The research notes that “the purpose of the portfolio is to pay for an ongoing liability, which in the case of a retiree is to provide retirement income.” The “liability” of retirement income is obviously heavily influenced by inflation as one of the greatest risks in retirement is losing purchasing power over time.

How it works

To illustrate this concept Morningstar compares the performance of 3 test portfolios under various inflation conditions. Their “Liability-Relative Portfolio” performs the best under medium to high inflation, most notably because of the high allocation to US TIPS at nearly 50%.

While this is a constructive point, you want your portfolio composition to be reflective of your overall cash flow needs; using the Liability Relative asset allocation they describe places a heavy bet on high inflation in retirement.

This seems a bit presumptive to put such a heavy allocation on inflation protected securities throughout retirement. We would like to see this allocation adjusted throughout the retirement period based on market conditions and the economic environment, rather than a fixed assumption that inflation will be high.

Risk Capacity

This strategy relates closely back to asset allocation and using a risk level compatible with your goals. We feel that using a guide like our risk capacity model for portfolio construction and continuously monitoring those investments is more critical to long term success than making a particular bet on inflation conditions. The Morningstar analysis seems to reflect this as Liability Relative Optimization is the least impactful of the five factors, estimated to add only $.02 on every $1 of retirement income.

A Step in the Right Direction

Overall, the Gamma research is a step in the right direction toward measuring money managers by a metric other than investment performance. While producing alpha over long periods of time is achievable with a consistent strategy, it is impossible to deliver over every time period. The benefit of making good financial planning decisions also extends far beyond the annual return on your investment portfolio.

This research identifies five factors that add to retirement income. However, we feel this is just the tip of the iceberg to what solid planning can achieve. In the context of retirement this is very powerful, but it also begs the question, how much value can be added if prudent strategies are applied throughout your career?

Asset Location

Asset Location refers to where asset types are held.  For example, a general rule of thumb is to hold stocks in taxable accounts as they are subject to lower capital gains taxes, and to hold bonds in tax-deferred accounts since their income is taxed at ordinary rates.

Of course, client specific considerations always have to be taken into account, but applying these principals over time can reduce tax liability and increase net worth potential.

Withdrawal sourcing

Withdrawal sourcing refers to which accounts you pull from to meet your income needs.  If you are using the 4% rule, as we discussed in a previous post, then you may just apply this to your IRA or 401k.

However, annual tax planning would likely identify savings that could be achieved by shifting some of those withdrawals to another account type.  This can be very beneficial in retirement, especially taking into account the taxation of social security.

The Morningstar analysis looks at the use of a 401k or IRA combined with a taxable account.  However, they do not include a Roth IRA and note that, “additional potential Gamma gains are possible for a retiree who has money in Roth-IRA type account.”

Roth IRA

The Roth IRA is a very valuable retirement planning tool, and as financial planners we typically recommend it to all clients who are eligible.  Since the accounts are relatively new, current retirees may only have a modest balance in Roth IRAs.

However, contributing to Roth IRAs throughout your career has the potential to add significant value to your retirement income and allow further tax efficiency.

Photo credit: DucDigital

What’s the catch?

The most important thing to note is that a payout rate is far different from a rate of return.  The payout rate is only achieved if you live a very long time.  Premature death 10-15 years into annuity payments will yield a negative return on your investment.

Click to enlarge

The following chart illustrates how the annuity will yield a negative return in the first several years after purchase and approach the payout rate over time.

Notice that if we assume purchasing the annuity at age 65, the rate of return does not turn positive until after age 80.

What is an annuity?

Purchasing a fixed annuity is essentially buying insurance against living too long and it is important to note that it works very similarly to other forms of insurance.

Your money is pooled with funds from other annuitants and those who live a very long time benefit from the lifetime income stream while those who die early lose much of their investment.

Since the greatest financial risk for retirees is running out of money, this is a popular strategy and can be worthwhile depending on the rest of your financial situation and how long you expect to live.

However, the factors described above, the costs associated with annuities, as well as other factors often make them unattractive.

Our two cents…

In our view, this illustrates that the use of an annuity is less definitive in retirement planning than the other strategies and needs to be analyzed in the context of each client specific situation rather than accepted as appropriate in all cases.

But financial planning isn’t “one-size-fits-all.” Before any major decisions, be sure to consult a financial planner who can advise you on the best course of action based on your personal situation.

Unfortunately, many retirees rely on a rule of thumb or use no plan at all when deciding how much to withdraw. Many people have heard of the 4% rule. Essentially this rule of thumb entails withdrawing 4% from your nest egg in the first year of retirement and adjusting that amount for inflation annually. This is advice you would likely find in a Do-It-Yourself investing manual.

