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Painless Ways to Increase Cash Flow
Prices of key goods are high and rising,
and most investments are down. Higher costs and lower income mean times are
getting a bit tougher financially, and people are being more prudent with their
money. Smart money moves don't have to be painful. People can increase
their cash flow with a little bit of work and discipline. The combination can
translate into some shrewd money moves.
Here are some simple strategies to improve cash flow.
Reducing power. The gas pumps aren't the only place energy
prices are climbing. Home energy costs, especially electric bills, are rising in
many areas. A few simple changes in habits can cut that bill.
You probably are using more kilowatts than a few years ago because
of all the new electric gadgets. Electronics consume electricity when in standby
or idle mode. Guilty gadgets include computers, printers, televisions, DVD
players, and other video and audio equipment. To avoid this power drain,
electronics should be turned off completely between uses. Also, unplug
rechargers when gadgets are fully charged or not in the charger. An idle charger
consumes electricity.
Consolidate to cut fees. Most financial firms offer some
discount when customers consolidate services. Have a checking account, mortgage,
and credit card at the same bank and those pesky fees and minimums will be
reduced or eliminated. Brokers and mutual fund firms often aggregate accounts of
the same person or family to decide if breakpoints are reached for reducing or
waiving fees. Insurance companies usually charge lower premiums to consumers who
have more than one policy with them.
Plan your payments. Avoid ATM fees by using only the ATMs of
your bank. Avoid late payment fees and finance charges by ensuring bills are
paid on time. A way to ensure on-time payment is to set up automatic payment
plans. Many utilities and credit cards can draft payments directly from customer
accounts. Banks often will set up automatic payment plans, or automatic payments
can be set up using online banking web sites or software such as Intuit's
Quicken or Microsoft Money.
Assume more risk. Insurance premiums can be reduced quickly
and easily by raising deductibles. A higher deductible means the policy owner
pays a higher amount of each claim and pays all smaller claims. Of course, the
policy owner must have the financial resources to be able to pay the higher
deductibles if losses are incurred.
Pay debts. Investment returns are low, especially for
conservative investors seeking income. A higher return on that cash might be
earned by repaying debt. Certainly paying high interest debt such as credit card
balances is a good use of available cash. Repaying lower interest debt such as
mortgages and home equity loans might be a good use of cash, depending on the
investment returns that would otherwise be earned on the cash.
Someone invested in an S&P 500 Index fund has a negative return for
the last 10 years and in retrospect would have been better off repaying even a
low interest loan with that cash. It is important, however, to consider
longer-term returns instead of the most recent returns when making this
decision. A conservative, mainstream investor might not earn more than the
interest rate on a mortgage over the next few years. An investor in our "hedge
fund" mutual fund portfolio or our Sector or Balanced Managed Portfolios is
likely to earn a higher return.
Bargain. Many businesses are open to bargaining and price
adjustments when asked, especially on large purchases. Simply ask if that is the
best price available, if there is a discount for cash payment, or if the price
is better at a different time of the week.
Don't shortchange the future. When cash is tight, many
people tend to reduce 401(k) contributions or other long-term savings. This
should be considered only when spending reductions have been maximized. The
long-term savings have to be made up at some point, along with the returns that
would have been earned on the contributions.
Avoid last resorts. Financial stress also leads people to
tap 401(k)s through loans or hardship withdrawals, take distributions from IRAs,
cash in or sell life insurance policies, or take out reverse mortgages. Each of
these strategies has its place, but only after all the alternatives have been
tried. August 2008.
How to Change Social Security Benefits
Deciding when to take Social Security
retirement benefits is one of the more difficult retirement decisions. The
decision affects lifetime monthly income of not only the recipient but also the
recipient's spouse. The choice of starting date can mean the difference of
thousands of dollars over the course of retirement.
Though few people realize it, the decision is not irrevocable.
The beginning date of Social Security retirements can be changed, and for many
people changing benefits after they have begun might be a good idea.
Let's take a look at the rules and some research by Laurence J.
Kotlikoff, a professor of economics at Boston University.
Most of you know that the level of Social Security retirement
benefits depends on the age the payments begin. The full benefit is paid to
someone who begins payments at full retirement age. Traditionally FRA is age 65,
but FRA is increasing on a sliding scale for those born after 1936 and
eventually will settle at 67. Benefits can begin as early as age 62, and
recipients will receive less than full retirement benefits for each month they
begin before FRA. Those who delay receiving benefits will be paid more than full
retirement benefits with the maximum benefit being paid to those who wait until
age 70. Details are in my book, The New Rules of Retirement.
The procedure for changing the beginning date of benefits is very
simple. At any point, a recipient of Social Security retirement benefits can
have them adjusted to the level that would be paid if they initially were begun
at a later age. The recipient completes Social Security Form 521, "Request for
Withdrawal of Application."
There is a price for changing the benefits. All benefits
received to date must be repaid. No interest is charged, and no
inflation-adjustment is made. The payments received are added, and that total
must be paid to Social Security to change the benefits. In effect, the recipient
has interest-free use of the money, and then can repay the benefits received and
opt to receive higher benefits for life.
When does it make sense to change the amount of benefits received?
After all, one must write a hefty check to the government to make the change.
Some who have enough wealth that they do not need the early Social
Security benefits to pay their living expenses believe it makes sense to begin
taking benefits early and invest each check received. Upon reaching age 70, they
plan to complete Form 521 and send a check to the government. They keep the
investment income and gains earned by the early benefits, and then they receive
the higher benefits for life.
One factor not to overlook is income taxes. Someone who can pay
living expenses without using the Social Security checks probably has an income
level that triggers taxes on some Social Security benefits. But keep this in
mind. When the benefits are repaid, either a deduction or credit might be
available on taxes paid on those benefits.
Let's look at a different situation. Max Profits uses the benefits
to pay living expenses but has other liquid assets. He began receiving benefits
before FRA. As he approaches age 70, he realizes how much the benefits would
increase if they were started at that age. Does it make sense for Max to use his
investment portfolio to repay the benefits received and buy the higher benefit
stream?
Professor Kotlikoff believes that in many cases it makes sense to
buy the higher benefits. He believes the way to analyze the decision is to
compare the cost of higher benefits with the cost of buying a commercial annuity
that would pay an amount equal to the difference between the two benefit levels.
His research indicates that most of the time it costs significantly more —40%
more or higher—to buy that amount of additional income through an annuity.
By returning the benefits to receive a higher benefit in effect Max
would be buying an annuity for the difference between the two Social Security
payment amounts. Buying that annuity from the government is likely to be cheaper
than buying it from a commercial insurer.
There are a few caveats and other points to consider.
Buying higher benefits from Social Security might mean less would
be available for children or other heirs. A surviving spouse will receive
survivor benefits, but children will receive nothing from Social Security.
Taxes are another consideration. The Social Security benefits
potentially are subject to income taxes if the recipient's income is high
enough. With an annuity, part of each payment will be a tax-free return of
principal. For example, for a 70-year-old married couple 64% of the annuity
payments would be excluded from gross income.
Another consideration is that if one already has passed age 70, the
payoff from trading up declines. Social Security benefits do not increase after
age 70, regardless of how long after age 70 one waits to begin benefits. In
addition, there would be more months of early benefits to repay in order to
receive the higher benefits.
Another factor to consider is how else the money could be invested.
If there are investment opportunities with higher returns or more security than
an annuity or higher Social Security benefits, those might be a better use of
the money.
People who began receiving Social Security benefits early should
re-evaluate that decision as they approach age 70. It might make sense for many
of them to pay to receive higher benefits for the rest of their lives.
Suppose someone has not yet begun retirement benefits and will not
need them to meet living expenses. Does it make sense for this person to begin
benefits early, invest them until age 70, and then pay back the benefits in
return for higher benefits? This is a more difficult decision, because
assumptions must be made. Considerations include the amount of income taxes on
the benefits and the investment return on the received benefits.
A final consideration: If too many people trade up for higher
benefits Congress might change the law. Currently about 100,000 people annually
pay for higher benefits. If Social Security reports that the number is rising
and it is costing the trust fund money, Congress might change the rules. That is
a risk for someone who deliberately begins benefits early with the intention of
paying for higher benefits later.
Retirement does not give many second chances and "do overs." A
little-known second chance is the decision of when to begin Social Security
benefits. Retirees approaching age 70 should consider whether it makes sense to
apply for higher benefits. July 2008. RW
In recent visits we explored how spousal
benefits can affect the decision of when to begin Social Security benefits. In
this visit we will take a look at one more scenario.
First, we'll review the key points from past visits.
A spouse is entitled to receive the higher of either his or her
earned retirement benefits or one-half of the spouse's benefits. In either case
the benefits are reduced if they are taken before normal retirement age.
If a person waits until full retirement age before beginning
benefits, he or she can elect to apply for only the spousal benefit. Later, the
person can apply for retirement benefits based on his or her earnings record.
The first advantage is that payments can begin at full retirement age, though
they are based on the spouse's benefits. The second advantage is that delaying
the beginning of one's own retirement benefits allows the delayed retirement
credit to increase the payments.
Here are a couple of additional scenarios, compliments of
syndicated columnist Humberto Cruz, that were verified by Social Security.
Suppose Max and Rosie Profits reach full retirement age. Max is
entitled to $2,000 monthly retirement benefits on his own record and Rosie is
entitled to $900 monthly based on her record. Max elects to take the $450
spousal benefit based on Rosie's record, and Rosie elects to take her $900
retirement benefit.
At age 70, Max files for retirement benefits based on his record,
which now are $2,700. In addition, Rosie applies to receive the spousal benefit,
which is one half Max's full retirement benefit. So, Rosie now is receiving
$1,000 monthly and Max is receiving $2,700 monthly. Each is indexed for
inflation.
Details are available on the Social Security web site at
www.socialsecurity.gov/retire2/-yourspouse.htm. July 2008. RW
More on Social Security Benefits and Spouses
Last month's discussion on coordinating
Social Security benefits among married couples generated a lot of interest.
