HS 353 Review David Littell, JD, ChFC®, CFP® Director, NYLCRI,

HS 353 Review David Littell, JD, ChFC®, CFP® Director, NYLCRI,
Boettner Chair in Research, Professor of Taxation The American College

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Review sessions for RICP®
May 22, 2014: 5-7 p.m. ET May 27, 2014: 5-7 p.m. ET If you are interested in learning more about these webinars please This is a 6 hour review session broken-down into 3, 2-hour webinar sessions for the 353: Retirement Income Process course.

Create an Effective Retirement Income Plan
Competency 1 Create an Effective Retirement Income Plan Section 1: Introduction to Retirement Income Planning Section 2: Understanding the Retirement Preparedness Data Section 3: The Retirement Income Process Section 4: The Business of Retirement Income Planning

Retirement Income Planning
No industry consensus on retirement income planning Lack of common definitions, use of terminology No common definition of retirement income planning Different approaches used by advisors Our group had no difficulty finding consensus on the following Solutions have to go across industry silos A plan is more than a spreadsheet printout showing that the plan has an 83% chance of success LO 1-1-1

Ensure that income needs will be met throughout retirement Plan for different time frames and uncertain time frames Help a client identify retirement income needs Requires evaluating assets and sources of income and figuring out ways to generate income from assets LO 1-1-1

Consider other financial goals (legacy) Consider contingencies (risks) and risk management techniques Consider tax and legal issues that can undermine the plan Consider tax strategies that can make the plan more successful LO 1-1-1

Different than Retirement Savings?
More complicated Generating income from assets is a new task Sequence of returns risk Mistakes are hard to recover from The client can undermine the plan Change is a constant and review is required Maybe Yes LO 1-1-1

Different than Retirement Savings?
Comprehensive planning is better Helping clients define a new life-phase Begin to prepare early for retirement risks Isn’t it really income planning even for the young? Maybe No LO 1-1-1

Retirement Decisions (Middle Income)
Profile Significant wealth tied up in their homes Few other financial assets Facing a retirement income shortfall or marginally prepared Key decisions for those struggling When to retire? Whether to work part-time during retirement? Accept a reduction in standard of living? At what age to claim Social Security benefits? How to address home equity? LO 1-1-2

Retirement Decisions (Middle Income)
Housing Afford to remain in home? How to tap home equity? Choose to relocate? Choose more appropriate housing? Financial Assets Purchase an annuity? Appropriate withdrawal rates? Appropriate asset allocation? Other Purchase LTCI? Medicare options? Employer retirement plans? How do decisions interrelate? LO 1-1-2

Additional for More Affluent Client
Nonqualified executive employer benefits Selling business interests Legacy bequest Tax planning LO 1-1-2

Practice Question LO 1-2-1
33. Which of the following statements about costs a client might face in retirement is/are correct? I. The present value (at age 65) of out of pocket medical costs will be higher for male clients than it will be for female clients. II. Costs for long term care in a nursing home vary significantly from state to state. A. I only B. II only C. Both I and II D. Neither I nor II LO 1-2-1

Costs of Retirement Present value of out of pocket medical costs (not long-term care) at age 65 Male median cost $65,000 (90% Prescription drug cost = $96,000) Female median $86,000 (90% = $124,000) Couple median $151,000 (90% = $220,000) Costs have come down in last two studies Underestimate if Medicare benefits reduced Medicare covers 62% of total costs Average annual cost in 2013 for a private nursing home is $83,950 Costs range significantly by state LO 1-2-1

34. Which of the following statements about the retirement preparedness of Americans is/are correct? I. Approximately 25 percent of American’s are financially prepared to meet their basic expenses in retirement and 75 percent are not. II. More high income individuals are at risk not to have basic necessities in retirement than low income individuals. A. I only B. II only C. Both I and II D. Neither I or II LO 1-2-2

Financial Preparation
If baby boomers and those in generation X retire at age 65, there is currently a $4.3 trillion retirement shortfall This only looks at meeting basic expenses and uninsured medical expenses 44% boomer at risk of retirement shortfall Income is an indicator of readiness (86% of the lowest quartile at risk/ 13% of highest) LO 1-2-2

Risk and Pension Coverage
For generation X 60% at risk (no retirement plan coverage) 18% (20 years of retirement plan coverage) Pension Coverage Full-time wage and salary workers 21 to 64 60% work for employer with plan 53% participate LO 1-2-2

Retirement Confidence
Retirement Confidence Survey 2013 24th annual survey from EBRI and Matthew Greenwald Interview 1,000 workers and 250 retirees Overall confidence of workers (2013) 13% really confident (27% in 2007) 27% of workers are not at all confident (10% not at all confident in 2007) Drop of confidence show more awareness but it hasn’t translated into a higher savings rate or additional planning Less confidence in retirees (41% very confident in 2007 only 18% today) LO 1-2-3

Retirement Confidence
Less prepared to meet long-term care needs 21% not at all confident of general preparation 39% not at all confident for long-term care needs Factors affecting confidence Income—lower income higher lack of confidence Age--Older and low income less confidence than younger low income Planning—more planning more confidence Debt—more debt more lack of confidence LO 1-2-3

Software Tools Who’s running the numbers
Advisor or back-office Advisor must understand the output Communication of results Software output not always user friendly Executive summary LO 1-2-3

Retirement Income Process
Step 1: Evaluate the client’s current situation Review quantitative data Cash flow statements show income and spending and provide a look into future spending needs Net worth statements can identify assets available to meet needs and identify debt Qualitative fact finding can tell you a lot about the client’s personal situation Step 2. Identify and prioritize retirement goals Many clients may need help envisioning future Many new tools can help clients envision retirement Consider retirement risks—especially those later in life Consider risk tolerance Step 3. Estimate retirement income needs Meet lifestyle goals in retirement Identify different types of expenses Income solutions for basic expenses may be different than discretionary ones Expenses do not stay constant over retirement LO 1-3-1

Step 4. Identify sources of income and assets available to generate retirement income Estimating pension and Social Security income Identifying other sources of income Inventory assets availability to meet retirement needs Step 5. Make a preliminary calculation of the client’s preparedness for retirement What type of software Assumptions that are chosen Step 6. Develop strategies for addressing a retirement income shortfall Saving more/Living on less Saving more effectively with tax advantaged plans Working full or part time Deferring Social Security Tapping home equity Improving investment performance LO 1-3-1

Step 7. Consider legal and tax issues that can derail the plan Use appropriate tax-advantaged vehicles for saving for retirement. Choose the appropriate order of withdrawals Leaving assets to other heirs Meeting charitable goals Step 8. Consider retirement contingencies (risks) The possibility that the client will live longer than expected The market will have a sustained down period in the first few years of retirement A spouse dies at an early age LO 1-3-1

Step 9. Determine an appropriate strategy for converting assets into income Comprehensive analysis of client’s situation Solutions should consider a range of options Converting assets to income begins with choosing the appropriate way of framing this issue Step 10. Integrate all considerations, product solutions and present alternatives, and agree upon There are trade-offs and clients will have to make some difficult choices Clients may not fully understand the issues until they see several alternatives LO 1-3-1

Financial Planning Process
Establish and define the client-planner relationship Gather information necessary to fulfill that engagement Analyze and evaluate the financial status Develop recommendations Communicate the recommendations Implement the recommendations Monitor the plan Practice within professional and regulatory standards LO 1-3-2

71. All of the following statements concerning Monte Carlo simulation software are correct EXCEPT A. It allows the planner to make predications of successful and unsuccessful outcomes for a retirement funding scenario. B. It can be used in both the retirement accumulation process and the retirement income planning process (decumulation). C. It cannot provide the probabilities of success for two or more different alternative courses of action. D. It can allow planners to use either historical returns or project future returns. LO 1-4-2

Monte Carlo Simulations
Probability of successful and unsuccessful outcomes Used for both retirement accumulation and decumulation Example: Test a withdrawal rate from a portfolio for specified time period Software runs thousands of simulated random trials Typically based on historical returns Boils complex process into a simple probability Useful for comparing two alternative courses of action (4% or 5%) Limitation is the definition of success Having one dollar left at the end of life may not feel like success Being one dollar shy may not feel like a failure Monte Carlo can be used in a number of contexts Random life expectancy Historical returns or project future returns LO 1-4-2

Behavioral Finance People care more about life meaning than money
Financial decisions are based on both sides of the brain—don’t be overly analytical Some advisors try to take the emotional considerations out of decision making instead of addressing emotional & analytical needs The advisor can not always control outcomes but they can manage expectations LO 1-4-3

