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Income Planning And Math; Be That Nerd


Matt Chancey CFP Fiduciary financial advisor orlando

If you are a regular Matt Chancey's Blog reader, you have probably noticed that I end some columns with the statement "be vigilant and stay alert." I do believe that is some of the best advice I can give with respect to creating a sound financial system. I teach and preach that same mantra to my clients and, therefore, encourage them to read a lot and question even more.

So it is not surprising that a client called me last week to ask about a recent article she had read in Forbes Magazine that discusses creating an income plan for retirement.

The article she read focuses on a financial strategy that does not use any annuities for income planning. An annuity is a contract with an insurance company where you give them a sum of money and depending on the amount given, they guarantee a set amount of income for life. (A good example of an annuity is Social Security. You give Uncle Sam your money, paycheck after paycheck, and in turn, he pays you income for the rest of your life.) If you have been listening to mainstream media, annuities have somehow become the ugly stepsister to more traditional investment strategies.

The scenario analyzed in the Forbes Magazine article was laid out like this: "Pauline" has 1 million bucks in an IRA and she is required to make withdrawals at a rate of $36,500 per year, initially. In order to meet her needs, the author of the article suggests that Pauline purchase: (i) $300,000 in US Treasury bonds that mature in May 2037 with a 5 percent coupon/interest rate (or $15,000 of annual interest income) at a premium, which would cost her $433,000; and then (ii) to invest the remaining $567,000 in a stock index fund assuming a 1.8 percent dividend rate and 5 percent growth.

(I need to take a quick timeout to explain the difference between the bond coupon rate and the bond yield. Although the bond may pay 5 percent per year, as the author explains, at maturity, Pauline will be left with only $300,000 in bonds. Therefore, if we do the math on those US Treasury bonds, over 22 years, the effective yield is only about 3.46 percent due to the $133,000 premium paid for the bond. Hmm . . . last time I checked, most income plans don’t work very well on 3.46 percent growth, you know why? That nasty word “inflation” which erodes purchasing power over time.)

Regardless, understanding the 5 percent coupon rate on the bonds and assuming 1.8 percent dividend rate on the stock fund, the author concluded that Pauline’s portfolio would yield $15,000 of interest per year and $10,500 of dividends. The $11,000 shortfall (needed to withdraw her $36,500 initial minimum distribution) could be met, the author suggests, by liquidating a portion of her index fund every year. The author concludes that at age 92 Pauline would have the $300,000 in bonds remaining and $824,000 in her stock account assuming a 5 percent real return from the stocks and an inflation rate of 1.5 percent. In total, he concludes that Pauline will have $1,124,000 left in her portfolio at age 92, which would total $124,000 in growth. That looks like something of a “golden” retirement, right?

Here is the problem: there are varying shades of financial brightness in those golden years. Oftentimes, it is hard to determine how to make your financial plan shine the brightest. So, what do we do to determine the best plan? We do the math.

One of the most important principles in creating a sound financial system is to never let emotion, misinformation, or clouded reasoning affect your decisions. One of the easiest solutions to avoid such a common problem is to do the math—crunch the numbers, because numbers don’t lie.

So let’s do the math on Pauline’s situation, using those “out of vogue” annuities. Again, let’s assume that Pauline has 1 million bucks and initially she needs to take $36,500 per year in distributions. What if she purchases an immediate annuity for $433,000 on a single life basis? With certain products, this could give Pauline approximately $30,000 of guaranteed lifetime income. If she were to invest the remaining $567,000 in a stock index fund as suggested in the article, which assumes 1.8 percent in dividends and a 5 percent growth rate, the ending of the story changes a bit. Instead of needing to take withdrawals of $21,500 ($10,500 in dividends and $11,000 in liquidations), Pauline will need to only take yearly withdrawals of $6,500 from her stock fund. Using such a strategy, at age 92, Pauline would have $1,414,000 left in her portfolio and $30,000 of guaranteed lifetime income.

That would leave Pauline with $290,000 more than she would have with the suggested annuity-free scenario, and don’t forget, she would also have pension-like guaranteed income of $30,000 for her lifetime.
Don’t you love when a little math can make the day shine a bit brighter? And most people think math is for nerds.

Now folks, I am no doomsday forecaster, but when it comes to financial markets, history often repeats itself. So, if I were talking to Pauline, I would suggest she ask herself what would happen if the market crashes, her portfolio does not incorporate any downside risk management and it suffers a significant loss, like so many did in 2001, 2002, and 2008. What if her stock fund only grows 2 percent? In the scenario that uses an annuity, at age 92, Pauline would have $700,000 remaining plus $30,000 of lifetime income. With the solution suggested in the Forbes Magazine article, she would have $590,000 remaining in her portfolio, with no guaranteed lifetime income. Pauline’s golden retirement is shining a bit brighter with an annuity included in her retirement strategy.
Heck, even Uncle Sam’s Government Accountability Office (GAO) has chimed in on the value of annuities. In its April 28, 2010, report to the US Senate, the GAO highly recommended income annuities as possible solutions to income planning in retirement.

Now, I’m not telling you to run out and purchase an annuity. That’s not the lesson here. What I am telling you to do is think about all possible solutions. Learn the questions to ask. Crunch the numbers. Lastly, understand that one size does not fit all when it comes to creating a financial system. Your retirement is different than your sister’s, your neighbor’s, and your coworker’s. It is your retirement.

Do the math folks, be that nerd.

As always, be vigilant and stay alert, because you deserve better.

Matt Chancey is a Fiduciary financial advisor based in Orlando FL. 

Annuity guarantees rely on the financial strength and claims-paying ability of the issuing insurer. Any comments regarding safe and secure investments, and guaranteed income streams refer only to fixed insurance products. They do not refer, in any way to securities or investment advisory products. Fixed Insurance and Annuity product guarantees are subject to the claims?paying ability of the issuing company and are not offered by Retirement Wealth Advisors. - 

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