How To Reduce Volatility in Your Retirement Income

The S&P 500 has dropped three days in a row, and after all the market calm of recent months, many investors must be thinking that the apocalypse looms.  There are understandable explanations for the recent downdrafts.  Islamic radicals of the Sunni variety have rapidly seized several towns and cities in Iraq, along with American weapons and vehicles provided to the Iraqi government (and the administration worries about giving small arms to moderate Syrian rebels?).  Iranian paramilitary troops, who are Shiites, supposedly are fighting alongside Iraqi government troops to retake territory seized by the Sunni radicals. Is Iran now a more important ally of the Iraqi government than the U.S.?

Russian tanks have reportedly rolled into Ukraine, where the fighting is escalating.  Bashir Assad is winning in Syria, and the moderate rebels that the U.S. supports seem to be almost inconsequential.  Most of East Asia is squabbling over this island or that, with contending nations issuing many a proclamation declaiming a neighbor as a ratfink, a double ratfink or even a triple ratfink. 

Domestic politics also create uncertainty for the markets.  Eric Cantor, House Majority Leader, was just defenestrated in a primary election by a guy from far right field whose name, even if we mentioned it now, you probably wouldn't recognize.  (But we're going to, because it's Dave Brat, a marvelously fitting name for a guy who ousted the Majority Leader.)  Cantor, who outspent his opponent's six-figure campaign by $5 million, convincingly proved that money isn't everything.  Not even in politics.  The Koch brothers must be scratching their heads about what checks to write next.

The markets will always be plagued by volatility.  And it tends to pop up when you least expect it.  That might be inherent in the definition of volatility, but you know what we mean.  Yogurt happens, but you don't want your retirement finances smeared with yogurt.  While there are no complete protections against the ups and downs of life, here are a few ideas for calming the financial waves.

Build Up Social Security Benefits.  Disregard the hyperbole.  Social Security will be there when you retire.  Maybe not exactly as it is now, but nevertheless in a meaningful form.  Any politician who votes to eliminate or sharply reduce Social Security retirement benefits will end up doing an Eric Cantor faster than Eric Cantor as voters reject the idea that they should have to eat dog food in their old age.  Work as long as you can to build up your benefits.

Get a Pension.  If you're lucky enough to get a pension, stick out it long enough in that job to qualify.  Although classic defined benefits pensions are usually found these days only alongside the remains of diplodocus, lasso one if you can.  Other pension arrangements, like cash balance plans, are a lot better than no pension. 

Save More.  Saving more is a salve for portfolio instability and financial insecurity.  Those that have the saving jones won't have to get loans.

Use Retirement Accounts.  Retirement accounts like 401(k)s, IRAs and so on offer tax advantages that let you leverage your retirement savings, while limiting your ability to prematurely spend your savings.  A particular advantage to a 401(k) account comes if your employer provides a matching contribution, which is the freest money most people can get.  Use these accounts as much as you can.

Diversity Your Investments.  The values of all assets wax and wane.  But they usually don't wax and wane in unison.  More commonly, some assets get yeasty while others do the fallen souffle thing.  And vice versa.  So a diversified portfolio is usually kind to your antacid budget.  There are moments, like the 2008-09 financial crisis, when it seems like almost all assets belly flop.  But these cognitively dissonant interludes are the exception and not the rule. 

Consider an Annuity.  A fixed annuity (one that pays a specified dollar amount per month) or a fixed annuity adjusted for inflation can be a reasonable way to provide a steady income.  Annuities aren't cheap, and you should buy only from an insurance company with a strong credit rating. Don't put more than about one-third to one-half of your portfolio into an annuity because cash needs in old age can be unpredictable and it helps to have a nice pool of cash or cash equivalents.  Be very cautious about variable annuities--they often have high expenses, and the point here is to reduce volatility, not subject yourself to it in another form. 

Health Insurance and Long Term Care Insurance.  Financial volatility can sometimes come from sudden increases in expenses, and not just decreases in portfolio values.  Health care and long term care needs are the biggest landmines in the journey through retirement.  Most retirees are covered by Medicare, but if you're not, then buy something else.  The Affordable Care Act, despite all the teeth-gnashing on the right, is likely to be a good option if you don't have anything else.  If you have a significant net worth, consider buying long term care insurance, especially if you have a spouse who may depend on that net worth after you've gone to the great Dance Party in the sky.  It's expensive, but so is long term care.  If you want more than the quality of care given to Medicaid patients, long term care insurance may be a good choice.

