FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
May 27, 2008

Investing During Retirement
By: Mike Posey

IN THIS ISSUE:

1.  Risk Considerations In A Retirement Portfolio

2.  No Shortage Of Investment Options

3.  Immediate Annuities

4.  Fixed-Income Alternatives

Introduction

We’re now in the home stretch in this series of Retirement Focus E-Letters dedicated to converting your nest egg into a retirement income stream.  Over the past year or so, I have written about how to determine how much might be enough to fund your retirement, as well as how to determine the best way to convert your nest egg into an income stream during your golden years.

As I promised in my March 18 Retirement Focus E-Letter, this week I’m going to address the issue of how to invest your money after retirement.  We’ll cover the importance of risk management during retirement as well as various ways to invest to produce the income you need.  In the end, we’ll discover that post-retirement investing is a delicate balance of risk and reward that must be achieved in order to reach your goal of a secure retirement.

Before launching into this week’s topic, I want to be sure to remind you that any investment information provided in this E-Letter is general in nature, and should not be construed as investment advice.  You should always evaluate investment options in light of your personal financial situation, retirement goals and any special circumstances you may have.  Ideally, you should consult a qualified investment professional who can take the time to review your situation and tailor an investment approach to meet your needs.

Revisiting Gary’s Risk Discussion  

Gary did a great job in his April 22 E-Letter that highlighted both common and lesser-known risks associated with investing.  His risk analysis discussion is especially important for those who are investing during retirement, since the negative consequences of taking on too much investment risk can be far greater during retirement than while accumulating a nest egg.

Just one example of a retirement portfolio’s heightened sensitivity to risk is the issue of investment losses in the early years of retirement.  To illustrate, let’s use real-life historical market data to show the effects of early market losses.  An investor retires on December 31, 1999 with a nest egg of $500,000, and decides to take 6% annual withdrawals.  To keep it simple, we’ll assume he decides to invest it in an S&P 500 Index fund, lured by that Index’s phenomenal returns (33.36% in 1997, 28.58% in 1998 and 21.04% in 1999) just prior to retirement.  The following table tells the story of this investor’s first three years in retirement:

Note that with the December 31, 2002 balance of $259,109, the January 2003 distribution would be only $15,547, or roughly half of the original amount of income at the beginning of retirement – all in the space of just three years.

Recalling Gary’s discussion about the amount of return required to break even, we find that it will take a total return of 93% just for this investor to get back to even, which will be especially hard to do considering an automatic 6% withdrawal each year. 

The moral of this story is that the combination of steady withdrawals and portfolio losses can send a retirement portfolio’s value into a downward spiral from which it might never recover, resulting in you possibly running out of money later in life, or reducing the level of income below what is needed for a comfortable retirement.  Granted, the above example chooses three of the worst years on record for the stock markets, but how do we know that the next three years won’t be a repeat of 2000 – 2002 in the stock market?  The answer is that we don’t, so retirees must invest with an eye on risk management.

The remainder of this article will address the various ways to invest during retirement.  Over the course of this discussion, the guiding principle will be to balance the various investment risks such that you will have both a meaningful level of income, but also avoid running out of money in retirement.

Retirement Investing – No Shortage Of Options

With the oldest of the Baby Boomers now eligible for Social Security early retirement, mutual funds, brokerage firms, insurance companies and the like have all come out with a variety of products designed to fill the need for retirement income.  Accompanying this deluge of products are reams of articles dedicated to advising both investors and investment professionals on how to position their retirement portfolios for optimum income and longevity.  As if this glut of frequently conflicting advice isn’t bad enough, add in a generous helping of warnings from regulatory agencies regarding scams and bogus investments aimed at seniors, and you get what Gary likes to call “information overload.”

My goal in this and subsequent E-Letters in this series will be to acquaint you with a variety of alternatives for post-retirement investing.  Be aware, however, that there is no possible way that I can provide information about every conceivable way to invest for retirement.  Nor can I launch into very detailed explanations of the products and investment strategies I do cover, since I am restricted as to space in these E-Letters.  Even so, my hope is that I can provide you with a basic knowledge of how each of these options works. 

