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Here’s a way to make your retirement savings last longer

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Survey after survey has shown that longevity risk, the risk of running out of money prior to death, is far and away the top concern for a generation of baby boomers. To address this, financial advisers have increasingly turned to annuities with lifetime income riders to help mitigate that risk. After a deferral period, the retiree can elect to receive a stream of income that’s guaranteed to last as long as they do.

Creating a guaranteed floor of income in retirement has been shown to confer an array of psychological and health benefits and is gaining wider currency among a generation of retirees. A recent survey by The Wall Street Journal showed that retirees with guaranteed income are generally happier and Stephen Dubner of “Freakonomics” fame has even made the case that it could extend your life.

But there’s a rarely discussed dark side of these annuity arrangements that should be brought to the fore, particularly given our country’s gloomy fiscal outlook and mounting debt load. Over 95% of the time these annuity arrangements are implemented within pretax vehicles such as IRAs. When the retiree elects a lifetime income therefore, that lifetime income shows up as taxable income on their tax return.

This poses two fairly significant problems.

First, because this guaranteed lifetime stream of income is taxable, it exposes the retiree to the impact of tax rate risk. There is growing consensus that tax rates even 10 years from now will be dramatically higher than they are today. Former comptroller general of the federal government David Walker has predicted that tax rates would have to double to pay for unfunded obligations such as Social Security, Medicare and Medicaid along with interest on the national debt.

More recently Ray Dalio, Larry Swedroe, Leon Cooperman, Larry Kotlikoff, and Ed Slott have said that tax rates have to rise dramatically soon, or we go broke as a nation. So, while guaranteed lifetime income might solve your problem at current tax rates, your after-tax income diminishes as tax rates creep higher over time. The resultant hole in your lifetime income would somehow have to be plugged. Retirees would likely be forced to spend down their other stock market assets to compensate. This could force them to exhaust their liquid savings far sooner than they thought possible.

The second problem is Social Security taxation. Any distributions from tax-deferred retirement accounts, including guaranteed lifetime income from annuities, count as provisional income. That’s the income the IRS tracks to determine whether they’re going to tax your Social Security. By drawing lifetime income out of annuity situated in your IRA, you could inadvertently breach the Provisional Income thresholds that cause Social Security taxation. It isn’t unusual for retirees who rely on their IRAs in retirement to pay anywhere from $3,000 to $6,000 in Social Security taxation. And how do they plug that hole in their Social Security? You guessed it, by spending down their stock market portfolio to compensate.

Here’s the bottom line: the combined cost of rising taxes and Social Security taxation could force you to spend down your retirement portfolio 7 to 10 years faster than you ever thought possible.

Historically annuity companies have addressed these two major issues by giving you the ability to convert your IRA annuity to a Roth IRA. But that option has always come with a major caveat. You had to convert your entire IRA annuity all in one year. Given a large enough annuity, that could easily push you into the highest marginal tax bracket. So much for trying to shield yourself from higher taxes. In an effort to avoid a doubling of taxes over time, you doubled your taxes in the short term!

More recently, a few insurance companies have pioneered what I call a Piecemeal Internal Roth Conversion (PIRC). This allows you to convert your IRA annuity to a Roth IRA in smaller amounts and over a time frame that can help stretch out your tax obligation, keeping you in much lower brackets along the way. Once the conversion is complete, you can then draw your guaranteed lifetime income from your Roth IRA. This shields you from the impact of rising tax rates and can put you in a position to receive your Social Security 100% tax-free.

Because of this, you won’t be forced to spend down all of your other assets to compensate, dramatically increasing the likelihood that your stock market portfolio will last as long as you do.

David McKnight is the author of The Power of Zero. His forthcoming book, Tax-Free Income for Life goes on sale Nov. 17 (Portfolio/Penguin Random House).



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Don’t stop investing in bonds

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Given the current doom and gloom, with the occasional spell of relief, over interest rates rising, does it still make sense to invest in bonds when saving for or living in retirement?

Well, it sure didn’t seem to make sense when interest rates were (and still are) at historic lows. Like, who in their right mind wants to earn 0.318% on a 10-year Treasury, which is what it was earning roughly one year ago?

And it might not make sense now that rates have risen from the March 2020 lows. Remember, the principal value of your bond does decline when interest rates rise.

But what folks might be missing in the current topsy-turvy environment is the role that bonds should or ought to play in a portfolio.

