Retirement Income Blog

Let’s first state three fundamental principles and then add the details.

1.      Start retirement with sufficient retirement savings

2.      Protect your retirement savings from erosion due to taxes and inflation

3.      Never lose money

Start with your desired retirement income and expenses.  Then, you can use a retirement income calculator to determine how much retirement savings you will need. You need to know how large of a nest egg is required for a comfortable retirement.  Most people don’t like to do this rigorous exercise of charting your expenses and income over time.  If you won’t do it, then hire a retirement planner who will.  I highly recommend the retirement planning software from J&L planners as it allows you to account for detailed changes in your income and expenses year by year.  Only by doing the math do you know how much you need and when you are able to retire. 

Next, you need to take advantage of as much tax shelter as possible.  For most retirees, that means using your unsheltered money first (e.g. your non-IRA, non-401k funds) .  You want to let your tax sheltered money grow as long as possible.  The caveat here is the uncertainty of future tax rates. Future income tax rates may be higher than today. You can have a retirement planner calculate for you the tax rate at which it is better to use your sheltered funds first.  In fact, understand that the plans you make at the beginning of retirement can change because of changes in tax rates or other variables.  That’s why smart retirees will update their retirement plan every 24 months.

Last, you need to be sure your principal never declines.  That would seem impossible based on the advice in the retirement-Income.net web site that recommends you keep 50% of your funds in stocks and everyone knows stocks go up as well as down.  BUT, you will never rely on these stocks for retirement income.  Your money will always be in at least 2 baskets—your liquidity basket from which you make withdrawals for your living expenses and your growth basket which replenishes your liquidity basket at long intervals.  You will never take funds from your growth basket to live on and the long intervals create a very high probability that you will only have gains in your growth basket between transfers to your liquidity basket.  Consider for example that over the last 80 years, when stocks have been left alone for 10 year time intervals, they gained in value 97% of the time.

Of course, in terms of protecting your retirement savings, there may be other asset protection measures such as trust and estate planning that you do for your heirs.

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One of the advantages of immediate fixed annuities is the feature that provides you with income for the rest of your life, for both you and your spouse, or simply to pay you for a fixed number of years. But what’s the best choice for you? Let’s consider some payouts based on annuity type and other factors to get a feel for what to potentially expect.

We’ll hypothetically assume a man has $50,000 to invest in an annuity. He’s 70 years old with a remaining average life expectancy of 16 years. What kind of payouts can he expect to get?

If he wants an immediate fixed life annuity on himself, a hypothetical insurance company  determines a monthly payout for him based on his sex, age, investment amount, and the current interest rate. The current interest rate is particularly important since their profit will be based on how much they’ll get for investing his $50,000. They’re predicting the man will die 16 years later (at least that’s their bet based on the average life expectancy of males age 70) so they know how many monthly payments they must make. They’re obliged to keep paying if the man lives longer, but also get to keep the investment if the he dies earlier than expected.

Life Expectancy
In our hypothetical case, the monthly payout is $385.  Incidentally, if the man were 80 years old his remaining life expectancy would be 11 years. So the insurance company would pay out $554 per month since they’ll be statistically paying for fewer months.

Gender
Women statistically live longer than men. A 70 year old woman has a remaining life expectancy of 20 years. This implies more monthly payouts by the insurance company so her payout is only $352 for that $50,000 investment. And if she were 80 years old, her monthly payout would be $498 – somewhat less that then 80 year old man’s, because of her still longer life expectancy.

Joint Life
A married couple may opt for a joint life annuity where payments will continue until the second spouse dies. In the case that both are 70 years old, the insurance company would pay $318 since statistically it turns out that between the two, the survivor would statistically live longer. The payout remains the same even if only one remains alive 

Finally, if the single 70 year old man chose an annuity for a certain period – 10 years – under the prevailing rates, he’d receive $515. But in this case, the insurance company would pay his beneficiary the remaining payments if he died. The payout is the same for the women since there’s no age or age-related sex difference issue here.

For the most current rates, use the immediate annuity calculator.

Immediate fixed annuities are the payment of a single premium to an insurance company in return for periodic payments over a specific period or life.  Once payments begin, the annuity cannot be surrendered for value (there are a few companies that do allow commutation–the surrender of the annuity for a discounted refund).  Income from annuitization is taxed part as ordinary income and part as return of capital and a 10% penalty could apply if the recipient is under age 59 1/2. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. For other ways to generate income in retirement, visit the retirement planning center.

