The Retirement Researcher’s Guide Series

Retirement Planning Guidebook

Navigating the Important Decisions for Retirement Success

Wade D. Pfau, PhD, CFA, RICP

Copyright © 2021 by Wade
Donald Pfau. All rights reserved.

Published by Retirement
Researcher Media, Vienna, Virginia.

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the accuracy or completeness of the contents of this book and specifically
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For information about special
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Library of Congress
Cataloging-in-Publication Data:

Pfau, Wade Donald, 1977–

Retirement Planning Guidebook /
Wade Donald Pfau.

pages cm

Includes index.

ISBN [978-1-945640-09-4]
(paperback) - ISBN [978-1-945640-10-0] (e-book) - ISBN [978-1-945640-11-7] (hardcover)

Library of Congress Control
Number: 2021912549

Retirement Researcher, Vienna,
VIRGINIA

1. Retirement Planning. 2.
Financial, Personal. I. Title.

Cover Design: Trevor Alexander

To
those seeking to do something great with their retirement

Table of
Contents

Table of Contents. v

Preface. ix

Acknowledgments. xi

Chapter 1: Retirement
Income Styles and Decisions. 1

Understanding Your Retirement Income
Style. 3

Navigating the Decisions for
Retirement Success. 15

Action Plan. 22

Further Reading. 23

Chapter 2: Retirement
Risks. 24

Longevity Risk. 24

Market and Sequence-of-return risk. 28

Spending Shocks and Other Surprises. 42

Action Plan. 51

Further Reading. 52

Chapter 3: Quantifying
Goals and Assessing Preparedness. 53

Determining the Retirement Budget 55

Assessing Retirement Preparedness. 67

Action Plan. 81

Further Readings. 81

Chapter 4: Sustainable
Spending from Investments. 82

Origins of the 4% Rule - William
Bengen’s SAFEMAX. 83

Reasons Why the 4% Rule May Be Too
High. 88

Reasons Why the 4% Rule May Be Too Low. 97

Action Plan. 111

Further Reading. 112

Chapter 5: Annuities and
Risk Pooling. 114

The Fundamental Logic of Annuities
with Lifetime Income. 114

Overview of Annuity Types. 119

Income Annuities – SPIAs and DIAs. 121

Deferred Annuities with Lifetime
Income Benefits. 128

Fitting Annuities into a Retirement
Plan. 138

Action Plan. 149

Further Reading. 151

Chapter 6: Social
Security. 152

Introducing the Social Security
Claiming Decision. 152

Brief History of Social Security. 155

Calculating Social Security Retirement
Benefits. 157

Philosophy and Practicalities of
Claiming Strategies. 160

When are People Claiming Social
Security?. 171

Social Security as Insurance. 172

Social Security as an “Investment” 173

Social Security: The Best Annuity
Money Can Buy. 180

Arguments for Claiming Social Security
Early. 181

Potential Directions for Social
Security Reform.. 183

Action Plan. 187

Further Reading. 188

Chapter 7: Medicare and
Health Insurance. 189

Health Insurance Options Prior to
Medicare Eligibility. 189

The ABCDs of Medicare. 192

Using the Medicare Plan Finder 202

Upon Reaching the Medicare Eligibility
Age. 207

Annual Open Enrollment Options Review. 215

Budgeting for Retirement Health Care
Expenses. 217

Action Plan. 227

Further Reading. 230

Chapter 8: Long-Term
Care Planning. 231

Defining a Long-Term Care Need. 232

Costs and Prevalence of Long-Term Care. 232

Demographic Challenges. 236

The Continuum of Long-Term Care. 236

Options for Funding Long-Term Care
Expenses. 241

Long-Term Care Insurance and Taxes. 252

Coverage Options for Long-Term Care
Insurance Policies. 253

Budgeting for Long-Term Care Expenses. 258

Action Plan. 261

Further Reading. 263

Chapter 9: Housing
Decisions in Retirement 264

Do Retirees Move?. 264

Characteristics of a Good Place to
Live in Retirement 265

Considerations for Settling More
Permanently in a Home. 270

Reverse Mortgages. 274

Action Plan. 285

Further Reading. 286

Chapter 10: Tax Planning
for Efficient Retirement Distributions. 287

The Basics of Income Taxes. 287

Tax Diversification. 295

Asset Location. 301

Obtaining Tax Advantages for Taxable
Assets. 304

Withdrawals from Tax-Advantaged
Retirement Plans. 309

Tax-Efficient Retirement Distribution
Strategies. 325

Pitfalls to Monitor When Generating
More Taxable Income. 329

Other Planning Ideas. 338

An Example for Tax Bracket Management 342

Action Plan. 359

Further Reading. 360

Chapter 11: Legacy and
Incapacity Planning. 361

Getting Your Financial House in Order 362

Components of an Estate Plan. 370

Tax Planning with Legacy and Estate
Considerations. 386

Required Minimum Distributions for
Inherited Assets. 398

Action Plan. 407

Further Reading. 408

Chapter 12: The
Non-Financial Aspects of Retirement Success. 409

Finding Your Purpose and Passion. 411

The Relationship between Work and
Retirement 414

Strengthening Relationships and Social
Connections. 419

Healthy and Active Lifestyle. 422

Retirement Spending – Ants and
Grasshoppers. 424

Action Plan. 424

Further Reading. 425

Chapter 13: Putting It
All Together 426

Getting Started Now. 426

Decisions at Specific Ages or Moments. 446

Ongoing Monitoring and Adjustments. 449

Avoiding Mistakes. 452

Opportunities for Further Engagement 454

The Retirement
Researcher’s Guide Series. 456

About the Author 457

Preface

The book is designed to help readers navigate key decisions
necessary for a successful retirement. The process of building a retirement
income strategy involves determining how to best combine retirement income
tools to optimize the balance between meeting your retirement goals and protecting
those goals from the unique risks of retirement. I engage in a deeper
exploration of retirement income tools, including investment-based approaches
and insurance-based approaches such as annuities. Most books on retirement
income are written from the perspective of one retirement income style. Here I
adopt a more comprehensive approach since different styles are legitimate and
the choice depends on personal preferences.

Additional chapters then dig deeper into other important
aspects for a retirement income plan, including how to develop a strategy for
claiming Social Security benefits, how to make decisions related to Medicare
and other health insurance, how to structure a plan for managing long-term care
needs, and how to choose your retirement housing and incorporate housing wealth
into your planning. This is followed by a deeper investigation of tax issues
and how to structure your retirement income to create the most tax-efficiency
during your life as well as for your beneficiaries. With legacy planning, I
also explore how to get your finances organized for incapacity and death.

After reading this book, I hope you will be able to identify
your preferred retirement income style, understand retirement plan risks, and
assess your retirement preparedness by comparing the value of your retirement
assets and liabilities.

The focus then shifts to the non-financial aspects of a
successful retirement, including the need to find your purpose and passion, to
understand if there is a role for work in retirement, to enhance your
relationships and social connections, and to maintain an active and healthy
lifestyle.

The book includes detailed action plans to help with your
decision making. The final chapter fits these pieces together into an
integrated series of steps to achieve financial and non-financial success in
retirement. Readers will come away with the detailed knowledge and planning
steps needed to make the most of their retirement years. The simple act of
proactively planning for retirement can improve retirement satisfaction and
happiness. Risks become less nebulous, and those with a plan can feel more
comfortable about what comes next.

Let me address the general philosophy that guides this book.
I focus on creating efficiencies for your retirement to stretch your resources
as far as possible. A retirement income plan should be based on planning to
live, not planning to die. While a long life obviously involves more expense
than a shorter life, this assumption should take precedence given that life
spans are increasing and the risks involved of under-planning. Fight the
impatience that could lead you to choose short-term expediencies carrying
greater long-term costs. Many efficiencies can be gained from a long-term focus
that supports a higher sustained living standard.

We will see many examples that focus on
building a better long-term plan. These include delaying Social Security
benefits, purchasing annuities with lifetime income protections, building a
diversified portfolio offering long-term prospects for growth, choosing
lifetime income options for defined-benefit pensions, identifying reserve
assets, strategically paying more taxes to enjoy substantial future tax
reductions, making home renovations and living arrangements with the idea of
aging in place, planning for the risk of cognitive decline that will make it
harder to manage your finances with age, developing an estate plan, and opening
a line of credit with a reverse mortgage.

With respect to the non-financial aspects of a successful
retirement as well, I do emphasize the dichotomy that develops. While on the
financial side we must plan for the possibility of a long retirement, it is the
non-financial side where we need to also better plan for the possibility of a
short retirement. We do not know how long our health will remain, and we must
prioritize making the most of our available time. It is also important to enjoy
the present while being prepared for the future.

This book is current with tax and estate
planning laws as of mid-2021. However, these are both areas with potential for
major changes to be made over the coming years, and some sections could lose
relevance. RetirementResearcher.com will provide a resource for updates on
rules or laws impacting retirees until I can get an updated edition of this
book released. Please visit www.retirementresearcher.com
and sign up for our weekly newsletter with our latest articles, invitations to
webinars, Q&A sessions, and more. The newsletter arrives to your inbox each
Saturday morning.

I also welcome your feedback and questions. You can reach me
at:

wade@retirementresearcher.com

Wade Pfau

Dallas, TX

August 2021

Acknowledgments

Writing a book is a major endeavor, and I have been helped
along the way by countless individuals. First and foremost, I would like to
thank my colleagues at Retirement Researcher and McLean Asset Management for
providing the vision and resources to make this book possible. I am grateful
for the leadership and willingness of Alex Murguia and Dean Umemoto to build a
firm that turns my retirement income research into practical solutions for
real-world retirees. I would also like to thank Trevor Alexander, Briana
Corbin, Rob Cordeau, Bob French, Paula Friedman, Christian Litscher, Morgan
Menzies, Kyle Meyer, Jason Rizkallah, and Jessica Wunder.

Furthermore, I am grateful to the American College of
Financial Services for their leadership and focus on retirement income
planning, particularly David Blanchett, Michael Finke, George Nichols, Kirk
Okumura, Steve Parrish, and Art Prunier.

I am also deeply indebted to Don and Lynne Komai and the
Watermark Design Office for inspiring the layout and design for this book.

I also wish to thank countless other practitioners, researchers,
and readers who have helped me along the way. A partial list must include Dana
Anspach, Rodney Bednar, Bill Bengen, Bill Bernstein, Jason Branning, Jason
Brown, J. Brent Burns, Ian Cahill, Bill Cason, Curtis Cloke, Jeremy Cooper, Wade
Dokken, Harold Evensky, Francois Gadenne, Jonathan Guyton, David Jacobs, Dean
Harder, Rick Hayes, Jamie Hopkins, Robert Huebscher, Stephen Huxley, Michael
Kitces, David Lau, David Littell, Kevin Lyles, Manish Malhotra, Ed McGill, Moshe
Milevsky, Aaron Minney, Dan Moisand, Brent Mondoskin, Sheryl Moore, John Olsen,
Emilio Pardo, Kerry Pechter, Robert Powell, John M. Prizer, Jr., Michelle
Richter, Will Robbins, Jason and Art Sanger, Bill Sharpe, Jeff Smith, Larry
Swedroe, Tomiko Toland, Joe Tomlinson, Bob Veres, Steve Vernon, and Bruce Wolfe.
I also pay tribute to Dirk Cotton and Dick Purcell, who were both important
influences on me and have passed away.

I also wish to thank my family for their support and the
sacrifices made to help me get this book written, especially during the
pandemic year.

Finally, I wish to thank everyone who has read and
participated at RetirementResearcher.com since 2010.

Chapter 1: Retirement
Income Styles and Decisions

When properly planned, retirement allows for the
freedom and flexibility to focus on one’s interests and passions after a
lifetime of work. A successful retirement requires important planning and
preparation on both the financial and non-financial sides of life. Complex and
interconnected decisions are necessary.

At the same time, the traditional concept of
retirement is increasingly unaffordable. People are living longer. If
retirement ages do not change, the number of years of retirement will continue
to increase. That also increases the costs of funding retirement.

An extended period of low interest rates has
further complicated retirement. Interest rates reached new historic lows as
part of the global pandemic in 2020. Unfortunately, low interest rates are
another factor that increases the amount of assets needed to fund retirement
spending.

Another concern is that many people are forced
into an early retirement that constrains the options and decisions around
retirement planning and saving. Whether it is due to a health problem, the need
to care for a family member, or an unexpected job loss, repeated surveys show
that more than 40 percent of Americans retire sooner than they had anticipated.
These surveys were completed before the global pandemic, and it is possible
that the percentage of people forced into an early retirement could rise.
Retirement may occur earlier than anticipated.

We have also seen a shift in the United States
away from traditional company pensions toward defined-contribution retirement
plans. This shifts the burden of funding retirements from employers, who could
pool risks regarding longevity and market volatility across all their workers,
toward individual employees who are now expected to manage investment portfolios
and to find the right asset drawdown strategy in the face of great unknowns
about personal longevity and portfolio returns.

Without the relative stability provided by employment earnings,
retirees must find a way to convert their financial resources into spending
power that will last the remainder of their lives. For those who have been
saving and accumulating in anticipation of a future retirement, the question
remains about what to do with the accumulated wealth upon retiring. Retirees
are more responsible than ever before for figuring out how to save, invest, and
then convert these savings into sustainable income for an ever-lengthening
number of retirement years. They may also have legacy goals and must consider
how to structure additional asset reserves to help fund large potential
spending shocks such as paying for long-term care.

This book provides a path forward for retirees. I aim to
make this book as self-contained and comprehensive as possible, though I do identify
additional resources for those wishing to dive deeper on certain retirement
decisions. I will navigate through the important decisions, both financial and
non-financial, for achieving retirement success. Action plans provide steps for
making important retirement decisions in an efficient manner.

It is worth spending a moment to describe what I mean by
efficiency, since this is such an important underlying concept in the book. I
use the definition from economics. We all face resource constraints, and
efficiency is about getting the most value out of a given set of resources. It
is about doing more with less. In the context of retirement, efficiency is
about how to obtain the most after-tax spending and legacy potential from one’s
assets. Retirement income planning is about finding efficient strategies. If
one strategy allows for more lifetime spending and a greater legacy value for
assets relative than another strategy, then it is more efficient.

We start our careers with a huge amount of human capital. This
is the value of our future lifetime earnings from work. Over the course of our
working years, our human capital is converted into income to cover both our
current expenses and to provide a source of savings to fund future goals. We
save to have resources for our spending needs during the years that we do not
work. We must decide how to position those savings between different financial
tools and products to support our future goals and to manage the risks
confronting those goals.

Efficiency must be defined from the longevity perspective.
This becomes an important theme throughout the book as well, as we will see
time and again how certain strategies can enhance efficiency over the long term,
but not necessarily over the short term. To get those long-term benefits,
short-term sacrifices may be needed. Examples include spending other assets to delay
the start of Social Security benefits, front-loading taxes to get the most
after-tax lifetime spending power, and using annuities with lifetime spending
protections.

Wealth management has traditionally focused on accumulating
assets without applying further thought to the shifts that occur after
retirement. But many things change. Spending must now be funded through
distributions from accumulated assets rather than from employment earnings. Spending
must be able to continue over an unknown period. The potential for spending
shocks grows.

A mountain-climbing analogy is useful for clarifying the distinction
between accumulation (the working years) and distribution (retirement).
Ultimately, the goal of climbing a mountain is not just to make it to the top; it
is also necessary to get back down safely. The skillset required to get down a mountain
is not the same as that needed to reach the summit. In fact, an experienced mountain
climber knows that it is more treacherous and dangerous to climb down a mountain.
On the way down, climbers must deal with greater fatigue when facing a
downslope compared to an upslope. Our bodies are designed in a way that makes
it easier to go up than to go down, which creates risks of falling farther and with
greater acceleration.

Exhibit 1.1

The Mountain-Climbing Analogy for Retirement

The retirement phase, when you are pulling
money from your accounts rather than accumulating wealth, is much like descending
a mountain. The objective of a retirement saver is not just to make it to the top
of the mountain, which we could view as achieving a wealth accumulation target
that we estimate will allow for a smooth transition to retirement. The real objective
is to make it down the mountain safely and smoothly by spending assets in a sustainable
manner for as long as we live.

Retirement planning is about identifying
goals, analyzing the risks confronting those goals, and building a sufficient
asset base to manage those goals. Retirees seek to sustain a living
standard while spending down assets over a finite but unknown length of time,
while also supporting goals related to legacy planning and providing liquidity
to assist with unexpected expenses. Efficiency is important to
the retirement plan because smart decision making facilitates the potential to
achieve desired goals with fewer assets. We will navigate through decisions
that become part of a comprehensive approach to making your best retirement.

Understanding Your Retirement Income Style

Before providing a summary of the decisions discussed in
future chapters, I want to dig in immediately with this chapter’s key
retirement decision that will guide how you may think about numerous other issues
and decisions that are part of your overall retirement plan. You should first determine
your retirement income style. If you have spent much time reading about
retirement income, it quickly becomes apparent that there are vastly different
viewpoints about the best way to approach retirement spending. Some people love
the stock market, others hate it. Some love annuities, others hate them. The
same goes for life insurance, reverse mortgages, long-term care insurance, and
various other products and tools. Commentators argue about questions such as
whether there is such a thing as a safe withdrawal rate from an investment
portfolio, whether annuities provide enough value for their costs, and whether
it is better to start Social Security as soon as possible or to defer
collecting benefits until closer to age 70.

In this regard, the financial services profession remains
quite siloed. There is an old saying that if the only tool you have is a
hammer, then everything starts to look like a nail. This tendency is alive and
well within the financial services industry as those on the investments side
tend to view an investment portfolio as the solution for any problem, while
those on the insurance side tend to view insurance products as the answer for
any financial question. Financial advisors and other pundits tend
to support the approach they feel most comfortable with or are otherwise
licensed or incentivized to provide, with little consideration for what may be
best for any given individual. The prevalent idea is that there is one
objectively superior retirement income approach for everyone, and anyone
suggesting otherwise must be guided by a conflict of interest.

The reality is that there are competing viable approaches
for retirement income. No one approach or retirement income
product works best for everyone. There is room for nuance, and it pays
to be agnostic. Understanding which approach is best for any given individual
means knowing more about that individual’s preferences and style. A vital first
step in building a retirement income plan is to first identify the style that
works for you. Defining a style and matching strategies to it provides an
important step forward in aligning individuals with their retirement income
strategies.

Understanding your style from the start can save time and
money. Adopting a strategy that fails to align with your
preferences can lead to a plan that is poorly implemented throughout
retirement. Frequently revising a retirement plan is a potentially costly
exercise that is prone to underperformance and inefficiencies. Retirees need to
be comfortable and “buy in” into their strategy.  Forcing the “wrong” strategy
on someone is not appropriate. There are dangers to filtering strategies based
on a financial professional or an investment media pundit’s world view rather
than seeking to better understand what strategies resonate with an individual’s
personal style. Meanwhile, financial advisors who work with retired clients can
understand their own style and how that may impact the advice they provide,
either by weeding out prospective clients who may not be aligned with the
advisor’s approach, or by being able to better serve clients by offering a
broader range of strategies. Matching preferences with strategies will lay a
foundation for achieving better retirement outcomes.

With “Professor of Retirement Income” as my formal academic
job title, I have felt it to be my responsibility to understand the different strategies
that exist around creating a retirement income plan.  In 2012, I attempted to
outline the characteristics of two fundamentally different philosophies for retirement
income planning—which I called probability-based and safety-first. I still
remember working on this during the subway rides back and forth to the
university in Tokyo where I taught at that time. These philosophies diverge on
the critical issue of where a retirement plan is best served: in the
risk/reward trade-offs of a diversified and aggressive investment portfolio, or
in the contractual protections of insurance products to fund key spending needs
before turning to investments as well.

Strong disagreements exist about how to position a retiree’s
assets to best meet retirement goals. The guidance and strategies provided to
retirees still largely depend on the viewpoints of the pundit, whether that
person works in the media, the financial services profession, or as a personal
finance blogger. What is missing is the concept that there are multiple
appropriate ways to approach retirement. Each pundit will have a personal style
that may be different from the style of the individual receiving that message,
which creates misalignment. Individuals optimize for different outcomes based
on personal styles. They have characteristics that can be determined to better
position a strategy that is “right” for them rather than hoping for an
alignment achieved through random matching with the viewpoint telling them what
is objectively “right.”

Different retirement income approaches are viable in the
sense that they work best for individuals with a specific set of preferences
and attitudes. When I described distinctions between probability-based and
safety-first, they were based on observations about how different commentators
in the retirement income space approached the matter of describing optimal
retirement approaches. We now understand that these distinctions can be
attributed to real and observable preferences.

Alex Murguia and I developed a survey which tested and
quantified the role of six specific and distinct retirement income factors which
make up a retirement income style. These factors identify a range of
preferences around retirement finances. To do this, we reviewed a wide range of
advisor and consumer-focused books and articles about retirement income written
from different perspectives to identify factors representing a range of
choices, either in terms of tradeoffs to be weighed or as different thought
perspectives for making retirement decisions. From this review, we identified
six factors that describe a range of potential preferences for retirees. Our
statistical analysis determined that all six factors identify distinct
preferences. Anyone interested in that statistical part can refer to the
research article listed in the further reading section at the end of the
chapter. It is worth discussing these factors because it is amazing how well they
work together to define styles that directly translate into a taxonomy of
specific retirement income strategies.

In conducting this survey with readers at
RetirementResearcher.com, we were able to formally demonstrate the importance
of two main sets of factors, as well as four additional supporting factors. We
found that two factors can best capture an individual’s retirement income style:
Probability-Based vs Safety-First and Optionality vs Commitment Orientation.
The other four factors play a secondary role through their correlations with
the primary factors to help further identify retirement income strategies.
These secondary factors include a Time-Based vs Perpetuity income floor,
Accumulation vs Distribution, Front-Loading vs Back-Loading income, and True vs
Technical Liquidity.

With the first factor, we use the probability-based and
safety-first names. The Probability-Based vs Safety-First factor details
how individuals prefer to source their retirement income from assets.
Probability-based income sources are dependent on the potential for market
growth to continually provide a sustainable retirement income stream. This
includes a traditional diversified investment portfolio or other assets that
have the expectation of growth with realized capital gains supporting
retirement income. Meanwhile, Safety-First income sources incorporate
contractual obligations. The spending provided through these sources is less
exposed to market swings. A safety-first approach may include protected sources
of income common with defined-benefit pensions, annuities with lifetime income
protections, and holding individual government bonds to maturity. The
safety-first approach does not depend on an expectation of market growth to
provide capital gains as a source of spending, since the income is
contractually driven. Though no strategy is completely safe, the inclusion of
contractual protections implies a relative degree of safety compared to relying
on unknown market outcomes.

The second main factor reflects the dimension of preferences
for Optionality vs Commitment. This approach details the degree of
flexibility sought with income strategies. Optionality reflects a preference
for keeping options open for retirement income. Those with an optionality
preference want to maintain flexibility with their strategies to respond to
more favorable economic developments or to a changing personal situation. This
preference aligns with retirement solutions that do not have pre-determined
holding periods and are amenable to making changes.

Conversely, commitment reflects a preference for committing
to a retirement income solution. There is less concern with potentially
unfavorable economic developments or a worsening personal situation because the
solution solves for a lifetime retirement income need. The security of having a
dedicated retirement income solution outweighs missing out on potentially more
positive future outcomes, and it may provide further satisfaction from having
made decisions and not feeling a lingering sensation that this retirement
income decision-making process must remain on one’s to-do list. Planning in
advance to manage potential cognitive decline and to protect family members who
may not be as financially savvy can also be a source of satisfaction in this
approach.

The other four factors we found play a more secondary role
for understanding retirement decisions. First, with the Time-Based vs
Perpetuity factor, retirees ultimately have two funding strategies for
building retirement income floors. They may either fund an income floor for
specific time periods or in perpetuity. Time-based funding strategies are used
to fund fixed windows of time in retirement. Building floors in perpetuity
involves using lifetime income protections through risk pooling.

Next is the Accumulation vs Distribution factor. Wealth
management traditionally focuses on accumulating assets without applying
further thought regarding the differences that may happen during retirement. It
is possible that individuals may approach investing during retirement rather
differently from investing for retirement, as retirees may worry less about
maximizing risk-adjusted returns and worry more about ensuring that their
assets can sustainably support their spending goals. The distinction for
accumulation and distribution details a preference for portfolio growth while
retired even though it will entail a more uncertain and lumpier retirement
income stream (Accumulation), or a preference for a more predictable retirement
income path to maintain a standard of living at the potential cost of foregoing
the highest possible investment account value at death (Distribution).

Those with an Accumulation mindset will be more comfortable
building a retirement portfolio using traditional investment tools designed for
maximizing asset returns subject to an accepted level of short-term volatility
as determined through risk tolerance questionnaires. Those with a Distribution
mindset will be optimizing a different objective related to supporting spending
goals in a sustainable manner. With a distribution mindset, investing during
retirement is a rather different matter from investing for retirement. In this
new retirement calculus, views about how to balance the trade-offs between
upside potential and downside protection can change. Retirees might find that
the risks associated with seeking return premiums on risky assets loom larger
than before, and they might be prepared to sacrifice more potential upside growth
to protect against the downside risks of being unable to meet spending
objectives.

Next, the Front-Loading vs Back-Loading Income factor
relates to the amount and pace of income to be received throughout retirement.
This factor can be directly linked to the tradeoffs identified by the concept
of longevity risk aversion. Longevity risk aversion represents a fear of
outliving assets in retirement, and it will impact some individuals more
strongly than others. Does a retiree feel more comfortable front-loading
portfolio distributions with higher spending early in retirement to better
ensure that savings can be enjoyed when one is more assured to be alive and
healthy (Front-Loading)? Or does an individual prefer to spend at a lower rate
in early retirement to better ensure that a particular lifestyle can be
maintained without cuts during the later stages of a potentially long
retirement horizon (Back-Loading)? Those who fear outliving their assets will prefer
back-loading income and will behave more conservatively.

An example may better illustrate this concept. Monte Carlo
simulations are often used in financial planning contexts to gain a better
understanding of the viability of a financial plan in the face of market and
longevity risks. Monte Carlo simulations create randomized series of market
returns to test the sustainability of financial plans through various market
environments. The results are reported with a probability of success, which is
the percent of cases where the plan meets the retirement goals without
depleting assets. Suppose a Monte Carlo simulation identifies a retirement
plan’s chance of success as 90 percent. This means that 90 percent of the time
the plan can be expected to work, but that 10 percent of the time the plan can
be expected to deplete resources too early. While perhaps agreeing that this
number is correctly calculated, the interpretation of what to do with it can be
different. For those with a Front-Loading preference, a 90 percent chance is a
more than reasonable starting point, and the retiree can proceed with this
plan. The plan has a high likelihood of success. If future updates determine
that the plan might be on course toward failure, a few changes, such as a
reduction in spending, should be adequate to get the plan back on track. Those
identifying with Back-Loaded spending, however, will be less comfortable with
this level of risk. These individuals will want a greater assurance that the
plan can work, as the thought of needing to make cuts to spending late in life
is a greater source of stress.

Finally, the True v Technical Liquidity factor
reflects differences between two ways that liquidity can be defined in
financial planning. Those who prefer True Liquidity would like to have assets
earmarked specifically as reserves for future unknown events that can derail a
retirement income plan. To be truly liquid, assets must not already be matched
to other financial goals such as planned retirement expenses or a specific
legacy goal. True Liquidity can involve the use of cash set asides, buffer
assets, and insurance. Those who prefer Technical Liquidity would rather raise
cash from investments or assets already earmarked for other goals when
necessary to fund unexpected expenses, with an understanding that cuts may then
need to be made elsewhere. Technical Liquidity refers more to a general sense
that there is a pot of assets to draw from for any type of expense. With a
comfort around Technical Liquidity, fewer assets may be needed to feel
comfortable with a retirement income plan because it is not necessary to have
as much additional reserve assets to cushion the potential spending shocks that
retirees face.

Another important element for this relates to income
annuities, in which a retiree earmarks some assets to support lifetime spending.
Annuitized assets are not liquid, but a true liquidity mindset would focus on
how this decision could increase the level of true liquidity for other
non-annuity assets that no longer need to be earmarked for the spending. A
technical liquidity mindset would focus on how the income annuity is not liquid.

With the six factors introduced, we are now getting to the
punchline for this discussion, which is how these factors correlate to help
identify retirement income styles that will map to specific retirement income
strategies. To explain this, Alex and I created the
Retirement Income Style Awareness® (RISA®) Profiles as
based on the RISA Matrix® shown in Exhibit 1.2. The RISA Profile®
is effectively a replacement for measuring risk tolerance that is broader and
includes more dimensions to be better suited to the complexities of retirement
income planning. The RISA Matrix lays out how the scores
calculated for each RISA factor can be utilized and matched to appropriate
retirement income strategies.

Exhibit 1.2

The RISA Matrix

Optionality
Orientation

Safety-First

Safety-First
&

Optionality

[Time Segmentation]

Probability-Based
& Optionality

[Total-Return Investing]

Probability-Based

Safety-First
& Commitment

[Income Protection]

Probability-Based
& Commitment

[Risk Wrap]

Commitment
Orientation

This process relies on the idea that even though these six
factors are statistically distinct from one another and reflect unique
characteristics, there are some correlations found between them. As those
correlations work together, we can identify retirement income styles and
strategies that match. I noted that the statistical analysis identified the two
main factors as probability-based vs safety-first and commitment vs optionality.
We create the RISA Matrix in the exhibit to show the intersection of these
preferences. The scale for probability-based vs safety-first is aligned
horizontally, and optionality vs commitment is aligned vertically. This creates
four distinct retirement income strategy quadrants, each of which is based on
an individual’s scores for these two main RISA factors. Important to this as
well is that the probability-based perspective is correlated with a preference
for optionality, while those with a safety-first outlook also tend to be more
commitment oriented. The four supporting factors are mixed in as well through
their correlations with the main factors to identify strategies more strongly.

From the available retirement income strategies, we identify
four main classes to match the four quadrants within the RISA Matrix. These are
total return, risk wrap, income protection, and time segmentation (or
bucketing). These strategies align closely with the common framework of
systematic withdrawals (total return), time segmentation, and essential vs.
discretionary (income protection and risk wrap). Although I am introducing
these approaches now, I will describe these strategies in much greater detail later
in Chapters 4 and 5.

Upper-Right Quadrant: Total-Return Investing

Starting at the upper-right quadrant of the RISA Matrix,
these are individuals whose preferences lean toward both probability-based and
optionality. Typically, individuals with these characteristics identify with
drawing income from a diversified investment portfolio rather than using
contractual sources to fund their retirement expenses. Investors rely on
portfolio growth to sustainably support their spending and do not want to
commit to a strategy. As for secondary characteristics in this quadrant, as
identified through their correlations with the two primary factors, these
individuals also tend toward an accumulation focus, technical liquidity,
front-loading for spending, and time-based flooring. Those who value
optionality wish to maintain the ability to consider retirement income
withdrawal options on an ongoing basis.  They are also more comfortable with
seeking market growth despite the volatility for spending. The individual is
likely to prefer a more variable income stream with the potential for
investment growth rather than a stable retirement income stream with more muted
potential growth. They want to enjoy their early retirement years and are
willing to accept the risk that they may have to make spending cuts later.

This quadrant provides the combination of preferences that I
have written about in the past as probability-based. These are
investments-centric approaches that rely on earning the risk premium from the
stock market. Stocks are expected to outperform bonds over sufficiently long
periods, and this investment outperformance will provide retirees with the
opportunity to fund a higher lifestyle. Should decent market returns
materialize and sufficiently outpace inflation, investment solutions can be
sustained indefinitely to support retirement goals. Those favoring investments
rely on the notion that while the stock market is volatile, it will eventually
provide favorable returns and will outperform bonds. The upside potential from
an investment portfolio is viewed as so significant that insurance products are
not needed. Investment approaches are probability-based in the
sense that they will probably work.

The roots of this retirement income strategy originated from
research conducted by California-based financial planner William Bengen in the
1990s. Bengen sought to determine the safe withdrawal rate from a financial
portfolio over a long retirement. Though the term safe withdrawal rate
uses the word safe, it is not part of the safety-first approach. The
probability-based school uses “safe” in a historical context as based on what
could have worked when tested with historical market returns. The question is:
how much can retirees withdraw from their savings, which are invested in a
diversified portfolio, while still maintaining sufficient confidence that they
can safely continue spending without running out of wealth? Finding strategies
that could have always worked with historical data make probability-based
advocates feel comfortable.

The probability-based approach seeks to maximize
risk-adjusted returns from the perspective of the total portfolio. Asset
allocation during retirement is generally defined in the same way as during the
accumulation phase—using the tools of modern portfolio theory to identify a
portfolio on the efficient frontier in terms of single-period trade-offs
between risk and return. Different volatile asset classes that are not
perfectly correlated are combined to create portfolios with lower volatility.
Investors aim to maximize wealth by seeking the highest possible return given
their capacity and tolerance for short-term market volatility. Probability-based
advocates are generally more optimistic about the long-run potential of stocks
to outperform bonds, so retirees are generally advised to take on as much risk
as they can tolerate to minimize the probability of plan failure. Answers about
asset allocation for retirees generally point to holding around 40 to 80
percent of the retirement portfolio in stocks.

The “annuity puzzle” is described by academic economists who
struggle to understand why commercial annuities are not more popular with
retirees. The solution to this puzzle for those in this quadrant is that not everyone
is optimizing for stable retirement income. There is an overlay of three
distinct factors in which individuals can maintain preferences for an
investment growth perspective, a willingness to accept volatile income with an
accumulation mindset, and a desire for optionality. These individuals simply do
not perceive a need for annuities as part of their planning.

The individuals whose style places them in this quadrant are
more likely to subscribe to a systematic withdrawal strategy based on a total
return investing approach for retirement income. Those who think
this style is most applicable to their situations will want to focus on Chapter
4, which provides a deeper investigation of the issues that surround
sustainable spending from investments.

Lower-Left Quadrant: Income Protection

The lower-left quadrant is home to individuals with a
safety-first and commitment orientation. Other secondary factors also
correlated with this quadrant include having a distribution mindset, a
preference for perpetuity income flooring, a preference for true liquidity, and
a desire to back-load spending to manage the fear of outliving assets. These
characteristics align with retirement income strategies traditionally referred
to as essential vs. discretionary or income flooring. Assets are positioned to
match the risk characteristics of a spending goal. There is a preference for
contractually-protected lifetime income to cover essential retirement expenses,
while a more diversified total return portfolio is used for discretionary
expenses. These characteristics associate with using income annuities through
the annuitization of assets to provide greater downside spending protection
with a lifetime commitment. We further describe income annuities in Chapter 5.

This quadrant reflects the set of characteristics that I
have described as safety-first over my years of writing about retirement
income. Safety-first advocates are generally more willing to
accept a role for insurance as a source of income protection to help manage
various retirement risks. For investments-only strategies, retirement risks are
generally managed by spending less in retirement, as longevity risk is managed
by assuming a long life, and market risk is managed by assuming poor market
returns. But insurance companies can pool these market and longevity
risks across a large base of retirees—much like traditional defined-benefit
pensions and Social Security—allowing for retirement spending that is more
closely aligned with average, long-term, fixed-income returns and average
longevity. Those with average lengths of life and average market
returns will have paid an insurance premium that is transferred to those who
experience a more costly combination of a longer retirement and poor market
returns. This could support a higher lifestyle than what is feasible for
someone self-managing these risks and who is more nervous about the possibility
of relying on market growth to avoid outliving assets.

Those more comfortable with the safety-first approach believe
that contractual guarantees are reliable and that staking your retirement
income on the assumption that favorable market returns will eventually arrive
is emotionally overwhelming and dangerous. These individuals are more concerned
about market risk, as a retiree gets only one opportunity for a successful
retirement. Essential spending needs, at least, should not be subject to market
whims. The safety-first school views investment-only solutions as undesirable
because the retiree retains all the longevity and market risks, which an
insurance company is better positioned to manage.

The safety-first school of thought was originally derived
from academic models about how people allocate their resources over a lifetime
to maximize their satisfaction. Academics, including many Nobel prize winners, have
studied these models since the 1920s to figure out how rational people make
optimal decisions in the face of scarcity.

Advocates of the safety-first approach view prioritization
of retirement goals as vital to developing a good retirement income strategy.
The investment strategy aims to match the risk characteristics of assets and
goals, so prioritization is a must. Safety-first advocates move away from asset
allocation for the investment portfolio to broader asset-liability matching,
which focuses more holistically on all household assets.

With asset-liability matching, investors are not trying to
maximize their year-to-year returns on a risk-adjusted basis, nor are they
trying to beat an investing benchmark. The goal is to have cash flows available
to meet spending needs as required. Contractual-based and committed income
strategies that do not rely on market growth are viewed as appropriate for core
retirement expenses.

For those in this quadrant, there is no need to discuss the
“safe” withdrawal rate that dominates the probability-based world. Growth
assets are only appropriate for discretionary goals where safety is less
relevant. Safety-first advocates dismiss probability-based ideas about safe
withdrawal rates by noting that there is no such constant safe spending from a
volatile investment portfolio. But once the basics are covered, there is more
flexibility to not worry about the performance of remaining investments.

Lower-Right Quadrant: Risk Wrap

The remaining two quadrants reflect hybrid styles that can
better align with the preferences of retirees who may not hold all the natural
correlations between different retirement income factors. Shifting to the
lower-right quadrant of the RISA Matrix, we find individuals whose RISA Profile
shows both a probability-based and commitment orientation. From the secondary
factors, this quadrant is also associated with a preference for technical
liquidity and for back-loading retirement income.

While individuals here maintain a probability-based outlook
with a desire for market participation, they also have desire to commit to a
solution that provides a structured income stream. Income annuities, which
require an irreversible commitment and a lack of growth potential, tend to be
non-starters for individuals in this quadrant. These individuals seek growth,
and they think in terms of technical liquidity, but they also have more
longevity risk aversion and are more comfortable with committing to strategies.
For these reasons, using only unprotected investment portfolios is also not
attractive.

Since the 1990s, the retirement industry has been creating structured
tools that are more aligned with the combinations of preferences found in this
quadrant. We use the term “risk wrap” as a general description of such tools. A
risk wrap strategy provides a blend of investment growth opportunities with
lifetime income benefits, generally through a variable or indexed annuity. Such
tools can be designed to offer upside growth potential alongside secured
lifetime spending even if markets perform poorly. Such tools also maintain
technical liquidity for the underlying assets, as deferred annuity assets
remain on the balance sheet and can be invested with their values shown on
portfolio statements. There is commitment and back-loaded protection, but these
strategies can also be reversed with remaining assets returned to those who
decide they no longer want or need the lifetime spending protection. While the
associated market exposure satisfies the probability-based dimension and the
products offer technical liquidity, purchasing a more structured and secured
retirement income guardrail through the lifetime income benefit addresses the
commitment and longevity risk aversion dimensions at work within this quadrant.
I will explain more about these tools in Chapter 5.

Upper-Left Quadrant: Time Segmentation

The upper-left quadrant identifies another hybrid case.
These are individuals with both safety-first and optionality preferences. They like
contractual protections, but they also prefer optionality. This quadrant is
also correlated with preferences for true liquidity and front-loaded retirement
spending.

Those whose factor scores place them in this quadrant
reflect a desire for retirement income solutions that are characterized by
contractually-driven income while still maintaining a high level of flexibility
to change strategies or accommodate ongoing changes. It can be difficult to
enter a contract while keeping options open, but the retirement world has
addressed this challenge with strategies related to investment-based bucketing
or time segmentation. These are also described in Chapter 4. Annuities with
lifetime commitments are less likely to appeal to individuals in this quadrant,
but these retirees may be satisfied with holding individual bonds to cover
upcoming expenses with contractual protections.

A time-segmentation or bucketing strategy usually sources
short-term retirement income needs with a rolling bond ladder or other fixed
income assets. Bond ladders are frequently implemented with
contractually-protected instruments (cash equivalents or government-issued
securities) that can be used for shorter to intermediate income needs, with a
diversified investment portfolio designed for longer-term expenses. That growth
portfolio will be used to gradually replenish the short-term buckets as those
assets are used to cover retirement expenses. Conceptually, some may also lump
time segmentation together with the idea of holding additional cash reserves outside
the investment portfolio to manage market volatility or for unexpected expenses.
These strategies address the need for asset safety by including short-term
contractual protections while maintaining high optionality for other investment
assets.

There is much debate about whether these strategies are
materially different from using total-return investing. In terms of behavior,
these strategies do have an important difference from a total-return portfolio
if they help people displaying this style’s characteristics to be more
comfortable with a growth portfolio. Short-term spending protections could help
some retirees get through bouts of market volatility without panicking. That
behavioral aspect is primarily where the value can lie. Much like risk wrap
strategies, time segmentation reflects a hybrid approach that can match a less
natural combination of preferences held by these retirees.

Discussions about retirement income planning can become
quite confusing as there are so many different viewpoints expressed in the
consumer media. Each individual investor must ultimately identify the style
that can best support his or her financial and psychological needs for
retirement. Financial service professionals and retirees should understand
which style they most identify with to know how that impacts advice and whether
retirees are speaking the same “language” as that guiding the advice they are
receiving. The RISA Profile provides a way for people to quickly understand
whether they are speaking the same language, and to find retirement income
strategies that are best aligned with their style.

Invitation
to Identify Your Retirement Income Style

I wear different hats as a university professor and a
registered investment advisor. My intention is for this book to serve as a
stand-alone educational tool. I learned my lesson with an earlier book that
generated a few negative reviews from readers who interpreted it as a sales
pitch for financial planning services. That makes me hesitant to start the
book with a discussion of a commercial product.

I have outlined the types of preferences associated with
each of four general retirement income styles. For this book to be
standalone, you could simply think about your preferences related to the six
retirement income factors and where that would place you on the RISA Matrix.

If you would like more guidance about how to find your
style, we have created the RISA Profile questionnaire to quickly guide respondents
toward an answer. It allows individuals to better understand
their retirement income style and to align it with a strategy that will
resonate.

I would like to offer you, as a reader, the opportunity to
take this questionnaire and receive a free RISA Profile report. This will let
you know where your preferences align in terms of the four quadrants of the
RISA Matrix. That may help you to know whether to focus more on Chapter 4 or
Chapter 5 as you read further.

To do this, please visit www.risaprofile.com/guidebook
to take the questionnaire and obtain your RISA
Profile results without cost or any further obligation. And please feel free
to share your feedback with me as this is a new tool we are constantly
striving to improve (wade@retirementresearcher.com).
I will now hold off on any further promotion like this throughout the
remainder of the book until the ending epilogue about opportunities for
further engagement. We now resume this stand-alone educational resource.

Navigating the Decisions for Retirement Success

We continue to navigate through the important decisions for
building a retirement income plan as efficiently as possible, seeking to meet spending
and legacy goals with the intention of also preserving liquidity to serve as
reserves for spending shocks. The thirteen chapters in this book provide an
investigation into the key retirement decisions and a framework for putting them
together.

Retirement Income Styles and Decisions (Chapter
1)

Identifying your retirement income style is a huge initial decision.
In this chapter, I describe a set of scorable retirement income factors that
define preferences for an overall retirement income style. The RISA Matrix
provides a way for retirees to understand how a range of preferences exist and
how those preferences can be identified and linked to appropriate retirement
income strategies. This provides a way to make sense of the plethora of
competing views about how to approach retirement income planning. The first key
decision to navigate in retirement is to develop an understanding about your
retirement income style. This helps with choosing from competing options and
tools for building your plan.

Retirement Risks (Chapter 2)

Chapter 2 provides an overview of retirement income risks.
Risk in this book means an inability to meet your financial goals. The three
basic risks for retirees are longevity risk, market risk, and spending shocks.
Longevity risk relates to not knowing how long you will live, and thus not
knowing how long you must make your wealth last. Market risk relates to the
possibility that poor market returns deplete available wealth more quickly than
anticipated. Market losses in the early years of retirement can
disproportionately hurt the sustainability of a retirement spending plan,
creating sequence-of-return risk that amplifies the impacts of market
volatility. Spending shocks are surprise expenses beyond the planned
budget, such as for long-term care and major health expenses. Spending shocks
require additional reserve assets to avoid having to spend assets intended to
support the ongoing retirement budget.

For a planned retirement budget, the overall cost of retirement
will be less with some combination of a shorter life, stronger market returns,
and fewer spending shocks. But retirement could become quite expensive when a
long life is combined with poor market returns and significant spending shocks.
The danger is that a combination of risks contributes to an overall retirement
cost that exceeds available assets. Developing strategies to manage retirement
risks is an important theme in the book.

Quantifying Goals and Assessing Preparedness
(Chapter 3)

Chapter 3 provides a framework to answer an important
question many pre-retirees and retirees are asking themselves. That is, am I on
the financial track toward supporting a successful retirement?

The first step to answering this question involves quantifying
retirement financial goals. These goals define the retirement expenses, or
liabilities, to be funded. Financial goals include to maximize spending power
(lifestyle) in such a way that spending can remain consistent and sustainable
without any drastic reductions, no matter how long the retirement lasts
(longevity). Other important goals may include leaving assets for subsequent
generations (legacy) and maintaining sufficient reserves for unplanned
contingencies (liquidity). Lifestyle, longevity, legacy, and liquidity are the
four Ls of retirement income. Effort is needed to figure out a realistic
retirement budget, as well as placing a monetary value on legacy goals and
reserves for contingencies.

A planning age and discount rate are then needed to quantify
retirement assets and liabilities as single values for today, which includes converting
future income and spending streams into their present value. The planning age
can be determined as a conservative age one is unlikely to outlive. I also assume
a conservative bond-like rate of return for the discount rate to determine if
there are sufficient assets to meet the anticipated retirement liabilities
through the planning age without requiring market risk.

Many assets can be used as part of the retirement income plan,
and they can be generalized as reliable income assets, diversified portfolio,
and reserves. Assets include investment accounts, retirement accounts, future
work, Social Security benefits, home equity, life insurance and other insurance
policies, and even family or community support.

The value of assets and liabilities can be compared by
calculating the funded ratio. This is the ratio of assets to liabilities,
assuming a conservative interest rate to translate future income and expenses
into today’s dollars. The funded ratio lets us know whether our plan will work by
investing financial assets in bonds to meet future expenses. The hope is that assets
exceed liabilities. The chapter concludes with a deeper consideration of
funding levels for specific goals and possible actions to improve the funded status
if assets fall short.

Sustainable Spending from Investments (Chapter 4)

The funded ratio provides a basic calculation about whether
retirement is funded without accepting market risk. Those investing with a more
diversified portfolio may feel comfortable relying on the stock market to
provide a higher portfolio return than bonds alone. Chapter 4 describes the
research-based approach for identifying the level of sustainable distributions from
a diversified investment portfolio. This is the heart of the total-return
investing quadrant of the RISA Matrix. It is also an important topic for anyone
with investment portfolios covering a portion of retirement expenses.

I start by describing the origins of the 4 percent rule for
retirement spending. The 4 percent rule is the starting point for how most
probability-based thinkers view sustainable retirement spending. I then
describe reasons why the 4 percent rule may be too high for today’s retirees.
Reasons include that it does not consider the international experience, that
low interest rates and high market valuations create a situation that has not
been tested in the historical data, and that retirees may deviate from its
assumptions about earning the index market returns, maintaining an aggressive
asset allocation, and using a total-return investing strategy. I also consider
the impact of taxes, the desire to maintain a safety margin for assets, and the
possibility that retirements may last longer than planned.

Then I shift to reasons why, despite the issues just
mentioned, the 4 percent rule may still be too low. Reasons include that the
retirement spending budget may not grow with inflation throughout retirement,
that retirees may be able to put together a more diversified investment
portfolio, that retirees may create a time segmentation or bucketing approach
to asset allocation, that retirees may use a more dynamic asset allocation,
that they are flexible about their spending, that they may have the capacity to
accept greater risk for depleting their investment assets late in retirement,
or that they may coordinate portfolio spending with distributions from a buffer
asset to help manage sequence-of-return risk.

Annuities and Risk Pooling (Chapter 5)

Annuities serve as another retirement income tool that allows
for greater spending than bonds alone. Annuities with lifetime income
protections can provide an effective way to build an income floor in perpetuity
for retirement. Annuities, as opposed to individual bonds, provide longevity
protection by hedging the risks associated with an unknown retirement length. Annuities
can be real or nominal, fixed or variable, and income payments can begin within
one year or be deferred to a later age. The simplest type of annuity is an
income annuity. I start with an exploration of these, and then continue to
explore other types of more complicated annuities, including deferred variable
annuities and fixed index annuities. Different annuities provide various
combinations of guaranteed income, liquidity, and upside growth potential.
Annuities used as tools to fund retirement spending will be especially
attractive to those with the income protection and risk wrap retirement income
styles.

After describing how different types of annuities work, the
chapter continues with a deeper discussion of fitting annuities into a
retirement income plan. Annuities with lifetime income protections provide a source
for reliable income to fill any gaps in relation to the assets earmarked for
longevity expenses. As for which annuity type is most suitable, the decision
involves striking the desired balance between downside protection and upside
potential with the annuity. I also discuss how to manage inflation risk with
annuities, and how a partial annuity strategy impacts legacy and liquidity.
Those purchasing annuities must also decide between selling stocks or bonds to
fund the purchase, and I make the case for annuities as a bond alternative. The
chapter concludes with a discussion of how to frame the issue of annuity fees
with respect to the role that the annuities play within the plan, impacting the
overall cost of retirement.

Social Security (Chapter 6)

Most households already have an annuity as part of their retirement
income plan: Social Security. For most Americans, Social Security benefits
serve as a core source of reliable income. As a government-backed,
inflation-adjusted monthly income for life, Social Security benefits can help
to manage longevity risk, inflation risk, and market risk. In addition to
retired worker benefits, Social Security also provides spousal, survivor, and
dependent benefits from a worker’s earnings record. For some households, the
value of lifetime Social Security benefits could exceed $1 million. It is vital
to understand that the Social Security claiming decision should be made
independently from the decision to leave the labor force. Claiming decisions
should not be taken lightly. It is possible to gain much from Social Security
simply by understanding how the system works.

This chapter outlines the steps required to have a firm
understanding about Social Security and how to approach your claiming decision.
I will discuss how Social Security retirement benefits are calculated and how
to factor in issues such a spousal and survivor benefit for couples, dependent
benefits, and benefits for divorcees. I will also look at the earnings test,
the windfall elimination provision and government pension offset. I also describe
the basic philosophies about claiming Social Security, including to view it as insurance
to protect for a long life, and breakeven analyses on when delaying benefits
will pay off. The basic guideline is that at least the higher earner in a
couple should consider delaying Social Security to age 70. I also describe the validity
of arguments made in favor of claiming Social Security early, which includes a
discussion of Social Security's history and potential reform options related to
what may happen as the Social Security trust fund approaches depletion. My
intention is to give you the knowledge and confidence to approach the Social
Security claiming decision in the manner that can create the most long-term
value for your plan.

Medicare and Health Insurance (Chapter 7)

Planning for retirement health expenses is an essential
component in a comprehensive retirement income plan. Chapter 7 explores retirement
health insurance options and retirement health expenses. Decisions made about
Medicare or other health insurance can help mitigate the risks of large
health-care spending shocks. The bulk of this discussion will be about
Medicare, which is available to most Americans upon reaching age 65. It is by
far the most important source of health insurance for retirees, and it requires
numerous decisions regarding whether to use Original Medicare or a Medicare
Advantage Plan, whether to use a Medicare Supplement with Original Medicare,
and how to obtain prescription drug coverage. I also cover health insurance
options for those retiring before reaching the Medicare eligibility age, and
the rules about using other private insurance after reaching Medicare
eligibility. I also discuss how to make ongoing annual decisions about Medicare.
The chapter finishes with a deeper dive into budgeting for health care expenses
and estimating reserves for retirement health care shocks.

Long-Term Care Planning (Chapter 8)

One of the largest spending shocks facing a retired
household is the need to pay for ongoing long-term care. A retirement income
plan must account for this risk, and various tools are available to help
control the impacts of long-term care costs on family wealth. Physical and
mental decline can lead to an inability to perform activities of daily living.
This could create need for the provision of in-home care, adult day care, or a
move to assisted living or a nursing home. Family members end up providing the
bulk of long-term care, often at great cost to themselves in terms of their
career, finances, and health. If family is not available, or if one is
otherwise seeking to minimize the potential burden on family, then a plan is
needed. The financial costs for funding long-term care expenses can be
significant. Without further action, the default plan for long-term care is to
self-fund any expenses or to receive care from family members until assets are
sufficiently depleted to qualify for Medicaid. But other options exist,
including traditional long-term care insurance and hybrid policies that combine
long-term care benefits with life insurance or an annuity. Advanced planning
for long-term care needs can help control the impact of spending shocks and
cognitive decline. I conclude the chapter with a discussion about estimating
the amount of reserve assets to hold for long-term care shocks.

Housing Decisions (Chapter 9)

Retirees must make numerous housing decisions related both
to where they want to live and how to incorporate their housing wealth into
their retirement plans. Chapter 9 includes background about whether retirees
think they will move and whether they do move in retirement. I also identify
characteristics of a good place to live in retirement, and considerations for
when one is thinking about moving into a home on a more permanent basis. Most
retirees wish to age in place, and I also discuss home modifications that can
make it easier to accomplish this in the face of physical limitations. If one
decides to live more permanently in a home which they own, housing wealth can
be used in a variety of ways in retirement. Housing can provide inflation
protection and some protection for the uncertain costs related to long-term
care. With cognitive or long-term care needs, housing could be used to delay
institutional living, and then housing wealth could be redeployed to cover the
costs of institutional living if it becomes necessary. With a reverse mortgage,
home equity can become a liquid buffer asset which can help reduce exposure to sequence-of-return
risk or as reserves for spending shocks. I conclude the chapter with an
explanation of the Home Equity Conversion Mortgage program, which is the most
common type of reverse mortgage available.

Tax-Efficient Retirement Spending (Chapter 10)

An important aspect of creating efficiencies in the
retirement income plan is to make sound decisions with respect to their tax
implications. When should taxes be paid to generate the most after-tax spending
and legacy for a given asset base? Answering this question requires digging
into the intricacies of our progressive tax system. In Chapter 10, which is the
longest chapter in the book, I describe tax-efficient retirement planning.

I start with the different tax advantages available in the
tax code and how to create tax diversification between taxable, tax-deferred,
and tax-exempt accounts. Then I describe asset location, or how to position
assets between these different types of accounts. I also mention how to obtain
tax advantages for taxable assets that go beyond the space available in
tax-deferred or tax-exempt retirement plans.

I also describe important issues for tax-advantaged
retirement accounts, including rules for required minimum distributions, early
withdrawal penalties and their exceptions, rollovers, transfers, Roth
conversions, and the pro-rata rules for IRAs with non-deductible contributions.
I also cover the rules for net unrealized appreciation on employer stock.

Then I dive into tax-efficient retirement distributions,
including tax bracket management, strategic Roth conversions, and long-term
capital gains harvesting. I also cover the pitfalls involved in generating more
taxable income, including the Social Security tax torpedo, increased Medicare
premiums, and the net investment income surtax. I also describe tax strategies
related to charitable giving, and I discuss the widow tax penalty regarding how
taxes will likely increase after the death of a spouse. I finish with a
detailed example to show how more tax-efficient retirement distributions using strategic
Roth conversions can significantly extend retirement portfolio longevity. With
the example, a tax-efficient strategy extends retirement sustainability by 5.63
years.

Legacy and Incapacity Planning (Chapter 11)

Chapter 11 shifts to the topic of preparing you and your
family for end-of-life issues. I first discuss how to get your finances
organized with easy access for those who need it in the event of an emergency.
This includes personal and family information, contact information for
professionals and service providers you work with, insurance information,
medical history, and details about various financial accounts.

Then I shift to other important estate planning issues. The
components of an estate plan involve tracking and organizing assets and taking
a careful look at how they are titled and whether they include beneficiary
designations. You will also want to create a will, decide about whether to
create trusts, choose a financial power of attorney, create your advance health
care directives, and outline your final wishes.

I then continue the discussion regarding tax-efficiency and
tax-planning considerations as it relates to a legacy goal. Tax planning for
legacy includes understanding aspects of the tax code related to the step-up in
cost basis at death, considering the tax brackets of different beneficiaries,
estimating estate taxes, using gifting strategies, and identifying roles for
life insurance and irrevocable trusts. It is also important to understand the
rules for required minimum distributions from various inherited retirement
accounts and annuities as this may impact tax planning decisions such as whether
to make strategic Roth conversions.

Non-Financial Aspects of Retirement Success
(Chapter 12)

Though Chapter 12 is relatively short, it is vitally
important to consider the non-financial aspects for enjoying retirement. Many
retirees become bored with retirement because they did not prepare themselves
sufficiently to cope with all the free time available in this phase of life. Retirees
need to identify their purpose and passion that will provide a reason to get
out of bed each morning. How will you like to spend your days in retirement?
Retirees may also consider their relationship with work, as it is possible to
work in retirement, either part time or even full time and possibly even in a
new field. Retirement can provide the financial independence to work because
you desire to do so, even at a lower wage or as a volunteer. Being
financially independent offers the opportunity to pursue and prioritize work
and activities that create meaning and value instead of those that provide the
largest paycheck. Continuing to work offers many benefits aside from the
income, in terms of staying active and engaged with your communities. Retirees
must also plan to ensure that their relationships and social connections remain
strong to avoid social isolation. Strengthened relationships with spouses,
other family members, and friends deserve your attention and preparation ahead
of retirement. Finally, enjoying a healthy and active lifestyle is an important
part of enjoying your days and improving your health. An active mind may also
help limit the onset of cognitive difficulties. Retirees who plan for these
non-financial aspects can be better prepared to manage the various trials and
tribulations of retirement and to enjoy stronger life satisfaction.

Putting it All Together (Chapter 13)

We have worked our way through the depths of
decision-making for retirement income. We have covered the important
decisions for navigating a successful retirement. Now it is time to fit these
pieces together into an overall planning approach to achieve financial and
non-financial success in retirement. In this chapter, I attempt to organize the
previous discussion into an integrated series of steps to take in a somewhat
chronological order to be prepared for your best retirement. The simple act of
proactively planning for retirement can improve retirement satisfaction and
happiness. This chapter puts together the various steps to take before
retirement, at certain moments in the transition to retirement, and on an ongoing
annual basis when updating your plan. It includes a discussion of the Retirement CARE AnalysisTM to finalize answers for various
retirement planning questions related to annuity use, asset allocation, and how
much to spend from investments. I also include a discussion about working with
a financial planner.

Action Plan

This chapter is introductory, laying the groundwork for the
rest of the book. Nonetheless, there are a few important takeaways, including
the very important matter of determining your retirement income style to guide your
approach for sourcing retirement income. Key action items include:

o
Understand the depth of decision-making for retirement.

o
Determine your retirement income style

o
Assess exposure to various retirement risks

o
Quantify your financial goals and assess your preparedness with
the funded ratio

o
Understand strategies for sustainable spending from investments

o
Understand strategies using annuities with risk pooling

o
Develop a claiming strategy for Social Security

o
Manage health care and Medicare decisions

o
Plan for long-term care risks

o
Decide about retirement housing and housing wealth

o
Build tax-efficient retirement distribution plans

o
Create plans for legacy and incapacity

o
Prepare for the non-financial aspects of retirement

o
Implement and monitor your retirement plan

o
Understand the factors to identify retirement income preferences
and how they interact to define retirement income styles.

o
Determine your preferred retirement income style.

Further Reading

Murguía, Alejandro, and Wade D. Pfau. 2021. “A Model
Approach to Selecting a Personalized Retirement Income Strategy.” Available at
SSRN: https://ssrn.com/abstract=3788425

Chapter 2: Retirement
Risks

In this chapter, I review the major retirement risks. We
must clarify the meaning of risk from the perspective of retirement and
personal finance. When accumulating assets, the financial services profession
generally defines risk as short-term market volatility. The ability of a risk-averse
investor to stomach portfolio volatility is an important constraint for asset
allocation decisions. But this is only part of the story for retirement income.
More importantly, the fundamental nature of risk for retirees is the threat
that events take place (unexpectedly long life, poor market returns, spending
shocks) that trigger a permanently lowered standard of living for subsequent
years. Risk for the household relates to the inability to meet financial goals
over a long-term planning horizon. Retirees must decide how much risk to their
lifestyle they are willing to accept, and this is a different decision than how
much short-term volatility they can stomach.

Risk capacity becomes an important concept for retirees. Risk
capacity refers to the ability of individuals to experience major portfolio
losses without suffering too adverse of an impact on their standard of living. Retirees
have less capacity to bear risk, as they become more vulnerable to a reduced
standard of living when risks manifest. The first day of retirement can be the
riskiest day of one’s life. Stable earnings disappear, and it may be very
difficult to obtain stable employment earnings again. The financial
circumstances for retirees differ from pre-retirees.

As noted, retirement risks generally fall into three
categories: longevity risk, market risk, and spending shocks. I will address
these in turn. The practical impact of retirement risks is that the amount of
assets needed to successfully fund retirement goals is unknown, which becomes a
problem when the amount of assets falls short of what is needed.

Longevity Risk

The fundamental risk for retirement is unknown longevity. How
long will your retirement plan need to support your budgeted expenses? Potential
life spans are uncertain. A new 65-year-old retiree may live for anywhere from
another year to more than 40 years. Longevity risk has a huge impact on the
cost of sustaining a lifetime spending budget. It is the risk of living longer
than anticipated and not having the resources to sustain spending over that
longer lifetime.

We have a sense of life expectancies, or how long the
average person lives. But the length of retirement could be much shorter or
longer than the statistical life expectancy. A long life is wonderful, but it
is also costlier and a bigger drain on resources. Half of the population will
outlive their statistical life expectancy. And life expectancies continue to
increase as scientific progress finds more ways to prolong life. For some
retirees, the fear of outliving their resources may exceed the fear of death.
This can create a paralyzing effect on retirement spending.

Moshe Milevsky coined the term longevity risk aversion
to describe the emotions related to how one feels about the possibility of
outliving one’s retirement assets. Beyond the objective information available
about mortality, longevity risk aversion is what will drive a retiree’s
decision about an appropriate planning age. Those with greater fear of
outliving their wealth will seek to build a financial plan that can be
sustained to a higher age for which there is a sufficiently low probability to
outlive.

This gets to the heart of the retirement income factor related
to Front-Loading vs Back-Loading income described in the previous chapter. Those
with a Front-Loading preference believe it is optimal to enjoy a
higher standard of living while one is still able to do so in early retirement.
Later cuts to spending can be made as needed. Those with a preference
for Back-Loading will want to assume the possibility of living much longer than
average to feel comfortable with their plan, and that will mean either spending
less early on to stretch assets out further or relying more on lifetime income
protections. These individuals do not want to reduce their standard of living
or to be a burden on their children at advanced ages.

This is about the tradeoff between maximizing today’s
lifestyle by accepting a shorter planning horizon, against protecting lifestyle
in the future by spending less today and planning for a longer time horizon.
While the probability of surviving to advanced ages is low, individuals must
determine how low a level of spending they are willing to accept today in their
effort to plan for a longer life and better ensure that they will not deplete
their assets before death. Alternatively, as the worry about outliving assets
increases, annuities with lifetime income protections will look increasingly
attractive. While the annuity-based cost for lifetime income remains the same,
the amount of assets needed to feel comfortable about funding retirement with
investments will continue to increase as one becomes more longevity risk averse.

What is the optimal way to choose a planning age? When
determining longevity, it may seem natural to base calculations on the
aggregate US population, but clear socioeconomic differences have been
identified in mortality rates. Higher income and wealth levels and more
education each correlate with longer lifespans. This may not be a matter of
causation (i.e., more income and education cause people to live longer), but
perhaps an underlying characteristic leads some people to have a more long-term
focus, and that, in turn, may lead them to seek more education and practice
better health habits. Though accidents and illnesses will unfortunately lead to
some exceptions, the very fact that you are reading this somewhat technical
tome on retirement income suggests you probably have a longer-term focus and should
at least expect to live longer than the average person. In this case, mortality
data based on population-wide averages will underestimate your potential longevity.

It is also important to keep in mind that while life
expectancy at birth is a more familiar number, it is of little relevance for
someone reaching retirement. If you have reached 65, then an obvious point to
note is that you did not die at a prior age. As obvious as it might be, this is
important information. As you age, your subsequent life expectancy increases.
The remaining number of years one can expect to live decreases, but not on a
one-to-one basis with age. We do not say that 90-year-olds have a negative life
expectancy, for instance. This matter also leads individuals to underestimate
how long they may live in retirement.

There are tools available that provide more precise
longevity estimates based on a person’s circumstances. Some tools ask many
questions about family history and current health to be quite precise, but I
would like to describe a simpler tool that can provide a longevity estimate in
minutes and without cost. The American Academy of Actuaries and the Society of
Actuaries created the Longevity Illustrator [www.longevityillustrator.org] to
help users develop personalized estimates for their longevity based on a few
questions about age, gender, smoking status, and overall health. This is a
simple way to allow for some fine-tuning with respect to longevity estimates. Exhibit
2.1 provides its output as an example for 65-year-olds based on their health
assessment and smoking status.

This exhibit provides sufficient details for current
65-year-olds to decide about their planning ages. For example, a nonsmoking 65-year-old
female in average health who is willing to accept a 10 percent chance for
outliving her financial plan would want her plan to work to age 98. For a male
with the same characteristics, age 96 corresponds to accepting the same amount
of longevity risk. If these two individuals were married and therefore need to
plan for the possibility that at least one of them is alive, then 100 becomes
the age where there is a 10 percent chance of survival. With two people, the
probability that at least one of them is still alive at an advanced age is
higher than for just one person alone, as now there are two chances for this to
happen.

In 1994, William Bengen chose 30 years as a conservative
planning horizon for a 65-year-old couple when he discussed sustainable
retirement spending. At that time, he assumed it was sufficiently unlikely for
couples to have anyone live past 95. But as mortality improves over time, this
planning horizon is becoming less conservative, especially for nonsmokers in
reasonable health. In fact, we can see that the 50th percentile of
longevity for a non-smoking couple in excellent health is age 94. This means
that 95 is much closer to a life expectancy than to a conservative planning age
needed to reasonably reduce the chance of outliving the retirement plan. For
these couples, 25 percent will still have one member alive at age 98, and 10
percent of them will still have someone living at age 102!

Exhibit 2.1

Planning Ages for 65-Year-Olds from the Longevity
Illustrator

Individuals born on January 1, 1956

Males

Nonsmoker

Smoker

Health Classification

Excellent

Average

Poor

Excellent

Average

Poor

Chance of Survival

90%

73

72

70

68

67

66

75%

81

78

75

73

71

69

50%

88

85

82

79

77

74

25%

94

91

88

86

83

79

10%

98

96

93

92

89

84

Females

Nonsmoker

Smoker

Health Classification

Excellent

Average

Poor

Excellent

Average

Poor

Chance of Survival

90%

76

74

72

70

69

67

75%

83

81

78

75

73

71

50%

90

88

85

83

80

77

25%

96

94

91

90

87

83

10%

101

98

96

96

93

88

Couples - Either Individual is Alive

Nonsmoker

Smoker

Health Classification

Excellent

Average

Poor

Excellent

Average

Poor

Chance of Survival

90%

84

82

79

76

74

71

75%

89

87

84

81

79

75

50%

94

92

89

87

84

80

25%

98

96

93

92

89

85

10%

102

100

97

98

94

89

Source: American Academy of Actuaries and Society of
Actuaries, Actuaries Longevity Illustrator,
http://www.longevityillustrator.org/, (accessed February 8, 2021).

We can now return to the question of choosing a planning
age. This is a personal decision to be based partly on objective
characteristics: gender, smoking status, health status and history, family
health history, and other socioeconomic characteristics that correlate with
mortality. It is also based on an individual’s answers to more subjective
questions: how do you feel about outliving your investment portfolio, and what
would be the impact on your standard of living if you outlived your portfolio? With
the Longevity Illustrator, these subjective factors can point to which
percentile of your estimated longevity distribution to use. As a general
starting point, the 25th percentile survival ages may be more
applicable to those with a reasonable Front-Loading preference, while the 10th
percentile survival ages may be more applicable to those with a reasonable
Back-Loading preference. One could consider going more extreme than this in
either direction, but these values provided by the Longevity Illustrator are
reasonable anchor points. The Longevity Illustrator or a related tool can also be
used if you are at a different age than shown in the exhibit to get appropriate
estimates for your personal circumstances.

Market and Sequence-of-return risk

A similar story exists regarding market risk. Markets are
volatile. Market volatility causes investment returns to vary over time. Even
with an average market return in mind, it is possible that markets could
perform at a below average rate for a prolonged period. Related to this, market
volatility is further amplified by the growing impact of sequence-of-return
risk in retirement. This is the heightened vulnerability individuals face
regarding the realized investment portfolio returns in the years around their
retirement date—it adds to the uncertainty by making retirement outcomes more
contingent on a shorter period of investment returns. What rate of return is
one comfortable assuming for the investment portfolio during retirement? The
lower is the assumed rate of return, the easier it will be for the financial
plan to exceed that hurdle and to work. With a higher assumed return, it will
be harder for the portfolio to keep pace and there will be greater risk for the
plan to fail. The implications of market risk work in the same manner as
longevity risk. That is, just as one seeks to plan for a long retirement with a
low chance to outlive, one must also build a plan that will be robust to below
average market returns. In this section, we explore the market risks for
different investment options.

Risks for Fixed-Income Assets

Bonds and related fixed-income assets provide a starting
point for thinking about funding retirement goals with investments. A bond is a
contractual obligation to make a series of payments on specific dates. Typically,
this includes interest payments made on a semiannual basis until the maturity
date and the return of the bond’s face value at maturity. Bonds are issued by
both governments and private corporations to raise funds, and they are
purchased by investors seeking an investment return on their capital. Bank CDs
also function as a type of bond in terms of providing cash flows at specified
dates, though they are not traded on secondary markets.

Market risk is frequently considered as exclusively applying
to the stock market, but bonds are also exposed to price volatility and the
risk of capital losses. Bond interest rates—both coupon rates and the yields
subsequently provided to investors—are determined by the interaction of supply
and demand for the bonds as they continue to be traded. Rising interest rates
will lower prices for existing bonds, so the subsequent return to the new
purchaser can match the higher returns available on new bonds with higher
interest rates. Conversely, lower interest rates will increase the selling price
for existing bonds. If sold at their face value, these older bonds offer higher
returns than newly issued bonds, and their owners will want to hold them. An
agreeable selling price can only be found if the bond sells at a premium, and
then the new purchaser receives a subsequent return on their purchase price
that is in line with newly issued bonds. The price of a bond on the secondary
market will fluctuate in the opposite direction of interest rates. Bond funds can
therefore experience capital gains and losses in the same manner as stocks.
This is called interest rate risk.

In the universe of bonds, there is not one single interest
rate. Differences in interest rates among bonds reflect several factors that
point to other types of bond risks:

·
the time to maturity for the bond (longer-term bonds will
experience more price volatility as interest rates change)

·
the credit risk of the bond (bonds that are more likely to
default on their promised payments are riskier and will have to reward
investors with higher yields)

·
liquidity (bonds that are less actively traded may offer higher
yields as investors will demand an additional return premium for sacrificing
liquidity)

·
the tax status of the bond (municipal bonds from state and local
government agencies are free from federal income taxes and thus offer lower
interest rates to be more equivalent to taxable bonds on a net-of-tax basis)

Bond prices fluctuate as buyers and sellers shift to new
equilibriums for pricing underlying risks related to maturity, credit, and
liquidity. Bonds may also feature other options that affect the price an
investor is willing to pay. For instance, if the bond is callable
(meaning the issuer retains the right to repay it early if interest rates
decline), the potential capital gains from a fall in interest rates are
reduced, which lowers the price investors will pay.

US government treasuries are generally seen as having the
lowest credit risk and high liquidity, and they will generally offer lower
yields than corporate bonds with the same maturity date. They are less likely
to default and create problems for borrowers to receive what is owed. They are
backed by the full faith and credit of the US government. Treasuries are also
free from state and local taxes.

As a bond provides a contractual right to a series of future
payments received at specified points of time, the price for a bond is simply
the present discounted value of its future cash flows. Bonds with more distant
maturity dates typically offer higher interest rates than bonds with earlier
maturity dates, since their prices (the present value of future payments)
fluctuate more with changing rates, making them riskier to hold.

A zero-coupon bond provides only the bond’s face
value at maturity. It will be sold at a discount to the face value to provide a
return and compensate for the risks related to holding it. A coupon bond
provides the face value at maturity in addition to a series of coupon payments
(often on a semiannual basis) until the maturity date. The coupon rate
is contractually defined as a percentage of the face value.

The yield to maturity for a bond is the internal rate
of return an investor will earn by holding the bond to maturity and receiving
its cash flows. It is the return the investor would get for buying the bond
today at its current asking price and holding it to maturity. If the price
matches the face value, then the yield will be the same as the coupon rate. The
yield to maturity for a new investor differs from the coupon rate whenever the
bond sells for a different price than its face value. If the ask price is
higher, then the yield will be less than the coupon, and if the ask price is
lower, then the yield will be higher than the coupon. The yield curve
shows the yields to maturity for a series of bonds—typically US Treasury
bonds—with the same credit quality but different maturity dates.

It is also important to address inflation and how to think
about bonds when they are meant to fund a liability, such as a retirement
spending goal, that grows with the consumer price index for inflation.
Fortunately, this is now practical as the United States began issuing Treasury
Inflation-Protected Securities (TIPS) in 1997. The face value and coupon
payments for TIPS are both indexed to keep pace with inflation and preserve
purchasing power, and their yields are quoted in real inflation-adjusted terms.
Whenever positive inflation (as opposed to deflation) is expected, real yields
will be less than the nominal yields quoted on traditional bonds. As an
approximation:

real interest rate = nominal interest rate − expected
inflation rate

For TIPS, the nominal yields are not known in advance
because they depend on the subsequently realized inflation experience.
Conversely, we know nominal yields for traditional bonds, but their real yields
can only be known after observing the realized path of inflation up to the
maturity date. If inflation is unexpectedly high, then the real return on
nominal bonds is less. TIPS, on the other hand, keep pace with higher inflation
because it triggers a higher nominal return above their underlying real
interest rate. Essentially, TIPS provide protection from unexpected inflation.
They outperform treasuries when inflation exceeds the implied break-even
inflation rate. This is a valuable attribute when spending is expected to grow
with inflation. Retirees generally get more use from insurance that protects
from high inflation, making TIPS a more natural candidate for retirement
portfolios.

Investors may expect a positive nominal return on their
investment (otherwise, there is no reason to invest), but that return may not offer
the capacity to keep pace with inflation. Unlike traditional bonds, TIPS yields
are quoted as real interest rates, and real interest rates can be negative. An
auction for a five-year note held in October 2010 made headlines as the real
yield dipped below zero (to -0.55 percent) for the first time. Though
surprising at the time, negative yields for TIPS have become the norm in recent
years. Even the 30-year TIPS yield fell below zero in March 2020.

With TIPS, we now have a better idea of market expectations
for future inflation, though I would not call it perfect. TIPS offer a
break-even inflation rate, defined as the difference in yields on the same
maturity of traditional treasuries and TIPS. TIPS yields may not reflect the
true underlying real interest rate because they have a few other components
built into their pricing, including a premium for their relative illiquidity since
they represent a smaller market than treasuries. Also, TIPs offer a potential
additional premium for the protection they provide against unexpected high
inflation. Nonetheless, the difference between Treasury and TIPS rates for the
same maturity represents a reasonable market estimate of future inflation
expectations.

We can also consider the distinction between holding bond
funds and individual bonds.  Holding individual fixed-income securities to
their maturity provides a way to protect funds earmarked for upcoming expenses.
This can be attractive to those preferring a time-segmented approach to
retirement income. Time segmentation uses individual bonds to support short to
medium-term spending, with a more aggressive investment portfolio with higher
expected returns to be deployed for long-term expenses. Holding bonds to maturity
avoids locking in any potential capital losses, as the cash flows provided by
the bond, including the return of face value at maturity, are known in advance.
With bond funds, the possibility of holding to maturity is not meaningful and
capital losses can occur when shares are sold to cover spending.

One other risk that we should mention for bonds is timing
risk. This is the risk of retiring in a low-interest rate environment that
makes funding retirement more expensive. It is an important problem that
today’s retirees face. With less interest income, retirees will be forced to
spend principal, meaning that a retirement spending goal cannot be sustained
for as long as it otherwise would. It is important to emphasize that, as a
retirement income tool, bonds of any type do not mitigate longevity risk.
Creating a bond ladder to fund retirement expenses will eventually lead to the
depletion of those assets. Low interest rates will cause this to happen sooner
rather than later.

When current interest rates are lower than the historical
averages, the historical average return is not relevant for someone seeking to
estimate future market returns. Most retirement planning software gets this
point wrong. The general problem with attempting to gain insights from the
historical outcomes is that future market returns are connected to the current
values for the sources of market returns, rather than to their historical
performance.

Returns on bonds depend on the initial bond yield and on
subsequent yield changes. Low bond yields will tend to translate into lower
returns due to less income and the heightened interest rate risk associated
with capital losses when interest rates rise. Historically, the relationship
between interest rates and subsequent bond returns has been quite tight. Decreasing
interest rates provide the only mechanism for bond returns to outpace bond
yields. As interest rates have experienced a gradual decline since the early
1980s, this has been a common feature of bonds. But the possibility for further
declining interest rates is limited when bond yields already start from a low
point.

If the objective for an asset base is to fund
a specific stream of spending on a year-by-year basis for a known length of
time, the least risky way to accomplish this is to build a bond ladder. If the
securities do not default, bond ladders provide intended cash flows to match
spending liabilities at the appropriate dates. If spending grows with
inflation, TIPS will provide protection from unexpectedly high inflation. Traditional
bonds will work for spending that does not grow with inflation, or that
otherwise grows at a fixed rate that is known in advance and can be
incorporated into the ladder construction. Holding bonds to maturity avoids realizing
interest rate risk, but if bonds are held as mutual funds, then the risk of
capital losses may be realized when selling shares to fund expenses.

