The next step is figuring out how you’re going to pay for it all without having to depend on the income from work to do it.

And that’s what we’re all after. Discovering that you have built up enough money to support your lifestyle without “having to work” is one of the most liberating days of your life.

It changes everything! It flips the entire equation in your favor.

That’s why at the beginning of every year, I urge you to lay the foundation for all of your planning and strategizing by first figuring out where you stand in relation to this goal of total financial independence.

Too often, people want to skip right over into more advanced strategies.

However, before you can begin to delve into tax strategies, investment strategies, or estate planning strategies, etc., you have to be crystal clear on where you stand in relation to your biggest goals.

And, the biggest goal I’ve heard the most over the last 23 years is “to be able to live the way we want without running out of money.”

The Second Step in The Relaxing Retirement Formula

As we’ve outlined over the last few weeks in studying John and Mary Independent vs. Ron and Rose Reactionary, it’s critical that you determine your level of dependence on your Retirement Bucket™, i.e. your retirement savings.

Do you need $1,000 per month over and above social security and a pension? Or do you need $10,000 per month?

As you might expect, there’s a huge difference.

If you’ve been following right along, then you answered the first half of that equation previously.

Now, to determine your level of dependence on your Retirement Bucket™, we need to figure out how you’re going to pay for the lifestyle you’ve outlined.

How much income will automatically come in?

When it will come in?

And, will it automatically keep pace with inflation?

Typically, fixed income sources in retirement fall into three main categories: social security, pensions, and rental property income, so let’s take a closer look at each of them.

Social Security

Let’s start with Social Security. If you and your spouse are already receiving social security retirement income, then you already know what your income is.

However, if you haven’t begun receiving your benefits, you want to determine the amount you’ll both receive as early as age 62 up to your “full” retirement age (typically age 66 if you’re reading this).

You should receive a social security benefits statement every year around your birthday which reveals your anticipated benefits under all options.

Pensions

The second source of fixed income is pensions. Under pensions, there are two main ways to receive a pension payout: as a lump sum check or as a monthly annuity (a monthly check).

If you can receive your pension in a lump sum, it is typically transferred directly to an IRA tax free and you are in charge of “creating” income from this lump sum of money in your IRA. It doesn’t happen automatically.

Assuming for a moment that you are receiving, or will receive, your pension in the form of a monthly annuity, you may select the single life annuity version (which ends at your death and does not continue to your spouse).

Or, you can select one of a variety of joint and survivor options to insure that your spouse receives some pension benefits when you pass away. If you’ve already retired, you may have already seen these: 100% joint and survivor, 50%, 66 2/3%, 10 year period certain, etc.

The key is to maximize your benefits while protecting your spouse in the most cost efficient manner. (I’ve explored the pros and cons of this in past articles and blogs, and will do so again soon)

Rental Property Income

Fixed income source #3 is rental property income. This is a place which requires you to do some real honest homework. And, that’s because what we’re looking to determine is “net” rental income, not gross.

Many people focus on the rent check(s) they receive each month. That’s a good start, but from that gross check each month there are numerous potential expenses that have to be taken into consideration: real estate taxes, mortgages (if you still have one), utilities (if you’re paying them), and most importantly, maintenance and repair.

Properties require upkeep. And, if you’re not the one doing the work, this can be quite costly. So, an honest, rational projection of future maintenance costs should be factored in to determine your “net” rental income that you can expect.

Once you have a clear picture of all 3 of these potential monthly income sources, we have to examine what they look like in the future. This is where we will continue in our next blog entry in this series.

Stay tuned!

This past Fall, I was referred to a very nice couple by one of our Relaxing Retirement members.

They were very well read and brought a lot of questions to the table which I really appreciate.

What led them to come in to see me was the fact that the husband was planning to retire after 37 years with his employer, and they now wanted to get a handle on “THE” right investment allocation in retirement.

They had done a lot of reading and the theory that made the most sense to them was the “100 minus your age” rule of thumb.

What this theory suggests is that the percentage of your overall allocation you should invest in equities (stock based investments) is 100 minus your age.

So, for example, if you’re 65 years old, you should allocate 35% to equity based investments. (100 – 65 (age) = 35%)

Based on that theory, everyone who is 65 years of age should invest 35% of their holdings in stock based investments.

It doesn’t matter what your circumstances, priorities, or tolerance for risk are.