Competency 2 Identify Retirement Income Needs and Objectives and Evaluate the Client’s Current Situation Section 1: Identify Retirement Budget Section 2: Sources of Income Section 3: Preliminary Calculations

Practice Question 2. A qualitative question that could help you better understand how your client feels about financial matters is A. How many children do you have? B. What keeps you up at night? C. What retirement assets do you have? D. What expenses do you have? LO 2-1-1

72. All of the following statements concerning gathering data about your client’s current situation for retirement income planning are correct EXCEPT A. Demographic information about family may be important for estate planning purposes but not retirement income planning. B. Asking questions about experiences with past financial advisors may help you understand what your client wants from the advisor. C. Questions about assets should include information about cost basis and how assets are titled. D. Questions about liabilities should include determining when any installment debts will be repaid. LO 2-1-1

Evaluate the Client’s Current Situation
Quantitative Balance sheet-Net worth Assets (value, basis, cost to maintain, title, personal or financial) Liabilities (mortgage, credit card) Verify data Cash flow statement One year identify expenses and income Keep details for one month Income (review all sources) Expenses (determine type) Demographic questions Family and relationships (including financial) Work Advisors Qualitative What is important? (activities/values) Financial concerns? Personality style (drivers/philosophers) What do they want from you LO 2-1-1

73. All of the following are advantages of a tool like Ready-2-Retire EXCEPT A. It can help clients begin to identify goals before sitting down with the advisor. B. It can help clients visualize what they would like to spend time doing in retirement. C. It can help educate clients about the risks faced in retirement. D. It can help inventory assets and income sources available to meet retirement needs. LO 2-1-2

Evaluate Risk Tolerance
How much uncertainty an investor can manage Accumulation portfolio—risk and return Retirement income—risk is failing to have enough and return is how much can be withdrawn from portfolio May change over time (age and health) Risk capacity Lower as you age because of loss of human capital Higher if you are well funded for retirement income needs Higher if more guaranteed income Pre-post retirement Pre retirement risk averse can save more Post retirement risk averse may have too little income LO 2-1-3

Inventory Income Sources
What sources of income are available? How much will be paid? How long will it last? Is the income source reliable? Does it have cost of living protection? Flexibility in payout options or other relevant features? In this section we discuss resources available to provide income in retirement. This learning objective focuses on income sources and the next focuses on assets available to create income. This is just a way to categorize resources and all are not that easily categorized. For example, a defined-benefit plan can pay out income for life—unless the client elects a lump sum distribution option—and now it's an asset instead of an income stream. Which category that a resource falls into is not important—but the fact that that flexibility is available is important. As we review sources of income that may be available--we want first to make sure that we consider all likely categories. When working with clients once an income source is available, it's appropriate to discuss how much, how long will it last, whether the income source reliable and other relevant features such as inflation protection and/or benefit flexibility. Here we will review the major categories that you are likely to find, and address some of the issues that may come up with each. LO 2-2-1

Inventory Income Sources
Social Security Reliability Cost of living increases Qualified defined-benefit plans Retirement age Early retirement—actuarial reductions, fewer years of service lower salary Deferred may provide more accruals, higher salary, actuarial increase Reliability (irrevocable trust—outside reach of creditors) Basic benefit is an annuity Private employers no cost of living increases Nonqualified benefits Often payable for a specified number of years Reliability (general creditor/vesting performance requirements) In this section we discuss resources available to provide income in retirement. This learning objective focuses on income sources and the next focuses on assets available to create income. This is just a way to categorize resources and all are not that easily categorized. For example, a defined-benefit plan can pay out income for life—unless the client elects a lump sum distribution option—and now it's an asset instead of an income stream. Which category that a resource falls into is not important—but the fact that that flexibility is available is important. As we review sources of income that may be available--we want first to make sure that we consider all likely categories. When working with clients once an income source is available, it's appropriate to discuss how much, how long will it last, whether the income source reliable and other relevant features such as inflation protection and/or benefit flexibility. Here we will review the major categories that you are likely to find, and address some of the issues that may come up with each. LO 2-2-1

75. All of the following statements concerning estimating Social Security benefits as part of the retirement income plan are correct EXCEPT A. An individual eligible for multiple benefits will only be eligible to receive one benefit at a time. B. Since benefit statements have been suspended, it is almost impossible to find out an individual’s retirement benefits. C. Benefits will generally increase over time since they are eligible for cost of living increases. D. Benefits could be cut back somewhat in the future if the funding shortfall is not resolved. LO 2-2-1

3. Which of the following statements concerning estimating nonqualified defined benefit plan benefits provided by private employers is correct? A. Benefits are generally paid out as a life annuity. B. Benefits may be rolled into an IRA, if a lump sum distribution is chosen. C. Benefits are generally secure as in most cases assets are held in an irrevocable trust. D. Benefits may be subject to a forfeiture provision if a do-not-compete clause is violated. LO 2-2-1

76. All of the following statements concerning assets that can be used to generate retirement income are correct EXCEPT A. The future value of a qualified profit-sharing benefit at retirement age is easy to determine. B. Some financial assets may not be available to meet retirement needs as they are earmarked for other purposes. C. Nonqualified deferred compensation may be at some risk if the company has financial difficulties. D. Qualified defined-contribution plans may offer an annuity distribution option at a favorable annuity rate. LO 2-2-2

Retirement Assumptions
Retirement age Average age is 62 Many retire earlier than planned (health/caregiving/loss of job) Pitfalls of choosing early Medicare not available to 65 Increased exposure to inflation Different situations require different tools Social Security benefits reduced Longevity 28% of those who live to 65 make it to age 90 Use life expectancy for those who live to 65 Consider individual health status and family history Inflation Use long-term estimates Software can model different rates for different expenses Retirement need Ratio approach as a rough estimate Expense method as you approach retirement LO 2-3-2

Calculations Different situations require different tools
Some only have Social Security and 401(k) Some have a wide range of resources Consumer tools may be too simple Professional tools should Be appropriate for the situation Allow manipulation of expense/income sources Output is important and can educate client Spreadsheets not a good communication tool Complex not always more accurate LO 2-3-2

4. Which of the following statements concerning assumptions used in determining retirement need is correct? A. Actuarial tables reveal that 68% of those who live to 65 will still be alive at age 90. B. It is appropriate to disregard the client’s health status in determining a life expectancy assumption. C. The expense method approach to estimating retirement need becomes more plausible as clients approach retirement age. D. It is best to use the most recent inflation rate when choosing an inflation assumption. LO 2-3-2

Choose Appropriate Strategies to Address Gaps in Income
Competency 3 Choose Appropriate Strategies to Address Gaps in Income Section 1: Saving More and/or Spending Less Section 2: Additional Work Section 3: Saving More Efficiently with Tax-Advantaged Plans Section 4: Deferring Social Security Section 5: Tapping Home Equity Section 6: Improving Portfolio Performance

Saving More Saving more has a limited impact on the income plan for those close to retirement Still important strategy Some can afford to save a lot more More years to retirement In combination with other strategies Using tax-advantaged plans Working longer The relationship with spending less Try out living on a reduced income Test drive whether that strategy will work Let’s start off with an example. This one is a bit discouraging as saving a bit more just prior to retirement will not have that much impact on a retirement income shortfall. Let’s use an example of a 58 year old individual with $100,000 of income, assets of $500,000. This individual is already trying hard and is saving 20 percent of pay—Let’s also assume to keep it simple, that he or she needs 85% of pre-retirement income in retirement. To run this calculation I used a freely available calculator called the Smart Money Retirement Planner. In the outline we’ve provided several other assumptions used in this calculation. In this example we used a life expectancy of age 90. Based on the assumptions—including an estimate of Social Security benefits—the individual retiring at age 65 has a clear shortfall—having an income deficit at age 81—and no remaining assets to supplement Social security at age 82. If the client works harder to save and can improve to a 25 percent of income—the situation improves a little—but not much now the shortfall occurs at age 82 one year later. 7 percent pre-retirement 6 percent post return 2.7 percent inflation 19 percent effective tax rate LO 3-1-1

Spend Less In Retirement
Spending less can mean reduced standard of living A well prioritized spending plan may make it easier to identify reductions Ideas for significant reductions Downsize Relocate Sell assets with significant expenses Temporary spending cuts can matter Can the same lifestyle be obtained with less? In the retirement income process let's remember that we started with determining how much was needed to meet the client's desired lifestyle. So when we talk about spending less—we are discussing a reduced standard of living, which can be a painful solution—especially if we are talking about spending less over a long-time frame. In the previous competency, we discussed a pretty thorough approach to preparing the spending plan—in some ways the more carefully this plan was crafted looking at retirement expenses carefully category by category the more difficult it may be to adjust the plan. On the other hand—if the spending plan carefully categorized and prioritized spending it may be easier to more quickly identify those expenses that do not feel as important to the client and can be more easily eliminated or reduced. LO 3-1-1