Risks for Stocks

Most people associate stocks with the asset
class most exposed to market risk. The reason to include stocks in a retirement
portfolio is their potential to generate higher returns than bonds. If this
potential for higher returns is realized, the overall cost of retirement will
be reduced based on the amount of assets that is needed at the beginning of
retirement to avoid cutting spending later in retirement and/or running out of
money in retirement.  More of the future spending can be covered by portfolio gains
than by the initial savings. Those comfortable with stock investments believe
they will provide a risk premium, meaning that stocks will outperform bonds
over reasonable lengths of time. The additional growth potential of stocks can
then more easily support a lifetime spending goal than bonds alone. While the
risk premium brings market risk back into the mix, the idea is that this risk
is sufficiently low, and a diversified portfolio provides stronger performance.

The case for using an aggressive investment portfolio with a
high stock allocation to fund retirement expenses rests on the idea that it
will probably work, based on the premise that stocks have historically performed
better than other asset classes, including bonds. Advocates for using
aggressive investment portfolios as the primary way to fund a retirement plan
often will allude to the concept of “stocks for the long run.” There is a
degree of comfort that an aggressive portfolio will provide sufficient returns
in time to maintain retirement sustainability.

In terms of the RISA Profile and retirement
income styles, I am describing preferences and attitudes associated with
probability-based, optionality, front-loading, technical liquidity, and
accumulation. Retirees with this style will often seek to create a diversified
portfolio including higher allocations to riskier asset classes like stocks to
provide growth for spending, liquidity, and legacy. Stocks are also important
for other RISA Profiles, but in other cases such confidence about stock market
growth is dampened and does not play such a pivotal of role in overall retirement
funding.

Stocks are important for retirees, so this
topic is worth a deeper exploration. Stocks simply provide an ownership stake
in a company. They provide access to company earnings based on its future
performance. Companies can pay dividends to their stockholders to distribute
profits, or they can reinvest profits into the firm to lay the foundation for
better performance and even larger dividends to owners in the future.

A company’s stock price can rise when
investors anticipate stronger future performance than they previously
anticipated, which can serve as a source of capital gains for stock owners who
sell shares. However, there are no contractual protections to receive either
capital gains or dividends. In the ownership structure, stockholders are
residual claimants, meaning that their rights to receive firm earnings or
assets fall behind most other claimants like bond holders or lenders. A company
could underperform relative to expectations, and the stock price could decrease
in anticipation of a reduced ability for the company to pay dividends in the
future. The returns from a stock over a specified holding period are the
dividend payments it makes plus any capital gains or capital losses. For owners
having to sell shares after a price decline, stocks could underperform relative
to bonds.

The value of a stock can be estimated as the
present value of its anticipated future dividend payments. This concept is the
same as bond pricing, in terms of being a discounted present value of future
cash flows, except that there are no contractual protections to support any anticipated
dividends. Projections of company performance can change over time, leading to
fluctuations in stock prices. With this price volatility, funding retirement
expenses by selling stocks can be risky as stock prices may be in decline at
the time they need to be sold, requiring more shares to be sold to meet an
expense.

Mutual funds and exchange-traded funds (ETFs)
provide a simple way for household investors to diversify across a broad range
of company stocks. These same investment vehicles exist for bonds as well. Stock
ETFs and mutual funds provide a collection of securities that help to reduce
the individual risks of companies by diversifying across a broader range of
companies. By limiting exposure to individual companies, this also limits
exposure to company specific risks. If company specific risks are independent
from one another, then this diversification leaves investors exposed to the
overall systematic market risk for the collection of stock holdings, but this
diversification creates less overall volatility.

Investors prefer certainty to uncertainty. A bond provides a
known yield with contractual protections helping to ensure that its return is
realized if the bond is held to maturity. Stock returns are more uncertain, as
they depend on the future performance of the company as well as on changing
investor perceptions about the company. If a stock offered the same average
return as bonds, but with greater volatility around that average, the typical
risk averse investor would not be willing to purchase it. Risk averse
individuals are willing to pay more to receive certainty, so less-volatile
assets should have lower expected returns. To accept risk, investors will seek
a higher expected return over time than they could receive from more reliable
bonds. That higher expected return represents the risk premium. Stocks can
generally be expected to outperform bonds over time, but such outperformance is
not predictable and there can be reasonably long stretches in which stock
returns lag bonds.

The potential risk premium to be earned by stocks provides
the key for why retirees may want to own them. We need to measure that
potential risk premium. There are a couple of ways to express average market
returns when we consider the relative returns of stocks and bonds. The first is
the arithmetic mean return. It is calculated by adding up all the annual
returns from the historical data and then dividing by the number of years in
the data set. The arithmetic mean represents the average historical growth rate
over a single year, but it does not reflect the growth rate over a longer
period. The compounded return represents the growth rate over multiple
years, and it is always less than the arithmetic mean for any volatile asset.
For long-term investors, it is the compounded return that matters.

To understand the volatility effect on compounded returns,
realize that positive and negative returns do not create a symmetric impact on
wealth. Negative returns must be followed by even larger positive returns to
get back to the initial level. For instance, a 50 percent drop requires a 100
percent gain to break even. For this reason, wealth will grow at a lower
compounded rate than the arithmetic average. Compounded returns take a larger
haircut as the volatility of returns increases.

The volatility of returns is typically measured by the
standard deviation, which quantifies the degree of fluctuations experienced
around the average outcome. Approximately, two-thirds of the returns fall
within the range of one standard deviation around the arithmetic mean. The
remaining one-third of historical returns were even more extreme in either
direction. Volatility reduces the predictability for realized returns. When
thinking of risk as volatility, we generally care most about the risk for
losses, but if market returns are symmetric around an average, then using
standard deviation will work just as well.

With this understanding, we can consider returns from the
historical data. A good starting point for understanding the risk premium
offered by stocks is to consider the historical returns for different asset
classes as determined with Morningstar and Ibbotson Associates data. They have
compiled US financial market returns since 1926 in their SBBI (Stocks,
Bonds, Bills, and Inflation) Yearbook. This data is usually the source for
calculating average historical market performance and creating assumptions for
future portfolio returns. We can use this data as a starting point for
understanding about historical market performance. We will focus on two asset
classes, large-capitalization US stocks and intermediate-term US government
bonds, as these serve as the foundation for the 4 percent rule guiding
total-return investment approaches and will be an important topic in Chapter 4.

For large-capitalization US stocks, as represented by the
S&P 500 index since its creation in the 1950s, and a more general index of
large companies in the years before that, the arithmetic mean return between
1926 and 2020 was 12.2 percent. As new data is added each year, this value
tends to fluctuate around roughly 12 percent, which is why that number is used
on occasion as an estimate for stocks returns. The historical standard
deviation was 19.7 percent (roughly 20 percent). This suggests that roughly two-thirds
of the historical annual returns fell between -7.5 percent and 31.9 percent. The
volatility impact was such that these stocks grew over time at an average
compounded rate of 10.3 percent over this 95-year historical period.

Moving to bonds, Morningstar data shows that
since 1926, the arithmetic mean return from intermediate-term government bonds
was 5.3 percent with a standard deviation of 5.6 percent. With the lower
volatility, the compounded return is only slightly less at 5.1 percent. Among
the universe of bond choices, retirement income studies generally show the most
favorable results with intermediate-term government bonds. They provide an
appropriate balance between generating higher yields while also maintaining
lower volatility to avoid jeopardizing the spending goals for the portfolio.
Including more types of bonds, such as corporate bonds, long-term bonds, or
short-term bills, can be justified for reasons other than maximizing the
sustainable spending rate from a portfolio.

We have described nominal historical returns, which include
the historical average inflation of about 2.9 percent. The real historical
returns after removing inflation put the analysis on a consistent basis over
time so that the long-run spending plans can be discussed in terms of constant
purchasing power. If we remove inflation from the historical
data, the respective arithmetic real returns for this stock and bond
data were 9.1 percent and 2.4 percent. The historical standard deviations for
these real returns were 19.7 percent and 6.6 percent. For the compounded
returns that reflect longer-term real growth rates, historically the S&P
500 provided an inflation-adjusted compounded return of 7.2 percent and
intermediate-term governments bonds grew at 2.2 percent above inflation. The
real historical risk premium for stocks over bonds with these asset classes is
6.7 percent in arithmetic terms and 5 percent in compounded terms.

These are the historical averages. For a lifetime financial
plan, the most intuitive way to express a portfolio return assumption is as an
inflation-adjusted (or real) compounding return. In the historical data, those
were the 7.2 percent and 2.2 percent numbers mentioned. But simple analyses
based on these returns as estimates for what retirees should expect in the
future may provide an incomplete picture that overstates the potential for specific
investment strategies. In addition to accounting for the impacts of volatility and
inflation, it is also important to consider lower interest rates, investment
fees, investor behavior, asset allocation, and taxes. Another important matter
is to adjust to a lower-than-average return to allow for a higher probability
of plan success. All too often, it seems that examples about retirement
planning are based on assumptions that investments will grow at a fixed 8
percent or more. While not impossible, the reality is that such return
assumptions are overly optimistic, especially for those approaching retirement.

The first issue to consider is the reality that interest
rates are lower today than their historical averages. The real yield on a
5-year TIPS at the present has fluctuated around -1.5 percent. That is 3.7
percent less than the historical real compounded return we noted for
intermediate-term bonds. Current interest rates are the best predictors for
subsequent bond returns, so it will be difficult for bonds to achieve their
historical averages. And if we believe that the risk premium for stocks should
not be higher at the present, we might assume that stock returns will be lower
in the future because of low bond yields. A common way to estimate stock
returns is to add an equity premium to a bond yield. This technique for
estimating returns is known as the capital asset pricing model. This model was
developed by William Sharpe in the 1960s, and he was awarded a Nobel Prize in
economics for his work in 1990 alongside Harry Markowitz.

The model posits that the expected return on a financial
asset is equal to a risk-free rate of return plus a risk premium multiplied by
a factor showing the relationship between the asset and the overall market
portfolio. For an overall market index like the S&P 500, this suggests that
its return should be equal to the return provided by low-risk assets like
Treasury bonds plus a risk premium to account for the volatility of stocks.
Adding the 5 percent historical compounded real premium from stocks to the
lower TIPS yield suggests a forward-looking compounded real return of 3.5
percent for stocks. If stocks continue to provide their historical average
returns while bond yields are lower, this implies that stocks are providing a
higher than historical return premium over bonds. While this outcome is possible,
someone developing conservative planning assumptions for their retirement would
probably not be comfortable with such an assumption. Even if interest rates
were to increase later in retirement, sequence-of-return risk describes how
upcoming returns matter most. Therefore, it is a good idea to make an
adjustment for returns necessary to obtain a more realistic picture about
retirement sustainability.

Sustainable spending rates for retirees are intricately
related to the returns provided by the underlying investment portfolio. And
with sequence-of-return risk, the returns experienced early on will weigh
disproportionately on outcomes. For those already spending, the assumption that
returns will one day normalize to their historical averages is much less
relevant than it is for accumulators who will rely on more distant market
returns. Current market conditions are much more relevant in retirement, which
means it would be a mistake to blindly apply a historical average return
without further thought.

Also, while a risk premium must be expected to induce
investors to position their assets into more volatile investments, there is no
reason to necessarily believe that historical excess returns provide the best
predictors about the future risk premium. The risk premium could be lower in
the future. Reasons for this include the possibility for random differences, a
realization that premiums could be more aligned with the lower international
experience, or that higher stock market valuations could create less relative
overperformance for stocks. Also, it may take longer than anticipated for
returns on stocks to outpace bonds, and retirees who are taking distributions are
vulnerable to this waiting game.

Another factor for making assumptions about net portfolio
returns is fees. The assumed return may need to be reduced further to account
for any fee drag associated with the management of the underlying investments.
The index returns do not account for real-world investment expenses. It is
possible to find index funds with low expense ratios, but the expenses for some
actively managed funds can exceed 1 percent or even 1.5 percent per year. These
are the operating expenses. There can also be an additional 12b-1 fee on some
mutual funds to help cover marketing and distribution costs for the investment
company. These expenses are listed separately from the operating expense ratio
and must not be ignored.

Some mutual funds will also charge a front-end or back-end
load as a percentage of the assets when mutual funds are bought or sold. Beyond
these explicit expenses, mutual funds may underperform market indices on
account of the transaction costs for trading inside the fund and for tax
inefficiencies created by fund turnover. In a 2014 article for the Financial
Analysts Journal, John Bogle estimated that the all-in expenses for
actively managed mutual funds could add up to as much as 2.27 percent before
the tax impact. Investment fees reduce portfolio returns accordingly. A 7
percent gross return with a 1 percent fee leads to a 6 percent net return, for
instance. It is the latter number that matters.

A related matter is investor behavior. Are investors
disciplined enough to stay the course with an investment strategy to earn the
underlying index market returns? In times of market stress, it is important for
retirees to stick with their financial plans and the asset allocation that
matches their tolerance for market volatility. Studies on retirement spending
from investment portfolios typically assume that retirees are rational
investors who rebalance right on schedule each year to their rather aggressive
stock allocations. They never panic and sell their stocks after a market
downturn.

For many retirees, this may not describe their reality.
Unfortunately, investors in financial markets tend to do the opposite of what
happens in most other markets: they buy more when prices are high and sell when
prices are low. This causes returns to drag behind what a “buy, hold, and
rebalance” investor could have earned. To the extent that households fall victim
to bad behaviors, the net returns and sustainable spending rates from their
investments will be less than otherwise possible. The behavior gap refers to
the concept that investor behavior may cause real individuals to underperform
relative to index market returns.

This behavior gap has been estimated at a couple percentage
points per year. For instance, Vanguard’s study of Advisor’s Alpha identifies
the most important factor explaining investor underperformance is a lack of
behavioral coaching to help investors stay the course and stick with their
plans. They estimate that having the wherewithal to stay the course in times of
market stress could add 1.5 percent of additional annualized returns to the
portfolios of typical investors. In other words, without behavioral coaching,
the typical investor could expect to underperform the markets by 1.5 percent
per year due to poor decision-making.

Asset allocation decisions are also relevant. Though many
articles about long-term investing will assume 8 or 12 percent returns, this
implicitly suggests that the investor holds 100 percent stocks. That will
rarely be the case, especially for retirees. As the asset allocation shifts
from stocks to bonds, the portfolio returns and standard deviations both
decrease. As retirees often seek to reduce their stock allocation in
retirement, it becomes important to base return assumptions on a more bond-heavy
portfolio that will have a lower expected return than a high-stock portfolio.

An asset allocation adjustment could also result in
compounded returns that are larger than simple portfolios of just stocks and
bonds. A more diversified portfolio including international assets, alternative
investments, real estate, and small-cap stocks could serve to increase the arithmetic
mean. Or diversification could reduce portfolio volatility, which can provide a
lift for the compounded return even if the arithmetic mean does not change.
Though it would entail risk, one might also wish to assign a premium to the
return assumption to account for a belief that the investment manager can beat
the returns on the underlying indices.

Another issue afflicting retirees is that tax drag will
affect returns, as ongoing taxes for interest, dividends, and realized capital
gains must be paid with the passage of time. Chapter 10 discusses these tax
issues more deeply. Bogle estimated the tax impact for taxable assets as an
additional 0.75 percent reduction in annual returns.

A final issue is that earlier we only identified average
stock and bond returns. A simple approach for building a financial plan is to
decide on a rate of return for the investment portfolio and to plug that value
into a spreadsheet to represent an assumed rate of asset growth. When we wish
for higher confidence that a plan will work, we do not plug in estimates for
average returns. The average will only work half of the time. A lower return is
assumed to have a plan that can work more than half of the time. In Chapter 3,
I will discuss calculating a funded ratio using bond yields as the assumed
return. Assuming a higher return than bonds requires risk.

More generally, Monte Carlo simulations provide an
alternative that is now widely used in financial planning software. Simulations
are used to develop sequences of random market returns fitting predetermined
characteristics to test how financial plans will perform in a wider variety of
good and bad market environments. The use of Monte Carlo tools has increased
considerably over the past decades, which can likely be attributed to lower
computing costs, increased recognition that returns are random, and the desire
to provide more robust financial plans. A thousand or more simulations could be
created to test the robustness of a retirement plan in many market
environments. Historical data is commonly used to set these input
characteristics. Most financial planning software works in this way. It is
possible to adjust the inputs for the factors we covered, including fees, tax
drag, and low interest rates. This is frequently ignored.

With Monte Carlo financial planning software, retirees
generally focus on building a plan that achieves a high probability of success,
such as 80 or 90 percent. This implicitly means the underlying assumed return
is below average. But when thinking in terms of a fixed return assumption, we
usually consider what we view as the best guess for future returns. Again, the
best guess only implies a 50 percent chance for success. To be consistent with
Monte Carlo planning based on a high probability of success, we must further
scale down a fixed rate of return from our best guess estimate. This is a point
which many investment management professionals have not internalized into their
thinking, as they are conditioned to using their idea about average returns as
the input.

Stock market risk relates to the idea that while stocks can
be expected to provide higher average returns than bonds, they do create more
risk. A retirement plan which relies on experiencing high market returns can
fail when those returns are not realized, especially in the pivotal early years
of retirement when the returns matter most. This creates the same general issue
as with longevity risk in that retirees may feel forced to assume lower
portfolio returns to ensure a sufficiently robust plan. When developing return
assumptions, it is important to adjust returns for lower compounded growth,
inflation, interest rates, fees, investor behavior, asset allocation, taxes,
and a desire to be conservative. Only then can we have confidence in the
viability of the retirement plan.

Lifetime Sequence-of-Return
Risk

When seeking to use portfolio returns as a source of
retirement spending, retirees must also deal with the sequence-of-return risk
that amplifies the impact of traditional investment volatility. Financial
market returns near the retirement date matter a great deal. Even with the same
average returns over a long period of time, retiring at the start of a bear
market is very dangerous because your wealth can be depleted quite rapidly, and
little may be left to benefit from any subsequent market recovery. With
sequence risk for portfolio distributions, the extra shares sold to meet a
spending goal when markets are down are no longer available to experience the
growth of any subsequent market recovery. The financial market returns
experienced in the fragile decade around the retirement date matter a great
deal more than retirees may realize.

Though sequence-of-return risk is related to general
investment risk and market volatility, it differs from general investment risk.
The average market return over a 30-year retirement period could be quite
generous. But if negative returns are experienced when you start spending from
your portfolio, you will face a difficult hurdle to overcome even if the market
offers higher returns later in retirement. This matter increases the impacts of
volatility risks described in the previous sections.

The dynamics of sequence risk suggest that a prolonged
recessionary environment early in retirement could jeopardize the retirement
prospects for a particular cohort of retirees. That scenario does not imply a
large-scale economic catastrophe. This is a subtle but important point. Some
retirees could experience very poor retirement outcomes relative to those
retiring a few years earlier or later. Sustainable withdrawal rates can fall
below what would be expected for average market returns over long periods of
time, because the ordering of those returns matters.

Individual investors are vulnerable to the sequence of
market returns experienced over their investing lifetimes. Individuals who behave
in the same way over their careers—saving the same percentage of the same
salary for the same number of years—can experience disparate outcomes based
solely on the specific sequence of investment returns that accompanies their
career and retirement. Actual wealth accumulations and sustainable withdrawal
rates will vary substantially among retirees, as these outcomes depend
disproportionately on the shorter sequence of returns just around the
retirement date. Returning to the labor force becomes increasingly difficult
and a market drop can be devastating.

Exhibit 2.2 attempts to give a clearer picture of how sequence-of-return
risk impacts both the accumulation and distribution phases, and how the impact
also grows with retirement distributions. The exhibit is based on statistical
regression analysis, which determines how much of the outcome (wealth
accumulation or sustainable withdrawal rate) can be explained by the returns
experienced in each year of the investing life cycle. The exhibit isolates the
impact of each year’s return on lifetime outcomes using a larger sample of one
million Monte Carlo simulations based on a 50 percent stock portfolio with the
same characteristics as the historical data. For the first 30 years (when
individuals are saving), the portion of the final wealth accumulation at the
retirement date that can be explained continues to grow. With wealth
accumulations at insignificant levels in the early part of one’s career, the
early returns have very little impact on the absolute level of wealth
accumulated at the end of the savings period. But as retirement approaches, a
given percentage return produces an increasing impact on the final wealth value
in absolute terms as those returns impact more years of contributions.

Exhibit 2.2

Lifetime Sequence-of-Return Risk

50/50 Asset Allocation, Inflation-Adjusted
Spending

1,000,000 Monte Carlo Simulations Based on SBBI
Data, 1926–2020,

S&P 500 and Intermediate-Term Government Bonds

In years 31 through 60, during the retirement distribution
phase, the exhibit shows the impact of each year’s return on the maximum
sustainable withdrawal rate. The return in the first retirement year has the
biggest impact on the level of sustainable retirement spending. Retirees are
extremely vulnerable to what happens just after they retire. As one moves
further into retirement, returns have a rapidly decreasing impact, as the
outcome for that retirement (high or low sustainable spending) was already set
in motion during the first 5-10 years.

Sequence-of-return risk affects individuals throughout their
entire investing lives. Individuals from different birth cohorts who otherwise
behave in identical ways may experience dramatically different wealth
accumulations and sustainable withdrawal rates. These outcomes are
unpredictable. Strategies using a volatile portfolio to target a wealth
accumulation goal or to sustain a constant spending strategy expose individuals
to much greater risk than you might expect when thinking about average market returns
over a 60-year investing cycle.

Spending Shocks and Other Surprises

If one could determine the precise amount to be spent in each
year of retirement, with no spending shock surprises to increase the spending
need, the risks for meeting that spending goal would reflect longevity and
market risk. A third category of risks for retirees are those that could cause
higher than anticipated spending needs. These are spending shocks. As we
discuss these, there are a few that may not strictly be spending shocks, but
they still fit well into this discussion because they shrink the asset base
available to fund expenses. A primary example of this type of surprise is an
involuntary early retirement or an inability to find work in retirement. Likewise,
a risk like cognitive decline could be realized as an increase in unanticipated
expenses, or it could simply lead to mistakes that reduce assets in
unanticipated ways. The point is that the cost of funding retirement expenses,
in terms of the assets needed at the beginning, may be greater than
anticipated. Ultimately, retirees must preserve flexibility and liquidity to
manage unplanned expenses. When attempting to budget over a long retirement, it
is important to include allowances for such contingencies. Here we describe the
different types of shocks for which retirees may include reserves as additional
protection.

Long-term care needs

Perhaps the biggest potential spending shock for most
retirees will be the need to pay for an extended stay in an institutional
setting to help manage long-term care needs. As a result of physical and mental
decline, retirees may eventually need assistance with performing the basic activities
of daily living. Those with extended care needs could find significant costs
added to their retirements. This risk is so significant that I devote an entire
chapter to it (Chapter 8). To avoid being repetitive, please refer to that
chapter for a detailed discussion of planning for long-term care risks.

Rising health care and prescription costs

Another important spending shock that receives an entire
chapter devoted to it is health care expenses in retirement (Chapter 7). Health
care prices tend to grow faster than consumer inflation, and it is hard to know
how to plan for distant health care costs. Health care costs typically rise
with age, but they can vary greatly based on how long one lives and what types
of diseases or health risks impact an individual. Again, to avoid having
overlapping discussions, please see Chapter 7 for a detailed discussion of
managing health care expenses in retirement.

Inflation

Retirees face the risk that inflation will erode the
purchasing power of their savings as they progress through retirement. Low
inflation may not be noticeable in the short term, but it can have a big impact
over a lengthy retirement, leaving retirees vulnerable. For instance, with 3
percent average annual inflation, the purchasing power of a dollar will fall by
more than half in twenty-three years. That type of increase essentially doubles
the cost of living. If we experience a bout of higher inflation, the risks are
even greater that spending needs will grow in an unsustainable manner.

To manage inflation risk, retirees must ensure that they are
including inflation in their projections for future expenses. This can be done
by assuming a particular inflation rate for the retirement plan and then adjusting
expenses over time for inflation, or by treating spending in today’s dollars
but then projecting assets at a real rate of return that has inflation removed.
If realized inflation ends up lower than assumed, this will strengthen the plan
as less spending will be needed and more will be left as legacy. However, inflation
risk is manifested if realized inflation is higher than assumed. This would
cause retirement spending to increase faster than anticipated, raising the
overall costs of the plan. Higher inflation can be understood as a spending
shock, as retirement expenses will grow larger than anticipated in the retirement
budget.

Inflation can be easier to manage during the working years
as salaries often increase with inflation. This can create a shock at
retirement as most retirement assets, aside from Social Security, do not
contain automatic increases to offset inflation. TIPS and I-bonds do provide an
opportunity to manage inflation risk by providing a real rate of return with
realized inflation added to the payments.

The common measure for inflation is the Consumer Price Index
for All Urban Consumers (CPI-U). But it will not match the actual inflation
experience of any individual household purchasing a different basket of goods
than assumed in the government calculations. The Bureau of Labor Statistics has
also created an experimental CPI for the elderly (CPI-E) that suggests their
consumption basket cost may grow at a faster overall rate. One way to also deal
with this issue in practice is to use different inflation rates for different
types of expenses. For instance, health expenses could be projected to grow
faster than the overall inflation rate. TIPS are presented by some as the
perfect hedge for retirement spending, but that is only true if a retiree’s
spending grows at the same rate as the CPI-U and one also does have to worry
about longevity risk.

On the other hand, the spending of many households will not
keep pace with inflation in retirement as their consumption basket changes over
time. Even though inflation will raise the costs of goods and services, a
retiree may naturally consume less with age, which means their overall budget
will not grow as quickly as the inflation rate. Strategies to help manage
inflation include assuming a reasonable inflation rate for spending, deferring
Social Security, using TIPS and I-bonds, choosing investments with growth
prospects at least as strong as inflation, and holding additional reserve
assets to treat high inflation as a spending shock.

Death of a spouse

Beyond the devastation of losing a loved one, significant
economic risks can also surround the death of a spouse. Assets can decrease
with the loss of Social Security and pension benefits, taxes can increase as the
survivor transitions to filing as single, and household expenses may not
decrease by enough to offset these other impacts. Though death is inevitable,
the timing is unknown, and the financial impacts are hard to predict.

On the asset side, any pension or annuities that pay based
on the single life of the deceased will end. As well, while Social Security has
survivor benefits, the overall amount of benefits paid to the household will
decrease by one-third to one-half. For single-earner households, benefits will
drop by about 33 percent as the spousal benefit ends. If both spouses earned
Social Security benefits based on their own records and had the same primary
insurance amounts, the total benefits drop by 50 percent.

Naturally, spending needs may fall after the death of a
spouse, but there is a danger that assets decrease faster than expenses. There
are economies of scale from living together, as household expenses do not fall
in half just because a two-person household becomes one. While some expenses
may fall, like the total food budget, there are still fixed expenses that do
not depend on the number of people in the household, such as home maintenance
and utility bills.

Another issue is taxes. In the year following death, the
survivor shifts from being able to file as married filing jointly to filing as
a single. This reduces the thresholds for tax brackets, making it more likely
to pay at higher marginal tax rates, to pay more taxes on Social Security
benefits, and to pay surcharges on Medicare premiums.

Also, less risk pooling is possible within the household
after the death of a spouse, such as having a healthy spouse to transport a
sick spouse to doctor visits and so forth. The death of a spouse also implies
the loss of a potential caregiver, which can then increase the likelihood of
needing to pay for long-term care expenses for the surviving spouse. Loneliness
can also harm health, leading to higher medical costs for the survivor.

Another risk is if the deceased spouse had handled the
family finances. The surviving spouse may not even be aware of how to access
everything, or how to manage the overall financial strategy. Surviving spouses
may be more vulnerable to experiencing elder abuse and financial fraud.

The loss of a spouse disproportionately impacts women, as
they tend to outlive their husbands. Women live longer on average, and they
tend to marry individuals older than themselves. Older men who remain alive
still tend to be with a spouse, whereas older women are much more likely to be
single. Widows become vulnerable, especially when they served as a caregiver to
the deceased spouse, which may have taken a toll on their finances and health.
We can observe this among older age groups, as poverty rates are the highest
for single women at advanced ages.

Some possible ways to manage the loss of spouse risk are to
first recognize that it is inevitable and make sure that both spouses
understand key aspects of the financial plan and can take control. This is
discussed further in Chapter 11. As well, this risk can be managed by choosing joint-life
options for annuities and pensions, having life insurance, planning for long-term
care, having a plan for lost income sources, having the family finances clearly
organized, and creating a proper estate plan well in advance. As well, one can plan
to maximize the Social Security survivor benefit as explained in Chapter 6,
which involves delaying Social Security for the high earner in the couple. When
budgeting, it is important to think about how the budget may evolve after the
loss of the spouse. Which expenses may decrease, and which may increase? Always
keep this contingency in mind when planning.

Unexpected family-related financial
responsibilities

Another family-related spending shock involves a need to
help other adult family members in unanticipated ways. Retirees may find
unexpected demands to help their parents, adult children, or even to become
caregivers for grandchildren. The concept of the “sandwich generation” has
developed as a name for the situation many near-retirees find themselves in
with having to care for aging parents while also finding that their adult
children are facing a more difficult time with leaving the home and becoming
financially independent from their parents. Job loss and hardships related to
the global pandemic may accelerate this issue for young adults who were less
established in their careers. This is a difficult risk to manage other than to
plan and budget for potential support to family as part of retirement expenses,
as well as making an effort to discuss limits with family on providing support
or co-signing on loans.

Divorce

A divorce can completely change the picture for retirement
income. The concept of “gray divorce” refers to the increase in divorce rates
happening at retirement ages. Divorce can be a spending shock in the sense that
a couple loses the economies of scale from living together. Though it may not
double costs, it is more expensive to pay for two separate homes after a couple
splits. As well, attorney fees and other costs related to the divorce may be
significant. This can be a difficult risk for spouses to discuss, but at least
it is important to include in a list of potential spending shocks facing
retirees.

When gray divorce happens in retirement, especially after a
long and relatively happy marriage, it may be because the couple had different
expectations about retirement and were not prepared for the potentially large
increase in the amount of time spent with one another. As well, some couples
just simply grow apart over time in ways that may be unavoidable. Though there
is no easy way to mitigate the risk of divorce, the discussion in Chapter 12
will be the most relevant for helping to ensure that spouses have the same
expectations and understandings for their retirements and have plans to fill
their time with meaningful activities both separately and together.

As well, if divorce is imminent, it is important to
understand the implications for Social Security, pensions, and other retirement
assets. Finalizing a divorce within ten years of marriage, for instance, would
remove the possibility of receiving Social Security benefits as an ex-spouse,
as discussed further in Chapter 6. A divorce should also be followed by a
careful review of estate planning documents and beneficiary designations to
ensure that matters are aligned with the new reality (see Chapter 11).

Changing public policy and tax rules

Public policy risk refers to the idea that the government
can change the rules. This makes planning harder as what may work best under
current rules could be much less effective under a different set of rules. Important
changes to the tax code and rules around tax-advantaged retirement accounts seem
to arrive every few years and those planning for retirement face a constantly
moving target. Possible changes include reduced benefits from Social Security
or Medicare, changing rules about IRAs, an increase in income or estate taxes, and
so on. Many expect an increase in taxes in the future, and the global pandemic
made such outcomes more likely. Retirees must keep this in mind, realizing that
it may be necessary to update plans over time to respond to changing policies,
and to perhaps include a bit more for budgeted taxes that current law might
suggest.

We can understand the nature of public policy risk just by
looking at some of the significant recent policy changes that impact retirement
planning:

·
In 2013, the Net Investment Income Tax created the potential to
increase marginal tax rates by 3.8 percent in various circumstances. (See
Chapter 10)

·
In 2015, Social Security began a phase-out of certain claiming
strategies that could have provided married couples with up to $50,000 of
additional lifetime benefits. (See Chapter 6)

·
In 2017, rules for the Home Equity Conversion Mortgage (reverse
mortgage) program were updated to increase the initial costs and reduce the
growth potential of setting up a reverse mortgage line of credit. (See Chapter
9)

·
In 2017, the Tax Cuts and Jobs Act provided a major overhaul of
the federal tax system with many implications, including making it more
difficult to itemize tax deductions and removing the ability to recharacterize
Roth conversions. (See Chapter 10)

·
In 2019, the SECURE Act changed the rules around required minimum
distributions for inherited retirement accounts. In many cases, beneficiaries
will have to fully distribute the accounts within ten years rather than being
able to apply a lifetime stretch to the distributions. (See Chapter 11)

Business risks for annuities and pensions

It is common to view bonds, annuities, and pensions as being
relatively free of risk. But an important risk to keep in mind is that
corporations can go out of business. This can result in defaults by bond
issuers, an insolvent annuity provider, a corporate pension plan which reneges
on its promises, the loss of employer benefits such as for retiree health care
and nonqualified executive compensation benefits, and the danger of holding too
much employer stock in a 401(k) plan.

Retirement income tools that rely on risk pooling to fund
retirement expenses, such as with traditional defined-benefit company pension
plans or annuities supporting lifetime income, do rely on a centralized actor
to manage the underlying funds to support these payments. Actuaries must make
calculations regarding asset returns and longevity to know how much contributions
or premiums are needed to cover the promised payments. Their projections can be
hit by unexpected events.

Defined benefit pension plans of private employers have
minimum funding requirements and contributions are made to an irrevocable
trust. But the plans may still not have sufficient assets to fund all the
promised benefits. Many plans are underfunded with respect to their obligations
to pay pensions. The Pension Benefit Guaranty Corporation does provide a
backstop to cover pensions from insolvent companies, but there are limits on
the pension amount covered and a widespread pension default could overwhelm
their resources. This pension insolvency risk can feed into the decision about
whether to choose a lump-sum payment or lifetime income from the
defined-benefit pension plan. Those who have more worry about the long-term
viability for the pension to make its obligated payments would lean toward
choosing the lump-sum option.

Also, a real concern to keep in mind is the long-term
viability of insurance companies providing annuities with lifetime protections.
Fear of an annuity company failure is a legitimate concern, though this risk
can be overstated. It is an extremely rare event that annuity policy holders
were not made whole on their promised payments in the past. Past performance
does not guarantee the future, but if one focuses on highly-rated insurance
companies and keeps premiums to any one company below their state’s insurance
guarantee limits, the risk of not being made whole on promised payments is very
low.

A comment about defined-contribution plans such as employer
401(k) plans is also relevant. These plans do not promise payments through risk
pooling, as the market and longevity risks are passed to the worker.
Contributions are made to irrevocable trusts, so the assets are secure and
protected from employer insolvency. However, market risk remains. This can
impact individuals who invest heavily in their own employer stock, which
reduces diversification and makes one more vulnerable to investment losses that
could be correlated with business problems that also risk one’s employment.
Broader diversification is often a worthwhile pursuit for plan holdings, though
before divesting employer stock, it is worthwhile to consider the potential for
receiving net unrealized appreciation treatment as described in Chapter 10.

Not sticking to the plan – excess withdrawal risk

It is possible to work hard to create a sustainable
retirement spending plan, only to see the plan fall apart due to general
overspending not necessarily related to other identified spending shocks. A
lack of discipline could lead to more spending for discretionary lifestyle
expenses, or it could even take the form of excessive financial gifts to
children or grandchildren. Another area where this risk can materialize is with
the choice of a variable spending strategy that allows for higher initial spending
because it calls for later cuts to be made that are not followed. The relevance
of this risk can generally be understood by retirees who have a lifetime of experience
to consider whether sticking to a budget is feasible. Those who struggle to
stick to a spending plan may benefit from an income annuity which prevents overspending
through the lack of liquidity and underlying access to funds. A retirement
income plan will only be as strong as the commitment to maintain it.

Frailty and declining cognitive abilities

Frailty risk refers to the deterioration of mental and
physical health that can happen with age. Frailty generally regards physical
decline, while cognitive decline relates to the mental aspects. Retirees may
increasingly struggle to take care of either their financial affairs, home and
property maintenance, lawn care and snow removal, cleaning, and transportation
needs, especially if they lose the ability to drive. Simple tasks such as
replacing light bulbs can become a challenge. Declining abilities to engage in financial
calculations and other types of cognitive impairment make it increasingly
difficult to manage a complex investment and withdrawal strategy as aging
progresses. This can increase retirement expenses either because services must
be paid for which could have otherwise been handled before, or because
individuals begin making mistakes, such as forgetting to pay bills and then
incurring late fees, that lead to unnecessary expenses.

A retirement income plan must incorporate the unfortunate
reality that many retirees will experience declining physical and cognitive
abilities. Frailty and cognitive decline are risks that will impact most
retirees to some degree over the course of a long retirement. Both can lead to
an increased reliance on others, which can increase costs and exposure to elder
abuse.

A vital way to help manage these risks is to anticipate them
and to plan for them. Actions that can be taken in this regard include choosing
housing where more of these issues are addressed, working with a trusted
financial planning firm that can be on the lookout for cognitive impairment and
help arrange for necessary additional help, relying on family members, a daily
money manager, or a corporate trustee, and creating documents for power of
attorney and a living trust.

While liquidity and flexibility are important, retirees
should also prepare for the reality that cognitive decline will hamper the
portfolio management skills of many as they age, increasing the desirability of
advanced planning and automation for late-in-life financial goals. As well, allowing
a trusted family member to handle your finances or working with a professional
financial planner can be important, and these decisions need to be made in
advance. The risk that an unprepared spouse will need to take over the finances
can happen before death, as the spouse who has taken responsibility to manage
the finances could develop reduced capacities that prevent the continuation of
these tasks. For a deeper exploration of these issues, Chapter 9 covers
retirement housing and Chapter 11 covers incapacity planning.

Financial elder abuse

As cognitive abilities decline and frailty sets in with
continued aging, retirees are increasingly at risk of becoming victims of bad
advice, fraud, or even outright theft. Culprits can include family members,
neighbors, friends, financial professionals, paid caregivers, staff at
institutional living facilities, and con-artists using phone, email,
traditional mail, and in-person solicitations. Though there is a risk of
strangers perpetuating fraud, most of this type of abuse is perpetuated by
individuals known to the victim.

Retirees tend to have assets and savings that attract
fraudsters, and they may be dealing with a variety of issues that can make them
more vulnerable. This includes declining cognitive abilities, health problems,
isolation, and loneliness. Victims may be unwilling to speak up and report abuse,
as well, because of embarrassment, fear losing independence, or fear of causing
trouble for the perpetrator. The danger is that nefarious individuals find a
way to siphon off assets from the retiree, which then translates into another
type of spending shock.

Ways to protect from elder abuse include staying organized,
keeping track of possessions, locking up important documents, opening and
sending one’s own mail, signing one’s own checks, freezing credit reports, and
using direct deposit for Social Security benefits and other payments. It may
also help to screen calls with voice mail rather than answering directly and
being caught off guard by a scam. Screening caregivers and advisors is also
important, as is including trusted family members in decisions. Ensure
that any caregivers are licensed, bonded, and insured, and have gone through
background checks. These matters require having a plan in place in
advance for when one is less able to handle financial affairs and becomes more
vulnerable to abuse.

Changing housing needs

Housing is a major retirement expense and housing needs can
change in retirement. Issues related to housing pose a significant spending
risk in that unexpected situations can result in substantial increases in
retirement costs. Over time, retirees may need housing with greater
accessibility or with ease of access by caregivers. Caregivers may not be
available in the local area, and couples may need to be split when one spouse
requires institutionalized care. Home repairs and home maintenance may grow in
cost if one chooses to age in place and as frailty sets in. These risks are
significant and are covered more thoroughly in Chapter 9.

Forced early retirement and reduced earnings
capacity

The risk of forced early retirement relates to both the risk
of losing your job before your planned retirement date or being unable to
maintain desired part-time employment in retirement. This risk manifests as a shock
to the asset side of the balance sheet, rather than as a spending shock. But
the effect is the same: a worsening ratio of assets to liabilities and less
funding for retirement.

For forced early retirement, a consistent finding from
household surveys is that about half of the population ends up retiring earlier
than anticipated. The Employee Benefit Research Institute has been tracking
this for years with their Retirement Confidence Survey, and they reported most
recently for 2020 that 48 percent of retirees had retired earlier than planned.
Similarly, Prudential reported most recently in 2019 that 51 percent of respondents
had retired earlier than planned.

Among those retiring earlier than planned, Prudential found
that only 23 percent indicated it was because they had enough to retire and
wanted to do so. The rest suggested that early retirement was involuntary and unanticipated.
Reasons include 46 percent who retired for health reasons, 18 percent who were
laid-off or otherwise lost their job, 12 percent who were offered an early
retirement package, and 11 percent who had to care for a loved one. The
differences in retirement ages were significant, as on average, individuals
expected to retire at 65 but actually retired at 59.

Early retirement can have huge financial ramifications. Delaying
retirement can serve as the best way to improve the funded status of a
retirement plan. Naturally, the reverse is also true. Retiring earlier than
planned means fewer years of working and saving, less time for assets to grow
and compound before distributions begin, a longer retirement planning horizon
to fund, and potentially smaller benefits from Social Security and traditional
pensions. Early retirement can also mean a loss of employer health insurance
benefits, necessitating finding other health insurance until reaching Medicare
eligibility at age 65. These factors can all have a significant impact on the
sustainability of a retirement plan.

This risk can extend into retirement if part-time work is
necessary to help fund retirement expenses. The EBRI Retirement Confidence
Survey found that while 79 percent expected to engage in part-time work in
retirement, only 29 percent of retirees did work. Often such work is not feasible
for any of the reasons mentioned regarding forced early retirement. Those who
continue with some work, do find it to be a positive experience, as work also provides
an opportunity to stay active and involved. Work can also help to provide
purpose, fill time, or maintain a social network, and losing these things can
be detrimental to health. Generally, it is important to try not to rely on
significant employment income during retirement.

For those who are still somewhat far from their planned
retirement date, it is important to incorporate the possibility that one must
retire earlier than planned. For instance, one could plan for a reduced but
adequate standard of living if needed at 10 years before the planned retirement
age as a Plan B inside a broader plan. Also, for reasons related to involuntary
job loss, it is important to maintain skills, education, and networks, in case
it becomes necessary to seek new employment.

Maintaining a healthy lifestyle can also help to manage potential
health risks that could force an earlier retirement. Also having long-term care
plans in place for loved ones can help manage the risk that someone must give
up their career to become the primary caregiver for a family member. As well,
one can make efforts to manage a career to avoid burnout, such as taking time
off, reducing responsibilities or making some cuts to the overall workload, so
that it becomes more feasible to extend work for longer.

More broadly, retirement can lead to a discrete reduction to
the value of human capital, which is an important risk. Retirees face reduced
flexibility to earn income in the labor markets to cushion their standard of
living from the impact of poor market returns. Risk capacity is the ability to
endure a decline in portfolio value without experiencing a substantial decline
to the standard of living. Prior to retirement, poor market returns might be
counteracted with a small increase in the savings rate, a brief retirement
delay, or even a slight increase in risk taking. Once retired, however, people
can find it hard to return to the labor force and are more likely to live on
fixed budgets. Retirees often experience large reductions in their risk
capacity as the value of their human capital declines. As a result, they are
left with fewer options for responding to poor portfolio returns.

Action Plan

The important concepts to incorporate into one’s thinking
about retirement are related to how retirement risks manifest. The amount of
assets required to fund the financial goals of retirement depends on how long you
live, your investment returns, and your exposure to various shocks. It is
important to begin thinking about retirement risk exposure:

o
Obtain longevity estimates using a tool such as the Longevity
Illustrator [www.longevityillustrator.org].

o
Those with a front-loading preference may prefer to use numbers
closer to the 25th percentile of outcomes

o
Those with a back-loading preference may prefer numbers closer to
the 10th percentile of outcomes

o
Market and sequence-of-return risk

o
Understand your comfort level with market risk as it relates to
your retirement income style

o
Decide on reasonable net-return assumptions for your retirement
portfolio

o
Assess exposures to various retirement spending shocks and other
surprises. As part of this assessment, consider the potential costs or impacts that
these risks could create:

o
Long-term care risks

o
Health care and prescription costs

o
Inflation

o
Death of a spouse

o
Unexpected family-related financial responsibilities

o
Divorce

o
Changing public policy and tax rules

o
Business risk for annuities and pensions

o
Excess withdrawal risk

o
Frailty and declining cognitive abilities

o
Financial elder abuse

o
Changing housing needs

o
Forced early retirement and reduced earnings capacity

Further Reading

Bogle, John C. 2014. “The Arithmetic of ‘All-In’
Investment Expenses.” Financial Analysts Journal 70 (January/February).

Society of Actuaries. 2020. Managing Post-Retirement
Risks: A Guide to Retirement Planning.

Society of Actuaries and American Academy of Actuaries.
2021. “The Longevity Illustrator.” http://www.longevityillustrator.org.

Chapter 3: Quantifying
Goals and Assessing Preparedness

An important question many pre-retirees and retirees ask
themselves is whether they are on the financial track toward creating a
successful retirement. This chapter provides a framework for determining the
answer. Assuming a bond-like return on assets, we seek to determine if there
are sufficient assets to meet the anticipated retirement liabilities, including
desired reserves for spending shocks. We quantify the assets and the
liabilities for the household and see which are larger.

I start by explaining how to quantify the financial goals for
retirement. These goals define the expenses, or liabilities, to be funded. Effort
is needed to determine a realistic retirement budget, anticipating the
retirement spending to meet our ongoing needs and desires. I also estimate
additional potential expenses for various contingencies that the retiree would
like to have on hand to feel fully comfortable that the plan can also manage
spending shocks and other retirement risks. I also consider legacy goals, which
can be incorporated explicitly as a liability to fund, or which can be
represented as the surplus wealth after sufficient assets have been earmarked
for ongoing spending and contingencies.

Then I shift to assets, as we seek to construct the
retirement balance sheet and to ultimately match assets with liabilities. What is
available to manage retirement expenses? With assets and liabilities
determined, we can calculate the funded ratio. This is the ratio of assets to
liabilities, assuming a conservative interest rate to translate future income
and expenses into today’s dollars. The funded ratio lets us know whether the
plan will work if retirees only invest in low-risk assets to meet their
lifetime liabilities. It is a great result if assets exceed liabilities, with a
funded status of over 100 percent, as it speaks to retirement preparedness. I
also consider possible actions for when assets fall short of liabilities and
retirement is underfunded.

The retirement income challenge lays out the broad
retirement income problem we are attempting to solve. The process of building a
retirement income strategy involves determining retirement goals and
effectively meeting and protecting those goals from retirement risks. We must
determine how to best combine retirement income tools and strategies to
optimize the balance between these objectives in ways that align with our personal
retirement income style. Exhibit 3.1 shows the retirement income challenge as a
series of concentric circles. The innermost circle summarizes the overall
process for retirement income. At the center, we must combine income tools to
best meet goals and balance risks. Possible goals are listed in the next
concentric circle. The third circle lists risks confronting those goals. The
final circle shows available income tools for retirement. Do you have enough
assets to fund tools that will help you meet your goals and manage your risks
in retirement?

Exhibit 3.1

The Retirement Income Challenge

For the retirement income challenge, we start with the
goals. The primary financial goal for most retirees relates to their annual spending:
maximize spending power (lifestyle) in such a way that spending can remain
consistent and sustainable without any drastic reductions, no matter how long
the retirement lasts (longevity). This is the retirement budget. Other
important goals may include leaving assets for subsequent generations (legacy)
and maintaining sufficient reserves for unexpected contingencies that have not
been earmarked for other purposes (liquidity). Lifestyle, longevity, legacy,
and liquidity are the four Ls of retirement income. We describe how to quantify
these goals, starting with the retirement budget.

Determining the
Retirement Budget

The fundamental financial goal in retirement is to fund your
ongoing budgeted expenses for the rest of your life. The budget, or spending
plan, relates to longevity and lifestyle goals, though we will not make this
distinction right away. Budgeting is not always enjoyable, but there are tools
available to help simplify the process. Budgeting can help to increase your confidence
and comfort about retirement if it helps you know you are on track.

It is common to be nervous about whether you have saved
enough for retirement when you do not have a good idea about what you have been
spending and what amount of spending will help you to support a comfortable lifestyle.
By determining a budget, it becomes easier to assess retirement preparedness. Perhaps
you already have sufficient savings, which could be a great comfort. If
underfunded, you can design a plan for how to respond. Decisions include
delaying retirement, reducing budgeted expenses, or assuming a higher rate of
return on your assets. There will be more clarity. A significant source of
uncertainty can now be better understood and managed.

The difficulty in budgeting for retirement, though, is that
many expenses will change alongside the act of retiring. New retirees undergo a
significant transition to their lifestyle. Even for those who have developed
precise records about annual spending in their pre-retirement years,
adjustments may be needed to account for changes happening at retirement. This
is especially the case for those who move as part of retiring. Retirement
budgeting requires tracking what you have spent and then planning for how those
expenses are likely to change. You will need a reasonable estimate of the
baseline expenses. How much do you anticipate spending on a year-to-year basis
in retirement? As retirement continues, will your overall expenses grow by less
or more than inflation?

Replacement Rates

As a brief starting point, one simple approach to avoid
making a budget is to simply follow a replacement rate rule for retirement
spending. An existing guideline is that retirees will spend 80 percent of their
pre-retirement income when they retire. This held up well as a population
average from a University of Georgia study conducted repeatedly since the
1970s. That study has not been updated since 2008, though. The intuition for
the 80 percent replacement rate concept is that the retirement budget reflects
salary less savings, taxes, and minor adjustments made for the reduction in
work-related expenses. After these adjustments, the average household spends
about 80 percent of what it earns.

Of course, even if this does reflect an average replacement
rate, there is variation around this number in individual cases. It also works
best when incomes are relatively stable, as when annual income is fluctuating the
question quickly becomes: 80 percent of what? This guideline is also not
relevant for those seeking to retire early and therefore use higher savings
rates. It also does not consider the possibility of splurging in the first few
retirement years. One must also factor in that pre-retirement spending may
include mortgage payments and spending on children that will not be necessary
after retiring. Those who were saving, paying a mortgage, raising children,
paying payroll taxes, and facing some employment expenses may find that they
can live comfortably on a much lower percentage of their pre-retirement salary.
All considered, it is not a very helpful rule at all, as some basic planning
can lead toward much more reasonable estimates for retirement expenses.

Tracking Recent Expenses

A better starting point is to build a retirement spending
plan. For this, it will be helpful to begin with a look at actual spending over
the previous few years. Your spending may change in retirement, but you need to
know your starting point and to fully uncover any spending that you might not
otherwise think about. Inflation has been low in recent years, but you might
also adjust your past expenses to account for rising price levels and to make
those expenses more reflective of today’s purchasing power. Once you have an
idea about your recent spending, it becomes easier to adjust these numbers for
what can change in retirement.

We can consider a simple list of spending categories to
include in your budget. This is a list of general expense categories and
sub-categories that can be used to make a spreadsheet where you can fill in the
appropriate numbers. You should feel free to customize these categories as you
see fit. You could move expenses around, consolidate, or expand categories as
appropriate for your situation. New categories could also be added as needed to
cover special situations that are not otherwise easy to fit into these existing
categories:

·
Charity

·
Clothing

·
Credit card rewards (points for travel, cash back)

·
Debt repayments (mortgage, car loans, education loans, credit
cards, other loans)

·
Entertainment (hobbies, leisure activities)

·
Food (groceries, restaurants)

·
Gifts (family support, education expenses)

·
Health care (insurance and Medicare premiums, out of pocket
expenses, dental, vision)

·
Home maintenance (landscaping, snow removal, home security, pool,
cleaner, pests, HVAC tune-up)

·
Home expenses (rent, HOA dues, repairs)

·
Insurance premiums (home, auto, umbrella, life, disability,
long-term care)

·
Memberships (fitness, civic organizations, warehouse clubs,
season tickets)

·
Miscellaneous household expenses (cleaning supplies, appliances,
computers)

·
Personal care

·
Phone (cellular, landline)

·
Subscriptions (newspapers, magazines, software, websites, music,
cloud storage)

·
Taxes (federal income, FICA, Medicare, state income, property
& local taxes)

·
Television and Internet (internet, cable TV, streaming services)

·
Transportation (auto maintenance, fuel, parking, insurance,
roadside assistance)

·
Travel (flights, hotel, insurance, local transportation, admission
tickets)

·
Utilities (water, electric, gas, home oil, waste disposal,
sewage)

·
Special large expenditures (child wedding, automobile purchases, major
home renovation, unique trip)

For examples about the flexibility for these categories, a
mortgage payment or property taxes could be included in a general home expense
category, as debt repayment, or as taxes, depending on what makes most sense to
you. About a mortgage, it is important to remember that many mortgage payments
include funds for property tax and homeowner’s insurance which will need to be reflected
in the budget after the mortgage is paid. Someone thinking to move and rent in
retirement may think of those expenses as later translating into rent.
Insurance is also a broad category with many of its expenses possibly showing
up elsewhere instead. For instance, homeowner’s insurance could go with home
expenses, auto insurance with transportation expenses, life insurance in a
separate category, and medical-related insurance could be classified separately
as part of health expenses. Another problem could creep up when shopping at
large box stores that offer groceries as well as other products. Trying to
separate expenses may be a pain. My solution, for instance, it to count all
spending at Costco as for groceries, though I know this is not the case. If one
is consistent and has categories that capture all spending it is fine to
develop a unique system that makes sense for you and helps to simplify your
life. It is total overall spending that matters most.

In terms of consolidating expenses, I find in my own case
that it is easier to have a general home expense category where I merge items
like clothing, entertainment, gifts, memberships, miscellaneous household
expenses, personal care, and subscriptions, which were all separate categories above.
I feel that this works fine in my family, and it does make it easier to have
fewer budget categories to manage. My personal budget includes the following
categories: home repairs, HOA dues, cell phone, internet, television,
utilities, insurance (car, home, umbrella, disability), groceries, restaurants,
household expenses, transportation, health care, travel, business deductions,
education and camps for children, credit card rewards, life insurance premiums,
charity, and taxes (federal income, FICA, Medicare, state income, local
property).

With the expense categories in place, you need a system for
collecting your expenses. For those who can manage the responsibility to not
overspend when using credit cards, they provide the opportunity to simplify the
budgeting process. Credit card statements provide a clear record of expenses.
Credit cards can also offer points and cash back opportunities to reduce
expenses. For those who may have more trouble with controlling spending, using
a debit card could be another alternative that also allows for expense
tracking, though it may lack rewards and other benefits.

I treat credit card rewards as a negative expense category,
providing an offset to reduce overall expenses. For cash back, this is easy to
incorporate. Though it requires more work, it can be meaningful to also incorporate
the value of plane or hotel benefits received through credit card rewards in
order to have a better estimate of total travel expenses, if one is reducing
them by using points that may not always be available. For instance, if I use
points to pay for a flight ticket that would have cost $550, I will create an
artificial transaction with my expenses for that plane ticket, and then create
a second transaction with the points as a negative monetary value that offsets
the ticket cost. This increases my travel expense category for budgeting
purposes without increasing my total expenses. In later years I can just assume
fewer credit card rewards.

Another issue relates to classifying expenses when paying
for items with cash. Using cash requires more work in terms of needing to keep
track of how the cash is spent. Because I do not use much cash, I simplify this
process and just count any ATM withdrawals as part of general household
expenses when the withdrawal is made. Because I personally use cash so rarely,
this does not have much impact on how my budget looks by category, and the
overall amount of expenses will still be correct. By tracking expenses from all
bank accounts and credit cards, it can be easy to monitor total expenses and
not experience leakages with spending from other places. Occasionally there
might be other slight adjustments to make, such as if one receives cash or a
gift card that does not otherwise show up with online transaction reports. Also,
you should check your payroll stubs to make sure you are accounting for taxes
and the full cost of any employer benefits that you may need to pay on your own
after retiring. Those types of expenses would also not otherwise show up on
credit card or bank statements.

Some may use budgeting to find and reduce unnecessary
expenses. Working through your past expenses does provide an opportunity to
catch recurring payments for services you no longer use and to cut other spending
waste. In such cases, having more refined categories may help. For others, the
goal is simply to determine overall annual spending. Fewer expense categories
may be needed, other than to have separate categories for expenses that will
change in retirement. For instance, in my own budget I have a separate category
for education and camp expenses for my children, since these types of expenses
can be substantial and will not continue after my children have grown. The
category could also morph into gifts for adult children or grandchildren.

You can also decide about how to treat car purchases or
other big-ticket items or home renovations that only happen occasionally but
provide service to the owner over time. An easy way is to include purchases in
the year made and then see what the average spending in that category works out
to be over time. This speaks to another important point, which is that you will
want to consider at least a few years of expenses to ensure that occasional
big-ticket items are not missed. Such expenses increase average annual spending
compared to only looking at a year without such expenses. In this regard, I
find it more helpful to think about budgeting on an annual basis instead of a
monthly basis, since monthly expenses can fluctuate so dramatically for the
same sorts of reasons. Some large expenses like property taxes or insurance
premiums may only show up once or twice each year. Of course, it may still be
important to know when in the year large expenses happen to make sure enough
funds are on hand, but otherwise the issue of fluctuating expenses tends to
smooth out over the year. Also, if you have identified major one-time expenses
for retirement, such as a home renovation or child’s wedding, you might track
these as separate liabilities outside your general budget.

I have referenced my own budgeting, and it may help to
explain a bit more about how I do it. I use the free online tool at Mint.com to
consolidate my credit card and bank accounts. Mint.com lets you then see the
consolidated list of transactions. At the bottom of their webpage, they have a
link to download those transactions to a spreadsheet. I do this and move them
to a separate spreadsheet where I keep track of my expenses on an annual basis.
With the raw downloaded numbers, I do adjust categories in my spreadsheet. I
reclassify many expense categories because I find that Mint.com has them
recorded wrong or at least not in the precise categories I like. I also remove
credit card bill payments and transfers to savings, as those represent double
counting or items that are not really expenses (unless you are paying interest
on your credit cards). I try to update my spreadsheet of expenses at least once
a quarter, as sometimes I must remember how certain expenses should be
classified and waiting too long can make that hard. I also classify payments
made by check into the right category, and as mentioned I treat ATM withdrawals
as general household expenses. This provides me with a very good record of
annual expenses that I can continue to build out and track over time.

Exhibits 3.2 and 3.3 show a hypothetical example for the
process of tracking past expenses and then planning for retirement expenses.
Exhibit 3.2 begins with the past expenses for a couple approaching retirement.
We can note a few trends. First, the gifts / children’s education category
declines dramatically during these five years, as the youngest child finished
college. We can also see expenses fluctuate quite a bit from year to year, and
we can note a dramatic drop in expenses for 2020 as related to reduced
discretionary spending opportunities during the global pandemic. There may not
be a truly “normal budget” for this couple as unique circumstances are common.
The best we can ultimately do will be to figure out reasonable average spending
amounts for categories.

Exhibit 3.2

Tracking Recent Expenses

Inflation Rate

2.11%

1.67%

2.29%

1.30%

Nominal Expenses

Cons. Price Index

92.97

94.93

96.51

98.72

100.00

AVERAGE

2017

2018

2019

2020

2021

Cell
phone

$1,122

$996

$996

$1,627

$996

$996

Charity

$4,793

$3,864

$5,200

$5,000

$4,500

$5,400

Gifts /
Children's Education

$9,777

$31,542

$17,292

$51

$0

$0

Groceries

$17,169

$17,633

$16,930

$17,142

$16,450

$17,690

Health
Care (including insurance)

$8,110

$9,530

$7,337

$8,590

$6,668

$8,425

Household
expenses

$26,079

$36,321

$27,551

$29,983

$17,100

$19,438

Housing
(maintenance, furniture)

$902

$0

$0

$3,750

$0

$760

Housing
(HOA dues)

$2,738

$2,690

$2,690

$2,690

$2,690

$2,930

Insurance

$3,228

$2,993

$3,150

$3,224

$3,360

$3,413

Internet

$954

$954

$954

$954

$954

$954

Property
Taxes / Apartment Rent

$13,416

$12,545

$12,989

$13,419

$13,849

$14,279

Restaurants

$2,100

$1,750

$2,164

$2,927

$1,276

$2,385

Television

$671

$312

$526

$555

$980

$980

Transportation

$2,253

$2,033

$2,924

$2,467

$1,700

$2,139

Travel
(International)

$6,278

$17,016

$0

$14,376

$0

$0

Travel
(Domestic)

$3,109

$4,690

$6,123

$3,190

$0

$1,540

Utilities
(gas, electric, water)

$3,124

$2,329

$2,896

$3,170

$3,512

$3,712

$105,823

$147,199

$109,722

$113,115

$74,035

$85,041

The category of property taxes is included separately, as
this couple currently owns their home with a fully paid mortgage, but they are
thinking to move and rent in retirement. That category can evolve to represent
home rent. Otherwise, we do not include taxes in this budget since taxes are so
closely linked to work and income. Tax projections for retirement will need to
be treated separately (see Chapter 10 for more on taxes). Knowing past taxes
paid may not provide much insight into future tax bills, beyond property taxes.
As well, transportation expenses were relatively low in these years, as the
last car purchase was in 2016, a year that is not shown in the exhibit. This is
something to consider when projecting future expenses. Finally, we note that
these are raw expenses from each year in nominal terms, but that the consumer
price index (with 2021 as a base year) is included at the top of the exhibit.
This will become important for the next step of projecting retirement expenses.

Projecting Retirement Expenses

Once we have a grasp of what we have been spending, we can
next turn to how spending might change in retirement. Some expenses will
decrease after retiring. These include expenses related to child-rearing for
children who have grown, the possibility for a mortgage to be paid off, the
potential for lower taxes as work decreases, especially payroll taxes, and the
lack of work expenses. Also, if moving to less expensive housing, home
maintenance bills and property taxes may also decline.

On the other hand, other expenses may increase. There is a
saying that every day is a Saturday in retirement, and leisure spending can be
higher than when most of one’s day was spent at work. One may wish to splurge a
bit, at least in the early retirement years. As well, health care, health
insurance premiums, long-term care expenses, and needing to outsource some
services that may have previously been manageable could all raise the costs of
retirement.

Exhibit 3.3 provides an example of the process for
translating past spending into a retirement budget. For this case, the couple
plans to sell their home and rent an apartment. The first thing to note about
this exhibit is that the recent annual spending numbers have been adjusted
upward to account for real spending in 2021 dollars based on the price index that
was shown in Exhibit 3.2. This is an important adjustment, which ultimately
increased the average annual spending for these five years from $105,823 in
nominal dollars to $110,232 in real dollars. It is the real dollar amounts that
are more relevant when projecting the retirement budget.

I have also added a column for the retirement budget next to
the average amounts. This provides an easy way to see what has been spent so
that we can adjust from a more relevant starting point. We can observe that
some categories are quite close to the past averages with perhaps a slight
upwards rounding as the household does not foresee changes in those categories.
Other categories do have bigger changes. For instance, gifts drop dramatically
as the household is no longer paying for education expenses, groceries are less
to account for fewer mouths to feed, health care increases as the couple
expects to pay more for health as they age and lose subsidized employer
benefits (the specific method for calculating their health expenses is
described in Chapter 7), housing increases to account for more furniture
purchases to accompany the move, property taxes shift to an expected rent of
$1,500 per month, restaurant spending increases as the retirees would like to
go to more restaurants as a part of filling leisure time, transportation
increases to budget in car purchases, and travel spending also increases to
account for more leisurely travel in retirement. For this couple, the overall
projected retirement budget is about $1,300 more than the average household
expenses over the past five years. The couple anticipates spending $111,564 per
year net of taxes. Taxes are not included here because that is a separate
process going beyond basic budgeting and will be considered in Chapter 10.

Exhibit 3.3

Projected Retirement Expenses

Real Expenses (Today's Dollars)

RETIREMENT

- PROJECTED -

AVERAGE

2017

2018

2019

2020

2021

Cell phone

$1,200

$1,162

$1,071

$1,049

$1,686

$1,009

$996

Charity

$5,000

$4,955

$4,156

$5,478

$5,181

$4,558

$5,400

Gifts / children's education

$3,000

$10,440

$33,928

$18,216

$53

$0

$0

Groceries

$18,000

$17,783

$18,967

$17,835

$17,761

$16,663

$17,690

Health Care

$11,464

$8,412

$10,251

$7,729

$8,900

$6,755

$8,425

Household expenses

$23,000

$27,184

$39,069

$29,024

$31,066

$17,322

$19,438

Housing (maintenance, furniture)

$1,500

$929

$0

$0

$3,885

$0

$760

Housing (HOA dues)

$0

$2,834

$2,894

$2,834

$2,787

$2,725

$2,930

Insurance

$3,300

$3,339

$3,220

$3,318

$3,340

$3,404

$3,413

Internet

$1,000

$988

$1,026

$1,005

$988

$966

$954

Property Taxes / Apartment Rent

$15,600

$13,878

$13,494

$13,683

$13,904

$14,029

$14,279

Restaurants

$3,000

$2,175

$1,883

$2,280

$3,033

$1,293

$2,385

Television

$1,000

$688

$336

$554

$575

$993

$980

Transportation

$7,500

$2,337

$2,187

$3,081

$2,556

$1,722

$2,139

Travel (International)

$10,000

$6,640

$18,303

$0

$14,895

$0

$0

Travel (Domestic)

$4,000

$3,268

$5,045

$6,450

$3,305

$0

$1,540

Utilities (gas, electric, water)

$3,000

$3,222

$2,506

$3,050

$3,285

$3,558

$3,712

$111,564

$110,232

$158,336

$115,586

$117,201

$74,996

$85,041

For budgeting, it never hurts to round-up when projecting
expenses to provide a more conservative target for future spending. It is
easier to underspend and have leftover funds than to overspend. The budgeting process
can be further refined with each passing year as new data on actual spending becomes
available. Seeing realized retirement expenses and then comparing them to the
projections can be illustrative in helping determine further adjustments.

When it comes to projecting retirement expenses, three of
the trickier categories to estimate will be health care, housing, and taxes. These
categories will receive more discussion in their own chapters. Medical costs
and insurance (Chapter 7) can change dramatically in retirement, as most
retirees will switch to Medicare at age 65. Housing (Chapter 9) may also
change, especially if one moves. Moving can impact homeowner’s insurance,
utilities, property taxes, home maintenance and repair costs, and the cost-of-living
in the new community. It may take a couple years to get a full picture about
the changes to the budget caused by a move, but at least knowing this and
planning for some flexibility can still guide you in the right direction.
Finally, income taxes change in retirement (Chapter 10) as wages are replaced
by distributions from assets that are taxed in a variety of ways. Tax bracket
management becomes important to controlling the amount of taxes paid.

Lifestyle and Longevity Expenses

Another budgeting issue is the distinction between lifestyle
and longevity expenses. Core retirement expenses are fixed and inflexible. But
that may not represent the entire budget. Some expenses may be discretionary. Is
there a baseline spending level you could manage comfortably and still feel
that retirement is going well, even if it does not include everything?

Exhibit 3.4

Lifestyle and Longevity Expenses

RETIREMENT - PROJECTED EXPENSES -

Real Expenses (Today's Dollars)

FULL LIFESTYLE

LONGEVITY ONLY

Cell phone

$1,200

$1,200

Charity

$5,000

$3,000

Gifts / children's education

$3,000

$600

Groceries

$18,000

$12,000

Health Care

$11,464

$11,464

Household expenses

$23,000

$19,000

Housing (maintenance, furniture)

$1,500

$1,000

Housing (HOA dues)

$0

$0

Insurance

$3,300

$3,300

Internet

$1,000

$1,000

Property Taxes / Apartment Rent

$15,600

$12,000

Restaurants

$3,000

$2,000

Television

$1,000

$800

Transportation

$7,500

$6,000

Travel (International)

$10,000

$2,000

Travel (Domestic)

$4,000

$2,000

Utilities (gas, electric, water)

$3,000

$3,000

$111,564

$80,364

In Exhibit 3.4, we extend our earlier example for a
projected retirement budget by including a distinction between the full
lifestyle ($111,564) and the longevity spending that one could accept as more
of a bare minimum in retirement ($80,364). The $31,200 difference is based on
the couple’s assessment about where spending could realistically be cut. For
this hypothetical couple, the biggest factors to reduce spending included less
for charity, fewer gifts, less on groceries and household expenses, a less
expensive apartment, fewer restaurant visits, and a substantial reduction to
the travel budget that would likely be expressed as less frequent trips, such
as an overseas trip once every few years instead of once per year.

Changing Expenses in Later Retirement

As if preparing a budget for retirement did not yet involve
enough speculation, another important matter to address is how the retirement
budget may evolve over a long retirement horizon. Exhibit 3.5 provides an
example for this couple who anticipates spending adjustments starting at age
80.

Exhibit 3.5

Changing Expenses in Retirement

RETIREMENT - PROJECTED LIFESTYLE
EXPENSES -

RETIREMENT - PROJECTED LONGEVITY
EXPENSES -

Real Expenses (Today's Dollars)

Ages 65 - 79

Ages 80+

Ages 65 - 79

Ages 80+

Cell phone

$1,200

$1,200

$1,200

$1,200

Charity

$5,000

$5,000

$3,000

$1,000

Gifts / children's education

$3,000

$3,000

$600

$600

Groceries

$18,000

$12,000

$12,000

$10,000

Health Care

$11,464

$22,928

$11,464

$22,928

Household expenses

$23,000

$15,000

$19,000

$13,000

Housing (maintenance, furniture)

$1,500

$500

$1,000

$500

Housing (HOA dues)

$0

$0

$0

$0

Insurance

$3,300

$3,300

$3,300

$3,300

Internet

$1,000

$1,000

$1,000

$1,000

Property Taxes / Apartment Rent

$15,600

$15,600

$12,000

$12,000

Restaurants

$3,000

$600

$2,000

$600

Television

$1,000

$800

$800

$800

Transportation

$7,500

$3,000

$6,000

$3,000

Travel (International)

$10,000

$0

$2,000

$0

Travel (Domestic)

$4,000

$1,000

$2,000

$1,000

Utilities (gas, electric, water)

$3,000

$3,000

$3,000

$3,000

$111,564

$87,928

$80,364

$73,928

Some retirees may avoid the issue of changing spending by
assuming that the budget will simply grow with consumer price inflation
throughout a long retirement. This is generally a conservative assumption that
could also provide a way to budget in assets for spending shocks as overall
spending for retirees will likely decline with age. But, as will be described
further in the next chapter, most retirees do experience declining spending
with age. Retirees may experience the Go-Go, Slow-Go, and No-Go years of retirement.
Early on, retirees are more active and have higher discretionary expenses for categories
such as travel and restaurants. Retirement spending tends to keep pace with
inflation. But retirees will eventually begin to slow down and become less active.
Spending no longer keeps pace with inflation and may even decline on a nominal
basis. Our couple reflects this situation by estimating real spending declines
starting at age 80. They reasonably anticipate a decline in groceries (less
gourmet cooking at home), household expenses, home furnishings, restaurants,
television, transportation, and travel.

They also plan for one category increase, which is to double
the real cost for health expenditures after age 80 to account for rising health
needs and the idea that health care inflation tends to exceed the overall
inflation rate (health spending is discussed in Chapter 7). The anticipated overall
spending decline will help to provide some relief for their retirement
finances, though it will also point to a need for reserve assets to cover
unanticipated late-in-life spending shocks that cannot be managed as easily by simply
redirecting other spending. Doubling health expenses was one way to prepare,
but there are also other possible expenses related to frailty and long-term
care. The risks related to these unknown changes can be incorporated partially
by leaning toward being conservative with the budget. For instance, the travel
budget could be kept after age 80 with the idea that these funds could be easily
redirected to other unexpected spending needs. To the extent that budgeted
expenses decline, these risks must be managed separately.

Legacy

In addition to your budget, do you have quantifiable legacy
goals? Is leaving a specific legacy important, or do you accept that legacy
will be whatever happens to be left over at the end without necessarily needing
to plan for a specific amount. Legacy goals can be defined for family,
charities, or other institutions. Legacy can also be split between ongoing
distributions as part of the budget, or as a specific amount to be provided at
death. Life insurance can also be a useful tool for providing a specific legacy
amount at death. To the extent that one has specific legacy goals in mind, it
is important to be thinking about these at the same time one is engaging the
budgeting process as legacy goals must also be funded to be fully prepared for
retirement. With this sense of retirement spending in terms of longevity,
lifestyle, and legacy goals, we can next turn to spending shocks and the impact
they will have on retirement funding.

Liquidity

The fourth L for retirement financial goals is liquidity to
cover spending shock contingencies. To feel comfortable about retiring, we need
to determine an amount of reserve assets that are not earmarked for longevity,
lifestyle, or legacy. These are reserves for spending shocks.

There are many potential spending shocks with different
possible costs. It is difficult to protect against all of them individually as
the total cost could become overwhelming. At some level, this discussion is
about creating a bucket of reserves large enough to manage risks, without
necessarily having enough to truly handle every possible risk happening all at
once. This is especially the case for those with more of a technical liquidity
mindset. Also, with the budgeting process, using higher spending estimates can
be a way to incorporate a level of spending shocks within the budget. The more
one targets to spend in the baseline budget, the less likely it becomes that
the full budgeted amount is spent, and some of this excess can be redeployed
for spending shocks.

Exhibit 3.6

The Liquidity Goal: Reserves to Cover Retirement
Spending Shocks

Spending Shock

Liability Target Amount

Comments

Long-term care

$514,653

We do not have long-term care insurance and will
investigate insurance options as we now realize the discomfort we have with
this risk. We do not wish to rely on other family members for care. We
recognize that some expenses will be offset in the budget in the event of
long-term care needs, which partially helps to manage the risk, but nonetheless
we feel the need to have a large set aside available to cover a lengthy
long-term care need. This amount reflects our estimates for long-term care
reserves identified in Chapter 8.

Health care (outside budget)

$83,012

We believe our health care budget is already
relatively conservative, including the doubling in real value after age 80.
Neither of us has significant health issues, however we do recognize this
risk and wish to have an additional layer of funds set aside for unexpected
health expenses that exceed what we have budgeted. We identify additional
reserves following the process outlined in Chapter 7.

Inflation

$0

Inflation risk is being hedged through the retirement
budget with the assumption that budgeted spending will grow with inflation.

Death of a spouse

$0

We have life insurance, and we plan to take care with
tax planning, and look at joint-life annuity options to minimize the
financial risks created by the death of a spouse. We do not feel a need for
an additional set aside.

Family-related responsibilities

$50,000

Our children are establishing their careers and it is
unlikely they will need our financial support. We have one living parent who
is still able to live independently. We view this risk as relatively minor,
but we would like to have some reserves available.

Divorce

$0

Though the risk is understood, we do not seek to set
aside reserve funds specifically for this.

Changing public policy and tax rules

$0

We recognize this risk by assuming tax rates will
increase in the future when we do our tax projections, and we will also
assume a small reduction to our anticipated Social Security benefits to
account for the risk of reduction. We feel these steps will properly cover
this risk.

Business risks for annuities and pensions

$0

We recognize this risk but feel that our protected
income sources will be sustainable.

Excess withdrawal risk

$0

By creating conservative spending estimates for our
budget as based on our actual spending experience, we feel we are able to
manage the risk of overspending.

Frailty and cognitive decline

$0

Our budget includes a spending increase on housing related
expenses. In the early retirement years, this is meant to cover furniture,
but over time it can be a resource to pay for additional home maintenance
needs we cannot handle. Renting in retirement should also help to manage this
risk.

Financial elderly abuse

$20,000

We find this risk to be difficult to quantify and
will work to have plans in place to minimize this risk. However, we have
decided that having a small set aside will help us to feel more comfortable.

Housing

$0

We are planning to rent in an active adult community
and aim to manage our housing needs over time through our budget.

Forced early retirement

$0

We have reached our desired retirement date and do
not include future work in our retirement plan.

Total

$667,665

Exhibit 3.6 provides an example for how to manage spending
shocks. I list each shock identified in Chapter 2, provide a numerical target for
associated reserves, and then provide comments about the decision. This example
does show the potential struggle we can have with trying to estimate the amount
of additional assets we seek for events that may not happen. In this example,
the couple is quite concerned about long-term care risk. They plan for institutional
care prices to rise faster than inflation and to last for multiple years. The
couple views this as the biggest potential spending shock risk and would feel
more comfortable if $514,653 of additional assets could be set aside at the
start of retirement as reserves for potential long-term care expenses. Chapter
8 explains how they derived this number. They will also investigate long-term
care insurance to see if it can be an option that would support a smaller reserve
for out-of-pocket long-term care expenses. They also decide to include $83,012
for health care in addition to the already conservative amount of health care
spending included in their budget. Chapter 7 explains how this number was
derived. After also targeting $50,000 for family related responsibilities and
$20,000 for elder abuse, they estimate that a contingency fund of $667,665
should be a reasonable amount of additional assets to have available for the
unexpected in retirement. For the other risks, they do not anticipate a specific
need to have additional reserves. If these reserve assets end up not being used
for spending shocks or other unanticipated expenses that exceed the budget,
they will likely become part of the eventual legacy for the couple.

Assessing Retirement Preparedness

After quantifying financial goals and their associated
liabilities, we are ready to begin the process of assessing retirement
preparedness. This process will be explained in terms of quantifying the funded
status or funded ratio for retirement. We compare available retirement assets
to retirement liabilities to determine whether there are sufficient assets to
meet the goals. This can be a helpful starting point for understanding plan
sustainability without the need to take market risk.

Retirement Income Optimization Map and
Retirement Assets

The Retirement Income Optimization Map (RIO-Map) illustrated
in Exhibit 3.7 identifies the process of mapping assets into retirement
liabilities. We have discussed goals and their associated liabilities already.
We are now ready to focus on the assets column of the RIO-Map. Assets consist
of more than just investment accounts, as we include every resource at the
household’s disposal for meeting retirement liabilities. Assets are divided between
reliable income sources, the diversified portfolio, and reserves.

First, reliable income assets are used to draw consistent
income to meet longevity goals by covering essential expenses. The idea for
reliable income is to first build a floor of low-risk, contractually-protected
income sources to serve basic spending needs in retirement. Reliable income
answers the question, “How can I create a base of secure income in retirement
that is safeguarded from market volatility?” Reliable income resources include Social
Security benefits, annuities with lifetime income protections, traditional
pensions, bond income ladders, cash accounts, and potentially continued
employment. In some cases, access to home equity through a reverse mortgage may
also provide reliable income. These income sources are not all inflation
adjusted, which means you need to make sure the floor will be sufficiently
protected from inflation, but the underlying idea for reliable income is to securely
fund essential expenses.

The safety-first approach will put greater emphasis on
ensuring that there is sufficient reliable income to meet longevity expenses. Those
with a probability-based style will feel less compelled to match reliable
income sources to longevity expenses, concluding that a diversified portfolio
using a “safe withdrawal rate” can work out just fine for this purpose. That
explains the probability-based arrow extending from the diversified portfolio
to essential expenses. Safety-first individuals will be less comfortable
treating a diversified portfolio as a source of reliable income.

