (for every dollar invested, the clientwill get 30 dollars at the advanced age).f. Disadvantages and trade-offs of an ALDA(1) <strong>The</strong> perception that clients are forfeiting their premiums if they do not livebeyond the delayed annuity start date, thus purchasing a product fromwhich they will never benefit.(2) Loss of liquidity(3) Loss of bequest opportunity(4) Loss of investment control4. Recommend a deferred variable annuity that promises a guaranteed living benefitpayment. (Video: What are the various guaranteed benefits available in a deferredannuity? Littell, Lemoine, Graves)a. Guaranteed minimum living benefit riders allow a client to pull out a benefit from avariable deferred annuity equal to a percentage of the initial premium.b. At the time for the money to come out of the contract, the client will receivespecified payments even if the underlying market for the annuity has dropped.c. A deferred variable annuity creates downside protection by providing guaranteedincome.(1) It eliminates the need to buy put contracts.(2) It allows the client to remain more aggressively invested in equitiesbecause of the floor protection.(3) <strong>The</strong> owner of a deferred variable annuity is effectively “paying” theinsurance company to engage in “hedges” that account for the guarantees.(4) Some older products may be more valuable than some newer products.d. <strong>The</strong> guaranteed minimum income benefit rider provides the client with aguaranteed income payment based on the initial premium (e.g., the client can pullout 4 to 5 percent of amounts put into the contract each year).e. <strong>The</strong> insurance company guarantees payments no matter how long the client lives.(1) Planning Point: If the client pulls out more than the allowable amount,it will void the agreement.f. <strong>The</strong> insurance company usually restricts what the underlying variable annuity canbe invested in (to protect its ability to provide the guarantee).5.7
g. Planning Point: Sometimes a high water mark walk-in is allowed. A high watermark walk-in allows the client to increase the amount of annual income that canbe pulled out (for a fee).h. <strong>The</strong> guaranteed minimum accumulation benefit rider guarantees a minimumincremental increase in each period.(1) Your client will pay a premium for this guarantee.i. <strong>The</strong> guaranteed minimum withdrawal benefit allows the client to withdraw aspecified value of the contract at a specified age.(1) A starting withdrawal at a later age will allow for a higher portion of thecontract to be pulled out than if the client had started at an earlier age.(2) This is different than the minimum income rider because the client canwithdraw a certain dollar amount.j. Death benefits are available from these products.k. How the deferred variable annuity product hedges against risks:(1) <strong>The</strong> product helps to mitigate longevity risk because annual income isguaranteed no matter how long the client lives.(2) <strong>The</strong> product does not specifically address the excess withdrawal riskproblem because funds can be freely spent. However, it does address theliquidity issue (discussed later) because in this unique product the clienthas both lifetime guarantees and liquidity.(3) Since the guaranteed minimum accumulation benefit rider guaranteesa minimum incremental increase in each period, the product can bedesigned to address inflation risk. Also, there may be underlying equityinvestments in the variable annuity, which help with inflation risk.5. Create a separate portfolio that is reserved for the later years of retirement.a. <strong>The</strong> client could set aside assets (the family home, rental property, a stockportfolio, etc.) that could remain untouched unless the client outlives the projectedage or experiences excess withdrawals or excess inflation with the main bodyof his other retirement assets.b. Reserving assets for the later retirement period serves to mitigate longevity riskbecause the assets are a hedge against outliving income since they remainavailable for that contingency.c. Reserving assets for the later retirement period serves to mitigate excesswithdrawal risk since these assets will not be consumed too early by the client.d. Reserving assets for the later retirement period can serve to protect againstinflation risk if they are invested in equities, TIPs, real estate, or other productsthat have historically done well to keep pace with inflation.e. Planning Point: Should the client die on or ahead of the projected schedule, notsuffer from excess withdrawal risk, or not experience abnormal inflation he or shecould alternatively use the separate portfolio for meeting bequest motives.f. If the client needs to “tap into” the second asset class in the later years ofretirement, he or she can set up a fail-safe withdrawal strategy for this asset baseor annuitize it so that assets cannot be outlived.g. Example: Arthur and Katie construct a retirement plan with the bulk of theirassets. However, they ignore a mutual fund with a current value of $50,000and their mortgage-free home currently valued at $200,000 when constructingtheir retirement income plan. If Arthur and/or Katie outlive the projected age oftheir retirement income plan then they turn the mutual fund and home into an5.8
income stream for their advanced years. If they both die in the time prescribedby the original retirement income plan, then the home and mutual fund can bebequeathed to their heirs through their will.h. Disadvantages of segregating a separate portfolio:(1) <strong>The</strong> client may not have the appropriate assets available to “put someaside” and therefore may hamper his/her ability to maintain the correctstandard of living in the early years of retirement.(2) Beneficiaries might feel “entitled” to specific assets and might resent losingthese assets at the advanced ages of their parents.6. Capitalize on the value of the home—Use a reverse mortgage, downsize and pull outequity, use the sale-leaseback strategy, or consider a home equity loan. We will focus onthe reverse mortgage strategy since it is the least obvious and one, which is growing inpopularity.a. A reverse mortgage is a loan against an individual’s home that does not requirerepayment as long as the client lives in the home (paid when the owner sellsthe home or dies).b. Planning Point: <strong>The</strong> client can get substantial amounts of money for current needswith no current payments by using a reverse mortgage.c. How it works:(1) Only available to owners 62 and older who own their principal residence(with little or no debt on the home).(2) Loan payment variables include:(a) Client’s age or joint ages (younger clients receive less income;older clients receive more income)(b) Current and expected equity (the more equity the larger the reversemortgage)(c) Interest rate and fees charged(d) <strong>The</strong> type of mortgage program—the HECM (the FHA’s Home EquityConversion Mortgage) program is the most popular (studied later)d. Payment options of a reverse mortgage include a lump sum payment at closing,or a credit line, or monthly paymentse. Planning Point: Most reverse mortgage loans are nonrecourse loans so themaximum that has to be paid back is the value of the home. In other words, overthe years the loan balance may well grow to exceed the value of the home and theclient or his estate will not be “on the hook” for the excess.f. If the client sells the home and the loan is paid off, the excess from the salebelongs to seller.g. Reverse mortgages are loans and not taxable.h. Using a reverse mortgage serves to mitigate longevity risk when the strategy isexecuted in the later retirement period. Also, note the nonrecourse feature of theloan protects against longevity risk because clients can’t outlive their monthlypayment option even if their payments exceed the equity in the home.i. Using a reverse mortgage serves to mitigate excess withdrawal risk when thestrategy is executed in the later retirement period since the home as a financialasset will not be consumed too early by the client.j. Disadvantages of a reverse mortgage:(1) Fees of a reverse mortgage can be high.5.9
(2) Clients may not be able to “age in place” thus negating the effectivenessof this strategy.k. Alternatives that are similar to a reverse mortgage:7. Invest in equities.(1) <strong>The</strong> client might consider selling the home and downsizing.(2) <strong>The</strong> client might consider selling the home to a family member and leasingit back from them.(3) <strong>The</strong> client may consider a home equity loan.a. <strong>The</strong> traditional assets for investment are stocks, bonds, and cash.(1) Stocks may be purchased directly or through any of several different typesof investment company arrangements such as mutual funds, closed-endfunds, ETFs, hedge funds, etc.(2) Bonds are even more likely to be purchased via an investment companyarrangement because of trading problems associated with trying to buysmaller amounts (e.g., under $100,000 of a particular bond issue).(3) When we refer to cash, we are actually referring to money marketinstruments such as Treasury bills, negotiable CDs, commercial paper,and bankers’ acceptances. In this case, the investment of choice is almostalways a money market mutual fund, because direct investment in moneymarket investments is monetarily prohibitiveb. Research has consistently shown that large portfolios of stocks always providesubstantially higher returns over long time periods than do large portfolios ofbonds, and that the bonds substantially outperform cash over long time periods.However, the amount of risk implicit in these investments, as represented by thestandard deviations of the returns on these securities follows in the same orderwith stocks being substantially more risky than the other two.c. In terms of fighting longevity risk, it is clear that retirees are best served byacquiring those assets with the highest expected rates of return. Research hasconsistently shown that for distribution portfolios (i.e., ones in which the investor isregularly taking money out of the portfolio), equity allocations on the order of 50percent to 75 percent have a much better chance of lasting for the lifetime of theretiree than portfolios with lesser allocations.d. Planning Point: Even a 70-year-old client is investing part of his or her retirementfunds for use when he or she is 90 or 95. <strong>The</strong> 20-to-25-year time horizon is bestserved by equity investments.e. <strong>The</strong> traditional market investments do not do anything to eliminate excesswithdrawal risk because these investments are typically highly marketable. Thus,retirees with a sudden urge to buy an RV or a vacation home can easily accessthe traditional market investments.f. Alternative investments (e.g., real estate) make it more difficult to withdraw moneybecause many of them are not marketable. <strong>The</strong>se type of investments providesome degree of security that the client will not consume assets too quickly. <strong>The</strong>length of time required to sell some of these assets, and the high costs of sellingsome of them, mean that a retiree will have to think for some time about theliquidation of these assets to raise funds for premature spending.g. <strong>The</strong> impact of investments on inflation risk is a mixed bag. <strong>The</strong>re is some debatewhether inflation helps or hurts stock in the aggregate. It is certainly the casethat some companies benefit from inflation and others are worse off as a result5.10
of it. However, because stocks are consistently the highest yielding assets, overlonger time periods they are the best positioned to offset the losses in purchasingpower represented by inflation.h. Timing risk can be quite serious with all types of investments, but probably mostproblematic with stocks. <strong>The</strong> stock market has shown the ability to drop over 20percent in one day, and to rise more than 10 percent in one day. Probably the bestway to deal with timing risk is to set a schedule as to when one will invest moneyor liquidate holdings, and then stick to that schedule.i. Planning Point: Ultimately, the retiree will have to make some sort of bet aboutfuture investment returns when he or she retires. If the market will have a majorcollapse during his or her retirement, then he or she clearly would be best off witha heavy investment in bonds, particularly well-rated ones. If the rate of inflationincreases significantly, then the retiree will be substantially better off with moreequities and fewer bonds. <strong>The</strong> ultimate safety—cash investments—would almostcertainly provide inadequate returns and result in clients becoming destitute whenthey are in their latter years of retirement.8. Ask the client to prepay expenses.a. By prepaying for a funeral, or paying off mortgages and other loans, the client willlower or eliminate expenses in retirement.b. Planning Point: When paying off any loan early, one is essentially investing one’smoney at the loan’s interest rate. Thus, one should not use money that is earning5 percent to pay off a loan that is costing 4 percent. However, taking money that isearning 2 percent and using it to pay off a loan costing 8 percent is a great dealand will substantially benefit the client over time.c. <strong>The</strong> lower the client’s expenses in retirement, the less inflation impacts the clientduring retirement. In addition, the client cannot prespend this money throughexcess withdrawals because it is being used to reduce future expenses (notcurrent excess consumption). Finally, this strategy may help with timing risk if theclient chose to lock in the cost at the right time.9. Good ideas for all types of retirement risks—other strategies that help to impede the riskof running out of money because of longevity risk, excess withdrawal risk, inflation risk,and timing risk (note these “universal solutions” work well for almost all types of risk, butoften for different reasons for each type of risk):a. Recommend that the client delay starting retirement. Planners should considerrecommending postponing retirement if the client is expecting to live longer, or ifinflation rates are projected to be high in the period following planned retirement.For example, a two-year delay in starting retirement means two fewer years oflongevity and inflation risk. However, this strategy will not work for the 40 percentof clients who were forced to retire earlier than planned.b. Recommend that the client go back to work full or part time. Reemployment maygive the client the extra income needed to offset longevity risk, make up for excesswithdrawals, act as a hedge against inflation, and offset timing risk. However, thereare reasons a postretirement employment solution may not work. <strong>The</strong>se include:(1) <strong>The</strong> client may not have the appropriate skills and training.(2) <strong>The</strong> client may have health restrictions that impede his/her ability to work.(3) Postretirement working is typically lower paying and does not providebenefits.(4) Postretirement work may not happen in a tight job market.5.11
c. Ensure that the client is receiving professional advice by working with a financialplanner or planners. Longevity risk, excess withdrawal risk, inflation risk, andtiming risk are serious and complex issues which require the expertise of trainedand experienced professional planners.d. Monitor the retirement income plan and lower spending if necessary. Plannersshould monitor a retirement income plan at least annually and adapt expendituresto make sure funds are not exhausted. <strong>The</strong> “stitch in time saves nine” proactiveadjustments can help to slow down the depletion of assets when necessary whichwill help keep the client from running out of money prior to his/her life expectancy(longevity risk) and from spending assets too quickly (excess withdrawal risk).e. Relocate to an area with a lower cost of living. This will work best to hedgeinflation risk and to stretch dollars as a protection against longevity risk.f. Involve both spouses in the financial planning process. Clients are less likely tosubject a surviving spouse to longevity and excess withdrawal risk when eachspouse has a say in the matter. For example, one spouse may act to restrictreckless spending by the other spouse. In addition, with both spouses involvedin planning the probability of using a joint and survivor annuity or delaying SocialSecurity in order to maximize the survivor benefit is more likely.g. Use cash value life insurance. Life insurance has always been thought of asthe traditional product for replacing income. Most clients realize its value forpre-retirement income replacement. However, your clients should realize its valuefor postretirement income replacement. Planners need to plan for the early deathof a spouse in retirement. <strong>The</strong> death benefit and/or the cash value will protectagainst longevity risk by providing another pool of income. Income settlementsfrom the policy can protect against excess withdrawal risk. An income settlementallows the beneficiary to leave the death benefit with the insurance company andparcel out the death benefit plus earnings on a periodic (e.g., monthly, annually,etc.) basis.(1) Planning Point: Cash value insurance would be the preferred method ofproviding this protection of additional retirement income. A term policy maybe either unavailable or too expensive to provide this protection.10. Recommend an appropriate approach to convert assets into income. In a later <strong>section</strong> ofthis course we will discuss in detail the systematic withdrawal approach, the so-called“bucket approach,” and the income floor approach as a way to turn the client’s assets intoa stream of retirement income.a. <strong>The</strong>se approaches can go a long way toward addressing client risks. We willrevisit the impact of each approach on retirement risks in the later competency.b. It is important that the planner coordinate the risks and solutions discussed in this<strong>section</strong> with the approaches discussed later (and vice versa) in order to allow for acomprehensive solution for the client.5.12
Retirement Income Checklist:Does Your Client’s Retirement Plan Consider these Postretirement Risks and Solutions?Concern/RiskConcern: Running outof money at the end ofretirement.Longevity Risk— thepossibility of outlivingresources by livinglonger than planned.Excess WithdrawalRisk— the depletionof retirement assetsthrough poorly plannedsystematic withdrawals.Inflation Risk—thepossibility that increasesin the price of goods andservices may impede theclient’s ability to maintainthe desired standard ofliving.Timing Risk—considers the variationsin sequences of actualevents beginning withdifferent time periods.Possible Solutions1. Defer claiming Social Security.2. Elect (from the employer plan) or purchase an immediate annuity3. Purchase an Advanced Life Delayed Annuity.4. Purchase a deferred annuity that also promises a guaranteed living benefit payment.5. Create a separate portfolio that is reserved until the later years of retirement.6. Capitalize on the value of the home—Use a reverse mortgage, downsize and pull outequity, use the sale-leaseback strategy, or consider a home equity loan.7. Increase the portfolio's sustainability by investing in equities.8. Prepay expenses.9. Delay starting retirement.10. Go back to work full-time or part-time.11. Use professional advice.12. Monitor the retirement income plan and lower spending if necessary.13. Relocate to an area with a lower cost of living.14. Involve both spouses in the financial planning process.15. Use cash value life insurance.16. Recommend the appropriate approach to convert assets into income.SECTION 2: THE RISKS AND SOLUTIONS ASSOCIATED WITHRUNNING OUT OF MONEY BECAUSE OF THE AGING PROCESSLO 5-2-1: Analyze the risks associated with running out of money becauseof the aging process1. Overview—<strong>The</strong>re are three risks associated with a client becoming old and frail over thecourse of his/her retirement. <strong>The</strong>se risks do not always apply to your client. For example,your client could remain healthy until his or her death (e.g., die in a car accident). If therisks do apply, both single individuals and couples will be affected. In a married couple,these risks will probably impact the financial future of the surviving spouse even if thesurviving spouse never experienced the risk herself. <strong>The</strong> risks associated with the agingprocess include:a. Long-term care riskb. Frailty riskc. Heath care expense risk2. Long-term care risk is the risk that dementia and/or physical impediments could restricta person from performing the activities of daily living and may require them to outlaysignificant resources for custodial or medical care. Your clients should be concernedabout needing long-term care for a variety of reasons:5.13
a. Example: Because of physical and mental infirmities, Caryl may need help withbasic activities such as dressing, taking a shower, or even eating. To get help,she may need to move to assisted living, a nursing home, or go to adult day care.Even if the family can provide care, it might be a significant financial burden forthem, especially if they have to cut back on work.b. A widow or widower who endures a long-term care event for his or her deceasedspouse may have the assets on which they need to live after the spouse diesdepleted by the long-term care event.c. In a recent year, the average cost of care in a nursing home totaled $80,300. <strong>The</strong>period of time spent in a nursing home varies by age and gender. About 30 percentof people who spend time in a nursing home spend between 1 and 3 years there.d. <strong>The</strong> cost of care for an assisted living facility ranges from a low average rate of$2,050 a month to a high average rate of $4,890 a month.e. <strong>The</strong> cost of home care varies by the provider. Typically, there are three levels ofproviders: home health aides, homemaker/companions, and adult day servicesproviders. <strong>The</strong> average cost for each of these levels of care in a recent year was$21.00/hour, $19.00/hour, and $66/day, respectively.f. Planning Point: Long-term care risk is compounded by a client’s longevity.g. Planning Point: Statistically speaking, women are more likely than men to needlong-term care.3. Frailty risk is the risk that as a result of deteriorating mental or physical health, a retireemay not be able to execute sound judgment in managing his/her financial affairs and/ormay become unable to conduct home maintenance. Frailty risk could be mental, physical,or both. Mental frailty risk may occur whether or not the client is legally determined tobe incapacitated (legally unable to manage their own affairs because they lack mentalcompetency). Your clients should be concerned about losing the ability to managefinancial affairs or to maintain their home for a variety of reasons:a. Example: Dennis finds himself getting confused when it comes to making financialdecisions and it becomes obvious that assistance is needed with these functions.Extra care is needed so bills do not go unpaid and proper oversight of investmentswill continue.b. Example: Rick has lost his driver’s license and with it the ability to run errandswithout help. His inability to drive may interfere with his ability to live independently.c. Example: Over the course of time, Jessica and Myron find it hard to maintain theirhome and must now pay for expenses that they used to perform themselves suchas painting, lawn care, snow removal, and some cleaning projects requiring heavyphysical labor. Home maintenance risk is exacerbated by the aging process.d. <strong>The</strong> majority of retirees seek to age in place.e. Planning Point: <strong>The</strong> home that is suitable for raising a family may be unsuitablefor retirement living. For example, high school taxes, staircases, and extra roomsto heat, cool, and maintain may be undesirable in retirement.f. <strong>The</strong> home may become unsuitable for the client and staying could risk the client’spersonal safety. Circumstances might necessitate relocating and consequentlyincurring additional expenses.g. Clients can lose the capacity to manage financial affairs, live independently, ormanage home maintenance slowly over time or all at once, unexpectedly.h. Planning Point: Daily money management is sometimes available through socialservice providers. For a modest hourly fee, they will pay your client’s bills,make bank deposits, balance your client’s checkbook, organize your client’stax information, and even negotiate with your client’s creditors. A daily money5.14
manager can even help your clients navigate the labyrinth of Medicare andinsurance bills.i. Planning Point: Make sure the client has a support network of family and friendsto help with incapacity risk. Charitable and religious based organizations can becontacted if extra support is needed.j. Planning Point: If you suspect that the client is having cognitive problems, youshould adapt how you communicate with the client. For example, invite the clientto bring a spouse or a trusted family member to the next meeting, make meetingsshorter but more frequent, and send the client a detailed copy of meeting notes.k. Although incapacity risk as described above does not always meet the legaldefinition of mental incapacity, the client could reach this level. When this is thecase, tools such as trusts, a durable power of attorney, and advanced directiveswill be needed. However, it is important that the client take care of these mattersbefore the legal incapacity begins since legal incapacity status will prohibit theclient from creating these arrangements.4. Health care expense risk is the risk of having inadequate medical insurance. Yourclients should be concerned about needing extensive and/or expensive medical carefor a variety of reasons:a. <strong>The</strong> client can be affected either by spiraling costs of health care or the need foran inordinate amount of medical care, or both.b. Example: At age 70, Bob may have serious problems with his feet. He will soondiscover that Medicare does not cover visits to a podiatrist. More importantly, overtime, uninsured medicines and treatments may inflate out of control.c. Clients are unable to predict what health care needs will occur and when theywill occur.d. According to Fidelity’s annual Retiree Health Care Costs Estimate, a 65-year-oldcouple who retired in 2011 will need more than $235,000 to cover health carecosts during their retirement. Since Fidelity started the annual estimate in 2002,estimated costs have increased by 6% a year. (<strong>The</strong> cost does not include possiblelong-term care expenses.)e. Health care risks are compounded by inflationary trends. Inflation on medical carehas often been higher than inflation on goods and services.5. Review of risks associated with aging: (Video: What health care risks do clients face inretirement? Tacchino, Woerheide, Rappaport)a. Clients may end up with costs not covered by insurance.b. Clients may be unable to take care of themselves. This can range from needingsome help to needing 24-hour care.c. Clients face the risk of having to become a caregiver.d. Clients face the risk that care-giving help may not be available.e. Clients face the risk of loss of a driver’s license and their independence.LO 5-2-2: Evaluate the solutions a planner can use to help his client addressthe risks associated with running out of money because of the agingprocess (long-term care risk, frailty risk, and health care expense risk)1. Recommend long-term care insurance. (Video: What is long-term care insurance?Tacchino, Morith, Leisle)a. Long-term care insurance is one of several private financing methods to coverthe cost of long-term care. A long-term care insurance contract gives the client5.15
options about where to get his/her care (nursing home, assisted living, or homehealth care) and who will provide the care.b. Long-term care insurance benefits are triggered if a client is unable to performtwo or more activities of daily living and the need for help is expected to last 90days or more, or if the client is cognitively impaired.c. Long-term care insurance policies include:(1) An elimination period—a deductible usually stated in terms of days. Thissets the amount of time the client needs to pay out of pocket.(2) Daily premium payments—the client will pay a higher premium for largeramounts and vice-versa.(3) Benefit lengths—determines how long a policy will pay for benefits. <strong>The</strong>client will pay a higher premium for longer payout periods and vice-versa.(4) <strong>The</strong>re are many other decisions that the planner and client must make todesign the policy. <strong>The</strong>re is no one-size fits all “off the shelf” policy.d. Planners must address the following assumptions in order to deal with long-termcare risk:(1) <strong>The</strong> impact of the need for long-term care on the client’s legacy or bequestmotives(2) <strong>The</strong> financial impact on the uninsured client(3) <strong>The</strong> benefits, premiums and co-pays that will be requirede. Choosing a long-term care policy means dealing with some known factors:(1) <strong>The</strong> current cost of health care in the area(2) Personal and family health history(3) Current and forecasted assets and income(4) <strong>The</strong> possibility of family supportf. Choosing a long-term care policy means dealing with some unknown factors:(1) Will the client need care?(2) When will the care begin?(3) How long will the client need care?(4) What type of care will be needed?(5) What will be the cost of the care?g. Planning Point: A compounding inflation rider will protect the client againstinflation risk as well as long-term care risk. In other words, a policy without thisrider may be ineffective.h. Planning Point: Clients without long-term care insurance may have to liquidatethe portfolio to pay for long-term care services. However, it is not just the moneyfrom the portfolio, but also the taxes and the foregone interest that factor into theexpense of not having insurance coverage.i. Example: In the 3 years prior to his death, Tony experiences the need for caregiving because frailty caused by Parkinson’s disease makes it impossible for himto bathe, feed, and dress himself. His wife Maria, who is also elderly, cannottake care of him without home health care services. In the area where Tonyand Maria live, home health care costs run $36,500 per year ($100 per day).Fortunately, Tony had long-term care insurance with a $100 per diem that lasted5.16
