There are three major mistakes commonly made in retirement income calculations. These three mistakes are 1) not estimating the impact taxes have on future income, 2) not taking into account home maintenance costs and 3) not deducting from Social Security income the cost of MedicareParts B and D coverage and the costs of Medigap coverage.

Impact of Taxes

We cannot know what the revenue hungry politicians will do with taxation at the county, state and local level. That said, when calculating the impact of taxes on future retirement income we can use the current rates. The best way to do this is to first calculate what your gross retirement income is projected to be and then run those numbers through a simple tax program like Turbo Tax. That should produce for you a much more accurate picture of what your after tax retirement income is likely to be.

Home Maintenance Costs

If you plan to live in a single family dwelling in retirement, your retirement income calculation has to include replacement of major appliances, a new roof, and heating and air conditioning units. When those expenses come into play depends on how old they are now. But with 20 and 30 year retirements common, even with new appliances/roof/hvac you will most likely have to replace them. These costs must be accounted for in your projections.

Deductions from Social Security for Medicare

Currently if you are single and are making $85,000 or less or married filing joint making $170,00 or less you must pay $99.90 per month for your Medicare Part B coverage. So reduce your Social Security by $100 a month for that cost. Medicare Part D premiums for drug coverage is currently $39.62 per month so that has to be deducted as well. If you purchase a Medigap policy to cover the holes left by Parts A&B the premium for that coverage runs about $164 per month. All in, these three medical costs run about $300 a month. That expense needs to be built into any retirement income calculations you do. Yes, you may lower the Part D and Medigap costs by joining a Medicare Advantage program. But those carry costs as well.

Projecting your retirement income is a very worthwhile task. Just make sure you avoid these three common mistakes when yo do your calculations.

You had a regular paycheck.

Your health care coverage probably came from your employer or, if self employed, paid from your company.

You had a fairly consistent set of monthly bills which you handled from your steady working income. The money left over after paying your bills was your “fun money”.

You had a 401(k) or 403(b) or a company pension plan at work administered by your employer and the investment choices were narrowed down to a relative few.

Your life was structured with Monday through Friday days at work and fun times on weekends, holidays and (usually) paid vacation.

There was a comforting regularity to it all, work provided a structure to your life which made day-to-day living a fairly easy routine.

AND THEN RETIREMENT HAPPENED

Now think forward to your retirement.

No more steady paychecks. You have to create your own paychecks using a combination of Social Security or pension income if you have one, and income from your savings.

No more company administered tax withholding which made tax time much less of a hassle.

You are now responsible for you own health care coverage. Even Medicare is now complicated with Parts A, B, C and D and the choice of government or private Medicare plans from which you have to choose. Then there is the whole long term “nursing home care” issue to face as you age.

You are now in charge of investing your savings. You have to roll out your 401(k) or 403(b) plan. You have to choose between a lump sum rollover into a self-directed IRA or annuitize the money over a period of time.

Instead of the Monday to Friday work structure, you have 8,000 Saturdays in a row.

Now what?

Now, you have a choice of whether to handle all of your financial and insurance affairs yourself or find somebody to help you.

Do yourself a huge favor, don’t try to do it yourself.

Why?

For starters, there are thousands of products, programs and plans available to you that, if you do it yourself, you will never know exist. The chances are that one or more of those options might just be the perfect one for your individual circumstances.

Next, there are new programs, plans and products introduced every day. If you are not tapped into the mainstream of the financial industry world you might miss something new that just might be perfect for you.

Finally, there is a complex interplay between taxation and the way you create and take income in retirement. The rules on the taxation of your Social Security alone are difficult to understand and working around them as much as possible takes a lot more planning than you can probably do.

Do not do it yourself when it comes to retirement income planning. Instead, find a financial coach to help you navigate safely through the complexities of retirement. By all means take investing classes, play around with retirement income calculators and read all the retirement blogs you can stand. But, when it comes time to put your retirement income plan into place, do an intense investment advisor search and find someone who you like and trust and let them be your guardian angel.

Do not do yourself in by trying to do it yourself.