Let’s take a few minutes to review the basic rules of this complicated issue,
and I will add some references to some key sources.
To keep things simple, we’ll assume the wife is the lower wage
earner. That will avoid constant references to “the spouse” and the “other
spouse” or “higher-earning spouse.” The rules apply regardless of which spouse
had the higher earnings.
A wife can begin receiving retirement benefits as early as 62. If
the wife begins benefits before her full retirement age (regardless of whether
the benefits are based on her work record or her husband’s), the benefits will
be reduced permanently. The reduction will depend on how many months early the
benefits begin.
A wife who begins benefits at her full retirement age can receive a
benefit equal to one-half the full retirement amount of her husband’s.
A wife also may receive benefits based on her own earnings record.
If that retirement benefit is less than one half of the other spouse's
retirement benefit, then the spouse will receive a combination of the two
benefits so that the total equals the higher amount. In effect, a wife receives
the higher of her earned benefits and one half of her husband’s retirement
benefits. But Social Security likes to phrase the benefit as a spouse receiving
his or her own benefit plus a benefit based on the other spouse's record.
A wife should not have to decide which is the higher benefit.
Social Security says it will check its records to ensure a retiree receives the
higher of the two benefits. Mistakes can be made, however, so if it appears that
a spouse is receiving less than the maximum benefit call Social Security to ask
about the difference.
Here is the part that excites many of our readers.
If a wife has reached full retirement age and is eligible for a
benefit based on either her husband’s earnings records or her own earnings
record, he or she has a choice. The wife can choose to receive only the spouse's
benefits now (one half the husband’s benefits) and delay receiving her own
retirement benefits until a later date. By delaying her own retirement benefits,
they will increase because the benefits begin after full retirement age,
qualifying for delayed retirement credits. Note that this result is possible
only when the wife applies for spousal benefits at full retirement age or later
and files for only the spousal benefit. Before full retirement age a person is
deemed to have filed for both spousal and retirement benefits.
Last month we discussed instances in which someone begins receiving
retirement benefits, and later decides it would have been better to wait and
receive a higher benefit. In those cases, the benefits received have to be
repaid to begin the higher benefit. In this last case, however, the spouse does
not have to repay the spousal benefits received before electing to take her own
earned retirement benefits. Repayment is required only when a person begins
benefits at one age, and then decides it would have been better to wait until a
later date and wants future benefits recalculated based on the later date.
The Social Security web site is very helpful in researching these
issues. First, be sure to spend some time with the site's calculators. They let
you view benefits for you and your spouse under different scenarios. Also, there
are several helpful publications available on the site, though they are not
always easy to find. Check the following addresses to fully research these
issues:
http://ssa.gov/retire2/yourspouse.htm
http://ssa.gov/pubs/10084.html
http://ssa.gov/pubs/10035.html
If you have any doubts about the rules, call Social Security to
discuss your situation. June 2008.
Reverse Mortgages Coming of Age
Reverse mortgages are booming. The
number of reverse mortgages issued is growing at a rapid rate (though the actual
number still is fairly small), and mortgage options available are increasing.
More options give older homeowners more potential benefits but also increase the
potential to make mistakes.
The industry's preferred term for reverse mortgages is Home Equity
Conversion Mortgage (HECM). The growth in the last few years is almost
staggering, especially considering the decline in other types of mortgages. In
the last year, issuance of reverse mortgages increased 40% to 50%, and since
2005 they have increased 250% to 300%.
Part of the reason for the growth is the increasing number of
homeowners in the right age group. Another reason is that the FHA increased the
number of reverse mortgages it will insure; it currently insures about 90% of
HECMs. Also, private lenders are more aggressively marketing the loans and
creating terms that are attractive to potential borrowers, including for loans
not insured by FHA. Another reason for the growth is a secondary market is
developing; lenders can package and sell the loans, then use the proceeds to
make new loans.
The uses of HECMs have changed. Traditionally, reverse
mortgages were loans of last resort for those in their late seventies and older
who needed cash for medical bills, home repairs, or other essentials. Now, HECMs
also are used to pay for travel, gifts to the grandchildren, and even a second
home.
In a reverse mortgage, a homeowner borrows against the home equity.
The loan proceeds can be received as a lump sum payment, a line of credit to be
tapped when desired, or a stream of annuity-like payments. Unlike a traditional
mortgage, the borrower does not make regular repayments. Instead, when the
borrower stops living in the home the lender is paid from the sale proceeds.
The fees for an HECM usually are high, about 5% or more of the
home's value in most cases. The fees can be added to the loan balance, so the
homeowner does not have to come up with the cash. In addition, interest is
charged. The interest rate usually is variable, but some loans now offer fixed
rates. The interest compounds as long as the loan is outstanding. Since the loan
is not repaid until the owner leaves the home, the lender does not know how long
that will be. On loans not insured by FHA, the lender takes the risk that the
loan, fees, and compounded interest exceed the value of the home when the
borrower lives in the home longer than expected. On FHA loans, the government
reimburses the lender for the loss.
During the loan period, the borrower is owner of the home and is
responsible for maintenance, taxes, and insurance.
Because of the high fees and compounding of interest, a homeowner
can borrow far less than the equity in the home. The maximum percentage of the
equity that can be borrowed depends on the owner's age, the interest rate
charged, and the lender.
Here are some ways reverse mortgages are used today.
§ The traditional user is a homeowner
with a paid-off home, limited income, and climbing expenses. For many years
HECMs were used primarily by women in their late seventies or older who were
living alone and needed money for medical expenses, home repairs, or general
living expenses.
§ Another use is to restructure other
debts and generate cash for new spending. An older couple might have substantial
home equity, a conventional mortgage, and adequate, reliable income. They take
out a reverse mortgage that pays the outstanding mortgage, a year's property
taxes, and the fees related to the loan. That frees up a significant part of the
income for more travel, spoiling the grandchildren, and other opportunities they
want to take advantage of during their active years.
§ A home equity line of credit can be
a substitute for long-term care insurance. If long-term care expenses do not
arise, the line of credit is not used. The fees related to the loan still have
to be paid, but the home equity passes to the next generation. The couple has
the security of knowing they have a way to pay for long-term care. In addition,
they do not have to use income to pay for long-term care insurance premiums.
§ Some homeowners are using HECMs for
more frivolous spending. They tap their home equity to buy recreational vehicles
or second homes. Or they use the proceeds to pay for vacations or new cars. Some
people use reverse mortgages to pay for gifts or education for grandchildren.
No matter the use of a home equity loan, potential borrowers need
to consider the same details. Otherwise, rates and fees will be too high and the
spendable portion of the home equity too small.
The loan principal insured by FHA is limited based on the median
home value in an area. This made HECMs unavailable to those with expensive homes
and significant home equity. In the last few years, however, some lenders have
made uninsured reverse mortgages available in substantial amounts, in some cases
on homes worth up to $10 million. Uninsured loans tend to have higher fees and
interest rates than insured loans.
Borrowers of FHA-insured loans must meet with a free, approved
counselor before agreeing to a loan. Different organizations offer the
counseling around the country, and some are funded at least partly by lenders. A
recent New York Times article asserted that the counseling quality is
uneven. The average counseling session lasts about one hour, but some borrowers
report shorter sessions. The counselors do not give advice but only try to
explain the loans and their different terms.
The loan fees can be significant, and there will be several types
of fees. Some borrowers do not fully understand the fees, because they are added
to loan principal. Potential borrowers need to be sure they understand the fees
being charged and how they are being paid. If the fees are paid from the loan or
added to the loan, interest will be charged on them over the life of the loan.
The fees can range from 2% to 7% of the home's value. They tend to
be higher on FHA-insured loans than on other loans. Fees might be lower on a
lump sum loan than on an annuity or line of credit loan, and they might be a
lower percentage of the home’s value on more valuable homes.
As on other types of loans, lenders often will trade lower expenses
for a higher interest rate.
There are interesting trade offs borrowers have to consider.
FHA-insured loans generally have higher fees and lower maximum loan amounts than
proprietary loans. But the FHA-insured loans also tend to have lower interest
rates. The borrower has to forecast which combination of loan options is likely
to leave more of the home equity for heirs or will provide the most cash during
the owners’ lifetimes.
A reverse mortgage is not for someone who is planning to leave the
home or its equity to heirs or charity. The home will be sold, and the proceeds
will first pay the HECM lender. Any remaining equity goes to the person named in
the homeowner's will, but it should be assumed that the amount will be small.
The interest rates assessed against the loan usually are variable.
Fixed rates now are available from some lenders, but the starting rate tends to
be higher than for the variable rate loans.
A key provision in a variable rate loan is the index used to
determine the rate. Usually the rate charged is the rate on an index plus some
additional percentage. The traditional rate for reverse mortgages is known as
the CMT index, which is based on treasury yields. Some loans are based on LIBOR.
The LIBOR-based loans are likely to charge less interest over the life of the
loan, but the lender might charge higher fees.
Reverse mortgages still are only about 1% of the total mortgage
market, but they can be valuable financial management tools for older
homeowners. Some of the best education materials on the loans are on the AARP
web site at www.aarp.org. Before making a decision, potential borrowers need to
fully understand these complicated products and contact several lenders to
compare terms before agreeing to a loan. May 2008.
With the economy slowing more people
have to face one of work life's more difficult issues: Should the early
retirement offer be accepted?
Evaluating the value and merits of a buyout offer can be difficult,
because the offer contains many parts. Here is a summary of key points to
consider when a buyout offer is received.
What is next? What the employee might do after accepting or
rejecting the offer is key.
In most cases the best employees take buyout offers because they
are confident of finding new work. Quality employees who reject the offers can
find themselves in position to rise faster than they would have before the work
force shrinkage. In addition, the employer might make better buyout offers a
year or two later.
It also is possible, however, that the company folds or is
purchased, and the employees who stayed have neither jobs nor the buyout
package.
When the buyout offer is accepted, will the employee retire or seek
other employment?