for the duration of the three years. Without the long-term care insurance, Mariawould lose $109,500 from the funds plus taxes and lost interest. She needs thismoney to sustain her after Tony’s death.j. Disadvantages of long-term care insurance:(1) Long-term care premiums may be spent on a benefit that is never used.(2) Long-term care insurance will not help for mild frailty risk (the client is onlyslightly confused, but not cognitively impaired or is limited but cannot meetthe 2 activities of daily living requirement).2. Capitalize on the house. Institute a reverse mortgage program, downsize to a retirementcommunity, choose to reside in a continuing care retirement community (CCRC), ortake a home equity loan.a. <strong>The</strong> reverse mortgage (described briefly earlier and in greater detail in a later<strong>section</strong> of the curriculum) can be an effective way to pay for a home health carelong-term care need.b. Example: Lou Anne and Jose have reached the later years of retirement whenLou Anne falls and breaks her hip and is no longer able to bathe or dress herselfand has limited mobility. <strong>The</strong> funds from a reverse mortgage could provideadequate income to pay for home health and custodial care, which will supplementJose’s contribution to the caregiving event.c. <strong>The</strong> reverse mortgage can provide the funds necessary to offset some of theexpenses of incapacity risk.d. Example: Kerri is a widow who has lost the ability to perform functions of homemaintenance and needs help paying the bills. She can use part of the money fromthe reverse mortgage to pay workers to keep up the home maintenance and theother part to pay a daily money manager to help pay bills.e. <strong>The</strong> reverse mortgage can provide a pool of funds from which to pay for uninsuredmedical bills.f. Example: Kathy has to have a major medical procedure and a large amount of thecost for it is not covered by her Medicare and Medicare supplement insurance.She can take out a reverse mortgage line of credit to pay the bills when theycome due.g. Disadvantages of using a reverse mortgage to pay for long-term care risk, frailtyrisk, or health care expense risk:(1) <strong>The</strong> funds available may not meet the cost of the risk.(2) <strong>The</strong> use of a reverse mortgage may undermine the desire to leave thehouse as a legacy to an heir.h. If the client plans ahead, they could have downsized to a retirement communityor a continuing care retirement community (CCRC). <strong>The</strong> act of downsizing is tosell the family home to gain assets for retirement by moving into a less expensiveretirement home. This can be done regardless of the client’s health.i. A CCRC will require the client to be in good health to be admitted. However, if theclient wants to minimize the risks of long-term care and frailty, this is an excellentoption for the following reasons:(1) CCRC’s provide a variety of levels of living experiences ranging fromindependent living in a private structure (house or apartment) to assistedliving, to nursing home care.5.17
(2) Facilities, monthly fees, and services vary widely. However, in most casesfor a one-time entrance fee and monthly payments, your client can expectthe following (most of which help with frailty risk and long-term care risk):(a) A safe senior friendly environment with opportunities to increasethe client’s support network of friends. (For example, if your clientdoes not show up to the common dining hall for dinner, the usualdinner companions may check up to see if the client just decided todine privately in his or her apartment or if there is a problem.)(b) Some housekeeping and meal preparation services.(c) Transportation to area shopping and entertainment events.(d) Facilities for assisted living care and a nursing home come in thefacility of the CCRC.j. Clients needing extra cash for the risks associated with aging can also consider ahome equity loan.3. Create a separate portfolio that is reserved for the later years of retirement.a. <strong>The</strong> same logic that applies to the reverse mortgage (as a pool of money toprovide for long-term care risk, frailty risk, and health care expense risk) can beused for the separate asset class strategy. In other words, just like holding thehouse in reserve as a hedge against these risks, the use of a separate assetclass serves the same purpose.4. Implement a Medicaid spend-down.a. Medicaid spend-down planning is the process of assisting individuals intransferring, shielding, and/or converting assets and income into a form that doesnot disqualify them from receiving Medicaid benefits.b. Clients who have assets and income that fall below specified levels may be eligiblefor coverage under their state’s Medicaid system. Coverage under Medicaid wouldalmost fully account for both health care expense risk and long-term care riskbecause Medicaid provides comprehensive health and long-term care coverage.c. Planning Point: Clients may not be happy with medical and long-term careservices provided for the poor since there is little choice on the types of benefitsavailable and where to obtain the services. In addition, the quality of theseservices may pale in comparison to the quality of private pay services.d. Whether the Medicaid solution is available depends on the financial status ofyour clients.(1) This solution will probably not be available for affluent clients because theirasset base and income stream are too high to qualify for eligibility, andplanning to qualify for eligibility (spend-down) will be unwise and nearlyimpossible to accomplish.(2) This solution will probably qualify for low income and asset clients becausethey will either be eligible without planning or a spend-down plan can beset in place to make them eligible for Medicaid.(3) This solution is not initially available for middle income and assetclients because they will not qualify for Medicaid. However, some elderlaw attorneys and others have created strategies for clients to divestthemselves of their assets and meet the lookback and other requirementsof the state law. In many cases, clients can still keep family assets such asthe home, which may be exempt from divestiture under state law.5.18
e. <strong>The</strong> specifics of how these plans operate are beyond the scope of this <strong>section</strong> ofthe course and will be covered later in the curriculum.5. Recommend that the client have advanced directives.a. Many health care costs are associated with end of life medical issues.b. Client’s can gain a measure of control over these costs by having advanceddirectives such as a durable power of attorney for health care and/or a living will.c. A living will is filled out by the competent client before end of life care is needed. Itis completed by the client to tell the physician what steps to take should the clientbe come terminally ill and unable to speak for his or her needs. It is limited inbreadth and flexibility.d. A durable power of attorney for health care requires a third party (e.g., spouse orchild) to make health care decisions when the terminally ill client cannot speak forthemselves. This can cover a broad spectrum of matters and can enable the thirdparty to decide if palliative care or aggressive medical care is warranted.e. An advanced directive addresses health care expense risk by putting somedegree of control with the client or her representative.6. Select effective health care coverage including the most appropriate Medicare, Medigap,and retiree health care policies.a. Medicare allows for many choices, which can address the frailty risks and healthcare expense risks of a client. In addition Medicare Supplemental policies alsoprovide a variety of health care options.b. Tailoring the most effective Medicare and/or Medicare Supplement plan will becrucial to keeping uninsured health care costs down and providing services forfrailty.c. It is beyond the scope of this <strong>section</strong> to analyze the labyrinth of choices available(done in another course). However, this strategy is vital to meeting the risksassociated with the aging process.d. Planning Point: Planners must also consider the coordination of Medicare withany retiree health benefits that the client has.7. Recommend health savings accounts (HSAs).a. Health savings accounts give working clients with so-called high deductible healthplans the ability to establish an account that has significant tax advantages.(1) Contributions to the account are tax deductible and distributions from theaccount are tax-free.(2) In 2012, the contribution limit is $3,100 for a single individual, and $6,250for a family. <strong>The</strong>re is also a $1,000 catch up contribution for clients whoare 55 and older.b. <strong>The</strong> money saved in an HSA can be used to pay for qualified medical expenses,long-term care premiums, and Medicare premiums and deductibles.c. Example: If your 55-year-old client David contributed $4,000 a year until he turned65 to the HSA and earned just 2 percent on his money, he would have $48,300 atage 65 to use for Medicare premiums, long-term care premiums, or other medicalexpenses. If David earned 5 percent, he would have $55,100 that could bedistributed tax free for his medical needs.d. <strong>The</strong>re are a wide variety of HSA investments from which the client can choose.e. <strong>The</strong> fund is established during the working years but can be used in retirementto pay for the expenses associated with long-term care insurance premiums,frailty risk, and health care expense risk.5.19
8. Other strategies that help to cope with the risks associated with the aging process(long-term care risk, frailty risk, health care expense risk). Note these “universal solutions”work well for almost all types of risk, but often for different reasons for each type of risk:a. Recommend that the client delay starting retirement. It is often a good idea topostpone retirement until Medicare begins. A client who retires is only entitled to18 months of COBRA coverage. And the coverage is typically expensive sincethe employer is no longer sharing the cost. Health care lapses prior to Medicarestarting at 65 cannot only be costly, but they also can be deadly if the client leavesa medical condition unattended while he waits for Medicare to kick in.b. Recommend that the client go back to work full or part time. Reemployment maygive the client the extra income needed to offset long-term care risk, frailty riskand health care risk. Some medical professionals will even go as far as to say thatcontinued work activity stimulates the brain and can lead to a postponement of theneed for long-term care or the onset of frailty. However, others point to the stressof work as causing frailty risk to visit the client at an earlier age.c. Ensure that the client is receiving professional advice by working with a financialplanner or planners. Choosing the proper Medicare and Medigap coverage canbe a complicated task.d. Monitor the retirement income plan and lower spending if necessary. (Plannersshould monitor at least annually and adapt expenditures to make sure funds areavailable to offset long-term care needs, frailty expenses, and uninsured medicalexpenses.)e. Relocate to an area with a lower cost of living. This will work best to hedgelong-term care and frailty risk since some areas carry a much lower price tagfor caregiving services, home maintenance services, and other service needsbrought about by frailty.9. Recommend an appropriate strategy to convert assets into income.a. In a later competency we will discuss in detail the systematic withdrawal strategy,the so-called “bucket approach” strategy, and the income floor strategy as a wayto turn the client’s assets into a stream of retirement income.b. <strong>The</strong>se strategies can go a long way toward addressing client risks. We will revisitthe impact of each strategy on retirement risks in a later competency.c. It is important that the planner coordinate the risks and solutions discussed in this<strong>section</strong> with the strategies discussed later (and vice versa) in order to allow for acomprehensive solution for the client.Retirement Income Checklist: Does Your Client’s Retirement Plan Consider these Post-Retirement Risks andSolutions?Concern/RiskConcern:Inability to pay for healthcare costs related to oldage.Long-Term Care Risk–the possibility of needingsignificant resourcesfor custodial or medicalcare if dementia and/orphysical impedimentsrestrict the ability toPossible Solutions1. Purchase long-term care insurance.2. Capitalize on the house. Institute a reverse mortgage program, downsize to aretirement community, choose to reside in a continuing care retirement community(CCRC), or take a home equity loan.3. Create a separate portfolio that is reserved until the later years of retirement.4. Implement a Medicaid spend-down.5. Have the client create advanced directives.6. Select effective health care coverage including the most appropriate Medicare,Medigap and retiree health care policies.5.20
Retirement Income Checklist: Does Your Client’s Retirement Plan Consider these Post-Retirement Risks andSolutions?Concern/Riskperform activities of dailyliving.Frailty Risk – thepossibility that mentaland/or physical frailtywould prohibit a clientfrom properly managinghis/her financial affairsand/or his/her home.Health Care ExpenseRisk – having inadequatemedical insurance.Possible Solutions7. Recommend health savings accounts (HSAs).8. Delay starting retirement.9. Go back to work full-time or part- time.10. Use professional advice.11. Monitor the retirement income plan and lower spending if necessary.12. Relocate to an area with a lower cost of living.13. Involve both spouses in the financial planning process.14. Recommend an appropriate approach to convert assets into income.SECTION 3: THE RISKS AND SOLUTIONS ASSOCIATED WITHRUNNING OUT OF MONEY BECAUSE THE CLIENT IS HOLDINGINVESTMENTS ASSETS DURING THE RETIREMENT PERIODLO 5-3-1: Analyze the risks of running out of money from depending oninvestments in retirement1. Overview—<strong>The</strong>re are 3 risks embedded in every retirement income plan that holdsinvestment assets that need to be converted into retirement income. <strong>The</strong>se risks apply toboth married and single clients. <strong>The</strong>y also apply to every client for which you need toplan regardless of his/her financial status. <strong>The</strong>se include:a. Investment risk (including but not limited to asset allocation risk, market risk,and sequence of returns risk)b. Reinvestment riskc. Liquidity riskd. When one holds investment assets, there are several issues to consider thatinvolve trade-offs between the different types of risk.e. <strong>The</strong> traditional financial securities for investment are stocks, bonds, and cash.Stocks may be purchased directly or through any of several different types ofinvestment company arrangements such as mutual funds, closed-end funds,ETFs, hedge funds, etc. Bonds are even more likely to be purchased via aninvestment company arrangement because of trading problems associated withtrying to buy smaller amounts (e.g., under $100,000 of a particular bond issue).When we refer to cash, we are actually referring to money market instrumentssuch as Treasury bills, negotiable CDs, commercial paper, bankers’ acceptances,a bank money market account, or a high-yield savings account. In this case, theinvestment of choice is almost always a money market mutual fund.f. Research has consistently shown that large portfolios of stocks always providesubstantially higher returns over long time periods than do large portfolios ofbonds, and that the bonds substantially outperform cash over long time periods.However, the amount of risk implicit in these investments, as represented by the5.21
standard deviations of the returns on these securities follows in the same orderwith stocks being substantially more risky than the other two.g. <strong>The</strong>re are other investments that a retiree might consider, and these are referredto as alternative investments. <strong>The</strong>se include such things as REITS (real estateinvestment trusts), nontraded REITS, equipment leases, oil and gas investments,managed futures, and private equity funds.h. Because of the difficulty of collecting large amounts of unbiased data to analyzethese alternative investments, we cannot say as much about them in terms ofhistorical performance but one of the goals in using alternative assets is toimprove portfolio diversification.2. Investment risk involves investing too conservatively, too aggressively, and/orinadequately diversifying assets (called asset allocation risk). <strong>The</strong>re is also market risk,which is the risk from events that cause all security prices to fall. Your clients should beconcerned about losing money in the financial markets for a variety of reasons:a. If realized, these risks can lead to the loss of capital or less-than-planned-forinvestment return.b. Example: Sue is about to retire and she fears a loss of principal on herinvestments and puts all of her assets into safe, but low yielding, certificates ofdeposit. However, these investments will produce a lower return than is neededfor the retirement period.c. Embedded in the issue of losing money in the financial markets is the risk ofreceiving low or negative returns in the early years of retirement (sequence ofreturns risk). For example, Rick retired in 2007 to face a 30 percent drop in hisportfolio shortly thereafter. <strong>The</strong> timing of this black swan market event had along-term negative effect on the ability of his retirement portfolio to provide him theneeded income.d. Example: Consider the following illustration of sequence risk. In Table A, Peggystarts with a portfolio worth $10,000. She draws out $1,100 at the end of eachperiod. Peggy earns the following returns in years 1 through 5: 40%, 20%, 0%,–20%, –40%. Note that at the end of the five years, she has $4,614 left in theaccount, even though Peggy has achieved a 0% arithmetic average rate of returnand drawn out a total of $5,500. In Table B, Gregg starts with the same amount,makes the same withdrawals, and earns the same rates of return, except inreverse order. Note that Gregg will fall $934 short of his fifth withdrawal. Thisdisparity of outcomes is the result of a bad case of sequence of returns risk.e.Table APeriod BOP ROR Value Withdrawal EOP1 $10,000 40% $14,000 $1,100 $12,9002 $12,900 20% $15,480 $1,100 $14,3803 $14,380 0% $14,380 $1,100 $13,2804 $13,280 –20% $10,624 $1,100 $ 9,5245 $ 9,524 –40% $ 5,714 $1,100 $ 4,614Table BPeriod BOP ROR Value Withdrawal EOP1 $10,000 –40% $6,000 $1,100 $4,9005.22
2 $4,900 –20% $3,920 $1,100 $2,8203 $2,820 0% $2,820 $1,100 $1,7204 $1,720 –20% $1,376 $1,100 $ 2765 $ 276 –40% $ 166 $1,100 $ (934)f. Planning Point: With market risk, the most fundamental piece of investmentadvice—diversification—does not work, if by diversification one means investingin different risky assets.g. Planning Point: Market risk is avoided by holding nonrisky assets such as CDsand savings bonds. However, these investments typically provide the lowest ratesof return available in the market place.h. Planning Point: Too often, clients who suffer market setbacks pull out of equitiesto create a “buy high, sell low” scenario. Research has shown that the actual ratesof return achieved by mutual funds are typically higher than the rates of returnachieved by investors in those mutual funds. This is because many individuals,left to their own investment timing, will base their investment decisions on recentmarket movements. Thus, when stock prices have been going up, they buy, andwhen stock prices are going down, they sell. So although everyone knows thatthe simple way to make money in investments is to buy low and sell high, manyinvestors will regularly end up buying high and selling low.3. Reinvestment risk is the chance that as higher-yielding fixed income investments mature,the client may need to reinvest that principal and possibly interest payments into alower-yield fixed income investment. Your clients should be concerned about beingunable to duplicate yield on fixed investments for a variety of reasons:a. Retirees often rely on returns from fixed income investments and may not be ableto acquire the needed rate of return when they must lock in the investment.b. Example: Arthur’s investments include a substantial portion in bonds of variousmaturities. As principle and interest payments come due, some of the cash iswithdrawn to cover expenses, and the rest is reinvested into new bonds. Arthurhears that interest rates have been falling, and is pleased to note that the valueof his bond portfolio has risen from $400,000 to $425,000. However, Arthur alsonotes that when he goes to reinvest his principal and interest payments, he isno longer able to find bonds with yields comparable to what he had previouslybeen getting. He realizes that because of the lower interest payments on the newbonds, his interest income from the portfolio is falling, and he will have to liquidatemore bonds than he anticipated to meet his needed withdrawals.c. Planning Point: Zero coupon bonds, since they do not make coupon interestpayments, eliminate the reinvestment risk associated with the coupon payments.An example of a zero coupon security is U.S. Treasury strips.4. Liquidity risk is the inability to have assets available to financially support unanticipatedcash flow needs. Clients should be concerned about being able to access fundsa. Example: Fengyum’s portfolio consists solely of single premium annuities andinvestments in extended maturity certificates of deposit. When a sudden accidentforces her to remodel her house for one floor living, she is unable to obtain thecash necessary to complete the project because of the restrictions on liquidatingthe annuities and penalties on early withdrawals from the certificates.b. Example: Russ owns undeveloped real estate when he is confronted with theneed to support his daughter who is out of work because of a recession caused by5.23
a collapse in the real estate market. Russ suffers from liquidity risk because hisundeveloped land cannot be sold for a fair price. Liquidity gives clients the greatestdegree of flexibility to adapt to their changing world. This financial independenceempowers them to shift their priorities and exercise control over their environment.c. Planning Point: An emergency fund can meet the client’s need for short-termliquidity without forcing the sale of illiquid assets to meet the needs of the financialemergency.LO 5-3-2: Evaluate the solutions a planner can use to help his clientaddress the risks associated with depending on investments in retirement(investment risk, asset allocation risk, market risk, sequence of returnsrisk, reinvestment risk, and liquidity risk)1. Use a laddered bond portfolio.a. Within an investment portfolio, it is possible to structure the bond holdings toenhance the ability of the portfolio to support the client. A bond ladder is one inwhich the portfolio is invested in bonds whose maturities are spread evenly acrossa selected time horizon.b. Example: A simple bond ladder would be a 10-year ladder, which would have 10percent of the portfolio mature each year. Suppose Tex has a $1,000,000 portfolio,and puts 60 percent into equities and 40 percent into bonds. <strong>The</strong> $600,000 inequities could be invested in several equity mutual funds that cover a varietyof objectives. <strong>The</strong> $400,000 in bonds could be invested across a 20-year timehorizon, wherein $20,000 is set to mature each year. Thus, regardless of whateverelse happens in the market, Tex knows he has $20,000 coming in each year.c. Bond ladders solve the investment risk problem in most cases becausegovernment and highly rated (e.g., AAA) bonds seldom default.d. Bonds may not help with reinvestment risk if they are coupon bonds and youare planning to reinvest the coupons.e. A bond ladder with government bonds will help with liquidity risk.f. A bond ladder that holds bonds that are thinly traded will be hurt with liquidity risk.2. Use an immunization strategy.a. An immunization strategy is a more sophisticated version of a bond ladder. Animmunization strategy is one wherein after selecting a time horizon, the clientbuys bonds whose duration statistic is approximately equal to the desired holdingperiod. By buying a bond whose duration statistic matches a desired holdingperiod, the client trades off price risk with reinvestment rate risk. A bond ladderonly assures that the par value is available at particular times in the future. It saysnothing about what the value of the reinvested coupons will be. <strong>The</strong> goal of animmunization strategy is that when the holding period is over, any gain or loss inthe price of the bonds will be offset exactly by a loss or gain in the value of thereinvested coupon payments, such that the client will receive the yield to maturitythat existed on the bond at the time of purchase.b. Example 1: A 4 percent coupon bond with a 10-year maturity and a yield tomaturity of 8 percent will have a duration statistic of 8.12 years. This means that ifone buys this bond today, and sells it in 8 years (2 years prior to maturity), thenone is more likely to attain a yield of 8 percent on this investment than if onehad simply bought a bond that matured in 8 years. <strong>The</strong> reason is that using thematurity does not incorporate the impact of interest rate changes on the reinvestedcoupons over the holding period.5.24
c. Example 2: If clients want a laddered portfolio with a 10-year time horizon, thenthere are 10 different holding periods, and each anniversary date becomes adesired holding period. <strong>The</strong> easiest way to immunize the portfolio is to buyzero-coupon bonds whose maturities match the desired payoff dates. <strong>The</strong> reasonis that a zero-coupon bond is the only one in which the duration statistic exactlymatches the maturity. So, if one wanted a 10-year bond ladder, it would be moreefficient to buy zero coupon bonds with the 10 different maturities than to buycoupon bonds whose maturity matches the desired payoff dates.d. <strong>The</strong> immunization strategy solves the investment risk problem in most casesbecause government and highly rated (e.g., AAA) bonds seldom default.e. <strong>The</strong> immunization strategy may not help with reinvestment risk when the client isusing coupon bonds and planning to reinvest the coupons.f. <strong>The</strong> immunization strategy using government bonds will help with liquidity risk.g. An immunization strategy that uses thinly traded bonds will hurt the client’sliquidity risk.3. Consider all retirement assets in the asset allocation model.a. Asset allocation must be matched to the client’s risk tolerance.b. Many clients become more risk averse as they enter and live through retirement.c. Tell clients the exposure in the investment portfolio is only a percentage of theirentire portfolio.d. A portfolio that only factors in investable assets may underrate the potential forequity investments. <strong>The</strong> portfolio should factor in Social Security, annuities, andhousing equities.e. Example: Don has the equivalent of a net present value of $300,000 in SocialSecurity. He also has $300,000 in home equity and $1,400,000 in an investmentportfolio. If Don feels a 60 percent equity position meets his risk aversion profile,he should invest $1,200,000 in equities (which is 60 percent times his entireportfolio of $2,000,000), rather than $840,000 in equities (which is 60 percenttimes his liquid investment portfolio of $1,400,000).f. This will help the clients who need more exposure to equities to accept thatexposure.4. Diversification and age-appropriate investments.5. Other strategies that help to impede the risk of holding investments in retirement include:a. Recommend that the client delay starting retirement. Postponing retirementmay allow a client to stockpile more investment assets in a 401(k) plan. <strong>The</strong>seadditional assets might serve as a hedge against investment losses.b. Recommend that the client go back to work full or part time. Reemployment maygive the client the extra income needed to offset investment losses.c. Ensure that the client is receiving professional advice by working with a financialplanner or planners. Too often clients are ill equipped to manage their portfolio.Professional advice can help a client avoid asset allocation mistakes.d. Monitor the retirement income plan and lower spending if necessary. Plannersshould monitor plans at least annually and adapt expenditures to make sure fundsare not exhausted because of the risks associated with portfolio management.e. Relocate to an area with a lower cost of living. This will work best to hedgeagainst investment losses.6. Recommend an appropriate strategy to convert assets into income.5.25
a. In a later competency we will discuss in detail the systematic withdrawal strategy,the so-called “bucket approach” strategy, and the income floor strategy as a wayto turn the client’s assets into a stream of retirement income.b. <strong>The</strong>se strategies can go a long way towards addressing client risks. We will revisitthe impact of each strategy on retirement risks in the later competency.c. It is important that the planner coordinate the risks and solutions discussed in this<strong>section</strong> with the strategies discussed later (and vice versa) in order to allow for acomprehensive solution for the client.7. Invest in inflation protected securities.a. Investing in inflation protected securities, like the U.S. Treasury’s Series I Savingsbonds, and its Treasury Inflation Protected Securities (TIPS) can provide inflationprotection for that part of the portfolio.b. Social Security benefits also have an inflation protection component because thebenefit payments receive an annual cost of living adjustment.Retirement Income Checklist: Does Your Client’s Retirement Plan Consider these Post-Retirement Concernsand Risks?Concern:Losing value on investment assetsheld during retirement.Asset Allocation Risk—invest tooconservatively, too aggressively,and/or do not diversify assets.Market Risk — possibility thatevent(s) could cause all securityprices to fall.Sequence of Returns Risk—receiving low or negative returns inearly retirement years.Reinvestment Risk — chance thatclient will be unable to duplicate yieldon fixed investments as they mature.1. Use laddered bonds.2. Use an immunization strategy.3. Consider all retirement assets in the asset allocation model.4. Diversification and age-appropriate investing.5. Recommend that the client delay starting retirement.6. Recommend that the client go back to work full or part time.7. Ensure that the client is receiving professional advice.8. Monitor the plan and lower spending if necessary.9. Relocate to an area with a lower cost of living.10. Recommend an appropriate approach to convert assets into income.11. Invest in inflation indexed securities.Liquidity Risk — inability to haveassets available to financially supportunanticipated cash flow needs.SECTION 4: THE RISKS AND SOLUTIONS ASSOCIATED WITHRUNNING OUT OF MONEY IN RETIREMENT BECAUSE OFSPECIFIC LIFE EVENTSLO 5-4-1: Analyze the risks and solutions associated with running out ofmoney in retirement because of specific life events (It’s a hard cruel world!)1. Overview—<strong>The</strong>re are 6 risks that may or may not happen to your client depending onhis or her specific situation. When applicable, these risks apply to both married andsingle clients. <strong>The</strong>se risks have highly specific solutions that apply to the highly specificproblems they present. <strong>The</strong>se include:5.26
