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• Editor's note: Some years ago, when I worked as a registered investment advisor, I wrote a book for clients about investing for retirement. I've reprinted some of the chapters here, especially, those addressing what I call "the greatest threat facing retiree-investors today."

May 15, 2010

 

 

 

 

The Greatest Threat Facing Retiree-Investors Today

The subject of money can be an emotionally-charged issue.

 

Possibly we still mentally hear a parent lecturing us on the virtues of financial prudence:

 

• “Put your money into something safe – don’t speculate, don’t gamble!”

• “The stock market is too risky – buy bank CDs – the government will protect your money!”

 

Our parents or grandparents lived through a cataclysmic economic event, one that forever shaped their worldview. It was the Great Depression of the 1930s.

 

Those who lived through it would never forget the 25% unemployment rates, the soup lines, massive stock market declines, and substantial price deflation.

 

FDR’s administration gave birth to Social Security during this tumultuous time -- but the government back then wasn’t too worried about big draining payouts.

 

It was not by accident that 65 was chosen as that magic age when one could begin to receive free income payments – because at that time, according to actuarial studies, the average person would not see his 65th birthday!

 

In 1935 the average person (all races, both sexes) would enjoy only 61.7 years of life! At that time, the average man retiring from work, if he lived to receive Social Security payments at all, would likely not see many of these checks. And if his life savings had been accumulated in bank CDs, there was little incentive for him to attempt to stretch this money over many years to come!

 

But, this is not 1935. And this is not your grandfather’s retirement.

 

Today, with vastly improved health care, seniors are not even considered “old” at age 70, much less at 65!

 

The issue of longevity – and how to prepare for it – is one of the great modern games of self-denial! Many people don’t want to talk about it – but it’s important that they do because it’s dangerous not to!

 

Let’s look at the numbers – based on the latest actuarial studies (Forbes, December 12, 2005):

 

• a 65-year-old woman has a 69% chance of reaching age 80; for men, it’s 56%;

• a 65-year-old woman has a 29% chance of reaching age 90; for men, it’s 18%;

• a 65-year-old woman has a 12% chance of reaching age 95; for men, it’s 6%;

• a 65-year-old woman has a 3.4% chance of reaching age 100; for men, it’s 1.3%.

 

Stated another way, among women aged 65, 1 out of 30 will reach age 100!

 

Becoming a centenarian is not all that far-fetched. And hitting age 90 is ten times more likely!

 

Will you become a centenarian?

 

Consider these statistics too:

 

• In 1990 there were over 37,000 centenarians in the U.S. – and almost 6,500 had reached age 105!

• Today – right now (2007) – in the United States there are over 55,000 people aged 100 or more!

• The International Longevity Center in New York City projects that in 40 years there will be close to 1 million centenarians in the U.S.

• In 2005 the Social Security Administration extended the life expectancy tables all the way up to 119.

• In the last 40 years the number of people reaching age 100 has increased almost ten times.

• The number of centenarians in the world today is close to 500,000.

 

The subject of longevity, as I said, is difficult for many people to talk about. Part of the problem is that things are changing so quickly in this area that we can hardly keep up.

Consider these facts of history:

 

• For thousands of years, all the way up to the year 1400, the average life span on the earth was only 25 to 30 years.

• The Renaissance, with its increased knowledge, began to change things. Between 1400 and 1800 average life spans in Europe and America jumped a whole 7 years to 37.

 

Think about this! For thousands of years people lived about 30 years or less – and then in only 400 years there was a 20%+ increase of 7 years!

 

• Between 1800 and 1900 the world witnessed many scientific advancements – and by 1900 the average life expectancy moved up 10 years to 47.

• But then, between 1900 and 2000, we saw a huge increase – 30 years -- the average person would now see 77.

 

And since the year 2000 the numbers have only gotten higher. The average woman today will live to 80!

 

If we were to plot all of this on a graph we would see, for thousands of years, a flat line representing most of the history of humankind. Around 1400 the trajectory finds a very slight elevation. But as the 1800s come into view the line begins to rise more and more steeply – and by the latter 1900s we see the line with a decidedly vertical slant!

 

• The trajectory of life expectancy is now going straight up!

 

The question has been asked:

 

• Is 70 the new 50?

 

And if this is true:

 

• Is 100 the new 70?

 

Decades of retirement has a big price tag.

 

Our parents and grandparents, survivors of the Great Depression, saw the financial world primarily with one view – safety of principal.

 

And when the mere age of 62 in 1935 was the average life expectancy, this was a valid concern. While safety of principal must never be forgotten, there are reasonable methods of dealing with this issue.

 

Today, however, when large numbers of people will, as a matter of course, live 20 years, 30 years and even longer beyond the “traditional” retirement age, we have a new primary risk to deal with!

 

• The greatest risk facing investors today is longevity risk – the risk of outliving one’s savings!

