FIFRadio: A conversation about annuities and long-term care insurance

On Monday, we had Steve Cooperstein on the Financial Impact Factor Radio show with Paul Petillo, managing editor of BlueCollarDollar.com/Target2025.com and Dave Kittredge and Dave Ng of FinancialFootprint.com. Steve's recent book was the topic for today's show: “Implications of the Perceptions of Post Retirement Risk for the Life Insurance Industry: Inside Track Marketing Opportunity, But Requiring Focused Retooling”.

It may have been written for advisors and academics and the insurance industry, but in doing so it offers us some interesting insights into how these folks think about us: the end user. Did I mention that Steve is an actuary?

 We talked to him about annuities and Long Term Care Insurance, the impact both of these products have on all age groups, what is wrong with them and how they can be improved. We solved a great deal in the hour we had together!



   

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Paul Petillo of Target2025.com/BlueCollarDollar.com

and Dave Kittredge and Dave Ng

of FinancialFootprint.com

on

The Financial Impact Factor

at Blog Talk Radio

Retirement Planning: On Being Too Old

Baby Boomers face all sorts of challenges when it comes to retirement. Are we ignoring the most obvious of those challenges when we refuse to think that we will one day be old - not just older, but old old.

It is a relatively well known phenomenon amongst the soon-to-be retired. You are jettisoned from your 401(k) with a large chunk of money, a lifetimes' worth of hard earned cash. You are forced to make a decision about what to do with it. Kept in its present form would require you pay taxes on it as it is. Rolled into an IRA allows you to hold off on distributions, possibly until you are 70 or begin to take money out. But some folks fall into the annuity trap.

This choice, the annuity, in whatever flavor you are sold by the insurance company is often picked when the newly retired person does so in the midst of what would be a bear market. 

For those not versed in that term, this a period of lower stock prices; the reverse of which would be a bull market. Most folks fall back on the same logic, perhaps not fully tested or vetted, that retiring in a down market is hardest on your retirement account because you have far less than you might have has had you retired when the market was on the upswing.

On paper it might look bad. But the bear market might be your friend, especially if you are the counterintuitive type not prone to believe the conventional wisdom. What is the conventional wisdom? To be upfront, something I disagree with in most cases in large part, because I don't think pat formulas work. We evolve and so does our thinking. Why, if that is true of us and we are the markets, do we insist on being harnessed by stringent parameters?

Because they provide comfort, a point of reference, a goal. No matter what name you assign them, they are prevalent and with so many personal finance and retirement "gurus" saying the same thing, you tend to fall lockstep into the same thinking. Withdraw 4% you chant and you will never run out of money.

I've disputed this notion in the past as not very wise or thoughtful. Two things helped me arrive at this conclusion. Long before Susan Jacoby wrote her new book about old age (Never Say Die: The Myth and Marketing of the New Old Age, Pantheon Books), which provides a no-hold-barred look at the distinct, perhaps inevitable slide the human body takes on its path to death, I was suggesting that we might live longer but what will living longer mean. Oh, we may live to 85, but our arrival signals the end of cognitive independence for more than half of us.

She blames the baby boomer, the reinventor of what life is as the culprit in this thinking. We may have changed the way our youth unfolded and we may have upset the norm throughout our working careers. But when it comes to old age, it doesn't matter whether you have some sort of can-do attitude, you won't be able to change what is going to happen to you. You may envision a life of vigor and vitality, volunteerism and travel. We all need something to keep us moving forward. But Jacoby says we are ignoring the hard facts of life. We'll still get old. And with age comes the maladies of that time. Still there and still the same unsolvable mysteries.

So we will reach a point somewhere in the future - and the odds are in favor of this thinking - when you will no longer be the person you are right now. The years that you believed would be full and vital are now gone and you are collecting in the form of equal - possibly inflation adjusted - income that you can't spend. You scrimped in the early years of your retirement, downsized, even counted every penny. And then later in life, it doesn't matter. My suggestion was to start out big and taper back. Perhaps gradually easing back from a 6-7% withdrawal rate in the first ten years of retirement to a paltry 2-3% by the time you are 80 years old.

The result would be more or less the same with you using the money in the early years to do what you thought you could do and scaling back as your new sedentary lifestyle takes hold, an inevitability we can't avoid. "Young old" is easy to imagine. "Old old", not so much.

But the choices we make right at the moment of retirement may have a greater impact on how well that retirement is financed than we may have previously thought. Those bear market retirees, the ones who graviate towards annuities more so than their cohorts who retire in the midst of a bull market, may end up doing better over a longer period than their more optimistic cohorts.

I am of course referring to the studies done by Wade Pfau, an associate professor at the National Graduate Institute for Policy Studies in Tokyo who has suggested that retiring during a bear market is actually the best case scenario. His thinking is that a bear market provides more upside potential than a bull market would. On this point, he may be right. Our penchant to follow the herd during a bull market gives the impression that markets will always go up.

And there is some proof that for a time, they will. There is also proof that if you retire during a robust bull market, you will be more inclined to believe that you possess some sort of powerful ability to manage your money better. But bull markets fall and this causes confusion among those who may have deluded themselves into thinking they were more skilled than they were.

Professor Pfau thinks that a 60/40 stock split is optimal and if you invest over the course of 30 years at a rate that is close to 17% of your pre-tax income, you will be able to have 50% of your pre-retirement income, inflation adjusted, throughout your retirement. Staring earlier will mean less needed to get to the same mark. And of course this excludes any other money you might receive in retirement.