With those caveats aside, it’s time to delve into ways you might want to invest during the course of your retirement.  As a general rule, I categorize the various post-retirement investment strategies into the following six broad categories:

1. Immediate Annuities – This is perhaps the simplest alternative in that it requires only one decision at the beginning of retirement.  While I will discuss other annuity contracts below, an immediate annuity is different in that its sole purpose is to make periodic payments of income over the lifetime of the policyholder. 
   
   
2. Fixed Income Alternatives – This type of investment includes bank certificates of deposit as well as insurance company fixed annuities.  It can also include individual bonds purchased to hold to maturity. The key characteristic of this group is that the initial and renewal interest rates are fixed by the issuer for a period of time.  For individual bonds, and CDs, the interest rate may be set until the bond’s maturity, while fixed annuities often have annual interest rate resets.
   
   
3. Variable Annuities – In addition to fixed annuities, the insurance industry has a whole host of variable annuity contracts.  Variable annuities differ from fixed contracts in that the value of the annuity will vary based on the performance of the markets.  Some have referred to variable annuities as a “mutual fund in an insurance wrapper,” and this is a pretty accurate description.  However, there are some major differences between mutual funds and variable annuities, which I will discuss in more detail later on.
   
   
4. Asset Allocation Alternatives – This is by far the largest category of investment alternatives, in that asset allocation strategies can range from single-product mutual fund purchases to individually tailored investment allocations provided by a financial professional.  The key in any asset allocation program is to diversify the portfolio in such a way as to balance the risk and reward of investing in light of an investor’s goals, risk tolerance and investment horizon.
   
   
5. Actively Managed Strategies – Actively managed strategies are similar to the asset allocation option in that a variety of securities are purchased with the overall goal of producing a retirement income.  However, actively managed strategies differ in that these programs are not passive buy-and-hold portfolios.  Instead, an active manager will generally seek to position investments in markets that they believe have the greatest potential for gain, and if markets are down or uncertain, the active manager may retreat to cash or even hedge long positions.
   
   
6. Other Alternatives – Within this catch-all category, I would place real estate (both direct investments and REITs) as well as other income-producing alternatives that you might not otherwise consider.

Due to space limitations, I’ll only be able to cover a couple of the above categories this week, with the remainder being covered in future Retirement Focus issues.  As I discuss these various options, I will include some links to additional information on these investment options.

Immediate Annuities

One of the major risks that retirees face is the possibility of outliving their money.  With fewer and fewer people being covered by defined benefit plans that can provide an income for life, the onus is being placed upon the individual retirees to make sure post-retirement investments are such that their money will not run out.

The immediate annuity contract addresses the risk of outliving your money by providing a periodic retirement check as long as you live.  There are even options available that provide an income for as long as you live, plus provide the same or a lesser amount to a surviving spouse as long as they live.  Most immediate annuity contracts are “fixed,” in that they provide an assumed level of return, but there are also variable immediate annuities, as I will discuss later on.

In fixed immediate annuity contracts, once the annuity is purchased, the amount of periodic income is set and will not vary in the future.  However, there are some fixed contracts being introduced that will provide for an increasing payment over time, as well as variable immediate annuities where the periodic payment varies with the investment performance.

The biggest advantage of these contracts is that the payments continue for life, even if your premium plus earnings would have otherwise been exhausted.  The insurance company takes on the risk that you will live longer than your actuarial life expectancy, while you take on the risks of dying early and your heirs losing access to the premium paid.

I wrote about the basics of an annuity payout in my July 24, 2007 E-Letter, along with the major advantages and disadvantages.  Rather than trying to summarize all of that material in this E-Letter, I encourage you to go back and read the Annuity Payout E-Letter to get up to speed on this investment option.

I do want to address several issues in regard to this method of providing retirement income.  First, it is important to remember that in most immediate annuity contracts, you cannot change your mind several years later and receive a distribution of the remaining value.  This is why most Advisors counsel retirees to not put their entire nest eggs into immediate annuities, since doing so could leave them without resources in case of an emergency expense.

The insurance industry is developing new immediate annuity products that address this illiquidity, but any flexibility comes at a cost.  Some immediate annuity contracts do allow limited withdrawals, but periodic payments may be reduced to compensate for this extra benefit.  Others allow withdrawals only during the early years of the contract, but charge a surrender fee if this option is exercised.  