a. Forced retirement riskb. Reemployment riskc. Public policy riskd. Loss-of-spouse riske. Unexpected financial responsibility riskf. Financial elder abuse risk2. Forced retirement risk is the possibility that work will end prematurely because of poorhealth, care-giving responsibilities, dismissal by the employer, lack of job satisfaction orfor other reasons. Your clients should be concerned about retiring earlier than plannedfor a variety of reasons:a. This is likely to lead to inadequate retirement income because the client has notgarnered the necessary resources to fund retirement needs.b. Example: Peggy plans to work until age 65, but her long time employer suddenlycloses her office when she is 61. (This scenario illustrates business continuityrisk.) <strong>The</strong>re are very few employers needing her skills in the area, and she isunable to find suitable employment. Not only are her plans to accumulate morefunds for retirement ambushed, but she may not be able to receive or afford healthcare coverage until she is eligible for Medicare.c. Planning Point: Over 40 percent of clients retire earlier than expected.d. Planning Point: Clients may have little or no warning to prepare them for forcedretirement.3. Forced retirement risk can be minimized in the following ways:a. Suggest that the client save for graded levels of retirement security at differentages. In other words, instead of thinking of the goal for retirement savings tobe X dollars by Y year (the year of projected retirement) think about saving forretirement as providing for a specified standard of living by, for example, ten yearsbefore retirement; a more comfortable standard of living, for example, at 5 yearsbefore retirement; and the desired standard of living at retirement. By setting thesavings program up to meet graded goals, you may encourage the client to saveearlier and to assess what the final years of work will mean to his/her retirement.Most importantly, however, you will have prepared a level of security in case anearly termination occurs. <strong>The</strong> start of retirement is no longer a “date.” <strong>The</strong> startof retirement should be thought of as a period (age 60-70), not a date (the Julyafter my 65 th birthday).b. Career management is another solution to the problem of forced retirement risk.<strong>The</strong> client who chooses to adapt his/her skills and education to current marketneeds and the client who chooses to work for the employer with the greater senseof job security and satisfaction will be better served than the client who does notseek these adaptations to his/her career.c. See if formal or informal phased retirement is possible. A client can plan hisor her career to slow down responsibilities, cut back on clients, or drop theresponsibilities associated with a second job.d. Example: Joe has always been a high school teacher who did landscaping work inthe summer. When he turned 60, he decided to stop the physically demandinglandscaping. This allowed him to continue teaching with summers off until age 67.e. Advise negotiating for golden handshakes and severance pay.f. Example: Maggie, age 61, is thinking of leaving work to take care of her motherwho needs care for an illness, which threatens to linger for several years. Maggieshould investigate whether her employer is willing to offer her a package to leaveemployment (e.g., health insurance and a lump sum payment based on her long5.27
years of service with the employer). Some employers are willing to offer incentivesbecause they are happy to replace a long-service employee who is highly paidwith a newer and less costly employee. Since discrimination laws make itimpossible to fire your long service client, the employer may be willing to talkabout a “deal” for voluntarily retiring. (<strong>The</strong> employer will probably not be awarethat the employee needed to retire for family reasons.)4. Reemployment risk is the inability to supplement retirement income with part timeemployment due to tight job markets, poor health and/or caregiving responsibilities.Your clients should be concerned about the ability to supplement retirement income withearnings from employment during retirement for a variety of reasons.a. Many retirees engage in an informal type of phased retirement by taking consultingpositions, part time jobs or even turning their hobbies into profit-making activities.This avenue of financial relief may be unavailable to your client under certaincircumstances.b. Example: Robert is an avid wood worker who had intended to make furniture andsell it on eBay throughout his retirement. However, poor physical health impededhis ability to practice his craft.5. Reemployment risk can be minimized in the following ways:a. Suggest that the client save for graded levels of retirement security at differentages. In other words, instead of thinking of the goal for retirement savings tobe X dollars by Y year (the year of projected retirement), think about saving forretirement as providing for a specified standard of living by, for example, ten yearsbefore retirement; a more comfortable standard of living, for example, at 5 yearsbefore retirement; and the desired standard of living at retirement. By settingthe savings program up to meet graded goals you may encourage the client tosave earlier and to assess what the final years of work will mean to his or herretirement. Most importantly, however, you will have prepared a level of security incase an early termination occurs. <strong>The</strong> start of retirement should be thought of as aperiod (age 60–70) not a date (the July after my 65 th birthday).6. Public policy change risk is an unanticipated transition in government programs that wereembedded in the retirement planning process, including, but not limited to, significant taxincreases (tax risk), elimination of tax benefits (tax risk), and elimination or minimizationof government programs such as Medicare and/or Social Security to the point where theywill not provide sufficient protection during retirement. Your clients should be concernedabout changing government policies for a variety of reasons.a. Example: Walt has saved diligently for retirement only to find the government hasadopted “means testing” and he is no longer eligible for certain programs becausehis income is too high.b. Example: Kathy who has decided to age in place may be affected by significantincreases in property taxes.7. Public policy change risk can be minimized in the following ways:a. Planning Point: <strong>The</strong>re are a lot less product and planning solutions available tocombat public policy change risk than there are for most other risks clients face.b. Clients will sometimes be “grandfathered” so that the public policy change will notimpact their particular situation.c. Use tax-free investments to avoid increases in the client’s marginal tax rateadversely affecting her rate of return.5.28
8. Loss-of-spouse risk involves the planning and financial hardships that may arise uponthe death of the first spouse. Your clients should be concerned about losing their spousefor a variety of financial reasons.a. In addition to the emotional consequences of losing a spouse, there are planningand financial hardships that may arise. <strong>The</strong> Society of Actuaries has conductedsurveys finding that people do not seem to comprehend the financial magnitude ofthe death of a spouse.b. Economists tell us that surviving spouses need 75 percent of the couple’s incometo maintain their standard of living. However, the death of a spouse is too oftenaccompanied by a decline in economic status. For one thing, the surviving spousemay not have the ability to manage finances. For another thing, some incomemay stop at a spouse’s death.c. Example: Eric retired at age 65 and began to receive a company pension. Toincrease monthly benefits, he chose the single life annuity, which ceased upon hisdeath, cutting his spouse’s income in half.d. Planning Point: Planners should educate both spouses about financial affairs.e. Planning Point: Within 5 years of the death of a spouse, 40 percent of widows fallinto poverty.f. Planning Point: Planners need to be aware of how to work with grieving clients.g. Planning Point: Planners need to understand the client’s support network.9. Loss-of-spouse risk can be minimized in the following ways:a. Involve both spouses in financial planning. This will help the surviving spouse tobetter cope with financial affairs. It may also lead to decisions that protect bothspouses.b. Use joint and survivor annuities instead of life only annuities.c. Carry life insurance after retirement.d. Proper estate planning (wills, trusts, and other estate documents) can minimizethe financial damage of the loss of the first spouse.10. Unexpected financial responsibility risk occurs when the client acquires additionalunanticipated expenses during the course of retirement. Your clients should be concernedabout assuming unexpected financial responsibilities for a variety of reasons.a. Example: Lisa’s adult child, a single mother, loses her job and needs assistance.Lisa decides to pay her daughter’s mortgage until she gets back on her feet. Eventhough Lisa may feel flush with significant wealth at the current time, she mustverify through a highly structured retirement income plan whether she can meetthese extra financial obligations. She does not want to be in the position to helpher children early in retirement only to become a financial burden to her childrenlater in retirement.b. <strong>The</strong> retirement period can be filled with the unexpected. A client may need tosupport a grandchild that was not even born at the time of his or her retirement.11. Unexpected financial responsibility risk can be minimized in the following ways:a. Planners should advise against helping others before the client has assured hehas enough assets for himself. Shedding light on the ability to sustain income forthe client enables the client to decide whether they can afford to help.12. Financial elder abuse risk is the possibility that an advisor or family member might preyon the frailty of the client, might recommend unwise strategies or investments, or mightembezzle assets from the client. Your clients should be concerned about bad advice,fraud and theft for a variety of reasons:5.29
a. Planning Point: Planners should be aware that elder financial abuse often comesfrom family members. Be careful who has power of attorney!b. Example: James, under the guise of taking care of his elderly father, abuses hispower of attorney to acquire assets for his drinking and gambling problem.c. Carefully screening caregivers and financial advisors (is the planner credentialedor properly licensed?) can help to avoid disaster.d. Planning Point: Remind clients that if it seems too good to be true, it probably is!e. Planning Point: Beware of people pressuring the client.13. Financial elder abuse risk can be minimized in the following ways:a. Clients must screen caregivers and planners carefully to ensure they are worthyof their trust.b. Having family members involved can lead to an open environment, which makes itharder for the client to be manipulated.14. <strong>The</strong> ethical side of elder abuse. (Video: What are the important ethical considerationswhen working with an older client? Tacchino, Moody, Duska)a. Elder abuse could be physical, psychological, or financial harm to a vulnerableelderly person.b. Statistics indicate that more financial elder abuse takes place because of familymembers than because of financial planners.c. A profile of a typical victim is someone who is in her 80’s, female, living alone,and cognitively impaired.d. <strong>The</strong> abuse may be brought about because the person is too polite to push backwhen necessary or because the person is lonely.e. Elder financial abuse goes unreported because people are embarrassed, they donot want to send a family member to jail, or they may lose caregiving.f. From an ethical standpoint the financial planner has three duties: 1) do not doharm, 2) prevent harm, and 3) do good.g. In order to meet his or her ethical duty the planner must have 1) the capability toprevent the action, 2) the proximity to the situation to act, and 3) the recognitionthat harm is possible.h. Professionalism requires intervention even if it means losing the client or havingyour advice ignored.i. Other solutions include 1) involving other people, 2) shedding light on the situation,3) communicating with the client and others, and 4) using prudence.SECTION 5: THE RISKS AND SOLUTIONS FOR BEING ILLPREPARED FOR RETIREMENTLO 5-5-1: Analyze unrealistic expectation risk and the other risks thatmake a client ill prepared to retire1. Unrealistic expectation risk is the false belief that adequate resources have been acquiredto fund retirement. Clients make poor choices because they were not properly educatedabout the consequences of insufficient retirement income planning. Your clients shouldbe concerned about the “leaping before they look” approach for a variety of reasons:a. One of the greatest threats to retirement security is the failure of clients torecognize that they should have been concerned about their financial ability to5.30
etire. This grave oversight could be eliminated if only the client had sought outplanning advice before retirement.b. Too many people “self-medicate” despite the fact that retirement income planningis a complicated endeavor that should be placed in the hands of a professional.According to a recent ING Retirement Research Institute study 71 percent of<strong>American</strong>s still lack a formal investment plan to help them reach their goals.c. Planning Point: <strong>The</strong> planner may find himself planning for clients who retired 10years ago at age 63 and are only now realizing that they are overmatched withregard to their financial future. Sadly, retirement security can be doomed evenbefore retirement begins for the following reasons:(1) Clients may have retired with significant mortgage, student loan, and/orconsumer debt that may erode the resources needed for retirementspending (high debt service risk).(2) Clients may have started saving for retirement too late (procrastinationrisk).(3) Clients may have experienced a setback with their employer plan such asoverinvestment in employer stock (speak to any former Enron employee)(asset allocation risk), consuming assets when switching jobs (oops, Iforgot to rollover plan funds and bought a boat instead!) (rollover risk).(4) Clients may have worked for an employer who did not provide a retirementplan (retirement-saving opportunity risk).(5) Clients might otherwise find themselves having a savings shortfall eventhough retirement age is beckoning (inadequate resource risk).2. Should your client present with this situation, your job is to either recommend a delayedretirement to garner more assets, or to provide cash flow management which will probablymean reducing the client’s budget and standard of living.SECTION 6: REVIEWLO 5-6-1: Solutions review1. <strong>The</strong>re are many macroeconomic risks clients face in retirement. (Video: Whatmacroeconomic risks do clients face in retirement? Tacchino, Woerheide, Rappaport)a. Stock market or investment riskb. Inflation risk(1) Probably the number one issuec. Government change risk(1) For example, we are talking about changes to Medicare.d. Interest rate risk2. What is market risk?a. <strong>The</strong> risk from events that cause all stock prices to fall.b. With market risk, the most fundamental piece of investment advice, diversification,does not work.c. <strong>The</strong> only defense is to put some of the client’s assets into truly safe, fixed-returnholdings, such as CDs.(1) In other words, build a floor income.5.31
(2) If you have locked in food, rent, and the basic expenses, then you can be alittle more adventurous with your discretionary funds.3. What is interest rate risk?a. Interest rate risk is risk associated with changes in market interest rates.b. <strong>The</strong>re are two sources of interest rate risk:(1) Price risk(a) When interest rates go up, prices go down.(b) When interest rates go down, prices go up.(2) Reinvestment rate risk(a) When interest rates are up, better yields on reinvested cash(b) When interest rates are down, worse yields on reinvested cashc. In recent years, interest rates have only fallen.4. Another risk is timing risk.(1) Retirees have found that their interest income has declined.a. Buy an interest rate product today, such as an annuity, and then have interestrates go up tomorrow, which means one could have gotten a better dealb. Best way to deal with timing risk on annuity purchases is to not buy the annuity allat once.(1) This is referred to as laddering one’s purchase, or engaging in timediversification.5. A risk that is specific to annuities is carrier risk.a. Even though there are state guarantee funds, the client may still want to splitthe annuity between issuers.6. Public policy risk is almost as scary as inflation risk.a. Currently, everyone believes Medicare will change.b. Social security will also likely change, although the changes may not be draconian.c. Prayer is certainly one way to deal with this, but a better way is just to havea good cushion.d. Although some people are concerned that late claiming exposes one to SocialSecurity rule changes, this is unlikely.(1) If there is no change in Social Security benefits or contributions, thenaround 2035, there would need to be a 23% cut in benefits, so they willhave to make some fine-tuning.(2) It really makes no sense to claim early because of uncertainty of whatmight happen with regard to the rules.(3) Remember, we are already means testing with regard to taxation ofbenefits.e. <strong>The</strong> real issue is not to build plans around the long-term operation of the existingtax rules.(1) This is referred to as tax diversification.f. Medicare is already essentially bankrupt, so something dramatic really does haveto happen with regard to this program.(1) Medicaid is another system that will have to change.5.32
(2) Co-pay and contributions are certainly likely to go up for these programs.(3) <strong>The</strong>re may be more restrictions on what care is delivered.(4) <strong>The</strong>re are discussions to unify Parts A and B.(5) It is certainly possible that changes in Medicare and Medicaid will be madethat affect current retirees.7. What can the client do about inflation risk?a. A 10% to 11% inflation rate would kill anyone’s retirement.b. First, put inflation protection into any annuity products, or at least fixed increases.c. Buy TIPs.d. <strong>The</strong> impact of inflation on equities may be sensitive to the nature of each company.e. Inflation always benefits people holding assets such as land and homes.f. Research shows that in the middle income market, nonfinancial assets such asthe home accounts for about 70% of people’s assets if we don’t count the presentvalues of Social Security or defined benefit pensions8. Conclusiona. <strong>The</strong>re is no good news here.b. We have to be worried about inflation risk, public policy risk, timing risk, andmarket risk.c. Spending less helps to mitigate risks.LO 5-6-2: Review major strategies that address most risks1. Delay starting retirement as long as possible.2. Go back to work if possible.3. Monitor the retirement income plan and lower spending if necessary.4. Create and monitor a well-diversified and age-appropriate portfolio.5. Use cash value life insurance.6. Involve both spouses in the financial planning and budgeting process.7. Engage a professional planner to provide help and advice.Review major multipurpose strategies and the risks they address1. Defer claiming Social Security to increase monthly benefits in the later years of retirement.This strategy:a. Helps to potentially minimize:(1) Longevity risk—Deferred claiming of Social Security benefits results ingreater income at older ages because larger monthly Social Securitychecks are paid as long as the client lives.(2) Excess withdrawal risk—Deferred claiming of Social Security benefitsensures clients will properly use assets to pay for legitimate expenseswhile they wait for increased Social Security benefits. Using assets topay for the increased annuity value of Social Security means that thoseassets won’t be prematurely spent.(3) Inflation risk—Deferred claiming of Social Security benefits means thatSocial Security cost of living adjustments will compound on a largermonthly benefit providing greater maintenance of purchasing power.5.33
(4) Loss-of-spouse risk—Deferred claiming of Social Security benefits couldresult in a larger survivor benefit for a widow or widower.(5) Investment risk—Deferred claiming of Social Security benefits achievesthe purpose of using assets to increase the annuity value of SocialSecurity, which effectively transfers the investment risk on those assetsfrom the client to the government.b. Hurts by potentially exacerbating(1) Liquidity risk—Deferred claiming of Social Security benefits will mean thatassets are consumed to pay for expenses while the client waits for largerSocial Security checks. Consuming those assets might impede the clientfrom having the funds needed for major expenses in retirement.(2) Public policy risk—Deferred claiming of Social Security benefits mightresult in the client losing the opportunity to get benefits which are takenaway (e.g., means testing) or missing the opportunity to be grandfatheredinto an existing system which is more beneficial to the client.2. Elect (from the employer plan) or purchase an immediate annuity to create a stream ofincome that will last a lifetime. This strategy:a. Helps to potentially minimize:(1) Longevity risk—An immediate annuity accomplishes providing a monthlycheck as long as he or she lives. <strong>The</strong> client cannot outlive this income.(2) Excess withdrawal risk—Using assets to purchase an immediate annuitymeans that those assets won’t be prematurely spent.(3) Inflation risk—If the immediate annuity has an inflation rider, it will help tomaintain purchasing power throughout retirement.(4) Reinvestment risk—<strong>The</strong> use of an immediate annuity locks in some assetswhen the annuity is purchased. <strong>The</strong>se funds are therefore not subject toreinvestment risk. What’s more, the annuity may be perceived to be the“conservative” portion of the portfolio and therefore the need to invest inTreasury bills and certificates of deposit (conservative investments that areespecially vulnerable to reinvestment risk) may be minimized or eliminated.(5) Investment risk—<strong>The</strong> use of an immediate annuity shifts the investmentrisk for the funds used to purchase the annuity from the client to the insurer.(6) Loss-of-spouse risk—Using a joint and survivor annuity will help to provideincome to the widowed spouse. However, a life only immediate annuity willhurt the economic status of the surviving spouse.b. Hurts by potentially exacerbating:(1) Liquidity risk—<strong>The</strong> use of an immediate annuity means assets areconsumed to pay for the annuity. Consuming those assets might impedethe client from having the funds needed for major expenses in retirement.(2) Loss-of-spouse risk—Using a life-only immediate annuity based on the lifeof the first to die will hurt the economic status of the surviving spouse.(3) Bequest opportunity—An annuity takes away the client’s ability to leavethose assets to his or her heirs.3. Purchase an advanced life delayed annuity (ALDA), also known as longevity insurance,that will pay regular income but beginning at a later age (such as 80). This strategy:5.34
a. Helps to potentially minimize:(1) Longevity risk—An ALDA is designed to provide the most cost-effectiveinsurance against longevity risk.(2) Excess withdrawal risk—Using assets to purchase ALDA means that thoseassets won’t be prematurely spent.(3) Inflation risk—An ALDA can be used as inflation hedge. It provides extrafunds later in retirement to make up for lost purchasing power.(4) Investment risk—<strong>The</strong> use of an ALDA shifts the investment risk for thefunds used to purchase the annuity from the client to the insurer.(5) Loss-of-spouse risk—Using an ALDA based on the life of the survivingspouse will help to provide income to the widowed spouse.b. Hurts by potentially exacerbating:(1) Liquidity risk—<strong>The</strong> use of an ALDA means assets are consumed to pay forthe annuity. Consuming those assets might impede the client from havingthe funds needed for major expenses in retirement.(2) Loss-of-spouse risk—Creating an ALDA based on the life of the spousewho dies first will take away assets from the widowed spouse.(3) Bequest opportunity—an annuity takes away the client’s ability to leavethose assets to his or her heirs.4. Purchase a deferred variable annuity that also promises a guaranteed living benefitpayment. This strategy:a. Helps to potentially minimize:(1) Longevity risk—<strong>The</strong> use of deferred variable annuity that also promises aguaranteed living benefit payment mitigates longevity risk because annualincome is guaranteed no matter how long the client lives.(2) Inflation risk—<strong>The</strong> use of deferred variable annuity that also promises aguaranteed living benefit payment mitigates inflation risk. If a guaranteedminimum accumulation rider is used, this rider guarantees a minimalincrease in each period to keep up with inflation. Also the underlying equityinvestments may help to keep pace with inflation.(3) Liquidity risk—<strong>The</strong> use of deferred variable annuity that also promises aguaranteed living benefit payment mitigates liquidity risk because the clienthas access to his or her money.(4) Point-in-time risk–inflation risk—<strong>The</strong> use of deferred variable annuity thatalso promises a guaranteed living benefit payment mitigates point-in-timerisk since some of the underlying investments are in equities.(5) Frailty risk–inflation risk—<strong>The</strong> use of deferred variable annuity that alsopromises a guaranteed living benefit payment mitigates frailty risk becausethe annual payments can be set up before the client suffers from confusionand then left on auto-pilot.(6) Loss-of-spouse risk—<strong>The</strong> use of deferred variable annuity that alsopromises a guaranteed living benefit payment mitigates spousal survivalrisk because death benefits are available from these products.b. Hurts by potentially exacerbating:5.35
(1) Excess withdrawal risk—<strong>The</strong> use of deferred variable annuity that alsopromises a guaranteed living benefit payment exacerbates excesswithdrawal risk because the client has access to and can prematurelyspend the capital in the annuity.(2) Inflation risk—<strong>The</strong> use of deferred variable annuity that also promises aguaranteed living benefit payment mitigates inflation risk. If a guaranteedminimum accumulation rider is not used, inflation protection is limited tothe protection provided by the underlying equities in the plan.(3) Financial elder abuse risk–Inflation risk—<strong>The</strong> use of deferred variableannuity that also promises a guaranteed living benefit paymentexacerbates financial elder abuse risk because an unscrupulous relativecan access the principal of the annuity.5. Create a separate portfolio that is reserved for a specific purpose or purposes. Thisstrategy:a. Helps to potentially minimize:(1) Longevity risk—A portfolio separate from the assets and income used forthe retirement income plan can be reserved to be used if the client hasan unusual life expectancy.(2) Excess withdrawal risk—A portfolio separate from the assets and incomeused for the retirement income plan means that those assets won’t beprematurely spent.(3) Long-term care risk—A portfolio separate from the assets and incomeused for the retirement income plan can be reserved to be used if the clienthas additional expenses for long-term care.(4) Incapacity risk—A portfolio separate from the assets and income used forthe retirement income plan can be reserved to be used if the client hasadditional expenses associated with his/her incapacity.(5) Health care expense risk—A portfolio separate from the assets and incomeused for the retirement income plan can be reserved to be used if the clienthas uninsured health care expenses.(6) Liquidity risk—A portfolio separate from the assets and income used forthe retirement income plan will allow the client to maintain liquidity.(7) Unexpected financial responsibility risk—A portfolio separate from theassets and income used for the retirement income plan can be reservedto be used if the client endures the unexpected expenses throughout thecourse of retirement.(8) Loss-of-spouse risk—A portfolio separate from the assets and incomeused for the retirement income plan can be reserved to be used if theclient loses his/her spouse.b. Hurts by potentially exacerbating:(1) Investment risk—Keeping a separate portfolio creates the extra risk ofinvesting that portfolio.(2) Financial elder abuse risk—A portfolio set aside for the later years ofretirement could be a tempting target for an unscrupulous relative orfinancial planner.5.36
6. Capitalize on the value of the home—Use a reverse mortgage, downsize and pull outequity, use the sale-leaseback strategy, or consider a home equity loan. (Focus on thereverse mortgage.)a. Helps to potentially minimize:(1) Longevity risk—A reverse mortgage can be used if the client has anunusual life expectancy.(2) Inflation risk—A reverse mortgage can be used if the client needs toaugment his income to maintain his purchasing power.(3) Long-term care risk—A reverse mortgage can be used if the client hasadditional expenses for long-term care.(4) Incapacity risk—A reverse mortgage can be used if the clients haveadditional expenses associated with their incapacity.(5) Health care expense risk—A reverse mortgage can be used if the clienthas uninsured health care expenses.(6) Liquidity risk—A reverse mortgage can be used to provide liquid cash inthe later stages of retirement.(7) Loss-of-spouse risk—A reverse mortgage can be used if the client loseshis/her spouse.b. Hurts by potentially exacerbating:7. Investing in equities(1) Bequest opportunity—May take away the client’s opportunity to leave thehouse to his or her heirs.a. Helps to potentially minimize:(1) Longevity risk—A portfolio that brings in more investment return because itinvests in equities will provide income for the later years of retirement.(2) Inflation risk—Since stocks are the highest yielding assets over longperiods of time, they are the best investments to offset the losses inpurchasing power.(3) Timing risk—If the stock market has larger than normal returns in the earlyyears of retirement, the client will benefit.(4) Asset allocation risk—If the appropriate portfolio is chosen.(5) Reinvestment risk—Stock holdings are not subject to reinvestment risk.(6) Liquidity risk—Since equity investments are highly marketable, they areavailable for use at a moment’s notice.b. Hurts by potentially exacerbating:(1) Excess withdrawal risk—Since equity investments are highly marketable,they may encourage a client to spend his/her assets too quickly.(2) Timing risk—If the stock market has losses in the early years of retirement,the client will be adversely affected.(3) Asset allocation risk—If an under-diversified portfolio exists(4) Market risk—When an event occurs to drop all stock prices, it will probablylower your client’s equity holdings.5.37
(5) Frailty risk—Managing assets will become difficult if the client’s mentalfaculties are compromised.(6) Loss-of-spouse risk—If the spouse who dies had the primary knowledge ofthe investment strategies, this risk is exacerbated.(7) Financial elder abuse risk—Equity investments can easily be embezzled.8. Purchase long-term care insurance.a. Helps to potentially minimize:(1) Inflation risk—If the long-term care insurance policy has an inflation rider.(2) Long-term care risk—Long-term care insurance directly provides the fundsneeded or a portion of the funds needed for a long-term care event.(3) Loss-of spouse-risk—Purchasing long-term care insurance on the life of aspouse who uses it will help the economic status of the surviving spouse.b. Hurts by potentially exacerbating:9. Prepay expenses(1) Liquidity risk—<strong>The</strong> use of long-term care insurance means assets areconsumed to pay for this insurance. Consuming those assets might impedethe client from having the funds needed for major expenses in retirement.(2) Loss-of-spouse risk—Purchasing long-term care insurance on the life of aspouse who does not use it will hurt the economic status of the survivingspouse.(3) Bequest opportunity—takes away the opportunity for long-term careinsurance premiums to be left to the client’s heirs.a. Helps to potentially minimize:(1) Longevity risk—A prepaid mortgage will allow a client who is able to “agein place” to live rent free (except for property taxes) no matter how longthe client lives.(2) Portfolio failure risk—prepaying necessary and legitimate expensesensures that those assets won’t be prematurely spent.(3) Inflation risk—Prepaying an item locks in the price at the current time andtherefore eliminates inflation risk.(4) Frailty risk—Prepaid expenses leave less for the client with failing mentalfaculties to worry about.b. Hurts by potentially exacerbating:(1) Investment risk—Clients who prepay expenses pass up the opportunitycost to invest in appreciating assets.(2) Liquidity risk—Prepaying expenses means losing the flexibility to use themoney for other purposes.10. Use a laddered bond and/or immunization strategy to provide the income stream.a. Helps to potentially minimize:(1) Excess withdrawal risk—Laddered bonds and the immunization strategyhelp prevent a client from prematurely spending assets.5.38