This is what is known as a classic “rule of thumb”, and as you can probably imagine, I have significant challenges with it for you.

Rules of Thumb

For starters, why do “rules of thumb” exist?

They exist to provide a broad guideline to the biggest audience possible.  They have nothing to do with you personally.

If the consequences of blindly following rules of thumb like this weren’t so costly and dangerous, I’d settle for just saying they’re silly.

However, the stakes are just too high.

The question to ask yourself is ‘am I willing to bet my financial future on a broad “rule of thumb” created for the masses’?

Before you answer, think about this.  If you have a serious medical condition, potentially life or death, do you base your actions on what is presented as a good “rule of thumb” in medical publications?

Or, do you prefer to have a prescription designed for you personally after a series of tests and evaluations?

I would wager a lot of money that it’s the latter for you.

It’s Different in Retirement

As you’ve heard me say more than once, when you’ve reached the stage in life you’re experiencing right now (where you’re dependent on the money you’ve saved to support your lifestyle), your overall “strategy” has to drastically change because the stakes are so high now if you fail.

Although it would certainly be more convenient if there was ‘one’ answer to “THE” right allocation question in retirement, there simply is not.

Here’s why…

How Dependent Are You?

Let’s take a look at two couples, both age 65.  Each couple has $1 million dollars in investments (a nice round number to work with), the same social security retirement income, and the same pensions.

John and Mary Independent have no mortgage or home equity line of credit, and have recently completed many of the major upgrades to their home, i.e. a new roof, vinyl siding, a new furnace, and new bathrooms.  They have always lived a very modest lifestyle with little or no debt.

Ron and Rose Reactionary still have $260,000 outstanding on a second mortgage they took out to pay for their kids’ college tuitions and weddings, and a condo down in Florida they bought a few years back.  They both drive high end cars.  And, while their home is very nice, after 29 years, it’s starting to look “tired” and could use some upgrades.

What’s the Difference?

The difference in this example is what it costs each couple to support their lifestyle.

The income that will be required by Ron and Rose will be much greater than John and Mary. Consequently, Ron and Rose will need to withdraw a much bigger amount each year from their investments than John and Mary.

In short, even before looking at anything else, it’s clear that Ron and Rose Reactionary are much more dependent on their investments than John and Mary Independent.

Without knowing anything else, if the both couples have the same amount of money saved, but Ron and Rose need to withdraw much more each month than John and Mary, don’t Ron and Rose need to earn more?

Don’t they require a greater rate of return than John and Mary in order to have their funds remain intact?

Of course.

Following that same train of thought, if they require a greater rate of return, shouldn’t they allocate their investments where they have a better chance of achieving that higher rate of return?

Certainly.

If that’s true, then how can they use the “100 minus their age” rule of thumb as a guideline for investing?

The obvious answer is they can’t.  It would be foolish.

This rule of thumb can’t possibly be appropriate for John and Mary AND Ron and Rose.

Their level of dependence on their investments is so drastically different for that to be possible.

What I’d like you to take away from this week’s Strategy is an understanding that while it might appear entertaining, and feel like you’re pushing the “Easy Button” when you read “rules of thumb” like this put out there for the masses, relying on them in your own situation can be dangerously simplistic.

It would be nice if “the” solution was that simple.  It would make our work together that much more simple.

However, after 22 years of working hands-on helping our members seamlessly transition to retirement, I can tell you that it never is.

Next week, we’re going to begin building The Relaxing Retirement Formula™, i.e. “the missing structure” you need to develop unstoppable financial confidence during this critical stage in your life.

It would be great if it didn’t take a crisis to get us to think and prioritize differently.

For me, one of those crisis events occurred when my mother got sick and passed away at the very young age of 57 when I was 20 years old.

After dealing with the reality of losing my mother (unfortunately, she was terminally ill for 19 months), the lesson for me was to never wait to do anything because you never know when it can all be taken away from you.

I would certainly have preferred that it didn’t take losing my mother for me to learn that lesson and prioritize a little better.

Progressing Toward Something

One of the great advantages of retirement is that you are free of the pressures you had to face at work.  However, without the deadlines and structure that work provides, some people feel lost.

That’s why it’s so important, whether you’re still working, or if you’ve already stopped, to give significant thought to what you want most out of life and then get busy doing it.

As you objectively look around at all the people in you come into contact with, something becomes obvious: certain individuals are more successful and happy than others.

