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Friday September 8, 2017

Annuities, Bonds, and Bad Advice

Recently I was working with a client on analyzing and reallocating his IRA investment portfolio. The portfolio was substantial (over $3M) and was 40% Equities, 40% Bond, and 20% Cash. I really liked this allocation for someone his age (70) and told him that the only real improvements would be using a responsive, tactical investment management platform and to improve his Bond Allocation. The fees on the products and funds he held were already low at an average cost of 1.14%.

In assessing the Bond Allocation, using Morningstar’s X-ray Analysis, we found that over half the total was held in High-Yield or junk bonds. While there is nothing inherently wrong with holding a portion of one’s Fixed Income allocation in High Yield Bonds as a means of diversification and improving the overall yield, a 60% allocation seemed a bit high. Moreover, the total yield on his Fixed Income/Bond allocation was only 3.4%.

I came back to this client with the suggestion of replacing his Fixed Income/Bond Allocation with a combination of Fixed Index Annuities. The criteria I used for my recommendations were that any fees associated with these FIA’s should be comparable to his current annual cost of the Bond Allocation, which was .96%., that any annuity carriers we considered should have a credit rating of A+ or better, and that we could reasonably expect to exceed the current yield of his Bond Portfolio.

Many leading advisors (myself included) view a fixed indexed annuity (FIA) as another fixed income asset and allocate them accordingly:
• An alternative to low yielding bond allocations.
• Allows the investment professional to be as “active” as necessary in other areas of
the wealth management process.
• Provides a range of interest crediting methods with both capped and uncapped
strategies managed by leading investment banks.
• Provides for an ongoing guaranteed income stream for the client and spouse if desired.

The two FIA’s I recommended for this client had internal fees of .95% and .4% respectively, for an average cost of ownership of .675% annually, lower than the current cost of his Bond Funds. The performance of these annuities were tied to underlying diversified stock indices that were managed with volatility controls and had the ability to shift allocations monthly. Disclaimer: Index Annuities are never meant to be a competitor for true equity investments and are not direct investments in the underlying market indices. A reasonable return expectation for this type of product would be between 3½% – 5% over time, with negative index periods earning a 0% return. That’s why they are a viable substitute for bond positions.

This would remove the Market Risk, Credit Risk and Interest Rate Risk associated with his current Bond Allocation, lower the overall annual cost and potentially improve the annual returns. In addition, there is the option of a guaranteed lifetime income that would protect the client (and his spouse) from the risk of extreme longevity. While there are substantial surrender charges in the early years to withdraw more than the annual free amount, Required Distributions from IRA’s are never penalized and that’s all the client anticipated ever withdrawing. Seemed like a no-brainer. Except that it wasn’t.

When we finished with the analysis of the FIA’s, their performance data, reasonable projections, and the financial data on the carriers that offer the products, we scheduled our next meeting for the following week to begin the transfers and implementation of this strategy.

This next meeting is where the process fell apart. Why? Because his (adult) kid heard somewhere that annuities weren’t a good thing to do. While I’m sure that this child is smart, expertise as an elementary school teacher doesn’t qualify one to render complex investment advice. But that’s sometimes how it goes; blood is thicker than 25 years of experience and numerous advanced planning designations. In these situations I just have to let it go or run the risk of insulting the client by impugning the intelligence of their oh- so-smart progeny.

In my opinion, Index Annuities are actually over-hyped and oversold by agents (often posing as fiduciary advisors) as the silver bullet for everything investment related. Cable stations and weekend radio shows are filled with agents dispensing advice about how Index Annuities are the answer to whatever ails you. Market-like returns? Index Annuities! High Growth, No Risk? Index Annuities! Erectile dysfunction? Index Annuities! The only thing more annoying is former TV stars telling people to stockpile gold for the coming financial apocalypse.

Why are annuities so over-hyped? Because they pay commissions. Earning commissions on these products is not inherently wrong or against the best interest of the client, unless the product is not properly positioned and/or sold for the wrong reason – strictly for earning a commission.