(2) Timing risk—Laddered bonds and the immunization strategy lock in yieldat the time of purchase. This can be fortunate for the client if yields godown in the future.(3) Frailty risk—Laddered bonds and the immunization strategy putinvestments on autopilot.(4) Asset allocation risk—Laddered bonds and the immunization strategy workwell for asset allocation if the right bonds are chosen.(5) Loss-of-spouse risk—Laddered bonds and the immunization strategy putinvestments on autopilot, thus giving the bereaved spouse one less thingto worry about.b. Hurts by potentially exacerbating:(1) Inflation risk—Laddered zero coupon bonds will lose purchasing power ifinflation occurs. In addition, since the immunization strategy was based ona prior (and lower) inflation rate, this strategy is also hurt by inflation.(2) Timing risk—Laddered bonds and the immunization strategy lock in yieldat the time of purchase. This can be unfortunate for the client if yieldsgo up in the future.(3) Asset allocation risk—if the client picks the wrong bonds.(4) Liquidity risk—depending on the bond selection, there could be little orno liquidity.(5) Financial elder abuse risk—Bonds can be embezzled.Understand major single-purpose strategies and the risks they address1. Relocate to an area with a lower cost of living: Helps to potentially minimize inflationrisk. <strong>The</strong> risk of losing purchasing power is lowered by relocating to an area in whichcosts are lower than the place from which the client moved. However, the client will losehis network of friends and family.2. Access Medicaid services: Helps to potentially minimize long-term care risk. Medicaidmay be available to pay for long-term care services if the client has no more than therequisite amount of assets and income. However, clients who divest their assets toqualify for Medicaid will not have assets and income available for other priorities andare exposed to liquidity risk. Note also that a client on Medicaid may also be eligiblefor health care services.3. Select the most appropriate Medicare and Medigap coverage: Helps to potentiallyminimize health care expense risk. <strong>The</strong> proper selection of coverage could lead to lessout of pocket and uninsured medical expenses for the client.4. Use health savings accounts (HSA): Helps to pay for health care expense risk. <strong>The</strong>HSA strategy can be an effective method of setting aside tax advantaged funds tospecifically pay for medical bills in retirement.5. Use tax free investments: Helps to minimize tax risk since the investment is not subjectto being affected by a large increase in the client’s personal tax situation.6. Plan to achieve graded levels of retirement security at different ages: Helps tocope with forced retirement or the need to leave work because of health or caregivingresponsibility because the client has achieved some level (although not the optimal level)of financial security.5.39
7. Practice good career management: Helps to cope with forced retirement because theclient may be less likely to be forced out by the employer and more marketable if theyare forced out.8. Institute informal or formal phased retirement: Helps to cope with forced retirementbecause the client maintains some income by working fewer hours.9. Negotiate golden handshakes and severance packages: Helps to cope with forcedretirement or the need to leave work because of health or caregiving responsibilitybecause the client negotiated a settlement or took a package that “softened the blow.”10. Use tax free investments: Helps to avoid tax risk because it obviates the risk of asudden change in federal or state income tax rates.11. Keep life insurance in force or use joint and survivor annuities: Helps to cope withloss-of-spouse risk because these insurance solutions help to protect the survivingspouse.12. Engage in proper estate planning: Helps to cope with loss-of-spouse risk becauseplans have been made for the contingency of the death of the first spouse.13. Carefully assess whether the client can afford to help others: Helps obviateunexpected financial responsibility risk because the retirement income plan has beenmapped out in such a way that the client is aware whether he/she can take on additionalfinancial responsibilities.14. Carefully select caregivers and financial advisors: Helps with financial elder abuserisk because time spent in screening caregivers and financial advisors can minimize therisk of fraud and embezzlement.Review the list of major risks we studied1. Longevity risk2. Excess withdrawal risk (also called portfolio failure risk)3. Inflation risk (also called purchasing power risk)4. Timing risk (also called point-in-time risk)5. Long-term care risk6. Frailty risk7. Heath care expense risk8. Investment risk9. Asset allocation risk10. Market risk11. Sequence of returns risk12. Reinvestment risk13. Liquidity risk14. Legacy risk15. Forced retirement risk16. Reemployment risk17. Public policy change risk18. Loss-of-spouse risk19. Unexpected financial responsibility risk20. Financial elder abuse risk5.40
21. Unrealistic expectation risk22. High debt service risk.23. Procrastination risk24. Overinvestment in employer stock risk25. Rollover risk26. Retirement-saving opportunity risk27. Inadequate resource risk5.41
Assignment 6CHOOSE APPROPRIATE STRATEGIES FORTURNING ASSETS INTO INCOME6Assignment 6SECTION 1: APPROACHES USED TO CONVERT RETIREMENTASSETS INTO RETIREMENT INCOMELO 6-1-1: Describe the three major approaches that can be used to turnretirement assets into retirement income1. Clients will be looking for help in converting the assets they saved for retirement into awell rationed stream of income in retirement.a. Changing from accumulation to decumulation is the crucial retirement incomeplanning issue.b. Clients will want to take the “pile of money” they saved for retirement andaccomplish several important objectives:(1) <strong>The</strong>y will want to have enough income to maintain the standard of livingthey enjoyed prior to retirement.(2) Example: Sam and Diane are both currently age 66 and will look to retirenext year. <strong>The</strong>y currently have a budget of $7,000 per month (it used to behigher but their mortgage is paid off and their kids have moved out and nolonger need the parents’ support). When they retire they want to continuepaying for the same budget items (e.g., food, entertainment, cell phone,cable, electricity, gas, water, property taxes, homeowners insurance, carpayments, car insurance, etc.)(3) <strong>The</strong>y will want to maintain their purchasing power throughout retirement.(4) Example: <strong>The</strong> goods and services Sam and Diane needed at 66 cost$7,000. However, they soon experience inflation which means they need$8,000 to pay the same bills and make comparable purchases.(5) <strong>The</strong>y will want to be able to adapt their budget to their changing needsthroughout retirement.(6) Example: As time goes on Sam and Diane find they are spending lessmoney on travel and entertainment and more money on out-of-pockethealth care costs.(7) <strong>The</strong>y typically will want to make it so they parcel out their “pile of money”so that it lasts for their entire lifetime and, if possible, leave a legacy totheir children when both have died.(8) Example: Sam and Diane will want a plan in place that makes it so theyare not going to run out of assets to convert into income in the laterstages of retirement. <strong>The</strong>y would like to leave an inheritance if possible,but not if it means severely restricting living on the budget to which theyare accustomed.6.1
(9) In addition to inflation and longevity risk, they want products and strategiesto protect against the other risks discussed in the prior <strong>section</strong> of thiscourse.(10)Example: Sam and Diane come to their planner to discuss an approach toproviding an inflation and longevity protected stream of income that whencombined with Social Security will help them to maintain a comfortablelifestyle and handle the myriad risks they may encounter.c. <strong>The</strong> research indicates that the overwhelming majority of surveyed advisors (over78 percent) first select an approach to provide retirement income, and then selectand manage the products needed to implement the approach—rather than using aproduct with an embedded strategy.d. <strong>The</strong>re are three prevalent approaches used in the current retirement incomeplanning environment:(1) <strong>The</strong> structured systematic withdrawal approach(2) <strong>The</strong> time-based segmentation approach (also known as the “bucketapproach” or the “age-banded” approach)(3) <strong>The</strong> essential-versus-discretionary approach (also known as flooring)(4) Planning Point: A combination of these approaches is also a distinctpossibility.2. <strong>The</strong> structured systematic withdrawal approacha. <strong>The</strong> Financial Planning Association (FPA) defines the systematic withdrawalapproach like this:(1) Diversify investments based on the client’s risk profile and manage thetotal return of the client’s entire portfolio. To provide income, withdraweither a predetermined or policy-based amount funded by a combination ofinterest, dividends, and/or portfolio holdings based on the client’s incomeneeds and economic conditions.b. <strong>The</strong> majority of surveyed financial advisors use the systematic withdrawalapproach and in 2011 recommended on average a 4.17 percent initial sustainablewithdrawal amount (discussed later). This dropped from 4.75 percent in theprevious year.c. Example: Rachel and Ross have $1,000,000 saved for their retirement. In thefirst year of retirement the planner using the structured systematic withdrawalapproach recommends that they consume $41,700 of their portfolio and combinethis with their Social Security checks to pay for expenses.3. <strong>The</strong> time-based segmentation approach (also known as the “bucket approach” or the“age-banded” approach)a. <strong>The</strong> FPA defines the time-based segmentation approach as follows:(1) Set up separate pools of investments with lowest risk investments in thenear-term time horizon “segment,” somewhat higher risk investments in thenext segment, and riskiest portfolio in the longest-term segment. Income isdrawn from one segment at a time. Once the first segment is depleted,assets from the second segment are used for income.b. About 38 percent of surveyed advisors frequently use or always use the so-calledbucket strategy.6.2
c. Example: Chuck and Sarah divide their retirement portfolio into three “buckets.”<strong>The</strong> first bucket will be used to provide their income from age 65–75. As you canimagine this bucket will be invested more conservatively than the other two partsof their retirement assets. <strong>The</strong> second bucket will be used to provide incomefrom 75–85 and can be invested with a moderate amount of aggressiveness(moderate risk/moderate return). <strong>The</strong> third bucket can be used to provide theneeded income from 85–95 and can be invested with the highest tolerable degreeof aggressiveness (higher risk/higher return).4. <strong>The</strong> essential-versus-discretionary approach (also known as flooring)a. <strong>The</strong> FPA defines the essential-versus-discretionary approach as follows:(1) Classify client’s retirement expenses as essential or discretionary. Low-riskinvestments or annuity guarantees are selected to fund the essentialexpenses. A mix of medium- and higher-risk investments is selected tofund the discretionary expenses. Income is drawn from the respectivepools to cover essential and discretionary expenses.b. About 33 percent of surveyed advisors frequently use or always use the so-calledflooring strategy.c. Example: Cliff and Claire have essential expenses such as food, rent, and utilitiesthat amount to $5,000 per month. Social Security will provide them with aninflation protected $3,000 a month. Cliff and Claire buy an annuity with a cost ofliving rider that provides an inflation-protected $2,000 a month to augment SocialSecurity in paying for mandatory expenses. <strong>The</strong>y then draw down income fromthe remainder of their assets to pay for their discretionary expenses.5. Structured systematic withdrawal approach. Under this approach, planners: (Video: Whatare the three approaches advisors are using when counseling clients about retirementincome planning? Tacchino, Kitces, Guyton)a. Manage retirement assets as a total portfolio (not a segmented or age-bandedportfolio)b. Create guidelines for safe withdrawals from year to year. <strong>The</strong>re are actuallyseveral schools of thought that are in use by practitioners here:(1) Take an initial withdrawal of the portfolio at retirement (e.g., 4 percentof $1,000,000, or $40,000 in the first year) and then adjust the $40,000each subsequent year for inflation regardless of the current value of theportfolio. In other words, the initial value is adjusted without “consulting”the current value of the portfolio on a year by year basis. This is themethod suggested in the initial and ground-breaking research on the topicthat using historical data would prove to be a fail-safe method for 30 yearseven if the market repeats its worst case 30-year pattern. Under thisapproach the payments are fixed year to year on an inflation-adjustedbasis. Planning can proceed accordingly for 30 years (or whatever thechosen time horizon) in a worst case scenario.(2) Take an initial withdrawal of the portfolio at retirement (e.g., 4 percent of$1,000,000, or $40,000 in the first year) and make that the “salary” eachyear for the client. <strong>The</strong>re is no adjustment for inflation, nor is the year toyear value of the portfolio “consulted” with regard to future distributions.This is a variation from the traditional approach. Under this approach thepayments are fixed year to year on a nominal (non-inflation adjusted)basis. Planning must account for loss of purchasing power separately.6.3
However, planning can proceed accordingly for 30 years (or whatever thechosen time horizon) in a worst case scenario.(3) Take an initial withdrawal of the portfolio at retirement (e.g., 4 percent of$1,000,000, or $40,000 in the first year) and make that the “salary” for thefirst year of retirement. In each subsequent year continue using the 4percent guideline, but apply it to the ending year’s account balance. Forexample, if the portfolio value at the start of year 2 is $1,200,000, the clientwould take a $48,000 distribution…if it is $800,000, the client will takea $32,000 distribution. This is a variation from the traditional approach.Under this approach the payments are variable. <strong>The</strong>y are not fixed fromyear to year but instead are linked to investment performance. Planningmust account for dramatic shifts in annual income separately.(4) Follow the methodologies in step 1 (e.g., take an initial withdrawal of theportfolio at retirement (e.g., 5 percent of $1,000,000, or $50,000 in thefirst year) and then adjust the $50,000 each subsequent year for inflationregardless of the current value of the portfolio. However, if the portfoliovalue is more or less than a specified value make adjustments to thepercentage withdrawn accordingly. In other words, the initial value isadjusted without “consulting” the current value of the portfolio on a year byyear basis unless that value triggers an adjustment. This is the methodsuggested by building on the groundbreaking research on the topic. Itallows for a larger initial withdrawal rate that would prove to be a fail-safemethod for 30 years because future withdrawals may need to be adjusted(up or down) based on future market conditions. Under this approach thepayments are fixed year to year on an inflation-adjusted basis. Planningcan proceed accordingly for 30 years (or whatever the chosen timehorizon) in a worst case scenario. However, adjustments to annual incomemust be made when trigger events occur.c. Create guidelines regarding which investments should be converted into income.Give special consideration to the tax implications involved.d. Build a bridge between “pool of money” and “stream of income”.e. Create annual income in retirement equal to the withdrawal rate, plus SocialSecurity, plus other income streams.6. Structured systematic withdrawals direct what the portfolio is meant to transfer intoregarding ongoing cash flows.a. Personal assets in a portfolio are only one of the pieces (fixed income options,pensions, Social Security, etc.).7. Bucket approach (also called age-banding and time-based segmentation)a. Instead of looking at the portfolio as a whole, break the portfolio into a series ofgroups.(1) Spending goals from ages 60 to 70. This bucket accounts for travel, etc.(2) Design a portfolio that meets that time horizon and goal.(3) Spending goals 70–80 bucket—invest this time frame differently(4) Spending goals 80+ bucket—invest this time frame differentlyb. Several different age bands are used.c. Each band has its own specific goals.d. Each band has its own time horizon.6.4
e. <strong>The</strong> bucket approach can be thought of as a subset of the systematic withdrawalapproach.f. Planning Point: <strong>The</strong> bucket approach may have more appeal to clients than thesystematic withdrawal approach—even though one could argue it is doing thesame thing as the systematic withdrawal approach—because:(1) <strong>The</strong> first bucket is not subject to market volatility(2) <strong>The</strong> other buckets are “down the road” so market volatility can be toleratedg. However, the sum of the buckets is not greater than the whole (it really is allocationof the whole portfolio).h. Planning Point: <strong>The</strong> bucket approach may lead to the same 50-50 / 60-40 portfoliothat was envisioned in the original systematic withdrawal portfolio approach.i. <strong>The</strong> buckets do not lead you to any differences in aggregate portfolio design thanthe systematic withdrawal approach.(1) However, clients understand the bucket approach better than thesystematic withdrawals.j. <strong>The</strong> risk of the bucket approach—what happens if you reach the time frame for thesecond bucket but the markets are not favorable for doing that(1) Policies and procedures need to be in place.8. Flooring (also known as essential vs. discretionary)a. Under the essential versus discretionary approach a portion of the portfolio isput into guaranteed or low-risk products or ladder strategies to create a “floor”for the client.b. <strong>The</strong> floor can be created with immediate annuities but it is not always created withimmediate annuities. <strong>The</strong>re are several other ways to create a floor.c. Planning Point: Regardless of which approach is used, Social Security (whenavailable) creates at least a partial floor. What’s more, a delayed Social Securityclaiming age creates a larger part of the floor.d. Sometimes the essential vs. discretionary approach is thought of as annuitizationfor the core piece and invest for the rest.e. Planning Point: Clients think of standard of living, not essential vs. discretionary(1) Flooring may require the lifestyle to be altered, if too much of the client’sassets must be consumed to provide the floor and not enough assets areleft to continue the discretionary purchases that are part of the client’sstandard of living.f. <strong>The</strong> strategy that forced clients to alter their standard of living the most after theGreat Recession of 2008 was discretionary vs. essential.(1) <strong>The</strong> fund for essential expenses left them with less “nest egg.”(2) <strong>The</strong> remainder nest egg was impacted and it made them adjust theirstandard of living.g. Is retirement success “food on the table and roof over the head,” or “meetinglife goals?”h. Planning Point: Distinguish between strategies that keep one from being destitutefrom strategies that help the client meet their goals. Sound retirement incomeplanning obligates the planner to use an approach that helps the client meet his orher goals, not just keep them from being destitute in retirement.6.5
LO 6-1-2: Understand the FPA’s “Financial Adviser Retirement IncomePlanning Experiences, Strategies, and Recommendations” research study1. Overview of the “Financial Adviser Retirement Income Planning Experiences, Strategies,and Recommendations” research study. This study indicates the following key facts:a. <strong>The</strong>re is an increased demand for retirement income services.b. <strong>The</strong> decumulation area of financial planning faces significant challenges andopportunities.c. <strong>The</strong> majority of surveyed advisors’ clients are already retired (30 percent),semi-retired (10 percent), or within 5 years of retirement (20 percent).d. <strong>The</strong> overwhelming majority of clients (81 percent) getting decumulation adviceare deemed delegators (clients who know they need to participate in the processbut expect their advisor to take primary responsibility for their financial success)as opposed to “validators” (do-it-yourselfers who want an advisor to give secondopinions and occasional advice).2. Usage of the three strategies according to the FPA Research <strong>Center</strong>:Advisor Use of Various Strategies/Approaches in Providing Retirement Income to ClientsSystematic withdrawal approach—Diversifyinvestments based on client’s risk profile and managethe total return of the client’s entire portfolio. Toprovide income, withdraw either a predeterminedor policy-based amount funded by a combination ofinterest, dividends, and/or portfolio holdings based onthe client’s income needs and economic conditions.Do NotUseOccasionallyUseFrequentlyUseAlwaysUse5.4% 19.8% 53.9% 20.8%Time-based segmentation approach—Set upseparate pools of investments with lowest riskinvestments in the near-term time horizon “segment,”somewhat higher risk investments in the next segment,and riskiest portfolio in the longest-term segment.Income is drawn from one segment at a time. Oncethe first segment is depleted, assets from the secondsegment are used for income.Essential-versus-discretionary incomeapproach—Classify client’s retirement expensesas essential or discretionary. Low-risk investmentsor annuity guarantees are selected to fund theessential expenses. A mix of medium- and higher-riskinvestments is selected to fund the discretionaryexpenses. Income is drawn from the respective poolsto cover essential and discretionary expenses.Less formal strategies—Clients mainly live ontheir pension and/or Social Security, which may besupplemented periodically.28.6% 33.8% 29.4% 8.2%35.0% 32.3% 26.2% 6.6%21.5% 56.0% 20.5% 2.0%Other 69.4% 22.7% 5.2% 2.7%6.6
3. Understanding systematic withdrawalsa. Many surveyed advisors adjust the amount of the systematic withdrawal on anon-going basis using various dynamic withdrawal strategies.b. <strong>The</strong> most common adjustments include adjusting(1) For inflation(2) In order to match the initial withdrawal percentage (resetting)(3) As a result of simulation analysis(4) As a result of expected stock market valuationc. Usage of the dynamic withdrawal strategies according to the FPA Research <strong>Center</strong>Use of Dynamic Withdrawal StrategiesYes, I may recommend adjustments to the withdrawal amount initiallyrecommended, but not based on the application of any specific policies.Yes, I may recommend adjustments to the withdrawal amount initiallyrecommended based on the application of dynamic withdrawal policies.No, I typically maintain the withdrawal amount initially recommended, except forinflation adjustments.35.3%29.5%18.8%No, I typically maintain the withdrawal amount initially recommended. 11.2%Not sure/ I don’t know 5.2%d. Adjustments according to the FPA Research <strong>Center</strong>Adjustments Typically Made by Advisors who Use Dynamic WithdrawalOPTIONSPERCENTAdjust the recommended withdrawal amount so that it keeps pace with inflation. 35.6%Adjust the recommended withdrawal amount if the current withdrawal ratepercentage varies too much from the initial withdrawal rate percentage.Adjust the recommended withdrawal amount based on the current results of aMonte Carlo or other simulation analysis.Adjust the recommended withdrawal amount based on current and expected stockmarket valuation levels.Adjust the recommended withdrawal amount so that it maintains the initialwithdrawal rate percentage.34.5%34.5%33.2%18.4%Other* 12.3%*Other responses most commonly include adjusting based on client need/goals, changes in clientsituation, and various market shifts.e. Surveyed advisors believed systematic withdrawals are more effective thantime-based segmentation (also known as the bucket approach) and theessential-versus-discretionary income approach (also known as flooring).4. Approach versus producta. <strong>The</strong> FPA research indicates that the overwhelming majority of surveyed advisors(over 78 percent) first select an approach, and then select and manage theproducts needed to implement the approach (rather than using a product withan embedded strategy).6.7
5. Products used by surveyed advisors:Survey of Products UsedPlease select any of the following financial products you use/recommend with your clients for retirement incomegeneration.OPTIONSPERCENTBond funds 78.8%Equity mutual funds 75.5%Bonds 69.4%Dividend-paying stocks 66.2%Exchange-traded funds (ETFs) 54.6%Real estate investment trusts (REITs) 49.7%Treasuries/TIPs 47.9%Variable annuities with guaranteed living benefits (GMIBs, GMABs, GMWBs) 46.2%CDs 44.2%Immediate annuities 39.5%Combination products (e.g., life insurance and long-term care) 28.1%Separately managed accounts (SMAs) 26.2%Fixed deferred annuities 26.2%Reverse mortgages 16.8%Limited partnerships 12.6%Target maturity funds 11.6%Long-term care annuities 10.4%Guaranteed payout funds 6.2%Other variable annuities 5.5%Managed payout funds (income replacement funds) 3.2%Other (please specify) 3.0%Advanced life deferred annuities (ALDA) 2.9%None 2.7%SECTION 2: THE SYSTEMATIC WITHDRAWAL APPROACHLO 6-2-1: Analyze the systematic withdrawal approach to retirementincome planning1. <strong>The</strong> most popular approach to turning retirement assets into retirement income is thesystematic withdrawal strategy.2. <strong>The</strong> systematic withdrawal strategy allows a client to methodically draw down from theirportfolio to create a steady cash flow for retirement.a. <strong>The</strong> amount of the portfolio that can be withdrawn each year to create incomedepends upon several factors.6.8
(1) <strong>The</strong> time horizon used in the calculation—Thirty years is typical; plannersshould be aware that the longer the time horizon that is used, the lower thewithdrawal rate that can be expected.(2) Inflation adjustments made each year to the withdrawal—Clients who planto make inflation adjustments should take lower withdrawal rates thanclients who do not.(3) <strong>The</strong> asset allocation of the portfolio—Larger amounts in stocks allow for ahigher withdrawal rate.(4) <strong>The</strong> amount annuitized—Larger amounts annuitized allow for a higherwithdrawal rate.b. <strong>The</strong> optimal withdrawal rate will vary from investor to investor and may vary overtime.c. Example: Able has a different degree of risk tolerance and a different view ofretirement than Baker. All else being equal, the planner may use a differentwithdrawal rate for Able than for Baker.d. Example: Charlie is comfortable with his withdrawal rate for the first few years ofretirement. However, personal circumstances and markets have changed andCharlie may feel the need to adjust the withdrawal rate.3. <strong>The</strong> premise of the systematic withdrawal research is that we consider all differenthistorical time periods using historical Monte Carlo analysis to determine a withdrawalrate that is safe under all conditions. (Video: What is the safe withdrawal rate strategy?Tacchino, Kitces, Guyton)a. <strong>The</strong> goal of the systematic withdrawal strategy is not to run out of money at theend of life (sometimes called portfolio failure)4. How it works:a. In order to maintain the portfolio so it does not run out of money, the amountwithdrawn in the first year of retirement (the first withdrawal period) is divided bythe withdrawal rate at the start of the withdrawal period.b. Example: Leslie has $2,000,000. Her planner determines that a 5 percent initialwithdrawal will preserve the portfolio for 30 years. Leslie can take out $100,000 inthe first year (5% x $2,000,000). She will then take out $100,000 plus inflation inyear two. She continues to inflate her withdrawals each year.c. <strong>The</strong> systematic withdrawal strategy started with William Bengen who researchedall possible 30-year time periods in history and determined what possible spendinglevel from the starting time horizon would have worked for all 30-year periods.(1) Some 30-year time periods were more bullish than bearish and vice versa.(2) He was seeking a fail-safe withdrawal rate.(3) <strong>The</strong> withdrawal rate that would have been low enough to survive all marketconditions tested was 4 percent per year adjusted annually for inflation.(4) <strong>The</strong>re are many time periods where the client could have spent 6 or 7percent of their account balance adjusted upwards each year for inflation.However, when a worst-case scenario is examined, the rate is 4% adjustedfor inflation.(5) <strong>The</strong> withdrawal rate strategy identifies the amount that can be taken outeach year and have the portfolio last under all projected scenarios for30 years.6.9