Exhibit 3.7

Retirement Income Optimization Map©

The next asset section of the RIO-Map is the diversified
portfolio, which can be used most effectively to meet lifestyle and legacy
goals. With the flooring in place for essentials, retirees can focus on upside growth
potential with these assets. The diversified portfolio includes brokerage
accounts, retirement accounts, and life insurance cash value. Since this extra
spending (such as for nice restaurants, extra vacations, etc.) is
discretionary, it will not be catastrophic if it must be reduced due to market
losses. There is more at stake here than just identifying an asset allocation.
We seek to determine how well you are positioned to effectively capture market
rates of return, how you have practically managed your portfolio in the past,
and what are your strengths and weaknesses in investment knowledge or
application that could lead to good or poor outcomes. The diversified portfolio
portion of the RIO-Map is about making sure that you have a unified strategy
that maximizes your retirement preferences, which is well coordinated with
reliable income and reserves.

The final component of assets is reserves. Reserves are
aimed to meet the goal of supporting liquidity for contingencies in retirement.
These are additional assets not already earmarked for other purposes, which can
provide cash flows to fund unexpected spending. Reserves are unique as well in
that many types of reserve assets may serve to reduce the potential size of the
contingency liability box rather than increase the size of the reserve asset
box. This means that we may not end up quantifying a dollar value for all
potential reserve assets, but instead just note a smaller contingency liability
when non-monetary reserve assets are available. For instance, having a strong
network of family and community support in place reduces the need for large
expenditures for care in the event of various long-term care, health,
cognition, or frailty shocks. As well, a long-term care insurance policy can
offset a portion of the tail risk for spending associated with experiencing a significant
long-term care need, reducing the size of this contingency. That would lead one
to reduce the monetary values identified when working through the spending
shock risks outlined in Exhibit 3.6. If the size of the reserve asset box is
aligned with the size of the contingency liability, the absolute size of these
two boxes is less relevant. The idea is that reserve assets can be used to
limit the impact of retirement spending shocks. Reserve assets may include
varying combinations of cash and income, insurance policies, the ability to age
in place, family assistance and obligations, taking care of one’s health, and having
a team of retirement professionals. Having extra investment assets available
beyond what is earmarked to cover other goals is also a source of reserve
assets providing true liquidity.

Viewing these reserves within the RIO-Map could help with
psychological angst about feelings of “not having enough” to manage retirement
risks. For those with a preference for true liquidity, for an asset to be
available to fund contingencies, it cannot be earmarked to cover a different
liability. Otherwise, if it is spent on something unexpected, it will no longer
be available to cover its original intent. This is a subtle point that can also
relate to longevity risk aversion. When relying on an investment portfolio to
cover retirement expenses, another reason why people may spend less could be
that they have a somewhat amorphous mental account in their mind about using
assets. They have earmarked the same pool of investments to cover both
lifestyle and liquidity, not clearly distinguishing how these objectives can be
separated. Thus, in a sense, they worry that their investments must provide
liquidity for contingencies, and they spend less in response. With the RIO-Map
framework, we can be more explicit about the available reserve assets, which
may allow retirees to feel more comfortable with supporting their lifestyle
goals more completely. The next step is to quantify the size of the RIO-Map
boxes by creating a retirement balance sheet that includes estimated values for
the assets and liabilities.

Funded Ratio

With a budget in place, we next need to think about the
overall cost of retirement. A problem with trying to determine the cost for
funding financial goals in retirement is that retirees must manage a differing
set of risks. Retirement risks include longevity risk, market
risk, and spending shocks. Even if the planned budget is exactly right
and the precise amount of future annual spending is known, retirees do not know
how long they will live and what future market returns will be. The retirement
budget will cost more to fund as one lives longer or experiences poor market
returns. Spending shocks add further uncertainty around how much will need to
be spent. When spending shocks are realized, the cost of
retirement grows further. At some point, retirement costs may exceed the
available assets.

The funded ratio provides a relatively simple way to
understand if one is prepared to fund their lifetime retirement goals as based
on their decisions related to these risks. One calculates if retirement assets are
large enough to meet retirement liabilities using assumptions about future
market returns, longevity, and spending shocks. A funded ratio of 1, implying a
funded status of 100 percent, means that retirees have just enough assets to
meet their liabilities. Overfunded and underfunded retirees have more or less
than this, respectively.

The funded ratio is based on the value of assets and
liabilities on the retirement balance sheet. It does not report a probability
of success for the financial plan like many financial planning software
programs. It is much simpler as it uses a fixed rate of return assumption as a “discount
rate” that converts the value of future cash flows into today’s dollars. When
the discount rate is chosen conservatively, the funded ratio lets us see
whether the goals of a retirement plan can be met without taking market risk. I
will base the discount rate on long-term bond interest rates, which implies
that plan assets will grow throughout retirement with a bond-like return. This
can provide better context about how much investment risk one may desire or
need when determining the right asset allocation for the plan. If you have
already won the game by having sufficient assets without taking risk, this can
be helpful in deciding just how much risk to take. A higher discount rate could
be used to imply that market returns will be higher, but this also adds risk
that poor market returns could reduce the funded status.

For the funded ratio, we must also choose a planning age to
define the possible length of retirement. The planning age can be based on
objective factors like your health status and subjective factors like your
longevity risk aversion. The more one worries about outliving
their wealth, the more conservative one must be with respect to assumptions
about longevity and portfolio returns. This would raise the assumed cost of
funding retirement, which would lead to accumulating more assets before one is
comfortable transitioning away from work. The
example I provide uses a planning age of 100 for the couple. They base their
planning age on the 90th percentile for longevity for a couple in
average health as was shown in Exhibit 2.1. Their concerns about longevity risk
aversion are satisfied if they have a plan in place that can work until age
100. For this example, I assume that both members of the couple survive to 100,
but the plan could be further tested for other scenarios in which one spouse
dies sooner as well.

In the previous section, I describe how to develop your
planned retirement budget. How will spending differ from preretirement, how
will it adjust for inflation or otherwise evolve over time, and how is it
divided between essential and discretionary expenses? We also need a proper
accounting of any legacy goals and estimates for potential spending shocks and contingencies.
These represent the liabilities for your retirement balance sheet. The next
step is to gather information about your retirement assets.

The retirement balance sheet shows the assets and
liabilities available for a retirement plan. It has a similar design as the
RIO-Map, but the difference is that now we attempt to quantify monetary values
for the assets and liabilities. The RIO-Map provided a visual illustration of
how assets are mapped to liabilities, and that is ultimately the goal with
creating the balance sheet for the funded ratio, but at a basic level it is not
necessary to start with that mapping. First, we seek to assess the overall
situation and then we can shift into examining the size of the boxes on your
RIO-Map. This sets the stage for moving into the retirement income funding
analysis by quantifying any gaps between the related asset and liability
components in the map.

A funded ratio involves more than just financial assets. The
retirement balance sheet is the starting point for building a retirement income
strategy. At the core is a desire to treat the household retirement problem in
the same way that pension funds treat their obligations. Assets should be
matched to liabilities with comparable levels of risk. This matching can either
be done on a balance sheet level, using the present values of asset and
liability streams, or it can be accomplished on a period-by-period basis to
match assets to ongoing spending needs. Structuring the retirement income
problem in this way makes it easier to keep track of the different aspects of
the plan and to make sure that each liability has a funding source. This also
allows retirees to more easily determine whether they have sufficient assets to
meet their retirement needs or if they may be underfunded. This organizational
framework also serves as a foundation for choosing an appropriate asset
allocation and for seeing clearly how different retirement income tools fit
into an overall plan.

The process for collecting information on your assets is
described in Chapter 11 as part of the discussion on getting your financial
house in order. You might check that discussion to ensure that you do not
overlook anything. We wish to identify the “present discounted value” of any
assets that can be used as part of funding retirement liabilities. These
present values include the current value of the financial portfolio (banking,
brokerage, and retirement plan accounts) and other resources or property currently
owned, such as the appraised value of real estate less estimated selling costs
and taxes, which could potentially be sold to fund future spending needs. It
also includes the present value of other income sources received over the
lifetime, such as future employment income, Social Security benefits, an
inheritance, pensions, and annuities. Meanwhile, liabilities include current
debts, such as a mortgage or loan balance, and the discounted present value of expenditures
related to the budget and taxes over the remaining lifetime, as well as contingencies
and legacy goals. Such income streams and ongoing expenditures will need to be
translated into a present value to add to the balance sheet.

We are separating assets and liabilities between amounts
known today and present values of future streams of income or expenses. As for future
income and spending, it may be easiest to keep track of these cash flows in
inflation-adjusted terms because this provides a translation for the value of
future amounts in terms of what can be understood today. To express matters in
inflation-adjusted terms, future income and spending needs, as well as the
discount rate used in the calculations, are all adjusted downward to account
for inflation. If one is consistent about expressing all terms either with
their real or nominal values, treating everything in either real or nominal
terms is fine. But I find real terms to be the easiest to understand as
inflation can just add confusion about the interpretation of future monetary
values in terms of their purchasing power.

Returning to the discount rate, the fixed return assumption
could be treated as bond yields, in which retirement income is based on
building a ladder of individual bonds. In this case, the yield would reflect
the average yield from the bond ladder if the yield curve were not otherwise
flat. The rate could also reflect the return assumptions for a diversified
investment portfolio. In this case, these returns would reflect the net compounding
return assumption for the portfolio after fees. The rate can express either
nominal or real returns. If nominal returns, then spending would also be
nominal and would increase with inflation. But we will generally treat the retirement
budget as a real spending value with the inflation effects removed. In this
case, the discount should be treated as real returns net of inflation. As
inflation is generally a positive number, real returns are less than nominal
returns and so the retirement cost will be higher for real spending.

As we are expressing future values in inflation-adjusted
terms, the rate of return or discount rate assumption I use reflects yields on
Treasury Inflation-Protected Securities (TIPS). These are inflation-protected
bonds issued by the US government which offer a real rate of return plus
realized inflation. Using a discount rate based on TIPS implies that investment
assets consist solely of TIPS, which is the “risk free” asset for an
inflation-adjusted spending goal assuming longevity risk is not an issue. The
long-term real interest rate on TIPS is approximately 0 percent at the time of
writing. That becomes my baseline discount rate for this analysis, as again the
starting point for the funded ratio will be to consider whether the retirement
plan is funded without taking on additional market risk.

This leads to the example of cash flows for our retiring
couple shown in Exhibit 3.8, identified through the planning age of 100. For
this couple, two assets will be received as cash flows: a pension and Social
Security benefits. The pension is $6,000 at age 65. It is the only cash flow
assumed not to grow with inflation. The lack of inflation adjustments is
reflected by having its real value decrease each year by an assumed 2 percent
inflation rate. Social Security benefits begin at age 70 and provide $52,220 of
annual real income, as the couple has decided to delay benefits and the low
earner did not qualify for an own benefit (see Chapter 6). One spouse also
holds a permanent life insurance policy with a death benefit that they
conservatively project to be worth $450,000 at age 100 in terms of today’s purchasing
power with a 2 percent inflation rate. The death benefit at age 100 is relevant
since that is the assumed age of death in the retirement plan. The couple may
have other assets such as a vehicle and personal belongings, but these are not
included as they will not be used to generate retirement income.

Exhibit 3.8

Determining the Present Values for Asset and
Liability Cash Flows,

Real Discount Rate = 0%

Income (Assets)

Spending (Liabilities)

Year

Age

Pension

Social Security

Life Insurance

Essential living needs

Taxes

Additional Lifestyle

2021

65

$6,000

$0

$0

$80,364

$5,578

$31,200

2022

66

$5,882

$0

$0

$80,364

$5,578

$31,200

2023

67

$5,767

$0

$0

$80,364

$5,578

$31,200

2024

68

$5,654

$0

$0

$80,364

$5,578

$31,200

2025

69

$5,543

$0

$0

$80,364

$5,578

$31,200

2026

70

$5,434

$52,200

$0

$80,364

$5,578

$31,200

2027

71

$5,328

$52,200

$0

$80,364

$5,578

$31,200

2028

72

$5,223

$52,200

$0

$80,364

$5,578

$31,200

…

2035

79

$4,547

$52,200

$0

$80,364

$5,578

$31,200

2036

80

$4,458

$52,200

$0

$73,928

$4,396

$14,000

…

2051

95

$3,312

$52,200

$0

$73,928

$4,396

$14,000

2052

96

$3,247

$52,200

$0

$73,928

$4,396

$14,000

2053

97

$3,184

$52,200

$0

$73,928

$4,396

$14,000

2054

98

$3,121

$52,200

$0

$73,928

$4,396

$14,000

2055

99

$3,060

$52,200

$0

$73,928

$4,396

$14,000

2056

100

$3,000

$52,200

$450,000

$73,928

$4,396

$14,000

Present Values

$155,992

$1,618,200

$450,000

$2,757,948

$175,997

$762,000

As for liabilities, we use the spending budget outlined in
Exhibit 3.5, in which longevity expenses are targeted at $80,364, and lifestyle
expenses represent an additional $31,200 for a total spending goal of $111,564
through age 79. Then, for age 80 and later, essential expenses are targeted at
$73,928 with an additional $14,000 of lifestyle expenses. These expenses are
expressed in real 2021 dollars with an assumption that these spending needs
will grow with inflation. I also estimate annual taxes as 5 percent of the
annual spending, which can be a reasonable estimate for a tax-efficient plan
based on their assets, as will be further explored in Chapter 10. I assume they
are in a state with no state income tax, but that would otherwise need to be
added to their estimates. The taxes may seem low, but the funded ratio is
calculated under the assumption that investments earn a low fixed rate of
return matching inflation. There will not be much tax on investment gains. If
investment returns end up higher, then more taxes will need to be paid, but the
overall funded ratio would also increase if the tax rates on investment
earnings are less than 100 percent.

With the cash flows in place and a planning age decided, the
next step is to calculate present values for these cash flows for the balance
sheet. The row with present values provides these calculations. Calculating
these present values requires using a discount rate to reduce the value of
future cash flows (assuming a positive discount rate) to account for needing
less assets today to fund future expenses. If I know my assets will grow with
interest, then I can set aside less today to cover future spending because the interim
expected asset growth will cover part of my need. The present value is simply
the amount of assets that would need to be set aside today to cover all the future
cash flows through the planning age assuming those assets earn interest that
matches the discount rate. A larger discount rate would mean less assets are
needed today because we could expect greater growth on the assets before they
are spent. It would also reduce the present value of assets arriving as future cash
flows for the same reason. For instance, a Social Security benefit received in
the future would be worth less today because if we had the benefit today, we
could earn interest during the intervening years.

We use a 0 percent real discount rate matching TIPS yields.
The present values of real cash flows are simply the sum of those cash flows.
But this would not be the case if the discount rate were different. We use 0
percent to discount the future cash flows which leads to the numbers shown in
the present values row. The value of the pension in today’s terms is $156k,
while Social Security is worth $1.62 million if the couple lives to 100. As an
aside, let that sink in… Social Security can be extremely valuable for
retirees. As for liabilities, the present value to cover the core longevity
expenses through age 100 is $2.76 million, while taxes add $176k and
discretionary lifestyle expenses are $762k. With a 0 percent real discount
rate, the life insurance policy death benefit at age 100 is also worth the same
$450k in today’s dollars. If you are interested to calculate present values for
your assets and liabilities, you can use the NPV function in Excel, with
inputs for the desired discount rate and the cells containing the cash flows to
be discounted and summed.

The next step for the funded ratio is to add these cash flow
present values with the current values of other assets and liabilities to make
the overall retirement balance sheet. Exhibit 3.9 provides an example. To the
present values of cash flows just described, we add additional assets and
liabilities. Assets include $360k as a net sales value for home equity, $26k in
checking accounts, $384k in brokerage accounts, $1.29 million of retirement
plan assets, and $211k in a Roth IRA.

Exhibit 3.9

The Funded Ratio for the Retirement Plan

Real Discount Rate:

0.0%

Assets

Liabilities

Reliable Income

$1,800,192

Longevity

$2,933,945

Social Security

$1,618,200

Essential living needs

$2,757,948

Company pensions

$155,992

Taxes

$175,997

Checking accounts

$26,000

Debt repayment

$0

Diversified Portfolio

$1,884,194

Lifestyle

$762,000

Brokerage accounts

$383,961

Additional Lifestyle

$762,000

IRA / 401(k)

$1,289,500

Roth IRA

$210,733

Reserves

$360,000

Contingencies (Liquidity)

$667,665

Home Equity

$360,000

Long-term care

$514,653

Health care

$83,012

Other spending shocks

$70,000

NON-LEGACY ASSETS

$4,044,386

NON-LEGACY LIABILITIES

$4,363,610

FUNDED RATIO:

92.7%

Additional Legacy Assets

Surplus (To Legacy) or
Shortfall

Whole Life Policy (Death
Benefit)

$450,000

Legacy (+) or Shortfall (-)

$130,776

Note: assets and liabilities listed in italics represent
present values for future cash flows; otherwise, they are current market
values.

Not counting the life insurance, assets total $4.04 million.
My decision to not count the life insurance is worth further discussion, as
life insurance can be tricky. This couple has decided not to incorporate a
specific legacy goal as a liability for their plan. Any surplus wealth at death
will be treated as a legacy, and they will continue to monitor this value. They
will think of their life insurance as a legacy asset for this purpose, though
there is a possibility that if their plan is underfunded, they could
potentially shift to including the cash value of the life insurance to become
an additional asset used to fund their retirement liabilities. Life insurance
is worth different amounts depending on whether the owner is still alive or has
died, and the funded ratio could be explored using different approaches about
how it is included. The smaller cash value is relevant if the policy will be
used to fund expenses while the owner is alive, but the larger death benefit is
relevant if the asset is incorporated into the plan at the owner’s death.

On the liabilities side, in addition to the spending values
described, which add up to $2.93 million of longevity expenses and $762k of
lifestyle expenses, we add the $668k of contingencies calculated in Exhibit 3.6
for this couple as based on their analysis of exposure to spending shocks.
These liabilities total $4.36 million. Not counting the life insurance, the
present value of assets is about $319k less than the present value of
liabilities. The funded status is 92.7 percent, suggesting that the couple is
underfunded with respect to their overall goals for retirement. Adding the
death benefit to their assets, they do now have a surplus of $131k, suggesting
that one potential way to improve their funded status is to incorporate the
cash value of the life insurance into the retirement income plan. If the cash
value is at least $319k, then the plan is funded by treating the cash value as
a funding mechanism for other liabilities. We will explore other options for
improving the funded status.

In this example, the funded ratio is less than one (when
life insurance is left out of the calculation), implying that the retirement is
underfunded. A few natural approaches present themselves as potential responses
to an underfunded status. Though perhaps easier said than done, options include
to increase assets, decrease liabilities, or earn a higher investment return as
expressed by using a larger discount rate for the calculations. Overfunded
retirees could reverse some of these ideas.

On the asset side, one could decide to delay retirement and
work longer. If it is feasible to continue working, delaying retirement is the
most powerful way to improve retirement sustainability, as it allows for more
savings and growth, a shorter subsequent retirement to fund, and a strengthened
ability to delay Social Security and possibly even increase the primary
insurance amount. Additional work impacts this plan by adding the present value
for the future earnings as an additional asset. One could simply add these
earnings net of taxes or add total earnings as an asset but increase the tax
liability to account for the income and payroll tax on these earnings.

Another option for those with longevity risk aversion (which
means using a high planning age and low discount rate to feel comfortable) is
to include annuities providing lifetime income in the retirement plan. As will
be described further in Chapter 5, annuity prices are based on objective
measures for mortality and life expectancy for the underlying risk pool, while
retirement plans with a conservative planning age assume that retirement lasts
longer than average. When individuals live to the planning age, the annuity pays
more by providing more spending through its mortality credits. In terms of the
funded ratio, this would be expressed as the present value of the annuity
payments through age 100 being worth more to the plan than the annuity premium,
which increases the value of assets on the balance sheet.

As for decreasing liabilities, this could be reflected
through updates for the retirement spending goals. Reducing the annual spending
budget, either now or in the future, will have the effect of decreasing the
present values for those spending streams. The amount set aside for spending
shocks could also be reduced, but with the understanding that this would
increase risk exposures for the retirement plan in terms of the potential for falling
short in funding other goals after managing large contingencies. Finally, if
the plan did include an explicit legacy goal, which this plan does not, that
goal could be adjusted downward to reduce the overall cost for the retirement
plan.

The third possibility is to assume a higher discount rate,
which will usually improve the funded status of a retirement plan because it
will typically lead to a bigger reduction in liabilities than in assets. Liabilities
tend to be more backdated in retirement (in technical terms, they have a higher
duration), especially if there is a legacy goal at the planning age or if there
are significant amounts of financial assets available today. It is possible
that a higher discount rate will reduce the funded status, perhaps in a rare
case such as a very large inheritance that arrives in the future. But generally,
a higher discount rate will improve the funded ratio and lead one to believe
their financial plan is more sustainable. This may be an illusion, as a higher
discount rate implies that underlying financial assets are invested more
aggressively, leading to a wider range of planning outcomes on both the upside
and downside. As the discount rate increases to include more volatility and
upside, there is a greater chance that asset returns will fall short of the
discount rate and subsequently reduce the funded status.

Assuming a higher discount rate is worth exploring further, because
while it does suggest taking additional risks, most retirees do not plan to
fund their retirement budget entirely with TIPS. Exhibit 3.10 shows the funded
status of this plan for different real discount rates. In this example,
increasing the real discount rate to a little over 1 percent would be
sufficient to fully fund the plan with assumed assets and liabilities. Earning such
a real rate of return in retirement is not an aggressive assumption, and some
retires may be comfortable with the idea that the plan is funded as their
expected portfolio returns will be sufficiently higher than what TIPS yields
can provide. At least, this reflects a target rate of return that would be
required to make the retirement plan work. To justify that assumption, an individual
could increase the discount rate based on a healthy portfolio allocation to
equities. But caution is suggested when moving in this direction, as any
returns assumed above a risk-free rate will be further accompanied by a
proportionate amount of volatility with respect to the outcome and a risk that
the plan could shift to become underfunded with a market downturn.

Regarding the numbers in Exhibit 3.10, a few additional
comments are warranted as the discount rate increases. The present values of any
cash flows will decrease as the discount rate increases, which explains why
asset values also decline. The values of Social Security, the pension, and the
life insurance will decrease. The present values will be less, but these assets
will still have the same future purchasing power. It is just a matter that less
assets would be required today to provide that purchasing power. These
calculations also assume that any financial or real assets that are not present
values will appreciate at the same discount rate. In this example, an increase
in the discount rate implies an unrealistic rate of return for checking account
assets and potentially for home values as well. In addition, I did not
re-calculate the tax liability for each discount rate. A higher rate of return
would translate into more taxes due, which would offset some of the increase in
the funded ratio.

Exhibit 3.10

Sensitivity of Funded Status to the Discount Rate

Real Discount Rate

Assets

Liabilities

Funded Status

-1%

$4,461,623

$5,096,169

87.5%

0%

$4,044,386

$4,363,610

92.7%

1%

$3,721,672

$3,791,422

98.2%

2%

$3,469,749

$3,339,797

103.9%

3%

$3,271,268

$2,979,588

109.8%

4%

$3,113,455

$2,689,294

115.8%

Individuals can decide to use different discount rates for
different assets and liabilities with the idea of employing higher discount
rates for less essential goals. For example, suppose the couple is comfortable
assuming greater market risk is taken for the assets earmarked for
contingencies. This would reduce the present value of the liability, which
would improve the funded status of the plan. As will be discussed in Chapter 8,
if we change the real discount rate for the long-term care contingency from 0
percent to 2 percent, the present value of this liability reduces from $515k to
$306k. One could also reasonably use a higher discount rate for the lifestyle
liabilities. For instance, a real discount rate of 2 percent values this
liability at $578k instead of $762k This improves the funded status of the plan,
with the understanding and acceptance of the risk that there are no contractual
protections regarding the asset growth as would be the case with TIPS.

Exhibit 3.11 provides an example of the funded ratio with
two changes made: the life insurance cash value is counted as a reserve and the
lifestyle liability is discounted at 2 percent. This has increased the funded
status to 101.2 percent, and now there is surplus wealth of $50k.

Exhibit 3.11

The Funded Ratio for the Retirement Plan

Treat life insurance
cash value as reserves and

use 2% real discount rate
for lifestyle expenses

Real Discount Rate:

0.0%

Assets

Liabilities

Reliable Income

$1,800,192

Longevity

$2,933,945

Social Security

$1,618,200

Essential living needs

$2,757,948

Company pensions

$155,992

Taxes

$175,997

Checking accounts

$26,000

Debt repayment

$0

Diversified Portfolio

$1,884,194

Lifestyle

$577,851

Brokerage accounts

$383,961

Additional Lifestyle

$577,851

IRA / 401(k)

$1,289,500

Roth IRA

$210,733

Reserves

$544,660

Contingencies (Liquidity)

$667,665

Home Equity

$360,000

Long-term care

$514,653

Whole Life (Cash Value)

$184,660

Health care

$83,012

Other spending shocks

$70,000

ASSETS

$4,229,046

LIABILITIES

$4,179,461

FUNDED RATIO:

101.2%

Legacy (+) or Shortfall (-)

$49,585

Another implication of the funded ratio is that asset
allocation can relate to the funded status. Mathematically, the optimal
allocation to volatile assets like stocks follows a U-shaped curve with a
minimum stock allocation when the funded status is 100 percent. Stock allocations
then become more aggressive as one moves further away in either direction.
However, when the funded status is less than 100 percent, the mathematical
optimization suggesting a higher stock allocation should be accepted with
caution. While attempts to make a Hail Mary pass to salvage a financial plan
may maximize the probability for a plan’s success, matters could also just as
easily backfire leaving the funded ratio in an even more dire condition.

Meanwhile, in fortunate situations where the plan has excess
funding, the implication is to think in terms of portfolio insurance in which
investment risk can increase as the funded status increases. Options include
either leaving the entire financial portfolio exposed to volatility or locking in
the liabilities with laddered fixed income assets that meet spending needs on a
rolling basis as new bonds mature, or otherwise with annuities that provide protected
lifetime income through mortality credits. Then the surplus wealth could be
invested for long-term growth. Those who are overfunded with a conservative
funded ratio projection will find that their funded status tends to grow even
stronger over time.

Probability-based thinkers feel comfortable with applying a
distribution rate to an investment portfolio to cover the various types of
expenses, while safety-first thinkers prefer reliable income to cover longevity
expenses. The reliable income assets may not always provide further upside, but
at least they prevent the potential downside tragedy of having achieved a goal
and then letting it slip. The danger is that the funded ratio falls, and the retiree
is subsequently unable to restore the funded status, which means that the
individual had and subsequently lost their ability to meet their lifetime
financial goals. To emphasize this point, having a fully funded plan at the
present does not ensure retirement success as interest rates could decrease and
market volatility may lead to losses. With reliable income, upside is still
possible with the other discretionary investment assets that become part of the
reserves and surplus wealth.

As an implication of the preceding discussion, one may
naturally wonder about the probabilities involved with the evolving funded
ratio status as life progresses. A market downturn could cause the funded
status to transition from overfunded to underfunded when volatile investment
assets are used to fund retirement liabilities. Using Monte Carlo simulations,
it is possible to analyze the distribution for the value of the funded ratio at
a future point in time, based on the starting point of today’s funded ratio. Naturally,
greater overfunding would also suggest a higher probability of success for the
plan when a volatile investment portfolio is used. Assets, liabilities, and the
funded ratio will fluctuate over time in response to portfolio returns,
interest rates, inflation, or unexpected spending needs. Obviously, as the
funded ratio drifts over time, it may be appropriate to adjust plans.

Finally, we can consider the funded status both from the
perspective of the overall RIO-Map and for different subcomponents of the map. Even
when the full plan is funded, there may be gaps in some categories, such as
whether there is sufficient reliable income to cover longevity expenses. We do
observe this happening with the example from Exhibit 3.9. The current reliable
income assets fall short of the longevity liability ($1.8 million compared to
$2.93 million), while the diversified portfolio exceeds the value of the
lifestyle liability ($1.88 million compared to $762k). A probability-based
couple may feel comfortable just considering the combined values (that is,
$3.68 million of assets compared to $3.7 of liabilities), but a safety-first
couple would consider converting part of the diversified portfolio into
reliable income assets such as annuities to achieve a better matching for these
sub-categories. They can also treat the excess portion of the diversified
portfolio as part of their reserves to achieve better alignment with the
contingency liability.

Building the retirement balance sheet is an important step
in creating a retirement income strategy. Assets should be matched to
liabilities with comparable levels of risk. Structuring the retirement income
problem in this way makes it easier to keep track of the different aspects of
the plan and to make sure that each liability has a funding source. This also
allows retirees to more easily determine whether they have sufficient assets to
meet their retirement needs or if they may be underfunded with respect to their
goals. This organizational framework also serves as a foundation for choosing
an appropriate asset allocation and for seeing clearly how different retirement
income tools fit into an overall plan.

In subsequent chapters we move forward with refining the details
from a funded ratio analysis. Looking ahead, Chapters 4 and 5 focus on
different approaches for deploying assets to fund retirement expenses. Using a
TIPS ladder, as is done with the funded ratio calculation, as a baseline
starting point, greater spending may be possible with a broader approach that
includes stocks and/or annuities. We cover sustainable spending from a
diversified investment portfolio in Chapter 4 and look at the role for
annuities to fund lifetime spending in Chapter 5. We also seek to monitor cash
flows and to understand the distribution needs from the investment portfolio
over time to monitor sequence-of-return risk and to ensure the timing of cash
flows works out in terms of assets being available to fund liabilities at the
right time.

Action Plan

We have covered the process of determining
whether you have sufficient assets to fund your retirement goals. The following
action items summarize the key steps for quantifying your goals and assessing
your retirement preparedness:

o
Estimate the Four Ls of retirement: longevity, lifestyle, legacy,
and liquidity.

o
Collect data on spending over the previous few years

o
Use past spending as well as analysis of what will change in
retirement to develop a baseline retirement budget

o
Organize the retirement budget as essential longevity expenses
and discretionary lifestyle expenses

o
Project how spending needs may evolve

o
Determine legacy goals

o
Assess exposure to spending shocks to determine a target for
reserves

o
Build a retirement balance sheet by collating household finances
and determining all assets and liabilities, including the present value for income
and expenses that happen in the future.

o
Choose a planning age and conservative discount rate to apply to
the funded ratio calculations, and then calculate the funded ratio.

o
If the plan is underfunded, take initial steps to determine a
course of action to improve comfort that one has a reasonably funded plan.

Further Readings

Noonan, Timothy, and Matt Smith. 2012. Someday Rich:
Planning for Sustainable Tomorrows Today. Hoboken, NJ: John Wiley.

Retirement Researcher. 2021. Take Our Funded Ratio
Analysis. www.retirementresearcher.com/funded-ratio

Chapter 4: Sustainable
Spending from Investments

In this chapter, we focus on the basics of sustainable portfolio
distributions in the face of longevity and market risk, which is an important
piece of any retirement plan that includes portfolio distributions as a
spending source. This chapter provides a summary of the content in my book, How
Much Can I Spend in Retirement? A Guide to Investment-Based Retirement Income
Strategies. Those seeking a deeper dive into these topics may refer to the
book for additional details.

The discussion begins with William Bengen’s classic research
from the 1990s that serves as the foundation for studying retirement spending using
“safe” withdrawal rates as based on historical data. He provided us with the concept
of the SAFEMAX, which is the highest sustainable spending rate from the
worst-case scenario observed in the US historical data. The SAFEMAX was later
re-framed in terms of portfolio success rates for different spending strategies,
with the idea then becoming to focus on withdrawal rates that are sufficiently
low to provide a high probability of success. With this historical data, the
rule identified by William Bengen is that for a thirty-year retirement period,
a 4 percent inflation-adjusted withdrawal rate using a 50–75 percent stock
allocation should be reasonably safe for retirees to use.

Understanding the many assumptions behind the 4 percent rule
are important, as suggested spending rates can vary dramatically by changing
assumptions. After discussing William Bengen’s work in more detail, we then investigate
the implications of the many assumptions incorporated in the classic withdrawal
rate studies. Some factors suggest that the estimates about sustainable
spending provided by traditional studies are too optimistic, such as:

·
US historical data is not sufficiently representative of what may
happen in the future

·
low interest rates and high stock market valuations jeopardize
retirement spending in ways not tested by the historical data

·
the portfolios of real-world investors – due to fees, asset
allocation choices, or investor behavior – may underperform compared to the
underlying index returns

·
moving toward income-investing approaches can increase risks

·
taxes can reduce the level of sustainable spending for a taxable
portfolio

·
there is a desire to build in a safety margin or bequest at the
end of the thirty-year time horizon

·
the retirement horizon may last longer than 30 years

However, other factors suggest
that reasonable spending levels may be higher than traditional studies imply. Possible
reasons include:

·
actual retirees may reduce their spending with age

·
retirees may build more diversified portfolios than used in the
basic research studies

·
retirees may benefit by managing downside risk with financial
derivatives

·
retirees may use bucketing or time segmentation strategies that
can help manage sequence risk

·
retirees may use a rising equity glide path instead of a fixed
asset allocation during retirement

·
retirees may have flexibility and are willing to adjust spending
for realized portfolio performance

·
some retirees may have the capacity and tolerance to accept
higher portfolio failure probabilities because they have sufficient sources of
income from outside their portfolios

·
retirees may draw on uncorrelated “buffer assets” from outside
their investment portfolio to support spending and provide relief to the
portfolio at key moments

This chapter provides the details that are an essential part
of the “probability-based” school of thought for retirement planning. This is
especially relevant for people who plan to fund their retirements using an
investment portfolio and those who are hesitant about using income annuities or
other insurance products. The discussion also matters for the safety-first
approach, since retirees will generally still seek to fund some discretionary
expenses from investments after allocating sufficient reliable income assets to
cover the basics. Ultimately, retirees face a tradeoff with investment spending
in retirement as spending more at the present means creating greater risk for
needing to reduce spending in the future. Retirees need to weigh the
consequences between spending too little and spending too much—that is, being
too frugal or running out of assets.

Origins of the 4% Rule - William Bengen’s SAFEMAX

In the early 1990s, William Bengen read misguided claims in
the popular press that average portfolio returns could guide the calculation of
sustainable retirement withdrawal rates. If stocks average 7 percent after
inflation, then plugging a 7 percent return into a spreadsheet suggests that
retirees could withdraw 7 percent each year without ever dipping into their
principal. Bengen recognized the naïveté of ignoring the real-world volatility
experienced around that 7 percent return, and he sought to determine what would
have worked historically for hypothetical retirees at different points.

For sustainable spending from an investment portfolio,
William Bengen’s work from the 1990s is the natural starting point on our
journey. William Bengen’s seminal study in the October 1994 Journal of
Financial Planning, “Determining Withdrawal Rates Using Historical Data,”
helped usher in the modern area of retirement withdrawal rate research by
codifying the importance of sequence-of-return risk. The problem he set up is
simple: a newly retired couple plans to withdraw an inflation-adjusted amount
from their savings at the end of every year for a thirty-year retirement
period. What is the highest annual sustainable percentage of retirement date
assets that can be withdrawn with inflation adjustments for a full thirty
years? For a sixty-five-year-old, this leads to a maximum planning age of
ninety-five, which Bengen felt was reasonably conservative.

To answer this question, Bengen obtained a copy of Ibbotson
Associates’ Stocks, Bonds, Bills, and Inflation yearbook, which provides
monthly data for a variety of US asset classes and inflation since January
1926. He decided to investigate using the S&P 500 index to represent the
stock market and intermediate-term government bonds to represent the bond
market.

He constructed rolling thirty-year periods from this data
(1926 through 1955, then 1927 through 1956, and so on), using a technique
called “historical simulations.” He calculated the maximum sustainable
withdrawal rate for each rolling historical period. Such an approach helps
illustrate the role of market volatility in a way that assuming a constant
portfolio return does not. Though he did not create the following illustration,
his spreadsheet calculations would have shown something like what we see in Exhibit
4.1.

Exhibit 4.1

Maximum Sustainable Withdrawal Rates

For 50/50 Asset Allocation, 30-Year Retirement,
Inflation Adjustments

Using SBBI Data, 1926–2020, S&P 500 and
Intermediate-Term Government Bonds

To bring greater realism to the discussion of safe
withdrawal rates in retirement, he focused his attention on what he later
called the “SAFEMAX”—the highest sustainable withdrawal rate for the worst-case
retirement scenario in the historical period. With a fixed 50/50 allocation for
stocks and bonds, the SAFEMAX was 4.15 percent, and it occurred for a new
hypothetical retiree in 1966 who experienced the 1966–1995 market returns.
Searching for this “worst-case scenario” puts the focus on spending conservatively.

For the following discussion, I mostly will use the same
assumptions as Bengen’s original research, with one exception: I assume
retirees make their withdrawals at the start of each year, while Bengen assumes
end-of-year withdrawals. I think withdrawals at the start of the year are more
realistic, since retirees need the funds in advance of spending them, and this
assumption causes my SAFEMAX to be 4.03 percent, compared to Bengen’s 4.15
percent.

Assume you start retirement with a $1 million portfolio; the
4.03 percent withdrawal rate means that you could withdraw $40,300 in the first
year of retirement. In each subsequent year, you could increase that spending
amount by the realized inflation rate from the previous year, and you would
have been able to sustain these distributions for at least 30 years in each
historical 30-year period of data. In all but this worst-case, you could have
spent at a higher rate, or if you did use 4.03 percent then you would have had
additional funds remaining at the end of 30 years.

The highest sustainable withdrawal rate was only a little
more than 4 percent with market returns from 1966 to 1995. This might be
surprising as that 50/50 portfolio provided a 4.7 percent average
inflation-adjusted return during those years. Accounting for volatility, the
compounded real growth rate for the portfolio in these thirty years was 4.2
percent. If the portfolio could have grown at a fixed 4.2 percent for thirty
years, someone withdrawing funds at the start of the year would have been able
to use a sustainable withdrawal rate of 5.7 percent of initial assets. The
actual withdrawal rate of 4.03 percent is quite a bit less. But why?

To be precise, a 1.3 percent fixed real return is all that
is needed to make the 4 percent rule work for 30 years. The further amplifying
effects of sequence risk on investment volatility made it seem like the
compounded return was only 1.3 percent for retirees that year, instead of the
actual 4.2 percent. Sequence risk amplified investment volatility, because the
30-year retirement could not rely on the average market return earned over the
30 years. The early part of the 1966 retirement was a tough time, with stock market
losses in 1966, 1969, and 1973–74. This early period set the course for
sustainable spending and caused spending to fall below what was implied by the
average over the whole period. The markets boomed in the second half of this
retirement period, but by then it was too late for the retiree. The portfolio
was already on an unsustainable trajectory, leading to the lowest sustainable withdrawal
rate in this historical period.

Bengen’s work pointed out that sequence-of-return risk will
reduce safe, sustainable withdrawal rates below what is implied by the average
portfolio return over retirement. Bengen showed that, historically, a 4 percent
initial withdrawal turned out to be much more realistic than higher numbers
found when ignoring market volatility. Hence, 4 percent became the guideline
for retirement withdrawals.

One other important factor from William Bengen’s original
study is asset allocation. In particular, he recommended that retirees maintain
a stock allocation of 50–75 percent, writing in his 1994 article, “I think it
is appropriate to advise the client to accept a stock allocation as close to 75
percent as possible, and in no cases less than 50 percent.”

Higher stock allocations tended to support higher withdrawal
rates, with little in the way of downside risk. The SAFEMAX does not appear to
be that much lower with higher stock allocations, though the potential for
upside with higher stock allocations is quite striking as higher sustainable
withdrawal rates are possible with all but the worst-case outcomes.

Low stock allocations resulted in lower SAFEMAXs, with an
all-bonds portfolio falling below a 2.5 percent spending rate. There is a sweet
spot between about 35 percent stocks and 80 percent stocks where higher stock
allocations have no discernable impact on the SAFEMAX. A 4 percent withdrawal
rate tended to work historically no matter what stock allocation was chosen in
this range. On the downside, retirees would have been just as well-off with 80
percent stocks as with 35 percent stocks.

Why, then, did William Bengen recommend 50–75 percent
stocks? Because when discussing outcomes other than the worst-case, the upside
potential was much greater with a higher stock allocation. Higher stock
allocations historically led to little downside spending risk, but plenty of
upside opportunity. With higher stock allocations, one could use higher
withdrawal rates and would leave more legacy at any given rate.

Another of the classic studies in the field of financial and
retirement planning is the “Trinity study,” a nickname for the article
“Retirement Spending: Choosing a Sustainable Withdrawal Rate,” by Philip L.
Cooley, Carl M. Hubbard, and Daniel T. Walz (all professors at Trinity
University in Texas). It appeared in the February 1998 issue of the Journal
of the American Association of Individual Investors. This study did help to
popularize the concept after being discussed in Scott Burns’ widely read
columns for the Dallas Morning News.

Their research followed the same methodology used by William
Bengen in his 1994 article. What was different in the Trinity study was the
shift in emphasis away from William Bengen’s SAFEMAX, or the highest withdrawal
rate possible in the worst-case scenario from history, toward the idea of
“portfolio success rates.” The Trinity study tallied up the percentage of times
that withdrawal rates fell below or above certain levels. They calculated these
portfolio success rates for different withdrawal rates, for different time
horizons, and for different asset allocations. What we can generally observe is
that success rates increase for lower withdrawal rates, shorter time horizons,
and higher stock allocations.

They also shifted from using intermediate-term government bonds
to long-term corporate bonds, which increased the bond volatility and reduced
the SAFEMAX below 4 percent in two historical periods for the 50/50 allocation
and 30-year time horizon scenario. This reduced the success rate for the 4
percent rule to 95 percent, which made it sound like the result of a Monte
Carlo simulation. Intermediate-term government bonds do provide the sweet spot
in terms of risk/return tradeoffs to support the highest worst-case withdrawal
rates.

An unfortunate side effect of the success rate redirection
is that the meaning of these portfolio success rates has been widely
misinterpreted. It meant that 4 percent worked 95 percent of the time in the
historical data, but that does not necessarily translate into saying that 4
percent has a 95 percent chance to work for newly retired individuals. It is
the latter group that people usually care about. One important issue today is
that interest rates are so low relative to history, and this is a very
important matter when assessing the viability of different withdrawal
strategies. In fact, there are numerous underlying assumptions for the 4
percent rule that may vary in their appropriateness for different retirees.

Simplifying assumptions were used in
early research, as the purpose was to provide a more realistic assessment of
sustainable spending than found when assuming a fixed average investment
return. But these studies subsequently took on a life of their own. The 4
percent rule has been widely adopted by the popular press and financial
planners as an appropriate guideline for retirees. The 4 percent rule is so
widely ingrained in the culture as a universal standard that people commonly
think it must apply to any retirement, regardless of the planning horizon. The
4 percent rule is calibrated to a thirty-year retirement. It is not necessarily
meant to apply to eighty-five-year-olds, nor can it be safely used by members
of the Financial Independence Retire Early (FIRE) community.

The basic philosophy and assumptions behind the 4 percent
rule include that the objective is to meet an overall lifestyle spending goal.
Retirees are assumed to desire smooth spending, but they also have an appetite
for market volatility. Retirees do not voluntarily reduce spending as they age
or adjust withdrawals in response to realized financial market returns.
Withdrawals are constant, inflation-adjusted amounts. Retirees earn the precise
underlying investment returns net of any fees for a fixed asset allocation with
annual portfolio rebalancing. The investment portfolio is either tax deferred
or tax free. The two financial assets are large-capitalization stocks (S&P
500) and intermediate-term US government bonds. The 4 percent rule assumes the
US historical experience is sufficiently representative of what future retirees
may expect for their own retirements.

With this approach, failure in retirement is defined as not
meeting the overall spending goal for the full assumed retirement time horizon.
The underlying objective is to keep the failure rate (the probability of depleting
investment assets) at a reasonably low level. For market risk management,
retirees use a relatively aggressive diversified portfolio focused on total
returns with spending from income and principal. For longevity risk management,
retirees assume a planning horizon sufficiently beyond life expectancy, for
instance 65-year-olds plan to live to 95. For management of spending shocks,
retirees focus on precautionary savings. As the 4 percent rule is calibrated to
be sustainable in the worst case from US history, it otherwise preserves assets
that will generally gradually become available to be deployed for contingencies
in other cases. These are a lot of assumptions. We should consider them more
carefully.

Reasons Why the 4% Rule May Be Too High

We will start with considerations about why 4 percent may be
too high as an estimate for a “safe” withdrawal rate in retirement.

The International Experience of the 4 Percent Rule

To begin, we should determine whether US historical data is
sufficiently representative to have a clear idea of forward-looking “safe”
spending rates. Classic safe withdrawal rate studies are largely based on the
Ibbotson Associates’ Stocks, Bonds, Bills, and Inflation (SBBI) data,
which outlines total returns for US financial markets since 1926. This should
be a concern for several important reasons. First, the period is too short to
develop a wide perspective of possible outcomes. Looking at thirty-year
retirements, there have only been about three independent observations since
1926.

Second, this period also coincides with the rise of the
United States as a world superpower. The twentieth century was a rather
remarkable and unparalleled era in the United States from the perspective of
any country at any point in history. The US economic engine grew and produced
extraordinarily during these years, which could give us overinflated estimates
of how high the spending rates and stock allocations can safely extend for
future retirees. Markets may behave differently in the future, so simply
extrapolating this experience is problematic.

An argument in support of the 4 percent rule is that the
post-1926 US historical period includes calamitous market events (Great
Depression, Great Stagnation of the 1970s, etc.). As such, the argument goes,
it is hard to imagine an even more dire situation awaiting future retirees. The
historical success of the 4 percent rule suggests that we can reasonably plan
for its continued success in the future.

But from a global perspective, asset returns enjoyed a
particularly favorable climate in the twentieth-century United States, and to
the extent that the United States may experience a more typical outcome in the
twenty-first century, present conceptions of safe withdrawal rates may be less
safe. Prospective retirees must consider whether they are comfortable basing
retirement decisions on the impressive but perhaps anomalous numbers found in
historical US data, or whether they should plan for something closer to the
average international experience.

My first foray into researching personal retirement planning
was a 2010 study of the sustainability of the 4 percent rule in other
developed-market countries. The study is based on a data set providing financial
market returns since 1900 for twenty developed-market countries plus
GDP-weighted world and world ex-US indexes. The data is from the
Dimson-Marsh-Staunton Global Returns Dataset provided by Ibbotson and
Morningstar.

From an international perspective,
a 4 percent withdrawal rate has been problematic. Updating that study and
focusing on a 50 percent stock allocation based on local-country stock and bond
markets, the 4 percent rule effectively survived historically only in Canada
and the United States. Even allowing for a 10 percent failure rate, 4 percent
made the cut only in Canada, the United States, New Zealand, and Denmark. In
half of the countries, the SAFEMAX fell below 3 percent. In World War II–era
Japan, the SAFEMAX was only 0.3 percent for 1937 retirees. The 4 percent rule
would have supported expenditures for only three years. Meanwhile,
hyperinflation in Austria led hypothetical retirees at the start of World War I
to only sustain a 0.1 percent withdrawal rate from their portfolios.
Shockingly, the 4 percent rule would have failed more than half of the time for
countries including Spain, Germany, France, Italy, and Austria. Italians
attempting to use the 4 percent rule in their domestic financial markets would
have faced failure in 76 percent of the historical periods (24 percent
success). Around the world, the 4 percent rule worked 68 percent of the time,
and the withdrawal would have needed to be lowered to 2.8 percent to have a 90
percent success rate aggregated across all the international data.

From the perspective of a US retiree, the question is this: will
the future provide the same asset return patterns as in the past, or should
Americans expect lower asset returns to levels more in line with the
experiences of other countries? International readers should keep in mind that
the 4 percent rule is based on US historical data. Cautious retirees will wish
to assume more conservative outcomes than what are found just with US
historical data.

The Impact of Low
Interest Rates and High Stock Market Valuations

Even if basing the spending analysis on this extraordinary
period is otherwise sensible, current market conditions still outweigh the past
events when developing sustainable spending rates. Rather than using historical
averages to define our capital market expectations, we should be thinking about
realistic assumptions based on what is possible for investors considering
present conditions. Though forecasting is hard, clues to better ground us in
the current reality can be found by looking at current interest rates and stock
market valuations.

For those presently reaching retirement, this leads to a
second concern beyond that suggested by the international data. US financial
markets have entered uncharted waters now regarding the low bond yields and
high stock market valuations facing investors.

Classic safe withdrawal rate studies investigate sustainable
withdrawal rates from rolling periods of the historical data, giving us an idea
of what would have worked in the past. For a thirty-year retirement period, we
can learn about the historical sustainable withdrawal rates beginning up to
thirty years ago (i.e., 1991). The question remains whether those past outcomes
provide reasonable expectations for the future.

This is worth repeating, as it is important to remember and
easy to forget. When looking at thirty-year retirements with historical
simulations, we can only consider retirements beginning up to 1991. This is
what we observed in Exhibit 4.1. With sequence-of-return risk, recent market
conditions only show up at the end of these retirements and have little bearing
on their outcomes. This matter extends beyond academic interest, as market
conditions have witnessed historical extremes in recent years, in terms of both
low interest rates and high stock market valuations.

The general problem with attempting to gain insights from
historical outcomes is that future market returns and withdrawal rate outcomes
are connected to the current values of market return sources. Future stock
returns depend on dividend income, growth of underlying earnings, and changes
in valuation multiples placed on earnings. If the current dividend yield is
below its historical average, then future stock returns will also tend to be
lower. When price-earnings multiples are high, markets tend to exhibit mean
reversion, so relatively lower future returns should be expected.

Returns on bonds, meanwhile, depend on the initial bond
yield and subsequent yield changes. Mathematically, if interest rates stay the same,
then current interest rates will reflect the subsequent return on bonds. Low
bond yields will tend to translate into lower returns due to less income and
the heightened interest rate risk associated with capital losses if interest
rates rise. This relationship is very tight. The early 1940s was the only other
period where ten-year Treasuries fell to the 2 percent range. Rates are even
lower now, and such low rates have not been tested by Bengen’s historical
simulations methodology.

Sustainable withdrawal rates are intricately related to the
returns provided by the underlying investment portfolio. With sequence-of-return
risk, the returns experienced in early retirement will weigh disproportionately
on the retirement outcome. Current market conditions are much more relevant
than historical averages.

This is a matter where Monte Carlo simulations shine, by
allowing simulations to begin from today’s starting point rather than
incorporating historical outcomes generated from completely different market
environments. We can consider an example about the sustainability of the 4
percent rule for different underlying assumptions about market returns.

We can use Monte Carlo simulations with the low interest rate
world of today as a starting point for the simulations. We will not make any
additional adjustments to reflect the high stock market valuation level, but we
will preserve the historical equity premium that stocks have earned above
bonds. So, when bond yields are low, stock returns must be less as well, as
there is no reason to believe that stocks would offer even higher premiums
above bonds than they have done in the past.

Exhibit 4.2 provides a way to compare the success rates for
the 4 percent rule using Monte Carlo simulations that reduce bond yields at the
start of retirement. This is compared with simulations calibrated to historical
averages, as well as with the results of rolling period historical simulations.
The simulations that start from lower yields reduce the average stock and bond
returns by 3.4 percent to center the average real bond return for intermediate-term government bonds at -1 percent.
This is a more appropriate real bond return for retirements beginning in 2021. This
exhibit makes clear that the low interest rate environment creates additional
stresses for the 4 percent rule that were not apparent in Monte Carlo simulations
calibrated to historical data with higher bond yield assumptions than are
available today. For a 50/50 asset allocation to stocks and bonds, these
simulations indicate that the 4 percent rule worked 100 percent of the time in
historical simulations, 97 percent of the time in randomized Monte Carlo
simulations based on the historical data, and 56 percent of the time in
simulations based on the lower average stock and bond returns. The 4 percent
rule may work for today’s retirees, but it is far from a sure bet or a “safe”
spending strategy. In fact, the likelihood of success is much closer to the
results of a coin flip.

With lower stock allocations, the 4 percent rule is even less
likely to work, because it places demands on spending above what today’s interest
rate environment can easily support. It is wishful thinking to believe that
bonds can earn higher rates of return than implied by today’s low interest rate
environment. Success is also less for higher stock allocations because of the
assumption that the historical risk premium is maintained on top of a lower
bond yield.

Exhibit 4.2

Portfolio Success Rates for a 4% Withdrawal Rate

Rolling vs. Monte Carlo Simulations

For a 30-Year Retirement, Inflations Adjustments

This exercise about looking at the impacts of interest rates
illustrates that assumptions about future returns matter a great deal. Arbitrarily
basing Monte Carlo simulations on historical averages, as many retirement
planning calculators do, may lead to overly optimistic results. Unfortunately,
this is a detail that is not widely understood to this day.

Do Retirees Earn
Underlying Market Index Returns?

Another optimistic assumption of classic safe withdrawal
rate studies is the assumption that retirees can precisely earn the underlying index
returns on their investment portfolios. Three factors dispute that idea. First,
expenses may reduce returns below the benchmark levels. Second, many
investors may make behavioral and timing mistakes of buying high and selling
low. Third, actively-managed funds do not precisely match the underlying
benchmarks. As such, many investors will experience investment returns
that lag the annually rebalanced and indexed portfolios enjoyed by the
hypothetical retiree used in the safe withdrawal rate studies. It is important
to consider the impact of account underperformance relative to benchmarks.

Consider if investors underperform the market index by 1
percent per year. With the index returns, a 1966 retiree could sustain
withdrawals over thirty years using a 4.03 percent withdrawal rate. With 1
percent underperformance, the SAFEMAX fell by 0.47 percentage points to 3.56
percent. From the perspective of the SAFEMAX, 1 percent underperformance would
have resulted in reduced potential spending power of 11.9 percent. Across the
historical period, underperformance caused the maximum sustainable withdrawal
rates to fall on average by 0.65 percentage points, or 10.9 percent of spending
power.

Despite common misconceptions, a one-to-one trade-off
between underperformance and withdrawal rates does not exist. As the portfolio
decreases in size, underperformance impacts a smaller amount of wealth, while
real withdrawal amounts for retirement spending do not change. This explains
why the 4 percent rule did not become the 3 percent rule in response to the
underperformance. Nevertheless, the potential to underperform indexed market
returns does have an important impact on the sustainability of the 4 percent
rule.

It is important to emphasize that this 1 percent underperformance
should not necessarily be viewed as fund management or financial advisory fees.
Doing that would confuse the reality that most investors, on their own, would
not be able to earn the underlying benchmark index returns. Evidence on
investor behavior suggests that investor returns trail behind overall market
performance even net of investment costs. This broader impact can be ascribed to
investor behavior and the tendency to buy high and sell low, as well as to use
active funds that trade more and underperform relative to the market indices.

Should Retirees Use a
Total-Return Investment Portfolio?

Total-return investing focuses on building diversified
portfolios from stocks and bonds to seek greater long-term investment growth.
By focusing on total return, the objective over the long run is to produce a
greater and steadier amount of income relative to what could be obtained by
investing for income by focusing solely on interest and dividends to support
spending without the need for principal drawdown.

Nonetheless, investing for income is quite popular in
practice. Many do-it-yourself retirees and advisors recommend investing for
income in retirement, shifting away from a total-return perspective. Such
methods have yet to receive much academic scrutiny, as it is difficult to
obtain good data on historical returns for portfolios that tilt toward higher-yielding
subsectors of the market.

Colleen Jaconetti, a senior investment analyst at Vanguard,
has taken care to discuss the issues and pitfalls that come with investing for
income. She explains that a retirement income strategy can be based on one of
two things: total return or income. In some cases, these strategies are the
same. If your asset allocation is designed from a total-return perspective and
you can live off the income provided by the portfolio and other income sources
from outside the portfolio (e.g., Social Security), then everything is fine.

The problem is what to do when the total-return portfolio
does not generate the desired income, as may be common when dividend yields and
interest rates are low. In such a situation, a total-return perspective would
have you maintain your strategic asset allocation while consuming your
principal or adjusting to lower spending. With an income perspective, the last
thing you want to do is consume your principal, so you would instead rearrange
your investments to provide enough income, so you do not have to sell any
assets to meet spending needs. In other words, you chase higher yields than a total
market portfolio that is weighted by the market capitalization of all
investment offerings. Often this means either shifting to higher-yielding
dividend stocks or to bond holdings offering either greater maturity or
increased credit risk.

Shifting away from a total market portfolio comes with risk.
For higher dividend stocks, the investment portfolio becomes less diversified
relative to the total stock market. Dividend-based approaches tend to
overweight value stocks relative to the broad market. Portfolios become more
concentrated as the top ten holdings in a dividend fund take up a higher
percentage of the total fund. It is also important to remember that dividend
stocks are not bonds, and the value of these assets is highly correlated with
the stock market. A stock downturn can decimate the portfolio value of dividend
stocks.

Also, the misconception persists that higher dividends
result in higher returns. In fact, the value of the portfolio drops by the
amount of the dividend. Total wealth is not affected by a dividend payment. It
may be worse, as the dividend may be taxed at a higher income tax rate rather
than the long-term capital gains rate, if it is not a qualified dividend. This
would diminish after-tax returns. Higher-yielding dividend stocks have
historically provided about the same total return as lower dividend stocks
before considering taxes.

As for higher-yielding bonds, the idea is to shift toward
longer maturity bonds or bonds with greater credit risk. First, switching to
higher-yielding, longer-term bonds leaves investors more exposed to capital
losses if interest rates increase. Long-term bond prices are more volatile.
With current low yields, a small increase in interest rates will result in
capital losses that cancel out any higher interest income. As for higher-yielding
corporate bonds, this leaves investors more exposed to default risk; when the
stock market drops, corporate bond prices tend to do the same, as increased
default risk works its way into higher interest rates. This credit risk must be
considered alongside any potential for increased yields.

By reaching for yield, investors trade higher current income
for a greater risk to future income. This risk must be accepted when moving
away from a total-return portfolio. Despite the popular belief, investing for
income is not necessarily superior to the total portfolio returns approach that
backs the 4 percent rule.

Is Any of the
Retirement Portfolio in a Taxable Account?

Most research on sustainable spending rates assumes spending
is either from a tax-free account such as a Roth IRA or a tax-deferred account
such as a traditional IRA. In the latter case, spending is assumed to be gross
of taxes, as any taxes due must be paid from the distributions.

For a taxable account, sustainable spending rates would be
negatively impacted by the need to pay ongoing taxes for interest, dividends,
any capital gains distributions from mutual funds, and realized net capital
gains when assets are sold or rebalanced. These taxes reduce the potential for
compounding growth. Because the tax situations of individuals will vary so
greatly in terms of tax rates, interest and dividends supported by the
portfolio, and the cost basis of the taxable account, it is impossible to
create one general number for a sustainable spending rate from a taxable
account. This is an area, though, where William Bengen has extended his
research to provide some guidance.

In his 2006 book on sustainable spending rates, Conserving
Client Portfolios during Retirement, William Bengen attempted to estimate
the impact of taxes on spending. He estimated that increasing the marginal
income tax rate by 25 percent would approximate the impact of capital gains
taxes. For instance, someone in a 25 percent tax bracket could estimate the
impact of taxes using a 31.25 percent tax rate to approximate the total income
tax liability.

Based on his historical SAFEMAX of 4.15 percent, Bengen
provides comparisons for different effective tax rates. For a 20 percent
effective tax rate (implying a marginal income tax rate of 16 percent), Bengen
estimates that the SAFEMAX fell from 4.15 percent to 3.67 percent (a 12 percent
decrease in spending power). If the effective tax rate is 35 percent, the
SAFEMAX drops to 3.38 percent. With a 45 percent effective tax rate, the
SAFEMAX is 3.2 percent. As tax rates increase, the stock allocation required to
maximize spending increases as well. That 3.2 percent SAFEMAX number, for
instance, requires a 90 percent stock allocation. One final point is that these
new withdrawal rate numbers represent numbers net of taxes. Meanwhile, for a
tax-deferred account, a SAFEMAX of 4.15 percent with a 25 percent tax rate
would reduce the net spending rate to 3.11 percent.

While I cannot provide generalized numbers to show the
impact of ongoing taxes on sustainable spending, basic estimates show that the
impact can be substantial. Ultimately, the way to manage this tax issue is not
necessarily to determine its impact on a sustainable withdrawal rate, but to
test the circumstances of one’s spending plan with a more complete model that
accounts for the different tax treatment between different types of assets.
Chapter 10 provides a focus on tax-planning for greater efficiency with
retirement distributions.

Is the Retiree Willing
to Plan for Complete Portfolio Depletion?

Traditional safe withdrawal rate research regularly assumes
that retirees will choose a withdrawal rate that leaves nothing behind at the
end of the retirement period. Retirees cling to inflation-adjusted withdrawal
amounts, which leaves them playing a game of chicken as their wealth plummets
toward zero. In addition, these hypothetical retirees do not make any
adjustments for the fact that as their final planned year of retirement
approaches, they are increasingly likely to live longer than their planning
age. This also means that retirees have no desire to leave a legacy from their
investments. The objective of the classical studies is to get a handle on the
maximum sustainable withdrawal rate from a portfolio of volatile assets over a
thirty-year retirement period without worrying about whether anything will
still be left at the end. When we talk about using a safe withdrawal rate, we
are describing a situation in which remaining wealth is potentially allowed to
fall to zero.

The safe withdrawal rate approach is meant to typically
provide leftover funds at the end of the time horizon when not in a worst-case
scenario. But the analysis will be different if we specifically incorporate a
desire that the worst cases still preserve some assets at the end of the time
horizon either as a safety margin or for legacy.

Consider spending rates to maintain the nominal value
of retirement date wealth at the end of the thirtieth year or maintaining the
real value of retirement date wealth at the end of the thirtieth year. The
value of wealth may decline and rebound in the interim, as I am only checking
the value of wealth after the thirtieth year. With our baseline assumptions for
a 50/50 portfolio, the classical wealth depletion assumption leads to the
worst-case scenario withdrawal rate of 4.03 percent. Switching to an objective
to preserve nominal wealth after thirty years, the SAFEMAX falls to 3.77
percent. The 4 percent rule would have been too aggressive to preserve nominal
wealth at four historical starting points. When people say they want to
preserve the value of their wealth, they are probably implicitly thinking in
terms of preserving the real purchasing power of their wealth, even if they do
not articulate it as such. People tend to suffer from “money illusion,” in
which they think in terms of nominal dollars when they really mean to consider
the real purchasing power of dollars. The 4 percent withdrawal rate preserves
the real purchasing power of initial wealth in about half of the historical
simulations, but the SAFEMAX is only 2.72 percent for a retiree seeking to
preserve the real value of their retirement date wealth in the worst-case. Any
strategy that builds in an additional safety-margin for wealth will experience
lower sustainable spending rates than if investment wealth may fall to zero.

What if Retirement
Lasts Longer Than 30 Years?

The 4 percent rule is based on a planning horizon of thirty
years. In 1994, Bill Bengen considered thirty years to be a reasonable planning
horizon for sixty-five-year-old couples, resulting in a planning age of
ninety-five. As discussed, the method for self-managing longevity risk is to
select a horizon you are unlikely to outlive and then developing a plan which
works that long. The horizon should be greater than life expectancy, as
retirees have a 50 percent chance of living beyond the average. The
conservative approach is to plan for a longer horizon and spend less so the
money lasts.

Many people use different planning ages, such as 90 or 100.
Those who are either younger or older than sixty-five may need to plan for more
or less than thirty years. Even sixty-five-year-olds may wish to plan for
different retirement durations depending on how conservative they wish to be
and how fearful they are of outliving their investment portfolio. A
sixty-five-year-old planning to live to 100 or 105 would need to plan for a
thirty-five or forty-year horizon. For healthy individuals in their sixties, we
are approaching the point where forty years must replace thirty years as a
conservative planning horizon. A longer horizon means spending less to sustain
the available resources.

If the retirement is longer than thirty years, the SAFEMAX
declines, but at a decreasing rate. The historical SAFEMAX for forty years
reduces to 3.72 percent, compared to 4.03 percent for thirty years. With US
historical data, an approximation that develops about the historical SAFEMAXs
for a 50/50 portfolio as they relate to the time horizon is that the SAFEMAX is
about 8 percent for ten-year horizons, 6 percent for fifteen years, 5 percent
for twenty years, 4 percent for thirty years, with a further reduction in the
direction of 3.5 percent as the time horizon progresses toward an indefinite
future. Longer time horizons will guide optimal retirement income solutions
toward lower withdrawal rates, higher stock allocations, and a stronger case
for guaranteed income retirement products.

Reasons Why the 4% Rule May Be Too Low

While we have covered issues that could lead to a lower
sustainable spending rate from a diversified investment portfolio, there are
other reasons to instead consider an even higher spending rate as we modify other
assumptions regarding the 4 percent rule.

What Are Reasonable
Spending Patterns for Retirees?

An important simplifying assumption in William Bengen’s
research is that retirees spend constant inflation-adjusted amounts throughout
retirement. Their budget at the start of retirement always grows precisely for
inflation. This behavior may be at odds with the actual spending patterns of
many retirees. An exploration of the data should give us an idea of how people
change their spending during retirement.

A well-known early example of spending changes over time for
retirees can be found in Michael Stein’s 1998 book, The Prosperous
Retirement: Guide to the New Reality. Stein says retirement happens in
three phases, popularly known as the Go-Go, Slow-Go, and No-Go years of
retirement. He found retirement spending to be greatest in the early active
phase of retirement through age seventy-five. In these Go-Go years,
discretionary expenses for things such as travel and restaurants are high, and
retirement spending tends to keep pace with inflation. Between the ages of
seventy-five and eighty-five, retirees enter a transition phase (Slow-Go) in
which they become less active and reduce discretionary expenditures. Spending
no longer keeps pace with inflation and may even decline on a nominal basis.
Finally, after age eighty-five, retirees enter the No-Go years, which are
signified by a much more modest spending budget whose growth will generally
also trail consumer price inflation.

A more recent contribution to the retirement spending debate
is David Blanchett’s work on the “retirement spending smile.” He notes that spending
tends to decrease both at and during retirement. While this again reflects the
average outcome, Blanchett’s data set provides some ability to follow the same
households over time throughout retirement. He uses real household survey data
to track the inflation-adjusted spending for retired households. Blanchett
observes a “retirement spending smile” that varies slightly for retirees with
different household spending levels. From age 65, a retiree might find that
their real expenditures decline by as much as 26 percent by age eighty-four.
After this point, average real expenditures increase, though they do not
necessarily exceed their initial retirement levels until retirees reach their
mid-nineties.

Blanchett observes that the spending smile reflects the same
types of outcomes we have described thus far. At the start of retirement,
retirees spend more as they enjoy traveling, eating out, and other types of
discretionary expenses. As they continue to age, retirees tend to slow down and
spend less. However, while discretionary expenses are declining, health costs
tend to rise, and later in retirement these rising health costs offset
reductions in other spending categories. Exhibit 4.3 provides a further
illustration of this process.

Exhibit 4.3

Understanding the Path of Real Retirement Spending
by Age

The assumption of constant inflation-adjusted spending,
according to Blanchett, will lead individuals to over save for retirement. The
easiest way to understand this is to simply explore historical sustainable
spending rates for different retirement spending patterns. As seen earlier, for
a thirty-year retirement and 50/50 portfolio, 4.03 percent represents the
historical worst-case sustainable spending rate. With the spending smile, the
initial spending rate can increase to account for subsequent spending declines.
In this case, I use Blanchett’s spending patterns to estimate the worst-case
initial spending rate as rising to 4.73 percent. For retirees basing their
spending on these historical worst-case numbers, the retirement smile pattern
would allow retirement to begin with almost 15 percent less accumulated wealth
than otherwise on account of this higher sustainable withdrawal rate. This
makes clear that retirement spending patterns are an important component of
deciding on a sustainable spending rate. Constant inflation-adjusted spending
is a simplifying and conservative assumption.

To decide on the right assumption between constant
inflation-adjusted spending, decreased spending, or a retirement spending smile,
the best approach will be to study the components of your spending during the
budgeting process and do as best as possible to project how these expenses may
change over time. One can err to the side of caution to assume that future
expenditures will not drop by too much. Spending may decline, so I would not
fault anyone for using assumptions of gradual real spending declines such as 10
percent or even 20 percent over the course of retirement. One may also assume a
spending decrease but then add more to the spending shocks and contingencies to
offset the risk that spending does not decline by as much as anticipated.
Ultimately, I would avoid moving too far in the reduced spending direction as a
baseline assumption. Though the inflation-adjusted withdrawal assumption could
be improved, it builds in reasonable conservatism and may not be too far off
for many retirees, even if the average retiree experience suggests
otherwise.

Can Retirees Benefit from a More Broadly
Diversified Portfolio?

Safe withdrawal rates are connected in vitally important
ways to underlying asset class choices and their return/volatility
characteristics. William Bengen’s original research used large-capitalization
US stocks and intermediate-term government bonds. Limiting the matter to two
basic asset classes may underestimate the potential spending for a more
diversified portfolio. Bengen even had ultimately concluded that with a more
diversified portfolio including a disproportionate amount of
small-capitalization stocks, 4.5 percent was a more reasonable SAFEMAX.

Expanding asset class choices can support a higher
sustainable spending rate. A more diversified portfolio can adjust the risk and
return tradeoffs. Even if the expected portfolio return does not increase, the
sustainable withdrawal rate could be increased if portfolio volatility is less.

In my article, “Capital Market
Expectations, Asset Allocation, and Safe Withdrawal Rates,” from the January
2012 Journal of Financial Planning, I provide a framework for connecting
portfolio returns and volatilities to identify sustainable spending rates more
broadly. My article proposed a general framework for determining a safe
withdrawal rate for a given retirement duration, acceptable failure
probability, asset allocation, and capital market expectations. I used Monte
Carlo simulations to calculate the combinations of real portfolio arithmetic
returns and volatilities that would support different withdrawal rates for
various retirement durations and acceptable failure probabilities. This can
quantify the specific impacts on the “safe withdrawal rate” as the portfolio
returns and volatilities adjust for different assumptions about the asset
classes used as well as their characteristics. More generally, this is what is
happening behind the scenes when one is calculating the sustainability of a
specific retirement plan using software with a specific set of capital market
assumptions and portfolio asset allocation. You will see this effect in terms
of how changing portfolio returns and volatilities will impact the probability
of success for the plan.

Of course, formulating appropriate capital market
expectations is hard. Volatility especially complicates the process. A common
view is that future stock returns will be lower than historical averages, but
what about stock volatility? Would lower stock returns be accompanied by lower
volatility, or is it reasonable to keep volatility the same? Might we even
expect volatility to increase? Pinpointing the precise combination of expected
returns and volatility is important for testing portfolio sustainability. The
point of all this is to recognize that assumptions made about asset class
characteristics is important in determining a spending rate, and that broader
diversification can improve spending by reducing volatility even if returns do
not increase.

The Use of Financial
Derivatives

Related to the idea of a more diversified asset allocation,
another approach that could potentially support a higher withdrawal rate is to
change the downside and upside characteristics of portfolio returns with
financial derivatives that sacrifice some of the potential upside growth by
placing a floor on downside risk. Depending on the mix of changes to upside and
downside, a higher sustainable spending rate is conceivable. Protecting from
downside losses in the early retirement years will help to manage sequence-of-return
risk, such that losing some exposure to upside growth can be justified. This is
an area which has not been well studied, as whether outcomes are improved depend
on whether the reduced downside losses create more overall benefits than the
costs of missing some upside. This is an area in which we may see more
developments in the future as ETFs are being developed to provide structured
returns along these lines, and as the popularity of fixed indexed annuities and
other structured annuities grow.

Can a Bucketing or Time Segmentation Approach
Help?

For standard investment approaches, bonds are generally
treated as a diversifying asset class that can help to reduce portfolio
volatility. The standard accumulation investing philosophy does not consider
how the nature of risk changes upon retirement. In short, it uses modern
portfolio theory to choose an asset allocation strategy that includes bonds as
part of a total-return investment portfolio. Bonds, with their lower expected
returns and volatility, offer a way to reduce the portfolio’s volatility to an
acceptable level while still maintaining a sufficient return.

This approach to using bonds has been challenged by advocates
of bucketing or time segmentation. The Financial Planning Association divides retirement
income strategies into three categories:
systematic withdrawals, time-based segmentation, and
essential-versus-discretionary income. We also made this distinction with the
RISA Matrix described in Chapter 1, in which those with probability-based and
optionality preferences point toward total-return investing approaches, while
those with safety-first and optionality preferences may consider bucketing and
time segmentation approaches.

The defining characteristic
of systematic withdrawal strategies is that rules are used to take
distributions in a systematic manner from an investment portfolio designed with
a total-return perspective spending consistently from both stocks and bonds. Time
segmentation differs from systematic withdrawals in that fixed-income assets
are held to maturity to guarantee upcoming retiree expenses over the short and
medium term. A growth portfolio is also built with more volatile assets having
higher expected returns, to be deployed to cover expenses in the more distant
future. Assets are dedicated to the
purpose they are best suited for: bonds generate predictable cash flows through
their contractual protections, and stocks provide less predictability but more
growth potential when left alone to perform. With the emphasis on optionality, those with a preference for time segmentation shy away
from the lifetime commitments of annuities. Time segmentation simply
involves investing differently for retirement spending goals falling at
different points in retirement.

A retirement income bond ladder is the natural starting
point for building a retirement income strategy. It can neutralize
market-related risks for the retirement income plan by holding bonds to
maturity, though it still exposes the retiree to longevity risk, as it is
possible to outlive the end-date chosen for the bond ladder. If one seeks to
spend more than the bond yield curve can support for a given ladder length, the
two options are to seek a risk premium through stock market investments, or to
pool longevity risk through insurance products. Time segmentation is
comfortable with stocks, but it seeks risk management by having a time horizon
built in for which stocks do not need to be sold so they will hopefully then have
time to recover from any downturn.

In this regard, a selling
point for time segmentation is that it avoids short-term sequence-of-return
risk, as the volatile growth assets will not need to be sold immediately after
a market drop to support retirement spending. The retiree can wait for markets
to recover before selling stocks to extend the bond ladder. A retirement
income ladder will naturally wind down if other assets from outside the ladder
are not used to extend it further as time passes. That means assets must be
sold at some point, and that means sequence risk may remain. But those
comfortable with this strategy believe that this risk is quite limited because
the windows created will provide the opportunity for growth with the long-term
assets before they ever need to be sold. Its
advocates are confident that sufficient upside growth will take place before
growth assets need to be sold to support spending. Sequence risk only
materializes when assets must be sold at a loss to support spending. Whether
time segmentation can avoid sequence risk becomes the key to determining
whether bucketing approaches might help to improve retirement outcomes relative
to a total-return investing approach aside from any behavioral benefits the
strategy can provide.

This becomes the primary question about time segmentation:
is it a superior way for retirees to invest because it better manages sequence-of-return
risk and can therefore support a higher spending rate? What
I have found in simulating time segmentation strategies is that any claim that it
can increase retirement spending must relate to the utilization of strategies
that can increase the stock allocation when markets are going down. Then, the
ability to invest more aggressively in market downturn leads to the improved
outcome. The mechanism available to shift
toward an increasing stock allocation is to simply avoid extending the bond ladder
over time; maturing bonds are spent and are not replaced. If this is done when
the portfolio looks to be in trouble, then time segmentation may help relative
to a total-return portfolio with a fixed asset allocation through the ability
to take on more risk.

But advocates of time
segmentation may also argue that even if it is not a better pure investing
strategy, it can at least lead to better retiree behavior because it is more
easily understood. Time segmentation can be more intuitive than the blender
approach of the total-return portfolio. People understand that certain assets
are to be used for different time horizons in retirement. It is a form of
mental accounting. When retirees instead have a front-end bond ladder, they
know there is time for stocks to recover before they need to be sold. This
provides the courage to leave stocks alone and focus on a more long-term
investing approach. The approach is simple and clear to explain and understand.

In the end, appeals to time segmentation should be based as
strongly on the behavioral aspects of the strategy as on its performance. For
retirees who may struggle to stay the course with a total-return investing
approach, the appealing logic of time segmentation could help them maintain
better investment discipline in retirement. While time segmentation by itself
may not provide a superior investing strategy when compared to a total-return
approach with matching dynamic asset allocation, it is a viable strategy
deserving of its place in the retirement income toolkit. Retirees must
understand, however, that its implementation will mean dynamic asset
allocations and adherence to a clear rule regarding when to extend the bond
ladder during retirement. Time segmentation cannot generally be used to justify
an increased withdrawal rate.

How Does a Rising Equity Glide Path Work?

Returning to total-return investing, a common assumption for
withdrawal rate studies is that the asset allocation remains fixed throughout
retirement and is rebalanced to the targeted allocation every year. Retirees
may not maintain the same fixed asset allocation throughout their retirements for
reasons separate from the time segmentation approach just discussed. Nevertheless,
this discussion follows the time segmentation discussion as the strategies that
I have found to work best in time segmentation will tend to mirror the idea of
using a rising equity glide path throughout retirement.

Changing asset allocation over retirement within the context
of a total-return investment portfolio can be understood as an attempt to
reduce portfolio volatility at key points in retirement to decrease the retiree’s
exposure to sequence-of-return risk. Even if the average market return is
decent, retirees are especially vulnerable to the impact of bad market returns
in early retirement. Sequence risk is uniquely caused by the attempt to spend a
constant amount each year from a volatile investment portfolio. Sequence risk
can be dampened by either letting spending fluctuate or reducing portfolio
volatility.

For reducing volatility, outside of just using a low-equity
allocation throughout retirement (which comes with its own sets of risks in
terms of being unable to support a spending goal beyond the bond yield curve), the
rising equity glide path concept reduces volatility when most
exposed to absolute wealth losses.

Rising equity glide paths for retirement aim to reduce
portfolio volatility in the pivotal years near retirement when a retiree is
most vulnerable to losing the most dollars of wealth with a given market drop.
People are most vulnerable and have the most at stake when their wealth is
largest, which generally happens around retirement. The suggested lifetime
stock allocation path thus becomes U-shaped: stock holdings are higher when
young, at their lowest around the retirement date, and higher again later in
retirement. Exhibit 4.4 illustrates this general pattern.

