Leverage and Retirement

Over the years I have written about the topic of retirement planning, I have witnessed some incredibly crazy thinking. Many of those thoughts have come home to roost often too late for the investor to do anything to fix the situation. We plan, we tell ourselves, to retire at a certain age with a certain amount of money based on a certain withdrawal rate.  But those plans are often dashed by unforeseen events that, in hindsight we should have anticipated.

Recent reports have pointed towards an increase in employee contributions to their 401(k) plans. These upticks, however slight lead many to conclude that we are starting to get the message. But which message are we holding on to? Is it the need to simply save more because we know the chances are we will need more or is it the result of some other encouraging news? I'm inclined to go with the second choice.

Retirement planning is a whole package endeavor. In other words, simply putting money away for retirement is not enough. Numerous other pieces of the puzzle come into play and this is what is often ignored. The effort is noteworthy only if you have developed a budget that is actually less generous, forcing you to face the reality of an income in retirement that is not the same as the one the you had while working.

This income reduced budgeting is practiced by too few close-to-retirement planners. At no time in the history of retirement planning - and I'm going way back to the generous days of the defined benefit plan or pension - was the payout at retirement designed to replace 100% of what you live on now. The number was actually closer to 70% replacement and that was only if you had worked within the confines of that pension for thirty years or more (and it was not impacted by changes from the company). The remainder was to be supplemented by Social Security.

But with advent of the defined contribution plan (401(k), 403(b)), with the responsibility for funding your retirement placed squarely on your shoulders, we were forced to face the possibility that 70% of our current income would not be replaced. In order to get those kinds of post-work rewards, we would have had to invest 12-15% of our pre-tax income, every year without fail, in good markets and bad. For too many people with this plan, that sort of budget-busting restriction was simply too much to embrace.

We are to be forgiven for our human-ness however. We make mistakes and follow the herd - when they sell, we sell and when they pile in, we follow. In both instances we turn our backs on the whole concept of retirement planning: steady and ever-increasing contributions without consideration for what the overall market is doing.

Our employers didn't help much either. They gave us matching contributions, took them away or reduced them, and when they re-introduced them, they were far smaller. And we misinterpreted this as a sign that they knew something we didn't and mimicked their actions: we reduced our contributions when the matches were lowered and increased them when they were raised. As I said, we can be forgiven this tendency but we won't be absolved of this sin of remission when we begin thinking about retirement.

One of the other keys to the seemingly good news about an increase in contributions in 2011 is backlit with some additional news. Auto-enrollment helped to raise the account balances of the overall plan (and as employment improves, so will the news that we are using the plans in a more robust way). But those auto-enrolled new hires were placed squarely in the plan's target date fund of choice.

Long-time readers know about my reservations with these funds. New readers should note: target date funds are often less transparent than stand-alone funds, the underlying portfolio can be suspect, the target date may not be far enough in the future to be realistic and to date, the rebalancing implied in the fund is not determined by any specific guidelines. In other words, those who are put in a target date fund via auto-enrollment would be wise to get into an index fund (or four raging across a variety of markets) as soon as possible.

Those folks, the youngest among us who are the most likely candidates for these auto-enrollment options can make changes that will get them much closer to the goal. Older workers, however don't. And they know it. But they have some advantages, at least in their mind that the younger worker doesn't: equity.

And that equity in their homes, combined with the historically low interest rate environment has given many Baby Boomers a second option: to borrow against their homes and take the refinanced money and put into their retirement accounts. Is it a good idea or one that is bound to backfire?

Three things make it risky. One the equity in your home may not recover. Older homeowners who tap their home's equity are doing so at the risk of increasing their mortgages at a time when additional debt, no matter how inexpensive is not prudent. Two: They are eliminating a safety valve that could be used if retirement got too rough: the reverse mortgage. And third, if they are forced to or simply want to sell, the equity in their property is not there to give them a downpayment for new housing.

Leveraging your home to finance your retirement account does come with some tax advantages though. Just because one account increases as one is leveraged doesn't necessarily give you a balanced approach. In other words, there are "veiled risks".

You will still need to allocate your portfolio to perform better than the cost of the new loan and the interest rate you pay. This means that year-over-year, you will need to do much better than you may have calculated. A four percent mortgage added into the cost of the refinance (another one percent) added to the rate of inflation (another three percent if it holds steady) means your portfolio will need to return north of eight percent year over year - without fail.

