Why You Shouldn’t Annuitize

As more companies do away with their pension programs, the insurance industry and the media are heavily promoting the use of immediate annuities to provide a dependable income stream during your retirement. But is that in your best interest? Normally, I say it is not. Read on to find out why. An immediate annuity is one where you pay an insurance company a lump sum in return for a stream of income. You can decide if the income stream is guaranteed for a certain number of years (period certain), for a set number of years or your lifetime—whichever is greater; and whether your spouse should receive benefits for his/her lifetime after your death. Since you can receive a set payment for life and can also provide for your spouse after your death, this is seen as a ‘perfect’ pension replacement. There are four main reasons that I don’t advise this. First, when you buy an immediate annuity you exchange a lump sum for a series of monthly payments. The lump sum is gone…forever. At that point your return is dependent on how long you and/or your spouse live (unless you chose period certain). If you live longer than the life insurance company expects then you get a higher overall return on your investment. If you die before then your return drops considerably. For instance, Jack and Jill are both 62 and buy a joint life annuity for $250,000. In return, they’ll receive $1468 every month for the rest of their lives, regardless of who dies first. After the remaining spouse dies, that’s it. Nothing goes to your children. Assuming their joint life expectancy is 85 years old, the internal rate of return on the annuity is about 4.6%. If they both die at 75 years old their average annual rate of return is negative 1.3%. If at least one of them lives to age 95 then the return on the investment was 6.1%. So your expected return is 4.6%, but your actual return may be more or less. That illustrates another reason that I don’t think people should annuitize—all they are doing the first so many years is getting back THEIR money. Picture putting that same $250,000 under your mattress. Then each month you reach in and pull out $1468. You wouldn’t run out of money until 14 years later! That’s if you aren’t earning interest on it. If you just put the money in a money market earning 3% you could keep using it until age 80. Interest rates have been going up and some money market accounts are paying 4.75%. Use one of those (or buy a 30-year Treasury bond) and you would cover the payments until one of you reached 86. There are other benefits of not annuitizing. If your situation changes and you want/need access to more than the $1468 a month, you have access to the remaining principal. If you die before the money runs out the remainder can go to your children. The return you receive isn’t based on how long you live but on how it is invested. Over time, inflation is your greatest risk. Jack and Jill’s annuity payment does not increase for inflation each year. If it did, it would be much lower to start with. Doing it yourself allows you to increase your payments over time if needed and/or based on your return. Obviously, I feel there are better ways to invest $250,000 than putting it in a money market or CD. Over a similar period of time, a well-managed, well-diversified portfolio of stocks, bonds and real estate should average 8% or more. If so, you can meet the same income payment, adjust it for inflation and possibly never even touch your principal. Even if you end up using some principal, the chances are much greater that there will be money leftover for your heirs. Some would rather let an insurance company bare the risks for them. There are risks to doing it yourself: interest rate risk, undisciplined spending, market risk, etc.. But these are easily mitigated in a well-managed portfolio, and are far outweighed by your ability to earn a higher return while maintaining access and control of your money. Have a financial question? Send me an email and I’ll personally respond, free of charge. Go to www.guardingyourwealth.com and click on ‘Ask Jeff’. In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.