A second risk when purchasing an immediate annuity is dying prior to reaching life expectancy, and especially during the early years of the contract.  In a life-only payout, all payments would cease and any windfall would go to the insurance company.  For this reason, annuity companies provide optional forms of payments such as period-certain, joint-and-survivor and installment refund options that can extend beyond the annuitant’s life span should an early death occur.  These alternative forms of payment, however, do come at the cost of lower periodic payments.

Since the payout from a fixed immediate annuity is set over the lifetime of the annuitant, another possible disadvantage is the loss of purchasing power.  According to the actuaries, a retiree at age 65 can expect to live around 18 more years.  However, it is not uncommon to see people live far beyond that point.  While the insurance company guarantees to pay an income for the life of the individual, they cannot guarantee that its buying power will remain the same.

In other words, inflation is the natural enemy of the fixed immediate annuity.  Using the Department of Labor’s inflation calculator, we can see that a $1,000 payout in 1988 would have the purchasing power of only about $550 today, while the same payout beginning in 1978 would have the buying power of only $303 after 30 years of inflation had taken its toll.  If future inflation trends are similar to those of the past 30 years, an annuitant could see his or her buying power halved in 20 years, and cut to a third in 30 years. 

The insurance industry has also addressed this disadvantage by providing a variable immediate annuity.  Like the fixed immediate annuity, the variable contract provides an income for life.  However, unlike its fixed counterpart, payments from the variable immediate annuity can rise or fall based on the performance of a portfolio of investments.

It works like this – the annuitant buys a variable immediate annuity from an insurance company and the initial monthly payment is calculated using an assumed rate of investment return.  After that, the monthly payment will be based on the performance of the investment portfolio chosen by the annuitant. 

If the investments do well, then payments can rise over time and possibly overcome the effects of inflation.  However, the annuitant also takes on market risk so that if the selected investments do poorly, the income payments will fall, possibly below what a fixed contract would have paid.  Some companies do provide a guarantee that payments cannot fall below 80% to 85% of the initial payout, but this comes at the cost of higher expense charges.

Just as with any other investment alternatives, fixed and variable immediate annuities are just one tool that can be used to provide retirement income.  The important thing to remember is that the guarantee of an income for life depends upon the strength of the company issuing the annuity contract.  Therefore, you should only place your money with an insurance company that you feel is safe, solid and will be around 30 years from now.

To assist you in your evaluation process, I recommend that you check out a prospective insurance company’s ratings with at least one of the five major insurance company rating services (Moody’s, A.M. Best Company, Weiss Research, Standard & Poor’s and Duff & Phelps).  A link to all of these ratings services can be found at the Insbuyer.com website at the following web address:  http://www.insbuyer.com/insurancenrating.htm.

You can also obtain quotes on how much monthly income your nest egg will purchase under various annuity options on many Internet websites.  You can find these websites by typing “immediate annuity quote” into an Internet search engine.  One I have found to be helpful is at http://www.immediateannuities.com.  Note that these guides are useful to get a general idea of what annuity income may be available, but you should always consult a qualified insurance professional before buying any annuity contract.

Fixed Income Alternatives

As noted above, the fixed income category covers a lot of different types of investments, and is characterized by paying a fixed or stated rate of return for a specific period of time.  In some fixed income investments, the fixed rate of return may span from several months to many years.  In others, such as a fixed deferred annuity contract, the interest rate may be revised annually.

Fixed income investments can also be subject to a wide range of tax treatment on the income produced by the investment, such as municipal bonds where interest is generally income tax free, to fixed deferred annuity contracts where taxation is deferred until withdrawn from the contract.  For a more detailed discussion of tax considerations, see my November 13, 2007 E-Letter.

Because the category of fixed income includes CDs and fixed annuities, many investors think that only low-return investments are included.  While it’s true that some fixed income investments do have low returns, there are others that have the potential for very attractive returns, even to investors that primarily invest in equities.  Of course, with this increased return potential comes a generous helping of increased risks as well.