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Let’s work up the ladder of rates that you can get from guaranteed retirement income sources. We skip treasury securities because bank deposits pay more and they also have a federal guarantee (up to $250,000 per depositor through 12/31/2009)

Bank Certificates of Deposit – in terms from 3 months to 5 years.  Generally, the longer the term, the higher the rate.  Interest is available monthly for a guaranteed retirement income or can compound. FDIC insured.  Rates available daily across the US at bankrate.com.   One year CD is 4% at most banks as of 10/28/08.  After inflation and taxes, you actually lose money.  Therefore, holding large sums for long periods in CDs is financially foolish.

Annuities—guaranteed by the issuing insurance company, safest companies rated AAA by Standard and Poors.  Large companies like Prudential and New York Life actually lent money to the US Government during the depression so deposits with them are pretty safe.  Use deferred annuities  (paying 5% or so) if you don’t need the income or immediate annuities if you need the income (often called retirement annuities).  A 70 year old male can get $769/month for life on a $100,000 deposit (equal to a 9.2% cash on cash return).  Payments end at death and nothing is left.  Some immediate annuities provide a feature for payments to heirs in case of early death.

Federally Backed Mortgage Notes—Although you’ve heard a lot in the news about Fannie Mae and Freddie Mac, the US government has backed their securities 100% giving them AAA safety.  The same goes for Ginnie Mae Securities.  Your money gets loaned for mortgages and the government agency guarantees your investment.  At 15 years, rates approximately 6%.  Actual term is uncertain as people can pay off their mortgages early.  Income is monthly.

Municipal bonds—a source of guaranteed retirement income from cities, states or municipal districts.  Buy those rated AAA for best security. Income is paid twice annually. Or, for another idea of guaranteed retirement income, build a ladder of zero-coupon municipal bonds.  Interest and principal is paid all at once at maturity.  Example:  male age 52 buys $75,000 face value of municipal bonds to mature starting at age 62 and for each year thereafter for 20 years to provide $75,000 of tax free income annually.  Cost today of each bond averages less than 40 cents per face value. Yields of 6% tax free currently.

Corporate bonds and preferred shares can be are a reliable source of guaranteed retirement income from corporations.  Again, for safety, buy those that are highly rated, at least A.  Some opportunities to get 8% at the current time.  Bonds pay interest twice annually and preferred shares pay dividends quarterly.  Dividends from preferred shares qualify for a reduced 15% income tax to help with tax planning.

Diversify amongst these guaranteed sources of retirement income and enjoy a more comfortable senior citizen retirement.

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A 457 retirement plan is a nonqualified (i.e. does not need to meet the restrictions set up by IRS under section 401) deferred compensation plan for government employees and tax-exempt organizations. The plan designed to comply with the rules of Iinternal Revenue Code section 457 is referred to as a Section 457 retirement plan. Employees are allowed to defer compensation on a pre-tax basis through payroll deductions that further allows them to defer federal and sometimes state taxes until the assets are withdrawn. In effect, a 457 retirement is quite similar to a 401k plan used by for-profit employers.

Participants in the Section 457 retirement plan can defer income up to 100% of the employee’s compensation limited to an annual amount set by IRS–$15,500 for 2008 plus a $5,000 catch-up contribution for people age 50+.

The types of entities that can establish a 457 retirement plan are states, subdivisions of states, instrumentalities or political subdivisions of states, or any entity other than a governmental unit that is exempt from federal income taxes. Governmental units that are exempt from federal income taxes include the following types of organizations:

charitable organizations
religious organizations
educational organizations
private hospitals
private foundations
labor unions
trade associations
fraternal orders
farmers cooperatives

Note that these tax exempt entities may also have a 401k plan for their employees and the employees may contribute to both plans up to the $15,500 maximum for each. There are no contributions by the employer with 457 retirement plans as there are with 401k plans. Additionally, your account in a 457 retirement plan can be rolled over just like a 401k, into an IRA or other qualifying tax sheltered plans. Unlike a 401k, if you retire or leave an employer before age 59 1/2, there is no 10% penalty for accessing your 457 retirement plan balance. Typically, employers that proivide a 457 retirement plan will also provide assistant from retirement consutltants to help understand the intracacies.

Below is a chart showing the differences and similarities between a 457 retirement plan and 401k plan. If you are eligible to participate in a 457 retirement plan, the decision to contribute would be part of the considerations of your whole retirement income plan.