The ideal situation is to accept the buyout offer, and then take a
new job with the same or similar compensation. The worker is in the same
financial position, with the addition of the buyout benefits. Before traveling
down this road, however, the worker needs to take a look at the job market. Are
comparable jobs available for similar compensation? Will employers hire someone
in the worker's age group? Will it be necessary to relocate or change industries
to receive adequate compensation? Workers who have not tested the job market for
a few years need current information before deciding.
Senior, competent employees often need months to find a suitable
position. Expenses have to be paid during that time. The buyout package might
merely be enough to maintain the current lifestyle until a new job is found.
Also, there are additional costs associated with a job search. In that case, the
employee would have been no worse off and perhaps better off staying in the old
job and looking for work at the same time.
When the employee leans toward retiring after the buyout, a careful
analysis of key factors is required. Those who receive buyout offers usually had
not seriously considered retirement at that point. They have not analyzed the
details of retirement and risk venturing into this phase of life unprepared.
Health insurance is often overlooked. Those who receive
buyout offers often do not realize how much the coverage costs and how difficult
it can be for someone age 50 or over to obtain individual coverage in many
markets, especially if the person has health issues.
Medicare does not kick in until one is eligible for Social
Security. The cost of coverage before that can make or break a retirement plan.
Continuing coverage from the employer can be purchased through the COBRA
requirements, but that lasts only 18 months and can be expensive. Sometimes an
employer negotiates individual coverage for employees as part of a buyout plan.
Most often, the employee is on his or her own to find coverage until Medicare
takes over.
The prospective early retiree needs to evaluate the full financial
picture to determine if current resources plus the buyout offer make retiring
now viable. Employees must look beyond current income and expenses Retirement is
likely to last a long time for those retiring before normal retirement age.
Inflation, home maintenance and repairs, replacing cars, and other
costs outside of the day-to-day expenses need to be considered. Failure to
factor these into a retirement plan can create a significant shortfall. May
2008.
Timing SS Benefits to Help Your Spouse
One of the least understood and most
confusing aspects of Social Security benefits are the spousal benefits. Much
attention is devoted to the best time for an individual to begin receiving
retirement benefits, but how that choice can affect the benefits of a spouse
receives much less attention.
In this visit we primarily are going to discuss spousal
retirement benefits, but lets first briefly discuss the rules for
survivor benefits.
A survivor receives the higher of his or her own earned benefit and
the survivor benefit. A surviving spouse who already has reached full retirement
age is entitled to a survivor benefit equal to what the deceased spouse was
receiving. A surviving spouse who applies for survivor benefits before full
retirement age will have the benefit reduced 0.42% for each month survivor is
below the full retirement age. The age at which the survivor began collecting
his or her own retirement benefits will not affect the amount of survivor
benefits.
Strategy: The longer one delays one's own retirement
benefits, the higher the amount a spouse could receive in survivor benefits.
Spouses also are entitled to retirement benefits. A married person
can receive retirement benefits based on either his or her own earnings record
or on the spouse's earnings, whichever is higher. The general rule is that a
spouse receives the higher of his or her own earned benefits and half of the
spouse's earned retirement benefit. But the spousal retirement benefit is
reduced if either spouse begins benefits before full retirement age. We'll look
at some examples shortly. To keep it simple, we’ll assume the wife is the
lower-earning spouse.
For a spouse to receive retirement benefits, the other spouse first
must be receiving retirement benefits. If the wife is ready to retire and wants
to receive benefits before her husband, the wife’s benefits will not be based on
the husband’s earned benefits. Theoretically the husband can begin receiving
retirement benefits while continuing to work. If the husband is under full
retirement age, however, the earnings limit will reduce the amount of those
benefits and that in turn will reduce the amount received by the wife. If the
salary of the husband is high enough, the benefits either spouse is eligible for
will be zero.
The wife, however, can begin receiving benefits based on her own
earnings record when the husband is not yet receiving benefits. After the
husband begins receiving benefits the wife can receive benefits based on the
husband’s earnings record. The benefits received by the wife at both times,
however, will be reduced if the wife begins benefits before his or her full
retirement age (FRA). Let's look at some examples.
Rosie Profits wants to begin receiving benefits while her husband
Max wants to delay benefits. Rosie is entitled to $500 monthly at full
retirement age based on her own earnings. When Max reaches FRA he will be
entitled to $1,800 monthly. Rosie can begin taking $500 now. When Max begins
benefits at FRA, Rosie will receive an additional $400 to bring her total to
$900 monthly—half of Max’s benefits. That assumes neither of them began
receiving benefits until reaching FRA.
Suppose Rosie begins receiving her benefits before her FRA. She
will receive a reduced benefit of let's say $400 monthly. When Max retires at
FRA, she still will receive the additional $400, bringing her monthly benefit to
only $800. By beginning benefits before FRA she permanently reduces her monthly
benefit, even after Max retires at FRA.
Now suppose Max begins benefits before Rosie reaches FRA, and Rosie
already began receiving $400 monthly before her FRA. Rosie's spousal benefit
will be reduced again, based on a formula. She should receive less than the $800
monthly in the previous example. A calculator on the Social Security web site at
www.socialsecurity.gov can compute the actual benefits for individual
situations.
As you can see, the rules and scenarios can get complicated. Social
Security's web site calculators can help explore results under different
scenarios. Others have studied the issue and concluded the best strategy for
most couples. Under these studies lifetime payouts are maximized if the
lower-earning spouse begins taking benefits early, say when first eligible at
age 62. The higher-earning spouse should wait to at least age 68 before taking
benefits and preferably to age 70.
Here's a peculiar scenario the law apparently allows. Max and Rosie
Profits are the same age. Rosie would be entitled to $1,000 monthly at her FRA;
Max would receive $2,000 at his FRA. Rosie begins benefits at 62, receiving
$750. Max wants to wait until age 70, but decides he needs some cash flow before
then. At FRA, Max applies to receive one half Rosie's benefits. He would receive
$500 (half Rosie's benefits at her FRA). At 70, Max can apply for benefits based
on his earnings record, which would pay benefits over $2,000 monthly.
What if a spouse now believes he or she made the wrong choice and
began benefits early? A retirement benefits recipient can change his or her mind
by filing a Withdrawal of Claim with SSA. Along with the form, the benefits
received to date have to be repaid. In the year prior benefits are repaid, the
recipient will receive a Form 1099 from SSA with a negative number, and that
amount might be either deductible on the tax return or taken as a credit for
income taxes paid on the previous benefits. For details check IRS Publication
915 and the Social Security benefits handbook. Both are available on the
agencies' web sites.
The bottom line is that it usually pays for at least one spouse to
wait before receiving benefits. Married couples should consider their benefits
jointly to maximize the family income, the benefits paid to each, and future
survivor benefits. April 2008. RW
IRAs are among the most valuable assets
many Americans own, and protecting those assets from creditors and lawsuits can
be a concern. This can be a tricky proposition, because IRAs are in a
netherworld of asset protection.
Protection for IRAs in federal bankruptcy court was improved by the
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. But IRAs still
can be vulnerable in other situations.
Assets of employer-sponsored qualified retirement plan assets are
protected from claims of creditors both in and out of bankruptcy actions under
the Employee Retirement Income Security Act of 1974. ERISA also overrides any
state laws that appear to allow creditors to reach retirement plan assets.
Protected plans include defined benefit pension, 401(k), and profit-sharing
plans. This protection, however, does not extend to plans that cover only the
business owner or the owner and his or her spouse. Those plans are protected in
federal bankruptcy actions but not in other instances. The full protection is
available if nonowners also participate in the plan.
IRAs are protected in federal bankruptcy actions, but the
protection varies by the type of IRA.
There is an unlimited exemption for rollover IRAs that contain assets
transferred from pension, profit-sharing, and 401(k) plans as well as for SEPs
and SIMPLE IRAs. The unlimited exemption for rollovers could be lost if the IRA
also contains other assets. For that reason, it is best to roll over employer
plan assets to a separate IRA instead of commingling them in an already-existing
IRA containing individual contributions.
A traditional IRA or Roth IRA receives bankruptcy protection under
the 2005 law, but not the unlimited exemption of employer-sponsored accounts. An
IRA containing individual contributions is an exempt asset in bankruptcy up to
$1 million (adjusted for inflation). Assets rolled over from a SEP or SIMPLE IRA
probably receive the same protection limit instead of their prior unlimited
protection. A bankruptcy judge has discretion to increase the $1 million limit
if the "interests of justice so require."
As a practical matter, the $1 million exemption is equivalent to an
unlimited exemption. Because of the relatively low contribution limits for IRAs,
an investor would need investment returns well above average over many years to
breach the limit. IRAs that exceed the $1 million limit are likely to contain
assets rolled over from employer-sponsored plans that are exempt if kept in a
separate rollover IRA. Technically, rollover assets can be commingled with other
IRA assets. The rolled over portion would have the unlimited exemption, and the
other portion the $1 million exemption. But the burden would be on the IRA owner
to show the principal amount of each portion plus the income and gains
attributable to each portion. It is safer and easier to keep rollover assets in
a separate IRA.
An account balance retains its protection while being rolled over
to another IRA or qualified retirement plan. The creditor cannot successfully
argue that the assets lost their protection at some point during transit.
Withdrawals lose their protection. Once money is withdrawn from a
protected account, it can be reached by creditors. Even forced withdrawals, such
as required minimum distributions, can be reached by creditors.
The federal bankruptcy protection, however, does not protect the
assets in other situations.
A creditor could sue for failure to pay in state court and attempt
to attach or seize assets or garnish wages. In such cases, federal bankruptcy
law does not apply. The anti-alienation provisions of ERISA protect assets
covered by it. But traditional IRAs, Roth IRAs, SEPs, and SIMPLE IRAs do not
receive that protection. For these assets, the protection in such situations
depends on state law.
State protection for IRAs varies considerably. A number of
states, such as Ohio, fully exempt both traditional and Roth IRAs from any
action to satisfy a judgment or court order and have no cap on the protection.
