Forecasts & Trends : Retirement

Retirement Focus: Target-Date Funds in the Crosshairs

Gary D. Halbert — Tue, 11 Aug 2009 19:25:00 GMT

By Mike Posey

IN THIS ISSUE:

Target-Date Funds 101
Advantages of Target-Date Funds
Criticisms of Target-Date Funds
The Feds Come Down on Target-Date Funds
Buy-and-Hold on a Stick

Introduction

Target-date mutual funds are a fairly recent entry into the mutual fund field, having been first introduced in the early 1990s. Since then, they have become very popular - especially after the passage of the Pension Protection Act in 2006. For those of you who may not be familiar with this type of investment, target-date funds are specialized mutual funds that offer an investor the option of buying a single fund that invests its assets based on an assumed date of retirement. As retirement nears, the fund's allocation is usually changed to become more conservative.

These funds have become hugely popular with investors because they represent a one-stop shopping opportunity for a diversified portfolio. Thus, they appeal to individual investors and 401(k) participants who are not comfortable making their own portfolio decisions. Just pick your date of retirement and your investment decision is made.

Usually structured as a mutual fund that invests in other mutual funds (a "fund-of-funds"), target-date products automatically allocate an investor's assets among a variety of asset classes, generally based on traditional asset allocation techniques.

Due to the simplicity of this approach, target-date funds have become standard features in scores of 401(k) plans where participants must direct the investment of their accounts. The premise is easy - just put your money in the fund that corresponds with your normal retirement date, sit back and let the fund take care of the details. At least that's the theory.

Too bad things have not gone as well in actual practice. Federal regulators including the Department of Labor and the SEC have been looking into the performance of these funds during the recent bear market. In addition, regulators are investigating the "need for additional guidance given the importance of these investments to the retirement savings of investors."

In this week's Retirement Focus E-Letter, I'm going to discuss the development of target-date funds, how they work and their advantages to investors. I'll also discuss the shortcomings of target-date funds, which became painfully evident over the course of this bear market. What we'll find is that, like many one-size-fits-all approaches, target-date funds can have some serious drawbacks.

The Basics of Target Date Funds

As I noted above, target-date funds are a one-size-fits-all investment solution usually structured as a mutual fund that invests its assets exclusively in other mutual funds. In most cases, the mutual fund family that sponsors the target-date funds directs its assets into other funds within the same fund family. Since most fund families sponsor a wide variety of mutual funds, it's usually not hard to achieve the fund's directive for diversification through an asset allocation strategy.

Target-date funds are also sometimes called "lifecycle funds," because they seek to provide an automatic approach to investing over time. As such, they are typically sold to investors as a sole investment. Otherwise, holdings outside of these funds could throw the asset allocation out of whack. For example, if a younger client put half of his or her 401(k) account in a target-date fund that had 80% invested in equities, yet held the other 50% of the account in cash, this would greatly reduce the overall equity exposure. Thus, target-date fund proponents suggest that participants should invest all of their contributions in this type of fund to get the best results.

Over time, target-date funds slowly shift their assets to more conservative funds as the assumed retirement date nears. In the industry, this is known as the fund's "glide path." As a general rule, the longer the fund has until the target retirement date, the higher the percentage invested in stocks. As the retirement date nears, more of the portfolio is shifted to bonds and other fixed-rate investments.

While allocations within target-date funds are generally based on asset allocation and Modern Portfolio Theory, it would be a mistake to assume that all funds have similar stock/bond allocation ratios. There is a wide variation in the amount of assets invested in equities and bonds, even among target-date funds with the same assumed retirement date (more about this later on).

Since all funds are not created equal in regard to the allocation to stocks and bonds and the glide path used, it is up to participants to determine whether the specific allocation method of any given target-date fund is appropriate for their investment goals and risk tolerance.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Advantages of Target-Date Funds

While many investors are not interested in a fund that makes all of the investment decisions for them, the creation of target-date funds did serve a real need. In the past, I have written about how some 401(k) participants will not make a decision as to how to invest their contributions. As a result, these contributions sit in low-earning cash or guaranteed-return funds, offering little hope of meeting the participants' retirement goals.

Target-date funds attempted to fix that by allowing a participant to make a single decision based on their assumed year of retirement. In theory, nothing could be easier. The participant was invested in a fund with the potential for growth and the employer was able to escape possible fiduciary liability for allowing an employee to remain in low-yielding investments.

However, even with this simplification, there were still 401(k) participants that would not even elect to invest in a target-date fund based on their retirement date. To remedy this situation, the Pension Protection Act of 2006 allowed employers to select "default" investments for participants who would not or could not make their own elections.

This law also strengthened automatic enrollment policies, so that now an employee can be enrolled into a 401(k) and have his or her money invested in a target-date fund without taking any action or making any investment decisions. Obviously, this is not a wise course of action on the part of the employee, but it can serve as a fail-safe for those who simply won't take action to secure a retirement nest egg.

Other advantages of target-date funds include the following:

Ideally, a target-date fund not only allows a participant to make a single investment decision upon participation, but also handles future rebalancing and allocation adjustments necessary to reduce portfolio risk as participants get older. In other words, it's billed as being a "set it and forget it" investment;
Likewise, in an ideal world, the target-date fund would not only provide for growth prior to retirement, but also provide a way to help retirees not outlive their money. The rationale here is that, absent target-date plans, many retirees move all of their money to "safe," fixed-rate investments upon retirement to avoid losses. By doing so, however, they might subject themselves to returns so low that they end up outliving their money. Many target-date funds maintain some level of equity investment even into retirement, which provides the potential for additional growth. Of course, it also provides for the potential for losses;
Gary has written many times about how studies conducted by the Dalbar organization show that investors who frequently change funds forfeit much of the long-term return. Target-date funds can help curb the desire to chase the latest hot performance among optional 401(k) investments by removing the need to make subsequent investment decisions after the initial purchase;
Many target-date funds have low minimum investments, making them available for even relatively small 401(k) contributions;
Asset allocations are managed by professionals within the mutual fund family sponsoring the target-date fund. Thus, participants have the potential benefit of professional management, but they are usually limited to an asset allocation strategy, which is a form of buy-and-hold investing that I do not recommend;
Some target-date funds offer the use of traditional mutual funds while others select among only passive index funds. The presence of a fund manager who tries to add value over and above the performance of an index can be an advantage, but there are no guarantees that they can always do so; and
Target-date funds can be an excellent way to take advantage of a strategy known as "dollar-cost averaging." This strategy is based on making investment purchases at regular intervals (usually monthly). Over time, contributions buy more shares when prices are lower and fewer shares when prices are high. The ultimate goal is to lower the total average cost per share purchased over a participant's working lifetime.

Disadvantages and Criticisms of Target-Date Funds

Almost since they were first introduced, target-date funds have met with criticism. Primarily, critics focus on the idea that a one-size-fits-all solution is rarely, if ever, appropriate for everyone who owns the fund. We know this to be true as the risk tolerance, return expectations and a host of other variables often determine an investor's comfort with a particular portfolio allocation.

Some dismiss this criticism by noting that 401(k) participants generally have the choice of whether or not to select their own mix of funds from those offered in the plan, so if a target-date fund is selected they should be satisfied with the result. This may be true, but it doesn't help participants who might get out of target-date funds because they are too aggressive for their risk tolerance.

Target-date funds have been the subject of a number of other criticisms, including the following:

Many target-date funds are sponsored by mutual fund families that allocate its assets only among mutual funds sponsored by the same organization. While this is not a guarantee of poor performance, a single mutual fund family usually does not have superior funds representing all asset classes;
Target-date funds are also sometimes criticized for adding a layer of fees on top of those charged by the underlying mutual funds in which they invest. In fact, some fund companies "double dip" by charging fees on the underlying funds as well as on the target-date fund. Others, however, do not charge additional management fees for their professional management services. Thus, it's important to check on what fees will be charged before making a decision to invest;
One of the biggest disadvantages of target-date funds is that it's sometimes hard to tell exactly how it will be managed over time. As I noted above, asset allocation strategies can vary widely among fund families, and can even be modified within a fund as time goes by. For instance, I read several articles back in the summer of 2008 that discussed how target-date funds were increasing their allocations to stocks. Guess how those funds did over the last half of 2008!

The lack of easily understood labeling on target-date funds can actually help to defeat the simplicity they try to provide. Participants who do not want to make their own asset allocation decisions are not likely to want to dig through a prospectus to see how their target-date fund will be managed. Plus, according to a 2008 study by the Financial Research Corp., it was even hard for professionals to discern specific investment strategies, making it very difficult to compare one target-date fund to another.
On a related note, recent research has found that the amount of a target-date fund's allocation to equities can vary widely among fund sponsors, even when the funds are close to their target retirement date. While many experts agree that some exposure to equities is necessary in retirement to provide a potential for growth, most agree that this allocation should be rather small.

A good example comes from a 2008 Investment News article that noted the Oppenheimer Transition 2010 Fund (designed for someone retiring in the year 2010) had 75% of its assets invested in stocks. Not surprisingly, it lost over 41% of its value in 2008, a loss even greater than that of the S&P 500 Index's drop of 37%. Now, just think of retirees in this fund that have just two years or less before retirement. It's unlikely that they'll make back much, if any, of this loss prior to their target retirement date;
Another possible disadvantage brought about by all the variation in target-date funds is that employers who use these funds as default options may find themselves having liability for selecting the wrong default fund;
While most fund companies and employers have done a good job communicating about how target-date funds work, a recent study by Janus Funds found that 60% of target-date fund holders incorrectly believe that these funds provide some pension-like guarantees. They do not offer any guarantees and are subject to market losses, as most participants found out in 2008;
As both employers and plan participants seek to evaluate and compare various target-date funds that may be available to them, they often find that the target-date funds have a very limited actual track record. The number of target-date funds has exploded in the last few years, so many have little to show as far as a track record. You can try to get a better picture by analyzing the track records of the underlying funds used, but this can be a rather complex task.

Even worse, a participant must not only decide if the current allocation is appropriate for his or her investment profile, but must also see if the glide path will result in an appropriate allocation in all future years. In other words, a target-date fund investor must decide up-front if all future allocation adjustments will be appropriate for his or her financial situation at that time, something that is impossible to know.

Again, I doubt that participants who already don't feel comfortable making their own investment decisions will go to this trouble. If not, they'll either stay invested in low-yielding investments, or pick the first target-date fund that sounds good without determining whether it is the most suitable option for them. Either way, their retirement security may be at risk;
As I noted above, target-date funds are designed to be a sole investment rather than part of an allocation of various funds. As such, however, a target-date fund may conflict with other investments a participant may hold outside of the 401(k) plan; and
While target-date funds may be useful for young participants who can benefit from dollar-cost-averaging, it may not be the most suitable investment for large accumulated balances. I'll discuss this in more detail later on, but target-date funds are nothing but buy-and-hold strategies on autopilot, which could subject large nest eggs to potentially significant losses.

As I have previously noted, any one-size-fits-all solution is bound to have negative implications for some who invest in these programs. However, target-date funds seem to have more than their fair share of disadvantages that can moderate, or even eliminate the advantages of these funds, depending upon the participant's personal situation.

The Feds to the Rescue

To say that many target-date funds did not fare well in the bear market of 2008 would be a vast understatement. In fact, we can say that most target-date funds didn't do very well. According to a recent speech by SEC Chairman Mary Schapiro, funds with target retirement dates of 2010 had returns in 2008 that varied from minus 3.6% to minus 41%. This is a huge disparity for a group of funds that are supposed to be designed for 401(k) participants retiring next year.

As you might suspect, the primary culprit causing this spread in returns was the wide variation in the stock allocations within the various target-date funds. Those with larger allocations to equities had the greatest losses, while those with lower equity allocations had smaller losses. However, large losses for employees who are close to retirement age were seen as especially disturbing to the SEC and Department of Labor (DOL), not to mention the unfortunate 401(k) participants who invested in these funds.

Plus, some funds actually increased their allocation to stocks last year, just before the market meltdown, in what can only be described as an attempt to chase returns. Supposedly, investors are paying their professional managers to apply a disciplined approach to investing, but chasing returns is what the Dalbar organization has identified as the reason average investors often earn poor returns. In my opinion, this is simply inexcusable for a professional money manager.

As a result of the shortcomings of target-date funds, the SEC and DOL held a joint hearing on these investments on June 18th. The purpose of this hearing was to have an "in-depth discussion" about the role of target-date funds in retirement planning as well as the need to improve regulation of these funds and better protect retail investors. In her opening statement, SEC Chairman Schapiro said:

Target date funds have become an increasingly popular investment option for Americans investing for retirement and educational needs. These funds and other similar investment options are financial products that allocate their investments among various asset classes. These funds automatically shift that allocation to more conservative investments as a "target" date approaches…

The "set it and forget it" approach of target date funds can be very appealing to investors. Target date funds were expected to make investing easier for the typical American and avoid the need for investors to constantly monitor market movements and realign personal investment allocations.

But, the reality of target date funds was quite surprising to many investors last year. It has been reported that the average loss in 2008 among 31 funds with a 2010 target date was almost 25 percent…

These varying results should cause all of us to pause and consider whether regulatory changes, industry reforms or other revisions are needed with respect to target date funds. And this is what I hope today's joint hearing will help us assess.

I researched our Morningstar Principia Pro software to find the 2010 target-date funds and did a bit of additional analysis. As usual, I searched only the "distinct portfolios" so that I wouldn't get multiple share classes of the same fund. The result was a group of 50 mutual funds falling within the "Target Date 2000 - 2010" Morningstar Category.

Sure enough, these funds had a wide variety of equity exposure, ranging from a low of around 10% to a high of over 65%. It is also important to note that this equity exposure was not just in relation to domestic stocks, but some funds had over 20% allocated to non-US stocks, which are usually deemed to be more aggressive than domestic stocks due to the currency risk involved.

In light of these statistics, it does appear that something probably needs to be done to standardize target-date funds, or at least provide for more disclosure. As I have said above, my concern is that investors may blindly buy a fund with the right target retirement date not knowing that the underlying investments may be far too risky. Of course, this can be avoided by carefully researching the prospectus, but the more research and due diligence is required of the participants, the less these funds are likely to be used. After all, the idea is to provide a solution to those who either can't or won't make their own asset allocation decision.

Plus, the skeptic in me wonders how effective the DOL and SEC will be in regulating these funds. After all, the DOL is the agency that approved these funds as a default investment just a couple of years ago, when all of the shortcomings of these funds were already well known.

Industry Not Waiting For Regulation

As you might imagine, the mutual fund industry is vowing to fight government regulations that dictate allocation percentages within target-date funds. The fund industry is also developing the next generation of target-date funds in an effort to correct the problems found in current products. One new innovation is to remove the requirement that all asset classes are managed by the same fund family. This "open architecture" could diversify the management of these funds, but might do little to affect the wide variation found in equity allocations.

Yet, I have to wonder whether the fund industry really understands the situation they have put target-date fund investors in, especially those who are close to retirement. A benefit plans consultant is quoted as saying the following in response to the industry's attempts to fix the inherent problems found in target-date funds: "It usually takes two or three tries to get the products right. The next generation products will correct deficiencies that the current crisis revealed."

And what about the retirees and near-retirees whose account balances are at risk while the fund industry makes these attempts to get its act together? If it's going to take two or three tries for the industry to get it right, you have to wonder what additional problems lie in these funds just waiting to spring upon unsuspecting investors.

Perhaps the most important news is coming from large corporate employers who are creating their own custom target-date portfolios using investments selected from among the various options available in their plans. These large employers can even customize their portfolios based on workplace demographics and the presence of other retirement plans. Unfortunately, this does little to help the millions of participants who work at smaller employers.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Conclusion: Buy-and-Hold on a Stick

While I do agree that target-date funds serve a purpose in that they offer a simple way for a 401(k) participant to invest when they might otherwise leave their contributions in cash, the variations in allocation methods and lack of transparency make it questionable as to whether these funds are better than the alternative. After all, the guys who left all of their contributions in cash or "safe" investments are looking like geniuses right now.

I am also concerned that many employers may have adopted target-date funds without appropriate analysis, and may now have subjected themselves to liability. One study suggested that 80% of large employers now offer target-date funds. These funds could be ticking time bombs if they have questionable allocations or an inappropriate glide path. Thus, employers could find themselves facing the very liability they sought to escape by using the target-date funds in the first place.

In the end, the real shortcoming of target-date funds is that they are simply buy-and-hold strategies on autopilot. As such, they have all of the shortcomings of buy-and-hold that Gary has written about many times in this E-Letter. Even if the DOL and SEC are successful in standardizing target-date fund allocations, it will be within the context of a buy-and-hold asset allocation portfolio.

As a practical matter, many employers who sponsor 401(k) plans opt for buy-and-hold mutual fund solutions at the direction of brokers or financial advisors who know of no other way to invest. It's too bad that they ignore active management strategies that might be attractive to participants who see the value of moving to cash to manage market risks.

The only thing clear at this point in time is that target-date funds will soon be changing. Let's hope it's for the better. In the meantime, if you are invested in a target-date fund, I suggest that you request a prospectus on your fund and read it carefully. See how your money is allocated now, and also how this allocation will change as you proceed down the glide path.

Hoping you retire in style,

Mike Posey

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Retirement Focus: Spotlight on Good News

Gary D. Halbert — Tue, 19 May 2009 20:34:00 GMT

By Mike Posey

IN THIS ISSUE:

Yes, There is Some Good News Out There
New Retirement Perspectives
New Investment Opportunities
A New Opportunity for 403(b) Participants

Introduction

I'm sure that many of you reading the title above think I have lost my mind. What good news could there be when 78 million Baby Boomers are bearing down on retirement with retirement portfolios that have been decimated by the recent bear market? What's good about the recent Social Security Trustees report that said that Medicare and Social Security will run out of money sooner than expected because of the current recession? And what's good about the federal government printing money to fund massive bailouts of the financial sector and others?

Granted, there's more than enough bad retirement news circulating out there, but I'm not going to dwell on that. You can find plenty of gloom and doom articles on the Internet with very little effort. Instead, I'm going to bring out some positive issues related to retirement planning in this week's E-Letter.

I recently attended an industry conference and one of the speakers really got my attention. She was from a communication firm and noted that many Investment Advisors are focusing too much on bad news and not enough on the positive aspects, and she's right. Negative news often allows us to identify with others, as in “misery loves company.” However, it can also lead to depression and inaction, which is often the wrong thing to do.

Focusing on the positive aspects of our situations can, on the other hand, lead to taking action to better our financial position. I often tell my wife, a chronic worrier, that she should worry only about things she can do something about. I suggest the same for investors. Like it or not, you can't single handedly solve the Social Security crisis, nor can you go back in time and replace lost retirement funds.

You can, however, change your perspective and focus on the beneficial things happening in the retirement market, even though they may be a bit hard to find. This E-Letter will focus on some of the positive things going on in the retirement market and show you how you might be able to participate. If you currently participate in a 403(b) plan at your employer, I have especially good news about a new way for you to access active management in your retirement account.

New Retirement Perspectives

Many of the positive things happening in relation to retirement do not involve investments or markets. Instead, they are readjustments of existing programs and ideas in order to fit the new reality facing retirement planning. In the section below, I'll discuss some of these concepts and how they may help you reach your own retirement goals.

Increased Savings – Lo and behold, it only took two bear markets within a decade to convince Americans that they should save some money. Since the onset of the most recent bear market, the US savings rate has gone from below zero to over 4%, and many believe it will continue to go higher as the economy recovers.

Actually the savings rate turned negative back in 2005, something that hadn't happened since the economy was in the throes of the Great Depression. A negative savings rate means that savings were actually being depleted in order to finance the purchase of big-ticket items such as homes, cars, boats and other material possessions. Of course, most American's weren't worried at the time because their homes were consistently rising in value. What a difference a few years and a credit crisis make.

I learned the importance of savings right out of college. I got a job offer from a company in Houston at a starting salary that was more than my father was making before he retired. He took me aside and told me that when he began his career in 1936, he was bringing home $35 per month and saving $10 of that. Of course, he and my mother lived with my grandparents and didn't own a car. Still, he left me with an indelible lesson that it's not what you make but what you save that counts. It now seems that the rest of the country is taking this lesson to heart.

The increase in savings is significant for several reasons. First, it means that individuals are taking charge of their own retirement destiny. Over the years, there has been no shortage of experts calling for Americans to save more, especially those in the Baby Boom generation nearing retirement. However, for a long time, these warnings went unheeded.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Increased saving is also significant in that it means Americans may be spending less for material goods in the future. Ironically, this might make the recovery from the current recession more difficult. Since approximately 70% of the US economy is related to consumer spending, an increased savings rate could have a major impact on future economic growth, a situation sometimes referred to as the “paradox of thrift.”

Finally, the increase in savings usually means that debt loads are being reduced. As Americans have chased material possessions over the past couple of decades, debt loads have increased significantly. Many used the increasing values of their homes as piggy banks through the use of home equity loans and credit card companies inundated all of us with attractive offers of easy credit. Hopefully, those days are gone and family balance sheets will again become healthy.

The question now is whether this new urge to save will continue after the recession is over and jobs are plentiful. In light of the recent warnings about the solvency of Social Security and Medicare, let's hope so. In keeping with the theme of this article, I'm going to be positive about the future of Americans' savings habits and believe that this new focus on saving money will continue. After all, you cannot consume your way into a comfortable retirement.

New Savings Programs and Incentives – One thing that our representatives in Washington do know is that the retirement security of many of their constituents is on the line. As a result, there have been a number of proposals to liberalize various rules to make saving for retirement even easier. Of course, with Congress you sometimes have to wonder how good intentions can result in really lousy proposals.

A good example is the proposal to hijack 401(k) plans floated by Democrats last year, which Gary discussed in detail in his November 4, 2008 E-Letter. Fortunately, this proposal got so much negative response that it never saw the light of day. Even though this idea was dead on arrival, I believe that future legislative action should make saving for retirement much easier.

However, it's also important to make sure that you are already taking advantage of all of the current programs available to you. For example, are you maximizing your 401(k) contributions and employer matching benefit? Do you make a non-deductible IRA contribution even if you're already covered by a retirement plan? Are you eligible for 403(b) or Section 457 deferred compensation plans where you work? Consult with your Human Resources Dept. to make sure you are taking advantage of all of the opportunities that may be open to you.

A New Look At Defined Benefit Plans – Once the backbone of employee benefits at large companies, defined benefit plans guarantee a pre-determined monthly benefit upon retirement without regard to fluctuations in investment returns. In other words, the employer assumes the market risk for these plans and must contribute whatever is necessary to make sure the plan is fully funded.

As you might imagine, many existing defined benefit plans are under stress right now. Plan investments have suffered losses and employers are being required to pay larger contributions at a time when the recession is cutting into revenues. So how is this good news, you ask?

It's good news because, in the right set of circumstances, the defined benefit plan may be an excellent way to build back a retirement nest egg with tax-deductible employer dollars. Since defined benefit contributions are based on actuarial assumptions of the amount necessary to fund a guaranteed monthly benefit, deductible employer contributions can be far greater than the maximum contributions allowed under a 401(k) or other defined contribution plan. Plus, the older you are, the greater your contribution must be to fund the benefit.

This weighting of contributions to older workers usually benefits owners and key employees more than rank-and-file employees, since they have less time to accumulate money for retirement. Fortunately, plan provisions and actuarial assumptions are somewhat flexible, usually allowing for a high degree of customization for the specific needs of an employer.

Amounts necessary to fund promised benefits must be calculated and contributed each year. Therefore, these plans should only be adopted by employers with steady cash flows. Defined benefit plans are also usually more expensive to administer than a 401(k) or defined contribution plan. However, for the employer who can direct most of the contributions to owners and key employees, the price may be well worth it.

One of the good things about defined benefit plans is that the funds are invested by the trustees of the plan and not by the individual participants. Since owners and key employees are usually the decision makers and trustees, a wide range of investment opportunities are available, including the actively managed programs that Gary frequently writes about.

New Investment Opportunities

Some of the positive aspects of retirement planning are in the form of new opportunities available to investors, while others are established ideas for which the timing may now be right. Below I will discuss just a few of the opportunities that I see opening up for IRA account holders and retirement plan participants.

Maximize Contributions – Actually, this is an old concept with a new emphasis. In what is going to sound heretical for a firm that promotes active management strategies, younger participants in 401(k) plans should be maximizing contributions and place them into quality mutual funds that have good long-term track records.

Obviously, I would prefer that 401(k) participants include actively managed strategies in their retirement portfolios, but most 401(k) plans do not have such options available. Instead, they usually have a list of mutual funds from which participants can choose. Some plans have more than others, but most usually have some well-known funds with generally good track records as well as index-based funds.

Even though investing in such funds is an exercise in buy-and-hold investing, participants with many years before retirement have several things going for them. First, the period of time between now and eventual retirement means that they will likely go through a variety of market cycles. While the current market malaise may last for a long time, it won't last forever. The economy and the stock markets will eventually recover which should be good for those with a long enough time horizon to wait around for it.

Younger participants also have the benefit of something known as “dollar-cost-averaging,” or DCA for short. This term simply refers to the fact that your monthly contributions buy shares at different prices over time. When the market is high, you buy expensive shares but when the market is down (like it is now), your contributions buy more shares. When the market does eventually break into a new bull phase, these “cheap” shares tend to have greater gains than those purchased in normal market conditions.

Finally, younger participants tend to have lower account balances in the plan since they are at the beginning of their accumulation phase. Thus, the magnitude of any bear market losses may not seem as great. Think of it this way – it's usually easier to deal with a $10,000 account dropping to $5,000 when you're in your twenties than to see a $500,000 account fall to $250,000 when you're in your fifties. DCA can help young participants rebuild their accounts over time, but may be of little help to an older participant. Active management strategies are usually best at helping to manage the risks in large portfolios, as I will discuss in more detail below.

Thus, even though we have had a market rally as I will discuss below, the major market indexes are still far under where they were in October of 2007 at the peak of the last cyclical bull market. Now is the time to contribute as much as you can each month into your 401(k) and buy shares while they're relatively cheap.

ENDORSED ADVERTISEMENT

The Market Has Bounced – In Gary's May 5 E-Letter, he discussed that the market's recent bounce may be an opportunity for investors to take some money off of the table by moving it away from failed buy-and-hold strategies. This is especially true for older retirement plan participants who have significant account balances and less time to recoup investment losses. Many account values have bounced back since the market lows in early March and now may be a good time to lock in some of that gain.

The idea behind selling into this rally comes from the possibility that this may just be a temporary bear market rally and not the beginning of a new bull market. As Gary also pointed out in the May 5 E-Letter, historical bear markets have often had substantial rallies only to resume their downward plunge later on.