Post provided by Javelin Marketing

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There are several types of employer sponsored retirement plans and your employer likely provides ONE of these.  You don’t have a choice but you want to have a basic understanding of the plan being offered to you and you want to participate as a way to maximize your retirement investing. Employers have these plans in place as a benefit that helps then attract better employees.  By making use of the plan, there is typically a tax savings to you.  In prior years, the money that went into the plan was contributed by the employer but that’s less and less true.  Most employer sponsored retirement plans now call for contributions from the employee such as 401k plans in for-profit companies and 401 and 403 plans in non-profits.
Employer sponsored retirement plans are called qualified plans because they comply with section 401(a) of the Internal Revenue Code. Employer contributions are tax-deductible and may be subject to vesting schedules. Participant contributions are always immediately vested. All contributions (employer and participant) and earnings are tax-deferred until they’re withdrawn.
Money purchase plans
A money purchase plan is a pension plan that has a mandatory annual contribution by the company. Company contributions can be as high as 25% of wages, up to IRS limits which change annually. The contribution formula is set by the plan terms. Contributions can be subjected to a vesting schedule. For example, if you leave after 2 years of employment, you may get 20% of your accounts value, after 3 years, 30% of your account value, and so on.
Profit-sharing plans
This is not a good name because profit sharing plans have nothing to do with sharing profits. In fact, with a profit-sharing plan the company management arbitrarily decides how much to contribute to the plan each year, up to 25% of wages. Vesting typically applies as described above as it does with most any employer sponsored retirement plan where the employer is contributing money.
401(k) plans
Most popular in for profit companies is the 401k because the company does not need to contribute anything to the plan, although many companies do.  These employer sponsored retirement plans allow you, the employee, to contribute funds for your retirement, similar to putting money in an IRA but you can contribute more to a 401k. By making pretax contributions, participants have an opportunity to reduce their current taxable income while saving for retirement. Some 401k plans also allow Roth contributions (no tax deduction today, but all earnings are withdrawn tax free, thereby maximizing retirement income).  Some companies provide a matching contribution as an extra incentive for the participants to contribute.

Participant deferrals do not count toward the deductible limits. Matching contributions may be subjected to a vesting schedule. Both participant and employer-matching contributions are subject to discrimination testing which is a way that the government insures that the plan is benefiting many employees, not just the highly paid.
Other employer sponsored retirement plans:
Simplified Employee Pension plans (SEP)

SEP contributions are funded with employer discretionary contributions and can be up to 25% of pay for each eligible employee. Participant contributions are not allowed except for some SARSEP plans still in existence. All employer contributions are made to IRAs for the benefit of the eligible employees and are 100% immediately vested. Contributions and earnings grow tax-deferred until the money is withdrawn by the participant but these types of plans have become less popular with the increased use of 401k plans.
Savings Incentive Match Plans for Employees (SIMPLE) IRAs
A SIMPLE IRA is a retirement plan for small businesses. The company must either match participant contributions (dollar for dollar up to 3% of pay) or make a contribution of 2% of pay for all eligible participants. Contributions are 100% immediately vested. To sponsor a SIMPLE, a business cannot have more than 100 eligible employees during the preceding calendar year.
403(b) plans
A 403(b) is a retirement plan for employees 501(c)(3) organizations on-profit organizations. Participants can make pretax contributions of up to $15,500 for 2008. Some organizations match participant contributions. Similar to a 401(k) plan, participant pretax contributions are 100% immediately vested, but matching contributions may be subjected to a vesting schedule.

Here are the contribution limits for 2008:

Employer-Sponsored Retirement Plans — 2008 Contributions

^* For individuals who are age 50 or older.

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Sources of Retirement Income You Control

Many retirees lack control over 50% or more of their retirement income.  For example, if a retiree has income of $50,000 annually, and $30,000 comes from social security and employer pension, the retiree controls less than half of his retirement income making those sources somewhat useless to discuss.  So let’s focus on the sources of retirement income you can control and how to boost them.

Interest Income
An important source of retirement income is Interest income.  Interest income comes from money you loan.  You may loan it to a bank (in the form of savings accounts or term deposits), you can loan it to a company in the form of owning a bond, you can loan it to a local government in the form of owning a municipal bond and you can loan it to a national government, US or otherwise.  In all cases, these sources of retirement income you control because you select the instruments to own.  Generally, the longer term instruments will pay you higher interest income.  For example, if you want to loan your money to the bank for 12 months, don’t be upset to earn only 4%.  If however you loan you money to IBM for ten years, you may earn 6%–a whopping 50% more in your retirement income.

