Retirement Planning for an Uncertain Future
by: James Stefurak, CFA
Retirement Planning for an Uncertain Future
Most Americans sit on their proverbial “three-legged stool” (pension, Social Security and investments) during retirement. As a financial curmudgeon, I prefer the floor. Despite decades of market experience and over-credentialing, I can’t reconcile traditional retirement planning with my belief that financial markets will implode, relegating many stools to firewood.
So how does a permabear plan for retirement when doubting the viability of these income sources? By sitting in cash, waiting for 1- better entry points and 2- Godot. Here are some ideas to keep your stool from collapsing, without going full-blown prepper.
1-Pensions
Millions rely on pension benefits once they stop working. These ‘defined benefits’, based on service and salary, promise an income stream throughout retirement.
But pensioners should be worried. Private plans are grossly underfunded (amid exaggerated assumptions). The PBGC, which “backs” these plans, should become insolvent for 10 million multi-employer beneficiaries by 2025.1
Public plans benefits are already being cut in some municipalities. By realistic estimates, these plans are already underfunded by $6 trillion.2 Beneficiaries should consider other income sources unless funding gaps magically disappear via increased employee contributions, investment performance or tax receipts.
Other Income Sources to Offset Benefit Cuts
Reverse Mortgage Line of Credit
Home equity conversion mortgages (reverse mortgages) may provide a backstop for pension cuts or a lack of savings. These loans aren’t ideal (high fees) but can address cash flow issues for certain retirees.
Three attractive conditions:
1. The loan isn’t ‘repaid’ until the youngest borrower leaves the home or dies.
2. You can’t get ‘underwater’ if values drop.
3. There’s no tax liability (‘loan proceeds’, not income).
Americans homeowners currently enjoy $5.4 trillion in equity (roughly $180,000 per household).3 So, if you’re age 62 or older and own a home with considerable equity, you probably qualify. Loan proceeds are paid ‘upfront’, monthly or as a line of credit.
How it Supplements Pension Income
Assume you tap the $180,000 in equity. The lender applies a Principal Limit Factor to determine borrowable funds. Depending on the situation, your $180,000 equity could amount to just $65,000 in available funds (bummer).
Apply this to pension payouts. Average annual corporate pensions benefits are $9,262.4 If this pensioner lost full-benefits, a reverse mortgage loan could ‘replace’ the payout for 7 years ($65,000 / $9,262 = 7.01).
Government pensions are typically higher. State/local pensions average $17,576 annually, while federal benefits are $22,172.5 Using the same methodology, loan proceeds could replace 3 years, 8 months of state/local benefits and 3 years of federal. While helpful, this won’t replace benefits for long.
Reverse Mortgage Line of Credit: A Better Option
Line of credit payouts are better for three reasons:
1. Reliability: The line can’t be frozen or canceled, unlike a bank HELOC.6
2. No Obligation: Once open, it doesn’t have to be used within certain time periods.
3. Credit Line Growth: The line’s available credit increases the longer it’s open, but not used.
These are attractive features, especially ‘credit line growth’. Establishing the reverse mortgage line of credit as early as possible (age 62) and leaving it open and unused as long as possible addresses longevity concerns. This strategy increases the borrowable amount per year and, if maintained long enough, can surpass your home’s total equity.7 If your pension gets cut, you’ll have a line of credit (that you don’t ‘repay’).
Retirees should view these options as lifelines. Make haste- if home equity values tank, as I expect, before you qualify, it’ll be too late. Keep in mind, 1- approvals are lengthy (counseling, appraisals, etc.) 2- if interest rates rise substantially before you open the line, it could mitigate the strategy’s effectiveness8 3- credit line growth ‘loopholes’ should eventually close for new borrowers.
2- Social Security
Challenges to Social Security are well-documented- demographics, fiscal problems, longevity trends, etc. The Social Security Administration itself predicts the trust could run out of money by 2034.9 Its future is uncertain and Millennials are rightfully worried- 80% fear Social Security won’t be there at retirement.10
Deferred Income Annuities
But millennials have options, like deferred income annuities. Considering their length until retirement, time’s on their side. These annuities can provide guaranteed income for life, beginning at future dates (up to 40 years later).
Assume today’s Social Security provides $1400 monthly. Using Schwab’s annuity estimator, millennials born in 1990 (age 28) could lock in a $1400 monthly payment, beginning in 2057 (age 67), with a one-time premium payment today of roughly $69,000.11
Fast forward to 2057 and they receive $1400 per month for life. Living to 97 would mean they’d receive roughly $504,000 in payouts over those 30 years, from a $69,000 payment. Like our line of credit example, the key to this strategy is starting as early as possible, ideally 40 years out. The longer you wait, the larger the premium.
Some Caveats
At risk of sounding Pollyannaish, the example ignores four factors– viability, inflation, taxes and counterparty risk:
• Viability: Most Millennials don’t have $69,000 to part with for 40 years (but some will). There are similar annuity products that allow periodic premium payments (with lower future benefits or higher total premiums paid).
• Inflation: Some lifetime annuities offer inflation riders. Protecting against 3% inflation on similar future guaranteed income annuities reduces monthly income by roughly $400 (lowering total payouts from $504,000 to $360,000).12
• Taxes: Deferred income annuities may be purchased inside retirement accounts, but future payouts should be taxable at ordinary income rates (currently higher than capital gains rates).
• Counterparty Risk: An annuity is a contract between the policyholder and insurance company, so payouts rely on the insurer’s solvency. Luckily, premium payments in our example are under $100,000, allowing state insurance regulators to backstop.