 

Maybe you are thinking that I have spent too much time discussing this issue of longevity – too many stats! I agree, but any undue lingering here is one of design. I’ve tried to emphasize this point because many find it hard to envision themselves reaching age 90 and more – yet, large numbers of us will do just that.

 

It’s a reality laced with serious economic consequences.

 

The Parable of the Postage Stamps

 

 

 

 

 

 

I have on my desk a small plastic case in which are mounted three first-class postage stamps. The first stamp is from 1960; the second from 1982; the third from 2003 – an interval of about 20 years separating the issuance of each stamp.

 

• The stamp from 1960 features an image of a boy scout, with right hand raised, offering the scout pledge – the face value of this stamp is 4 cents;

• A painting of George Washington is displayed on the 1982 stamp – face value is 20 cents;

• The delicate visage of Audrey Hepburn graces the 2003 stamp – face value of 37 cents.

 

I refer to these three as “The Parable of the Stamps” because they illustrate in microcosm a problem that all investors face – the ever-rising cost of living!

 

• Imagine yourself retiring in 1960. And let’s assume that your entire annual expenses are represented by that 4 cent stamp: food, clothing, shelter, medical services – all paid for by 4 cents. If your 1960 income is, let’s say, fixed at 8 cents, you’re doing well. You have more than enough cash to pay all of your bills.

 

So how are you doing 10 or 15 years later? It’s now the 1970s, and the cost of living has not been easy on any of us.

 

By 1971 your annual expenses – as represented by a first-class stamp – is now 8 cents! You are now just barely getting by financially. How could this be? You had more than enough money in 1960 to take care of all of your needs.

Three years later, 1974, greets us with a 25% rise in the cost of living. That basic stamp now costs 10 cents. These are difficult economic times with the OPEC oil embargo, wage and price controls, and a severe recession. Eight cents now no longer covers annual expenses, and you cut back on your standard of living to make ends meet.

 

Just one year later, 1975, costs jump again to 13 cents. This is a calamitous budgetary crisis.

 

Fast-forward now to 1982 – 22 years into retirement and you are now in your 80s – the cost of living, as represented by the stamps, has risen 5 times to 20 cents! Anyone on a fixed income during these difficult times finds his or her finances in total disarray, the terrible result of the high inflation years during the 1960s and 1970s.

 

And the question we must ask is this:

 

• If the cost of living is going to double or, possibly, rise even more in any 20-year period, what can be done to protect our retirement finances from this kind of devastation?

 

I think it was Phyllis Diller who once quipped: “I’ve been trying to teach my son the value of a dollar – so I gave him a quarter.”

 

That’s a funny line – but, of course, it masks a deadly truth. With each passing year, our money buys less and less. We have witnessed this process, a slow-motion train wreck, all of our lives!

 

I have more to say about the threat of the rising cost of living below in the sections on CDs and Bonds. Please study this information and also consider the following:

 

We live in an age when it is entirely likely for large numbers of us to spend almost as much -- or even more -- time in retirement than we spent in our working lives!

 

Even if inflationary forces grow at what are considered to be “modest” levels, let’s say, 3% to 4%, the cost of living will double in only 20 years!

 

This issue is of vital importance and needs to be addressed.

 

 

 

Mister 5 By 5

 

I’ve been searching for a simple teaching device to illustrate a vital point of understanding, one that many trip over. I hope the following might help.

 

There is a common fallacy associated with investing in savings vehicles such as CDs, annuities, municipal bonds – basically, anything that offers a fixed, low return -- today, that would be about 5%.

 

The reasoning goes something like this:

 

• “I like the safety and guarantees of CDs and annuities. They’re simple to understand and easy to work with. What’s wrong with earning a safe and predictable 5%? I could do worse than that! Maybe I should just put all of my money into these kinds of investments and not bother with anything else.”

 

I would be nice if this strategy could save us. I will be saying much more about this subject below in the chapters on bonds and CDs, but allow me to explain the “fatal flaw” here.

   + 5%      earn
   - 5%       spend
  (- 5%)      rising costs
   - 5%       net loss

 

 

I call this little illustration “Mr. 5 By 5.” (Think of the 1940s hit song.)

 

Let’s say you earn 5% in a CD or an annuity. And you spend 5% on your living expenses. Most people stop here, forgetting or minimizing another factor.

 

The 200-year U.S. annual average increase in the cost of living is close to 4%. Recent articles have stated that the current rate is above 5% (these also advise ignoring the “official” CPI rate which is understated). I’ve placed the 5% representing rising costs in parenthesis to suggest action that is subtle, creeping up on us over time.

 

Bottom line: This formula loses 5% a year and is headed straight for where you don’t want to go.

 

How bad is a 5% loss?

 

An annual 5% living-expense increase will double the cost of most things in only 15 years!