The only way to give your retirement income any sort of sure footing is to increase your contributions by a much wider margin than what has become known as the average - 8% - and pay down your mortgage.

Fifteen percent is still the optimum contribution rate and even that number will give you only 75% of your current income in retirement - provided you saved for twenty years or more. Paying down the mortgage reduces your overall cost of debt service while increasing your equity.

Retirement Planning and Fidelity's Long-Term Care Insurance Estimates

Recently, Fidelity, the mutual fund giant began surveying insurance providers asking how much long-term care insurance you might need to calculate into a retirement strategy, often referred to as a plan. In truth though, it is only a strategy that if followed over the course of a great many years, develops into what looks to be a well thought-out plan. Plans seem so inflexible. (I travel deeply into this jungle in the tenth chapter of the book Retirement Planning for the Utterly Confused.)

Mark Meiners, director of the Center for Health Policy, Research and Ethics in the College of Nursing and Health Science at George Mason University says “Unfortunately, many Americans falsely believe that their long-term care costs will be covered by Medicaid, but this is true only after they’ve spent themselves into impoverishment.”
As I write in the book, “I can tell you two things for sure. Social Security and Medicare will not pay for your long-term care.

“Most insurance companies use a fairly straightforward criterion when making the decision to pay the insured for their claim. The insurer will require a certified and licensed health provider do a determination of “chronically ill”.
“What is chronically ill you ask? Generally this refers to someone who is incapable of performing at least two daily activities of living such as feeding themselves, bathing and toiletry activities or someone who requires substantial supervision. This is often referred to as an ADL or Activity of Daily Living.
“Sounds simple enough but insurance companies rarely have fixed guidelines when it comes to triggering the policy. Policies can be written to cover a variety of care situations and you must determine this at the time of policy execution. Problem is how do you know what you will need. Will your policy need to cover a nursing home stay, of which a portion of the total is reimbursed over a preset time period?”

That said, I think everyone considering this kind of a policy read the book, I will take what Fidelity has suggested and see if it passes muster.

Fidelity recommends that folks considering a long-term care policy narrow the search to six categories, each with its own characteristics.

1) A policy premium that fits comfortably within a family’s financial means.

At first glance this sounds like a relatively easy target but the main problem with retirement and the saving for it, those premiums can eat up a good deal of potential retirement cash. Finding the right balance between saving and tossing the cash to an insurance policy, that is cheaper the earlier you buy it, can be so difficult to determine that most folks who may need it will pass on the chance.

Fidelity writes that, “Investors should carefully forecast their ability to pay the premiums year after year.” I think is both bold and wrongheaded by a mutual fund company to refer to insurance as investment. Insurance is not a liquid asset.

Bottom line: Figure about $200 a month if you are fifty years old, in good health and have prioritized all of your other insurance products based on risk. A 65-year-old might pay as much as $350.


2) Backing by a carrier with a strong track record of paying claims.

I have argued this topic over the past months with numerous people in the field. Fidelity offers this piece of advice: “The ability to receive policy benefits depends on the integrity of the company and its history of financial strength.” This is huge unknown since so few are actually in the position to pay out on claims. Once the baby Boomers retire en masse, it will be difficult to switch policies if your insurer turns out to be financially unable to handle a sudden increase in claimants. Like all insurance products, the gamble is on both ends, with the insurer and the policyholder.

3) Comprehensive coverage that covers in-home as well as facilities-based care.

Fidelity found that families want “flexibility in terms of the services they opt for when facing a long term care challenge.” Remember, this kind of flexibility will cost you extra. Few folks calculate in the inflation factor and/or whether the facility will keep you. Most folks would rather stay at home.

4) A benefit period of at least 2, but no more than 4 years, for each person.

Most people split the difference.

The numbers Fidelity analyzed are not so bad in terms of how they were gathered. But consider this. Most disability policies run for five years. The data they collected “on over 6 million long-term care insurance policies sold between 1984 and 2004, found that 75 percent of all individuals would not have exhausted benefits lasting 2 years. A 4-year benefit period would have been adequate 90 percent of the time.”

Sometimes, companies will separate the policy into nursing home or in-home care coverage but the lifetime benefit is easily calculated by multiplying the benefit times the policy coverage period.