A major advantage of fixed income investments is that they are generally not highly correlated with equity investments.  As a result, including certain types of fixed income investments in a diversified retirement portfolio can lower a portfolio’s volatility, and sometimes even offset losses in the equity portion of the portfolio.  While the major thrust of this article is the production of income from fixed income investments, this non-correlation can be just as beneficial after retirement as it is in the accumulation phase.  As a general rule, the category of fixed income investments usually includes the following types of investments:

1. Certificates of Deposit (CDs) – This category is very familiar as most people have had a CD at one time in their life or another.  The CD may be one offered by your local bank, or can be a CD offered by a local broker.  These “brokered CDs” often have higher rates of return than those of your local bank, so they are worth checking out.  All are fully insured by the FDIC up to the maximum amount permitted by law and, as a result, usually have a very modest return.  Interest can accumulate in the CD, or be withdrawn monthly to provide retirement income.
   
   A relatively new type of CD known as an “equity-indexed CD” can provide a higher rate of return based on the appreciation of a stock index such as the S&P 500 Index.  However, these CDs usually require that you lock in your investment for a period of five or more years, and do not usually provide for interest payments during this time.  Thus, they may be of limited use for retirees who need current income from their investments.  You can learn more about this innovative form of CD at the following website: http://www.sec.gov/answers/equitylinkedcds.htm.
   
   As with bonds that I will discuss below, the most common way to invest in CDs for retirement is by “laddering” the maturity dates.  I discussed this process in my December 11, 2007 E-Letter, so I won’t repeat it here.  One good place to check for the going rate of return on various types of CDs is on the Bankrate.com website at http://www.bankrate.com/brm/rate/deposits_home.asp.
   
   
2. Fixed Deferred Annuity Contracts – I discussed fixed immediate annuities above, but a “fixed deferred” annuity contract is sometimes used as a low-risk investment that may have a little higher annual return than a CD, as well as offer more flexibility than an immediate annuity.  While fixed deferred annuities are usually built for the accumulation phase before retirement, they can also be used during retirement by withdrawing interest and principal as needed.
   
   However, be aware that fixed deferred annuity contracts often have a surrender charge if you change your mind and want to invest elsewhere.  Periodic partial distributions often escape this surrender charge, but it’s something you want to ask about before you invest.  As with an immediate annuity, the safety of your investment depends on the strength of the issuing company.  Therefore, do your homework before investing.
   
   In addition, fixed deferred annuities will sometimes offer a high “bonus” rate of return in the early years to provide an incentive for you to invest.  However, you will want to ask the issuing insurance company for a copy of their renewal rate history to see how you might fare after the bonus period has ended.  This renewal rate can never go below a minimum guaranteed rate of interest, but this guaranteed rate is often very low. 
   
   A very specialized form of fixed deferred annuity is known as the “equity-indexed annuity,” in which you can participate in a particular stock market index’s gain, but be guaranteed to not lose any money if the market goes down.  Since this investment usually requires that you lock up your money for some period of time, I won’t discuss this option since this type of annuity is not used for generating monthly income.  However, I plan to do a future E-Letter on this very interesting type of fixed deferred annuity.
   
   Annuity contracts are sometimes seen as a beneficial investment for risk-averse investors since they offer a minimum guaranteed rate of interest, provided that the insurance carrier you select is stable and solid.  However, while Consumer Reports (CRMA) had high praise for immediate annuities, they did not share the same opinion of fixed immediate annuities.  They said:
   
   CRMA experts found that even with all the tax advantages, annuities are usually poor investments. They come with lofty fees and stiff withdrawal penalties. If you invest with a shaky insurer that goes out of business and you have a fixed-rate annuity, the state only guarantees that you will get some of your investment back.
   
   You can get more information about annuities on the Internet at the Annuity Buyer’s Guide website at http://www.annuitybuyersguide.com/what-is-an-annuity-.html.
   
   
3. Bonds – This category includes a wide variety of debt instruments and can range from Treasury notes and bonds to high-yield corporate issues.  This investment process may involve purchasing individual bonds rather than investing in bond mutual funds.  As a general rule, the longer the maturity of the bond, the higher the interest paid.
   
   Perhaps the bond most interesting to retirees is the municipal bond, which can escape federal income taxation in most cases.  As a result, the interest rate on these bonds is usually lower than in similar taxable bonds.  Thus, the value of tax deferral depends upon your tax bracket, since a low tax bracket may not merit the reduced interest rate.  It is also important to note that tax-exempt interest from municipal bonds is added back for purposes of determining how much of your Social Security benefit may be taxable, so remember this if you choose to invest in this type of investment.
   