 

Never lose sight of “Mr. 5 By 5.”

 

If you place your savings in fixed, low-return investments, over time “Mr. 5 By 5” will steal your money. In only 15 years today’s dollar will retain only 50 cents of purchasing power – you’re getting close to Phyllis Diller’s 25 cents!

 

This is the most serious threat of financial loss facing retirees today!

 

What’s needed? “Mr. 5 By 5” requires a complete make-over and needs to look like this:

   + 10%    earn
   - 5%       spend
  (- 5%)      rising costs

 

 

This formula will protect you from losses due to inflation, will maintain your purchasing power.

 

 

 

 

Bonds

 

A bond is a debt instrument.

 

An investor who “buys” a bond, in fact, is loaning money to a bond issuer, a government or corporate entity.

 

A bond certificate is a contract that states the interest rate and when the loan will be repaid to the investor.

 

Bonds typically have loan terms of 10 years or more.

 

The bond market allows investors to buy and sell bonds of all types. It is much larger than the stock market with average daily trading volumes of $1 trillion!

(When “bonds” are mentioned, some people think of U.S. Savings Bonds – I am not referring to these. They offer low returns and do not trade on a bond market.)

I have heard that during retirement years an investment portfolio should consist primarily of bonds. Is this a good idea?

Many advisors promote such a strategy. But history teaches us that this is not the prudent course.

Popular wisdom claims that bonds will tend to “smooth out the bumps” in a portfolio – the idea is that stock prices are quite volatile, but bond prices are steady and provide an even keel.

This sounds pleasantly predictable and formulaic to investors -- but, unfortunately, such claims generate more heat than light – all of this will take you in a direction that you really don’t want to go. Here’s why:

• Few seem to understand that bond prices can be just as volatile as stock prices!

 

Those who make implied claims that bonds lend “stability” to a portfolio are conveniently forgetting about interest rate risk – it’s the risk that a bond will fluctuate in price as interest rates change.

Here’s the general rule:

• When interest rates go up, bond prices go down.
• When interest rates go down, bond prices go up.

 

 

If this process is unfamiliar to you, allow me to share a few figures that might help:

Annual Interest	Bond Price at Time of Purchase	Current Yield
$80	$600	13.3%
$80	$700	11.4%
$80	$800	10.0%
$80	$900	8.9%
$80	$1,000	8.0%
$80	$1,100	7.3%
$80	$1,200	6.7%
$80	$1,300	6.2%
$80	$1,400	5.7%
$80	$1,500	5.3%
$80	$2,000	4.0%

Notice the annual interest. It’s the same for all bond prices. This means that, as long as a bond issuer remains financially sound, it will pay $80 a year to the owner of the $1000 face-value bond.

Ok, let’s look at this $1000 face-value bond. When the bond was brand new, the original owner paid $1000 for it. A bond owner can always wait until maturity and receive the full face value. Since that first owner paid $1000, he or she will receive a yield of 8% on the original investment -- because $80 is 8% of $1000.

But later, Mr. First Owner decides not to wait until bond maturity, which might be 10 to 30 years in the future – cash is needed now – so the bond is sold. Let’s assume that since the original purchase interest rates have been moving down and are now just above 6%. This means that all income securities of a certain credit-quality class will all be priced to yield about the same amount.

And how is that accomplished?

• Think of the middle section of the above chart as a sliding scale – prices for the bond move up and down the scale based on – not the $80, since that remains constant – but according to current interest rates.

If current interest rates drop to 6%, the bond automatically finds its price level at around $1300, well above the face-value of $1000. But if rates shoot up, for example to 10%, the bond will find itself discounted at $800.

 

 

• Why? Because that’s what the annual return of $80 is worth when interest rates hit 10%.

 

Remember the general rule?

• When interest rates go up, bond prices go down.
• When interest rates go down, bond prices go up.

This interest rate risk is one of the hazards for bondholders, especially for those who might need to sell bonds before maturity.

Many of you reading this might remember the wild rollercoaster ride that interest rates took in the early 1980s. The prime rate hit 21.5%!!! The price of 30-year U.S. Government Bonds nose-dived by about 50%!!! Yes, of course, an investor could always hold the bonds to maturity to get full face value, but that’s not much comfort when maturity is the better part of 30 years away.

Anybody who bought bonds in order to have “stability” in his or her portfolio was badly shaken. Yes, this is an extreme example of interest rate gyrations, but “extreme examples” in the financial markets seem to pop up each decade and must be planned for.

In 1995 Forbes featured an article entitled, Who Needs Bonds? The author cited academic studies covering a time-frame of most of the 20th century. The study offered statistical evidence that bonds do not provide “worthwhile [portfolio] diversification as [their prices] often move in the same direction as stocks … bonds were not a good hedge against weakness in stocks.”

Why is all this so?