Exhibit 4.4

Stylized Lifetime Stock Allocation Glide Path with
a Rising Equity Glide Path in Retirement

The idea of a rising equity glide path in retirement is
counterintuitive, as conventional wisdom says that stock allocation should
decline with age. But the rising equity glide path is intended to be treated as
a risk management technique in retirement. It may help support spending and
wealth in retirement at times when retirement goals may be most at risk.

To understand the concept of rising equity glide paths, it
is worthwhile to consider four general economic environments retirees may face.
First, financial markets may do well throughout the entire retirement period.
In this case, retirement should be successful regardless of asset allocation
strategy, though more aggressive strategies will support a larger legacy. Next,
the entire retirement may be confronted by poor market returns. In this case,
no allocation strategy can save retirement. A rising stock allocation would at
least fare better than a more aggressive asset allocation throughout. Third,
financial markets may perform well in early retirement but poorly later in
retirement. In this case, sequence risk will not manifest, and the sustainable
withdrawal rate will be high. Rising equity glide paths will work, but they may
leave less legacy than otherwise. Finally, the rising stock glide path excels
in scenarios that have historically led to the worst outcomes for retirees.
That is, markets fare poorly early in retirement and then recover later in
retirement. These scenarios have created the lowest withdrawal rates for past
retirees, and this is where a rising equity glide path can support improved
retirement outcomes.

While the rising equity glide path idea is intended as a
risk management technique, there are obvious real-world implications that may
limit its usefulness. Primarily, it may be that as people age, it becomes
increasingly difficult to stay the course in response to market volatility, and
retirees who have experienced a period in early retirement where they dealt
with less volatility may not be prepared to deal with volatility again late in
life. Perhaps the best implication from research along these lines is to at
least not think about continuing to reduce stock allocations throughout
retirement, and that it may be okay to start retirement with a lower stock
allocation than the traditional withdrawal rate studies suggest.

As well, when thinking about the entire retirement balance
sheet, retirees may be using a rising equity glide path without even realizing
it. If we think of Social Security, pensions, and annuities as bond-like assets
whose remaining value declines with age, those who maintain a fixed asset
allocation in their portfolios and who to do not experience the sequence risk
that causes rapid portfolio decline may experience an increase in their
allocation to stocks as their retirement progresses.

What if Retirees are Flexible About Their
Spending?

William Bengen’s 1994 article introduced the concept of the
4 percent rule for retirement withdrawals. He defined the sustainable spending
rate as the percentage of retirement date assets that can be withdrawn, with
this spending amount adjusted for inflation in subsequent years. In this scenario,
the retirement portfolio will not deplete for at least thirty years with an
allocation of at least 50 percent to stocks. Bengen’s rule says to adjust
spending annually for inflation and maintain constant inflation-adjusted
spending until the portfolio depletes. Annual spending increases by the
previous year’s inflation rate. Spending does not respond at all to portfolio
investment performance in retirement.

While this assumption may reflect the preferences of
many retirees to smooth their spending as much as possible, real-world
individuals will inevitably adjust their spending over time in response to performance
of their portfolio. Cuts will be made if the markets are down. Retirees will
not generally play the implied game of chicken by keeping their real spending
constant as their portfolios plummet toward zero. It is an unrealistic
assumption.

Being flexible with spending matters a great deal. Constant
spending from a volatile portfolio is a unique source of sequence-of-return
risk that can be partially alleviated by reducing spending when the portfolio
drops in value. Traditional safety-first advocates would argue that the Bengen
strategy is inherently flawed—those seeking constant spending should use a less
volatile retirement portfolio, and those who accept portfolio volatility should
also accept spending volatility.

Thus, an important mechanism for managing sequence risk is
to allow spending to fluctuate over time. Reducing spending in the event of a market
decline provides a release valve for sequence-of-return risk that can allow the
initial withdrawal rate to increase. This is because the current withdrawal
rate does not have to be increased by as much when the portfolio loses value. This
allows for less shares to be sold at a loss and more assets to remain available
in the investment portfolio to experience any subsequent market recovery. Managing
sequence-of-return risk in this manner allows synergies to develop, making it
possible to keep spending at a higher average level than a constant inflation-adjusted
strategy without any flexibility, while maintaining the same overall risk for
portfolio depletion. With spending flexibility, the initial withdrawal rate can
increase by more than one might think on account of these synergies created
through decreasing sequence risk. As such, estimates obtained with a constant
inflation-adjusted spending assumption may be overly conservative for those
willing and able to adjust their spending later.

While the constant inflation-adjusted spending strategy
provides a useful benchmark and baseline for analyzing sustainable retirement
spending strategies, it should probably not be viewed as a realistic or
reasonable retirement income strategy. Efficient retirement strategies must
adjust spending at least somewhat for portfolio volatility. The question then
becomes how and when to make these adjustments.

On the spectrum of spending strategies, the fixed-percentage
withdrawal strategy is the opposite of constant inflation-adjusted spending. The
fixed-percentage strategy calls for retirees to spend a constant percentage of
the remaining portfolio balance in each year of retirement. Occasionally the
popular press will mistakenly define the 4 percent rule this way (a 4 percent
fixed percentage strategy calls for withdrawing 4 percent of the remaining
account balance each year), but the accepted definition of the 4 percent rule
is the constant inflation-adjustment spending strategy described earlier. To be
clear, with constant inflation-adjusted spending, the withdrawal rate will
change throughout retirement as the portfolio value changes. The withdrawal
rate adjusts, while spending stays the same. But with the fixed-percentage
rule, the withdrawal rate stays the same, while spending adjusts.

An advantage of the fixed-percentage strategy is that, since
it always spends a percentage of what remains, it never depletes the
portfolio. Of course, spending could fall to uncomfortably low levels, but the
concept of portfolio failure rates is inapplicable here. In addition, spending
increases when market returns outpace the spending rate, and the portfolio
grows. As well, this strategy eliminates sequence-of-return risk, as late and
great Dirk Cotton first pointed out in 2013 at his Retirement Café blog. The
fixed-percentage approach provides a clear mechanism for reducing spending
after a portfolio decline. As with investing a lump sum of assets, the specific
order of returns makes no difference to the final outcomes realized with this
strategy. As such, we can expect the sustainable spending rate to be higher
than with constant inflation-adjusted withdrawals.

As for disadvantages, when combined with volatile
investments, spending can become extremely volatile with this strategy, making
it difficult for retirees to budget for the future. For a fixed retirement
budget, managing retirement with this rule could be a challenge. Those
considering this rule should probably be thinking in terms of applying it to
discretionary expenses that allow more flexibility for spending reductions that
will not derail a retiree’s standard of living.

With these advantages and limitations in mind, it is
important to remember that the fixed percentage rule is the opposite extreme
from constant spending. Most practical approaches to flexible retirement
spending seek to balance the trade-offs between reduced sequence risk and
increased spending volatility by only partially linking spending to portfolio
performance.  Variable spending strategies tend to seek a compromise between
holding spending steady to avoid fluctuations in lifestyle and varying spending
enough to adequately protect from the risk of portfolio depletion. Compromise
strategies provide a mechanism to smooth spending adjustments made in response
to market volatility. Many strategies seek to obtain some advantages of the
fixed-percentage rule, while also reducing the frequency and size of spending
adjustments and placing bounds on how far spending can increase or decrease.

For example, William Bengen has also described
floor-and-ceiling withdrawals as one such spending compromise. This method
begins by applying the fixed percentage rule, which allows greater spending
when markets do well, and which forces spending reductions when markets do
poorly. Bengen also adds hard dollar ceilings and floors on spending. Spending
is not allowed to fluctuate outside of a specified range. So, the
fixed-percentage rule is applied when spending falls inside the bands and a
constant amount strategy is applied at the ceiling or floor when the
fixed-percentage rule would force spending outside of this range. This keeps
spending from drifting too far from its initial levels, helping to smooth
spending fluctuations while helping to manage sequence risk and allowing for a
higher initial spending rate.

There are also countless other examples of variable spending
strategies that apply different approaches to adjusting spending. Jonathan Guyton
and William Klinger, for instance, developed a series of decision rules that allow
for a higher initial spending rate but provide guardrails around spending to
keep the ongoing distribution rate from rising too high as a percentage of
remaining assets. For another example, David Zolt introduced the Target
Percentage Adjustment method. It provides a rule for determining when spending
adjusts for inflation or remains fixed in nominal terms.

Another style of spending rule involves using actuarial
methods. Actuarial methods generally involve retirees recalculating their
sustainable spending annually based on the remaining portfolio balance,
remaining longevity, and expected portfolio returns. This approach uses an
increasing percentage from the remaining portfolio over time to accounting for
the shortening remaining life expectancy as one ages. A simple form for the
actuarial method is to use the Internal Revenue Services’ required minimum distribution
(RMD) rules (these spending rules always use Table III for RMD rates, see
Chapter 10 for more on this) as a more general guide for sustainable spending. For
the purposes of tax collection, the RMD rules indicate a by-age percentage that
must be withdrawn from tax-deferred accounts.

The RMD rule contains the actuarial components of spending a
percentage of remaining assets, which is calibrated to an updating remaining
life expectancy. Its deficiency is that it does not provide a mechanism for
users to adjust their portfolio return assumption beyond what government policy
makers initially assumed when developing the by-age RMD rates. The RMD rules
assume investment returns of 0 percent, so they do not reflect asset allocation
or other market return assumptions. With this conservative return assumption,
some retirees may decide the RMD strategy provides overly conservative spending
rates. Another possibility, then, is to increase all the RMD rates by a chosen
factor to increase spending. Any of these variable spending strategies will
reduce sequence risk in retirement and allow for higher initial spending rates,
potentially higher average spending amounts, and a generally more efficient
spenddown of assets than the baseline constant inflation-adjusted spending
strategy associated with the traditional 4 percent rule.

How Does an “Optimal”
Withdrawal Rate Relate to a “Safe” Withdrawal Rate?

The Trinity study that we mentioned earlier had established
the idea of focusing on success rates and failure rates, building into our
psyche the idea that one’s retirement is a failure if the investment portfolio
depletes. This has put too much emphasis on the portfolio and on spending
conservatively to keep failure rates low. This is not the whole story, as certain
circumstances may allow retirees to accept a higher probability of “failure”
and spend more aggressively from their investment portfolio. Depleting the
investment portfolio is not always catastrophic.

We must evaluate the trade-off between reducing spending today
to better protect future spending potential and seeking to enjoy the highest
possible living standard today even if that creates greater risks for having to
make cutbacks later in retirement. This speaks to the RISA Profile factor of
Front-Loading or Back-Loading retirement income. Withdrawal rate studies have
typically focused on the probability of depleting the portfolio while still
alive, without considering what is lost in terms of life satisfaction by using
a lower withdrawal rate and spending less, implying a strong Back-Loading
preference. When using low withdrawal rates, retirees will typically leave
behind a large pot of wealth (unless their retirement returns sequence matches
the worst-case scenario). Less retirement spending and unintendedly large
legacies are not the goals for most retirees.

When taking portfolio spending out of the vacuum, there are
four interrelated factors that we must consider:

·
Reliable income sources: what proportion of your retirement
spending is covered through reliable income sources from outside the investment
portfolio?

·
Longevity risk aversion: how fearful are you about outliving your
investment portfolio in retirement? This is an emotional characteristic
unrelated to whether you may outlive your portfolio in an objective sense. It
reflects a preference for Back-Loading.

·
Spending flexibility: is it possible to reduce portfolio
distributions without creating significant harm to your standard of living?

·
Availability of reserves: what other resources are available that
have not been earmarked to manage spending and can be used to cover
contingencies?

These factors all relate to what is an acceptable
probability of success, or probability of failure, for the retirement plan. For
someone who worries and loses sleep about outliving his or her portfolio, does
not have much additional income from outside the portfolio, mostly faces fixed
expenses without much room to make cuts, and does not have much in the way of
backup reserves, it may be necessary to plan for a quite high probability of
success. This will imply using a lower stock allocation and a lower spending
rate.

However, for someone who has less fear about outliving his
or her portfolio, has additional income sources from outside the portfolio that
reduce the lifestyle impact of depleting investments, has the flexibility to
cut portfolio distributions without adversely impacting lifestyle, and has
sufficient additional reserves, a higher spending rate accompanied by a lower
probability of success can be “optimal.”

To be more explicit about what all of this means, we must
distinguish between “safe” withdrawal rates and “optimal” withdrawal rates. While
we discussed earlier how the 4 percent rule may be too high for those focused
on identifying a sustainable withdrawal rate that will not deplete the
portfolio over a thirty-year period, this does not necessarily forbid the use
of 4 percent or higher. Retirees may still choose higher withdrawal rates as a
part of downplaying the potential impact of investment portfolio depletion. A
higher withdrawal rate may be optimal in some cases even though it is associated
with a high probability of failure. A simple focus on a retirement income
strategy that applies a low failure rate for the investment portfolio is
woefully incomplete. Retirees need to be thinking about a more complete model
that incorporates these factors.

How Might Using a Buffer Asset Help?

There are four general ways to manage sequence of returns
and longevity risk for a retirement spending budget. These include spending
less, being flexible with spending and reducing it after downturns, reducing the
sensitivity of spending to portfolio volatility, and strategically drawing from
non-correlated buffer assets held outside the investment portfolio. We now
consider that fourth approach.

Buffer assets are held outside the financial portfolio and
can be drawn from to cover retirement spending when the portfolio is in danger.
Returns on these assets should not be correlated with the financial portfolio,
since the purpose of these buffer assets is to support spending when the
portfolio is otherwise falling short. Buffer assets must be liquid and must not
decline in value along with a general market downturn. In other words, buffer
assets should have non-negative returns. Buffer assets are conceptually
different from time segmentation and as such are held outside of the portfolio.
They will only be employed temporarily under certain market conditions. However,
in terms of the RISA Profile and the RISA Matrix, strategies that involve a
heavy use of buffer assets will mostly fit best in the time segmentation
quadrant. The three buffer assets that have been described are cash holdings,
cash value for whole life insurance, and a growing line of credit for a Home
Equity Conversion Mortgage (reverse mortgage).

The original buffer asset is to maintain a separate cash
reserve, perhaps with two or more years of retirement expenses, separate from
the rest of the investment portfolio. Harold Evensky was an early adopter of
the cash reserve strategy, having developed the “five-year mantra” for his
clients in the 1980s. Writing about it in the 2006 book, Retirement Income
Redesigned, Evensky extolled the behavioral benefits of his approach, as it
helped his clients to avoid panic during downturns and to stay the course with
up to five years to wait for market recovery. While this might sound like time
segmentation, the difference is that this cash is not spent on a consistent
basis. It is set aside as a spending resource only for when the portfolio looks
to be in danger. Cash can be a drag on portfolio returns, and in recent years
more attention has focused on other alternatives such as the reverse mortgage
and life insurance to be used in the same general way as buffer assets or
volatility buffers.

In isolation, using buffer assets may look expensive. With
cash holdings, yield is sacrificed. Reverse mortgages and whole life insurance
include notable set-up expenses and do reflect using loans that will accumulate
interest. But buffer assets should not be viewed in isolation. They are a piece
of a larger puzzle that retirees are trying to solve. The costs can be offset
by gains elsewhere in the overall financial plan through their ability to help
manage sequence-of-return risk. Buffer assets can work to protect the
investment portfolio from incurring excessive distributions. That helps to
manage sequence risk, which allows for the portfolio to maintain a higher long-term
balance exceeding the buffer asset costs. This creates an overall net benefit
through the synergies of better managing sequence-of-return risk.

In my simulations, I have found that the benefits for the
portfolio from reducing the sequence risk were more than able to offset the
costs for setting up and using either a reverse mortgages or whole life
insurance as a buffer asset in a coordinated strategy. The benefits from
reducing distribution pressures on the investment portfolio more than offset the
costs of spending from these buffer assets. Buffer assets provide a
sophisticated technique to grapple with sequence-of-return risk by only
spending from the buffer when the retiree is vulnerable to locking in portfolio
losses.

As for how to implement a decision rule for when to spend
from the buffer asset, practitioners of these approaches describe many
different approaches. I have tested numerous possibilities and found a very
simple rule to use which works just as well as any of the more complicated systems
out there. It involves considering the size of the investment portfolio at the
beginning of retirement. At subsequent points, whenever a distribution is
sought to cover spending, compare the nominal value of the portfolio at that
point to its initial retirement level. If the portfolio is larger than at the
start of retirement, then spend from it. But if the remaining portfolio balance
is falling short of where it started, then take the distribution from the
buffer asset. If the portfolio subsequently recovers and exceeds its starting
level, one then has discretion about whether to voluntarily pay down the loan
balance on the buffer asset to preserve its potential use again later in
retirement. This is not necessary though, since loan balances on buffer assets
do not have any set repayment schedule and can be deferred to death or to when
otherwise leaving the home in the case of a reverse mortgage.

Action Plan

We have described the assumptions and evolution of the 4
percent guideline for spending from investments in retirement, and then we
considered a series of factors explaining why retirees may wish to use either a
lower or a higher spending rate from their own investments. The action items for
this discussion relate to how one goes about fitting these factors together to
determine an overall strategy for the diversified portfolio component of
retirement spending.

However, while it is important to include this discussion
early in the process of retirement income planning, these determinations should
be made later in the planning process when it comes time to fit all the pieces
together. For example, you cannot really decide on a withdrawal rate before you
have considered whether to use an annuity. I developed the Retirement CARE
AnalysisTM as a framework for incorporating this discussion into
planning so that one can determine appropriate investment spending and asset
allocation strategies for the retirement income plan. We will return to this topic
in Chapter 13 as part of putting these pieces together. For this reason, I am
holding off on providing a list of action items for this chapter.

There is a key point with which to finish the chapter. I
have developed a reputation as being quite concerned about using the 4 percent
rule in practice. Especially with low interest rates, I am concerned that 4
percent is too aggressive for a retiree who really wants to meet the rule’s underlying
assumptions. But retirees can implement a variety of techniques described here that
can increase withdrawal rates, such as reducing their spending later in
retirement, using a broader asset allocation, adjusting spending in response to
portfolio performance, tapping into buffer assets from outside the portfolio, and
accessing reliable income from outside the portfolio that reduces the harm
created if the 4 percent rule does not work. With all these factors at play, a
retiree might still find it to be appropriate to use a withdrawal rate of 4
percent or higher at the start of retirement even if the 4 percent rule, as
strictly defined, is not safe.

Further Reading

Bengen, William P. 1994.
“Determining Withdrawal Rates Using Historical Data.” Journal of Financial
Planning 7 (4): 171–180.

Bengen, William P. 2006. Conserving Client Portfolios
during Retirement. Denver: FPA Press.

Bengen, William P. 2012. “How Much Is Enough?” Financial
Advisor (May).

Blanchett, David. 2014. “Exploring the Retirement
Consumption Puzzles.” Journal of Financial Planning 27 (5): 34–42.

Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz.
1998. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable.” American
Association of Individual Investors Journal 20 (2): 16–21.

Cotton, Dirk. 2013. “Clarifying Sequence of Returns Risk
(Part 2, with Pictures!).” Retirement Café (blog), September 20.

Finke, Michael, Wade D. Pfau, and Duncan Williams. 2012.
“Spending Flexibility and Safe Withdrawal Rates.” Journal of Financial
Planning 25 (3): 44–51.

Guyton, Jonathan T., and William J. Klinger. 2006.
“Decision Rules and Maximum Initial Withdrawal Rates.” Journal of Financial
Planning 19:49–57.

Huxley, Stephen J., and J. Brent Burns. 2004. Asset
Dedication: How to Grow Wealthy with the Next Generation of Asset Allocation.
New York: McGraw-Hill.

Jaconetti, Colleen. 2012. “Investing for Income in
Today’s Environment.” The American College–New York Life Center for Retirement
Income Video Series.
https://retirement.theamericancollege.edu/video-library/investing-income-todays-environment.

Pfau, Wade D. 2010. “An International Perspective on
Safe Withdrawal Rates: The Demise of the 4% Rule?” Journal of Financial
Planning 23 (12): 52–61.

Pfau, Wade D. 2012. “Capital Market Expectations, Asset
Allocation, and Safe Withdrawal Rates.” Journal of Financial Planning 25
(1): 36–43.

Pfau, Wade. 2017. How Much Can I Spend in Retirement:
A Guide to Investment-Based Retirement Income Strategies. McLean, VA:
Retirement Researcher Media.

Pfau, Wade D., and Michael E. Kitces. 2014. “Reducing
Retirement Risk with a Rising Equity Glide Path.” Journal of Financial
Planning 27 (1): 38–45.

Stein, Michael. 1998. The Prosperous Retirement:
Guide to the New Reality. Emstco Press.

Chapter 5:
Annuities and Risk Pooling

Annuities are another important tool for
funding retirement spending. They are contracts which can be structured to
provide a series of payments from an insurance company, either for life or for
a fixed period. Lifetime income protections available through annuities can
support a retirement income goal through risk pooling and mortality credits. The
contract owner is the one who buys and makes decisions about an annuity
contract. The annuitant is the person or persons on whose age and survival is
used to determine annuity payments. The contract owner is often also the
annuitant, but this is not strictly necessary. The beneficiary is the one who
will receive any death proceeds from the annuity.

A Caveat on Annuities

In this discussion, I am mostly making an
implicit assumption that the annuity is competitively priced. Fees reflect what
is needed to support the guarantees provided by the insurance company and to
keep the company profitable. But fees are not excessive such that the value
to the consumer is eliminated. Not all annuities are created equally in this
regard. Deferred annuities, especially, can be complex financial instruments.
That complexity can hide a lack of competitiveness in the pricing of
individual products. An annuity that is pitched along with a free dinner
presentation is possibly not the type of financial product I have in mind.
One should tread carefully. Due diligence and a comparison with other annuity
options is necessary to ensure that the product is priced fairly and aligns
with the purchaser’s expectations. I do not want the “bad” annuities out
there to catch a free-ride off of my explanations about “good” annuities.

Many types of annuities exist. Our focus will
be on immediate and deferred income annuities, deferred variable annuities, and
deferred fixed index annuities. In providing an overview of annuity types and
how they can be incorporated into retirement planning, this chapter
provides a summary of the content from my book, Safety-First Retirement Planning:
An Integrated Approach for a Worry-Free Retirement. Readers seeking a
deeper dive into these topics may refer to that book for additional details.

We now will discuss the basic logic behind annuities, how
different types of annuities work, and how annuities can fit into a retirement
income plan.

The Fundamental Logic of Annuities with Lifetime
Income

Before digging deeper into different types of annuities, it
is worth first focusing on how a basic life-only income annuity works and how
it fits into retirement planning. A simple annuity can effectively replace bond
holdings in a retirement plan that are earmarked to meet the lifetime spending
goal. The question is why should a retiree hold any bonds in the portion of
their asset base designed to cover ongoing retirement spending goals?

Premiums for the income annuity are invested in bonds (the
insurance company adds your premium to its bond-heavy general account). The
annuity then provides payments precisely matched to the length of time they are
needed. Stocks provide opportunities for greater investment growth. Individual
bonds can support an income for a fixed period, but they do not offer longevity
protection beyond the horizon of the bond ladder created. Bond funds are
volatile, exposing retirees to potential losses and sequence risk while still
not providing enough upside potential to support a particularly high level of
spending over a long retirement. Risk pooling with an income annuity can
support a higher level of lifetime spending compared to bonds. Stocks also
offer the opportunity for higher spending, but without any guarantee that
stocks will outperform bonds and provide capital gains during the pivotal early
years of retirement.

Income annuities can be viewed as a type of coupon bond
which provides payments for an uncertain length of time in which the principal
value is not repaid upon death. Another way to think about income annuities is
that they provide a laddered collection of zero-coupon bonds that support
retirement spending for as long as the annuitant lives. Much like a
defined-benefit pension plan, income annuities provide value to their owners by
pooling risks across a large grouping of individuals.

Longevity risk is one of the key risks which can be managed
effectively by an income annuity. Investment and sequence risk are also
alleviated through the more conservative investing and asset-liability matching
approach on the part of the insurance company for the underlying assets held in
the insurance company’s general account. The payout rates for an income annuity
assume bond-like returns and longevity is further supported through risk
pooling and mortality credits, rather than by seeking outsized stock market
returns.

Longevity risk relates to not knowing how long a given individual
will live. But while we do not know the longevity for any one individual, insurance
company actuaries can estimate how longevity patterns will play out for a large
cohort of individuals. The “special sauce” of the income annuity is that it can
provide payouts linked to the average longevity of the owners because those who
die early end up leaving money on the table to subsidize the payments to those
who live longer. Though it may seem counterintuitive to subsidize payments to
others, this act can allow all owners in the risk pool to enjoy a higher
standard of living than bonds could support. All annuity owners know that the
mortality credits will be waiting for them if they do end up living beyond life
expectancy.

Meanwhile, sequence risk relates to the amplified impacts
that investment volatility has on a retirement income plan that seeks to
sustain withdrawals from a volatile investment portfolio. Even though we may
expect stocks to outperform bonds, this amplified investment risk also forces
conservative individuals to spend less in case their early retirement years are
affected by a sequence of poor investment returns. Many retirement plans are
based on Monte Carlo simulations with a high probability of success, which
implicitly assumes lower investment returns. An income annuity also avoids
sequence risk because the underlying assets are invested by the annuity
provider, mostly into individual bonds which create income that matches the
company’s obligations for covering its promised annuity payments.

In hindsight, those who experienced either shorter
retirements or who benefited from retiring at a time with strong market returns
would have probably preferred if they had not purchased an income annuity. Income
annuities are a form of insurance. They insure against outliving assets due to
some combination of a long life and poor market returns. In the same vein,
someone who purchased automobile insurance might wish they had gone without if
they never had an accident. But this misses the point of insurance. We use
insurance to protect against low probability but costly events. In this case,
an income annuity provides insurance against outliving assets and insufficient income
late in retirement.

Income annuities offer an important benefit to those who do
not make it long into retirement, especially for those who are particularly
worried about outliving their assets. That benefit can be seen when comparing the
income annuity to the alternative of basing retirement spending strictly on a
systematic withdrawal strategy from an investment portfolio. To “self-annuitize,”
a retiree must spend more conservatively to account for the small possibility
of living to age ninety-five or beyond while also being affected by a poor
sequence of market returns in early retirement. The income annuity supports a
higher spending rate and standard of living than this from the outset. All
income annuity owners, both the short-lived and long-lived, can enjoy a higher
standard of living during their life than they would have otherwise felt
comfortable with by taking equivalent amounts of distributions from their
investments.

Upon entering retirement, a retiree has several options regarding
allocations between stocks, bonds, and income annuities. Let us consider a
simple example with four different approaches. With the basic understanding in
place, we can then dig in deeper.

Bonds

Suppose a retiree wants to stretch the nest-egg over twenty
years and will earn 0 percent returns by investing in bonds. We could assume
higher bond returns, but that would simply complicate the math without changing
the intuition behind the example. Since insurance companies also invest in
bonds, higher interest rates would increase the annuity payout rate as well. With
0 percent returns, these bonds allow for spending at 5 percent of the initial
portfolio balance—the sustainable spending rate—every year for twenty years. With
this spend rate, bonds will leave nothing to support spending beyond year
twenty.

Income Annuities

Now suppose life expectancy is twenty years and longevity
risk is added to the equation. Some will not make it twenty years; others will
live longer. With the 0 percent returns the annuity provider earns from bonds,
the provider could still support this 5 percent spending rate through risk
pooling and mortality credits no matter how long the annuitant survives.

“Self-annuitization”

Now suppose the retiree “self-annuitizes” instead by
managing this longevity risk without insurance. This requires picking a
planning age one is unlikely to outlive. Suppose the retiree decides to plan
under the assumption that retirement will last for thirty years. In this case,
to spread assets out over thirty years with a 0 percent investment return, the
spending rate must fall to 3.33 percent. Note as well, the spending rate could
only be 2.5 percent to support expenses for forty years. In this situation,
there is a direct relationship between a longer life and a lower rate of spending.
Retirees are forced to spend less to the extent they worry about outliving
their portfolio. In terms of an unintended legacy, if one did live for twenty
years, then a third of the assets would remain with a thirty-year plan, or half
of the assets would remain with a forty-year plan. Compared with an annuity, using
bonds leads to a lower than possible retirement lifestyle and potentially an unintentionally
large legacy, but with risk for shortfalls for an even longer than planned
lifetime.

Stocks

Alternatively, one could seek an investment return higher
than 0 percent by including stocks. With a fixed annual investment return of
3.1 percent, the retiree could support the 5 percent spending rate for thirty
years. With a 4.2 percent investment return, spending could be supported for
forty years. The question then centers around how likely it is for the
portfolio to earn these higher rates of return through a stock-heavy focus.

Stocks create risk. Seeking this higher investment return requires
the retiree to accept portfolio volatility with a growing allocation to stocks.
Spending from investments further heightens sequence risk. A few poor returns
early on could easily derail the attempt to support that 5 percent spending
rate for as long as the plan targets. While it is possible to obtain the higher
returns necessary to support a bigger spending level in this way, there is no
guarantee that this approach will be successful. The stocks strategy provides
greater upside potential for wealth to grow, but it also creates greater
downside risk that the retiree will not be able to meet the spending goal
throughout retirement. The range of potential outcomes widens.

The introduction of stock market risk requires two
additional elements for the decision-making of our risk averse retiree. What
failure probability does she comfortably and willingly accept that her
portfolio will not be able to support spending through the planning age? As
well, how high of stock allocation is she willing to accept, in terms of her
ability to stomach the daily volatility experienced by her investment
portfolio? With volatile investments and a fixed spending goal, some
probability for portfolio depletion must be accepted by anyone seeking upside
growth potential through the equity risk premium.

Annuitized assets do not provide upside in the sense that a
legacy would be left when markets do well, but they also eliminate downside
spending risk. The long-lived do receive a form of upside through mortality
credits. The effective return from the annuity matches what the stocks needed
to earn to support those longer retirements. For our example in which we said
that stocks required a 4.2 percent return to fund a 5 percent distribution rate
for 40 years, an annuity is providing this same return to an owner who happens
to live this long.

“Self-annuitizing” requires lower spending, and stocks could
support higher spending with upside growth, but that adds risk as well. As for bonds,
ultimately, the question is this: why hold any bonds in the part of the
retirement portfolio designed to meet spending obligations? The income annuity
invests in bonds and provides payments precisely matched to the length of
retirement, while stocks provide opportunities for greater investment growth above
bonds. Bonds alone hold no advantage.

The income annuity provides a license to spend more from the
start of retirement due to the insurance company’s ability to pool risk.
Supported spending from an income annuity is higher because it is based on reaching
life expectancy, and should the retiree live beyond life expectancy, the higher
income continues to be sustained because of the subsidies arriving from those
who died early. The expectation that subsidies will arrive as needed allows
spending to increase for everyone from the very start of retirement. Exhibit 5.1
highlights how mortality credits represent a third source of spending with an
income annuity beyond the spenddown of principal and the interest generated by
that principal.

Regarding sequence risk, for those who “self-annuitize,”
there are two options for deciding how to spend from investments. One is to
spend at the same rate as the annuity with the hope of either dying before
running out of money, or the hope that the investments earn strong enough
returns to sustain the higher spending rate indefinitely. This approach
requires acceptance of the possibility that the standard of living may need to
be cut later in retirement should the hopes for sustained investment growth not
pan out. The alternative is to spend less early on and, should good market
returns materialize, increase spending later or leave a bigger legacy. The
problem with intending to increase spending over time is that it is the reverse
of what most people generally wish to do, which is to spend more early in
retirement and cut back as life slows down at more advanced ages.

Exhibit 5.1

Sources of Income Annuity Payouts

Overview of Annuity Types

The previous explanation about how an annuity
can contribute to a plan was based on the simplest form of an annuity: A
life-only income annuity. Now we are ready to step back to describe the broader
annuity universe.

A fundamental aspect that defines an annuity
is that it is a contract which can be annuitized to provide a series of
payments from the insurance company, either for life or for a fixed period.
However, today there are many annuities that downplay this aspect of annuitization.
As the tax code in the United States provides tax-deferral advantages for
annuities, other forms of annuities have evolved with a greater emphasis on
providing tax-deferred growth for the assets in the annuity with a de-emphasis
on their income-generating abilities. As well, more recent developments include
optional riders that can be added to annuities to support a lifetime income
without having to annuitize the contract.

Two broad classifications for annuities exist:
fixed and variable. Simply, fixed annuities credit interest to the underlying
assets in the annuity at a fixed rate (which can change over time), while
variable annuities position the premiums into subaccounts that allow for
investments into different funds earning a variable rate of return. Fixed
annuities pool assets in the insurance company’s general account, while
variable annuities hold assets in separate investment subaccounts that are like
mutual funds. Since variable annuities behave more like investments, those
selling them need to be properly licensed in most states to sell both insurance
and investments.

This definition about fixed and variable
annuities can be confusing. First, income annuities are fixed annuities, but
they do not show an underlying account balance to which interest is credited.
Rather, the insurance company determines the payout rate based, in part, on the
interest it projects to earn on the underlying premiums held in its general
account.

Second, fixed index annuities can be
structured to credit interest based on the performance of a volatile investment
index. This can make them sound more like a variable annuity, but technically
it is just a matter that fixed interest is being credited based on outcomes for
a volatile index. Fixed index annuities provide principal protection, which
means that one cannot experience any capital losses from negative market
returns. Unlike a variable annuity, fixed index annuities do not provide
subaccounts in which investments are made. They only credit interest based on
the performance of a linked index. Variable annuities subaccounts can experience
loss.

An even more recent development is structured
annuities that behave a lot like index annuities, but which can experience
losses. These are technically a type of variable annuity, and they go by many
names including buffered annuities, variable index annuities, or registered
index-linked annuities (RILAs). Finally, variable annuities could include
subaccount options that provide fixed returns in the same manner as a fixed
annuity, but the distinction is that variable annuities position the assets in
investment subaccounts, unlike fixed annuities that hold them as part of the
insurance company’s pooled general account.

One other potentially confusing way to
classify annuities is whether they are immediate or deferred. This distinction
is relevant because it affects the tax treatment for annuities, as will be
discussed in Chapter 10. The confusion relates to how these terms are used in
two different ways with annuities. Formally, the classification is not related
to when guaranteed income begins, but rather to when the act of annuitization
takes place. Some deferred annuities could provide income immediately through
structured lifetime payments, while some immediate annuities may defer income
payments. For the former, the variable annuities and index annuities with
income riders that we discuss are both types of deferred annuities, even if
guaranteed distributions start immediately. The reason they are still called
deferred annuities in this case is that technically the contract does not
annuitize unless the contract value of the underlying assets has fallen to
zero.

Meanwhile, for immediate annuities the act of
annuitizing the assets takes place at the time the premium is paid. There is no
liquidity for the underlying premiums past that stage. “Immediate” immediate
annuities, such as single-premium immediate annuities (SPIAs), begin income
payments within one year of annuitization, while deferred immediate annuities
begin income payments at least one year past the date of annuitization. Since
the name “deferred immediate annuity” is so confusing, a more common alternative
name for them is deferred income annuity (DIA). Regarding the more confusing
name, though, the immediate part of the name refers to immediate annuitization,
and the deferred part of the name refers to the delay in starting the
annuitized payments.

Annuities
for Accumulation

For retirement income, the discussion of
annuities naturally tends toward using them for systematic payouts in
retirement, either for a lifetime or for a fixed period. However, through
their ability to provide tax deferral for gains, annuities can also be used
as pure accumulation tools. Though
every annuity, by definition, must include a means to convert into a
guaranteed income stream, this is not the priority when used for
accumulation. Owners may plan to eventually have the lump-sum
contract value returned after it has provided tax deferral. Chapter 10 dives
deeper into the tax aspects of annuities.

Deferred fixed annuities (DFAs), or multiyear guaranteed
annuities (MYGAs), are the annuity equivalent of holding CDs or other
shorter-term fixed-income investments to a targeted maturity date. Their objective
is to seek competitive after-tax fixed income returns for assets. This may be
possible through their principal protection and lack of interest rate risk
(they do not lose value when interest rates rise) and their tax deferral.

Fixed index annuities (FIAs) can also be used in a similar
manner. We discuss FIAs later with an optional lifetime withdrawal benefit
included. But when such benefits are not included, FIAs can be treated as
another alternative to a taxable bond portfolio providing principal
protection, tax deferral, and some exposure to market upside which could make
them competitive with the after-tax returns on bonds.

A low-cost deferred variable annuity may also be used for
tax deferral rather than thinking of it as a source for lifetime income. Deferred variable annuities were created in the 1950s in the United
States as a tax-deferred vehicle for accumulating assets. They grew in
popularity after the Tax Reform Act of 1986 limited the opportunities for
tax-deferred savings in qualified retirement plans. Such a deferred variable
annuity with low costs and de-emphasized guarantees provides tax deferral for
those investors who have already filled other options and seek to invest
further in tax-inefficient asset classes that may generate ordinary income
and short-term capital gains. To benefit from tax deferral, it is vital that
the annuity costs are less than the tax benefits.

Income Annuities – SPIAs and DIAs

We now shift to longer discussions for the key types of
annuities used for retirement income planning. For those seeking to spend more
in retirement than the bond yield curve can support, the alternative to seeking
risk premium through an aggressive asset allocation is to use risk pooling.

Income annuities are the simplest type of insurance products
which trade a lump-sum payment for protected lifetime income. The ability to
convert a portion of assets (as it is not an all-or-nothing decision) into a
guaranteed income stream is a fundamental retirement income tool which
contrasts with an investment portfolio in terms of the advantages and
disadvantages for managing retirement risks. Income annuities are fixed
annuities, and they are annuitized at the time of contract issuance and premium
payment. This means they are immediate annuities, even if the start date for
payments is deferred.

We start our discussion of annuities with the income annuity
because it is the most straightforward and easy-to-understand way to convert a
pot of money into a guaranteed stream of spending for life. Income annuities
are also known as immediate annuities, single-premium immediate annuities
(SPIAs), deferred income annuities (DIAs), qualified longevity annuity
contracts (QLACs), or longevity insurance.

Risk pooling and mortality credits are the drivers of value
from an income annuity. The annuitant accepts the risk of dying early and
receiving fewer payments from the annuity in exchange for the ability to
continue receiving payments no matter how long one ends up living. By pooling
longevity risk with a collection of individuals, an income annuity allows its
owners to earmark assets by only needing to fund retirement as though they will
earn fixed income returns and live to their life expectancy. Those who end up
living beyond their life expectancy will have their continuing benefits
subsidized by those who die before life expectancy. While this clearly benefits
the long-lived, we can also conclude that it benefits the short-lived as well
by allowing them to enjoy a higher standard of living than they might have otherwise
been comfortable supporting from an unguaranteed investment portfolio. This can
allow for more spending and a more satisfying retirement experience, and more
peace of mind compared to those self-managing longevity risk by spending less
and then leaving too much behind at death.

Menu of Income Annuity Features and Options

Income annuities can be either immediate or deferred in terms
of when their payments begin, though as noted these are all technically immediate
annuities because the contract is annuitized. An immediate income annuity
begins income payments within one year of the purchase date, while a deferred
income annuity does not begin payments until at least one year after the
purchase date. A deferred income annuity purchased at retirement with income
beginning at age eighty or eighty-five is also referred to as longevity
insurance.

After the Treasury Department updated regulations in 2014 to
facilitate the use of longevity insurance inside retirement plans, longevity
insurance is now also known as a qualified longevity annuity contract (QLAC).
In practice, deferred income annuities are used less as a form of longevity
insurance and more for prepaying retirement and removing market risk in the
pivotal preretirement years. In such a case, one might purchase a deferred
income annuity at age fifty-five or sixty, for instance, for income to begin at
sixty-five.

Single life income annuities only cover one person’s life.
With such an annuity, income payments continue until the annuitant’s death. A
joint life annuity, on the other hand, continues payments for as long as at
least one of two annuitants survives. Often joint annuities are set up for two spouses,
but marriage is not a requirement for two annuitants to be included on a joint life
contract.

Since payments are expected to last longer when two lives
are covered, the joint protection comes at the cost of a lower initial payout
rate. A joint life and 100 percent survivor annuity provides the same payment
as long as one annuitant is alive. This is the most popular option in practice.
With a joint life and 67 percent survivor annuity, for instance, the payment
would reduce by 33 percent upon the first annuitant’s death, allowing for a
higher initial payment.

A life-only income annuity is the Platonic ideal, offering the
highest payout and the most mortality credits. Payouts are highest because the
purchaser is taking the most “hit by a bus risk”—the common fear of signing an
annuity contract and then being hit by a bus and killed on the way out of the
office. Life-only annuities are popular with academics because acceptance of
this risk makes more funds available to the longer-surviving members of the
risk pool, allowing one to buy protected lifetime income at the lowest possible
cost. In practice, many annuity buyers will be uncomfortable with a life-only
annuity. CANNEX, a firm providing annuity quotes, finds that only
about 15 percent of the inquiries it receives are for life-only options.

A variety of other flavors will lower the payout rate but
may otherwise make the income annuity a more palatable choice. By offering less
mortality credits to the risk pool because you want some protection for your beneficiary
in the event of an early death, you should, in turn, expect to receive less
mortality credits back from the risk pool in the event of a long life. This is
the nature of the trade-off that results in a lower payout rate for added
protections. Other flavors of annuities that lower the payout rate in exchange
for providing protections to a beneficiary for an early death include:

·
Cash refund provision: Provides a cash refund of the difference
to the beneficiary if death happens before the owner receives cumulative
payments from the annuity that add up to the initial premium payment. CANNEX
reports that about half of the requests it receives include the cash refund.

·
Lifetime with ten-year period certain annuity: Pays for life. If death
happens before annuity payments were made for at least ten years, the
beneficiary continues receiving payments for the full ten years. These
period-certain guarantees can also be arranged for any number of years, such as
five, fifteen, or twenty.

·
Installment refund: Works very similarly to the cash refund,
except beneficiaries receive the difference as continued annuity payments in
installments until the full premium has been returned, rather than receiving a
one-time refund.

·
Period certain: An income annuity does not require lifetime payments.
It may just make payments for a set period. This works the same way as building
a bond ladder and can be an alternative to individual bonds when considering
retirement income bond ladder strategies.

As well, there are generally three options regarding
payments:

·
Fixed or level income annuity: These annuities will pay the same
amount on an ongoing basis for as long as the contract requires. The purchasing
power of the income payments will decrease over time as there is no adjustment
made for inflation. CANNEX notes that most requests it receives are for this
option.

·
COLA: A cost-of-living adjustment (COLA) provision allows payments
grow at a fixed compounding rate each year. For instance, if I decide that 2 percent
is a reasonable assumption for future inflation, I might choose a COLA of 2 percent
with the intention of preserving the purchasing power for my annuity income. If
realized inflation ends up being higher, I will lose purchasing power over
time, but purchasing power would increase if realized inflation ends up being
lower. COLAs can only approximate the inflation experience in retirement. With
payments increasing over time, the initial payment will be less than with a
fixed or level annuity.

·
CPI: One could add a provision that the income growth rate of the
annuity payments precisely matches the Consumer Price Index (CPI). When
inflation is low, income grows more slowly, as do living costs for the retiree.
When inflation is high, income grows more quickly to better support the
increasing cost of living. CPI-adjusted income annuities hedge inflation risk
in the same manner as TIPS. These have been offered in the past, but since
January 2020 no company has been offering CPI-adjusted income annuities in the
United States.

Income Annuity Pricing

Pricing income annuities is not as hard as one might think,
as the basic recipe requires just three ingredients:

1.      Mortality
rates (which vary by age and gender) impact how long payments will be made. Younger
people will have longer projected payout periods, which means that payout rates
must be lower.

2.      Interest
rates impact the returns the annuity provider can earn from investing the annuity
premiums. Higher interest rates imply higher payout rates because the insurance
company will be able to earn more interest on the premiums in their general
account supporting the annuity payments.

3.      Overhead
costs relate to extra charges an annuity provider seeks to cover business
expenses and to manage risks related to the accuracy of their future mortality
and interest rate predictions.

Including mortality rates in the pricing is the secret sauce
of the annuity. Retirees could just build a bond ladder on their own and set
aside the full present value of their lifetime spending. But because a retiree
does not know how long she may live, it becomes necessary to plan for an age
well beyond average life expectancy. Annuity owners obtain a discount on the
bond ladder pricing because the survival probabilities to each subsequent age
indicate whether these payments will need to be made. The annuity price is a
survival-weighted present value of potential lifetime payments. Any one individual
is either alive or dead. But for a large pool of individuals representing the
customer base of the annuity provider, the company can rely on the law of large
numbers to evaluate what percentage of customers will remain alive at each
subsequent age. If there is only a 10 percent chance that someone is alive at
age 100, the insurer only needs to set aside 10 percent as much for that payment
as someone who self-manages the risk. This is risk pooling.

The bond ladder costs more, with the benefit that the bond
ladder supports some legacy if retirement is shorter than assumed with the
ladder construction. But the bond ladder does not provide any additional
longevity protection beyond the end date of the ladder as assets are fully
depleted at that time. With the income annuity, that longevity protection can
be provided while devoting less funds to the goal.

The life-only income annuity offers the highest payout
because it creates the most risk about receiving fewer payments for any
beneficiary in the event of an early death. Adding a period-certain payment or
a cash refund reduces the potential mortality credits that the annuity owner
offers to the risk pool. The higher payout on a life-only
income annuity provides compensation for accepting the risk of an early death.

Academics who study income annuities
generally suggest a life-only income to fully maximize the income-producing
power, with legacy goals covered through other means. But cash refund and
period-certain provisions are quite popular in practice. Psychologically, for
many it is too difficult to overcome the perceived lack of fairness with a
life-only income annuity in which one could die shortly after paying the premium
and then receive back little in return.

Payout Rates and Rates of Return for Income
Annuities

The pricing of an income annuity is typically described
using either the monthly income amount it generates, or as the annual payout
rate of the income received as a percentage of the premium amount. For instance,
an income annuity might offer $481.67 per month for a $100,000 premium. For twelve
months, that sums to $5,780, which is 5.78 percent of the initial premium amount.
The annuity payout rate is 5.78 percent. After aligning with assumptions about
how spending may grow with inflation, this payout rate is directly comparable
to a sustainable withdrawal rate from initial retirement date assets for an
investment portfolio. Both rates incorporate the idea that principal is spent
in addition to any investment returns.

It is important to recognize that the payout rate is not a return
on the annuity, which may create some confusion. It is wrong to compare the
payout rate to an interest rate that involves the subsequent return of
principal. For instance, if you can earn 1 percent by holding a CD and 5.78
percent from an income annuity, the income annuity is not almost six times more
powerful than the CD.

The problem is that the 1 percent number for the CD only
represents its interest payments. The principal value is returned at maturity.
Meanwhile, a 5.78 percent payout from an annuity includes interest and
principal payments (as well as mortality credits—the true source of additional
returns beyond that provided by a fixed-income alternative). Principal is being
spent as well, and so the comparison to the CD rate is neither fair nor
meaningful.

The annuity does have a return, but it is less
straightforward to calculate. To know the annuity return, it is
necessary to know how long the annuitant will live and how many annuity
payments will be generated. Or, at least, returns can only be calculated by
assuming how long income payments will be received. A longer life means more
payments from the annuity, which helps to increase the return it provides over
time. And if the underlying investments in the general account provide a higher
return, that feeds into a higher annuity payout rate, which helps to boost the
annuity’s return more quickly as well. For life-only annuities, returns start
out negative, as cumulative payments fall short of the premium paid. The return
crosses from negative to positive when the total payments received exceed the
premium paid. With enough time, the return can eventually exceed the payout
rate. A competitive income annuity will provide a return matching bonds at
around the owner’s life expectancy. Eventually those continuing cash flows will
imply returns that are competitive with stocks.

An income annuity is designed to provide a higher return to
people who live longer and therefore need higher returns to fund their
retirements. Though tragic to consider, those who do not live as long do not
end up needing strong returns to fund their retirement. This is how annuities
can better match to the funding needs of a retirement plan.

Money’s Worth Measures for Income Annuities

Annuities have a reputation for being a
high-fee financial product. Is this reputation deserved? We will address this for
different types of annuities, starting first with income annuities. It is a bit
complicated to answer this for income annuities because they do not have
visible fees. There are no fees extracted from the quoted payout rate,
as the payout rate is already a net number after fees have been deducted
internally. Simply, with the internal fees, the quoted payout
rate is lower than otherwise possible.

Fortunately, we can reverse engineer the fair
price for an income annuity without fees and then compare it with real-world
annuity payout rates to obtain a money’s worth measure for the income annuity. The
“fair price” without overhead costs just involves using interest rates and
mortality rates to calculate the survival-weighted present value of the
potential lifetime payments. The additional complication relates to making
reasonable assumptions for interest rates and mortality rates.

In determining the money’s worth for an
annuity, we must consider three issues: could the retiree earn the same returns
from her own fixed-income investments with the same risk level, how does the
retiree’s objectively determined longevity prospects compare with that of the
overall risk pool, and how much does the retiree value mortality credits as
based on her longevity risk aversion and subjective views about how long she
might live. Purchasing income annuities can be a win-win situation both for the
consumer and the insurance company when the benefits created through risk
pooling are shared between both parties in the transaction.

First, can a retiree invest in the same fixed-income
portfolio and earn the same returns as the insurance company can obtain for its
general account? We note that the insurance company may be able to obtain
higher investment yields because of its ability to diversify among
higher-yielding bonds with greater credit risk, to use asset-liability matching
to hold less liquid and longer-term bonds, and to receive institutional pricing
on purchases which avoids the pricing mark-ups faced by retail investors.

Second, it is important to be realistic about
longevity when determining whether an income annuity is priced fairly. Someone
who can reasonably expect to live longer than average should not try to
calculate a fair price using population-average mortality. If annuity prices
are simulated with mortality rates for the general population, that will cause
the money’s worth measures to be lower and annuities to look more expensive. My
readers will tend to display characteristics that are associated with increased
longevity, such as higher education levels, more income, greater wealth, and a
stronger health focus. When this is the case, money’s worth estimates based on
mortality tables reflecting the longer lifespans of annuitants are more
reasonable to use.

Third, separate from the objective money’s
worth measure, it is important to also consider the subjective value being
received by the annuity owner. For those with longevity risk aversion, the
prospects of spending from investments may be such that an income annuity could
still support more spending than the retiree otherwise would be comfortable
taking from investments. With an investments-only strategy, longevity
risk aversion is manifested through a lower spending rate from investment
assets. Because income annuities pool longevity risk, they can help to reduce
the worry individuals have about outliving their assets.

The income annuity payout is based on objective mortality
statistics rather than subjective fears. The case for an income annuity becomes
stronger for individuals more worried about longevity. Such
individuals may value income annuities at more than their fair price. For
instance, if my life expectancy is 85, but I build a financial plan to work
until age 95, adding an income annuity to the plan will improve my funding
status. The present value of the annuity payments is greater when I plan to
live to 95, because the annuity is priced with objective mortality data where
people do not live that long on average. The income annuity provides risk
pooling and mortality credits that individuals cannot create on their own. Just
because money’s worth measures imply underlying costs to the owner does not
necessarily mean that annuities are a bad deal for anyone who experiences
longevity risk aversion.

For example, a $100,000 premium may be quoted
as supporting $600 per month for life. Without any built-in fees, perhaps the
fair monthly income could have been $610 or $620. This reverse engineering
process lets one estimate the costs built into an income annuity. If an income
annuity provides $600 per month, but we simulate that a fair price is to
provide $610 per month, then the money’s worth of the annuity is $600 / $610 =
0.9836. In this case, the commercial annuity pays 1.64 percent less than the
fair price. We could interpret this 1.64 percent as an upfront transaction cost
or one-time fee for purchasing the annuity. At the same time, perhaps the
household could not invest for as much yield as the insurance company or might
have an unusually long expected lifespan, such that a more personalized fair
monthly income is only $580 or $590. In this case, the annuity provides a great
deal. These matters are not transparent. We must calculate the actuarially fair
price for an annuity and then compare it to the actual price. Then we have a
better sense of the “money’s worth” from the annuity.

Deferred Annuities with Lifetime
Income Benefits

Generally, the most efficient means for balancing
protected income and investment upside is to use annuities as a replacement for
bonds and combine life-only income annuities with aggressive stock portfolios.
However, this requires a degree of investor self-control and long-term focus
that may be difficult to achieve in practice. It requires accepting both the
loss of liquidity as annuity assets disappear from the portfolio balance, as
well as accepting a more aggressive asset allocation for what remains in the
portfolio. Many retirees are nervous about these trade-offs.

As a means for accommodating the concerns of
real-world retirees, deferred variable annuities (VAs) and fixed index
annuities (FIAs) with lifetime spending protections have developed as a more
palatable compromise. In practice, sales of deferred annuities dwarf sales of
immediate annuities.

With deferred annuities, owners continue to
see the annuity assets on their financial statements as part of the overall
portfolio balance. As well, those assets maintain exposure to market upside
that is not provided within an income annuity. The appeal to retirees is based
on the combination of downside protection with a protected income stream,
upside growth potential through their underlying investments (or links to
investment indices in the case of fixed index annuities), and liquidity for the
underlying assets, while also offering the potential for tax-deferral. Retirees
can see their account values, they can continue to make choices about how their
funds are invested, they can access their funds, and any funds remaining at
death are generally available to beneficiaries as a death benefit, all while
ensuring protected income through the inclusion of an optional guaranteed
living withdrawal benefit (GLWB) rider on the contract.

Nevertheless, the features and workings of
deferred annuities with lifetime income benefit riders can be rather complex. For
those just starting to investigate deferred variable or index annuities,
complexities relate to understanding how returns are calculated for the
contract value, how the income guarantees work, and how fees are structured.

Contract Value Growth

The underlying contract value of deferred
annuity assets can grow (or shrink, with variable annuities) throughout the
life of the contract. With variable annuities, the process is straightforward
and comparable to how most will understand investing with brokerage accounts. VAs
allow for the direct investment of premiums into subaccounts representing
different asset classes and their investment performance less distributions and
fees will determine the value of remaining assets over time. Variable annuity
subaccounts are subject to capital losses.

Since FIAs are fixed annuities, crediting interest is
the technical term for the returns generated by their contract value. FIA
premiums are added to the general account of the insurance company and credit
interest to the owner based either on a fixed return or on the performance of a
linked market index. FIAs offer index-linked interest, but they are not
invested directly into the underlying index. There are no subaccounts. They
simply pay interest to the owner using a formula linked to the index performance.

With FIAs, the credited interest (or returns) can be
structured more precisely in terms of controlling downside and upside
exposures. FIAs protect principal in the sense that 0 percent interest is
credited even if the underlying index declines significantly in value. To
obtain this protection, FIA owners should expect to receive only a portion of
any positive gains experienced by the index. Overall, FIAs may reduce the
volatility of the underlying contract value relative to a variable annuity.

For FIAs, insurance companies generally offer access to different
index options as well as a fixed interest option. Contract owners can often
combine these options in any way they choose and can change the allocations at
the start of each new term. Common index choices include the S&P 500 for
large capitalization US stocks, or the MSCI EAFE index that provides
representation for international stocks. Only the price returns (capital gains
or capital losses) matter with these indices as dividends are excluded from the
returns when determining credited interest. This is because financial
derivatives are used to link performance rather than owning the underlying
assets, so dividends are not available.

Almost countless crediting methods are used in practice and
there is a trend to increase the complexity of the methods used. With the
chosen index, interest crediting will generally be based on a formula that can
include floors, caps, participation rates, and spreads. As an example, we will
consider an annual reset one-year term point-to-point crediting method with
a participation rate.

The one-year term and the point-to-point method means that
the changes in the index values on one-year contract anniversaries will be used
to calculate interest. Annual point-to-point looks at the change in the index
at two different dates, one year apart. At the end of each yearly term on the
anniversary date of the contract, the interest-crediting formula uses the index
gain for that year (the price return, not including dividends) to credit
interest. A floor of 0 percent is protected, and a participation rate
determines the percentage of upside gains that are credited.

As for the annual reset design, this reflects how interest
crediting calculations start fresh for each term. If the index lost 10 percent
in the previous year and the FIA credited 0 percent interest for that year, it
is only the new point-to-point change for the current year that matters to
calculate the new term’s interest. There is no need for cumulative gains to
make up for previous losses when the annual reset provision is included.

A simple way to think about the downside protection with the
guaranteed floor is that the insurance company buys enough bonds with the
annuity contract value that the growth of that portion with interest will match
the original contract value at the end of the term. With what is left after
purchasing bonds to protect the principal, the insurance company keeps a
portion to cover company expenses and profit motives, and the remainder is the
“options budget” used to purchase upside exposure to the index.

When the FIA offers a participation rate on upside, the
insurance company can use the “options budget” to buy a one-year at-the-money
call option on the S&P 500 index. This is a financial derivative that
provides its owner with the right, but not the obligation, to buy shares of the
S&P 500 at the option’s strike price. The option is at-the-money if the
strike price matches the current value of the index. If the index loses value
during the term, the option expires worthless, and principal was protected with
the bonds. If the index experiences capital gains (not including reinvested
dividends) during the term, the owner receives exposure to the upside through
the call option. The participation rate is the ratio of the “options budget” to
the price of the call option, which provides the percentage of index gains
received.

Because there is a cost for creating protection for the
contract value against a loss when the index declines in value, one should not
expect to receive the full upside potential from the index. The call options
will generally cost more than the size of the options budget. FIAs do not
provide a way to get the returns from the stock market without accepting the
risk of the stock market.

The parameters offered by an FIA will depend in large part
on the level of interest rates and the cost of financial derivatives for the
associated index. Higher interest rates mean that principal can be protected
with less assets, which then leaves more for the options budget used to
purchase upside exposure. Less expensive call options will also allow for more
upside participation to be purchased. Factors that reduce the options prices
include less implied volatility for the underlying index, an increase in the
strike price for the option relative to the current index price, a lower
risk-free interest rate, and a shorter term to maturity. Participation rates
can conceivably be higher than 100 percent if interest rates are high enough
and the call options are cheap enough. On a related point, it should also be
clear that if the owner is willing to accept a lower floor, it would be
possible to gain more upside potential since less is needed for bonds and more
is available to purchase call options.

It is also vitally important to understand that the amount
of upside potential that can be offered by an FIA will vary over time as
interest rates and call option prices change. With an annual reset design, the
insurance company must repeat the process each year and will face different
interest rates and call option pricing as these variables change values over
time. More upside potential is possible with higher interest rates and cheaper
call options, and vice versa. This is the reason why insurance companies maintain
the freedom to change the contract parameters (such as the fixed rate,
participation rate, cap rate, or spread) at the beginning of each new term,
subject to a minimum or maximum value allowed for each parameter within the
contract.

With indexed annuities, the floor could be negative or there
may be other mechanisms that allow for capital losses on the contract value. If
the floor is less than zero, then the annuity is technically a variable annuity
that maintains most characteristics of the FIA except that it is also regulated
as a security because it can experience losses. These types of structured annuities
are growing in popularity and go by various names including registered
index-linked annuities. Aside from a negative floor, these annuities may also
have buffers. For instance, a product that provides a 10 percent buffer would
mean that the interest credited is zero percent for index losses of up to 10
percent. If the index loses more than 10 percent, then this approach would
credit the amount of the loss exceeding 10 percent. An 18 percent loss on the
index would lead to an annuity loss of 8 percent, but an 8 percent loss for the
index would lead to no loss. Accepting this greater downside risk can support
more upside potential, which contributes to their growing use in the
marketplace.

Lifetime Income Benefits

We have just described contract value growth
for deferred annuities. For deferred annuities offering guaranteed lifetime
withdrawal benefits, there can be a separate and parallel set of calculations
to determine a benefit base and guaranteed income amount. We must consider how
guaranteed income is determined for both the growth during the deferral and distribution
periods.

Before going further, I must emphasize that
obtaining guaranteed income through a lifetime income rider is not the same as
annuitizing the contract. The contract is still technically deferred after
lifetime income begins. The benefit rider supports an allowed annual
distribution amount for the lifetime of the annuitant, or annuitants in the
case of a joint contract. Ultimately, while the underlying contract value of
assets remains positive, retirees are spending their own money. The insurance
company then pays from its own resources after the contract value depletes.
Contract value depletion is what eventually triggers annuitization.

First consider the growth process for the
guaranteed benefit base during the deferral or accumulation period before
distributions begin. This growth is important because it is subsequently used
to determine the amount of guaranteed lifetime income provided by the annuity.
The deferral period can be skipped if the retiree starts lifetime distributions
immediately.

There are two general ways that lifetime
income benefits can grow in a deferral period before the lifetime income commences.
The first is a more complicated method that includes a benefit base, a rollup
rate, and the possibility for step-ups. Deferred annuities with income
guarantee riders generally support the ability to lock-in a guaranteed growth
rate on the benefit base during the accumulation period, and also offer the
ability to define the benefit base as the high watermark of the contract value
of the underlying assets on anniversary dates if that growth is higher than the
guaranteed rate. The benefit base is a hypothetical number used to calculate
the amount of guaranteed income paid during the withdrawal phase. It is
distinct from the contract value of assets, which is what the owner could
access based on actual account growth net of fees and any surrender charges.

For this method, a guaranteed lifetime
withdrawal benefit rider supports an income for life at a fixed withdrawal
percentage (based on the age when distributions begin) of the guaranteed
benefit base. It initially equals the premium paid into the annuity, which is
also the initial contract value for the assets. Over time, the contract value
of assets can rise or fall depending on realized investment returns and as fees
and distributions are taken from the asset base. On any contract anniversary,
if the contract value of the underlying assets has reached a new high watermark
and exceeds the guaranteed benefit base, that base is stepped up to the new
high watermark value. This increases the subsequent amount of guaranteed
income. During the deferral period before distributions begin, an annuity may
also offer a guaranteed rollup rate to increase the benefit base automatically
over time if the value of the underlying contracted assets has not otherwise
grown larger on its own. Generally, the benefit base can grow at the higher of
either a guaranteed rollup rate or the high watermark achieved through contract
value growth.

Roll-up rates are often misunderstood as
guaranteed returns for the annuity. These rates do not impact the contract
value of assets. Their role is only to determine the hypothetical benefit base
that is combined with a guaranteed withdrawal rate to determine the guaranteed
lifetime income. It is the interaction of these two components that matters.

At some point, the owner may stop deferring
and turn on their lifetime distributions. If the retiree does not take out more
than the guaranteed withdrawal amounts, guaranteed withdrawals never decrease,
even if the account balance falls to zero. One exception to this is that some
companies market a feature that allows for higher distributions when assets
remain and lower distributions after assets deplete. The contract may be
terminated at any point with the contract value of the remaining assets, net of
any potential surrender charges, returned to the owner.

Deferred annuities generally make a
distinction between distributions that are covered by the lifetime income
guarantee rider, and one-time distributions that are not covered by the
guarantee. Non-lifetime distributions may be allowed before guaranteed income
begins. That distinction is important, as it would generally allow rollups to
continue, as rollups mostly end once guaranteed distributions begin. As well,
non-lifetime distributions beyond the guaranteed level are allowed after the
guaranteed distributions begin, but this will reduce subsequent guarantees.

The deferral period ends once guaranteed
lifetime distributions commence, beginning the distribution period. Guaranteed
income will be set using an age-based guaranteed withdrawal or payout
percentage rate applied to the value of the benefit base. The guaranteed withdrawal
rate multiplied by the benefit base sets a guaranteed distribution amount
supported for life, even if the contract value of the underlying assets is
depleted. Guaranteed distributions may even increase through step-ups if new
high watermarks are reached for the underlying asset base on the designated
dates when this is checked.

For a simple example, a company might offer
the following payout rates to single individuals based on the age that lifetime
withdrawals begin: 4.5 percent for ages fifty-nine to sixty-four, 5 percent for
ages sixty-five to sixty-nine, 5.5 percent for ages seventy to seventy-nine,
and 6.5 percent for ages eighty and over. For couples, payout rates would
generally be 0.5 percent less and would be based on the age of the younger person.
For couples, another possibility could be that the payout rates remain the same
as for singles, but that a higher fee is charged to support the guarantee over
the longer expected joint lifetime. GLWB annuity payouts generally do not make
a distinction between genders, which would provide benefit to longer living
women relative to men.

There is another way that lifetime income benefits can be
structured that moves away from the hypothetical benefit base and the rollup
rate. This alternative approach is more commonly found with FIAs, while the
method just described is more common for variable annuities. In the alternate
formulation, a lifetime withdrawal percentage, which is still defined by age
bands, is determined at the time the GLWB is added to the annuity. In this
case, it is the age that the benefit is purchased rather than the age that
income begins. Then, rather than using a rollup rate with a benefit base, there
is a deferral credit that increases the withdrawal rate for each year that the
owner defers the start of their lifetime income distributions. When lifetime
distributions begin, they are set as a percentage of the contract value at that
time, where the percentage is rising over time on account of the deferral
credits.

For example, suppose a fifty-five-year-old purchases an FIA
that includes this type of income rider. For this contract, the withdrawal
percentage when purchased at fifty-five is 4.5 percent, and the deferral credit
is 0.3 percent for each year that the individual delays the start of income.
The individual plans to retire at age sixty-five, which would provide ten years
of deferral. That would mean that the lifetime withdrawal percentage is 7.5
percent (4.5 + 0.3 x 10) of the contract value at that age. In this case,
principal is protected only on a gross basis before the rider fee is applied at
the end of each year. Principal would be protected in terms of zero interest
being credited when the index lost value, but the optional benefit charge could
then reduce the value of the principal.

Moshe Milevsky has described the separate
presentation of rollup rates and guaranteed withdrawal rates as telling
consumers the temperature in Celsius when individuals can only make sense of
temperatures provided in Fahrenheit. In this case, what a retiree will
understand is the amount of income guaranteed by the annuity. It may not be
immediately obvious to someone whether an annuity with a 5 percent rollup rate
and 5 percent withdrawal rate is better than an annuity with a 4 percent rollup
rate and a 6 percent withdrawal rate.

Many consumers misinterpret the guaranteed
growth rate on their benefit base as a guaranteed investment return, not
realizing that it is the combination of a growth rate on the benefit base and
the withdrawal rate applied to the benefit base that determine the level of
guaranteed income. These two factors cannot be disentangled. A higher rollup
rate combined with a lower payout rate does not necessarily leave consumers in
a better position. For these reasons, the second deferral credit method is
easier to understand and has a more direct correspondence to how the payout
rate on a deferred income annuity increases with the length of deferrals.

With either method, the payouts on deferred
annuities at different ages will generally be less than the payouts offered by
an immediate annuity purchased at the same age. This can be expected since deferred
annuities provide the advantages of liquidity and potential for upside growth
in the guaranteed income. However, there can be exceptions. For instance,
especially with a long deferral period, the insurance company can expect
that some FIA owners will lapse and not take the guaranteed distributions from
the FIA despite paying for the income rider. This takes the insurance company
off the hook for making good on its guarantee, and through competitive pricing
some of this benefit is returned to the other owners in the risk pool. With an
income annuity, there is no flexibility and so no possibility for mistakes on
the part of owners.

As well, one difference from VAs is that upside potential
for step-ups with FIAs may be more limited. The interest crediting method might
even prevent the possibility of a step-up during the accumulation period with
the rollup rate and benefit base approach. This could happen when a cap on
credited interest is less than the rollup rate, especially when the optional
rider fee would reduce the net cap applied. With the distribution phase as
well, the capped gains could be less than the guaranteed withdrawal amount plus
the rider fee, preventing the possibility for step-ups. For this reason,
greater focus with FIAs should be on their minimum guaranteed protections
without necessarily thinking that step-ups will provide further increases.

The practical impact of the optional rider fee will be to
reduce the contract value a bit more quickly leading to a lower death benefit
than otherwise. But with the focus on income rather than accumulation, the
rider fee is of secondary importance. The goal is not to find the lowest rider
fee, as it would generally support a less generous guarantee, but to find the annuity
that offers the most value through lifetime income to the individual for a
given rider cost. When the individual survives long enough that the annuity contract
value is depleted, the benefit continues to support lifetime income and the
previous fee drag becomes irrelevant.

The income riders on deferred annuities
provide the ability to receive mortality credits, which can reduce the asset base
required to support a lifetime spending goal. The rider fees paid for the
income guarantee provide insurance that the spending will be protected in case
someone experiences a combination of either living too long or experiencing
sufficiently poor market returns that they outlive their underlying investment
assets and cannot otherwise sustain an income for life.

Death Benefits

The standard death benefit for a deferred
annuity is the greater of the contract value of any remaining assets at death, or
the total premiums paid less distributions received by death. It is provided to
the beneficiary. In addition to optional GLWBs (also called living benefits),
deferred annuities also offer optional death benefit riders that create an
opportunity for more than the standard death benefit. One should look carefully
at these as they could be counterproductive for those focusing on getting the
most guaranteed income from their variable annuity. For instance, a common
death benefit rider could support a death benefit equal to the full value of
the annuity premiums if at least one dollar remains in the contract by an
advanced age. One must consider whether it is a wise choice if the focus is
otherwise placed on maximizing the spending power afforded by an income
guarantee, which can involve spending down the contract value completely to
trigger the lifetime income protection. Nonetheless, retirees may consider
these optional enhanced death benefits on deferred annuities as an alternative
to life insurance for funding legacy goals.

Fees

Providing a guaranteed lifetime withdrawal
benefit is a risky endeavor for the insurance company. The insurance company is
obligated to provide lifetime income payments at the guaranteed level if the
underlying assets held within the annuity have been depleted. Variable
annuities with living benefits require managing market risk in addition to
longevity risk. For FIAs, because of principal protection, the rider fees for
living benefits only need manage longevity risk. The greater the investment
volatility and the higher the guaranteed withdrawals that the insurance company
allows, the greater is the cost for creating a risk management framework to
support that guarantee.

When people mention that annuities have high
fees, they generally have variable annuities in mind. Deferred variable
annuities generally have several types of ongoing fees. The first relate to the
underlying funds expenses that would be included with any mutual fund
investment. The only issue to consider here is whether the funds within the
subaccounts have elevated fees due to the inclusion of 12b-1 fees in their
expense ratios, and whether investment options available to the individual
outside of the variable annuity also include 12b-1 fees. These fund fees are
charged on the contract value of underlying assets.

The second type of fee relates to mortality
and expense charges for the insurance company. These fees help to support the
risk pooling and business costs of the insurance company as well as a basic
annuity death benefit. These fees are also generally charged on the contract
value.

A third type of fee that may exist in the
short run are contingent deferred sales charges (or surrender charges) for
those seeking non-lifetime distributions above the allowed levels in the early years
of the contract. Surrender charges receive much of the criticism related
to the fee levels for annuities. Deferred annuities are liquid in that they may
be surrendered with the contract value returned as an excess distribution above
the guaranteed distribution level. But in the early years of the contract, surrender
charges may limit the portion that can be returned without paying a fee. For
instance, surrender charges could work on a sliding scale basis starting at 7 percent
in the first year the annuity is held, and then gradually reducing by 1 percent
a year down to zero after the seventh year that the annuity is held. In this
case, after the seventh year the surrender charges end, and the contract value
will be fully liquid in all subsequent years. Deferred annuities are meant to
be long-term holdings and surrender charges help to recoup the fixed set-up costs
to the insurer for those who leave early.

Finally, optional GLWB riders or enhanced death
benefits require an additional ongoing charge. Rider charges end after the
account is depleted, though this is the source of lifetime protections. Rider
charges can be confusing because they may be charged in three different ways. The
most expensive option is to have the rider charged on the annuity’s benefit
base. As the contract value approaches $0, this will increase the rider cost as
a percentage of remaining assets and work to deplete the contract value more
quickly. Two other options include charging the rider on the contract value of
assets and charging the rider on a declining benefit base equal to the benefit
base less cumulative guaranteed distributions.

With these various fees, it is possible that
total variable annuity fees could add up to more than 3 percent. This, along with
surrender charges, is how variable annuities have developed a reputation as
being a high-cost product.

We can compare this to fixed index annuities,
or fixed annuities more generally. FIAs with living benefits do not require
market risk management since principal is protected and the general account of
the insurance company is designed with asset-liability matching. Only longevity
risk must be managed with the rider fees. FIAs also differ from VAs in
that, as with an income annuity, FIA fees tend to be structured internally to
the product such that there are no observable fees to reduce the contract
value. Fees can be kept internal because they are based on a spread between
what the insurer earns on the assets and what it pays out. The insurance
company earns more from investing the premiums than it pays to the owner. As
with income annuities, it is also possible to reverse engineer and estimate the
internal costs and “money’s worth” for an FIA. This process does get more
complicated because financial derivatives are being used behind the scenes to
provide exposure to market upside. Internal fees are reflected through the
limits placed on the upside growth potential. Of course, upside growth
potential must be limited to support the downside risk protections. The
internal fees for the FIA just mean that upside growth potential is less than
it could have been if the insurance company did not need to cover its expenses
and profit needs.

At the same time, though, households may not be able to earn
the same rates of returns on their funds as an insurance company that obtains
institutional pricing on trades, improved diversification, and longer-term
investment holding periods. The living benefit also provides risk pooling and
mortality credits. It is not always the case that households could easily
replicate on their own what the FIA provides as an accumulation tool even
before adding the longevity protection.

FIAs do not have subaccount charges or mortality and expense
charges. The exceptions to the lack of external fees include that FIAs may
still have a surrender charge schedule in the early years for excess
distributions. This is done to allow the insurance company to invest the
premium in longer-term assets and to cover the company’s fixed expenses for
providing the annuity. These surrender charges will gradually disappear for
long-term owners. As well, any optional lifetime income benefits or enhanced
death benefits added to the contract have observable fees that will be deducted
from the contract value. Though otherwise protected, the contract value of the
FIA could decline on a net basis after accounting for optional rider fees.

Fitting Annuities into a Retirement Plan

A retirement income strategy can extend beyond traditional investment
management to also use insurance and risk pooling with annuities as a part of
managing the changing risks of retirement. The process of building a retirement
income strategy involves determining how to best combine retirement income
tools to optimize the balance between meeting your retirement goals and protecting
those goals from the unique risks of retirement. Retirement risks come in many
forms, including unknown planning horizons, market volatility, inflation, and
other spending shocks. Each of these risks must be managed by combining
different tools and tactics, each with different relative strengths and
weaknesses.

Retirement spending goals can be met through
distributions from the investment portfolio, through annuitized income
annuities, and through lifetime distribution provisions from deferred
annuities. Product allocation is about how to combine these different tools
into an overall plan. With this approach to retirement risk, it becomes
hard to counter the notion that risk pooling and insurance have an important
and valuable role to play. But this still leaves many questions about what type
of annuity to use and what specific contributions an annuity can make.

Filling an Income Gap with an Annuity

A common question about annuities is how much should be
allocated to them. The question is often framed as though the annuity is
another asset class in an asset allocation problem. What is the right asset
allocation between stocks, bonds, and annuities? A better way to approach this question
is to ask how much annuity income is needed to meet the longevity (and potentially
lifestyle) retirement expenses.

The Retirement Income Optimization MapTM (RIO MapTM)
framework described in Chapter 3 provides a summary for how to approach
retirement income. Retirement assets are matched to the liabilities connected
to the four L retirement goals (longevity, lifestyle, legacy, and liquidity).
Assets are positioned in three general categories: reliable income resources,
the diversified portfolio, and reserve assets. Reliable income includes Social
Security and pension benefits, individual bonds, and different types of
annuities providing lifetime income protections. The diversified portfolio is
the traditional investment portfolio and can also include life insurance for
matching to a legacy goal or for coordinating with investments to cover
spending. Reserves are remaining assets that have not been earmarked to cover
other goals and are truly liquid and available to help support retirement
contingencies.

With this framework, the amount of portfolio assets to
earmark as an annuity premium is based on how much is needed to support at
least the longevity goals after accounting for the other reliable income
resources. For example, suppose an individual reaches retirement with $1
million in an IRA and a $30,000 Social Security benefit. This retiree seeks to
spend $70,000 per year, of which $45,000 is deemed as essential expenses. After
Social Security, there is a $15,000 gap for reliable income. Suppose the
retiree is considering an annuity with a 5.78 percent payout rate for lifetime
income. The cost of filling the income gap is the $15,000 gap divided by
0.0578, which is $259,516. This represents 25.9 percent of portfolio assets, and
it would serve as the starting point for analyzing the annuity allocation
decision. The retiree must evaluate whether this is a reasonable portion of the
overall asset base to devote toward an annuity. To make the decision more
precise will require tax considerations as well as a strategy for managing
inflation for the spending goal. But this process is the easiest and most
practical way to think about allocating assets to annuities with income
protections.

Upside Exposure, Downside Protection, and
Liquidity Provisions

Given a targeted amount of annuity income, the next question
becomes what type of annuity to use: income annuities, variable annuities, or index
annuities? Each provides a different balance among the tradeoffs between upside
potential, downside protection, and liquidity provisions.

As a simple starting point, income annuities, when treated
as bonds, will frequently be the most efficient way to incorporate lifetime
income into a plan. This was a conclusion I have reached when exploring the efficient
frontier for retirement income where I look at performance of various
combinations of asset classes and annuities. I found that stocks and income
annuities replace stocks and bonds on the efficient frontier for retirement
income planning. The efficient frontier is about the tradeoffs between risk and
return and finding asset and product allocations that cannot provide greater
advantage for one without creating loss for the other. For retirement, that
involves the trade-off between satisfying spending goals for life and
preserving financial assets for legacy and liquidity. Deferred annuities with
lifetime income provisions also tend to beat bonds for retirement income because
of the mortality credits they provide to help support spending in the event of
a long retirement.

In practice, it is uncommon to find someone who is
comfortable with the combination of a life-only income annuity and very
aggressive asset allocation for the remainder of the investment portfolio. The
math shows this to be the most effective combination, but it is not the most
palatable as retirees have concerns about both life-only annuities and high
stock allocations for the rest.

Deferred variable annuities and fixed index annuities play a
role for those attracted to the upside and liquidity features they offer
compared to income annuities. In some circumstances, they may even make it to
the efficient frontier of options by providing higher protected income levels
or a better overall asset allocation for retirees struggling with the concept
that income annuities should replace bonds. Deferred annuities also offer
greater flexibilities for the income start date and the opportunity
to exchange into a different annuity or even no annuity in the future, as there
is less lock-in when the contract has not been annuitized.