Not only that, but in stark contrast to most people who’s optimism fades with age, these same individuals are more energetic, enthusiastic, and confident.

There are many explanations for this, but the number one reason for a loss of momentum in retirement is a lack of prioritizing and goal setting.  Without it, everyone loses their sense of direction and confidence.

Instead of being excited about what lies ahead, retirees become increasingly nostalgic about their youthful years, and the “good old days”.

However, those who continuously clarify and act on their goals benefit from the law of compound interest, i.e. just like with money, the more you invest in visualizing and working toward a better future, the better your future automatically becomes.

The most exciting part of life is knowing that you’re progressing toward something.  And, that’s why it’s so important to have written goals in retirement, not just weakly stated ones like new years’ resolutions that quickly turn sour.

My Recommendation To You

As we begin 2012 together, take a moment to step back and think with no distractions.

Clarify and prioritize what’s most important to you without it taking a crisis to motivate you to do so.

Lock the doors, turn off the television, shut off the cell phone and the ringer on your phone, pull out a pad of paper and a pen, and sit in a comfortable chair in your favorite spot in your home.

Tell everyone to give you some ‘quiet’ time.

While you’re in that spot, relax and think ahead 20 years from now, 10 years from now, or even just 3 years from now.

Put yourself out there and look back to today.  Looking back over those years:

• What would you like to say you did?
• Who did you spend your time with?
• Where did you spend your time?

Once you’ve compiled your list, prioritize them in order of importance to you personally.

Ask yourself, “what steps do I have to take right now to make this happen?”

And, “who might be able to help me?”

Keep the list visible to you in your home so you see it on a daily basis.

Share your list with people who are close to you.  Don’t waste your time sharing it with those who don’t truly have your best interests and happiness at heart.

You will be amazed at how much everyone wants to help you get what you want when you ask for help.

Your retirement years provide you with a new lease on life.  You now have the opportunity to clean the slate and spend all of your time doing what you want, when you want, where you want, and with whomever you choose.

However, that doesn’t just fall into place without careful thought and action.  To get what you really want, you have to plan and act constantly.

Life can be short.  Don’t let it have to take a crisis in your life to realize this.

Get out there and soak it all up.  Be busy!  Be exhausted!

In most cases, if you really boil it down, it’s because you can’t stand the thought of paying all of those long term care insurance premiums and never collecting on the benefits if you don’t get sick and require care.

If that’s true for you, I don’t blame you. It is a significant amount of money to part with.

However, if you haven’t bought long term care insurance, 100% of the financial risk still sits in your lap.

If you or your spouse gets sick, there are two alternatives:

• You pay for care out of your pocket, thus draining your Retirement Bucket™ for your healthy spouse, or
• You qualify for Medicaid and the government pays for your care. However, in order to qualify, you have to spend or give away everything you have (except $2,000), and be without anything for five years in order to qualify.

Neither of those options sounds too appealing.

A New Alternative

To combat this roadblock to purchasing coverage, several insurance companies have gotten creative and developed an alternative: a combination life insurance and long term care insurance policy.

The reason this is attractive to some is if you never claim long term care insurance benefits, you can either claim a cash surrender value in the policy, or your heirs are guaranteed a tax free death benefit greater than the premiums you’ve paid over your lifetime.

Essentially, this is a permanent single premium life insurance policy that is guaranteed to pay your heirs a benefit at your death.

However, the new wrinkle is you can also use it to get reimbursed for expenses related to home health care, assisted living, or a nursing home.

What this essentially does is provide protection against the threat of long term care expenses while guaranteeing that you or your heirs will get a return on your premiums paid.

Not a bad alternative!

Mechanics

The mechanics of these policies vary between companies. However, you are essentially paying a one-time premium for the plan.

In return, you receive a pool of money that you and/or your spouse can tap into for long term care expenses.

Whatever benefits are not claimed during your lifetime are paid out to your beneficiaries at your death.

If you’ve been thinking about long term care, but you haven’t been able to pull the trigger on coverage, perhaps this is the answer for you.

Both lose all sense of potential loss which leads them to do things they never would have done intelligently, like loading up on technology stocks in 1999 with price multiples of 75 to 1, or emotionally buying a condo in Naples, Florida in 2005 for investment purposes!

While the Riskless Euphoria Zone is a major contributor to why retirees earned 58.1% less than the stock market index and 85% less than the bond market index over the last 20 years, the opposite was an equal contributor.

