Retirement is a long journey that you should plan to last three decades. During the journey you’ll be using the money you have previously saved, earnings from your investments, government or private pension, Social Security and maybe earned income, inheritance or gifts. As the years pass the same goods and services will cost more and more as inflation erodes purchasing power. Unexpected emergencies, deteriorating health, bad decisions, rotten luck and sorry investments are also possible. It’s easy to see why the greatest fear of retirement is “running out of money”.

The stock market is known to all, but understood by few. This is the place where you can buy and sell partial ownership (shares of common stocks) in great American companies. The price of shares is a function of both short and long term influences. In the short run prices are affected by investors’ expectations about where the market & economy are headed, global developments, quarterly earnings and numerous other real or psychological factors. In the longer run stock values generally track corporate earnings with consistently profitable and growing companies going up in value and unprofitable or shrinking companies going down. Since few, if any, of these underlying drivers of values are known, the stock market is inherently risky. You can double your money if you guess right or lose it all if you guess wrong. As was witnessed during America’s Great Depression or in Japan since 1990, stocks can consistently lose value over many years, or even decades.

Those who sell stocks to the general public make a commission each time a stock is bought or sold; therefore, it is in their best interest that people participate in the market. The “investments” bought and sold take many shapes and sizes from shares of individual stocks, mutual funds, options and more with each offering a dazzling array of choices. To keep you committed to the market Wall Street’s “representatives” have devised a bewildering language of jargon that most of us, and many of them, don’t understand. Added to the jargon are myths they spin to keep you committed. Myths like “don’t sell now you’ll miss the coming rally, in the long run you’ll be fine or don’t think losses when the market falls, think buying opportunity.” Even though these myths are consistently wrong, many retirees stay the course and keep their money in the market.

So, will the market come back? How long is the long run? Do you have the nerve to buy when the market tanks? By journeying back into the most recent past, analyzing market trends in other countries or recalling your past market experiences, you’ll conclude one thing: the market is risky. It can take your retirement money and never say sorry. Yet, the stock market is the main depository for retirement money because myths like “long term you’ll do better in the market” are simply too powerful to resist. I encourage you to resist the temptation if any of the following fits you: (a) you’ll need all your savings to get you and your loved one to the end of retirement’s journey; (b) you have no way to replace losses if you guess wrong; (c) you don’t fully understand the risks you are taking; (d) your past worries with the stock market has kept you from sleeping; (e) the broker/money manager that is telling you what to do today is the same that lost you money yesterday. If you believe the market is not potentially hazardous to your retirement well being, please study the American stock market movements over the past 20 years or review Japan’s experience since 1990. Below are the graphs of both. Is the Nikkei two decades ahead of the DJIA? Is the DJIA now at its historical peak like Japan’s Nikkei was in 1990? Will the DJIA mirror the Nikkei and fall to 2500 in the next 20 years? Looking back 20 years from now will we be looking up at the last peak in 2007 or looking down from a higher peak? Anything is possible so please be careful with your retirement money.

Shelby J. Smith, Ph.D.
August 25, 2011

Most Americans get Social Security benefits or possibly a pension, but these generally fall short of what is needed for their planned retirement lifestyle. Let’s say you’re in the middle of retirement, your savings are running low and you’re facing your greatest fear: running out of money. You have equity in your home but selling it and moving in with children, a relative or to an apartment is a dreadful thought. What can you do?

The U.S. Department of Housing and Urban Development (“HUD”) has a program whereby the Federal Housing Administration (“FHA”) and others guarantee loans made by private lenders against the equity in your home. To qualify there must be equity in your home above your mortgage if there is one, the youngest owner or joint owner must be at least age 62 and the home must be your primary residence. You do not have to make mortgage or interest payments during your lifetime. You, or your heirs, have the right to repay the loan at any time. The loan repayment amount can never exceed the home’s sales price or the appraised value if there is no sale. The shortfall, if any, is guaranteed by insurance purchased from the FHA or others. The amount of money loaned on your home equity is a function of your age, current interest rates, amount of home equity and the appraised value of your home. The loan is called a reverse mortgage and is gaining favor among retirees that want to use their home’s equity to supplement their retirement income.

Once the reverse mortgage is made you agree to live in your home, keep it in good repairs, maintain your homeowners’ insurance and pay the real estate taxes. You may use the money from the reverse mortgage however you wish. The money will be paid to you as a lump sum, installment payments or a line of credit that you can draw down as needed. Let’s say you decide to take a lump sum payment.