Of course, the recent rally could mark the beginning of a new bull market. If that is the case, then taking money out of the market will mean you'll miss out on possible future gains. That's why we recommend that you consider moving only part of your account to cash and not all of it. You might start with 25% of your account and then see how the market performs in the future before taking any further action.

And I'll go ahead and warn you that your buy-and-hold broker or Advisor is likely to become apoplectic should you decide to move some money off of the table. He or she will point to the market's recent rally as evidence that buy-and-hold works (it doesn't) and that moving part of your account to cash will mean that portion of your account will miss out on the new bull market sure to come. Don't fall for their line of bull, do what's best for your future retirement.

New Investment Options – Whether you are already in cash or take the advice above to liquidate part of your buy-and-hold portfolio, the investment options available to you depend upon the type of plan you have. If you participate in a 401(k) plan, your options are usually limited to a set group of mutual funds, with some plans providing more choices than others. For less aggressive investors, cash or fixed income investments may be the best alternative. While earnings will be small, safety of principal is high.

More aggressive 401(k) investors may want to see if specialized “bear market” funds are available in your plan in case the downtrend resumes soon. These funds could act as a hedge of sorts on the remainder of the portfolio since they tend to move in the opposite direction of the market. Thus, if the market goes down, these funds actually have the potential to gain. Of course, if the market goes up, these funds will generally lose money, which is why this strategy is usually best only for aggressive investors.

You can find such funds on the Morningstar database (www.morningstar.com) listed under the Bear Market Fund category. Be aware that most 401(k) plans will not have this type of fund available, and that some bear market funds are better than others. Bear market funds should never make up the bulk of your portfolio, even if you think the market is destined for a downturn.

There are also other types of mutual funds that actively manage their assets, with some even moving to cash in bear markets. Thus, it pays to do some homework on the funds available to you before making a decision on how to allocate your contributions. It's also a good idea to consult with a qualified Investment Advisor before using any of these specialized funds in your portfolio.

If you are in a self-directed type of account such as a traditional or Roth IRA, you have even more options for money that you may want to move out of buy-and-hold positions. You can also move to fixed rate investments or bear market funds, as noted above, but you also have the flexibility to explore other alternatives that might not be available to 401(k) participants. I have listed just a few of those below for you to consider:

First, several of the professional money managers we recommend are available to manage self-directed IRA accounts. These active managers have become increasingly popular in light of the latest bear market, as you might imagine. Some of these active managers have seen a flood of new accounts in recent months, as an increasing number of former buy-and-hold brokers and Investment Advisors are seeking out actively managed programs to offer to their clients.

Our company is a member of the National Association of Active Investment Managers (NAAIM), which is an organization dedicated to the promotion of active investment strategies. I recently attended NAAIM's national conference and was surprised to see that a third of the attendees were new members. Most of the new members I talked to were former buy-and-hold believers who are now seeking out new strategies.

What do they know that you may not know? Simple, they know that buy-and-hold strategies only tend to work in bull markets when virtually all stocks are going up. In bear markets, however, the underpinnings of asset allocation and Modern Portfolio Theory fall apart, leaving investors vulnerable to potentially huge market losses.
Another possible alternative available to those with self-directed IRAs or other qualified retirement accounts is that of purchasing real estate. REAL ESTATE!! Are you crazy, Mike??

Well, not quite. It's no secret that real estate prices in certain markets have been hammered, possibly below what might be considered a reasonable valuation. It's also no secret that during tough economic times, those with cash can often make very good deals on real estate. Unfortunately, many investors have most of their cash tied up in an IRA and think that direct real estate investments are not possible.

While the subject of buying real estate in an IRA is somewhat complicated and far beyond the scope of this small newsletter section, I do want to make you aware of some ways in which you might use your IRA money to purchase real estate. The first way to do so is to purchase real estate as an asset of your IRA. Since your IRA is a trust entity, it can hold title to real estate just as it can own financial assets. You can even have rental property that spins off monthly income into your IRA.

The trick is to find a corporate IRA trustee or custodian who will agree to hold real estate in a self-directed IRA. To be honest, there are not many firms that will do this, but a few of the more specialized companies will agree to hold real property. The requirements and fees to purchase and hold real estate vary by custodian, and some will even allow you to debt finance property in your IRA as long as you can find a willing bank to lend you the money through your IRA. Just be aware that debt financing property in your IRA may bring about unrelated business taxable income (UBTI) issues.

Also be aware that there are significant restrictions on what you can do with the property held by your IRA. The “prohibited transaction” regulations applicable to IRAs dictate that you or your close relatives cannot use the property yourself and that property management must usually be handled by an unrelated third party.

In other words, you cannot buy yourself or your kids a house with money from your IRA, nor can your kids move into a rent house owned by your IRA. You also can't buy raw land with your IRA and then build your house on it. Likewise, you cannot use personal funds to pay upkeep expenses, property taxes, etc. on property held by your IRA since doing so is considered to be extending credit to your IRA under the prohibited transaction rules. All expenses must be drawn from your IRA and all income must be paid to your IRA.

I have actually purchased a piece of rental property through an IRA I had with Sterling Trust Company in Waco, Texas. While it was a good investment, I found the hassles of dealing with property in an IRA to be more than I wanted to put up with. However, if you are willing to put up with the paperwork and procedures necessary, this might be an attractive alternative for you to consider.

A second way to use IRA assets to purchase real estate eliminates some of the headaches of having the IRA actually hold the asset. Under what is known as a Section 72(t) distribution, IRA account holders can take distributions from their IRA without the 10% penalty tax even if they are under age 59½ as long as certain conditions are met. The distributions must be calculated over the life expectancy of the account holder and must continue for a specified period of time.

Some savvy IRA account holders have figured out that taking such a distribution and using the proceeds to purchase a second home or vacation property is a beneficial use of IRA funds. Since some wealthy individuals can experience disproportionate taxation on IRA assets upon their death, any way to transfer assets from the IRA to another asset is welcomed.

The mechanics of how this works are somewhat complex, but a thumbnail sketch is that the IRA account holder calculates an amount necessary to fund the purchase of a property. Then, an experienced tax professional helps to determine the amount of IRA assets necessary to be moved to a separate IRA to produce a distribution sufficient to cover monthly payments. While the IRA distributions are taxable, account holders under age 59½ will escape the 10% penalty tax as long as the requirements of Section 72(t) are met. In addition, an offsetting deduction for mortgage interest and taxes on the second home should reduce or eliminate any taxation on the IRA distribution.

The result is a tax-efficient transfer of money from the IRA to a hard asset without penalty taxes and without the prohibited transaction restrictions associated with holding property in your IRA. It can also be a valuable estate planning tool in the right situation. Obviously, your IRA must be a certain size in order to fund distributions sufficiently large to cover the mortgage costs, and you shouldn't do this if your IRA money is all you have for retirement.

There are a number of drawbacks to using a 72(t) distribution, not the least of which are severe IRS penalties if the rules are not followed, so don't try this on your own. It's important to consult with a tax professional who is experienced in calculating these distributions under all of the allowed methods before deciding to proceed. In addition, the tax benefit relies on an offsetting deduction for mortgage interest and property taxes on a second home, which could be eliminated by Congress in the future.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

New Flexibility for 403(b) Participants

As I noted above, employer retirement plans can sometimes box participants in by offering very limited investment choices. Nowhere is this more evident than in some 403(b) programs established for schools, hospitals, charitable organizations and other qualifying employers. Many 403(b) participants have a variety of mutual funds and annuity contracts available to them, but with little direction as to how best to use them in a diversified portfolio, much like a 401(k).

For 403(b) participants who are feeling boxed in, we have some exciting news. Potomac Fund Management, our oldest and most established active money manager relationship, has made us aware of a new program that has been especially developed for investors with 403(b) accounts. The only requirement is that the employer must have made the Fidelity family of mutual funds available to 403(b) investors.

The new investment alternative works like this: 403(b) participants move an amount of money that they want Potomac to manage to the Fidelity funds platform. At the same time, they execute an investment management agreement with Potomac Fund Management that authorizes Potomac to trade the account on behalf of the participant. Potomac then uses its trading model based on years of experience and expertise to manage the investor's account.

Best of all, it is not necessary to have the employer approve Potomac to manage the account. If Fidelity funds are already available under the employer's program, then Potomac can manage the account without any further approvals. Potomac will manage the account using the same model employed in their Guardian Program that we have been recommending since 1996. The main difference is that Potomac must limit its choices to the available Fidelity funds in the 403(b) program, while Guardian can use virtually any mutual fund family.

We are still in the process of finalizing our due diligence review of this new product, but since we are already very happy with Potomac and their Guardian program, we anticipate that this will take only a short time.

If you have a 403(b) program and the Fidelity funds are offered as investment alternatives, we want to hear from you. Click on this special 403(b) Information Link to register your interest in this program. Once we complete our due diligence process, we will rush information to you with complete details about Potomac's 403(b) alternative, including a strategy description and actual track record.

If you are unsure about whether your employer has authorized the use of the Fidelity funds, check with your Plan Administrator or your employer's Human Resources Dept. If you have any questions about this program or would like to see if it may be suitable for you, please give us a call at 800-348-3601, send us an e-mail at info@halbertwealth.com or complete the online request form at our 403(b) Information Link. As always, Potomac's past performance is not necessarily indicative of future results.

Action Items

As I noted above, my philosophy has always been to worry only about things that you can do something about. While there's no shortage of bad news today, my article this week provides a number of positive ideas that may apply to your retirement situation. I urge you to seriously consider any of the following items that might fit your individual circumstances:

Maximize your participation in any retirement plan and take advantage of dollar-cost-averaging where available;
If you are older and your retirement portfolio has increased in value due to the recent bounce in the market, consider taking some money off of the table;
Follow congressional action on retirement plan issues to see if new programs are created that might benefit you. If you are an business owner looking to rebuild your retirement portfolio, consider adopting a defined benefit plan for small employers;
When considering the options available to you in your retirement plan or IRA, don't be afraid to think outside of the box. This means you may want to consider new types of bear market funds, active management programs and even real estate. Just make sure you are comfortable with the risks, special characteristics and administrative requirements for each; and
Finally, if you have felt trapped inside a 403(b) program with limited choices, consider Potomac's new 403(b) managed account program if your plan offers the Fidelity family of mutual funds.

Very best regards,

Mike Posey

Retirement Focus - Year-End Retirement Sugarplums

Gary D. Halbert — Tue, 16 Dec 2008 20:27:04 GMT

by Mike Posey

IN THIS ISSUE:

Mandatory IRA Distributions
IRA Charitable Contributions
Roth Conversions
Max Out Retirement Contributions
Plan Your 2009 Investment Strategy

Introduction

The Christmas season is upon us and the end of 2008 will be here before we know it. At this time of year, many people "coast" for the rest of the year, enjoying the holidays and using those vacation days before they are lost at the end of the year. Actually, coasting is probably not the most appropriate term, since it seems that the holidays are sometimes busier than even our toughest work schedule.

However, the end of the year is also a very busy time for retirement planning, both for those who provide plan and investment services, as well as for sponsors and participants. This is especially true this year due to the bear market having decimated many retirement portfolios. Not only do smaller nest eggs sometimes require special year-end planning, but there have also been calls for the Treasury to waive certain requirements related to retirement distributions.

Specifically, some members of Congress and even AARP have joined together to request that the minimum distribution requirements applicable to taxpayers over the age of 70½ be frozen for 2008 due to the hit most IRAs and other defined contribution plans have taken in the market this year. This may or may not be a good idea, depending upon your circumstances, but no matter what form it may take, you need to be prepared to take appropriate action if you have not already done so.

This week, I'll discuss the proposal to waive the minimum distribution rules, as well as discuss what to do if they are not waived. I'll also toss in a number of other retirement sugarplums to dance in your heads before kicking back for what's left of 2008.

Mandatory IRA Distributions

As I mentioned above, various members of Congress and other interested groups have requested that Congress and/or Treasury Secretary Paulson waive the rules that require minimum annual distributions be made to taxpayers age 70½ or older from IRAs and certain other types of defined contribution retirement accounts. The Required Minimum Distribution (RMD) rule exists, by the way, to insure that these retirement plans do not postpone payment of taxes on accumulated balances in perpetuity.

Since there are some account holders who may not ever need to access this money for retirement income purposes, the IRS requires that a certain portion be liquidated each year, beginning in the year in which the account holder turns age 70½. The payout is calculated based on a formula that liquidates the entire account over the estimated remaining lifetime of the individual.

However, one small glitch in the calculation is that the distribution for 2008 would be based on the accumulated value as of 12/31/2007. Since most retirement accounts hold stocks, bonds and/or mutual funds, there's a very good chance that the account value is FAR LESS now than it was at the beginning of the year. Thus, unless the rule is modified in some way, the percentage of the account required to be liquidated would be much larger than if the current value were to be used.

Various proposals have been floated to address the situation, ranging from allowing the current value to be used for the calculation to waiving the RMD rule entirely for a period of time. Financial industry experts have been somewhat divided on waiving the RMD rule. Some say that cashing out shares of stocks or mutual funds at a depreciated value locks in losses and eliminates any chance to participate in any market rebound we might see in the future.

Others, however, say this provision would primarily help those wealthy enough to take only minimum distributions from their Traditional IRAs. And let's not forget that any modification of the RMD rules would also affect income tax revenues. Maintaining the RMD rule for 2008 would be best from a Treasury tax revenue standpoint since the 12/31/2007 cumulative IRA account values are likely much larger than they are now.

To address the growing chorus of organizations calling for RMD relief, the House and Senate have recently passed the Worker, Retiree and Employer Recovery Act of 2008 (HR7327). Among other things, this bill contains a provision that would suspend the RMD rules for 2009 (but not 2008!!!). The bill is now headed to President Bush and he is expected to sign it.

It is unfortunate that the bill did nothing to help those who are required to take 2008 RMDs, which are still required by December 31st (or April 1st, if you just turned 70½ in 2008). If you fail to take the RMD, you will be subject to a penalty tax of 50% of the amount that should have been withdrawn. Therefore, do NOT assume that passage of this bill relieves you from having to take a RMD for 2008 – it doesn't.

As a practical matter this bill is like most political solutions – long on form and short on substance. While politicians can hold press conferences and brag that they are helping senior citizens, they failed to address the key issue of having to sell depreciated assets for this tax year. As a bonus, the politicians also get to reap the benefits of tax revenues based on substantially higher values than retirees now enjoy. What else is new?

Importantly, you may still be able to minimize the effects of having to sell assets at a loss by requesting your IRA or 401(k) plan trustee or custodian to do what's known as an "in-kind" distribution. This means that the custodian transfers stock or mutual fund shares to you rather than cashing them out and sending you a check. You still have to take an equivalent amount of shares to equal the distribution required by the 12/31/2007 value and pay tax on this amount, but you will still hold the shares in case of a possible rebound in value in the future.

Even better, you can usually direct the custodian or trustee as to which investments you want to take as a distribution. For long-term income tax planning, you might want to transfer shares in 2008 that you feel may have a higher potential for future gain and leave others in the IRA for subsequent required distributions. The thinking is that identifying investments with greater gain potential may result in lower future income taxes, assuming long-term capital gains tax rates remain considerably lower than ordinary income tax rates in the future. Just be sure to talk to your tax professional and/or financial advisor if you have questions about which assets to take as an in-kind distribution.

Charitable Donations From An IRA

Earlier this year, Congress passed legislation that allows individuals age 70½ or older to make a one-time transfer of up to $100,000 from an IRA to a qualified charity. While IRA account holders do not get a tax deduction for the gift, they also do not have to claim the IRA distribution as income. Thus, for someone who does not need their IRA for retirement income purposes, this allowance permits them to use up to $100,000 of it to benefit the charity of their choice.

Admittedly, this provision applies to a very small segment of the population, but those who can take advantage of this opportunity find that it can be an integral part of their estate and gift planning. Since IRAs are often subject to both estate and income taxes at death, the ability to make what amounts to a pre-tax contribution can be very attractive.

Also note that it may be beneficial to make a transfer this year while the IRA value is down due to the bear market. Making an in-kind rollover contribution to a charity may potentially result in a much bigger bang for the buck on behalf of your favorite charity should the market experience a rebound in the near future.

While charitable IRA rollovers have been extended through December 31, 2009, you need to move quickly if you want to make such a contribution effective for 2008. Since you must involve your IRA trustee or custodian in the transaction, time is of the essence. Fortunately, many major charities and IRA custodians are familiar with processing these transactions and can provide their help to expedite the transaction.

Roth IRA Conversions

If you have a traditional IRA, retirement distributions will generally be subject to ordinary income tax in the year in which you take the money. The conventional wisdom used to be that retirees would be in a lower tax bracket than they were in during their working years, so tax deferral was always beneficial. However, as this is written, current tax rates are among the lowest we've ever seen, so it is no longer a given that future tax rates applicable to retirees are likely to be lower (especially with the Democrats in control of the White House and Congress).

Back in 1997, the Roth IRA was introduced to offer an alternative to taxpayers who wanted to save for retirement. Without going into full detail, Roth IRAs differed from traditional IRAs in that contributions to the Roth IRA would not be deductible from current income, but if held for a minimum period of time, all earnings would escape future taxation.

Individuals with traditional IRAs were also given the option to convert their existing IRAs to Roth IRAs under certain conditions. Roth IRA conversions are currently available only to IRA account holders whose modified adjusted gross income (MAGI) is less than $100,000. While not everyone with a traditional IRA can benefit from a conversion, they can be beneficial if the right set of circumstances exist.

The conversion process involves deciding whether conversion makes sense for you, working with your IRA trustee or custodian and then paying income tax on the amount converted. While taxes are currently due, there is no 10% penalty tax applied if you convert your traditional IRA to a Roth IRA before age 59½. You will need to contact your IRA trustee or custodian to determine the exact process you must go through to effect a conversion.

Depending upon the size of the traditional IRA, the taxes due can be quite a large sum. However, if you believe that tax rates are lower now than they may be in the future during your retirement, then it may make sense to make the conversion. This is especially true this year, since the bear market has reduced the value of many traditional IRAs, thus reducing the income taxes that would be due upon conversion of the entire account.

The details of the decision process of whether or not to convert a traditional IRA to a Roth IRA is one that involves a number of factors that are beyond the scope of this section of the E-Letter. But as a general rule, Roth IRAs are more beneficial for younger investors who have lots of time for tax-free earnings to grow. Even so, a conversion can also be beneficial for older IRA account holders in certain situations.

The potential advantages of converting your traditional IRA to a Roth IRA include the following:

A Roth IRA of the same size as a regular IRA actually has a greater economic value since distributions will not be reduced by income taxes;
There is no requirement that minimum distributions begin at age 70½ as is the case with a traditional IRA;
Roth IRAs remove the risk of higher future tax rates, since amounts can be withdrawn tax-free in retirement;
Partial conversions can be done if the taxpayer does not have enough money from other sources to pay the income taxes necessary upon a full conversion; and
Roth IRAs can also simplify estate planning since the balance of a Roth IRA transferred to an heir will not be subject to income taxes, though it may be subject to estate taxes.

There are, however, potential disadvantages of making the conversion to a Roth IRA, including:

It is possible that future tax rates could be lower than current tax rates, though I doubt it;
The amount of tax due upon conversion can be considerable, and could push the account holder into a higher tax bracket. Plus, some IRA account holders cannot pay the taxes on a full conversion from other resources and resort to withdrawing money from the IRA to pay the tax, possibly subjecting themselves to a 10% penalty tax if they are under age 59½. In both of these situations, it is sometimes better to do a partial conversion to minimize these disadvantages;
State income tax issues can also sometimes come into play when making a Roth IRA conversion;
Older traditional IRA account holders may not have enough time prior to retirement to make up the current taxes that must be paid on the conversion; and
The taxation upon conversion is determined by the value of the account at the time of conversion. Thus, if the value drops later on in the year, like we saw in October and November of this year, the taxes due can be a much larger share of the year-end traditional IRA value than they were at the date of conversion (more about this later on).

If it appears that making the conversion would be beneficial for you, then doing so before the end of 2008 may reduce the taxes due upon conversion due to the effects of the bear market. However, time is short as the money must be removed from your traditional IRA before the end of the year to be effective. Fortunately, you do have until after the end of the year to place the money into the new Roth IRA, but the process must begin before the end of this month.

I mentioned above that one of the disadvantages of conversion is that if you converted a traditional IRA to a Roth IRA earlier in 2008, the taxes due will be based on the value at the time of conversion. However, we all know that many IRAs have experienced large losses in October and November of this year. Thus, the taxes due on an early 2008 conversion will likely be much larger than if they had been calculated based on the December value of the IRA.

Fortunately, there is a way to fix this, but it involves a bit of paperwork. The rules allow for a Roth IRA "recharacterization" in which the Roth IRA is converted back to a traditional IRA, thus eliminating the income taxes due upon conversion. This recharacterization can be done any time up to the tax return due date, including extensions, so you effectively have until October of 2009 to "undo" the transaction.

Oh, and for those of you thinking ahead and considering recharacterizing a prior Roth conversion and then immediately converting the IRA again at a lower value, the IRS is one step ahead of you. The conversion rules provide that if you recharacterize an IRA conversion, you have to wait until the next tax year to do another conversion.

Again, this has been just a very brief discussion of the conversion and recharacterization process. The final decision must be based on all the tax and other consequences applicable to your individual situation. Thus, it is imperative that you consult a qualified tax professional or financial advisor prior to taking any action in regard to the conversion process.

Max Out 401(k) contributions

While it is very late in the year, you may also want to consider maxing out your 401(k) contributions. Many employer plans allow for very high contribution percentages, which can be used to increase the amount of your 2008 pre-tax 401(k) contributions here at the end of the year. You will need to consult with your Human Resources Department to determine how much you can contribute and when your payroll request must be submitted, but if you can afford the extra deduction, it's a good way to "top-off" your 401(k).

The same idea can apply to year-end bonuses paid on or before December 31st. Many employer 401(k) plans allow employees to elect whether or not to include or exclude bonuses from the 401(k) contribution election. However, you may also be able to contribute a larger percentage of your bonus to your 401(k). This not only increases the amount of pre-tax contribution for 2008, but may also increase your employer matching contribution, depending upon the specific provisions of your plan.

Now is also a good time to make any adjustments in your payroll deduction for next year. The maximum 401(k) employee contribution has been increased from $15,500 to $16,500 for 2009. In addition, the "catch-up" contribution limit for participants age 50 or older has increased from $5,000 to $5,500 for 2009. You may want to increase your applicable contribution percentage to take advantage of these new limits.

In addition, it is important to note that payroll systems usually do not recognize employees age 50 or over and allow catch-up contributions. For example, let's say you are over age 50 and have a contribution percentage that allows you to reach the $16,500 maximum contribution level in September of 2009. If you want to continue your contributions after that under the catch-up contribution rule, you may need to take additional action.

Check with your Human Resources Department to see if your employer's payroll system will automatically recognize that you are eligible to contribute an additional $5,500 due to your age, or if it will require you to set up a separate catch-up contribution deduction. I suspect that most payroll systems require you to make an additional election in order to take advantage of the catch-up contribution.

Plan Your Investment Strategy

One of the most frequent questions we get from 401(k) participants is when they should get back into the market. It's a very good question, and we're always happy to hear that some participants elected to move to cash, thus escaping some of the carnage we've seen in the market. However, there may still be a lot of risk of being in the market, so the decision of whether to stay in cash or get back into the market is a hard one, even for those of us in the investment business who participate in our employers' 401(k) plans.

For investors with IRAs or personal investment portfolios that are now largely in cash, we offer a number of risk-managed alternatives that have the ability to go to cash or hedged positions, or even go short in an effort to minimize the effects of uncertain markets. In many 401(k) plans, however, choices are limited to a variety of mutual funds that may or may not incorporate active management techniques to control risk.

While it is not possible to provide investment advice without knowing the specific situation of the investor, there are some very general rules that may be helpful to you in your 401(k) investing at a time like this when the market is extremely volatile and advice from the talking heads on financial shows seems to go in all different directions.

What 401(k) investors want to know when they call us is whether it is safe to invest in the stock market again, essentially asking if we've hit "the bottom" and prices will rise from this point on. While there have been some notable financial gurus saying that the market has reached the bottom and it's poised for a rebound, no one can know this for certain. The only predictable thing about the subprime crisis and resulting bear market has been their unpredictability.

The subprime contagion has spread to different sectors of the global economy over time, so no one really knows whether we have seen the final effects, or whether there's more to come. The uncertainty currently gripping the stock market has made it emotionally difficult for many 401(k) participants to direct the investment of their accounts. They hear advice saying to buy in when the market is low in order to maximize future returns, but then hear other "experts" say that the US is headed for another Great Depression.

The only thing we do know is that the market is nearer the bottom now than it was earlier this year, and certainly a better buy than when it hit new record highs in October of 2007. However, buying in now could lead to losses should the market fall further in the future. So how should you invest your 401(k) money in such a situation?

If you have a large cash or fixed-income investment position in your 401(k) plan, one answer to this question may be to consider using a technique called "dollar cost averaging" (DCA). In a nutshell, dollar cost averaging means to invest money in increments over time rather than doing it in one lump sum. The premise is that you purchase shares at different price levels over time, so you worry less about whether you're buying in at the bottom or not.

In essence, you are already using DCA in your 401(k) since your monthly contributions buy shares of investments at different prices during your employment. While using DCA to invest a large cash balance requires more of your personal involvement than do regular monthly contributions, it can also relieve some of the emotional stress from trying to guess when we hit "the bottom" in the stock market.

The amount of your cash reserve that is invested and the timing of those investments are variables that you control. Some investors may be comfortable with only moving 10% of the cash position into investments at any given time, while others may want to do much more. The timing can be every month, every quarter or even just whenever you feel comfortable in making another investment. The important thing is that timing "the bottom" becomes less important as your average share cost reflects a variety of price levels.

I would be remiss if I didn't mention that studies have been published which indicate investing a lump sum all at one time can lead to higher eventual returns than using DCA to gradually enter the market. Since I have not studied the detailed methodology behind each of these studies, I can't comment on their validity, but I did want to mention that not all brokers and financial advisors agree with using DCA (especially those who get paid only as the money is invested).

Since it's impossible to tell whether future market conditions will be similar to those covered in the studies mentioned above, I think it's also important to focus on the emotional issues that are addressed by DCA. If you can be comfortable with averaging your cash position into the market, this may be better than agonizing over when to pull the trigger and invest a lump sum.

In fact, we sometimes see 401(k) participants who simply can't decide when to invest a large cash position, so they remain on the sidelines even after the market begins to rebound. By the time they finally decide, the bull market rally is in full force, and they may have missed out on much of the market's rebound.