In theory, simple income annuities should offer the highest guaranteed
payout rates. Their simple design lacks any special features like liquidity and
upside potential that require additional cost. The income annuity can offer the
most downside protection but no upside potential. Even though that downside benefit
may be less, an important selling point of deferred annuities is that they potentially
provide more than just a minimum guaranteed withdrawal benefit. More generally,
fixed annuities should offer higher guaranteed withdrawals than variable
annuities because fixed annuities do not need to manage market risk in addition
to longevity risk. With principal protection, the worst-case scenarios for
fixed annuities can be known. FIAs will fall in between income annuities and variable
annuities both in terms of their downside protections and upside potential. Variable
annuities will require the greatest costs to provide protection, since they
also manage market risk, and this will generally lead them to offer the least
downside protection in terms of guaranteed lifetime withdrawal benefits. But competitive
variable annuities will provide the most upside potential, especially with
lower costs, higher quality investment choices, and investment freedom to
choose an aggressive asset allocation.

Generally, as just described, accepting less upside
potential allows for the possibility of more robust downside protections. But
there can be exceptions. FIAs can occasionally have higher guaranteed payout
rates than income annuities, as deferred annuities provide discretion to owners
to make irrational decisions. Not everyone takes advantage of distributing the
full allowed guaranteed amounts from deferred annuities, which reduces the odds
for the contract value to deplete and eases pressure on the insurer. Through
competition, this can lead to a higher payout rate on the living benefit for an
FIA. There can also occasionally be exceptions in which variable annuities can
offer comparable guarantees to fixed annuities, particularly in cases where the
VA may have very limited bond subaccount options for investments that lead to
less downside risk. Indeed, the type of annuity offering the most guaranteed
income can vary depending on household characteristics, the length of deferral,
and potential future changes in pricing and product offerings. Shopping around
between different types of annuities to obtain the best deal available at any
given moment is a worthwhile endeavor.

This provides a framework for choosing between annuity
types. It is worthwhile to first investigate what the guaranteed income levels are
with different annuities at the targeted retirement date if purchased today.
The annuity offering the most guaranteed downside income then becomes the
baseline. Then consider whether there are additional reasons to choose a
different annuity with less guaranteed income but with attractive liquidity
provisions, upside growth potential, or even a better death benefit. When
comparing deferred annuities with income annuities, including a cash refund
provision for the income annuity would provide the closest approximation to the
standard death benefit of deferred annuities. The difference in worst-case guaranteed
income levels from different annuities reflects the effective cost of these other
features. Especially, with upside, if growth potential is achieved for deferred
annuities, then step-ups may be realized, and lifetime income could be higher
than the minimum guaranteed level.

With the investment options and annuity
features, how likely is it that the contract value can grow, and how important
is it to the retiree to maintain the liquidity provided by the contract for
those assets? About liquidity, we must remember that deferred annuities may not
provide true liquidity if those assets are earmarked for income because excess
distributions beyond the guaranteed amount will reduce the subsequent amount of
guaranteed income provided. One application of deferred annuities, though, is
to pay for the income protection to manage sequence risk and then if sequence
is not realized in the early retirement years, one may decide to drop the
guarantee from their plan. If a retiree values this liquidity and optionality about
changing the decision later, then comparing the amount of guaranteed income
lost to provide the liquidity (and upside) helps to quantify the tradeoff for
the decision between income annuities and deferred variable annuities with
income guarantees.

To summarize, but with a reminder that there
are exceptions to these trends, the variable annuity maintains a contract value
that can rise and fall with the markets, creating more upside potential and
downside risk than other annuities. The fixed index annuity offers upside
potential and liquidity, but generally less upside potential than a variable
annuity and less minimum guaranteed income than an income annuity. It falls in
the middle. Income annuities do not offer liquidity or upside, but they are usually
the most efficient way to secure a stream of protected lifetime income with the
least amount of assets. The idea would be to then use other non-annuity assets
as the source for liquidity and upside, which leads to the next section.

Annuities, Asset Allocation, Legacy, and True
Liquidity

The next important detail is deciding which investment
assets should be sold to fund the annuity purchase. The potential benefit from
annuities depends in part on how they are treated as part of asset allocation.
Annuities have a better chance to work when they are treated as a bond and
funded through the sale of bonds. Annuities become a bond replacement. That is
the idea of the efficient frontier for retirement income mentioned in the
previous section: stocks and annuities, instead of stocks and bonds. Over the
long term, this can lay the foundation for greater legacy and liquidity for the
retirement plan after also providing a stronger foundation to meet spending
goals.

Annuities are not the intended source for legacy or
liquidity. Income annuities do not provide liquidity or legacy without adding
provisions which reduce the value of their mortality credits. As well, for
deferred annuities with income benefits, the point is to use these assets to
support spending and the liquidity and legacy potential of the assets is of
less importance even though it may be a behavioral selling point for the
annuity. These assets can be spent down because they continue to provide income
even after they are depleted, and this can provide relief for other non-annuity
assets to have less commitment to funding spending and more opportunity to
grow.

There is more to the story about liquidity and legacy as
relates to how an annuity fits into an overall plan. Often the discussion
around annuities frames the matter incorrectly, as if it is an all-or-nothing
decision. Partial annuity allocations let us think about how we allocate assets
toward meeting different goals.

Annuities will work best when their owners view them as part
of the “bond” allocation for retirement, so that overall stock holdings do not
decrease with a partial annuity strategy. To keep the value of stock holdings the
same, this does suggest that the stock allocation will be higher for the
remaining portfolio assets outside the annuity. While this can cause some
behavioral concerns, treating the annuity as a bond is justified.

In the discussion about “optimal withdrawal rates” from the
previous chapter, we noted that for someone who worries about outliving his or
her portfolio, does not have much additional income from outside the portfolio,
mostly faces fixed expenses without much room to make cuts and does not have
much in the way of backup reserves, it may be necessary to spend and invest quite
conservatively to achieve a high probability of plan success. This individual
has less capacity to bear financial market risk because their lifestyle is more
vulnerable to a market downturn. In an investments-only world, such individuals
would look to using a lower stock allocation and a lower spending rate.

Meanwhile, someone who has less fear about outliving his or
her portfolio, has additional income sources from outside the portfolio, has
the flexibility to cut portfolio spending without adversely impacting the
living standard, and has sufficient additional reserves, a higher spending rate
and more aggressive asset allocation could be quite satisfactory and optimal. Repositioning
a portion of assets into an annuity offering lifetime income protections will
contribute to better achieving these characteristics.

First, reliable income is increased through the annuity.
More of the spending goal is now covered by reliable income assets that are not
exposed to downside market risk. I use the term GRIP, or Guaranteed Retirement
Income Percentage, to describe this concept. When the GRIP increases, more of
the total spending budget is covered by resources with lifetime protections.
This reduces the harm of investment portfolio depletion because more retirement
spending is available outside the portfolio. With less exposure to downside
market risk, the retiree has greater risk capacity and can rest more easily
with a higher stock allocation for what remains. Adding protected lifetime
income provides a stronger GRIP on retirement.

Second, for those with longevity risk aversion who are
planning for a retirement lasting beyond life expectancy, using annuities with
lifetime income benefits can mean that the present value of annuity benefits in
the financial plan is greater than the annuity cost. With this subjective view
toward longevity, the annuity asset is worth more than the premium, and this
increases the funded ratio for the plan. Though the annuity does not increase
plan assets in the objective sense, it does increase assets in the subjective
sense that the plan is aiming to work to an advanced age, and people who live
longer will receive more from the annuity. The remaining portfolio is available
for more discretionary uses since the mortality credits of the annuity are
covering more of the spending goal in the long run. The retirement is more
secure, justifying a higher stock allocation for the portfolio piece of the
asset base.

The third factor is the availability of
reserves. What other resources are available that have not been earmarked to
manage spending and can be used to cover contingencies? Having more reserves
available means less reliance on the assets covering other goals to outperform
and to create reserves through market gains. By helping to meet spending goals
with less assets, the annuity creates additional reserves that provide true
liquidity. With this added flexibility, the retiree can feel more comfortable
with the aggressive asset allocation because there is less exposure to the
possibility of having to sell assets at a loss to cover contingencies, and then
not having enough left to cover other subsequent spending needs.

Finally, traditional risk aversion is the countervailing
force for all of this, and this is the factor that may receive the most
attention. Though the investment portfolio is a smaller portion of the overall
asset base after some of it is sold to purchase the annuity, the retiree must
still be comfortable with the greater short-term portfolio volatility that a
more aggressive asset allocation will imply. Conceptually this is justified, as
we have discussed. But the retiree must accept and understand these points to
avoid the potential of panicking and not following the strategy during market
downturns. An income annuity is still an asset even though it does not appear
on the portfolio statement. To be effective, retirees should view the annuity
as part of their bond holdings and adjust their portfolio accordingly. This is
also an area where deferred annuities can help with the psychology behind
holding annuities. If retirees cannot overcome the psychological hurdle to adopt
a higher stock allocation after adding an annuity, the likely outcome will be a
reduction in their overall allocation to stocks, which will undermine the
effectiveness of a partial annuity strategy.

To better make this case, we can also discuss why annuities
are “bond” like in their characteristics. First, income annuities provide
bond-like returns with an additional overlay of mortality credits. The
insurance company providing the annuity is investing those funds primarily in a
fixed-income portfolio. For someone wishing to spend at a rate beyond what the
bond yield curve can support, bond investments will essentially ensure that the
plan will fail. Income annuities are actuarial bonds. They provide
longevity protection which is unavailable with traditional bonds. Income
annuities are like a bond with a maturity date that is unknown in advance, but
which is calibrated and hedged specifically to cover the amount of lifetime spending
needed by retirees.

Likewise, fixed index annuities that are linked to stock
indices will also be more effective for those who treat them as part of their
bonds. With principal protection, FIAs have less downside risk than either
stocks or bonds. Bonds, of course, can experience capital losses when interest
rates rise. But can enough upside be captured with the FIA to beat either
stocks or bonds on a risk-adjusted basis? Though the interest they credit may
be linked to a stock index, the returns on FIAs will be closer to bonds than to
stocks. Owners should not think about FIAs as an alternative to owning stocks
but rather as another option for fixed-income assets that protects principal
and has the potential to outperform bonds when considered net of taxes and
fees. With their principal protection, retirees may even consider increasing
their stock allocation when replacing bonds with an FIA. The point is that FIAs
provide returns comparable to bonds and can be treated as such even when linked
to a stock index.

For variable annuities, the discussion is more complex as
these annuities allow for stock investments to be held in the subaccounts. But
when providing for lifetime spending, the guaranteed living withdrawal benefit
serves as a “put option” on the stock market. Put options are financial
derivatives that provide upside exposure while protecting from downside risk. When
the stock market drops, even though the contract value declines, a GLWB
protects lifetime retirement spending from this downside risk. This can allow retirees to feel more comfortable increasing their stock allocation in
the variable annuity relative to an unprotected portfolio, or to otherwise view
the variable annuity as a bond-like asset when framing retirement risk as the
ability to meet financial goals rather than the underlying volatility of assets.

Moshe Milevsky and Vladyslav Kyrychenko have provided
research based on over one-million variable annuity policy holders showing that
those with optional income guarantees were willing to have about a 5 percent to 30 percent higher stock
allocation than those without guarantees on their variable annuities. For
instance, someone willing to hold 30 percent stocks
without a guarantee may increase their stock allocation to between 35 percent and 60 percent with an income
guarantee in place. This demonstrates an understanding and willingness in
practice to view stocks held inside the variable annuity as being less “risky”
to spending goals.

Having the income guarantee supported with
actuarial bonds increases the risk capacity of retirees, as their retirement
standard of living is less vulnerable to a market downturn. This can provide
the capacity to use a higher stock allocation when a guarantee is in place,
both inside and outside of a variable annuity. This works inside the variable
annuity because the income guarantee protects income on the downside while
still offering upside potential. Outside the variable annuity, the income
guarantee reduces the harm created if portfolio assets deplete, providing
increased risk capacity.

There are situations when variable and index
annuities might help to achieve more efficient outcomes in retirement in terms of
the combination of spending and legacy over retirement portfolios without a
variable or index annuity component. These relate to asset allocation and
whether it may change when an income guarantee is in place. Income guarantees
provide greater relative benefit to retirees who are either willing to invest
more aggressively because of the guarantee, or who would otherwise be
uncomfortable using stocks in retirement.

Those who accept the notion that the income
guarantee increases risk capacity and are willing to use a more aggressive
asset allocation than otherwise both inside and outside of the annuity, could
find that the additional exposure to the stock market equity premium more than
offsets the annuity fees when markets perform well in retirement. The guarantee
is also valuable if it otherwise stops retirees from panicking and selling
stocks after a market drop. And when markets perform poorly, by paying an
insurance premium for the income protection, one should anticipate depleting
the underlying asset base sooner than with a lower-cost, investments-only
strategy. But because the annuity still includes a lifetime guarantee, retirement
spending will be supported after assets deplete.

Variable and index annuities could also create
better outcomes for those who would simply use a lower stock allocation no
matter the chosen retirement strategy, but who are unwilling to sacrifice the
liquidity foregone with an income annuity. With a low stock allocation,
investment assets are more likely to deplete, as there is only so much spending
that bonds can support. The annuity provides the opportunity to continue with
income for life even after the contract value of assets is gone. Without
exposure to the risk premium, the contract value of underlying assets is more
assured to deplete in the event of a long retirement. With investments-only,
asset depletion ends the ability to spend, but an income guarantee assures this
continued spending ability for life.

When allocating from bonds to annuities with lifetime income
protections in the retirement income plan, the risk pooling from annuities can
lay the foundation for more legacy (at least after life expectancy) and
liquidity in the financial plan. In early retirement, legacy will naturally be
less with partial annuitization or with a deferred annuity with surrender
charges. But for conservative spenders where the payout rate from the annuity
is higher than the initial withdrawal rate, with partial annuity use there is less
pressure on the portfolio in the early retirement years. This allows non-annuity
assets to grow more over time as mortality credits reduce the need to spend these
other investment assets. The remaining investment assets may eventually grow to
catch up with where an investments-only strategy would have been at about the
life expectancy. Beyond that age, the increasing role for mortality credits
allows the partial annuity strategy to get further ahead with legacy compared
to an investments-only strategy.

When retirement is short, partial annuity strategies often
lead to a smaller legacy, though the remaining legacy from investment assets is
still reasonably large. For longer retirements, partial annuity strategies
provide sound spending support while also fortifying a larger legacy. By
requiring less assets to meet spending, risk capacity increases and the
withdrawal rate from remaining assets decreases. Non-annuity assets can grow
with less sequence risk, creating better long-term opportunities for legacy. Short-term
sacrifice supports long-term gain.

As for true liquidity in the plan, consider a couple who
believes that the 4 percent rule serves as an appropriate guide for their
retirement spending. They seek to spend $40,000 per year with inflation adjustments,
and they have $1 million invested in stocks or bonds through their brokerage
account. Does this couple have any liquidity? Yes, technically, since they do
have $1 million of liquid financial assets. But in a meaningful sense, this
couple does not have liquidity. They are not free to use that $1 million
for other purposes. The full amount must be tied up to support their spending
objectives. An investment portfolio is a liquid asset, but some of its
liquidity may be illusionary if those assets are already earmarked for specific
goals. This distinction is important because there are cases when tying up a
portion of assets in something illiquid, such as an income annuity, may allow
for the household liabilities to be covered more cheaply than could be done
when all assets are positioned to provide technical liquidity.

Many real-world retirees end up earmarking more assets than
necessary to support income, and therefore spend less than possible because
there is no guarantee component with investments, and they worry about
outliving their assets. In simple terms, an annuity with lifetime income
benefits that pools longevity risk may allow lifetime spending to be met at a
cost of twenty years of the spending objective, while self-funding for
longevity may require setting aside enough from an investment portfolio to
cover thirty to forty years of expenses. The amount to be set aside with
investments grows with the longevity risk aversion of the retiree. Because risk
pooling allows for less to be set aside to cover the spending goal, there is
now greater true liquidity and therefore more to cover other unexpected
contingencies without jeopardizing core-spending needs. True liquidity will be
larger whenever the payout rate for the annuity is greater than the determined “safe”
withdrawal rate from investments as based on the retiree’s risk aversion. As
this will be the case for risk averse retirees who plan for living longer than
average while earning below average portfolio returns, allocating to an annuity
to cover an income gap can create more true liquidity for the overall
retirement plan. Risk pooling and mortality credits allow for less to be set
aside to cover the spending goal, creating greater true liquidity to cover
other unexpected contingencies without jeopardizing core spending needs.
Liquidity, as it is traditionally defined in securities markets, is of little
value as a distinct retirement goal. The distinction between technical and true
liquidity is important.

Inflation Risk Management and Annuities

A common question about annuities relates to inflation
protection and whether it should be incorporated into the annuity. We can
distinguish between whether the retiree needs the annuity to provide
inflation protection and whether the retiree wants the annuity to
provide inflation protection. With a lower payout rate,
an income annuity providing income growth and inflation protection will require
a larger premium to build up the same initial spending power. Alternatively,
the same premium amount will buy less initial income when this income grows
over time. Obtaining inflation protection means trading less spending early on
for more spending later. Likewise, many deferred annuities with GLWBs may offer
the potential for step-ups to keep pace with inflation, but retirees should
recognize that the probability this will happen could be low as the retirement
gets longer.

The tradeoff is that with level annuity spending, the
remaining investment portfolio must also cover the subsequent inflation
adjustments that the level annuity does not provide. Less can go into the
annuity initially, leaving more in the portfolio, but the subsequent demands on
the portfolio will be greater to also cover the missing inflation adjustment
for the annuity portion. As it turns out, the lower withdrawal rate from
investments can help assets to grow and to manage sequence risk, such that the
higher spending need later in retirement can be more effectively managed. For
this reason, I do not think it is necessary to include inflation protection
into the annuity. I think that the common concern about annuities not providing
inflation protection is framing it as an all-or-nothing decision, rather than
recognizing that the annuity facilitates the use of other non-annuity assets as
a source of inflation protection.

Meanwhile, the decision about whether the retiree will want
inflation protection for the annuity is a different matter. Some worry quite a
bit that inflation will be much higher in the future than it is today. The
possibility of high inflation would make the inflation-adjusted annuity a more
attractive choice. At the present, CPI-adjusted annuities are not available,
and having a fixed COLA will not really help with an unexpectedly high
inflation rate. If CPI-adjusted annuities were available, the retiree must
decide whether it is worth paying the additional cost to obtain contractually
protected lifetime inflation-adjusted income beyond what Social Security
provides, or whether to instead use a lower initial premium to obtain level
income from the annuity. The retiree can then try to manage the inflation risk
through the investment portfolio and through the synergies of reducing sequence
risk by being able to use a lower distribution rate from the remaining
investments. While there is a risk because there is not an asset specifically
linked to inflation, my research suggests that the latter approach is generally
worthwhile.

One additional important point about this discussion is that
it has presupposed that retirees desire their overall spending to consistently
keep pace with inflation. The reality is that the inflation-adjusted spending
for many retirees can be expected to decline with age. Other income sources,
such as Social Security, will adjust their benefits with inflation. And as partial
annuity strategies mean that only a fraction of overall income is provided by
the annuity, it may be the case that an income annuity with level payments will
match the spending needs of real retirees more precisely. In other words,
having those inflation adjustments may not even be necessary in many cases. If
retirees do find that their inflation-adjusted reliable income is falling short
of their longevity spending goals, it is always possible to ladder in additional
annuities to support more reliable income.

Framing Annuity Fees

We have described the
fees for different types of annuities, and it is worth returning to this issue.
As we noted, fees for fixed annuities are often less and are based on spreads
between what the insurer can earn on the assets and what is credited as
interest. They must be reverse engineered since there are not always explicit
fees beyond those on optional benefits.

This discussion is mostly about variable
annuities. Their fees are often presented as one of the biggest objections to
annuities, and sometimes fixed annuities get caught in that crossfire. Variable
annuities have generally come under attack for the higher internal costs
relative to an unprotected investment portfolio.

It is important to frame the issue of variable
annuity fees in terms of the potential value the variable annuity can provide
to a retirement income plan. Variable annuities may have higher ongoing charges
than non-annuity investment portfolios, but a portion of those fees are to pay
for the assurance of a lifetime income in the face of longevity and market
risk.

It may be easiest to think about the fee issue
by comparing to simple income annuities. Income annuities do not include
transparent fees, as the fees are internal to the product and the payout rate
is provided on a net basis. Money’s worth measures can be used to back out the
implied fees for an income annuity. But if we frame the income annuity in the
same way as a variable annuity, we conclude that the income annuity has a 100
percent fee at the time the contract is signed, and the premium is paid. Once
an income annuity is purchased, assets are relinquished to the insurance
company and will be inaccessible at any point in the future when the annuitant
remains alive (there could be a cash refund provision at death). There is no
contract value.

In contrast, deferred variable annuities
provide liquidity through the contract value. Variable annuity liquidity allows
for the guarantee to be ended at any time, returning any remaining assets.
Excess distributions are allowed with a proportional reduction to the
guarantee. The fee drag will work to gradually reduce the contract value over
time rather than eliminating it immediately.

In practice, we do not describe the income
annuity as having a 100 percent fee. Rather, we focus on the role its
guaranteed income can play in the overall financial plan. Variable
annuities maintain a contract value which has a higher cost associated with it,
but the focus should be on how much must be earmarked to fund different
retirement goals. With risk pooling, an income rider may allow fewer assets to
be earmarked to meet retirement spending needs, which supports the annuity’s
value proposition. Also, if fewer assets are needed to comfortably meet the
spending goal, then even a higher fee drag on a smaller asset base may not lead
to more overall fees.

More broadly, in the context of the retirement
income plan, focusing on the internal costs of a variable annuity is not the
best way to frame the problem we are attempting to solve. Is an
investments-only strategy with lower internal fees preferable if that approach
to managing longevity and sequence risk translates to spending less or delaying
retirement? That is the context in which to assess fees: can they support
better outcomes through risk pooling that reduce the overall costs of the plan
in terms of the asset base required to meet the financial goals of retirement?

There is also another aspect of variable annuities related
to asset allocation. If one maintains the same asset allocation
both inside and outside of the variable annuity, then the additional fees for a
variable annuity can be expected to deplete the underlying value of the assets
more quickly than if they were held in an unprotected investment account with
lower fees. However, this outcome changes since an income guarantee can support
using a higher stock allocation within a variable annuity. In this case, when
markets do well in retirement, the additional exposure to the risk premium can
more than offset the higher costs of the variable annuity to allow for greater
overall growth in assets. This can support greater legacy after meeting the
same spending goal. If markets perform poorly in retirement, the additional
costs within the variable annuity could cause depletion of assets sooner than
otherwise. But with poor returns, the investments-only portfolio will be on
track to depletion shortly thereafter. With the variable annuity assets, at
least, the income guarantee continues to support spending after the contract
value depletes. With investments-only, spending power ends. The simple argument that higher fees makes annuities
unattractive is not the whole story.

Action Plan

For retirees who view annuities as a bond
replacement and whose overall spending goal implies a lower withdrawal rate
than the annuity payout rate, partial annuity strategies can increase success
rates, raise the proportion of lifetime spending goals that can be covered, and
improve legacy outcomes especially for those living beyond life expectancy,
relative to an investments-only strategy. The mortality credits provided
through risk pooling provide relief for the distribution needs from non-annuity
assets, giving them more potential to grow. But not everyone will need or want
an annuity. Some retirees may already have plenty of lifetime annuity income through
Social Security and traditional defined-benefit pensions. The action items for
determining whether and how to include annuities within your retirement income
plan include:

o
Assess whether your characteristics and preferences are aligned
with obtaining greater value from an annuity.

o
Your RISA Profile suggests that your preferences align with income
protection and risk wrap strategies.

o
You have an income gap in which there is not enough reliable
income to cover your longevity expenses.

o
Your risk tolerance limits your comfort with stocks in
retirement. The case for annuities is stronger for those with a lower stock
allocation.

o
You have greater longevity risk aversion. Concerns about
outliving retirement assets lead to more relative benefits from annuities as
the alternative is to spend even less from investments.

o
You view annuities as a replacement for bonds and are comfortable
using a higher stock allocation with remaining investment assets.

o
You seek protection from making behavioral mistakes with your
investment portfolio, you lack self-control for spending, or you find investments
intimidating. Annuities may also protect less financially savvy family members.

o
Learn about the features and mechanics of different annuities.

o
When comparing annuities for lifetime income, it is essential to first
focus on the minimum guaranteed withdrawals for your purchase age and
anticipated income starting age.

o
Consider your preferences for tradeoffs between upside and
downside, the desire for liquidity, and the types of asset allocations you
would use both with and without income protections.

o
Determine whether there may be an annuity option with other
attractive features that make it worth accepting even if it does not have the
strongest downside guarantees.

o
Determine the income gap you are seeking to fill and decide
whether the amount of assets needed to fill that gap with annuities is
reasonable. Decide on a premium amount.

o
Take your time with making this purchase decision.

o
Discuss the decision with family members to coordinate both with
the spouse and with any potential heirs.

o
Work with someone who is familiar with the vast array of
available annuities and understands which work better for different purposes,
ages, and deferral periods.

o
Make sure you understand how the annuity works with respect to
its various features and fees.

o
Understand how the annuity taxes work (see Chapter 10).

o
Only add living or death benefits that you intend to use.

o
Consider diversifying purchases between different companies and
even different types of annuities.

Further Reading

Milevsky, Moshe A., and V. Kyrychenko. 2008. “Portfolio
Choice with Puts: Evidence from Variable Annuities.” Financial Analysts
Journal, Vol. 64, No. 3 (May/June), p. 80–95.

Olsen, John L. 2020. John Olsen’s Guide to Annuities
for the Consumer, 4th Edition. St. Louis: John Olsen.

Pfau, Wade D. 2019. Safety-First Retirement Planning:
An Integrated Approach for a Worry-Free Retirement. Vienna, VA: Retirement
Researcher Media.

Chapter 6: Social Security

Social Security retirement benefits support a
lifetime income in the same way as an annuity. For most Americans, Social
Security benefits serve as the core component of retirement income. About 90
percent of retirees in the United States will be eligible for Social Security. As
a government-backed, inflation-adjusted monthly income for life, Social Security
benefits help to manage longevity risk, inflation risk, and market risk. In
addition to retirement worker benefits, Social Security also provides spousal,
survivor, and dependent benefits from the retired worker’s earnings record. Social
Security benefits also receive preferential tax treatment.

This makes the Social Security claiming
decision very important. It is vital to understand that the decision for when
to start Social Security should be made independently from when one decides to
leave the labor force. Claiming decisions should not be taken lightly. It is
possible to gain much from Social Security simply by understanding how the
system works.

This chapter will walk you through the steps
required to have a firm understanding about Social Security claiming. I will
discuss how Social Security benefits are calculated and how to factor in issues
such as spousal and survivor benefits for couples, dependent benefits, and
benefits for divorcees. I will also look at the earnings test, and the windfall
elimination provision and government pension offset for those spending a
portion of their careers outside of the Social Security system. I will also
explain cases where benefits may be suspended for strategic reasons.

I also consider the philosophies about
claiming Social Security, including its insurance value to protect for a
long-life, breakeven analyses on when delaying benefits will pay off, and the validity
of arguments made in favor of claiming Social Security early. The latter
involves a discussion of Social Security's history, and potential reform
options related to what may happen as the Social Security trust fund approaches
depletion. The intention for this chapter is to give you the knowledge and
confidence to approach Social Security to create the most long-term value for
your retirement income plan.

Introducing the Social
Security Claiming Decision

Any discussion of life annuities would not be
complete without discussing a life annuity that will be available to most
Americans: Social Security.  The Social Security claiming decision should
be made independently from when one decides to quit working and retire. Too
many people believe they are related and that a visit to the Social Security
office is an automatic part of leaving work. It is perfectly okay to retire and
to wait until a later date to begin Social Security benefits.

Deciding when to claim Social Security benefits is
complicated. Entire books are available for those who really want to dig deep
into this subject (see Further Reading at the end of the chapter for my
favorites). I will take the approach of summarizing the key issues and ideas at
work to give readers a good understanding about how to proceed, and to know
which specific special cases may apply to their situation that could require a
deeper dive.

A key idea in this chapter is that because
Social Security is so complicated, it is worthwhile to take the time to investigate
your situation with a comprehensive Social Security claiming software package.
Even with a small nominal cost, the difference in lifetime outcomes between
good and bad claiming strategies could add up in some cases to be more than
$100,000 of additional lifetime benefits. There are a lot of special
circumstances that could otherwise be too easily overlooked.

I do not have any affiliation with the
following software programs, and these are not endorsements, but I do have
respect for their creators. Any of these programs are available to consumers,
as opposed to financial advisors, and should provide a good idea about a proper
course forward:

·
Mike Piper’s Open Social Security (https://opensocialsecurity.com/)
is a free open-source online calculator.

·
Larry Kotlikoff’s Maximize my Social Security (www.maximizemysocialsecurity.com)
offers an annual household license for $40.

·
William Reichenstein and William Meyer’s Social Security
Solutions (https://www.socialsecuritysolutions.com/) offers various pricing
options starting from $19.95 for a year of access and a detailed custom report.

If you are ambitious and test your case in all
three programs, you may find slight differences in the recommended claiming
strategies. These will result from different assumptions used regarding
longevity and interest rates. Making sure that the assumptions used in each
program are the same should close any gaps. Especially, longevity assumptions
can create a big impact on which strategy works out best. But overall, the
optimal strategies from each program will ultimately lead to similar outcomes
and the differences between strategies that are close to optimal will be small
enough that you have some flexibility for your choice. The difference in
lifetime outcomes between “good” and “bad” strategies can be massive.

Another key point is that the Social Security claiming
decision must be made as part of an overall plan and not in
isolation. It is important to coordinate with investments or other assets in
terms of building a Social Security delay bridge if retiring before claiming, to
coordinate on the tax side to pay less taxes over time by better managing tax
brackets (see chapter 10), and to coordinate with respect to how Social
Security impacts the Retirement CARE AnalysisTM by providing more
capacity to bear financial market risk (see chapter 13).

In January 2021, the Social Security Administration reported
that the average monthly Social Security benefit for retired workers is $1,543
per month, or $18,516 per year. For a couple, total benefits would be larger if
two people are eligible for benefits, either on their own work records or as a
spouse. Individuals with above average lifetime earnings will be entitled to
even larger benefits, and the average benefit received is less than otherwise
possible because most Americans claim benefits before their full retirement age
and are subject to benefit reduction factors. Delaying the start of your
benefit would also help to provide a larger amount.

The Social Security Administration’s online calculator shows
that individuals turning 70 and claiming at this age in 2021, and who earned
the maximum taxable earnings over their career up to this point, will be
entitled to a maximum possible benefit of $3,895 per month or $46,740 per year.
Over 20 years, that is $934,800 of real spending power just for the worker’s
benefit. It will exceed $1 million including spousal benefits or for a
retirement lasting beyond 20 years.

The full retirement age has been 66 in recent
years, applying to those born between 1943 and 1954. As of 2021, the full
retirement age begins increasing by two months each year until it reaches 67 in
2027 for those born in 1960 and later. In 2021, those turning 62 face a full
retirement age of 66 and 10 months, and anyone 61 or younger faces a full
retirement age of 67. Since we are getting close to that point and to simplify
the math around not having to factor in benefits for partial years, I will
treat 67 as the full retirement age for examples used in this chapter.
Nonetheless, individuals can claim their Social Security retirement benefits as
early as age 62 (with reductions) and will receive delay credits for their own
benefit after the full retirement age for waiting up to age 70. There is
no reward provided for delaying beyond age 70.

To the extent that wages will grow faster than consumer prices,
current Social Security rules support further benefit growth for wage earners
born at later dates. And it is also important to remember that benefits will
grow with inflation throughout retirement.

I will also use an additional simplification
about birth dates. A quirky aspect of Social Security is that one is assumed to
reach an age on the day before their birthday. Someone born on January 1 is treated
as being born in the previous year. In the previous paragraph, when I refer to
those born in 1954, for instance, I mean born between January 2, 1954, and
January 1, 1955. To facilitate the discussion, I keep this as simple as
possible, but it is important to remember for those born on the first day of
the month.

Social Security is a significant retirement asset. The
present value of Social Security benefits at retirement, which can total
hundreds of thousands or even millions of dollars, joins home equity as the top
two assets available for most American retirees, easily dwarfing the value of
investment portfolios. Especially for lower- and middle-income Americans,
Social Security may end up supporting most retirement spending.

For higher lifetime earners and savers, the relative
importance of Social Security will be less. Nonetheless, for those experiencing
a sufficiently long retirement, total Social Security benefits could easily
exceed $1 million, and optimal Social Security claiming decisions could end up
supporting more than $100,000 of additional retirement income, relative
to less effective claiming choices. It is hard to find people wealthy enough
that this is not a big deal.

It is also important to recognize that case workers at
Social Security offices may not know about sophisticated claiming strategies,
as they otherwise generally assume that the reason for visiting them is because
you want your benefits to start sooner rather than later. They cannot advise
you on your decision.

Social Security claiming strategies involve deciding on
which age to claim retirement benefits. Those benefits can be claimed starting
at age 62, and additional credits are available for delaying benefits up until
age 70. For a single person, the claiming decision is a matter of picking the
start date for benefits. The decision is more complicated for couples or
singles with dependents, though. For couples, each spouse must consider when to
claim their own benefit, when to claim their spousal benefit (for the few left
that can make this distinction), and the impact of their claiming decision on
whether their spouse has access to a spousal benefit and the size of a survivor
benefit. Any potential benefits for dependents must also be factored into these
decisions as well.

Brief History of Social
Security

Recipients of Social Security benefits today include not
just retirees, but also disabled workers, spouses, and young children of
deceased or disabled workers, and the spouses, dependents, and survivors of
retirees. However, this was not always the case. In fact, the original Social
Security Act of 1935 created retirement benefits for only the retired worker,
who became eligible at age 65. In 1939, Congress passed amendments to extend
benefits to spouses and minor children of retired workers, as well as to the
widows and minor children of deceased workers. Disability insurance arrived in
1954, and in subsequent years, the disability program expanded to include the
families of disabled workers. In 1972, Congress passed legislation to create
annual cost-of-living adjustments for benefits. Prior to that time, benefit
increases were subject to the whims of Congress and happened only
intermittently.

The 1975 Social Security Trustee’s report estimated that the
Old-Age, Survivors, and Disability Insurance (OASDI) Trust Funds would be
depleted by 1979. Administrators generally desire to have the Trust Fund be on
track to cover net outflows (given all the expected future tax collections and
interest less benefit payments) for at least 75 years. This was a serious
problem. In 1977, Congress enacted amendments to deal with the impending
financial problems. The amendments increased the payroll tax, increased the
amount of income that was eligible for the payroll tax, and reduced benefits
slightly. The economic slowdown in the early 1980s again left the Trust Fund with
serious funding problems.

Alan Greenspan, who would later gain greater fame as a long-serving
chair of the Federal Reserve Board, headed a commission to examine this problem
in 1983. The Greenspan Commission called for, and Congress subsequently passed
into law, an increase in the full retirement age to gradually extend from 65 to
67, increases in Social Security tax rates, and the addition of new taxes on
the benefits of the wealthiest individuals. The goal was to solve the immediate
financial problems and to build up a surplus over the next few decades in
anticipation of the inevitable Trust Fund drain resulting from the coming baby
boomer retirements.

Under the current law, the combined employee/employer tax
rate for the Old-Age, Survivors, and Disability Insurance (OASDI) fund is 12.4
percent. Medicare adds another 2.9 percent to this, bringing the total to 15.3
percent. This amount is split equally between employers and employees, or is
paid entirely by the self-employed, up to a maximum taxable limit for the OASDI
part that is $142,800 in 2021. The Medicare part does not have an upper limit
and there is an additional 0.9 percent Medicare surtax on higher earners. As
noted, the full retirement age is now slowly ascending toward 67 for those born
in 1960 and later.

That Social Security is expected to again undergo funding shortages
at some point in the future should come as no surprise. Social Security in the
United States is meant to be pay-as-you-go, meaning that each generation of
current workers pays for the benefits of current beneficiaries. Three trends,
though, make this an increasingly difficult task despite the present surpluses.
First, the baby boomer cohort is of unprecedented size and is now in the
process of reaching traditional retirement ages. Second, life spans are
becoming longer, meaning that the retiring baby boomers will enjoy longer
retirements and receive more benefits. The third important trend is the
decrease in fertility rates. During the height of the baby boom, women, on
average, were having between 3.5 and 4 children each during their lifetimes. The
2021 Trustee’s Report expects the long-run fertility rate in the United
States to be just 2.0.

Combining these three trends means that there will be fewer
workers available to support retirees. Throughout Social Security’s history,
the ratio of covered workers contributing to Social Security relative to the
number of retirement and survivor beneficiaries has witnessed gradual decline.
Still though, in 2000 there were 3.9 workers per retired beneficiary. In 2020,
the Social Security Trustees estimate only 3.2 covered workers per beneficiary,
and the best guess is that by 2030 there will be 2.7 workers per beneficiary. If
we add recipients of spousal, child, survivor, and disability benefits to the
calculation as well, the Trustees expect there to be only 2.4 workers per
Social Security beneficiary by 2030. New contributions will not be able to pay
for promised benefits due to the misalignment of the worker to beneficiary
ratio.

This poses a clear problem. As indicated, a legacy of the
1983 Greenspan Commission is that the Trust Fund accumulates more each year
than it spends to build a buffer. However, the size of the Trust Fund for
retirement and survivors benefits peaked in 2010 and is now in decline. The
current best guess in the 2021 Trustee’s Report is that the combined
Social Security Trust Fund will be depleted by 2034. The report’s release was
delayed until August 31, 2001, and now accounts for impacts related to the
global pandemic. Subsequent years will be met with cuts in benefits, increases
in taxes, or borrowing from the rest of the government’s budget. This is not to
say that near retirees should expect Social Security to disappear, as there are
a variety of reforms which could be implemented to get the system back on
track. As well, even if no action is taken, the inflows of new payroll taxes
and taxes on benefits will be sufficient to cover more than 75 percent of
benefits due. I discuss reform options further near the end of the chapter.

Calculating Social
Security Retirement Benefits

It is meaningful to consider how retirement benefits are
calculated. The Social Security Administration has now followed the same
approach for calculating benefits since 1979. Necessary ingredients in the
benefit computation include finding the average indexed monthly earnings
(AIME), converting this into the primary insurance amount (PIA), using the
primary insurance amount to calculate the starting benefit for all relevant
family members, checking to ensure that the total benefit payments do not
exceed the family maximum, and then increasing the annual benefits using the
cost-of-living adjustment for all remaining years of the recipient’s
eligibility. With more details, the steps for determining one’s Social Security
benefit are as follows:

Determine Eligibility. To be eligible for retirement benefits,
a minimum amount of taxable earnings must be recorded for at least 40 quarters
(10 years). In 2021, a quarter of coverage is provided for $1,470 of eligible
earnings, so that income of $5,880 of covered earnings would provide a year of
credits. The Social Security Statement shows the lifetime taxable earnings for
a worker. This statement used to be mailed annually. It is now mailed every
five years. One can obtain a copy of their statement online by following the
links at http://www.ssa.gov/myaccount.
This is a useful document to help you budget for what your Social Security
benefits will be, and it is otherwise important and worthwhile to check this
document to make sure that Social Security has a proper recording of your
earnings history. Keep in mind that the earnings listed are only up to each
year’s maximum taxable amount (which is $142,800 in 2021 but has been rising
faster than inflation and used to be much less). Projected benefits on the
statement assume no future inflation or wage growth, and that you continue to
work until the age that you begin benefits.

Calculate Average Indexed Monthly Earnings (AIME).
The AIME is the average of the top 420 months of earnings up to maximum taxable
amounts. That is 35 years, and earnings are only tracked at the annual level. Past
earnings through age 60 are indexed to higher amounts to account for
economy-wide average wage growth. After age 60, earnings still count but are not
indexed. This makes the Average Wage Index at age 60 very important for
determining benefits. For someone whose career was shorter than 35 years, the
AIME can include years with $0 earnings. For someone who has already logged 35
years of earnings, payroll taxes continue for additional work, but new wages
must be high enough to displace other wages from the list of the top 35 years
to have an impact on benefits. As well, even for those who still work while
receiving benefits, payroll taxes continue and the AIME can subsequently be
increased to reflect new earnings that enter the top 35 years. That can
increase subsequent benefits beyond the amount of cost-of-living adjustments.

Calculate Primary Insurance Amount (PIA). Next, the
PIA is calculated to determine the available benefits at the full retirement
age (FRA). Until 2020, the full retirement age is 66. It now begins a gradual
increase of two months per year toward 67 in 2027 for those born in 1960 and
later. The PIA calculation translates the AIME using a progressive benefit
formula which provides a higher percentage of the AIME to lower-wage workers
and a lower percentage for higher-wage earnings. The PIA formula provides a 90
percent replacement rate for the lowest range of the AIME, a 32 percent replacement
rate for a middle range, and a 15 percent replacement rate for an upper range.
The ranges used to calculate the PIA are based on the year that the worker
reaches age 62 and are linked to the average wage index at age 60. For those
reaching 62 in 2021, the 90 percent factor applies to the first $996 of the
AIME, 32 percent applies to the range of AIME between $996 and $6,002, and 15
percent applies for the amount of the AIME over $6,002. The PIA is then lowered
to the closest multiple of 10 cents.

With the different percentage bend points in the formula, higher
AIME values will translate into a lower overall replacement rate for benefits. This
works out to the average benefit being about 40 percent of average wages each
year, though Andrew Biggs of the American Enterprise Institute has pointed out
that this widely publicized 40 percent number is not how most people think
about replacement rates. He calculates that the average benefit replaces about
53 percent of average inflation-adjusted lifetime earnings. Because of the
progressive nature of the benefit formula, those with less than average
earnings, or with higher earnings for a smaller number of years, would
experience higher replacement rates, while those with a lengthy record of above
average earnings would experience a lower replacement rate.

Translate the PIA into a benefit amount based on claiming
age. The PIA provides the benefit available at the full retirement age.
Benefits adjust upward or downward depending on when they start relative to the
full retirement age. For each month of delay beyond the full retirement age,
the benefit increases by 0.67 percent. This sums to an 8 percent increase in
benefits per year (not compounded). For each month of early uptake relative to
the FRA, the benefit reduces by 0.56 percent per month for the first 36 months
of early uptake, and by an additional 0.42 percent for any months beyond that.

Since claiming earlier means more years of benefit receipt
while claiming later means less years, these adjustments were designed to be
actuarially fair. This means it should not matter what age one claims their
benefit for single individuals who live to their life expectancy. However,
those calculations for actuarial fairness were made in the early 1980s and they
no longer hold for today’s retirees who live longer and face lower interest
rates. Retirement benefits can be claimed as early as age 62, and delay credits
are provided up to age 70. Exhibit 6.1 summarizes how the claiming age adjusts
the PIA to determine the actual retirement benefit in inflation-adjusted terms.
Actual benefit increases would be even larger to account for annual
cost-of-living adjustments provided after age 62.

Exhibit 6.1

Social Security Benefit Adjustments by Age

Adjustments by Age

Claiming Age

Full Retirement Age = 66

Full Retirement Age = 67

62

75%

70%

63

80%

75%

64

87%

80%

65

93%

87%

66

100%

93%

67

108%

100%

68

116%

108%

69

124%

116%

70

132%

124%

Account for additional spousal and dependent benefits.
A worker’s record can also be used to support spousal, dependent, and survivor
benefits. Dependent benefits are available to children under 18, children who
became disabled before 22, and even parents who rely on the earner for more
than 50 percent of their income. Divorcees who were married for at least 10
years are also eligible for benefits based on an ex-spouse’s record. These
additional benefits are provided up to a family maximum, which is the highest
total amount of benefits that one worker’s earnings record can support to
individuals other than the worker. There is an exception for divorce benefits, which
exist outside of these limits.

Adjusting benefits for inflation. It is easier to
refer to Social Security benefits in terms of their value expressed in today’s dollars
rather than inflated future values that include those inflation impacts. In
practice, Social Security retirement benefits will grow in nominal terms to
reflect changes in consumer prices. Social Security benefits adjust for the
Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W)
starting at the age of eligibility, which is 62 for retirement benefits. These
increases apply to subsequent benefits even for those who have not yet claimed.

Philosophy and
Practicalities of Claiming Strategies

Social Security claiming strategies can be extremely
complicated. Treatises on this topic provide page after page of details,
nuances, and exceptions. When you consider all the possible strategies for a
couple given that each person can claim for each of 96 months between the ages
of 62 and 70, there are millions of potential claiming strategies with spousal
and survivor benefits mixed in. Very few people in the world fully understand
all the Social Security rules that have accumulated since 1935. In fact, many
case workers at Social Security offices are not trained in the nuances of the
system and may tell you that you are unable to do something which is permitted
under the rules. While it is best to prepare in advance for a visit to the
Social Security Office, and even to take written explanations with photocopies
from the Social Security handbook suggesting what you want to do is allowed, it
is not necessarily practical or a good use of time to become an expert on all
the nuances of Social Security claiming.

Rather, it is vital to use robust software which can
maximize the Social Security claiming decision for your personalized situation.
The costs for using software could help to provide more than $100,000 in net
gains over a household’s lifetime. Readers may use such software either
directly on their own, or may choose to work with a financial advisor who
maintains a license to test their clients’ situations with such software. I
provided the names and web addresses for three options in the introduction to
this chapter. It is best to use a comprehensive program like the ones
suggested, rather than a more basic calculator that does not cover all possible
angles, especially regarding dependent and disability benefits or matters like
the Government Pension Offset and Windfall Elimination Provision. I will
provide a basic introduction to claiming Social Security with an overview of
the main issues and possible special cases. The software will have you covered
on these issues if you understand how to enter the inputs correctly and do not
overlook the relevant tabs.

Keeping matters as simple as possible, eligibility for retirement
benefits requires reaching age 62 and having at least 40 quarters (10 years)
with sufficient Social Security covered earnings. Full retirement age comes
later and as mentioned it is shifting from age 66 to 67. Important items to
keep in mind about the full retirement age include:

·
It is the age that one is entitled to the full retirement benefit
(PIA)

·
The earnings test ends so that one can receive Social Security
without reductions even while continuing to work

·
Some of the more creative strategies that became available at
full retirement age have been scaled down, but there remain a few possibilities
around suspending benefits or filing a restricted application that become
available at full retirement age

Single Individuals

For single individuals with no dependents, Social Security
claiming is an easier endeavor, though it is probably worthwhile to still
double check one’s strategy using a high-quality software program. That is just
to make sure that one has not missed out on any special opportunities, such as
a possibility for an ex-spouse or survivor benefit as well. This could also
help to avoid a surprise with the Windfall Elimination Provision for those who
worked in noncovered jobs for a part of their careers. Otherwise, a single individual
only needs to decide on a claiming age. Unless one is in such dire
circumstances that he or she simply does not have assets to fund a delay in
benefits, or unless one has a valid medical opinion that he or she is unlikely to
live beyond age 80, it is important to seriously consider the possibility for
delaying benefits to support a permanently enhanced lifestyle and to obtain the
full insurance value from Social Security.

Couples

Those with spouses and dependents face a
more complicated decision-making process. For couples, the claiming
decision is more difficult, especially when both spouses are eligible for
benefits based on their own earnings records. Each spouse is potentially
eligible for benefits based on:

·
their own work record (plus your spouse is also eligible for a
benefit based on your record)

·
a spousal benefit based on a living spouse’s record

·
a survivor benefit based on a deceased spouse’s record

One is eligible for spousal benefits at age 62 if married
for at least one year. The spousal benefit is up to 50 percent of the spouse’s
primary insurance amount. Claiming a spousal benefit before full retirement age
results in a reduction. At age 62, the percentage is 35 percent for those with
a full retirement age of 66 and 32.5 percent for those with a full retirement
age of 67. There are no delay credits for a spouse to extend claiming the
spousal benefit beyond his or her full retirement age.

As well, to be clear, the spousal benefit is based on the
worker’s primary insurance amount and is based on the age that the spouse
claims but not on the age that the worker claims. Unlike the survivor benefit,
the spousal benefit is not impacted by the age that the worker claims his or
her own benefit, however it is necessary for the worker to have claimed
before the spouse is able to claim a spousal benefit on that earnings record. This
could affect older spouses who are not eligible for benefits on their own
record. For example, a 70-year-old who did not work is married to a 60-year-old-worker.
The 70-year-old cannot obtain a Social Security spousal benefit until the
younger spouse claims.

Except for the rare case that one can still file a
restricted application (see callout box on the Bipartisan Budget Act of 2015),
an individual is now deemed as always filing for both their own worker benefit
and their spousal benefit. It is no longer possible to file for one without
filing for the other. If the spouse has not yet claimed, then any additional
spousal benefits will not be added until that time. But then they will automatically
start. In that case, the claiming age for the spousal benefit will adjust to
the age that the benefit payment begins.

If one is claiming before full retirement age, the process
for determining the full benefit received is a bit complicated. The benefit has
two components: the worker’s own benefit first, and then any additional top-off
to the benefit that represents the difference between the spousal benefit and
the own benefit. Each of these portions will then separately be subjected to
any reductions for claiming early. Also, claiming after the full retirement age
would increase one’s own benefit, but the spousal benefit does not receive any
further increases for delayed claiming. The spousal benefit is based on the
spouse’s primary insurance amount and so the age that the worker claims is not
directly connected to the amount of the spousal benefit. As mentioned, it is
necessary for the worker to claim before the spouse can receive. And while
delaying claiming does not directly lead to a bigger spousal benefit (unless it
relates to continued work that increases the AIME and the PIA), it will feed
into the opportunity to potentially receive a larger survivor benefit.

Spousal benefits are complicated, so it is worth summarizing
the previous discussion with different wording that can highlight key points.
The worker needs to have filed for their own benefit before a spouse can claim
the spousal benefit. A spouse at full retirement age is eligible for up to 50
percent of the worker’s primary insurance amount. Having that worker claim
early or late does not impact the amount of the spousal benefit. Finally, if
the spouse claims before full retirement age, then the benefit is reduced, but
there are no delay credits for extending the spousal benefit past the full retirement
age.

I will provide an example for a married couple who are the
same age, because this is complex. The PIA for the husband at full retirement
age is $2,500. The PIA for the wife at full retirement age is $900. Their full
retirement age is 67. The husband plans to claim at full retirement age and the
wife plans to claim five years earlier at age 62. We want to determine the
amount of the wife’s benefit now and later.

The wife’s total benefit at full retirement age is $1,250,
or 50 percent of the husband’s benefit. This consists of $900 of her own
benefit and a $350 top off for the spousal benefit. She claims five years
earlier and this is before her husband claims. So, she receives 70 percent of $900,
or $630 as a benefit until full retirement age. Then at full retirement age her
husband claims, and she is now eligible for the spousal benefit. Since she
begins receiving her spousal benefit at full retirement age, she is eligible to
receive that full $350 top-off amount without reduction, which is added to her
own reduced $630 benefit for $980 total.

This is only a simple introduction to the complex world of
Social Security claiming for couples. A further relevant factor is the ratio of
primary insurance amounts for each spouse, as this impacts the relevance for
both own worker and spousal benefits. If the primary insurance amount for the
lower earning spouse is at least half of the primary insurance amount for the
higher earning spouse, then spousal benefits are not relevant. That can further
push the high earner to delayed claiming. But if one spouse could receive very
little from his or her own benefit, there could be an advantage for the high
earner to claim sooner to allow for more years of spousal benefit to be
received. Especially, as delay credits are not available for spousal benefits,
these benefits could simply be lost. This loss must be balanced against the
potential gains for increasing the survivor benefit through deferral. Another
matter relates to age differences between the spouses. If the higher earner is
also older, this strengthens the case for delay as that benefit has a greater
opportunity to be obtained for longer through the survivor benefit. This aspect
is weakened when the higher earner is younger.

We are getting a taste of Social Security’s complexity when
it comes to spousal benefits. It is worth repeating, again, that the minimal
expenses required to test one’s situation with a high-quality comprehensive
Social Security calculator is incredibly worthwhile, as such software could
provide a strategy that garners significant additional benefits over one’s
lifetime. These decisions are not easy to figure out on one’s own, and this is
a matter for which a basic investment of time and energy can lead to meaningful
improvements for one’s retirement finances.

Bipartisan
Budget Act of 2015

Social Security claiming strategies became a hot topic in
the early 2010s. Larry Kotlikoff’s book, Get What’s Yours: The Secrets to
Maxing Out Your Social Security, was the #3 best-selling book at Amazon in
early 2015, and this was not just for a short period after its initial
release.

The interest in Social Security dropped off dramatically
after the unexpected provisions included in the Bipartisan Budget Act of 2015
began a phaseout for newfound and sophisticated claiming strategies to wring more
out of Social Security. By allowing for the voluntary suspension of
retirement benefits at full retirement age, the Senior Citizens’ Freedom to
Work Act of 2000 had created some likely unintended opportunities to get an
extra windfall out of Social Security. Legislators intended to lessen the
Social Security penalty for people who work through age 70. Loopholes
developed that allowed retirees to take advantage of the new provisions even
if they had already left the labor force.

In one strategy for couples, after reaching the full
retirement age, someone could file a restricted application for their spousal
benefit without having been deemed as filing for their own retirement benefit
as well. For those whose spouses had already claimed benefits, this gave the
higher earner in a couple a chance to get spousal benefits for the four years
they are waiting to begin collecting their own benefits at 70. This option is
no longer available for those born after January 1, 1954, meaning that anyone
still eligible to do this is at least 67 in 2021. There may still
occasionally be someone under age 70 who could benefit from this. For those
too young to be eligible, the rule today is that one is automatically deemed
as having filed for their own retirement benefits and any spousal benefits they
are eligible for and cannot do this type of restricted application from among
these two options. By 2024 there will not be anyone left who could possibly
benefit from this restricted filing.

Alternatively, after the full retirement age, someone could
file for and then suspend their own benefit. This allowed spouses and dependents
to begin claiming benefits on the worker’s record, perhaps but not necessarily
with the restricted application just discussed, while the worker continued to
earn delay credits up to age 70. Such action might provide an additional
$50,000 just for a spouse over four years that is otherwise lost for those
who were not aware of this option. This was the subject of Chapter 1 in the
old edition of Larry’s book. It is no longer possible to use this strategy at
all. Suspending benefits after full retirement age is still allowed, but the
new rule is that one cannot receive spousal or dependent benefits from
another’s record if that person has suspended his or her benefit.

Survivor Benefits

Regarding survivor benefits linked to a retirement benefit,
a few additional comments are worthwhile. The first is that full retirement
ages for survivor benefits can be slightly different than for retirement
benefits. To be eligible for the survivor benefit, the marriage must have
generally lasted for at least nine months. Generally, the scheduled increases
in full retirement ages for survivor benefits lag retirement benefits by about
two years. As well, early claiming for survivor benefits can began at age 60.
There are reductions for survivor benefits when claiming before full retirement
age and survivor benefits are also subject to the earnings test before full
retirement age.

The survivor benefit at full retirement age is equal to the deceased
spouse’s benefit if that spouse has already claimed. If the deceased spouse did
not yet claim, the survivor benefit is the larger of the deceased spouse’s
primary insurance amount or the benefit that the deceased spouse would have
received if claiming at the time of death. That increases the survivor benefit
above the deceased worker’s primary insurance amount for those delaying
benefits past the full retirement age. Unlike spousal benefits, survivor
benefits reflect the delayed retirement credits earned by the deceased worker.

There is a provision that the survivor benefit when claimed
at full retirement age is at least 82.5 percent of the deceased’s primary
insurance amount. This could result in a slight increase to survivors for
workers who claimed at closer to age 62.  Nonetheless, delaying benefits can generally
support a larger survivor benefit from that worker’s record.

Survivor benefits can be available before age 60 as well in
cases where the surviving spouse is disabled or is caring for children under
16. In such cases, the benefit would end once the qualifying condition ended,
and the survivor would become eligible again for the “retirement version” of
the survivor benefit at age 60.

Another important point about survivor benefits is that they
do allow for a separate claiming decision. A restricted application is possible
for survivor benefits. With spousal benefits, except for the rare remaining
exception mentioned in the call-out box, one is deemed to have filed for their
own benefit to get access to spousal benefits. Restricted applications are mostly
phased out for spouses. But that is not the case with survivor benefits. This
allows for special coordination opportunities for widows, depending on the
relative size of their benefit options.

For instance, if the worker benefit would ultimately be
larger, one could claim the survivor’s benefit early and delay their own worker
benefit to age 70 to take advantage of delay credits. Survivor benefits do not
increase with delay credits past the full retirement age, but for those whose
survivor benefits are significantly larger, it could be worthwhile to begin the
worker’s benefit at age 62 and then switch to the survivor benefit at full
retirement age. Again, this is a subtle and confusing point: the survivor
benefit increases if the deceased worker had delayed beyond full retirement age
but not if the survivor delays claiming the survivor benefit beyond full
retirement age. There are more possibilities to explore with Social Security
claiming for younger widows. A good Social Security claiming software program
can help make better sense of these options.

Because of survivor benefits, the case for the higher
earning spouse to delay benefits becomes even stronger because the delay
credits will feed into both retirement and survivor benefits. The survivor
benefit is the full amount that the deceased worker is receiving or would
receive if claiming at the time of death. Thus, the relevant age for the higher
earning spouse extends beyond his/her own age of death to his/her age when the
last surviving member of the couple passes away. For a couple, joint
survivorship is higher. As well, if the higher earning spouse is significantly
older, their record could generate survivor benefits for many years, making
Social Security delay extremely attractive. To reiterate, the higher earner
claims based on number of years benefits will be generated by the earnings
record for the longest living member of the couple.

Matters are different for the lower earning spouse, and the
claiming decision for the lower earning spouse is also impacted by the
differences in their lifetime earnings and primary insurance amounts. There are
many circumstances when the lower earning spouse might claim at a younger age,
with considerations about how each of the spouses may receive some short-term
benefits from the lower earner’s record. Generally, the case for delay until 70
is weaker for the lower-earning spouse, because the relative length for these benefits
is when both spouses remain alive. Once one spouse has passed away, only the
higher earner’s benefit is relevant: either the higher earner lives and
continues receiving their own retirement benefit, or the lower earner lives and
can switch to a survivor benefit based on the higher earner’s record.

Dependent Benefits

Other dependents may also be eligible for Social Security
benefits as based on a retired worker’s earnings record. A family maximum limit
applies to the total benefits paid on a worker’s record (excluding benefits
paid to ex-spouses) that will fall around 150 to 187.5 percent of the primary
insurance amount. When the family maximum is reached, all benefits except for
the worker’s own benefit (if alive) will be reduced proportionately so that the
total amount matches the maximum.

When the family limit has not been reached, dependent
children are eligible for 50 percent of their retired parent’s primary
insurance amount, and 75 percent is available as a survivor benefit from a
deceased parent. These benefits are available to unmarried children under 18,
18 and 19-year-olds who are attending primary or secondary school, and those 18
and older who are disabled when the disability happened before age 22. Spouses
are also entitled to the full spousal benefit when caring for children under 16
or when caring for the disabled adult child of the worker. Once there are not
eligible children, the dependent spouse benefit stops until the spouse becomes
eligible for retirement benefits. This creates a distinction between a spousal
benefit when caring for dependents and a spousal benefit for retirement. Dependent
parents who are age 62 and older when the primary supporter dies and when that
primary supporter provided at least half of the parent’s support are also
eligible. For one parent, the benefit is 82.5 percent of the primary insurance
amount, and two parents can each receive 75 percent of the primary insurance
amount.

Dependents do add a complication to the claiming decision.
Early claiming may be wise in some cases where not claiming means permanently
losing access to the dependent benefits. One might also consider claiming
before full retirement age to obtain these dependent benefits and then suspending
again after full retirement age to collect some delay credits. But the decision
is complicated and certainly worth testing with software to compare the
tradeoff with receiving more dependent benefits versus losing the opportunity
for higher future retirement and survivor benefits.

Divorce

Divorced individuals are also eligible for
benefits on an ex-spouse’s earnings record provided the marriage lasted at
least ten years and the individual is not currently married. If an individual
has multiple ex-spouses where eligibility for a benefit is in place, then the
individual can receive the largest of these benefit options. If the divorce was
finalized within the past two years, then the ex-spouse must have filed already
for the divorced spouse to receive benefits, as is the case with spousal benefits.
But this requirement ends two years after divorce. A divorced person can
receive benefits even if the ex-spouse has not yet claimed, though that
ex-spouse must be at least 62 years old. As well, divorce benefits are not
counted as part of the family maximum benefit limits for one person’s earnings
record. Otherwise, rules for divorced spouse benefits are comparable to the
rules for spousal benefits.

As for survivor benefits, these are also
available to divorced individuals. An individual can re-marry after age 60 (or
after 50 if disabled) and still be eligible for a survivor benefit from an
ex-spouse’s record even though they would not be eligible for the divorced
spouse benefit. As ex-spouses pass away, individuals can switch to survivor
benefits from ex-spouses offering the highest overall benefit. Divorced
individuals should monitor this situation since the Social Security
Administration may not proactively reach out regarding a higher benefit
possibility once an ex-spouse has passed away.

Earnings Test

Those who continue to work while collecting
Social Security before their full retirement age may find that they must return
their benefits if they earn too much. In 2021, those under the full retirement
age will have to return $1 of benefits for every $2 earned above $1,580 per
month or $18,960 per year. This changes in the year one reaches full retirement
age and only for the months before reaching that age. During this short period,
$1 of benefits is withheld for each $3 of earnings above $4,210 per month or $50,520
per year. Upon reaching full retirement age, the earnings test ends and full
benefits are available without any offset.

Benefits lost to the earnings test are not
necessarily permanently lost. After reaching the full retirement age, the claiming
age is adjusted upward to account for the number of months of benefits lost to
the test, which will reduce the degree of the reduction one had for claiming
early. Subsequent benefits will be larger. Nonetheless, it may not be wise to
claim early while working as this permanently affects survivor benefits if death
occurs before full retirement age.

One other important point to make is that
continued work can increase benefits if the total covered earnings in a year
can replace an old year from the top 35 used for the AIME calculation. For
those continuing to work, it is possible to increase the primary insurance
amount even after benefits have started. The Social Security Administration
automatically recomputes benefits each year even after benefits start. Earnings
would need to displace one of the top 35 years to have an impact, but this can
become more likely as wages past age 60 are not indexed and have a chance to be
larger if they are growing with economy-wide average wages. For those with less
than 35 years of earnings, any new earnings will replace a $0 from the
calculations to create an obvious benefit.

Windfall Elimination Provision and Government
Pension Offset

Not all employment in the United States is
covered under the Social Security system. Some state and local government
agencies, federal civilians who began employment prior to 1984, railroad
workers, and non-profit organizations may provide separate pensions and are exempt
from collecting Social Security payroll taxes from their employees. For those
who spend a portion of their career at a noncovered job that provides a pension
and a portion of their career earning Social Security credits, it could be
possible to earn additional lifetime payments in a way that most would feel is
unfair. This relates to the progressive nature of the Social Security benefit
formula. Since Social Security considers the top 35 years of earnings, those
working only a part of their career in covered employment will appear poorer
and will receive a higher replacement rate on their average indexed monthly
earnings. Combined with their other pension from noncovered work, this
individual could receive more total pension income than Social Security would
have provided if the whole career had been in covered work.

To help remedy this situation, Social
Security created the Windfall Elimination Provision (WEP) and the Government
Pension Offset (GPO) as part of their 1983 reforms. The WEP reduces one’s
primary insurance amount from Social Security for those receiving a pension
from noncovered work. This leads to a lower Social Security benefit for the
worker and any spouse or dependents receiving benefits from that worker’s
record. It is important to note that while the WEP reduces benefits when the
worker is alive, the WEP is not applied to any survivor’s benefits generated by
that worker’s record. It applies for those with less than 30 years of
substantial earnings that were subject to the payroll tax. Note that
substantial earnings are different from the earnings needed to earn full Social
Security credits in a year. In 2021, the substantial earnings threshold was $26,550.

The WEP works by impacting how average
indexed monthly earnings are translated into the primary insurance amount. As
explained, for the first portion of income, the primary insurance amount
receives a 90 percent replacement rate. For those in noncovered work who have
20 years or less of substantial Social Security earnings, that 90 percent is
reduced to 40 percent. That leads to a maximum reduction of the primary
insurance amount of $498 in 2021. The factor adjusts from 40 percent up to its
original 90 percent as the years of earnings increases from 20 to 30. There is
no reduction for anyone who has a noncovered pension and still has more than 30
years of substantial earnings covered by Social Security. Also, the benefit
reduction from the WEP cannot be greater than half of the pension received from
noncovered work. Finally, the WEP can lower spousal and other dependent
benefits because of the reduced primary insurance amount, but survivor benefits
are not impacted by the WEP.

Meanwhile, the GPO affects spousal,
divorce, and survivor benefits that an individual would have been eligible for
when receiving pensions from outside work not covered by Social Security. For
those earning a pension from noncovered work, any spousal and survivor benefits
this person could receive are reduced by two-thirds of the pension amount. With
a large enough pension, this could eliminate the ability to receive these
benefits through someone else’s earnings record.

A Spousal Benefit Less Than 50 Percent of the Worker’s Benefit?

For those who have already claimed Social
Security and have read that spousal benefits are equal to 50 percent of the
worker’s benefit, one might be puzzled to find a different situation in which
the spousal benefit is less.  To review, I have identified several reasons
why a spouse’s benefit could be less than 50 percent of the worker’s benefit:

The spouse claimed before the full
retirement age. Doing so will lead to a reduction factor being applied to the
spouse’s benefit.

Before full retirement age, benefits are
subject to the earnings test if the individual is still working.

The worker delayed past his or her full
retirement age. This will provide delay credits to the worker, but the
spousal benefit is based on the worker’s primary insurance amount and would
not receive those delay credits. The value of a worker’s delay to the spouse
is not through the spousal benefit, but through the survivor benefit. Also,
though not directly relevant to this point, this is a good chance to provide
a reminder that spouses and survivors do not obtain delay credits for beginning
past their full retirement age.

A spouse who is impacted by the
government pension offset could see a reduction to the entitled spousal
benefit.

Finally, for workers with multiple
dependents receiving benefits, the family maximum limits may apply and reduce
the benefits received by each of those dependents, including the spouse.

Disability Benefits

Some individuals may already be receiving
disability benefits from Social Security as they approach retirement. The
disability benefit is equal to the primary insurance amount for that worker.
After reaching age 62, disabled individuals can also receive spousal benefits
from spouses who have claimed if the spousal benefit is
greater than the disability benefit. Spouses can also file for spousal benefits
based on the disabled worker’s primary insurance amount. When the disabled
individual reaches the full retirement age, the disability benefit is
automatically converted into a retirement benefit equal to the primary
insurance amount. There is no disability benefit beyond that age. Individuals
do have the option to suspend their benefit at the full retirement age. In this
case, a disabled beneficiary could suspend the new retirement benefit at full
retirement age to get delay credits for the years up to age 70 and then start
again. Another point about disability benefits is that those who are disabled
for 24 months will automatically be enrolled in
Medicare even before age 65.

Suspending Benefits and Redo Opportunities

Though the Bipartisan Budget Act of 2015
eliminated the file and suspend strategy as a path to additional spousal
benefits, redo and suspend strategies are still available. Redo opportunities
where suspending benefits could come in handy include:

·
You can withdraw your application for retirement
benefits and repay any benefits received during the 12 months after benefits
begin. This provides a way to change your mind and delay further. This is
allowed once in a worker’s lifetime.

·
For those who claimed early, it is also possible
to suspend benefits after the full retirement age to earn some delay credits.

·
Those who were disabled before the full retirement
age are automatically converted to retirement benefits at that time. These
individuals could then suspend their benefits to subsequently earn delay
credits past the full retirement age.

·
For those who regret claiming early, going back
to work before full retirement age can trigger the earnings test that operates in
practice as a forced suspension of benefits.

Remember, unlike the old file and suspend
strategy, spouse and dependent benefits are stopped during the suspension
period. The purpose of these strategies is to try to create some delay credits
if one regrets having claimed too early. Suspending benefits at or after the
full retirement age allows for delay credits and higher subsequent lifetime
benefits in inflation-adjusted terms. Inflation-adjusted longevity
insurance is extremely valuable and should not be overlooked.

One other related point is that when filing for retirement
benefits after the full retirement age, one can request that benefits begin up
to six months before the filing date, but not before the full retirement age.
In fact, the Social Security Administration may assume this retroactive filing
is desired, such that someone claiming at age 70 might be pushed to 69 and 6
months unless they firmly state that they do not want this to happen. Any
retroactive benefits that are sought will be received as a lump-sum and
subsequent benefits would be reduced to account for the earlier claiming age.
Those past full retirement age who wanted to delay further, but who find
themselves in need of cash for an expected situation, could file and suspend to
claim this six months of benefits as a lump sum. This would lead to a loss of
six months of delay credits, but it may be a worthwhile opportunity for those
in a bind.

Taxes on Social Security Benefits

Making a portion of Social Security benefits taxable for
federal income tax purposes started as part of the 1983 Social Security
reforms. At first, up to 50 percent of benefits were taxable. Since 1994, up to
85 percent of Social Security benefits are taxable when incomes exceed certain
thresholds. Managing the portion of taxable Social Security benefits becomes an
important part of managing a tax-efficient retirement distribution strategy.
Retirees can work to avoid the Social Security tax torpedo, which is an
increase in marginal tax rates paid when a dollar of income also uniquely
generates additional taxes on Social Security benefits. This important matter
will be addressed as a part of the tax planning discussion in Chapter 10.

When are People Claiming Social Security?

One of the hottest topics in retirement income planning over
the past ten years has been how to help individuals strategize their Social
Security claiming decisions. These discussions used to delve into the
intricacies of approaches like “file and suspend” or “file a restricted
application” that could provide higher benefits but were phased out starting in
November 2015. The general theme emerging from these discussions is that there
can be value in delaying the start of benefits past the earliest allowed ages.

This message has been getting through to the public. Using
numbers reported in the 2020 Annual Statistical Supplement to the Social
Security Bulletin, I find that the last year the percentage of nondisabled
Social Security retirement beneficiaries who claimed benefits at 62 was over 50
percent was in 2011. It fell from 50.5 percent that year to 32.7 percent in 2019.
Meanwhile, those who delayed claiming until past their full retirement age was
still under 6 percent until as late as 2009. It has been steadily climbing
since, reaching 19.5 percent of new beneficiaries in 2019. This historical data
is provided in Exhibit 6.2, demonstrating a clear change in claiming patterns for
more recent years. The reason to exclude disabled individuals from these
calculations is that those receiving disability benefits will automatically
transition into retirement benefits at their full retirement age, which
artificially increases cases where there was not discretion available regarding
the choice. In recent years, about 16 to 17 percent of new retirement
beneficiaries have represented these conversions from disability benefits.

Exhibit 6.2

Age distribution of new Social Security
retirement beneficiaries

Excluding individuals on disability who transition
into retirement benefits at Full Retirement Age (FRA)

Source: Own calculations using
Table 6.B5 from the 2020 Annual Statistical Supplement to the Social
Security Bulletin

It is hard to be certain whether education on Social
Security claiming is responsible for these recent shifts, or whether other
factors may be at work. Nonetheless, as these trends continue, it is reasonable
to think that education is an important factor. With an understanding about how
benefits are calculated and how different benefits work, we now shift our
attention to that education about choosing a claiming strategy.

Social Security as
Insurance

We can think about the Social Security claiming decision in
terms of how it plays out in the event of a short or long retirement. How do
the consequences of claiming interact with longevity risk? We can think of four
general outcomes for Social Security: claim early and experience a short
retirement, claim early and experience a long retirement, claim late and
experience a short retirement, and claim late and experience a long retirement.
The consequences of these different outcomes are summarized in Exhibit 6.3.

Exhibit 6.3

The Outcomes for Social Security Claiming Decisions

Claim Early

Claim Late

Short Retirement

Worked Out

Minimal Harm Done

Long Retirement

Permanent Reduced Lifestyle

Permanent Increased Lifestyle

It is surely unfortunate to experience a short retirement.
In relation to Social Security, claiming early would have gotten the most out
of the program. But claiming late would have resulted in minimal harm. Less
would be obtained from Social Security, but there would have also been less
pressure on the investment portfolio and other assets. A short retirement is
less costly and so beneficiaries will still receive plenty of leftover assets
even if Social Security is delayed.

Consequences become more severe with longer retirements, and
this is where the focus of decision-making should be placed. When claiming
early, a retiree is setting up conditions for a permanently reduced standard of
living in retirement. A long retirement combined with Social Security delay
supports a permanently enhanced lifestyle. The point is that greater emphasis
should be placed on what happens in longer retirements, since the financial
consequences are more severe, and this is when delaying Social Security provides
a clear positive impact.

This discussion points to Social Security being viewed as
insurance. Social Security retirement benefits are inflation-adjusted, and
government backed. With lifetime cash flows, they mitigate longevity,
inflation, and market risk for retirees. For risk-averse retirees who would
otherwise invest more heavily in bonds, which do not provide longevity
protection, the insurance value of Social Security becomes even stronger
because there would otherwise be less potential for upside growth. Social Security
also provides spousal and survival benefits, as well as benefits for dependent
children. Importantly, survival and disability benefits are also available for
pre-retirees, which is extra insurance value provided before retirement begins.
Any discussion about Social Security as an investment should not forget about
this insurance value.

It is a bummer to die early. But regret about Social
Security claiming does not exist after death. Avoiding premature death is
outside of our control, apart from taking care of our health. The real concern
and focus that we can better control is to avoid a situation in which we
outlive our assets. A bit of patience with Social Security can really help individuals
to manage their longevity risk. The view of Social Security as insurance is to
delay claiming and to take advantage of the delay credits that will really pay
off if one experiences a long retirement.

Social Security as an “Investment”

The alternative to treating Social Security as insurance is
to view it as an investment, or as a gamble on how long one lives. This can be
problematic. The investment approach focuses more on the breakeven age for when
it finally pays to delay benefits. With inflation-adjusted discount rates of 0
percent to 2 percent, the breakeven age is around 80 to 84. Though these ages
are within the range of life expectancies for 62-year-olds, they appear
to be high, and retirees start to worry that they may not live long enough for
delay to be beneficial. People start to worry about losing out on potential
benefits if they delay and then die early, rather than emphasizing the
consequences of depleting assets if they live a long time.

As well, sometimes it is financial advisors who get ahead of
themselves, thinking that they can invest the early Social Security benefits
better and provide more lifetime wealth to their clients. I have seen advisors say
that it makes no sense to delay Social Security, because the advisor can invest
the benefits and earn a higher return for their clients over the long run.

Certainly, if realized investment returns are high enough,
then claiming early is advantageous. But the odds are not in favor of getting
that sort of investment return over the eight-year delay period, especially in
our current world of low interest rates. As well, one might be surprised about
just how high the implied return on delaying Social Security can be.

The confidence involved in thinking that one can claim early
and invest the benefits for greater returns requires amplifying risk for an
asset that should otherwise be treated as a true backstop and safeguard for
retirement income. It is difficult to fathom how the additional upside
potential outweighs the downside risks from claiming Social Security early and
investing the proceeds in the stock market, except possibly for those who are
sufficiently overfunded that they simply have no need to spend from their Social
Security benefits and are purely focused on legacy.

Nevertheless, while I prefer thinking of Social Security
delay as a form of insurance, I think we can reframe the discussion to
view Social Security delay as a rather attractive “investment” proposition as
well. This involves better understanding the additional credits provided by
delaying Social Security benefits, which were meant to be “actuarially fair.”

For someone living to their life expectancy, it should not
matter in principle what age they claim their benefits. The increase in
benefits from delay should precisely offset the fewer number of years that
benefits will subsequently be received. However, these calculations about
actuarial fairness for the delay credits were made as part of the 1983
Amendments to Social Security. The calculations are close to 40 years old, and
changes since that time suggest that delaying now provides net advantages.

First, Social Security actuaries calculated the delay
factors assuming that the real interest rate is 2.9 percent. Recently, the
yield on 30-year TIPS is about 0 percent. It is negative for shorter-term TIPS.
As an inflation-adjusted bond, TIPS are the closest type of investment to what
Social Security provides as an inflation-adjusted income (though TIPS do not
support this income over an unknown lifetime). Lower interest rates today mean
that we should expect lower returns on other types of investments, which supports
delaying Social Security to obtain higher overall returns for the assets on the
retirement balance sheet.

The second change relates to longevity, which continues to
improve. Retirees are now living longer than they were in 1983. This also favors
delaying Social Security, as it improves the odds for living long enough to
enjoy positive net benefits from delayed claiming. On a related note, Social
Security actuaries considered aggregate longevity for the population of Social
Security participants, and people who read books about retirement planning are
not average. My readers can expect to live for longer than the average Social
Security participant.

A simple example can help to illustrate how delaying Social
Security can work as an “investment” which helps to improve portfolio
sustainability for retirees. What follows is not an effort to optimize any
decision-making, but rather to observe the long-term impacts of two different
claiming strategies.

Consider a single 62-year-old with no eligible dependents who
has already left the workforce. This leaves out additional complications,
though having a spouse entitled to survivor benefits would further strengthen
the case for delay, while having dependent children might weaken the case. This
individual is simply thinking about the decision between claiming Social
Security at 62 or at 70.

Someone aged 62 in 2021 would experience a full retirement
age of 66 and 10 months. To avoid the complication of dealing with partial
years, I consider the case for someone who turns 62 in 2022 such that the full
retirement age is 67.

For the example, the overall annual spending goal is $60,000
in today’s terms. Future spending grows with inflation. Her full retirement age
is 67, and her PIA is $2,500 per month or $30,000 per year in today’s dollars
(all dollars are expressed as their age 62 values, though in subsequent years cost-of-living
adjustments would be applied both to the overall spending goal and Social
Security benefits). Should she claim at 62, her benefit would be reduced by 30
percent to $1,750 per month or $21,000 per year. Should she delay until 70, her
benefit grows by 24 percent from the PIA to $3,100 per month or $37,200 per
year. Inflation-adjusted Social Security benefits are 77 percent larger when
claimed at 70 relative to 62.

To meet her $60,000 spending goal, any amount above what is
provided by Social Security will be funded by withdrawals from an investment
portfolio worth $866,000 today. This creates two lifetime spending scenarios.
By claiming at 62, Social Security provides $21,000 of income, and $39,000 is
withdrawn from the investment portfolio (see Exhibit 6.4).

Exhibit 6.4

Claiming Social Security Early at 62

Meanwhile, when claiming at 70, $60,000 will have to be
supported by the portfolio for the first eight years of retirement. Starting at
70, Social Security then provides $37,200 with the remaining $22,800 coming
from the portfolio (see Exhibit 6.5).