You are probably saying to yourself, 'that's a lot of income to sock away' and you'd be right. But this is one thing that hasn't changed: if you think you haven't been putting enough away, you are probably right. If you think old age is something that will resemble the first day of retirement for the next 30 years, you would be wrong.

Baby Boomers should be thinking about spending more when they are healthiest. Because 'old old' doesn't give you the chance to revise your planned 'young old' retirement.

Paul Petillo is the managing editor of Target2025.com/BlueCollarDollar.com

The Cassandras are talking about Munis

If you are a municipal bond investor, you have done either one of two things. Believed the recent rhetoric about the imminent bankruptcy of numerous large American cities and with thosebankruptcies, a default on the municipal bonds they have issued or do not believe that this can happen.

Those that believe have been reported as selling their investments, divesting almost a third of what was invested in these securities since November of last year. This makes less knowledgeable investors skittish to say the least and worried - as all bond investors tend to be - that you will ve left holding what are essentially worthless securities.

Volatility has been seen in this market and if Vanguard's recent withdrawal from the muni ETF market is any indication, you might be right. But some logical evidence points to other reasons why this is overblown.

Many 30-year AAA tax-free bonds now yield over 5%. These ratings are key to the quality of these bonds. Lower ratings mean higher yield offerings and with it, an outward indication that risk exists. But if you are in the top federal tax bracket, you’d have to earn almost 8% in a taxable bond to get that kind of after-tax yield. In this interest rate environment, that’s nothing to sniff at.

Plus, municipal bond issuance will drop to $350 billion this year from $430 billion last year. If you took Economics 101, you know that decreasing supply generally firms prices up.

The extension of the Bush era tax cuts do play a role as do the slumping US Treasury rates. Some experts, Bill Gross, the man who manages Pimco investments recently declared, “I don’t subscribe to the theory that there will be lots of municipal bankruptcies.”

Panic creates the illusion that there are bubbles in certain markets, municipal bond markets not excluded. Ignoring risks make people worry more than they should. The bottom line: there is volatility in every investment and the chance you will lose money. But municipal bonds will not default  en masse anytime soon. Unless of course, the economy fails to recover.

Paul Petillo is the Managing Editor of Target2025.com/BlueCollarDollar.com

Risky (Retirement) Business

Most of us make a flawed assumption about retirement. We save (or as I prefer, invest) for our retirement and do so based on the fact that the taxes we pay now will be the same when we retire. This sort of assumption, according to the Center for Retirement Research at Boston College, puts 51% of American households at risk of not having enough to sustain their pre-retirement lifestyle in a post-retirement world.

The CCR takes the view that if this nation stays on its current course, and nothing is done about the increased level of Federal spending, "government debt will increase from the 2010 level of 61 percent of GDP to 79 percent by 2020, 118 percent by 2030, and 180 percent by 2040." This sort of escalation will result in one of two things happening to offset those increases: the government will need to reduce spending or increase taxes - or both. Neither option bodes well for those planning on retirement.

The Center is focused on a broad-based National Retirement Risk Index (NRRI) that "measures the percentage of working-age households who are ‘at risk’ of being financially unprepared for retirement." Even if the taxes we pay remain the same as they are today, most American households will find retirement financially challenging. But what if they rise as the report suggests they will - or better will need to?

The report was issued prior to the extension of the Bush-era tax cuts, which had they been allowed to expire, would have increased the overall taxes most of us pay impacting the amount of money we currently save for retirement. As a group, we react to incentives or in the case of increased taxes, disincentives in predictable ways. 

First, we tend to invest less (if the pull back of the company match following the market downturn in 2008 and our failure to make up the shortfall in the wake of that decision is any indication) as we adjust our household budgets.

Those budgetary needs are real and present. But the future needs in retirement as a result are a real and present danger most of us are ignoring. Add the possibility (or the real likelihood) that taxes will increase in the coming decades from their current levels, and you have a recipe for financial disaster brewing beneath the surface.

The CCR projects that a value-added tax (VAT) would be necessary by 2020, and this tax, once introduced would need to escalate from 0.9% to 8.1% in the thirty years following its introduction. Social Security taxes would also need to increase from the current payroll tax of 12.4% to 14.7% by 2050. The group most at risk: older workers who have little time remaining in the workforce to increase their contributions to offset that shortfall. Younger workers would have time to adjust but the need to do so might cause a natural human reaction when faced with some tough economic decisions is to recoil, not regroup.

If a value-added tax were instituted, the retired worker would face some serious financial challenges that they may not have planned for while building their nest-egg. Granted, Social SEcurity tax increases would not impact this group, but once retired, each change in the tax structure, no matter how minute would lower the available amount of money they might need (and counted on) and i doing so, increase retirement risk.

In the wake of any fiscal policy changes to make up for the growing GDP, the CCR suggests that a higher target replacement rate would be needed. There is only one way to do this: increase contributions. Doing so would have the net effect of slowing the ability of any group to sustain a lifestyle current to the one they have and if they failed to budget for tax increases, put their retirement hopes and dreams in jeopardy.

Gen Xers would need to budget to spend less and invest more at a time when college debt, families and independence impact their day-to-day financial decisions. While this group can adjust their consumption rates to make up for the shortfall, it is unclear that they will. Late Boomers, those caught between the distant retires (Gen Xers) and the soon-to-be retirees (Early Boomers) also face risks. While those risks are not as great as their older cohorts, it would require them to make drastic cuts in how they currently live to make up for the projected shortfall in retirement.