Safety, not income

According to Larry Swedroe, co-author of Your Complete Guide to a Successful Retirement and director of research at Buckingham Strategic Wealth, the main role of fixed income in your portfolio should be safety, not return, not income, not cash flow.

In other words, if all else goes to pot, if stocks should crater, bonds are there to provide safety of principal—at least at maturity.

Plus, bonds are there for diversification purposes. Bond prices should rise when in value when other assets, say, stocks are falling in value, and vice versa.

“Rule No. 1 that every investor should abide by is that you want to make sure your portfolio has a sufficient amount of safe, fixed income to dampen the overall risk of the portfolio to an acceptable level,” he said. “Because if not, and equities drop, which they tend to do once every 10, 15 years or so, 40, 50% or whatever, then you’re going to exceed your tolerance for risk.”

At best, he said, you won’t be able to sleep, enjoy your life, and everything else. And, at worse, you’ll engage in the worst thing you could do: panic and sell. “And once you sell…I think you’re virtually doomed to fail unless you just get lucky.”

Bottom line for Swedroe: “You have to have enough safe bonds.”

Now how much you should invest in bonds, stocks and cash is, according to Sébastien Page, author of Beyond Diversification and head of global multiasset at T. Rowe Price, “is, without doubt, the most important portfolio construction decision an investor makes.”

How much to invest in bonds?

According to Swedroe, how much you should invest in fixed income is a function of your ability to take risk. And your ability to take risk is determined by four factors: your investment horizon, the stability of earned income, your need for liquidity, and options that can be exercised should the be a need for a plan B. What’s more, Swedroe said owning bonds whose maturity is beyond your investment horizon takes on more risk than is inappropriate.

Ability to take risks

Investment horizon (years)

Maximum equity allocation (%)

0-3

0

4

10

4

20

6

30

7

40

8-9

50

10

60

11

70

12-15

80

16-19

90

20+

100

Source: Your Complete Guide to a Successful & Secure Retirement

Like Swedroe, Page also believes the decision turns in part on one’s human capital, the present value of your future salary income. And once you factor in a person’s human capital, which Page argues acts more like a stock than a bond, a balanced portfolio with a healthy allocation to stocks, not bonds, is the answer.

To be fair, the allocation to bonds isn’t static throughout the life cycle in either Page’s or Swedroe’s model portfolios.

For instance, in Page’s model portfolios, you’d allocate 15% to bonds in the 20 years before retirement, 45% at retirement, and 69% some 20 years into retirement, which is close to the rule-of-thumb that would have you subtract your age from 120 to determine how much to invest in stocks and how much in bonds. So, if you were 47, you’d invest 73% in stocks and if you were 87 you’d invest 33% in stocks.

The right bonds depend on your investment objectives

Investing in the right bonds is equally important as investing in bonds, said Massi De Santis, a certified financial planner with DESMO Wealth Advisors. According to De Santis, the right bonds help you avoid unnecessary risks and make the most out of your portfolio, particularly in a low interest rate environment.

What are the right bonds? That depends on your investment objective.

For growth portfolios, De Santis recommends that the bond component should be diversified across the bond universe, including government, government agency, investment-grade corporate and global bonds. The duration should be in the intermediate range (about 5-7 years).

The Vanguard Total Bond Market Index Fund ETF
BND,
-0.06%
,
the SPDR Bloomberg Barclays International Treasury Bond ETF
BWX,
-0.34%
,
and iShares Core US Aggregate Bond
AGG,
-0.07%

 are ETFs that would work for this objective.

For conservative portfolios, De Santis recommends highly rated short- to intermediate- bond durations that are similar to the horizon of the goal. The iShares 0-3 Month Treasury Bond
SGOV,
,
SPDR Bloomberg Barclays 1-3 Month T-Bill ETF
BIL,
,
Vanguard Short-Term Treasury Index Fund ETF
VGSH,
,
Vanguard Short-Term Bond Index Fund
BSV,
-0.02%
,
iShares Core 1-5 Year USD Bond ETF
ISTB,
+0.04%
,
and iShares 1-3 Year International Treasury Bond ETF
SHG,
+2.51%

are ETFs that would work for this objective.

And for income-focused portfolios, De Santis recommends government, inflation-protected and investment-grade corporate bonds where the duration of the goal is the average maturity. The iShares TIPS Bond ETF
TIP,
+0.10%

and the Vanguard Long-Term Bond Index Fund ETF
BLV,
-0.19%

 are examples of ETFs that would work for this objective.