Some states exempt traditional IRAs but not Roth IRAs. Then, there are states
such as Minnesota that provide limited protection. Minnesota exempts only
$30,000 plus whatever amount is "reasonably necessary" to support the debtor, a
spouse, and any dependents. Nevada protects only $500,000 of retirement assets.
South Carolina exempts only the amount "reasonably necessary" to support the
debtor, a spouse, and any dependents. Virginia's exemption applies only to a
balance providing an annual benefit up to $17,500.
What can an IRA owner do if he or she lives in a state that
provides modest protection for IRAs? There are states competing to attract IRA
balances.
One alternative for people concerned about their account balances
is the true self-directed IRA combined with a limited liability company or
limited partnership as discussed in the May and July 2004 issues. The LLC or FLP
provides protection under state law, and the creditor cannot compel the IRA
owner to make a distribution from the entity into the IRA where the creditor can
reach it.
A few states, especially Delaware and Ohio, created individual
retirement trusts instead of custodial accounts. The trusts qualify as IRAs
under the tax law but offer additional creditor protection and estate planning
choices. Delaware IRAs, for example, have spendthrift provisions.
It is not clear how much protection these trusts offer. A
non-Delaware court could rule that a non-Delaware resident cannot use the
Delaware IRA to give assets more protection than IRAs in the state of residence.
IRA trusts are more expensive and only a few Delaware institutions
offer them, such as NatCity Trust Co. and Capital Trust Co. Fees at NatCity
recently were 1.1% of assets, which includes asset management services. Capital
Trust offers IRA trusts through financial advisors and charges 0.3% on the first
$1 million, or a minimum fee of $1,250. The financial advisor normally charges
additional fees. April 2008.
Investors suddenly are concerned about
something they haven't considered for years: That their securities broker might
go out of business.
The credit and mortgage crises revealed that some brokers are
more exposed to subprime mortgages than their customers realized. Merrill
Lynch was a big player and took substantial write downs of its assets. E*Trade
has a mortgage subsidiary that suffered significant losses. There were rumors
that E*Trade's existence was in doubt until it received a $2.5 billion
investment from hedge fund Citadel Investments last Fall.
The question we have received from some readers is: What happens to
a customer's account when a broker fails?
Bank accounts have the Federal Deposit Insurance Corporation, a
federal government entity that guarantees the safety of accounts up to a ceiling
amount. For brokerage accounts there is the Securities Investor Protection
Corporation (SIPC), a nonprofit group founded by financial services firms, not
the government. Brokers technically own the assets in customer accounts; they
are listed in the name of the broker not the customer. SIPC's job is to help
return the assets to investors.
Brokers are required to insure accounts with SIPC. If a
broker fails, SIPC first attempts to return all stocks, bonds, and options to
the customers for whose accounts they were purchased. The trustee put in charge
of overseeing the broker’s assets is given cash from SIPC to buy these covered
assets from the broker and give them to the customers. Then, the broker's cash,
futures, currencies, commodities and other noncovered assets are divided pro
rata among customers who bought those assets.
Beyond that, SIPC covers losses up to $500,000 per customer with a
$100,000 ceiling for cash. Many brokers purchase from private insurers coverage
above these limits. Money markets funds are considered securities, not cash.
Exchange-traded funds are securities, regardless of their underlying assets.
Securities that are registered in a customer's name are returned to the customer
regardless of any coverage limits.
Time can be a factor. Assets and customer accounts are frozen
until the trustee and SIPC can sort things out and return assets to customers.
The process takes anywhere from weeks to years, depending on the condition of
the broker's and the customer's records.
Customers who want to maximize protection should consider not
holding more than $500,000 of assets at more than one broker. Alternatives are
to check the excess insurance of a broker and who issues that insurance. Other
goods steps are to check a broker's rating from S&P and other rating agencies,
and its capitalization and market cap. A review of the extent of a broker's
business for potential bombs such as subprime mortgages also is a good idea.
Another concern is the firm that does trading for the broker, known as a
clearing firm. This firm might be holding many of the securities in its name,
and its failure would delay a customer's access to the assets.
More information about the insurance and recovery process is
available at www.sipc.org, including a brochure on brokerage firm liquidations.
March 2008.
Handling Retirement Financial Surprises
Financial surprises in retirement can
blow a hole in your plans. Particularly for early retirees surprises are very
damaging to well-laid plans.
The scenario occurs with frequency. A couple diligently worked up a
detailed plan that covered all the expenses of their desired lifestyle. They
ventured into retirement secure in the belief that they were financially
comfortable.
Then, one or more major surprises surface. Unplanned medical
expenses are a major shock to plans. Major home expenses, lower than expected
investment returns, and family emergencies are other sources of surprise.
When paying for unplanned expenses retirees lose not only the cash
paid for the expenses but all the future income it was expected to generate.
Over a retirement of 10 to 30 years, that income is quite a sum.
When the unexpected jolt to cash flow arises, retirees needs to
know how to respond. Here are some key strategies to consider.
§ Plan for it. Annual spending in a
retirement plan should include the irregular and even "unexpected" expenses. The
spending plan should provide a place for the irregular cash drains. I often
recommend that the monthly expenses include "sinking fund" expenses. For
example, someone who plans to purchase a new car every four years would list a
few hundred dollars for automobiles in the monthly spending plan. That amount
won’t be spent each month. The sinking fund, however, ensures that when the
spending numbers are run through a computer model the retiree has a better idea
of whether enough really has been saved for retirement. Sinking funds can be set
up for home repairs and even for unexpected emergencies.
§ Save more. An alternative to the
sinking fund is to establish a cushion in the retirement fund. Don't retire
until the fund has $100,000 or more beyond what is needed to generate cash for
your planned lifestyle.
§ Cut spending. Most retirement
spending plans are flexible. There are variable expenses that can be cut or
delayed. The typical retiree can spend less on travel, dining out, spoiling the
grandchildren, and other discretionary items. The reduction does not have to be
significant. A cut of 5% or so is enough to get most plans back on track.
§ Back to work. Those who retired
just a few years before the emergency often can return to work, even on a part
time basis. They might do something similar to the work they retired from or
seek other work to bring in a few dollars until the plan is back on track. More
and more employers are "senior friendly," so returning to work is a more viable
option than it used to be. Many retirees who take jobs related to their hobbies
instead of their old jobs find that the employment increases their enjoyment of
retirement.
Retirees should expect the unexpected in their spending. The best
solution is to have built a cushion in the retirement plan that anticipates the
occasional unplanned expenses. Even when that wasn't done, there still are
options that can get the plan back on track. February 2008.
The New Retirement Income Funds
The big financial services companies are
heatedly competing for the assets of retiring Baby Boomers. In decades past
these companies competed for the easy business of servicing those who need to
accumulate capital for retirement. The firms emphasized convenience, cost, and
growth potential.
Things are more complicated as the Boomers begin to enter the draw
down or cash out period of their lives. They want strategies for withdrawing
retirement income so that it lasts the rest of their lives. Insurers have been
responding by pushing traditional annuities and modifying them in some ways. We
have covered these changes in detail in recent visits.
Mutual funds and brokers are starting to respond. Fidelity,
Vanguard, and Charles Schwab all have rolled out or soon will roll out new
vehicles targeted at the Boomer retiree market.
Boomers have not flocked to annuities for retirement income. Boomer
retirees want to know how much income they safely can spend each year without
depleting their assets. They also want to avoid complicated investments with
high fees. They do not want access to their capital limited, especially in case
of emer-gencies, and they do not want to forfeit the opportunity to pass assets
to their heirs. Boomer retirees also do not want to put much of their principal
at risk, yet many of them want the potential to participate in bull markets.
The first to roll out new products is Fidelity Investments with 11
mutual funds called Income Replacement Funds. They consist of holdings in other
Fidelity mutual funds. (Fidelity also has rolled out a new deferred variable
annuity.)
The Income Replacement Funds are sort of the inverse or mirror
image of the target date or lifecycle funds that have become popular retirement
saving vehicles. The goal of the new funds is to convert savings into steady
retirement income that will last a given period.
Fidelity tries to help the retiree determine how much he or she
safely can withdraw each year based on his or her age, goals, and risk
tolerance. Each fund has a target liquidation date. They start at 2016 and run
every two years through 2036. Each fund has a different asset allocation with a
different emphasis on the goals of asset growth, income, and preservation of
principal.
Fidelity then calculates a payment rate the shareholder is to
receive the first year, and monthly payments are made. Each year the payment is
recalculated based on how the overall fund has performed. If the fund loses
value, the income for the next year probably will decline. If the fund has a
higher return than anticipated, the payment for the next year will increase.
The annual payments are calculated to liquidate the principal and
earnings of the fund by the end date. That means if you pick the wrong target
date and spend all the income as it is received, you probably will run out of
money. The fees vary based on the duration of the fund. If the shareholder
passes away before the target date, heirs can inherit the shares.
The new Fidelity annuity is similar to others now issued by
insurers. The annuity makes an annual payout equal to 5% of the amount invested
in the annuity. The payout is guaranteed to last for life and never to decline.
The payout can be increased with good investment performance, but no increases
are allowed after age 85. Extra amounts can be taken for emergencies, but those
withdrawals reduce future payouts. Any surplus in the annuity can be inherited
by heirs.
Vanguard's version of retirement income funds soon will be
available to shareholders. It will be offering three mutual funds called Managed
Payout Funds.
Like the Fidelity funds, these funds will invest primarily in other
Vanguard funds. There will be some unique features. The asset allocation in the
Vanguard funds will try to match assets that have low or negative correlations
with each other. In addition, the Managed Payout Funds will include strategies
that are not available in other Vanguard funds, such as commodity-linked assets,
market neutral strategies, and absolute return strategies. The goal is for
the funds to earn positive returns in most market environments. The concept
is similar to our portfolio of "hedge fund" mutual funds.
A committee of senior Vanguard investment professionals will
determine the strategic allocation of each fund, and Vanguard's quantitative
group will handle daily management.