The report concludes withe following statement: "If households were to respond by cutting savings as well as consumption, due to choice or necessity, the percentage of households ‘at risk’ would be larger.  This brief errs on the conservative side by assuming no behavioral effect." But we know better.

We know that you will make some bad choices between now and then. If tax levels rise while you are still employed, the impact will be direct on how much money you take home. If you realize that your retirement calculations are incorrect, you may conclude that working longer (rather than saving more and adjusting spending habits) is the only way to make for lost ground and a diminishing timeframe.

We know that you will perceive risk as the enemy and find ways to reduce your exposure to risk by reverting to more conservative investment schemes like target date funds. This will have the net effect of protecting your money while forfeiting potential growth opportunities. The younger you are when you recoil from risk, the longer it will take to reach optimum retirement levels. Ironically, avoiding risk while you are working increases your retirement risk.

There are options. The first and most obvious is increase your contributions. This is the right choice to make but comes with a caveat: you cannot increase your debt in the process, a normal reaction to lower daily spending opportunities because your budget has tightened.

The second and less obvious choice is to assume some risk either in your 401(k) or outside. It is true that the current tax rate will be extended. So why not pay the taxes for your retirement income now in the form of a Roth IRA while rates are predictable and lower than future rates?

Here's an idea worth considering: invest in your 401(k) up to 10% of your pre-tax income, match or no match (more if you can). Use the most aggressive funds in the plan to position yourself for the greatest amount of growth (if you are younger - Gen Xer or an Early Boomer). On the outside of that plan, open a Roth IRA and focus your investments on an index fund such as the S&P500.

Because of the tax efficiency of an index, paying the taxes in the future on what your tax-free principal has earned, even if they are higher, would be less than what your 401(k) or traditional IRA owner would pay. There is no fixed time to begin taking distributions (it is possible this could change but a lot of tax analysts think this is unlikely) and your estate is better served with a Roth IRA. Because you can begin distributions when you want, this could be an added boost for your retirement income in the advent of any tax increases in the future.

No one can say for sure that taxes will stay the same or go up. We do know one thing for certain: they will go up - as will inflation. If you aren't planning for this, you should and the sooner the better.

Your Retirement: It is Still up to You

The stock markets seem to be poised for what has been termed often as the "Santa Claus rally". Consumers, at least according to business surveys, are beginning to spend. And this is all occurring, while in the shadows, the economy or its numbers remain little changed. That and most of us are still suffering from investment paralysis. 

Here we are, years after the fall of 2008, and the average middle class worker still has an account balance that is far from where it should be - if they plan on retiring. When most of us think is retirement age, we think in terms of what has been the generally accepted retirement age. This unfortunately is a failure on two fronts: yours and the plan sponsor.

Your responsibility is in the contribution.According to a Wells Fargo survey (pdf) conducted among 357 plans, middle class is defined as: "those aged 30 to 69 with $40,000 to $100,000 in household income or $25,000 to $100,000 in investable assets and those aged 25 to 29 with income or investable assets of $25,000 to $100,000." This group knows that they will need more than $300,000 to fund a basic retirement yet, on average those balances fall far short of that goal with $20,000. Is it any wonder that this group is increasingly buying into the notion that working longer is a fact of life in the post-downturn world?

Most of the middle class group contributes only about 7% of their pre-tax income to these plans. And if the survey is any indication, much of the fault lies in the employer's approach to these plans. The study suggests that employers are concerned about their legal liabilities in helping their employees even as they acknowledge the shared role in helping those workers.

These fiduciary concerns are widespread among plan sponsors who worry that should they provide advice, and that advice doesn't meet employee expectations, they will see the plan sued. 

This has led these employers to look for plans that offer third party advice, shifting the liability to another player. What they fail to embrace is that using a TPA (third party administrator) doesn't lessen the liability. While 89% of the plan sponsors understand that there is a need for retirement help, only 71% (as of 2009) think that they should help those employees understand what the plan can do for them.

In order of importance, and in reality, employers do something else entirely and your defined contribution plan's ability to get you there is reflective of this lackluster effort. Only 35% of the DC sponsors surveyed think that education is important, 22% encourage greater participation and increased contributions, 9% think investment diversification is important while only 2% facilitate the planning process by pointing out what is need in retirement and helping their employees use the plan to achieve this.

Are more funds in the plan the answer? Some DC sponsors believe they are and are looking to increase their offerings. But often, plans with more than fifteen funds aren't necessarily giving the employee more choices that suit their needs. The new choices are often in the form of target date funds and other more conservative investment offerings. This is often done at the exclusion of more suitable offerings (such as aggressive mutual funds for younger workers). Once again, they fear retribution for suggesting anything akin to risk.

DC sponsors are worried about what the industry calls investment paralysis. Too many funds, studies have suggested, often have lower overall participation rates that those with 15 fund or fewer in their plans. Because there is a growing movement to offer auto-enrollment, choosing a fund for that new employee often requires the plan to carry a wide variety of target date funds to pinpoint a "potential" retirement year.

But understanding the need and acting on it, from both a participants point-of-view and that of the DC sponsor are often far from what they are actually doing. Plan sponsors need to understand more than just the investment array, plan design, distribution options, education and communication, and fees charged by the plan. It is their fiduciary responsibility, one that carries legal risks if mishandled, to measure their plan's impact. Only 15%, according to the survey do so.

The employer still offers matching contributions in many defined contribution plans. But how and what are a matter of debate. Many still offer matches that are tied to company stock, put restrictions on access to those matching funds, and use the auto-increase contribution system as a way to offset raises. Often, maintaining the 401(k) plans they might have, as many of the companies surveyed suggested, is done for the sole purpose of getting and retaining new employees. This, in light of less-than-robust private hiring, might come at a reduction of other benefit programs.