Of course you may come up with all types of reasons  not to lend to IBM–its not as safe as the bank, ten years is too long, etc. but all of these excuses add up to a much smaller paycheck for you.

Dividend Income
Dividend income from stocks and mutual funds can be an important and significant source of retirement income. If you own mutual funds, there are funds oriented toward paying a consistent dividend income and those that do not.  Are you in the right funds?  Similarly, there are value stocks that pay dividends in the 5% neighborhood while many growth stocks pay no dividends at all.  By your selection of stocks and funds, you control this important source of retirement income.

Annuitization
Although many retirees don’t often think of their retirement income in the following way, they should.  Your assets are always a source of retirement income and how much of your assets you “annuitize,” i.e. convert to an income stream, is a personal decision that can be the difference between eating filet mignon or dog food.  The simplest way to create this source of retirement income is to buy a life annuity from an insurance company.  For example, a 70 year old male purchasing a life annuity for $10,000 can expect payments of $8,500 annually for life.  Of course, when he dies, the $100,000 is gone.  BY purchasing the life annuity, he has converted capital to a source of lifetime income. The immediate annuity calculators will give you an idea of how much retirement income you can obtain in this manner.

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McKinsey in their recent report on The Coming Shakeout in the Defined Benefit Market estimates that 50-75% of all private Defined Benefit assets will be in a frozen or terminated status by 2012.  In plain English this means that retirement plans offered by companies will cease or terminate in the next few years.  If you are working, the pension plan is likely to cease and your balance will be rolled over into a 401k  — meaning that any future contributions to your retirement plan will come from you, not the company.   If you are already retired, it’s likely you will get a lump sum payout as the employer will terminate the plan. In other words—you’re on your own. Start with the retirement income calculator to determine your needs.

The trend in retirement solutions is that you must fend for yourself.  Companies, being for-profit entities are facing the music and closing down their plans because they simply cannot afford them.  The US Government can delay facing the music and keep people in denial that the Social Security system will never sustain itself.   While people currently age 65 or older will likely not see any changes to their Social Security benefits, they will likely see a dilution in their employer retirement benefits, possibly with a reduction in monthly pension payments or the reduction or elimination of heath care benefits.  Those under age 65 should not rely on anyone but themselves for retirement solutions.

Fortunately, there is a lot you can control that determines your comfort in retirement.  These retirement solutions include:

Where you live—if you live in a high costs area (e.g. Ney York, California), move to a lower cost area.  You may not like this option, but it could be the keystone to your retirement solution program. Lower housing costs mean more that you add to your retirement nest egg.

Lifestyle choices–opt for savings and not luxuries—vacations, luxury cars, dining out, even driving 75 on the freeway instead of 55 all take money out of your pocket today that could go to retirement savings. 
Keep working—you may still retire from your current job at retirement age but consider doing what you enjoy and also making money.  You can get a HUGE impact on your retirement solutions by working more years (you get the double benefit of not consuming any of your retirement nest egg and having it continue to grow for each year you continue to work).

Investing better – it’s easy to let money sit rather than be properly invested.  As you see from the table below, investors expose half of their 401k assets to equities and this should be higher, particularly for those more than 10 years form retirement.

Allocation of 401k Assets -- More Equities Needed for Sound Retirement Solution

Also, determine how much of your assets you are willing to “annutize.”  Some retirees are fixated on leaving and inheritance or a house to their heirs.  If they annuitize that asset into an income stream, they can live more comfortably.  Annuitization can be accomplished with or without commercial annuities.

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Want to play the stock market without risk?  FDIC insurance will help you do that.

The FDIC insures the “index-linked” CDs offered by some banks. These CDs pay interest based upon the overall performance of a stock market index, and your principal deposit is FDIC insured up to current limits (generally $100,000 and $250,000 for retirement accounts). Here’s an example of how one of these CDs works. Please note, however, that the various features of these CDs vary from bank to bank (e.g., maturity, interest rate determination, withdrawal penalties).

Here’s a hypothetical example. You make a deposit, say $10,000. The FDIC insured CD has a 3.75 year maturity, non-callable. At the end of 3.75 years, you would receive your deposit back plus interest based upon the movement of a pre-selected stock market index, such as the S&P 500.(1) Let’s assume that the S&P 500 index increases 3% per calendar quarter over the next 3.75 years. In this hypothetical example, you would receive $12,271.  That’s equal to a 5.6% annual return.  Had you invested in the S&P 500 index, you would have received 12% annually, plus dividends. But with the CD, even if the market drops, you still have your original $10,000 FDIC insured.