5. Since markets have varying outcomes and the worst-case may not happen, other resultscan occur:a. If you retire on the eve of the next great depression, you may end up spendingyour last dollar and dying. (Eek-out the 30 years of spending without money left.)b. <strong>The</strong> safe withdrawal rate centers on a worst-case scenario. If the clientexperiences an average scenario, he will earn an excess spread.c. Under the safe withdrawal rate of 4 percent, 96 percent of the time the client willhave their principle left over.d. Under the safe withdrawal rate of 4 percent, at the median level wealth isincreased by a factor of 1.6.e. <strong>The</strong> safe withdrawal rate research has often been misinterpreted to indicate thatclients need to save enough money to only draw down 4 percent per year adjustedannually for inflation. This may be extremely difficult for most clients.6. <strong>The</strong> initial modeling by Bengen assumed investing in only three alternatives (an S&P 500fund, an intermediate government bond fund, and Treasury bills). His later researchexpanded investment options. By adding small cap funds, the research evolved to say ifyou always want to get a raise for inflation and want to make the money last for 30 years,you can use a 4.5 percent withdrawal rate.7. A variation on systematic withdrawals examines how triggers which adjust the withdrawalrate impact the safe withdrawal ratea. Guyton’s research allows the initial withdrawal rate to be between 5 and 5.5percent as long as triggers are used to adjust the withdrawal rate.8. <strong>The</strong>re are a variety of strategies that can move the “4 percent number” noticeably higher:a. Planners who are not adapting the “4 percent rule” may be forcing clients to liveon much less money than they can sustainably withdraw.b. Safe withdrawals are not an auto-pilot program(1) If the portfolio outpaces the withdrawals, the client can spend more. Inother words, if markets move favorably, spending can be increased.(2) However, if markets do not go favorably, the client’s money will last for30 years.(3) Setting and resetting floors is a desired part of the process. Plannersshould keep “ratcheting” withdrawals to adapt to the client’s changingcircumstances.(4) <strong>The</strong> safe withdrawal rate as adjusted, sustains the client’s standard of living9. Some planners use annuities to keep it so that the floor will not fall below what amountsto a decline in the standard of living for clients.a. Annuities give guarantees (better than the safe withdrawal rate)b. Annuities protect against longevity risk (the safe withdrawal rate stops at 30 years)c. <strong>The</strong> annuity leaves nothing at the end. <strong>The</strong> safe withdrawal rate approach getsboth a spending income and the potential to keep all the principled. <strong>The</strong> safe withdrawal rate secures the longevity side (not as well as an annuity)and it allows for preservation of principle and legacy options.10. Safe withdrawal rates target an income that will sustain standard of living for 30 years, butthere is an upside.11. Do not frame what the client needs to save based on the safe withdrawal rate. This is amiscalculation and misuse of the research.6.10
12. Four percent is not the number.a. “<strong>The</strong> number” increases for a more globally diversified portfolio.b. “<strong>The</strong> number” increases if withdrawals start at a time when markets are nothighly valued.c. “<strong>The</strong> number” increases if the client can take small decreases in withdrawals (ifthe client is willing to adjust spending in tough economic times).d. “<strong>The</strong> number” increases if planners and their clients are willing to makeadjustments along the way (react to the environment around them).e. Planning Point: <strong>The</strong> portfolio does not need to solve all spending needs. <strong>The</strong>re areother assets like Social Security, legacies, and the house that may help determinethe burden of the portfolio and consequently affect the safe withdrawal rate.13. <strong>The</strong> systematic withdrawal rate is not about how much we want to spend in retirement. Itis about how much of the retirement spending the portfolio is able to support. In otherwords, consider money from Social Security and other products.a. <strong>The</strong> portfolio needs to be connected to the retirement income puzzle.b. However, the portfolio does not need to solve all of the retirement income puzzle.14. <strong>The</strong>re are three strands of spending literature that address the question, “How muchcan you withdraw from your portfolio in any given year?” (Video: What is the traditionalthinking about sustainable withdrawal rates? Tacchino, Woerheide, Milevsky)a. Historical Monte Carlo analysis (historical Monte Carlo analysis can lead to asustainability number)b. Forward looking Monte Carlo analysis (forward looking Monte Carlo analysis canlead to a sustainability number)c. Avoid Monte Carlo analysis, but look at the probability of sustainability(1) Calculating a probability without referring to Monte Carlo simulators15. Common themes in the literature:a. Asset allocation is 50 to 75% equity (fixed over the retirement period)b. A real 4 to 5% withdrawal rate appears to be sustainable(1) $1,000,000—take 4% in the first year ($40,000). One strategy is to justtake $40,000 a year.(2) Another strategy is to inflation adjust the $40,000 [$40,000 x (1 + inflationrate)](3) A “real withdrawal rate” indicates inflation adjustments occur.c. A difference between 4 and 5 percent (100 basis points) can have a big impactover time.d. One can justify withdrawal rates of 4 to 7.5% depending on how effectively theportfolio is managed.e. <strong>The</strong> value of the literature is that it educates people to dramatically reduce theirexpectations concerning the amount they can withdraw.f. Withdrawal rates depend on time horizon. <strong>The</strong> longer the time horizon the lowerthe withdrawal rate.g. Annuity, Social Security, and pension income all factor into what a reasonablewithdrawal rate is for the client.h. Planning Point: For some clients it is more difficult to spend money than to savemoney.6.11
16. Early in the outline, we identified 4 different ways that the initial and current-yearsystematic withdrawal rates could be calculated.a. Take an initial withdrawal of the portfolio at retirement (e.g., 4 percent of$1,000,000, or $40,000 in the first year) and then adjust the $40,000 eachsubsequent year for inflation regardless of the current value of the portfolio.b. Take an initial withdrawal of the portfolio at retirement (e.g., 4 percent of$1,000,000, or $40,000 in the first year) and make that the “salary” each year forthe client. <strong>The</strong>re is no adjustment for inflation.c. Take an initial withdrawal of the portfolio at retirement (e.g., 4 percent of$1,000,000, or $40,000 in the first year) and make that the “salary” for the first yearof retirement. In each subsequent year continue using the 4 percent guideline, butapply it to the ending year’s account balance.d. Follow the methodologies in step a. [e.g., take an initial withdrawal of the portfolioat retirement (e.g., 5 percent of $1,000,000, or $50,000 in the first year)] andthen adjust the $50,000 each subsequent year for inflation regardless of thecurrent value of the portfolio. However, if the portfolio value is more or less than aspecified value make adjustments to the percentage withdrawn accordingly. Inother words, the initial value is adjusted without “consulting” the current value ofthe portfolio on a year by year basis unless that value triggers an adjustment.17. What makes most sense?a. <strong>The</strong> “triggered adjustment” method described in “d” above reflects the latestand best thinking on the topic because it allows a higher initial withdrawalrate (approximately 5.5% depending on the circumstances). In the majority ofcircumstances the higher potential withdrawal rate gives clients a more realisticchance to continue their preretirement standard of living throughout retirement.<strong>The</strong> lower 4 percent rate leaves clients with almost there entire principal in manycases. With affluent clients this may be desirable. However, for client’s trying tosqueeze their assets as tightly as possible to provide retirement income this resultmay not be desirable. In other words, if the goal is to get the most realistic streamof income that supports a desired lifestyle, then a system that leaves most of theprincipal is likely to short-change the income stream. Higher withdrawal rates (insome cases above the 5.5 percent rate) are therefore necessary and desirable.Recall that in the video Professor Milevsky indicated withdrawal rates up to 7.5%are possible in a good economy if the portfolio is smartly invested.b. But what about longevity protection? After all, the value of the initial Bengenresearch (first a 4%, then 4.5% withdrawal rates) was that the portfolio wasfail-safe for 30 years. After all, clients want their assets to provide an incomestream for 30 years or more. This is where the triggered withdrawal adjustmentscome in. In Guyton’s research (discussed in Competency 7 of this course), a policyis implemented that acts like guardrails to keep the portfolio on track to last for the30 years (or whatever duration is used). If the market goes down dramatically,the client will be asked to cut back on withdrawals. This is a natural and desiredconsequence of a down market anyway! <strong>The</strong> trigger will ensure assets last for the“duration” but not at the expense of starving the client in the current year.18. Example: Fred and Ethel have a $1,000,000 portfolio and are comfortable with a 6percent withdrawal rate, which they will adjust if a market trigger occurs. In year one, theytake $60,000 ($1,000,000 x .06). Inflation over year one was 4 percent, so in year two,they will take $62,400 ($60,000 x 1.04). <strong>The</strong> next year brings 3 percent inflation so theydraw down $64,272 ($62,400 x 1.03). In the next year, a trigger event occurs because6.12
markets have declined by a specified percentage. Fred and Ethel will lower the amountthey take down according to predetermined methods.LO 6-2-2: Describe what happens under the systematic withdrawalapproach if the client outlives the time horizon1. Systematic withdrawals are calculated over a specified time horizon. (Video: Whathappens if the client outlives the systematic withdrawal rate time horizon? Tacchino,Kitces, Guyton)a. 30 years is the industry standard that is typically used.b. If the client lives 30 years, and the worst-case scenario occurs, they will run outof assets.2. How can the problem be avoided?a. Do not just use 30 years in your practice.b. Discuss with the client how long the time horizon should last.(1) Use the amount of time with which the client is comfortable.(2) <strong>The</strong>re should be a natural conclusion based on the client’s current age,family longevity, and health history.(3) <strong>The</strong> time horizon should become client specific.(a) Some 70-year old clients will insist on 30 years.(b) Some 60-year old clients will ask for 20 years.3. <strong>The</strong> withdrawal rate is recalculated to match the client’s time horizon. Safe withdrawalrates are built around worst-case scenarios that are not likely to occura. 96 percent of time all the principle is leftb. In the median result, we finish with 1.6 times the original result.c. In many circumstances there will be a cushion of growth.LO 6-2-3: Analyze how sustainable withdrawal rates apply to the middleclass1. What if the withdrawal rate does not sustain lifestyle? (Video: How do sustainablewithdrawal rates apply to the middle class? Tacchino, Kitces, Guyton)2. <strong>The</strong> tighter it is for the client, the more important it is to focus on the expense side—notthe income side.a. What expenses can be reduced without compromising the quality of life?b. Social Security plays a more important role for the middle class.(1) Delaying Social Security will become important for the middle class.c. Do not put the client in a scenario where they will run out of assets before theirdeath by suggesting systematic withdrawals that will allow a client to run out ofmoney.d. Do not ignore purchasing power (inflation) risk.e. Clients who do not have enough assets to retire should keep working and delayretirement if possible.f. Because of Social Security, lower-class clients with a modest portfolio may be ableto continue their standard of living in retirement. For example, Archie and Edithare lower middle income and about to retire. Archie will receive $1,500 per month($18,000 annually) from Social Security. Edith will get $750 ($9,000 annually). A6.13
$300,000 portfolio with a 4% withdrawal rate gives these clients $12,000. <strong>The</strong>irincome in the first year of retirement will be nearly $40,000.g. Work longer, save more, spend less if the client’s assets are insufficienth. Cash flow planning should be done to link-up income with expenses if the client’sassets are insufficient.i. Goals need to be relative to the “dollars.”j. <strong>The</strong> safe withdrawal rate is only one pillar of the retirement income picture.Planners should look at:(1) Cash flow(2) Needs and wants(3) Social Security planningk. Planning can help any situation.3. Glide path issue, success to variability Issuea. Glide path deals with the change in equity allocation over time (as you get older,reduce equity allocation)LO 6-2-4: Understand the effect of glide path on portfolio sustainability1. Blanchett looks at which equity allocations give a person the lowest probability of failure.(Video: What is the Impact of Glide Path On the Success of a Retirement Portfolio:Tacchino, Woerheide, Milevsky)a. Initial research—constant asset allocationb. Variation 1– reduced equity allocation by 1 percent a yearc. Variation 2 — stair step rule—every 10 years Blanchett reduced the equityallocation by 10 percentd. Other variations — convex glide path (dramatic initially and then levels off) andconcave glide path (slow reduction initially and rapid later)2. <strong>The</strong> resource sought to answer the question for each scenario (a–d), which glide pathprovided the lowest risk of portfolio failure?a. <strong>The</strong> result: Constant portfolio over all ages was the best to avoid portfolio failure.b. <strong>The</strong> result: <strong>The</strong> allocation to equities should not change over time.3. Important finding — reduction in standard deviation is important4. Important finding — Blanchett looks at the probability of ruin but also looks at thevariability in portfolioa. Planners should maximize the success to variability ratio.b. Conclusion—100% equity portfolios do bestc. It is a good idea to introduce the standard deviation of the portfolio as relevant, notjust the portfolio’s failure rate.d. Blanchett came up with risk/risk ratioe. Failure rates do not capture everything.f. We need to talk about the magnitude of failure.g. Attempts to come up with the magnitude of the risk, not just the probability ofthe risk are important.h. <strong>The</strong> models count a shortfall of 1 cent as the same as shortfall of $100,000. Thisneeds to be changed and the Blanchett article gets credit for recognizing this.i. What is a practitioner to do?(1) Identify the issue6.14
(2) Annuities and long-term care and equities as part of the packageSECTION 3: THE BUCKET APPROACHLO 6-3-1: Analyze the bucket approach to retirement income planning1. A second way practitioners convert assets into a well-managed stream of income inretirement is known as the bucket approach (also called “time segmentation” and “agebanding”)2. <strong>The</strong> focus of the bucket approach is to break up retirement into distinct time incrementsand choose investments that deliver specified outcomes at different times.a. In rare instances, buckets are categorized not by time, but by the risk level of theassets, or the needs or expenses these assets are expected to cover. However,the most common type of bucket segmentation is by time and we will focus ontime segmentation in this course.b. How time segmentation works:(1) It is common to choose three 10-year time segments representing the 30years of retirement.(2) However, the segments can vary in length depending on the client’sdesires and can be more or less than 30 years.(3) <strong>The</strong> assets needed for the short-term horizon are invested to be drawndown in the earliest time segment. <strong>The</strong>y may be invested in ladderedbonds, they may use an immunization strategy, or they may use someother liquid or cash position.(4) <strong>The</strong> goal is to provide specified streams of income for specified budgets atspecified times.(5) <strong>The</strong> assets needed for later time periods (the second and third buckets)are invested for growth. Both investment and product allocations can bedifferent depending on the corresponding bucket.(6) <strong>The</strong> bucket approach can compensate better than other approaches forthe fact that the client faces different risks in different phases of retirement.(7) Under the bucket approach, the planner and client think of the overallportfolio as separate buckets that are invested according to when themoney will be distributed.(8) Over time, assets in the second bucket are redeployed into the first bucket.In addition, assets in the third bucket are redeployed from the third to thesecond bucket.(9) As the client ages, the total portfolio would be adjusted to move slowlytoward a more conservative approach overall as assets shift from onebucket to another.(10)<strong>The</strong> bucket approach integrates asset allocation with income allocation.c. In a white paper by Principal entitled “Income Distribution: Comparing a BucketStrategy and a Systematic Withdrawal Strategy,” the following example is used:(1) To better understand the bucket strategy, we will demonstrate using anexample that utilizes three buckets.6.15
(2) When initially established, the first bucket contains cash and cashequivalents and is intended to be utilized and contain sufficient funds tomeet spending over the first five years of retirement.(3) <strong>The</strong> second bucket is intended to meet spending needs in years six tofifteen of retirement. It contains mostly fixed income securities, which arelikely to experience greater volatility than cash, but, because they are inthe second bucket, the retiree has a longer time period to ride out marketswings.(4) <strong>The</strong> third bucket contains mostly equities, a traditionally more risky andvolatile asset class. It is intended to meet expenses in the years beyondthe fifteenth year of retirement, again providing opportunity to ride outswings with the intention of reaping the potential rewards.(5) <strong>The</strong>se buckets will need to be redistributed over time. At a regularfrequency, the first bucket will need to draw from the second to continue tomeet its intended use of covering expenses over the next five-year period.(6) For the second bucket to continue to meet its intended use, it will need todraw from the third.(7) Should market returns create sufficient balances to meet each bucket’sobjective, redistribution among buckets would not occur.(8) <strong>The</strong> balances of each bucket would be analyzed at a regular frequency,and, if a certain target balance is not met, then a redistribution would occur.3. In actuality, the bucket approach is really a specific way of implementing systematicwithdrawals.a. Both funds primarily rely on self-management of assetsb. Both funds call for the systematic draw-down of assets to create retirement incomec. <strong>The</strong> bucket approach refines how assets are invested to target them for meetingspecific timing and budgeting goals4. Example: Patricia sees her retirement as a dynamic experience divided into a period ofbudget items needed for a high degree of activity (the so-called “go-go” years). <strong>The</strong>n she6.16
anticipates ramping down her activity and adjusting her budget accordingly (the so-called“slow-go” years). <strong>The</strong>n she anticipates a sedentary period at the end of retirementduring which she will cope with health care issues (the so-called “no-go” years). Patriciawill set up her budgets accordingly and target her investments to match her changingspending needs.5. Major issue — how do we match up investment strategies with the age banding approach?6. Age banding recognizes that needs differ at differing time periods of retirement.a. Understanding of expenses equals understanding the term structure of needs(1) Later retirement moneys needed for health care(2) Earlier retirement moneys needed for leisure activities7. <strong>The</strong> traditional portfolio looks at 30 years (Video: How can a retirement portfolio beconstructed to match the changing expense patterns during retirement? Littell, Tacchino,Basu)a. Is it a 30-year portfolio or a 3-month portfolio?b. If the portfolio has one required rate of return, there is a mismatch between termrisk and portfolio return.c. <strong>The</strong> retirement portfolio should require a higher rate of return for 30 years thanfor 1 year.d. If the money needed for year “20” is stuck in a portfolio for money for year “1” wecannot invest properly. This would create a mismatch.8. Segmenting into age bands helps a person get a greater rate of return.a. It allows the client to be more aggressive with money reserved for future periods.b. <strong>The</strong> immediate time period will be more conservative.9. Bucket approach investing works really well from a behavioral economics standpoint:a. Stocks are for later time periods, so the client can buy and hold rather than worryabout short-term market fluctuations.b. Without looking at a bucket approach, it is difficult to rationalize to a client whystocks should be in a retirement fund.c. Clients can sleep better at night.10. Major issue — how does flooring affect the age banding?a. If we have separated out into necessities, conveniences, and luxuries (prioritiesset)b. Immediate annuity for 1 st (present) age band (the 80s)c. Deferred annuity for 2 nd age band (the 70s) for necessities (annuitize at 70)d. Covering the necessities with guaranteed income11. Variable portion of age banding allows us to forgo luxuries during down markets.12. Variable portion of age banding allows us to take out more for luxuries during up markets.13. Breaking up age bands into needs and luxuries60s 70s 80sNeeds Needs NeedsLuxuries Luxuries Luxuriesa. More likely to work with flooring and age banding6.17
. <strong>The</strong> floor might be different for the three different age bands.14. Age banding allows the planner and the client to visualize the entire retirement period.a. Clients can know in X times, I will be able to do Y.b. That is a planned life!15. Without age banding, people may not be as focused on how to apportion their money(withdrawals) for necessities and luxuries.a. We leave as little room for error by dissecting the investing as many ways as wecan and creating components in the plan.LO 6-3-2: Understand the different phases of retirement and how to dividea retirement portfolio into multiple portfolios1. Changes during retirement can be: (Video: What are the phases of retirement? Tacchino,Woerheide, Rappaport)a. Sudden or gradualb. Planned or unplannedc. Financial or nonfinancial in nature2. <strong>The</strong> three phases of retirementa. Phase one—<strong>The</strong> client is the same as he was before retirement. This typicallymeans the client has no limitations (fully active).b. Phase two—<strong>The</strong> client experiences moderate limitations.(1) Occurs at different times for different people in the relationship(2) Relationships and interactions with others become more meaningfulc. Phase three—<strong>The</strong> client experiences significant limitations.(1) Appropriate and regular support are needed(2) Family caregivers may need to leave their own jobs3. We never know when a person will move from one phase to the next.4. Ways to conceptualize the changes:a. Changes in healthb. Changes in physical capabilityc. Changes in family status (death, divorce, remarriage)d. Renewal of caregiving for a childe. Changes in financial status5. Clients need to think through and plan for the various changes ahead.6. Clients should consider having activity portfolios. Activity portfolios are a document whichspecifies how a client will stay engaged as they move through the different phasesof retirement.7. Key issue — how can a portfolio be divided into multiple portfolios in order toaccommodate the dynamic nature of retirement? (Video: What is the theory behinddividing a retirement portfolio into multiple sub portfolios? Littell, Tacchino, Basu)a. Planners should create three subportfolios—one for each bucket of retirementb. <strong>The</strong> first bucket should be invested conservatively.(1) <strong>The</strong>se are the assets needed to create income the soonest.(2) We need to minimize variability with this portfolio.6.18
c. Each of the three portfolios will have a certain or guaranteed income stream.(1) <strong>The</strong> guarantee could be the Social Security annuity.(2) <strong>The</strong> guarantee could be immediate or deferred annuities.(3) <strong>The</strong> Social Security and/or annuity component will be keyed towards thenecessities for all three 10-year age bands.(a) Editor’s Note: This part of the video actually crosses over to“morphing” the bucket approach with the flooring approach(discussed next).d. Once the flooring is set for all three age bands and specific necessities, thenget the asset allocation issue:(1) First portfolio as conservative as possible:(a) Fixed income securities(b) Bond ladders(c) Treasury bonds(d) Some inflation hedge securities (TIPs)(2) <strong>The</strong> second bucket is 1½ to 2 macroeconomic cycles of growth andrecession. This allows the client to manage the portfolio(a) Some equities for growth(b) Bring in other assets to diversify (it’s not just stocks and bonds)real estate, commodities, REITs(3) <strong>The</strong> third bucket will have even more risk(a) Bring in small caps, emerging markets, high yielding bonds(b) Can take more risk(c) Since you are investing for 25 years versus 2 years, the termpremium should be 2 to 3 percent more8. How does parsing the investments into buckets affect the psyche of the investor?a. When breaking the portfolio into three pieces, how much you need to save forretirement goes down.b. <strong>The</strong> marginal increase in rate of return can grow return enough to lowercontributions.c. When you break it down, the client will be reassured to see how you specificallyaddressed their needs.d. Even if markets fall dramatically in the short run, we know that the equity money isbeing used much later, so we will sleep better.e. <strong>The</strong> bucket investment strategy allows the client to buy and hold.9. Additional psychological benefits of time segmentation from the Principal white paper“Income Distribution: Comparing a Bucket Strategy and a Systematic WithdrawalStrategy”a. A bucket strategy can address the client preference for smaller simplified issues.b. <strong>The</strong> bucket strategy helps take a large problem and parcels it into manageablepieces.c. <strong>The</strong> bucket strategy may lead to self-control and minimize excess withdrawalrisk because:(1) It links money directly with goals.6.19
(2) It serves as a form of mental accounting.(3) It compartmentalizes assets into a long-term box which may be perceivedas “locked” (and thus not available for current consumption).LO 6-3-3: Understand how bucket portfolios should be reallocated overtime1. Up to this point, we have looked at segmenting investments into three portfolios and howto initially create those portfolios. (Video: With the multiple retirement portfolio approach,how should portfolios be reallocated over time? Littell, Tacchino, Basu)2. Under the bucket approach, the portfolio will be depleted at the end of each time period.(Editor’s note: this is a different way of approaching the bucket portfolios than wassuggested in the Principal white paper discussed earlier which consistently replenishedthe “spending bucket.” Both methods are viable ways to reallocate the client’s portfolio.)3. Under the bucket approach, we recognize that at each period of time, significant lifestylechanges can occur.a. Each period has different expense structures.b. Example: After 75, leisure activities go down and health care expenses go up.4. <strong>The</strong> bucket strategy allows the client to adapt goals and vision over time.a. Changes to the investment portfolio accommodate the natural fluidity of retirementand life changes.5. Reallocation of the portfolio starts with a budget.a. Look at what is actually spent compared to what was projected to be spent.b. As a general rule, planners need to monitor spending so it meets the budget (getclients back on track).c. However, sometimes spending changes are needed.6. In addition to being adapted to changing budget needs, the portfolio can react to achanging economy.7. Planning Point: Planners should not confuse the need for budget changes andreallocation with the need for an emergency funda. <strong>The</strong> emergency fund should be used in some instances.b. A changed budget and asset allocation should be used in others.c. Planners need to keep in mind there are some things clients cannot do evenfor their families.8. Planning Point: By monitoring their clients, planners can restructure the portfolio basedon spending, the economy, and inflation.9. <strong>The</strong> bucket approach allows a more adaptable investment plan.a. Buckets can be invested for the unknowns.b. If planners err on the conservative side, and things do not go awry, then the clientwill have more money for their heirs.6.20
SECTION 4: THE ESSENTIAL VERSUS DISCRETIONARY(FLOORING) APPROACHLO 6-4-1: Analyze the flooring approach to retirement income planning1. A third way practitioners convert assets into a well-managed stream of income inretirement is known as flooring (also called the essential versus discretionary approach).2. <strong>The</strong> focus of the flooring approach is to distinguish between essential and nonessentialretirement income needs and create an investment strategy to address botha. Some cash flow is targeted with guaranteed or low risk investments to meetessential day to day living expenses (e.g., housing, food, energy costs)b. Once the “floor” is set, the remainder of the portfolio is managed to meetdiscretionary spending goals.c. Needs versus wants versus wishes(1) Planners must focus the client’s attention to distinguishing what they feelneeds “absolute protection” versus things that they want to have but couldlive without versus things that they wish to have if the finances allow for it.(2) Needs are typically “purchased” with annuity protection, a bond ladder, orsome other approach to investing which locks down the payment.(3) Wants and wishes come from a managed portfolio.3. Example: George and Gracie would like to lock in money to pay for rent, groceries,and car insurance (among other fixed expenses). <strong>The</strong>y purchase an immediate annuitywith an inflation rider to provide monthly income on a joint and survivor basis until theyboth have died. George and Gracie can combine their annuity income with their SocialSecurity income to pay for the basic expenses. <strong>The</strong>y will then use the remainder of theirportfolio to provide for their budgetary “wants and wishes.”4. What is the flooring approach to retirement income planning? (Video: What is thetheoretical support for the flooring approach to retirement income planning? Littell, Pfau)a. <strong>The</strong>re is no universal definition for flooring.b. <strong>The</strong> basic idea is that funds need to be available to meet basic needs in retirement.c. <strong>The</strong>se expenses should be locked in through annuitization or building a bondladder.5. What is the theoretical justification for the flooring approach?a. Life cycle finance theoryb. Utility (happiness) from spending increases for additional spending but at adecreasing rate—income spent on essential needs provides the most utility.c. Goal of life cycle finance theory is to smooth income over the life cycled. To ensure income smoothing the optimal strategy is to meet basic income needswith assets that do not exhibit volatility and to meet discretionary expensesthrough withdrawals from remaining assets.6. Why choose the flooring approach to retirement income planning? (Video: Why choosethe flooring approach to retirement income planning: Littell, Graves, Hegna)a. Longevity risk is a risk multiplier as those who live a long life also have greaterexposure to inflation risk, health and long-term care risk, and market risks.b. Only annuities can protect against longevity risk.(1) Immediate life annuities(2) Longevity insurance (income annuities beginning at an advanced age)6.21