If you are still in a DC plan and your employer's match is not as adequate as it should be, this doesn't let you off the hook. You still need to save more, much more than you are presently doing. While it is true that 5% is the cut-off point where pre-tax contribution investments don't impact take-home pay, some sacrifice on the employee's end is needed. And this should be done,match or no match.

If your employer's 401(k) plan is not as robust as it should be or doesn't fit your age needs, open an IRA or Roth IRA on your own. Contributing to both plans (10% to your 401(k) and the maximum allowed to an IRA or Roth IRA) is your responsibility. While we still look to the company we work for for guidance, and even to the point where we believe they care about us and our retirement future, the facts are not bearing this fuzzy feeling out in the surveys I have read.

As Laurie Nordquist, director of Wells Fargo Institutional Retirement Trust said: "If people aren't willing to pay for advice they are going to get a more vanilla approach to planning," adding, "But a simple plan is better than no plan."

Paul Petillo is the managing editor of Target2025.com/BlueCollarDollar.com

Insuring Your Retirement Plan

The essence of the word plan suggests that you need to formulate a strategy ahead of time. According toBusinessDictionary.com a plan is a "Written account of intended future course of action (scheme) aimed at achieving specific goal(s) or objective(s) within a specific timeframe. It explains in detail what needs to be done, when, how, and by whom, and often includes best case, expected case, and worst case scenarios." 

In retirement planning, it means constructing an investment strategy that will help you meet the needs of a time when you no longer want to work - or at least work in the same capacity you have for most of your life. You make assumptions about that period of time and incorporate those into the plan: accumulating wealth, managing debt, staying healthy, paying off mortgages are just a few of the examples of acting to ensure that those assumptions have a chance of coming to fruition.

You approach retirement planning with a certain degree of optimism. Otherwise, why bother? But adulthood can leave us far more pragmatic and because we know things can go wrong - investments can sour, housing can lose value, our health can take a turn for the worse, and debt can be created with the simplest of financial mishaps - and all with unforeseen results.

So we insure. We insure our property against lose, our health against illness and sometimes our investments as well. And we insure our personal contribution to the rest of the people in our lives with life insurance.

Insurance, particularly life insurance is bought when we feel responsible for those around us in a way that we can't really explain. We want these loved ones to continue on without us but to do so without financial hardship that our lives have prevented. We want them to continue on with their lives allowing our children to reach their potential (such as college) and our spouses to be able to live in a way that is supportive of our children.

There is no clear answer to how much is enough. If you were asked how much you would need to live comfortably without ever having to work again, say through a lottery winning, you would probably answer $2-3 million. Yet when we shop for insurance, we often think in terms of a fraction of that.

Insurance is part of a good retirement plan. Too much or the wrong type of insurance can put pressure on your ability to invest enough to get to a comfortable retirement. Not enough, and your family will not be able to survive financially should your income suddenly disappear.

The least expensive insurance is term insurance. It offers the most coverage for the smallest premium but comes with one caveat: it ends after a certain period of time. In other words, if you never use it (and both you and the insurer hope this is what happens), you lose it. Often sold in 20-year increments, it does what it is supposed to do and if you are fortunate, it will never be needed.

Whole life insurance is exactly that: it is a policy that lasts a lifetime provided you keep it long enough and pay the premiums. It builds up a cash value which acts as an investment of sorts and will, after a period of time, begin to pay the premiums for you. But the coverage for the same amount as a term life policy is often much lower and if you want a lot of coverage, the premiums are much higher.

If you are contemplating buying whole life do so only if you are on firm financial footing and can keep your retirement accounts fully funded. Buy term if you are younger, building a family and are likely to face financial hurdles in the coming years. The vast majority of those who buy whole life insurance end up selling the policy after a certain period and if they buy insurance again, they buy term.

Term life insurance is the least expensive when you are young and you can get the most coverage as a result.

You do need to keep two things in mind when buying any insurance product: be truthful and forthcoming with as much information as possible when buying the policy. Although, according to the insurance industry, almost all claims are paid without question, 0.05% of the remaining claims are challenged.  In all cases, be prepared for the fight that might ensue (an example can be found here) if the policy you are using was recently bought. And, always buy from a company whose name you recognize, is rated highly and will be around for the term of the policy.

Paul Petillo is the managing editor of BlueCollarDollar.com and Target2025.com

Roth IRA and Taxes

Putnam recently surveyed clients about this and found that investors who could pay the taxes on their tax-deferred accounts now, at their current tax rate, are not flocking to this retirement product the way they assumed they would.  The Putnam Investments LLC survey was focused on the higher tax bracket IRA owners who could take advantage of the window of opportunity that would allow them to spread their tax liability over 2011 and 2012 making their future tax obligation disappear.

According to Christine Fahlund, senior financial planner for Baltimore-based T. Rowe Price Group Inc. the fear of the government lifting the tax-free status of these plans would leave the higher income earners – the IRS lifted the income restrictions which had previously been at $100,000 – in jeopardy.  She said in a recent Bloomberg article: “If that happened, you would have accelerated your tax payments unnecessarily.”

More here on Roth IRAs and Taxes

The Once-Bitten 401(k) Investor

A great number of investors reacted in a very predictable fashion as the Great Recession took hold.  They sold their holdings on the way down, in large part because no one could predict how far down would actually be and stopped contributing to their 401(k) plans.  Employers, as we have discussed here, suspended their matching contributions for several reasons (no need to spend money where it didn't need to be spent and there was no longer any reason to offer this as an incentive to keep or hire new employees).