One option would be to purchase an immediate annuity that pays you, and your surviving spouse if you elect, a guaranteed lifetime income. The immediate annuity will pay a guaranteed lifetime income regardless of how long you live. If you use the immediate annuity make sure you choose a term certain, say ten years, with a lifetime option. This means if you die prematurely your named beneficiary will get payments for the amount of time remaining on the ten years. If you die after the tenth year has lapsed, the annuity payments will stop.

Another option is to purchase a deferred annuity with a guaranteed lifetime income rider. You may have to “hold out” enough money to provide the first year’s income unless the guaranteed lifetime income can be started immediately. The advantage of this option is that you can later change our mind and withdraw your remaining money lump sum. To take advantage of a reverse mortgage to supplement your retirement income, you should first discuss the strategy with a financial planner. For steps to a reverse mortgage see: http://www.reversemortgage.org/Default.aspx?tabid=236.

Shelby J. Smith, Ph.D.
August 24, 2011

Who thinks taxes will rise in the years ahead? Everyone, that’s who! Who has money in the market? Virtually everyone because Wall Street has convinced us that we’ll do better there long-term. The only options currently available in employer-sponsored retirement plans are market investments, and when money is rolled to IRAs or otherwise invested old habits point us toward “the market”. We’re bombarded with ads about “market advantages” and when the crash comes the message changes to “don’t sell now, you’ll be fine longer term, selling now turns paper losses into real losses, ad nauseam”. Meanwhile Washington whistles past the graveyard of worried-to-death retirees as the market changes from Bull to Bear. Lemons mean lemonade!

If you have an IRA that is in the market, you currently have less money because the volatile market has moved south. I’m convinced, and I suspect you are as well, that future taxes are headed higher for everyone. Maybe you have money in low paying bank CDs that are wasting away to inflation. Why not convert some or all of your IRA money to a Roth IRA? You could pay the taxes with zero-interest-earning bank money. If you want, you could even move the new Roth IRA money to a safe harbor like a fixed index-linked annuity. The annuity’s bonus will offset some or all of your market losses and your lower account value means the income taxes will be less even if future taxes don’t rise. Also, if you have a change of mind or circumstances you can “recharacterize”, or do over, and go back to your traditional IRA. Why might you change your mind? Your tax rates could fall; money left in the market could lose more value; your job, health or other circumstances could change. The Roth IRA conversion do-over is truly the free lunch for smart people, served courtesy of a loophole in the Roth IRA provisions. Let’s look at more detail.

The money converted to a Roth IRA must be counted as income in the year of conversion and ordinary income taxes paid. Accordingly, you will want to make sure you don’t graduate to a higher tax bracket. If so, you can convert some of your money with plans to convert more next year. If you later change your mind you can unwind the conversion and go back to your IRA without having a tax liability. If you do a partial conversion, I predict you’ll have ample opportunities in the next couple of years because the outlook for the market is not encouraging. The DJIA is currently at about the same level as April 1999, and that’s before adjustment for inflation. This 12-year period is roughly half an average retirement; thus, so much for the “Wall Street Myth” that you’ll be okay in the long run. The market in the most recent decade has earned very poor returns.

If you go from a market investment to a traditional or index-linked annuity with a bonus, you need to do the conversion to a Roth IRA before you move the money into an annuity. The reason for this sequence is because if you convert to a Roth after the annuity is purchased, your account value could be higher which means you could pay income taxes on the bonus. I say “could” because this matter has not been addressed by the IRS and you don’t want to be the test case; thus, do the conversion before the bonus annuity is purchased. If your brokerage firm is reluctant or slow to complete the conversion to a Roth, you can move the money as an IRA to your bank’s money market account via trustee-to-trustee transfer, convert to a Roth and then transfer again via transfer to the annuity with a bonus. There is no limit on the number of trustee-to-trustee transfers, but a rollover that pays you the money can only be done once per year.

If you want a good summary of Roth Conversions that also shows you how to use fixed and index-linked annuities, read my recently updated “Conversion to Tax-Free Roth IRA” at www.theretirementpros.com.

Shelby J. Smith, Ph.D.
August 23, 2011

In a Wall Street Journal Article on August 15, 2011 titled “Which Way to Retirement?”  Kelly Greene wrote:

“Hitting the “sell” button on your stock portfolio, after the Dow Jones Industrial Average has fallen 11.1% in three weeks’ time, could hurt you more than anything else. Not only would you be locking in losses prematurely to preserve capital you might not need for years, but you also would miss out on any future rally.”