But there’s no doubt that annuities can and do solve many of the challenges faced by retirees. The puzzle has been that consumers, and advisors to a large extent, don’t understand where annuities fit or how to use them effectively.

For me there are three primary uses for annuities in my practice – replacing Bonds or Bond Funds with a more efficient alternative in a client’s comprehensive financial plan, filling a defined need for current or future income, or for that client that just can’t stomach any real market risk.

A Wall Street Journal article once referred to income annuities as “super bonds,” which is not the most accurate term. A more appropriate term would be “actuarial bonds.” Extensive research in the field of Retirement Income Planning concludes that income annuities significantly improve retirement outcomes over what is possible with bonds or bond funds.

Unless of course your clients’ kids heard something from somewhere and doesn’t like them.

But for actual research, I suggest the following blogs:
https://retirementresearcher.com/
http://www.theretirementcafe.com/
http://squaredawayblog.bc.edu/

Thursday June 16, 2016

Assessing The Risks in Your Financial Plan

The following is a re-posting of a discussion thread from APViewpoint by Harold Evensky. This defines and assesses the types of Risks associated with one’s Financial Planning and how to address and weight them in importance.  Link: http://www.apviewpoint.com/viewpoint-home

This site is full of information and opinions from thought leaders from across the spectrum of investment and financial planning.

Harold Evensky – 15 Jun 2016 12:46

An interesting and obviously important discussion. Here goes my 2 cents.

There are three risk metrics a planner needs to consider – Risk Need; Risk Capacity and Risk Tolerance. Unfortunately they do not necessarily correlate well with each other. I believe that in designing a policy allocation only two are controlling – Capacity and Tolerance.

Risk Need is the level of risk (i.e., equity allocation) necessary for the client to have a high probability of achieving all of his goals,

Risk Capacity is a measure of the ability of the portfolio to sustain a significant loss and still provide the client with a high probability of achieving his goals.

Risk Tolerance – after many years of thinking about this concept I’ve concluded that there is only one appropriate definition for a practitioner. What is that threshold of emotional pain just before a client will call and say “Harold, I can’t stand it anymore!! Sell me out and take me to cash.” I’m well aware of the objection that determining this “tolerance” is problematical; however, I have no idea how an advisor can make a recommendation for a client without some opinion on this parameter.

The reason I do not believe “Need” is a planning criteria is that if the “Need” requires an equity allocation higher than the client’s Capacity and Tolerance constraints the advisors responsibility is to educate the client on the need to revisit ‘Needs,’ not increase risk. While it may be tempting to acquiesce to a client’s response during a period of positive or stable markets “Well, OK, I guess I can take more risk in order to meet my goals.” When the bottom drops out they will quickly forget their prior willingness and will likely make that “sell me out call.”

Finally, while tolerance is typically the determining factor, on occasion an investor’s Risk Tolerance is significantly higher than their portfolio’s Capacity. In that case, Capacity is the controlling factor.

Thursday September 24, 2015

More Changes to Reverse Mortgages

This is from September 24, 2015, edition of Boston College’s Center for Retirement Research Squared Away Blog:

The federal government continues to work out the kinks in its reverse mortgage program. The latest change allows a non-borrower to remain in her home after her spouse, who signed the reverse mortgage, has died.

The federal government established its reverse mortgage program in the 1990s to provide an alternative source of income for retirees over age 62. These Home Equity Conversion Mortgages (or HECMs) are secured by the equity in borrowers’ houses, and the loans are repaid only when they move or die. The loans are federally insured to ensure that borrowers get all the funds they’re promised, even if the lender fails, and that lenders are repaid, even if the value of the property securing the loan declines.

A June 2015 regulation effectively allows lenders to permit a surviving, non-borrowing spouse to remain in the home, postponing loan repayment until she moves or dies. To qualify, the original reverse mortgage must have been approved by the Federal Housing Administration prior to August 4, 2014 and the property tax and insurance payments must be up to date and other conditions met.