Adding to the mad dash to protect dwindling balances, target date funds and bond funds swelled with new contributions. This was, in many instances, akin to stuffing money under the mattress.  Not that some these funds did poorly or had mediocre performance, although many did, investors felt protected or at least safe from the chaos and volatility of the open markets.  It was a flight to risk-free, or at least, invest-and-forget investments.


Once-Bitten
Historically, the bad news of a falling stock market lasts about six months.  This quick, fall-off-a-cliff drop to the bottom is often followed by a market where investors find innumerable bargains. Over the last decade, unlike all of the previous data on the equities market, recent recoveries, this one included have come at record speed.  Five years in-between market drops and recoveries is not the norm.  But possibly, could be.

This may have something to do with a much larger segment of the investment market coming from 401(k) investments. Although these plans have been around for thirty years, they have not really caught on until recently and even that trend is not fully employed by those who have access to these types of plans.  Pensions may have gone away but 401(k) plans have not fully replaced them with the working public.

That fact leaves many investors vulnerable to their emotions and to the forces that promote the marketplace.  A recent study done by Hewitt Associates found that the vast majority, or what they termed typical, investor under the age of forty had moved some or all of their retirement funds into target date funds.  Those over the age of forty found the move to bond funds more appealing.  Both of these investments, albeit conservative in nature, were forgivable. They were doing what any "once bitten" investor would do.

Read more here.

Paul Petillo is the Managing Editor of Target2025.com and BlueCollarDollar.com

Should You use Annuities in Retirement?

Annuities are back in the news.  And the insurance industry is jumping for joy.  Should you?

The Obama Middle Class Task Force is looking to annuities as a way to make retirement just a little more secure.  While they have come up with numerous incentives, they should also consider a fixed lifetime tax on all retirement income up to a certain amount.  They have discussed this for the first $10,000 of annuity income but they could also extend this incentive to IRAs as well.  If the retiree (or future retiree) could determine how much of a bite taxes would take, they could better estimate how much they will actually get when they retire.  Currently, the assumption is that retirees will earn less and therefore be taxed at a lower rate.  Guaranteeing that rate will enable folks to project better. 

Unless you or the insurer passes away!  More on annuities at Target2025.com

Why Investors Do What They Do: Regret

One of the basic assumptions in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret.

Regret is a math problem believe it or not and has long been discussed as component of statistical gathering. In her book "The Nature and Growth of Modern Mathematics" Edna Ernestine Kramer suggests that by using Professor Leonard Savage's regret matrix, something she defines as "the difference between the actual payoff" as a result of "some pure strategy and the payoff he might have received" had the test subject known for example, what could have happened.

As an integral part of decision theory, Savage's 1951 study of the subject was not the first. Blaise Pascal may have been when he proposed his wager. Nor was it the last. Investors have a tendency to look for benchmarks. Mutual funds use benchmarks to tout their investment prowess. And the probability that doing either of these exercises as being worthwhile is debatable.

Investing, no matter how lonely that decision you make seems, is always a competitive one. Failing to realize that your decision's success needs to have taken into account how other people doing the same thing is often commonplace. Yet, this is often not decided based on any specific thought. You see where other folks are investing. If they flock, you flock. If they flee, you flee. Human nature actually and genetically wired for survival. And you make the decision on how to allocate based on what you fear most: risk.

But our big brains get in the way. This is where regret comes into the picture. Savage constructed a criterion he called the Minimax Regret. We are at an investment point in time where we are (if not already have been) subject to regret in doses much larger than we have experienced before. These reactions and the rationale you may have used to make your decision was based on minimizing your risk for a situation that may well have passed.

This will result in a portfolio recovery period that will take you much longer to get back to even than someone who had not reacted or regretted their investment decisions. The market makers, those you placed your trust in, if blindly and unknowingly, made numerous wrong choices and everything fell in. The mutual funds that are used by you to achieve long-term gains have now repositioned their holdings to begin again in the aftermath of the last twelve months. Denying risk at this point (heading off to an index fund or worse, a target-dated fund) will not allow risk to play a role in your financial recovery.

Regret is a surprisingly destructive part of an investor's behaviors. Anticipating past history in making investment decisions allows regret (the "what if" is replaced with the "what if I don't") to strangle risk and not allow it to do the job it is supposed to do.

Next up: The media

Why Investors Do What They Do: Narrow Framing

In our previous discussion about loss aversion, we looked at what was the beginning of Kahneman's prospect theory. Coupled with loss aversion, narrow framing represents a look at how investors perceive their chances at wealth but only when they see it as the sole component. This is a discussion about risk. More importantly, a discussion about regret.

When you (or as you are often referred to when being discussed by economic types, an agent) moves into the stock market, be it through individual ownership or through mutual funds, you are changing your wealth allocation. Obviously, the easiest measure of wealth is more tangible elements such as what you get paid (human capital) which also includes what you may have saved (not invested) and the worth of your real assets, such as your home. Once you commit a certain portion of either of those two assets to the investment of your choice, you begin to open the door to regret.

This regret is the result of accessibility and the misuse of the different decision rule. Accessibility is what it is: information that is readily available almost instantaneously through any number of mediums and the ability to enter into the market without restrictions. The different decision rule is described in Walter L. Wallace's book "Principles of Scientific Sociology": [the agent]"chooses whichever means optimizes the end in question". This thinking is looking for what could be crudely referred to as the most bang for the buck. Freud called this the pleasure principle.