The fund's are slated to have annual payouts of 3%, 5% and 7% of
the asset value the first year. As with the Fidelity funds, there is no
guarantee of positive returns or that the payouts can be maintained for a
specific period.
Charles Schwab & Co. also will be offering a competing product
named the Schwab Premier Income Fund. Its goal is to pay a somewhat steady
income to shareholders. It will invest in a range of assets, including some not
generally available to individual investors. The fund plans to invest in
derivatives, including credit default swaps. These contracts enable an investor
to purchase an income-producing asset such as a bond while shifting some of the
risk of the investment to someone else.
The offerings from all three groups allow shareholders to sell
their holdings at any time.
All these funds seek to be substitutes for annuities, including
annuities already offered by these firms. The advantages they have over
traditional annuities is that the income and asset value can grow, and excess
amounts can be left to heirs. The owners can change their minds at any time and
sell the shares. The funds also probably carry lower expenses and will make
higher initial payouts than annuities.
Their disadvantages compared to annuities are that they do not
guarantee income will last for a lifetime or that it will not decline.
As with the target date or lifecyle funds, these funds are for
investors who want someone else to make the decisions for them.
The funds all seem to follow our belief that distributions from a
retirement portfolio should fluctuate with the amount of capital. We have
discussed at length in past visits different strategies for determining the
annual payout, and these are available in the Archive on the web site. The
Vanguard and Schwab funds also follow our belief that retirees should not be
restricted to traditional "long only" investments, because principal can decline
too much in a serious bear market.
Before investing with any of these funds, retirees should consider
why the funds would achieve their goals better than our recommended diversified
portfolios combined with a sensible withdrawal formula. While the fund companies
spend a lot of time back-testing their asset allocations to find allocations
that are likely to meet investors’ goals, there is no guarantee that the future
will replicate the past.
A retiree should try to have multiple sources of income.
Ideally there is guaranteed income to cover basic expenses, coming from Social
Security and perhaps a pension or immediate annuity. Other assets can be
invested in a range of assets that together should meet the retiree's goals, and
perhaps one or more of these funds will fit into that picture, but they won’t be
the last word.
Expect more innovations from these companies and from insurers as
they seek to give Baby Boomers reliable income at low cost and with the
potential for growth and access to additional principal for special needs.
January 2008.
How to Preserve Retirement Capital
The greatest fear about retirement is
running out of money. There are three risks that could cause one to run out of
money. Investments could earn less than estimated; the retiree might live much
longer than anticipated; and spending could be greater than estimated, because
of either inflation or higher consumption.
In last month's visit, we discussed different spending strategies
to help a portfolio last. This month, we will look at portfolio strategies that
can be linked with the spending strategies to further increase the portfolio's
life and might even allow higher spending in retirement than the traditional
approaches.
The traditional retirement portfolio is mostly stocks and bonds,
with an overweight to bonds and other income investments. More recently in at
least the early years of retirement the portfolio has been overweighted to
stocks, because the portfolio has to last 20 years or longer. It needs to grow
to maintain its purchasing power in the face of inflation. The traditional
portfolio is highly dependent on the performance of the major stock and bond
indexes and is subject to long-term bear markets in stocks and bonds. Those bear
markets are why the "safe withdrawal rate" for traditional portfolios is just
above 4% of the value the first year with an addition for inflation after that.
There are other portfolio strategies that work better for the
21st century retiree.
One strategy we have recommended for some time and that has been
adopted by others is the emergency fund or cash reserve fund.
Set aside a portion of your portfolio equal to one to three years
of estimated spending. You choose the amount. Invest this part of the portfolio
in super-safe assets such as money market funds and certificates of deposit. The
rest of the retirement assets are invested for the long term.
Interest, dividends, and sales of shares from the main portfolio
are used to pay for living expenses when the portfolio is rising or stable. But
when a bear market knocks down the value of the portfolio, there is no need to
sell assets at depressed prices. Instead, use the safety fund to pay for
expenses. After the markets recover, profits from the main portfolio can be used
to replenish the safety fund and again to pay for expenses.
The size of the safety fund depends on how bad a bear market the
retiree wants to defend against and on the value of the total portfolio. Since
the safety fund will earn lower returns long term than a traditional portfolio,
this approach can reduce the long-term returns of the total portfolio but it
also allows the retiree to take a bit more risk in the rest of the portfolio.
Not everyone has a large enough retirement fund to set aside
several years of expenses in a low-yielding safety fund. An option for them is
to put part of the retirement portfolio in immediate annuities paying a fixed
amount for life.
Studies show that, on paper at least, immediate annuities extend
the life of a retirement portfolio and decrease the risk of outliving one's
assets. I discussed this in detail in my book, The New Rules of Retirement.
A problem with immediate annuities is that interest rates now are
low, and the annuities are offering low payout rates. If rates rise, annuities
will offer higher payouts. In addition, the payout is fixed and not indexed for
inflation. Yet, research, especially new research by Ibbotson Associates,
indicates that by one's early seventies putting part of the portfolio in
immediate annuities extends the life of the portfolio.
Non-traditional strategies for the main portfolio also should be
used, even if the safety fund or immediate annuities are not used.
Retirees need to move away from the traditional stock and bond
portfolio. The retirement portfolio should have assets that earn equity-like
returns over the long term but that are not tied closely to the returns of the
major stock and bond indexes. That move takes away some of the benefits of a
long stock bull market but also diminishes the drawbacks of a long stock bear
market.
Pension funds are starting to do this by adding commodities,
timber, and other investments to their portfolios. We offer several ways to
achieve this result in our portfolios.
The Core Portfolios use value managers who reduce the effects of
bear markets in their assigned asset classes by avoiding the riskiest
investments and investing with a margin of safety. Core Portfolios also include
international stocks and real estate, which are not always included in the
traditional portfolio.
In the Managed Portfolios we apply the margin of safety approach to
the entire portfolio. We look for investment classes that have margins of safety
and are selling at discounts. When appropriate, we own investments that we would
not own in the Core Portfolios because of their long-term risks and volatility
but that can generate strong returns for extended periods.
Another alternative is the portfolio of "hedge fund" mutual funds
that we update about every quarter. This portfolio contains mutual funds that
use the strategies of the better hedge funds. These mutual funds historically
have earned high long-term returns. Even better, they have low correlations with
each other and with the stock market indexes. More details are in this month's
Portfolio Watch.
The retiree should use a collection of tools to make retirement
assets last. The initial spending rate should be set at a sustainable level. In
addition, the retiree should be prepared to vary withdrawals and spending based
on personal spending (not Consumer Price Inflation) and market fluctuations. A
portfolio that is more diversified than traditional portfolios and that adjusts
its allocation based on extreme market valuations will avoid the worst effects
of sustained bear markets in stocks. By considering the entire toolbox and using
those tools that are appropriate for him or her, the retiree greatly increases
the likelihood that the portfolio will last through retirement. December 2007.
How to Vary Spending During Retirement
The traditional retirement plan projects
that spending will rise steadily each year in line with inflation. That model
does not work well for today's retirees. When retirement lasts 20 or 30 years or
longer, a more realistic model of spending and scheduled withdrawals is needed.
A retiree wants to avoid a spending and withdrawal schedule that
depletes the retirement fund too quickly. This can happen if investment returns
are below expectations or the retiree lives longer than estimated. Most
retirees take this risk, because they underestimate longevity (a married couple
should assume one spouse will live near age 100) and overestimate the safe
withdrawal rate to be around 8% or more of the initial portfolio value.
There also is an opposite risk. A retiree with a strong fear of
running out of money might live much more frugally than required. That would be
great for heirs, because they will inherit a sizeable portfolio, but it reduces
the retiree's standard of living.
Unlike the projections in most models, retirement spending does not
increase in a straight line. It varies over time. In addition, markets also do
not move in a straight line. They are volatile and can have extended bear
markets and bull markets. These fluctuations in the portfolio value should
influence annual spending.
Over the years I have found two models that accommodate real-life
retirement spending and portfolio fluctuations. They are more realistic than the
straight-line models generally in use.
One model is to adapt the spending formula used by the Yale
University endowment.
The first step is to set the withdrawal percentage for the first
year of retirement. Most studies conclude that the maximum safe rate is just
over 4% of the portfolio's value. After the first year, the distribution is
determined by using two separate formulas. The first formula is last year's
distribution plus the inflation rate for the last year. Multiply that amount by
70%.
The second formula is your initial withdrawal rate multiplied by
the fund's value at the start of the second year. Multiply that result by 30%.
Add the two results together to get the distribution for the year.
Here's an example. The withdrawal rate is set at 4.5%, and the
initial portfolio value is $600,000. The first year's withdrawal is $27,000.
After the first year, the portfolio's value is $625,000, and inflation was 2%.
Using the first formula, 2% inflation is added to $27,000, then multiplied by
70%. That result is $19,278. Under the second formula, $625,000 is multiplied by
4.5%, and then by 30%. The result is $8,437.50. Add the two products together
and the second year distribution is $27,715.50.
Under this formula, spending fluctuates with the markets and
inflation, but the changes are not as volatile as the markets and inflation are.
If the markets experience an extended decline, spending declines gradually.
During bull markets, spending increases faster than inflation. That allows one
to enjoy some of the excess gains of the bull market. But the spending does not
rise enough to absorb all the investment gains. The formula leaves a cushion
against the inevitable market downturns.
The other model is based on the spending cycles that occur during
retirement.
Spending varies by age. Even after retirement there are
several cycles. For most people, annual spending peaks around age 50 and then
steadily declines, according to the Department of Labor's Consumer
Expenditures in 2003.
There are additional fluctuations after 50. For many people, there
is a bump in spending immediately after retirement. There is a burst of spending
on pent-up demands such as travel and recreation. After age 75, spending
declines somewhat rapidly.
Retirees can plan for a three-stage spending cycle.