The spousal provision adds to earlier changes, detailed in a 2014 report by the Center for Retirement Research, aimed at improving the HECM program’s fiscal viability while protecting borrowers and lenders. These regulations were a response to riskier homeowners who had tapped their home equity to cope with the Great Recession. The regulations reduced the amount of equity that borrowers could extract upfront and also introduced financial assessments of homeowners to ensure they’re able to pay their taxes and insurance.

Today, the maximum amount allowed for a reverse mortgage is calculated based on the value of the home (up to a $625,000 value), current interest rates, and the borrower’s age. Homeowners generally are limited to borrowing just 60 percent of that personal maximum in the first year of the loan.

When the reverse mortgage closes, borrowers pay an insurance premium equal to 0.5 percent of their house’s value, which can be paid using funds from the loan. They also pay an annual insurance fee of 1.25 percent of the loan amount, in addition to the normal interest charges.

Despite the changes, few people have a reverse mortgage – just 52,757 were approved in 2014. But as more baby boomers reach retirement with insufficient savings, more of them should consider a reverse mortgage as one option for supporting their retirement needs.

Thursday August 20, 2015

The Future of Retirement Is Now

The following is reprinted from the Center for Retirement Research’s August 18, 2015, Squared Away blog:

Gray, small, and distinctly female.

This is what the director of MIT’s AgeLab, Joseph Coughlin, sees when he peers into the future of retirement.

“The context and definition of retirement is changing,” Coughlin said earlier this month at the Retirement Research Consortium meeting, where nearly two dozen researchers also presented their Consortium-funded work on a range of retirement topics. Their research summaries can be found at this link to the Center for Retirement Research, which supports this blog and is a consortium member.

Coughlin spooled out a list of stunning facts to impress on his audience the dramatic impact of rising longevity and graying populations in the developed world, and he urged them to think in fresh ways about retirement. In Japan, for example, adult diapers are outselling baby diapers. China already faces a looming worker shortage, and Germany’s population is in sharp decline. In 2047, there will be more Americans over age 60 than children under 15.

“The country will have the demographics of Florida,” Coughlin said.

The attitudes and comportment of the ballooning population of U.S. retirees – baby boomers – will be more confident and less polite than their parents’ generation, he predicted.

The U.S. labor force is also graying with the aging population. The average age of physicians in this country is already 53, and it’s 49 for nurses, 51 for truck drivers, 56 for financial advisers, and 50 for engineers. In five years, more than one-quarter of the U.S. labor force will be over 55, according to the Stanford Center on Longevity. And an AARP study finds that 40 percent of boomers say they plan to work “until they drop.” But to assume you can keep working, because “you have a master’s or PhD is a joke,” Coughlin warned. “If you don’t stay aggressive about your learning, you’ll fall behind.”

When he says the future is “small,” he means family size is shrinking, with implications for retirees and the elderly. More Americans today than in the 1970s live in a household of one, especially women. In the 1970s, nine out of 10 women had children, but today just eight out of 10 do, he said. This points to a future in which there will be fewer children to care for aging parents. And fewer caregiving spouses: divorce among people over age 50 has also increased dramatically in recent decades.

As the population ages, he sees women, who tend to live longer, becoming more influential, because they already make decisions about retirement and child care. Women, particularly oldest daughters, also do the heavy lifting for parental care.

Older people today are “old but not sick,” but they have multiple chronic conditions, often managed with multiple medications. Aging in the home will be a prime location for the kind of technological innovations Coughlin’s AgeLab specializes in.

He predicted that seniors increasingly will rely on gadgets like implantable sensors to monitor their blood pressure or smart mirrors that detect worrisome changes in their health or gait. He even talked about a $100,000 pop-up house, so mothers-in-law can live (alone?) in their children’s back yard.

The future is here, and Coughlin suggests that everyone “really rethink the contract around what retirement is.”