Retirement Investor Performance Gap Reason #3: Panic

Retirement Investor Panic can be measured the same way as Euphoria, except in the opposite direction.

When you’re in the Panic phase, there is a complete sense that there is no price at which you can intelligently sell because it will always be lower tomorrow…and then lower again the next day after that.

You’ve watched the news. You’ve read all the articles. They’re “all” saying it so it must be true: “It will never come back. And, if it does, it won’t come back in your lifetime!”

So, the only solution is to get out.

If you’ve paid even a little attention to the news over the last six months when the stock market has resembled a rollercoaster ride at Disney World, you’ve seen this in droves. Especially on the heels of what occurred in 2008-2009.

When you’ve reached this point, you’re in the Panic Phase and history has proven that it’s extremely destructive.

At each great market bottom over the last 65 years, including the one we experienced in March, 2009, and the correction we experienced over the summer this year, the exact same headlines existed in newspapers:

“This Time Is Different”

Those four words may be the most destructive collection of words for any investor.

The reality is that it’s always different…..yet the same. The problem is that when we’re in the middle of the “fire”, it’s challenging to remain calm and rational and think long term.

In the short term, it always appears to be a completely unique period of time. And, the mass media does a great job of selling that.

However, if you study history, what you’ll find is that what contributed to most market bottoms was the same factor.

How to Think About This

What I want you to know is that I’m not suggesting that you should just blissfully invest and pay no attention to anything.

I’m also not suggesting that you shouldn’t feel anxious at times.

What I am suggesting is that the difference between getting market returns and the returns earned by the overwhelming majority of retirees over the last twenty years, which were 58% to 85% less than market index returns, is NOT due to the market.

If it was due to the market, everyone would earn what the market has produced which is extraordinary long term returns.

But, the average retiree earned 58.1% less than the stock market index and 85% less than the bond market index over the last 20 years.

The question you have to ask yourself is WHY.

And, the answer is it’s due to investor behavior.

In other words, what retirees do as opposed to how markets perform, which is 100% in your control.

That’s the good news. Each of these is completely in your control.

To quickly refresh your memory, and to ingrain these numbers and their effects in your mind, here’s what DALBAR’s study on the results for the 20 year period ending in December, 2010 revealed:

• The Average annual return of the S&P 500 Stock Market Index from 1991 thru 2010 was 9.14% (including dividends reinvested)
• However, the average annual return of the “average” equity mutual fund investor (not investment, but an investor, i.e. a person) over the same 20 year period was 3.83%
• The Average annual return of the Barclays Aggregate Bond Index from 1991 thru 2010 was 6.89%
• However, the average annual return of the “average” bond mutual fund investor (not investment, but an investor, i.e. a person) over the same 20 year period was 1.01% (a difference of 85.3% per year).

What these numbers tell us is that, while the S&P 500 Market Index delivered a strong average annual return over those 20 years of 9.14%, the average stock mutual fund investor (a person, not an investment) only achieved 3.83%!

That means that the average equity investor’s return was 58.1% less than the broad market index each and every year!

The Effect

There are many, many reasons why social security statistics continue to demonstrate that only 6% of Americans are financially independent at retirement age, and can continue their same standard of living throughout their retirement years.

This DALBAR report illustrates a huge one!

The wonderful news out of all of this, however, is that it’s completely within your control to close this performance gap.

This ugly performance gap is not the result of bad investments or bad markets.

They are the direct result of poor investor strategy and behavior (action or inaction), all of which you have the ability to control!

Enjoying the relaxing retirement that you’ve worked so hard for and deserve requires not only action on your part, but resisting the allure of the wrong actions taken by the overwhelming majority of retirees.

In this blog entry, I’d like to walk you through one of the reasons why this awful performance gap exists so that you can avoid being a victim.

And, after the record breaking month we’ve just witnessed, this is especially appropriate right now!

Performance Gap Reason #2: Riskless Euphoria

What exactly do I mean by Euphoria, and how does it apply to investing?

Well, it’s the financial equivalent of “rapture of the deep” which is a phenomenon that overtakes scuba divers when they dive down really deep.

Divers get completely blissed out and they lose any adult sense of danger.

The same thing occurs with investment Euphoria.

When you’re in The Euphoria Zone, there’s a complete loss of the idea that principle loss is even a possibility.