When To Start Social Security Benefits

Conventional wisdom and many financial planners say that you should start taking Social Security benefits as soon as you are eligible. For many, that is at age 62. This is another time that conventional wisdom may be wrong. Read on to see whether you should delay receiving those benefits. A bird in the hand is better than two in the bush, right? There’s no guarantee that you will be able to catch the birds in the bush and you know that you already have a bird in hand. If that bird represents your next meal then you’d be a fool to let it go in hopes of catching several birds in the bush. On the other hand, if you have enough birds in the freezer to feed you for several months it might be worth taking the chance on the multiple birds in the bush. Better yet, is there a way you could have both? If the bird in question is your social security benefits, you may do better waiting for the birds in the bush. This is especially true if you have enough money in savings to meet your needs for the next several years. Even if it means spending down your principal to postpone the date you start benefits, you may be far ahead in the long run. You’d get the bird in hand and the ones in the bush! On the other hand, if you aren’t able to meet your needs based on what you’ve set aside, than the bird-in-the-hand (taking benefits at age 62) is the better choice. Regardless of when you start Social Security payments, make sure you don’t delay receiving Medicare. Conventional wisdom says that you should take benefits at age 62 because you can invest that money and earn a better return then Social Security does. We’ve all heard how the average return on the Social Security Trust Fund is only 1%, right? Wrong. You can earn a guaranteed 8.25% per year by delaying when you start receiving benefits from age 62 to age 66. And it doesn’t depend on what the stock market does. It doesn’t matter what happens to interest rates. Taking benefits at age 62 results in receiving only 75% of the amount you would get if you wait until you turn 66. Every year you wait, the amount you receive increases. By waiting until age 66, the annual increase averages 8.25% per year. The average annual return you are guaranteed by waiting until age 70 is 10% per year. Benefits increase 8% every year past age 66. Waiting from age 62 to age 70 results in monthly payments that are 81% higher. If you or your spouse lives beyond age 79 then you will be better off delaying benefits. Average life expectancies indicate that roughly 50% of those age 62 today will live beyond age 80. Medical advances will only increase that over time. The risk of delaying benefits is that the main breadwinner may die prior to your breakeven age. That would still result in higher monthly payments to the surviving spouse who may live much longer. You can also use low-cost term life insurance to make up for the lost benefits. Many of those retiring today have not set aside enough to provide for themselves and their spouse for the rest of their lives. Some face the prospect of draining their retirement savings and living just off of Social Security if they live beyond their 80’s. Even if you will use up your savings more quickly in the short-term, delaying the start date until age 70 could significantly improve your Social Security lifestyle. There’s no way to tell with certainty what the best decision is for you because none of us know our life expectancy. If you think, based on your family history and present health that you will live beyond age 79 and you have enough assets to provide the money you need until age 65 or 70, then you may want to wait. Some insurance companies recommend buying an immediate annuity to provide a payment equivalent to what Social Security would otherwise provide, but I don’t recommend that approach and will explain why in the next article. Have a financial question? Send me an email and I’ll personally respond, free of charge. Go to www.guardingyourwealth.com and click on ‘Ask Jeff’. In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.

Are Low Cost Annuities A Good Choice?

I’ve disliked variable annuities for many years because of their high fees and onerous surrender penalties. Now, low-cost variable annuities are available that slash fees and do away with the surrender penalties. Does this change my opinion on the use of variable annuities? Read on to find out. There is $1.8 trillion dollars invested in annuities and a lot of that money is in variable annuities. To put this in perspective, there are $2.1 trillion in 401(k) assets. That’s right. There’s almost as much money in annuities as there is in 401(k) retirement programs! As I’ve mentioned in previous articles on variable annuities (available at www.guardingyourwealth.com), variable annuities are sold because of two main features—tax deferral and a death benefit guarantee. Tax-deferral is emphasized if you are investing non-retirement money. Instead of having to pay taxes on dividends, interest and gains each year, those taxes are deferred until you withdraw the money from the annuity. This used to be an attractive option, but not since capital gains and dividend tax rates have been lowered to a maximum of 15%. You see, earnings withdrawn from an annuity are taxed at higher ordinary income rates. These can be as high as 33%. In years past there wasn’t much difference between ordinary income tax rates and those on dividends and capital gains. Now, there is a substantial penalty when earnings are taxed as ordinary income. As a result, it can take decades before you really see the benefit of tax-deferral. The other main selling point of variable annuities is the death benefit guarantee. Investors like the peace of mind knowing that even if the market drops substantially, their heirs will get at least what they initially invested when they pass away. This is used to entice investors to choose an annuity for their IRA where the annuity’s tax-deferral feature is worthless. Unfortunately, investors had to pay through the nose for those benefits—typically 1.4% of the value of your account each year. On a $200,000 account, you would be paying $2800 a year. Over ten years it is likely those benefits would cost over $30,000. That’s some of the most expensive insurance you will ever buy. Now there are new, low-cost variable annuities available from companies like Fidelity and Vanguard that lower the costs of these benefits. For instance, Fidelity offers one that charges ¼% in fees each year. That’s 1.15% less each year then the typical variable annuity. The Fidelity variable annuity still offers the much touted benefit of tax-deferral but it does not offer the death benefit guarantee. If the death benefit is the main reason you want a variable annuity, you can achieve that goal with the Fidelity variable annuity by purchasing a separate term life insurance policy. Doing so would save a 60-year old non-smoking man almost $15,000 over ten years versus the typical variable annuity. As investors age, these savings decrease. But even then, you have to realize that your ‘guarantee’ is actually much higher with a private life insurance policy than it is with the broker-sold variable annuity. In the broker-sold variable annuity, your either get the market value of the contract OR the death benefit, whichever is higher. When you buy a low-cost variable annuity and a separate life insurance policy your heirs receive the market value of the annuity PLUS the death benefit of the life insurance policy. Even if the annuity loses half of its value, your heirs still end up with 50% more than the broker sold annuity. So even if it costs the same it is still more benefit. And you can keep the insurance policy even if you cash out your annuity. The only situation I would recommend a low-cost, no surrender penalty variable annuity is if you currently have non-retirement money in a high-cost variable annuity and you have amassed a significant gain. Even if you have surrender charges, it may be worthwhile—see how many years it would take to make up the difference. For everyone else, I still do not recommend it. If you have IRA money in an annuity, I suggest a non-annuity IRA when your surrender penalties end. You can achieve the same benefits for far less cost. Have a financial question? Send me an email and I’ll personally respond, free of charge. Go to www.guardingyourwealth.com and click on ‘Ask Jeff’. In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.