(3) Income rider benefits in a variable or fixed annuityc. Life insurance industry can take the risk of longevity as the risks involved in lifeinsurance and annuities can offset each other.7. How to build an income plana. Must meet basic expenses with lifetime income, which can also include SocialSecurity and company pensionsb. Income annuities remove market risks, deflation risk, order of return risk, andwithdrawal rate riskc. Long-term care risk can be addressed with long-term care insurance and the riskof an early death addressed with life insurance.d. Optimize the rest of the portfolio with a diversified portfolio to address the primaryremaining risk—inflation.e. Inflation can also be addressed by purchasing additional income over time wheninvestment performance is good.f. Another option is to buy inflation-adjusted annuities, but very few use this product.8. Other advantages of annuitization9.a. Peace of mind—can sleep better at night knowing that income needs will be metb. Simplicity—especially important in the later stages of retirementc. Yarri (1965) (using lifecycle theory) showed that annuitization optimized retirementincome over an uncertain life expectancy.LO 6-4-2: <strong>The</strong> annuity puzzle1. Flooring often comes down to a decision to purchase an annuity product to lock in thefloor for the client’s lifetime.a. Even though a retiree’s objectives will change over time, some basic expenses(e.g., food and rent) must be accounted for each and every month the client lives.2. <strong>The</strong>re is a high degree of aversion to voluntary annuitization among retirees even thoughannuities offer security and sustained income.3. Advantages of annuitizing the floor with a fixed immediate annuitya. Annuities defeat mortality risk. <strong>The</strong> client is given a stream of income for as longas they live.b. Annuitants might enjoy a “mortality premium”—those who have long lives willbenefit from the pooling of assets with those who have short lives.c. Annuities suit clients with a low level of risk tolerance because they eliminatethe volatility of investing the client’s assets. (Note: this is not true if a variableannuity is used.)d. Annuities may be more desirable if they are framed in a consumption frame asopposed to an investment frame.e. Annuities prevent a client from consuming assets too quickly. <strong>The</strong>y are anexcellent antidote to excess withdrawal risk.4. Disadvantages of annuitizing the floor with a fixed immediate annuitya. Clients lose liquidity because they have given up control and management of thatportion of the assets that are annuitized.b. Clients lose the opportunity to bequest annuitized assets to their heirs.c. <strong>The</strong>y are a poor “investment” if the client dies young.6.22
d. Clients give up investment control. If a client has confidence in their personalfinancial abilities, investing the floor amount may be a more desirable strategyfor their situation.e. <strong>The</strong> annuity may be redundant. After all, any client who receives Social Securityalready gets an inflation-adjusted annuity.f. Annuities may be overpriced. In addition, your client may be dissuaded fromannuitizing in today’s low interest rate environment.g. Some client’s see annuities as a longevity gamble where they believe they will notlive long enough to make back their initial investment.h. <strong>The</strong> irrevocable and absolute nature of the annuity could be responsible for aclient’s aversion to the product.SECTION 5: HOW THE APPROACHES MITIGATE RISKSLO 6-5-1: Analyze how the three strategies to create retirement incomeaffect retirement risks1. Longevity riska. Longevity risk is best addressed through the flooring strategy because of thereliance of this strategy on annuities.b. Systematic withdrawals and the bucket approaches can also be very good hedgesagainst longevity risk because:2. Excess withdrawal risk(1) In many cases, the systematic withdrawal approach has a large portfolioleft after a 30-year time horizon. This is not the case for a worst casescenario.(2) <strong>The</strong> 30-year time horizon can be adjusted to create a time frame thatexceeds any reasonable life expectancy expectation.(3) <strong>The</strong> bucket approach and the systematic withdrawal strategy allow assetsto grow and add wealth that can be used in the later stages of retirement.a. Excess withdrawal risk is best addressed through the flooring strategy because ofthe reliance of this strategy on annuities.b. Systematic withdrawal and the bucket approach can also be a very good hedgeagainst excess withdrawal risk because:3. Inflation risk(1) <strong>The</strong>se strategies control (but do not limit) the amount consumed each year.A client following the plan will generally eliminate excess withdrawal risk.A client who abandons the plan will do so at the sacrifice of exacerbatingexcess withdrawal risk.(2) <strong>The</strong> bucket approach and the systematic withdrawal strategy allow forgreater asset accumulation than an annuitized flooring strategy. <strong>The</strong>possibility for greater growth of assets may prove to be a greater hedgeagainst systematic withdrawals which block excess consumption (basedon annuitization) if the assets grow sufficiently to produce additionalincome for the later retirement period.6.23
a. Inflation risk is best addressed through an approach that allows more of theclient’s assets to be invested in equities for a longer period of time. This wouldtypically be the systematic withdrawal and the bucket approach.b. <strong>The</strong> flooring approach does not typically provide for a hedge against inflationunless a cost of living rider is added to the annuity or a variable annuity is used.c. Planning Point: Cost of living riders are often capped at a stipulated percentage,which may be lower than actual inflation.d. A flooring strategy that relies on a delayed Social Security claiming for most ofthe flooring can be very effective because the Social Security benefit is adjustedfor inflation.4. Reinvestment riska. <strong>The</strong> bucket strategy will have the greatest difficulty managing reinvestment riskbecause the near-term bucket must be replenished with short-term investmentslike bonds, CDs, and other investments that are particularly sensitive toreinvestment risk.b. <strong>The</strong> systematic withdrawal strategy can also be subject to reinvestment risk but toa lesser extent than the bucket strategy.5. Liquidity and legacy riska. <strong>The</strong> flooring strategy creates the greatest liquidity and legacy risk problembecause of the use of an annuity to create the floorb. Systematic withdrawals preserve more liquidity than the bucket strategy becausetheoretically less of the investments are tied up in short-term, illiquid investments.However, this may not always be the case depending on the asset allocationmodel used.LO 6-5-2: Recognize common sense solutions1. Regardless of the approach or products used, set aside two-to-five years’ worth ofwithdrawals into low risk investments that can provide income in the short-term period.This avoids the need to draw down variable assets during a down market.a. This strategy is emphasized in the bucket approach. In fact, one could argue it isthe central point of the bucket approach. However, it can be easily implementedin the systematic withdrawal approach by tapping into the conservative partof the portfolio in down markets. It is less necessary in the flooring approachbecause fundamental spending has been secured in a manner that reducesmarket variability.b. This common sense solution illustrates both a strength and a weakness of theflooring strategy. By locking in flooring with a bond ladder, immediate annuity, oranother method, the client has secured assets to account for basic expenseswithout having to be concerned with market risk. On the other hand, if too manyassets are used to create the floor, the client is “missing out on” the samevariability that provides upside return potential to grow assets to be sufficient tosatisfy retirement income needs.2. Regardless of the approach or products used, use a sufficient amount of assets to providegrowth in the long-term. By investing in equities and trying to gain greater return throughgreater risk, the client is effectively addressing longevity risk, inflation risk, and other risks.a. This strategy is emphasized in a systematic withdrawal approach that calls forproper asset allocation over the long-term retirement horizon. <strong>The</strong> strategy is builtinto the bucket approach because the second and especially the third buckets are6.24
geared toward long-term growth. This strategy is partially built into the flooringapproach because it is anticipated that assets not used to secure the floor can beinvested more aggressively.b. Risk tolerance is a key to this part of time diversification, but so is client education.c. Time diversification in this context means investing assets for near term, locked-inincome, and for far term growth to accommodate creating a portfolio that will besufficient for a retirement that could last 30 years or more.d. It goes without saying that it is important to work within the client’s risk capacity.But it needs to be emphasized that the client should be educated about theimportance of equities for the long haul. Just because the client has stoppedworking, it does not mean their money can stop working for them. In fact, theirmoney needs to work for them harder than ever.e. Example: Mary Anne decides to reduce the risk of volatility in her portfolio and isfearful of her assets losing value, so she opts for more stable investments suchas CDs. However, the low return generated by the CDs increases her risk ofoutliving assets.3. Employ product diversification to create and sustain a retirement income plana. Product diversification means combining financial products with different strengthsand features to protect the client against risks and implement the chosen strategy.b. <strong>The</strong>re is no single product solution that mitigates all retirement risks.c. <strong>The</strong>re is no single product solution that meets the need of the chosen approach tofunding retirement income (systematic withdrawal, bucket, or flooring).d. Effective product diversification can help defeat many of the risks the client faces.e. Effective product diversification can be used to implement the approach to fundingretirement income (systematic withdrawal, bucket, or flooring).f. At a time in life when there is little room for error, the combination of risks createsa puzzle that can only be solved with product diversification in the context ofthe optimal approach.g. Example: Carmella and Tim can use an immediate annuity to create a guaranteedincome floor and invest the other portion of the portfolio more aggressively togenerate income for future needs.4. Understand that all clients are already partially annuitized and plan accordingly.a. Every client receiving Social Security (and this is almost all clients) is alreadyreceiving an inflation adjusted joint and survivor annuity.b. Since Social Security retirement benefits are adjusted for the cost of living, theyare a perfect match to buy basic expenses like food, utility, cable, cell phone, andother bills. Regardless of whether your client has chosen to floor, the presenceof Social Security in the retirement income plan means they are already partiallyfloored. Clients should therefore use Social Security benefits to pay for essentialexpenses. Clients wishing to create a floor for some other essential expenses canpurchase an immediate annuity to meet this task.c. Considering that almost all retirement income plans have the Social Security floorshould enable the planner to think a little differently and invest a little differently inthe systematic withdrawal approach, bucket approach, and flooring approach.d. Considering that almost all retirement income plans have the Social Securityfloor should enable the planner to think differently about retirement risks. <strong>The</strong>planner and client must incorporate in how Social Security factors into their riskminimization strategy.e. <strong>The</strong> percentage of retirement income provided by Social Security varies by theclient’s earning history. Affluent clients who earned six figure salaries while6.25
employed will receive a lower replacement ratio from Social Security than lessaffluent clients who earned average or below average wages.f. Example: Glenn was a “low” earner who made $20,000 last year and comparableamounts in previous years. He will receive about $10,500 per year from SocialSecurity, which replaces over 50 percent of his salary when retired on a cost ofliving adjusted basis. Planning for Glenn is made easier because the planneronly needs to worry about the remaining portion of retirement income. However,planning may become more complicated if Glenn has little saved.g. Example: Christella was a “high” earner who always made over the taxable wagebase in her career. In the year before retirement, she earned $250,000. She willreceive about $30,000 per year from Social Security. However, this only replaces12 percent of her income. <strong>The</strong> retirement income approach and the risks that needto be addressed are much greater in Christella’s situation than in Glenn’s situation.5. Tax diversification may help to create a better after-tax retirement income stream.a. Tax-planning strategies to diversify assets across investments with various taxtreatments (tax deferred, tax free, taxable at ordinary income rates, taxableat capital gains rates) may help clients manage retirement distributions moreefficiently.b. Tax diversification can be part of any retirement approach (systematic withdrawals,buckets, or floors)c. Tax diversification can be used to minimized tax risk, but it also may help withother risks because a tax-efficient income stream will last longer than an incomestream that is not tax-efficient.6. Balance the client’s need for sufficient income, investment losses, avoidance of risks, andthe control to change their minds.a. All clients face competing interests including:(1) Control over assets versus guaranteed income(2) Using income today versus holding income for growth so it can be usedtomorrow(3) Investment growth versus investment security(4) Trading off one risk for anotherb. Retirement income planning is all about finding the approach, products, and riskmitigation strategies that balance these competing interests.7. Balance the trade-offs necessary to create an optional plan for the client’s situation.a. Trade-offs include:(1) High investment returns vs. safety of investments(2) Investment returns vs. predictability of income(3) Guarantees vs. access to assets(4) Guarantees vs. liquidity(5) Guarantees vs. bequests(6) Uncertain asset adequacy vs. longevity risk protection(7) Limiting expenditures vs. uncertain asset adequacy(8) More longevity protection vs. funds to be used for long-term care anduncertain health expenses6.26
. Trade-offs involve:(1) Irrevocable decisions vs. decisions that can be changed in the future(2) Segmenting time periods vs. looking at the big picture(3) Spending vs. saving for later retirement(4) <strong>The</strong> personal situation the client might experience vs. planning for the“objective client”6.27
Assignment 7INTEGRATING APPROACHES, RISKS,PRODUCTS, AND STRATEGIES TO CREATE AN EFFECTIVERETIREMENT INCOME PLAN7Assignment 7SECTION 1: RETIREMENT INCOME PRODUCTSLO 7-1-1: Managing cash flow in retirement1. Outlinea. Cash and retirement planningb. Liquidityc. Holding cashd. Protecting cashe. Alternative cash investments2. <strong>The</strong> need for cash in retirement3. Liquiditya. Systematic withdrawal – cash is what we withdraw into(1) Electronically transfer on a set date(2) Two accounts(a) Less frequent (taxes, annual payments, emergency fund) less liquid(b) More frequent (everyday spending) more liquid(3) Brokerage house, credit union, bank, online(a) Service(b) Yieldb. Bucket Approach – cash is part of our short-term bucket(1) Blended with bonds, money market funds(2) Brokerage house, insurance company(a) Integration with other buckets(b) Service(c) Yieldc. Flooring approach – cash as depositing mechanism(1) Similar to systematic withdrawal(2) Less emphasis on emergency funda. Turn into cash (physical currency or check) within 48 hoursb. Keeps value – no fire sale or discountc. Does not create a debit or loand. More liquid = less yield4. Rates and terms associated with casha. Prime rate7.1
(1) Rate at which banks lend to their premier customers(2) Not always available for consumersb. Federal funds rate(1) Rate at which banks lend to each other(2) Member banks of Federal Reservec. Discount rate(1) Rate at which Federal Reserve lends to member banks(2) Occasionally lends to companies or institutions5. Holding casha. Convenience or yield(1) Access to funds(2) Yield on funds(3) Customer serviceb. Community banks and credit unions(1) Easy to access and face-to-face communication(2) May have limited range of services(3) Potential fees on lower-balance accounts(4) Competitive yields(5) Limited access to “free” ATM machines(6) Limited access to customer service after hoursc. National banks and credit unions(1) Full range of services(2) Automated help and support centers(3) Less ability to resolve customer concerns(4) Competitive yields(5) Tie accounts directly to premium/debt servicesd. <strong>Online</strong> banking institutions(1) Higher yields(2) Limited services(3) Automated help and support centerse. Brokerage houses and insurance accounts(1) Higher yields(2) Limited access or check writing costs(3) Integrated with retirement investments(4) Full range of services(5) Limited ability for face to face customer service6. Protecting casha. Federal Deposit Insurance Commission (FDIC)7.2
(1) Coverage for bank failure or institution collapse(2) $250,000 per registration (title) for each institution(3) Unlimited coverage of noninterest bearing checking accounts (throughthe end of 2012)(4) Small and large banks(5) Full faith and credit of U.S. Governmentb. National Credit Union Share Insurance Fund (NCUSIF)(1) $250,000 per registration per institution coverage(2) Local or national credit unions(3) Full faith and credit of U.S. Governmentc. State insurance agencies(1) Coverage amount varies by state(2) Covers amount in cash deposits at insurance companiesd. Securities Investor Protection Corporation (SIPC)(1) Brokerage account cash up to $250,000 per account registration perinstitution(2) Brokerage firm failure or insolvency(3) Fraudulent trading7. Short-term instruments(4) Protection provided through the Financial Industry Regulatory Authority(FINRA) and the Security and Exchange Commission (SEC)a. Certificates of deposit (CDs)(1) Issued by a bank and other depository institution(2) Brokered CDs(3) Special termsb. Money market deposit accounts(1) Withdrawals limited to specified number(2) Carry nontrivial minimum balance requirementc. Savings bonds(1) Low-denomination Treasury issue(2) Designed to appeal to small investor(3) Types: Series EE, HH, Id. Treasury bills(1) Sold at discount to par(2) Interest — difference between purchase and selling price (or maturityvalue)(3) Competitive and noncompetitive bids8. Short-term debt instrumentsa. Eurodollar deposits7.3
. Dollar-denominated liabilities of banks located outside of the U.S., usually Europec. Slightly higher than other money market ratesd. Less regulatory constraints on these banksLO 7-1-2: Using investments in stocks in retirement income planning1. Differentiating stocks by attributea. Growthb. Incomec. Value(1) Net income goes to one of two places — retained earnings or dividends.(2) Pays little or no money out to shareholders in the form of a dividend(3) Shareholders realize returns as capital gains when stocks are sold.(1) Shareholders receive an income stream from the shares in the form ofquarterly cash dividends.(1) Value stocks are considered to be undervalued by the market. Valueinvestors hope to buy cheap and realize excess returns when the marketrecognizes the stock’s true value.d. Market capitalization (share price X shares outstanding)(1) No hard and fast definitions but…(a) Large-cap stocks(a) Over $10 billion(b) Mid-cap stocks(a) $2 billion – $10 billion(b) Small-cap stocks(a) $300 million – $2 billion(b) Historically, small cap stocks have been more volatile thanmid- and large-cap stocks and less liquid.(2) Free float and market capitalizatione. Stock’s beta(a) Some stock market indexes, like the S&P 500, only consider sharesthat are free to trade in the market capitalization measure. Called“free float,” it is a measure of the publicly available shares.(1) A stock’s beta is the measure of its market specific risk. <strong>The</strong> overall markethas a beta of 1 by definition.f. International equities(1) Benefits(a) Low beta stocks are considered more conservative investments.(b) High beta stocks are considered more aggressive investments.(a) International diversification(b) Growth prospects in foreign economies7.4
(2) Markets(a) Emerging markets(b) Developed markets(3) Correlations are not static(a) A benefit of investing in uncorrelated markets is how it will evenout over time.(b) Picking up yield and reducing risk(4) <strong>The</strong> market cap, value, growth, and other attributes apply to internationalequity investing, as well as domestic investing, but investing ininternational equities has other considerations for the U.S. investor. Note:www.sec.gov/pdf/ininvest.pdf(a) Market transparency(b) Liquidity(c) Taxation(d) Foreign exchange rates(e) Legal remedies that are not U.S. law(f) Political risks(5) Alternative ways to invest internationally(a) <strong>American</strong> Depository Receipts (ADRs)(a) Foreign shares trading in U.S. markets as ADRs. <strong>The</strong>sesettle and clear in U.S. dollars(b) Stock mutual funds focused on international investments(c) U.S. multinational corporations2. Investing in stocks as part of a retirement income plana. Investment horizon in the retirement income portfolio can match investmenthorizon in the accumulation portfolio.(1) Avoiding the asset class in a retirement income portfolio is not the answer.<strong>The</strong> advisor has to work with the client to balance income needs with risktolerance.b. Total return stock investing(1) Total return = dividend yield + capital gains yieldc. Higher expected returns(a) Advisors need to get clients to the point where it is okay to touchprincipal. A discussion with the client about total return investingcan help them understand that retirement income does not have tocome from just dividend checks and coupon interest payments.(1) Stocks as an asset class should, based on established risk premiums,earn a higher return over time than bonds or cash. Higher returns meanhigher potential rates of return.d. What type of account holds the shares?(1) Taxable account7.5
(a) Dividend taxed in year paid out(b) Capital gains taxed when realized(2) Tax-advantaged retirement accounte. Inflation hedge(a) Qualified distributions from tax-deferred retirement accounts aretaxed as ordinary income.(b) Qualified distributions from Roth IRA accounts are not taxed inretirement.(1) Stocks have historically been thought of as an investment that acts asa hedge against inflation. In periods of high inflation (more than 5%)stocks do not tend to keep pace with inflation. In the more typical 2–5%inflationary environment, they do tend to keep ahead of inflation. Resultsare mixed over recent years with the lost decade 1999–2009 having stocksearn a negative yield.f. Estate planning considerations(1) Investing in individual stocks in a taxable account allows the client to namebeneficiaries of the shares in his or her will. Those shares, depending onthe current tax law, may receive a step-up in basis as of the decedent’sdate of death (or alternative valuation date), eliminating the capital gainson the shares over the decedent’s holding period.g. Hedging stock returns(1) Using options, futures, and options on futures to provide portfolio insuranceagainst downside risk. Option collars can finance part of the portfolioinsurance but potentially limit the upside potential.(2) Using exchange-traded funds (ETFs) and exchange-traded notes (ETNs)to hedge stock portfolio performance(3) Deferred variable annuity with guaranteed lifetime riders(4) Equity-indexed annuityLO 7-1-3: Using bonds in retirement income planning1. Durationa. Duration refers to the weighted average length of time until an investor will receivecash inflows from a bond.b. Duration is an important concept for financial planners to understand becauseprices of bonds move inversely with yields and the magnitude of the movementincreases with the duration of the bond. Interestingly, duration approximatelydenotes the percentage change in the price of a bond per percentage pointchange in yield.(1) Example: <strong>The</strong> price of a bond with a 2-year duration will decrease by about2% if interest rates increase by 1%. However, the price of a bond with a10-year duration will decrease by about 10% if interest rates increase by1%. However, price risk is only one of the interest rate risks specific tobond investing.c. Another major risk is reinvestment risk, which refers to the risk that one will haveto reinvest their cash flows at a lower rate of interest.7.6
2. Credit qualitya. Credit quality refers to an issuer’s ability to fulfill its contractual obligation to makeinterest and principal payments to investors.3. Bond fund performancea. Price risk is realized when interest rates increase. Reinvestment risk is realizedwhen interest rates decrease. <strong>The</strong>re are two approaches to immunizing a bondportfolio from interest rate risks altogether, such that price risk cancels outreinvestment risk: laddering and duration matching.b. <strong>The</strong> first strategy, known as laddering, dedicates cash inflows from bonds toparticular periods of consumption during retirement. In other words, it dedicates aportfolio of bonds to meeting specific periods of consumption over the portfoliodecumulation phase of one’s life.(1) <strong>The</strong> benefit of this strategy is that it provides for complete immunization ofinterest rate risks and it has little explicit ongoing costs.(2) <strong>The</strong> downside is that it often entails holding a concentrated portfolioof bonds that have some degree of credit risk, which means that theinvestor is unnecessarily bearing idiosyncratic risk that he is not beingcompensated for because they can be “diversified away.”c. For many investors, especially middle class investors who would be forced to holda nondiversified portfolio of bonds if they employ laddering, duration matching is asuperior alternative strategy.d. Duration matching involves seeking to calibrate one’s choice of fixed incomeproducts such that the asset-weighted duration of the fixed income products isequal to the dollar-weighted average length of time until an investor will use moneyfrom the portfolio to fund consumption.(1) Example: If the investor is considering one bond fund with an averageduration of 5 years and another with an average duration of 10 years, andthe investor’s dollar-weighted average length of time until consumption is7.5 years, then the investor will invest equal amounts of money in eachfund. <strong>The</strong> investor will need to rebalance the portfolio on an ongoing basisto keep the duration of the assets matched up with the duration of theliabilities. It is important to note that the price risk realized in period 1 giventhe scenario involving an interest rate shock is counteracted by a higherrate of return on reinvested cash flows in periods 1 through 7.5.e. <strong>The</strong> benefits of using products to achieve duration matching potentially lowerportfolio risk and also provide a simpler asset management process for thefinancial planner as much of this task is delegated to a fund manager. <strong>The</strong>costs are explicit, in terms of higher ongoing expenses, and also implicit. <strong>The</strong>implicit costs are imprecision in duration matching and also the resultant costof rebalancing. Additionally, there may be some negative tax consequencesassociated with mutual funds due to ongoing capital gains distributions.f. Now we turn to the topic of credit quality. Domian and Reichenstein (2008) showthat mutual funds that invest in high-yield bonds, also known as junk bonds, havereturn characteristics that are a hybrid of stocks and bonds. In other words, aninvestor in a high-yield bond fund can be thought of having some holdings in aninvestment-grade bond fund and some in a stock fund.(1) Example: <strong>The</strong>y find that bond funds with an average credit quality of CCCare about half bond fund and half stock fund in terms of the behavior of7.7
4. Taxationtheir return generating process. It is important for financial planners to beaware of this in the asset allocation process.g. For all of their effort, how good are bond fund managers at predicting credit risk?Cici and Gibson (2010) find that bond fund managers fail, on average, to selectbonds that outperform others with similar characteristics. <strong>The</strong>y also find that bondfunds have rather limited factor-timing ability. <strong>The</strong>y find that the return contributionfrom both security selection and factor timing is less than management fees andtransaction costs.(1) Example: <strong>The</strong> return contribution from security selection and factortiming was 27 basis points per year, on average, for actively managedinvestment-grade bond funds. However, management fees and transactioncosts were 88 basis points per year. <strong>The</strong> return contribution from securityselection and factor timing was 4 basis points per year, on average, foractively managed high-yield bond funds. However, the management feesand transaction costs were 138 basis points per year. Cici and Gibsonattribute this underperformance largely to the bond market being moreefficient than the stock market due to a higher proportion of the marketparticipants being informed traders. Perhaps it is this relative efficiencythat underpins Domian and Reichenstein’s (2010) finding that one of thestrongest predictors of bond fund returns is expenses.a. Clients who own bonds or bond funds in taxable accounts should be aware thattheir tax treatment will differ depending on whether they invest in treasuries,municipal bonds, or corporate bonds.(1) <strong>The</strong> interest on treasuries is not subject to state taxation.(2) <strong>The</strong> interest on municipal bonds is not subject to federal taxation.(3) If the issuer of a municipal bond is of the same state the investor is aresident of, then the interest on municipal bonds is generally not subject tostate taxation either.(4) <strong>The</strong> interest on corporate bonds is fully subject to both state and localtaxation.b. <strong>The</strong> tax advantages of municipal bonds come at a cost of lower yields. It thereforemakes little sense for municipal bonds to be considered for inclusion in qualifiedaccounts. <strong>The</strong>y should be considered for inclusion in taxable accounts only if theafter-tax expected return on the municipal bonds exceeds the after-tax expectedreturn on corporate bonds. Longstaff (2009) finds that the break-even marginaltax rate is roughly equivalent to the maximum federal marginal tax rate, whichsuggests that municipal bonds are most suitable for high income investors.c. Treasuries are unique in that they are considered by most to be free of credit riskand also have an inflation-protected variety known as TIPS. Because treasuriesare considered by most to be free of credit risk, they are a rather attractivecandidate for laddering strategies. TIPS take the guesswork out of estimatinginflation because they automatically adjust for changes in consumer prices.<strong>The</strong>refore they protect a portfolio from inflation risk.7.8