Narrow framing demands a high equity return both now and in the future. Does this take into account market shifts, both up and down? Not really nor is a realistic approach in the long-term. But loss aversion and narrow framing are not separate thinking.

One of the most famous examples was described by Paul Samuelson, a noted economist, Nobel Prize winner and the person who bridged theoretical and applied economics. When he offered to flip a coin, the prize being $200 if the flip went his colleagues way of loss $100 if the flip went Samuelson's direction, the colleague declined on both accounts. This is loss aversion. When the perception that the loss is greater than the possibility of winning, the investor tends to freeze.

The different decision rule is often described as a way to optimize the end so as not compromise or to incur the minimum amount of cost. Luigi Guiso of the Einaudi Institute for Economics and Finance Via Due Macelli in Rome tested narrow framing using the lottery question, much like Samuelson's coin flip. What he discovered was that if you allow the subject of the test to have time to think about their personal economic and financial situation before you asked them whether they would like to win twice as much as they might lose, they were more apt to attempt to try the game of chance. He wrote: "attitudes towards regret and reliance on intuition rather than reasoning are likely to drive the tendency to frame choices narrowly."

In their book "The Routines of Decision Making" By Tilmann Betsch and Susanne Haberstroh, the authors suggest that the more routine a decision is - such as investing for retirement - the more likely a person was to resist forecasting. In other words, even if the recent economic downturn had been forecasted, and in some instances it was, the person who might be most at risk of losing value in their 401(k) because of out-sized risk or an overabundant share of their portfolio in their company's stock, might have ignored what was obviously a warning. The markets had routinely ascended along with the value of the portfolio and they had seen this as a reoccurring event that probably would not end in the foreseeable future.

This problem is best manifested in the doctor's office. Your physician gives you news about your health that you are skeptical about or might be life-altering depending on your decision. How do you decide how many second or third opinions you garner to help you decide? Suppose those decisions don't jive with how you are feeling?

Next up: Anchoring

SIMPLEs and UNI-DBs for Small Businesses

When the tax laws were written for small businesses, they were often much more generous. For instance, an employer with only him/herself as an employee can save enormous amounts of money for their retirement - far more than the employee or business owner at a much larger company.

Today we discuss the SIMPLE IRA and the Solo or Uni Defined Benefit Plan for small business in the last of our three part series.

The SIMPLE IRA, named because those letter stand for savings incentive match plans for employees, are a much cheaper and far less complicated way for small employers to establish and administer than a traditional 401(k).

This type of plan is indeed easier to manage and implement but there are a few rules you need to keep in mind before choosing a SIMPLE IRA plan for you and your employees. You are required to make a contribution for every worker who receives $5,000 or more in compensation. It doesn't have to be a lot but it has to be something up to but not exceeding $11,800 for the calendar year 2009.

The contributions may resemble an employer match, just like those used when larger companies match employee contributions to their defined contribution plans (401(k)) But the employee must first elect to contribute to the plan themselves and your match to their contribution can not exceed 3% of their salary.

Employers may also choose to make the contribution on the employees behalf, contributing up to 2% of each worker's wages, whether the worker contributes to the plan or not. This "non-elective" mandatory company match of 2% is required to be made on behalf of every employee.

Aside from the fact that the plan cost less to administer, the strings that tether the SIMPLE IRA might not be right for you or your company.

SIMPLEs have a built-in special tax penalty of 15% that is added to the 10% early withdrawal penalty for SIMPLE IRA withdrawals made within the first two years of opening a SIMPLE plan. Although your retirement plan should not be considered a source of income, this penalty can make it more difficult to access that money in times of dire emergency. (But please, consider every other option first before withdrawing built up investments in these plans.)

Because of that string, a SIMPLE IRA can be much less flexible than a 401(k) plan for the average small business. Keep in mind the following while considering this type of plan. Will you be the only employee? If so, a Solo 401(k) might be best. If you are planning to grow your business slowly, adding employees on as needed, you should consider that contribution requirement. An employer must make contributions for all eligible employees and while they are doing so, no contributions can be made to other qualified retirement plans.

The contributions you make to the employees plan belong to the employee immediately after they are posted. This immediate vesting can be troublesome for some seasonal type of employers who do not expect to retain employees or demand their loyalty for a long period of time.

Should you as an employer decide to end the plan, you must wait until the calendar year is completed and while you are waiting, you are obligated to continue with payments to the employee's plan. And here is something else you should consider: no loans are allowed.

If you however fit this profile: older than 50 and earning more than $120,000 per year, have no more that four employees, been in business for at least three or more years and are willing to make mandatory contributions to the plan for three consecutive years of $45,000 or more, there is possibly no better plan on the planet better than this one.

But these plans can be quite a bit more complicated and require you have help with the legalities. But you will find it well worth it especially if you are earing or expect to earn those sums now and in the near future.

KEOGH plans were put to the wayside with the creation of SIMPLEs. If you still have a KEOGH plan in place, the paper work to rollover the plan is relatively straightforward but still must be done by a plan professional. But I believe that if you do rollover a KEOGH, you, your employees and your retirement future will much better off for the effort.

