For the overwhelming majority of Americans, having secure retirement income in the future doesn't seem like a very sure thing. Consider the traditional "three-legged stool" that past generations had in place to support their retirement:
• First and foremost, a pension or some form of defined contribution plan from a company where you have worked. Sadly, these plans have all but disappeared. In their place are 401(k) plans where the responsibility is on the individual to contribute to his or her personal retirement.
• Second, Social Security. For those of us age 50 or younger, there are serious concerns as to the long-term solvency of this program. At a minimum, it would be realistic to assume that qualifying ages to receive Social Security will continue to be raised, and perhaps even some form of "means testing" introduced. The bottom line? Over the long run, this benefit simply won't continue as it always has, and in the same form.
• The third leg is personal savings. In the past, savings were an additional supplement to the above retirement finance components. With the extinction of traditional pension plans and widely anticipated alterations in the social security safety system, this is now the most important leg of the stool.
The key for investors today is to find ways to translate personal savings into more assured income streams in retirement—in effect, to create one's own personal pension plan. Here are two strategies that most average investors can adopt:
• Create a laddered debt portfolio*. This is a strategy for managing fixed-income investments in which the investor divides his or her investment dollars evenly among bonds or CDs that mature at regular intervals (i.e., every six months, once a year, every two years, every five years, etc.).
Here's how it works. Let's say you have $50,000 in savings that you want to allocate more money toward bonds. Using this approach, you could buy five different bonds. The face value of each bond would be $10,000. Each bond would have a different maturity and interest rate. One bond would mature in one year, another in three years, and the remaining bonds would mature in six-plus years.
The goal is to generate consistent returns while lowering risk and maintaining as much liquidity as possible. By staggering the maturity dates, you won't be locked into one particular bond for too long. This is an important consideration given today's low-interest rate environment, because sooner or later, interest rates will rise, and bond investors will want the opportunity to capitalize on higher rates.
The second reason for a diverse bond mix is that it provides investors with the ability to adjust cash flows according to their financial situation. This is important for retirees who depend on the cash flows from investments as a source of income. Having a consistent stream of maturing bonds allows for access to liquid funds. If an unexpected situation arises, such as the loss of a job, you would have a steady source of ready cash.
Because many types of bonds can be "called"—in effect, prepaid by the issuer of the bonds—an added benefit with this approach is that it reduces the risk that all the bonds in one's portfolio will be called at once.
• Tax deferred variable annuity with a living benefit income rider**. The growth of tax-deferred annuities has soared in recent years as stock market volatility has prompted insurers to create products that offer individuals the ability to participate in market returns while placing a "safety net" under the income that a variable annuity can provide. With a variable annuity, an investment component exists in a managed pool of assets, called "subaccounts," that comes with the insurance contract intended to offer various protection features, such as a death benefit and other available options for an extra charge or fee, often called "riders." Any earnings growth is tax-deferred, meaning taxes won't be due until you begin receiving payments. In exchange for your investment, the insurance company agrees to pay a stream of income over time, depending on the contract chosen.
This is how such a living benefit income rider typically works: Let's say you have $100,000 to invest. If you purchase your contract with a "living benefit income rider," you would be guaranteed an income of 5 percent or $5,000 per year for life even if market conditions eroded your principal to zero. In the event that the market rises substantially, you may be able to lock in higher income levels as the principal value rises.
One downside to these retirement vehicles is that while the investor may enjoy a guaranteed income of, let's say, 5 percent of the initial investment or some subsequent high-water mark for the rest of that investor's life, the underlying principal will fluctuate with market conditions.
Another criticism of these income guarantee riders is that the fees can be relatively high. Proponents, however, would argue that providing investors the ability to invest in the stock market while guaranteeing a known income stream regardless of market performance is a strategy that should not be overlooked.
Like it or not, for most Americans, the changing face of retirement means that we need to adopt new tactics to get investment results that are as close as possible to what our parents and grandparents enjoyed. With some detailed planning, we can each have our own personal pension plan.
Doug Lockwood, CFP is a Partner at Harbor Lights Financial Group, a full service wealth-management team that has been dedicated to assisting clients in the accumulation and preservation of their wealth for over eighteen years. He was recently named one of America's Top 100 Financial Advisors by Registered Rep Magazine (August 2010) based on assets under management.
Doug Lockwood is a registered representative with and securities offered and advisory services through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC.
* Bonds are subject to market and interest-rate risk if sold prior to maturity. Selling bonds prior to maturity may make the actual yield differ from their advertised yield and may involve a loss or gain. Bond values will decline as interest rates rise and are subject to availability and change in price.
** Variable annuities are long-term, tax-deferred investment vehicles designed for retirement purposes and contain both an investment and insurance component and carry insurance related charges. They are sold only by prospectus. Guarantees are based on claims paying ability of the issuer. Withdrawals made prior to age 59 ½ are subject to 10 percent IRS penalty tax and surrender charges may apply.
Riders are additional guarantee options that are available to an annuity or life insurance contract holder. While some riders are part of an existing contract, many others may carry additional fees, charges, and restrictions, including minimum holding periods and age requirements. The contract holder should review their contract carefully before purchasing. Guarantees are based on the claims paying ability of the issuing insurance company.