You May Be Too Conservative

You may be in danger of running out of money and not even realize it. Investing conservatively today might actually jeopardize your lifestyle tomorrow. Read on to see what I mean and how you can tell if your retirement comfort is in danger. Traditional financial planning ‘wisdom’ says that as you get older you should become more conservative with your investments. The profession equates ‘more conservative’ with owning more fixed investments such as bonds or certificates of deposit. The rule of thumb is that you should have your age in bonds—if you are 50 years old, you should have 50% of your portfolio in bonds. But conventional wisdom ignores the fact that life expectancies are rising dramatically. Longevity places a tremendous burden on our investment portfolios. Think about it. You may end up living off of your nest egg for a longer period of time than it took you to save it. Conventional wisdom also says that you will probably only need 70% of your pre-retirement income to live off of. But very few retirees choose to reduce their standard of living. The bottom line is that you probably need to earn more than you think. Let me give you an example. Let’s say you set aside one million dollars to fund your retirement. It sounds like a lot of money, but a million dollars doesn’t buy what it used to! Let’s also assume that you need $50,000 a year off of your investments to supplement your Social Security income. That’s sounds like it should be really easy. All you have to do is earn 5% and you will make enough to take out $50,000 a year. So why not put the majority of your portfolio in conservative investments? The reason is because you must earn much more then 5% a year if you want to maintain the same purchasing power. The amount of money we withdraw may be the same, but it will buy less and less. The historical rate of inflation is around 2.5% - 3% a year. If we need $50,000 this year, we will need $51,500 next year to live the same lifestyle. We’ll need $53,045 the year after that. In ten years that amount climbs to $65,239. Twenty years down the road—still well within the life expectancy of the 60-year old retiree, $87,675 will be needed. After 30 years you will need a staggering $117,828 to buy the same things that $50,000 buys today. If all you earn each year is 5%, you will start spending principal the second year! Each year you will have to use more and more of your original investment to maintain the same lifestyle. The entire one million dollars will be gone in 26 years. To maintain your lifestyle and the one million dollar original investment, the portfolio will need to average about 7% per year. That’s about 40% more each year than what conventional wisdom tells you! Here’s the problem most retirees face. You need to earn more, but that will require you to invest more in real estate and equities. The fear of losing money keeps many from pursuing the rate of return they need. The brokerage industry’s answer to this problem is that you just need to relax. If the market goes down, just hang in there—it will come back. That’s crazy. The insurance industry’s answer is to buy an annuity. They suggest equity-indexed annuities or variable annuities with lifetime income benefits. Unfortunately, these ‘benefits’ are often more illusion then reality and require you to lock up your money for years. It’s ridiculous. You don’t have to lose control of your money or place all of it at risk in order to pursue higher returns. It may take time, but you can find advisors who have developed solutions. For instance, I’ve developed the Portfolio Guardian. With it, my clients are comfortable investing in ways that will earn them a higher return, because they know that the downside risk of loss is limited. And they retain complete control. Don’t put your lifestyle at risk. Find out if you are investing too conservatively so you can make adjustments before it’s too late. I’ve created a simple spreadsheet that will allow you to see how much you need to earn. Go to www.guardingyourwealth.com and click on ‘Ask Jeff’ to request your copy. In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.