The 4% rule is strong in theory, but it is inherently problematic in practice as it does not take into account lifestyle changes and extraordinary expenses that are likely to occur over 30 years or so in retirement.

Given the dynamic nature of our lives, it is not surprising that the recent Gamma research by Morningstar indicates that using a Dynamic Withdrawal Strategy has the greatest impact on increasing your retirement income. “Under this approach, the percentage withdrawn from the portfolio will vary in a given year based on assumed remaining life expectancy of the retiree/s and the portfolio equity allocation.”

At Financial Symmetry, our financial planners go a couple of steps further in developing custom retirement income strategies and optimizing Gamma. In addition to creating a dynamic withdrawal strategy, our process allows for adjustments based on changes in the tax code and/or lifestyle changes as they arise. This typically also entails evaluating when to start social security, the best pension distribution option, and plan feasibility over time.

The Gamma research highlights the importance of continuously monitoring your financial position and making adjustments regularly to stay on track. Contact one of our financial planners to find out how a dynamic withdrawal strategy can work for you.

Photo credit: stockmonkeys.com

In our previous post we noted that the research on Gamma identifies 5 financial planning strategies that add to retirement income.  The first of these is Total Wealth Asset Allocation.  The simplest definition of this is using a client specific asset allocation strategy based on how much risk is appropriate rather than relying primarily on risk tolerance or a basic rule of thumb (60% stocks/40% bonds).

Morningstar goes on to say that, “Most techniques used to determine the asset allocation for a client are relatively subjective and focus primarily on risk preference (i.e., an investor’s aversion to risk) and ignore risk capacity (i.e., an investor’s ability to assume risk). In practice, however, we believe asset allocation should be based on a combination of risk preference and risk capacity, although primarily risk capacity.”  The Gamma research cites the 2010 Survey of Consumer Finances which suggests that the average stock allocation for investors age 65-95 is only 20%.  This may be overly conservative in many cases, leading retirees to lose pace with inflation and strain their long term income potential.

We agree with Morningstar that this is a very valuable part of the financial planning process.  At Financial Symmetry, we have been using a similar strategy for over a decade with our Risk Capacity Model.   This allows our financial planners to determine how much risk is appropriate for your investment accounts and design a strategy customized to your specific needs.  Using such a model provides for keeping enough funds in conservative investments to meet your short term needs, while allowing other funds to be invested for the long term.

Source: Morningstar Research, “Alpha, Beta and now…Gamma” September 8, 2012

The Morningstar research introduced a new concept called “Gamma.”  Gamma is intended to determine the additional retirement income that can be achieved by smart financial planning and presents a new way to measure the value potential in a financial planning relationship.

Many investors understand that comparing their investment performance to index benchmarks is one good way to see the value provided by their financial advisor.  In the investment world, this is known as alpha-the excess return provided through active management.

Other benefits of working with a financial advisor, such as tax efficiency and smart asset allocation, are much more difficult to measure.  The Morningstar research attempts to do just that by quantifying the additional value of financial planning strategies, “Gamma.”

The report notes that “Individual investors invest to achieve goals (typically an inflation-adjusted standard of living), and doing the things that help an investor achieve those goals (i.e., adding Gamma) is a different type of value than can be attributed to alpha or beta (a measure of risk) alone, and is in many ways more valuable. Therefore, asset-only metrics are an incomplete means of measuring retirement strategy performance.”

This research identifies five strategies that can add to retirement income.  We’ll look at each of these in more detail in future blog posts.

Source: Tax Credits

Traditionally the costs associated with investing have been fairly difficult to ascertain.  Mutual funds charge expense ratios to pay managers and support staff while custodians and plan administrators also need to be compensated.  These costs are deducted from the funds invested in your accounts, but typically the expenses are not itemized on your statement and many investors are unaware they even exist.

A 2011 AARP survey concluded that 71% of 401k participants did not know they were paying for any plan costs.  New fee disclosure regulations intend to make these fees more transparent for both employers and employees.  The quarterly statement you receive in November should provide new details on the fees deducted from your account.  It should explain how the plan works and what fees may be applied in addition to showing the investment options and their corresponding performance and operating expenses.

While many investors are not familiar with the fees in their 401k, the costs associated with these plans are something we monitor closely for all of our clients.  Some plans are better than others in terms of investment choices, expense ratios, and administration costs.  These are things we take into account when deciding how to allocate investments across accounts and whether to rollover plan balances after retirement or a job change.  If you have questions about the new fee disclosures please contact us to review the statements with you.