Again, dollar cost averaging is an investment strategy that may or may not fit your investment goals or risk tolerance, but it is one you can consider as we continue to watch the market's large up and down swings. If you would like to learn more about using this technique to ease back into the stock market, give one of our Investment Consultants a call at 800-348-3601 or send us an e-mail at info@halbertwealth.com. We'll be happy to help you.

Conclusions and Happy Holidays

Since I won't likely be writing another Retirement Focus issue prior to the end of the year, I'd like to take this opportunity to thank all of you who have been regular readers during the year, and especially those who have contributed comments and suggestions along the way. This feedback helps me to target the retirement issues that are of most concern.

As we look forward to 2009, it's almost certain that we will see additional legislation and regulatory changes as the federal government seeks to mitigate the effects of the credit crunch and resulting bear market. As new pronouncements are made, I will do my best to bring them to your attention so that you can take advantage of those that apply to your financial situation.

In the meantime, I hope you have the merriest of Christmases, or whichever holiday you may be celebrating, and a safe and happy New Year.

P.S. - From Gary

I would like to thank Mike for all the very good information he provides to all of us in his periodic Retirement Focus issues. With his background as the former president of a large trust company, he is certainly better qualified to understand and explain these often complicated retirement account issues than am I.

In addition to all the good information Mike provides, it also gives me a much-needed break from writing every so often. So, I also thank him for that!

With Warmest Holiday Wishes,

Mike Posey

SPECIAL ARTICLES

How We All Will End The Recession
http://www.forbes.com/opinions/2008/12/15/recession-catalyst-recovery-oped-cx_bw_rs_1216wesburystein.html

5 Myths About Our Sputtering Economy
http://www.washingtonpost.com/wp-dyn/content/article/2008/12/12/AR2008121203364_2.html

Five Opportunities to Help Beat World Recession
http://www.bloomberg.com/apps/news?pid=20601039&sid=aS98ereBggE8&refer=columnist_lynn

Obama's Judges vs. Republican Opposition

Gary D. Halbert — Tue, 02 Dec 2008 23:02:31 GMT

IN THIS ISSUE:

Judicial Appointments - A Most Important Issue
The Bush Record On Judicial Appointments
Get Ready For Liberal Judicial Nominees
Will Minority Republicans Roll Over Or Fight Back?
What About The Obama Supreme Court?
Conclusions - What Obama Has In Store

Editor's Note

It didn't come entirely as a surprise that I got a lot of negative feedback on my November 4 E-Letter about the Democrats holding hearings on ways to highjack our 401(k) plans - and eventually other types of retirement accounts as well - into a quasi-socialistic "let us take care of you" Guaranteed Retirement Accounts (GRA).

Since that E-Letter was sent in the late afternoon on Election Day, I'm sure many readers didn't see it until Wednesday, and perhaps more than a few readers thought it came across as a sour-grapes piece because Barack Obama won the election by a comfortable margin.

In actuality, my article on the 401(k) proposal had nothing to do with Obama. Democrats were already holding these hearings before the election, and it will be these same Democrats who may send a bill to the president for his signature with the provisions I discussed, or worse.

The most important point, however, is that I have said since the inception of this E-Letter that I write about politics because I firmly believe that politics affect investments and the markets, and vice versa. Anyone with common sense should recognize that my article about the Democrats' 401(k) trial balloon actually proves the point I have been making all along.

The 401(k) proposal was purposely sweetened to fix the problem of recent large market losses by having 401(k) participants turn their accounts over to the government, which would in turn restore such account values to their August 15 balances. But the trade-off would be that these accounts would be invested in 3% government bonds, and Congress could then spend the money as it always does. Tell me how this does not affect our investments!

If you have been reading this E-Letter very long, you know that I often remind my readers of the unintended consequences that sometimes arise from laws intended to "help" people or right a perceived wrong. A good example is the Alternative Minimum Tax (AMT) law. When originally passed, it was targeted at less than 200 super-rich who were not deemed to be paying their fair share of taxes. Now, it hits millions in the middle class right where it hurts, and Congress has been wrestling with how to undo what was done in error.

If Congress can capitalize on the fear gripping retirement plan participants and pass a 401(k)/GRA law or something like it, we could be in for another round of unintended consequences. However, one consequence I can already predict is going to be higher taxes, and not just on those making over $250,000 per year.

Why write about politics and investments? So you, my readers, will know what's going on and contact your congressional representatives to tell them what you think. As for those who feel that I shouldn't write about politics in general, and about conservative politics in particular, I suggest you consider it a learning experience - just as I do when I regularly read liberal points of view.

Introduction

I have long maintained that the most enduring legacy of many presidents is often the judicial appointments they make, and especially those for Justices of the Supreme Court. You may recall that I wrote about the importance of this issue in regard to the 2008 election in my July 1, 2008 E-Letter.

Most people focus only on the Supreme Court nominations that presidents make during their terms in office. However, there are also very important judicial appointments presidents make to the various District Courts and the Circuit Courts of Appeal. Since judicial appointments are for life, they not only have the potential to extend a president's legacy beyond one or two terms in office, but can also affect the manner in which laws and even the Constitution are interpreted for many years to come.

It's no wonder then that the Democrats are now very excited about the prospects of judicial appointments. As President-elect Obama prepares to take office, he enjoys a majority in both Houses of Congress. As such, his judicial nominations should be slam dunks, no matter how liberal they are, unlike when President Bush found it almost impossible to get appointees confirmed as the Democrats found them to be "too conservative."

I'm sure you will recall this issue playing out before us as George W. Bush fought with Senate Democrats to have his nominees for federal judiciary vacancies confirmed. This confrontation eventually introduced such terms as "nuclear option" and "Gang of 14" into the national lexicon, which I will discuss further as we go along.

In a President Obama Administration, the shoe will be on the other foot, and it will be the Republicans in the minority who will be fighting Obama's presumably liberal and possibly activist judicial nominations. It's going to be very interesting to see how much or how little difficulty Obama will have filling judicial vacancies with left-leaning judges while his party controls the Senate.

Currently, there are 37 federal judiciary vacancies with 26 Bush appointments pending. Virtually all of the names pending the certification process were nominated in 2007 or later, while the Democrats have had control of Congress. Thus, there's little wonder why these nominees have not been confirmed, and I trust they never will. With a Democratic president and Congress, the liberals have to be salivating at the prospect of being able to substitute their own nominees for all of these vacancies.

This week, I'm going to discuss the importance of federal judiciary appointments, and what kind of judges Obama is likely to nominate. Will the Republicans roll over and allow liberal judicial nominations to be confirmed? Or, will they exhibit the same cohesiveness that Democrats showed during the Bush Administration and attempt to block unacceptable nominees, even though they are in the minority? These are good questions, and ones that might be among the earliest tests of the Republican Party.

Judicial Appointments - A Lasting Presidential Legacy

As a practical matter, many of the policies of a particular presidential administration may disappear shortly after they leave office. However, judicial appointments continue on for the life of the appointee and thus, can have a much longer effect. Unfortunately, most Americans are usually more attuned to what new administration policies are being proposed and what laws are being passed by Congress than the judges that are being appointed to the courts.

The federal judiciary includes Supreme Court justices, US Courts of Appeals (Circuit Court) judges, and District Court judges. Individuals for these positions are nominated by the President and confirmed by the Senate. Nominees are typically suggested by members of the president's political party, and generally share a similar political ideology.

Before being confirmed, however, the nominees are subjected to confirmation hearings by the Senate Judiciary Committee, and these events are usually more of a partisan political forum than actual hearings. Once these hearings are completed, the full Senate votes on the nominees. A simple majority vote is necessary for confirmation, and judges are appointed for a life term. Obviously, the Democrats will have more than a simple majority in the Senate next year and beyond.

In years past, these judicial hearings were generally quite respectable with tempered dialogue between the Committee members asking the questions and the nominees. But those days of reasoned debate vanished when Ronald Reagan nominated Robert Bork for the Supreme Court in 1987. Judge Bork, who was a devout anti-abortion conservative, was vehemently opposed by the Democrats who attacked him viciously.

Judge Bork unfortunately became the ‘poster child' of such partisan attacks, lending his name to a now-generic verb - "Borked" - meaning to prevent someone from attaining a public office by attacking their character and/or political philosophy. While Robert Bork's name was eventually withdrawn from nomination, similar attacks occurred during the confirmation hearings of Justice Clarence Thomas. One speaker at a 1991 National Organization for Women conference stated, in reference to Clarence Thomas, "We're going to Bork him. We're going to kill him politically..." Despite these attacks, Thomas was eventually confirmed by the Senate, but not until after one of the ugliest hearings processes in recent memory.

Thus, it was no surprise that President Bush had difficulty getting many of his judicial appointments confirmed, especially when the Democrats regained majority control of Congress beginning in January 2007. Since then, judicial hearings have regularly been highly politicized, decency and decorum were thrown out the window, and nominees were frequently subjected to an uncomfortable and often bitter confirmation process filled with both partisan and personal attacks.

Now, it will be very interesting to see how things change next year when Barack Obama becomes president. I fully expect the Democrat-controlled Senate to once again return to the days of decency and decorum and rush to confirm Obama's judicial appointees, many of whom are almost certain to be "activist" judges... But I'm getting ahead of myself.

The Bush Record On Judicial Appointments

During his two terms, President Bush has had mixed success in regard to federal judiciary vacancies. According to the White House website, Bush has had 61 Circuit Court judges and 261 District Court judges confirmed as of October 6, 2008. Plus, President Bush has had two nominees for Supreme Court justices also confirmed by the Senate.

However, as discussed above, the road to these confirmations was not without serious bumps along the way, and numerous nominees withdrew their names after being blocked by Democrats. The Dems didn't approve of judicial nominees with political values attuned to those of Republicans, and who would be more likely to resist "legislating from the bench" and other forms of judicial activism.

Thus, Senate Democrats banded together and filibustered Bush's "objectionable" nominees during Senate debate. I'm sure you recall from high school government class that a filibuster is an obstructionist tactic, usually in the form of indefinite debate, intended to stall or kill legislation by preventing it from coming to a vote. It is most often used by a minority party to block votes on objectionable legislation, or in the case of this discussion, votes on judicial nominees.

There is a way to end a filibuster, called "cloture," which ends debate and forces a vote. Invoking cloture takes the vote of three-fifths of the Senate, or 60 Senators. Thus, if the minority party knows that the majority party can muster 60 votes, it probably wouldn't pursue a filibuster. However, if the majority party does not have 60 votes to bring debate to an end, then even the threat of a filibuster can be a powerful weapon.

During President Bush's first term, and until the end of 2006, the Senate Democrats knew that the Republicans could not muster the 60 votes necessary to invoke cloture. As a result, Senate Democrats threatened to filibuster those judicial nominees that they felt were inappropriate for the job due to their conservative political views.

All of this came to a head in 2005 when Senator Trent Lott coined the term "nuclear option" in regard to a little-used procedural way to end a filibuster with a majority vote instead of the usual three-fifths rule. The term was later changed to "constitutional option" in light of negative connotations surrounding anything termed "nuclear," but the result is the same.

Interestingly, the Republicans lost their nerve and chose not to use the nuclear option for shutting down Democrats' filibusters over judicial nominees, which disappointed many conservatives. The Republicans buckled when the Democrats threatened to shut down the Senate and prevent consideration of routine legislative business if the Republicans tried the nuclear option.

Threatened with gridlock over judicial nominations, the stalemate was finally broken by the now-famous "Gang of 14," led by none other than John McCain, among others. The Gang of 14 was a bipartisan group made up of enough Senators from both political parties to prevent the use of the nuclear option as well as filibusters in regard to judicial nominees. The result was that certain of President Bush's nominees were blocked, but others were confirmed without filibusters, nuclear options or shutting down the Senate.

I'm providing all of this background because now the tables are turned and the Democrats are in control of both the Executive and Legislative branches of government. Depending on the outcome of Senate elections in Minnesota and Georgia, the Dems may or may not have the 60 votes necessary to invoke cloture, so we could see a repeat of the 2005 judicial battle played out in the months and years ahead - only this time with the Republicans in the minority. I will come back to this issue later on.

Get Ready For Liberal Judicial Nominees

Of course, Senate Republicans might not threaten filibusters if they feel the judges nominated by President Obama are mainstream jurists who are not judicial activists or do not engage in "legislating from the bench." Some consider the Cabinet appointments President-elect Obama has announced so far as being moderates for the most part, so they expect future judiciary nominations might be the same.

However, Obama's appointments so far have largely been announced to show Wall Street and foreign nations that he's willing to go with experience rather than a strict liberal philosophical alignment. Since judicial appointments can carry on long after these Cabinet members are retired and selling their memoirs, it's possible that Obama might pay homage to the far left by nominating liberal judges. This is actually what I expect to happen.

Since we do not yet know the identity of Obama's judicial nominees, we don't really know how liberal they might be, or how the Republicans will react. However, we do have some hints about who Obama may nominate based on his past statements.

Considering that Barack Obama was a professor of constitutional law for 10 years would seem to indicate that he knows a thing or two about the principles upon which the country was founded. However, constitutional lawyers, scholars and judges tend to fall into one of two categories: First, is the category called "originalists," meaning that they tend to believe that the Constitution should be interpreted based on its original wording and intent.

Basically, originalists believe that if judges are allowed to interpret the Constitution to mean anything they want within the context of current society, then the Constitution means little or nothing. Instead, originalists believe that the original document is sufficiently flexible to take into consideration the changes in our society without sacrificing the wording and original intent of the Founding Fathers.

The other constitutional interpretation category is made up of legal practitioners and scholars who believe the Constitution is a "living document" that should evolve over time to take into consideration societal changes. In contrast to originalists, those who support the living document thesis believe the Constitution should be subject to re-interpretation and even amendment from time to time to fit the needs of current society.

Generally speaking, most conservatives are originalists, while most moderates and liberals support the ‘living document' interpretation of the Constitution. Unfortunately, the majority of lawyers, judges and legal professors are now in the living document camp, as noted in a recent speech by Supreme Court Justice Antonin Scalia.

So, in which camp does Obama reside? He's firmly in the camp of those who believe the Constitution should be interpreted as a "living document." This is not just speculation by conservative pundits, but is clearly evident from Obama's writings and speeches regarding judicial issues. The following are quotes made by or about Obama on various occasions that speak directly to the issue:

From Obama's book, The Audacity of Hope: "I have to side with Justice Breyer's view of the Constitution--that it is not a static but rather a living document and must be read in the context of an ever-changing world."
When asked about what kind of justice he would want to appoint to the Supreme Court during a primary debate, Obama said, "I taught constitutional law for 10 years, and . . . when you look at what makes a great Supreme Court justice, it's not just the particular issue and how they rule, but it's their conception of the Court. And part of the role of the Court is that it is going to protect people who may be vulnerable in the political process, the outsider, the minority, those who are vulnerable, those who don't have a lot of clout."

". . . ometimes we're only looking at academics or people who've been in the [lower] court. If we can find people who have life experience and they understand what it means to be on the outside, what it means to have the system not work for them, that's the kind of person I want on the Supreme Court."
In explaining his vote against [Supreme Court Nominee John] Roberts, Obama opined that deciding the "truly difficult" cases requires resort to "one's deepest values, one's core concerns, one's broader perspectives on how the world works, and the depth and breadth of one's empathy." In short, "the critical ingredient is supplied by what is in the judge's heart [not the Constitution]."
"We need somebody who's got the heart, the empathy, to recognize what it's like to be a young teenage mom, the empathy to understand what it's like to be poor or African-American or gay or disabled or old - and that's the criterion by which I'll be selecting my judges."
Surprisingly, however, when faced with the nomination of conservative Janice Rogers Brown for the DC Circuit Court of Appeals, Obama said the following in opposing her confirmation: "The test of a qualified judicial nominee is also not whether that person has their own political views. Every jurist surely does. The test is whether he or she can effectively subordinate their views in order to decide each case on the facts and the merits alone. That is what keeps our judiciary independent in America. That is what our Founders intended."

Hmmmm....It seems that our new president is fine with straying from a strict interpretation of the Constitution in some cases, but not in others. Put differently, Obama seems to believe it is fine for liberal judges to "interpret" the Constitution as they see fit, but conservative judges must "subordinate their views."

In any event, it's pretty clear, at least to me, that Obama is in the camp that believes the Constitution is a living document and should be interpreted accordingly. In other words, judicial activism will be just fine as long as it's the little guy against the big guy, but is not acceptable if it is deemed to line up with a conservative political mindset.

In addition to his own well-documented feelings about judicial activism, there is little doubt Obama will also feel pressure from Democrats in Congress to appoint liberal, activist judges. Based on a number of articles and blog entries I have read, the liberals feel that it's high time they had their turn to appoint judges with political views akin to their own. In essence, they see the federal judiciary as being slanted to the right as a result of Republican presidential administrations in 20 of the last 28 years.

Will The Republicans Roll Over Or Fight Back?

There seems to be no question about the liberal ideology that is likely to influence Obama's judicial nominees. As noted above, Obama's own words indicate that he advocates judicial activism on matters where the heart should overrule the letter of the law. Thus, the big question becomes, what will Republicans do when faced with Obama's liberal judicial nominees with a proven record of judicial activism?

While judicial appointments may not be the first potential area of conflict the Republicans will encounter with the new Administration, they are likely to become prominent within the first year of an Obama presidency, especially given the many unfilled judicial seats. How they react to Obama's judicial nominees, especially if they are known judicial activists, may set the tone for the next four years or longer.

As noted above, when the Democrats were in the minority and were faced with conservative nominees, they held together and filibustered nominees that they felt were too conservative for their tastes. President Bush was forced to withdraw numerous judicial nominees. This resistance eventually escalated to the point when the Gang of 14 intervened. The point is, all of this resulted in more moderate judicial nominees after 2005.

Knowing that the Senate Republicans didn't resort to the "nuclear option" when they were in the majority, will they wake up and become a cohesive resistance to activist judges nominated by Obama? Or will they roll over and allow them to be confirmed? I hope that they do provide some stiff resistance to judges who want to legislate from the bench, but I have to admit that I wonder if the defeated Republican establishment has the stomach for such a fight.

Of course, the next question to ask is whether the Democrats will be as fearful of using the "nuclear option" should the Republicans filibuster Obama nominees. Buoyed by the shift in power to the left in both the Executive and Legislative branches of government, my bet is the Dems will have no trouble at all resorting to the nuclear option to block efforts by the minority Republicans to stall judicial appointments.

Not only do I think the Senate Democrats won't hesitate to use the nuclear option, I also think their constituency would rebel if they hesitate to employ this drastic step. There is no doubt that the liberals are going to demand that Obama load the courts up with the most activist judges they can find. It remains to be seen if he will oblige them, but I would not be surprised.

What About The Obama Supreme Court?

Much of the above analysis is directed toward appointments to the District and Circuit Courts. While these positions are certainly important, we also need to be thinking about the potential for Supreme Court appointments during Obama's presidency. As I noted above, I wrote about the importance of the 2008 presidential election on the makeup of the Supreme Court back in July. However, since we now know who the president will be over the next four (or possibly eight) years, it bears repeating.

It is very likely that President Obama will have the opportunity to appoint at least two and possibly three Supreme Court justices in his four year term, and probably more if he wins a second term. Considering the above discussion about the liberal mindset Obama has in regard to judicial activism, his Supreme Court appointments are almost certain to be on the liberal side.

Thus, let's look at the current makeup of the court, and who may be retiring soon. In the current makeup of the Supreme Court, we have four generally conservative judges - Roberts, Scalia, Thomas and Alito; four consistently liberal judges - Stevens, Souter, Ginsburg and Breyer; and one sometimes swing voter - Anthony Kennedy (often more on the liberal side).

Casual readers might tend to think it is a good idea to have the High Court so well balanced. Admittedly, there are arguments to support such a position. But President Obama has the potential to change that if more than two Supreme Court justices retire on his watch.

Supreme Court justices tend to keep their retirement thoughts and plans to themselves, so there is no way to know with certainty if any of the current justices are likely to retire over the next four years. However, it is believed that some of the older Supreme Court justices have had health issues, so it would seem very likely that at least one or two or more will retire over the next four years.

Next, it has long been believed that certain Supreme Court justices prefer to retire when the sitting president is someone who shares their political ideology, and who is likely to appoint a like-minded replacement. So, even if their health isn't a problem, some justices choose to retire when it is politically expedient in terms of their likely replacements.

Now that Barack Obama is President-elect, it is widely believed that the two most likely Justices to retire will be John Paul Stevens and Ruth Bader Ginsburg. Justice Stevens is now 88 years old, so it would come as no surprise if he chooses to retire during the next four years, perhaps as early as next year.

Interestingly, Justice Stevens was thought to be a conservative judge when Richard Nixon appointed him to the 7th Circuit Court of Appeals in 1970, and when Gerald Ford appointed him to the Supreme Court in 1975. Yet Justice Stevens was at best a moderate on the High Court in his early years, and soon shifted to the liberal side on most issues.

The next most likely Justice to retire is thought to be Ruth Bader Ginsburg, who is now 75 years old. Justice Ginsburg was diagnosed with colorectal cancer in 1999 and underwent surgery followed by chemotherapy and radiation treatments. While the surgery and treatments were deemed to be successful, it is unclear how long she wishes to remain on the High Court. Justice Ginsburg is widely considered to be the most liberal justice on the Court, and like Justice Stevens, she may have been waiting to retire until someone more liberal is in the White House.

Most analysts agree that the make-up of the High Court won't change much if Justices Stevens and Ginsburg retire (or pass away) during an Obama presidency, and I might agree. Obama will likely appoint two equally liberal judges. I think we can count on that.

Judging by age alone, the next most likely justices to retire over the next few years are Antonin Scalia (72) and Anthony Kennedy (72). Importantly, if either Justice Scalia or Justice Kennedy should retire, Obama will have the opportunity to dramatically shift the balance on the High Court to the liberal side. Justice Scalia is widely considered to be the most conservative judge on the Supreme Court. If Justice Kennedy, who is considered the "swing" vote, is replaced with another liberal ideologue, that too would represent a significant shift on the High Court.

Conclusions - Who Knows What Obama Has In Store

President Obama will likely have the opportunity to appoint at least two Supreme Court justices in the next four years. His appointments will very likely be liberal, "living document" judges. Most likely, Obama will be appointing liberal judges to replace retiring liberal judges with no net change on the overall balance of the High Court. That's the good news, we hope.

Yet if more than two Justices retire in the next four years, or should Obama go on to a second term, he may have the opportunity to shift the Supreme Court to a much more liberal bias. And keep in mind, these Supreme Court choices are lifetime appointments.

As a practical matter, I don't care quite so much what the political orientation of a judge is, IF they make their decisions based on what the Constitution says and not what they want it to say. No doubt there are some conservative judges that slant their interpretations to fit their political orientation, but I think they are the vast minority. Likewise there are plenty of other judges who are overly liberal in their decisions.

Judicial activism, however, is alive and well and it now appears that we have a president and majority in Congress who agrees with this method of interpreting the Constitution and the laws of the land. Fortunately, Presidents Reagan, Bush I and Bush II have had a conservative impact on the judiciary that should continue to reduce legislation from the bench in the future. But that can change decidedly in President Obama's Administration.

I have reluctantly refrained from discussing my many problems with Barack Obama in recent weeks as it looked increasingly that he would be our next president. And now he is. So just as well that I refrained. I have chosen my topics carefully.

As I discussed last month, our 401(k) plans may be at risk of government takeover under the new Democrat regime. This week, I focused on the Supreme Court and lower court implications. These are two topics we Americans need to be very aware of.

There will be other topics that we, as investors, will need to focus intently on in the months ahead, and I will get back to those in future issues. The combination of the global recession and financial crisis will likely dominate upcoming topics. But we cannot lose sight of critical issues like our retirement plans, the Supreme Court and what the liberal Congress is up to.

With a new, liberal president coming into office, we need to keep our antennae up!

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

Obama's Judges and the Senate
http://online.wsj.com/article/SB122792243571465873.html?mod=googlenews_wsj

Obama's Far-Reaching Reforms Can Wait
http://www.realclearpolitics.com/articles/2008/12/obamas_hard_choice.html

In Barack we trust? (written by a liberal)
http://www.salon.com/opinion/feature/2008/11/29/obama_choices/

Bill Clinton to release donor list & more (very interesting)
http://www.politico.com/news/stories/1108/16054.html

The Democrats' Plan To Highjack Your 401(k)

Gary D. Halbert — Tue, 04 Nov 2008 22:19:23 GMT

IN THIS ISSUE:

The Economy Falling Fast Into Recession
Democrats Want To Highjack Your 401(k)
The Democrats' 401(k) Replacement Plan
Socialism Du Jour - "Spread The Wealth Around"
Can We Afford This Nonsense? No, But So What
Conclusions - After Today, Anything Is Possible

Introduction

On this Election Day that is expected to end with a win for Senator Barack Obama, I think it's important to let you in on what the liberals in Congress are already discussing about your retirement planning options. Earlier in October, Congressional Democrats began discussing the possibility of eliminating the favorable tax benefits related to 401(k) plans, effectively killing the very popular retirement planning device.

In its place, the Dems propose to enact a government-sponsored plan that would transfer the role of total retirement security into its hands. The problem is, could the investment options be limited to only a special type of government bond? You know, the kind they use for the Social Security System where you can claim there's a trust fund but the money's all gone.

In any other circumstances, I would say that this proposal doesn't have a snowball's chance of becoming law. However, a year ago I would have told you it would be next to impossible for the Fed and Treasury to guarantee hundreds of billions in worthless bonds, force mergers of financial services companies, buy hundreds of billions in equity stakes in our largest banks or take ownership in a public corporation. If the Dems get a supermajority in both Houses of Congress, I won't be surprised by any neo-socialist boondoggles that may well appear, especially if Obama wins the election.

I fear that the recent bailout maneuvers have started us on a slippery slope toward socialism. Where will it stop? Hopefully, today. If not then, we might see it get a lot worse before it gets better. Whatever turns out to be the case, you need to know what may be coming on the retirement account front, specifically for 401(k)s.

Before we get to that, I will quickly review the latest economic numbers which are grim. We are now in a recession, textbook definition or not, and I expect it will only get worse for some time to come. I will have a more detailed analysis on the economy and what we should expect in an upcoming E-Letter.

The Economy Falling Fast Into Recession

Last Thursday the Commerce Department announced that 3Q Gross Domestic Product fell at an annual rate of -0.3%. This was the "advance" report which relies on somewhat scant data for September, so the next GDP report late this month could well be revised downward. The much-watched ISM Manufacturing Index plunged from 43.5 in September to 38.9 in October, a 26-year low. The Chicago Purchasing Managers Index, a proxy for business spending, imploded from 56.7 in September to 37.8 in October.