“Declining interest rates push up bond prices, but they also push up stock prices. In other words, declining interest rates are good for both stocks and bonds. Conversely, rising interest rates are bad for both, so they tend to move together more often than not.”

I have seen 15 or 20-year performance charts of bond mutual funds that claim an average return of 10% or more from bonds. If I invest in bonds or a bond mutual fund might I get a 10% return during the next 15 or 20 years?

The answer is -- almost certainly no.
Here’s why:

Marketing pieces sponsored by bond mutual funds featuring average returns since the 1980s are factually true – but some are also very misleading. These charts offer the implication that out-sized gains could be yours once more.

But the macroeconomic factors that produced these above-average bond returns are not with us today.

What caused these stellar returns?

Think about what’s been happening to interest rates for the last 25 years or so. Above I briefly referred to the very high interest rates of the early 1980s. Since that dramatic upward spike, rates have been coming down and down and down – all through the 1980s, all through the 1990s, and into the first years of the new millennium.
And what happens when interest rates move down?

Look again at the chart above. Notice that as interest rates move down, bond prices go up!

This is the cause of the big gains in bonds during the last 25 years. But rates today, as we all know, are relatively low. Today in 2007 the 30-year U.S. bond yields a measly 4.8%. We don’t need to be a dark-suit financial analyst to tell us that there’s not going to be another 15-point drop in rates from here.

This means that the potential for capital gains in bonds is very slim indeed. The next big move in interest rates, if and when it comes, can only be to the upside – and what will happen then? Long-term bondholders will suffer big losses as prices drop – the above chart tells you why.

What are Treasury Inflation Protected Securities (TIPS)?

Since 1997 the U.S. Government has offered what is known as Treasury Inflation Protected Securities or TIPS. TIPS rise in value as the consumer price index increases.
Are TIPS a good idea?

 

In my opinion, I don’t think so. They’re ok, but I think there are better alternatives. Though TIPS have an inflation-protection feature, this benefit is not free. The investor is charged for this protection by way of a smaller return.

For example, the average yield for a normal 10-year Treasury bond might be 4.3% -- but the 10-year TIPS might offer only 2.5%. Not too exciting.

Another big problem with TIPS is that the consumer price index (CPI) understates the inflation rate. There have been many articles discussing this of late, basically saying that “the CPI is a lie.” Low-balling the CPI means that TIPS will increase at a rate falling short of the true cost of living.

BONDS:  THE BOTTOM LINE

 

Can bonds help you to create that safe and growing retirement income that you can’t outlive?

 

If today were 1980 and 30-year U.S. bonds were yielding 15%, you could lock in a 15% cash return for 30 years!! Imagine that! And this doesn’t include your principal tripling in value over the next 25 years as rates sink lower and lower. Incredible!

 

[Editor’s note: By the way – I once did research at the library and looked at all of the old Forbes articles from the 1980s. I wanted to see what the smart money was saying in 1982 and before, at the start of the great Reagan bull market. One would think that, in the very early 1980s, advisors would be shouting to everyone to buy the long-term bonds in order to lock in 15% rates for 30 years. Well, guess what! I didn’t see one article advising that. Instead I saw a lot of gloom-and-doom sentiment asserting that Reagan’s tax-cutting “trickle down” fiscal policies were all wrong and that the country was headed for a new Depression – they said that interest rates would shoot up to 20% or 30% and to wait until then to lock in bond rates. This kind of blind wrong-headedness continued for some years into the 1980s, all the while the stock market kept on reaching new high after new high, with interest rates coming down and down – it was the time of the greatest economic expansion in the history of the world!!! The careers of certain previously long-standing Forbes writers never recovered from this kind of stupidity and they were dropped from the editorial staff never to be seen again.]

 

Well, this isn’t 1980, and there is little reason to buy long-term bonds today -- only to run the risk of rates moving up from here and suffering sinking bond prices. As the Forbes articles put it, Who Needs Bonds?

 

Another big problem with bonds is that the $80 annual interest payment, of which I spoke above, is fixed for years to come. This fixed income is no match for the ravages of inflation and the upward spiral of the cost of living. I advise you to always remember the lesson outlined in the Money magazine article (see below).

Any fixed income security that you might buy should be short-term in nature and used as a temporary parking place for cash.

 

 

Annuities: Overview

 

Allow me to begin this discussion by letting you know that I consider annuities to be of sub-par quality in terms of building a growing retirement income.

 

There are many problems with annuities. As mentioned above, in recent years, Forbes featured an article entitled, The Great Annuity Rip-Off, with the sub-title, “How Gullible Can Investors Get?”

 

Even so, annuities are hot items today, promoted often by “financial advisors.” So many “financial planning seminars” that you might see advertised are designed to sell nothing but annuities.

 

Why is this?

 

The incentives are enormous. Up-front commissions on long-term annuities range from 7% to 12%! One single successful seminar can net an annuity salesperson $100,000! Follow the money.

