Forecasts & Trends : Retirement Planning

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

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

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

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

SPECIAL ARTICLES

Boomers' Eagerness to Retire Could Cost Them
http://www.usatoday.com/money/perfi/retirement/2008-01-13-turning-62-cover_N.htm

The Oil Speculation Debate
http://calculatedrisk.blogspot.com/2008/05/oil-speculation-debate.html

No Clear Map for Clinton's Political Future
http://www.washingtonpost.com/wp-dyn/content/article/2008/05/26/AR2008052602006.html

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Forecasts & Trends : Retirement Planning

Retirement Focus: Target-Date Funds in the Crosshairs

Retirement Focus: Spotlight on Good News

Retirement Focus - Year-End Retirement Sugarplums

Introduction

Mandatory IRA Distributions

Charitable Donations From An IRA

Roth IRA Conversions

Max Out 401(k) contributions

Plan Your Investment Strategy

Conclusions and Happy Holidays

Retirement Focus - What Now???

Introduction

Avoiding Costly Bear Market Mistakes

Active Management Strategies Revisited

Other Post-Retirement Investment Alternatives

Conclusion – Consider A Combination Of Strategies

Retirement Focus - Post-Retirement Asset Allocation

Introduction

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

The Many Faces Of Asset Allocation

Income Strategies In Asset Allocation Portfolios

Pros And Cons of Using MPT During Retirement

Conclusions

Retirement Focus - More Post-Retirement Investing

Introduction

Variable Annuity Investments

Variable Deferred Annuities

Variable Annuities Continue To Improve

Retirement Tidbit – Making The Most Of Retirement

Conclusion

Investing During Retirement

Introduction

Revisiting Gary's Risk Discussion

Retirement Investing - No Shortage Of Options

Immediate Annuities

Fixed Income Alternatives

Answering Your Retirement Planning Questions

Retirement Focus - The All-Important Withdrawal Percentage

Retirement Focus - Post-Retirement Income Planning, Part 2

Retirement Focus - Pros & Cons of Annuity Payouts