The article goes on to tell horror stories about people who had planned to retire but now can’t because of market losses.  Here are a couple excerpts:

“Lynette Robinson, a 65-year-old executive director of a consortium of colleges, was planning on retiring this November —until her investments took a hit this past week.”

“Kevin Fitzgerald, a 55-year-old marketing executive in Highland, Colo., says he regrets not hedging his 401(k) investments after watching his account lose $250,000 — one-third of its value — last week. Now, he expects to work at least 11 more years.”

Notice article’s advice: don’t sell now because “you’ll be locking in losses”, “you’ll miss the coming rally” and later advice was given to purchase a variable annuity.  A variable annuity is simply a very expensive (pointed out in the article) mutual fund in an insurance company wrapper to make it tax deferred.  Yes, you can get lifetime income from variable annuities but if you decide to bail out early you’ll get the underlying value of the sub-accounts, i.e., mutual funds, and if the market is down they’ll be underwater. 

From this article we’re led to believe if we sell now we’ll be “locking in losses”.  Would it be fair to say that if the market continues to fall we could be locking in smaller losses?  Surely we’re not being told that this is the bottom because no one knows where that might be.  Second, since we’re advised that we could miss the next rally, does this mean there will be a “next rally”?  What is not being told about the next rally is “when” and “starting from what level”.  Last time we had a meltdown it continued until losses were 54% and then it started to rally, stalled and then headed south again.  We’re currently a long way from the last peak and there’s speculation about another market meltdown.  What then?    

The WSJ article is very typical because the “safe money” options are never considered. What is wrong with saying “the stock market is too risky for those near retirement who cannot afford to retire if the market declines”?  What’s wrong is that the authors of such articles and their newspapers are influenced by the loud voices of Wall Street and Wall Street does not offer safe money options.  Since Wall Street only makes commissions when Main Street keeps their money in the market (so they won’t realize losses or miss the next rally), I’m not surprised at their “hang in there everything will be fine in the long run” advice.  Did you know that the S&P is currently at the same levels as 1999 and that’s before inflation is taken into account. Is 12 years long-term?  It is if you’re retired – in fact, it’s about half the typical retirement.  So maybe you will not be “good in the long run”.

My advice to those in retirement’s red zone is to take their money out of the market unless they can afford to lose it.  If they elect to ignore this advice, they may have to forget retiring, work longer or settle for a watered down retirement.  Look at any 401(k) and you’ll see only market options.  Most employer-sponsored retirement plans aren’t retirement plans at all, they’re “investment accounts”.  By not selling you’ll avoid losses, catch the next rally and live happily ever after! Why do retirees continue to believe this nonsense when history proves it’s a myth?

Shelby J. Smith, Ph.D.
August 19, 2011

“It’s best to leave stocks alone to recover from the loss and to draw instead on the fixed-income (bond) portion of your portfolio.”  Katherine Reynolds Lewis, Bankrate, Inc., August 11, 2011

The above statement was made in an article titled “5 Fixed-Income Bear-Market Strategies for Retirement”.  While this appears to be solid advice and mirrors “conventional wisdom” it is based on two questionable assumptions: (1) stocks will recover and (2) bonds are immune to losses. 

If you have your retirement money in a portfolio containing both stocks (including mutual funds) and bonds and have losses in your stocks, the above advice says you should avoid selling stocks for income because you’d have to sell more shares for a given income than if prices had not declined.  Instead you are advised to sell bonds in your portfolio to give your stocks time to recover.

Is there some law that prevents stocks and bonds from losing value simultaneously?  The answer is NO.  If stocks are falling and interest rates are rising, you’ll be losing money in both stocks and bonds.  Has this ever happened?  It most certainly has, as a cursory review of history reveals. So the assumption on which the “conventional wisdom” is based has a serious flaw.

Second, how do you know stocks will recover?  In August 2011 the Dow Jones Industrial Average (“DJIA”), a closely followed index that measures movements in the stock market, is at the same level as August 1999.  That’s 12 years without gains and that’s before we take into account inflation.  If adjustment for inflation were made, the DJIA would be much lower today than it was in 1999.  Twelve years is roughly one-half of a typical retirement and most retirees simply cannot wait this long in hopes that their stocks will recover.

Unfortunately there is no market strategy that guarantees you’ll not run out of money before retirement ends.  Accordingly, it might be prudent to avoid the market with your retirement money UNLESS you have more than needed for retirement and can afford the potential losses. 

Sadly, far too many retirees cannot afford the risks of the market yet that is exactly where they have their life savings that they hope will carry them through retirement.  Retirement is about keeping what you’ve got rather than trying to earn above market returns by gambling in the market. 