 

What is an annuity?

 

The word “annuity” might remind you of another related word, “annual,” which can help us with a definition.

 

The general mission of an annuity is to provide an “annual” income for life.

An annuity is a contract. The basic scenario is this: Someone pays a sum of money to an insurance company. The insurance company will guarantee a certain distribution of income over a stated period of time or until the death of the person(s) named in the contract.

 

Another way of thinking about an annuity is to see it as the reverse of a life insurance policy.

 

• Life insurance offers protection against financial loss due to dying too soon; an annuity offers protection against financial loss due to living too long – in the sense that one might outlive one’s savings.

 

The risks to the insurance company regarding each of these are different.

With life insurance, the insurance company must be able to pay possibly large sums of money in the event of premature death; with annuities, the insurance company must have the financial backing to make income payments to an annuity holder for potentially many years to come.

 

How do annuities work?

 

Generally, annuities have two possible phases:

 

(1) The Accumulation or Savings Phase: During this phase money is put into an annuity account. The annuity purchaser usually has the option of making savings deposits over many years; or a single lump sum can be deposited.

 

It is possible to skip the accumulation phase and, with a single lump sum investment, go straight to the distribution phase. This is called an immediate annuity.

 

• One of the biggest advantages to investors is that during the accumulation phase one’s money compounds completely tax-deferred.

• During the accumulation phase the annuity is called a deferred annuity because income payments have not started; that is, they are “deferred.”

 

(2) The Annuitization or Distribution Phase: During this phase, income is received by the investor.

 

During the distribution phase, what if I just want to receive a lump sum of money?

 

There are several payment options from which to choose:

 

• Life Annuity with No Refund: provides payments for life;
• Life with Refund: provides payments for life; however, if the annuitant dies before receiving at least as much as had been paid in, a beneficiary will receive the balance;
• Life with Term Certain: provides payments for life, with a minimum payout period;
• Joint and Survivor: provides payments during the lifetimes of two individuals;
• Fixed Period: provides payments for a stated period of time;
• Lump Sum: provides for a single lump sum payout.

It should be kept in mind that the more guarantees the insurance company is required to make, the greater its risk and costs; therefore, with increasing guarantees, the payout will be lower.

 

What are surrender charges?

 

The insurance company has many costs related to annuities.

 

• It has been stated, as a general rule, that for every dollar of annuity premium taken in, the insurance company has only ten cents to work with to pay for marketing costs and to earn a profit.

 

Because of the costs of creating a new annuity, plus the costs of making various guarantees to the annuity purchaser, the insurance company would lose money if investors treated an annuity as a short-term investment. This is why the insurance company requires a certain term of years during which it will levy a “surrender charge” --which is a kind of “penalty for early withdrawal” -- if money is taken too soon. The insurance company needs this period of time to make up its costs regarding the issuing of the new annuity – and among its biggest costs are the large commissions paid to salespeople.

 

Most surrender charges go down with each passing year and taper to zero after the full term of the surrender-charge period.

 

Remember: The annuity is designed to be a long-term place to keep your retirement savings. If you use it as a short-term investment vehicle, there will be a charge – like “penalties for early withdrawal” for a bank CD.

 

With all of this in mind, most annuity contracts do allow one to withdraw 10% of savings per year without incurring surrender charges. But consult your tax advisor regarding any IRS tax penalties.

 

Is tax deferral really all that important?

 

There’s an old saying: It’s not what you make, but what you get to keep that’s important!

 

Here’s a simple formula to help you find out if a tax-free yield is better than a taxable yield:

tax-free yield (divided by) 1 – tax rate

 

Assume that your federal and state taxes combined take 33% of your income. And, let’s say that you can get a 4% return tax free. But you can also earn 5.75% in a taxable account – which is the better return with taxes considered?

 

Subtract 0.33 from 1. This equals 0.67. Divide 4 by 0.67. This equals 5.97.

 

This means that for someone in the 33% tax bracket, a 4% tax-free yield is better than a 5.75% taxable yield – better by almost a quarter of a percent.

 

Will an annuity be affected by the probate process?

 

This is one of the primary advantages of annuities. Generally speaking, because an annuity is a contract, it bypasses the probate process, allowing beneficiaries to have immediate access to funds.

 

What is a premium bonus?

 

Some insurance companies, in order to attract your business, offer what’s called a premium bonus – of up to 10% (or even more). This means that if you have $100,000 to invest in an annuity, $10,000 extra will be deposited to your account for a total of $110,000!

 

How can the insurance company do this and remain financially sound?

 

The insurance company will generally require you to agree to a longer surrender-charge period. This will give them more time to make up for this extra cost to them.

 

Are all insurance companies the same when it comes to annuities?

 

It is prudent to deal with a highly rated insurance company. Since the insurance company makes certain payout guarantees in the annuity contract, it is best to do business with an insurance company with strong financial backing.