Option #1: You can continue to withdraw your required minimum deposit every year until you pass away. Then, if you have named beneficiary(s) of your IRA they will inherit your IRA and continue to take out required minimum distributions based on their age until the account is emptied. This is usually called a “stretch IRA” and it is a perfectly fine way to go.

Option #2: You can convert your IRA into a stream of annual income payments using a Single Premium Immediate Annuity (SPIA).  If you are insurable you can buy a life insurance policy whose death benefit is greater than the IRA account you started with. You will pay taxes on the SPIA income every year, but the life insurance death benefit is paid as a tax free lump sum when you pass away to your beneficiary(s). This is a way to convert what is a taxable event (annual IRA withdrawals) into a tax free legacy.  This strategy is best used if you have no current or future need for your IRA income and wish to leave a tax free legacy to your beneficiary(s)

Option #3: You can convert your taxable IRA into a non-Taxable Roth IRA. You will pay taxes on the amount you convert from a taxable to a Roth IRA in the tax year you do the conversion. Once the money is in the Roth IRA you will pay no further taxes on the money. You can make this conversion all in one year or convert some of your IRA every year to lessen the tax bite. This option works particularly well if your tax bracket is much lower than your beneficiary(s) tax bracket. This is because your lower tax bracket will take less of the IRA conversion.

Before deciding on which IRA option is best for you I strongly suggest that you work with your tax advisor and financial advisor to make sure what you do makes sense for you. By shopping around and doing annuity comparisons you can get the best rate for your SPIA. Different annuites have different annuity formulas, so having professional advice is very helpful in sorting out which are best for you.

Actively managed mutual funds engage in stock picking, market timing and/or track record investing as their investment strategies of choice. These three strategies often require massive trading in the market as they chase the next “hot stock”. This trading activity is not free. There are both explicit and implicit costs involved with every trade. The explicit costs are the cost paid to the broker(s) who transact the trades, the “spread”. Implicit costs are the impact large and frequent trades do to a stock’s price. It is smple supply and demand. If I  am dumping thousands of shares of XYZ into the market, the sudden availability of so many shares in the market has a depressive affect on the price I get for the sale. Conversely, if I am buying a large chunk of stock the sudden demand can drive the cost of those shares up.

Last, but not least, all this trading activity generates short term gains and losses in the mutual fund. As a shareholder you have to pay taxes on short term gains. If the stock was held for less than a year you pay the higher ordinary income rate on the gains versus the lower capital gains rate on shares held more than a year.

All in, you could be paying as much as 3-6% per year of your total mutual fund account due to these high and hidden actively managed mutual fund fees.

So, if you were outraged by the $5 bank fee you should be livid over the high and hidden costs you are paying on your actively managed mutual fund. Get yourself into a low cost, low turnover index or asset class fund. You will save thousands of dollars.

To better educate yourself on this topic please read both “The Myths” and The Truth” section on my website, www.modernportfolio.com

The Tortoise and the Hare

Let’s pretend that we are looking to put $100,000 into a stock mutual fund. We do our homework and find two funds that both have a 10 year average annual return of 10%.  One fund is the Tortoise fund (Ticker Symbol XSLOW) and the other is the Hare Fund (Ticker Symbol XFAST). Given the fact that these two funds have the same average annual 10 year return most people would say that they offer identical prospects for long term growth. Let’s take a closer look at the Tortoise Fund versus the Hare fund:

The Tortoise Fund versus the Hare Fund

$100,000 Invested – Equal 10% – 10 Year Average Annual Return

                                                  The Tortoise Fund                                          The Hare Fund

As you can see from the table above, the Tortoise fund outperformed the Hare fund by $30,113 over the 10 year period despite having an identical 10 year average annual return!!!

The difference between the return of the two funds lies in the volatility of the sequence of the returns.

The Tortoise fund plodded along with steady returns over the 10 years. The Hare fund’s returns were spectacular in some years and abysmal in others. Volatility was the difference maker in this hypothetical illustration as volatility can be the difference maker in real life investments.