Like many policies that have a wide swath of unknown territory to deal with, such as LTC policies, there is generally a waiting period before the policy kicks in. Because Medicare covers the first one hundred days, many LTC policies do not begin before 90 days. You can request a shorter waiting period but the monthly premium is often prohibitively higher.

5) Five percent guaranteed annual benefit increase except for buyers older than age 75.

Fidelity seems to have little faith in the Federal Reserve’s ability to use monetary policy to keep inflation in check. The 5% mark is well about what the nation’s top bankers deem suitable. Inflation protection usually comes via a rider on the policy. Three percent is usually the norm with the costs of this add-on rising with each percentage point in protection.


6) For joint policies, a “shared coverage” provision that enables each insured person to tap the other’s benefits if necessary.

This may be one extra cost too many.

Now consider the following. You put $180 away in a portfolio with a modest long-term return of 9% and save it for 20 years, taxed at 10% and with inflation calculated at 3%, you would have amassed $56,447. The policy paying $300 would cover only $129,600 in total lifetime cost, which, if you suspect you will be in relatively good health, will leave paying for a policy that may have been just as well been paid for in cash.

If you need cold hard facts... You will need $100,000 in savings at retirement for both you and your spouse to cover health care and insurance. From that point, you should calculate your retirement savings.

I would pass on the LTC if you were planning on leaving nothing to your heirs (but you still need to save much than you are now unless you want to spend those golden years with your kids). But if your heirs are concerned about you spending down their inheritance, ask them to chip in on an LTC policy and then it might be worth the costs.

Retirement Planning and Risky Portfolios

They must be pretty smart down in Corpus Christi. I’ve never been there. Judging by the personal finance column that appears in the Caller-Times, H. Swint Friday a professor of finance at Texas A&M University-Corpus Christi with a doctorate in finance and a master's in economics and is a certified financial planner thinks they are. From what I gather, the folks who live there, even the beginners down in Texas take risks.



Corpus Christi Harbor

Mr. Friday, whose column titled Personal Finance 101 suggests some restructuring for your portfolio based on research offered by Harry Markowitz, a mathematical economist. Professor Markowitz, also no slouch in the credit department is also mentioned as the founder of the Modern Portfolio Theory and was involved in optimal portfolio performance research.

We all know what optimal portfolio performance is. Right? No? Without a lot of the mathematical twists and turns, it is the perfect balance of risk. Providing of course you know what kind of risk tolerance you have, which many of us don’t, you can create what Mr. Friday and Markowitz call an M portfolio.

This, at least according to Mr. Friday, is beginner’s stuff. All you have to do is understand that “Higher standard deviation portfolios are more volatile” which I'm sure all of you know.

In all fairness, before he dangles the hope of the perfect portfolio in front of those readers, he does offer some disclaimers. You should be well aware of composition, a nice word that offers up a blend of not only tolerance and wealth but also the intent. The desire for returns, as Mr. Friday writes is not even on the list when investors in Corpus Christi consider building this type of investment.

You would hope that your financial adviser has the sense to pick up on all of these nuances, subtract liabilities and then, calculate what you are worth as an earner. The higher the net pay, the greater the score your financial adviser might give you for your ability to live up to your potential human capital.

“Human capital” is what pensions are all about. Companies were able to exploit your human capital when you were younger and as you aged, offered payment for years of loyalty with a pension for your after-work years. In retirement planning outside of a pension, this carries extra importance. It is why it so critical to get going as early as possible in your working career on building a retirement account to allow compounding to do most of the heavy lifting.

When Mr. Friday discusses human capital, he is looking at the potential for losing everything against the how long your income recovery time is.

Mr. Markowitz’s portfolio research suggests that his M portfolio, after buying risk free T-bills as a hedge against the risk, what the investor should “own to some degree is a mix of all the assets in the world at their respective values in the world portfolio of assets. That is, each asset including oil, timber, gold, silver, beef, art, real estate and so on is included in this portfolio and they are included at their current representative value in the world portfolio. So, for example, if the total value of the world's portfolio is $100 and the total value of the world's oil is $1 then oil would have a 1 percent representation in the M portfolio.”

All you beginners out there get that? Did it offer any of you experts out there something that you might find plausible?