FEATURE	Solo or Self Employed 401K	Solo-DB	SEP-IRA
Eligibility	One person only. (Multiple owners and spouses allowed, but no other employees)	Business owner and up to 4 employees	No limit on number of employees. (most organizations prefer the 401K )
Key Features	Low Cost ($0 to $25/yr) Contributions to plan are discretionary. IRS form 5500-EZ filing required for balances over $250,000 Roth 401k feature	Annual Fees (about $1600/yr +) Offers the largest tax- deductible retirement contribution permitted by law Mandatory contributions for at least 5 years	Very Low cost (about $15/yr) Contributions to plan are discretionary. contributions are made for one employee they must be made by the employer for all eligible employees
Loans	Loans are allowed	Loans are allowed	No Loans
Contribution Limits *	See Self Employed Owner Only Calculator or Contribution limits for max contribution limits.
Deadline to open plan	December 31 or End of company’s fiscal year	December 31 or End of company’s fiscal year	Up to time of tax filing
Deadline to contribute to plan	Employer contributions must be made by the employer's tax filing deadline plus extensions	Employer contributions must be made by the employer's tax filing deadline plus extensions	Before the employer's tax filing deadline plus extensions

Retirement Planning: What the Financial Planners are Thinking

We have a multi-dimensional problem when it comes to retirement thinking. We want to pinpoint numerous factors in our retirement plan, when in fact, the effort might be wasted. Much like the physicist who wants to measure a particle, quantum mechanics explains that it cannot be done, in part because it would change the particle by trying to stop it. Making a retirement plan pause gives you no measurable assurance that where you are right now is going to be the right move somewhere down the road.

These financial planners, their opinion which many will still turn to even if their advice led us down this road in the first place, are still called upon to give direction. I have neighbors who fret over the fate of their retirement accounts yet as soon as a son or daughter wants to make a financial decision, the first step is to set up an appointment with a financial planner.

Now these planners are looking for a way to regain your trust - many still have your business but largely feel uncomfortable with the disappointed looks on your faces. To address this, they have begun offering some suggestions, which although not new, they are a shift from too much risk to finding a way to eliminate what they see as unnecessary risk.

In a recent article to financial planners, The Investment News offers some suggestions that will no doubt be taken by their lobby group to Washington. They think that Social Security will remain a part of a retirement plan. They do concede that fixing this program will require not only a cut in benefits but an increase in taxes. Not very imaginative but keep in mind, this group is not likely to waste too many braincells on a program that produces no profits.

Instead, they are focusing on readjusting their client's portfolio from (age-appropriate) risk to vanilla risk (read that as a long-term relationship with folks who seek a way to get ahead by taking a much slower vehicle). This could add as many as ten years to your working life.

The net effect of working longer - besides working longer - is a more fully funded plan. But that funding will not have realized its full potential without a certain amount of risk. Many planners, as they restructure your plan for you will move your money into more costly types of investments that, on the surface, offer less risk.

Not all index funds are created equally and the shift into target dated funds does not come cheap and in some cases, are not a proven way to soften risk. Index funds can suffer from what is known as style drift, a way to enhance the return of the index by taking on an actively managed methodology.

Target dated funds are still suspect. There is no proof they do what they promise and do it for less cost. I have had problems with fund companies selling these funds as the risk free, cost effective ways to save the retirement community. And planners have become one of the forward sales makers for this product.

Adding to the list of products this group is looking to sell to lawmakers is the right to annuitize retirement income at age fifty. The thinking here is so simple, it is almost backward thinking. They are suggesting that the investor in a defined contribution plan take their money and essentially take it off the table, guaranteeing it will be there when they retire. This would allow folks who were unsure about the future to "buy" an annuity, with its high fees and suspect growth aspect instead of switching to a lower risk platform.

The suggestion that employers begin a retirement plan for all employees that have failed to do so and docking pay to fund it, seems, at least on the surface, to be a good idea. A bit Orwellian but the strategy is worth looking at for all workers before something like this becomes law. After that, the employer may pick the plan and in doing so, may not fully understand their fiduciary responsibility. But then, they would probably hire a planner.

Retirement Planning: The Annuity as a New Idea?

When the new ideas seem complicated, they are not workable for the average investor/employee. Pensions were simple. You worked and when that long career was over, you were rewarded. The advent of the 401(k), a Wall Street invention unlike any other profit generating idea ever created, was offered to the most captive group of investors, add a little fear of the future and you have the perfect income producing vehicle.

And then, say it could be better. Say it needs to be improved. Say it is not really our fault – we are smart enough just not as logical as previously thought. There are far too many of us not using these tools and far too many potentially profitable fees left uncollected.

Which gives folks like Professor Merton, the John and Natty McArthur University Professor at Harvard Business School and a winner of the 1997 Nobel Memorial Prize in Economic Sciences an opportunity.

Its just too bad Prof. Merton mentioned annuities. He actually had my attention until that point. Perhaps I should begin with the thinking about retirement allocation that he so deftly describes as" "But that knowledge won't qualify you to decide how much mid-cap European stock you should have in your portfolio, any more than it would enable you to perform surgery on yourself." True enough, but removing a splinter is simple surgery; transplanting a heart on the other hand is not.

If knowledge and time truly are the only obstacles - although I believe that the ever complicated financial products that are available are designed to make us feel less than qualified to remove even a simple splinter, then Wall Street should demystify the process.

If annuities were truly the solution, then businesses could once again create a pension with guarantees. Why they don't is quite easy to answer: They do like the cost structure.

Retirement, as we have come to dream about, is a time in life when we can rely on an income that we worked hard for and the time to enjoy it. Granted, this has been redefined with every passing day - each uptick in inflation, each economic downturn and each political misstep with taxes and spending, keep that dream from fully developing.