The best way to identify this in anyone, including yourself, is when their identification of loss, or their definition of risk, is being outperformed by somebody else!

They completely lose sight of their objectives and their plans and, instead, are attracted to the bright, shiny object of someone hitting a temporary investment home run.

When all you’re worried about is somebody making more money than you are, you’re in The Euphoria Zone.

What they lose sight of completely is the fact that in order to achieve higher and higher rates of return, they must take on greater and greater amount of principle risk.

1997 to 1999: The “New” Economy

The classic example of this was from 1997 through 1999 when people bought internet stocks at price multiples of 75 to 1!

Even those who were earning good rates of return doing what they were already doing. But, that didn’t matter because others were earning more so they jumped into the pond without a second thought about the potential ramifications.

2005: Real Estate

Another example of this was real estate in 2005. There was no price that was too high to pay for a pre-developed condo in Boca Raton, or Naples Florida because they just knew it would double in price in 3 years!

In hindsight, we now know what the result of this is. Condos in those towns are now selling for 25 to 40 cents on the dollar. I have a friend who bought a condo in Naples for $429,000 that he can’t sell today for $160,000!

What essentially occurs in The Euphoria Zone is the complete loss of any sense of risk at all. None.

And, that’s one of the biggest mistakes that leads to irrational investing and the horrific results revealed in the Dalbar Report.

Stay out of the trap!

I’ve recently had the opportunity to share some good news with a very nice couple who was referred to us by one of our Relaxing Retirement members.

But, then I had the obligation to share some bad news as well.

Their story is so important that it led me to do some more research that I will be sharing with you in the coming weeks.

For today, however, I’d like to tell you about the good news and the bad news.

In order to protect their privacy, I’m going to refer to this couple as Gary and Barbara.

Gary and Barbara are both 64 years old and they now find themselves in the same place as many of our Relaxing Retirement members today.

They’re empty nesters and they’re emotionally ready to retire and get more involved in the “grandparenting” business because their middle daughter just gave them their third grandchild in less than two years!

How great is that!

Can We Afford It?

What Gary and Barbara want to know from me is if they can afford to retire.
And, if they can, how do they generate lifestyle sustaining income because they’ve never done this before.

This is a key commonality that I see so much. They’ve never done this before and they’re just not confident.

One of the big reasons why they lacked 100% confidence is their investment performance over the last few years, and all of this market volatility that we’ve been experiencing.

During their Retirement Confidence Preparation System™ meeting that we had, in addition to having an extensive conversation about their experiences and their priorities, I also had the opportunity to review their investment holdings because they brought several years worth of statements that they kept neatly in a large 3-ring binder as we requested.

While reviewing their statements during our meeting, I noticed that there was a lot of activity (buying and selling) at random times, so I asked what triggered all of that movement.

Gary’s answer is what sent me on the research assignment that I’m going to share with you.

His answer is one that I hear far too often: “I evaluate what’s doing well and what’s not and I reallocate.”

My response was, “reallocate to what?”

Gary’s answer: “out of what wasn’t performing well to what was performing better.”

The Good News

Now, as I’ve done in the past, I’d like to reserve my reaction to his comments for a few minutes, and report to you the good news I shared with them!

When we designed their Retirement Blueprint™ and ran their Retirement Resource Forecasters™, taking into account all of their priorities and all their resources, the good news that I had for them was they had enough money to make it all work!

Enough money and income to continue living the way they wanted without running out of money over their expected lifetime.

Now, as you can imagine, this was huge relief for them. And, something they did not realize before we met and designed their Retirement Blueprint™.

As you can imagine, they were on a real high at this point. However, that soon simmered as I alerted them that I had to temper it with some precautionary bad news.

The Bad News I Had to Share

After carefully evaluating their last three years worth of investment statements, the bad news I had to report to them was if they continued doing what they had been doing, there was a high likelihood that they’d run out of money within 7 to 9 years!

I know…ouch!

Now, why did I have to tell Gary and Barbara this when I just told them that they had enough money to support their lifestyle for the duration of their life expectancy?

The reason I had to tell them this was their Retirement Resource Forecasters™ had some assumptions built into them.

First, we have to account for the fact that they’ll need more and more income each year just to remain in the same position due to inflation.

And, second, we have to assume that they can earn the investment rate of return that they need to earn in order to keep pace with inflation, which, for them, is not a very high return.