So, when confronted with seemingly equal investments based on average annual return the next level of analysis for decision making is the volatility of the individual year annual returns which created the 3, 5 or 10 year average annual return. As can be seen from the table above, the investment with the lower volatility outperformed the investment with the higher volatility.  Fortunately, investment scientists have devised a measurement of volatility which makes these comparisons very easy to make.

The Tortoise and the Hare: Scientific Measurement of Volatility

In the table above the bottom line is titled “1 Standard Deviation”.  Standard Deviation is a scientific measurement of volatility. 1 Standard Deviation is how much the annual returns deviate above or below the average return 67% of the time. Our Tortoise fund has an average annual return of 10% and a Standard Deviation of 4.5. That means that two out of three years the annual return was somewhere between 14.5% (the annual average plus the Standard deviation) and 5.5% (the annual average minus the Standard Deviation). Our Hare fund has a Standard Deviation of 18.6. So, using our new volatility measurement tool, two out of three years it has an annual return between 28.6% and -8.6% (average annual return of 10% plus 18.6 and minus 18.6).

Be You the Tortoise or Be You the Hare?

Volatility has an enormous impact on long term returns. Volatility is a clear cut investment risk.  Investors are terrified of downward volatility (and in love with upward volatility) yet they have no idea how much volatility is built into their investment portfolio.  Your investment portfolio is volatile and it has a Standard Deviation which measures your personal level of volatility risk. Armed with the new knowledge from this article perhaps you will do your homework on your personal level of volatility risk, or seek out a financial coach who will guide you in this discovery process. The answer you uncover will tell you whether you are a tortoise or a hare in volatility risk.

About the Author

Glenn M. Kenney is a Sacramento Financial Advisor with 38 years of industry experience who has helped thousands of clients plan for their retirement. He is laser focused on the national crisis of helping baby boomers not outlive their money in retirement by building sound retirement money machines. His website is www.modernportfolio.com.

I would like to suggest to the Occupy Wall Street people that they rally around an issue which would go a long way towards righting a very great wrong.  As things stand now, Wall Street has made it legal to take money from mutual fund investor’s accounts without telling them how much they are taking nor when they take it. That’s right, every day Wall Street deducts money from people’s mutual fund accounts and nowhere do they tell them how much.  These hidden fees amount to many billions of dollars taken from the hard earned savings of the American people.  The vast majority of mutual fund owners have no idea how much they are paying in annual expense fees and implicit and explicit trading costs because Wall Street’s clout with Washington law makers has made this thievery legal.

I suggest that the Occupy Wall Street protestors demand a full and complete disclosure of all costs and fees Wall Street charges mutual fund investors.  This is an issue that hits Wall Street  in its pocketbook, right where it really hurts.  The American people deserve full and complete disclosure of all mutual fund fees and costs so that they can make much better informed decisions on where and how to invest their hard earned money. Reducing these fees is an important part of not outliving their money in retirement.

As a Sacramento financial advisor and fee only investment planner I help my clients learn how much money Wall Street is charging them for their mutual funds and, in most cases, help them reduce these charges by 50% or more. Reducing investment costs is a prime directive in creating Retirement Money Machines.

The Five Key Annuity Points I Look At

There are five key points in every annuity to look at; 1) surrender penalties and Market Value Adjustments, 2)how the money is paid out at death, 3) how much money can be taken out every year without penalty, 4) how surrender penalties are waived to pay for healthcare costs and 5) the interest crediting mechanism

1) Surrender Penalties and Market Value Adjustment (MVA)

Surrender penalties and MVA’s are charges you pay for taking out more money from your annuity than the contract allows out penalty free, up to and including taking out all of the money…a full surrender of the contract. Surrender typically last for 5-14 years and decline over time. MVA’s are arcane annuity calculations which can increase or decrease your surrender penalties. Essentially, if the interest rate of US Government bonds are higher than when bought your annuity you will pay an extra MVA penalty. If US Government interest rates is lower than when you bought, you could receive a positive MVA adjustment to your surrender penalties. With US Government interest rates at an all time low, obviously your MVA will increase your surrender penalties going forward. So, DO NOT PURCHASE ANNUITIES WITH AN MVA RIGHT NOW.