 

Who might be interested in annuities?

 

• Someone who wants a guarantee of continuing income;
• Someone who wants money to grow on a tax-deferred basis;
• Someone who wants an investment that will bypass the probate process.

 

I have heard that money from IRAs, 401(k)s or other qualified plan money should not be invested in annuities because IRA money and the like is already enjoying tax-deferred status. Is this the right way of looking at this?

 

The tax-deferred issue is a valid one – but there could be other reasons why someone might want to invest in an annuity. Look again at the above answer for reasons why someone might want an annuity. Generally, however, I would not recommend annuities for an IRA.

 

Do I have to pass a health test in order to buy an annuity?

 

The general rule is no because the insurance company does not incur risk when an investor dies prematurely.

 

Annuity payments received by women tend to be lower – why is that?

 

The reason is that statistically women live longer than men, a fact supported by actuarial evidence.

 

What is a 1035 exchange?

 

1035 refers to a provision in the tax code which allows one to switch from one annuity to another without incurring tax penalties.

 

What is the most important thing to keep in mind when buying an annuity?

 

Maybe the most important thing to keep in mind is that an annuity is a long-term investment. The insurance company offers many guarantees and has costs associated with these. For this reason the insurance company requires that investment money be left in place for some years.

 

How will my money be invested in the annuity?

 

Investors have three primary choices regarding annuity investment options:

 

• Fixed Annuities
• Variable Annuities
• Fixed Index Annuities

 

The highlights of each will be discussed:

 

Fixed Annuities

 

Fixed annuities offer a rate of return that is fixed and certain.

 

The annuity holder doesn’t have to worry about the day-to-day business of investing money – this is all done by the insurance company.

 

The insurance company guarantees the investor’s principal against loss.

During the distribution phase income received is also fixed.

FIXED ANNUITIES:  THE BOTTOM LINE

 

Can fixed annuities help you create that safe and growing retirement income that you can’t outlive?

 

The answer is: quite unlikely. Think of “Mr. 5 By 5” mentioned above.

 

Fixed annuity rates are usually too low to bother with. It’s true that money invested in fixed annuities is safe in terms of loss of principal, but after the accumulation phase there will be no further growth.

 

This means that fixed annuities will suffer the effects of the ever-rising cost of living. The problem of inflation has been discussed in earlier chapters and all of this applies to fixed annuities. Never forget the inflation factor as this will eat your retirement savings alive after fewer years than you might guess!

Variable Annuities

 

A variable annuity, in basic terms, is a mutual fund -- with insurance attached to it.

 

A variable annuity is not like a fixed annuity. Money does not grow at a fixed rate.

The value of a variable annuity is subject to all of the ups-and-downs that impact mutual funds.

VARIABLE ANNUITIES:  THE BOTTOM LINE

 

Can variable annuities help you create that safe and growing retirement income that you can’t outlive?

 

The answer is: I cannot recommend variable annuities at the present time.

 

In the above chapters on stocks, bonds, and mutual funds, I outline several reasons why the typical mutual fund is likely to deliver mediocre results for some years to come.

 

As such, I would recommend other places to invest your retirement savings.

 

Fixed Index Annuities

 

A fixed index annuity sounds like an investment in stocks. The name might cause some to assume that this is a kind of variable annuity.

 

This is not the case.

 

Here are some general, quick facts that apply to most fixed index annuities:

 

• It is a kind of fixed annuity.
• As with all fixed annuities, the principal is guaranteed. The preservation of your capital is guaranteed.
• It offers a certain guaranteed minimum interest rate return.
• It gives you an opportunity for extra interest based on the performance of an external index; for example, the S&P 500.
• It allows you to participate in some of the gains of the stock market without any of the downside risk!
• It will make money when the stock market rises but will not lose money when the market falls!
• Once interest is credited to your account, it is “locked in” – you cannot lose it due to a market downturn!
• The annuity investor does not have to monitor and keep track of investments or the market and make decisions on how to allocate investment funds.

 

If fixed index annuities are not a stock market investment (like variable annuities), how is money made when the stock market rises?

 

With a traditional fixed annuity, interest is credited to the annuity account based on current interest rates: the higher the current rates, of course, the greater the interest credited to the annuity account.

 

The fixed index annuity is also a fixed annuity and interest is also credited to the annuity account. But the difference lies in how the interest is credited to the account.

 

With the fixed index annuity, interest is not credited based upon current rates – interest is credited based upon how the stock or bond market behaved in any given year.

Again, this is not a stock market investment -- but an investment that earns interest based upon the activity of the stock or bond market.

 

If my money is not invested in the stock market, how can the insurance company offer returns or gains based on the stock market?

 

According to annuity experts, insurance companies generally will invest your annuity dollar like this:

 

• 10 cents goes to marketing costs and profit for the company.