LO 7-1-4: Using mutual funds and other professionally managed funds inretirement income planning1. Mutual funds in retirement planninga. Define and describe mutual fundsb. Categorize and identify types of managed products, including mutual fundsc. Risks and costs of mutual fund investingd. Selecting mutual funds for retirement income planning2. Mutual fund fundamentalsa. Mutual funds are financial intermediaries(1) Why are intermediaries important in our economy?(2) What financial intermediaries did you use today?3. UITs and management investment companiesa. Management investment companies(1) Open ended “mutual funds” – NAV(2) Close ended – similar to a stock(3) Diversified or nondiversified(4) Shell company4. Uniform mutual fund rules5. Taxationa. 75% / 25%b. 75% of assets may not:(1) Acquire more than 10% of a controlling interest(2) Have more than 5% in any one securityc. 25% of assets(1) Fair game(2) Invest in anything they want(3) Generally not utilizedd. Additional IRS rules to keep pass-through statusa. Distribute 90% of gross income from securities (avoids income tax)b. Distribute 98% of ordinary income and LTCG (avoids excise tax)c. Subchapter M – pass through6. Services provideda. Investment adviserb. Administratorc. Custodiand. Transfer agente. Distributor7. Operational structuresa. Open ended(1) Trade at NAV(2) Fund acts to distribute7.9
. Close ended(1) IPO style launch(2) Premium and discountsc. Unit investment trusts(1) Set it and forget it(2) Liquidity issues8. Guiding investment policy(3) Compensation challengesa. Investment philosophy(1) Capital accumulation(2) Income(3) Target date(4) Aggressive(5) Conservative(6) Long-term(7) Strategic(8) Nationalityb. Investment mix(1) Equity(a) Size(b) Type(c) Industry(d) Sector(2) Fixed income(a) Size(b) Type(3) Blended9. Identifying a fund(c) Taxation(d) Duration(a) Alternative assetsa. Equity/bond/type of assetb. Nationality(1) Capitalization(a) PE identifier(a) Active/passive(b) Investment company(c) Compensation type7.10
(2) Sector(3) Other10. Classifying a mutual funda. Self-assessmentb. Performance assessmentc. Morningstard. Ibbotson11. Equity style boxa. Morningstar equity style box12. Fixed income style box13. Additional considerationsa. Active or passiveb. Real estate(1) REITS (public/private)(2) Equity vs. mortgage(3) Indexc. Target date fundsd. Alternative funds(1) Private equity(2) Hedge funds14. Management choices(3) Limited partnershipsa. Investment objectiveb. Style driftc. Single agent or committeed. Quant program15. Special investment strategies16. Indexinga. Sectorb. Industryc. Actived. Focusede. Goal orientedf. Current holdingsa. Open endedb. ETF(1) NAV redemptions(2) Low cost(3) Direct with mutual fund(1) Intraday trading(2) Lower cost7.11
(3) Tax control17. Conversations in product selectiona. When would you consider:18. Ethical issues(1) Individual equities over stock mutual fund?(2) Variable annuity over stock mutual fund?(3) Individual bonds over bond mutual fund?(4) Deferred annuity over bond mutual fund?a. Using one investment company or branching out?(1) Expertise(2) Asset classes(3) Breakpointsb. Commission(1) Share type(2) Short term compensation or long-term clientsc. Alternative product choices(1) Mutual funds in IRAs(2) Deferred annuities in IRAs19. Assess client and fund objectives.a. Match client objectives to fund investment policy.b. Analyze client risk tolerance.(1) Does client risk tolerance match the client investment objectives?(2) Assess the capacity and ability to take risk.c. Analyze the fund components.(1) Do the fund components match the fund investment objectives?(2) Assess past performance, style drift.(3) Read the prospectus.20. Selecting a mutual funda. Client focused(1) Asset classes(2) History(3) Cost(4) Management type(5) Performance(6) Supportb. Objectivity and fairness21. Analyzing mutual fundsa. Style analysis7.12
(1) Benchmarking mutual funds(2) Appropriate(3) On target(4) Costb. 1-, 3-, 5- and 10-year comparisons(1) Index (find the correct index)(2) Peer group(3) Compare to industry; not market22. Systematic approacha. Consider a blended portfolio(1) Equity and bond mutual fund holdings (80%)(a) Domestic and international(b) Diversification and low correlations are key(2) Alternative funds to combat inflation (20%)(3) Low annual costs(4) Avoid back-end or redemption chargesb. Monthly withdrawals(1) Set a date (1 st of month) to eliminate timing risk(2) Fund proceeds settle to cash account23. Bucket approacha. Consider distinct funds for each bucket(1) Equity based fund for long-term holdings(a) (15+ year needs)(b) Value and growth(c) Tax efficient(2) Bond based funds for mid-term holdings(a) (10–15 year needs)(b) Varying durations(c) Safer (80%) with some higher yield components (20%)(3) Cash based instruments for short-term holdings(a) (1–5 year needs)(b) Tax friendly(c) Lower yield than other buckets(d) Stress liquidity24. Flooring approacha. Mutual funds are not intended to “guarantee.”(1) Avoid mutual funds if guaranteed income is absolutely needed.(2) Blend mutual funds with other higher cost guarantee-based products.7.13
(3) Mutual funds provide lower cost professional management.(a) Consider for bequest motives in flooring strategies(b) Utilize for liquid assetsLO 7-1-5: Using annuities in retirement income planning1. Objectivea. Summarize the wide range of available annuity products.b. Describe how they can be used in retirement income planning.2. Tax characteristicsa. Qualified annuities(1) Same tax treatment as other assets held in tax advantaged plans(2) Tax deferral on entire benefit or tax-exempt Roth treatmentb. Nonqualified annuities3. Immediate annuities(1) Tax deferral on earnings(2) Tax treatment of withdrawals depends upon whether benefit has beenannuitizeda. An immediate annuity is a contract that provides for periodic payouts that beginwithin one year of the contract date.b. Immediate annuities are purchased with a single premium. However, settlementoptions offered in a deferred annuity or even with a life insurance policy are otherways to access the immediate annuity form of payment.c. Most annuities provide for specified, fixed payments. However, variable immediateannuities are a hybrid product, providing payments for a guaranteed lengthof time, but with variable payments depending upon the performance of theunderlying assets.4. Immediate fixed annuitiesa. Immediate fixed annuities have a wide range of payment options.b. Life annuities can be on a single life or joint and survivor, providing either thesame payment to a surviving annuitant or a reduced amount. With life annuities,payments continue until the death of the annuitant.(1) This feature can be both the strength and limitation of a life annuity. <strong>The</strong>strength is that the benefit has a lower cost because of the insurancepooling.(2) However, clients may be squeamish about the possibility of dying youngand receiving a limited number of payments.c. Life annuities may be purchased for a term certain guaranteed period of time,such as 5 or 10 years, or offer a refund feature that pays out the remaining initialpremium to a beneficiary. <strong>The</strong>se features, however do affect the cost of theannuity.d. Not all immediate annuities pay benefits for life. Term certain annuities that pay aspecified benefit for a limited period of time are quite common as well. <strong>The</strong>se canbe used in retirement income planning in a number of ways.7.14
(1) Example: One approach is to cover expenses for a bridge period—such asfrom age 62 to 70 to support deferral of Social Security benefits.(2) With the bucket approach, a term certain annuity may be an appropriateproduct to provide income for the expenses over the most current incomebucket.(3) Term certain annuities are also used by some in a low interestenvironment—to defer the decision to purchase a life annuity.e. Immediate fixed annuities are a common approach for creating a reliable incomefloor under the flooring approach. <strong>The</strong> three issues involved in choosing anannuity for flooring purposes include:(1) Choosing the type of annuity—for example, single life or a joint andsurvivor annuity.(2) When to purchase the annuity as the amount of the payment dependsupon the underlying interest rates that change over time.(3) <strong>The</strong> reliability of the promise—which relates to the rating of the insurancecompany from which the annuity is being purchased.5. Immediate annuity innovationsa. Accessing principal(1) Some products today offer on a limited basis the ability to access a portionof the principal.(2) If a lump sum withdrawal is elected, future annuity payments will bereduced to reflect the withdrawal.b. Another limitation is the concern for the loss of purchasing power due to inflation.(1) Annuities today can be purchased with inflation protection.(2) Products that tie increases to the CPI will generally have a cap on theamount of potential increases.(3) Other products provide for a specified increase each year, such as 3percent.c. Creating an income floor(1) When creating an income floor a strong argument can be made that aninflation adjusted annuity providing for guaranteed lifetime income for thelife (lives) of the annuitant(s) is the appropriate product.(2) In the current low interest environment, laddering purchases of immediatelife annuities without inflation protection is another common approach.6. Immediate variable annuitiesa. Immediate variable annuities are a hybrid product that combines the guarantee ofcontinuing payments with the potential for increasing payments if the underlyinginvestments outperform the assumptions.(1) <strong>The</strong> client will generally have some options with regard to the choice ofinterest assumption.(2) Choosing a lower assumption will mean lower initial payments, but createsa better potential for increasing payments over time.(3) Assuming that the client chooses an investment portfolio that includes asignificant exposure to equities the product is also considered an indirect7.15
way to obtain increasing payments to address the need for inflationprotection.b. It is a little hard to characterize how this product line fits into the various incomestrategies. It is best suited for flooring, although you can argue that the lack ofcertainty in payments makes it less appropriate than a fixed life annuity with builtin inflation protection.7. Deferred income annuitiesa. In the course to this point we’ve discussed longevity insurance—which in its purestform is a life or joint life annuity that provides for fixed annuity payments, butbeginning at an advanced age.(1) <strong>The</strong>se annuities are intended to be purchased a number of years beforebenefits begin.(2) <strong>The</strong>y are an inexpensive way to address the longevity risk becausepayments begin much later and payments are made for a limited periodof time or no payments will be paid at all if the annuitants die prior to thestart date.b. Variations on longevity insurance(1) A refund feature if the participant dies before payments begin(2) If annuity payments are deferred for many years, inflation protection shouldbe considered.c. Another type of deferred income annuity is the fixed term annuity that providesfixed benefit payments at a later date.8. Deferred annuities(1) This type of product fits into the bucket strategy well as deferred incomeannuities can be purchased in advance to fill income needs for any of thebuckets created for different time periods.(2) This allows the advisor to target very specific income levels for differenttime periods.(3) <strong>The</strong>se annuities can be purchased with or without inflation protection.(4) <strong>The</strong> limitation of this approach to providing guaranteed income is the lackof longevity protection.(5) <strong>The</strong> advantage as compared to life annuities is that they provide a deathbenefit in the case of an early death.a. Deferred annuities are annuities intended to pay out benefits at a later date.b. Types include those that pay a fixed rate of return, those that provide a rate whichis tied to an equity index, and variable annuities that give annuitants the option tochoose the investment options in the annuity.c. All deferred annuities provide for settlement options—meaning various forms ofannuity payments under terms specified in the contract or allow the contract holderto keep the policy in the deferred status throughout retirement.d. Deferred annuities will have a surrender charge for a specified period, and it isnot uncommon for the penalty to be reduced during the surrender period. Forexample, take an annuity with an 8 year surrender period. It may have a 7%surrender charge in the first year and a 1% charge in year 7.7.16
(1) Deferred annuities may waive surrender charges at the death of theannuitant or if the policyowner wants to annuitize contract values into aguaranteed income stream.(2) For those who need income from the annuity soon after purchase, mostpolicies provide for withdrawals without penalty as long as the amountdoes not exceed 10% of the account's value.(3) If taking withdrawals from a deferred annuity soon after purchase isrequired it is important to consider the surrender charges. <strong>The</strong>se chargeslimit the ability to access the account for an emergency of large paymentsas well.e. Even though deferred annuities allow annuitization, and may provide favorableannuity rates, most policy owners today do not annuitize—but take withdrawals asneeded. <strong>The</strong>re is a tax implication for this decision, when an annuity is annuitizeda portion of each payment is a return of investment that is not taxed. With adeferred annuity, distributions are fully taxed until all earnings have been paid out.9. Fixed deferred annuitiesa. Fixed guarantees(1) Fixed-interest deferred annuities may be purchased with single or flexibleinvestments.(2) <strong>The</strong> contract holder will be entitled to a guaranteed interest rate which canbe guaranteed for a period ranging from one to 10 years.(3) After the guaranteed period is up, the guarantee will be reset, but notbelow the minimum guaranteed interest rate.(4) Deferred fixed annuities can be an alternative to CD investments in aretirement accumulation or income portfolio—allowing the potential forbetter tax treatment, and in some cases more withdrawal flexibility.b. Indexed annuities(1) Indexed annuities provide an interest rate that is not fixed—but will be tiedtypically to an equity index, such as the S&P 500.(2) <strong>The</strong>re are a number of methods for crediting interest and it is important tounderstand how the product works. Most methods provide some sort ofcap on the interest that can be credited each year.(3) What makes the indexed annuity different than investment products or avariable annuity is that there will also be a minimum guaranteed interestrate. It may be 0%, but that still means that policy owner cannot have anegative return.(4) Because of the range of products it can be difficult to compare products.Conceptually, indexed annuities are a way to participate in the upside ofthe equity market while limiting the downside risk.10. Variable deferred annuitiesa. Deferred variable annuities offer the opportunity for the policy owner to choosefrom a range of investment alternatives, including investing in equities throughpooled funds.b. <strong>The</strong>y do not offer the downside protection of the indexed annuity, but theyallow fuller participation in the upside. Deferred annuities today offer indirect7.17
protection from the downside risk with the guaranteed lifetime benefit riders thatwe discussed in Competency 5.c. <strong>The</strong> lifetime income riders provide the very important function of making retireesmore comfortable with an equity position in the portfolio.d. <strong>The</strong>se products, especially the guaranteed benefit riders are complex and violatingthe terms may invalidate the guarantee—making it important to understand theproduct. As each company tries to be innovative, it does make it more difficultto compare products.SECTION 2: APPLYING PRODUCTSLO 7-2-1: Applying products to approaches1. Overview: <strong>The</strong> systematic withdrawal approach requires skilled investment managementby the retirement income specialist. (Video: What investment strategies should be usedfor the systematic withdrawal approach? Littell, Lemoine, Kitces, Guyton)2. Before the planner and client can choose products, they must start with an assetallocation model.a. Asset allocation involves decisions about risk and returns (trade-offs the clientfaces)b. Asset allocation must account for the types of returns needed to make theretirement income plan work.c. Asset allocation must account for the types of risks the client can tolerate.3. Once asset allocation is set, the products often fall naturally in place to fill the necessaryallocations needed.a. Products should “plug the client’s holes.”b. Products should limit the client’s risk exposures (not just investment risk, butall types of risk).4. Research indicates that the optimal equity allocation is between 40–70 percent inequities. (Editor’s note: In other parts of this course we have also referred to a 50–75percent allocation in equities. Professionals can disagree about the exact amount, butplanners should all be in the same “ballpark.”)a. Too much in equities might mean that the portfolio cannot recover from marketdeclines.b. Too little investment in equities exposes the client to inflation risk and longevity risk.(1) <strong>The</strong> portfolio will not generate enough growth for the client’s time horizonor long-term purchasing power needs.(2) Balanced portfolios are essential to the safe withdrawal rate strategy.5. Too much market risk will expose clients to the economy. Too little market risk will exposeclients to inflation and longevity risk.6. Once the appropriate allocation is chosen, planners should consider the following:a. <strong>The</strong> planner needs to do more than monitor, manage, and rebalance the portfolio.b. <strong>The</strong> planner must account for the fact that a part of the portfolio will provide annualincome for the client.c. Planners should avoid having their product holdings act at cross-purposes. Forexample, a Standard and Poor’s 500 indexed fund includes both value and growth7.18
stocks which might have wide dispersions in any given year. <strong>The</strong> planner mustcontrol the access points to the assets separately.d. Planners who do not hold funds separately (and just rely on the index or themanager of the product) may not be comfortable with the results. In other words,this fund may force assets to be sold at a low value.e. Fund managers need to think about the particular client’s current income need.f. At any given point in time, the planner should be able to determine where to getthe assets to fund the client’s current income need.7. ETFs have become popular because of the granularity that can be created with assetallocation.a. Planners can capitalize on ETFs by rebalancing, or active management strategies,or tactically waiting to see what needs to be sold to generate current incomefor the client.b. If the client owns enough asset classes, it is likely they will be able to sell a“winner” to fund current income.8. As the client’s net worth declines over time, it becomes more difficult to own assets insmall enough pieces in order to effectively create retirement income.a. Planners often revert back to balanced funds and other combined products at thisjuncture in order to maintain cost efficiency.9. <strong>The</strong> market in which the client is involved may dictate the investment strategy used.a. Middle-market clients may use more mutual funds. Affluent-market clients mayuse ETFs or individual stock or bond holdings.b. In some cases, it may be less about the size of the client’s portfolio (middlemarket vs. affluent) and it may be about how the planner is compensated. Butthis constitutes an ethical violation since the client’s situation, not planners, shoulddictate the portfolio.10. Investment strategies that control when taxes are realized may add value to the client.LO 7-2-2: Investment products used for the systematic withdrawalapproach1. Overview: <strong>The</strong>re are an unlimited amount of products that can be used to invest clientassets when the systematic withdrawal approach is used. What follows is a list ofsome of the strengths, weaknesses, and applications of some of the more commonproducts. (Video: What investment products should be used for the systematic withdrawalapproach? Littell, Lemoine, Kitces, Guyton)2. Bond mutual funds, which are actively managed, may be appropriate for the incomeproducing portion of the portfolio.3. Deferred fund annuities may be appropriate for the income producing portion of theportfolio.a. Planners should avoid surrender charges.4. Deferred variable annuities may be appropriate for the equity side of the portfolio heldfor the later years.a. <strong>The</strong>y can help to protect the withdrawal rate.5. Growth and value equity funds might be appropriate for the side of the portfolio heldfor later years.7.19
6. Today’s annuitization rates are not favorable for clients.7. GMWBs are better when they have a lower cost structure.8. Mutual funds are excellent vehicles for tax deferred products such as IRAs and 401(k)funds.9. Managed funds or ETFs where the growth can be taxed as capital gains can be beneficialproducts for the systematic withdrawal method.10. Individual bonds work for the current income producing side of the systematic withdrawalportfolio.11. Bond UITs (unit investment trusts) have target maturity dates for the bond portfolio andcan give the client the best of diversification as well as maturity dates (with low cost).12. Planning Point: Avoid bond holdings that are likely to suffer the most when equities suffer.<strong>The</strong>y will not be helpful to provide sustainable withdrawals.13. Treasuries and high quality bonds may be able to provide income when equity marketsare down.14. <strong>The</strong> role of bonds is different when the client is taking distributions and has an additionalresponsibility to manage volatility.a. <strong>The</strong> principle of the bond becomes the source of the withdrawal.b. <strong>The</strong> changing value of bonds is meaningful to the retirement income portfolio.15. Bond UITs are not only about low costs. <strong>The</strong>y are also appealing because:a. <strong>The</strong>y work well when there is investment volatility.b. <strong>The</strong>y have maturity dates.c. In today’s environment, they might be better than bond ETFs.d. <strong>The</strong>y allow more control than bond indexed funds.16. Planning Point: Certain products may be more attractive in certain environments.a. Annuity products are more appealing when bought at higher market valuationlevels.17. Planning Point: <strong>The</strong> choice of a product depends on the environment in which it ispurchased.18. Target date funds may be used in a retirement portfolio. However, there may be confusionregarding the underlying construction of a target date fund.a. Example: a target date fund for any given year might have a wide range of howmuch is invested in equities.b. Planners must be aware of the underlying allocation of a target date fund.c. Balanced, diversified target funds can be good, but(1) <strong>The</strong> wide range of equity funds for the same year can be misleading.(2) <strong>The</strong> granularity of owning pieces individually may be important forsystematic withdrawals.(3) Planners need to be aware of how the asset allocation will change overtime (and it’s hard to map this).(4) If a planner is familiar with the details of the target date fund, it may workfor the client.19. Products used in the systematic withdrawal approach — the basics: (Video: What type ofequity investments should be used in a decumulation portfolio? Tacchino, Woerheide,Nanigian, Lemoine)7.20
a. Investment company is the general name for any type of investment vehicle wherepeople pool their money to make purchases.(1) <strong>The</strong> most common type of investment company is a mutual fund.(2) Other types of investment companies include:(a) Exchange traded funds (ETFs)(b) Closed-end funds(c) Dual purpose investment companies(d) Hedge funds(3) Hedge funds are not desirable for a decumulation portfolio because of:b. ETFs vs. mutual funds(a) <strong>The</strong> illiquidity involved in the product(b) Manipulation of rates of return regarding investment success(1) <strong>The</strong> sophistication of the investor and the size of the portfolio are going togovern the type of equities the client will choose.(2) Smaller/less sophisticated investors should be in an open-ended mutualfund which is actively managed.(a) <strong>The</strong>se investors should have a “two mutual fund solution” (forexample, a growth fund and a bond fund).(3) Larger/more sophisticated investors (portfolios over $500,000) need toconsider alternatives to a “two mutual fund solution.”(a) ETFs have low cost and high liquidity, so they may be appropriatefor part of this investor’s portfolio.c. A $2 million fund should have a separately managed account with a dedicatedfund manager picking and selling investments.(1) However, indexed funds can outperform the actively managed funds.(2) Beware of fees. <strong>The</strong> higher the management fee, the lower the fundperformance (by the amount of the management fee or more).d. Indexed mutual funds and indexed ETFs are a primary consideration for retirementinvesting.e. ETFs do not provide a large amount of options with a unique type of investmentobjective. Conversely, mutual funds may provide unique objective opportunities.f. Direct investments, such as private placements and limited partnerships, have alack of liquidity, high costs, and corporate control issues, which make them lesssuitable for a decumulation portfolio.g. In addition to looking at investments as a function of net worth, it should also belooked at as a function of the wealth the client has compared to the wealth that isbeing drawn out of the portfolio.(1) If the wealth is 50 to 100 times the amount consumed in one year, the riskthat the client can take can be greater than if the client has a portfolio thatis only 30 times the amount consumed in one year.(2) Direct investments and other investment products at the most riskypinnacle of the pyramid of investment returns became more plausible whenthe ratio of portfolio to the annual need is significant.7.21
h. Planning Point: Markets are very efficient, so it is unlikely that abnormal returnscan be generated.i. Planning Point: Research has shown that in some periods actively managedfunds outperform and in other periods passively managed funds outperform.j. Investments with long time horizons will overlap and make investment in activelymanaged funds attractive (for example, hedge funds).k. Net worth takes on a different meaning during decumulation. A client whosewithdrawal requirements are “more significant” is in a much different position thana client whose withdrawal requirements are “less significant.”(1) It is a function of absolute and relative risk tolerance.(a) Absolute = X dollars in stock(b) Relative = X percentage in stockLO 7-2-3: Products used in the bucket approach to retirement incomeplanning1. Overview: <strong>The</strong> bucket approach to retirement income planning calls for special attentionto be paid to investment products used for the “near-term” bucket. Buckets beyondthe near-term bucket can use many of the products that were discussed early in thiscompetency and the products used with systematic withdrawals. (Video: What productswork best with the bucket approach to retirement income planning? Littell, Lemoine,Kitces, Guyton)2. <strong>The</strong> bucket approach uses more investment accounts than the systematic withdrawalapproach.3. <strong>The</strong> client and planner want to identify and work with the short-term money bucket, sothese assets must be specifically identified and segregated.a. <strong>The</strong> short-term bucket is less likely to be able to use institutional shares becauseof the lower amount of resources devoted to it.b. <strong>The</strong> short-term bucket will rely on a more retail approach.c. <strong>The</strong> short-term bucket needs to remove volatility for the client.d. <strong>The</strong> short-term bucket is usually more cash heavy.4. In the aggregate, the systematic withdrawal approach and bucket approach may havea similar asset allocation model.a. <strong>The</strong> long-term buckets are typically subject to more volatility because the “safe”assets are clustered in the near-term bucket and the long-term bucket includesmore of the “risky” assets.5. <strong>The</strong> short-term bucket identifies where the cash flows come from for the next set ofyears in the client’s life.6. Short-term buckets invest in:a. Cashb. Individual bondsc. Bond UITs with clear maturity datesd. Fixed annuities with fixed maturity time horizons7. Short-term buckets not only identify that the portfolio will liquidate what it needs, they alsoidentify where the money will come from for the next few years, and they specificallyidentify the assets which are to be liquidated.a. <strong>The</strong> client using a short-term bucket knows exactly where the cash is coming from.7.22
. <strong>The</strong> products that are used need to reflect the client’s knowledge of where themoney is coming from.c. Products in the short-term bucket should minimize liquidation fees and transactioncosts.8. Any “distant” buckets will be more identified with the equity investment portion of theneed for asset allocation.LO 7-2-4: Products for the flooring approach1. Overview: <strong>The</strong> flooring approach to retirement planning calls for special products to beused to set the floor. In other words, products used for essential spending are muchdifferent than products used for discretionary spending. (Video: What are the productsused when the flooring approach is followed? Tacchino, Woerheide, Nanigian, Lemoine)2. Items included in the floor are basic needs such as:a. Foodb. Shelterc. Clothingd. Transportation3. Immediate annuities can serve as an excellent base for the floor (if the environment isright to purchase them).4. TIPs can also be used to set up a floor.5. Laddering annuities may help to set the floor.6. Immediate annuities become very viable at interest rates over 5 percent.7. Discretionary expenses raise the following considerations:a. <strong>The</strong> products used depend on the importance of the expenditure to the client.b. <strong>The</strong>re is a continuum of expenses in retirement ranging from critical for survival, tocritical for enjoyment of life, to not critical at all, but nice to have.c. Once clients have effectively set a floor, then they can choose products that fittheir other goals and wishes.8. <strong>The</strong> panel’s selections for flooring:a. Social Security and inflation adjusted fixed annuityb. I-bonds: <strong>The</strong>se are attractive in today’s interest rate environment and they alsoprovide inflation protection.c. TIPs9. <strong>The</strong> panel’s selections for discretionary expenses:a. Equities and mutual fundsb. Deferred annuity with a death benefitc. Stock mutual funds that invest in less liquid stocksSECTION 3: PRACTICAL APPLICATIONLO 7-3-1: Identify practical issues that arise in the retirement incomeplanning process1. Forming the client relationship (Video: Forming the client relationship with a retirementincome plan: Littell, Tacchino, Kitces, Guyton)7.23