One way to compare these strategies is with the implied
withdrawal rate needed from the portfolio after accounting for Social Security.
By claiming at 62, the inflation-adjusted withdrawal rate to meet the spending
goal is:

Withdrawal Rate = ($60,000 – $21,000) / $866,000 = 4.50%

When claiming at 70, there could be two different withdrawal
rates for before and after 70. However, it would not be wise to use a volatile
investment portfolio for the full spending amount when Social Security is
delayed, as that would magnify sequence risk. Instead, I assume that eight
years of age 70 Social Security benefits will be set aside from the portfolio
at age 62 and earn a 0 percent real interest rate. This used to be a
conservative assumption, but today TIPS yields are negative so some risk would
need to be taken. This means that $37,200 x 8 = $297,600 will be set aside as a
Social Security delay bridge illustrated in Exhibit 6.6, leaving the other $568,400
for withdrawals.

Exhibit 6.5

Delaying Social Security to 70

The required withdrawal rate to meet the spending goal
throughout retirement is now:

Withdrawal Rate = ($60,000 – $37,200) / ($866,000 – $297,600)
= 4.01%

Exhibit 6.6

Social Security Delay Bridge

In this example, Social Security delay allowed the
withdrawal rate to drop from 4.50 percent to 4.01 percent. This improves
retirement sustainability. The investment portfolio is less likely to be
depleted and more income remains available through the higher Social
Security benefit if the portfolio depletes. In other words, running out of
financial assets is both less likely to happen and less damaging when it does
happen.

Allowing for the same probability of portfolio depletion by
matching up the withdrawal rates, total spending could be increased by about 5
percent to $62,778 to use the same 4.5 percent withdrawal rate as when claiming
early. The magnitude of the difference would be larger if the retiree’s
spending goal and asset base were smaller relative to the Social Security
benefits, and vice versa. And remember, 77 percent more income is still
available than otherwise in the event of portfolio depletion. This is the
permanently enhanced lifestyle possible with Social Security delay. The basics
of this example are illustrated in Exhibit 6.7.

Exhibit 6.7

Impact of Social Security Delay on Retirement Withdrawal
Rates

Impact of Social Security Delay on Retirement Withdrawal
Rates

Claim at Age 62

Claim at Age 70

Spending Goal

$60,000

$60,000

Social Security Benefit

$21,000

$37,200

Portfolio Withdrawal

$39,000

$22,800

Investment Portfolio

$866,000

$866,000

Set Aside for Social Security Delay

$0

$297,600

Remaining Portfolio

$866,000

$568,400

Withdrawal Rate

4.50%

4.01%

For this strategy to work effectively, the overall spending
goal cannot be too large relative to the size of the financial portfolio. For
instance, if the portfolio is $300,000, there would hardly be enough to create
the delay bridge. Otherwise, a large enough portfolio will allow for Social
Security delay to reduce the required portfolio withdrawal rate. And if the
portfolio is not large enough, it is more of a reflection that the overall
spending goal is not realistic, rather than an indictment against Social
Security delay. Though, as will be pointed out later, severely underfunded
retirees without alternatives may be forced to claim Social Security early and
accept a permanently reduced lifestyle.

The previous discussion has demonstrated how delaying Social
Security receipt can improve the sustainability of a retirement income plan. It
is necessary to withdraw more until Social Security starts, but retirees can
then withdraw less after starting Social Security. The strategy is not fool proof
with only a volatile investment portfolio as a backstop, because a bad sequence
of returns early in retirement could cause the portfolio to drop in value,
locking in losses. But assets can be carved out of the main investment
portfolio to create a Social Security delay bridge. Possibilities for this
bridge include structuring a bond or CD ladder or using a fixed-term income
annuity. Another alternative for retirees is to use other buffer assets from
outside the financial portfolio, such as home equity through a reverse mortgage
or the cash value from a life insurance policy.

A second way to understand the delay of Social Security
benefits as an investment is to calculate the implied rate of return on the
cash flows that Social Security provides for different claiming strategies. I now
look at the internal rates of return on the cash flows that Social Security
provides. The “investment” value of delaying Social Security
can also be seen through these internal rates of return since they will
represent return hurdles that other investments would need to beat to provide
better outcomes.

Exhibit 6.8 provides this information for the same example
with someone whose full retirement age is 67 and whose primary insurance amount
is $30,000 of annual benefits. Delaying Social Security from age 62 to age 70
can be reviewed as making an investment of $21,000 annually for eight years
which provides a payment of $37,200 annually starting at age 70 and continuing
for life. Because these are real purchasing values at age 62, the returns
implied by these cash flows are real returns and realized inflation could be added
to them to get the total nominal return. These real returns become positive at
age 80, reflecting the breakeven age when delaying starts to pay off. The real
return is 3.8 percent by age 85, 5.3 percent by age 90, 6.1 percent by age 95,
and 6.6 percent by age 100.

For government-backed, inflation-adjusted
income, this can be compared to TIPS yields which have been hovering around 0
percent or less. Looking not far beyond life expectancies, these returns from
Social Security delay even become competitive with the historical compounded
real returns provided by the stock market. Again, one would need their
investments to beat these returns for early claiming decisions to pay off.

The real-world caveat to consider, of course, is
whether a high portfolio return assumption can be justified, as it would
require taking substantial market risk. The probability that you could
consistently earn a compounded real return of 6 percent is rather low, and to
have any opportunity to achieve this return would require retirement
assets to be mostly invested in stocks.

Though it depends on survival, delaying
Social Security offers attractive investment returns compared to safe
alternatives available today. It can really pay to spend down other assets more
quickly until age 70. Though the portfolio will be smaller at 70, the reduced
spending needs after 70 – because Social Security is paying 77 percent more in
real terms – will leave you increasingly better off forever after. Those lucky
enough to live far into retirement will preserve more of their portfolio for
their heirs and be thankful they delayed Social Security.

Exhibit 6.8

Impact of Social Security Delay on Retirement
Withdrawal Rates

Age

Real Benefits with Age 62 Start

Real Benefits with Age 70 Start

Difference

Real Return on Delaying by Age

62

$21,000

$0

-$21,000

63

$21,000

$0

-$21,000

64

$21,000

$0

-$21,000

65

$21,000

$0

-$21,000

66

$21,000

$0

-$21,000

67

$21,000

$0

-$21,000

68

$21,000

$0

-$21,000

69

$21,000

$0

-$21,000

70

$21,000

$37,200

$16,200

71

$21,000

$37,200

$16,200

72

$21,000

$37,200

$16,200

-22.2%

73

$21,000

$37,200

$16,200

-15.5%

74

$21,000

$37,200

$16,200

-10.9%

75

$21,000

$37,200

$16,200

-7.6%

76

$21,000

$37,200

$16,200

-5.1%

77

$21,000

$37,200

$16,200

-3.2%

78

$21,000

$37,200

$16,200

-1.7%

79

$21,000

$37,200

$16,200

-0.4%

80

$21,000

$37,200

$16,200

0.6%

81

$21,000

$37,200

$16,200

1.5%

82

$21,000

$37,200

$16,200

2.2%

83

$21,000

$37,200

$16,200

2.8%

84

$21,000

$37,200

$16,200

3.3%

85

$21,000

$37,200

$16,200

3.8%

86

$21,000

$37,200

$16,200

4.2%

87

$21,000

$37,200

$16,200

4.5%

88

$21,000

$37,200

$16,200

4.8%

89

$21,000

$37,200

$16,200

5.1%

90

$21,000

$37,200

$16,200

5.3%

…

…

…

…

…

95

$21,000

$37,200

$16,200

6.1%

…

…

…

…

…

100

$21,000

$37,200

$16,200

6.6%

Social Security: The
Best Annuity Money Can Buy

A final frame for viewing the Social
Security claiming decision is as an annuity purchase. By starting at age 70
instead of 62, the retiree misses eight years of receiving a benefit of $21,000.
But starting at 70 provides the retiree a net increase in benefits of $16,200
per year for as long as he or she lives. The eight years of lost benefits could
be viewed as a premium payment for a $16,200 inflation-adjusted lifetime income
starting at 70.

By not claiming until 70, the eight-year
loss of Social Security benefits sums to $168,000, which would also be its
present value with a 0 percent real interest rate. We could view that $168,000
as the approximate premium to buy a deferred income annuity with
inflation-adjusted annual income of $16,200 beginning at age 70. The implied
payout rate on the “annuity” provided by delaying Social Security is 9.64
percent.

This is quite attractive when compared to
commercial annuities. The current marketplace does not even offer an
inflation-adjusted income annuity at the time of writing. Social Security is
inflation adjusted. We can only approximate inflation by choosing a fixed
cost-of-living adjustment for the annuity, though this would not protect
spending power if actual inflation rose higher. As well, the $16,200 difference
in benefits is measured in today’s dollars and it would grow with inflation for
the next eight years. We are forced to also assume an inflation rate for the
next eight years to properly discount the income to be received from a
commercial annuity.

For the comparisons, we must assume an
inflation rate to have the annuity benefit grow by each year, and to also
reduce the purchasing power for the first payment received in eight years so it
is expressed in today’s dollars. I will assume a 2 percent inflation rate, and
it is important to note that the commercial annuity would look increasingly
worse as the assumed inflation rate increases.

In April 2021, the best available deal at
immediateannuities.com for an eight-year deferred income annuity with a
$168,000 premium for a 62-year-old with a 2 percent cost-of-living adjustment
on payments is $12,612 of annual income for men, $11,280 for women, and $9,384
for couples with a 100 percent survivors benefit that would be the closest
match for Social Security survivor benefits to the high earner. With eight
years of 2 percent inflation, the real purchasing power for these spending
numbers are $10,764 for males, $9,627 for females, and $8,009 for couples.

These represent payout rates of 6.41
percent for men, 5.73 percent for women, and 4.77 percent for couples. Each of
these three numbers can be compared to the 9.64 percent payout implied by
treating Social Security delay as purchasing an annuity. Social Security delay
provides a higher payout rate and stronger inflation protection than
commercially available annuities. Delaying Social Security should be the first
step for anyone considering annuities as part of their retirement income plan.
Commercial annuities do not beat the implied payout rates on delaying Social
Security.

Arguments for Claiming Social
Security Early

Legitimate arguments do also exist for claiming Social
Security early. Some individuals simply need the funds to survive and have no
other income alternatives to cover delaying their benefits. Delaying retirement
would be a better option, but it is not always possible. Claiming early in such
circumstances may be unavoidable.

Another reasonable situation to claim early is for
individuals with legitimate medical reasons to believe they will not live to their
80s. This should be based on a medical diagnosis and not just on a hunch. In
this instance, it is important to consider survivor and dependent benefits
based on the earnings history. Age of death is not the only factor in
determining the optimal household solution. Related to this point, a spouse who
will be impacted by the government pension offset for spousal and survivor
benefits might decide against delay.

Some strategies also legitimately call for the spouse with a
smaller primary insurance amount to start benefits earlier as part of
maximizing lifetime household benefits. As I discussed, the benefit for the low
earner is only relevant until the age that the first member of the couple
passes away. Claiming software will often report optimal results for the high
earner to delay, but the low earner to start earlier.

The higher earner might also occasionally claim earlier to
take advantage of benefits for dependent children, a spouse caring for
dependent children, or dependent parents, or to otherwise allow a spouse to
claim the spousal retirement benefit sooner. Especially in cases with dependent
children who will grow past their eligibility, it is possible to claim at an
earlier age to tap into these ephemeral dependent benefits and then suspend
again after full retirement age to gain some delay credits toward age 70.  With
so many options and so much money at stake, I cannot emphasize enough the
importance of testing individual situations using comprehensive Social Security
planning software that includes all relevant variables.

Other reasons can be used to justify
claiming Social Security early, but I generally find them less compelling. For
instance, some have made the rather dubious claim that an investment
portfolio can be expected to produce higher returns than those offered by
Social Security delay. While portfolios could produce higher
returns, it is unwise to count on it, especially this close to retirement.

This uncertain quest for upside growth means giving up a
valuable, lifelong, inflation-adjusted income stream. To make risks comparable,
the appropriate investment would be TIPS. To generate the returns needed to
beat Social Security delay would require a high tolerance for risk and an aggressive
asset allocation, not to mention plenty of discretionary wealth. People tend to
be overconfident about their investing prowess, making it easy to fall into a
behavioral trap. Earlier I described the investment return hurdles that exist to
justify claiming early from an investment perspective. Beyond life expectancy,
those hurdles are tough to beat.

The Social Security claiming decision can also be viewed in
terms of the breakeven age you have to reach before the delay decision pays
off. This causes some to feel like they are gambling their savings by delaying,
considering that they could die before the strategy pays off. But it is
important not to view the Social Security decision this way. The breakeven age
analysis misses the insurance value provided by Social Security. What matters
more is the possibility of outliving your assets, and this is where Social
Security can really help. If you choose to delay and then die before collecting
or breaking even, you will not be around to regret it. Regret comes when you
live a long life and think about how you could have been better off if you had
delayed.

If someone dies early in retirement, they leave a larger
nest egg to the next generation. Being the bigger of two already large numbers
may not have much of an impact on the financial circumstances for heirs who are
already receiving a large and unexpected bequest.

The nature of the legacy changes for longer and more
expensive retirements. Delaying Social Security lowers the likelihood of
depleting your financial assets, meaning less strain on any potential heir to
provide reverse support. The potential to leave a larger relative legacy
is higher with delayed Social Security in these long-retirement cases when the
available bequests will otherwise be less. This is when each dollar of
additional bequest will count for more. It may seem counterintuitive, but a
retiree may be doing their beneficiaries a favor by delaying benefits.

A final reason for claiming early is the idea that Social
Security will go away, which can create an urgency to claim early to obtain
benefit from the system before it is too late. This matter is addressed in the
next section.

Potential Directions for
Social Security Reform

A Retirement Researcher reader eloquently stated what I find
to be a common sentiment:

I’m cynical; for my retirement planning I assume that
I’ll pay into Social Security until I stop working and I assume that I’ll draw
nothing out i.e all cost, no benefit. This is a ‘worst case’ so anything else
with any benefit will be a pleasant surprise.

A common argument for claiming Social Security early is that
the program is about to be dramatically overhauled in a way that leaves
retirees attempting to get a little out of the system before it disappears. But
it seems rather unlikely that any impending reforms would leave at least near
retirees with significant reductions to their benefits.

The widespread belief that Social Security is bankrupt and
about to disappear has existed for a long time. I can remember walking around
Washington, D.C., in the late 1990s and receiving a pamphlet on the National
Mall suggesting that there are more Americans who believe that UFOs visit us on
earth than who believe that Social Security will be there when they retire.

I commonly hear from individuals that they will plan for
retirement assuming there will be no Social Security, and any benefits they do
get will be icing on the cake. While I generally support conservative
assumptions for planning purposes, I think this viewpoint takes matters too
far. For my own personal planning, my conservative planning assumption is that
I will receive 75 percent of my presently legislated projected benefits, and I
am much further away from collecting benefits than today’s near retirees.

While Social Security has funding problems, the situation is
not quite so dire as to think it will disappear entirely or otherwise be
converted into a pure welfare program. The general goal of reforming Social
Security is to help place the Trust Funds into 75-year actuarial balance.

The 2021 Trustee’s Report estimates that the combined
Social Security Trust funds (OASDI) are not generating enough revenue to stay
in balance past 2034, and that an immediate increase in the payroll tax of 3.54
percentage points (shared between employees and employers) would be needed for
the Social Security system to maintain its solvency for the next 75 years.

If no action is taken, Social Security benefits would have
to receive an across-the-board 22 percent reduction so that the inflows of new
contributions from workers could cover the outflows of benefit payments
starting in 2034.

The Congressional Research Service provides an interesting
report to explain what happens if the Trust Funds deplete and the full
legislated benefits could not be paid. It notes how there are two conflicting
laws: the Social Security Act requires benefits to be paid, but the
Antideficiency Act says that the government cannot spend more than its
available funds. The lack of funds to pay the benefits does not remove the
obligation to pay entitled benefits and lawsuits about this would surely
happen. For there to really be an across-the-board benefit cut, Congress would
have to step in to legislate it, rather than a cut becoming the default through
inaction. In the process of creating such legislation, Congress would probably
find a compromise between benefit cuts and tax increases as happened in 1983. It
is not hyperbole to suggest that a major reduction to benefits would be very
unpopular with the public. A big across-the-board reduction to benefits is unlikely.

The presently legislated course for Social Security includes
a continued increase in the full retirement age to 67, an OASDI payroll tax of
12.4 percent, the use of CPI-W to make annual cost-of-living adjustments, and
the use of the average wage index for indexing benefits at the age of first
eligibility. There are a multitude of ways in which Social Security reform
could proceed to get Social Security back on track to a 75-year actuarial
balance. Exhibit 6.9 provides a list of various reform options.

Exhibit 6.9

Social Security Reform Options

Reforms Impacting

Current or Near Retirees

Other Reforms

Use a smaller COLA

Increase payroll tax rate

Use more than top 35 years of earnings

Increase maximum taxable earnings

Link benefit reductions to longevity improvements

Gradually raise full retirement age

Means testing for benefits

Switch from “wage indexing” to “price indexing”

Make Social Security benefits fully taxable

Expand Trust Fund beyond US Treasuries

Many reform options would have minimal impact on current or
near retirees. Options include an increase in payroll tax rates, or a lift in
the ceiling on maximum taxable earnings. With payroll tax increases, only those
still in the workforce would be impacted at the end of their careers.

A gradual increase in the full retirement age consistent
with the 1983 reforms would also not affect those already near retirement. After
all, the individuals first impacted by the full retirement age increase to 67
were only 23 years-old when the reform passed. Retirement age increases could
be accomplished in a fixed manner, such as gradually shifting the full
retirement age to 69 or 70. Another possibility is to calibrate the full
retirement age to match the shift in longevity. As the population naturally
lives longer, the full retirement age automatically adjusts to match the
changes. One problem with increasing the full retirement age, though, is that
it can be considered as a regressive reform. The gains in longevity are not
shared across the population, and those groups with lesser longevity prospects
or who find it difficult to continue to work at later ages would be unduly
impacted by such a reform.

Another popular reform idea is to switch from “wage
indexing” to “price indexing” when calculating Social Security benefits. Though
this sounds somewhat technical, it would allow current or near retirees to
escape the burden of reform. Instead, reform would compound over time so that
younger people will eventually receive lower and lower benefits relative to
their wages and payroll taxes. Benefits would effectively be frozen at today’s
levels even if the standard of living continues to improve in the future as
expected. As an attempt to look out for young people, I oppose this reform for
its particularly stark intergenerational impacts.

Finally, a reform that would not affect benefits is to
expand the investment approach of the Social Security Trust Fund to include
additional investment options beyond the current specially issued non-tradable
Treasury bonds. This reform was discussed during the 1990s, though nothing ever
became of it. A related reform idea popularized by President Bush in the 2000s
was to carve out a portion of Social Security payroll taxes to create Personal
Retirement Accounts. This reform also did not make it far into the legislative
process.

There are other reform ideas which could also impact current
or near retirees today with the introduction of near-term benefit reductions.
For instance, Social Security benefit growth could be linked to a new price
index which grows less rapidly, or the cost-of-living adjustments (COLA) could
be set at one percent less than the consumer price index. The impact of this
reform would be to gradually reduce the real purchasing power of benefits over
time. The justification for such a reform is that the current CPI-W measure
used by the Social Security Administration may overstate inflation and that
people tend to spend less as they age. Objections to this reform include that
it would leave the extreme elderly and widows more vulnerable to poverty, and
it may be the case that expenses for some vulnerable elderly rise faster than
the CPI-W.

Another reform which would lead to benefit reductions is to increase
the number of years used to calculate the average-indexed monthly earnings.
This would bring in more years with lower earnings to reduce the calculated average
lifetime wages that enter the benefit formula.

A popular reform internationally is to provide a more direct
and automated link between longevity improvements and the full retirement age. But
another variation is to link longevity improvements to benefits paid by
reducing benefits to account for a longer period of receipt.

A reform which could have a bigger impact on wealthier
individuals who are about to retire is the introduction of means-testing for
benefits. Those with sufficient means, represented either through other income
sources or wealth accumulations, would no longer be eligible to receive Social
Security benefits. Such a reform would run counter to the entire history of the
Social Security program, which has always sought a clear link between benefits
and contributions. Means testing would convert the Social Security program into
a welfare program. In this regard, it seems unlikely that such a reform could
happen, though politicians do discuss this possibility from time to time. For
those deemed as wealthier by the law, this is the only type of reform that
could lead to a more significant reduction in benefits for some members of the
population.

To be clear, there are stealthier ways to create means
testing than doing it outright. The progressive benefit formula could be made
more progressive, for instance, by reducing the replacement rate for higher
earners. Also, taxing Social Security benefits was a way to move toward means
testing in a sneakier and less direct manner. Social Security benefits could
still be made fully taxable. This provides a push toward means testing without
being as explicit about it.

While higher income individuals may have some justification
to worry about means testing, it seems incredibly unlikely that a wholesale
reduction in benefits would be enacted for the general population of current
and near retirees. It is overly conservative for near retirees to be worried
that Social Security will disappear entirely. It is tough to justify the idea
that one should claim early to get something before it is too late.

Social Security still requires significant reform, but it is
by no means on the road to disappearing. Other structural changes will be
needed in the coming years, but Social Security will still be around. This is a
clear example of “public policy risk,” in which changing tax and entitlement
laws can throw a wrench into the planning process. Congress is free to change
Social Security benefits at any time, but it will surely remain as a core
resource to support retirement spending. Retirees should take care to develop a
proper claiming strategy that provides long-term benefits under the assumption
that Social Security will exist.

Action Plan

Choosing your Social Security claiming strategy is a key
part of building a retirement income plan. The benefit application can be done
online, by phone, or in person at a Social Security office. Though Social
Security claiming is just one step in building a retirement income plan, the
value of lifetime Social Security benefits can dwarf many other retirement
assets. Thought and care are needed to determine how to claim Social Security
in the most effective manner for the household. Here are key steps to take:

o
Obtain your updated Social Security Statement at ssa.gov

o
Check your statement’s earnings history for accuracy and understand
the assumptions used for estimating your benefits

o
future covered earnings

o
economy-wide wage growth and inflation

o
Familiarize yourself with the basic claiming philosophies

o
View Social Security as longevity insurance

o
Analyze Social Security from breakeven age perspective

o
Understand basic Social Security rules

o
Worker benefits, spousal benefits, survivor benefits, ex-spouse
benefits, and benefits for other dependents

o
Consider applicability of the earnings test when claiming and
working before full retirement age

o
Identify exposure to windfall elimination provision and
government pension offset

o
Those collecting disability benefits should understand the
transition to retirement benefits

o
Identify possibilities for suspending benefits

o
Collect the relevant information for making a claiming decision

o
Benefits from your earnings record: spouse & dependents

o
Your eligibility for benefits from other’s earnings records:
spouse, ex-spouse, survivor

o
Role of earnings test, windfall elimination provision, government
pension offset, disability benefits

o
Availability of resources to support delayed claiming

o
Dependence on Social Security as reliable income

o
Risk tolerance

o
Use software to calculate the optimal claiming strategy and
compare with other options

o
Build a strategy to support deferring benefits when applicable

o
Identify how to meet spending goals before benefits begin
(portfolio distributions, part-time work, reverse mortgage, life insurance cash
value)

o
Consider tax planning opportunities while deferring (see Chapter
10)

Further Reading

Biggs, Andrew. 2014. “Better no Social Security
Replacement Rates than Wrong Replacement Rates.” AEIdeas Series (September 3).

Congressional Research Service. 2020. Social Security:
What Would Happen If the Trust Funds Ran Out? Available from https://crsreports.congress.gov/product/pdf/RL/RL33514

Kotlikoff, Laurence J. Philip Moeller, and Paul Solman.
2016. Get What’s Yours: The Secrets to Maxing Out Your Social Security.
Simon & Schuster.

Piper, Mike. 2017. Social Security Made Simple.
Simple Subjects.

Reichenstein, William, and William Meyer. 2017. Social
Security Strategies. CreateSpace.

Chapter 7: Medicare
and Health Insurance

Planning for retirement health
expenses is an essential component in a comprehensive retirement
income plan. This chapter explores retirement health
insurance options and retirement health expenses. The bulk of this discussion
will be about Medicare, which is available to most Americans upon reaching age
65. As the most important source of health insurance for retirees, decisions
must be made regarding whether to use Original Medicare or a Medicare Advantage
Plan, whether to use a Medicare Supplement with Original Medicare, and how to
obtain prescription drug coverage. A lack of understanding about the rules of
Medicare can lead to gaps in coverage, overpayment on services or coverage, and
unanticipated outcomes. I also cover health insurance options for those
retiring before reaching Medicare eligibility age, and the rules about using
other private insurance after reaching Medicare eligibility. I also discuss
ongoing annual Medicare elections as well as how to develop a budget for
retirement health expenses. I discuss budgeting towards the end of the chapter because
retirement health care costs will closely relate to decisions made regarding
insurance. I will finish with an action plan for health care in retirement.

Health Insurance Options Prior to Medicare
Eligibility

Medicare qualification typically occurs at age
65; non-citizens must be 65 and legally resident in the United States for at
least five years. There are a few exceptions where coverage can begin before
age 65, including qualification after receiving Social Security disability
benefits for 24 months (or immediately if the disability benefits are triggered
by the onset of amyotrophic lateral sclerosis), or by a determination of
end-stage renal disease.

Otherwise, anyone who retires prior to age 65 must
obtain health insurance elsewhere. I consider the options generally available
here. Early retirees must also determine how to get health insurance for their
family members and to decide on the best option. Factors that play into the
decision about health insurance include premiums, deductibles, coinsurance and
copayments, out-of-pocket maximums, covered providers, prescription coverage,
supplemental benefits like dental care, and availability for family members.

Many individuals who otherwise might retire
early may remain in the workforce due to the high cost of insurance outside of
the employer-provided insurance ecosystem. Despite this constraint, the
Affordable Care Act remains a way to obtain health coverage, especially if none
of the other methods we describe are available, including coverage through a
spouse, retiree health coverage, or COBRA. Though not technically insurance,
members of faith-based communities may also consider healthshare programs.

Coverage Through a Spouse

When one spouse has retired but the other is
still working, the best approach may be to obtain health insurance coverage
through the spouse or domestic partner’s health plan. This coverage is often
subsidized by the employer and may be more cost effective than other options
when it is available. It may also provide more options for prescription drugs
and other services like dental care. When available, this coverage can be the
starting point for comparisons with other potential options.

Another consideration for obtaining coverage
through a spouse that must also be coordinated is when that spouse becomes
eligible for Medicare. If the working spouse changes to Medicare and drops the
coverage at work, the previously retired spouse (assuming this spouse is still
under 65) and any dependents would lose their coverage. Medicare is only for
individuals, not family members.

Employer-Provided Retiree Health Insurance

Employer benefits for some retirees may
include retirement health insurance that can fill the coverage need in the
years leading up to Medicare enrollment at age 65. Retiree coverage may also be
available through other work-related organizations like unions or professional
societies. This type of coverage is becoming less common as employers move away
from these types of offerings. Government employees are much more likely to
have access to these benefits than those employed privately, as 65 percent of
public employers and 13 percent of private companies offer retirement health
insurance to at least some employees in 2019. It is also important to
investigate how the coverage interacts with other aspects of employer benefits.
For instance, a decision about a defined-benefit pension could impact whether
retirement health coverage is available. Even when offered, though, the retired
employees may be paying an increasing portion of the costs for these benefits. You
may still wish to compare the costs for this coverage with other options. Nonetheless,
when it is available, this is an important coverage option for earlier retirees
waiting for Medicare to begin.

Coverage through COBRA

Those working at employers with 20 or more
employees may continue their same group health insurance coverage through COBRA
for up to 18 months after leaving work, if the departure was for reasons other
than gross misconduct. For coverage to continue, one must already be enrolled
in the plan before leaving work. This could help fill a short gap in coverage
for those close to age 65. This coverage may be costly, though, as the individual
will need to also pay for the portion of coverage that had been paid by the
employer in addition to the employee portion, plus another 2 percent for
administrative costs. For many employers that subsidize coverage, this could
represent a very large increase in total premiums.

Coverage through other means may be cheaper,
especially through income-based subsidies available through the Affordable Care
Act. Nonetheless, for those who may be just a few months away from Medicare
eligibility, temporarily paying a higher premium through COBRA may be a better
option than trying to find alternative coverage that includes preferred in-network
health providers. Deductibles play an important role in this decision,
potentially offsetting at least some of the higher cost of COBRA if deductibles
have already been met earlier in the year.

Coverage through the Affordable Care Act or
Private Market

Health insurance may also be obtained through
the state and federal exchanges created by the Affordable Care Act that began
operating in January 2014, or through the private insurance market. The
Affordable Care Act made it dramatically easier for those retiring before 65 to
find health insurance coverage without the risk of rejection for pre-existing
conditions. Information about how and when to sign up, as well as the available
coverage and costs, is available at HealthCare.gov. Plans are available as
Bronze, Silver, Gold, and Platinum, with premiums generally increasing and
out-of-pocket costs decreasing as one progresses through the list.

Early retirees may also be able to benefit
from subsidies for coverage that are available to those whose modified adjusted
gross incomes are less than 400 percent of the federal poverty level. The
poverty level varies by household size, and in 2021, for example, the 400
percent ceiling is $69,680 for a two-person household. The American Rescue Plan
Act of 2021 passed in March 2021 does temporarily increase access to subsidies
above the 400 percent limit in 2021 and 2022. Chapter 10 provides more
discussion about the tax-planning implications for these subsidies. It is
important to note that the provisions of the Affordable Care Act are politically
contentious, and the program could experience drastic changes in the coming
years. Early retirees may not wish to become too dependent on obtaining
coverage this way over a multi-year period, in case such coverage is not always
available, its subsidies are reduced, or its costs otherwise become
unaffordable. Insurance can also be purchased from companies outside of the
Affordable Care Act exchanges, but this type of coverage will not be eligible
for the subsidies.

Healthshare Programs

One other option that is not insurance, but
which is growing in popularity with over one million participants in the United
States, is a healthshare program. These are typically operated through
Christian organizations. These programs often look like insurance, but they are
not regulated like insurance and do not have contracts that require that health
bills be covered. They may also require the acceptance of specific religious
principles and cost-sharing may not be provided for certain health issues related to activities that are deemed to
be against the religious beliefs. These aspects may be attractive to some
members, but the main benefit is financial, as the costs to participate may be
less than with other health insurance options.

The ABCDs of Medicare

Medicare is a health insurance program
primarily available to those aged 65 and older. Created in 1965 as part of
Lyndon B. Johnson’s Great Society, it is administered through the federal
government’s Centers for Medicare and Medicaid Services in the Department of
Health and Human Services. Its funding sources include payroll taxes, earnings
on its trust fund, premium payments, and taxes on Social Security benefits.
Medicare is not designed to cover all health expenses for retirees, but it is an
important program that serves as the primary insurance for most retirees.

Those eligible for Medicare must make a
variety of decisions related to Parts A, B, and D of the program, along with
the possibility of using Part C in place of A, B, and sometimes D, as well as
having supplement choices with plans ranging from A to N. There really is an
ABCs of Medicare to consider. Parts A and B operate through the federal
government, while Medicare Advantage, supplement plans, and Part D are made
available through private insurers.

Medicare Part A – Hospital Insurance

Part A of Medicare is hospital insurance
provided through the federal government. It covers inpatient care in hospitals,
inpatient skilled nursing facility care (but not custodial care or long-term
care), hospice care, and home health care. For inpatient hospital care in
semi-private rooms, this includes meals, nursing care, drugs, and other hospital
services. Inpatient psychiatric care is also available for up to 190 days in a
lifetime.

There is usually not a specific premium to be
paid for Part A, as it is covered through the payroll taxes from your working
years, like with Social Security. Receiving Part A without a premium is linked
very closely to how one qualifies for Social Security by having 40 or more
quarters of Medicare-covered employment or being entitled to Social Security
benefits based on a spouse or ex-spouse’s earnings record, and that spouse is
at least 62. Also, in rare cases where someone did not qualify for Part A
through payroll taxes, it is possible in 2021 to purchase Part A coverage with
a $471 monthly premium for those who have less than 30 quarters of coverage and
$259 per month for those with 30 to 39 quarters.

Part A does include deductibles and
co-payments as determined through benefit periods, which are different from calendar
years. A benefit period for hospital coverage provides a fixed amount of
coverage that resets when a new benefit period starts. A benefit period begins
on the first day of a hospital stay and ends once 60 days have passed since
receiving inpatient care at a hospital or skilled nursing facility. The start
of a benefit period triggers a new deductible to be paid, which makes it
possible that a deductible may need to be covered twice (or more) in one year.
For hospital stays in 2021, there is a $1,484 deductible applied to each
benefit period. After meeting the deductible, the rest of the costs for those
first 60 days of inpatient hospital care is covered. Then, for days 61 to 90,
inpatient stays have a daily $371 copayment. After receiving 90 days of
inpatient care, coverage for the benefit period ends, but one also has access
to an additional 60 lifetime reserve days. On these days, there is a daily $742
copayment. Beyond this point, the individual will face all costs from the
hospital stay during a given benefit period. Again, a new benefit period will
start once 60 days have passed since receiving inpatient care.

Part A also includes some care at a skilled
nursing facility provided that many conditions are met. Skilled nursing care
can be available for up to 100 days for a need related to an inpatient hospital
stay for at least three days and is certified by a doctor that the care is
needed. When a hospital stay may only last three days, it is important to
clarify that you have been admitted for inpatient care rather than considered
for outpatient observation even if staying overnight. For the first 20 days of
skilled care, there is no additional charge once the deductible has been
covered, but days 21-100 require an additional daily copayment of $185.50. No
benefits are available beyond 100 days. A limited amount of home care is also
available through a Medicare-certified home health agency under limited
circumstances.

Medicare Part A also covers hospice care with
certification of a terminal illness with less than six months to live. Hospice
care includes comfort care instead of attempting to cure your illness. Benefits
include pain relief, symptom management, medical, nursing, and social services,
medical equipment, and spiritual and grief counseling for you and your family.

These are the only types of Medicare coverage
that relate to what people may have in mind about long-term care. But Medicare
is not a provider of traditional custodial care for those with long-term needs.
We discuss this further in the next chapter.

Medicare Part B – Medical Insurance

Part B of Medicare is for the basic medical
insurance for preventative care including vaccines and wellness visits, doctor’s
visits, outpatient care, medical equipment, home health services, ambulance
services deemed necessary, mental health services, and other eligible types of
care not involved with hospital stays. These services must be medically
necessary. Specific coverage exceptions, though, include dental care, dentures,
vision care, cosmetic surgery, and hearings aids. With a few exceptions,
prescription drugs are not covered, though one can also obtain a Part D plan
for this coverage. Part B is funded through premiums and general tax revenues
rather than payroll taxes, and it is also administered through the federal
government.

Part A and Part B coverage for Medicare allows
an individual to use any doctor, hospital, or service provider that accepts
Medicare for payment. Most medical professionals (98-99 percent) do accept
Medicare, so this is typically not a concern. There is no need to choose a
primary care physician and referrals to specialists are generally not
necessary.

Medicare Part B includes a $203 deductible in
2021 and a 20 percent coinsurance rate for most doctor’s services and
outpatient care. There is no out-of-pocket maximum payment with this
coinsurance. As medical bills can be costly, even a 20 percent coinsurance rate
could lead to significant strains on retirement assets.

Part B requires a monthly premium along with the
deductible and coinsurance or co-pay amounts. The base monthly premium for
Medicare Part B in 2021 is $148.50 per month. When modified gross adjusted
incomes from two years prior exceed certain thresholds, the Part B premiums
increase according to an Income Related Monthly Adjustment Amount (IRMAA). This
becomes an important tax-planning implication for retirement and is discussed
further in Chapter 10.

There is a hold harmless provision for
baseline Part B premiums for those who are already receiving Social Security
benefits. It says that net Social Security benefits cannot decrease after
accounting for Medicare Part B premiums. This means that Part B premiums cannot
increase by more than the Social Security COLA amount for existing
beneficiaries. This creates a problem for those not yet receiving Social
Security; they must bear the full costs for additional premiums needed to cover
expenses. When Social Security COLAs are low, those not yet on Social Security
may have to pay more. This can be counted as a slight knock against delaying
Social Security, and it really is a problem with existing law that should be
fixed, but it generally would not overturn the arguments for delay provided in
the previous chapter. I estimated that the cumulative impact of low COLAs in
2015 and 2016 was about $550 of total additional Part B base premiums for those
who had not claimed Social Security.

Medicare Advantage Plans – Part C

“Original Medicare” refers to someone enrolled
in Parts A, B, and possibly D of Medicare. There is an alternative to Original
Medicare called Medicare Advantage. It is Part C. Presently about one-third of
Medicare enrollees choose Medicare Advantage, while two-thirds stay with
Original Medicare.

Medicare Advantage plans are provided through
private insurers rather than directly from the federal government. Medicare
regulates the services they must provide, which generally include anything
provided through Medicare Parts A and B. Medicare Advantage can also provide
additional services, such as for dental care, vision, hearing, nutrition
services, in-home support, home modifications, or fitness plans, and most
Medicare Advantage plans provide prescription drug coverage. Those who do not
receive prescription drug coverage through their Medicare Advantage plan can
use a Part D plan or other creditable coverage instead. About the added
benefits, it is important to examine them carefully as they may be limited in
their practical use.

A key difference for Medicare Advantage is
that it is less universal, as users are generally limited to in-network
doctors, hospitals, and providers. Referrals may be needed to see specialists. Medicare
Advantage plans are focused on specific service areas and may have few
in-network options outside those geographic areas. There can be additional
charges for out-of-network care, which is reminiscent of how many private
health insurance plans work but is not an issue with Original Medicare. An
exception to this is made for emergency care, which will be considered
in-network anywhere in the United States.

Medicare Advantage plans are structured in any
variety of ways including as health maintenance organization (HMO) plans,
preferred provider organization (PPO) plans, fee-for-service plans, special
needs plans, and medical savings account plans. Depending on where one lives,
there may be around 33 Medicare Advantage choices. HMOs are the most popular
advantage option. They limit care to in-network providers and charge lower
premiums. PPOs, in contrast, allow for out-of-network visits as well, but at a
higher cost. Some Medicare Advantage plans are group plans made available to
retirees through certain employers and unions.

For those covered by Medicare Advantage, one
still pays the usual Medicare Part B premium plus an additional premium charged
by the Advantage plan. In 2021, the Kaiser Family Foundation reports that 54
percent of Medicare Advantage plans did not require an extra premium, and the
extra premium amount averaged $21 per month across all plans, or $46 per month
among those plans charging a premium. Medicare then also pays a fee to the
Advantage plan to share some of the premium it collected from you. As well, just
like with Original Medicare, Medicare Advantage plans can require deductibles,
coinsurance, and copayments. How these are structured can vary between plans.

A benefit of Medicare Advantage, unlike
Original Medicare, is that it offers a maximum out-of-pocket expense limit for
costs related to Medicare Part A and Part B benefits. For 2021, these
out-of-pocket maximums can be at most $7,550 for in-network care and $11,300
for out-of-network care. After those limits are reached, Medicare Advantage
will cover all eligible costs for the rest of the year.

An important choice that individuals will make
when enrolling in Medicare is to choose between Original Medicare and Medicare
Advantage. As based on our summary, reasons that individuals may lean toward choosing
Original Medicare include:

·
Live in two parts of the country throughout the year, such as
those spending the winter in a warmer climate, which makes finding in-network
providers more difficult with Medicare Advantage

·
Preferred health care providers would not be in-network

·
Tend to use more health care services and see more specialists

·
Value the options provided by Original Medicare to not be
restricted to in-network providers from a limited-service area

·
Desire to have a comprehensive supplement to help limit
out-of-pocket costs

·
For those traveling internationally, including a supplement can
provide some international coverage that is not generally available with
Medicare Advantage

Meanwhile, those who may lean toward choosing Medicare
Advantage may be attracted to:

·
Lower overall premiums compared to adding Part D and a
comprehensive supplement with Original Medicare

·
Preferred health care providers are all in-network for the plan

·
Tend to use less health care services so that the copayments and
coinsurance costs will be less of an issue and overall out-of-pocket costs may
be less

·
Find value in the additional benefits such as dental, vision, or hearing

·
Some individuals with chronic conditions may find special needs
Medicare Advantage plans that are better tailored to their situation

·
Appreciate the all-in-one aspect of not needing to differentiate
between A, B, D, and a supplement plan.

Comparing the overall cost differences between
Original Medicare and Medicare Advantage can be complicated because costs will
depend on the amount of health care services used and on the choice of a
supplement with Original Medicare. There will be tradeoffs between paying
higher premiums to reduce the potential long tail of high uncovered expenses. A
lower premium is not the only objective, as overall costs may end up higher as
more care is used. Original Medicare with a comprehensive supplement will
result in higher overall premiums but less subsequent out-of-pocket costs and
more stable overall spending on health care. Total out-of-pocket costs with a
comprehensive supplement can be less than with Medicare Advantage. In the
absence of a supplement, however, costs with Original Medicare will be much
more dependent on the amount of health care used, as compared with Medicare
Advantage that offers an annual cap on expenses.

Meanwhile, Medicare Advantage can provide
lower overall premiums, but then higher costs as health care is utilized, until
finally reaching an out-of-pocket maximum for the year that could be higher
than Original Medicare with a comprehensive supplement. This can mean fewer
overall costs for those not using much health care, but then eventually higher
overall costs as more health care is utilized, though at least there is a ceiling
on how high those costs can go.

It is not an easy decision, and you may
benefit from speaking about your specific situation with someone who is
familiar with the various options available in your area and who can help to
analyze your potential overall costs for different options as based on the
types of health care you typically need. Of course, as new medical problems
develop, this sort of look-back process on the health care you have used may be
less helpful, but comparing different programs based on past health care needs
is certainly a valuable starting point to understanding the implications of your
choices.

Medicare Part D – Prescription Drug Coverage

Medicare Part D is the source of prescription
drug coverage for those enrolled in Original Medicare. It is also available to
those who choose a Medicare Advantage plan that does not include drug coverage.
Much of the discussion about choosing among Part D plans applies as well to analyzing
the drug coverage provided by Medicare Advantage.

Part D plans are provided through private
insurers. Depending on where you live, there could be 30 or more available
plans from which to choose. Plans vary in numerous important ways that can
dramatically impact an individual’s total prescription costs for a given year. The
details which vary between Part D and Medicare Advantage plans include:

·
Monthly premium amounts

·
Amount of annual deductible, copayments, and coinsurance

·
The formulary, or list of drugs covered, which can be changed
from year to year and even during a year

·
The breakdown of tiers and costs for covered drugs

·
Lists of pharmacies that are preferred in-network, standard
in-network, or out-of-network

·
Whether prescriptions can be filled by mail order

·
Step therapy rules, where lower tier drugs need to be used first

·
Whether prior authorization is required before filling a
prescription

·
Quantity limits on prescriptions

·
Medicare star ratings for plan quality, ranked from one to five
stars

Part D plans charge premiums, include a
deductible, and have coinsurance rates for prescription purchases. When
choosing among plans, it is the total costs for covering one’s prescriptions
that matters, and that is the sum for these different components. One cannot
look at any of these issues in isolation.

Plans charge a monthly premium that can vary
widely by plan, though Medicare identifies that the average base premium amount
nationally in 2021 is $33.06 per month, or about $397 per year. As with Part B,
Part D premiums are also exposed to the income-related monthly adjusted amounts
that can raise premiums for those with higher incomes in retirement. Planning
for this situation is described in Chapter 10.

The costs for prescriptions depend on the
plan’s formulary, which lists the drugs covered by the plan and classifies them
into different cost categories. Plans may also vary by their list of covered
pharmacies as well as whether prescriptions can be filled through the mail, as
this will be a consideration for those wishing to use a specific pharmacy. For
those using a specific list of prescriptions, studying these formularies
becomes important in estimating the total prescription costs under different
plans. As a first step, make sure the plan you are considering covers the
prescriptions you use. Then consider the out-of-pocket costs for each
prescription with the plan, and any quantity or purchase limits.

Prescription costs also depend on total
spending over a year’s time. The cost for a particular prescription depends on
which of three phases of coverage you are current in: the initial coverage
phase, the gap coverage phase, and the catastrophic phase.

This can get complicated, but it is summarized
nicely in the Medicare and You handbook for 2021: “Once you and your
plan spend $4,130 combined on drugs including the deductible, you will pay no
more than 25 percent of the cost until your out-of-pocket spending is $6,550.
Then you receive “catastrophic coverage” in which you pay no more than 5
percent of the cost for covered drugs for the rest of the year.”

In other words, the initial phase applies
until spending (not counting premiums) reaches $4,130. The gap coverage phase then
applies until your spending gets to $6,550. Beyond this amount, you have
entered the catastrophic coverage phase. Individuals may also be using drugs
that are not covered by their Part D plan and do not count as part of these
thresholds.

In the initial phase, the standard or minimum
coverage required through a Part D plan is a $445 deductible in 2021 before
coverage begins, but this deductible may be less and even $0. After the
deductible, plans can charge differently for different tiers of drugs and
whether they are brand-name or generic. The coinsurance rates can be set high
or low, or there may be copayments. When the coverage gap phase begins,
coinsurance rates cannot be more than 25 percent. But again, they can be less.
Finally, in the catastrophic phase the results are more standard: the
coinsurance rate is 5 percent but not less than $3.60 for a generic
prescription and $8.95 for a brand-name prescription.

Exhibit 7.1 provides an example showing how a
randomly chosen plan structured its coverage. This information is provided for all
plans using Medicare’s important Plan Finder tool (Medicare.gov/plan-compare) which
is explained later in this chapter. The point to take from the exhibit is there
are many components to pricing and these numbers can vary by plan and can be
presented as copays or coinsurance. As well, each drug may be in a different
tier for different plans, and some plans may not even include the drug. If left
to one’s own devices, it could be a nightmare to compare plans for a specific
set of medications.

Exhibit 7.1

Example of Part D Drug Costs Using Medicare Plan
Finder

Tiers

Initial coverage phase

Gap coverage phase

Catastrophic coverage phase

Preferred Generic

$5 copay

$5 copay

Generic drugs:

$3.60 copay or 5% (whichever costs more)

Brand-name drugs:

$8.95 copay or 5% (whichever costs more)

Generic

$10 copay

$10 copay

Preferred Brand

$47 copay

For all other drugs, you pay 25% for generic drugs
and 25% for brand-name drugs

Non-Preferred Drug

50% coinsurance

Specialty Tier

33% coinsurance

Medicare Supplement (Medigap) Plans

For those enrolled in Original Medicare,
optional Medicare Supplement or Medigap insurance policies are available from
private insurers to cover some or most of the deductibles, coinsurance, and
copayments for Medicare Parts A and B. These plans are only an option for
Original Medicare and may not be used with Medicare Advantage.

The premiums for these policies vary by
company and coverage plan. The methods used for determining premiums also vary,
which can be an issue for those planning to keep the supplement throughout
retirement. Some cost structures start higher but then grow more slowly, while
others start lower but include larger anticipated increases over time.

Premiums based on attained age are most common,
probably because they start the lowest. For these plans, prices vary based on
your age at the time of enrolling in the plan, and they also increase as you
age, and your costs of care are expected to rise. After enrolling, it is the
only method that uses your current age as part of determining ongoing premiums.
Premiums adjust over time to reflect the costs of claims for the insurance
company, but everyone with the same attained age and same starting age will
have the same premium. Next, community-based premiums have a single price for a
service area regardless of age. This approach has less growth in premiums since
your premiums do not increase specifically because you get older. Potential
premium increases instead reflect the overall costs in the community to the
insurer. This approach is how Medicare Advantage plans are priced. Finally,
issue-age policies are based on when you first purchase the plan, and the price
does not specifically change because you get older.

Despite the different premiums and methods for
determining them, plans of the same type offer standardized coverage. States
regulate coverage and so there could be slight differences between states, but
within a state the coverage is fully standardized for each plan type. Plans are
also guaranteed to be renewed for your lifetime once in place if you continue
paying the premiums. These plans provide benefits only for costs related to
Parts A and B. They do not cover other types of missing benefits such as dental
care and they do not cover out-of-pocket costs for prescription drug coverage. Another
point of comparison for supplement plans is whether your preferred health care
providers will process the paperwork for the plan you choose, or whether you
will have to do the paperwork yourself. You may ask your preferred care
providers about this.

There are currently eight supplement plans
available to new enrollees, along with two more for those who enrolled in
Medicare before January 1, 2020. Each provides standardized coverage according
to the terms of that type of plan. Exhibit 7.2 provides details about the ten
types of plans.

Exhibit 7.2

Medicare Supplement (Medigap) Plan Options

A

B

C*

D

F*

G

K

L

M

N

Benefits | Premiums

$864

$1,188

$1,476

$1,344

$1,488

$1,152

$492

$828

$1,224

$948

Part A co-insurance and hospital costs up to 365 days
beyond initial Medicare benefits

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Part B co-insurance

and co-payments

Yes

Yes

Yes

Yes

Yes

Yes

50%

75%

Yes

Yes

Blood (first 3 pints)

Yes

Yes

Yes

Yes

Yes

Yes

50%

75%

Yes

Yes

Part A hospice co-insurance or co-payment

Yes

Yes

Yes

Yes

Yes

Yes

50%

75%

Yes

Yes

Skilled nursing facility care co-insurance

No

No

Yes

Yes

Yes

Yes

50%

75%

Yes

Yes

Part A deductible

No

Yes

Yes

Yes

Yes

Yes

50%

75%

50%

Yes

Part B deductible

No

No

Yes

No

Yes

No

No

No

No

No

Part B excess charge

No

No

No

No

Yes

Yes

No

No

No

No

Foreign travel exchange

(up to plan limits)

No

No

80%

80%

80%

80%

No

No

80%

80%

Out-of-pocket limit

n/a

n/a

n/a

n/a

n/a

n/a

$5,880

$2,940

n/a

n/a

* Plan C and Plan F are not available to
those newly eligible for Medicare after January 1, 2020.

Note: As an example, premiums reflect the
lowest annual premium for a 65-year-old non-smoker female in Fairfax County,
Virginia, for 2021. Personal pricing options are at Medicare.gov/plan-compare

The more comprehensive plans are more popular
in practice. In recent years, Plan F is the most comprehensive available
supplement. It covered the deductibles and coinsurance for Parts A and B
completely so that there will not be any out-of-pocket costs. This will lead to
higher premiums but less overall costs when adding those additional expenses related
to high health care usage in a year. Starting for those newly eligible for
Medicare after January 1, 2020, it is no longer possible to have the Part B
deductible covered through a supplement. Those already covered with Plan F or
Plan C can keep it, and those who first enrolled in Medicare before this date
can still switch to these plans, but otherwise Plan G is now the most
comprehensive plan for new enrollees. It covers everything included with Plan F
except for the $203 Part B deductible. Some states do also offer
high-deductible versions for Plan F and Plan G. These require paying all costs
up to $2,370 in 2021 and then the plan pays. The tradeoff is that these plans will
have lower premiums.

Average premium costs do not bear out the idea
that more comprehensive coverage is always more expensive. This may be due to
the lack of plan availability in different regions or different pricing
formulas. There may also be more competition for some types of plans in your
area. The purpose of including an example of premiums is to provide a sense of
what these premiums may be on an approximate basis. It is important to shop for
different plans available where you live and to not be intimidated about
looking at more comprehensive plans because you are worried about costs. It is
also important to remember that premiums are for individuals and plans must be
purchased separately for each member of a couple. Each spouse is also free to
choose a different plan based on their differing health characteristics and
preferences.

Potential benefits are completely standardized
across insurers for each plan type. All supplement plans cover coinsurance
amounts for Part A as well as an additional 365 days of hospital coverage.
Plans K and L are higher-deductible style plans and only cover a portion of the
next three benefits but with out-of-pocket limits, while the remaining plans
otherwise cover Part B co-insurance and co-payments, 3 pints of blood, and Part
A hospice coinsurance and copayments. Plan A offers the least additional
coverage, with only these first four benefits provided. The remaining benefits
on the list are only available with certain plans. These include the
co-insurance for skilled nursing care, the Part A deductible (and Part B with
earlier enrollees), and foreign travel benefits.

The Part B excess charge refers to whether a
medical provider has “accepted assignment” from Medicare. This means the
medical provider has agreed to be paid directly by Medicare and to accept the
Medicare approved payment amount. The medical provider will not charge more to
the patient than the Medicare deductible or co-insurance amounts. Most medical
providers do accept assignment, but you are welcome to ask about this before
receiving care. Those who do not accept assignment may charge up to 15 percent
more than the Medicare allowed amount. For expensive care, this can add up to a
lot. The Part B excess charge benefit then covers the additional costs for care
that exceed what Medicare pays for medical providers who have not accepted
assignment.

Exhibit 7.3 provides more detail about the
potential value for these different types of benefits. The choice between
supplement plans involves the premiums as well as the self-assessed likelihood
of using the benefits provided through different plans.

Exhibit 7.3

Medicare Supplement (Medigap) Plan Benefits

Benefit Type

Potential Monetary Value of Coverage (2021)

Part A co-insurance and hospital costs up to 365 days
beyond initial Medicare benefits

Covers $371 copay for days 61-90, then covers full
cost beyond 90 days for up to 365 days

Part B co-insurance

and co-payments

Covers the 20% coinsurance rate for care received
after deductible is met

Blood (first 3 pints)

Covers when a hospital buys blood for you, otherwise
you pay the hospital costs for the first three units of blood in a calendar
year

Part A hospice co-insurance or co-payment

Covers $5 copayments for prescription pain and
symptom management drugs, and 5% coinsurance for Medicare-approved inpatient
respite care

Skilled nursing facility care co-insurance

Covers the $185.50 copayment per day for days 21-100

Part A deductible

Covers the $1,484 deductible per benefit period

Part B deductible

Covers the $203 per year deductible

Part B excess charge

Covers charges exceeding Medicare reimbursement rates
for health care providers who do not "accept assignment" from
Medicare

Foreign travel exchange

(up to plan limits)

Medicare generally does not cover health care while
traveling outside the United States. This covers foreign travel emergency
care if it begins during the first 60 days of the trip, and covers 80% of
billed charges for certain medically necessary emergency care outside of the US
after a $250 deductible (lifetime limit = $50,000)

Out-of-pocket limit

Original Medicare does not have out-of-pocket
maximums

Not everyone using Original Medicare will need
a Medicare supplement plan. Some of the most risk tolerant may prefer to take
the risks related to potential health care costs based on the amount of care
used, while others may obtain this type of additional coverage through their retiree
health insurance plans or other secondary coverage options.

For the risk averse, Original Medicare
alongside a comprehensive Medicare supplement may be the best option. Though
premiums will be higher, most health expenses will be covered through benefits
instead of paid out-of-pocket. This combination alleviates potential concerns about
staying in-network because care can be obtained from any medical provider who
works with Medicare. There is also no need to worry about whether a provider
accepts assignment from Medicare because coverage is standardized along with
the ability to maintain the same type of plan for life. In terms of annual
updates, the only ongoing decision relates to choosing a Part D plan to prove
the most cost-effective coverage for the following year. It is not necessary to
keep up with changes in Medicare Advantage plans. You can switch to a Medicare
Advantage plan later in retirement if you wish to, but if you instead use
Medicare Advantage from the start, you may not be able to later switch to coverage
from a desired supplement. This is a detail I will address later.

Using the Medicare Plan Finder

Medicare provides the Plan Finder (Medicare.gov/plan-compare)
to help participants learn more about the various options in their community
for Part D prescription plans, Medicare Advantage plans, and Medicare
supplements. The tool is probably the most useful for analyzing prescription
drug costs, while it provides the least amount of information for Medicare
supplements. We will discuss this tool, but one additional detail worth noting
first are the star ratings. Each plan includes a star rating for the plan
quality and performance. It is based on whether members were getting
preventative care, how they manage chronic conditions, member survey results,
member complaints, and customer service outcomes. The results range from one to
five stars, with five being the best. It is not necessary to log into your
Medicare account to use the tool.

Medicare Part D Plans

If we could make the heroic assumptions that
an individual knows their exact list of prescriptions for the following year
and that no changes to the formularies are made mid-year, it is possible to use
the Plan Finder tool to calculate total costs for your list of prescriptions per
plan and to then choose the one supporting the lowest overall costs. We do not
know this information with certainty, but it can still be helpful as a start.

Regarding mid-year changes to formularies,
this is especially hard to predict, and we may not be able to plan for it. When
it happens, the plan should provide a reasonable alternative option at similar
cost. We might lean toward a plan with a higher star rating under the
assumption that the plan will be more cooperative to help with these
situations.

The other input, which is our list of
medications used in the next year, does require some guesswork on our part. To
estimate this, it is worthwhile to begin accumulating a detailed list of your
prescriptions each year to help refine and estimate your needs for the coming
year, hoping that no new conditions develop to throw off your plans (among
other downsides from new health problems). If you already have a sense that new
medication will be needed in the following year, you might test plan options
with and without the medication. You might also compare generic and brand name
options for medicines. The goal is to see how much different plans will cost to
meet your anticipated prescription needs in the following year.

With this list of anticipated prescriptions,
we are now ready to sit down with Medicare’s Plan Finder. At this website, you
can select to view the Part D plans, and enter your zip code and county of
residence. Choose “yes” if you want to see your drug costs when you compare plans.
To get the widest analysis, choose both mail-order and retail pharmacy options
for how you normally fill prescriptions. You can then enter your list of
prescription drugs you wish to test, as well as all the potential pharmacies
you could consider. You are only allowed to enter five pharmacies at a time,
which could require re-running a few times to make sure you have been able to
consider all the viable pharmacy options. Calculated costs can also vary quite
dramatically by pharmacy. If you have chosen pharmacies that are generally
being included as a preferred-provider for your available plans, then you may
have a good idea about your options with just five pharmacy choices. After
entering this information, you will receive a list of insurance plans that you
can rank by:

·
Lowest yearly drug deductible

·
Lowest drug and premium cost

·
Lowest monthly premiums

The only one of these choices that really
matters is the middle one: how much will you pay in total for your annual
prescriptions after accounting for both premiums and the costs you pay toward
each prescription. Knowing who has the lowest deductible or lowest monthly
premiums is not helpful since this is just one component of costs. You may also
filter the results by having drug coverage accepted across the US, by the star
rating of the insurance plan, and by individual insurance carriers.

To provide a sense of the possible outcomes, I
tried using the Planner with a few random prescriptions. Thirty plan options
were available in my search. Total drug and premium costs ranged from $1,359.42
for the least expensive plan (which included $85.80 for monthly premiums, using
a retail pharmacy, a $435 deductible, and a 3.5-star rating) up to $3,119.77
for the most expensive plan (which included $86.80 for monthly premiums, using
mail-order pharmacy, a $250 deductible, and a 3-star rating). Monthly premiums
ranged from $13.20 at the lowest (but with a $2,898.81 total cost) to $147.20
at the highest (but with a $1,522.62 total cost). Deductibles ranged from $0 to
$435. If I limited options to those providing national coverage, the lowest
total cost was $1,850.98. There were no 5-star plans, but if I instead limited
options to 4 stars and higher, the lowest total cost was $3,091.11.

Results varied widely in this simple example,
which leads to a few conclusions about finding a Part D plan:

·
Focus on total costs for your estimated prescriptions, not lowest
premium or deductible. Plans with higher premiums or deductibles may offer
lower total costs for your prescription needs.

·
If you are finding that your prescription drugs are not covered
or may be covered in a more expensive tier, discuss with your health care
provider about whether there are more affordable options.

·
If you do not use prescriptions at all, you might focus on plans
with lower premiums, but make sure to study how the charges work in the initial
coverage phase of the plan.

·
Make sure to include options for mail-order as well as at least a
few local pharmacies, as the results can vary between these options. If none of
the pharmacies you enter regularly shows up as a preferred option, then
consider expanding further with your retail pharmacy choices to find a
preferred pharmacy that is popular with your local plan options.

·
Consider how much you value having either national coverage or a
high star rating if it leads to greater costs.

I think it is worth checking up on your Part D
choice annually. If you are already updating your list of medications throughout
the year, this whole review process can be done in a couple of hours each
autumn and could lead to substantial cost savings for the following year.

Medicare Advantage

The Medicare Plan Finder provides a similar
system for comparing Medicare Advantage plans both with and without
prescription drug coverage. For drug coverage, the process is quite similar as
with Part D plans. Select to find health and drug plans, view Medicare
Advantage plans, provide your zip code and county of residence, and select “yes”
for viewing drug costs when comparing plans. Again, you may enter to use both mail
and retail pharmacies, select up to five pharmacies, and enter your prescription
drugs.

When I did this for the 22182 zip code, I was
provided a list of 26 plans. The plans could be sorted by their drug
deductible, health plan deductible, drug and premium cost, or monthly premium. The
most useful of these metrics is the combined drug and premium costs. You might
also consider copays and coinsurance rates, but the tool does not otherwise
allow you to input medical procedures to estimate costs of care in the same way
as can be done for prescriptions.

The results can be further filtered for
various options related to whether the plan is a health maintenance
organization (HMO) or a preferred provider organization (PPO), and what
additional benefits are available regarding vision, transportation, dental,
fitness or hearing. Plans can also be considered as based on their star rating,
specific insurance carrier, or whether you want to remove plans that include
the drug coverage.

With a simple test I tried that included
medications for both high blood pressure and cholesterol, the total yearly
costs for premiums and drug expenses ranged from $2,342.76 to $5,056.20 across
the plans. The least costly plan included $84 for monthly premiums, a $0 health
deductible, $360 drug deductible, and health out-of-pocket maximums of $7,550
for in-network and $10,000 for out-of-network. It included a variety of supplemental
benefits, except for transportation, in-home support, home safety devices and
modifications, and an emergency response device. Primary doctor visits have $15
copays and specialists have $50 copays. Linking to this plan for further
details does provide a great deal of information related to plan benefits and
costs, extra benefits, optional packages, drug coverage and costs, star
ratings, and contact information. The tool does provide a link that allows for
online enrollment in the plan.

Medical information is less comprehensive than
with Part D. Prescription costs are shown in the same way as with Part D plans,
but out-of-pocket costs for health care services cannot feasibly be shown. This
makes it harder to compare plans as it relates to the types of doctors and
specialists you see. The Plan Finder does not confirm what medical providers
are covered by the plan, so this information will need to be obtained separately
on the insurance company’s website or by asking your preferred providers. While
the Medicare website offers details about the types of coverage and the
associated out-of-pocket costs, you may also have questions for the insurer
about the specific nature of these benefits.

Medicare Supplement Plans

The Plan Finder information provided for
Medicare supplements is not particularly useful. The tool does allow you to
search for a list of available plans in your zip code. It also provides the
range of premiums for available plans with each plan letter as based on
information you provide about your age, gender, and tobacco use. It also does
provide other information about plan coverage as discussed earlier, but since
these details are all standardized by plan type there is nothing new to learn.

The problem with the tool is that when you
click to view policies for a given plan type, you do not receive helpful
information to choose among the companies. For instance, when I clicked to view
the available Plan G options in the 22182 zip code, I received a list of 48
supplement plans arranged by insurance company. The only information provided
is contact information by insurance company and how the plan is priced in terms
of attained age, community pricing, or issue age. The actual plan premiums are
not shown, so there is no way to know how to begin your search. In addition,
clicking on web links may lead you to the insurance company’s general webpage
instead of their supplement page, while a further search of the website is not
clear as to whether that the company even offers supplement plans. In some
states you may have to make a phone call to gather specific information.

As I investigated the tool, I did find one
large insurance company that provides premium quotes as well as an online
application process for the fifth state I tried (the first four states
indicated that state law prohibited sharing this information through the
webpage). Then I found another company which did offer online premium
information and online enrollment in all these states. It is possible to successfully
use the Plan Finder tool to enroll in a Medicare supplement. But it may not
always be easy, and in some states in may be necessary to call companies to get
information about their options.

Because supplements should be treated more as
a lifetime commitment, you may wish to work with an independent broker to
review your options and save time. Alternatively, it is just a matter of doing
the legwork of connecting with each company and discovering their options.
Since the benefits are standardized by plan type, the only two variables that
matter are the premiums and the choice of the insurance company. The major
questions to answer are your comfort level with the company’s stability, the
company’s customer experience and whether your health providers have
relationships with the company such that they are willing to handle the billing
and claims paperwork.

Getting Additional Help

If you would like help regarding Medicare
beyond what is available with the Plan Finder, there are various other
options.  The Center for Medicare Services does provide these tools:

·
Physician Compare (https://www.medicare.gov/physiciancompare/)

·
Hospital Compare (https://www.medicare.gov/hospitalcompare/)

The physician compare tool includes information
about whether providers accept assignment from Medicare along with other
demographic information and specialties, but it does not include whether they
work with different Medicare Advantage plans.

Medicare personnel are also available 24 hours
a day by phone for counseling (1-800-633-4227), and you can also talk to
knowledgeable volunteers through the Medicare Rights Center
(www.medicarerights.org) and your state’s State Health Insurance Assistance
Program (www.shiptacenter.org). Finally, you may wish to speak to a
professional   who can help you select the right Medicare option. Captive
agents can help with specific plans from an insurer, and independent brokers
may provide access to a variety of plans. Brokers are generally paid through a
commission from the Advantage, supplement, or drug plan you choose, rather than
being paid directly by you. As such, from your perspective, their services are
free, as you would not pay less by enrolling directly with the insurer. With
drug plans and Medicare Advantage, the Plan Finder can be more helpful to
narrow the options. But Medicare supplements require more effort to find out premium
rates, which is where a broker may be especially helpful. A good broker can
also serve as a check to make sure you have not overlooked any issues discussed
in this chapter, especially regarding decisions you may still make for other primary
or secondary coverage, or when you may have to be underwritten as part of
joining a supplement.

Upon Reaching the Medicare Eligibility Age

In this section we examine the process for
your initial enrollment into Medicare, including when it will happen, when you
might be able to delay, and what decisions you will need to make. Most
individuals reach Medicare eligibility when they turn 65. More precisely,
Medicare can begin as early as the first day of the month in which one reaches
65. Those born on the first day of the month can begin Medicare at the start of
the previous month. We mentioned the exceptions to be able to qualify before
65, which include having end-stage renal disease or receiving Social Security
disability benefits for at least two years. To simplify the discussion, I will
focus on when it is the act of reaching age 65 that makes one eligible.

Enrolling at Age 65

For those who become eligible at age 65, the initial
enrollment period for Medicare is the seven-month window which includes the
three months before reaching age 65, the month that one reaches 65, and then
the three months after reaching age 65. If you want to have Medicare begin
precisely in the month you turn 65, you need to enroll in the three months
before reaching 65. Practically speaking, this makes sense because otherwise
coverage will not begin immediately. Initial enrollment involves making
decisions about Medicare Parts A, B, and D, Medicare Advantage, and a Medicare supplement
plan.

Each of these components for Medicare has
subtle distinctions about how their precise initial enrollment period is
defined. I just outlined the initial enrollment period for Parts A and B. As a
practical matter, you will likely be best served to act during the earlier
three months so that your coverage for all the different components you want
can begin when you reach 65. This also avoids any hassles related to the
possibility you might not have a primary insurance provider immediately after
your 65th birthday. You do not want other health coverage to end
before your Medicare coverage begins.

If you decide to use a Medicare Advantage
plan, you can enroll so it begins coverage at the same time as Part A and B.
When first turning 65, Medicare Advantage also provides a one-year trial period
that allows changing to Original Medicare and choosing a supplement without
underwriting. You may decide instead to use a supplement and/or a Part D plan.
With Part D, you must be enrolled in either Part A or Part B already (or both),
but the initial enrollment period otherwise matches A and B.

As for a supplement, its open enrollment
period technically begins on the first day of the month after turning 65 and
being enrolled in Medicare Part B. It lasts for six months. This is the case
when enrolling in Part B during the initial enrollment period or the special
enrollment period, but not the general enrollment period (more on these later).
This is called the Medigap Open Enrollment Period. In many states you may be
able to apply in advance so that your coverage can start at the same time as Part
B. This is the best opportunity to choose a supplement because individuals
cannot be denied coverage or charged a higher monthly premium during this
period for existing medical conditions. Afterward, if you wish to join or
exchange a supplement, you will need to have your coverage underwritten by insurers,
which may result in either higher premiums or the denial of coverage.

If you are already collecting Social Security
benefits or railroad retirement benefits at age 65, you will be automatically
enrolled in Medicare Parts A and B at 65. You can opt out of Part B, but those
collecting Social Security cannot opt out of Part A. If you are not collecting
Social Security yet, the enrollment process is not automatic. You must take
action to enroll in Medicare. This is important to remember, since as the full
retirement age for Social Security is no longer age 65, it is easy to lose
track that Medicare is still based on turning 65. Enrolling can be done online
(socialsecurity.gov/benefits/medicare), by phone, or in person at a Social
Security office. Contact Medicare three months before reaching age 65 if you
will not be automatically enrolled. Filing for Social Security benefits forces
enrollment in at least in Part A at age 65. If you do want to defer enrolling
in Medicare, it is another reason to delay Social Security claiming.

Upon reaching age 65, many individuals decide
to terminate other health insurance coverage and switch fully to Medicare. With
one exception, Medicare becomes the primary payer by law at age 65, with any
other coverage as secondary. Secondary insurance will only pay toward costs not
covered by the primary payer and it may not pay anything if one does not enroll
in Medicare and therefore has no primary coverage. It is also important to make
sure that your pre-65 health insurer does not automatically enroll you in their
Medicare Advantage plan, as this would take away the potential value from investigating
your options.

Not everyone will enroll in Medicare at 65.
Some can be allowed to delay because they maintain active employment and
receive primary employer coverage, but everyone else is taking a risk by not
having primary health insurance. Enrolling in Medicare is not mandatory, but if
you wait beyond initial eligibility and you do not otherwise have a primary
payer for health insurance or creditable coverage for prescription drugs, then
you may face medical bills and gaps in coverage. If you subsequently enroll,
your premiums may also include a penalty.

Working Past Age 65 with Employer Coverage as
Primary Payer

As more people work past age 65, enrollment
issues related to Medicare get more complicated and confusing. Not everyone has
to enroll in Medicare. But delaying Medicare enrollment without creating
coverage gaps and potential premium penalties is only possible if you or a
spouse are actively working at a company with 20 or more employees and are
covered through that company or union’s group health insurance plan that
remains by law as a primary payer. This coverage must be based on active
employment at the company. This is the circumstance under which you can delay
Medicare without loss of primary coverage.

If you or your spouse meet this very specific
requirement, you are eligible to wait on enrolling in Medicare. You should
check with your benefits administrator to confirm precisely how your insurance
works with Medicare. You may also wish to confirm these points by investigating
the plan’s summary of benefits section on interactions with Medicare. Assuming
your insurance does maintain a primary payer status, there are a few additional
matters to consider.

But first, to be clear about this point and to
provide further emphasis about its importance, I provide a list of cases where
the health coverage mentioned is not a substitute for enrolling
in Medicare at age 65:

·
Covered by an employer health insurance plan, but the employer
has less than 20 employees

·
Continuing to work but covered by an Affordable Care Act health
plan from an insurance exchange or private insurer

·
Retired but receiving health insurance through a retiree health
insurance plan from a previous employer

·
Receiving coverage through a religious-based healthshare plan

·
Receiving coverage as a VA benefit or through TRICARE for Life

·
Receiving coverage through COBRA from a previous employer

·
Receiving health coverage through Medicaid

Unfortunately, many in these circumstances do not
realize that they must enroll in Medicare to obtain primary coverage. For those
who have formally confirmed that they can truly defer Medicare without risk,
the first decision is whether to go ahead and enroll in Medicare at 65 or wait
for your special enrollment period after you end work. Enrolling in Medicare
Part A does not create any premium or cost, and it may help to cover some
hospital expenses not covered by your employer health insurance. Most will want
to enroll in Part A without delay for these reasons. One exception is that
enrolling in Part A means that you can no longer contribute to an HSA even if
your employer health insurance is a qualified high-deductible plan. Aside from
this consideration, there is no other reason to delay enrolling in Part A. One
other complicated note about HSA plans is that Part A coverage can be applied
retroactively for up to six months if you are waiting past age 65, so it is
best to stop making HSA contributions if you intend to enroll in Medicare in
the next six months.

As for Part B, consider whether it is worth
keeping your eligible employer plan or switching to Part B. Relevant issues for
making this decision include the relative costs and range of coverage for the
two plans, whether you have already met deductibles with the employer plan, and
whether there are other family members (spouse or dependents) who maintain
coverage through the employer plan that will lose their coverage if you switch
to Medicare.

Remember, Medicare is for individuals. It does
not provide family coverage. With a younger spouse who cannot qualify for
Medicare, you may compare options for an Affordable Care Act policy against
maintaining employer insurance for broader family access. As well, when you are
still working, it may be more likely that you will exceed income thresholds
that result in higher Part B premiums, which would impact the relevant costs
for your choices. Of course, for those who decide not to maintain the eligible
employer plan, it is important to follow through and complete your Medicare
enrollment.

Coordinating with Secondary Health Coverage
Past Age 65

Many retirees will have access to valid types
of secondary health coverage in retirement that can potentially serve the role
of a supplement or as creditable prescription drug coverage to take the place
of a Part D plan. You may have aspects of these two types of coverage through Medicaid,
an employer or union health plan, COBRA, the Federal Employee Health Benefits
program, Christian-based healthshare programs such as the Senior Assist program
offered through Medi-share, Veterans programs, TRICARE for the military,
various health programs for Native Americans, and even some older supplement
plans (which are no longer available to new enrollees) include drug coverage.

According to a Vanguard study from 2018, which
we describe further in the section about health care costs, the most common
approach with Medicare is to use secondary coverage for filling gaps. Their
study notes that 12 percent of Medicare enrollees choose Original Medicare and
a Part D plan without a supplement or secondary coverage, 21 percent of
enrollees choose Original Medicare with a Part D plan and a supplement, 32
percent choose Medicare Advantage with drug coverage, and 35 percent used
Original Medicare along with other secondary coverage.

Deciding about whether to use secondary
coverage (especially if it is not free) or to choose a Part D or supplement (or
Advantage) plan can be quite complex and it will likely be worth talking
through all the options with a professional who is up-to-date on both your secondary
coverage as well as the Medicare options for your area. If you have coverage
through an employer or union, you should also check with the benefits
administrator about the potential need or other implications (such as losing
the employer coverage) for signing up with a Part D plan or a Medicare
Advantage plan. Indeed, maintaining the outside insurance may also be necessary
to keep other family members covered, and you will want to take care that your
decisions regarding various aspects of Medicare do not impact your ability to
maintain this outside coverage for your family.

If there are no other family members needing
the coverage, the choice otherwise relates to premiums and all the different
aspects of coverage regarding out-of-pocket expenses, the possibility to
receive benefits for items not covered by Medicare, and access to doctors and
health providers. Determine how much of the Medicare Parts A and B deductibles,
coinsurance, and copayments will be covered by your secondary source.

It may be the case that Medicare offers better
opportunities than any other coverage you have, especially if you are paying
premiums for the other coverage. But it is impossible to figure this out
without a careful comparison of the options. It is also important to obtain a
letter from the insurer stating that the plan qualifies as creditable
prescription drug coverage to avoid penalties if you choose to later enroll in
a Part D plan. As a final comment, if health or prescription bills are becoming
onerous, financial assistance is also available through programs such as Extra
Help for prescription drugs, various Medicare Savings Programs, Medicaid, and
Supplemental Security Income.

Enrolling Later During a Special Enrollment
Period

For those who meet the coverage requirement
for delaying enrollment at age 65, it is possible to wait until the special
enrollment period to first register with Medicare, or to sign up for Part B
if already enrolled in Part A. The special enrollment period for Part B is the
eight months that begin the month after either eligible active employment ends
or health insurance coverage from that employer ends, whichever happens first.
There is also the ability to enroll at any time before this as well, as in
practice this exception extends the initial enrollment period through the start
of the special enrollment period.

Enrolling during the special enrollment period
is more complex because you will need to demonstrate qualifying coverage during
the period after 65 up until your special period started. Those required to
enroll during the special enrollment period but who fail to do so will lack a
primary payer and face potential premium penalties.

As soon as you discontinue primary active employer
coverage, the enrollment deadlines for switching to Medicare include eight
months for Part B, 63 days for Part D, the date that Part B is effective for
Medicare Advantage, and six months after Part B is effective for a supplement.
To simplify your options and avoid a lapse in coverage, decide on what coverage
you want, and put those coverages into effect the day after your employer
coverage ends.

There are also special enrollment periods available
when certain events happen for those who are already enrolled in Medicare but
may have had secondary coverage to help with prescription drugs or in place of
a supplement. Medicare Advantage also offers special enrollment periods to
select a Medicare Advantage plan outside of open enrollment periods under certain
conditions. During special enrollment periods, it is possible to change from
Medicare Advantage to Original Medicare, to switch from Original Medicare to
Medicare Advantage, and to switch from one Medicare Advantage plan to another.

For Medicare Advantage, situations that
trigger these special enrollment periods include moving to a new residence,
experiencing a change in Medicaid status or other low-income subsidies or
assistance, moving in or out of a skilled nursing care facility, leaving a PACE
program (in selected states), losing creditable prescription drug coverage,
losing employer-sponsored health insurance coverage, having your Medicare
Advantage plan canceled, wanting to switch to a five-star Medicare Advantage
plan, or other special circumstances.

When you are in a special enrollment period,
you may also be able to select from a subset of supplement plans without
underwriting if you are otherwise outside of the initial period and might otherwise
be denied coverage. In these special cases, guaranteed issue of coverage is
available for plans A, B, G, K, and L only. There are also other exceptions in
some states, as rules for supplements are created at the state level.

These special enrollment periods for Medicare
supplements can be triggered by events including losing coverage through
Medicare Advantage because the plan ends or you move out of its service area,
you had other secondary health coverage that ends, and other various cases. In
this regard, having other retirement health coverage that is cancelled could
allow for more opportunities with choosing a supplement plan.

Though there are exceptions as noted that can
vary by state as well, there is a risk that you cannot obtain a Medicare
supplement if you do not choose it initially and do not experience a valid
trigger that creates a special enrollment period. This aspect of Medicare
supplements creates an important planning issue because it is possible to
permanently miss the chance for a Medicare supplement.