   Obviously, the greater the security of the bond, the lower the interest rate will be.  Thus, Treasury bonds secured by the full faith and credit of the US government are considered to be the safest.  There are even Treasury Inflation Protected Securities (TIPS) that are not only backed by the US government, but also adjust their return for inflation.
   
   At the other end of the spectrum are high-yield corporate bonds, which are also called “junk bonds,” and for a good reason.  High-yield bonds are issued by companies with less than stellar prospects for the future.  Thus, there is not only no guarantee they will be paid upon maturity, but the company may not even survive to pay the interest.  However, some retirees with smaller portfolios may be attracted to these bonds since they provide a higher level of income than other options.  Just remember that this high level of income comes with substantially higher risk.
   
   As I noted above in regard to CDs, the most common form of investment in bonds during retirement should involve “laddering” the maturity dates so that you have periodic liquidity.  This also serves to make sure that you get the advantage of both short-term liquidity and the generally higher interest rates on long-term maturities.  Another advantage of using individual bonds to fund retirement is that you can build a ladder of various types of bonds, both government and corporate, to provide additional diversification.
   
   Another important thing to remember when investing in bonds is that the market values of the bonds may fluctuate over time with prevailing interest rates.  As a general rule, when interest rates go higher, bond prices go lower.  This could cause retirees some concern when they get brokerage statements showing that their nest egg has lost value.  However, laddering strategies usually provide for keeping the bonds until maturity, at which time they will pay full par value.  Thus, don’t let periodic market dips concern you as long as you have planned to hold on to maturity.
   
   
4. Unit Investment Trusts (UITs) – This is a specialized type of investment offered by brokerage firms that consists of a portfolio of similar securities held for a specified time and usually pays a pre-determined rate of return for the duration of the trust.  While many UITs are set up to invest in a portfolio of bonds, there are some that also include stocks.  UITs are considered to be buy-and-hold investments with a fixed maturity, and interest income from the portfolio is paid periodically to shareholders, making them attractive to retirees. 
   
   Principal is returned to the investor upon maturity of the trust.  Since most UITs invest in bonds that pay their par value upon maturity, there is generally little principal risk in these investments.  Of course, this is not the case with any UIT that contains stocks.  Loss of principal may also occur if an investor liquidates units prior to maturity.
   
   While a UIT is similar to a mutual fund, it differs in that once the portfolio of securities is selected, there is no active management of assets.  As a result, operating expenses of UITs are often lower than actively managed bond mutual funds.  UITs are generally seen as a low-risk, low-return form of investing, but may be appropriate for a portion of your retirement money.  Be aware, however, that up-front sales loads can be considerable in  UITs, so compare returns net of these expenses to other alternatives before investing.  You can learn more about UITs at the following website sponsored by the SEC:  http://www.sec.gov/answers/uit.htm.

There are other types of fixed income investments not covered above such as US savings bonds, money market mutual funds, convertible bonds, zero-coupon bonds, and the now infamous mortgage-backed securities, among others.  There are also bond mutual funds for virtually all types of debt instruments that provide many of the same advantages of buying individual bonds, but relieve the investor of having to decide which bonds to buy.  The key to including any fixed income investment in a post-retirement portfolio is usually the ability to have a safe, stable amount of income with at least some measure of principal protection.

That’s it for this week.  In my next Retirement Focus issue, I’ll continue discussing the various ways to invest for retirement.  Until then, if you have any questions about the options given above, or would like me to cover a specific investment option, please feel free to contact me at info@halbertwealth.com.

Best regards,

Mike Posey

SPECIAL ARTICLES

Boomers’ Eagerness to Retire Could Cost Them
http://www.usatoday.com/money/perfi/retirement/2008-01-13-turning-62-cover_N.htm

The Oil Speculation Debate
http://calculatedrisk.blogspot.com/2008/05/oil-speculation-debate.html

No Clear Map for Clinton’s Political Future
http://www.washingtonpost.com/wp-dyn/content/article/2008/05/26/AR2008052602006.html

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