Work Longer Working longer either full-or part-time can Significantly affect the plan Example: 58-year-old single individual with $100,000 of income, assets of $500,000, saving 20% of pay, and needing 85% of income Retire at age 65 income shortfall at 81 Retire at 66 income shortfall at 86 Retire at 67 and assets sufficient until 90 Smart Money retirement calculator 7 percent pre-retirement 6 percent post return 2.7 percent inflation 19 percent effective tax rate Add $25,000 of income 65 through 70 and retire at 65 now assets last to 88 LO 3-2-1

Protecting Employment Opportunities
Many retire earlier than planned Primary concern is work available and feasible? How can an older worker better ensure employment opportunities? Job skills and professional network Healthy lifestyle Avoid burnout LO 3-2-1

41. Which of the following statements concerning tax-advantaged retirement savings plan opportunities for consulting income for an individual who also has another job and contributes the maximum salary deferrals to the company’s 401(k) plan is (are) correct? I. The individual could set up a SEP to shelter a portion of the consulting income as long as the two business entities are unrelated. II. The individual could set up a 401(k) plan for the consulting income and make maximum salary deferrals as long as the two business entities are unrelated. A. I only B. II only C. Both I and II D. Neither I nor II LO 3-3-1

Supplemental Income (second job or consulting income)
General rule Individual working for two unrelated employers can have benefits in both plans Controlled group, affiliated service group rules require related employers to be treated as one employer Exception for salary deferrals Salary deferrals to 401(k), 403(b), and SIMPLEs are aggregated across unrelated employers Exception for 403(b) plan participation 415 limit applies to contributions to 403(b) plans and other plans of a business owner LO 3-3-1

Self-Employed Plan Options (unincorporated, no other job and no employees)
SEP 20% of Schedule C income reduced by Social Security deduction (415(c) limit) up to lesser of 100% income or $50,000 in 2012) 401(k) plan 20% plus $17,000 salary deferrals plus $5,500 catch-up (2012) Totals can not exceed 415(c)—however $5,500 in addition (total $55,500) Include Roth election for salary deferrals Defined-benefit Only plan that contributions can exceed 415(c) LO 3-3-1

79. All of the following are good candidates to choose a Roth Election in a 401(k) plan EXCEPT A. Ralph, who is working part-time this year because he has gone back to school at night B. Jean, who is earning much more this year than usual due to royalties from a book C. Sandy, who has all of her savings in tax-deferred accounts and expects to be in the same tax bracket in retirement D. Larry, who is trying to maximize his tax advantaged savings this year LO 3-3-2

Comparing Roth/Tax Deferral Tax Considerations
Tax Rates Choose tax deferral if tax rates are lower in retirement Choose Roth if tax rates increase in retirement Same accumulation if tax rates remain the same Future tax rates Young people currently in low tax bracket Some may be temporarily in a low tax bracket Some expect tax increase (top bracket) Middle-income likely to be in lower bracket Beneficiaries (widow) may be in a higher tax bracket LO 3-3-2

Other Reasons to Roth Save More No required distributions
A $22,500 Roth contribution results in $22,500 of after-tax retirement income Same pre-tax deferral reduces current income by $14,625 and only results in $14,625 of after-tax retirement income No required distributions Tax-efficient asset for heirs Tax diversification LO 3-3-2

Roth Conversion Issues
Roth IRA Conversion Rules Anyone can do it (no income limits) By 12/31/12 to convert for 2012 Taxed on value at time of conversion Can recharacterize by the following October 15 Convert when tax rates are currently low Look for opportunities to convert Consider projections of future tax rates Pre-paying a future tax obligation—a different way to save for retirement Reduces inheritance taxes Look for depressed asset values—ability to recharacterize LO 3-3-2

6. Jennie and Johnny are both age 58, are married, and have AGI of $300,000. Both are employees of large companies and maximize contributions to their companies’ 401(k) plans. Jennie can make additional contributions to a tax-advantaged retirement plan for the year by A. Making additional contributions to the 401(k) plan under a Roth election. B. Making deductible contributions to an IRA. C. Setting up a SEP to shelter a portion of their investment earnings. D. Making nondeductible contributions to an IRA and then converting to a Roth IRA. LO 3-3-3

Practice Question 7. Gretta is married, self-employed with no employees, age 72 and earns $50,000 of Schedule C earnings. In order to shelter as much income as possible she should adopt a A. SEP B. Profit-sharing plan C. Money purchase pension plan D. 401(k) plan LO 3-3-3

Social Security Basics
Benefits are based on 35 years of wage history Benefit options on Social Security calculators—the detailed calculator provides the best estimate LO 3-4-1

80. Deferring Social Security retirement benefits has the following benefits EXCEPT A. Deferring results in a higher percentage of retirement income that is inflation protected. B. Deferring increases the percentage of earnings replaced by Social Security. C. The benefit increases continue as long as the worker defers Social Security. D. Deferring Social Security benefits increase the worker’s benefit as well as the widow(er) benefit. LO 3-4-1

Everyone Wants a Good Deal
Take early to get money’s worth (Break even analysis) Betting on dying young—a bad gamble—losing means a long life with too little income Wealthier individuals who can afford to look at it this way are more likely to live longer lives Maybe ok if short life-expectancy Spousal survivor benefits Surviving spouse receives the higher of the two retirement benefits Even if short life expectancy—spouse may not (the larger benefit is paid for the joint lifetime) LO 3-4-1

Deferral Changing the frame Supporting deferral
Deferral increases monthly benefit Cost is the lost payments Determine price of annuity with CPI Supporting deferral Work Other accounts Receiving smaller benefits from Social Security LO 3-4-1

Social Security to Support Deferral
Divorced spouse takes spousal benefit at full retirement age and switches to worker’s benefit at age 70 Married couples Claim Social Security worker’s benefit to start spousal benefit then suspend worker’s benefit Both work—worker with higher benefit receives the spousal benefit and defers the worker’s benefit LO 3-4-1

42. When using the break-even approach to choosing Social Security benefits, which of the following statements is (are) correct? (LO 3-4-1) I. A single individual with a short life expectancy is the best candidate for beginning benefits early. II. Those with higher socio-economic status may have more incentive to defer benefits. A. I only B. II only C. Both I and II D. Neither I nor II LO 3-4-1

Accessing Home Equity Downsizing Reverse mortgage Conventional loan
Mortgage or line of credit Good for short-term need (lower expenses) Payback—or foreclosure Single purpose loan State and local government programs Purpose such as property tax deferral Low cost or forgiven May limit other borrowing Downsizing Don’t wait to sell in a crisis Replacement housing may not be available Reverse mortgage Longer term solution Nonrecourse loan Range of distribution options LO 3-5-1

Reverse Mortgage Basics
HECM provides FHA insurance All owners age 62 or older Applies to principal residence Amount based on age, home value, interest rate Repayment only at time of sale Debt grows over the time of the loan Nonrecourse loan No income tax consequences of payment Payment options (lump sum / line of credit / tenure) LO 3-5-1

Planning Considerations
Long-term care planning Pay for home care Use with LTCI or other funding approaches Emergency fund Hold for years of bad investment performance Use to meet basic needs and stay in home Creating a regular income stream Downsize Reverse mortgage tenure option Short-term to defer Social Security Reducing debt expenses Downsizing to payoff debt Reverse mortgage lump sum Refinance conventional mortgage LO 3-5-1

8. Which of the following statements about reverse mortgages is correct? A. Repayment is required immediately if the loan exceeds 50 percent of the value of the home. B. Loans payments are treated as taxable income to the homeowner. C. If the home’s value exceeds the loan amount, the bank would receive the windfall when the home is sold. D. Payment choices include a lump sum, line of credit and tenure option. LO 3-5-1

Improving Portfolio Performance
Mutual fund research Higher expenses generally reduce return Avoid closet index funds Choose newly launched funds Choose funds with ownership by managers and directors Choose institutional class shares Choose funds with short-term redemption fees Avoid worst performers Bank-affiliated funds have underperformed Broker sold funds tend to underperform LO 3-6-1

Practice Question 9. An actively managed stock mutual fund that has a high level of overlap with the appropriate benchmark is referred to as a A. Value fund B. Closeted index fund C. Growth fund D. Large cap fund LO 3-6-1