The attractive feature of such CDs is that you could earn a higher amount of interest than the fixed rates offered by most banks. However, you could earn zero if the stock market falls during the term of the CD. Your full deposit is always returned to you at maturity no matter what occurs in the stock market due to the FDIC insurance. Index-linked CDs are subject to early withdrawal penalties, and an investor is not guaranteed to receive 100% of his or her principal investment if funds are withdrawn prior to maturity. Also, an investor’s right of early withdrawal can be limited to certain dates.

Note that some varieties have a “cap” limiting the gain. For example, a 100% cap would mean that a $10,000 CD would not provide more than $20,000 no matter how large the gain in the stock market index. Others may have a call feature allowing the issuing bank to redeem the CD before maturity at pre-stated prices.
Yet others may have a “participation rate” where you partially participate in the index gain. For example, if the stock index rises by 100% and your participation rate is 50%, you enjoy only half of the market gain. All of these features are included in the descriptive materials. So read and understand them carefully before you invest.  If consfused, take the description ot an accountant or financial planner for interpretation.

If you think that the stock market performs well over the long term, index-linked CDs could interest you. It’s an opportunity to participate in potential market gains and to protect your principal from market losses. But some people may still opt for the traditional CD with its fixed payment of 3 to 5 % (Bankrate.com’s national average rate for five year CD was 3.39% as of 2/04/08).

If today’s CD rates leave you yearning for a higher return with safety, FDIC insured index-linked CDs could be for you.

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Callable CDs

“Callable CDs” are a variety of CDs that often pay more than regular (non-callable) CDs. These CDs come with Federal Deposit Insurance Corporation insurance (FDIC), full principal repayment at maturity and above-average yields.  These insured CDs appeal to safety-conscious retirees looking for income.

Although FDIC insured, that does not mean they are not without risk. These FDIC insured CDs have features you must understand. Before you jump at the rate offered by some ad in the Sunday newspaper, here’s what you need to know about the features offered:

High Rate
The higher rate could be temporary. Some callable CDs are callable after a year or two, which means you can get paid off and your high rate stops. Although your principal may still be insured by the FDIC, you may be required to find another place to invest your money which could subject your investment to interest rate risk (i.e having to accept a lower rate than you were earning). Although the bank could have the option to pay you back after one or two years, you do not have the same flexibility.  If you want to terminate your deposit, it could cost you as described below.

Banks offer FDIC insured callable CDs to shift interest rate risk to the depositor. Because the depositor is taking on this interest rate risk, a callable CD will have a higher yield than the same maturity CD without a call provision. The additional yield is partial compensation for the depositor accepting the interest rate risk. Callable CDs typically have terms of 10 or 20 years. Therefore, these CDs are typically suitable for someone who does not need liquidity and wants higher returns than a non-callable CD and the safety afforded by the FDIC protection. Consider that earning more on your money could reduce the need for you to tap into your principal investments. If you buy such higher-paying CDs, it might be wise to keep other money for liquidity available in a money market account or bank account.

Although money market accounts are typically considered to be safer than many equity investments, money-market shares are redeemable at net asset value, which may be more or less than original cost. An investment in a money market fund is not insured or guaranteed by the FDIC or any other government agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in such a fund.

These callable CDs are suitable for:
• People who want to protect their “core” principal that they never want to spend
• People who want to leave money for heirs
• People who need to safely maximize income
• People who have adequate liquid resources

Take these precautions:
Someone may tell you that you can sell these CDs at any time. It is true that most banks will buy back the CD from you but it could be at a steep discount. The ONLY way to be sure to get all of our pricnciapl back is to hold the CD to maturity (could be 10+ years) or until called by the bank. With respect to principal repayment, the bank’s obligation is to pay you back at maturity.

You may be told that if you pass away before the CD matures, your heirs can “put” the CD back to the bank and get the principal. This offer however is dependent upon the bank having enough funds in the “put” pool. Your heirs will have priority but could wait to see cash, months if not years.

To find callabale CDs at 6%, just do a Google serach on “callable CDs” and you will encounter many offerings.  This site does not require any login http://www.bergencapital.com/clientservices/inventory/cd_inventory_new_issue.htm