But I should emphasize that the single biggest drag on any retirement savings is the cost of getting there. We can play "minimum/maximum needed income" games all day but the simplest solution would be to give the employee a financial review on the same day businesses take the time to give them appraisals. Having the employee opt for channeling their next pay raise or bonus into a long-term plan might be all the incentive they need to continue to work harder all while giving the employee a sense that the company is more than just a "gatekeeper" and closer to the good old days of pensions, when the company seemed to actually care about loyalty and rewarded it with a defined benefit.

Now I fully realize that we will never be able to go back to those days, but annuities - an investment/insurance hybrid of dubious nature and questionable need is not the answer.

Retirement Planning - A is for Asset Allocation

Today, we begin a look at the alphabet soup that has become investing and more importantly, retirement planning. For most people, the concept of saving is already understood, the downside effects of having debt has been completely drilled in - from every angle imaginable, and the importance of a retirement plan or planning strategy is absolutely necessary to prevent financial disaster when we hit or sixties or seventies.

A is for Asset Allocation

When there is market turmoil, one of the first things you should examine is how well you have allocated the assets in your retirement portfolio. This is no easy task.

If your 401(k) was properly allocated a year ago, before the economy slowed down, with mutual funds that were focused on growing your money and with your risk tolerance in mind, you will be fine. Fundamentally, not that much has changed.

Smart investors know they need to give their portfolios twelve months to fully utilize the plan. History has shown that with time, many of the imbalances that have a stranglehold on the markets will loosen their grip and things will return to normal.

Hold tight, time will come to the rescue.

What is asset allocation?

How those assets are positioned in your retirement portfolio however is a different matter.

In a retirement plan, asset allocation takes on a different meaning. In your portfolio, you should have basket of mutual funds that focus on different parts of the market. This method of investing protects you from swings in the market that is often specific to one group of investments. The markets rarely fail altogether.

The most recent example of this happened in early 2008 when the stocks of banks and other financial institutions began to falter. The most famous was the failure of technology stocks in 2000. Had you not allocated your assets properly, you would have felt a greater loss than the market as a whole did. Asset allocation protects you from this.

The Right Mix

In order for asset allocation to work, you need to determine two things: your age and your risk tolerance. Age is not so much a reference to how old you are but how far off in the distant or near future your retirement is.

Your risk tolerance is a reference to how much of your investments you are willing to put to the test.

If you are in your twenties, it is generally assumed that you should be the most tolerant of risk, investing in growth mutual funds and able to overcome any short-term problems.

Allocation assets becomes much more important once you reach forty, beginning to temper your risk and protect some of your assets. By age sixty, you should be investing a conservative mix of stocks and bonds.

How to get the Right Allocation

Perhaps the simplest way: invest in target funds that save for a future retirement date. These types of funds gradually change your assets over the years, essentially re-allocating for you.

Retirement Planning and “Under the Microscope”

The notion that seeing something up close, really up close was first championed by a relatively obscure scientist named Robert Hooke. Now seventeenth science was a sort of cutthroat business, with each new discovery lending itself to potential fame and fortune. Among Hooke’s contemporaries were Christian Huygens, Antony van Leeuwenhoek, Christopher Wren, Robert Boyle, and Isaac Newton. We’ll get to Mr. van Leeuwenhoek in a moment.



Hooke’s Microscope

Hooke set the stage in the early seventeenth century with his numerous accomplishments among which included the universal joint, the iris diaphragm, and an early prototype of the respirator. He is also credited with the invention of the anchor escapement (increased the accuracy of the pendulum and another mechanical clock function, the balance spring. Hooke also served as the Chief Surveyor helping to rebuild London after the Great Fire of 1666.



Anchor Escapement

Hooke pushed the theory of motors further along by working out the correct theory of combustion, devising "Hooke's Law" to describe elasticity, worked with Boyle on the physics of gases and is also credited with the invention or improvement of a wide variety of meteorological instruments (barometer, anemometer, hygrometer)

But as I begin the conversation on annuitized retirement, it is Antony van Leeuwenhoek that best identifies with what the average man can accomplish. In retirement planning, we are all “everyperson”, mostly ordinary with hidden talents and skills that often are undeveloped or fully realized. Antony van Leeuwenhoek invention of the microscope, actually a well-developed and honed magnifying glass gave the world, which tended to look to the heavens for answers, a closer peak at the world around them.

“. . . my work, which I've done for a long time, was not pursued in order to gain the praise I now enjoy, but chiefly from a craving after knowledge, which I notice resides in me more than in most other men. And therewithal, whenever I found out anything remarkable, I have thought it my duty to put down my discovery on paper, so that all ingenious people might be informed thereof.”

Antony van Leeuwenhoek. Letter of June 12, 1716

According to history, “Leeuwenhoek's skill at grinding lenses, together with his naturally acute eyesight and great care in adjusting the lighting where he worked, enabled him to build microscopes that magnified over 200 times, with clearer and brighter images than any of his colleagues could achieve.” Not bad for someone who sported no formal educational background and was largely without the fortune that many of his contemporaries were accustomed to using to further their studies.



Antony van Leeuwenhoek’s Microscope

Annuities demand that you understand one of the most complicated tools invented for the average person and their retirement plan. The instrument, part insurance, part mutual fund is hard to resist. It offers, to the unsuspecting, the opportunity to do two things: protect the ones you love and grow your money.

Unfortunately, this type of investment does not always perform as promised and those who believe it do often face a rude awakening when they try to exit. In this book we take our first hard look at annuities – there will be others in upcoming publications – since my first book, “Building Wealth in a Paycheck-to-Paycheck World”. Be warned: you may not like what you read.