Mr. Friday’s lesson in how to build a portfolio has merit but not for anyone who considers themselves at more than the halfway point of their working career. Such a portfolio would probably do spectacularly considering the rising prices of commodities of late. With demand looking to increase for the world’s limited supply of what looks like a long list of raw materials, even a few that might qualify as hedges against inflation, the average investor would be better off avoiding such risk the way the M portfolio outlines.

But if it seemed like something you just have to try, consider doing it as part of a mutual fund/ETF. One, operated by the noteworthy Jim Rogers comes to mind. According to RCG Alternative Investments site, “The Rogers International Commodity Index (RICI) represents the value of a compendium (or "basket") of commodities employed in the global economy, ranging from agricultural products (such as wheat, corn and cotton) and energy products (including crude oil, gasoline and natural gas) to metals and minerals (including gold, silver, aluminum and lead). As of July 31, 1998, there were thirty-five different contracts represented in the Index.”

This would mean your portfolio, if constructed as suggested, would be based on only two investments: The commodity index (The RICI TRAKRS Index is a total return index designed by Merrill Lynch, Pierce, Fenner & Smith Incorporated and is traded as a Dow Jones Index) and T-bills. I would be wary of that kind of limited diversification no matter how much you made, how risky you felt, or what you estimated your human capital to be worth.

Adding some additional investments and bringing each of those investments down from 50% each to only 10% would give you just enough risk for any portfolio. Both investments are hedges against inflation and although that might seem like a logical place to put your money today, allocating too much of it in both would not give you the long-range options that a balanced risk portfolio would.

Retirement Planning and the Rebalance

(Author’s note: This topic will be discussed at length in the book I am currently working on, Mutual Funds for the Utterly Confused, scheduled for a January 2009 publication. You can look for updates on the book at Mutual Funds – Explained as it is written and edited.)

There are some really smart people out there asking some really intelligent questions. Jie (Jay) Cai is one of them. He is currently Assistant Professor at Drexel University in the Department of Finance at the LeBow College of Business in Philadelphia, Pennsylvania. The work he does, while often academic, touches on some of the thoughts that the average investor might have in the course of making decisions about whether to invest in this fund or that one.



The subject of rebalancing comes up often. As investors age, they are often advised to rebalance their individual portfolios to avoid unnecessary risk or exposure for a market that might be too volatile – a suggestion seems better suited for another era. If the argument for retirement savings is based on the fact, as we discuss in the book, that we have not saved enough, then why are we acting as if we did and rebalancing our portfolios.



Mr. Cai along with another very bright fellow, Todd Houge (The University of Iowa, Henry B. Tippie College of Business, Department of Finance) took a long look at the effects of rebalancing inside an index. What they discovered might be considered enlightening.

Before we move on too far, just a brief reminder of what an index does. It is meant to extract a certain group of stocks from the market because of some type of criteria. The S&P 500, an index that is managed by the Standard and Poors Company, keeps track of the largest 500 companies based on market capitalization (or worth – shares outstanding multiplied by the price of those shares). Numerous companies do this to help investor get an idea of how the market is performing based upon just such a grouping. Only the Dow Jones Industrial Average is price-weighted.



Cai and Houge focused their efforts on the index most commonly used to track smaller sized companies, the Russell 2000. Unlike the S&P 500, which actually has 500 companies in its index and among them, the best performing rarely get removed; a small-cap index does not carry the whole of the small-cap universe. They simply can’t.

The reason is simple. Many of the companies in this type of index are too small, rarely traded and considered illiquid. If the Russell 2000 suddenly shifted its balance, all of the funds that track that index would need to purchase the new shares of the latest addition while selling the shares of the latest deletion. This could have not only a negative effect on the share price, but would, in some cases punish the funds who need to buy those companies but are unable to find an adequate amount of shares in the marketplace.



But suppose you didn’t sell the shares of the companies kicked to the proverbial curb. According to the two men, “a value-weighted portfolio of index deletions return an average of 1.52% per month compared to only 0.87% for non-new issue index additions.” This continues for the next five years although the gap does narrow somewhat.

More so in the next book than this one, I talk about how and why actively managed mutual funds choose a certain index. Some are actually trying to mimic the index while some are trading the same companies held within the index. It would be hardly fair to compare a small-cap growth fund with the largest names on Wall Street.

Here’s the problem. Index funds have their place in a retirement portfolio and, it is not inside your retirement account. (Buy the book to find out why. If you already own the book, you know why.) Actively managed funds that look to compare themselves to an index, do so to attract investors to their performance. Trouble is, too many actively managed funds do not practice a buy and hold strategy.