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These money and investing tips can remind you to not take Mr. Market’s moods personally

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Don’t miss these top money and investing features:

These money and investing stories, popular with MarketWatch readers over the past week, help you make sense of your investment portfolio when stocks and bonds are choppy and Mr. Market’s mood seems to change hourly.

Sign up here to get MarketWatch’s best mutual funds and ETF stories emailed to you weekly!



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Emerging market equities’ place in retirement portfolios

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How much should you allocate of your retirement portfolio to emerging market equities?

It’s a timely question, since many widely-followed Wall Street firms are telling their clients that emerging market stocks are the only equity category whose expected return over the next decade is above inflation. Perhaps the most prominent of such firms is GMO, the Boston-based investment firm co-founded by Jeremy Grantham. It is projecting that the emerging market equity category will beat inflation over the next seven years by 5.0% annualized. In contrast, the firm is forecasting a 6.2% annualized loss to inflation over the same period for the S&P 500
SPX,
+1.95%
.

As is also widely known, however, GMO has been making similar forecasts for many years now, and at least so far has been very wrong. Over the trailing 10 years, according to FactSet, the iShares MSCI Emerging Markets ETF
EEM,
+1.09%

  has produced a 3.4% annualized return, almost 10 annualized percentage points below the 13.3% annualized return of the SPDR S&P 500
SPY,
+1.84%
.

Fortunately for our purposes, Credit Suisse has just released the latest edition of its Global Investment Returns Yearbook, authored by finance professors Elroy Dimson, Paul Marsh, and Mike Staunton. This yearbook arguably is the most comprehensive database of global returns, as it reports performance since 1900 for “equities, bonds, cash, currencies and factors in 23 countries.” For the first time, furthermore, this year’s yearbook was “broadened to include 90 developed markets and emerging markets.”

This long-term perspective is especially crucial when assessing emerging markets. That’s because we can all too easily forget that many emerging stock markets disappeared altogether at various points since 1900 due to “major events such as revolutions, wars and crises.” Their losses need to be taken into account when judging emerging markets’ prospects, and this Yearbook does.

This long-term perspective is crucial for another reason as well: Some emerging markets over the last 121 years have performed so spectacularly that they graduated to the “developed” category. Index providers employ a complicated methodology for determining when that graduation takes place and, as you can imagine, a lot is riding on that determination. But the inevitable result is that some of these emerging markets’ spectacular performance gets credited to developed market benchmarks rather than to emerging market indices. This yearbook’s authors employ an elaborate methodology to place each market each year in the appropriate categories.

You may say you don’t care how a country’s stock market is classified, just so long as it performs well. But you should care. If you invest in emerging market equity index funds, you at least implicitly are relying on the decisions that index providers make about what counts as an emerging market. There’s no way around it.

Long-term performance

Without further ado, let me turn to what the Credit Suisse Yearbook reports. Over the last 121 years, emerging market equities have produced a 6.8% annualized return to a US-dollar investor, 1.6 percentage points below that of developed markets’ 8.4% annualized. I note in passing that developed market bonds beat emerging market bonds over this period by a similar magnitude: 4.9% annualized versus 2.7%. These returns are plotted in the accompanying chart.

These long-term returns suggest that the last decade’s results are not as unusual as they may otherwise seem.

Do these results mean that there’s no need to allocate any of your retirement portfolios to emerging market equities? Not necessarily. Part of the rationale for investing in them derives from their potential diversification benefits: If they zig while developed market equities zag, and vice versa, then a portfolio that invests in both would incur significantly lower volatility, or risk, than one that invests in developed market equities alone. This in turn could translate to superior risk-adjusted performance even if emerging market equities underperform.

The yearbook’s authors find that emerging market equities do provide some diversification benefit. However, that benefit has been declining over the last several decades, as correlations between their returns and those of developed markets have been rising.

The bottom line? I came away from this latest edition of the Credit Suisse Yearbook with diminished long-term expectations for emerging market equities.

That doesn’t mean we should automatically avoid them. But we should base any decision to invest in them on other factors besides their long-term returns.

GMO and the other firms advocating for emerging market equities do just that, by the way, basing their bullishness on valuation considerations. They believe that emerging market stocks are very cheap, according to any of number of valuation metrics, both in their own right and relative to developed market (and especially U.S.) stocks.

GMO and similar firms may very well be right, of course. But the 121-year record suggests that they will have to be very right indeed to overcome emerging market equities’ long-term tendency to lag developed market equities.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.



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