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Modern Retirement Theory: A Conversation with Central Chapter Mississippi Society of CPAs
- 1. Modern Retirement Theory www.modernretirementtheory.com Conversation with Central Chapter Mississippi Society of CPAs March 18 th , 2010 Jason K. Branning, CFP® [email_address] M. Ray Grubbs, Ph. D. [email_address]
- 10. Hierarchy of Funds Funding Priority Legacy Fund Discretionary Fund Contingency Fund Base Fund
- 11. MRT Planning Context Longevity Base Fund Discretionary Fund Legacy Fund Conditions within Longevity Contingency Fund Discretionary Fund Legacy Fund
Editor's Notes
- MRT begins with the question of client longevity. Longevity may be analogous to time horizon. Planners use government mortality tables when making assumptions about mortality, yet each person is unique, and living too long or dying too early in retirement has significant financial ramifications to a partner, beneficiaries and an estate. The second major question MRT asks is: What are the conditions within a client’s longevity? What are the specific conditions 10 years before and during retirement? These conditions are defined as market fluctuations, sequence of returns upon retirement, personal health concerns or care-giving for family members. Mitigating the effects of highly consequential negative conditions within retirement will protect the funding of a designated retirement lifestyle.
- History of Retirement Plans – Brief Review: The 401(k) provision was created in 1978 as part of that year's Tax Revenue Act: 401(k) plans quickly became a leading factor in the evolving retirement benefits business. From 1984 to 1991, the number of plans increased more than 150 percent. The number of employees able to participate in 401(k) plans rose from 7 million in 1983 to more than 48 million by 1991 The advent of 401(k) plans helped effect a philosophical shift among employers, from the provision of defined-benefit pension plans for employees to the administration of defined-contribution retirement plans. In the past, companies had offered true pension plans which guaranteed all individuals a predetermined retirement benefit. But after 1981, rather than providing an employer-funded pension, many companies began to give employees the opportunity to save for their own retirement through a cash or deferred arrangement such as a 401(k). This change helped level the playing field for small businesses, which were now able to offer the same type of retirement benefits as many larger employers. Small businesses thus found themselves better able to attract and retain qualified employees who may previously have opted for the security of a large company and its pension plan. (Source: http://www.encyclopedia.com/doc/1G2-2687200278.html) MRT recognizes that Retirement is a consumption and preservation phase of life rather than an accumulation phase. MRT encompasses balance-sheet asset management, preservation and utilization strategies at the individual client level. This model views retirement as an absolute, non-negotiable goal rather than a relative one. In the framework of MRT, retirement is an absolute goal set by the client. Like college savings goal, when Jr. is 18, he/she is off to college. The money needs to be there. People preparing for years to retire at 65, should not have to ask the market for permission to act on their goal. Effects of negative sequence of returns on retirees in the first few years.
- MRT: Individuals to establish what is in effect a “private pension” Framing a retirement plan around longevity and conditions within longevity requires an integrated financial planning approach. These integrated strategies will mitigate, insure against and diversify these individual and specific risks in each client’s unique situation. MRT is more focused on individualized outcome, rather than using group averages.