Asset Location Issues Tax-exempt and tax-deferred enjoy tax-free growth Individual in 25% tax bracket has a $750 Roth IRA and $1,000 IRA. Both grow by 100%. Individual has $1,500 after-tax in both accounts So investor receives 100% of the return and takes 100% of risk Taxable government shares in returns and risk Average return 10% and 20% standard deviation Year 1, +10%, year 2 -10%, year 3 +30% with a 15% tax rate Year %, Year %, year % (8.5% average and 17% standard deviation) LO 3-6-2

Asset Location Principals
Hold stocks in taxable account Hold bonds and other investments taxed as ordinary income in the tax deferred plan Stocks traded frequently consider tax-deferred plan Consider asset allocation decisions on an after-tax basis LO 3-6-2

45. Which of the following statements concerning asset location and asset allocation decisions based on tax considerations is (are) correct? (LO 3-6-2) I. Asset allocation decisions should disregard the differences in the tax aspects of different accounts. II. Hold stocks in the taxable account and bonds in the tax-advantaged retirement accounts to the fullest extent possible. A. I only B. II only C. Both I and II D. Neither I nor II LO 3-6-2

Competency 4 Evaluate the income tax, estate issues, and other threats to the retirement income plan
Section 1: Income Tax Considerations Section 2: Estate Planning Considerations Section 3: Incompetency

Qualified Plan Paperwork
Benefit election form Qualified joint and survivor annuity notice and waiver forms Right to a direct rollover Notice of tax treatment 1099R—lump sum distributions LO 4-1-1

Qualified Plan Tax Checklist
Is there any special tax treatment? Is a portion attributable to a 401(k) Roth account? Is the participant under age 59½ and if so do any of the exceptions apply? Is there any cost basis in the plan? Is there a distribution of employer stock? Is the recipient a death beneficiary and not the participant? LO 4-1-2

Practice Question 11. Ralph has a $50,000 IRA with $30,000 of nondeductible contributions and a $250,000 rollover IRA that has no cost basis. If he withdraws $20,000 from the nondeductible IRA how much of the distribution is subject to income tax. A. $0 B. $12,000 C. $18,000 D. $20,000 LO 4-1-2

Roth Tax Checklist Is the distribution from a Roth IRA or Roth Account? Is the distribution a qualifying withdrawal? Is it best to roll Roth Accounts to a Roth IRA? If a non qualifying Roth IRA withdrawal What is being withdrawn? Have contributions been fully recovered? If earnings does the 10% penalty apply? LO 4-1-2

Non-qualifying Withdrawals
Roth IRAs Contributions withdrawn first without tax Earnings taxed as ordinary income and penalty Roth accounts Prorated recovery rule Tax problem resolved by rolling to Roth IRA LO 4-1-2

48. Jill receives a distribution from her 401(k) plan. In determining the tax treatment of the distribution, which of following questions is (are) relevant? I. Is Jill single? II. Has Jill received employer stock as part of the distribution? A. I only B. II only C. Both I and II D. Neither I nor II LO 4-1-2

RMD Planning Checklist
Identify who is responsible for RMD compliance Inventory all plans subject to RMD rules Determine whether distributions can be deferred for qualified plans Identify what plans can be aggregated Carefully review beneficiary forms consider adding contingent beneficiaries Look to maximize “stretch” except for years in which withdrawals or Roth IRA conversions can occur at low tax rates Consider charitable beneficiaries to eliminate taxes LO 4-1-3

49. Bob, age 75 owns two IRAs, one pays out a life annuity and the other is an account plan. His beneficiary for both IRAs is his 35-year-old niece. Which of the following statements concerning the required minimum distribution (RMD) rules that apply to these plans is (are) correct? I. The distribution from the IRA paying a life annuity may reduce the RMD from the account plan IRA. II. The calculation of the required distribution for the account plan is based on his niece’s life expectancy. A. I only B. II only C. Both I and II D. Neither I nor II LO 4-1-3

81. All of the following statements concerning IRA beneficiary designations are correct EXCEPT A. Under the required minimum distribution rules, the beneficiary chosen will impact how long distributions can be stretched out after the death of the participant. B. If a beneficiary form is not completed the plan will provide for a default beneficiary. C. Plans generally do not allow contingent beneficiaries. D. A charitable beneficiary can be a way to eliminate income taxes on distributions paid to the charity after the death of the participant. LO 4-1-3

50. George and Georgia are 62, retired and are not yet receiving Social Security benefits. They have taxable investments and a large tax-deferred rollover IRA. Which of the following is (are) tax-efficient withdrawal strategy(ies) for this couple? I. They should take all distributions from the tax deferred account first to avoid required minimum distributions. II. They should consider taking some distributions from the tax deferred account and converting them to a Roth IRA. A. I only B. II only C. Both I and II D. Neither I nor II LO 4-1-4

Tax Treatment of Annuities
Qualified Nonqualified Earnings tax-deferred as long as owner is “natural person” Preannuitization period Earnings taxed first 10% early withdrawal penalty applies Annuitization Exclusion ratio LO 4-1-5

Tax Treatment of Social Security
Provisional income AGI Tax exempt interest ½ Social Security benefits Provisional income exceeding thresholds Single $25,000 (up to 50%) $34,000 (up to 85%) Married $32,000 (50%) $44,000 (85%) LO 4-1-6

Lifetime Gifts Outright In trust Eliminates from estate
Annual exclusion Medical and educational expenses Gift tax credit Considerations Can you afford it? Can the donee manage the transfer? What property should be given away? What are the income tax issues? Estate planning essentially is taking the client’s answer to the “who”, “how”, and when questions and designing an efficient mechanism to transfer the wealth with minimal transfer tax costs. There are some basic techniques that are employed in some combination. First, to the extent possible, the client can reduce his or her tax base by making lifetime gifts. Second, there is a significant exemption available to everyone against taxable transfers during lifetime or at death. The current exemption amount is $5,120,000 for 2012 and no taxes will be paid until cumulative transfers have exceeded this amount. Third, married individuals can make gifts or bequests to their spouses through the unlimited gift or estate tax marital deduction. To prevent tax abuse, rules for the marital deduction are complex and often involve significant planning with specialized trusts. Finally, life insurance is generally viewed as the most efficient inheritance because, unlike retirement accounts, the death benefits from a life insurance policy you received income tax free by the heirs. Through the use of third party ownership of the policy on the decedent’s life, the life insurance proceeds can also be transferred free of federal estate taxes. The most typical arrangement is the irrevocable life insurance trust. LO 4-2-1

52. Which of the following statements concerning lifetime gifts in an estate plan is (are) correct? I. A donee may not always be ready to receive a substantial gift. II. Property with built-in loss potential should be gifted as the loss can be deducted by the donee. A. I only B. II only C. Both I and II D. Neither I nor II LO 4-2-1

Practice Question 53. Which of the following statements concerning a charitable gift annuity is (are) correct? I. Payments from a charitable gift annuity funded with cash will be partially tax-exempt until the annuitant reaches his or her life expectancy. II. The annuitant bears a risk of nonpayment from the issuing charity as well as from inflation. A. I only B. II only C. Both I and II D. Neither I nor II LO 4-2-2

Charitable Gift Annuities
Taxation A portion taxable and a portion return of investment until basis recovered Investment risk On charity as it must fulfill promise even if contributed asset has become worthless Donor recourse is lawsuit against charity, donor is general creditor Inflation risk Fixed payments expose non-charitable beneficiary to inflation Administrative costs Simple multi-page contract Lawyers, accountants, financial advisor expense rarely incurred LO 4-2-2

82. All of the following statements about the merits of charitable unitrusts (CRUT) compared to those of the charitable annuity trusts (CRAT) are correct EXCEPT A. The CRAT provides less risk of investment loss than does the CRUT. B. The CRUT is simpler to administer than the CRAT. C. The CRUT offers less risk of its payments being diminished by inflation. D. The CRUT provides more flexibility than the CRAT in structuring the timing of the payment to the noncharitable beneficiaries. LO 4-2-2

Qualities of a CRAT Investment Inflation Administrative expenses
CRAT shifts investment risk to remainder beneficiary which may receive nothing. Income beneficiary sues trustee for breach of fiduciary duty if insufficient trust assets Inflation Fixed payments expose non-charitable beneficiary to inflation Administrative expenses Trust agreement, legal, accounting, professional trustee LO 4-2-2

Qualities of a CRUT Investment risk Inflation Administrative expenses
Unitrusts distribute market risk more evenly between income and remainder beneficiaries though both have risk By limiting income payout to DNI in the NICRUT or NIMCRUT, net income unitrusts, especially NICRUTs, shift market growth to charitable remainder beneficiary Inflation Non-charitable beneficiary not exposed since potential in sharing in any future appreciation Administrative expenses Trust agreement, legal, accounting, professional trustee More complex than CRAT because annual valuation LO 4-2-2