Part-time Work.  Okay, you want to hear about retirement, not employment.  But part-time employment reduces the extent you need to draw down your savings, so you can keep more powder dry for later.  It also lessens your risk of dying from the boredom of day time TV.  It may boost your Social Security benefits (depending on your work history).  And the dignity of work is better than the indignity of looking for sales on dog food.

Why Insurance Products Can Make Lousy Investments

If you're considering an insurance product that includes an investment feature, consider the following two examples of why you might want to say no.

Mass Mutual.  On Nov. 15, 2012, the SEC sued Massachusetts Mutual Life Insurance Company in an administrative proceeding (an agency process somewhat like a court case, although conducted within the SEC instead of in a court).  Mass Mutual settled without admitting or denying the SEC's charges.  The essential accusation the agency leveled against Mass Mutual was that it didn't adequately explain to customers how withdrawals from variable annuities under certain circumstances could drain their accounts of value.  (See the SEC's press release at http://www.sec.gov/news/press/2012/2012-230.htm.)

Variable annuities involve the customer making periodic payments for a number of years and directing how the money is invested in a tax sheltered annuity. Eventually, the invested amounts can be used to purchase an income stream from the insurance company. The investments may do well or poorly.  To ameliorate the potential for poor investment returns, Mass Mutual offered an optional rider that, for an additional premium, gave customers a GMIB, or Guaranteed Minimum Income Benefit.  The GMIB guaranteed a minimum value that customers could use eventually to purchase an income stream, regardless of how poorly their investments did.

The GMIB could increase by 5% or 6%, depending on the rider.  Mass Mutual capped the level of the GMIB (through a somewhat complex formula).  Once the cap was reached, the GMIB wouldn't increase.  Mass Mutual also allowed customers to make withdrawals from their annuities before they converted the investment value into an income stream.  If they made a withdrawal before the GMIB reached its cap, the withdrawal would reduce the GMIB value (and the value of the invested assets as well), but wouldn't prevent the GMIB from continuing to increase.  However, after the GMIB reached its cap, withdrawals would decrease the GMIB and it wouldn't increase the next year.  Thus, making withdrawals after the GMIB reached its cap could permanently shrink the GMIB--under some potential circumstances, to zero.  According to the SEC, Mass Mutual didn't clearly explain how the GMIB, which might be thought by customers to be a guaranteed minimum value, wasn't guaranteed if the customer made withdrawals after it reached its cap.

Got it?  Pretty simple, right?  To be sure, after it was nabbed by the SEC, Mass Mutual did the right thing and eliminated the cap on the GMIB.  But if you furrowed your brow over the details of this annuity (and we've just summarized them--read the SEC's press release and order cited above for a gorier rendition), you should think twice--and then three times--and then four times--and then five, six, seven and many more times before investing in a variable annuity.

Universal Life.  The other example is in today's Wall Street Journal (Nov. 17-18, 2012, P. B9), which reports that low interest rates may require universal life insurance policy holders to pay higher premiums or face the cancellation of their policies.  Universal life is a form of permanent life insurance that allows customers to have life insurance coverage for long periods of time (i.e., longer than the perhaps 20 years allowed in term life coverage), often with flexibility in the amounts of the premiums paid.  Universal life also has an investment feature, and customers can use money from the investment account to help cover the cost of their life insurance.  As customers age, the cost of life insurance coverage naturally increases.  But today's low interest rate environment has been detrimental to investment returns, including those of universal life policies.  Many universal life customers are facing the need to pay increased premiums, or see a reduction of their life insurance coverage or even the cancellation of their policies.  Large numbers of universal life policies were sold years ago, before the Federal Reserve declared war on positive interest rates.  So the current low rate environment and its consequences for universal life policies probably come as a surprise to many customers. 

Insurance products like variable annuities and permanent life insurance can sometimes put customers into the middle of the complexities of the financial markets.  You're subject to many of the same risks as professional investors and traders.  But you probably don't have the same level of knowledge, experience, and information as they do.  Sophisticated insurance products can be labyrinthine mazes of risk shifting, and it's possible to run into the Minotaur.  Traditional insurance, which consists of the pooling of risks, can offer sensible protections.  But stick to policies that are easy to understand, because then you'll know what you're getting into.  Term life and fixed annuities can be useful for many people. Super dooper, turbo-charged complex insurance products that also invest your savings, pick up your dry cleaning and get the oil changed in your car are to be viewed cautiously, and then skeptically.