Consumer confidence fell off a cliff in October, plunging from 61.4 in September all the way down to 38.0, an all-time low for the index. Personal consumption spending fell 0.3% and durable goods orders slumped 2.9% in September (latest data available). General Motors reported yesterday that car sales for October were down over 45% from yearago levels. Retailers are bracing for a very disappointing holiday season.

Our economy is in serious trouble, folks! And the credit crunch is far from over. I could see this recession lasting a year or longer. I will have more detailed economic analysis in the next week or so, depending on what new surprises we see in the days just ahead.

Democrats Want To Highjack Your 401(k)

By now, many of you may have read about a new Democratic proposal to eliminate the tax incentives provided to 401(k) retirement plans, and replace them with 'government-guaranteed' retirement accounts. On its face, this plan is being touted as a way to restore stock market losses incurred by 401(k) participants over the past couple of months. However, the real agenda is far more rooted in liberal ideology. If you read what follows, I think you'll agree, and it should scare you!

Before getting into what has been proposed, let's take a look at exactly what the Democratic proposal would do away with. Many Americans are not aware of all of the tax benefits available to help workers save for retirement in 401(k) plans, including plenty of people who actually have these retirement plans. The Democrats are no-doubt counting on participants not knowing what they are giving up to make the sale easier.

The Democrats' proposal does not seek to do away with 401(k) plans. Instead, it places the tax advantages enjoyed by employers and employees in the crosshairs. Therefore, it would be beneficial to review just what those tax advantages are. Note that the following benefits pertain to traditional 401(k)s, but are not applicable to special "Roth" 401(k) contributions, which I will cover a little later on. Again, these are the current tax advantages for 401(k) accounts:

Employee contributions to the 401(k) are deductible for income tax purposes, but not for Social Security tax purposes;
Employer contributions are not taxed as compensation to participating employees for income tax or Social Security tax purposes;
Earnings (interest, dividends, capital gains, etc.) on employer and employee contributions are not currently taxed to the participant, but are allowed to accumulate on a tax-deferred basis. To illustrate, let's compare the accumulation of a contribution of $300 per month on a taxable and tax-deferred basis. Assuming a 30-year time horizon and 6% earnings (which are for illustration purposes only and not guaranteed), the taxable account would grow to $172,453, while the tax-deferred account would grow to $227,146. You can see the results using other assumptions by going to the following website for a tax-deferral calculator:

http://www.calcxml.com/do/inv07
Finally, assets grow tax-deferred in traditional 401(k) plans, not tax-free. Thus, withdrawals at retirement are taxed as ordinary income in the year in which they are actually withdrawn. Most retirees withdraw annually only what they need to supplement their other sources of retirement income.

I noted above that these tax benefits pertain to traditional 401(k) plans, but they do not apply to special "Roth-type" contributions and earnings. In Roth plans, contributions are not tax-deductible when made. However, earnings on all Roth contributions can be withdrawn tax-free IF they are held for a sufficient period of time. For younger 401(k) participants, this can be a huge advantage. Note, however, that these special rules do not apply to employer matching contributions.

As you can see, the tax benefits associated with traditional 401(k) plan contributions and earnings are not only favorable to the employer, but also to the employee. The ability to grow retirement assets on a tax-deferred basis is a huge benefit, and is part of the reason that these plans have gained so much in popularity over the last 20 years or so.

The Democrats' 401(k) Replacement Plan

I have read a number of articles describing the alternative 401(k) plan being considered by some of the Democratic leadership. This plan was the brainchild of Dr. Teresa Ghilarducci, an economics-policy professor at the New School for Social Research in New York (where else?). However, I got so many different details from the various articles I read, I figured it would be best to review Dr. Ghilarducci's own testimony and briefing paper rather than counting on hearsay.

It's a good thing I did, because Dr. Ghilarducci's original proposal is quite different in some respects than the plan she revealed in her Congressional testimony. However, either proposal would still likely result in the death of 401(k) plans and would put the government in the role of providing retirement security. Here are the details of her original briefing paper from November of 2007:

As already noted, the proposal would not do away with 401(k) plans, but would eliminate all of the tax benefits as discussed above. I must assume that this also means the tax benefits associated with Roth-type 401(k) contributions as well. This would, in effect, kill 401(k) plans as the tax incentives for employers and employees are the main drivers for their adoption and participation.
Instead of employer-sponsored 401(k) plans, the government would set up special Guaranteed Retirement Accounts (GRAs). Participation would be mandatory for all workers except for those who are covered by an equivalent or better defined benefit retirement plan.
Required contributions of 5% of salary (equally shared by employer and employee) would be made to the GRA each year, and would be administered by the Social Security Administration. Contributions will apply only up to the Social Security earnings cap (currently $102,000 for 2008), and workers will have the option to make additional after-tax contributions to the GRA.
To offset the loss of before-tax contributions in 401(k) plans, workers would receive an annual $600 refundable tax credit, indexed to inflation. Note that the "refundable" nature of this tax credit insures that workers receive it even though they may not pay any income taxes. For lower-paid workers, all or part of the $600 tax credit would be directed into the GRA to insure at least a $600 annual contribution for every worker.
As noted above, the GRAs would be administered by the Social Security Administration and would be guaranteed at least a 3% annual return. However, the original proposal suggests that these contributions be managed by a unit of the government's Thrift Savings Plan, and not placed into government IOUs. Independent trustees would direct the investment of contributions and have the authority to hire commercial money managers. While the government would guarantee a minimum return of 3%, it would also be possible to earn excess returns which could be credited to GRA accounts.
Finally, at retirement, GRA account balances are converted to inflation-indexed annuities based upon the life expectancy of the participant. Even so, individuals will be permitted to take a partial lump-sum distribution equal to the greater of 10% of their account balance or $10,000, and will also be able to select among optional survivor benefits in exchange for a smaller monthly check.

The supposed benefits of this new retirement arrangement will be to provide a benefit roughly equal to 25% of the pre-retirement income of a full-time worker who works 40 years and retires at age 65. Noting that Social Security replaces approximately 45% of pre-retirement income of the average worker earning $40,000, the proposal states that the combined programs can replace 70% of pre-retirement income of such workers.

Of course, that only applies to workers earning their "averages" and working for the period of time they consider to be typical. The actual amount of replacement income will depend upon actual earnings. A table in Dr. Ghilarducci's briefing paper notes that a "high earner" averaging $60,000 per year in earnings at retirement will replace only 61% of pre-retirement pay, while a "low earner" with only $20,000 of earnings at retirement will replace 89% of pre-retirement pay. Now that's what I call spreading the wealth, but more about that later on.

There are many other details of this plan that space does not permit me to discuss. For more details of the original proposal, see Dr. Ghilarducci's briefing paper for the Economic Policy Institute at the following web address:

http://www.sharedprosperity.org/bp204.html

Congressional Testimony Paints A Different Picture

It's safe to say that Dr. Ghilarducci's original proposal is not as bad as what we heard being proposed during her October testimony before the Committee on Education and Labor. This testimony provides some insights as to how the proposal has changed as the markets have wreaked havoc upon the account balances of 401(k) participants, and the government has moved to "bail out" various financial sectors.

For example, the original proposal didn't spend much time talking about "trading in" existing 401(k) accounts for the new GRA, but Dr. Ghilarducci's testimony notes that such a trade-in could occur based on "mid-August [stock market] prices." In other words, the government would pony up the difference between participants' current reduced account balances and what they had in mid-August before the latest stock market meltdown.

Other testimony given during the same Committee hearings stated that $2 trillion of value had been lost by participants in 401(k)s, IRAs and similar retirement plans over the course of the past 15 months. How much of this represented "lost" 401(k) balances is unknown, but whatever disappeared between mid-August and October would be restored by the government.

Also recall how Dr. Ghilarducci originally proposed a reasonable trustee-directed investment plan for the entire GRA. However, her recent Congressional testimony modified this stance. She now proposes that 401(k) accounts "traded in" to restore their mid-August values would be invested in a special type of government bond that earns 3%, adjusted for inflation. The testimony makes it clear that the government bond proposal would apply only to restored account balances traded in for GRAs, but who knows what Congress may decide.

Plus, we all know that these special bonds would likely be similar to those in the Social Security "trust funds." It is a sad fact that money contributed to the Social Security trust funds is simply spent by the government in exchange for IOUs. I have written previously about how the Congressional Budget Office described the bonds in the Social Security trust fund back in 2002, but I'll reproduce it below just to drive home the point:

"Trust fund holdings, as internal liabilities between government accounts, are not assets of the government. Nor do they represent money owed to program recipients individually; payments to Social Security recipients and beneficiaries of other social insurance programs are based on a variety of rules set by law unrelated to trust fund holdings. A federal trust fund is basically an accounting device that measures the difference between the income designated for a specific program and the expenditures made to its beneficiaries. The accumulated difference, or balance, often represents a reserve of future 'spending authority' for the program, but it is not a reserve of money for making payments." [Emphasis added]

"In the future, when receipts for such programs as Social Security fall below their expenditures, the legal authority to pay benefits will exist as long as their trust funds have balances, but the government will have to generate cash to pay benefits either by running a surplus in the rest of the budget--which would probably require cutting other spending or raising taxes--or by borrowing from the public."

Understand that the above described makeover plan for 401(k)s is just the starting point, especially under an Obama Administration and Democrat majorities in the House and Senate.

Specifically, Dr. Ghilarducci's testimony also made it clear that she is not just aiming at 401(k) plans, but also various other types of "defined contribution" plans including profit sharing, money purchase pension plans, 403(b) plans and even IRAs. Perhaps we should christen this proposal "Social Insecurity 2.0."

Other details are far less than clear right now, such as the tax treatment of 401(k) account balances transferred into a GRA, what would happen to workers who don't fit the "average worker's" 40 years to contribute to the plan, and many, many others. If this plan gains any traction in the new Congress, I'm sure we'll hear more about these and other details yet to be disclosed.

Whatever the final form of an actual bill to introduce GRAs, if any, Dr. Ghilarducci's proposals are still a major diversion from retirement planning law that has steadily evolved since the passage of the Economic Recovery and Income Security Act of 1974, otherwise known as ERISA. What would cause Congressional Democrats to trash over 30 years' worth of retirement planning law? I'll give you a hint: it starts with an "S."

Socialism Du Jour - "Spread The Wealth Around"

The first hint at the real motivations behind the GRA proposal should come from the fact that Dr. Ghilarducci's paper was published by the Economic Policy Institute, not exactly a bastion of conservative thought. Plus, the table of contents on the briefing paper was punctuated by the tagline "Agenda for Shared Prosperity." Isn't this just another way to say, as Senator Obama suggests, to "spread the wealth around?"

And don't think this is just an over-the-top reaction from a conservative. Dr. Ghilarducci, the architect of the new plan, said the following during a recent interview:

And what's amazing about this is that it's actually, um, doesn't cost the government anybody (sic). I'm just rearranging the tax breaks that are available now for 401(k)s and spreading -- spreading the wealth.
[Emphasis added - GDH]

You would think that the Democrats would have coached her to not describe it in those exact words, but the bottom line is that spreading the wealth is exactly what GRAs are designed to do.

The carrot at the end of the stick is the restoration of accounts to their August 2008 values, before the latest market crash. Imagine how many Americans would jump at the chance to recoup the market losses of the last couple of months!

Free money, or so it would seem. That's how socialism works: give 'em a short-term benefit in exchange for a lifetime of bondage.

While a lot of Dr. Ghilarducci's testimony dealt with enhancing retirement security, reducing investment-related fees and making up for losses incurred during the recent bear market, a quick review of her Congressional testimony reveals the real reason for this desire to change to a new government-sponsored universal retirement plan.

According to Dr. Ghilarducci, the current system of providing tax incentives to companies and workers for sponsoring and participating in 401(k)-type plans is inefficient. While you and I might define the term "inefficient" much differently, for purposes of the "spread the wealth" crowd, Dr. Ghilarducci defines it as having too much of the tax subsidies go to people who actually pay taxes (ie - higher income earners).

Her testimony notes that 6% of taxpayers with incomes over $100,000 per year reap 50% of the total tax benefits from 401(k) and related plans. Never mind that this 6% of taxpayers pay the lion's share of all income taxes. I don't have numbers for the top 6%, but in 2006, the top 5% of taxpayers paid 60% of all income taxes. Plus, approximately 1/3 of filers pay no income tax at all based on 2006 income tax statistics.

I would argue that it makes sense that people who actually pay taxes should be the ones receiving the lion's share of any tax benefits, not those who pay no taxes at all. Demographics would also seem to dictate that high earners would get most of the benefits. My firm counsels workers to start contributing to their 401(k) plan early to allow compound interest to grow. Thus, it makes sense that those with larger balances are those who have been saving a long time, and who are most likely to have worked their way up into high-paying positions. This proves that working hard and saving early pays off in the long run.

However, the Democrats now want to say that those who worked hard to excel and who took advantage of tax incentives to save a sizeable nest egg should be punished and have their tax benefits given to those who have not been as industrious or mindful about saving.

The bottom line is that this whole proposal is nothing more than a way to redistribute wealth based on liberal ideology. It's being sold as a way to restore balances, guarantee minimum future returns and reduce the uncertainty of market-based investments, but you can rest assured that it's just another step on the road to increased government control of every part of our lives, also known as socialism.

A New Democratic Piggy Bank

I also find it very interesting that one of the new wrinkles that has appeared in Dr. Ghilarducci's proposal between its original release and her recent testimony would allow 401(k) participants to have their account balance restored if they move their account into a new government bond. Considering that billions of dollars will be required to bail out Wall Street due to the subprime crisis, the future of social programs under a Democratically controlled Congress were in question. Where would they get the money?

Now we know one way they might try to get some cash in the coffers - highjack our 401(k)s and other tax-deferred retirement accounts.

Plus, it is currently unknown how much, if any, of the ongoing contributions would be allocated to these special government bonds. Since the whole matter is currently in flux, I could see a Democratic Congress mandating all or part of ongoing contributions be placed into government-guaranteed bonds. Sure, the Democrats will try to sell GRAs as a way to insure retirement stability, but it will really be a way to have access to a gigantic stash of cash.

Can We Afford This Nonsense? No, But So What?

This new 401(k) replacement proposal results in affordability issues at several levels. First, can the government afford to restore mid-August values for everyone in a defined contribution type of retirement plan? After all, the amount of money to do so would be gargantuan! Well, I guess it can as long as they keep the printing presses going at the Fed. However, that doesn't mean it's affordable.

The Congressional Budget Office has estimated that all types of retirement plans (IRAs, defined benefit, 401(k), etc.) have lost apprx. $2 trillion over the last 15 months due to stock market declines. I cannot find a statistic showing how much of that loss was in defined contribution plans like 401(k)s, but I would guess it's in the hundreds of billions.

Plus, what about the defined benefit plans that are now going to be under-funded. It probably won't be long until we see companies with at-risk pension plans asking for a bailout of their own. If we bail out 401(k) participants, can we justify not bailing out employers who may have no other choice than to terminate their plan if they can't get a government handout?

Another level of affordability is in relation to the returns needed in a 401(k) to produce a meaningful retirement benefit. The proposed bond investments will guarantee 3% above inflation on balances "traded in" to the GRA. Since inflation historically runs about 3% per year, that means a 6% return. It will be hard for workers to build much wealth with such low returns.

Finally, we have to look at the effects on the stock market. We don't know exactly how the money "traded in" to a GRA will be treated, but that giant sucking sound you'll hear might be money flowing out of the equity markets and into government bonds. That will mean more downward pressure on stock market prices.

And what will the government do with the trillions of dollars it will be given? Three guesses and the first two don't count: Spend it, of course. Maybe this is how Obama gets the money to fund his lavish new spending programs. It could happen.

What is really hard to understand is that Democrats continually grouse about the regressive nature of the Social Security tax, which is currently 7.65% of pay (matched by the employer). Self-employed individuals must pay both shares, so their tax rate is 15.30%. While Obama's tax plan promises to rebate part of this tax, it would seem a contradiction to add yet another 5% mandatory contribution/tax/whatever for employees to pay. Plus, if employers have to pay half of this mandatory contribution, it will represent yet another expense during a period of recession. Not a good idea!

The entire idea of replacing employer-sponsored 401(k) plans with a government sponsored Social Security - II plan would have been considered ludicrous prior to August of this year. However, after banks, brokerage firms, insurance companies and car makers all lined up for a share of government's largesse, it's now not hard to imagine something this insane actually becoming law.

Conclusions - After Today, Anything May Be Possible

Considering that this proposal has been trotted out during a Committee hearing at a time when Congress is not even in session likely indicates that it's no more than a trial balloon to gauge public reaction. Dr. Ghilarducci's original proposal made no waves when it was released a year ago, likely because no one felt there was a snowball's chance of it ever becoming law.

Now, however, times have changed. The recent market meltdown has many investors worried about their ability to retire with sufficient income. On top of that, lawmakers have seen that the major Wall Street bailouts have been passed without riots in the streets. This just might give them the ability to answer all of their constituents who have asked, "Hey, where's my bailout?"

I want to think that this proposal has very little chance of ever becoming law. Over the last 2-3 decades, there has been a continual expansion of tax incentives to get workers to save for retirement, and for employers to help them do so, and there is no doubt this has been a good thing. Thus, I would hope this will not be dismantled in the next Congress.

But we should all understand that, if Barack Obama becomes our new president with supermajorities in Congress, anything is possible. A massive expansion of government and a rollback of our freedoms are not out of the question. Such an expansion of government has to be funded somewhere, and 401(k)s and other supposedly sacred retirement plans, including IRAs, may appear to be the low-hanging fruit to the liberals who will be in control in Washington.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

'Panic of 2008' - Will the Democrats bring us a Depression? (must read)
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_hassett&sid=aY3kqxNeV7lU

We Could Be In for a Lurch to the Left
http://online.wsj.com/article/SB122576065024095511.html

Economic Ills Will Force Winner's Hand
http://online.wsj.com/article/SB122575838410095279.html

Thomas Sowell - Obama all "Ego and Mouth"
http://www.realclearpolitics.com/articles/2008/11/ego_and_mouth.html

Retirement Focus - What Now???

Gary D. Halbert — Wed, 29 Oct 2008 00:16:44 GMT

by Mike Posey

IN THIS ISSUE:

Avoiding Costly Bear Market Mistakes
Active Management Revisited
Other Post-Retirement Investment Alternatives
Combining Strategies

Introduction

To say that the world has changed since I last wrote to you on August 26th would be a vast understatement. Long-time cornerstones of the financial services industry have either been forced into mergers or have ceased to exist. The credit markets have seized up, choking off vital sources of borrowing for corporations and consumers alike. And the US government has embarked upon what might best be called a domestic "sovereign wealth fund."

Trillions of dollars of investor assets (including retirement funds) have literally vaporized in front of our eyes. For those accumulating assets prior to retirement, the recent market activity could mean working longer and/or saving more of each paycheck. For those already in retirement, however, the situation could be much worse. It could mean going back to work, learning to live on a lot less money, or a combination of the two.

This week, I'm going to follow my original plan to complete the series of E-Letters dedicated to investing after retirement. My next category to discuss was that of actively managed investments. Since Gary did such a good job of discussing those investment strategies last week, I'll only add a few observations to what he already wrote. Then, I'll move on to a discussion of investment alternatives that don't neatly fit in other categories.

Before that, however, I'm going to address some very timely issues in relation to post-retirement investing during the market turmoil we are now experiencing. All investors are nervous about the market, but those in retirement are understandably more fearful of how the stock market meltdown has affected their retirement assets. Since we know that fear is a major emotional trigger for investment decisions, I want to inject some calm reason to help you avoid making costly investment mistakes in this market environment.

As always, I need to point out that any investment information provided in this E-Letter is general in nature, and should not be construed as specific investment or insurance advice. You should always evaluate insurance and investment options in light of your personal financial situation, retirement goals and any special circumstances you may have.

Avoiding Costly Bear Market Mistakes

As I noted above, many retirees now fear that their nest eggs may not carry them through retirement after having been devastated by the recent stock market decline. For those who had not saved all that much to begin with, this fear is now close to panic as the prospects of a longer life span are now on a collision course with a smaller (much smaller in some cases) retirement fund.

Fear and panic often blind investors as to the best actions to take in regard to their retirement assets. Combine that with the constantly changing advice from the financial media and the empty promises of scam artists and it becomes hard to know exactly what to do. To help any readers who may be in that situation, I offer the following advice on ways to avoid making costly investment mistakes in retirement:

Keep retirement distributions realistic. Actually, long before the recent market decline, I had read of studies documenting how recent retirees were withdrawing far too much from their retirement assets to be sustainable. One article I saw was entitled "Delusional Distribution Strategies," alluding to the idea that many Baby Boomers assume they could take annual distributions of 10% and still have sufficient income throughout retirement.

As I have mentioned in my Retirement Focus E-Letters, many experts suggest a more reasonable withdrawal rate of 4% to 6% per year is most appropriate. If that was true before the recent market meltdown, it may be necessary to withdraw even less that 4-6%, especially for retirement portfolios that may have suffered significant losses. Increasing the withdrawal rate on a portfolio of assets that has declined in value only makes the problem worse, and hastens the day when the portfolio can no longer provide a sufficient income stream.

Thus, if you are retired and the value of your investments has been hit hard by the market's bailout blues, seek out other ways to supplement income rather than by increasing your withdrawal rate to a level that may be unsustainable. For details about these other options, see my February 19, 2008 Retirement Focus issue.
Be careful when liquidating assets. It's been said that cash is king when markets take a dive, and who wouldn't want to have been in cash or fixed-rate investments over the past year or so? However, if you have an equity portfolio that has suffered major losses, you may want to resist the temptation to cash out now.

The reason? While no one knows how much further this bear market has to run, it's certain that if you cash out now, you realize all of the losses that are now just on paper. Remembering back to the 1987 market dive, we saw that those who held onto their investments were eventually rewarded by having their value restored. Those who sold out at the bottom and stayed in cash over the next couple of years didn't get this rebound.

While it may sound strange coming from a firm that promotes actively managed accounts and moving to cash in bad markets, there are some times when holding onto losing investments may be the best alternative. This is especially true when the markets are hit with selling pressures that are not based on fundamentals, but rather on news reports, selling by hedge funds, mutual funds and other panicked investors, and a generous helping of global uncertainty.

As these selling pressures diminish over time, it's possible that equity prices will eventually rebound. And while they may not get back to their original October 2007 values, they may pare losses enough to make it worthwhile to have waited to liquidate. Of course, there's no guarantee that market prices will rebound within any given time period, and losses could get a lot worse before the market gets better.

A final caution is in regard to income producing property. If you have bonds, dividend-paying stocks or other income-producing assets, it is often best to concentrate on the sufficiency and stability of ongoing income payments rather than the market price of the underlying asset. If the ongoing income stream appears to be stable and is sufficient for your needs, then selling out may be a big mistake.
Don't try to "make it all back" in risky investments. Retirees need to resist the temptation to seek out investments that will let them "make it all back." I recall after the end of the 2000 – 2002 bear market, we had several investors in or near retirement contact us wanting to find an investment that would quickly restore all of the money they had lost during the bear market.

While investments do exist that have the potential for oversized gains, it's important to remember that they generally have oversized risks that goes along with them. The bottom line is that retirees who push the risk envelope to make up lost ground could end up losing even more of their nest eggs.

Thus, when investing during retirement it's usually best to seek out investments that are suitable to your goals and risk tolerance and not buy the latest hot performance. It's also preferable to invest in programs with actual track records that span different market cycles rather than putting money with short-term performers who may only be a "flash in the pan."
Be aware of scam artists. Both Gary and I have previously written about investment scams, and especially those aimed at retirees. Be aware that the huge losses in the stock market are going to be fertile ground for scam artists who will promise the world, but deliver only misery. Just remember, if it sounds too good to be true, it probably is.

Active Management Strategies Revisited

As I mentioned in the introduction, Gary has already written extensively about actively managed investment strategies in last week's E-Letter. That being the case, I'll only add a few comments of my own to highlight how these strategies can be effective during retirement. First, however, let me summarize the other post-retirement investment options that I have already discussed.

In my initial discussion of post-retirement investing alternatives in the May 27 Retirement Focus, I mentioned the following ways to invest during retirement, each with its own set of advantages and disadvantages:

Immediate Annuities;
Fixed Income Alternatives;
Variable Annuities;
Asset Allocation Alternatives;
Actively Managed Strategies; and
Other Alternatives.

I covered the first two of these alternatives in the May 27 E-Letter, and discussed variable annuities in the July 15 issue. Asset allocation strategies were covered in my August 26 E-Letter, and as noted above, Gary discussed actively managed investment strategies in the October 21 Forecasts & Trends E-Letter.

As Gary discussed last week, active management strategies are those that involve actively moving from one investment to another in an effort to provide superior risk-managed returns. While the active management category encompasses a number of different money management strategies, Gary spent most of last week's E-Letter talking about a specific active strategy known as "market timing." This strategy seeks to move out of the market or into hedged positions during bear markets and major corrections, and then back into the market as conditions improve.

Through the years, the idea of market timing has not always been easy to sell. During the late 1990s, the tech bubble was buoying the entire stock market, with 20%-plus annual returns commonplace in the major market indexes. Needless to say, investors didn't think they needed a strategy that would take them out of the market.

Savvy investors, however, knew that the market couldn't continue to provide double-digit returns forever. Sure enough, the bear market of 2000 – 2002 once again underscored the need for an investment strategy that has the ability to go to cash or hedge long positions during extended declining markets.

Beginning in 2003, the stock market experienced a new bull market phase that continued through the third quarter of 2007. Guess what! Investors again forgot the lesson learned about having a money management strategy that would move out of the market. "Index investing" once again became the fad, with an emphasis on low fees rather than risk management. Account balances once again soared, with both the Dow and S&P 500 Indexes entering new record territory.

As is often the case, those who do not learn from history are destined to repeat it, and repeat it they did. Beginning in November of 2007, the market started digesting the steady stream of bad news about the subprime mortgage crisis and resulting credit crunch. I probably don't need to tell you what has happened since then, but suffice it to say that, as this is written, the S&P 500 Index stands not too far from its 2002 low. The subprime debacle has served as a big eraser of sorts, obliterating most of the equity gains experienced since the last bear market.

Will the lesson be learned this time around? I suspect that it will, especially by those who are seeking to nurse a wounded nest egg during retirement. A second major bear market within the first decade of the 21st Century should be reason enough for all investors to look more toward risk management, and not just focus on short-term performance or the lowest fees.

While Gary covered the topic of actively managed investment strategies very well, I do want to point out the following issues that are particular to someone who is investing for post-retirement income rather than pre-retirement accumulation:

Be prepared for more frequent trading activity. Most experienced investors are wary of frequent trading in their accounts. Fear of having their accounts "churned" to generate new commissions is a real threat in many brokerage accounts. Thus, when active management strategies generate numerous trades over the course of a year, some investors become concerned about the level of activity.