The first cycle can be referred to as the honeymoon period of the
first few years. This is when the retiree has pent-up demands and also is
relatively young and healthy. After that period, the lifestyle becomes more
normal and regular. Spending settles at a level that is lower than during the
initial years of retirement.
Sometime after age 75, spending is likely to downshift again. The
Department of Labor study indicates that spending by those over age 75 is 25% or
more below that of younger retirees. People simply become less active at some
point, even when they are healthy.
There might be a fourth spending stage in which major medical
expenses or long-term care expenses are incurred. Often when this occurs other
living expenses decline. The total expenses incurred by the retiree during that
period depend on the extent of insurance coverage.
Under this model, a retiree plans to spend more in the first years
of retirement. Perhaps spending could rise to as much as the 8% of the portfolio
that many pre-retirees say they are planning. After a few years, the plan has a
spending decline, following by another decline in later years.
A variation of the spending cycle approach is to divide your
retirement portfolio into two portions. One portion is 85% of the portfolio.
You spend plan this amount in roughly equal installments until age 85. If you
retire at 65, you can spend one twentieth the first year, one nineteenth the
second year, and so on.
In the meantime, the other 15% is invested in a portfolio designed
to grow in value over the 20 years. At age 85, if you are still alive, this
second portfolio can be spent or used to purchase an annuity.
Either of these variable spending models recognizes that most
retirees have flexibility in their budgets. A number of expenses can be deferred
or eliminated, such as travel, auto purchases, and home repairs or remodeling.
Other expenses can be increased or reduced from year to year, including dining
out and entertainment.
Retirees should plan on flexibility in their spending. Adjust
expenditures for inflation, portfolio volatility, health, and other factors.
Varying spending and withdrawals from the portfolio increase the probability of
having financial security through retirement and leaving an inheritance for
heirs. November 2007.
My 1990 Honda Accord still is cruising
toward 200,000 miles. I enjoy the tones of respect it gets from mechanics on
those rare occasions when it needs work done. Even more, I like the cost
savings. Owning a car for a long time not only avoids interest and principal
payments but also holds down insurance and taxes.
My approach to cars is not for everyone. Yet, there are a lot of
other easy ways to save money.
Saving money is easier than earning a higher salary or greater
investment returns. It also is more certain. Here are some strategies for
putting more money in your pocket from both little ticket and big ticket items.
Avoid late payments. Credit card issuers love it when a
payment is late. First they charge a finance charge of about $39. On top of that
is interest on the late payment. It is easy for busy people to make a payment a
few days late, especially when some cards require payment less than 30 days
after a bill is received. Yet, the finance charge can be avoided by having the
minimum payment made by the due date, and it is simple to set up an automatic
payment for at least the minimum.
Anyone using online bill paying can set up an automatic payment for
the monthly minimum. Each online system has its own way of setting up automatic
payments, but I believe they all provide for it. You can create an automatic
payment of say $50 to the credit card by your due date each month. When you have
time the rest of the bill can be paid. This won't avoid interest on the unpaid
charges, but it will avoid a finance charge or late fee.
Another method is to talk to your bank or the credit card company
about automatic drafts from your checking account. The bank will send full
payment to the card when the bill is submitted to it. You avoid both late
charges and interest by having full payment made this way. You still have 30
days from when the bill was submitted to challenge any charges. Most utility
companies and others that issue monthly bills also have systems for automatic
payment. You still receive paper bills for review under these systems.
Ask for the best deal. Most people take their regular
monthly bills for granted. They selected a service plan when they first signed
up and have not reviewed it since. Yet, things have changed. It is a good idea
to call the service providers once a year or so to ask if there is a better
deal. This is particularly true of companies that have some kind of competition,
such as cable and internet providers, telephone companies, and wireless service
providers. Many of these companies will give you their best current deal if you
ask, especially if they think you might move to a competitor.
Even when dealing with monopolies such as electric and gas
utilities periodic inquiries can be profitable. Often these companies have
different plans. For example, many offer a lower rate if you allow them to
reduce or cut your use during peak periods. Others offer variable rate pricing
that can be valuable if you are able to use less energy when others cannot or
won't cut back.
Auto financing is a steady leak of cash for many people. Too
many auto buyers focus on the monthly payment. They want a certain type of car
as long as the monthly payment stays within their target. Auto sellers are very
accommodating. They develop financing packages to meet the desired monthly
payment.
The problem is that the buyer's goals often are achieved by
stretching the loan term. It used to be rare to see an auto loan for more than
three years. Now, auto loans routinely last for five, seven, or even nine years.
The average car loan today is for about 70 months. This creates several
problems.
Longer-term loans carry higher interest rates. Since the loan lasts
longer, the buyer also pays more interest over the life of the loan. The longer
the loan term, the higher the total cost of the car. Few buyers, in fact, know
the total cost of their cars.
Another problem is that the car depreciates more rapidly than loan
principal is paid. At most points during the life of a long-term loan the amount
due is greater than the value of the car. This is known as an upside down loan.
If the buyer wants a new car before the loan term, the trade-in will not pay the
loan. Most auto sellers accommodate this by putting the difference on the new
loan and stretching the loan term again.
Before signing an auto loan know the total cost of the purchase,
including both the auto's cost and the total interest payments. Also, know at
what point the balance on the loan will cross over so that it is less than the
resale value of the car.
Overseas travel is more expensive now that the dollar is
declining against most currencies. The cost can rise higher because of currency
conversion costs. How you pay for charges overseas can be critical.
The easiest method is to use a credit card. In recent years, credit
card companies realized this and increased their fees for payments overseas.
There are two costs to consider when making overseas payments. One
cost is the exchange rate. Not all companies use the same exchange rate, and
different rates can reduce your spending money by several percentage points.
Visa and American Express post their estimated exchange rates on their web sites
each day. MasterCard requests cardholders call their banks for the daily rate.
The next cost is the transaction fee. Most cards now charge 2% for
each foreign currency transaction. (Lesson: Do not put small foreign currency
purchases on a credit card; pay cash in the foreign currency.) In addition, the
bank issuing the card might impose another fee of up to 1% of the transaction's
value. You can view a chart of the fees charged by the major cards at
www.bankrate.com or contact your card issuer.
Using a foreign ATM can be even more expensive. You will incur most
of the same costs as using a credit card, plus pay ATM fees.
The cheapest approach might be to take traveler's checks in the
currency of the country to which you are traveling, if they are available.
American Express will not charge for traveler's checks purchased at their
branches by cardholders. Otherwise, there usually is a fee of 1% or so for
foreign traveler's checks.
You need to determine all the costs of making overseas purchases by
each of the different methods. Otherwise, your foreign trip will cost more than
you expected, and you won't know the real cost until the credit card bill
arrives. September 2007.
The Safe Withdrawal Rate Revisited
The greatest retirement planning fear of most people
is the possibility of outliving their money. One way to avoid that fate is to
save a lot and invest well during the accumulation years. Those steps are widely
discussed.
Less attention is devoted to the second part of the retirement plan, the
withdrawal phase. Gone are the days when most retirees could move a portfolio
into safe income investments such as CDs or treasury bonds and live off the
interest. Rates are too low for most people to maintain their standards of
living solely on the income. In addition, over today’s longer life expectancies
inflation eats away at the purchasing power of a fixed income. A retiree's
income needs to increase over time, so a retiree needs to invest at least partly
for growth and withdraw part of the portfolio each year.
The question then is how much the retiree can safely withdraw each year without
depleting the portfolio early. Several studies indicate that the "safe
withdrawal rate" in retirement is between 4% and 5% of a retiree's portfolio the
first year, and the closer to 4% the safer one is. After the first year, the
withdrawal amount is increased for inflation each year. Even this withdrawal
rate is not 100% safe. There still is only a 90% or so probability of not
outliving one's portfolio, meaning there is a probability of around 10% of
running out of money.
A 4% withdrawal rate does not provide many people with a luxurious retirement. A
$1 million portfolio generates a $40,000 distribution the first year at a 4%
distribution rate. (After 15 years of 3% annual increases, the distribution is
over $62,000.) A 5% rate equals $50,000 the first year.
Many people believe that the 4% withdrawal rate is too low to maintain the
standard of living they desire and that their savings and investments warrant.
Is the 4% rate too low? Instead of looking at the conclusions of the studies,
let's look at the assumptions that resulted in the conclusions. Then, consider
if the assumptions should be adjusted in your situation. If you believe the
assumptions do not apply to you or are willing to take some risks that are
eliminated in the assumptions, a higher rate could be appropriate for you. Let's
discuss the assumptions.
The studies assume a traditional investment portfolio of stocks and bonds, or
stocks, bonds, and cash. Then, the portfolio is run through different scenarios
based on historic returns. After 500 or more scenarios, the probability of
success is computed. Because historic returns are used, the portfolios
experience extended bear markets of below average or negative returns which can
last 20 years.
Investors are likely to achieve different degrees of success with different
portfolios. The effects of extended bear markets in U.S. stocks and bonds are
mitigated by adding international stocks, real estate, and other assets, as we
have in our portfolios. In addition, the scenarios assume a fixed portfolio
allocation over time. If the portfolio is adjusted to remove highly valued
investments and those without margins of safety, as our Managed Portfolios are,
they are less likely to experience long periods of modest or negative returns to
which portfolios primarily of stocks and bonds are subject.
You also might retire at or near the end of a bear market. In that case,
investment returns during the first half of your retirement are likely to be
above average, allowing a higher withdrawal rate.
If one assumes a more diversified portfolio than those used in the models and
perhaps some judicious changes in the portfolio over time, the portfolio is
likely to sustain a higher withdrawal rate than 4%.
The annual increase for inflation is built into all models, but recent research
calls into question automatically increasing spending with the Consumer Price
Index. Retirees often do not increase their spending with inflation. As one ages
spending on many items actually declines. The spending item that grows the most
is medical care. If one has good medical expense coverage, even that budget item
will not cause a significant boost in overall spending.