While annuities have hefty fees embedded within their calculations, the attractiveness of the strategy, for perma-bears, is guaranteed future income without stock market risk (it’s essentially a pension risk transfer). If Social Security becomes impaired, this will have been a very smart move.
3- Investments
Investments refers to assets in defined contribution plans like 401(k)s and IRAs. Good news: bull markets have vaulted U.S. retirement assets to roughly $25 trillion.13 Bad News: low rates, market optimism and longevity worries created overly-aggressive equity allocations.
An ICI study revealed that two-thirds of retirement assets are in equities (equity mutual funds, employee stock ownerships plans and the equity portion of balanced funds).14 It’s probably higher today since the data was from 2015.
If nearing retirement, emphasize capital preservation, not longevity risk, despite deft marketing campaigns. You won’t have time to recover from a prolonged bear market. Remember, a 50% loss requires a gain of 100% to get back to even.
The ‘income streams’ from retirement plans (dividends, income, systematic withdrawals of principal) are as uncertain as the stool’s other legs. Some ideas to reduce portfolio risk:
Remain Invested with Same Asset Allocations
Go on a Low-Cap Diet
Mega-cap stocks have ballooned within indices. For example, Amazon, Alphabet and Apple have led technology to comprise over 25% of the S&P 500.15 They’re also top holdings in many other funds (growth and value). The rise in passive investing has unknowingly transported ‘concentration risk’ into many portfolios.
Consider rotating out of large-cap growth funds and passive ETFs (SPY, QQQ) into an equal-weighted S&P 500 fund. Since each stock is weighted equally, concentration risk is mitigated. Your portfolio has already benefitted from the passive investing boom, so reducing exposure could curtail outsized losses in a selloff. The result should be the same equity allocation with lower risk.
If your 401(k) doesn’t offer equal-weight products, consider purchasing one in an IRA (just don’t take the money out of the 401(k) to do it). Or, consider a Roth 401(k) or ‘managed accounts’ format which offer more flexibility.
Remain Invested with Different Asset Allocations
Adding Other Asset Classes
Reallocating to other asset classes can also lower portfolio risk. Traditional 50/50 equity and fixed income portfolios aren’t safe when markets collapse. While loosely-to-negatively correlated in normal times, correlations rise in chaos (ala Financial Crisis) due to the ‘credit’ segments in bond funds (investment grade and junk corporates) acting like equities.
Some asset classes provide historically lower correlations with benchmark U.S. equities including FX, U.S. Treasuries, international stocks and metals (gold has proven ability to weather downturns).
Liquid alternative investments provide ‘directional diversification’. Market neutral/long-short ETFs achieve neutral market exposure but can tilt long or short, opportunistically. Individuals now utilize these strategies without accreditation.
Make a Dash for Cash
Cash is the forgotten asset class. High-cash levels aren’t popular in retirement accounts (advisors don’t earn much and clients don’t like running out of money in retirement), but that should change. Today, the yield on 1-Year T-Bills is greater than the S&P 500’s dividend yield.
401(k) plans should offer sweep/money market accounts. If possible, utilize Treasury-only money funds- the short maturities protect against duration risk and principal loss. And if rates rise persistently, you’ll roll over into higher yields.
Where should the cash come from? Consider trimming corporate bonds. Junk bonds are toxic but ‘investment grade’ bonds are also risky due to:
1- Near-record durations (interest rate sensitivity) from ZIRP.
2- Credit Risk- Many investment-grade funds are severely overweight BBB segments that could quickly become junk-rated.
3- Liquidity Risk- Corporate bond funds are inherently illiquid as underlying bonds may become untradeable under duress.
Monitor Exposure to Employer Stock
Advisors recommend just 10% of company stock as pension assets. If yours has significantly more:
• Halt future contributions and reallocate elsewhere (even if offered a discount). A 10% savings won’t console a 100% wipeout (ask Lehman or Enron employees).
• Hedge. If there’s vesting restrictions, consider out-of-the-money put options (‘catastrophe puts’) as insurance.
• If vested, consider liquidating some shares.
These ideas, while a bit unorthodox, could make your Golden Years a little shinier. Remember, every investor’s situation is different. This article is not intended as specific investment advice, rather, ideas to run by a qualified financial and tax advisor.
1https://www.pbgc.gov/news/press/releases/pr17-04
2https://www.alec.org/app/uploads/2017/12/2017-Unaccountable-and-Unaffordable-FINAL_DEC_WEB.pdf
3https://www.cnbc.com/2018/04/02/homeowners-are-sitting-on-5-point-4-trillion-in-ready-cash-the-most-ever.html
4,5http://www.pensionrights.org/publications/statistic/income-pensions
6http://www.interest.com/mortgage/advice/reverse-mortgage-disadvantages-advantages/
7,8https://www.forbes.com/sites/wadepfau/2016/03/01/how-does-the-line-of-credit-for-a-reverse-mortgage-work/#543d590a22b5
9https://www.ssa.gov/oact/trsum/
10https://www.marketwatch.com/story/millennials-will-get-social-security-but-theres-a-catch-2018-04-10
11https://www.schwab.com/public/schwab/investing/accounts_products/investment/annuities/income_annuity/fixed_income_annuity_calculator
12https://www.newretirement.com/annuity-confirm-dashboard.aspx#content-mid
13https://www.thinkadvisor.com/2015/06/30/total-retirement-assets-near-25-trillion-mark/?slreturn=20180402094200
14https://www.ici.org/policy/retirement/plan/401k/faqs_401k
15https://www.bloomberg.com/news/articles/2018-02-28/s-p-500-hits-tech-heavy-milestone-last-seen-amid-dot-com-bubble
