Jul 10, 2014

The Retirement Time Bomb No One Wants to Acknowledge

Medical science has extended life expectancy significantly over the last decade. Today a male who reaches age 65 can expect to live to age 84, according to the Social Security Administration. Female life expectancy for the same period is age 86.

In 2008, Barbara Walters hosted a TV program entitled. Live to 150, Can You Do It? On the show, she asked the audience to guess how many people are at least 100 years’ old in the United States. Would you believe at the time (2008), there were more than 84,000? That number has been climbing at an astonishing rate. By the time America’s baby boomers reach that milestone, there could be more than a million centenarians.

In Andy Kessler’s The End of Medicine and Ray Kurzweil’s Fantastic Voyage, they predict the end of heart disease, stroke and cancer owing to new imaging techniques, nanotech, viral and protein science, and genetics. These two celebrated futurists believe that these developments will create a major increase in lifespan, overall health and a steady reversal of the aging process within five to ten years.

The implications of medical improvements in the treatment of the major diseases that cause infirmity and death may revolutionize the longevity of boomers reaching retirement, as well as the population at large. This increase in longevity will change how we think about retirement and the way we plan for it. Unfortunately, few are talking about this issue.

To repeat, people are living longer on average (males to 84; females to 86). One out of every four 65-year olds today will live past age 90, and one out of 10 will live past age 95, according to data compiled by the Social Security Administration. Calculate your own life expectancy by using Social Security’s Life Expectancy Calculator.

Might you reach 95? And what are you doing about it to ensure you do not outlive your money?

DISTRIBUTION ELECTIONS

My focus for this blog is to explore and advise on all things to do with nonqualified deferred compensation plans, which make up a large percentage of highly compensated executive’s wealth accumulation for retirement benefits. Here, I want to discuss what impact some of these executive’s decisions may have on their retirement income. However, these implications impact all retirees.

I have been designing and funding nonqualified plans for over 30 years, and like most advisors, with a focus on accumulation. But let me alert you to an ominous development: Many of my participants who accumulated large account balances in their plans are now running out of money. They took ten or 15-year distribution elections, and have now lived beyond those elections. Worse yet, many who were concerned with their company’s general creditor status took lump sums, paid income tax on those distributions, and were forced to invest after tax in their retirement years. With people living longer, my focus now is on the quintessential importance of distribution, especially how one can design a retirement plan to generate guaranteed lifetime income.

ASSET ALLOCATION

Formulas for retirement asset allocation used by standard financial advisors assume similar life expectancies; they typically allocate fixed income assets at time of retirement for a 65 year-old at 50 to 60 percent. As the retiree ages, the asset allocation percentage increases for fixed income in their current models.

Historically, this asset allocation accomplished two purposes: principal preservation and provision for a planned withdrawal process from the generated interest income. However, with fixed-interest rates so low, retirees today depend on stock market returns to generate the higher returns needed, even though their advisors recommend different asset allocations!

LOOK AT HISTORY

The 1980s and 1990s saw one of the largest gains in stock market value in United States history. Due to this twenty-year rise in value, many of today’s retired executives and many who are going to be retiring in the next decade came to see a rising stock market as “normal.” While millions of investors still hope the stock market will return to the “good old days” and “act normal,” Bill Gross of PIMCO says that investors need to “wake up to the fact that we are in a ‘new normal.’”

Let’s look at recent history: 1999 to 2009. Since inflation averaged approximately 3 percent per year in the past decade, investors who left money in the stock market lost more than 30 percent of their buying power over this ten-year period. And when they add mutual fund fees of one percent per year and financial advisors fees of one percent per year to flat returns, these investors would have lost five percent of their spending power.

So how should executives allocate their account balances in their retirement years?

IMPACT OF INFLATION

Inflation is a top concern. Ten-year bonds now pay 2.6 percent. An investor can get a higher return by assuming more risk, but he/she needs to balance this decision with the knowledge that bond-market cycles have periodic wash outs of higher yielding securities that destroy principal similar to the one we experienced with the subprime fiasco.

Long-term inflation in the United States hovers at three percent. Thus, ten-year bonds roughly cover expected inflation.

The income from ten-year bonds will roughly cover expected inflation as long as the investor can reinvest all of the income received in comparable returning bonds. Unfortunately, that income is meant for living expenses and is only available after payment of any investment management fees and taxes the investor incurs. But expenses that grow faster than average inflation rate, such as medical costs, future cost shifts and reduction of social security benefits, added taxes and any unforeseen expense, will further reduce future income.

Thus, if the plan at retirement includes only living expenses after income taxes, there resides little re-investment room in the portfolio to keep pace with inflation. So the retiree loses considerable purchasing power over time. This condition represents the law of compounding in reverse; know that it will result in an income loss of 50 to 60 percent of purchasing power in a 25 to 30-year period.

What’s more, as more of the portfolio is committed to fixed income, the retiree becomes less and less able to maintain his standard of living. In my opinion, this is simply not a reasonable solution!

FUTURE TAX RATES

Another characteristic of the new normal is the reality of higher taxes to pay for the recordbreaking federal budget deficit and state budget deficits. Since executives, with all of their wealth accumulation, may be paying even more in taxes at the same moment they’re trying to accumulate more to recover from investment loses suffered, there will be far less money for retirement distribution.

Will taxes be higher when you take distributions from your plan?

NEW ERA OF ASSET MANAGEMENT

So today’s nonqualified plans, as currently designed, may not be affording executives adequate preparation for expected longevity and future taxes. Consider too the “industry standard” investment strategy approach which, in my opinion, fails to protect the current purchasing power of a retiree over an extended retirement period. In short, the old solutions no longer work.

The consequences of these failures, until corrected, will create serious issues for the highly compensated in their retirement years.

By taking a long-term financial planning view to plan design, you can overcome today’s deficiencies at retirement. This situation is one driver leading to an unprecedented interest in annuities by retirees and pre-retirees. Index annuity sales are rising almost every year. In fact, many people would now like an annuity option in their 401(k) plan or other defined contribution plan, according to Met Life’s Annual Study of Employee Benefit Trends.

Why not in your nonqualified plan too?

At Benefit Funding Group, we focus on building vehicles for income generation and asset distribution for nonqualified participants across America. Influenced by the breakthrough research of the leading academics in retirement income planning—Professor David F. Babbel and Professor Craig B. Merrill of the Wharton Financial Institutions Center―we see measurable value in using annuities in funding strategies for nonqualified plans, especially indexed annuities that provide principal protection.