Enrolling in Medicare at Other Times

While there is no requirement to enroll in
Medicare once eligibility is triggered, potential costs include the lack of a
primary insurance carrier to pay for health expenses. We now discuss what
happens when people miss enrolling in Original Medicare during either the
initial enrollment period or during the special enrollment period (if
applicable).

If you miss the initial and special enrollment
periods, you must then wait until the next general enrollment period to
sign up. These only happen from January 1 and March 31 of each year, with
coverage then beginning on July 1 after enrolling. With these provisions,
someone who decides they want to enroll in April would have to wait a full 15
months before their coverage can begin. This could lead to a large gap of time without
sufficient health coverage or even a primary insurer. For any health issues
arising during this time, costs of care could be quite high. In addition to
being responsible to provide full payment for your health expenses during the
delay while you wait for coverage, you may face medical underwriting with
Medicare supplements, and you may have to pay penalties for your subsequent
Medicare premiums. We have described many different enrollment periods now, and
it can be confusing. Exhibit 7.4 provides a summary of these details.

Exhibit 7.4

Initial and Ongoing Enrollment for Medicare

Which

When

What

Initial Signup for Medicare

Initial Enrollment Period

7 months beginning 3 months before the month you turn
65

Signup for Part A and Part B, as well as Medicare
Advantage Plan and/or Part D

Special Enrollment Period

Anytime while actively employed with primary coverage
plus 8 months beginning after employment or coverage ends, whichever is first

For those who did not have to sign up during initial
enrollment period because they held active employer group health plan
coverage that maintained primary payer status. Signup for Part A and Part B,
as well as Medicare Advantage Plan and/or a Part D plan

Medigap Open Enrollment Period

6 months beginning on the first day of the month you
turn 65 and are enrolled in Part B

Allows for enrollment in Medicare supplement without
underwriting. The Part B signup must happen during the initial or special
enrollment period, not the general enrollment period

General Enrollment Period

Jan. 1 to March 31, with coverage starting July 1

For those who did not sign up during initial period
or special enrollment period (if applicable). Can sign up for Part A, B, D,
Medicare Advantage, and/or a supplement (subject to underwriting)

Making Changes to Medicare

Open Enrollment Period

October 15 - December 7, with changes effective on
Jan. 1

Change between Original Medicare and Medicare
Advantage; Change Medicare Advantage plans; Change Part D plans; Change
supplement plans (subject to underwriting)

Medicare Advantage Open Enrollment Period

January 1 - March 31

Those with Medicare Advantage can switch their plan
or change to Original Medicare and choose Part D plan and supplement (subject
to underwriting)

Medicare Advantage Special Enrollment Periods

Meet a trigger requirement

May join, switch, or drop Medicare Advantage
throughout year if a special trigger is met

Part D Special Enrollment Periods

Meet a trigger requirement

May make changes to Part D plan throughout year if a
special trigger is met

Medigap Special Enrollment Periods

Meet a trigger requirement

Certain Medicare supplement plans will be available
with guaranteed issue to avoid underwriting, accessibility varies by state

5-Star Special Enrollment Period

Dec. 8 to Nov. 30

May switch to a 5-star Medicare Advantage or Part D
plan

The premium penalty results in a permanent
increase in the Part B premiums. Premiums increase by 10 percent for each full
12-month period when coverage should have existed, based on the length from the
end of the allowed enrollment period until the time you sign up. For those who
do have to pay premiums on Part A coverage, there is also a temporary 10
percent penalty applied to premiums that lasts twice the length of the period
of delay.

As well, if you are eligible for Medicare, you
must have creditable prescription drug coverage from a secondary coverage
source to avoid paying penalties on Part D premiums should you ever wish to
sign up in the future. If delaying prescription coverage through Part D or
Medicare Advantage, then you should obtain and keep a letter each year from
your provider stating that it provides “creditable coverage” for prescriptions.
If this coverage ends and new coverage is not obtained within 63 days, then
penalties for Part D begin to accumulate. The penalty for not signing up for
Part D and having a period of non-coverage after the initial or special
enrollment period ends is calculated as one percent of the national base
beneficiary premium ($33.06 in 2021) multiplied by the number of full uncovered
months for drugs and then rounded to the nearest ten cents. The penalty
increase for premiums is permanent.

Annual Open Enrollment Options Review

Medicare choices can be overwhelming. Many treat Medicare as
a one-time decision made at initial enrollment, and then never revisit whether
they are still receiving the best available coverage for their situation. Plans
and personal needs change. Each year Medicare provides an open enrollment
period to make changes. If you do not act during this period, you will keep the
same plan choices for the following year.

The annual open enrollment window for Medicare
occurs yearly from October 15 and December 7 for those who are already enrolled
in Medicare. When changing plans, new coverage begins on January 1 of the
following year. The options available include changing Part D plans, changing
Medicare supplements, changing Advantage plans, or switching between Original
Medicare and Medicare Advantage. At least for prescription drugs, annually
reviewing options to see if there are better choices available is a good idea.
Medicare also provides a broader open enrollment opportunity throughout the
year to switch to a Medicare Advantage or Part D plan with a five-star quality
rating.

Each year, Medicare Advantage and Part D plans
send out documentation, which details the coverage you received in the current
year and how it might change in the following year. Changes will be outlined in
the Annual Notice of Change and the Evidence of Coverage, both of which should
arrive in time to digest for open enrollment decisions. Items that were covered
may be lost. Other plan options may also change, such that your best coverage
choices can differ. Each year you can review your available options the using
Medicare Plan Finder tool (Medicare.gov/plan-compare).

Changing Part D Plans

While it is possible to change Part D plans annually,
inertia tends to set in after initial enrollment. Many never check to see if
there are better options available for their Part D coverage even as available
plans and their own personal needs change. This can be a costly mistake. For
Part D, changes to your plan coverage will be outlined in the Annual Notice of
Change and the Evidence of Coverage. These detail the formulary of drugs
covered by your plan, their tiers, how much you pay, and any changes in
coverage, costs, provider networks, service area, and other features for the
upcoming year.

It is important to consider the available
options on a regular basis for reasons related to changes in the types of
prescriptions you use, as well as changes in the formularies, premiums,
deductibles, and drug costs covered under each available plan. A change may
also be needed if you move to a new area or if your plan is discontinued. You
will want to determine if there is a more cost-effective option for the
medications you expect to use in the following year. A couple hours of effort with
the Plan Finder could save hundreds or even thousands of dollars.

Changing between Medicare Advantage and
Original Medicare

During the annual open enrollment window for
changing between Medicare Advantage and Original Medicare, it is possible to
move in either direction. Those enrolled in Medicare Advantage also have the
option to switch to a different Medicare Advantage plan. With Medicare
Advantage, make sure that your preferred doctors, hospitals, and other care
providers will remain on the covered list. When the provider network changes to
remove preferred care providers, you may either work with the insurer to find
acceptable alternatives, or you may look for a new plan.

As well, for Medicare Advantage plans covering
prescriptions, the same issues apply regarding changes to the formularies and
costs of drugs. Insurers could even decide to stop offering your plan, which
will require choosing another or returning to Original Medicare. Again, the
goal of this exploration is to see if there are changes to either your
situation or the available options that will lead to more cost-effective
solutions.

A second window also opens from January 1 to March
31 only for those using Medicare Advantage. You can drop a Medicare Advantage
plan to return to Original Medicare and choose a Part D plan and a supplement,
or you can switch to a different Medicare Advantage Plan. This provides some
extra flexibility for those using Medicare Advantage to be comfortable with their
choices.

Changing Medicare Supplements & Reduced
Options

We have explained that you may not have all
the supplement plan options available after your Medigap Open Enrollment
Period, which is the six months after turning 65 or signing up for Part B
during a special enrollment period. This can limit your options during the
annual open enrollment period (which has a similar name but is not the same). Though
state law manages this and there can be exceptions, including that certain
events can trigger a special enrollment period with guaranteed issue for some
options, the default assumption is that those seeking to join a supplement plan
after the initial period should expect to face medical underwriting with their
application. This underwriting can result in either higher premiums or declined
coverage. Even if your application is accepted, you may experience a six-month
period where pre-existing conditions are not covered as well. A professional
may be able to help you strategize about which company to apply for the best
opportunity to pass the underwriting.

During the annual open enrollment period, be
cautious about dropping a Medicare Advantage plan until you know that you will
be covered by the supplement you want at a premium you can accept. As well, if
you are seeking to switch from Original Medicare to Medicare Advantage, it is
important to understand that there is a possibility you may not be able to someday
return to the supplement plan you gave up.

For those who have a supplement already, since
benefits within a particular supplement are standardized, the only item that
changes on an annual basis is its premium. The Annual Notice of Rate will also
arrive before open enrollment to notify you of any premium changes. You can
expect rates to increase over time, even more quickly if you choose the attained-age
option. One will not be switching supplements regularly.

These issues create an important complication
for Medicare planning. You might want to use Medicare Advantage in early
retirement when expenses are lower, but then switch to Original Medicare with a
comprehensive supplement later in retirement to have stronger overall coverage.
This can be risky because if you do not start a Medicare supplement during your
initial period of eligibility, you may not be able to qualify to receive it in
the future. This contrasts to Medicare Advantage and Part D plans that can be
easily changed each year. This creates additional value to start with a Medicare
supplement in that you can always decide to drop it, but if you do not choose
it initially then it may not be available later.

Budgeting for Retirement Health Care Expenses

How much should a retiree budget to cover
remaining lifetime health expenses? This can be a complicated question to
answer. We will first take a brief look at estimates of total lifetime expenses
for the average retiree, and then we can consider more deeply how individuals
can develop more personalized annual estimates for their retirement budgets.

The components for medical expenses in
retirement include premiums for health insurance, including the various
components of Medicare and any other primary or secondary coverage, plus
deductibles and co-payments for covered care, plus costs for non-covered care
including dental care, eye exams, and certain types of drugs and care that fall
outside of Medicare coverage. In these discussions of health care cost estimates,
we do not include long-term care spending. Long-term care is an entirely
separate topic covered in the next chapter.

We can tackle the health care spending plan by creating a
budget for health expenses, projecting how much they may grow throughout
retirement, and deciding how much to pad the budget with conservative
projections about future spending. As an alternative to being more conservative
within the budget, we could also set aside a larger reserve for health spending
shocks.

Existing Lump-Sum Estimates of Average Costs

Several organizations provide estimates for
the total lump-sum amount needed by an average retiree to cover remaining
lifetime health care expenses. Two of the most well-known studies that are
frequently updated include those from Fidelity and the Employee Benefit
Research Institute. Their estimates differ quite dramatically.

For instance, Fidelity creates an annual Retiree
Health Care Cost Estimate. In 2020, they estimated that the average couple in
retirement will need $295,000 set aside at the start of retirement to cover
medical expenses, excluding long-term care. This breaks down to $140,000 for a
man and $155,000 for a longer living woman. These estimates are updated
annually, and the estimates do tend to grow faster than overall inflation. In
2014, for instance, their estimate was $220,000 for a couple.

The Fidelity estimates are based on a couple
each at age 65 in 2020 who will live to their median life expectancies, rather
than to a conservative planning age. They estimate average spending, such that
half of retired couples could expect to spend more than the projected amount,
but half could expect to spend less. Longevity, as well as health status and
geographic location will all play a role in determining an individual’s or
couple’s costs. Fidelity divides the $295,000 cost estimate as 39 percent for
Medicare Part B and D premiums, 42 percent for other medical expenses including
co-payments, co-insurance, and deductibles for doctor and hospital visits, and
19 percent for drugs. Their assumption is that the couple uses Original
Medicare and a Part D plan without a supplement. These estimates do not include
over-the-counter medications or dental care.

The Employee Benefit Research Institute (EBRI) is another
source of estimates. They create an ongoing study that estimates retirement
health care expenses. The expenses include premiums for Medicare Parts B and D,
premiums for the comprehensive Plan G supplement plan, and other out-of-pocket
health and prescription expenses. In 2020, they estimate lifetime costs for
65-year-olds based on a Monte Carlo simulation. The median cost (which means
having at least enough 50 percent of the time) for health and prescription drug
expenses is $73,000 for men, $95,000 for women, and $168,000 for a couple. This
estimate is dramatically less than the one provided by Fidelity, which may be
partly explained by the supplement plan preventing large out-of-pocket costs.
It is hard to be precise because neither study clarifies their assumptions about
important details such as health care cost growth and the discount rate applied
to future expenses. To increase the chances for having enough, EBRI also
reports on the thresholds for higher expenses, with either health expenses or
prescription expenses at the 90th percentile of the cost distribution.
If both health care expenses and drug expenses are on the high side, the total
costs for the couple grow to $325,000.

A Broader Model for Refining Annual Expense Estimates

These lifetime expense estimates can be useful as a starting
point. But the estimates are full of assumptions regarding current costs,
inflation rates applied to future costs, discount rates applied to future costs,
and the length of retirement. These assumptions can be difficult to unravel,
which in turn makes it hard to know how much to set aside annually.

In practical terms, it will be more useful to develop
personalized estimates for a retirement health care budget, and to then project
how that budget may evolve. This will still require assumptions, as predicting
future medical expenses and inflation is inherently complex and uncertain. But
we can surely develop more personalized spending estimates.

To start, Vanguard and Mercer developed a more refined model
to estimate annual health care costs in their 2018 article, “Planning for
Health Care Costs in Retirement.” They note that personal cost estimates will
relate to factors including health status and risks, the presence of chronic
conditions in one’s family history, coverage choices regarding Medicare options
and other primary or secondary health insurance, the degree of subsidies
provided through one’s insurance choices, age, location, and whether one pays
the IRMAA surcharges on Medicare premiums.

They also emphasize the importance of considering how
expenses change after switching to different insurance in retirement, and the potential
loss of employer subsidies for insurance. One cannot simply extrapolate
pre-retirement health spending into retirement. For example, those using ACA
marketplace plans and who do not receive subsidies may see their health
spending fall dramatically when switching to Medicare, while those who have
highly subsidized employer-based insurance before retirement may not see much
change in total health spending.

Geographic location can also have an important impact on
costs. Location does not impact Medicare Part B premiums, but Part D, Medicare
Advantage, and Medicare supplement premiums can all vary in price by zip code.
The Vanguard study found that the cheapest Plan F supplement available by zip
code ranged from $1,488 to $3,348 per year in 2017. As well, out-of-pocket care
expenses are also linked to local costs-of-living. It will be important to plug
in realistic premium and cost estimates as you develop your budget.

Vanguard also considered three risk levels for health
spending as based on the presence of twelve chronic health conditions. These
twelve conditions include hypertension, high cholesterol, rheumatoid arthritis
or osteoarthritis, heart disease, diabetes, chronic kidney disease, depression,
Alzheimer’s disease or other related dementia, chronic obstructive pulmonary disease,
cancer, asthma, and osteoporosis. The study considers the presence of these
conditions both in the individual and their parents’ medical histories. Chronic
conditions along with smoking status and the number of doctor visits are used
to identify high, medium, and low risk categories. High risk characteristics
include smoking, frequent doctor visits, and two or more chronic conditions.
Low-risk individuals are free of any chronic conditions and do not smoke.
Medium risk falls somewhere in between as possible smokers with one chronic
condition.

Regarding Medicare Part B and Part D premiums,
they do vary by income levels. This becomes an important issue with
tax-efficient retirement planning that we discuss further in Chapter 10. There,
Exhibit 10.15 shows combined premiums for various incomes levels. In 2021,
individuals with modified adjusted gross incomes two years prior of less than
$88,000 for singles and $176,000 for those married filing jointly, will face
annual Medicare Part B and D premiums of about $2,179 per person, or $4,358 for
a couple. The Part B portion is fixed, but the Part D portion varies, and this
estimate is based on its average value. Approximately five percent of Medicare
recipients are paying higher than this baseline premium level, and so the
general cost estimates for health care spending in retirement use these
baselines. But at the extreme for the highest income earners, these Medicare
premiums alone could be $7,381 per individual or $14,762 for a couple in 2021.

Vanguard models costs for health insurance premiums and
out-of-pocket health expenses including dental and vision. They consider cases
where an individual uses Original Medicare without a supplement or other
secondary coverage, and Original Medicare with a comprehensive supplement. Vanguard
models for women because their costs tend to be slightly higher than men,
though they note that the gender difference in health costs is less than two
percent. They provide results for 65-year-olds.

Exhibit 7.5 provides a summary of their study results. Expenses
vary by risk categories as well as whether more comprehensive insurance is used
to control out-of-pocket costs. You may wish to inflate these numbers by about
10 to 20 percent to update for today, as the study is from 2018, but these
numbers may help you to determine where along the spectrum you may fall before
doing a deeper dive to estimate your actual expenses. Vanguard provides the
median health spending as well as the distribution of possibilities for
different levels of risk when using Original Medicare either with no supplement
or with the most comprehensive (at the time) Plan F supplement. As we
understand, the higher premiums for Plan F do raise total costs when less
health care is needed, but the point of insurance is to reduce the potential
costs at the higher percentiles of the distribution. Nonetheless, we do also
see that it is only for the higher risk cases that the Medicare supplement
helps control costs, as out-of-pocket spending is not otherwise high enough for
those falling in the lower and medium risk categories.

Exhibit 7.5

Vanguard Study on the Range of Annual Health Care
Costs for a

65-Year-Old Woman with Baseline Medicare Premiums
in 2018

Health risk

Low

Medium

High

Low

Medium

High

Geography,
cost-of-living

Low

Medium

High

Low

Medium

High

Supplemental
coverage

None

None

None

Plan F

Plan F

Plan F

Median

$3,300

$3,900

$7,700

$4,700

$5,200

$6,900

10th percentile

$3,000

$3,200

$3,500

$4,700

$4,900

$5,500

25th percentile

$3,100

$3,400

$4,700

$4,700

$5,000

$5,900

75th percentile

$3,700

$4,900

$13,500

$4,800

$5,600

$8,700

90th percentile

$4,200

$6,600

$21,800

$4,800

$6,000

$11,000

Source: Vanguard, “Planning for Health Care Costs in
Retirement”

This exhibit exposes the tradeoffs that retirees face with
their health decisions: pay for comprehensive coverage and your costs are
likely to rise on average, though in cases with extremely high expenses you may
find a large benefit. We see with Vanguard’s study that the cost benefits from
a comprehensive supplement do not arise until one is in the higher risk
categories. This might speak to the idea of switching to a comprehensive
supplement later in retirement, but we have discussed how that may not be
possible due to the underwriting. One cannot simply wait until health expenses
start to rise and expect to be accepted for a comprehensive Medicare
supplement.

A retiree must decide whether to obtain a supplement at the
beginning and pay the higher premiums for years in anticipation of future
benefits when health problems arise. There is no simple answer about how to decide
this, as it ultimately depends on your preferences and level of risk aversion.
More risk averse individuals would choose a comprehensive supplement to be
protected from the beginning, while less risk averse individuals may take their
chances with an approach that has lower average costs but more exposure to
spending shocks. One may also factor in the degree of set-aside reserves needed
for health, which would certainly be less if one chooses to pay for a
comprehensive supplement. For those worried about not having enough, skipping
the supplement does not necessarily lower the assets one needs to feel
comfortable about affording health care. It just shifts more to a need to hold
additional reserves outside of the budget.

The other aspect of health expenses is how they will evolve
during retirement. Health expenses tend to grow faster than overall inflation. Health
care utilization also tends to increase with age as well, separately from
inflation, which causes a further increase for the health budget over time. An inflation rate for health care expenses is often estimated at 5 to 7
percent. For Medicare enrollees, Vanguard uses an inflation rate of 5.6
percent for health expenses, compared to 2.6 percent for overall inflation.
This indicates a 3 percent real growth rate for health expenses, which would
double the real cost after 23 years. Incorporating the idea that health usage
tends to also increase with age, it makes sense to build in an assumption that
the real cost of health spending will double after 15 to 20 years.

But while health expenses grow, there will likely be
offsetting effects as spending in other categories tends to fall over time. David
Blanchett has written about the retirement spending smile to explain the
patterns of expenditures for typical retirees. At the start of retirement,
retirees spend more as they enjoy traveling, eating out, and other types of
discretionary expenses. As they continue to age, retirees tend to slow down and
spend less. While discretionary expenses are declining, health costs tend to
rise, but the overall impact may still be a decline in real spending until very
late in retirement. Exhibit 7.6 provides a hypothetical illustration of this
process.

Exhibit 7.6

Understanding the Path of Real Retirement Spending
by Age

When you create your retirement budget, if you simply assume
that your overall budget will grow along with consumer price inflation
throughout retirement, then you may already have a sufficiently conservative
spending assumption. Even though health expenses can be expected to rise,
perhaps at around 5 to 7 percent annually, those increases may be more than
offset by declines in other categories, relative to an overall assumption that
all expense categories in retirement stay fixed in inflation-adjusted terms. Constant
inflation-adjusted spending is a simplifying and conservative assumption that
can more than handle the issue of health expense growth in retirement. In other
words, you have taken care of this aspect of health spending risk already if
you use a simplified assumption that your overall retirement budget will grow
with consumer price inflation. If your budget does incorporate reduced spending
in other categories with age, then you may find it more important to include an
increase in health expenses with age.

Tracking Past Expenses

As a part of the budgeting process described
in Chapter 3, it can be helpful to carefully track past expenses related to
health care. This includes any out-of-pocket expenses found as you analyze your
expense history, including over-the-counter medications or other health
expenses that do not go to insurance. But when it comes to expenses reflecting
what you paid out of pocket on insurance-covered health care, to get a better
sense of overall costs, you may also include a separate accounting for the
component of costs that went through your health insurance.

Your insurance documentation will generally provide this
information. You might keep detailed information on your health care
expenditures in your pre-retirement years: not just the amount you paid, but
the amounts covered by the plan and what the costs would have been without
health insurance coverage that may have negotiated for a lower rate.
Information from the insurer usually indicates the amount billed, the insurance
plan discount, the amount paid by the plan, and the out-of-pocket cost. For expenses through health insurance, you could prepare separate lists
for prescriptions, health care services, and Medicare non-covered items like
dental, vision, and hearing.

Knowing the details around total costs in
addition to what is left as an out-of-pocket expense can help you to better
understand what your health expenses could be with different coverage. A
complication is that many insurers negotiate prices with the health providers
(reflected in the insurance plan discount), so that it is hard to know what you
might end up paying in the future, but at least tracking this information can
give you a better sense about the possibilities. Many insurer websites will
provide a straightforward way to download these details into a spreadsheet.

Using past expenses to extrapolate future health expenses
has its limitations. New or different health problems may develop, or past
health problems may be resolved. Moving to a new location, or even just
obtaining insurance from a difference source, can lead to a complete
rearrangement regarding the nature of health costs. Subsidies (either from
employers or the government) for your coverage can change. Nonetheless, having
a better sense about past spending is an important starting point to help
clarify the presence of chronic conditions, the use of various medications, the
frequency of medical visits, and your typical health expenses.

Creating a Budget and Reserves Estimate

In budgeting for retirement health expenses, we have three
levers to adjust when deciding how to manage expected expenses and potential surprises:

·
Create a baseline annual budgeted amount to cover health expenses
in retirement. Though health spending will fluctuate over time, finding an
appropriate average amount should work well as a budgeting device, especially
if there is additional insurance to help control the size of spending shocks.
The baseline number can be increased to build greater conservatism into the
budget.

·
Estimate how health costs will change over time both in terms of
an overall inflation rate and a potential growing need for care. This can be
complicated, but assuming real health expenses will double over 15 to 20 years
is a reasonable starting point. Also consider how other budgeted expenses might
naturally change over time, especially if health expenses increase. For
instance, a travel budget could potentially be tapped for health expenses since
the ability to travel may be compromised if severe health situations arise. For
most retirees, just having an overall assumption that the budget grows with
inflation will be sufficient to handle rising health expenses through offsets
in other categories.

·
Include a pool of reserve funds that can be tapped to cover unexpected
health expenses that exceed the budgeted amounts.

We can develop assumptions for a spending budget with a
desired amount of built-in conservatism, and we can also earmark reserves to
manage health care spending shocks that extend beyond our assumptions. We can
also consider that as health expenses start to increase, this may naturally
reduce other expenditures in the budget such as travel and leisure. These
natural types of expense offsets may help to control the overall impact of
rising health costs. While these costs vary based on personal
characteristics, the range of potential costs can be controlled somewhat by
using more insurance such as a comprehensive Medicare supplement. That would exchange
a fixed premium amount for reduced volatility around the amounts of
deductibles, co-payments, and co-insurance paid for health expenses. Regarding
reserves set aside for unexpected expenses, they can naturally be less as
greater conservatism is otherwise built into the budget and use of insurance. For
reserves, keep in mind that the lump-sum estimates for retirement costs we
started the section with (such as the $295,000 number for couples from
Fidelity) include amounts in the budget already, so health care reserves would
not need to be as large.

We now walk through the questions to be answered
as a part of making your retirement budget and reserves for health care
expenses:

o
Will you use Medicare Part A? Will you pay a premium? Do you have
a supplement or other secondary coverage to help with deductibles, co-payments,
and co-insurance? What is a reasonable amount to budget for hospital
out-of-pocket costs?

o
Will you use Medicare Part B? Will your premium be subject to
income related Medicare adjustment amounts? Do you have a supplement or other
secondary coverage to help with deductibles, co-payments, and co-insurance?
What is a reasonable amount to budget for out-of-pocket costs related to
medical expenses?

o
Will you be covered through active employer primary health
insurance in retirement? How long might this last? What are your premiums? What
is a reasonable amount to budget for out-of-pocket costs related to health
expenses? As well, if you are retiring before reaching Medicare eligibility,
this category also reflects your pre-retirement health insurance.

o
Will you use a Medicare Advantage plan? Is there an additional
premium? Does it include prescription drug coverage or is that needed
elsewhere? What is a reasonable amount to budget for out-of-pocket costs
related to health expenses?

o
Will you use Medicare Part D? Will your premium be subject to
income related Medicare adjustment amounts? What is a reasonable amount to
budget for out-of-pocket costs related prescription drugs?

o
Will you use a Medicare supplement plan? What is the premium? The
impact on out-of-pocket costs should be reflected through lower cost estimates
for Part A and Part B.

o
Will you be covered through other secondary coverage in
retirement? How long might this last? What are your premiums? Will it work in
place of either prescription coverage or a supplement plan? The impact on
out-of-pocket costs should be reflected through other categories.

o
Will you have other noncovered health-related expenses in
retirement. This can include items such as dental, eyewear, or hearing aids,
over-the-counter medications or other noncovered prescriptions, or other health
spending not covered by insurance.

o
Remember, long-term care expenses are a separate topic that will
be covered in the next chapter. They are not part of this budget.

Exhibit 7.7 provides an example for how to
identify a budget for health expenses. It includes various categories and
crosses out the ones not relevant for the example. In this hypothetical
example, the couple is not exposed to IRMAA increases for Part B and D
premiums. The first spouse chooses Original Medicare with a comprehensive Plan
G supplement with estimated premiums of $2,000. Alongside Part B and D
premiums, this individual also anticipates $1,200 of out-of-pocket prescription
expenses and another $1,000 for noncovered care. This was based on assessments
from tracking past health expenses. The second spouse decided to use a Medicare
Advantage plan including prescription coverage with $720 of annual premiums.
Along with the Part B premium, this spouse anticipates $1,500 of health and
prescription out-of-pocket expenses related to Medicare and sets aside another
$1,000 for noncovered expenses. Together, this couple budgets $11,464 for
retirement health spending. Their budget will use the simplification that these
expenses grow for overall inflation, but they will revisit this budget over
time as they learn more about their health expenses in retirement and will
assume that this budget doubles in real terms starting at age 80.

Exhibit 7.7

Hypothetical Household Budget for a Couple’s Health
Expenses

Premiums

Out-of-Pocket Costs

Medicare Part A

$0

$0

Medicare Part B (factor in IRMAA)

$1,782

$0

Active Employer-Based Primary Coverage

-------------

-------------

Medicare Advantage (Part C)

-------------

-------------

Medicare Part D (factor in IRMAA)

$480

$1,200

Medicare Supplement

$2,000

(impacts in Part A & B)

Other Secondary Insurance Coverage

-------------

-------------

Other noncovered health-related expenses

n/a

$1,000

TOTAL

$6,462

Medicare Part A

$0

$0

Medicare Part B (factor in IRMAA)

$1,782

$0

Active Employer-Based Primary Coverage

-------------

-------------

Medicare Advantage (Part C)

$720

$1,500

Medicare Part D (factor in IRMAA)

-------------

-------------

Medicare Supplement

-------------

-------------

Other Secondary Insurance Coverage

-------------

-------------

Other noncovered health-related expenses

n/a

$1,000

TOTAL

$5,002

TOTAL (Couple)

$11,464

This couple has tried to be conservative with
their projected health care expenses. Nonetheless, it can be hard to overcome a
nagging feeling that savings are insufficient to overcome whatever retirement
throws their way. To help build additional comfort with their planning, the
couple decides to earmark additional funds as reserves to cover unexpected
health care expenses. The nature of uncertain expenses is difficult to
quantify, but to help organize their thinking, Exhibit 7.8 provides a basic
calculator to determine how much reserves they wish to set aside at retirement
to cover unexpected health care expenses. They are 65 and decide they would
feel better if starting at 80 they could handle an additional $2,000 of health
expenses through their planning age of 100. The $2,000 of expenses is
identified in today’s dollars, but the couple includes an assumption that the $2,000
need grows with 5 percent inflation to match health cost growth, while the
overall consumer price inflation is 2 percent. Thus, the health care spending
amount is growing at about 3 percent faster than the overall inflation rate,
which matches the assumption used in the Vanguard study. They also think in
terms of the funded ratio from Chapter 3, in which they use a conservative 0
percent real discount factor to determine how much to set aside today to cover
this additional expense starting at age 80. The calculation identified that to
be comfortable meeting this additional spending need, they would like to have $83,012
of additional reserve assets at the start of retirement to manage their health
care spending risk. These inputs we have discussed, including the health care
budget and health care reserves estimate, are then used in the overall
retirement preparedness calculations in Chapter 3.

Exhibit 7.8

Health Care Reserves Estimator

Current Age

65

Age that Additional Expenditure Begins

80

Age that Additional Expenditure Ends

100

Additional Annual Health Care Expenditure (Today's
Dollars)

$2,000

Inflation Rate for Health Care

5%

Overall Inflation Rate

2%

Real Discount Rate

0%

Health Care Reserves (Today's Dollars)

$83,012

Action Plan

Health expenses are a major component of
retirement spending. Precise expenses can be hard to estimate and become more
uncertain because of health spending shocks not covered through insurance. The
action plan for health care in retirement relates to finding the appropriate
health care and prescription drug coverage throughout retirement and having a
plan to cover health care related expenses. This action plan can be organized
into several phases: before Medicare eligibility, at Medicare eligibility, and
ongoing decision making.

The most risk-averse action plan for
retirement health care is generally to enroll in Original Medicare, choose a
comprehensive Medicare supplement plan (Plan G for new enrollees), and choose a
highly rated Plan D prescription drug plan with reasonable costs for your
expected prescriptions. Then each year during the annual open enrollment
period, you simply review Plan D options and pick a new plan as desired.
Variations for this conservative baseline strategy include foregoing a
supplement or secondary coverage plan with Original Medicare, choosing a
Medicare Advantage plan, or using other retirement health coverage as a
secondary payer or as creditable prescription coverage.

In the years before Medicare eligibility:

o
If retiring before age 65, make sure you have considered how to
obtain health insurance and what health costs you will face until reaching Medicare
eligibility age

o
Coverage may be available through an employer, a spouse’s plan, the
Affordable Care Act marketplace, other private insurance, retiree health
insurance, a healthshare plan, or COBRA

o
Make sure that spouse and dependents have coverage if you are
retiring and leaving your employer plan

o
Develop estimates for a baseline health care budget, how it may
grow, and potential cost shifting from other categories

o
Make sure you have budgeted for dental, vision, hearing, or other
types of health-related needs that may not be covered by your insurance choices

o
Decide on an amount of reserves to help with higher than
anticipated expenses

As you reach Medicare eligibility age:

o
If you would like professional assistance, identify an independent
broker specializing in Medicare to guide you

o
If you or your spouse is still actively employed, determine
whether your employer health insurance can be counted as primary insurance
after you reach age 65

o
If Medicare will become your primary insurance, plan for timely Medicare
enrollment to avoid penalties and a lapse in coverage

o
Read Medicare and You book at Medicare.gov

o
Choose Original Medicare or Medicare Advantage

o
Choose a Part D drug plan, drug coverage through Medicare
Advantage, or coverage through other secondary health insurance with creditable
coverage

o
With Original Medicare, decide whether to purchase a Medicare
supplement plan or whether other secondary retirement health insurance can play
this role

o
Determine whether there are any impacts from Medicare decisions
on any of your other employer benefits

o
If thinking to switch from secondary coverage to a supplement
later, determine if you will potentially be eligible for a special enrollment
period at some point to provide access to some plans without underwriting

o
Use Plan Finder tool at Medicare.gov/plan-compare

o
Make sure that spouse and dependents have coverage if you are
switching your coverage to Medicare

o
Enroll in Medicare online, by phone, or at your local Social
Security office

o
Open account at MyMedicare.gov to keep track of your Medicare
claims and obtain information about your coverage

o
Medicare personnel are available 24 hours a day by phone

for counseling (1-800-633-4227), and you can also talk to knowledgeable
volunteers through the Medicare Rights Center (www.medicarerights.org) and your
state’s State Health Insurance Assistance Program (www.shiptacenter.org)

Ongoing annual decisions:

o
Update health care budget and reserves based on recent spending
and health care usage

o
Maintain a list of prescription drugs to use with testing for the
best personalized prescription drug plan during each open enrollment

o
Check each year during open enrollment (October 15 to December 7)
about a new drug plan and other options

o
New Part D prescription plan

o
Move from Medicare Advantage to Original Medicare or vice versa

o
Choose a new Medicare supplement plan with Original Medicare (be aware
of underwriting and the potential denial of your application)

o
Use preventative care benefits and maintain a healthy lifestyle

Finally, I conclude this chapter with a list
of potential Medicare mistakes that have arisen in this discussion. Double
check that you understand the following points and do not make mistakes in
relation to any of them:

o
Medicare coverage is based on individuals. Medicare does not
provide family benefits or benefits to a younger spouse. Each spouse can make
separate decisions about their own coverage.

o
If you have not claimed Social Security before age 65 (which the
lessons of this book suggest should generally be the case), your Medicare
enrollment is not automatic. Plan to act.

o
By law Medicare becomes the primary payer for health coverage
upon reaching the age of eligibility except for those who can maintain coverage
through active employment (by yourself or a spouse) at a firm with at least 20
employees.

o
For those with secondary coverage through other health insurance,
it is important to enroll at least in Parts A and B, and then carefully analyze
the costs and coverage for different options related to using the secondary
insurance or using Medicare for prescription and supplemental coverage.

o
Understand that using only Medicare Parts A, B, and D can lead to
significant exposure to uncapped medical expenses if you experience costly
health events.

o
Especially if you have secondary coverage that provides primary
coverage for other family members, be careful about making decisions that could
have unintended consequences as based on the rules of your health plan.

o
Understand that if you do not have primary coverage by law after
turning 65 and do not enroll in Medicare, you may find yourself without health
coverage and may have to wait up to 15 months to begin coverage during a
general enrollment period.

o
When comparing different health options, do not make decisions based
solely on which option has the lowest premiums or deductibles. Instead,
consider the full costs under various options.

o
Medicare is not meant to be set-it-and-forget-it. Each year you
can review your options and make changes to some aspects of your health care
coverage as your needs or program benefits change.

o
Understand that outside of the initial enrollment period and
somewhat with special enrollment periods, applications for Medicare supplements
will be underwritten and potentially denied. Those wanting a comprehensive
supplement should consider enrolling during their initial Medigap Open
Enrollment Period.

o
Taking care of your health and using preventative care can
provide long-term cost savings and a higher quality of life.

Further Reading

Department of Health and Human Services. 2021. Medicare
and You: The Official U.S. Government Medicare Book. Available at https://www.medicare.gov/Pubs/pdf/10050-Medicare-and-You.pdf

Guyton, Derek, Jennifer Leming, Stephen Weber, Jacklin
Youssef, and Jean Young. 2018. “Planning for Health Care Costs in Retirement.”
Vanguard Research (June).

Oh, Jae W. 2020. Maximize Your Medicare: Qualify for
Benefits, Protect Your Health, and Minimize Your Costs. 2020-2021 Edition.
New York City: Allworth Press.

Moeller, Philip. 2016. Get What’s Yours for Medicare:
Maximize Your Coverage, Minimize Your Costs.  New York City: Simon &
Schuster.

Chapter 8: Long-Term
Care Planning

Most of the research about retirement income
planning focuses on two of the three major retirement risks: market volatility
and longevity risk. The question to be answered is how well does a
predetermined spending plan work in the face of low returns and a long life?
The third major risk of spending shocks receives less attention. Being able to
meet a predetermined spending plan alone is not sufficient. There must also be
mechanisms in place to deal with the various contingencies and unexpected
spending shocks that may arise during a long retirement.

Long-term care (LTC) spending represents perhaps
the most severe spending shock that can impact retirees. Long-term care is a
general category for care related to physical, mental, social, and medical
needs in the event of significant physical or mental decline. The potential for
such decline accelerates with age. This is a distinct matter from general
health care expenses which were covered in the previous chapter.

Lifetime long-term care expenses for retirees are
uncertain. About half of retirees may be able to make it through retirement
without facing even $1 of long-term care expenses. But at the extreme,
long-term care costs can exceed $1 million. An expensive LTC event could derail
an otherwise well-built retirement plan. This problem is growing as people live
longer, since it becomes more likely that care will be needed for longer as
well. Older individuals suffer from higher rates of physical and cognitive
problems, and they may have fewer family members or friends who are positioned
to provide sustained daily assistance.

Because costs for care are high, and the
probabilities that care will be needed are not particularly low, most long-term
care funding strategies will add significant expenses to a retirement plan.
These expenses can manifest in the form of insurance premiums or as additional
reserve assets to be set aside beyond assets needed for lifestyle, longevity, and
legacy.

Planning for how to manage these potential
expenses is an important part of a retirement income plan. However, it is often
overlooked or avoided. Many are unwilling to confront the questions and
possibilities related to losing their own independence. Psychologically, it can
be difficult to face morbidity as no one likes thinking about the possibility of
being unable to effectively handle the basic activities of daily living. It is
a natural response to think that this is something that only happens to other
people.

A common misperception also remains that
Medicare pays for long-term care. It does not. Few people make proper plans for
long-term care. This lack of planning can create strains as long-term care expenses
deplete household assets, bankrupt a surviving spouse, or add burdens for other
family members who may end up making large sacrifices to provide care.

The default long-term care plan will be to
self-fund expenses until assets are depleted and to then transition into
Medicaid. But there are other possibilities. No retirement income plan is
complete without a proper consideration of how to plan most effectively for
potential LTC expenses.

Defining a Long-Term
Care Need

Long-term care is generally defined as
requiring assistance with normal activities of daily living (ADLs) for more
than 100 days. Any event lasting less than 100 days, such as recovery after a
surgery, is not considered to be a long-term care need and would also have a
smaller financial impact on the household. However, common statistics about how
most people will need long-term care, such as the oft-cited number at
longtermcare.gov that at least 70 percent of people aged 65 and older will need
long-term care services during their lifetimes, also generally include
short-term care.

More specifically, especially when it comes to
qualifying for long-term care benefits, a long-term care need is defined as
requiring help with two or more of six common ADLs: bathing, continence
(maintaining control of bowel and bladder functions), dressing, eating,
toileting, and transferring – such as to or from a bed. Difficulties with
dressing and bathing generally develop first. Defining exactly when long-term
care is needed to qualify for benefits can become a rather technical issue, and
it is generally determined by a physician or other medical professional.
Cognitive impairments such as dementia may also serve as an indicator for a
long-term care need, even if the impairment does not immediately lead to an
inability to perform ADLs. Triggers for requiring long-term care can relate to
both physical and mental decline.

Higher order activities which may require
assistance without necessarily qualifying for long-term care benefits include
managing household finances, driving, and housecleaning. This assistance would
more commonly be provided by family and friends, rather than formally hired
caregivers. These are called incidental activities for daily living (IADLs).

Costs and Prevalence of
Long-Term Care

How likely is a person to experience a need
for long-term care? Long-term care needs are a possibility which should be
planned for, so the specific probability with which they happen is less
important. Nonetheless, it is understandable to want to know more about the
possibilities. This is a challenging question, and we can find occasional
research reports that address it. Fortunately, to avoid having to use even
older reports, the Department of Health and Human Services (DHHS) issued a
research brief on this topic in January 2021, which provides information and
estimates for individuals turning age 65 in the years 2020 to 2024. They
estimate forward-looking lifetime long-term care needs and costs for this
population.

Exhibit 8.1 show the DHHS estimates that 51
percent of men and 61 percent of women in this age group will need long-term
care at some point, and that the average lengths for care are 2.3 years for men
and 3.2 years for women. They also estimated that 41 percent of men and 50
percent of women will require care for one year or longer, while 18 percent of
men and 26 percent of women will need care for at least 5 years. Across the
population, 56 percent will need care for an average of 2.8 years, with 22
percent of the population requiring care for at least 5 years. Those who will
experience long-term-care needs are not an insignificant
portion of the population. Many retirees will require long-term care support during their lifetimes, so careful planning is warranted.

Exhibit 8.1

Projected Long-Term Care Needs, Persons Turning 65
in 2020-24

Men

Women

Combined

Percentage who will need care

51%

61%

56%

Average number of years

2.3

3.2

2.8

Percentage needing no care

49%

39%

44%

Percentage needing 1 year or less

10%

11%

10%

Percentage needing 1-2 years

9%

9%

9%

Percentage needing 2-5 years

14%

16%

15%

Percentage needing 5+ years

18%

26%

22%

Source: Department of Health and Human Services, January
2021

The estimates in Exhibit 8.1 include time
spent receiving care at home from unpaid caregivers, which is a substantial
portion of the care received. Exhibit 8.2 provides numbers that are less dire,
as it looks only at the need for paid long-term care, with unpaid care
provided by family and friends at home excluded from the estimates. With this
adjustment, 41 percent of men and 53 percent of women will use paid care during
their remaining lifetimes. Average durations are much less, as men use paid
care for an average of 0.9 years while women need 1.3 years of care. Only 5
percent of men and 9 percent of women will use paid care for 5 or more years.
Combined, 47 percent of the population turning 65 in 2020 to 2024 are projected
to use paid care for an average of 1.1 years, with 7 percent requiring paid
care for at least 5 years.

Exhibit 8.2

Projected Use of Paid Long-Term Care, Persons Turning
65 in 2020-24

Men

Women

Combined

Percentage who will need paid care

41%

53%

47%

Average number of years

0.9

1.3

1.1

Percentage needing no paid care

59%

47%

53%

Percentage needing 1 year or less

18%

21%

20%

Percentage needing 1-2 years

8%

9%

8%

Percentage needing 2-5 years

10%

15%

12%

Percentage needing 5+ years

5%

9%

7%

Source: Department of Health and Human Services, January
2021

As for the costs of lifetime care, DHHS uses
cost estimates for the Genworth study we discuss shortly, and projects them to
the future with assumptions that institutional care prices will grow at 3.8
percent annually and home care prices will grow at 3.2 percent annually. Their
modeling estimates long-term care utilization at different ages. Discounting at
their 2.5 percent assumed rate of consumer price inflation (which means a real
discount rate of 0 percent) to be consistent with our descriptions about
discounting future costs into today’s dollars, they estimate that average
lifetime expenditures for the 41 percent of men needing paid care are $142,200 in
2020 dollars. For the 53 percent of women needing paid care, the average
lifetime cost in 2020 dollars is $175,500. Averaging between genders, those
needing paid care over their lifetime would require an average of $161,400 to
be set aside by the age of 65. These expenditures do include amounts from
Medicaid, which can provide relief for those with an expectation that Medicaid will
be a necessary funding mechanism. For others, these amounts are paid
out-of-pocket or through insurance.

Long-term care planning is an especially important
consideration for women. Wives tend to be younger than their husbands and tend to
also live longer. Women are more likely to experience a period of widowhood.
They are more likely to serve as long-term caregivers for the men in their
lives, and they are then more likely to be widowed and alone by the time they
need their own care. The DHHS estimates show that on average women will require
$33,300 more to be set aside by 65 to cover their additional long-term care
expenses. Women may have fewer financial assets remaining by the point they
need care as well, especially in cases when a spouse required care earlier.

The need for long-term care can be triggered
by accidents, chronic illness, or conditions such as Alzheimer’s disease. The
need for care increases with age, though accidents and illness can cause
younger people to also need care. With age, the odds for needing care increase
as debilitating conditions like strokes and dementia leave more individuals
vulnerable. At a personal level, the odds for needing long-term care are higher
for individuals with greater longevity in their family history and for those
with a family medical history including dementia, Alzheimer’s disease, and
neurological disorders. Healthy individuals might ironically be more in need of
care, as living a long life also means experiencing greater odds for physical
or mental decline near the end.

I just provided lifetime care cost estimates
from DHHS. Those estimates were based on the annual
Cost of Care Survey from Genworth, a major provider of long-term care
insurance. The most recent version of this study is for costs in 2020, and
their estimates are shown in Exhibit 8.3. Costs for
long-term care vary by geographic region, type of facility and services used,
and reasons for care. Genworth provides estimates at the local level, but I
will describe the national median costs. Annual care costs for those remaining
at home average $53,772 for those needing homemaker services (assistance with
cooking, cleaning, and errands), $54,912 for those needing a home health aide
(personal care to help with ADLs, but not medical care), and $19,236 for adult
day care services. For those requiring institutionalized care, the median
annual costs in the United States are $51,600 for an assisted living facility,
$93,072 for a semi-private room in a nursing home, and $105,852 for a private
nursing home room.

Exhibit 8.3

Median Costs of Long-Term Care in the United States,
2020

Daily

Monthly

Annually

Homemaker services

$147

$4,481

$53,772

Home health aide

$150

$4,576

$54,912

Adult day care

$53

$1,603

$19,236

Assisted living facility

$141

$4,300

$51,600

Nursing home (semi-private room)

$255

$7,756

$93,072

Nursing home (private room)

$290

$8,821

$105,852

Source: Genworth Cost of Care Survey, 2021

It is important to emphasize that these are
median values at the national level. Median costs in specific states vary
widely. For instance, a private room in a nursing home generally exceeds $100k
per year in the northeast, the upper midwest, the west coast, Alaska, and
Hawaii. Alaska is an anomaly, with a $436,540 median annual cost. Within the
continental United States, Connecticut is most expensive state with a $172,280
median annual cost. The cheapest state is Missouri, where the annual median
cost is $68,985. Annual median costs in 2020 also fell below $80k in Arkansas, Texas,
Louisiana, and Oklahoma.

It is also important to consider inflation for
long-term care costs, as these reported costs are only for a calendar year.
Generally, the cost of long-term care has risen faster than overall consumer
price inflation. Cost increases stabilized in recent years as more facilities
have opened, but the demographic trends show more people needing care and fewer
people available to provide it, suggesting that cost increases could be
substantial in the coming years as baby boomers approach their 70s and 80s. For
the Genworth cost surveys from 2014 to 2020, the 5-year annualized growth rates
for median costs across the United States were 3.8 percent for homemaker
services, 3.71 percent for home health aides, 1.45 percent for adult day care,
3.62 percent for assisted living, and 3 percent for nursing home facilities.
This is a period where overall inflation averaged about 1.8 percent per year.
Those who may not need long-term care support until 20 to 30 years from now
should surely anticipate that the costs they will face are going to grow faster
than the overall inflation rate.

Demographic Challenges

The need for long-term care will continue to
grow as baby boomers start to reach more advanced ages and people continue to
live longer than ever before, requiring a longer period for care. As one
example of the growing trend, the number of Americans afflicted with
Alzheimer’s disease could triple by 2050 without significant medical advances
to stop the disease.

Changing demographics also feed into this
concern, as the proportion of older people relative to younger people continues
to increase. As Americans are having fewer children, and as dual-income
households in which both spouses maintain careers have become the norm, there
will be fewer opportunities to obtain long-term care support from children or
other family members as well as fewer people in the labor force who could be
paid to provide care. Family members who are ultimately forced to leave the
workforce to provide care will sacrifice lost wages, Social Security benefits,
and savings. Additionally, the stress from providing such care could also lead
to greater health problems for the caregiver.

An aging population with fewer younger family
members to provide care, coupled with fewer young people in general who can
serve as paid providers for long-term care services, will likely continue to
increase the future costs of quality care. The impacts of increasing demand for
care and the decreasing supply of caregivers means inevitably higher prices
unless new technological improvements and automation can be developed to allow
more care needs to be met without human intervention.

Different funding sources for long-term care
needs will be discussed shortly, but an immediate implication for these
demographic trends is that the idea of planning ahead to spend down assets to
receive long-term care services through Medicaid may become an increasingly
unattractive option for those who can otherwise afford to avoid it. With fewer
available workers, there is a risk that care quality provided through Medicaid
facilities may decline in the future.

The Continuum of
Long-Term Care

Many receive long-term care at their homes or
at community centers or adult day care centers. Institutionalized living is not
always required, and proper long-term care planning may allow one to remain at
home for longer than otherwise possible. For many, staying at home will be
preferable during the transition when more long-term care assistance starts to
be needed. However, additional options along the continuum of care include
assisted living facilities, continuing care retirement communities, and nursing
homes. Though some of these options may be skipped for any individual,
long-term care needs generally progress along these lines:

·
Assistance provided by friends and families at home

·
Home visits from health care aides

·
Adult day care centers

·
Assisted living

·
Nursing home

·
Hospice

It is important to distinguish between two
types of care: skilled and custodial. Skilled care is for when
intensive medical attention is needed, generally for less than 100 days as it
results from a short-term medical condition from which the patient is expected
to recover. Private health insurance and Medicare may both cover short-term
skilled care needs when certain conditions are met.

Custodial care – also known as “non-skilled
care” – is for patients with a chronic condition from which recovery is not expected.
This care is mostly for help with activities of daily living (ADLs), rather
than providing specific medical treatments. Custodial care does not require a
professional and can be provided by family members or unlicensed workers. Most
long-term care falls into the category of custodial care.

Health insurance and Medicare do not cover
custodial care, as they are reserved for care relating to acute medical
conditions and short-term needs with expected recovery. Custodial care must be
funded by other means such as personal savings, Medicaid, or long-term care
insurance.

When looking for specific care options, it may
be helpful to work with a geriatric care manager or care coordinator who knows
the options in your area. These are paid professionals who can help guide you
through the various care options and supporting services. Some long-term care
insurance policies will provide a care coordinator as a policy benefit.

Home Care

Long-term care generally begins with receiving
some assistance at home, especially with proper planning to make funding for
this possible. Home care is typically provided by unpaid family members, though
care from paid providers such as home health aides is also a common approach.
Many businesses offer home care services, making the option to stay at home
more viable today than in the past. Even with family members available to
provide care, enlisting paid support can reduce family stress and help family
members focus more on social interactions and less on care needs.

The “aging in place” movement has risen from
growing recognition that it will ultimately be cheaper for society if
individuals can stay at home longer instead of moving to an institution. Staying
at home also generally helps to support the physical and emotional health of
the care recipient if the individual does not become too socially isolated. More
resources are available to support aging in place. Homes can be retrofitted in
many ways to allow for better support and to make homes safer. Community
services are available that provide meals, social interaction, and
transportation to doctor appointments. Medicaid is also simplifying the process
to cover home care especially as part of the response to the global pandemic.

Adult Day Care, Community Centers, and Other
Respite Support

When unpaid family members serve as the
primary long-term care providers, services such as adult day care centers can
give caregivers the freedom to go to work or otherwise take a break from the
ongoing demands of providing care. Services providing respite support allow a
primary caregiver to have short breaks. Visits to such centers can also benefit
the patient, as regular social interaction can help sustain the patient’s
ability to live at home longer, thus delaying the transition to a more
institutionalized living environment. Such services are becoming more popular
to help facilitate the growing demands of the aging population. Many
communities will also provide senior community centers that offer a variety of
resources and social activities for the community.

Assisted Living Facilities

Next are assisted living facilities for
individuals who still maintain some independence, but who do also need more
assistance. Support and services vary widely among different assisted living
facilities, but they usually provide meals, help with medication, housekeeping,
transportation, daily assistance for ADLs at scheduled times, and recreational
and social activities. Many assisted living facilities are equipped to provide
varying degrees of care up to the point of requiring full-time nursing care.

Generally, one must pay out-of-pocket to live
at an assisted-living facility, especially if the move is made before the
requirements to trigger benefits from long-term care insurance have been met.
Costs may involve an upfront fee and ongoing monthly fees. Assisted living
facilities tend to be less regulated and it is important to review their
contracts with an elder law attorney. Important questions to ask a facility
include what the monthly fees cover and how they may change in the future.
Important non-financial questions when considering assisted-living facilities
include:

·
Who assesses what care is needed and when needs change?

·
What limits are placed on the amount of care received?

·
What is the process for determining when conditions have worsened
so that care can no longer be provided at the facility?

·
What happens if the resident runs out of funds to pay the ongoing
fees?

·
How are grievances handled with respect to issues about joining
meals, taking medication, moving around inside or outside the community, and so
on?

·
What is the housekeeping schedule, and how is assistance for
various activities of daily living scheduled?

·
Are the staff properly trained and what qualifications do they
hold?

·
Does the facility have resources to provide sufficient support to
residents who may show initial signs of dementia or confusion about their
circumstances?

Nursing Homes

When most people think of long-term care,
their image probably involves care at a nursing home. More options are
available today for home care and assisted living, which will help many avoid
ever having to use the nursing home option. But nursing homes serve as a last
resort for those requiring extensive long-term and medical care services in the
final months or years of life. The quality and costs of nursing homes vary, and
those who can pay through means other than Medicaid may find they receive better
arrangements.

Nursing homes are state-licensed facilities
providing residents with skilled and custodial care services. They tend to
provide the most expensive level of care services but can offer 24-hour care to
residents. Some nursing homes may have specific wings for Alzheimer’s patients.
Medicare provides a Nursing Home Compare service at their website (www.medicare.gov)
to help learn about certified options in your local community. Certified
nursing care facilities are eligible to receive Medicare and Medicaid payments,
which is important if you run out of funding during your stay and need support
from Medicaid.

Hospice Care

Hospice care is available at the end of life
to relieve discomfort for terminally ill patients who are not expected to
recover. Hospice care can be provided in one’s home or at an institution.
Medicare may cover hospice care if a doctor certifies that the patient is
expected to live for less than six months.

Continuing Care Retirement Communities (CCRCs)

Another option for long-term care is a continuing
care retirement community (CCRC). These begin with independent living and
provide a full range of long-term care services from active and independent
living to assisted living to nursing care in the same community. CCRCs provide
the option to increase care as needed over time. With all levels of care
provided, CCRCs are meant to be a permanent solution for retirement living
needs. It can be challenging or costly to modify a CCRC contract if one decides
to leave.

Most CCRCs will require that new residents can
still live fully independently upon moving in. If greater care is already
needed, the application to the CCRC may be rejected. CCRCs also generally
require an entrance fee and monthly payments. Entrance fees can be high, even
up to $400,000. These fees can be structured as all-inclusive or paid on a
fee-for-service basis as needed with a smaller upfront fee. The all-inclusive
version can be viewed as an alternative way to obtain long-term care protection,
such that also having long-term care insurance may mean doubling up unnecessarily
if choosing a full-service CCRC option. The initial contract should state the
nature of housing and long-term care services to be provided for life.

An important distinction for CCRCs is that
future nursing home care services are included as part of the initial package,
which reduces the need to find a new facility in the future. This can be
convenient for spouses and friends in the community to make visits after
nursing home care is needed, since the facility is close by. Some CCRCs require
the purchase of a group long-term care insurance contract as an entrance
requirement.

Important questions to ask when considering
CCRCs include:

·
What is the entrance fee and is it refundable?

·
What do the monthly fees cover?

·
What are other possible expenses in addition to monthly fees?

·
What is the nature of accommodations, and do these accommodations
change if one member in a couple transitions to nursing care?

·
Can monthly fees increase and under what circumstances?

·
What types of long-term care services are provided and what is
the cost for additional services?

·
Does the facility require a long-term care insurance policy?

·
Is there a waiting list for entering?

Long-Term Care and the Global Pandemic

Incidence of COVID-19, visiting
restrictions, and threats to their financial sustainability have placed
long-term care facilities at the center of the news about the global pandemic
in 2020. This may lead to permanent changes in how long-term care
institutions fit into retirement planning. It is possible that such
institutions will play a smaller role in the future. Individuals may be less
comfortable with financial models that involve paying a large upfront fee for
the provision of lifetime care. We may see an even faster shift toward the
provision of care at home as individuals may view long-term care institutions
as riskier places to live.

With CCRCs, the
resident must trust that the managing company will remain in business to
provide the contracted services over the long term. This is a reasonable
concern, so it is acceptable and important to vet the financial strength of the
facility to help determine if it is on a sustainable trajectory. Having a
well-qualified elder law attorney review the stipulations in any contract is
important.

Options for Funding Long-Term Care Expenses

The four general ways to finance long-term
care expenses include:

·
Self-funding with personal assets

·
Medicaid

·
Traditional long-term care insurance (LTCI)

·
Hybrid policies combining long-term care with life insurance or
annuities

To better understand the options, the overall cost
of long-term care can be defined as:

LTC Cost = LTC Expenses + LTCI Premiums –
LTCI Benefits

This equation highlights that the overall cost
of funding long-term care is comprised of the actual expenses for care plus any
premiums paid for long-term care insurance, less any benefits received (including
death benefits or other auxiliary benefits, when applicable) from the insurance
policies. For this formula, one may consider Medicaid payments as a type of
insurance benefit that reduces out-of-pocket expenses. It is the net
out-of-pocket expenses that matter. When experiencing LTC spending shocks, the
formula suggests that insurance has positive value if its benefits exceed the premiums
to help reduce the overall care costs.

Before we go any further, notice that Medicare
and health insurance are not on the above list of funding options. The
misperception that Medicare provides long-term care support is common. But Medicare
provides support only in limited situations when an individual spent at least
three days in a hospital and is then confined to home or an institution,
requires skilled nursing or rehabilitative care for the same condition from a
Medicare-certified professional as prescribed by a doctor, and is expecting a
full recovery. When these conditions apply, full benefits last 20 days and partial
support ends after 100 days. For eligible veterans, benefits from the Veterans
Administration may provide a care option.

Numerous considerations are involved in deciding
between the four funding options: age, health, ability to receive help from
family or friends without overburdening them, wealth levels and how they may
relate to Medicaid qualifications, legacy objectives, risk tolerance related to
the financial impact of unknown long-term care events, and the costs and
benefits of different types of insurance. As far as funding is concerned,
developing a written plan, and sharing it with family members can help to avoid
misunderstandings about providing and paying for care. You should also ensure
family members know about any funds set aside or any insurance policies
designed to support care in case you are incapacitated when care needs arise.

Self-Funding

Self-funding means long-term care expenses will
be paid through distributions from household assets. Potential funding sources
could include investments, cash value in life insurance policies, or home
equity. This strategy keeps the full risk for long-term care spending on the
household and results in the widest range of potential spending outcomes. If no
long-term care event occurs, there is no cost for self-funding. Any reserves
that had been set-aside for long-term care will likely wind up as part of a
larger legacy. But without any risk-sharing, the full burden of potentially
very high expenses remains as a risk for the retirement plan.

Risk-averse individuals may prefer to pay a
premium to better protect wealth in the event of an expensive long-term care
event, even if this carries a loss should no long-term care event arise. Risks
of self-funding include potential high costs, investment risks for the
underlying assets, and difficulties with managing investment assets after a
long-term care need begins. Unknown spending needs also require setting aside
reserve assets to feel comfortable that there will be enough to self-fund care,
which raises the amount of assets required to feel financially independent.

For self-funding, ask yourself if you have
sufficient financial resources to cover an expensive long-term care shock and
still meet the remaining financial goals for retirement. Which specific
resources could be used for long-term care expenses? How will they be invested?
What impact would these expenditures have on the standard of living for
remaining household members and potential beneficiaries? Is this a risk that
can be accepted, or could insurance provide a positive impact by helping pool
this risk and reduce the potential size of the shock?

When discussing the budget in Chapter 3, I
provided an example for a couple that did not have other forms of long-term
care protection and included about $500,000 as a contingency liability to cover
long-term care expenses after also considering other offsets to the budget
created by an LTC need. We will walk through the example for obtaining that estimate
near the end of this chapter. It provides a framework for thinking about
self-funding. Though it is hard to be precise with this quantification, the budgeted
amount should be in the ballpark of providing a 90 percent chance that enough is
being set aside to cover the eventual long-term care expenses if both members
of a couple require paid care. When considering whether self-funding is the
right approach, one might also estimate how much those reserves could be
reduced while still feeling comfortable with the plan if insurance benefits are
also available. Clearly, the self-funding option is only possible for those
with sufficient discretionary assets to meet potential expenses. With
sufficient assets, those with high risk tolerance may prefer the increasing
variability in net care expenses from self-funding. Others with a lower risk
tolerance might choose to pool some of the risks through an insurance company.

Another risk tolerance consideration with
self-funding is what kind of investment returns can be earned by the reserve
assets. The more conservatively the assets earmarked for long-term care are
invested, the less potential upside growth they can obtain. Those with a greater
risk tolerance who invest more aggressively may find that self-funding fits
their circumstances, though they are taking on risk about the amount of
available funds, while those who would otherwise invest the assets more
conservatively – in cash or CDs, perhaps – may benefit more from an insurance
solution that is priced assuming similarly low underlying returns.

The self-funding route may also be more
attractive to individuals with a family history free of health problems that
result in the need for long-term care. Also, those with the potential to
receive care from family or friends without creating an excess burden may feel that
self-funding is a safer bet as overall costs will be less even with a greater
care need.

Along these lines, self-funding could force a
retiree to rely more greatly on family care, which introduces potential
opportunity costs not included in formal cost calculations. Up to 70 percent of
long-term care may be supported informally by family members. Caregivers often
experience increased stress and health problems, and they could be forced to
make sacrifices in their careers that could result in substantially reduced
lifetime earnings. The health problems created by providing long-term care
could potentially result in the caregiver eventually also needing long-term
care.

One other matter that should be mentioned
about self-funding is the potential psychological risk of feeling guilty about
spending on long-term care when it is needed. Even without explicit pressure,
there is a natural hesitancy that some may have about spending assets on their
own long-term care needs. There can be feelings of guilt related to the
perception of spending someone else’s inheritance. In some cases, family
pressure may be explicit, resulting in less long-term care usage to preserve
funds for an inheritance. This issue may be important with second marriages and
conflicts between children from earlier marriages and the new spouse. Having long-term
care insurance can solve for this potential problem, even for the wealthy who
could afford to self-fund, as one rarely would feel guilty about spending the
insurance company’s money.

We can also briefly mention another more
imprecise long-term care funding source. Some individuals view qualified
longevity annuity contracts or other deferred income annuities as a funding
means for long-term care. This is an imprecise method based on the idea of
planning to have increased sources of income starting at around age 80 or 85,
which corresponds to when one is more likely to face long-term care expenses.

Medicaid

Medicaid is the most common funding option for
paid long-term care in the United States. It generally serves as a last-resort
once assets and income decline to sufficiently low levels. Medicaid is the main
option for those entering retirement with little savings. It is also the go-to
for continuing with care after available resources have been depleted.

The qualifications for Medicaid – assets,
income, and medical need – vary widely by state. This makes it hard to
generalize about the process. Some states require relative impoverishment to
qualify for Medicaid, while others allow substantial assets to be set aside for
a spouse through the community spouse resource amount. As well, some states allow
qualification only for the “categorically needy” whose income and wealth falls
below thresholds without considering medical bills, while other states have
more generous “medically needy” rules that allow for benefits when LTC expenses
otherwise push higher incomes below the thresholds.

To a limited extent, it may be possible to
reposition assets with the aid of an elder law attorney to work around Medicaid
rules and gain access to care with some assets still protected. This is a
controversial strategy known as “Medicaid planning.” Some view it as unethical,
while others say they are entitled to the welfare benefits through their
lifetime tax payments.

For this process, there are countable and
non-countable assets when determining Medicaid eligibility, which can differ by
state. A simple part of the planning process is to move assets from countable
categories to non-countable categories, or to simply spend from countable
categories on items not covered by Medicaid such as hearing aids or a
specialized wheelchair. Other ideas include paying down a mortgage, making home
improvements, or purchasing a new car. Spousal retirement plans are
non-countable in some states, which suggests trying to preserve those. Some
states do not count the primary residence, an automobile, assets belonging to a
family business, furniture, or other personal belongings. Spouses also have
protections to maintain some assets for their own use.

Medicaid is making such planning increasingly
difficult by limiting the ability to transfer assets so that they do not get
used to pay for long-term care. There is now a five-year look-back period on
any asset transfers to determine if they are acceptable or if Medicaid eligibility
will be delayed to account for the transfers. Any invalid transfers will delay
Medicaid benefits by the number of months equal to the transfer amount divided
by the average monthly nursing facility cost in the state. Invalid transfers
may also include annuity purchases or moving assets to a trust. Transfers made
at least 60 months before care is requested are allowed, which can benefit
those making plans well in advance. Also, efforts to recover Medicaid benefits
from the estates of beneficiaries have increased as states work harder to
reduce overall Medicaid expenditures. This can include placing a lien on the
home that was considered as a non-countable asset during life. A specialized
elder law attorney can guide this planning.

Medicaid planning may be helpful for those
with limited resources and health problems preventing them from qualifying for
long-term care insurance. Available resources may still need to be spent on
long-term care needs, and qualification for Medicaid could occur if long-term
care needs persist. The perception that wealthy individuals are qualifying for
Medicaid while protecting significant assets is likely overstated.

Because Medicaid reimbursement to long-term
care facilities is generally lower than the true cost, self-funding patients
may receive priority admission – and potentially higher-quality care – over
Medicaid patients. It can be helpful to enter a nursing home or other
institution before beginning Medicaid receipt. Also, understand the institution’s
procedures for what happens if you switch to Medicaid after care begins, as you
may be moved to a less desirable room. As an increasing number of people
require long-term care, making it difficult for everyone to receive the same high
quality, those who would otherwise be able to cover their bills outside of
Medicaid may come to regret using Medicaid planning techniques that lead to
lower quality care. Nonetheless, Medicaid remains as an important funding
source for those lacking other options.

Traditional Long-Term Care Insurance

The traditional health-based long-term care insurance
(LTCI) strategy involves paying an ongoing premium for long-term care insurance
until a long-term care event takes place, and then gaining eligibility to
receive a defined amount of long-term care benefits for a defined period as
care is received. Estimates from the National Association of Insurance
Commissioners in 2018 suggest that less than six percent of the population aged
50 and older in the United States have a LTCI policy. While it is not popular
in practice, a description of this tool is worthwhile to ensure that the option
is understood and utilized when helpful.

At the point that one can set aside enough
reserve assets to feel comfortable, wealth becomes sufficient to self-fund
long-term care expenses. But reasonable individuals may still decide to include
insurance in their plans as part of an overall risk management strategy. The
potential benefits from having LTCI include the risk management aspect that
overall costs can be reduced when significant long-term care needs happen. This
leverages the potential value of long-term care dollars by incorporating risk
pooling to extend their reach through the benefits. With LTCI, less reserves need
to be set aside for the purpose of funding long-term care. Long-term care
insurance can also help with maintaining independence by allowing for the
receipt of care without burdening family members and being more willing to
receive care without the guilt of spending someone’s inheritance. Many
long-term care policies will also include the provision of a care coordinator
who can help manage the long-term care process and gain access to the best
facilities or home-care programs. Beneficiaries from these policies may receive
better guidance about finding good care, and they may receive better
opportunities to enter high-quality facilities.

Wealth levels can be too low to benefit from
insurance. Premiums may not be affordable, and there could be a risk of lapsing
on the policy if premiums become too much of a burden. There may be little that
can be done to avoid the eventual need for Medicaid. It may make less sense to
purchase insurance if there is not much wealth to protect and Medicaid will ultimately
pay for care. One might hold a small amount of insurance as part of a
transition into Medicaid eligibility.

Some states also have state partnership
programs in which qualified insurance policies can help to protect assets from
subsequent Medicaid eligibility. The amount of insurance benefits become a
protected amount of non-countable household assets for Medicaid qualification,
once the full benefit amount of the policy has been received. These policies
are only relevant for individuals who may need Medicaid at some point. As these
decisions depend upon the varying rules for each state, seeking guidance from a
local elder care law attorney will be valuable.

There are risks for owning long-term care
insurance. Risks include the potential for premium increases, the possibility
that long-term care costs will exceed available benefits, and the possibility
that claims will be denied or that certain expenses are not covered by the
policy.

Variables to consider when determining whether
to purchase a long-term care policy include age, health status, and family
medical history. These factors help to determine the probability for requiring
care as well as the level of policy premiums. Naturally, the odds for needing
care rise at higher ages, for those with poor health, and for those with a
family history of dementia or other debilitating conditions.

Consider available financial resources when
thinking about long-term care insurance. Can you comfortably pay the premiums,
and is it reasonable to expect that premiums can be paid even with premium
hikes? In terms of total assets, are you able to self-fund long-term care? If
so, are you willing to take the risk about the total cost for self-funding, or
would you rather use insurance to help narrow the tails for potential costs? In
this context, risk tolerance can be measured as your degree of willingness to
subject your standard of living and/or legacy objectives to the risk of
substantial long-term care spending shocks. Risk averse individuals are more
willing to pay an insurance premium to offset the impact of a significant
long-term care shock.

Upon deciding to purchase an insurance policy,
it is best not to wait too long before doing so. A general guideline is that it
is appropriate to start a policy while in your 50s, though there can be valid
reasons to start sooner or later. Generally, you do not want to wait too long
to start because premiums can increase with age at rates faster than the
savings from not starting sooner, and because there is a growing risk that you
will develop health problems that will disqualify you from initiating coverage.
The process requires underwriting, and once health conditions have developed
which make the need for care more likely, it may be too late to qualify.

Nonetheless, at younger ages there may be
other insurance needs which weigh more heavily when determining how to allocate
a limited pool of dollars. For a young person with a family to support, life
insurance and disability insurance may be more important than long-term care
insurance. It is important to find the balance between being old enough that
other insurance needs have been sufficiently met, while being young enough to
still be in good health to qualify for coverage with reasonable premiums.

Some policies offer a shared benefits rider
for couples, which can be substantially cheaper than buying two separate
policies. A joint policy can provide lower costs because it is less likely that
two spouses will require expensive care, and because one spouse will often
provide care to the other, which reduces claims on the insurance policy. There
is a risk, though, that one spouse uses up all the available benefits.

How much does LTCI cost? When searching for
current prices, the only online calculator I could find is at the Mutual of
Omaha website. Exhibit 8.4 provides examples of premiums from their cost
calculator as based on starting age for the policy. The policy I checked
provides a $4,500 monthly benefit and a 36-month benefit period, for a total benefit
pool of $162,000. There is no inflation adjustment for the benefit, and
benefits begin after a 90-day wait period. The couple’s premium reflects
purchase by each spouse with a 15 percent discount for both using insurance. It
is not a pooled benefit though, as each has a separate three years of coverage.

Exhibit 8.4

Annual Premiums for Mutual of Omaha Long-Term
Care Insurance

Cost for Monthly Maximum Benefit of $4,500,
36-month Benefit Period

Initial
Age

Male

Female

Couple

45 years old

$1,884

$3,096

$4,233

50 years old

$2,076

$3,432

$4,682

55 years old

$2,304

$3,876

$5,253

60 years old

$2,664

$4,536

$6,120

65 years old

$3,336

$5,592

$7,589

Note: For residents of Virginia. Rates may
vary by state. Quotes obtained on March 15, 2021. Policy provides 36 months of
benefits ($162,000 total coverage per person). https://www.mutualofomaha.com/long-term-care-insurance/calculator

We can further analyze these numbers to better
understand the potential value proposition of the insurance. The sooner LTC is
needed so that premiums end and benefits start, the better is the financial outcome
from the insurance. Suppose that premiums do not ever increase and that a LTC
need begins at age 85 allowing for maximum benefits to be received for next three
years. As the 50-year-old mark is a commonly suggested age for starting
insurance, I will use this as an example. The 50-year-old pays premiums for 35
years through age 85. For men, this sums to $72,660, and for women it is
$120,120. Then, $54,000 is provided annually as benefits from age 85 through 87.
The internal rate of return on these premium and benefit cash flows are 3.9
percent for men and 1.5 percent for women. For couples, it is 3.4 percent, if
both members of the couple independently experience LTC events at age 85. These
are nominal returns, rather than real returns, because none of these monetary
values receive inflation adjustments.

Especially for women, it may be reasonable to
assume that these rates of return could be beaten with reserve assets invested
relatively conservatively, even if interest rates never increase from today’s
levels. The idea is that instead of paying premiums, the assets are kept and
invested as reserve assets. Returns are low even without premium increases and
assuming the full benefit pool is received for care. If the LTC event happens
sooner, it improves the outlook for insurance. For example, if the care need
otherwise starts at 80, returns are 5.3 percent for men, 2.6 percent for women,
and 4.7 percent for the couple. With care coming sooner, the household is less
at risk anyway as their overall retirement with likely be shorter. The value
proposition is less if the LTC event happens even later, and that corresponds
to when assets may be at greater risk of depletion.

With these return estimates, we can at least
note that LTCI provides higher net-of-tax returns. Benefits are received tax-free
and there is implied tax-deferral on premiums compared to investing in a
taxable account requiring ongoing taxes on interest. There may also be opportunities
to deduct the insurance premiums, though this is less likely after retirement
as it becomes harder to itemize beyond the standard deduction. Nonetheless, this
LTCI policy does not fully cover the spending risk as the total benefit pool is
capped and bills could easily exceed these thresholds when care is needed. These
cost-benefit considerations may explain why LTCI is held by relatively few
Americans.

Long-term care insurance has traveled along a
rocky road since its inception. When people entered a nursing home after a
hospital stay, early long-term care insurance policies of the 1960s generally
only supported stays in nursing home facilities that required skilled care
rather than custodial care. This is exactly what Medicare covers, and since skilled
care is rarely needed for longer than Medicare provides, these types of
policies rarely provided benefits and left a stain on the industry.

By the 1990s, new policies covered an
increasingly general range of long-term care needs, including help with
activities of daily living and/or cognitive decline. Coverage is generally for
skilled care, intermediate care, and custodial care. The typical policy today
covers nursing homes, assisted living, and home care. It may also cover other
needs like homemaker services, hospice care, adult day care, international
coverage, respite care (temporary care from others to provide a break for
informal caregivers), bed reservation (which holds a spot at an institution
while away for a hospital stay), care coordination, caregiver training, and supportive
equipment. The range of expenses covered by long-term care insurance varies,
and it is important to understand what exactly is covered by a contract.

The long-term care insurance market expanded
rapidly during the 1990s. However, many companies entering the market offered a
level of benefits which could not be supported by premiums. Some companies
overestimated lapse rates as more contracts were held longer than expected.
With medical improvements, people were also living longer than anticipated when
under claim. Insurers also underestimated the recent decline of interest rates,
which meant they were earning less on their invested premiums to pay claims. State
insurance regulators must approve premium increases, which may be necessary if
the alternative is that insurers are unable to pay claims. As it stands, even
with substantial premium hikes, older policies may have lower premiums than if
the same policy was issued today. Some companies simply priced policies too low
to generate more sales in the ongoing battle between the marketing departments
and actuaries at insurance companies.

The contracts usually offer guaranteed renewal
or are defined as having level premiums. This does not guarantee against
increasing premiums. It only means that premiums do not increase solely because
of changes in age or health status. Level premiums require only that the
company must charge the same premium to everyone who bought policies within the
group at a point in time, not that premiums remain at the same level. If the
insurance company convinces the state insurance commission that higher premiums
are needed to support the promised benefits for that group, all policyholders
within a group may experience the same increase in rates.

The financial strains created by these
underpriced insurance contracts have led to dramatic consolidation in recent
years, with fewer insurers writing new policies today. Those still issuing new
policies have had to raise premiums and reduce benefits. Research by Christopher Finefrock, Suzanne Gradisher, and Caleb Nitz from 2015
found that among 58 companies that had written long-term care insurance policies, only four never initiated a rate increase. They also found
that, for instance, only 12 carriers were actively selling new long-term care
insurance policies in California. Meanwhile, an additional 46 companies with
existing policies had stopped issuing new policies.

For many retirees on a fixed budget, premium
increases became unaffordable and countless policies lapsed. These premium
increases left many Americans nervous about purchasing traditional long-term
care insurance. In the future, premium increases may be less common as
companies have a better grasp on how to price their policies, and as interest
rates are unlikely to fall dramatically lower than their current low levels.
Nonetheless, it is wise to at least anticipate a possibility that premiums
could increase by 50 percent or more during the period leading up to a benefit
claim. It is important to shop around between different providers as the
ability to qualify and the health classification for premiums may be different
between companies. Buying based on who offers the lowest premium is risky,
since the company may be seeking upfront sales and may be less stable.

Public hesitation about long-term care
insurance stems from numerous concerns. As with many other insurance options,
people struggle to place appropriate value in something they may not end up
using. Consumers fear future rate increases could affect their ability to keep
paying for the policy. They have concerns about underwriting and the lack of
standardization among contracts making it difficult to know what is and is not
covered, as well as the finite coverage provided by contracts which may still
leave them with expenses extending beyond coverage limits.

Another important concern for traditional
long-term care insurance is the possibility of inadvertent lapsing. The Center
for Retirement Research at Boston College released a troubling study in 2015
which found that about 25 percent of policy holders who entered a nursing home
had let their policy lapse during the preceding four years, resulting in loss
of benefits they had supported with premiums earlier in their lives. The
troubling implication of this research is that two of the top hardships
experienced in the years leading to entering a nursing home – financial strain
and cognitive decline – led to a lapse in coverage when it was most needed. By
following households over time, they learned that lower scores on cognitive
tests increased the likelihood of needing long-term care and increased
the odds for lapsing their existing long-term care insurance policies. The
importance of having family, friends, or professional assistance during this
time cannot be overstated.