2) How the Money is Paid Out at Death

Some annuity contracts pay out the full account value at the death of the annuity owner. Some annuity contracts will reduce the full account value at death by any surrender penalties or MVA. This can be a big hit to the death benefit. Some companies will not pay a lump sum death benefit at death. They require the death proceeds to be paid out over 5 years. LOOK FOR ANNUITY CONTRACTS THAT PAY FULL ACCOUNT VALUE IN A LUMP SUM AT THE DEATH OF THE ANNUITY OWNER.

3)How Much Money Can Be Taken Out Each Year Without Penalty? (Liquidity)

Most annuity contracts allow penalty free withdrawals of 10% per year without penalty. Some contracts allow more than 10% penalty free withdrawals, some less. Some allow for cumulative penalty free withdrawals. Always check the liquidity provisions before purchasing an annuity.

4) How Surrender Penalties Are Waived For Long Term Healthcare Costs

There is an entire spectrum of healthcare choices from full on nursing homes to in home care. Annuity contracts vary widely on how much of the surrender penalty will be waived when withdrawing money from your annuity to help pay for these kinds of costs. The best ones pay for all levels of care, allow a 100% penalty free withdrawal of full account value, and have a 30 or 60 day wait period. Other annuity contracts have more onerous healthcare withdrawal provisions. Some allow only allow penalty free withdrawals for skilled nursing home expenses only . Others permit only a portion of the account value to be withdrawn. When looking at an annuity, look for the most liberal of healthcare withdrawal provisions, ideally 100% free withdrawal for all levels of care.

5) The Interest Crediting Mechanism

There are two basic type of interest crediting mechanisms. Either a stated fixed interest is paid or the interest credit is tied to the ups and downs of an external index like the S&P 500. Some annuities pay up front bonuses. Others guarantee an interest rate but only for calculating a future stream of income withdrawals. Stated fixed interest annuity contracts are pretty straightforward. It is the index linked, equity index annuity whose interest crediting mechanisms are almost impossible for the average joe annuity buyer to decipher. I cannot in this short space go into the details, visit my website at modernportfolio.com and contact me if you want a education for this topic.

There are good, bad and downright ugly annuity contracts being sold every day. Make sure you get a good one. I hope this short treatment of annuities helped you out.

About The Author

Glenn M. Kenney is a Sacramento Financial Advisor with 38 years experience helping people answer questions like “how much money do I need to retire?”. He provides annuity services including annuity comparisons and education on annuity formulas. He specializes in building Retirement Money Machines for his clients so they do not outlive their money.

What is a Fixed Deferred Annuity?

A fixed deferred annuity is a contract between you and an insurance company. You give them a chunk of money and they give you a contract which spells out what they will do with it and for you. There are many terms in the contract which you’d best understand if you do not want any nasty surprises down the line. Fixed annuities will guarantee 100% of your principal and guarantee a (usually small) interest rate.  In exchange for these guarantees the company subjects you to a Surrender Penalty Schedule. The surrender penalty is an annuity calculation which applies a penalty to any money you withdraw from the annuity. The length of these surrender penalties are usually 5, 7,10 or more years. A typical surrender penalty schedule would be a 10% withdrawal penalty in year one, 9% in year 2, 8% in year 3 etc.  So, for example, if you put $100,000 in an annuity, made 3% in the first year and took all the money out at the end of the first year you would pay a surrender penalty of  $10,300 (10% of the annuity value of $103,000)  and get back $92,700.

Whoa, wait a minute!  The contract said that my principal was 100% guaranteed, how come I got back less than my principal?

Read the contract. It does guarantee 100% of your principal payment  but 100% minus any surrender penalties!  Now, as the years go by the surrender penalty goes down and your annuity value goes up. So, at some point, even paying the surrender penalty you can take out more than the principal you put in because the amount you have made is larger than the surrender penalty.