Is Your Portfolio Properly Seasoned?

The effect interest rates have on the performance of our economy cannot be overstated. Understanding how interest rates affect the business cycle will help you know how to structure your portfolio to achieve growth while minimizing risk. Read on to learn more. Would you wear a winter parka on a Florida beach in the middle of summer? Of course not. I doubt any of us would wear a bikini to go ice fishing in the middle of a Minnesota winter—I know I wouldn’t! Clothes are a tool that is used to help regulate our body temperature. They protect us from the cold or keep us from over-heating. Their proper use determines our comfort from one season to the next. We don’t want our body temperature to wildly fluctuate up and down. It’s the same when it comes to investing. Unfortunately, many don’t understand the changing of economic seasons and therefore fail to adjust the clothing used in their portfolio. As many saw in 1997-2000 and 2000-2002, the investment clothes that work in one season are close to useless in another. There are economic business cycles. There are seasons when the economy is expanding, other’s when it is contracting. There are also times (called peaks and troughs) that are like spring and fall—times of transition from one major cycle to the other. Interest rates are one key in determining where we are in that cycle. The Federal Reserve uses the rate it charges on over night loans to banks (the Fed Funds rate) as an accelerator or brake on the economy. It may seem strange that small changes in the over night rate banks pay could have an impact on the overall economy. Banks lend more money then they receive in deposits. That ‘extra’ money comes from inter-bank loans and is referred to as the Fed Funds Market. It stands to reason that if a bank pays more on what it borrows, it will have to earn more on what it lends. The Federal Reserve controls the Fed Funds rate by putting money into the inter-bank loan market or by taking it out. Just as supply and demand causes the price of a stock to go up or down, so is the interest rate charged in the Fed Funds market. By putting money in or taking money out the Federal Reserve is able to artificially control the supply demand balance. Interest rates affect every area of our economy. If you have to pay a higher interest rate on a mortgage your monthly payment is going to be higher. Since you can only afford to spend so much a month on that payment, the interest rate affects the how much home you can afford. Likewise, most businesses borrow money to fund expansion, cover inventory and to smooth out cash-flow. Just like the homeowner, they have a limited amount they can afford in payments each month. The amount they borrow affects whether they can build bigger plants, buy more computers or hire additional employees. Different industries do well in different parts of the economic cycle. The construction industry will perform best during periods of low interest rates because low interest rates are designed to spur growth. When people and businesses can borrow at low rates they will build new homes, skyscrapers and factories. Similarly, we each tend to buy the same amount of toothpaste and toilet paper regardless of where interest rates are. The companies that make those essentials aren’t going to see the big change in demand for their product that a construction company might. Equity investments can be categorized as cyclical or non-cyclical based on how they are affected by changes in the economic cycle. The proportion of each in a portfolio will greatly affect the overall volatility. I recommend having a of high-quality non-cyclical companies. You can then introduce cyclical companies as the seasons change to add additional growth. Make sure you adjust the cyclicals as the seasons change. Economic cycles don’t just affect stocks. They determine whether it is a good time to own bonds, and what type of bonds to own, as well. The last several years, interest rates have been at historic lows. You don’t want to lock in low rates for 30 years. When interest rates are above the historic norms, that’s when you want to stretch out your maturities. Think of your investment portfolio as a living, breathing entity. Recognize that the investments used in it will determine your comfort level as the economic seasons change. Doing so properly will allow you to increase your return while reducing your risk. Take advantage of economic cycles. Don’t let them take advantage of you. Have a financial question? Send me an email and I’ll personally respond, free of charge. Go to www.guardingyourwealth.com and click on ‘Ask Jeff’. In addition to being a nationally syndicated columnist and Certified Financial Planning Practitioner, Mr. Voudrie provides personal, private money management services to clients nationwide.