Generally speaking, the trading in an active management strategy is done to manage risk, and not to generate additional commission income. In fact, most actively managed portfolios that I'm familiar with do not generate commissions. Instead, they usually involve the trading of mutual funds on a no-load basis, or individual stocks and bonds within a "wrap" account that charges a flat asset-based fee.

In some cases, frequent trading activity can result in added costs to the investor over and above the management fee paid. Therefore, it's important to determine whether an active money manager has the potential to provide a level of return that justifies any additional fees from active trading. This determination is one of the many "due diligence" services we perform for our clients in the AdvisorLink® Program that Gary discussed last week.
Consider the tax aspects of active management. Due to the potential for frequent trading as noted above, many actively managed investment programs are not "tax efficient." Essentially, this means that most, if not all, gains will be treated as short-term capital gains and taxed as ordinary income rather than under the more favorable long-term capital gains rates for assets held for a year or more.

As a result, many investors place actively managed strategies in their IRA, annuity or other tax-qualified plan, and use taxable accounts for other types of investments that have the potential for gains that would qualify for special long-term capital gain tax treatment. That's why it's always a good idea to consult a tax professional or qualified Investment Advisor to determine which assets may be best inside or outside of an IRA or annuity.
Consider total returns when taking income. Within an actively managed portfolio, the goal is primarily risk management and producing "total returns," which include interest, dividends and capital gains. Thus, few of the actively managed programs we run across specifically try to manage solely for income. While some income is usually produced from interest-bearing accounts and dividends from mutual funds, most of any increase in value generally comes from gains from trading activity.

That being the case, it is usually best to withdraw income by taking whatever interest and dividend income the investments have produced, and then liquidating assets in order to get to the appropriate withdrawal percentage you seek. Most mutual fund and brokerage companies have a way to automatically withdraw a certain percentage of assets on a periodic basis, which makes it easy.

However, don't let an automatic withdrawal election lull you into complacency. It's sometimes easy to get used to regular withdrawals and forget about the underlying performance of your portfolio. Thus, it's important to continue to closely monitor the performance of your account and adjust the withdrawal percentage over time as may be appropriate.

The current stock market environment underscores the need for active management strategies that seek to manage portfolio risk. In fact, as Gary pointed out last week, these strategies can be a valuable addition to virtually any suitable investment portfolio. For retirees, it's imperative to seek out the counsel of an Investment Advisor or other qualified professional in order to help insure that active management strategies are properly integrated into an overall portfolio.

Conclusion – Consider A Combination Of Strategies

This marks the end of my series of E-Letters on investing after retirement. While the stock market meltdown has placed an exclamation mark behind the need to manage risk during your retirement years, it may have also underlined the need to have at least part of your nest egg in guaranteed retirement assets such as an immediate annuity that pays a constant amount of monthly income.

Thus, many Advisors recommend a mixture of the various investment and payout techniques I have mentioned in this series. Some recommend anywhere from 50% to 80% of the portfolio should go to a guaranteed immediate annuity payout. This will provide a stable level of income that can then be supplemented with the remainder of assets invested using other techniques I have discussed. However, other Advisors shun immediate annuities as they do not provide for increased income over a potentially long retirement.

While I tend to agree with the combination approach, the best solution should be one based on a retiree's individual wants, needs and financial situation. Someone with a predictable monthly income from a defined benefit pension plan will have a different planning need than someone whose only retirement assets are in the form of personal savings. Between these two extremes lie a myriad of combinations of asset types and tax consequences that must be evaluated for the best fit during retirement.

As the Baby Boom generation continues to enter into retirement, we're sure to see even more innovative solutions from the financial services industry over time. Hopefully, this series of E-Letters has provided you with a road map to follow and armed you with the kind of questions you need to ask about any financial instrument designed to produce income. After all, scam artists will be after your money as well.

As always, I welcome your questions and comments regarding this article as well as any other retirement topic. Just send an e-mail with your input or questions to info@halbertwealth.com. Also feel free to forward this article to anyone you feel may benefit from the information.

Best regards,

Mike Posey

P.S. from Gary:

I would strongly urge all of you to read the following article from Accuracy In Media. While it starts out being critical of President Bush, it goes on to point how a President Obama would be in a unique position to advance a socialist-leaning agenda. With the government now owning equity stakes in major banks and insurance companies, the US is ripe for a move toward socialism. This is an article I wish all voters had the chance to see.

http://www.aim.org/aim-column/bush-embraces-obamas-socialism/

Retirement Focus - Post-Retirement Asset Allocation

Gary D. Halbert — Tue, 26 Aug 2008 21:19:00 GMT

by Mike Posey

IN THIS ISSUE:

Asset Allocation And Modern Portfolio Theory
The Many Faces of Asset Allocation
Income Strategies Using Asset Allocation
Advantages And Disadvantages of Asset Allocation

Introduction

This week, I am going to continue the series of E-Letters dedicated to investing during retirement. As I continue this series, it's important to note that this series discusses investment strategies that can be used after retirement, when many retirees must depend upon their nest eggs for income.

In my initial discussion of post-retirement investing alternatives in the May 27 Retirement Focus, I mentioned that there are a myriad of ways to invest during the payout phase, each with its own set of advantages and disadvantages. For purposes of our discussion, I placed these investment strategies into the following broad categories:

Immediate Annuities;
Fixed Income Alternatives;
Variable Annuities;
Asset Allocation Alternatives;
Actively Managed Strategies; and
Other Alternatives.

I covered the first two of these alternatives in the May 27 E-Letter, and discussed variable annuities in the July 15 issue. This week, I'll move on to alternative #4, Asset Allocation and its many variations. Like variable annuities, asset allocation provides the potential for higher gains and the prospect of higher withdrawals during retirement, but at a cost of higher risk.

As always, I need to point out that any investment information provided in this E-Letter is general in nature, and should not be construed as investment or insurance advice. You should always evaluate insurance and investment options in light of your personal financial situation, retirement goals and any special circumstances you may have. Ideally, you should consult with a qualified insurance agent and/or investment professional who can take the time to review your situation and tailor an investment approach to meet your needs.

The Basics Of Asset Allocation And Modern Portfolio Theory ("MPT")

The concept of asset allocation could be called the embodiment of the old adage about "not putting all of your eggs into one basket." You don't have to look very far to find life lessons about violating this rule. Just ask employees of WorldCom or Enron, whose retirement savings were largely tied up in company stock, and they will likely attest to the importance of diversification. Investors who loaded up on questionable tech stocks in the late 1990s, only to see them fall 70% or more later on, can also sing a verse from that same sad song.

Though we often see investors who fail to pay attention to the need for diversification, the fact is that asset allocation has been around for a long time. Wise investors have long spread their investments over a variety of alternatives, so as not to have a portfolio too concentrated in one stock or asset class. Historically, the method for diversifying a portfolio was largely one of personal preference. That is, until a method to quantify the balance between risk and return was developed.

One of the major building blocks of modern asset allocation is a 1952 study by Nobel Laureate Harry Markowitz. This study, which introduced the concept of "Modern Portfolio Theory," or MPT for short, was among the first to measure and quantify the benefits of diversification. The result was a way to mathematically optimize the risk/reward balance in a portfolio, something Markowitz called the "Efficient Frontier."

However, it wasn't until the 1980s that Markowitz's MPT idea gained traction. In 1986, another study was published by Gary Brinson and others which concluded that apprx. 90% of the variance of returns in any given portfolio could be explained by the way assets were allocated among various asset classes (stocks, bonds, real estate, etc.). According to that study, stock selection and other factors accounted for only 10% of return variation. Taken together, these studies formed the basis of the modern asset allocation movement.

It is important to note that not everyone has jumped on the asset allocation bandwagon. There are plenty of critics that point to shortcomings in the studies that serve as the foundation of the modern incarnation of this money management strategy. I'll discuss these in further detail later on when I cover possible disadvantages of asset allocation strategies.

Before that, however, let's explore the various forms asset allocation programs may take. It may surprise you that some highly touted investment products are nothing more than asset allocation programs in disguise.

The Many Faces Of Asset Allocation

As noted above, asset allocation is one of the most popular and pervasive money management strategies used today. It is employed by not only investment professionals, but also by many individual investors who utilize free Internet resources to determine their allocations.

In the discussion above, I provided a few of the key words that you might look for when evaluating whether an investment alternative is based on asset allocation. If you hear your financial advisor say something about "MPT," or the "Efficient Frontier," or that the way assets are allocated is the #1 determinant of portfolio performance, then you are likely dealing with an asset allocation strategy.

However, asset allocation programs are not always identified as such. In this time of specialization, many investment professionals and even financial services companies do not want to publicize that they are simply doing asset allocation like everyone else, even if that's exactly what they are doing. For example, an Advisor who wants to impress clients with his or her stock picking skills will certainly not want to dwell on the Brinson study which found that 90% of a portfolio's performance can be explained by asset allocation and only 10% by stock selection and timing of asset purchases.

Below, I have provided a variety of ways you might see asset allocation marketed, some clearly marked as asset allocation and others not so clear:

1. Brokerage Accounts – Everyone from the large New York wire houses to independent Investment Advisors often use brokerage accounts to employ asset allocation strategies. While brokerage accounts can hold individual stocks and bonds as well as mutual funds, in this section I'll just deal with individual securities, since mutual funds are discussed in more detail below.

As a practical matter, when individual securities are used, it is sometimes hard to determine whether a traditional asset allocation strategy is being employed. As I noted above, the broker may want to come across as a great stock picker, so asset allocation may be kept in the background. Plus, a properly diversified portfolio of individual stocks and bonds will often contain a large number of securities, so even going through your account statement can be quite a chore. This need for diversification can also lead to high minimum investment requirements on such accounts.

If you received a formal proposal before investing, this information often discusses the strategy to be employed. If you read through the proposal and notice some of the key words I have discussed above, chances are you are in an asset allocation program. However, the real key to understanding your brokerage account investment lies in asking your investment professional the right questions, such as what methodology your broker is using to diversify the portfolio.

For brokerage accounts used in retirement, it is important to monitor the amount of trading, which will directly affect expenses in the account. Unscrupulous brokers sometimes "churn" accounts, meaning they buy and sell needlessly, to increase brokerage commissions to themselves. While this is a detrimental practice in any account, it can be especially harmful in a retirement account where these brokerage expenses may reduce the amount of income that can be paid from the account. Remember that asset allocation is a buy-and-hold approach, so frequent trading should not be necessary.

A possible advantage of a brokerage account during retirement can be selection of specific bonds or other income producing securities that may have higher interest payments than might be available from a mutual fund or ETF that holds many different bond issues. Of course, the opposite might also be true.

2. Mutual Fund Programs – Mutual fund-based asset allocation programs are probably the most common types seen. The automatic diversification of the mutual fund, coupled with the ease of targeting specific asset classes makes these programs a natural fit. In many respects, a mutual fund program is much like the individual stock brokerage account listed above, except that it usually contains fewer holdings and can be accessed at lower minimum investments.

Mutual fund-based asset allocation programs come in a variety of colors and flavors, but I usually lump them into two general categories – those that use actively managed mutual funds and those that use low-cost index funds. Programs using actively managed mutual funds seek not only to find the correct asset allocation mix for a particular client, but also the best individual mutual fund within each asset class. This is not always easy to do among the thousands of mutual funds in existence, but the Morningstar database and sophisticated evaluation software help to ease the burden.

Asset allocation programs using stock and bond index mutual funds are becoming more prevalent as the number of index-related funds continues to grow. You can now find an index mutual fund based on just about any stock or bond index you'd want to include in an asset allocation portfolio.

More importantly, those who promote index investing point again to the 1980s Brinson study which concluded that up to 90% of the performance of a given portfolio is based on the way assets are allocated. Why pay the generally higher fees associated with actively managed mutual funds when you can get 90% of the same benefit from low-cost index funds in the right asset classes? Of course, this also assumes the Brinson study is accurate, which is the subject of much debate in the financial services industry.

The fee differential can be especially important during retirement, since expenses must be netted out of investment returns before they are distributed for income. As a general rule, the higher the expenses in an asset allocation strategy, the lower the income. Many who practice asset allocation concentrate on a fund's expense ratio to help select funds. Here, those using index funds have an advantage, since these funds usually have lower expense ratios than actively managed funds. As a general rule, mutual funds with front-end loads or deferred sales charges should be avoided.

3. Deferred Variable Annuities – While I covered the subject of variable annuities in a previous Retirement Focus E-Letter, it is worthwhile to mention that many professionals who recommend these contracts also utilize asset allocation methodologies for selecting the various sub-accounts in which to invest. Beyond that, these contracts operate much like the mutual fund portfolios discussed above, so I won't repeat that again. Just remember that deferred variable annuities can have significant lock-up periods and high surrender charges, which may make them inappropriate for those in retirement.

4. Exchange Traded Funds (ETFs) – ETFs are a relatively new phenomenon and are proliferating at a fast pace. Essentially, an ETF might be described as a hybrid of a mutual fund and an individual stock, so much of the above discussion concerning mutual funds also applies to these instruments. The ETF is made up of a variety of stock or bond holdings, usually in a way that seeks to emulate a particular stock or bond index. However, unlike mutual funds that trade only once per day, ETFs can be traded throughout the day just like a stock.

The first ETF was the Standard & Poor's Depository Receipt (SPDR), usually referred to as the "Spider," created in 1993. Since then, it has been joined by literally hundreds of other ETFs that seek to mimic the performance of a variety of domestic and international stock and bond indexes. There are now even ETFs that track the performance of specific commodities and a variety of commodities indexes.

As a practical matter, the ability to buy or sell an ETF at any time during the day is of questionable value in an asset allocation strategy since the primary purposes is to buy and hold securities in various asset classes. The real value of ETFs is in the variety of stock, bond and other indexes that are represented, and expense charges that are usually about half of those of index mutual funds. Again, low expenses can mean more money in the retiree's pocket.

5. Target and Lifestyle Mutual Funds – Other relatively new entrants on the retirement scene have been so-called "target" and "lifestyle" funds. These mutual funds are examples of investments that may not appear to be based on an asset allocation strategy, but are definitely in that camp. Both target and lifestyle funds seek to meet investor goals by providing a pre-set asset allocation strategy within a single fund. In most cases, these funds allocate their assets among other mutual funds that fit the asset class criteria.

While the terms "target" and "lifestyle" are sometimes used interchangeably in the financial media, there are definitely differences that you need to know about, which I will discuss in more detail below.

Lifestyle funds are generally considered to be funds that contain an asset allocation that remains relatively static over time, and is geared toward a particular risk tolerance. For example, conservative, moderate and aggressive risk lifestyle funds are common. Each invests its assets to match the asset allocation appropriate for the governing risk tolerance, and only minor changes are made over time. For retirees, there are lifestyle income funds with an asset allocation designed to provide long-term retirement income.

In contrast to the lifestyle funds, target retirement funds (also sometimes called "life-cycle" funds) are designed to gradually modify the underlying asset allocation based on the advancing age of the investor. These funds start out more aggressively and then gradually become more conservative as retirement nears. After retirement, the asset allocation is set to provide retirement income, much as in the lifestyle income fund described above.

The obvious benefit of these funds is that they can provide a "one-stop" solution for investors who cannot decide upon an optimal asset allocation. This is especially true prior to retirement in 401(k) plans where participants must select their own investments. However, it's vitally important to know whether the asset allocation will be adjusted over time, or stay roughly the same.

One possible drawback of many of these offerings is that they consist of mutual funds managed by the fund family that sponsors the target or lifestyle fund. This results in a concentration into a single fund family. Plus, unless you are using index funds, it's highly unlikely that a single fund family will have the top funds in every asset class.

A possible solution is a variety of variable annuities that offer target and lifestyle sub-accounts. Many of these variable annuity contracts select funds from a variety of fund families, thus providing additional diversification to the investor.

A final word about target and lifestyle funds is that if you want to use these funds, you probably need to use only these funds. Since these funds have their own pre-set asset allocation, placing only part of your assets into this type of fund and then investing the remainder differently may actually negate the diversification benefits in the target or lifestyle fund.

That being the case, I would only recommend these funds to those who simply don't want to or are incapable of making their own investment decisions and want a fund family or insurance company to do it for them.

This is obviously not an exhaustive discussion of all of the possible ways you can access asset allocation. However, it's enough to let you see that asset allocation strategies are very prevalent, and are likely to become more so as the Baby Boomers retire. Just remember that any MPT-based asset allocation strategy has its gaze fixed in the rear-view mirror. To the extent that the future performs like the past, then they will likely be successful. If not, then you might not achieve the level of income you desire in retirement. That's why periodic monitoring of the allocations and results is absolutely necessary, whether in a pre-retirement or post-retirement program.

Income Strategies In Asset Allocation Portfolios

Just as there are a myriad of ways to practice asset allocation, there are almost as many ways to take income from an asset allocation portfolio. For the sake of simplification, I have placed the alternatives into two very broad categories: portfolios managed for income and portfolios managed for growth. I'll discuss each in more detail below.

Portfolios Managed for Income – This asset allocation technique leans toward fixed income investments and dividend producing stocks in order to provide a stream of retirement income. While some equity investments are usually included in income portfolios, the concentration of fixed-income investments usually makes the overall portfolio more conservative in nature.

In most cases, income produced by the fixed income investments is paid out of the account for retirement income purposes. In brokerage accounts, it's common for the income to be swept to a money market or cash fund where it can be easily withdrawn. All or part of your dividend and interest income can also be reinvested if not needed for current retirement income.

In an optimum scenario, income produced by your portfolio would provide sufficient retirement income when combined with other sources such as Social Security benefits and any traditional pension benefits you may have. The downside of an income portfolio is that the types of investments included in such an allocation may not provide sufficient growth for the future, especially in light of ever-longer life expectancies.

While many income portfolios assume that the principal will remain invested and not be touched, this may not be feasible if the income produced by the portfolio is insufficient for retirement needs. In such cases, you and your advisor will need to determine an appropriate withdrawal percentage as I discussed in my February 19 E-Letter.

A final word about income portfolios is that, as a general rule, the important factor is the income produced, and not the periodic value of the underlying assets. Unless it's necessary to invade your principal, you usually don't need to worry about the current value of bonds or income producing stocks in your portfolio as long as they are producing the level of income that is expected from them. This is especially true with individual bonds, since market values may vary widely over time, but the full par value will generally be paid if the bonds are held to maturity.

Portfolios Managed for Growth – This asset allocation strategy is designed to attempt to maximize gains, which could be from a combination of capital gains and income from investments. As noted above, income portfolios may not provide sufficient growth to cover inflation over ever-expanding life expectancies. A portfolio managed for growth is designed to overcome this shortcoming by including more in the way of growth investments such as equities, which have historically outperformed fixed income investments.

The method for taking income from a growth portfolio is typically by means of a set withdrawal percentage, as I discussed in my February 19 E-Letter. To the extent that the desired withdrawal percentage exceeds dividends or interest produced by income investments in the portfolio (if any), equity assets will have to be sold to produce the needed additional liquidity.

A growth portfolio has the potential to provide a higher level of income, assuming the growth of the overall portfolio exceeds income available from an income portfolio. However, since growth portfolios generally have higher allocations to equity securities, there is also a greater potential for loss.

It works this way: As I noted above, a decrease in the value of a fixed income portfolio may not adversely affect the income paid from the portfolio, assuming interest and dividend payments remain the same. In a growth portfolio, however, the withdrawal percentage determines the level of income, but the performance of the portfolio determines the extent to which principal may be invaded. In years when equities lose money, withdrawals are taken on top of these losses.

Thus, if equity investments are too aggressive or if market conditions are bad for an extended period of time, a growth portfolio has the potential to underperform an income portfolio, and possibly even drop to a level of income that is insufficient for retirement needs. This is why periodic monitoring of the performance of your asset allocation strategy is imperative.

Another factor relating to which of these alternatives may be best is the issue of taxation. For tax-qualified accounts such as IRAs, all proceeds are paid out as ordinary income. Thus, the goal with your IRA asset allocation should be to maximize returns, since none of the income will be subject to special capital gains or dividend tax rates.

For taxable accounts, we currently have very favorable dividend and long-term capital gains tax rates, which should be considered when building a post-retirement portfolio. After all, money paid in taxes is not available for spending. However, you must also remain aware of what's going on in Washington, as a change in tax policy could mean a change in your asset allocation strategy. Don't expect your broker or financial advisor to automatically contact you when tax laws change. Instead, you need to be proactive and contact your advisor as soon as you hear of changes that may affect the way your money is invested.

Pros And Cons of Using MPT During Retirement

As with virtually any money management strategy, asset allocation has both advantages and disadvantages. In addition, there are a number of very smart experts who say that the use of MPT and the Brinson study are not appropriate for asset allocation, or at the very least, lead to a misguided opinion. Thus, it is useful to discuss some of the major positives and negatives of MPT-based asset allocation:

Advantages of Asset Allocation:

1. First and foremost, asset allocation generally provides a method for investing that is a technically based method of diversification and not dependent upon the opinion of the advisor or investor. While the basis for asset allocation comes from historical relationships among asset classes, it's at least a way to include a mechanized analysis and allocation strategy based on an investor's age, risk tolerance and a variety of other factors.

2. When I discussed the use of immediate annuities after retirement, you will recall that the fixed immediate annuity provides a constant level of income over the lifetime of the individual, and also that of a surviving spouse if the joint and survivor option is chosen. An asset allocation portfolio also has the ability to provide lifetime income, but it also has the potential to provide increasing levels of income based on prevailing interest rates and/or equity returns.

3. Another advantage of asset allocation over fixed immediate annuities is that an investor's money is not locked up in a contract, and is available for emergency expenses, if necessary.

4. Asset allocation portfolios with significant equity holdings have the potential to continue to grow and even provide an estate for surviving heirs.

5. A properly established asset allocation portfolio offers the chance to periodically rebalance the account, at which time the investor's needs and risk tolerance can be verified, and changes made within the portfolio as may be necessary.

6. Finally, basic static asset allocation has led to a number of variants, some of which are known as "dynamic" asset allocation and "tactical" asset allocation. These alternatives seek to address some of the criticism of static asset allocation by allowing for deviations from the normal asset allocation mix in order to take advantage of perceived investment opportunities.

Disadvantages of Asset Allocation:

1. While asset allocation is a very common strategy used in pre-retirement, its advantages do not always flow through to post-retirement investment portfolios. That's because pre-retirement asset allocation often involves "dollar cost averaging," where assets are contributed over a long period of time during various market cycles. Post-retirement asset allocation usually means investing the entire portfolio at one time.

2. Asset allocation strategies can provide income over the course of a retiree's lifetime, but it cannot guarantee a set level of payments as can the fixed immediate annuity. If portfolio performance is poor, especially in the early years, it's even possible to run out of money in an asset allocation portfolio, depending upon the withdrawal strategy used.

3. As noted above, asset allocation is based on historical relationships among asset classes. However, these relationships change over time. The Rydex mutual fund family has published an example of how the "Efficient Frontier" has actually been very different over the course of the last five decades. Since the performance of a retiree's asset allocation portfolio will depend upon the relationships among asset classes over the next 20 to 30 years, which among these variations will be the "right" one for the retirement scenario? (Click HERE to see the Rydex flyer.)

Just in the last 10 years we have seen that there are some chinks in the asset allocation armor. Specifically, asset allocation holds that diversifying among equity asset classes, such as large-cap, mid-cap and small-cap stocks, or growth stocks and value stocks, etc., etc. will protect the portfolio since each asset class has a different risk and reward structure. However, the bear market of 2000 – 2002 showed us that when times are tough, all equity classes sank together. Some had greater losses than others, but most equity asset classes were under water.

4. As previously discussed, there are many critics of the 1980s Brinson study. As noted above, the original study claimed that asset allocation explained apprx. 90% of the variation of returns among portfolios. However, critics point out that variation of returns and level of returns are two very different things. Some even claim that Markowitz's MPT concept was "hijacked" to address portfolio strategies that it was never intended to apply to.

I am not going to try to referee the fight between those for and against asset allocation. However, the view that MPT was never intended to address modern asset allocation might be at least partially validated by a revelation in 2005 that Markowitz did not use MPT-based asset allocation when investing his own money. Gary wrote about this surprising news in his May 24, 2005 issue of the Forecasts & Trends E-Letter.

5. Investors often see asset allocation as a "set it and forget it" type of strategy. Nothing could be further from the truth. Allocations need to be rebalanced over time, and possibly significantly altered due to a change in an investor's personal financial situation. Failure to do this, whether on the part of the investor or the advisor, can lead to the failure to provide adequate retirement income.

6. Finally, it's impossible to know which allocation is correct for the future. I noted above how there is disagreement in the financial services industry as to the appropriate allocation to equities in a retiree's portfolio. Some suggest 20% and even less, while others maintain that a minimum of 50% should be kept in stocks. Which is right? As usual, it depends.

Conclusions

While asset allocation (and its many variations and incarnations) is a very common pre-retirement investment strategy, we have seen that not all of its advantages follow through to post-retirement portfolios. I think the extensive use of MPT-based asset allocation comes down to an old adage that says: "If all you've got in your tool kit is a hammer, then every problem looks like a nail."

The financial services industry is heavily invested in the concept of asset allocation. Just look at the proliferation of mutual funds and ETFs based on the various asset classes. Before MPT-based asset allocation became popular, such specialization was less common. Now, funds have to fit into the MPT software's asset allocation chart or risk being totally ignored.

Even so, an appropriate asset allocation properly monitored can be a successful strategy for those in retirement. Such portfolios stress the importance of diversification among different types of investments, and usually involve periodic monitoring to assure the original allocation is still viable for the investor. Monte Carlo simulations have also been helpful. These simulations project the probability of success of a given allocation. While not perfect, a Monte Carlo simulation does introduce the concept of losses to retirees, and how this can affect their ability to meet their retirement goals.

Next time, I'll address the idea of actively managed investment strategies.

Best regards,

Mike Posey

Storms On The Horizon - The Entitlement Time Bomb

Gary D. Halbert — Tue, 19 Aug 2008 21:18:56 GMT

IN THIS ISSUE:

Largest Budget Deficit In History Coming In 2009
A Sobering Reminder From The Fed's Richard Fisher
Deficits To Explode In Coming Decades
Conclusions - Why No One Is Talking About This

Introduction

At the end of July, the White House announced its forecast for the federal budget deficit for fiscal year 2009, which begins next month. The deficit is shocking - an estimated $482 billion, and that does not include apprx. $80 billion that will be spent on the war in Iraq, or a possible second economic stimulus package that is being debated in Congress. So the 2009 deficit will go well beyond a half a trillion dollars! It will be the largest budget deficit in US history.