However, given Gary and Barbara’s “system” of investing, they had little or no chance of accomplishing that.

What they actually employed was not a system, but random selection and timing.

Their allocation actually wasn’t that bad three years ago. It was actually fairly well diversified.

However, they continuously killed that diversification by trying to shift out of what just performed poorly over to what had performed better.

Gary and Barbara’s “System”

Unfortunately, Gary and Barbara’s investment “system”, or better stated: “behavior” is not unusual.

Statistics tell us that it’s the norm.

As you’ve heard me report before, there’s a financial research firm located here in Boston by the name of DALBAR. And, every year, DALBAR performs a quantitative analysis of investor behavior.

Upon investigation, I discovered that their 2011 study for the 20 year period covering 1991 – 2010 has been published, so I purchased it.

Here’s what the report reveals:

• The Average annual return of the S&P 500 Stock Market Index from 1991 – 2010 was 9.14% (including dividends reinvested)
• However, the average annual return of the “average” equity mutual fund investor (not investment, but an investor, i.e. a person) over the same 20 year period was 3.83%

Take a moment to stop and re-read those two numbers for a moment and let them sink in.

What these numbers tell us is that, while the S&P 500 Market Index delivered a strong average annual return over those 20 years of 9.14%, the average stock mutual fund investor (a person, not an investment) only achieved 3.83%!

That means that the average equity investor’s return was 58.1% less than the broad market index each and every year!

Bond Investors fared even worse. Here are the DALBAR statistics for them:

• The Average annual return of the Barclays Aggregate Bond Index from 1991 – 2010 was 6.89%
• However, the average annual return of the “average” bond mutual fund investor (not investment, but an investor, i.e. a person) over the same 20 year period was 1.01% (a difference of 85.3% per year).

How incredible is that!

It’s mind boggling, but it doesn’t surprise me after what I’ve witnessed over the last 22 years in this business.

Just think about Gary and Barbara’s story that I just shared with you!

We’re Fighting the Wrong Problem

What you can’t help but take away from those statistics is that, while it makes all the news, markets (or bad investments) are not our biggest problem.

The BIG problem is investor behavior, which is driven by their “strategy” or lack thereof.

Forget for a moment about trying to “beat the market” which is what everybody talks about.

The average stock mutual fund investor earned 58% less each and every year than the S&P 500 market index (a market barometer of “average” returns, not above average!).

Think about that for a moment. Something that we all can control is what our biggest problem is.

It’s uncomfortable, but it’s the only logical and rational conclusion we can reach given the results of this research report. What else could possibly explain the massive difference in real life returns that people receive?

The obvious question is why, and what can we do to close this performance gap?

Well, there are several easily correctable “strategic mistakes” that I’ve personally witnessed over the last 22 years that I’d like to share with you.

Stay tuned. I’m not sure there’s anything more important about investing during your retirement years than what I’m going to reveal to you in the coming weeks.

As promised, here are some examples of situations where I believe the use of an annuity is inappropriate.

Buying a Variable Annuity Inside of Your IRA or Roth IRA

A classic example of a situation I see way too often that I don’t recommend is investing in a variable annuity inside your IRA or Roth IRA.

One of the many benefits of an annuity is tax deferred growth of your money. However, all investments held inside of an IRA or Roth IRA grow tax deferred already.

Given this, why would you need to place a tax deferred vehicle (annuity) inside of a tax deferred vehicle (your IRA)?

There really is no valid reason to do so.

Unfortunately, one of the main reasons why it’s recommended so often is the commission paid on an annuity vs. a traditional mutual fund. Annuities typically pay much higher commissions, so there’s a significant incentive for a broker to sell an annuity instead of just a mutual fund.

All things being equal, this alone would not be a profound problem. However, in order to pay those higher commissions, the insurance company sponsoring the variable annuity must charge you higher fees!

For this reason, I do not recommend this practice.

Equity Indexed Annuities

During volatile financial markets, products are created and heavily marketed which appear to be “one-size-fits-all” solutions.

In my opinion, equity indexed annuities fall into this category. Their promise is to allow you to invest in the stock market (using one or more indexes, like the S&P 500), yet not lose any money personally if the market index goes down.

When you first hear the concept, it sounds extremely attractive. In short, you get all the benefits of the stock market without the downside risk.

However, as with most financial instruments, you have to read the fine print.

Insurance companies do place a floor on your deposit so that when you withdraw funds from the equity indexed annuity, you will receive no less than you deposited.