15. Which of following statements concerning strategies for delegating health care decisions is correct? A. A do not resuscitate order can substitute for a health care power of attorney. B. An individual with a declaration of heath care (living will) must also appoint a health care power of attorney. C. Guardianship is the most effective way to delegate health care decisions upon incapacity. D. When adopting a health care power of attorney it is appropriate to choose both an agent and a contingent agent. LO 4-3-1

16. Which of the following statements concerning a power of attorney is correct? A. With a power of attorney the agent delegates certain responsibilities to the principal. B. The problem with a springing power of attorney is that the power terminates after the task has been completed. C. The durable power of attorney terminates at the death of the principal. D. Courts generally interpret the powers of a durable power of attorney broadly. LO 4-3-2

83. All of the following statements concerning incapacity planning for financial decisions are correct EXCEPT A. Incapacity may be an appropriate time to convert a term life insurance policy to a permanent product. B. A special needs trust is an appropriate vehicle for managing incapacity for an older client. C. Some qualified plan trustees will not be willing to make benefit payments to a participant’s power of attorney D. A powerful combination of tools for incapacity planning is a power of attorney combined with a revocable living trust. LO 4-3-2

Competency 5 Evaluate retirement risks and offer alternative solutions to address these risks Section 1: Outliving resources Section 2: Risks associated with aging Section 3: Investment risks Section 4: Risks associated with work Section 5: Risks associated with family Section 6: Other risks

Longevity Facts Alive at 65—average life expectancy
Male = 84 Female = 86 1 in 4 will live past age 90 1 in 10 will live past 95 Social Security calculator Male born in 1953: Age 60 = 83.4 Age 66 = 84.6 Age 70 = 86 Beginning to understand this issue starts with understanding statistics about life expectancy. According to the Social Security Commission, the average life expectancy for those still alive at age 65 for a male is age 84 and for a female is age 86. Maybe more important are the odds of living longer. 1 in 4 will live past age 90 but only in 10 will live past 95. To help identify average life expectancy, Social Security has a calculator. I tried the calculator for me--a male born in The calculator indicated that age 60 average life expectancy is 83.4 years. If I am alive at age 66 life expectancy extends to 84.6 and at age 70 life expectancy extends to age 86. Longevity Risk LO 5-1-1

Longevity Solutions Transfer risk Income for indefinite period
Reverse mortgage—tenure Rental income Dividend paying stock Business interests Defer Social Security Life annuity from employer retirement plan Purchase immediate life annuity Purchase deferred income annuity Deferred annuity (annuitize or income rider Life insurance contract (settlement options/ 1035 for annuity) Systematic withdrawals Withdrawal rate tied to length of retirement Make adjustments More equities Transferring the risk of living too long requires increasing sources of income that provide income for life. Life annuity income can be increased first by deferring Social Security payments. This can be a cost effective approach, and Social Security benefits are also eligible for cost of living increases and for a couple, the higher of the two social security benefits is payable as long as either spouse is alive. Another option is electing life annuity payments from an employer sponsored retirement plan. Many employees with the option to take a lump sum benefit do not make this choice, they elect the lump sum instead. The other option is to purchase an annuity. Here there are a number of product options that address longevity risk. First is purchasing an immediate life annuity to create a stream of income for either the life of a single individual or over the joint lives of a couple. Life annuities can provide protection from dying young by purchasing a term certain or refund feature. Immediate annuities can be purchased at retirement or layered over time in case a person's health status changes as they age. Longevity Risk LO 5-1-1

Contingency Fund Create a portfolio that you don't touch until the later years of retirement Create a contingency fund with: Diversified portfolio Consider a Roth IRA Withdrawals from permanent life insurance contracts Loans from a reverse mortgage line of credit Another way to protect against longevity risk is to maintain a portfolio that is used for the later years of retirement. In one of the strategies that we will discuss in the next competency, called time segmentation—portfolios are built for different parts of retirement. The portfolio for the later years can take on more risk—meaning a higher percentage of equities—because funds are not intended to be spent for many years. Even without that specific strategy, a contingency fund can be built that can be used for longevity as well as other risks. A contingency fund for this risk can be a diversified portfolio—with investments that emphasize long-term growth. A Roth IRA makes a good tax wrapper for this type of account since the value is not diminished by taxes, and if the funds are not needed, the Roth if a very tax efficient vehicle to leave to heirs. A contingency fund could also be the cash value of a life insurance policy—the goal may be to provide the death benefit for heirs, but if needed the cash value can be withdrawn or borrowed from the policy. A reverse mortgage with a line of credit payout option is another good contingency plan. Longevity Risk LO 5-1-1

Inflation Facts Strategies
Some economists worry that the federal deficit may lead to high inflation. Even modest inflation can significantly erode purchasing power over time. Higher inflation rates for retirees Strategies Increasing inflation adjusted income (defer Social Security/TIPs/inflation adjusted annuity) Building increasing streams of income (bonds/annuities) Choosing investments with inflation hedge (equities) Other (withdrawal strategies/prepay expenses) When we think about inflation, many advisors and economists worry the most about years of high inflation. In the U.S. for example, double-digit inflation existed from 1979– Around the world in the 20th century many developed countries saw prolonged periods of high inflation. We will see in a later course that high inflation around the world had a negative impact on the sustainability of a 4% withdrawal rate--important research conducted by Wade Pfau. In addition, today we have some economists that are very concerned that the large Federal deficit may lead to high inflation. It's also important to understand that even modest inflation rates can significantly erode purchasing power over time. For Example: 3 percent annual inflation will mean that costs double for a client who retired at 62 and is now 86. When considering inflation it is also a factor that inflation may affect retirees disporportionately as they spend on items that have higher than average inflation rates. For example, Medical inflation—something that will definitely affect retired clients—has historically been higher than regular inflation. Xxxx senior inflation rate Inflation Risk LO 5-1-2

Excess Withdrawal Risk
Factors Sustainable withdrawal rate research Appropriate adjustments Could have too much or too little spending Careful planning Choose withdrawal rate carefully Stick with distribution plan (client can undermine) Plan for contingencies and other risks Lock-in to avoid risk Income annuities Income riders Bond ladders Sustainable withdrawal rate research—In the next competency we will discuss some of the research on how much can be withdrawn from a portfolio without risking portfolio failure. As you will learn the answer is complicated, and depends upon the length of retirement, the asset allocation, and whether rates of return will match historical returns. It is not easy to determine whether a withdrawal rate from a portfolio is sustainable and requires expertise and computer software. Another factor that affects how much can be withdrawn is whether the client is willing to make adjustments based on market conditions. Another factor is the ability to stay within the discipline of a withdrawal plan. Taking withdrawals from a portfolio allows for flexibility, but that can be a disadvantage as well—when the adult children are buying houses, the grandchildren are going to college or other compelling reasons to spend appear, it’s hard to stay within the discipline of a spending plan. Finally, you can say that to ensure that a portfolio lasts a lifetime, the withdrawal rate needs to be conservative. This has the downside that retirees may not fully enjoy retirement out of a concern of running out of money. So taking withdrawals from a portfolio presents both a risk of spending too much, or spending less than can be afforded. Excess Withdrawal Risk LO 5-1-3

Health Expense Risk Choosing appropriate insurance
Saving enough (amount/level of preparation) Medicare advantage may provide more benefits Pre-Medicare gap—exchanges are new option Shop for insurance plans Choose generic drugs (25% of total costs) Go outside the country for care Solutions for Health Care Cost Risks Planning for unexpected health care costs begins by choosing appropriate insurance. For those age 65 and above who are eligible for Medicare, it means understanding options under Medicare and choosing insurance to supplement Medicare. Having comprehensive insurance helps to make costs more predictable and avoid any extraordinary expenses. Medicare has no cap on out-of-pocket expenses—creating a limit requires supplementing Medicare. In the facts section we discussed the amount of funds needed at retirement to be able to cover insurance premiums and out of pocket costs in retirement. A critical part of planning is making sure that sufficient funds are available to meet these expenses. As we discussed, it is not that easy a calculation, as we saw a big difference between average health case expenses and those with higher costs. So a question becomes how well does the client want to be prepared? Also, when modeling health care expenses, you can build in a lump sum amount to the amount needed at retirement or estimate annual expenses each year. When calculating an annual cost of health care expenses another issue becomes a consideration of inflation. Inflation for medical expenses is generally significantly higher than for other expenses. However, it is not certain that health care costs will continue to rise faster than other costs in the future. Finally, it’s important to understand that the numbers we have been talking about only address health care costs. They do not include costs for those who can not life independently—we address this expenses in the discussion of long-term care risk, or do they reflect additional expenses for getting help with running a home and handling financial affairs which we discuss in frailty risk. These costs are extra! Health Expense Risk LO 5-2-1