- In the individual case: no one knows how markets will look when you desire to retire. No one can predict their health status in 1 year or tomorrow Example: 1 year to live – why work if you have money saved? NO ONE KNOWS THE FUTURE
- Retirement is about preservation and utilization maximization, not asset growth. There is cessation of wages and the ability to work may be limited or impossible based on health. Secure *Pension guarantee *FDIC/Credit Union *State Guaranty Association Stable *Create a retirement environment where “you go to the mailbox” each month and know what will be there when you open the envelope. No wide income fluctuations in income due to markets Sustainable *Income needs to adjust over time for inflation, and be available over lifetime
- First, during the retirement phase of life, there is reduction or cessation of work and therefore earned income. Retirees have stopped working due to health status, or the belief that they have enough money saved to spend the balance of their time free from the constraints of the modern work force. Without earned income, many retirees see a reduction in taxes owed, as many states do not charge income taxes on required minimum distributions from IRAs, pension payouts, or social security income. The nature of income changes during the retirement years. Secondly, the retirement phase differs from the accumulation phase by shifting priority to preservation and utilization. In many cases, the time horizon for the accumulation years equals the distribution phase, but how well assets are preserved and utilized in retirement affects a retiree’s lifestyle. However, simply because the accumulation and distribution time horizons are nearly the same, does not mean they are equal in other ways. Negative sequence of returns for the retiree’s investment portfolio that is also taking income distributions compounds the losses because the inverse of compounding interest occurs, de-compounding. De-compounding may mean that the portfolio can never recover in a poor market environment and is more prone to sustainability failure. Even in a market recovery, the retiree still needs income to live from investments, but the portfolio needs time to recover losses without cash withdrawals. These competing interests of retirees needing income, yet the portfolio needing time to recover ultimately leads to a change of lifestyle. Therefore, lifestyle preservation is directly linked to asset preservation and utilization. The third difference is the role of inflation during retirement. Inflation is hedged during the accumulation phase by equity exposure in portfolios. However, with a presumed reduction in equity holdings during retirement, inflation becomes a potentially lifestyle altering force. Finding more secure ways to hedge inflation is essential for lifestyle preservation during the retirement phase. Such possibilities are through laddering assets for income over time or by waiting to take Social Security Benefits until age 66 or beyond. MRT Funding Goals for Retirees - Replace Income that will be lost upon retirement in a tax efficient manner - Protect the balance sheet against a catastrophic event (e.g. long term care) - Utilize the balance sheet – use all assets (as needed) on the balance sheet to meet retirement goals. - Preserve the at retirement lifestyle – retire and stay retired
- Priority Structure for answering the question – CAN I RETIRE? If we can replace income you were making, and Base Replacement of income of A retirement lifestyle Uses guaranteed income streams that offer backstops [FDIC, PBGC, Guaranty Association limits] RISKS: Inflation / Credit Risk Contingency – Black Swan Mitigating and transferring risk is essential to maintaining a sustainable retirement lifestyle. This fund offers a hedge against the unpredictable, yet highly consequential events that may occur from a personal medical issue, changes in estate laws or with markets. Medical risks Long Term Care - LTC contract / CCF Legal Review - laws Change, Review 3 to 5. Not only do estate laws change, but there is the potential for estate taxes to be due in a negative market cycle. In this scenario, a life insurance policy can help pay estate taxes rather than the estate being forced to sell depreciated assets. Mitigating the reduction of an estate should be accounted for in retirement planning. Discretionary * After lifetime income is secure and catastrophic scenarios mitigated, a flexible income fund can be established. The resources of this fund have a time horizon of two to 10 years. We advise 2 to 5 years of expenses in cash or laddered CDs to protect against a normal market cycle and based on risk tolerance. Beyond this cash position, remaining assets in this fund can be invested for a more moderate time horizon - travel expenses, auto purchases and other events that are flexible in need or occurrence. Legacy The final MRT set-aside is the legacy fund. These assets are anticipated to be used for inheritance or charitable purposes.
- The Base fund is unique because in the Retirement Theory model, one must satisfy the base, before any other funds are planned for. Middle Left – Expenses Analysis of actual expenses Assign expenses into an MRT Fund Middle Right – Income by source Known retirement income (SS) Comparison Gap – Determine tax efficient Income that can be derived from the Balance Sheet New Income sources must meet the S,S,S test in order to be applied to the Base Fund
- In comparing Base Fund Expenses and Income, the first priority is to cover at least 100% of base expenses by Base Income. MRT requires a minimum income to expense ratio of 1. In most cases, it is recommended that a the coverage ratio is slightly higher than 1, i.e. 1.05. MRT does not want this ratio to get too high, as it may cause Base Income to fail to be tax efficient. Ex. Income from Asset 1 represents 50% of the Base Fund Expenses. So Asset 1 offers a 50% Coverage Contribution. Therefore, we need to determine other assets that can contribute the balance of the Base Fund Income need in order to satisfy the Coverage Ratio.