However, a few key points to note:

• If you withdraw funds over the first 10 to 25 years, you have to pay a stiff surrender charge for access to your money. And, I’ve seen that charge be as high as 15%.
• Your upside potential is limited. If the S&P 500, or whatever index your annuity is tied to, earns 10%, you don’t get credited with a 10% gain on your equity indexed annuity. Your gains are capped at a much lower percentage and the insurance company keeps the rest.

Without knowing any more, if you objectively stand back and examine this product, you have to ask yourself how the insurance company can take on this exposure and not have a problem down the road.

In 2008, for example, when the market dropped over 37%, how did their company stand up when they had to guarantee no losses to their equity indexed annuity customers? How are they going to keep that promise indefinitely if the stock market doesn’t cooperate?

For this reason alone, I’m not a fan of equity indexed annuities.

To sum up, as I outlined last week, I do believe there are situations which warrant using an annuity. I simply believe that those situations are much, much more narrow than those currently being sold today.

Three Final Recommendations

Once you’ve digested these last four Strategies of the Week dissecting annuities, and your interest is peaked, here are just a few more recommendations for you before purchasing one:

• Access to Your Money: Be very clear on the language of the insurance company’s surrender charges when you need access to your money. This is critical.
• Insurance Company Ratings: With fixed annuities specifically, be careful to examine the independent ratings of any insurance company you’re considering. Remember, how well you do is directly tied to the performance of that insurance company.
• Fees: Specific to variable annuities, be very clear what their insurance charges are to run the annuity, typically 1.50% or so. If a variable annuity is what you’re after, a few companies now have very low cost variable annuities.

I hope this has been helpful for you.

This included immediate vs. deferred annuities, fixed vs. variable annuities, and the accumulation and distribution phases of all annuities.

Now that we have this basic understanding, let’s take it a step further and delve into some of the pros and cons of using annuities.

As I stated last week, annuities are not all good or all bad. They’re simply a tool to have in your planning toolbox.

And, like any tool, they can work well in solving specific problems, but never as a one-size-fits-all solution.

Pros

• Guaranteed Income for Life: Sounds pretty attractive, doesn’t it? If you annuitize your annuity, you lock in a guaranteed payment for as long as you live if you wish. This can be an extremely attractive feature for some. If you live to be 156, you still receive your monthly check. (This assumes that the health of your insurance company remains sound and they can fulfill that commitment. A rather aggressive assumption.)

• Tax Deferral: All interest and gains inside your annuity grow tax deferred. So, as an example, if you have $500,000 in bank CDs, and you earn 3%, that $15,000 of interest you receive from the bank is subject to ordinary income taxes in the year you receive it. Even if you don’t spend the interest and roll it back into the CD.  If the same $500,000 was held in an annuity, your $15,000 of interest (or gain) would not be taxed until you withdraw funds from the annuity. The long term compound interest benefits from this can be substantial because the money that would have gone to pay taxes each year can continue to grow.
• Investment Flexibility: As I mentioned last week, variable annuities allow you to invest in a variety of investment subaccounts which act like mutual funds you would purchase outside of an annuity. This allows you to take advantage of investment diversification and the potential to keep pace with inflation.

• Withdrawal Privileges: Many annuities offer very stringent withdrawal policies, and penalize you for withdrawing your funds during the first six to twelve years (some even longer). Charges for early withdrawal can be as high as 15% of the amount you withdraw. However, some allow you to withdraw all your gains or 10% of the accumulated value in any given year without surrender charges. (Be sure to check the fine print)

Cons

• Surrender Charges: As I just alluded to, most annuity companies charge hefty surrender fees if you remove money from the plan during the first six to twelve years. For example, it is not uncommon for a fixed annuity carrier to charge you 9% if you want to remove funds during the first year of your plan. Most “Equity Indexed” annuities, which have been heavily marketed by insurance companies lately, have as long as a 20 year surrender charge period with surrender charges as high as 15%! Because of this, you have to be very careful about your need for the money you’re placing in the annuity.

• Fixed Annuities: Many companies lure customers in with “bonus” interest in the first year. You’ll see ads in the newspapers like this all the time. While the interest rate can be attractive, it’s typically only for one year. After the first year, the interest you receive is based on the performance of the underlying insurance company. If you don’t like the interest they’re paying in year two and beyond, you have no recourse other than to withdraw your money. However, as I stated above, you may very well be subject to a hefty surrender charge.