• 70 cents goes to long-term bonds which guarantee principal.

• 20 cents is used to buy call options on a stock index.

 

I discussed stock options in one of the early chapters. They work this way: If the market goes up, these options will appreciate in value, allowing the insurance company to credit a corresponding amount of interest to your annuity account.

How much interest will I earn with fixed index annuities?

Fixed index annuities were designed by the insurance industry to offer a chance for a better rate of return than other savings instruments of similar safety. Many fixed index annuities have delivered an average return of 5% to 6% to investors.

 

Are there fees with fixed index annuities?

 

Fixed index annuities do have fees – but not like, for example, a mutual fund which might charge an upfront commission. Fees for fixed index annuities are similar to bank fees for CDs – you don’t really see the fees unless you decide to take your money out early – then there are “penalties for early withdrawal.”

 

It is possible to take some money out “early” if you need it. Most annuities allow for 10% withdrawals per year. Try to find one that allows for 10% of the full account value, not just 10% of premiums paid. Some annuities set you up with a checkbook to make it very easy to access your money. I would want that feature.

 

Can I lose money with fixed index annuities?

 

You can lose money with those “penalties for early withdrawal.” If you try to get your money early, you will be hit by fees. Also, there might be negative tax consequences as well – don’t put money into anything that isn’t earmarked as long-term savings!

 

Are all fixed index annuities pretty much the same?

 

They are not the same. There are about 60 insurance companies offering over 400 different annuity plans.

 

• There are an assortment of fees, calculated in dissimilar ways;
• A range of external indexes might be used, each with its own characteristics;
• Interest is credited employing various methods: some credit interest annually, some after a period of years; some set maximum interest amounts that can be earned in any one year; some have fees that do not change, others have the latitude to adjust fees;
• The result of all of these issues is that some insurance companies might allow you 100% participation in the annual interest earned -- but still credit your account less interest than another company with a 70% participation rate.

 

All of these possible differences can create a lot of confusion -- and much of this is probably designed to be confusing. No-risk participation in stock market gains sounds very appealing -- but when the potential return is analyzed, there’s not too much there to get excited about.

 

What if the stock market goes down 20% in one year? I understand that my principal will be protected-- but do I have to wait for the market to reclaim that 20% and “get back to even” before I can have gains credited to my account again?

 

No. This is one of the advantages of fixed index annuities. Also, there is one feature that I will mention which seems to be better than others. It is known as the annual reset method of crediting interest.

 

If the market ends the year down 20%, your starting point is “reset” at that lower level. This means that if the market recovers by 15% the next year, you will share in some of that 15% gain – even though the market is still “underwater” in terms of where it was 2 years before!!

 

The annual reset method works well in both rising markets and in up-and-down markets. Quite frankly, there are no other kinds of markets. Markets do not go down and down forever.

 

This volatility is all you need to make some money with the annual reset method. Generally, ignoring cash dividends for the moment, if you invest in stocks directly or via mutual funds or variable annuities, you will make money only if stocks go up – but with fixed index annuities all you need is price volatility. History shows that this is one thing not in short supply.

 

Few insurance companies use the annual reset method. Here’s what one author says: “… an annual reset design is very expensive for the insurer… [and] has the lowest participation rate [among insurers].”

 

Because this method is expensive for the insurer, the insurer can limit its risk and costs by employing things like caps and participation rates. This means that in years when the stock market goes up wildly, your upside will be capped at a certain level; or you will be allowed to participate in gains according to certain limiting percentages.

 

Many of the fixed index annuities offer to credit interest based upon a monthly average of stock market gains. I think it’s usually best to avoid these. The stock market can often lie dormant for significant stretches of time – but then burst to life and move many percentage points in a short period of time. It’s better to choose a crediting system that allows you to share in outsized gains when they occur rather than an “averaging” system that is designed to “smooth out” your returns to puny low levels. Discuss this with your advisor.

 

FIXED INDEX ANNUITIES:  THE BOTTOM LINE

 

Can fixed index annuities help you create that safe and growing retirement income that you can’t outlive?

 

The answer is: not really. Even the better fixed index annuities offer the prospects for only mediocre returns, probably no better than a long-term average of around 5% to 6%. The above-discussed message from The Parable of The Stamps tells us why 5% to 6% will likely not solve our financial problems.

 

Annuity salespeople will try to scare you by emphasizing the “volatility” of other investments – all the while ignoring the greatest scare of all, running out of money due to the ever-rising cost of living.

 

 

 

Failing with "Guaranteed" Investments

Guaranteed or fixed-income investments may have an important place in some investors' serious-money portfolio. But is it possible to get too much of a good thing?
And are all securities in this class about the same, that is, is a CD or municipal bond just as good as a T-bill or something else? In any case, how can the notion of a "guaranteed" investment be properly linked with "failing"?