Long-term Care Facts 70% of retirees need long-term care at some point
70% of services are provided by family members Negative impact on family caregiver’s career and health Less than 10% of those age 65 have long-term care insurance Average length of long-term care: 2.2 years for male 3.7 years for female $85,000 – U.S. average for one year in a semi-private U.S. nursing home room Alzheimer’s is the number one cause of long-term care Understanding the risk of needing long-term care services is very important. Nearly 70% of all people will need long-term care services. Roughly 70% of all long-term care services are provided by family members outside of an institutional setting. However, this care is shown to negatively impact the caregivers own health and career. Less than 10% of people aged 65 have long-term care insurance to help fund the costs assocaited with long-term care. Which can be substantial as the average length of long-term care needed from a male is 2.2 years and a female is 3.7 years. This coupled with the fact that a semi-private room in a U.S. nursing home costs on average 85,000 dollars a year in 2013. Lastly, Alzheimer’s is the number one cause of long-term care. The risk of developing Alzheimer’s increases as an individual ages, as does the risk of needing long-term care services. As people live longer, the risk of needing long-term care will also increase. Long-Term Care Risk LO 5-2-2

Long-Term Care--Solutions
Insurance Medicare/Medicaid Other programs (Veteran’s benefits) CCRC Hybrid annuity/life-insurance Controlling costs (maintain health) Planning for long-term care The first step when planning for long-term care is to understand the risks and costs associated with long-term care. THe client needs to determine how they want to pay for long-term care and how will care be delivered. Additionally, it is important to take inventory of funding sources you currently have at your disposal for long-term care costs. Do you have long-term care insurance, do you have family members willing to provide care, do you have the option to use a reverse mortage to fund your long-term care costs, are there government programs available for you? Long-Term Care Risk LO 5-2-2

Frailty Solutions Financial Management Household management
Choosing others to make decisions Family members Daily money managers Corporate trustees Control mechanisms Power of attorney Living trust Avoid guardianship Simplify finances (automate and solutions like annuities) Household management Families may help with chores Hire others for home maintenance—be careful! Choose alternative housing Financial management solutions for frailty Having others step in to make decisions may mean involving a family member, hiring a daily money manager, or even selecting a corporate trustee to make investment decisions. Giving someone control is generally done with a power of attorney, which is either currently in force (durable power) or becomes effective only when you are no longer able to make decisions (springing power). Having assets in a living trust is another option, and you can remain the trustee until such time that you name a successor. Preplanning with the documents described here is critical to avoid having to go through a court incompetency hearing in which a court appointed guardian is chosen Simplifying finances can also be helpful by using direct deposit for income payments and automatic withdrawals for regular bills. Some retirement products are simpler to manage as well, such as an immediate life annuity. Frailty Risk LO 5-2-3

Elder Abuse--Facts The annual loss $2.6 billion
Many victims are never the same emotionally The typical victim is a woman age 70 to 89--however, victims represent a diverse profile Families, friends, neighbors, and caregivers were the most frequent perpetrators (55%) of elder financial abuse. Sixty percent of family perpetrators are adult children. Lets look at some of the facts regarding financial elder abuse. Financial elder abuse has a significant impact on retireees every single year. For example, the annual loss due to financial elder abuse is 2.6 billion dollars. Additionally, this elder abuse takes a mental and emotional toll on the victim. These individuals often suffer long-term effects from being taken advantage of and lose trust in others. The typical victim is a woman aged 70 to 89. However, many older men are also taken advantage of and the problem exists across all ethnic and socioeconomic lines. Perhaps the most upsetting part regarding financial elder abuse is who perpetrates these crimes. Roughly 55% of the perpetrators are family members, friends, neighbors, or caregivers. Additionally, sixty percent of family perpetrators are adult children, the exact people many of the elderly family members were relying upon for help. Typical crimes of elder abuse include misuse of powers of attorney, stealing money, using credit cards, and borrowing against the elder person’s home. Financial Elder Abuse Risk LO 5-2-4

Market Risk Hard to determine value at retirement
Saving for 30 years—with different time periods Average accumulation was 10 times salary, but outcomes ranged from 3 to 27 times salary Hard to avoid market risk entirely Increasing equity exposure generally improves portfolio sustainability and ending wealth Equity exposure is key to address the deep risk of inflation Solutions Bifurcated investment strategy Have the lowest exposure to equities at retirement age Purchase downside protection with derivatives and income riders in deferred annuities Wade Pfau illustrated the power of market risk on retirement income planning in a blog post in which he discussed research in which examined 151 hypothetical portfolios. In all cases he assumed a thirty year saving period in which the portfolio received market returns. The only difference being the 30 years being measured– and he used 180 years of historical market returns. What he showed was the amount accumulated at retirement varied a lot-- the average accumulation was 10 times salary, but outcomes ranged from 3 to 27 times salary depending upon the 30 year period tested. The impact of the specific rates of return in the final years of accumulation when the value was the highest had the most impact on the ending value at retirement. This shouldn’t be too hard to visualize—with 2008 not that far behind us. The individual retiring at the end of 2007 may have had a million dollars, while the same person retiring a year later may have only had $700,000 if they the portfolio lost 30 percent of it’s value. It’s also interesting that taking the same portfolios forward another 30 years, using a constant inflation-adjusted withdrawal strategy, he also found that the actual maximum sustainable withdrawal rates over 30-years ranged anywhere from 1.9% to 10.9%. Sustainable withdrawal rates are disproportationately explained by the returns in the early part of retirement. So you can say that market risk and the risk of bad timing of returns is most acute in the final years prior to retirement and the first few years of retirement. Investment Risks LO 5-3-1

Liquidity Inability to have assets available to support unanticipated cash flow needs Planning for sufficient liquidity is an important part of a retirement income plan Is liquidity real or perceived? Flexibility is a related concern Liquidity risk is the inability to have assets available to financially support unanticipated cash flow needs. We could argue whether liquidity is a risk or just a characteristic of an investment—the ability to sell the investment at a reasonable value quickly. —but regardless of what we call it we can all agree that planning for having sufficient liquidity is an important part of a retirement income plan—as we know that retirement comes with unexpected expenses and the need to be able to sell investments. One of the often touted advantages to taking systematic withdrawals from a diversified portfolio is that the strategy offers liquidity. Some would argue that if you are taking withdrawals from a portfolio—that you don’t really have liquidity as you need the assets to meet the withdrawal requirements. But when we talk about liquidity, most are also thinking about flexibility as well—that is in the ability to change strategies in the face of new law changes, investment conditions or other reasons. Clearly a systematic withdrawal strategy offers flexibility. Investment Risks LO 5-3-1

Sequence of Return--Solutions
Reduce volatility Purchase life annuities Build a bond ladder Lower allocation to equities at retirement More asset classes to reduce standard deviation Withdrawal strategy that allows for adjustments Provide for portfolio downside protection Purchase derivatives to protect against downside risk Purchase living benefit riders Sequence of returns risk is tied in part to portfolio volatility. Reducing volatility in the retirement portfolio reduces sequence of return risk. This can be done by Purchasing life annuities or buying bonds to build a specified income stream over a specified number of years in retirement. Sequence of Returns Risk LO 5-3-2

Forced Retirement Facts
MMI study—54% of oldest boomers retired earlier than planned Fewer than 10% had adequate resources 32% cited health reasons/25% cited job loss EBRI—47% retire earlier than planned 55% due to health or disabilities Solutions Plan for a range of retirement ages Negotiate for a severance package If you don’t think that having to retire earlier than planned is a big deal—think again. Study after study consistently show that more than 40 percent retire earlier than planned. Here are two specific studies. A 2013 study from the MetLife Mature Market Institute looking at behavior of the oldest baby boomers indicated that a whopping 54% had retired earlier than planned. In fewer than 10 percent of the cases was it due to having adequate resources to afford retirement. The other cases were for negative reasons. The most often given reason was health concerns, and 25 percent cited a loss of job as a reason. In the 2013 Retirement Confidence Survey from EBRI 47% of retirees indicate that they retired earlier than planned. Of this group 55% retired due to health or disabilities, 20% due to downsizing or company closures and 23% for caregiving responsibilities. Forced Retirement Risk LO 5-4-1