The national debt is now at $9.6 trillion and will rise well above $10 trillion next year. And that amount does not include the trillions of dollars in unfunded liabilities for Social Security, Medicare and Medicaid. The US faces a debt crisis of incredible proportion over the next several decades. Everyone knows it, but no one seems willing to do anything to stop it.

What follows is one of the most troubling things I have read in a long time. It is a recent speech by Dallas Federal Reserve President Richard W. Fisher. Last week I noted that Mr. Fisher has been the lone voice on the FOMC that has voted against Chairman Bernanke & Company, and argues that interest rates should be rising. In checking into Mr. Fisher's positions, I ran across the following speech he gave recently to the Commonwealth Club of California.

Let me warn you, Mr. Fisher's remarks are going to trouble you. They may even scare you. But you need to read what follows:

Remarks by Dallas Fed President Richard W. Fisher
May 28, 2008

[QUOTE] Thank you, Bruce [Ericson]. I am honored to be here this evening and am grateful for the invitation to speak to the Commonwealth Club of California.

Alan Greenspan and Paul Volcker, two of Ben Bernanke's linear ancestors as chairmen of the Federal Reserve, have been in the news quite a bit lately. Yet, we rarely hear about William McChesney Martin, a magnificent public servant who was Fed chairman during five presidencies and to this day holds the record for the longest tenure: 19 years...

Bill Martin was nominated to run and lose on the Alfalfa Party ticket in 1966, while serving as Fed chairman during Lyndon Johnson's term. In his acceptance speech, he announced that, given his proclivities as a central banker, he would take his cues from the German philosopher Goethe, "who said that people could endure anything except continual prosperity." Therefore, Martin declared, he would adopt a platform proclaiming that as a president he planned to "make life endurable again by stamping out prosperity."

"I shall conduct the administration of the country," he said, "exactly as I have so successfully conducted the affairs of the Federal Reserve. To that end, I shall assemble the best brains that can be found...ask their advice on all matters...and completely confound them by following all their conflicting counsel."

It is true, Bruce, that as you said in your introduction, I am one of the 17 people who participate in Federal Open Market Committee (FOMC) deliberations and provide Ben Bernanke with "conflicting counsel" as the committee cobbles together a monetary policy that seeks to promote America's economic prosperity, Goethe to the contrary. But tonight I speak for neither the committee, nor the chairman, nor any of the other good people that serve the Federal Reserve System. I speak solely in my own capacity. I want to speak to you tonight about an economic problem that we must soon confront or else risk losing our primacy as the world's most powerful and dynamic economy.

Forty-three years ago this Sunday, Bill Martin delivered a commencement address to Columbia University that was far more sober than his Alfalfa Club speech. The opening lines of that Columbia address were as follows: "When economic prospects are at their brightest, the dangers of complacency and recklessness are greatest. As our prosperity proceeds on its record-breaking path, it behooves every one of us to scan the horizon of our national and international economy for danger signals so as to be ready for any storm."

Today, our fellow citizens and financial markets are paying the price for falling victim to the complacency and recklessness Martin warned against. Few scanned the horizon for trouble brewing as we proceeded along a path of unparalleled prosperity fueled by an unsustainable housing bubble and unbridled credit markets. Armchair or Monday morning quarterbacks will long debate whether the Fed could have/should have/would have taken away the punchbowl that lubricated that blowout party. I have given my opinion on that matter elsewhere and won't go near that subject tonight. What counts now is what we have done more recently and where we go from here. Whatever the sins of omission or commission committed by our predecessors, the Bernanke FOMC's objective is to use a new set of tools to calm the tempest in the credit markets to get them back to functioning in a more orderly fashion. We trust that the various term credit facilities we have recently introduced are helping restore confidence while the credit markets undertake self-corrective initiatives and lawmakers consider new regulatory schemes.

I am also not going to engage in a discussion of present monetary policy tonight, except to say that if inflationary developments and, more important, inflation expectations, continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic economic scenario. Inflation is the most insidious enemy of capitalism. No central banker can countenance it, not least the men and women of the Federal Reserve.

Tonight, I want to talk about a different matter. In keeping with Bill Martin's advice, I have been scanning the horizon for danger signals even as we continue working to recover from the recent turmoil. In the distance, I see a frightful storm brewing in the form of untethered government debt. I choose the words—"frightful storm"—deliberately to avoid hyperbole. Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets that we are now working so hard to correct.

You might wonder why a central banker would be concerned with fiscal matters. Fiscal policy is, after all, the responsibility of the Congress, not the Federal Reserve. Congress, and Congress alone, has the power to tax and spend. From this monetary policymaker's point of view, though, deficits matter for what we do at the Fed. There are many reasons why. Economists have found that structural deficits raise long-run interest rates, complicating the Fed's dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road. I will return to that shortly. First, let me give you the unvarnished facts of our nation's fiscal predicament.

Eight years ago, our federal budget, crafted by a Democratic president and enacted by a Republican Congress, produced a fiscal surplus of $236 billion, the first surplus in almost 40 years and the highest nominal-dollar surplus in American history. While the Fed is scrupulously nonpartisan and nonpolitical, I mention this to emphasize that the deficit/debt issue knows no party and can be solved only by both parties working together. For a brief time, with surpluses projected into the future as far as the eye could see, economists and policymakers alike began to contemplate a bucolic future in which interest payments would form an ever-declining share of federal outlays, a future where Treasury bonds and debt-ceiling legislation would become dusty relics of a long-forgotten past. The Fed even had concerns about how open market operations would be conducted in a marketplace short of Treasury debt.

That utopian scenario did not last for long. Over the next seven years, federal spending grew at a 6.2 percent nominal annual rate while receipts grew at only 3.5 percent. Of course, certain areas of government, like national defense, had to spend more in the wake of 9/11. But nondefense discretionary spending actually rose 6.4 percent annually during this timeframe, outpacing the growth in total expenditures. Deficits soon returned, reaching an expected $410 billion for 2008—a $600 billion swing from where we were just eight years ago. This $410 billion estimate, by the way, was made before the recently passed farm bill and supplemental defense appropriation and without considering a proposed patch for the Alternative Minimum Tax—all measures that will lead to a further ballooning of government deficits.

In keeping with the tradition of rosy scenarios, official budget projections suggest this deficit will be relatively short-lived. They almost always do. According to the official calculus, following a second $400-billion-plus deficit in 2009, the red ink should fall to $160 billion in 2010 and $95 billion in 2011, and then the budget swings to a $48 billion surplus in 2012.

If you do the math, however, you might be forgiven for sensing that these felicitous projections look a tad dodgy. To reach the projected 2012 surplus, outlays are assumed to rise at a 2.4 percent nominal annual rate over the next four years—less than half as fast as they rose the previous seven years. Revenue is assumed to rise at a 6.7 percent nominal annual rate over the next four years—almost double the rate of the past seven years. Using spending and revenue growth rates that have actually prevailed in recent years, the 2012 surplus quickly evaporates and becomes a deficit, potentially of several hundred billion dollars.

Doing deficit math is always a sobering exercise. It becomes an outright painful one when you apply your calculator to the long-run fiscal challenge posed by entitlement programs. Were I not a taciturn central banker, I would say the mathematics of the long-term outlook for entitlements, left unchanged, is nothing short of catastrophic.

Typically, critics ranging from the Concord Coalition to Ross Perot begin by wringing their collective hands over the unfunded liabilities of Social Security. A little history gives you a view as to why. Franklin Roosevelt originally conceived a social security system in which individuals would fund their own retirements through payroll-tax contributions. But Congress quickly realized that such a system could not put much money into the pockets of indigent elderly citizens ravaged by the Great Depression. Instead, a pay-as-you-go funding system was embraced, making each generation's retirement the responsibility of its children.

Now, fast forward 70 or so years and ask this question: What is the mathematical predicament of Social Security today? Answer: The amount of money the Social Security system would need today to cover all unfunded liabilities from now on—what fiscal economists call the "infinite horizon discounted value" of what has already been promised recipients but has no funding mechanism currently in place—is $13.6 trillion, an amount slightly less than the annual gross domestic product of the United States.

Demographics explain why this is so. Birthrates have fallen dramatically, reducing the worker-retiree ratio and leaving today's workers pulling a bigger load than the system designers ever envisioned. Life spans have lengthened without a corresponding increase in the retirement age, leaving retirees in a position to receive benefits far longer than the system designers envisioned. Formulae for benefits and cost-of-living adjustments have also contributed to the growth in unfunded liabilities.

The good news is this Social Security shortfall might be manageable. While the issues regarding Social Security reform are complex, it is at least possible to imagine how Congress might find, within a $14 trillion economy, ways to wrestle with a $13 trillion unfunded liability. The bad news is that Social Security is the lesser of our entitlement worries. It is but the tip of the unfunded liability iceberg. The much bigger concern is Medicare, a program established in 1965, the same prosperous year that Bill Martin cautioned his Columbia University audience to be wary of complacency and storms on the horizon.

Medicare was a pay-as-you-go program from the very beginning, despite warnings from some congressional leaders...who foresaw some of the long-term fiscal issues such a financing system could pose. Unfortunately, they were right.

Please sit tight while I walk you through the math of Medicare. As you may know, the program comes in three parts: Medicare Part A, which covers hospital stays; Medicare B, which covers doctor visits; and Medicare D, the drug benefit that went into effect just 29 months ago. The infinite-horizon present discounted value of the unfunded liability for Medicare A is $34.4 trillion. The unfunded liability of Medicare B is an additional $34 trillion. The shortfall for Medicare D adds another $17.2 trillion. The total? If you wanted to cover the unfunded liability of all three programs today, you would be stuck with an $85.6 trillion bill. That is more than six times as large as the bill for Social Security. It is more than six times the annual output of the entire U.S. economy.

Why is the Medicare figure so large? There is a mix of reasons, really. In part, it is due to the same birthrate and life-expectancy issues that affect Social Security. In part, it is due to ever-costlier advances in medical technology and the willingness of Medicare to pay for them. And in part, it is due to expanded benefits—the new drug benefit program's unfunded liability is by itself one-third greater than all of Social Security's.

Add together the unfunded liabilities from Medicare and Social Security, and it comes to $99.2 trillion over the infinite horizon. Traditional Medicare composes about 69 percent, the new drug benefit roughly 17 percent and Social Security the remaining 14 percent.

I want to remind you that I am only talking about the unfunded portions of Social Security and Medicare. It is what the current payment scheme of Social Security payroll taxes, Medicare payroll taxes, membership fees for Medicare B, copays, deductibles and all other revenue currently channeled to our entitlement system will not cover under current rules. These existing revenue streams must remain in place in perpetuity to handle the "funded" entitlement liabilities. Reduce or eliminate this income and the unfunded liability grows. Increase benefits and the liability grows as well.

Let's say you and I and Bruce Ericson and every U.S. citizen who is alive today decided to fully address this unfunded liability through lump-sum payments from our own pocketbooks, so that all of us and all future generations could be secure in the knowledge that we and they would receive promised benefits in perpetuity. How much would we have to pay if we split the tab? Again, the math is painful. With a total population of 304 million, from infants to the elderly, the per-person payment to the federal treasury would come to $330,000. This comes to $1.3 million per family of four—over 25 times the average household's income.

Clearly, once-and-for-all contributions would be an unbearable burden. Alternatively, we could address the entitlement shortfall through policy changes that would affect ourselves and future generations. For example, a permanent 68 percent increase in federal income tax revenue—from individual and corporate taxpayers—would suffice to fully fund our entitlement programs. Or we could instead divert 68 percent of current income-tax revenues from their intended uses to the entitlement system, which would accomplish the same thing.

Suppose we decided to tackle the issue solely on the spending side. It turns out that total discretionary spending in the federal budget, if maintained at its current share of GDP in perpetuity, is 3 percent larger than the entitlement shortfall. So all we would have to do to fully fund our nation's entitlement programs would be to cut discretionary spending by 97 percent. But hold on. That discretionary spending includes defense and national security, education, the environment and many other areas, not just those controversial earmarks that make the evening news. All of them would have to be cut—almost eliminated, really—to tackle this problem through discretionary spending.

I hope that gives you some idea of just how large the problem is. And just to drive an important point home, these spending cuts or tax increases would need to be made immediately and maintained in perpetuity to solve the entitlement deficit problem. Discretionary spending would have to be reduced by 97 percent not only for our generation, but for our children and their children and every generation of children to come. And similarly on the taxation side, income tax revenue would have to rise 68 percent and remain that high forever. Remember, though, I said tax revenue, not tax rates. Who knows how much individual and corporate tax rates would have to change to increase revenue by 68 percent?

If these possible solutions to the unfunded-liability problem seem draconian, it's because they are draconian. But they do serve to give you a sense of the severity of the problem. To be sure, there are ways to lessen the reliance on any single policy and the burden borne by any particular set of citizens. Most proposals to address long-term entitlement debt, for example, rely on a combination of tax increases, benefit reductions and eligibility changes to find the trillions necessary to safeguard the system over the long term.

No combination of tax hikes and spending cuts, though, will change the total burden borne by current and future generations. For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact. The decision we must make is whether to shoulder a substantial portion of that burden today or compel future generations to bear its full weight.

Now that you are all thoroughly depressed, let me come back to monetary policy and the Fed.

It is only natural to cast about for a solution—any solution—to avoid the fiscal pain we know is necessary because we succumbed to complacency and put off dealing with this looming fiscal disaster. Throughout history, many nations, when confronted by sizable debts they were unable or unwilling to repay, have seized upon an apparently painless solution to this dilemma: monetization. Just have the monetary authority run cash off the printing presses until the debt is repaid, the story goes, then promise to be responsible from that point on and hope your sins will be forgiven by God and Milton Friedman and everyone else.

We know from centuries of evidence in countless economies, from ancient Rome to today's Zimbabwe, that running the printing press to pay off today's bills leads to much worse problems later on. The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid.

Earlier I mentioned the Fed's dual mandate to manage growth and inflation. In the long run, growth cannot be sustained if markets are undermined by inflation. Stable prices go hand in hand with achieving sustainable economic growth. I have said many, many times that inflation is a sinister beast that, if uncaged, devours savings, erodes consumers' purchasing power, decimates returns on capital, undermines the reliability of financial accounting, distracts the attention of corporate management, undercuts employment growth and real wages, and debases the currency.

Purging rampant inflation and a debased currency requires administering a harsh medicine. We have been there, and we know the cure that was wrought by the FOMC under Paul Volcker. Even the perception that the Fed is pursuing a cheap-money strategy to accommodate fiscal burdens, should it take root, is a paramount risk to the long-term welfare of the U.S. economy. The Federal Reserve will never let this happen. It is not an option. Ever. Period.

The way we resolve these liabilities—and resolve them we must—will affect our own well-being as well as the prospects of future generations and the global economy. Failing to face up to our responsibility will produce the mother of all financial storms. The warning signals have been flashing for years, but we find it easier to ignore them than to take action. Will we take the painful fiscal steps necessary to prevent the storm by reducing and eventually eliminating our fiscal imbalances? That depends on you.

I mean "you" literally. This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them. You are the ones who let them get away with burdening your children and grandchildren rather than yourselves with the bill for your entitlement programs.

This issue transcends political affiliation. When George Shultz, one of San Francisco's greatest Republican public servants, was director of President Nixon's Office of Management and Budget, he became worried about the amount of money Congress was proposing to spend. After some nights of tossing and turning, he called legendary staffer Sam Cohen into his office. Cohen had a long memory of budget matters and knew every zig and zag of budget history. "Sam," Shultz asked, "tell me something just between you and me. Is there any difference between Republicans and Democrats when it comes to spending money?" Cohen looked at him, furrowed his brow and, after thinking about it, replied, "Mr. Shultz, there is only one difference: Democrats enjoy it more."

Yet no one, Democrat or Republican, enjoys placing our children and grandchildren and their children and grandchildren in harm's way. No one wants to see the frightful storm of unfunded long-term liabilities destroy our economy or threaten the independence and authority of our central bank or tear our currency asunder.

Of late, we have heard many complaints about the weakness of the dollar against the euro and other currencies. It was recently argued in the op-ed pages of the Financial Times that one reason for the demise of the British pound was the need to liquidate England's international reserves to pay off the costs of the Great Wars. In the end, the pound, it was essentially argued, was sunk by the kaiser's army and Hitler's bombs. Right now, we—you and I—are launching fiscal bombs against ourselves. You have it in your power as the electors of our fiscal authorities to prevent this destruction. Please do so.

Note: The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System. [END QUOTE]

Deficits To Explode In Coming Decades

The following chart provided by the Heritage Foundation, based on Congressional Budget Office projections, illustrates how federal deficits will explode over the next 70 or so years due to the skyrocketing costs of Social Security, Medicare and Medicaid. Sadly, this is the future we are leaving for our children and grandchildren.

Conclusions

I think any intelligent person who reads Mr. Fisher's speech above will realize that there is no way the United States can afford to pay the nearly one hundred trillion dollars (or more) in unfunded liabilities of Social Security, Medicare and Medicaid over the coming decades. Some might argue that the government should simply "print" the money to pay for it. That would be disastrous! It would result in an explosion in inflation, followed by a depression, in my opinion, not to mention the implosion of the major investment markets.

I wish I had the solution or at least some creative suggestions for the future, so that we could end this E-Letter on a positive note. But I do not. Our politicians have knowingly created an entitlement state that we can never pay for - all with the unstated purpose of buying our votes.

Mr. Fisher's admonishment to all of us is to elect responsible representatives who will take necessary action. And what action would that be? Cut government spending dramatically and balance the budget. Yetwe've seen both parties spend outrageously when in power, and neither party has made any serious attempt to address the looming Social Security and Medicare crises.

President Bush made a half-hearted attempt to put Social Security on the table following his re-election in 2004. He was roundly criticized by the Democrats and ignored by the Republicans. Thus, Mr. Fisher's advice is easy to give, but hard to follow.

Even if we had disciplined leaders in the White House and in Congress who were willing to risk their political careers to tackle the massive unfunded entitlement liability, now approaching $100 trillion dollars, the question is, have we waited too long? Obviously. Are these expenditures on autopilot without any way to avoid the massive deficits that are sure to come? They certainly are today.

So why is virtually no one talking about it? Why is it that we are only hearing this warning from the president of the Federal Reserve Bank of Dallas? Why not Fed chairman Bernanke? And why is it that this isn't an issue for either of the current presidential candidates?

I wish I knew the answers. In closing, the following civilization cycle comes to mind. Each of the great civilizations in the world passed through a series of stages from their birth to their decline to their death. Historians have listed these in ten stages:

Bondage to spiritual faith, to great courage to liberty, to abundance to selfishness, to complacency to apathy, to moral decay to dependence, and back to bondage.

Sorry to end on a negative note, but it is what it is.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

How Obama is like his communist father (bet you haven't seen this).
http://www.ibdeditorial.com/IBDArticles.aspx?id=303952499910291

McCain Shines at Saddleback Forum (he really did!)
http://www.realclearpolitics.com/articles/2008/08/small_hopes_and_large_upsets.html

Is the tide turning for McCain? (libs are getting nervous)
http://ac360.blogs.cnn.com/2008/08/18/is-the-tide-turning/

Ukraine & Georgia should be admitted to NATO now.
http://ibdeditorials.com/IBDArticles.aspx?id=303952651252204

Retirement Focus - More Post-Retirement Investing

Gary D. Halbert — Tue, 15 Jul 2008 19:57:50 GMT

by Mike Posey

IN THIS ISSUE:

A Primer On Variable Annuities
Variable Deferred Annuities
Disadvantages Of Variable Deferred Annuities
Variable Annuities Continue To Improve
Retirement Tidbit – Making The Most Of Retirement

Introduction

This week, I am going to continue the series of E-Letters dedicated to investing during retirement. In past Retirement Focus issues, I have covered how to determine how much money is enough at retirement, as well as the various ways of taking retirement income. However, the success of any withdrawal option is going to hinge upon the way your nest egg is invested during retirement.

In my initial discussion about post-retirement investing in the May 27 Retirement Focus, I mentioned that there are a myriad of ways to invest during the payout phase, each with its own set of advantages and disadvantages. For purposes of simplifying our discussion, I categorized these investment strategies into the following broad categories:

Immediate Annuities;
Fixed Income Alternatives;
Variable Annuities;
Asset Allocation Alternatives;
Actively Managed Strategies; and
Other Alternatives.

I covered the first two of these alternatives in the May 27 E-Letter. However, I realize that immediate annuities and fixed income alternatives are considered to be among the most conservative of investment strategies, so they may not be able to provide the level of income needed for retirement. This is especially true in light of Baby Boomers who have not saved enough for retirement, as well as the prospect of ever-increasing life expectancies.

This week, I'll delve deeper into alternative #3, variable annuities, which have the potential for higher gains and the prospect of higher withdrawals during retirement. However, as we move up the list of post-retirement investment alternatives, it is also important to note that we also increase the risk of investment loss.

I'm also going to revive the “Retirement Tidbit” concept that I discussed when I first started writing these Retirement Focus E-Letters. These tidbits are ideas or resources related to retirement that probably wouldn't fill up an entire e-letter, but are still important to mention. This week, our tidbit is even more interesting in that it involves a publication written by a Forecasts & Trends E-Letter reader. I think you'll enjoy what he has to say.

I want to remind you that any investment information provided in this E-Letter is general in nature, and should not be construed as investment or insurance advice. You should always evaluate insurance and investment options in light of your personal financial situation, retirement goals and any special circumstances you may have. Ideally, you should consult a qualified insurance and/or investment professional who can take the time to review your situation and tailor an investment approach to meet your needs.

Variable Annuity Investments

Variable annuities have been around for a long time, and are experiencing a new growth trend as the Baby Boom generation is beginning to take retirement a little more seriously. As I mentioned in the May 27 Retirement Focus issue, a variable annuity is often defined as being a “mutual fund in an insurance wrapper,” but not everyone knows what that means.

In this article, I'll seek to better explain the variable annuity concept as well as discuss when these contracts may be the best alternatives for part of your post-retirement investing. Note, however, that a discussion about all of the characteristics of variable annuities is far beyond the scope of this brief E-Letter. Since the theme of this series of E-Letters is how to invest during retirement, I'll keep most of my comments focused on the features of variable annuities that may make them suitable for that phase of your investing life.

Basically, a variable annuity is a type of deferred annuity contract where returns are dependent upon the market performance of a selected group of investments. Thus, variable annuities differ from fixed annuities in that returns are tied to the market and not a pre-determined fixed rate of return set by the insurance company. They also differ in that market action can result in losses as well as gains in a variable contract.

To access market-rate returns, each variable annuity offers a group of equity and/or bond “sub-accounts,” which are essentially mutual funds within the annuity. While various types of insurance provisions can guarantee the original principal and sometimes even certain gains upon the death of the annuitant, there are usually no guarantees as to a variable annuity's annual performance as there are in fixed annuities. There are, however, certain “living benefit” riders that I will discuss later on that can provide some measure of performance guarantee – for a fee.

As a practical matter, the management of the sub-accounts available in variable annuities is usually a matter of using asset allocation and/or active management investment strategies, both of which are alternative post-retirement investment strategies that will be covered in later Retirement Focus issues. Some companies also have pre-set portfolios from which to choose, but these are usually based on an asset allocation strategy tailored to various risk tolerance categories.

There are two basic types of variable annuities – variable immediate annuities and variable deferred annuities. The variable immediate annuity is much like the fixed immediate annuities I wrote about last time, in that they are designed to make periodic (usually monthly) distributions to an annuitant during retirement. The variable immediate annuity differs from the fixed version in that the amount of the periodic payment can change over time based on investment returns, while fixed immediate annuity payments are usually the same amount for life.

The potential for payments from a variable immediate annuity to increase over time can be a welcome feature for annuitants who are concerned about maintaining their purchasing power throughout retirement. As life expectancies continue to grow longer, the variable immediate annuity provides the potential for keeping up with the ravages of inflation. However, investment gains are obviously not guaranteed in a variable immediate annuity. If repeated losses occur, the payment from a variable immediate annuity could end up being far less than what would have been available from a fixed annuity.

To help counteract this disadvantage, some variable immediate annuity sponsors have come up with a “floor” payment, usually consisting of 80% or 85% of the amount of monthly payment at the beginning of the contract. With this feature, even if the sub-accounts incur investment losses, the monthly benefit will never fall below this floor. However, this added insurance comes at the cost of higher fees which, in turn, reduce the investment return of the sub-accounts.

The use of variable immediate annuities is growing, especially as Baby Boomers start hitting early retirement age. For some, the potential for monthly income payments to grow over time may help to offset the fact that they saved too little over their working lifetimes. For others, however, the possibility of receiving lower payments over time due to investment losses makes variable immediate annuities less attractive than the fixed immediate annuity. As a compromise, some investors include both fixed and variable immediate annuities in their retirement portfolios to provide a combination of stability and the potential for future gains.

Variable Deferred Annuities

The second type of variable annuity is the variable deferred annuity. Much like the fixed deferred annuity I discussed in my May 27 E-Letter, the variable deferred annuity is designed to be a way to accumulate savings on a tax-deferred basis over an investor's working lifetime. Ideally (at least for the insurance company), the variable annuity investor will convert the accumulated value at retirement into a variable immediate annuity income stream. However, according to most reports, very few deferred annuity contracts are ever “annuitized.”

While variable deferred annuities are typically an investment vehicle used during the accumulation phase of an investor's working lifetime, they are now being marketed to retirees in ever-increasing numbers. Part of the reason is that investors do not usually like putting all of their money into an immediate annuity where it is usually locked up for the rest of their lives with little or no liquidity. Another reason for this increased popularity among retirees is that insurance companies have become very creative in offering new riders for variable annuities that make them more attractive as a post-retirement option.

Even though variable deferred annuities might be suitable for both pre- and post-retirement investors, the focus of this E-Letter is investment alternatives during retirement. Thus, I'll focus most of my comments on features of variable deferred annuities that retirees find beneficial. I hope to do a separate, more general E-Letter on pre-retirement uses of variable deferred annuities sometime in the future.

That being said, the primary benefit of a variable deferred annuity in both pre-and post-retirement investment scenarios is tax-deferral. Gains within the contract are generally not taxed until withdrawn upon annuitization or surrender of the contract. This feature can be especially attractive when using active management strategies that produce short-term gains and losses.

In the past, variable deferred annuities were not viewed to be optimum post-retirement investments since periodic withdrawals were not encouraged, and sometimes even penalized. This restriction was generally the result of the long-term nature of the contract, as well as large up-front selling commissions that made it necessary for the insurance company to encourage keeping the contract in force, even if it meant subjecting the investor to significant surrender charges upon early termination.

However, as fewer workers are being covered by pension plans with guaranteed monthly benefits, the variable deferred annuity has evolved to be more “withdrawal friendly” for those in retirement. While many contracts still pay significant up-front commissions to the insurance agent and have surrender charges for early termination, they also provide for certain amounts of annual distributions that are not subject to an early withdrawal charge. Some have even gone so far as to provide for guaranteed levels of withdrawals even if the investment experience is negative.