Take a stroll back through the years since 1999 and review what has happened to the market.  From mid-January 2000 until early October 2002 the market fell 38% in response to the dot.com bust and did not recover to the 2000 level until early October 2006 – over six and a half years later.  After the market matched the 2000 peak it continued to rise until early October 2007.  It then went into a tailspin loss of 54% in response to the housing bubble before bottoming out in early March 2009.  Since then it has been extremely volatile and has recovered only 62% of the previous loss at the time of this writing.

Where will the market go from here?  No one knows but the economic signs are not encouraging for the stock market in the foreseeable future.  How about bonds?  When interest rates rise, bond values fall. So which way do you think interest rates are going in the next several years?  Loose fiscal policy during and after the Great Recession points toward future inflation and higher interest rates.  Currently interest rates are the lowest in a generation and there is little room for further declines; thus, the odds favor higher future interest rates and falling bond prices.

If your retirement money is in the market – stocks, mutual funds, variable annuities and/or bonds – ask yourself this question: can I afford losses?  If the answer is NO then why are you in the market?  There are safe money options that guarantee you a lifetime income regardless of what the market or interest rates do.  This is where at least some of your retirement money belongs.

Shelby J. Smith, Ph.D.
August 18, 2011

In recent months the financial press has been filled with recommendations to use immediate annuities to lock up a lifetime income. Even the Government Accounting Office (“GAO”) recommends supplementing Social Security with a lifetime income annuity. In today’s low interest rate environment, immediate annuities that lock in historically low rates might not be a smart move because logic says stay in “short maturities” when rates are low. How can a lifetime income be locked-up now, yet not locked into today’s low rates? Here are two alternatives that deserve your consideration.

First is the “laddered approach” to investing. Since you’ll likely use your money piecemeal over the full length of your retirement, some investments can mature near-term to meet next up needs whereas other money can be earmarked for late-in-retirement use. Accordingly, it makes sense to select maturities that come due when the expected expenditure will occur. You can ladder maturities rather than locking in today’s near zero interest rates. Let’s consider an example.

Assume you have $250,000 in retirement savings and want to supplement your Social Security and other income over the next twenty-five years. A five-rung income ladder can be built for you by allocating money to each rung, or bucket. We’ll start with an immediate annuity as the GAO has recommended and use term annuities for the other rungs. We’ve assumed a 3% rate for the immediate annuity, a 5% return on the longer money and a 3% rate of inflation. The first rung of your ladder will use $59,000 to purchase an immediate annuity that pays approximately $12,900 a year for five years. The next rung will use $50,250 to provide at least $14,815 income for years 5 through 10 – slightly higher to compensate for inflation. Rungs 3, 4 and 5 will use $45,283, $40,803 and $36,766 respectively to provide income of $17,037, $19,593 and $22,532 for the three remaining five-year periods. The unused $17,898 will serve as reserve emergency savings that grows to $29,154 at the end of ten years and $47,489 in twenty years and is always available for use.

Bear in mind that a very conservative 5% earnings rate was used over the entire 25 year period. Judging from history, it seems logical to assume that you’ll do much better, which means the annual income shown above will be higher. Importantly, you have not locked in today’s fixed rates for the entire period as happens if only an immediate annuity is used. Using fixed index-linked annuities as the savings choices gives you safety, flexibility, predictability and tax advantages. A plan similar to the foregoing can easily be prepared by your financial advisor and just as easily implemented to give you peace of mind. Since future interest rates are unknown, your future income will be close approximations. To take up the potential slack the reserve emergency fund is created. Your plan not only has inflation protection and potential higher future earnings rates but also prevents you from running out of money.

The second option that beat an immediate annuity is the “lazy way”: lock in a lifetime income using an index-linked fixed annuity whose gains are permanently retained even if the market nosedives or interest rates go to zero. Once your guaranteed income is turned on, there are automatic lifetime income guarantees and peace of mind. You will not earn a bundle if the market soars but you won’t sing the blues if the market tail spins.

Up-front bonuses and rate guarantees allow you to not only earn great rates until the income is started, but to know precisely the minimum amount of your lifetime income. While this isn’t as exciting as trying to outguess the market or as near-sighted as keeping all your money liquid as if it will be needed tomorrow, it is a prudent and safe way to address your greatest fear of outliving your money. Work with your financial advisor to craft the right plan for your circumstances so you can find peace of mind in retirement.

Shelby J. Smith, Ph.D.
August 2011