Instead of an automatic withdrawal increase equal to the CPI, a steady rate of
increase between 2% to 4% can be used, as can a periodic increase. Many
retirement spending models now assume percentage spending decreases after age 70
or 75. These assumptions also sustain a higher withdrawal rate than do the
assumptions used in the safe withdrawal rate studies.
An alternative to consider after the first year is the formula used by the Yale
Endowment. After the first year, multiply the prior year’s spending by the
inflation rate. Multiply this by 70%. Then, multiply the current value of your
retirement fund by the first year withdrawal rate. Multiply that by 30%. Add
together the two products, and that is your spending for the year.
These three key assumptions do the most to determine the safe withdrawal rate.
The most important factor, however, is the portfolio allocation. A more
diversified portfolio avoids the worst effects of bear markets in U.S. stocks
and bonds and can sustain a withdrawal rate of up to 7% rather than a 4% rate.
Each change has its risks, of course. Adhering to a 4% rate comes closer to
ensuring a steady income for life but risks reducing the standard of living
below what it could have been. Increasing the rate closer to 7% takes the risk
that the assumptions are too optimistic and spending reductions will be required
later in life. August 2007.
People are saving more for retirement
than is generally believed, but are they saving enough?
Two recent studies found that most people are on course to have
enough saved for retirement. One study surveyed those born between 1931 and 1941
and found that at least 80% accumulated adequate funds for retirement. A
separate study whose authors included two economists at the Federal Reserve
concluded that among those ages 51 and older most will have enough resources for
optimal retirement.
In a recent debate about 401(k) plans an official of a firm that
manages such plans pointed out the misleading nature of claims that the average
account has only a few thousand dollars. A high percentage of those accounts are
young people who are only starting to save. He pointed out that the accounts of
older workers have far more money in them and those accounts combined with other
assets generally are enough for retirement. Also, the plans have been
significant retirement saving vehicles for only 15 or 20 years. When today's
youngsters retire after 30 or more years of contributions, they will have
sizeable balances. Today, 401(k) participants in their 60s who have had their
plans at least six years have about $181,000 in their accounts.
But is this enough?
You probably have heard that you should have $1 million or more
saved at retirement. The traditional retirement planning model starts with your
pre-retirement income, assumes you will spend some percentage of that in
retirement (usually 75% or 80%), and that inflation will increase the expenses
each year. The data from those assumptions are used to project how much you need
to save for retirement. If your projections are done using most web sites and
retirement planning software or with the assistance of a financial services
firm, they probably are done in some variation of this method.
As we pointed out in the past and in my book The New Rules of
Retirement, the percentage of pre-retirement income used varies, and there
is little or no research to back up any of the percentages. Recent research
from economists suggests that the approach is wrong and overstates the amount of
money needed in retirement. Some of the research concludes people are being
told to save way too much.
Consumption falls in retirement for most people, but traditional
researchers conclude that is because most people did not save enough. People
adapt to their means rather than continuing their desired lifestyles.
Most of the new research, however, states that consumption falls by
design. Retirees have more time and more choices, allowing them to buy carefully
and do more for themselves. They can spend less without feeling deprived.
Here are some ways retirees spend less than their pre-retirement
income without reducing their standard of living. A very high percentage of
retirees own their homes free of mortgages and have paid for their children's
education. In addition, they eat fewer meals at restaurants but do so by cutting
out fast food meals while visiting better restaurants the same amount of time.
Older golfers play more, but they play at non-peak times when the fees are
lower. Retirees can travel at non-peak times when costs are lower because they
do not have to work around the school schedule. Work-related expenses, of
course, are eliminated. If income is lower, then taxes also are likely to be
lower, though that is true less often than in the past.
Since retirees have more time, they often will do for themselves
things they paid others to do when both spouses had careers. These tasks include
food preparation, cooking, cleaning, and yard work.
One study argues that there is no research showing that retirees
spend more each year, which is a major assumption of the standard retirement
planning models.
To the contrary, the recent research by economists shows that
people are less active as they age, and that brings down living costs. While
medical expenses are likely to rise, most other expenses decline over time.
To reflect these results, some financial planners now propose a three-stage
model for retirement spending. There is a burst of extra spending in the first
five years or so of retirement because of pent-up desires such as travel. During
this period, spending might equal or exceed pre-retirement annual income.
In the second phase, spending is less robust as retirees settle
into more of a routine. They travel less and spend less on big items. Finally,
people in their 80s and 90s spend considerably less in most cases than they did
earlier in retirement. They are less active and might downsize their entire
lifestyle.
There are consequences if traditional retirement planning is wrong.
Saving too much during the working years means depriving yourself and your
family of things when you were younger and arguably more likely to enjoy then.
Another consequence is that people might be able to withdraw safely more than
the 4% annually from their retirement plans that is often recommended, improving
their retirement standard of living. Of course, heirs might end up with more
money if their parents are oversaving and underspending.
One economist, Lawrence J. Kotlikoff of Boston University,
developed software called ESPlanner, available for about $199, using dynamic
programming rather than traditional retirement spending models. It attempts to
incorporate some of the lifestyle adjustments and spending changes over time
that we have discussed. Also, Kotlikoff looks at pre-retirement spending and
determines which expenses you won't need in retirement.
For most people the software estimates savings needs to be far
lower than the widely-used web sites and software. Kotlikoff says
overestimations range from about 35% to almost 80%. A downside is that the data
entry is more burdensome than for the other models.
It is too early to know how accurate Kotlikoff's model is. I
suspect he has gone to the other extreme and underestimates spending. I have
said for years that the traditional planning model is wrong. The pre-retiree
needs to determine the lifestyle he or she wants in retirement and how much that
will cost today. Apply inflation to each expense to learn how much that
lifestyle will cost in retirement and how much money needs to be saved. Also,
plan for periodic major expenses and emergencies. Then, plan on reduced spending
in the later years. Preretirement income is not a factor. Whether that approach
results in a higher or lower target than the traditional method depends on your
desired lifestyle. That is the real point. Retirement planning should not use
rules of thumb. It should use your goals and lifestyle. June 2007. RW
The Futures of Social Security and Medicare
The trustees of the Social Security and
Medicare Trust Funds issued their annual report recently, and as usual it was
dismal. Yet, buried within the report is some reasonably good news for those who
want to see it. That news also is important to those who are planning their
retirement income over the next few decades.
Though Social Security gets most of the attention, Medicare is
in much worse shape. This year the Medicare fund will pay out more in
benefits than it receives in payroll taxes and other revenue. This annual
deficit will grow over time and absorb all of the program’s reserves in 2019
under current projections.
Social Security still is taking in more money through payroll taxes
than it pays out. That will continue until about 2017. The reserve will be
exhausted in 2041.
The trustees estimate that Social Security could be brought into
balance over 75 years with some combination of an immediate increase of 16% in
the payroll taxes or a 13% reduction in benefits. Greater changes are required
to ensure sustainability of the program beyond 75 years. For Medicare some
immediate combination of a 122% increase in the payroll tax and 51% reduction in
outlays is needed to make the program sustainable over 75 years.
The Medicare projections are for Part A. The trustees point out
that Part B and the new Part D prescription drug program are expected to be
adequately funded indefinitely. That is because current law requires premium
increases and funding from general revenues to equal expected costs each year.
The bad news for those programs is that their expenses amounted to 1.3% of GDP
in 2006 but will grow to 4.7% of GDP in 2081. There will be related increases in
beneficiary premiums during that time.
All this is rather daunting for government officials, taxpayers,
and program beneficiaries. But, as I said, there is some good news.
The first bit of good news is that the "days of reckoning" are
farther away than they were a year ago and even farther than five years ago.
The trustees use fairly conservative assumptions to make the projections. In
recent years, results have been better than assumed. Inflation is lower, and
economic growth is stronger. (The bad news from the programs’ standpoint is that
people are living longer.) The program will be in better shape than projections
as long as the projections are more pessimistic than real world results.
More developments along this line could put the systems in better
shape over the years. Another factor that could help the programs is increased
immigration. More workers mean more taxes than projected flowing into the
programs. Later retirements and delayed receipt of Social Security benefits also
would be helpful.
Other good news for most people is that tax revenues into Social
Security will finance about 75% of scheduled benefits in 2041 and later. For
Medicare, revenues will pay 79% of annual benefits after 2019. That means the
programs can last indefinitely if layouts are trimmed to 75% and 79% of current
levels. This can be accomplished through means-testing, such as denying benefits
or imposing higher costs on upper income beneficiaries. Also, overall benefits
could be trimmed a bit. For example, the annual increases in Social Security
benefits could be reduced to something less than the Consumer Price Index.
Medicare might reduce long-term costs by covering more preventive tests and
care.
Future retirees, especially those with higher incomes, should
factor in the possibility of means-testing and reduced benefits.
The trustees lament the lack of action toward addressing the
deficits. They point out that the longer Congress waits to take action the
greater will be the required changes. June 2007.
Financial and retirement planning start
with answering the question in the headline. After determining how you are
doing, the next step is to define the actions that are needed to either help you
do better or at least maintain your current status.
Answering the first question is not as easy as many people suppose.
Traditionally, planners look at the value of one's investments and
other assets and compare that to the present value of future spending. There are
several downsides to this approach. It relies on projections over many years
that in turn rely on assumptions of unknowns such as inflation, tax rates, and
investment returns. Small mistakes or changes in the assumptions greatly
change the evaluation of one's financial health. In addition, the
traditional approach does not consider an individual's full financial picture.
An alternative, developed by financial planner Charles J. Farrell
and first published in The Journal of Financial Planning, recommends also
using three personal financial ratios that are based on income. The ratios then
are compared to benchmarks based on one's age. The theory is that someone with
ratios at the recommended levels is on track to retire comfortably at age 65.
One or more ratios outside the recommended level will tell the individual which
changes to make to return to the track.
The ratios are defined below. In each ratio, Income is salary or
business income. Income from investments is not included. The table gives the
recommended ranges.
Savings-to-income. Savings consist of investment assets but
not equity in the principal residence. Business owners can use the sale value of
their businesses.