a. <strong>The</strong> client may not be clear about what he or she wants from the relationshipwith the financial advisor.b. <strong>The</strong> advisor may need to help the client define the relationship.c. Clients may have the following concerns:(1) Can they retire?(2) How to retire?(3) Can you help me through the retirement phase?d. Individuals do not seek help from an advisor unless there is some event or needthat has driven them to seek advice.e. With an ongoing relationship with a client, sometimes the advisor identifies that itis time to consider retirement income planning as the next step.f. Regardless of the task to be performed, the financial planning process of buildingrapport, gathering data and the other steps remains the same.2. Gathering data for the retirement income plan (Video: Gathering data for the retirementincome plan: Littell, Tacchino, Kitces, Guyton)a. Clients have not lived through this before so they do not have any experiencewith this stage of life.b. Those without a clear vision will tend to plan around their current lifestyle.c. Those with a clearer vision may be able to identify what will be different abouttheir retirement lifestyle.d. Clients are going through a difficult life change which can have an impact onthe plan.(1) More time with a spouse is a big change.(2) No longer having the meaning associated with work can be traumatic.(3) This might translate into a changing or unpredictable course of action.e. Are clients forthcoming about their personal data?(1) Generally yes if they are looking for help.(2) <strong>The</strong> more difficult issue is that there are many questions that the clientsimply cannot answer about this new stage of life that they have neverexperienced.(3) A client may, for example, be the one person who is least able to identifythe costs of retirement.(4) Clients can be a couple, in which case each partner may have differentvisions of retirement.(5) Many find the forthcoming retirement period quite frightening.(6) If one spouse has been handling the finances, he or she may be concernedabout whether judgment will be passed on the job he or she has beendoing.f. Couples may have very different visions of retirement.g. Be sure to spend enough time to understand your client’s goals and aspirations.Once you begin to focus on the facts, this part of the conversation becomes moredifficult.h. Ask questions to help understand how the client feels about scarcity such as, “Howhave you decided in the past whether you have enough money to do something?”7.24
i. Data gathering about goals may continue over years and retirement is in part trialand error. For example, a client plans to retire to the golf course and six monthslater decides that it is not a satisfying life and decides to go back to work.3. Analyzing data for the retirement income plan (Video: Analyzing data for the retirementincome plan: Littell, Tacchino, Kitces, Guyton)a. <strong>The</strong> evaluation usually begins with a software program helping to determinewhether the client’s objectives can be met.b. A limitation of software is that it assumes no future intervention (which is quiteunrealistic).c. However, it is still a necessary starting point.d. What happens if there is a shortfall?(1) A good strategy is to identify three key elements that the client wants andindicate that the client may be able to have two of the three.(2) Since planning often requires trade-offs, it is not a good idea for theplanning to be done in “the back room.” It is better to model alternativeswith the client and use the tools to instantly identify the impact of eachalternative.(3) It is not easy to identify the impact of a change in the plan (for example,retire a year later or earn more on the portfolio) without trying out thenumbers.(4) Determining what trade-offs the client will be willing to make begins inthe data gathering process.e. Decisions focus around only three major areas:(1) When to retire?(2) At what level of income?(3) What risks (that the goals will not be met) are acceptable?(4) Planning Point: Try to summarize with a simple presentation such asa single PowerPoint slide.4. Communicating the retirement income plan to the client (Video: Communicating theretirement income plan to the client: Littell, Tacchino, Kitces, Guyton)a. Make it a conversation and not a presentation.(1) You are not presenting a plan — you are planning with the client.(2) It can take pressure off the client and the planner to realize that it is anongoing process.(3) <strong>The</strong> plan is often chosen by the client as alternatives are presented.(4) Some use mind mapping software to capture the client’s decisions of themeeting.b. How many client meetings are required to develop a plan?(1) An initial “get to know you” meeting(2) A second meeting for data gathering(3) A third meeting to present alternatives and determine a course of action5. Implementing the retirement income plan (Video: Implementing the retirement incomeplan: Littell, Tacchino, Kitces, Guyton)7.25
a. Problems with implementation are often tied to information that the planner doesnot know (for example, marital problems, health issues).b. <strong>The</strong> planning process stirs up a lot of issues that may have to be addressed.c. If the client is too “hands on” during the process, he or she may not be “buyinginto” the plan or there may be a lack of trust.d. If implementation is seen by the clients as being driven by the advisor, they mayresist the process.e. Sometimes the issues that get in the way of implementation can be predicted atthe beginning of the process if you are asking the right questions.6. Monitoring the retirement income plan (Video: Monitoring the retirement income plan:Littell, Tacchino, Kitces, Guyton)a. <strong>The</strong> consequences of change in retirement are more serious because there arefewer options to resolve the problem.b. This means paying close attention and reacting more quickly to issues that arisethan in other life stages.c. <strong>The</strong> client views monitoring as “am I still okay?”d. <strong>The</strong> time frame is shorter and the impact of change is larger, meaning that there isa lot of responsibility on the advisor.e. <strong>The</strong>re can be disconnects between the advisor’s goal of making sure that the clientis going to have sufficient resources and the client’s willingness to accept change.f. How often do you stay in touch with the clients?(1) Two annual meetings(2) Four written quarterly reports(3) Four to six other touch points (newsletters and other notices of currentevents)g. <strong>The</strong>re is some annual planning required (specifically tax planning).h. Clients also need to monitor the advisor as well.LO 7-3-2: Ensuring client participation in the retirement income plan1. Findings from behavioral finance that affect how financial advisors work with their clients(Video: Ensuring client participation in the retirement income plan: Littell, Jordan)a. <strong>The</strong> way people make financial decisions has never changed. However, today weare beginning to have a better understanding of that process through behavioralfinance research.b. We understand that we have to consider not just knowledge, but also how peoplefeel about a decision.c. We need to frame the conversation around income — and not about assets.d. Successfully working with clients requires managing clients’ expectations. It is notpossible to have control over market conditions. Also, many will face a shortfallin retirement and they need help (maybe some tough love) to appreciate thesituation.2. How do we translate this information into practical ways of working with clients?a. Clients want a process, not a product.b. Questions need to be devised that elicit feelings as well as facts.c. <strong>The</strong> clients needs to feel that the solution matches their needs.3. MetLife income analyzer tool7.26
a. Sample questions to identify how a client feels about the importance of guaranteesunderstanding that the trade-off is flexibility(1) I prefer a predictable retirement income check each month, like a regularpaycheck, in exchange for giving up some of my ability to take moreincome when I may need it. (agree/disagree)(2) I do not want to worry about the ups and downs of the market after I retireand the effect on my income, even though I may miss out on opportunitiesto increase my income level if the market goes up. (agree/disagree)(3) I am much less concerned with how long my retirement funds last andmuch more concerned with living my desired lifestyle in my earlierretirement years. (agree/disagree)(4) It is important for a large portion of the income generated from this accountto last my entire lifetime. (agree/disagree)(5) I would be comfortable giving up access to this money in order to receivethe most income possible. (agree/disagree)b. Note how these questions are framed(1) <strong>The</strong> focus is on income, not asset value.(2) Each question states something positive about guaranteed lifetime incomeor control and flexibility over one’s retirement savings. <strong>The</strong>n the questiongoes on to point out the trade-off that comes with that positive attribute.(3) Looking for a “gut” reaction by only offering the “agree” or “disagree” choice(4) Also consider internal conflicts with their decision by asking the same thingwith different framing (question 1 and question 5).4. Feeding back the results to the clienta. Take the results from the questionnaire and put it in the framework of a retirementincome mind-set.b. Example: For the individual who wants a balanced approach (between guaranteesand flexibility), the advisor asks whether the following represents how the clientfeels. “Your answers show that you value flexibility and guarantees of your money.You are willing to give up some control for a predictable income stream. Youwould also like to be somewhat involved in the management of your investments.Based on your answers, the combination of investment options that may be mostappropriate for you would include balanced amounts of various withdrawal optionsand lifetime income guarantees.”5. Take the client’s solution and offer products that fit that solution.a. Based on the client’s profile, offer a combination of products that may includeinvestment, deferred annuity with an income rider, immediate annuity, andlongevity insurance.b. Clients and advisors may resist immediate life annuities as part of the solution intoday’s low interest environment.(1) Immediate life annuities offer guaranteed income protecting against thedownside risk.(2) Without on inflation rider, they do retain exposure to inflation risk.(3) As compared to other fixed income investments today, they do give peoplethe opportunity to have a much higher sustainable payout rate.7.27
c. Product solutions work together to address a range of risks.(1) <strong>The</strong>re is a role for both a traditional portfolio and a deferred annuity thatprovides for downside protection with an income rider.(2) Longevity insurance provides protection for later in life at a low cost.LO 7-3-3: Choosing software tools for retirement income planning1. Tools for retirement income planning (Video: Software tools for retirement incomeplanning: Littell, McLellan, Lemoine)a. For simple plans, tools used for retirement savings may be sufficient.b. For more complex plans, the function of a software tool should:(1) Help the advisor determine alternatives(2) Condense the advisor’s advice into a clear plan of actionc. More sophisticated software, like Monte Carlo analysis software, lets the advisorfine-tune alternatives and identify which alternative has an acceptable probabilityof success.d. <strong>The</strong> advisor cannot run the software without knowing the assumptions used inthe calculations.e. For the more sophisticated clients and for the income portion of the plan, it isimportant to use the type of software that allows us to not only help with someportfolio decisions, but to help the client see how everything comes together.f. Commit to training – when the decision is made to adopt that type of sophisticatedtool, there needs to be some sort of decision on committing time and resources,and to keep the software updated and current.g. <strong>The</strong> software tool must remain a tool and never a substitute for common senseand knowing the client.h. Educating the client(1) A more sophisticated tool requires more explaining and communicatingwith the client.(2) <strong>The</strong> software can be effective as an elaborate visual aid to inform andeducate your client on the many different moving parts in a financial planand get them thinking about the contingencies and possibilities.i. Not all tools have to be sophisticated—and sometimes there are so many movingparts that it does not add to the accuracy of the estimate.j. <strong>The</strong> advisor is inevitably responsible for the recommendations.SECTION 4: MONITORING AND ADJUSTING THE PLANLO 7-4-1: Understand methods for monitoring the sustainability ofretirement income1. Planners are obligated to focus on their client’s decumulation plan on an ongoing basis.a. Missteps in any direction can blow up the client’s plan!b. Planners must account for the following:(1) Is the portfolio meeting expectations?(2) Has the client been exposed to an unanticipated level of a particularretirement risk?7.28
(3) Is the client following the plan?(4) Is retirement income sustainable?(5) And many other issues!c. A tool called a RisQuotient calculation is one way to monitor sustainability.2. <strong>The</strong> basic idea to determine a RisQuotient calculation is to arrive at a portfolio failurerate that incorporates an uncertain longevity. (Video: How can the planner monitorsustainability of retirement income for her client? Tacchino, Woerheide, Milevsky)a. <strong>The</strong> RisQuotient avoids a Monte Carlo simulation and does the monitoringanalytically.3. <strong>The</strong> four numerical ingredients for determining the portfolio probability of failure are:a. Expected investment return adjusted for inflationb. Volatility risk of the portfolio as measured by its standard deviationc. Median remaining life span. This is the 50% point in the longevity tables.(1) For simplicity, a client can just use the mean life expectancy, as this isquite close to the median.d. Inflation-adjusted spending rate, as a percent of the initial retirement nest egge. In order to monitor susceptibility, the RisQuotient calculation plugs four numbersinto a model.(1) How bullish is the client on the stock market?(2) How volatile is the portfolio?(3) How long will the client live?(4) What is the client’s spending rate?f. Equity risk premium(1) <strong>The</strong> more optimistic the client is about what equities will earn, the more theclient can withdraw, and the more sustainable the spending rate.(2) Market direction is subjective.4. Does risk tolerance play a role in this process?a. With respect to the portfolio asset allocation and the associated standard deviation,use the client’s risk tolerance to determine the numbers in the spreadsheet.b. Once the asset allocation has been set and an assumption made about theexpected return and standard deviation on this portfolio, then use the formula.5. <strong>The</strong> traditional retirement analysis process was to assume a client would live for 30 years,and to assume a constant rate of return on this portfolio.a. William Sharpe refers to this as financial planning in fantasy land.b. <strong>The</strong> next evolution in the process is to introduce uncertainty about life expectancyand about the rate of return on the portfolio.6. Who makes the call on the numbers that go into the spreadsheet?a. It starts with a risk tolerance questionnaire, which allows the planner to select theoptimal portfolio on the efficient frontier which represents the best combinationof risk and expected return the client can live with.b. Note that now we are talking about retirement risk tolerance, not just risk tolerance.Is there a difference?7.29
(1) A problem is that if the client is suddenly more conservative, we know thatthe more conservative the portfolio, the greater the probability of ruin.(2) Ultimately, we are noting that there is a need for planners to reconcileestate planning concerns, risk of ruin, and lifestyle (spending) objectives.c. Once the percentage of ruin is computed, what is a “reasonable” value?(1) <strong>The</strong>re is no simple answer. If the RisQuotient is “high,” the client and theplanner need to start dealing with the potential problems (for example,spend less or reduce portfolio volatility). If it is “low,” then the client andthe planner can take comfort in that:(a) It is possible the client may be able to spend more if the RisQuotientis low!(b) An 80–85% probability of sustainability is certainly a number totake comfort in.(2) If RisQuotient is too high, the client must make one of four changes:(a) Spend less(b) Invest more aggressively(c) Reduce portfolio volatility(d) Reduce remaining life span!7. For more information how to calculate a RisQuotient, see “A Gentle Introduction to theCalculus of Sustainable Income: What Is Your RisQuotient” by Moshe Milevsky, July 2007Journal of Financial Service Professionals.8. Stress testing the retirement portfolioa. Planners should be prepared to stress test the portfolio to see how susceptible it isto unusual market conditions.b. <strong>The</strong>re are also strategies that can be employed to avoid portfolio failure in unusualsituations.9. How can the planner monitor whether the client’s withdrawal sustainability is susceptibleto unusual market conditions? Calculate the client’s SORDEX and use this tool to stresstest their portfolio. (Video: How can the planner monitor whether the client’s withdrawalsustainability is susceptible to unusual market conditions? Tacchino, Milevsky)a. What is the Black Swan?(1) It is an unexpected event that changes conventional thinking.(2) This SORDEX proposal is based on the observation that our traditionaleconomic models cannot predict our current situation.b. Many planners use Monte Carlo analysis to assess a client’s financial plan.(1) It is used to assess whether retirement income is sustainable.(2) <strong>The</strong> models consider spending rate, asset allocation, and expectedlongevity.(3) In October 2007, these models clearly gave a false sense of security.(4) <strong>The</strong> same analysis a year later (after the stock market decline) would likelyhave given a much worse assessment.(5) <strong>The</strong> problem is that a simple assessment does not include a sense ofrisk exposure to changes in outlook.7.30
c. We need an early-warning system to prepare clients for a dramatic change in thepossibility of a portfolio failure much like blood pressure monitor makes us awareof high blood pressure problems.(1) How do you distinguish between portfolio failure rates and their likelihoodto change?(2) We need a new model that provides a warning sign which signals exposureif market changes occur for the worse.(3) Derivative tells a client how fast something can change. A high derivativenumber means that changes can occur rapidly. This is the thinking behindthe SORDEX stress test.d. Pensions and annuities in a portfolio are less likely to trigger an alarm (they willgive a portfolio a “low” derivative number).(1) <strong>The</strong> products in the portfolio have an impact.(2) <strong>The</strong>re is nothing wrong with Monte Carlo as a tool. It just needs to beaugmented.(3) How does this system, known as SORDEX, work to monitor the situation?(a) <strong>The</strong> first analysis should be for the client’s current situation and asecond analysis should be for extreme circumstances.(b) SORDEX is based on the ratio of success in the two analyses.(c) A high SORDEX ratio means the planner should monitor the clientmore frequently.• A big problem for planners is how frequently to meet witheach client.• Should meet more frequently with those at high risk andless frequently with those at low risk• <strong>The</strong> SORDEX ratio provides both an early warning systemand a method of prioritizing.(d) If excess sensitivity exists, a reallocation of assets may bewarranted to give a high sustainability.• Clients should consider more guaranteed products.• <strong>The</strong>re is never one unique asset allocation. <strong>The</strong>re are lotsof acceptable ones.• Choosing a method to get an acceptable sustainabilityratio means finding the method most likely to work underextreme circumstances (creating a high sustainability thatdoes not change).• This certainly means some form of an annuity.• <strong>The</strong> goal is a high sustainability that will not changesdramatically in a short period of time.e. When talking about portfolio failure, there are really two issues(1) Probability of failure(2) Magnitude of failure(3) An annuity with lifetime guarantees is not the only solution. Structureproducts are offered by:(a) Insurance companies7.31
(b) A traditional fund company(c) An investment bank(d) A hedge fund(4) <strong>The</strong> issue is always about first recognizing the risk and then abouttransferring it elsewhere. It is risk management…not investments!(5) Annuities should be sold first and foremost as a risk management product,not an investment product.(6) For the individual, it is both about growing assets and managing liabilities.(a) In this case, liabilities are such things as the dignity of one’s lifestyleand covering the necessary costs of health care.f. One of the biggest things to change in our society is the phaseout ofdefined-benefit pensions in favor of defined-contribution plans, which means morerisk for the individual.(1) Tomorrow’s retirees are more susceptible than today’s retirees (today’sretirees have defined-benefit plans).LO 7-4-2: Understand how to adjust sustainable withdrawal rates1. One sustainable withdrawal strategy allows a slightly higher initial withdrawal rate as longas the client is willing to adjust withdrawals when triggers are tripped.a. An important way to do this is the capital preservation rule (also known as theguardrail rule).2. <strong>The</strong>re are four different things that can happen to a decumulation portfolio from yearto year: (Video: What are the strategies that can be used to modify the systematicwithdrawal technique when volatile market conditions occur? Tacchino, Kitces, Guyton)a. Increase this year’s rate distribution by the rate of inflation.b. Freeze at last year’s distribution level.c. Increase this year’s distribution level by more than the rate of inflation.d. Reduce this year’s rate of distribution from last year’s amount.3. Is there an effect on the safe withdrawal rate if another option besides increasing annualwithdrawals by the rate of inflation is used? — Yes!4. Under the default position, planners should increase this year’s distribution by the rate ofinflation.5. If last year’s portfolio had a loss, the client should freeze the distribution at last year’slevel. In other words, there will be no adjustment for inflation.6. If the withdrawal rate is more than 20 percent above where the client started (this happensin falling markets), then the client needs to reduce what they are taking out by 10 percent.a. Example: <strong>The</strong> client starts withdrawals at 5.5 percent of asset value. Markets godown and the amount that the client might have taken out next year would havein fact equaled 6.8 percent of their asset value. This should trigger the capitalpreservation rule and the client should cut spending by 10 percent.b. Capital preservation rule – this rule goes into effect when the client hits the 20percent “guardrail.” It calls for the client to reduce his/her distribution by 10 percentof what they would have taken when a triggering event occurs.7.32
c. <strong>The</strong> “guardrail” steers the client back toward the center of the road. In other words,a 20 percent increase from the initial withdrawal rate (for example, 5.5 percentinitial withdrawal rate or higher) and the client must cut back by 10 percent.7. If the withdrawal rate is more than 20 percent below where the client started (this happensin rising markets), then the client can increase what they are taking out.a. If the withdrawal rate is falling to more than 20 percent of where the client started(for example, the 5.5 percent withdrawal rate drops to 4.4 percent), then the clientcan increase the amount taken out by 10 percent.8. Using triggers to adapt the sustainable withdrawals enables a 100 basis point increase inthe initial sustainable withdrawal rate over a 40-year period.9. When markets go down, clients expect to be told by the planner to spend less. Correctiveaction is a natural reaction that should not encounter resistance from the client.a. Tell clients that the safe withdrawal rate anticipates market declines.b. Let clients know the cuts are typically modest.c. Let clients know when times are tough, clients need to “tighten their belt” a little.10. When markets decline and a cut in spending is needed, the first cut takes spending backtoward the unadapted initial withdrawal rate. In other words, the capital preservationtriggers allow for the client to have a greater withdrawal rate, and when it needs to betrimmed, the first time for the trim takes us toward where we might have started had wenot used the capital preservation withdrawal rate to begin with!a. You go from a withdrawal rate of 4.5 to 5.5 percent by being willing to go back to aratio of 4.5 when the portfolio declines.11. <strong>The</strong> withdrawal policy statement spells out to a client that if their portfolio falls by X,their spending should fall by Y.12. <strong>The</strong> 10 percent cutback is not the same as a 10 percent lifestyle cutback.a. It takes two “10 percent cuts” to get from a 5.5 percent withdrawal rate to a 4.5percent withdrawal rate.b. Example: <strong>The</strong> client has a $60,000 income ($30,000 from Social Security, $30,000from portfolio withdrawals). <strong>The</strong> Social Security piece is unaffected by the capitalpreservation adjustment. <strong>The</strong> $30,000 from capital goes down to $27,000.However, some of the $3,000 that “gets lost” is tax payments. In reality, out of the$60,000 income, the client’s reduction is only 3 or 4 percent!13. <strong>The</strong> modeling for the capital preservation adjustment takes into account various scenariosfor inflation fluctuations and market fluctuations.SECTION 5: CASE STUDIESLO 7-5-1: Case study: Evelyn and Bruce1. Case study: Evelyn and Brucea. Evelyn is planning on retiring from a local school district this year. She recentlyreceived her benefit options from the school’s defined benefit plan and is lookingfor advice on her options.b. Evelyn and husband Bruce, both 63, have been happily married for 28 years.c. Bruce retired last year from a local community college.7.33
d. Evelyn is in great health and her mother (age 85) is still alive and independent.Bruce has high blood pressure and both parents have passed away.e. Evelyn earns $70,000. Bruce did as well. In the last year since Bruce has retiredthey have been able to live on about $90,000 (pretax) and have been takingwithdrawals from Bruce’s 403(b) plan to make up the difference.f. <strong>The</strong>y will have an additional health care expense of $20,000 a year for the nexttwo years—until they become Medicare eligible.g. <strong>The</strong>y have a $400,000 home with no mortgage.h. <strong>The</strong>y have $30,000 in a savings account.i. Bruce has $300,000 in a 403(b) account and Evelyn has $100,000.j. <strong>The</strong>y do not have any long term care insurance or any other plan for addressinglong-term care.k. Neither have an interest in part-time work.l. Bruce’s Social Security PIA at full retirement age is $1,600 a month.m. Evelyn’s Social Security PIA is $1,100 a month.n. Evelyn’s defined benefit options include a(1) Straight life annuity of $5,500 a month(2) Joint and 50% survivor annuity of $5,100(3) Joint and 100% survivor annuity of $4,700(4) Evelyn has also paid into this plan and she can choose to take hercontributions of $173,000 as a lump sum. That would reduce her monthlypayments (single life annuity) by about $1,100 a month.(5) <strong>The</strong> joint and survivor annuity options are unusual in that she can choosean alternative beneficiary if Bruce predeceases her.o. Bruce has not yet begun to receive his pension benefit.(1) Life annuity $2,400 a month at age 65(2) Early payment allowed with a 6% reduction each year(3) Further reductions for a joint and survivor benefit option(4) Lump sum also availablep. <strong>The</strong>y start the process looking for advice about Evelyn’s benefit optionsq. <strong>The</strong>y have a clear preference for guaranteed income in relation to potential forinvestment growth.r. <strong>The</strong>y are not particularly interested in choosing or managing investments.s. <strong>The</strong>y are motivated to helping their children—sooner than later.t. (Video: Case study: Evelyn and Bruce: Littell, Lemoine, Kitces, Guyton)LO 7-5-2: Case study: Lisa1. Case study: Lisaa. Lisa, age 58, was recently divorced after being married for 25 years and is stillrecovering from the divorce. She is beginning to look forward and is trying to figureout if she can afford to retire. Her plan was always to retire at age 62 but she isaware that this might be more difficult after the divorce.b. She works three to four days a week as a realtor earning about $30,000 a year.c. Lisa has $200,000 in a money market fund from the sale of the couple’s home.d. She rents an apartment and covers expenses with her income and $2,000 amonth from the money market fund.7.34
e. Lisa has a checking account with $2,000.f. Lisa received $350,000 of her ex-husband’s 401(k) plan pursuant to a qualifieddomestic relations order.g. When Lisa is not working she spends time with her mother (Roberta) age 84 whois in poor health and is suffering from dementia.h. Her planner is a CFP® professional who had both Lisa and her husband as clientswhen they were married. (Both are comfortable with this arrangement.)i. <strong>The</strong> planner also works as Roberta’s financial adviser.j. (Video: Case study: Lisa: Tacchino, Lemoine, Kitces, Guyton)LO 7-5-3: Case study: Joe and Jane1. Case study: Joe and Janea. Joe (age 58) and Jane (age 55) have been happily married for 30 years and areboth currently employed. <strong>The</strong>y expect to continue their jobs until Joe turns 70. Joeearns $220,000 as a software engineer for a large company. Jane stayed homewith their kids most of her married life and started a job as an assistant managerat a local gift shop 5 years ago. Jane makes $40,000 per year.b. Joe has $900,000 in a 401(k) plan.c. Jane has $50,000 in a SEP-IRA.d. Joe has 1,000 nonqualified stock options from his employer. <strong>The</strong> options havea 10-year duration and were issued 3 years ago at $40 per share. <strong>The</strong> stock iscurrently worth $47 per share.e. Joe will receive $30,000 a year in Social Security benefits at full retirement age(age 66).f. Jane is eligible for $7,000 a year in Social Security benefits on her own earningsrecord at full retirement age (age 66 and 6 months).g. Joe has a $1,000 per month life annuity pension from a prior employer.h. <strong>The</strong>ir house is worth $600,000 and they have 5 years left on the mortgage with anoutstanding loan balance of $79,000.i. <strong>The</strong>ir vacation home at the lake is worth $200,000 and they have 15 years left onthe mortgage and still owe $140,000.j. <strong>The</strong>y have $25,000 in a savings account.k. <strong>The</strong>y are interested in leaving a legacy to their two children (and hopefully theiryet to be born grandchildren) but not at the expense of sacrificing their standardof living in retirement.l. <strong>The</strong>y are both in good health. But Jane’s mother developed dementia at an earlyage (70).m. <strong>The</strong>y are currently spending approximately $14,000 to $15,000 a month.n. (Video: Case study: Joe and Jane: Tacchino, Lemoine, Kitces, Guyton)7.35
RESOURCES FOR COMPETENCY 7: INTEGRATINGAPPROACHES, RISKS, PRODUCTS, AND STRATEGIES TOCREATE AN EFFECTIVE RETIREMENT INCOME PLANSection 4: Monitoring and Adjusting the Plan• A Gentle Introduction to the Calculus of Sustainable Income: What Is Your RetirementRisQuotient?• Retirement Income Sustainability: How to Measure the Tail of a Black Swan7.36
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