A surprising number of people fixate on risk of capital loss as their only problem. Granted, this is not something to forget, but, frankly, this is not the prime threat to the average investor. The great destroyer of wealth in our generation has been the rising cost of living! Bonds, T-bills, CDs, annuities and the like offer varying degrees of guarantee relative to risk of capital loss, but typically offer no protection regarding the risk of inflation.

Read about the case of Dr. Charles Mayo (of the famous clinic) and his heirs:

The Supreme Court of Minnesota was asked by the Mayo heirs to change the instructions of a trust created by their famous donor. Dr. Mayo had left instructions that trust assets could be invested only in "mortgages, municipal bonds or any other form of income-bearing property but not corporate stock."

Obviously, the good doctor was quite risk averse and, wanting the best for his heirs, tried to protect them from loss from "risky" stocks. However, 20 years after his death, inflation had cut the asset value of the trust portfolio by more than 50%! The High Court granted the heirs permission to change the investment instructions to allow for stock purchases on the basis that this was in keeping with Dr. Mayo's intent to preserve trust assets, notwithstanding his ignorance regarding the threat of inflation and the benefit of investing in common stocks (In Re Mayo Trust, 105 N.W. 2d 900, 1960).

 

 

 

Here's another famous person whose net worth was hit hard by cashing out of stocks and buying municipal bonds and T-bills: "Whatever you may think of Ross Perot as a politician, you have to admit he has been a lousy investor lately... Perot got on The Forbes Four Hundred by starting ... EDS... In 1987 he was worth $2.9 billion and was number three on the list. At that time he held a huge position in bonds and T-bills... [today he's dropped to] 33rd place on The Forbes Four Hundred. Had he in 1987, instead of staying in cash and near-cash instruments, simply invested in an S&P 500 index fund, he would still be about number three on [the list] and would be worth $7 billion -- nearly three times what he is worth today... If you want your net worth to grow, [stay in stocks]. Bonds are OK if you are very old or can't afford any [market-fluctuation] risk" (Forbes, October 16, 1995).

What about municipal bonds? I don't like them very much. The tax break is nice, but the return is too low. Inflation will eat you. The guarantee here is, all things considered, a guaranteed loss. And I'm under-whelmed by the safety of principal factor here as well. Municipal bonds derive strength only from a municipality's ability to tax its residents, something O.K. in a good economy but a shaky reed on which to support your financial future if you suspect that the country could head into tough economic times down the road. Also, recent articles have warned investors about state and local governments’ unfunded health care liabilities – all of this means that there’s no compelling and absolute safety to be gained by hiding in municipals.

 

 

 

Though risk of inflation is probably the most important point on this subject of "guaranteed" investments, a word should be said about purported safety of capital. A guaranteed investment is only as good as its guarantor. Is it conceivable that there could ever come a day when U.S. Govt. securities might not be worth cashing in? Seems strange to contemplate it, but then we've never before had a multi-trillion dollar debt.
Though written many years ago, it's worth listening to what Warren Buffett has said on this subject:

"...we dislike the purchase of most long-term bonds under most circumstances and have bought very few in recent years. That's because bonds are as sound as a dollar -- and we view the long-term outlook for dollars as dismal. We believe substantial inflation lies ahead, although we have no idea what the average rate will turn out to be. Furthermore, we think there is a small, but not insignificant, chance of runaway inflation. Such a possibility may seem absurd, considering the rate to which inflation has dropped. But we believe that the present fiscal policy -- featuring a huge deficit -- is both extremely dangerous and difficult to reverse. (So far, most politicians in both parties have followed Charlie Brown's advice: 'No problem is so big that it can't be run away from.') Without a reversal, high rates of inflation may be delayed (perhaps for a long time), but will not be avoided. If high rates materialize, they bring with them the potential for a runaway upward spiral... In that circumstance, a diversified stock portfolio would almost surely suffer an enormous loss in real value. But bonds [and CDs, etc.] already outstanding would suffer far more."

Sober thoughts from the world's greatest investor. Mr. Buffett wrote these words in 1985 (his annual report) when the US federal debt had risen to $1 trillion. More true today, his cautionary advice has not lost its potency several trillions of debt-dollars later.

Let's talk extremism. What kinds of investments survive when world empires fall?
I'm not about to write anything in stone, but consider this: The Soviet Union is no more and ruble-denominated CD's, bonds, and t-bills are suitable for wallpaper -- but McDonalds wasn't overly fazed by the revolution and continues to push burgers in Red Square and in a hundred other countries! Forbes reports: "Those who held stocks through the German hyperinflation of the 1920s preserved capital while bondholders were wiped out. The same happened with German and Japanese stocks after World War II."

There may be a lesson for us here.

 

Why Is It Important To Double My Income Over Time? Why Can’t I Just Spend Whatever Income My Investments Produce?

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