In the insurance industry, such benefits are called “living benefits,” in that they are guarantees paid during the lifetime of an annuitant rather than to beneficiaries upon death. Living benefits can come in a variety of forms, with some being more important before retirement, and others afterwards. The living benefits most applicable to post-retirement investing are as follows:

Guaranteed minimum income benefits provide for a monthly income based on a stated annual growth rate, usually 5% to 7%, even if the actual investment results in the sub-accounts is less (or even negative). Note, however, that this benefit is generally only available if you take periodic income from the contract, but not if you want to surrender the contract for a lump sum.
Guaranteed minimum withdrawal benefits that allow an annuitant to withdraw a fixed percentage of the annuity premiums (usually 5% to 7%) for a specified period of time. Such withdrawals can continue until the end of the specified time, or until all premiums have been withdrawn. This feature guarantees return of all premiums, even if investment losses result in the loss of some of the original principal. However, investment gains can increase allowed withdrawals over time.
Guaranteed minimum withdrawals for life allow an annuitant to withdraw a smaller percentage, usually 4% to 5%, of the original premium for life, without regard to investment performance. Thus, these payments continue even after they reach the amount of original premium paid, and even if poor investment performance erodes principal. As above, good investment performance can increase future withdrawals.

These guaranteed income features are what really separates variable deferred annuities from mutual fund investment portfolios. Sure, it's possible to set up an investment portfolio to pay a certain level of income, and have that income vary with the performance of the underlying investments. It may even be possible to guarantee principal over a certain period of time using zero coupon bonds. However, mutual fund companies and brokerage firms are not going to guarantee all or part of that payment for the life of the investor. Insurance companies, on the other hand, specialize in such guarantees.

A final benefit of a variable deferred annuity may be asset protection. In some states, money held in annuity contracts may be protected from creditors. In such cases, physicians and others in occupations with a high economic risk may find that asset protection may offset any negatives associated with these contracts. However, asset protection is not available in all states, so it's important to contact your state insurance regulator to determine whether or not this benefit is available where you live.

That's the good news. The bad news is that all of the favorable features discussed above come at a cost, and sometimes this cost can be considerable. Plus, the cost is sometimes not measured in dollars, but rather in lost flexibility or access to your principal. Therefore, along with the various advantages discussed above, it's also important to review some possible disadvantages of variable deferred annuities as a post-retirement investment.

Drawbacks Of Variable Deferred Annuities

In the investment industry, the variable deferred annuity is either one of the most valued or most maligned investments, depending upon your perspective. As I discussed above, variable deferred annuity contracts offer the ability to participate in market gains and losses on a tax-deferred basis, as well as provide some level of insurance benefit to heirs. Some also offer living benefits that offset some of the criticisms of earlier generation variable annuity contracts.

Outside of the insurance industry, however, variable deferred annuities generally get a cold reception. Liz Pulliam Weston has an article about variable deferred annuities on the MSN Money website entitled, “The Worst Retirement Investment You Can Make.” Just the title gives you some idea of how many Investment Advisors view variable annuities. This and many other similar articles I have reviewed discuss that the benefits offered by variable deferred annuities are more than offset by negative features of these contracts. These disadvantages include, but are not limited to, the following:

Tax deferral or tax trap? As noted above, one of the most frequently cited advantages of variable deferred annuities is the deferral of taxation on investment gains. However, what's not always said is that a variable deferred annuity converts all types of gains to ordinary income. Thus, there are no long-term capital gains or dividend tax treatment, just ordinary income subject to the standard tax rates. Tax rules also dictate how much of each distribution is taxable income and how much is return of principal, which can reduce tax planning flexibility.

In retirement, any amount paid in income taxes obviously reduces the amount available to spend for life's necessities. The current tax rates for dividends and long-term capital gains are very attractive, and can reduce the tax bite on retirement distributions. That being the case, the tax deferral available in a variable deferred annuity may not be worth the difference in tax rates that may apply. Should dividend and capital gains tax rates rise in the future, then this disadvantage may become less of a factor.
Next, opponents of variable deferred annuities cite the penalties for early withdrawal as a major negative. While there is a special penalty tax that applies to distributions prior to age 59½, that is not a consideration for this article as we are talking about post-retirement investments which usually occur after that age. Instead, the issue is being locked into an insurance contract by way of surrender charges that can last 10 years or more, depending upon the contract.
Variable deferred annuities also have a death benefit that guarantees beneficiaries receive no less than the premiums paid, and sometimes even part of the gains earned on the contract. Opponents, however, say that this insurance is often of little value and is overpriced.
Advisors also complain that all of the bells and whistles now available in variable deferred annuity contracts make them far more complex, both for agents to sell and clients to understand. This complexity, or what we like to call “moving parts,” can have a far different effect than what is anticipated by the annuitant.
Some of the insurance companies offering guaranteed living benefits do so on the condition that the premium is invested only in designed portfolios established by the company. This, in turn, reduces investment flexibility for the investor in exchange for guaranteed levels of income or withdrawals.
Fees – Fees – Fees. As in just about any endeavor in life, variable annuity guarantees come at a cost. In some cases, the cost to provide insurance, guaranteed benefits and investment management shaves quite a bit off of the return realized in the sub-accounts. Morningstar reports that the average variable deferred annuity contract charges fees of 2.44%, including fees for managing the sub-accounts, while the average open-ended mutual fund charges 1.32%.
Perhaps the biggest rub comes in the form of surrender penalties for early termination, since these are usually designed to cover the large up-front commissions paid to insurance agents on many variable deferred annuity contracts. It seems that the fee-only Investment Advisor world has a problem with those who sell on commission, and perhaps they always will.
This conflict is at least partially due to the fact that relatively high front-end commissions coupled with restricted exit provisions lend themselves to questionable sales practices. Consequently, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) keep variable annuity sales practices under close regulatory scrutiny. Stories abound of agents who have sold variable annuities to investors who were unsuitable for such investments, primarily for the purpose of maximizing their commissions.

While the above discussion of advantages and disadvantages does not contain every possible pro or con of variable annuities, my primary focus has been to make you aware that they are not the one-stop retirement investments that some free-lunch seminars make them out to be. Where they work, they can be a big advantage. Where they don't, however, they can be disastrous.

Variable Annuities Continue To Improve

So, how should a retiree approach the issue of buying a variable annuity? The first thing to do is realize that deferred and immediate variable annuity contracts are two of many tools available to retirees to provide income during retirement. However, they are not necessarily the best choice for all retirees. Variable annuities seem to work best for investors who value guarantees and are concerned about outliving their money, but who also want the potential to share in market gains over time.

Since I have worked for a life insurance company in the past, my opinion may be a little different than those of other Investment Advisors. I tend to think that both variable deferred and immediate annuities have a place in some investors' portfolios, but the situation has to be just right. I also think that the insurance industry is getting close to a more viable combination of guarantees and features at an acceptable level of fees.

For example, several companies have already come out with “longevity insurance,” which is an immediate annuity that is purchased at retirement, say age 65, but starts paying a lifetime monthly income at age 80 or 85. This type of policy allows retirees to take larger withdrawals in early years from other assets, knowing that a safety net will kick in later on.

We have also seen the insurance industry roll out some variable annuity policies aimed at fee-only Investment Advisors instead of commissioned agents, and I expect these offerings will be expanded in the future. A good example of this is a variable annuity policy that we offer to our clients that has no commissions, no surrender penalty and no insurance charges. The only fee is a flat monthly charge to maintain the insurance policy, plus the regular investment management fees charged by our recommended Advisors.

As you can see, the insurance industry is being very proactive in meeting the needs of present and future retirees, and I look for them to continue to provide innovative retirement solutions in the future. With 78 million Baby Boomers approaching retirement, they have every incentive to do so.

Retirement Tidbit – Making The Most Of Retirement

Since I began writing these Retirement Focus issues last year, the primary focus has been on the financial aspects of retirement. Working for an Investment Advisory firm, these issues tend to be our primary focus, especially as we read that members of the Baby Boom generation have not set enough money aside for their eventual retirement. However, the financial aspect of retirement is just one of many things to consider for those who are at or near retirement age.

Recently, I was very pleasantly surprised to receive a package in the mail from one of our readers, Dave Brazier. While Dave praised the work I had done on the financial aspects of retirement, he reminded me that another important aspect for retirees is how best to utilize their time in such a way as to “bring them fulfillment and enjoyment in their retirement years.”

Dave's comments immediately made me think back to the many individuals I have known and talked to about their retirement. When I was younger, I didn't think much about time management in retirement, since it seemed to me that retirees had all the time in the world to do anything they wanted. However, as I worked in the retirement field and talked to more people who were actually in retirement, most said that the reality of retirement is very different than what they had planned.

We often joke about retirees spending all of their time traveling or fishing or playing golf, but I learned from my retired friends that there is only so much fishing or golfing you can do before boredom sets in. In other words, these things were great as diversions from a busy workload, but were not as much fun when they became the “only thing to do.”

Fortunately, Dave has a solution for our readers who are retired, or who are nearing that goal. Since his own retirement in May of 2000, Dave has explored ways to successfully move from working full time to a fulfilling retirement. The results have been collected in a book he has entitled, “Have the Time of Your Life in Retirement.” This book offers a wealth of planning and time management advice drawn from Dave's own retirement experience. However, rather than describing it myself, I'll put it in Dave's own words from his letter:

“The enclosed book…describes a simple process to help people transition from the work force into retirement and provides insights to help retirees enrich their retirement living. Almost everyone who reads [my book] will find an activity or some advice that will enhance their retirement experience.”

“The book describes a key process I used to help me in my successful transition to a fulfilling retirement in New Hampshire. This tool helped me broaden my activities to include trout fishing, keeping a journal, cooking, hunting wild mushrooms, making maple sugar, doing crossword puzzles, making apple cider, etc. [makes you wonder how he found the time to write a book, doesn't it? JMP] It has been a process that has continued to guide me over the last eight years. Retirement should be an exciting phase of people's lives and this book can help retirees achieve this objective.”

“[My book] is ideal for the person who is considering or in the process of retiring. Often people do not adequately prepare for life after working and boredom sets in after the initial retirement euphoria begins to fade. This book can help prevent this phenomenon. It is also ideal for those who have retired and have not achieved the excitement or fulfillment they expected. This book can help them explore the available alternatives. In addition, it can also serve as a valuable resource for those who are in retirement and having a great time. I know I am always looking for new ideas or activities to add to my ‘potential to do' list. This book was written to aid people in finding new passions in life.”

I think the thing that struck me the most about Dave's letter and his book is his use of the words “excitement” and “fulfillment.” I have to admit that when I think of retirement, “rest” is the first word that comes to mind. However, Dave seems to realize that “rest” can lead to “rust,” and I've always heard that it's better to wear out than rust out.

I found Dave's book to be concise and easy to read. It's only 90 pages, including Appendices, so it's easy to read in one sitting. However, if you employ all of his suggestions and checklists, it will keep you busy much longer, possibly for the rest of your retirement years. It has the ring of a book by someone who has not only mastered his own retirement strategy, but who earnestly wants to help others to find the same level of fulfillment.

Dave's book is available from Amazon.Com, Barnes and Noble, www.tatepublishing.com or www.retiretothegoodlife.com, and is distributed by Ingram/Spring Arbor, a major book supplier. The price on Amazon is only $9.99, a small investment to make for an enjoyable retirement. Neither ProFutures Investments nor Halbert Wealth Management will receive any compensation should you decide to purchase Dave's book.

I highly recommend this book to anyone who is at or near retirement, and I think it's a great “how-to” book for just about anyone contemplating how they will spend their retirement years. Even if you have been retired for a number of years, Dave's book may be able to help you find additional activities that can lead to greater fulfillment.

There are also a number of other resources available to retirees that can also help add enjoyment to their retirement years. One that I came across years ago is an Internet-based organization with the address of www.2young2retire.com. This website has a number of activities and resources to consider, and also has a periodic e-mail update available by subscription. Of course, you can also obtain information about retirement activities from the AARP website (www.aarp.org), if you can make it past all of the political stuff.

Conclusion

As we have seen, variable deferred and immediate annuities are among the many tools available to retirees and financial professionals. While they offer many advantages in both pre- and post-retirement scenarios, they also have some significant disadvantages which must also be addressed before making an investment.

Reviewing all of the pros and cons of these investments is especially important since most contracts have significant surrender charges if you terminate the investment within the surrender period, which can be a period of seven years or more. Thus, it's not something that you can buy now and change your mind about next year.

You should also be aware that the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have both warned seniors about “free-lunch” seminars that subject attendees to high-pressure sales tactics in an attempt to get them to invest in variable annuities. According to these regulatory bodies, such seminars often misrepresent the benefits of variable annuities and downplay any disadvantages of these contracts. Be wary of any such invitations and never commit to purchase a variable annuity, or any other investment, before taking the materials home and thoroughly checking them out.

That's it for this week. In my next Retirement Focus issue, I'll continue discussing the various ways to invest during retirement. Until then, if you have any questions about the options given above, or would like me to cover a specific investment option, please feel free to contact me at info@halbertwealth.com.

Best regards,

Mike Posey

SPECIAL ARTICLES

Variable Annuities: Emerging From the Dark Side?
http://spwfe.fpanet.org:10005/public/Unclassified%20Records/FPA%20Journal%20March%202007%20-%20Focus_%20Reconsidering%20Annuities.pdf

"Free Lunch" Investment Seminars — Avoiding the Heartburn of a Hard Sell
http://www.finra.org/InvestorInformation/InvestmentChoices/InvestorNewsNewsletter/p036753

The Corn Ethanol Myth & My Retirement

Gary D. Halbert — Tue, 03 Jun 2008 21:46:16 GMT

IN THIS ISSUE:

Ethanol: A Feel-Good Political Ploy
No Solution To Current Fuel Woes
Potential Negative Economic Impact
No Benefit From Existing Infrastructure
Other Types Of Ethanol Show Promise
Conclusions – Ethanol Is Not The Silver Bullet

Pondering My Retirement

Introduction

You don’t need me to tell you that oil and gas prices are at record levels. It seems like folks talk about little else these days and rightly so. The massive increase in oil and gas prices has stunned the consumer. How far have prices risen over the past year? On May 22, 2007 crude hit a high of $66.35 and one year later on May 22, 2008 it hit an all-time high of $135.08; a 104% increase! Gasoline prices over the same time frame have gone from $3.22 a gallon to $3.93 a gallon on average nationwide. And if you are thinking that gas still has room to the upside, you are exactly right.

With that unpleasant news on all of our minds, we want to take a look this week at what many politicians are pushing as the key to our energy independence - corn ethanol. Corn ethanol is being promoted by politicians as the “silver bullet” to our energy problems, and farmers are racing to plant as much corn as they can everywhere that they can. But is corn ethanol really the answer? This week, we argue that the answer is probably not.

In the discussion below, Spencer Wright will walk us through the pros and cons of corn ethanol. Together, we will point out that corn ethanol is likely no more energy or cost effective than fossil fuels. Some experts argue that a gallon of corn ethanol requires more energy than it produces. We believe that corn ethanol is not the promised answer to US energy independence, and that the widespread promotion of ethanol, should it continue, will cause food prices to continue to ratchet higher in the years to come.

This is why we entitled this article “The Ethanol Myth.” What follows is a good deal of information you are not likely to hear in the mainstream press and certainly not from the politicians in Washington who have bought hook-line-and-sinker into the ethanol story for their own political gain.

And finally, as much as I hate to admit it, I am having thoughts of retirement even at the ripe old/young age of 56. I will share my thoughts with you at the end of this week’s E-Letter. Let’s get started.

THE ETHANOL MYTH

by Spencer Wright

Ethanol: A Feel-Good Political Ploy

Corn-based ethanol was first championed by US agribusiness during the 1970’s gasoline crisis and has now returned with a vengeance. This time it has been totally and completely embraced by politicians on both sides of the aisle in Congress. Why? Simple, it is green, it is economical and it will help us reduce our dependence on foreign oil, or so the politicians in Washington tell us. Yet as you will see below, corn ethanol is likely none of these things. By embracing corn-based ethanol, politicians can claim that they are environmentally friendly and that they are doing something about rising fuel costs all at the same time.

Of course it is no coincidence that massive agribusiness combines like Archer Daniels Midland have been promoting (read: lobbying for) corn ethanol in Washington since the 1970s. And they have been very, very successful. So successful, in fact, that ethanol receives a government price subsidy of apprx. $1.90 per gallon! And that is only part of the massive government perks for ethanol producers.

ADM is one of the largest grain producers in the world, possessing the capacity to produce over 1.1 billion gallons of corn ethanol per year for which it receives nearly $526,000,000 in total subsidies from the government. As a result ADM and other agribusiness combines are big time lobbyists for corn ethanol.

It is also important to remember that Iowa is a major corn and ethanol producer. Why is this important? Well, Iowa holds the first in the nation presidential caucus to launch each general election season. Prospective presidents can’t come through Iowa and bash corn-based ethanol. Those that do tend to lose.

So agribusiness lobbyists convince the politicians that corn ethanol is actually a viable alternative to petroleum; the politicians, in turn, redirect federal tax dollars to support the ethanol industry and agribusiness through subsidies and tax credits ($5.7 billion in federal tax credits over the next five years alone); and then they return to their constituencies where they tell us how green they are, and that they are working hard for a solution to high gas prices and are also making America more secure as we wean ourselves off of foreign oil.

I am sorry folks, but this is nothing but a “feel-good” political ploy that is terribly wrong.

No Solution To Current Fuel Woes

At this point, I want to clarify that most of my comments are related to ethanol made from corn, and not other sources such as sugar cane. While corn is something that America has in abundance, it is among the least efficient raw materials for making ethanol, as I will discuss in more detail below. All of the abundance and lobbying can’t change this fact.

Corn ethanol is very expensive to produce and would never make it in a free market without its massive federal subsidies. Even at $3.93 on average for gasoline? Yes. The current average price at the pump for E85 ethanol is $3.12. If we add on the $1.90 government subsidy, you get a per gallon price of $5.02. There are some who price E85’s real cost to the consumer at $6.89 per gallon after a number of other government subsidies and perks are added in. While I would not go that far, clearly corn ethanol cannot stand on its own.

Of course, it isn’t only the cost that weighs on corn ethanol. It is also highly inefficient. Ethanol from any source is 20-30% less efficient than gasoline, making it more expensive per highway mile. It takes about 450 pounds of corn to produce the ethanol to fill one SUV tank, or enough corn to feed the average person for a year.

But wait, it gets worse: some studies show that more than one gallon of combined fossil fuels is required to produce one gallon of corn ethanol. How can this be? Well, fields must be plowed, corn must be planted and grown, fertilized, harvested and trucked to ethanol producers - and all that uses fossil fuels. As a result, the energy production to energy output ratio of ethanol is very nearly 1:1. Not exactly an energy saving proposition, is it?

In addition, the process of making corn ethanol requires an estimated four gallons of water to produce one gallon of ethanol, and some studies show an even higher water-to-ethanol ratio. The pro-ethanol lobby disputes this assertion with some claiming that there is actually a gain of clean water from the process. Reading the pro-ethanol material, however, reveals that they do not consider the approximately 80% of the water used which evaporates during the cooling process as “lost.”

Here, I guess you have to think like an ecologist. While most of us think that alternative uses for water pulled from aquifers as being for irrigating other crops, drinking or other industrial uses, the pro-ethanol forces feel it’s just as valuable released as water vapor to return to the earth as rain at some point, eventually making it into reservoirs and the underground water table. To say the least, this is going to take quite a bit of time.

To an extent, they may be correct, but the question is how long are you willing to wait? Depleting scarce Midwest water resources now and then waiting for the water to return in the form of rain at some point is not an exact science. The Ogallala Aquifer below much of the Midwest is currently being depleted faster than it can be recharged, and cranking up more ethanol plants will accelerate this process.

Of course, that doesn’t seem to deter the corn ethanol faithful. 147 corn ethanol refineries have been built over the past 30 years, and hundreds more are under construction to be completed over the next decade. The Bush Administration has championed an increase in corn ethanol production over the next decade, seeking to create nearly 11.5 billion gallons a year of ethanol by 2017. Never mind that this level of ethanol production would require the usage of an estimated 50% of the nation’s corn crop each year.

Even IF this goal is accomplished, it will only replace approximately 10% or less of the nation’s fossil fuel usage. Currently ethanol represents only about 3% of total fuel consumption, hardly amounting to energy independence

Potential Negative Economic Impact

The government’s plan to drastically ramp up corn ethanol production to its 2017 goal is, to say the least, problematic. Diverting half of the nation’s corn crop to ethanol will create alarming repercussions in other areas – all of which will be felt in our pocketbooks. Consider this from the EPA:

According to the National Corn Growers Association, about eighty percent of all corn grown in the U.S. is consumed by domestic and overseas livestock, poultry, and fish production. The crop is fed as ground grain, silage, high-moisture, and high-oil corn. About 12% of the U.S. corn crop ends up in foods that are either consumed directly (e.g. corn chips) or indirectly (e.g. high fructose corn syrup).

So if 80% of the crop is used as feed, 12% as food and the remaining 8% or so is used for ethanol, what happens to the equation when ethanol skyrockets to 50% of total crop usage? It doesn’t take a genius to realize that prices will rise! As I write this, corn has just hit an all-time high of $6.00 per bushel. Just imagine where we go from here! Food costs are rising rapidly and will likely continue to do so. It is basic economics that all costs are passed along.

The US is currently experiencing the worst food price inflation in 17 years. Food prices rose 4% in 2007 and could rise as much as 4.5% or more in 2008 according to the Department of Agriculture. The April CPI summary from the Bureau of Labor Statistics has food and beverages increasing at an estimated annual rate of 6.1%! Compare this to an average annual rise of only 2.5% over the last 15 years.

Is corn ethanol solely to blame for these increases? No, at least not yet. But if the government’s plans to ramp up corn ethanol production to 11.5 billion gallons per year by 2017 actually come to pass, much higher food prices could be in our future.

As the average American family feels the squeeze of higher food and energy prices, farmers are poised to harvest a bumper crop of government cash. Through hundreds of billions of dollars in federal subsidies over the years, there has been nothing less than a naked transfer of wealth from non-farmers to farmers. Corn-based ethanol will only bloat federal subsidies and hasten this transfer of wealth.

Take the latest record large farm bill, for example. On May 14 and 15, the House and Senate voted overwhelmingly to pass the latest $307 billion farm bill which is loaded with pork and earmarks that will go to wealthy farmers in addition to windfall profits from soaring crop prices. Not only will the latest farm bill spend over $300 billion of taxpayer money, it also extends dozens of other federal farm subsidies for another 5-10 years. So the farm lobby succeeded in winning another government windfall even as farm incomes are exploding.

Don’t you find it interesting that consumers cry foul and want windfall profit taxes and an end to oil company subsidies when gas prices rise, but allow huge subsidies to corporate farms to go unchecked when food prices follow suit? Of course, no politician wants to be seen as turning his or her back on the “family farm,” so expect such misguided government giveaways to continue. Oh well… back to ethanol.

No Benefit From Existing Infrastructure

Another factor in the inefficiency of corn ethanol lies in the way it must be transported. The current energy flow infrastructure in the US is designed to transport fossil fuels, petroleum and natural gas, through specially designed and constructed pipelines. This means that no matter where you live, generally speaking you have roughly equal access to these fuels and at roughly the same market price across the country. This is not so for ethanol.

Because corn ethanol cannot be easily transported through existing petroleum pipelines, it has no existing national infrastructure and must therefore be transported by truck to one of the 1,556 E85 stations across the country. That is only about 8% of all gas stations in the US, and the trucks that transport the E85 are burning diesel or gasoline, thus contributing to corn ethanol’s inefficiency.

The lack of a unified infrastructure also leads to regional price instability. Currently there is a 15% or more spread in the price of E85 at the pump across the country, largely due to delivery costs. In my home state of Texas alone, there is a 9% spread across the state.

Since ethanol cannot use the current oil and gas infrastructure, a new one will have to be built specifically to handle ethanol, if the politicians have their way. Who knows how many hundreds of billions of dollars it will cost or how many decades it will take to build it? So we face the potential of a burgeoning ethanol industry with no centralized means of distribution that will only contribute to higher prices at the pump in the future.

Other Types Of Ethanol Show Promise

Not all forms of ethanol are as seemingly hopeless as corn ethanol. A significant step up from corn-based ethanol is sugar ethanol, which is the leading form of ethanol in global production, accounting for well over half. It is sugar and its byproducts that have fueled Brazil’s amazingly successful ethanol industry, which is far and away the world leader.

Brazil’s ethanol program uses cheap sugar cane, mainly bagasse or cane-waste. This, combined with modern equipment, provides a 22% ethanol blend used in petroleum nationwide, as well as a 100% hydrous ethanol for the country’s four million cars. Today, Brazil gets more than 30% of its automobile fuels from sugar cane-based ethanol.

Unlike corn, sugar ethanol provides a much higher energy production-to-output ratio of about 1:6 to 1:8. This makes it several times more efficient than corn. So why don’t we use sugar based ethanol? Actually, we do, non-maize (corn) ethanol production in the US accounts for 3% of total production.

Why so little when it is clearly superior to corn? Well, for one thing, the agribusiness lobby is far too strong to allow sugar to have a chance in the US. The other limitation to producing sugar ethanol in the US is our climate. Only Florida, Louisiana, Hawaii and Texas have suitable climates for growing sugar cane, and only in certain areas of those states. And forget about importing sugar-based ethanol, because there’s a stiff $0.54 per gallon tariff on all imported ethanol, thanks to the agribusiness lobby.

Brazil has managed to carve out a thriving ethanol industry that employs over a million people and exports hundreds of millions of barrels a year - including about 160 million to the US (despite the tariff). Notorious global financier George Soros has recently invested $900 million in Brazilian ethanol production.

Actually, there are forms of ethanol that are even more efficient than sugar. Cellulosic ethanol is produced from “lignocellulosic biomass” which is wood residue, paper waste, agricultural residue and some dedicated crops like tall woody grasses. This form of ethanol has the capacity to produce 1:10 to 1:12 input/output ratio. Cellulosic ethanol facilities are currently under construction, though they will represent only a small portion of overall US ethanol production for now.

Conclusions – Ethanol Is Not The Silver Bullet

It is clear that corn ethanol, despite being a darling of the politicians, is not the answer to rising fuel costs or energy independence. As discussed above, corn ethanol is inefficient to produce and results in an input output ratio arguably no better than 1:1. But even if we include the more efficient forms of ethanol such as sugar and cellulosic, ethanol is still not the answer to our energy dilemma. There is no panacea to replace fossil fuels. It is going to take more than one new source of energy.