While you may be able to reduce your investment fees by rolling over a high cost plan after a job change or retirement, what can you do if you are stuck in a high cost plan with your current employer?  Even if plan expenses are high, contributing to your 401k is still likely a good savings strategy.  Your employer may offer a generous matching program to offset some of the higher costs or there may be a few good mutual fund choices that complement the rest of your portfolio.  Putting the spotlight on fees should also pressure plan administrators to examine their offerings more closely.  You may also consider contacting your HR department to request lower cost fund offerings.

Have you been seeing the commercial below a lot lately?

What is Medicare Open Enrollment?

It is open enrollment season for Medicare prescription drug (Part D) and Medicare Advantage Plans (Part C).  The enrollment period runs from October 15th through December 7th and allows participants to make changes to their coverage for the coming year.  (Download PDF: Understanding Medicare Enrollment Periods)

How does your current coverage compare?

A recent survey released by Medicare Today and KRC Research found that the majority of seniors are satisfied with their current coverage and only 1 in 3 plan to comparison shop for a new plan this year.  However, the study also notes that most are not aware of the open enrollment period or the comparison tools available.  (Download PDF of full report.)

Where do I begin?

Even if you are satisfied with your current coverage, it is a good idea to reevaluate your options every year to make sure it is still the best fit for you.  You may even be able to save some money.  Below are some tools to help with your shopping:

• The Medicare website offers a Plan Finder Tool to evaluate your options.
• The State Health Insurance Assistance Program
• The Medicare Rights Center (1-800-333-4114)

The recent Semi-Annual letter from Davis NY Venture had the best description of this risk that I have read in some time:

…In the face of such negative articles and press reports, the desire to sell stocks 12 years into a bear market in order to buy bonds at their all-time high or hold cash with a zero percent interest rate is perfectly understandable from a psychological point of view. However, it is likely to be significantly wrong from an economic point of view. Nervousness, pessimism and uncertainty have driven down prices and the golden rule of investing is that low prices increase future returns.

… The idea that cash and low yielding government bonds are “risk free” is one of the most dangerous fictions there is. After all, a dollar hidden under a mattress 50 years ago has lost more than 80% of its purchasing power and now can only buy what 20 cents used to buy. It is hard to understand how an asset that has declined 80% in value over 50 years can be considered risk free. Yet despite an 80% decline in purchasing power over 50 years, investors continue to describe holding cash as “risk free.” A dollar invested in the late 1960s in Davis New York Venture Fund has increased its purchasing power twenty fold and now has a nominal value of more than $100.¹⁴

Our positive outlook for stock returns is not based on a rosy economic outlook. The deflationary trends from global deleveraging continue, Europe is a mess, Washington dysfunctional, and Asia slowing. But today’s low valuations discount a great deal of bad news. Furthermore, because our companies tend to pay dividends and repurchase shares, they should be able to generate satisfactory investor returns even with relatively anemic earnings growth. In short, by remembering that stocks represent actual ownership in real operating businesses, investors can focus on the quality, durability and profitability of these businesses and tune out the blaring headlines, day-to-day noise and rampant pessimism. While no one can know for sure what the future holds, we do know that our Portfolio is made up of world-class companies generating an earnings yield of close to 8%, much of which they are returning to shareholders. These facts are what make us look to the future with optimism.

We share this general viewpoint and outlook for the markets over the long term.  Unfortunately, holding only investments that are “risk free” is like living a life that is “stress free,” it is simply not possible.  Therefore we have to operate in the world we have and use tools to manage the risk inherent in investing.

What is your exposure?

Businessweek recently ran an article exposing $2 billion in losses last year among employees of the five largest Wall Street banks-JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley.  The losses were attributable to company stock, in many cases the employee’s largest holding within their 401k plans.

With the recent Occupy Wall Street movement and anger towards the 1%, you may not feel much sympathy for Wall Street employees.  However, this predicament is not unique to employees of financial companies and highlights the danger of a familiarity bias.  This bias is similar to the “home team bias” in sports and leads to buying companies that you know or have a certain loyalty to.  Working for a company for many years may even breed an emotional attachment to the stock position.  This is understandable as career success may have been tied to growth of the company.

The article cites Morgan Stanley’s practice of matching 401k contributions with shares of company stock as one of the ways employee accounts become over weighted in employer stock.  This is just one example of how employee’s portfolios can accumulate a large percentage in company stock.  Several years’ worth of Employee Stock Purchase Plan contributions, Stock Options, Restricted Stock Units, a 401k position all coupled with company growth can lead to an over-allocation in an individual stock.  These positions also tend to be scattered among multiple accounts.

Unfortunately, many investors don’t even realize that they are exposing themselves to so much risk.  Unless you consistently review your investment accounts, you may not know what percentage you have allocated to company stock.  Applying a diversified investment strategy over the long term and periodically reviewing your portfolio reduces the likelihood of suffering the consequences of a familiarity bias.