So, the lesson for this blog is, grasshoppah, when considering the purchase of a fixed annuity, you should hone in on how long and how high are the surrender penalties.   You, or your financial coach, should determine what the estimated break even point in the annuity…the point at which you can get, after paying surrender penalties, at least all you original investment back. If you might need that money before the breakeven year, you’d best rethink buying that annuity.

In my next blog I will cover other nasty surprises in fixed annuities like the MVA, death benefit payment, nursing home withdrawal provisions and taxation.

Glenn M. Kenney is an independent fee only financial planner. He is a Sacramento Financial Advisor who helps people build retirement money machines so they do not outlive their money. He also helps answer questions like “how much money do I need to retire.”  You can learn more on his website www.modernportfolio.com

Define Annuity

You set up an annuity by giving an insurance company a chunk of money. They give you a contract that tells you how your money will perform. There are four words which define the basic types of annuities: they are either fixed or variable and either immediate or deferred.

Both fixed and variable annuities provide a tax deferral of the gains realized in the contract as long as you leave the gains in there. A fixed annuity provides a 100% principal guarantee, a guaranteed minimum interest rate and a “current” interest rate either declared by the company or determined from an external interest crediting calculation such as a stock market index. A variable annuity does not provide any principal or interest guarantees. You make (or lose) money in a variable annuity based on the performance of the “sub accounts” of the annuity. Sub accounts are typically mutual funds so your gain or loss depends on the stock market’s performance.

A deferred annuity is one which the money you put in is intended to stay there for some years before you tap into it. Hence “deferred” means you put off until some future point taking your money out. An immediate annuity is one which begins to pay out immediately, usually set up for a certain number of years or a lifetime of payment.

So you can have a fixed deferred annuity or a fixed immediate annuity. You can have a variable deferred annuity or a variable immediate annuity. This is a very basic intro to define annuities and to annuity comparisons. 

The Good, The Bad, and The Ugly

There are thousands of annuities you can buy. There are thousands of insurance sales people who are very eager to sell you them Unfortunately, far too many sales people sell inappropriate annuity products to unwary and too-trusting consumers. Surrender penalties are directly related to commissions. The higher the surrender penalties, the bigger the commissions. So there is a strong bias for too many annuity sales people to sell annuities with higher surrender charges, which, of course, sticks it to you.

Please check  my website, www.modernportfolio.com, as I will help you avoid being scammed by unethical annuity sales people and guide you through to the very best annuity for your Retirement Money Machine

Your Retirement Money Machine is the way in which you set up your financial assets to maximize the probability of not outliving your money. Your Retirement Money Machine is the system, the method, the blueprint for providing income for a decent retirement no matter how long you may live and no matter what economic challenges you may experience.

You have a choice. You can build your Retirement Money Machine by design, each component working in tandem with all the others, experiencing minimal operating costs, being tax efficient and flexible enough to respond to every challenge you may face. A machine that quietly and efficiently takes care of you and yours.

Or you can be like most people and have a random collection of uncoordinated “financial stuff”…an annuity you bought from some guy, an IRA account with investments you don’t really understand, a couple of CD’s and a stock account with a big brokerage company whose statements and investments confuse the heck out of you. Those are the Retirement Money Machines that are sputtering and smoking, leaking oil, badly in need of a tune up and not likely to get you very far.

It always amazes me that the same people who think that fixing their garbage disposal is too complicated think that generating decades of wealth from passive investing in a dynamic and complex financial world is something they can handle themselves.

Achieving an optimal Retirement Money Machine requires you to hire a financial planner with broad knowledge of the entire spectrum of financial products from stock market investing to fixed products like annuities, bonds, and bank instruments. The person tasked with building your Retirement Money Machine should also have a basic understanding of income taxation, Social Security benefits, Medicare (Parts A, B, C, and D) MediCal, and private health insurance. Most importantly, your Financial Coach should have a very clear understanding of where you are now and where you want to be in 5, 10 and 20 years. Finally, your Financial Coach needs to be with you for the rest of your life to provide wise counsel when things get rough.

And yes, you will have to pay your Financial Coach. However, if the relationship is working right, what you pay will be returned to you many times over during your lifetime.