Product Solutions: Retirement Planning

While many products are touted as retirement savings vehicles, tailoring a retirement savings plan to individual circumstances and preferences goes far in motivating savers to participate in accumulating a retirement nest egg. An integrated approach to developing a retirement portfolio includes paying attention to estate and tax issues, investment and withdrawal time horizons, risk acceptable to the investor, and income requirements of the portfolio.

Often it is helpful to determine a base income that includes survivor, safety and a portion of the freedom budgets (see the section on budgeting for further information the referenced budgets). Once the base income is determined, a plan to accumulate sufficient assets and income sources to provide that base income seems prudent. Lifestyle enhancements such as travel, capital purchases, philanthropy, etc., may then be addressed separately. Care should be taken when determining how to integrate governmental entitlement programs and pensions into a retirement income plan, as they are vulnerable to being decreased or eliminated. Ideally, base income should be generated primarily from private savings rather than from third party income sources.

Professional practitioners and small business owners necessarily commit a substantial amount of their current and future net worth to their business. Real estate investors often rely on future appreciation and cash flow from their properties to provide security during retirement. Developing a exist strategy from properties and businesses is essential to successfully realizing a dependable retirement income. Business owners (primarily) have the option of devising defined benefit plans designed to provide an income stream based on a formula of earnings while employed. Such plans can be tax-qualified or non-qualified. These plans must account for company assets and cash flows as well as tax effects on funds to both the company and individuals participating in the plan. Defined benefit plans are often funded by fixed investment options such as insurance contracts (i.e., life insurance policies or annuities), although other options are available.

Tax-qualified defined contribution plans are the most common retirement savings vehicles. These plans include traditional and Roth IRAs, 401(k)s, Profit Sharing Plans, Simplified Employee Pension Plans (SEPs), Deferred Compensation Plans for public employees, 403(b)s (also known as Tax Sheltered Annuities (accounts) or TSAs, and others. The feature that differentiates these plans from traditional pension plans and government entitlement programs (Social Security, etc.) is the investment risk being borne by the individual participant, not the business or sponsoring organization. This is an important distinction because the decision as to where funds are invested falls to the participant, not a professional hired by the company who is compensated to manage the account and ostensibly has expertise in managing retirement funds.

Traditional and Roth plans offer different income tax benefits. Governmental regulations allow for income tax breaks either when funds are deposited into a designated retirement savings account (traditional) or when funds are withdrawn (Roth). Only rarely are benefits available on both ends, and governmental agencies work aggressively to close any “loop holes” in regulations that allow for what they consider to be excessive income tax breaks. Developing pools of money that have different tax treatment is a prudent strategy for accumulating a nest egg. Tax qualified plans, tax deferred savings vehicles, tax-free investments, assets producing capital gains and other tax-favored approaches should be considered. Please refer to the section on tax-planning for additional information.

While often a desirable place to save for retirement, tax-qualified plans are not the only choices for retirement savings. Cash value life insurance policies, non-qualified annuities, bank certificates of deposit, tax-free bonds, dividend-paying stocks, and many other investment vehicles are available to fund a retirement nest egg. The overriding issue with purchasing any investment, whether for retirement or not, is understanding the benefits and potential risks associated with that investment.

There is a growing propensity among purveyors of financial products to attach “bells and whistles” to products, ostensibly addressing multiple financial planning concerns within a single product. For example, since it is essential to consider the impact of potential long-term care expenses and medical costs in conjunction with retirement, “asset-based” products exist to provide both retirement income and long-term care funding in the same contract. Another common feature used in retirement accounts is some sort of income guarantee underwritten by counterparty, most often an insurance company. The effect of an income guarantee is to transfer investment risk to that third party. Sometimes these guarantees are referred to as private pension plans, since the benefits somewhat mirror defined benefit plans.

Life expectancy is another factor that must be addressed in a comprehensive retirement plan. One approach to deal with an extended life expectancy is to purchase a longevity income vehicle, such as an annuity that beings to pay out only after age 80. Laddering portions of the retirement nest egg to produce income during subsequent income phases allows for better portfolio positioning to achieve both growth and distribution of assets within appropriate risk parameters.

Asset allocation in retirement accounts should reflect the time horizon until money will be withdrawn from the account as well as the risk tolerance of the investor. Given recent capital markets history, it is difficult for many savers to muster the optimism to commit their money towards the types of investments that may best fit the timeframe and risk parameters necessary for long-term investing success. For those with more than ten years remaining before they will begin spending from their next egg, as well as for funds for current retirees that will be accessed more than ten years in the future, long-term market returns matter. Too often retirement nest eggs have too little exposure to asset classes (i.e., stocks) that can provide the returns necessary to accumulate sufficient retirement assets. To be sure, investment risk management is important—a relatively new metric for evaluating a manager’s value is upside vs. downside capture ratios, which measure how that manager’s risk management techniques reduce declines in poor market conditions as compared to a benchmark (as well as gains achieved during positive markets against the same benchmark). Ultimately, portfolios must have returns sufficient of provide an increasing income stream that accounts for inflation as experiences by seniors (not just the US Government version of CPI inflation). Portfolios must also reflect the risk tolerance of the saver. That risk tolerance should be expressed numerically, not simply in the relative terms of conservative, moderate, or aggressive.

Time horizons of less than ten years must necessarily be evaluated differently. Rather than investment returns measured in long-term market averages, the sequence of returns becomes much more relevant in shorter time frames, since a significant decline in portfolio value immediately prior to withdrawals or while funds are being spent from the account could mean failure of the next egg to provide the amount or length of income required.