Reemployment Risk Facts
EBRI work in retirement 2013 expecting to work 69% 2013 retirees actually working 25% Reasons for work in retirement (2010 RCS) Almost all gave a positive reason for working stay active and involved (92 percent) enjoyed working (86 percent) Those working solely for nonfinancial reasons is small Ninety percent identified at least one financial reason The EBRI retirement confidence survey asks retirees about work and retirement. Every year the report has shown that percentage that actually work in retirement is much lower that the percentage of pre retirees report that they expect to work in retirement. In 2013 for example, 69%t of those still working expect to work in retirement, while the percentage of retirees actually working is only 25%. The 2013 survey did not ask about reasons why people work in retirement, but that question was asked in the 2010 survey. In that survey Almost all gave a positive reason for working. 92 percent said they wanted to stay active and involved. 86 percent said they enjoyed working. But the number of those working solely for nonfinancial reasons is small. Ninety percent identified at least one financial reason for working. The reasons included wanting to buy extras, a decrease in the value of their savings or investments, needing money to make ends meet, and Keeping health insurance or other benefits. Reemployment Risk LO 5-4-2

Employer Insolvency Private employers Public employers
Defined-benefit plans: Irrevocable trust: PBGC Defined-contribution plans: Irrevocable trust Executive benefits Employees are general creditors Assets remain available to claims of creditors Public employers Defined-benefit plans of municipalities Municipalities can file for bankruptcy Determine priority of pension claims Defined-benefit plans of states States can not file for bankruptcy Earned benefits generally have high standing ERISA provides significant protection for participants of defined benefit plans sponsored by private employers. Employers must meet minimum funding requirements and contributions are made to an irrevocable trust that is outside the reach of the employer to use for other business reasons or creditors of the entity. Even if the minimum funding rules are satisfied it is possible for a plan to have insufficient assets to provide all benefits if the company faced bankruptcy and terminated the plan. For this reason all defined benefit plans covering more than 25 employees are subject to the PBGC insurance program. Employers pay annual premiums and if the plan is terminated with insufficient assets for an employer in financial difficulty, the PBGC will guarantee that benefits will be paid—up to a maximum of about $50,000 a year. With small plans not covered by the program, it is possible that the plan will terminate with somewhat of a shortfall—but ERISA imposes some limits on payouts to highly compensated employees—so it is possible that the rank and file employees would receive all of their benefits. Defined contribution plans provide a benefit based on the participant’s account balance. Both employer and employee contributions are made to an irrevocable trust—meaning that these benefits are quite secure. A defined contribution plan benefit is tied to the investment experience of plan assets, and in most plans that include employee contributions the employees choose the investments. If assets are invested in employer stock—now there is a clear risk of loss if the company has financial problems and the value of the stock declines. To protect participants from this issue, there are limited situations in which employees have no choice but to hold the employer stock—this is more likely in an ESOP. In 401(k) plans sponsored by publically traded companies, there is a diversification requirement that provides that most participants must be given the option to diversity investments. Benefits provided to executives under nonqualified deferred compensation programs are quite different. Here the employee does have risk, and is treated as a general creditor if the employer faces bankruptcy. With nonqualified programs the tax rules require that any assets held to pay benefits—even if held in trust—must be available to the claims of company creditors. Employer Insolvency Risk LO 5-4-3

Loss of Spouse Solutions
Involve both spouses in planning Proper estate planning Maximize the Social Security survivor benefit Choose joint and survivor annuities Life insurance (first-to-die) Long-term care planning Clearly planning for a solution involves ensuring that income needs are satisfied for the surviving spouse. There are a number of ways to accomplish this, but one fact is sure, both spouses need to be involved in the process of building the retirement income plan. If one of the spouses is not comfortable with making financial decisions, the plan needs to address this issue as well. Another part of the plan involves proper estate planning to make sure that wills, trusts and beneficiary designations have been properly completed to protect the spouse. In terms of the financial plan there are number of ways to protect the spouse. One is to make sure that Social Security decisions maximize the survivor benefit. As Social Security continues to pay the larger of the two benefits—a key planning strategy is to defer the larger benefit to maximize the survivor benefit. Loss of Spouse Risk LO 5-5-1

Unexpected Financial Responsibilities
Six in ten (62%) age 50+ today provide financial support to family members Worry about controlling how much they give Concerned about running out of money and being a burden on their families 5.8 million children live in grandparents' homes I think that there are two distinct issues here—one is that seniors want to help their family members and many do. As a Six in ten (62%) age 50+ today provide financial support to family members. This issue was explored in the 2013 Merrill Lynch Study, Family and Retirement, the Elephant in the room. This report explored the issue of helping family members and balancing that with retirement security. As that report showed, older adults are also concerned about being a burden on their children. The study pointed that many struggle with putting appropriate boundaries around their giving. But there is a second issue as well. There are many family situations that are truly unexpected—an adult child loses a job or loses their home in a natural disaster. Adult children may have problems that result in having to take care of grandchildren. A 2013 AARP reports that 5.8 million children live in homes with a grandparent as the head of household. Unexpected Financial Responsibility Risk LO 5-5-2

Other Risks Timing risk Public policy Solutions
Considers the variations in sequences of actual events that can have a significant impact on retirement security. Inflation/market/sequence of return/black swan Public policy An unanticipated change in government policy Tax/Social Security/Health care Solutions Regular review of the plan Advisor who is an RICP Diversification (Roth/tax-deferred) Timing Risk LO 5-6-1

Competency 6 Choose Appropriate Strategies for Turning Assets into Income
Section 1: Approaches Used to Convert Retirement Assets into Retirement Income Section 2: The Systematic Withdrawal Approach Section 3: The Bucket Approach Section 4: The Essential versus Discretionary (Flooring) Approach Section 5: How the Approaches Mitigate Risks

Describe the Three Major Approaches
The structured systematic withdrawal approach The time-based segmentation approach (also known as the “bucket approach” or the “age-banded” approach) The essential-versus-discretionary approach (also known as flooring) LO 6-1-1

61. Which of the following statements comparing the different approaches to retirement income planning is/are correct? I. According to one study, the approach that forced clients to alter their standard of living the most after the Great Recession of 2008 was the systematic withdrawal approach. II. Even though the bucket approach segments investments, the bucket approach may lead to the same portfolio allocation that was envisioned in the original systematic withdrawal portfolio approach. A. I only B. II only C. Both I and II D. Neither I nor II LO 6-1-1

88. All of the following statements about the “Financial Adviser Retirement Income Planning Experiences, Strategies, and Recommendations” research study are correct EXCEPT A. The overwhelming majority of clients getting decumulation advice are considered validators (do-it-yourselfers who want an advisor to give second opinions and occasional advice). B. There is an increased demand for retirement income services. C. The most popular approach to providing retirement income to clients is the systematic withdrawal approach. D. Many surveyed advisors adjust the amount of the systematic withdrawal on an on-going basis using various dynamic withdrawal strategies LO 6-1-2

Structured Systematic Withdrawals
Diversify investments based on risk profile Manage for total return Withdraw a predetermined or policy-based amount Withdraws funded by a combination of interest, dividends, portfolio holdings LO 6-2-1

Systematic Withdrawal Approaches
Most research is based on Initial withdrawal rate (4% of $1,000,000 = $40,000) Inflation adjusted for following years Other approaches for subsequent years No inflation adjustments Withdrawals based on current values Use first approach with guard rails LO 6-2-1

Safe Withdrawal Rate Based on historical analysis the 4 (or 4.5) rate is sustainable in the worst case scenario Also assumes steady inflation adjusted spending pattern Choosing the safe withdrawal rate Comfort of sustaining the worst case scenario Future may not look like the past May be forcing clients to live on less--for many time periods 6-7% would be successful In most cases this approach results in leaving a substantial legacy or the ability to spend more later LO 6-2-1

Safe Withdrawal Rate Research
Rate increases with more globally diversified portfolio Rate increases if withdrawals start at a time when markets are not highly valued Rate increases if the client can take small decreases in withdrawals in down markets Rate increases with a shorter time horizon LO 6-2-1

Factors Choosing Withdrawal Rate
Withdrawal rate for future years (inflation adjusted) Time horizon Other sources of income Asset allocation Amount annuitized Importance of legacy goal Willingness to accept risk in exchange for opportunity to spend more LO 6-2-1

Sustainable Withdrawal Rates and the Middle Class
The tighter it is for the client, the more important it is to focus on the expense side—not the income side. Social Security plays a more important role for the middle class. Do not try and extend portfolio withdrawal rates beyond what is reasonable—but should take advantage of research findings—consider higher withdrawal rate with adjustments for market conditions LO 6-2-3