Ethanol may be a step in the right direction, as will other promising technologies such as advanced electric power and fuel cell technology. The key point to remember is that petroleum is an extremely versatile resource. As such, it does not lend itself to being replaced by a single alternative fuel. Instead, it will take several new sources of energy to replace fossil fuels.

Unfortunately, the fact is that even in the best of circumstances, these emerging energy technologies are likely 10-15 years away from having any significant impact. Thus, the only short-term solutions to domestic fuel costs is to increase the supply of fossil fuels from existing sources, and this means opening up more wells in the US (including ANWR and offshore), tap more proven reserves, construct new refineries, build both coal and nuclear power plants and change our consumption levels thorough elevated CAFÉ (Corporate Average Fuel Economy) standards and lifestyle alteration. And all of that will still take at least five years or so to have a substantial impact.

It now appears that high energy prices are here to stay and we all need to find a way to adjust. Back to you, Gary.

My Take On Ethanol
by Gary Halbert

Thanks, Spencer.

When I asked Spencer to research and write a piece on ethanol, I knew it would result in competing claims. For every argument in favor of corn ethanol, you can find one (or more) on the other side of the issue. Each side has its own set of studies, but they point in very different directions.

That being the case, how can we non-scientists know which claims are correct and which are bogus? I wish I had the answer, but I don’t. What I do know is that corn appears to be an inefficient raw material upon which to base our hopes for energy independence and, more importantly, if we commit 50% of future corn crops to ethanol, food prices will skyrocket even further. I’m not sure that American citizens realize the economic impact this feel-good policy may have on their pocketbooks.

With politicians having now jumped on the corn ethanol bandwagon, one might think that we could depend upon our elected officials to cut through the confusion and come up with a solution based on the real facts. Unfortunately, we all know that money greases the wheels in Washington, so the lobbyists will likely have more influence than any objective scientists.

The result is that it is likely to cost us all more money to buy food and fuel because of a politically expedient solution that embraces an inefficient technology. The thought of all the other political “solutions” that ended up having unintended consequences later on comes to mind.

Along that same line of thought, I have been following another piece of legislation that also has its genesis in questionable science. The Lieberman-Warner “Climate Security Act” is now making its way through the US Senate. While I do not intend to open the entire global warming can of worms at this point, I do know that it is now becoming very popular to be seen as “green” on Capitol Hill.

As a result, it is important for all of us to keep an eye on this legislation, as it also holds the potential to increase all of our cost of living in an effort to curb greenhouse gases, while other countries such as China continue to produce greenhouse gases unabated. President Bush says he will veto this bill if it gets to his desk, so the politicians are likely to delay this bill until the next president takes office. Stay tuned!

PONDERING MY RETIREMENT

by Gary Halbert

It was 32 years ago this month when I began my career in the investment business in 1976 at the ripe old age of 24. I have been in it ever since. It has been an interesting ride, and I have always had the hands-down best clients on the planet. But this year, I’ve been thinking of retiring. Yes, retiring at the age of 56.

But before you drop your jaw, let me assure you I am not thinking about retiring from my career in the investment business. Rather, I am considering retiring from my other job which is coaching youth sports. My son graduated from high school in May and will be off to college in the fall, so my coaching days, with him at least, are officially over.

I never had any intention of coaching my kids in sports. I was not a star athlete in high school or college, although I did play football, basketball and baseball as I was growing up. No, I was abducted into coaching, completely to my surprise. The abduction began in 1995, I think it was, when I took my son to his first tee-ball practice. When we arrived, I saw only one adult man there with 12-14 little kids. Out of concern for safety, I hung around waiting for the other coach to show up. No one did, so I stayed and helped for the whole practice. The same thing happened the next day.

At the end of the second practice, the coach called me over to his pickup truck. He reached inside and handed me a cap and a tee shirt and quietly said, You’ll be my assistant coach. What, me a coach?

What I didn’t know was that this man was the head of the local Youth Association in our area. What I also didn’t know was that he coached everything year-round - baseball, football and basketball. The tee-ball season was such a joy, despite my lack of experience, that I followed him into football as a coach in the fall, and on to basketball after that.

I had no idea that I would end up coaching my two kids year-round for the next 12 years. More importantly, I had no idea that coaching would become such a demanding and rewarding part of my life. The folks in my office call it my “other job.”

I can’t begin to describe how much coaching has meant to me, how much closer it has drawn me to my two kids, and how it has introduced me to some of the best friends I have ever had.

Most of the guys I coached with in the early years sent their kids to public schools, so their coaching careers ended after only a few years. My kids, on the other hand, have always attended a private Christian school that is always looking for volunteer Dads to coach. So I continued to coach my kids through middle school and high school.

Coaching these kids over the years has given me many of the best memories I have had in my life. My daughter will be a junior in high school this fall, but I don’t coach her basketball team anymore. So when the final pitch was thrown and the final out was made in my son’s last baseball playoff game in early May, it hit me in the dugout afterward as I was packing all the equipment: my coaching career may be over.

I have a standing invitation with the Athletic Director at our school to return next year and continue coaching. In fact, he frequently asks, You are coming back, right? I’ve been thinking about it a great deal over the last month. I just don’t know if I will continue to be so passionate about it without a kid on the teams.

I haven’t made my mind up yet, but I am thinking of just being a fan next school year, and see what that’s like. If I can’t stand being in the bleachers, I can always un-retire the next year. I know I’ll dearly miss those kids calling me Coach Halbert.

Kudos To My Son

Since this E-Letter is free of charge, I want to brag for a moment about my oldest child who just graduated from high school. He graduated Magna Cum Laude along with seven other students in his class, making straight As in his senior year. In football, he made the All-District and All-State first teams as a record-setting wide receiver. He also made the All-State Academic Team based on his school grades. In basketball and baseball, he also won All-District honors.

He was the only student in his class to win such honors in three different sports in one school year. He was nominated by our Athletic Director for “Athlete of the Year” in the Texas Association of Private & Parochial Schools statewide.

Watching him present his Senior Thesis (a requirement at our school) and hit it out of the park, if I do say so myself, and then watching him graduate from high school has been a very emotional experience for me. I’m not ready to let him go, but at the same time, I have every confidence that he will do very well in college where he plans to pursue a degree in engineering.

Debi and I are very proud of him!

Now that our son will be off at college, our high school sports focus will now be my daughter's activities. While she doesn't play as many sports as our son, she is definitely just as competitive!

(Thanks for indulging me.)

Best regards,

SPECIAL ARTICLES

The Many Myths of Ethanol
http://www.realclearpolitics.com/articles/2007/05/the_many_myths_of_ethanol.html

The Clean Energy Scam
http://www.time.com/time/magazine/article/0,9171,1725975,00.html

Forget the Ethanol Myth
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_wasik&sid=aOS8e5kvDESE

Investing During Retirement

Gary D. Halbert — Tue, 27 May 2008 20:37:12 GMT

By: Mike Posey

IN THIS ISSUE:

Risk Considerations In A Retirement Portfolio
No Shortage Of Investment Options
Immediate Annuities
Fixed-Income Alternatives

Introduction

We're now in the home stretch in this series of Retirement Focus E-Letters dedicated to converting your nest egg into a retirement income stream. Over the past year or so, I have written about how to determine how much might be enough to fund your retirement, as well as how to determine the best way to convert your nest egg into an income stream during your golden years.

As I promised in my March 18 Retirement Focus E-Letter, this week I'm going to address the issue of how to invest your money after retirement. We'll cover the importance of risk management during retirement as well as various ways to invest to produce the income you need. In the end, we'll discover that post-retirement investing is a delicate balance of risk and reward that must be achieved in order to reach your goal of a secure retirement.

Before launching into this week's topic, I want to be sure to remind you that any investment information provided in this E-Letter is general in nature, and should not be construed as investment advice. You should always evaluate investment options in light of your personal financial situation, retirement goals and any special circumstances you may have. Ideally, you should consult a qualified investment professional who can take the time to review your situation and tailor an investment approach to meet your needs.

Revisiting Gary's Risk Discussion

Gary did a great job in his April 22 E-Letter that highlighted both common and lesser-known risks associated with investing. His risk analysis discussion is especially important for those who are investing during retirement, since the negative consequences of taking on too much investment risk can be far greater during retirement than while accumulating a nest egg.

Just one example of a retirement portfolio's heightened sensitivity to risk is the issue of investment losses in the early years of retirement. To illustrate, let's use real-life historical market data to show the effects of early market losses. An investor retires on December 31, 1999 with a nest egg of $500,000, and decides to take 6% annual withdrawals. To keep it simple, we'll assume he decides to invest it in an S&P 500 Index fund, lured by that Index's phenomenal returns (33.36% in 1997, 28.58% in 1998 and 21.04% in 1999) just prior to retirement. The following table tells the story of this investor's first three years in retirement:

Year	Beginning Balance	Income Distribution	Investment Gain/Loss	Ending Balance
2000	$500,000	$30,000	( 9.11%)	$427,183
2001	$427,183	$25,631	(11.88%)	$353,848
2002	$353,848	$21,231	(22.10%)	$259,109

Note that with the December 31, 2002 balance of $259,109, the January 2003 distribution would be only $15,547, or roughly half of the original amount of income at the beginning of retirement - all in the space of just three years.

Recalling Gary's discussion about the amount of return required to break even, we find that it will take a total return of 93% just for this investor to get back to even, which will be especially hard to do considering an automatic 6% withdrawal each year.

The moral of this story is that the combination of steady withdrawals and portfolio losses can send a retirement portfolio's value into a downward spiral from which it might never recover, resulting in you possibly running out of money later in life, or reducing the level of income below what is needed for a comfortable retirement. Granted, the above example chooses three of the worst years on record for the stock markets, but how do we know that the next three years won't be a repeat of 2000 - 2002 in the stock market? The answer is that we don't, so retirees must invest with an eye on risk management.

The remainder of this article will address the various ways to invest during retirement. Over the course of this discussion, the guiding principle will be to balance the various investment risks such that you will have both a meaningful level of income, but also avoid running out of money in retirement.

Retirement Investing - No Shortage Of Options

With the oldest of the Baby Boomers now eligible for Social Security early retirement, mutual funds, brokerage firms, insurance companies and the like have all come out with a variety of products designed to fill the need for retirement income. Accompanying this deluge of products are reams of articles dedicated to advising both investors and investment professionals on how to position their retirement portfolios for optimum income and longevity. As if this glut of frequently conflicting advice isn't bad enough, add in a generous helping of warnings from regulatory agencies regarding scams and bogus investments aimed at seniors, and you get what Gary likes to call "information overload."

My goal in this and subsequent E-Letters in this series will be to acquaint you with a variety of alternatives for post-retirement investing. Be aware, however, that there is no possible way that I can provide information about every conceivable way to invest for retirement. Nor can I launch into very detailed explanations of the products and investment strategies I do cover, since I am restricted as to space in these E-Letters. Even so, my hope is that I can provide you with a basic knowledge of how each of these options works.

With those caveats aside, it's time to delve into ways you might want to invest during the course of your retirement. As a general rule, I categorize the various post-retirement investment strategies into the following six broad categories:

Immediate Annuities - This is perhaps the simplest alternative in that it requires only one decision at the beginning of retirement. While I will discuss other annuity contracts below, an immediate annuity is different in that its sole purpose is to make periodic payments of income over the lifetime of the policyholder.
Fixed Income Alternatives - This type of investment includes bank certificates of deposit as well as insurance company fixed annuities. It can also include individual bonds purchased to hold to maturity. The key characteristic of this group is that the initial and renewal interest rates are fixed by the issuer for a period of time. For individual bonds, and CDs, the interest rate may be set until the bond's maturity, while fixed annuities often have annual interest rate resets.
Variable Annuities - In addition to fixed annuities, the insurance industry has a whole host of variable annuity contracts. Variable annuities differ from fixed contracts in that the value of the annuity will vary based on the performance of the markets. Some have referred to variable annuities as a "mutual fund in an insurance wrapper," and this is a pretty accurate description. However, there are some major differences between mutual funds and variable annuities, which I will discuss in more detail later on.
Asset Allocation Alternatives - This is by far the largest category of investment alternatives, in that asset allocation strategies can range from single-product mutual fund purchases to individually tailored investment allocations provided by a financial professional. The key in any asset allocation program is to diversify the portfolio in such a way as to balance the risk and reward of investing in light of an investor's goals, risk tolerance and investment horizon.
Actively Managed Strategies - Actively managed strategies are similar to the asset allocation option in that a variety of securities are purchased with the overall goal of producing a retirement income. However, actively managed strategies differ in that these programs are not passive buy-and-hold portfolios. Instead, an active manager will generally seek to position investments in markets that they believe have the greatest potential for gain, and if markets are down or uncertain, the active manager may retreat to cash or even hedge long positions.
Other Alternatives - Within this catch-all category, I would place real estate (both direct investments and REITs) as well as other income-producing alternatives that you might not otherwise consider.

Due to space limitations, I'll only be able to cover a couple of the above categories this week, with the remainder being covered in future Retirement Focus issues. As I discuss these various options, I will include some links to additional information on these investment options.

Immediate Annuities

One of the major risks that retirees face is the possibility of outliving their money. With fewer and fewer people being covered by defined benefit plans that can provide an income for life, the onus is being placed upon the individual retirees to make sure post-retirement investments are such that their money will not run out.

The immediate annuity contract addresses the risk of outliving your money by providing a periodic retirement check as long as you live. There are even options available that provide an income for as long as you live, plus provide the same or a lesser amount to a surviving spouse as long as they live. Most immediate annuity contracts are "fixed," in that they provide an assumed level of return, but there are also variable immediate annuities, as I will discuss later on.

In fixed immediate annuity contracts, once the annuity is purchased, the amount of periodic income is set and will not vary in the future. However, there are some fixed contracts being introduced that will provide for an increasing payment over time, as well as variable immediate annuities where the periodic payment varies with the investment performance.

The biggest advantage of these contracts is that the payments continue for life, even if your premium plus earnings would have otherwise been exhausted. The insurance company takes on the risk that you will live longer than your actuarial life expectancy, while you take on the risks of dying early and your heirs losing access to the premium paid.

I wrote about the basics of an annuity payout in my July 24, 2007 E-Letter, along with the major advantages and disadvantages. Rather than trying to summarize all of that material in this E-Letter, I encourage you to go back and read the Annuity Payout E-Letter to get up to speed on this investment option.

I do want to address several issues in regard to this method of providing retirement income. First, it is important to remember that in most immediate annuity contracts, you cannot change your mind several years later and receive a distribution of the remaining value. This is why most Advisors counsel retirees to not put their entire nest eggs into immediate annuities, since doing so could leave them without resources in case of an emergency expense.

The insurance industry is developing new immediate annuity products that address this illiquidity, but any flexibility comes at a cost. Some immediate annuity contracts do allow limited withdrawals, but periodic payments may be reduced to compensate for this extra benefit. Others allow withdrawals only during the early years of the contract, but charge a surrender fee if this option is exercised.

A second risk when purchasing an immediate annuity is dying prior to reaching life expectancy, and especially during the early years of the contract. In a life-only payout, all payments would cease and any windfall would go to the insurance company. For this reason, annuity companies provide optional forms of payments such as period-certain, joint-and-survivor and installment refund options that can extend beyond the annuitant's life span should an early death occur. These alternative forms of payment, however, do come at the cost of lower periodic payments.

Since the payout from a fixed immediate annuity is set over the lifetime of the annuitant, another possible disadvantage is the loss of purchasing power. According to the actuaries, a retiree at age 65 can expect to live around 18 more years. However, it is not uncommon to see people live far beyond that point. While the insurance company guarantees to pay an income for the life of the individual, they cannot guarantee that its buying power will remain the same.

In other words, inflation is the natural enemy of the fixed immediate annuity. Using the Department of Labor's inflation calculator, we can see that a $1,000 payout in 1988 would have the purchasing power of only about $550 today, while the same payout beginning in 1978 would have the buying power of only $303 after 30 years of inflation had taken its toll. If future inflation trends are similar to those of the past 30 years, an annuitant could see his or her buying power halved in 20 years, and cut to a third in 30 years.

The insurance industry has also addressed this disadvantage by providing a variable immediate annuity. Like the fixed immediate annuity, the variable contract provides an income for life. However, unlike its fixed counterpart, payments from the variable immediate annuity can rise or fall based on the performance of a portfolio of investments.

It works like this - the annuitant buys a variable immediate annuity from an insurance company and the initial monthly payment is calculated using an assumed rate of investment return. After that, the monthly payment will be based on the performance of the investment portfolio chosen by the annuitant.

If the investments do well, then payments can rise over time and possibly overcome the effects of inflation. However, the annuitant also takes on market risk so that if the selected investments do poorly, the income payments will fall, possibly below what a fixed contract would have paid. Some companies do provide a guarantee that payments cannot fall below 80% to 85% of the initial payout, but this comes at the cost of higher expense charges.

Just as with any other investment alternatives, fixed and variable immediate annuities are just one tool that can be used to provide retirement income. The important thing to remember is that the guarantee of an income for life depends upon the strength of the company issuing the annuity contract. Therefore, you should only place your money with an insurance company that you feel is safe, solid and will be around 30 years from now.

To assist you in your evaluation process, I recommend that you check out a prospective insurance company's ratings with at least one of the five major insurance company rating services (Moody's, A.M. Best Company, Weiss Research, Standard & Poor's and Duff & Phelps). A link to all of these ratings services can be found at the Insbuyer.com website at the following web address: http://www.insbuyer.com/insurancenrating.htm.

You can also obtain quotes on how much monthly income your nest egg will purchase under various annuity options on many Internet websites. You can find these websites by typing "immediate annuity quote" into an Internet search engine. One I have found to be helpful is at http://www.immediateannuities.com. Note that these guides are useful to get a general idea of what annuity income may be available, but you should always consult a qualified insurance professional before buying any annuity contract.

Fixed Income Alternatives

As noted above, the fixed income category covers a lot of different types of investments, and is characterized by paying a fixed or stated rate of return for a specific period of time. In some fixed income investments, the fixed rate of return may span from several months to many years. In others, such as a fixed deferred annuity contract, the interest rate may be revised annually.

Fixed income investments can also be subject to a wide range of tax treatment on the income produced by the investment, such as municipal bonds where interest is generally income tax free, to fixed deferred annuity contracts where taxation is deferred until withdrawn from the contract. For a more detailed discussion of tax considerations, see my November 13, 2007 E-Letter.

Because the category of fixed income includes CDs and fixed annuities, many investors think that only low-return investments are included. While it's true that some fixed income investments do have low returns, there are others that have the potential for very attractive returns, even to investors that primarily invest in equities. Of course, with this increased return potential comes a generous helping of increased risks as well.

A major advantage of fixed income investments is that they are generally not highly correlated with equity investments. As a result, including certain types of fixed income investments in a diversified retirement portfolio can lower a portfolio's volatility, and sometimes even offset losses in the equity portion of the portfolio. While the major thrust of this article is the production of income from fixed income investments, this non-correlation can be just as beneficial after retirement as it is in the accumulation phase. As a general rule, the category of fixed income investments usually includes the following types of investments:

Certificates of Deposit (CDs) - This category is very familiar as most people have had a CD at one time in their life or another. The CD may be one offered by your local bank, or can be a CD offered by a local broker. These "brokered CDs" often have higher rates of return than those of your local bank, so they are worth checking out. All are fully insured by the FDIC up to the maximum amount permitted by law and, as a result, usually have a very modest return. Interest can accumulate in the CD, or be withdrawn monthly to provide retirement income.

A relatively new type of CD known as an "equity-indexed CD" can provide a higher rate of return based on the appreciation of a stock index such as the S&P 500 Index. However, these CDs usually require that you lock in your investment for a period of five or more years, and do not usually provide for interest payments during this time. Thus, they may be of limited use for retirees who need current income from their investments. You can learn more about this innovative form of CD at the following website: http://www.sec.gov/answers/equitylinkedcds.htm.

As with bonds that I will discuss below, the most common way to invest in CDs for retirement is by "laddering" the maturity dates. I discussed this process in my December 11, 2007 E-Letter, so I won't repeat it here. One good place to check for the going rate of return on various types of CDs is on the Bankrate.com website at http://www.bankrate.com/brm/rate/deposits_home.asp.
Fixed Deferred Annuity Contracts - I discussed fixed immediate annuities above, but a "fixed deferred" annuity contract is sometimes used as a low-risk investment that may have a little higher annual return than a CD, as well as offer more flexibility than an immediate annuity. While fixed deferred annuities are usually built for the accumulation phase before retirement, they can also be used during retirement by withdrawing interest and principal as needed.

However, be aware that fixed deferred annuity contracts often have a surrender charge if you change your mind and want to invest elsewhere. Periodic partial distributions often escape this surrender charge, but it's something you want to ask about before you invest. As with an immediate annuity, the safety of your investment depends on the strength of the issuing company. Therefore, do your homework before investing.

In addition, fixed deferred annuities will sometimes offer a high "bonus" rate of return in the early years to provide an incentive for you to invest. However, you will want to ask the issuing insurance company for a copy of their renewal rate history to see how you might fare after the bonus period has ended. This renewal rate can never go below a minimum guaranteed rate of interest, but this guaranteed rate is often very low.

A very specialized form of fixed deferred annuity is known as the "equity-indexed annuity," in which you can participate in a particular stock market index's gain, but be guaranteed to not lose any money if the market goes down. Since this investment usually requires that you lock up your money for some period of time, I won't discuss this option since this type of annuity is not used for generating monthly income. However, I plan to do a future E-Letter on this very interesting type of fixed deferred annuity.

Annuity contracts are sometimes seen as a beneficial investment for risk-averse investors since they offer a minimum guaranteed rate of interest, provided that the insurance carrier you select is stable and solid. However, while Consumer Reports (CRMA) had high praise for immediate annuities, they did not share the same opinion of fixed immediate annuities. They said:

CRMA experts found that even with all the tax advantages, annuities are usually poor investments. They come with lofty fees and stiff withdrawal penalties. If you invest with a shaky insurer that goes out of business and you have a fixed-rate annuity, the state only guarantees that you will get some of your investment back.

You can get more information about annuities on the Internet at the Annuity Buyer's Guide website at http://www.annuitybuyersguide.com/what-is-an-annuity-.html.
Bonds - This category includes a wide variety of debt instruments and can range from Treasury notes and bonds to high-yield corporate issues. This investment process may involve purchasing individual bonds rather than investing in bond mutual funds. As a general rule, the longer the maturity of the bond, the higher the interest paid.

Perhaps the bond most interesting to retirees is the municipal bond, which can escape federal income taxation in most cases. As a result, the interest rate on these bonds is usually lower than in similar taxable bonds. Thus, the value of tax deferral depends upon your tax bracket, since a low tax bracket may not merit the reduced interest rate. It is also important to note that tax-exempt interest from municipal bonds is added back for purposes of determining how much of your Social Security benefit may be taxable, so remember this if you choose to invest in this type of investment.

Obviously, the greater the security of the bond, the lower the interest rate will be. Thus, Treasury bonds secured by the full faith and credit of the US government are considered to be the safest. There are even Treasury Inflation Protected Securities (TIPS) that are not only backed by the US government, but also adjust their return for inflation.

At the other end of the spectrum are high-yield corporate bonds, which are also called "junk bonds," and for a good reason. High-yield bonds are issued by companies with less than stellar prospects for the future. Thus, there is not only no guarantee they will be paid upon maturity, but the company may not even survive to pay the interest. However, some retirees with smaller portfolios may be attracted to these bonds since they provide a higher level of income than other options. Just remember that this high level of income comes with substantially higher risk.

As I noted above in regard to CDs, the most common form of investment in bonds during retirement should involve "laddering" the maturity dates so that you have periodic liquidity. This also serves to make sure that you get the advantage of both short-term liquidity and the generally higher interest rates on long-term maturities. Another advantage of using individual bonds to fund retirement is that you can build a ladder of various types of bonds, both government and corporate, to provide additional diversification.

Another important thing to remember when investing in bonds is that the market values of the bonds may fluctuate over time with prevailing interest rates. As a general rule, when interest rates go higher, bond prices go lower. This could cause retirees some concern when they get brokerage statements showing that their nest egg has lost value. However, laddering strategies usually provide for keeping the bonds until maturity, at which time they will pay full par value. Thus, don't let periodic market dips concern you as long as you have planned to hold on to maturity.
Unit Investment Trusts (UITs) - This is a specialized type of investment offered by brokerage firms that consists of a portfolio of similar securities held for a specified time and usually pays a pre-determined rate of return for the duration of the trust. While many UITs are set up to invest in a portfolio of bonds, there are some that also include stocks. UITs are considered to be buy-and-hold investments with a fixed maturity, and interest income from the portfolio is paid periodically to shareholders, making them attractive to retirees.

Principal is returned to the investor upon maturity of the trust. Since most UITs invest in bonds that pay their par value upon maturity, there is generally little principal risk in these investments. Of course, this is not the case with any UIT that contains stocks. Loss of principal may also occur if an investor liquidates units prior to maturity.

While a UIT is similar to a mutual fund, it differs in that once the portfolio of securities is selected, there is no active management of assets. As a result, operating expenses of UITs are often lower than actively managed bond mutual funds. UITs are generally seen as a low-risk, low-return form of investing, but may be appropriate for a portion of your retirement money. Be aware, however, that up-front sales loads can be considerable in UITs, so compare returns net of these expenses to other alternatives before investing. You can learn more about UITs at the following website sponsored by the SEC: http://www.sec.gov/answers/uit.htm.

There are other types of fixed income investments not covered above such as US savings bonds, money market mutual funds, convertible bonds, zero-coupon bonds, and the now infamous mortgage-backed securities, among others. There are also bond mutual funds for virtually all types of debt instruments that provide many of the same advantages of buying individual bonds, but relieve the investor of having to decide which bonds to buy. The key to including any fixed income investment in a post-retirement portfolio is usually the ability to have a safe, stable amount of income with at least some measure of principal protection.

That's it for this week. In my next Retirement Focus issue, I'll continue discussing the various ways to invest for retirement. Until then, if you have any questions about the options given above, or would like me to cover a specific investment option, please feel free to contact me at info@halbertwealth.com.

Best regards,

Mike Posey

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Mandatory IRA Distributions

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Roth IRA Conversions

Max Out 401(k) contributions

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Conclusions and Happy Holidays

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The Economy Falling Fast Into Recession

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PONDERING MY RETIREMENT

Investing During Retirement

Introduction

Revisiting Gary's Risk Discussion

Retirement Investing - No Shortage Of Options

Immediate Annuities

Fixed Income Alternatives

2008 Social Security Trustees Report – Same Old Song

Answering Your Retirement Planning Questions

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Reverse Mortgages Offer New Hope For Seniors

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