What Cai and Houge discovered suggests that if fund managers do try and mimic an index, they may be leaving money on the table so to speak. If they continued to hold the deleted stocks from the index, they would do better than if they had tried to follow the index too closely.

And how can you follow the Russell 2000 too closely. The index, according to the authors of the paper changes on a certain day each year and unlike many of the other indexes is not based on some “proprietary selection process.” In choosing the Russell 2000 to track, they stumbled onto an index that changes shape often and sometimes in a huge way.

“Russell replaces an average of 457 firms or nearly 23% of the index holdings each year. The annual turnover ranges,” they wrote “from a low of 309 companies in 1980 to a high of 690 companies in 2000. Since delisted securities are not replaced between reconstitution dates, the number of additions always exceeds the number of deletions.”

The person focused on retirement planning can draw two conclusions from this. First, not all indexes are created equal, necessarily do as you would suspect and might be more active than you would imagine.



The second is much simpler. Indexes often bill themselves as safe havens for investors and some might be safer than others, but the performance numbers they use in their sale material might not be as good as an actively managed fund that acts passively. Turnover may become the key statistic in determining the overall long-term strength of a mutual fund.

You can read the full paper, titled “Index Rebalancing and Long-Term Portfolio Performance” here or download the PDF

Retirement Planning and the Tanabata

The use of this popular Japanese festival in the book is not of an accidental nature. The long-term belief throughout all my years writing about personal finance, investing and retirement planning as the ultimate goal, I have always looked at the world of finance with a less than trustful eye. It is sort of a “where there’s smoke, there must be fire” kind of thinking.

When the opportunity to create a profit is coupled with someone else’s inexperience, the money involved needs to be closely watched. In other words, if there is a financial product in close proximity to an individual who is just the slight bit confused, deception has more than ample chance to rear its ugly head.

Tanabata is a festival built on deception. With a little love story as an aside and the right amount of penance to be served, the story resonates with not only adults, but especially with children.

Tanabata is referred to as the Star Festival. It is traditionally held on July 7th and involves the placing of wish-filled notes on colorful strips of paper and hanging them on the trees. Then the children and a good deal of adults as well, pray for their wishes to come true.

Does that sound like your retirement plan?

(In the book, I actually tell you about one of the numerous celebrations held worldwide. 77 BoaDrum is celebrated in New York City each year in honor of the festival.)



There is a sadder story associated with the celebration that originated in China and made its way to Japan. It tells of a how a young farmer, smitten by a beautiful goddess, lies to gain proximity to her. They search for a robe she assumes I missing. His plan worked. They fell in love and spent many years together.



But one day, as fate would have it, she found a small piece of the robe tucked among some roofing material. Mikeran, the farmer has his the robe and forgotten it. Time had left only a shred of the clothing, but just enough for the goddess Tanabata to recognize the robe she had lost all those years ago.

She was furious, leaving him until he completed the penance she had punished him to complete. He was to weave a thousand pairs of straw shoes. The festival, in their honor, occurs on the one day the lovers are permitted to meet.

The astrological event surrounding the festival, also steeped in the lore of the holiday, occurs when the stars Altair and Vega intersect in the Milky Way.



This particular facet of the festival revolves around another less than savory story. This one was also centered on love but was focused on the ethic of work and loyalty to family. The young princess Orihime, a weaver, worked long hours at her craft, weaving beautiful cloth for her father by the river. She dreamed of one day meeting someone but feared her longing would never be fulfilled.

Her father, Tenkou, worried about his daughter’s happiness, arranged a marriage of sorts with a herder from across the river. His daughter fell in love and like so many young people filled with newfound passions, the two neglected their work in favor of spending time with each other. Her husband Ushikai’s cows wandered – since the story is celestial, those cows scattered across the heavens, and his wife’s weaving ceased.

Tenkou was furious separating them on opposites sides of a river. Orihime was devastated and begged her father to let the two to meet. He did and that day is July 7th.



I write in the book that it is “vitally important to build this structure piece by piece, with the right amount of thoughtfulness and the right amount of risk.”

Your retirement planning should be more than just tying colorful wishes to a tree. But too often, we only visit our retirement portfolio once a year, if at all, and we tie those plans to be fated to the wind.