Glide Path Glide path deals with the change in equity allocation over time (as you get older, reduce equity allocation) Constant portfolio over all ages was the best to avoid portfolio failure. Reduction in standard deviation is important LO 6-2-4

89. All of the following statements about the safe withdrawal rate are correct EXCEPT A. Using a safe withdrawal rate of 4 percent means that 96 percent of the time the client will have their principal left over. B. Using a safe withdrawal rate of 4 percent means that at the median level wealth is increased by a factor of 1.6. C. The safe withdrawal rate research should be interpreted to indicate that clients need to save enough money to only draw down 4 percent per year, adjusted annually for inflation. D. The safe withdrawal rate approach to retirement income planning focuses on making the client’s assets last for the specified period (e.g., 30 years) under a worst case scenario for investments. LO 6-2-1

Bucket Approach Create time segmented portfolios to meet income needs for specified time periods Some divide buckets not based on time segments but based on asset classes or other classification Choose investments based on portfolio objectives Most conservative for short-term bucket and most aggressive for longest-term Distribute assets from first bucket before second and so forth LO 6-3-1

Why Consider Time Segmentation?
The three phases of retirement Phase one—The client is the same as he was before retirement. This typically means the client has no limitations (fully active). Phase two—The client experiences moderate limitations. Occurs at different times for different people in the relationship Relationships and interactions with others become more meaningful Phase three—The client experiences significant limitations. Appropriate and regular support are needed Family caregivers may need to leave their own jobs Planning is not just financial planning for the supports needed at the next stage Activity portfolio—document what am I going to do to stay engaged LO 6-3-2

Strengths Integrates asset allocation with income allocation
Can accommodate different risks that occur in different phases of retirement Bucket approach may resonate well with clients: Stocks are for later time periods, so the client can buy and hold rather than worry about short-term market fluctuations. Without looking at a bucket approach, it is difficult to rationalize to a client why stocks should be in a retirement fund. Clients can sleep better at night. Total asset allocation may be similar to systematic withdrawals LO 6-3-1

How Time Segmentation Works
Common to choose three 10-year time segments representing the 30 years of retirement (this can vary) Estimates of retirement needs for each period can vary—allowing a more accurate calculation of need Assets in short-term bucket meet current income needs--laddered bonds, term certain annuities or other The assets needed for later time periods (the second and third buckets) are invested for growth Accommodates both investment and product allocation Over time adjustments can be made As one bucket is emptied As goals and objectives change As the economic conditions change LO 6-3-1

65. Which of the following are rationales for using the bucket approach to retirement income planning rather than the systematic withdrawal approach? I. If the portfolio has one required rate of return under the systematic withdrawal method, there is a mismatch between term risk and portfolio return which does not occur in the bucket method, which accounts for matching up term risk and portfolio return. II. Bucket approach investing works better from the behavioral economics standpoint than systematic withdrawal investing. A. I only B. II only C. Both I and II D. Neither I nor II LO 6-3-1

Flooring LO 6-4-1 Flooring (also known as essential vs. discretionary)
A portion of the portfolio is put into guaranteed or low-risk products or ladder strategies to create an income “floor” to meet essential expenses Social Security (when available) creates at least a partial floor—delaying increases floor Sometimes the essential vs. discretionary approach is thought of as annuitization for the core piece and invest for the rest Guarantee the basic expenses—allow for upside potential on the discretionary expenses A challenge can be that clients think of standard of living, not essential vs. discretionary expenses LO 6-4-1

Flooring Example: George and Gracie would like to lock in money to pay for rent, groceries, and car insurance (among other fixed expenses). They purchase an immediate annuity with an inflation rider to provide monthly income on a joint and survivor basis until they both have died. George and Gracie can combine their annuity income with their Social Security income to pay for the basic expenses. They will then use the remainder of their portfolio to provide for their budgetary “wants and wishes.” LO 6-4-1

The Annuity Puzzle LO 6-4-2
There is a high degree of aversion to voluntary annuitization among retirees even though annuities offer security and sustained income. Advantages of annuitizing the floor with a fixed immediate annuity Annuities defeat mortality risk. The client is given a stream of income for as long as they live. Annuitants might enjoy a “mortality premium”—those who have long lives will benefit from the pooling of assets with those who have short lives. Annuities suit clients with a low level of risk tolerance because they eliminate the volatility of investing the client’s assets. Annuities prevent a client from consuming assets too quickly. They are an excellent antidote to excess withdrawal risk. LO 6-4-2

Analyze How Strategies Affect Risks
Longevity risk Flooring with annuities provides direct protection Other approaches do not protect directly If investments are successful assets will be available Both approaches are flexible and can allow for change when circumstances change Excess withdrawal risk Locking in with the flooring approach eliminates the option of spending too much Other approaches focus on choosing appropriate risk and reevaluating the plan LO 6-5-1

Analyze How Strategies Affect Risks
Inflation risk Use approach that allows more assets invested in equities Purchase inflation adjusted life annuity Variable annuity with guaranteed income rider Reinvestment risk Bucket strategy requires changing investments frequently Also applies to other strategies that require reinvestment over time LO 6-5-1

Liquidity and Legacy Risk
The flooring strategy creates the greatest liquidity and legacy risk problem because of the use of an annuity to create the floor Systematic withdrawals and bucket strategy better address these risks LO 6-5-1

Competency 7 Integrating approaches, risks, products, and strategies to create an effective retirement income plan Section 1: Retirement Income Products Section 2: Applying Products Section 3: Practical Application Section 4: Monitoring and Adjusting the Plan Section 5: Case Studies

T/F Section 7-1 Large cap stocks are more likely to provide a risk premium than small-cap stocks The FDIC insurance limit at a single institution applies to all of an individual’s accounts regardless of how they are titled. Thirty year treasuries would effectively protect against price risk but not reinvestment risk. A variable immediate annuity provides a floor income with a possibility of increasing benefits. Open ended indexed mutual funds can be traded intra-day.

Systematic Withdrawal Investment Strategies
Start with asset allocation appropriate for client’s risk tolerance Equity position to sustain withdrawals (50-70%) Too little increases exposure to longevity and inflation risk Too much adds to portfolio failure risk Consider separate holdings to allow redemption of appreciating assets LO 7-2-1

95. All of the following statements concerning the asset allocation model used when the systematic withdrawal approach is followed are correct EXCEPT A. A large percentage in equities will help the client with inflation and longevity risk, but may hurt the client with market risk. B. At any given point in time, the planner should be able to determine which assets will be targeted to provide current income. C. ETFs should not be used with systematic withdrawals because the surrender charges involved with this product make them undesirable to provide current income. D. If a client owns enough asset classes, it is more likely they will be able to sell a “winner” to fund current income. LO 7-2-1

Products for the flooring approach
Immediate annuities Deferred annuities with benefit riders I bonds Tips Discretionary expenses Systematic withdrawals Bucket approach LO 7-2-4

96. All of the following statements about investment products used with clients who are following the systematic withdrawal approach are correct EXCEPT A. Deferred variable annuities may be appropriate for the equity side of the portfolio that is held to provide income in the later years. B. Growth equity funds may be appropriate for the equity side of the portfolio that is held to provide income in the later years. C. Bond unit investment trusts (Bond UITs) can give the clients target maturity dates. D. Clients should link their bond holdings to positively correlate with equity markets (when equities go up, bonds go up). LO 7-2-1

Practical Considerations
Client may not be clear what they want Only arrive when there is pressing need Haven’t lived through this before Lot’s of starts and stops along the way Understand goals before getting to facts Spouses can have very different visions Work through alternatives with clients LO 7-3-1

Practical Considerations
Planning focuses on when to retire, at what income level, and how much risk is acceptable Help client obtain two of three goals (with a shortfall) Communicate alternatives—let client help choose plan There is often information you don’t know Resistance may mean client did not “buy” plan Be quick to address issues--without overreacting Some annual planning (tax) is required Reach out to clients in a number of ways (meetings, s, statements) LO 7-3-1

Monitoring the Plan Sec 7-4 RisQuotient
Monitoring the retirement portfolio Use a mathematical formula (not Monte Carlo analysis) Factors in longevity, expected return, standard deviation and spending rate High risquotient means risk of failure—time to act Sordex—stress testing the portfolio Compares the client’s current situation to what would happen in extreme circumstances High ratio means more monitoring required What is the capital preservation rule? Withdrawal rate increases 20% reduce payments by 10% and if withdrawal rate decreases 20% increase 10% Portfolio loss means no inflation adjusted withdrawals Sec 7-4

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HS 353 Review David Littell, JD, ChFC®, CFP® Director, NYLCRI,

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HS 353 Review David Littell, JD, ChFC®, CFP® Director, NYLCRI,

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