Debt-to-income. Debt is broadly defined, so it includes all
payments obligated under auto leases and similar financing. Consumer debt such
as credit cards also count.
Savings-rate-to-income. This is the percentage of pretax
income put into savings annually. It includes all contributions to any
investment account, whether tax qualified or not, and also employer
contributions to 401(k)s or other plans.
If someone did not save enough in the early years, he will have a
low savings to income ratio. This indicates the savings rate will have to be
increased above 12% to raise the ratio. It won't be possible to increase savings
enough to raise the ratio to the recommended level in one year. Instead, the
goal once one falls behind is to adjust savings to reach the recommended level
by retirement age.
The recommended values are based on several assumptions. Generally,
Mr. Farrell assumes that retirement spending will be about 80% of pre-retirement
income and that 12% of income must be saved each year to reach that goal. He
also assumes the post-retirement withdrawal rate from the investment portfolio
will be about 5%. The withdrawals plus Social Security will be enough to reach
80% of pre-retirement income.
The ratios also assume the annual return on investments will be
inflation plus 5%. This is higher than the stock market indexes have returned
since 1998 and, as we discussed in past visits, could be higher than the returns
the next few years. It also could be higher than most investors will earn based
on their investment decisions. Investors who anticipate lower returns have to
adjust the ratios.
The debt-to-income ratio is based on a level that is needed to
reach the 12% savings rate-to-income ratio. It likely is lower than the debt
levels of many people. It also assumes that debt will decline over time, which
is not the case for many people.
The ratios are useful and have the benefit of being easier to
compute than a full retirement saving and spending plan. The ratios are most
useful to people who start to use them before age 40. At that point, retirement
goals are rather hazy, and there is enough flexibility to keep from getting too
far off track. For older people, trying to adjust current finances to fit the
ratios could be difficult, and it is not clear that the ratios are the right
target once one gets closer to retirement.
The main problem with the ratios is that they assume everyone is
the same and that many of the traditional assumptions (such as that retirement
spending will be about 80% of pre-retirement income) are valid. In these monthly
visits and in my book, The New Rules of Retirement, we explored the assumptions
in some depth. We concluded that the assumptions are dangerous to many people.
The better approach is to decide what you want to do in
retirement. Some will want to spend as much or more as they did before
retirement, at least for a few years. Others will spend less. For most people,
spending will vary over retirement. That is why the more you can customize
spending plans, the more accurate your investment and savings goals will be.
Another good approach is described in The Millionaire Next Door
by Thomas J. Stanley and William D. Danko. The book says most millionaires want
to see their next worth increase by 1% to 2% each year. That sounds modest, but
a 1% gain in net worth is a substantial amount of money for many people.
The ratios can be used by younger people to set targets and start
on the right track. As retirement nears, customized plans and goals should be
developed instead of using ratios based on cookie-cutter planning. We will delve
into these issues again in the next visit or two, because new research and new
tools are available to plan retirement spending and required saving. May 2007.
RW
| PERSONAL FINANCIAL RATIOS | |||
| Savings to | Debt to | Savings Rate | |
| Age | Income | Income | to Income |
| 30 | 0.10 | 1.70 | 12% |
| 35 | 0.90 | 1.50 | 12% |
| 40 | 1.70 | 1.25 | 12% |
| 45 | 3.00 | 1.00 | 12% |
| 50 | 4.50 | 0.75 | 12% |
| 55 | 6.50 | 0.50 | 12% |
| 60 | 8.80 | 0.20 | 12% |
| 65 | 12.00 | 0.00 | 12% |
Recommended ratios by Charles J. Farrell, “Personal Financial Ratios: An Elegant Road Map to Financial Health and Retirement,” Journal of Financial Planning, January 2006.
The Surge in Reverse Mortgages
Reverse mortgages suddenly are booming.
The number of reverse mortgages insured by the federal government surged by 77%
in 2006. Areas with high home prices and a high percentage of older people see
the greatest number of the mortgages issued.
Several factors are behind the increase in reverse mortgages.
The aging population increases demand, as does the growth in home equity.
Federal insurance of the loans and new protective regulations also make reverse
mortgages more attractive. Coming soon are innovations by lenders to reduce
costs and make the loans more appealing.
The concept of a reverse mortgage is simple.
A homeowner borrows money. The loan can be distributed in a lump
sum, as a stream of equal payments for life, or through a line of credit. No
payments are due as long as the borrower is living in the home. The lender is
paid when the borrower moves from the home or passes away. Proceeds from the
sale of the home are used to repay the loan plus interest and expenses. The
amount due from the borrower or his estate never can exceed the value of the
home. If the lender is due more than that, it either absorbs the loss or
collects from the federal insurance, if it was an insured loan.
For the loan to be federally-insured, the borrower must be age 62
or older. The borrower must be counseled by an adviser who is independent of the
lender and approved by the Department of Housing and Urban Development. There is
a ceiling amount on loans insured by HUD, which varies by region and is based on
median home values. HUD imposes these rules because it insures the loans.
It is important for the borrower to understand the costs of
reverse mortgages, because this is an expensive way to borrow.
The loan carries an interest rate similar to that on a 30-year
mortgage, though the rate might be variable instead of fixed. In addition, there
are costs including an application fee, origination fee, closing costs, and a
monthly servicing fee, which usually is 0.5% of the loan balance. These costs
often total to around 8% of the home's value. About two percentage points of
this will be paid to the federal government for insurance. The costs all are
backloaded; no payments are due until the home is sold. The interest on the loan
compounds until the loan is repaid.
The amount that can be borrowed is limited, because the lender
wants to be paid in full and the government wants to limit the loans it has to
cover. The older you are, the greater the percentage of the home's value that
can be borrowed. But not many people are able to borrow more than 50% of a
home's value. To develop an estimate of how much you might be able to borrow,
visit www.reversemortgage.org.
The major lenders of federally-insured reverse mortgages now are
Wells Fargo and Financial Freedom. But more lenders will be entering the market,
including Bank of America, over the next year or so. This competition should
reduce costs and interest rates. If you are considering a reverse mortgage, it
might be a good idea to wait a year or two if possible. HUD also is considering
reductions in the origination fee and insurance premiums.
Reverse mortgages above the HUD ceiling are available in what are
called jumbo loans that are issued by lenders and carry no federal insurance.
These loans might be for a higher percentage of the home's value than the HUD
loans, but they also can have higher costs and interest rates.
A reverse mortgage is a way to use home equity without moving
out of the home and without having to make payments during life. But it is
an expensive way to borrow and will reduce or eliminate any inheritance left for
heirs. For these reasons, it should be a last resort. It should be considered
only after other financial resources and options are exhausted. The typical
reverse mortgage borrower is a woman in her late seventies or older. Younger
people generally should not use reverse mortgages, because they will be able to
borrow only a small percentage of the equity. The rest will go to interest and
costs.
There has been a trend recently of relatively younger homeowners
using reverse mortgages to pay for vacations or other nonessentials. A person
could be in quite a bind if he uses a home equity loan in the early years of
retirement to pay for nonessentials, and then later in life needs money to pay
for a nursing home, medical expenses, or home repairs. March 2007.
Pension Lump Sum Payouts to Decline
Lump sum pension payouts are likely to fall for many retirees
over the next few years. The Pension Protection Act of 2006 changed the rules
for computing payouts, and they apply retroactively.
The new rules affect people in old-fashioned defined benefit
pension plans. These are the plans that guarantee annuities to members at
retirement. Members of those plans often have the option of taking a lump sum
payout instead of the fixed payments.
Previously, the lump sum payouts were computed using a treasury
bond interest rate. The new law requires the pension funds to use a corporate
bond rate to compute the lump sum. The corporate yield is higher than the
treasury rate. Using the higher rate will result in a lower lump sum payout,
because the plan is assuming that the retiree will earn a higher rate of return
on the money.
Another change is in the life expectancy table to be used when
computing the lump sum. The new table assumes longer life expectancy. That
actually boosts payouts, because people need more money if they will live
longer. The net effect of both changes is that plan members who opt for a
lump sum are likely to receive a lower amount than under the old rules.
The new rules begin to take effect in 2008 and are phased in over
five years. Because of the phase-in, the rules actually boost lump sums in 2008
for at least some retirees. That is because the life expectancy tables are
initiated without a phase in, but the interest rate change is phased in. The
result is a higher lump sum in 2008 under the new rules than would have been
paid under the old rules but lower payouts in subsequent years. But some higher
income retirees face the changes in 2006 and later.
Defined benefit plan members who plan to retire in the next few
years should consider their options carefully. Those who want a lump sum
might choose to retire in 2007 or 2008 if they have flexibility. Those who
retire later should reconsider taking a lump sum.
There are several reasons why a retiree might want to forego a
guaranteed retirement income and take a lump sum.
One reason to take a lump sum is concern about the financial health
of the pension plan sponsor. Some sponsors in airline, steel, and other
industries have filed for bankruptcy protection and had their pension plan
obligations discharged. That is not a big problem if the annuity is no more than
the maximum amount guaranteed by the Pension Benefit Guaranty Corporation. But
it does spell trouble for higher income retirees.
A lump sum also is favored by retirees who believe that they will
be able to earn a higher return on the money than the rate assumed in the plan’s
computations. If they deliver, then they will have more money to spend in
retirement or to leave to their heirs.
Retirees with poor health or ancestors with short life spans might
take lump sums. They would receive less money over their lifetimes from an
annuity if indeed they expire before life expectancy, and none would be left for
heirs.
Some retirees choose a lump sum because they have large cash
expenses in the first few years of retirement. They want the lump sum to pay
those expenses instead of having to borrow money and repay the loans from their
annuities over time. January 2007.
Evaluating Those Free-Financing Ads
Flip through the ads in the
newspapers and you will find offers for attractive financing of purchases of
high-ticker consumer items. The offer usually states there is no-interest for a
period of one year to three years. The offers are most likely to cover purchases
of electronics (such as big screen televisions) and furniture.
Are these deals as attractive a