• Variable Annuity Options: There are two issues I’d like to call your attention to:
  • Insurance companies contract with mutual fund firms to provide some of that firm’s funds in their variable annuity contract. While their subaccount “lineup” may be impressive, it’s not locked in place for life. If the subaccounts you really like are removed from the plan, you can only invest in the remaining subaccount options. And, as in the last example, if you don’t like those remaining options, you may have to pay a significant surrender charge to make a change to another plan.
  • Cost: Insurance companies who sponsor variable annuities charge fees in order to run the program. This cost typically hovers around 1.50%. In the long run, this is considerable, so you want to be very clear about what your company charges. The good news is that market forces have worked and some companies now offer very attractive plans with significantly lower fees.
• Ordinary Income Tax Rates: As I noted above, one of the attractive features of an annuity is tax deferred growth. However, all gains removed from annuities are taxed at ordinary income tax rates as opposed to capital gains tax rates which are currently much lower. Even if your stock market based subaccount in your variable annuity doubles in price, you don’t pay capital gains tax on that gain. Instead, you pay ordinary income tax rates when you withdraw funds from your plan. If you purchased a mutual fund outside of an annuity, and it doubled in price, you would pay capital gains tax rates on that realized gain (currently 15%).

• Annuitizing: While guaranteed income for life is attractive, it comes with a price tag by the insurance company. If you deposit $500,000 into an annuity and select the single life payout, you receive income payments for as long as you live. However, when you pass away, the insurance keeps the principal, even if that occurs in the first year. As I outlined last week, you may choose to protect your spouse by choosing a period certain or joint and survivor option, by payments still end at the end of the period or at your deaths. This is a critical factor to clearly understand.

While this list is certainly not exhaustive, understanding these points gives you a significant advantage.

In the near future, I’m going to give you some examples of situations where an annuity might be useful for you, and some examples where they’re being oversold that you

During periods of turmoil and volatility (and thus uncertainty), each of us seeks to understand what’s really going on, and how it relates to our well being.

That’s an innate trait among all fully functioning and responsible adults.

It’s actually a built in defense mechanism hardwired in our brains.

The first question to ponder today during this current period of uncertainty is who do we pay attention to in our attempt to come to some semblance of “understanding”?

As we’ve talked about before, most retirees gravitate to the so-called “experts” the mass media trots out in front of us daily for insights into where we’re going in the future.

Are They Right?

Is this a good idea?

After all, economist and author John Kenneth Galbraith was famous for saying, “the function of economic forecasting is to make astrology look respectable.”

In my opinion, you have to be very careful of “expert” opinion.

Let me give you an example:

Between 1982 and December 2008, the Wall Street Journal surveyed all of the top economists to get predictions of the direction of interest rates in the future.

Now, before we continue, I’d like to magnify the point that they were not asked to predict what interest rates would be in the future.  They were simply asked to predict the direction of interest rates in the future, i.e. higher vs. lower.

In 2008, the Wall Street Journal measured the predictions vs. the actual direction of interest rates from 1982 to 2008 and published them in their Survey of Economists.

Here’s what that survey revealed…

Overall, the economists’ forecasts were wrong in 36 of the 53 time periods!

That means they were wrong 68% of the time!

Can you believe that?  2 out of 3 times they were wrong about the “direction” of future interest rates.

They couldn’t even get that right more than half the time.

If they can’t get this right, who can?

The Strategy

So, what can we learn from this?

Simply this: don’t waste time and energy focusing on variables that are unknowable and uncontrollable over the short term (like the direction of interest rates or the stock market).

Instead, focus your energy on things you can control like:

• knowing your income and expense numbers cold,
• calculating the investment rate of return you need to earn to help you keep pace with inflation so you don’t run out of money,
• diversifying your holdings over many different styles of investments, each of which will perform differently during various periods of time,
• remaining disciplined with your carefully determined and planned for allocation during different market cycles, and
• objectively holding each investment accountable to its stated goal, and making adjustments if necessary.

After 22 years of intensely studying and working hands-on with all of you, I can confirm that being on the “cutting edge” of current information (from so-called experts) is no recipe for total financial security and the relaxing retirement you desire.

Continue to focus on what you can control, and just smile the next time you hear some “expert” profoundly state what he or she believes will happen in the future.