Hybrid Insurance
Policies

Attempts to combat concerns about traditional
long-term care insurance have resulted in combination or hybrid products using
an asset-based approach to fund long-term care. These new approaches generally
combine long-term care funding with life insurance or an annuity. Annuity
products are rare, as low interest rates have made it hard to offer additional
long-term care benefits on top of a guaranteed return for the annuity. But the use
of hybrid life insurance products has grown rapidly in popularity. Even for
those who cannot obtain long-term care benefits through their life insurance,
another option may be a life settlement or viatical settlement that can provide
more than the cash value of the policy to cover expenses, though this would
require giving up the policy’s death benefit.

There are two general types of life insurance
approaches to long-term care. The first is most like a traditional permanent
life insurance policy, except that it includes an optional rider allowing the
death benefit to be received on an accelerated basis to pay for qualifying
long-term care needs. These types of policies do not provide more than the
death benefit and will include different provisions about how the death benefit
can be received in advance for long-term care. The rules will generally require
standard eligibility for two ADLs or cognitive impairment, will include an
elimination provision, will not provide inflation protection, and will provide
the full benefit amount as a cash payment rather than requiring reimbursement
for expenses. Since these policies do not provide support beyond the death
benefit, they may be more suitable for individuals expecting shorter long-term
care needs.

The second option is an asset-based approach
linking a long-term care policy to life insurance. These can be viewed foremost
as intended for long-term care, with the ability to extend long-term care
benefits beyond the amount of the life insurance death benefit. For instance,
one asset-based strategy involves the purchase of a long-term care insurance
policy bundled with whole life insurance. This may be accomplished with a
single upfront premium, a set of premiums for a fixed term, or ongoing
premiums. The cash value generally grows at a low fixed rate and is liquid
after surrender charges.

Long-term care expenses are first subtracted
from the cash value before the insurance company must cover care expenses with
other resources, which allows these policies to be viewed as high-deductible
policies. These policies generally provide a death benefit for a fixed amount,
less any long-term care claims. To be clear, there are additional charges for
the life insurance benefit. The death benefit is available for long-term care,
and an optional continuation of benefit rider for the policy could allow for
long-term care benefits to continue even after the death benefit depletes.

When choosing large upfront premiums, these
policies may provide an outlet for funds that would have been invested in
short-term fixed income reserve assets anyway, so the opportunity costs from
potential lost investment growth are less. When compared to low-yielding
short-term fixed income assets, a competitive return is provided by the death
benefit in the event of a long-life and unused long-term care benefits. The
internal rate of return, however, could be significantly higher if the
long-term care benefits or death benefit are received earlier in retirement. As
well, it is important to remember the tax advantages related to tax-deferral
inside the contract as well as receiving the death benefit and long-term care
benefits on an income tax-free basis.

Conceptually, households may view the hybrid
policy as part of their reserve assets which provide leverage for the assets if
there is a long-term care need. This can support a reduced overall need for
reserve assets to fund spending shocks related to long-term care. If no care is
needed, then the death benefit provided to the estate may imply returns that
are similar to having just invested the reserve assets conservatively
throughout retirement. But the point is that less assets may have been needed
to feel comfortable when having the LTC risk covered by the policy.

To consider a basic example for how these
policies may be structured, suppose a one-time $70,000 premium is placed into a
life insurance contract that provides a death benefit of $125,000. The death
benefit can be spent down in advance at a set rate for qualified long-term care
expenses, and the unused cash value of the contract remains liquid (after
surrender charges) while growing at a modest rate similar to short-term fixed
income investments after deducting insurance charges. Tapping the cash value
for non-qualified expenses would negate the value of the insurance, though. Of
importance is that those insurance charges were guaranteed in advance as part
of the policy and cannot be increased, unlike the case with traditional
long-term care insurance.

A continuation of benefit rider may be added,
which can even allow for lifetime benefits after the maximum benefit period for
the base policy has been reached. Underwriting is generally slightly easier
than traditional LTCI. In some cases, a phone interview or basic health
questionnaire and no medical exam is sufficient. Simplified underwriting makes
this option available to those who may not otherwise qualify for traditional
long-term care insurance. Some policies are also issued jointly for spouses to
share, with the death benefit provided at the second death.

Many hybrid policies also offer
return-of-premium provisions if the owner decides not to hold the contract
through death. Such provisions can be expensive to include, which reduces the
leverage that assets can provide for long-term care. But this is another feature
that must be balanced against a potential future need for funds to pay for
long-term care.

These newer approaches have sought to
eliminate the perceived disadvantages of traditional long-term care insurance,
such as premium hikes, finite benefit periods, fears about not making it
through the underwriting process, and the general use-it-or-lose-it nature of
insurance products. The death benefit is provided when the assets are not used
for long-term care expenses. Premium increases can be avoided by paying with a
single premium or with a guaranteed set of premiums for a finite time. Versions
are available that lock costs in at the start, which alleviates the concern of holding
traditional long-term care insurance that can inadvertently lapse in the period
leading up to needing care.

Long-Term Care Insurance and Taxes

Long-term care insurance can also provide tax
benefits. First, long-term care benefits are generally received tax-free. All
benefits from reimbursement policies are tax free, while cash benefit payments
are tax-free up to a limit of $400 per day in 2021. This is generally true for
both traditional long-term care insurance and hybrid policies.

As for premiums, qualified traditional
long-term care insurance policies can be tax deductible. Most policies issued today
are qualified, which means they meet certain requirements including that the
insured cannot perform at least two ADLs or faces a several cognitive impairment
for at least 90 days. Most hybrid policies do not qualify for premium
deductibility, except possibly for the portion of premiums going to the
continuation of benefits, as one requirement to be qualified is that any death
benefit on the policy cannot exceed the aggregate premiums paid.

Regarding premium deductibility, two
frameworks exist. For employers paying premiums on behalf of employees, or for
the self-employed, premiums can be fully deductible as an above-the-line business
expense up to limits. There are many exceptions for this deductibility that
relate to different types of corporate structures. Therefore, it is important
to discuss your situation with an accountant.

For others with qualified policies, including
those paying premiums themselves when employed by others or those who are
retired, premiums are not deductible as an above-the-line expense. But they can
be included with other eligible medical expenses as a below-the-line deduction
when itemizing and when exceeding 7.5 percent of adjusted gross income. A
deeper discussion of tax planning to clarify this terminology is provided in
Chapter 10. Some states also provide tax deductions or even tax credits for
long-term care insurance premiums.

There are age-based limits on the amount of
premiums that can be deducted for qualified policies. These are spelled out in
Exhibit 8.5. These limits also apply to the amount of long-term care insurance
premiums that can be paid annually as an eligible expense from a health savings
account.

Exhibit 8.5

Tax Deductibility Limits for Long-Term Care
Insurance Premiums in 2021

Taxpayer (Age at End of Tax Year)

Deductible
Limit

40 or
younger

$450

Between 41
and 50

$850

Between 51
and 60

$1,690

Between 61
and 70

$4,520

71 and older

$5,640

For those with existing life insurance and
annuity policies, it may be possible to engage in a 1035 exchange to a new
policy that includes long-term care protections without triggering a taxable
event. This could serve as another source of funds to provide long-term care
protections.

Coverage Options for Long-Term Care Insurance
Policies

Both traditional and newer hybrid insurance
policies provide numerous options. At the most basic level, these include:

·
How much time passes before benefits start?

·
How much benefits are provided per period?

·
How long are benefits provided?

·
What is the total benefit pool available?

There are other important considerations as
well, which we delve into.

Elimination or waiting period

First, what is the initial elimination period
before benefits begin? This choice could be viewed as a deductible, with longer
elimination periods serving as the equivalent of a less costly high-deductible
policy.

Since many long-term care events have short
durations, a short elimination period could substantially raise the cost of
insurance. It may also not be necessary. In certain circumstances, Medicare or
health insurance may cover a portion of the costs for short-term events.

Elimination periods in the range of two to
three months may be a reasonable compromise for those with sufficient assets to
fund the initial care. A common elimination period is 90 days. Elimination
periods of up to one year may work best for retirees who can afford to fund
short-term events themselves and wish only to protect themselves from the risk
of more serious and costly events while helping to lower insurance costs.

Another important detail about the elimination
period is whether it is defined in terms of calendar days or service days.
Calendar days begin the count as soon as eligibility is determined. Service
days only count days when care is received. This could substantially lengthen
the elimination period if, for instance, care is only received two days per
week. All else being the same, service day elimination periods will increase
the time before benefits are received, which should lower the premiums.

Monthly or daily amount, period of coverage,
and total benefit pool

Most benefits are defined in terms of a
monthly or daily maximum payable benefit amount. Determining the appropriate
level depends on the cost of care in your community, your ability to partially
fund some expenses in other ways, and the affordability of the premiums.

The period of coverage indicates how long
benefits are available. As most policies allow the period to be extended when
less than the full periodic benefit amount is used, a key consideration for the
periodic amount and period of coverage is the total benefit pool available to
be used. For instance, a $150 daily benefit provided for five years would
provide maximum benefits of 150 x 365 x 5 = $273,750. Or, in our example of
coverage from Exhibit 8.4, the policy provided a $4,500 monthly benefit for
three years, for maximum benefits of 4500 x 36 months = $162,000. Long-term
care benefits up to these total amounts are available. Coverage ends without
further benefit payments when the total pool is spent. If less than the full
amount of coverage is received each period, the total length of coverage can be
extended until the total pool of funds is used.

Most traditional insurance policies allow for
care coverage from one to five years. Lifetime coverage is now rare for
traditional policies, though some hybrid policies may still offer lifetime continuation
of benefit riders.

Inflation protection

Long-term care benefits may be calibrated to
the costs of care at the present, but those costs will grow over time. Should
the long-term care benefit grow over time as well? This is an important
question, as the long-term care benefits may not be received until 20 or 30
years later and long-term care costs often grow at a faster rate than overall
consumer price inflation. Today’s cost of care may only be a fraction of future
care costs. But inflation protection may increase premiums substantially.

Common options for inflation include no
benefit growth, a simple growth rate, or a compounding growth rate. Growth
rates may be 3 percent or 5 percent. Some policies may even link coverage
growth to the consumer price index. Generally, at the start of each anniversary
for coverage, the daily or monthly benefit amount and any remaining portion of the
total benefit pool are increased by the policy’s inflation rate.

Exhibit 8.6

Tracking Growth for a $5,000 Monthly Benefit Using
Different Inflation Factors

Exhibit 8.6 provides an example of the impact
of different growth rates for a baseline monthly benefit amount of $5,000. With
no growth, the benefit amount remains at $5,000. With a simple growth rate, a
fixed amount is added to the benefit each year. For instance, 3 percent simple
growth adds $150 to the monthly benefit amount each year. After 40 years of
coverage, monthly benefits grow to $10,850. Meanwhile a 5 percent simple growth
rate adds $250 per year. After 40 years, the benefit is $14,750. With
compounding growth, the amount of growth increases over time as the rate is
applied to the latest benefit amount rather than the initial amount. With 3
percent compounding growth, the benefit is $15,835 after 40 years (which is
more than with 5 percent simple), as opposed to $33,524 with 5 percent
compounding growth. It takes about 33 years for a 3 percent compound growth
rate to catch up to and exceed a 5 percent simple growth rate, making the
choice among these options less than obvious. Compounding growth should better
reflect the pattern of cost growth in the future, but simple growth may be a
more affordable option.

The choice is also complicated because there
is no way to know when you will need care and how inflation will impact costs then.
Simple growth may not be able to keep pace with long-term care costs, but it at
least provides some growth relative to a flat benefit.

Another option to support a growing benefit
amount over time is a provision within the contract that allows the periodic
purchase of additional coverage. This provides an opportunity to obtain more
coverage in the future in exchange for additional premium without overcoming
the hurdle of additional underwriting and without an initial commitment to the additional
expenses involved in purchasing additional insurance or an inflation rider.

How benefit amounts are determined and paid

Several options are available for benefit
payments. The reimbursement method requires paying the provider and then
submitting a claim for reimbursement from the insurer. It requires more effort
to keep track of and submit receipts. The indemnity method pays the beneficiary
a specific benefit amount for any period that services are received, which
could be more than actual expenses. The cash method provides payments even when
receiving unpaid informal care from family or other volunteers.

By better matching up with actual expenses,
the reimbursement method is usually the most cost effective for premiums
because it will result in smaller claims that only cover paid expenses. Paying more
for benefits that can exceed the actual costs for care may not make sense. Nonetheless,
an advantage for cash-based methods is that benefits can be used to pay informal
caregivers as well.

One other related issue is whether the benefit
period is daily or monthly. For those receiving different amounts of care each
day, a monthly benefit period can potentially provide flexibility for covering
more of the costs. This can be understood with a simple example by comparing a
$150 daily policy with a $4,500 monthly policy. Suppose an individual receives
care for 20 days in the month, and each day of care costs $200. With the daily
policy, only up to $150 is reimbursed per day, so the total benefit received
for the month is 20 x 150 = $3,000. For the monthly policy, up to $4,500 for
the month is reimbursed, and so the full $4,000 of expenses in this example
would be covered.

Qualifying expenses

It is also important to consider which
expenses qualify for benefits. Early policies only supported skilled nursing
home care after a qualifying hospital stay. New policies are less restrictive,
but standards may vary about what is covered. Identify whether a policy will
cover home care, assisted living, and nursing homes. Additionally, do expenses
for adult day care or other respite care qualify? What about care options that
have not been invented yet? The ability to receive care at home is important
because the alternative would involve moving out to qualify for benefits from
the insurance policy. Home care and respite care benefits also provide relief
for family members serving as caregivers, making it possible to delay moving to
an institution for a longer period. Some policies may even provide benefits to
pay for informal caregivers such as family and friends who do not normally live
in the same home. Having more comprehensive coverage provides greater flexibility.

In terms of what qualifies for benefit
coverage, the standard has become that you need to either be unable to perform
two of six standard Activities of Daily Living (ADLs) or be cognitively
impaired as determined by a qualified physician or other licensed health care
practitioner. But qualifications may differ between companies and policies, so
it is important to consider this issue carefully.

For example, a policy requiring two ADL
limitations to qualify for benefits is of little value if bathing is missing
from the list, as that is often the first ADL requiring help. Also, bathing
could be defined in different ways, such as being able to get into a bathtub or
being able to conduct a sponge bath. Standard definitions or fixed lists of
ADLs do not exist, so you must be careful when comparing different policies. It
is also important to make sure that cognitive impairment is a qualifying
condition, especially if an impaired individual can still perform ADLs.

For an example, this is how the Federal Long
Term Care Insurance Program, which serves federal employees and military,
defines their benefit coverage: “when a licensed health care practitioner
certifies, and we agree, that you are unable to perform at least two of six
activities of daily living without substantial assistance for a period expected
to last at least 90 days or you require substantial supervision to protect
yourself due to a severe cognitive impairment, such as Alzheimer’s disease.”
Their six activities are bathing, dressing, toileting, continence, eating, and
transferring (from bed to chair).

Option for pooled benefits for a couple

It can be cheaper for spouses to buy a joint
policy than for each spouse to buy a separate policy. For example, the premiums
for six years of benefits to be jointly shared will be cheaper than two
separate policies each with three years of benefits. Even if benefits are not
shared jointly, lowered premiums can be attributed to a better chance that claims
will be less because one spouse cares for the other, and because of the reduced
probability that both spouses will experience conditions which qualify
for expensive long-term care benefit payouts.

Underwriting requirements

Another consideration is the degree of
underwriting and the health classification provided for insurance premiums. It
is worthwhile to shop among different companies, as they may arrive at
competing conclusions about appropriate premiums based on their underwriting.
Those in good health will likely benefit from more stringent underwriting that
can result in a lower premium. Everything else being the same, those in poorer
health would prefer a less rigorous underwriting process.

Hybrid policies generally have fewer
underwriting requirements, as a questionnaire and telephone interview may be
sufficient without needing an additional medical examination. A hybrid policy
may be the only insurance option for those with health conditions that prevent
them from qualifying for a traditional insurance policy. It is important to
remember that the risk for an application to be rejected grows with age as one
is more likely to experience disqualifying medical conditions.

Other considerations

A few other considerations for comparing
different policies include issues such as secondary benefits. Does the policy include
liquidity or death benefit options for unused coverage? How frequently are
premiums paid? Is there is a one-time premium option? Can premiums be increased
in the future? Is there a waiver of premiums once benefits begin? If coverage
is received and the need ends, can premiums and coverage be renewed? Does the
policy pay any dividends? Are benefits available if one chooses to live abroad?
Does the policy offer the services of a care coordinator who can help to answer
questions and develop a plan for your specific needs? Also consider the
viability of the insurer to pay claims, as determined through credit rating,
past involvement with the long-term care industry, and experience with claims
payouts and customer complaints.

Finally, the lack of standardization among
long-term care insurance policies means that you should be careful about the
specifics for each individual contract under consideration. Does the policy
cover the variety of potential living arrangements or care you may need or want
to receive in the future? Some policies may only cover care at home or at
certain institutions, while a comprehensive policy will cover any type of care
no matter where it is received. It is surely worthwhile to have a qualified
elder law attorney study the contract for any potential issues or misunderstandings.

With these considerations when designing a
long-term care insurance policy, we can provide a summary of ways to lower a
policy premium. These include reducing the level of inflation protection, reducing
the periodic benefit and total benefit amounts, adding longer elimination
periods before benefits begin, using a shared policy for spouses, initiating
the policy when younger, and keeping initial coverage low but including a rider
to allow for future insurance purchases.

Budgeting for Long-Term Care Expenses

We end the chapter with a discussion about
budgeting for long-term care expenses. When we described budgeting for health
care expenses, that involved a combination of building annual expenses into the
budget and creating a reserves set-aside for spending shocks. Long-term care is
different because the baseline budget will not need to include long-term care
spending beyond any long-term care insurance premiums.

Long-term care funding is otherwise a problem
of managing reserves for potential expenses that range from $0 (the outcome for
half of the population) to more than $1 million. How much of a reserve is
needed for long term care depends on the types of scenarios you want to be
financially equipped to handle in the future. When might a long-term care event
happen, how long might it last, what will the out-of-pocket expenses to cover
care be, how much might other budgeted spending drop if long-term care is
needed, what is the inflation rate for long-term care as well as the overall price
level, and what discount rate will be used to convert future expenses back into
the reserve amounts needed today?

An important factor that will help with
managing long-term care expenses is the reduction in other expenses that will
naturally occur following a move into an institution. When you see the
costs for long-term care, it is important to recognize that they are not fully
additive to your existing budget. If you are spending $90,000 on nursing home
care, some other expenses in your budget would reduce in response to offset
some portion of these costs in terms of net household expenses. For couples
there is the possibility that one spouse requires extended long-term care in an
institution, while the other remains at home with a similar overall budget, but
if you are projecting out prolonged long-term care events for two spouses, at
some point there may not be a family home and much of the existing budget could
be redirected to long-term care. By redeploying some of the existing budget to
cover long-term care expenses, the additional reserve assets desired may be
less than expected.

Exhibit 8.7 extends the budget described in
Chapter 3 to provide estimates for this couple’s budget after age 80 when one
spouse moves to a nursing home, and then later if the surviving spouse also
moves to a nursing home. These estimates involve speculation as they are
experiences one has not had, and you might be conservative regarding estimates
about how much other expenses will be reduced. But it is important to recognize
that the quoted cost of nursing home care would not simply be added on top of
the existing budget. There will be offsets. In the exhibit, the couple
estimates their total spending at $87,928 in today’s dollars once they reach
age 80. Working through this exercise, they estimate that if one spouse moves
to institutional living, the budget for everything else will reduce by $23,600
to $64,328. Later, if that spouse were to pass away and the surviving spouse
then also moves to a long-term care institution, then other spending will fall
by $71,714 to $16,214. With a long-term care need, the couple estimates major
reductions for charity, gifts, groceries, household expenses, housing,
insurance, property taxes (for the survivor), television, travel, and
utilities.

Exhibit 8.7

Retirement Budget with and without Long-Term Care
Events

RETIREMENT - PROJECTED LIFESTYLE
EXPENSES -

Real Expenses (Today's Dollars)

Ages 65 - 79

Ages 80+

Budget After

Long-Term Care

For First Spouse

Long-Term Care

(Last Survivor)

Cell phone

$1,200

$1,200

$1,200

$750

Charity

$5,000

$5,000

$1,000

$0

Gifts / children's education

$3,000

$3,000

$600

$0

Groceries

$18,000

$12,000

$7,000

$500

Health Care

$11,464

$22,928

$22,928

$11,464

Household expenses

$23,000

$15,000

$7,500

$2,500

Housing (maintenance, furniture)

$1,500

$500

$500

$0

Housing (HOA dues)

$0

$0

$0

$0

Insurance

$3,300

$3,300

$3,300

$0

Internet

$1,000

$1,000

$1,000

$0

Property Taxes / Apartment Rent

$15,600

$15,600

$12,000

$0

Restaurants

$3,000

$600

$500

$0

Television

$1,000

$800

$800

$0

Transportation

$7,500

$3,000

$3,000

$1,000

Travel (International)

$10,000

$0

$0

$0

Travel (Domestic)

$4,000

$1,000

$0

$0

Utilities (gas, electric, water)

$3,000

$3,000

$3,000

$0

$111,564

$87,928

$64,328

$16,214

Reduction to Ages 80+ Budget

$23,600

$71,714

With these estimated inputs, we can now shift
to the long-term care reserves estimator shown in Exhibit 8.8. Each spouse is
65 when making these projections. After considering possible care scenarios and
their probabilities, they would like to be prepared for a scenario in which the
first spouse spends two years in a semi-private room at a nursing home starting
at age 80, and the second spouse spends three-years in a semi-private nursing
home starting at age 97. For the cost of this care, they input the national
median average for semi-private nursing home care in 2020, though this could be
further refined as based on where they expect to live when care is needed. As
well, they do not have other long-term care insurance so the full costs will be
paid out of pocket. They also do not anticipate using Medicaid to fund their
care.

The care cost will grow at the inflation rate
for long-term care, which they input as 4 percent as based on our earlier
discussion. They also include the budget offsets from Exhibit 8.7, which they
project to grow at an overall consumer price inflation rate of 2 percent. They are
not assuming constant inflation-adjusted spending throughout retirement because
we already did adjust their budget downward to reflect the slow-go years
starting at age 80. Finally, they discount this future spending using the same
0 percent real discount rate from the funded ratio analysis in Chapter 3. They
wish to see the costs for funding their plan without assuming stock market
gains. With these inputs, they estimate a reserves requirement today of $203,903
for the first spouse and $310,750 for the second spouse. The total reserves
needed to feel comfortable with their plan is $514,653.  This is a large number
they would like to have set aside to feel financially independent and ready for
retirement. It is quite sensitive to assumptions.

Exhibit 8.8

Long-Term Care Reserves Estimator

First Spouse

Second Spouse

Total

Current Age

65

65

Age that Long-Term Care Need Begins

80

97

Duration of Long-Term Care Need

2

3

Annual Out-of-Pocket Long-Term Care Cost (Today's
Dollars)

$93,072

$93,072

Assumed Reduction to Other Budgeted Spending (Today's
Dollars)

$23,600

$71,714

Inflation Rate for Long-Term Care

4%

4%

Overall Inflation Rate

2%

2%

Real Discount Rate

0%

0%

Long-Term Care Reserves

$203,903

$310,750

$514,653

Because care is received so far in the future,
the value of the discount rate and the difference between long-term care
inflation and overall inflation become very important. A higher discount rate
and a smaller differential between the cost-growth rates will both contribute
to much lower reserve needs. For example, if we simply shift the inflation rate
for long-term care to 3 percent, total reserves fall to $337,174. Moving that
back to 4 percent, if we use a real discount rate of 1 percent, the total
reserves reduce to $394,558. At 2 percent, reserves fall to $305,532. For
someone investing their long-term care reserves in a diversified portfolio, it
could be justified to use a higher discount rate, especially since Medicaid can
always serve as a back-up if one did end up without enough reserves to cover
long-term care expenses. I would not fault anyone for using a higher discount
rate for their long-term care reserves than they use for other retirement
liabilities, but I do keep the 0 percent discount rate for the discussion in
Chapter 3. This decision depends on the comfort level with a future ability to
reasonably manage a relatively significant long-term care event. That is a
personal matter, which also depends on whether there are insurance options that
could also be tapped or whether Medicaid can be a back-up plan if the perfect
financial storm of a bad sequence of returns, a long life, and an expensive
long-term care shock were to all strike simultaneously. Cumulatively, this is a
low-probability event.

Action Plan

These are the key steps to manage long-term
care risk in retirement:

o
Identify the long-term care options and costs in your community. Consider
how other budgeted expenses, such as travel, may be reduced if long-term care
is needed. Decide where you would like to receive care. Determine whether CCRCs
are a consideration.

o
Understand what your default plan of care will be if you do not
take further action. This includes taking an inventory of what you have at the
present:

o
traditional long-term care insurance policies

o
permanent life insurance with long-term care benefits or other
hybrid policies

o
family members who may be willing and able to help without
creating too much burden

o
reserves that can be earmarked to cover long-term care expenses

o
the level of countable assets that would be spent before reaching
Medicaid eligibility in your state

o
Identify the potential to self-fund long-term care expenses and
the potential impacts this could have on other family members.

o
Identify a reasonable amount of reserve assets to set aside as a
funding source for long-term care.

o
Is this amount realistic?

o
How will it be invested?

o
Do any family members expected to provide care understand and
accept the obligation?

o
Determine whether Medicaid may be unavoidable as part of a
long-term care plan. Consult with an elder law attorney to assist with Medicaid
planning as needed.

o
If interested to offset some of the spending risk related to
self-funding, explore a variety of options to include traditional long-term
care insurance or hybrid approaches.

o
Will your health allow you to qualify for coverage?

o
How much of the long-term care spending risk would you like to
offset through insurance?

o
How much of the risk can you afford to offset?

o
Will you pay for coverage with investment assets or through the
exchange of existing insurance policies?

o
How much would the coverage lower your need to hold reserves for
self-funding while still feeling comfortable?

o
When considering insurance, determine what makes the most sense
regarding the tradeoffs between premiums and the periodic benefit amount, total
coverage, inflation adjustments, and elimination period?

o
Traditional long-term care insurance may appeal to those who can
obtain tax deductions for premiums, may use a partnership plan to provide
further asset protection for Medicaid, and wish to include inflation protection
riders.

o
Hybrid policies may appeal to those seeking stability for premium
amounts, protections for the use-it-or-lose-it aspect, have health issues that
make it hard to qualify for traditional insurance, and have existing insurance available
that could be exchanged to these policies.

o
Provide family members with your written plan for long-term care
so they can easily implement it if you are cognitively impaired. The plan
includes details about sources of care, sources of funds, insurance policies,
and any professionals who may be available to answer questions, such as a care
coordinator provided by an insurance policy.

o
Periodically review the plan to make updates or changes.

o
Take care of your health and stay active to help avoid the
development of conditions that trigger long-term care needs.

Further Reading

Department of Health and Human Services. 2021.
“Long-Term Services and Supports for Older Americans: Risks and Financing,
2020.” ASPE Research Brief (January).

Finefrock, Christopher, Suzanne Gradisher, and Caleb
Nitz. 2015. “Long-Term Care Insurance: Comparisons for Determining the Best
Options for Clients.” Journal of Financial Planning. 28 (2): 36-43.

Genworth. 2021.  Genworth 2021 Cost of Care Survey.
https://www.genworth.com/aging-and-you/finances/cost-of-care.html

Hou, Wenliang, Wei Sun, and Anthony Webb. 2015. “Why Do
People Lapse their Long-Term Care Insurance?” Boston College Center for
Retirement Research Working Paper #15-17.

Matthews, Joseph L.  2020. Long-Term Care: How to
Plan and Pay for It.  Berkeley:  NOLO.

Chapter 9: Housing
Decisions in Retirement

Developing a plan to meet housing needs throughout
retirement is an important decision. Most retirees will continue to live at the
same home as before retirement, but the thought of moving is a consideration
for many and a reality for some. Some retirees will move multiple times
throughout retirement. Housing options do multiply for retirees with greater
flexibility to consider RV living, active adult communities, continuing care
retirement communities, and living abroad, among other possibilities.

As part of this process, retirees should think
about how housing needs may change during retirement in response to physical
and cognitive decline. One or more moves may become necessary in retirement for
health-related reasons, but planning can reduce both the need for, and the impact
created by moving.

While a home provides an emotional anchor of
daily comfort, shelter, memories, and proximity to both friends and community,
it is also a major source of wealth for retirees and near retirees. For many
Americans, home equity provides a substantial part of their net worth. The
home’s value is often greater than that of the household’s investment
portfolio. This is an asset that can also be treated in a strategic manner as
part of retirement income.

As well, expenses related to the home
(property taxes, utility bills, home maintenance, and upkeep) can add up to a
significant portion of the overall household budget. The Center for Retirement
Research at Boston College analyzed numbers for retired couples aged sixty-five
to seventy-four and found that housing expenses represented 30 percent of the
typical household budget.

In this chapter, we consider retirement
housing in greater detail. We consider the characteristics for a good home in
retirement. For homeowners, we also consider planning aspects related to being
able to age in place, to generate income through the home, and whether to carry
a mortgage into retirement.

Do Retirees Move?

New retirees frequently feel more freedom and
flexibility to live where they wish. While working and raising children,
families are more firmly locked in place by proximity to employment and
schools. Upon retirement, a move to a community with a less highly rated school
and no daily commute could mean lower property taxes and increased savings for
the retirement budget. There is the potential to improve finances by moving to
a state with a more tax-friendly environment for retirees. This newfound
freedom can create a whole new set of options that might not have been
realistic in the past.

Nevertheless, most retirees do choose to stay
put. Richard Green and Hyojung Lee studied households and found that the
propensity to move peaks in an individual’s twenties and then declines until
about fifty. Moving then stays at these lowest relative levels for higher ages.
Older individuals are less likely to move, and the rate of moving does not rise
at typical retirement ages. There is an uptick in moving at more advanced ages,
but this reflects a need to move for health-related reasons, such as to
assisted living or a nursing home.

In Spring 2016, the American College of
Financial Services conducted a survey of 1,003 people between the ages of 55
and 75 with at least $100,000 of investment assets and $100,000 of home equity.
When asked a question about whether you plan to remain in your current home for
as long as you possibly can, 60 percent said yes, 23 percent said maybe, and 17
percent said no.

As well, in a Merrill Lynch Retirement Study
conducted in partnership with Age Wave and published in 2015, the results
showed that among retirees aged fifty and older, only 37 percent had moved in
retirement, while another 27 percent anticipate moving at some point, and 36
percent of retirees had no plans to move. The most popular reason to not move
was loving one’s home, while important reasons for moving were listed as being
closer to family, decreasing home expenses, fulfilling health needs, and
changes in marital status.

The decision to move or stay put relates to
decisions about priorities and preferences among numerous characteristics. We
will return to topics relevant for those who choose to remain in the same home,
but first we review relevant considerations for new retirees thinking about the
best place to live.

Characteristics of a Good Place to Live in
Retirement

Joseph Coughlin, the director of the MIT
AgeLab, created three basic questions to identify quality-of-life issues for
retirement:

·
Who will change my lightbulbs?

·
How will I get an ice-cream cone?

·
Whom will I have lunch with?

An essential part of answering these questions
involves solving for the right type and location of housing. These questions
illustrate how our lives will change as our bodies slow down and health issues
or other aspects of aging make us less mobile.

For some early retirees, moving around
frequently and traveling may be common, but these are important considerations
for anyone considering settling down more permanently in one location.

These questions focus on whether we can
continue to live in and properly maintain the same home, whether we have access
to a community that lets us continue to enjoy basic conveniences even if we
stop driving our own cars, and what will happen to our social lives and
opportunities to remain active as old friends also become less mobile or move
away.

Will we live in communities that keep these
key aspects of quality living accessible to us? For new retirees, any
difficulty with answering these questions may still reside in the distant
future, but the major life changes associated with retirement provide a good
opportunity to reflect on the different possibilities and develop a set of
contingency plans.

Ultimately, one of the greatest dangers to
quality of life in retirement is the risk of becoming increasingly isolated with
only television or web surfing to pass the time. On the emotional side, the
housing decision may relate in large part to figuring out how to best answer
Coughlin’s three questions over the long term.

Because of its important connection to the
emotional and financial aspects of retirement, it is worthwhile to think
carefully about housing options and potential uses for home equity. The
importance of living somewhere with social connections, transportation options,
quality health care, and long-term care services increases with age. In the
more immediate present, you need to think about where to live, how long to stay
there, and whether to move later in retirement. Plenty of justifications exist
for staying put or for moving early in retirement.

It is important to anticipate changing life
needs in advance, as moving becomes more difficult as we age. Putting off these
matters may result in the need to make quick and suboptimal decisions in the face
of impairments that may arise. Planning around finding a good place to live and
making the necessarily modifications in advance can allow for more desirable long-term
outcomes.

Decisions to move must not be taken lightly.
It is easy to make a move based on a vision that does not become reality. It is
worth conducting a trial move by renting for a few months during different
seasons to make sure that the move feels right. This way, if things do not work
out as planned, you have avoided a potentially costly and difficult situation.

We consider reasons for moving, which can also
relate to reasons for staying put if these priorities are already fulfilled. Issues
relate primarily to the changing emphasis of life’s priorities and needs. There
are numerous considerations that each retiree will need to prioritize to decide
on the best options. The media provides rankings about the best places for
retirees to live, which may involve different combinations of these factors.
Such lists may be helpful with ideas and important considerations, but the
article’s methodology may not match your priorities. Let us consider some of
the important matters.

Affordability

First, affordability and retirement
sustainability on the financial side are important. Housing is a major expense,
and the current home may be larger and more expensive than necessary. Empty
nesters may no longer require a home large enough to accommodate an entire
family. Large homes require more cleaning, maneuvering, heating, cooling, and
maintenance.

Many retirees will consider downsizing as one
way to free up home equity for other retirement expenses. Downsizing does not
necessarily mean moving to a physically smaller home; it can mean moving to a
similar-sized home in a less expensive area. The arithmetic of converting home
equity through downsizing is straightforward. If you pay off the mortgage on a
$300,000 home, sell it, and move into a $200,000 home, you have freed up
$100,000 of home equity for other uses. This may also reduce housing-related
expenses for the budget.

An important caveat about downsizing is that
it can be dangerous to assume that it will provide an important source of
retirement funding. The same study of retirees conducted by Merrill Lynch and
AgeWave also found what they refer to as a “downsize surprise,” where many
retirees who planned to downsize ended up not wanting to do so once they
retired. For those who had moved since retirement, 51 percent moved to a
smaller home, 19 percent to a same-sized home, and 30 percent to a larger home.
For those who chose to upsize, the most important reason given was to have more
space for family members (including grandchildren) to visit. The AgeWave study
makes clear that downsizing is not the only moving option for retirees, and it
should not be viewed as a given.

Besides housing costs, one can also consider other
cost of living expenses. How would the basic costs of daily living change in a
new location? Are homeowner’s insurance policies and utilities more expensive?
Is it necessary to pay for trash pickup and other services? Consider as well
that health insurance, health care, and long-term care costs can vary
dramatically by location.

Furthermore, what is the tax situation? Tax
considerations include state income tax rates and whether some retirement
income sources such as Social Security are excluded from state income taxes.
State and local sales taxes, state inheritance taxes, and local property taxes
are also important considerations to factor in the retirement budget with a
move. With sales tax, one may also consider if certain categories of expenses,
such as food or prescriptions, are exempt. As well, there may be local
government programs to provide property-tax relief for the aged.

Home
Ownership vs. Renting

Another consideration related to moving in
retirement is simply selling your home and then renting a new place. This
frees up home equity and provides the flexibility to make more frequent moves
before settling down. Renting provides the option to change the living situation
more frequently, and some retirees may value this and wish to move multiple
times during retirement.

As for financial considerations, the home is
a large, undiversified asset that may not appreciate over time. Many retirees
will find themselves fortunate if their home value can maintain pace with
inflation, though there are certainly opportunities for faster home
appreciation in some parts of the country. By selling, home equity can be
re-invested into a more diversified investment portfolio that may have the
potential to earn higher long-term investment returns.

As well, though there will now be a rental
expense, other retirement costs will reduce. First, property taxes are gone.
Rent for an apartment may even be comparable to what was paid in property
taxes on a family home in a good school district. As well, there will be
savings on home maintenance, repairs, and homeowner’s insurance. Deciding
whether to own or rent is an important consideration for retirees on the
move.

Proximity to Family and Friends

Another important issue that becomes very
personal is the location of family and friends. Does moving mean leaving such
individuals behind? What are the odds of making friends in the new location?
Alternatively, children may have moved to other parts of the country, and new
retirees may wish to move to be closer to their grandchildren. If children and
grandchildren live elsewhere, the choice may become more related to remaining
near friends or moving to be close to family. As today’s new retirees are also
called the sandwich generation on account of their potential need to care for
both their aging parents as well as their adult children or grandchildren,
moves may also be related to these needs.

Maintaining social ties and not becoming
isolated is important in retirement. Being close to family and friends can help
in this regard. As well, meeting new people and developing a social network in a
new community can fulfill this same purpose. It is important to have someone who
can provide occasional checks and help you avoid isolation. As aging progresses,
obtaining trusted support for lawn care, snow removal, home maintenance, cleaning,
and food delivery services can be very helpful. These are important considerations,
especially for retirees who lack friends and family nearby to help with these
matters.

Agreeable Climate, Community, & Leisure Activities

When considering a move, many opportunities
exist for retirees to find communities with active networks for social
activities related to specific hobbies or interests.

There are various living options for retirees
during their more active years of retirement. Aside from continuing in the same
home, opportunities include extensive traveling by RV or living abroad. They
can involve communities organized by age, religion, lifestyle, recreational
interests, or hobbies. Think, for example, of a neighborhood organized around a
golf course. It could also be a college or university town which may allow
cultural opportunities and the ability to take courses or engage in other
educational activities. Naturally occurring retirement communities are
neighborhoods in which the residents gradually shifted toward being retirees
over time who may work together to provide social support or other services for
residents.

Active adult communities are another option.
They are available both for age 55+ (in which 80 percent of residents must be
at least 55) and 62+ (in which all residents must be at least 62). These are
the only housing options allowing for age discrimination. They can provide
organized activities and social support. These types of communities generally
do not provide health care or assisted-living options. But they are
increasingly available in areas with favorable climates, in university towns,
or in other places attractive to retirees.

When making a big move, it is important to
consider the year-round climate. A place that was nice to visit in the winter
may be unbearably hot in the summer. As well, tourist areas that may be lively
during their peak seasons can be dramatically different during the off-season.
Especially when moving for reasons discussed here, a trial-run of renting in
the area for a more extended period can be valuable to ensure that it is the
right fit.

Continuing-care retirement communities are
another option that can provide social networking benefits as well as covering
potential long-term care needs. These can be an option for those seeking only
to make one move who do not want to move again later for health reasons. These
are described in more detail in the previous chapter about long-term care.

Opportunities for Part-Time Work

Anyone interested in working part-time,
full-time, or in volunteering, needs to consider whether a specific locale is
conducive to these opportunities.

Health Care and Long-Term Care Options

Another consideration is the availability of
high-quality medical facilities in the area. Those with specific health
conditions may already understand the need to live close to specific medical
facilities providing the needed care. For others, it is important to recognize
that care needs may grow over time and so choosing a place located near
first-class hospitals and medical facilities is an important part of aging in
place.

When considering relocating, remember that Medicare
Advantage and some other types of health insurance are location-specific for in-network
care. Relocating may require changing Medicare options. Original Medicare may
be a better choice for retirees who are frequently on the move.

Diverse Transportation Options

For long-term planners, it is important to
consider the availability of transportation options outside of using your own
car, such as public transportation, taxis or services like Uber, or volunteer
services from non-profit organizations. Is the location walkable and
accessible? An important part of planning involves less dependency on your own
ability to drive a car. Being isolated in the suburbs could accelerate any
decline experienced, and this can subsequently make a move more difficult. The
aging process will slowly reduce mobility. Moving with long-term needs in mind
will increase your chances of aging in place and maintaining quick access to
important medical care.

Considerations for Settling More Permanently in a Home

Many retirees have family, community ties, and
friendships that they do not wish to leave behind. Many have significant
memories and good feelings about their homes and wish to maintain this
stability and familiarity. A home can be an important part of one’s emotional
identity, so many choose not to leave that anchor behind. Homeowners tend to
take pride in ownership and might not care to go through the moving process
again. New technologies and the possibility of renovating one’s home can also
make aging in place easier than in the past. After considering the points from
the previous section, most retirees will decide that the best option is to
remain in place in retirement. We look now at some issues to help ensure the
best outcomes for this decision.

Aging in Place

Staying at home over the long-term requires
anticipating future potential needs related to physical and cognitive limitations
and making sure that life can continue comfortably at the same home. Aging in place refers to the growing industry
around helping members of the aging population remain in their homes despite
functional or cognitive impairments. New technologies and services are always coming
on the market designed to support those wishing to age in place. By renovating
an existing home to age in place, retirees can maintain familiarity and
comfort, delaying or potentially avoiding any future move to institutional
settings.

Merrill Lynch and AgeWave conducted a survey
of retirees aged fifty and older and found that 85 percent viewed their own
home as the preferred location for receiving long-term care. Beyond this, 10
percent were looking at assisted living facilities, 4 percent considered moving
in with other family members, and 1 percent expressed interest in nursing
homes. Home care is often the more desirable and less expensive option, and it
can be extended with sufficient planning. As well, government agencies have
expressed support for the idea and have promoted the concept, as aging in place
often requires less contribution from government programs like Medicaid than do
nursing homes or assisted-living facilities.

Professionals can provide guidance about
specific home renovations to better support aging in place. Universal design
features and other characteristics that can lay a stronger foundation for aging
in place include:

·
Walk-in showers, grab bars, and other bathroom safety features

·
Single-floor living with no stairs (kitchen, bathing facility,
and bedroom are all on one floor), or an elevator allowing access to other
floors

·
Wheelchair accessibility: ramps to the home, wide doors and
hallways that can fit a wheelchair, and at least one wheelchair-accessible
entrance to the home

·
Levers for door handles and faucets rather than a twisting knob

·
Good lighting in case sight is diminished

·
Accessible cabinets and closets as well as lowered counters to
allow for cooking while sitting

·
Softened non-skid flooring to help cushion any falls, but no rugs
or other floor items that could create a tripping hazard

·
Accessible electric controls and switches that are not too high
off the ground

·
New technologies to monitor health status and medicine use

The planning required to age in place offers
several potential paths depending on your specific desires and needs. If you
stay put, renovating your home can make it livable even if you have physical or
cognitive impairments. If you move, you can look for a new home with the
necessary renovations already in place and a community where many types of care
are readily accessible. By ensuring that these steps are taken, it will be
easier to avoid future health-related moves, which is an important goal for
most retirees.

Generating Income Through the Home

For those seeking additional income, there are
a few options that can be considered with one’s primary residence. For extra
income, a room or a portion of the home could be rented to a traditional
renter. One might even add a rental apartment to the home, such as above a
detached garage. On a short-term basis and when allowed by local regulations,
this type of approach could also be used with services such as Airbnb. Such an
approach will not be for everyone, but some retirees may desire the potential
for more social interactions that could occur with additional people in the
home.

Carrying a Mortgage into Retirement

More Americans are now entering retirement
while still carrying a mortgage. In 2014 (which remains their most recent study
of this), the Consumer Finance Protection Bureau reported that the percentage
of Americans aged sixty-five and older with a mortgage rose from 22 percent in
2001 to 30 percent in 2011—a rise from 3.8 million to 6.1 million. Among
individuals over seventy-five, those who still had mortgages rose from 8.4
percent to 21.2 percent. This is consistent with the Merrill Lynch and Age Wave
survey which determined that 81 percent of the respondents owned their homes,
and among homeowners, 28 percent still held a mortgage.

For those approaching or already in retirement
with a mortgage, it is worth considering whether to accelerate payments on the
mortgage. This decision involves the general points made about pre-paying a
mortgage earlier in life, but the decision may come out differently as the
nature of investment risk and volatility grows as one approaches retirement.
Another option is to refinance a mortgage into a reverse mortgage, which we
consider later in the chapter.

When we think about risk tolerance and asset
allocation in a broader perspective beyond just an investment portfolio, a
mortgage is effectively a “negative bond.” It represents a bond you have issued
instead of a bond you own. Instead of receiving interest like a typical bond,
interest is charged to the borrower on the outstanding mortgage balance at the
rate set by the mortgage. Paying down mortgage principal means reducing the
amount of “assets” held that pay a negative interest rate. In other words, it
can be viewed as investing in an asset yielding a rate of return equal to the
mortgage rate. A mortgage is a liability, of course, so this is just a
theoretical exercise to think more broadly about the mortgage decision.

Consider a very basic example of a fixed rate
mortgage with a 3.5 percent interest rate. After making my obligated mortgage
payment, suppose I have an extra $1,000. For this example, there is already an
established emergency fund and no other debt, such as credit cards or student
loans, with higher interest rates. If I use the $1,000 to make a voluntary
principal payment on the mortgage, it reduces my interest growth on $1,000 of
principal on an annual basis by 3.5 percent. I can compare that to other
investment alternatives. If I were to invest that $1,000 in a CD paying 1
percent, then I would be better off paying down the mortgage instead. If there
were another safe investment paying 6 percent, then I would be better off
investing in the asset earning 6 percent instead of voluntarily pre-paying down
the mortgage balance that would “earn” 3.5 percent.

An important consideration, though, is that
the potential to earn a higher return than the mortgage interest rate will
generally require accepting risk. There will rarely be a safe investment
earning more than mortgage interest rates, except perhaps if someone locked in
a mortgage at a low rate and then interest rates later rise.

When it involves taking risk, the decision to
pre-pay a mortgage requires a consideration of risk tolerance. Holding a mortgage
means holding a negative bond and leveraging the home equity to seek the
potential for a higher investment return. The asset allocation is effectively
more aggressive with a mortgage. Risk tolerance guides this pre-pay decision,
with the understanding that risk tolerance can decline at retirement, and
investment volatility can have a bigger impact at retirement with the amplified
sequence-of-return risk that distributions create.

Another factor impacting those near retirement
is the decline in human capital. Income from working is often also viewed as a
more bond-like asset. Pre-paying a mortgage can serve to reduce the overall
risk of the household balance sheet to align better with the risk tolerance as
one approaches retirement and has less bonds in the form of human capital.
Psychologically, this can also make near retirees more comfortable to know that
the stress of paying a mortgage is no longer an issue.

As well, once work stops, paying a mortgage
requires taking distributions from assets. If this involves distributions from
a tax-deferred account, then adjusted gross income may be increased in ways
that cause other undesired tax consequences, such as triggering taxes on Social
Security benefits. Tax planning for retirement will be considered in much
greater detail in the next chapter.

Another matter relates to the potential tax
advantages of holding a mortgage. Interest on acquisition debt, which is debt
to build, acquire, or substantially improve a home, can be deducted. But to be
deductible, itemized deductions need to exceed the standard deduction. After
the changes to the tax code made in late 2017, it has become increasingly
difficult to itemize. When the standard deduction is taken, there is no tax
benefit provided from mortgage interest deductibility. Even when one itemizes,
only the amount that exceeds the standard deduction is receiving any real tax
benefit.

As well, individuals must understand that the
portion of mortgage payments allocated to interest declines with mortgages as
the principal is re-paid. An example of this is shown in Exhibit 9.1, in which
a $300,000 home is purchased with a 30-year fixed 3.5 percent rate mortgage and
a 20 percent down payment. Annual mortgage payments sum to $13,049.12, and
initially a large portion of payments are for interest on the loan balance. As
time passes, interest payments decrease as the balance gets smaller, and a
larger portion of the payment is used to cover principal. Late in the mortgage
period most of the payments are for principal and are not deductible. This
reduces potential to receive a tax benefit from the mortgage over time.
Retirees with a mortgage may find that this large expense in early retirement
forces them to take portfolio distributions that they may have otherwise avoided,
which can also avoid tax headaches.

Exhibit 9.1

Interest Portion of Mortgage Payments for Fixed
3.5% Rate 30-Year Mortgage on a $300,000 Home with 20% Down Payment

Reverse Mortgages

After considering other housing options, if you
have decided to remain in an eligible home (or move into one), you may want to
consider a Home Equity Conversion Mortgage (HECM–pronounced “heck-um”). These are
commonly known as reverse mortgages. This is another topic that I have written
a full book about. Here I am providing a brief overview of my first book, Reverse
Mortgages: How to use Reverse Mortgages to Secure Your Retirement, which is
available for those seeking a deeper dive.

Reverse mortgages have a relatively short
history in the United States, originating with a Maine bank in 1961. The 1987
Housing and Community Development Act saw the federal government systemize
reverse mortgages through the Home Equity Conversion Mortgage program under the
auspices of the US Department of Housing and Urban Development (HUD).

Today, most reverse mortgages in the United
States are HECM reverse mortgages, which are regulated and insured through the
federal government by HUD and the Federal Housing Authority (FHA). Options
outside of the federal program are becoming more common, such as jumbo reverse
mortgages for amounts exceeding federal limits. As well, there are fixed-rate
HECMs without a line of credit option. But I will focus here on the most common
type of reverse mortgage: the variable-rate HECM.

In the past, any discussion of reverse
mortgages as a retirement-income tool typically focused on real or perceived
negatives related to traditionally high costs and potentially inappropriate
uses of funds. These conversations often included misguided ideas about the
homeowner losing title to the home and hyperbole about the “American Dream”
becoming the “American Nightmare.” Reverse mortgages have been portrayed as a
desperate last resort option.

However, recent developments have made it
harder to dismiss reverse mortgages outright. Especially, since 2013, the
federal government has been refining regulations for its HECM program to improve
the sustainability of the underlying mortgage insurance fund, to better protect
eligible nonborrowing spouses, and to ensure that borrowers have sufficient
financial resources to continue paying their property taxes, homeowner’s
insurance, and home-maintenance expenses. The thrust of these changes has been
to ensure that reverse mortgages are used responsibly as part of an overall
retirement-income strategy rather than to fritter away assets.

On the academic side, recent research articles
have demonstrated how responsible use of a reverse mortgage can enhance an
overall retirement-income plan. Importantly, this research incorporates
realistic costs for reverse mortgages, both in relation to their initial
up-front costs and the ongoing growth of any outstanding loan balance.
Quantified benefits I describe here are understood to exist only after netting
out realistic costs associated with reverse mortgages.

Reverse mortgages give responsible retirees
the option to create liquidity for an otherwise illiquid asset, which can, in
turn, potentially support a more efficient retirement-income strategy (more
spending and/or more legacy). Liquidity is created by allowing homeowners to
borrow against the value of the home with the flexibility to defer repayment
until they have permanently left the home.

Regarding the intuition for why reverse
mortgages may be a useful tool, we have described how retirees must support a
series of expenses—longevity and lifestyle spending goals, unexpected
contingencies, legacy goals—to enjoy a successful retirement. Suppose that
retirees only have two assets—beyond Social Security and any pensions—to meet
their spending obligations: an investment portfolio and home equity. The task
is to link these assets to spending obligations efficiently while also
mitigating retirement risks like longevity, market volatility, and spending
surprises that can impact the plan.

The fundamental question is this: How can
these two assets work to meet spending goals while simultaneously preserving
remaining assets to cover contingencies and support a legacy? Spending from
either asset today means less for future spending and legacy. For the
portfolio, spending reduces the remaining asset balance and sacrifices
subsequent growth on those investments. Likewise, spending a portion of home
equity surrenders future legacy through the increase and subsequent growth of
the loan balance. Both effects work in the same way, so the question is how to
best coordinate the use of these two assets to meet spending while also preserving
reserves and legacy.

When a household has an investment portfolio
and home equity, the “default” strategy tends to value spending down investment
assets first and preserving home equity, with the goal of supporting a legacy
through a debt-free home. A reverse mortgage is viewed as an option, but it is
only a last resort once the investment portfolio has been depleted and vital
spending needs are threatened.

Recent research on this matter has generally
found this conventional wisdom constraining and counterproductive. Initiating
the reverse mortgage earlier and coordinating spending from home equity
throughout retirement can help meet spending goals while also providing a
larger legacy. That is the nature of retirement-income efficiency: using assets
in a way that allows for more spending and/or more legacy.

Legacy wealth is the combined value of any
remaining financial assets plus any remaining home equity after repaying the
reverse-mortgage loan balance. Money is fungible, and the specific ratio of
financial assets and remaining home equity is not important. In the final
analysis, only the sum of these two components matters. For heirs wishing to
keep the home, a larger legacy offers an extra bonus of additional financial
assets after the loan balance has been repaid. The home is not
lost.

While taking money from the reverse mortgage
reduces the home-equity component, it does not necessarily reduce the overall
net worth or legacy value of assets. Wanting to specifically preserve the home
may be a psychological constraint which leads to a less efficient retirement.

There are two potential benefits involved in
obtaining a reverse mortgage earlier in retirement that offer the potential to
improve retirement efficiencies despite their costs. First, coordinating
withdrawals from a reverse mortgage reduces strain on portfolio withdrawals,
which helps manage sequence-of-return risk. This is the buffer asset concept at
work; reverse mortgages sidestep the sequence risk created by spending from a
volatile portfolio by providing an alternative source of spending after market
declines. If not used as a buffer asset, continually funding part of retirement
spending from the reverse mortgage reduces the distribution rate from remaining
assets and a lower distribution rate means less exposure to sequence risk.

The second potential benefit of opening the
reverse mortgage early—especially when interest rates are low—is that the
principal limit or borrowing capacity will continue to grow throughout
retirement. Reverse mortgages are nonrecourse loans, meaning that even if the
loan balance is greater than the subsequent home value, the borrower does not
have to repay more than the home is worth. Sufficiently long retirements carry
a reasonable possibility that the available credit may eventually exceed the
value of the home, especially if the home value stagnates. The borrower and/or
estate will not be on the hook for repaying more than the value of the home
when the loan becomes due. In these cases, mortgage-insurance premiums paid to
the government are used to make sure that the lender does not experience a
loss. This line-of-credit growth is one of the most important and confusing
aspects of reverse mortgages.

Research reveals the possibility of sustaining
a spending goal while also leaving a larger legacy at death. Strategically
using home equity can lead to a more efficient strategy than the less flexible
option of viewing the home as the legacy asset that must not be touched until
everything else is gone. This analysis provides a way to test whether the costs
of the reverse mortgage—in terms of the up-front costs and compounding growth
of the loan balance—are outweighed by the benefits of mitigating sequence risk.
Strategic use of a reverse-mortgage line of credit is shown to improve
retirement sustainability, despite the costs, without adversely impacting
legacy wealth. Next, we will consider how this all works.

How the HECM Program
Works

There are many aspects involved in understanding
how reverse mortgages work. We will consider the eligibility requirements, how
the borrowing capacity is determined, the upfront and ongoing costs for using a
reverse mortgage, the spending options, why the line of credit for a HECM
grows, why it generally makes sense to open a reverse mortgage line of credit
before it may be needed, and repayment and tax issues for reverse mortgages.

First, basic requirements to become an
eligible HECM borrower include:

·
age (at least sixty-two)

·
equity in your home (any existing mortgage or loan can be
refinanced with HECM proceeds)

·
financial resources to cover tax, insurance, and maintenance

·
no other federal debt

·
competency

·
receipt of a certificate from an FHA-approved counselor for
attending a personal counseling session on home-equity options

HUD provides a list of approved counselors on
its website. For your property to be eligible, it
must:

·
serve as your primary residence

·
meet FHA property standards and flood requirements

·
be an FHA-eligible property type

·
pass an FHA appraisal

·
be maintained to meet FHA health and safety standards

If your home does not meet all standards, some
home improvements may also be required before you can initiate a reverse
mortgage. As well, the obligations to pay property taxes, homeowner’s
insurance, and home maintenance should not be viewed as extraordinary, as they
are required for any type of mortgage. This protects the lender by keeping up
the value of the collateral for the loan.

Next, consider how the initial borrowing
capacity for the HECM is determined. The principal limit
represents the credit capacity available with a HECM reverse mortgage. It is
based on the principal limit
factor (PLF) table published by HUD. The table shows the percentage of the home
equity up to the lending limit that can be accessed initially. Because
HECMs are nonrecourse loans, the principal limit that can be borrowed must be
less than the home’s value to reduce the potential for the loan balance outgrowing
it. The available credit amount is determined primarily by the appraised home
value, the homeowner’s age (or, for couples, the age of the younger eligible
spouse—and one spouse must be at least sixty-two), a lender’s margin, and an
expected interest rate that has been the ten-year LIBOR swap rate but is
currently undergoing a transition to Treasury rates. The PLF determines the
borrowing amount as a percentage of the appraised home value, up to the FHA
mortgage limit of $822,375. If the home’s appraisal value exceeds $822,375,
this serves as a maximum to which the PLF is applied.

When setting up a HECM, up-front costs for
reverse mortgages come in three categories. First, the mortgage lender can
charge an origination fee. These are related to the home value and are capped
at $6,000 for homes worth more than $400,000. These fees are the maximum
allowed by the government. Lenders have discretion to reduce or waive these
fees. A second source of up-front costs is the initial mortgage-insurance
premium paid to the government, which is 2 percent of the home value. Its
maximum value is $16,448 for homes appraised at or above the $822,375 limit. The
purpose of the mortgage-insurance premium is to cover the guarantees provided
by the FHA to the borrower and lender. Finally, there are traditional mortgage closing
costs. These include the costs of the FHA-mandated counseling session, a home
appraisal, credit checks, and any costs related to titling. If the appraisal
shows shortcomings of the home that could impact health or safety, then
additional home repairs may be required as part of setting up the reverse
mortgage. The up-front costs could be paid from other resources or financed
from the proceeds of the reverse mortgage loan and repaid later with interest. You
should plan to stay in your home long enough to justify payment of any up-front
costs.

The ongoing costs for a reverse mortgage
relate to the interest accruing on any outstanding loan balance, as well as any
servicing fees. Servicing fees can be up to $35 per month, though they are
generally now incorporated into a higher margin rate rather than charged
directly to the borrower. The principal limit grows over time at the effective
rate, which consists of a variable short-term interest rate such as the one-month
or one-year LIBOR rate or Treasury rate, a lender’s margin, and an annual
mortgage-insurance premium of 0.5 percent.

The short-term rates are the only variable
part for future growth. The lender’s margin rate and ongoing mortgage-insurance
premium are set contractually at the onset of the loan and cannot change. The
margin rate charged on the loan balance is the primary way that the lender—or
any buyer on the secondary market—earns revenue, especially lenders who have
forgone the origination and servicing fees. Estimates for reasonable margin
rates are generally between 1.75 percent and 4.5 percent, with higher numbers
typically being associated with lower origination and/or servicing costs.

The principal limit, loan balance, and
remaining line of credit all grow at the same variable rate. The sum of the
loan balance, line of credit, and any set-aside is the principal limit.
Interest and insurance premiums are charged on the loan balance, but not on
set-asides or the line of credit. Set-asides are not part of the loan balance
until they are used, but they limit access to the line of credit. Though
interest and insurance premiums are not levied on set-asides or the line of
credit, both components grow as if interest and premiums were charged.
This is the key.

When funds are borrowed, the line of credit
decreases and the loan balance increases. Conversely, voluntary repayments
increase the amount of the line of credit by transferring funds from the loan
balance, which will then continue to grow at the effective rate, allowing for
access to more credit later.

The overall principal limit consists of the
loan balance, remaining line of credit, and any set-asides. These factors grow
at the same effective rate, which increases the size of the overall pie over
time. If no further spending or repayment happens over time, the proportions of
each of these components of the principal limit remain the same since they all
grow at the same rate.

Having unused line of credit growth is a
valuable consideration for opening a reverse mortgage sooner rather than later.
It is also a detail that creates a great deal of confusion for those first
learning about reverse mortgages, perhaps because it seems that this feature is
almost too good to be true.

I believe that the motivation for the
government’s design of the HECM reverse-mortgage program is based on an
underlying assumption that borrowers will spend from their line of credit
sooner rather than later. Implicitly, the growth in the principal limit would
then reflect growth of the loan balance more than the growth of the line of
credit. In other words, designers assumed that the loan balance would be a
large percentage of the principal limit.

The line of credit happens to grow at the same
rate as the loan balance, and, if left unused, it can grow quite large. There
was probably never an expectation that such open lines of credit would just be
left alone for long periods. However, as I will discuss, the bulk of the research
on this matter since 2012 suggests that this sort of delayed gradual use of the
line of credit can be extremely helpful in prolonging the longevity of an
investment portfolio. This could be viewed as a financial planning trick to
create an unintended advantage through government rules.

A simple example may help illuminate the
concept further. Consider two individuals. Each opens a reverse mortgage with a
principal limit of $100,000. For simplicity’s sake, assume that ten years
later, the principal limit for both borrowers has grown to $200,000.

Person A takes out the entire $100,000
initially from the reverse mortgage (100 percent of the principal limit is the
loan balance). For this person, the $200,000 principal limit after ten years
reflects a $200,000 loan balance (the loan balance is still 100 percent of the
principal limit), which consists of the initial $100,000 received plus another
$100,000 divided between accumulated interest payments and insurance premiums.

Person B takes a different route and opens a
reverse mortgage but does not use any of the credit, so the $200,000 principal
limit at the end of ten years reflects the value fully of the line of credit.
The principal limit was still 100 percent in the line of credit. This value was
calculated with an implicit assumption that interest and insurance payments
have been accruing, even though they have not.

Person B can then take out the full $200,000
after ten years and have the same loan balance as Person A, but Person B has
received $200,000 rather than $100,000. At this point, Person B has bypassed
the accumulation of interest and insurance during that period.

Generally, opening the line of credit earlier
allows for greater availability of future credit relative to waiting until
later in retirement to start a HECM. Had Person B waited for the ten years
before opening the line of credit, that $200,000 available would have surely
been less unless the home value dramatically appreciates, or interest rates experience
a large decline during that ten-year period.

With that information in place, we can begin
looking at HECM strategies. The proceeds from the variable-rate HECM can be
taken out in any of four ways. First is a lump-sum payment. One can take out a
large amount initially, though not necessarily the full amount available.
Second, the tenure payment option works similarly to an income annuity, with a
fixed monthly payment guaranteed to be received while the borrower remains in
the home (which, to be clear, is not the same as dying, as the borrower may
leave the home while still alive or otherwise fail to meet homeowner
obligations). Tenure payments allow for additional spending from the HECM even
when the line of credit has been fully used. The mortgage-insurance fund bears
the risk that payouts and loan growth from the tenure-payment option exceed the
subsequent value of the home when the loan becomes due. This creates a type of
“mortality credits” like with an annuity. Third, the term payment is a fixed
monthly payment received for a fixed amount of time.

Finally, users have the line of credit. Home
equity does not need to be spent initially—or ever. The line of credit can be
open and left to grow at a variable interest rate as an available asset to
cover a variety of contingencies later in retirement. Distributions can be
taken from the remaining line of credit whenever desired until the line of
credit has been used in its entirety.

Repayment of a HECM loan balance may be
deferred until the last borrower or eligible nonborrowing spouse no longer meets
the terms for maintaining the loan, either through death, moving or selling the
home, or failing to maintain the homeowner’s obligations such as paying
property taxes. Prior to that time, repayments can be made voluntarily at any
point, with no penalty for early repayment, to help reduce future interest due
and allow for a larger line of credit to grow for subsequent use.

The HECM is a nonrecourse loan. The borrower
(or borrower’s estate) is not obligated to pay the lender more than the smaller
of the loan balance or 95 percent of the home’s appraised value at that time.
When the final repayment is due, the title for the home remains with the
borrower or estate. Should beneficiaries wish to keep the home, the smaller of
the loan balance or 95 percent of the appraised home value can be repaid with
other funds. Heirs can also refinance the home with a traditional mortgage
should they wish to keep it. If they decide to sell the home, they keep
anything beyond the outstanding loan balance. Should the loan balance exceed
what the home can reasonably be sold for, heirs can simply give the home to the
lender through a deed in lieu of foreclosure without worrying about selling it
themselves.

Generally, the borrower or heirs have up to
360 days to sell the home or refinance when the loan comes due, but this
requires a few extensions from the lender. If you intend to use the full 360
days, it is essential that you maintain regular contact and work with the
lender during that time.

As for taxes, distributions from reverse
mortgages are treated as loan advances and do not reflect taxable income. They
are not included in adjusted gross income and do not impact Medicare premiums
or the taxation of Social Security benefits. In this regard, proceeds from a
reverse mortgage behave the same way as Roth IRA distributions. They can
provide a way to increase spending power without pushing you into a higher tax
bracket.

A more complex area relates to eligible
deductions on interest payments for reverse mortgages. If the interest is
related to acquisition debt, it can be deductible when itemizing. Acquisition
debt is debt to build, acquire, or substantially improve a primary residence.
This includes refinancing a mortgage that was for acquisition debt. If the
reverse mortgage is used for general retirement spending, its interest will not
be deductible. Interest deductibility is also based on the year it is repaid,
not when it is incurred. This can lead to a potentially large tax deduction if
the loan balance is paid all in one year, and it is important to strategize
around making sure the deduction can provide value. For example, an interest
payment may provide the opportunity for a strategic Roth conversion to create
income that offsets the deduction.

HELOC vs. HECM

Either a traditional home-equity line of
credit (HELOC—pronounced “he-lock”) or a HECM can serve as a source
for contingency funds in retirement. Both cannot be combined on a given home.
People often think that they should just use a HELOC and not bother with a
HECM, but there are important differences to consider between the two
options.

A HELOC may have lower start-up costs, but
in most other ways the advantage is with a HECM. With a HELOC, repayments are
required sooner. Users of a HECM can voluntarily repay sooner but are under
no obligation to make any repayment while eligible for the loan.

In addition, retirees may not qualify for a
HELOC if they do not have regular income. Though HECMs added new safeguards
in 2015 to make sure that they are not used solely as a last resort by those
who have otherwise depleted their resources, the qualification requirements
are less stringent than for a HELOC. A HECM may still be available with
set-asides included to cover tax, insurance, and maintenance obligations.

A HECM also differs from a HELOC in that its
line of credit cannot be canceled, frozen, or reduced. This was a large
problem with HELOCs during the 2008 financial crisis and the global pandemic
in 2020. With a HECM, borrowers are ensured access to their line of credit. No
such protections are available with HELOCs. One also should not forget that
the principal limit and line of credit for a HECM will grow throughout
retirement, unlike the fixed amount available with a HELOC.

The HECM is noncancelable, it has flexible
payback control, and the line of credit grows over time independent of home
value. If your goal is to set up a liquid contingency fund, make sure that
you examine these important distinctions between HECMs and HELOCs.

Potential Strategies
for a HECM

With this background, we now consider the many
ways to use a HECM in retirement. Exhibit 9.2 provides a framework for
organizing potential strategies. These are ordered from ways that spend
available credit more quickly to ways that open the line of credit as a type of
insurance backstop that may never need to be tapped. We consider these in turn.

Exhibit 9:2 The Spectrum of Reverse-Mortgage Strategies

Spend Down Credit (Favors Low Margin Rate / High
Upfront Costs)

Portfolio/Debt Coordination

for Housing

Refinance an Existing Mortgage

Transition from Traditional Mortgage to Reverse
Mortgage

Fund Home Renovations to Allow for Aging in Place

HECM for Purchase for New Home

Portfolio Coordination

for Retirement Spending

Spend Home Equity First to Leverage Portfolio Upside
Potential

Coordinate HECM Spending to Mitigate Sequence Risk

Use Tenure Payments to Reduce Portfolio Withdrawals

Funding Source

for Retirement Efficiency Improvements

Tenure Payments as Annuity Alternative

Social Security Delay Bridge

Tax Bracket Management or Pay Taxes for Roth
Conversions

Pay Premiums for Existing Long-Term Care Insurance
Policy

Preserve Credit

as Insurance Policy

Support Retirement Spending After Portfolio Depletion

Protective Hedge for Home Value

Provides Contingency Fund for Spending Shocks

(In home care, health expenses, divorce settlement)

Preserve Credit (Favors High Margin Rate / Low
Upfront Costs)

First, coordinating housing-related issues
with the investment portfolio and a reverse mortgage can be a critical step in
a structurally sound retirement plan. Briefly, for those not carrying a
substantial mortgage into retirement, a simple HECM use is to fund home
renovations to better support the ability to age in place. This may help
retirees to remain in their homes for longer, reducing pressure to move into an
institutionalized setting. Other options include providing an alternative to carrying
a traditional mortgage into retirement or using the HECM for Purchase program
to purchase a new home in retirement.

As well, mortgage debt in retirement presents
an additional planning challenge. For retirement distributions, additional fixed
payments related to paying off debt create a strain for retirees due to the
heightened withdrawal needs triggering greater exposure to sequence-of-return
risk. Exposure rises because the debt payments are fixed and require greater
distributions than otherwise, so if there is a market decline early in
retirement, the portfolio is further strained as an even greater percentage of
what is left in the portfolio must be taken to meet these fixed expenses.

The general idea is that a reverse mortgage
used primarily to refinance an existing mortgage creates more flexibility for
distributions from the investment portfolio by removing a fixed expense from
household budgeting in the pivotal early-retirement years. During
preretirement, it is common to pay off the mortgage more slowly in hopes that
investment returns will outpace the borrowing costs on the mortgage. As we
discussed, this approach becomes riskier in retirement, as distribution needs
heighten the retiree’s vulnerability and exposure to market volatility.

For retirees still carrying a traditional
mortgage, two options are to use a HECM to refinance the existing mortgage and
then not worry about repaying the loan balance until it becomes due, or to use
the HECM to refinance an existing mortgage and then continue making voluntary
payments to reduce the size of the loan balance and increase the available line
of credit throughout retirement. Both options performed well in my simulations against
options to either pay off the mortgage at the start of retirement with
financial assets or to continue making payments on the traditional mortgage in
retirement from the financial portfolio, and then only treating a reverse
mortgage as a last resort option if investment assets deplete. The ability to
mitigate sequence-of-return risk by refinancing the mortgage with a HECM is
beneficial enough to offset its costs.

When purchasing a new home in retirement, the
HECM for Purchase program provides a funding option that can be compared against
alternatives such as paying cash for the home or obtaining a fifteen-year
traditional mortgage. Again, the question becomes whether the benefits created
through the HECM by reducing demands on the portfolio to pay for the retirement
home are valuable enough to offset the HECM’s costs. I have found that using
the HECM for Purchase to reduce the distribution rate from investment assets is
a powerful way to manage sequence-of-return risk that creates net advantages
after considering the reverse mortgage upfront and ongoing costs.

The second category of uses is to coordinate
spending from investment portfolios with the reverse mortgage when funding the
retirement spending goal. Sequence risk increases with higher withdrawal rates.
Drawing from a reverse mortgage has the potential to mitigate this aspect of
sequence risk for an investment portfolio by reducing the need for portfolio
withdrawals either generally, or just at inopportune times. Coordinating
potential spending with distributions from a reverse-mortgage line of credit
can be an effective way to help manage the sequence-of-return risk in
retirement. This has been demonstrated in a series of research articles since
2012 highlighting how the strategic use of a reverse mortgage can either
preserve greater overall legacy wealth for a given spending goal, or otherwise
sustain a higher spending amount for longer in retirement.

The conventional wisdom on how to treat
housing wealth in retirement was to preserve it as a last-resort asset for when
all else has failed. But this failure to coordinate home equity with the investment
portfolio or to attach a growing line of credit to home equity leads to less
efficient retirement outcomes by not fully realizing potential ways to manage
sequence risk. A reverse mortgage can reduce the need to maintain a larger cash
buffer, provide the flexibility to hold on to investments during bear markets, allow
flexibility to use home equity as a source of spending, and improve portfolio
survivorship rates without an adverse impact on legacy.

For the third category, a reverse mortgage may
be a helpful resource to support certain strategies that require paying
short-term costs to obtain long-term benefits, such as:

·
to fund the creation of a Social Security delay bridge

·
to use the tenure-payment option as an alternative to purchasing
an income annuity

·
to use the reverse mortgage as a longevity insurance alternative

·
to pay for the taxes on strategic Roth conversions

·
to help avoid falling into a higher marginal tax bracket when
sourcing income to meet spending obligations

·
to maintain an existing long-term care insurance policy by paying
insurance premiums from the line of credit

The final category of use for a HECM is to
preserve the line of credit as an insurance policy against a variety of
retirement risks. Preserving credit as insurance involves setting up a HECM as
early as possible and then leaving it unused until needed. The up-front costs
for the reverse mortgage could be treated as an insurance premium that may never
need to be used if everything else goes well in retirement. However, a variety
of potential pitfalls face retirees, and implementing a reverse mortgage
earlier in retirement could support a sizeable pool of contingency assets.
Potential insurance provided by the growing line of credit in this context
includes protection from declining home values, funds to pay for in-home care to
avoid, or at least delay, the need to move to an institution, or as a tool for
splitting the home equity in the event of a divorce.

If you think a reverse mortgage may be worth
considering, a next step can be to discuss options with a lender. Finding a
trustworthy reverse-mortgage lender is not necessarily easy for those beginning
the process, but you might seek referrals from your financial advisor, or from
friends or family who have felt satisfied with their lenders. It is important
to speak with a few different lenders and to get a sense of the range of
possibilities regarding the options in terms of up-front costs, the lender’s margin,
and ongoing costs, and whether the lender can serve as a resource to address
any servicing issues after the loan is initiated. Costs will vary and can
depend on how the loan is used: those wishing to set up a line of credit as a
later resource may have to pay a higher up-front cost than those who plan to
spend more quickly from the HECM by refinancing a mortgage. It is important to
consider more than just who offers the lowest up-front costs, because having a
personal connection to the lender can be important for any subsequent servicing
issues or questions, and because the interaction of up-front and ongoing costs
can be complicated.

Action Plan

Housing decisions are an important aspect of
retirement planning. The following action plan can ensure that housing
decisions are made to better support long-term retirement success.

o
Identify the aspects of retirement housing that are most
important

o
Begin thinking about housing options in advance of retirement and
determine whether a move will be part of your plan

o
Conduct trials in any new area to make sure that moving there is
the right decision

o
Make housing decisions in anticipation that physical and mental
impairments may happen with age that impact what you need

o
Understand how housing decisions could be impacted by long-term
care needs and how moving becomes more difficult with age

o
Some retirees will want to move frequently in retirement, while
others may wish to stay put or to only move once. Once one gets to the stage of
thinking that their current or next home will be more permanent, it is
important to consider whether:

o
The home is affordable and the home-related costs, as well as how
they may change with age, are budgeted

o
The home is near family, friends, or a social network that can
help prevent growing isolation in retirement

o
The home provides an agreeable climate with the right blend of
activities and opportunities to have an enjoyable retirement lifestyle

o
The home is in a location that supports any desired work or
volunteer opportunities

o
The home is accessible to health facilities and long-term care
opportunities

o
The community provides a diverse set of transportation options beyond
self-driving

o
Home renovations are done to support aging in place

o
For those owning an eligible home, consider whether it is
worthwhile to incorporate a HECM early on as part of an overall strategy rather
than treating it as a last-resort option

Further Reading

Center for Retirement Research at Boston College. 2014. Using Your House for Income in Retirement.

Coughlin, Joseph F. 2013. “3 Questions Predict Future
Quality of Life.” MarketWatch RetireMentors Series
(April 17).

Giordano, Shelley. 2019. What’s the
Deal With Reverse Mortgages? 2nd Edition. Washington, DC: Rethink
Press.

Green, Richard. 2013. “Who Moves? Not Old People.” Forbes (July 23).

Merrill Lynch and Age Wave. 2015. “Home in Retirement:
More Freedom, New Choices.”

Pfau, Wade D. 2018. Reverse Mortgages: How to Use
Reverse Mortgages to Secure Your Retirement. 2nd Edition. McLean,
VA: Retirement Researcher Media.

Sacks, Barry H., and Stephen R. Sacks. 2012. “Reversing
the Conventional Wisdom: Using Home Equity to Supplement Retirement Income.” Journal of Financial Planning 25
(2): 43–52.

Salter, John R., Shaun A. Pfeiffer, and Harold R.
Evensky. 2012. “Standby Reverse Mortgages: A Risk Management Tool for
Retirement Distributions.” Journal of Financial Planning 25 (8): 40–48.

Chapter 10:
Tax Planning for Efficient Retirement Distributions

Tax planning for retirement is as complicated
as the ever-expanding tax code might suggest. But applying some key principles
can lay a foundation for more tax-efficient distributions that will prolong the
sustainability of retirement assets. These efficiencies result from the progressive
tax system used in the United States. Tax rates increase with income, such that
managing taxable income in a strategic manner over time can help with paying
taxes when tax rates are low, while avoiding the need to realize more taxable
income when tax rates are high. Tax planning can help improve the efficiency of
a portfolio distribution plan by taking advantage of tax diversification, asset
location, and tax bracket management. With the complicated tax code, there are
many pitfalls and opportunities to consider, and this chapter provides an
overview of tax-related issues for retirement distributions.

Incorporating tax planning is a very important part of
building an efficient portfolio distribution strategy. For those still in the
pre-retirement years, we will discuss how to set up investments for tax
efficiency in retirement. After that, we move into managing taxes during
retirement. We will consider how to get more spending power without pushing the
tax bill too high, and how to take advantage of any leftover tax bracket
capacity. This discussion is about strategically controlling taxes to pay them
at times when the marginal tax rate is lower. This often involves front-loading
some tax payments in retirement, which becomes another example of short-term
sacrifice for long-term gain.

We will finish the discussion by also including the impact
of taxable income on Social Security and Medicare premiums and consider some
other tax strategies to lay the foundation for enhanced after-tax spending.
This discussion is meant as an overview of tax considerations and does not
consider every nuance of the tax code. While we highlight big picture issues,
you should also rely on a tax professional to help develop and confirm specific
tax strategies.

The Basics of Income Taxes

Like many countries, the United States has a progressive tax
system. This means that the income tax bill increases in a more than
proportional way as income increases. Because this process starts fresh for
each tax year, it is the foundation for strategizing about greater tax
efficiency in retirement.

Tax Brackets, Marginal Tax Rates, and Effective
Tax Rates

When considering taxes, we must distinguish between marginal
tax rates and effective tax rates. The marginal tax rate is tax paid on last
dollar of income. It will be higher at larger taxable incomes due to the
progressive tax rates. Generally, it is the tax bracket that your taxable
income reaches, though there can be exceptions when more income uniquely also makes
Social Security taxable, increases the premiums for Medicare, or eliminates
one’s ability to qualify for various tax deductions or tax credits. When
looking at an additional dollar of income, it is the marginal tax rate that
matters.

We will focus on federal income taxes, but many states have
their own progressive income tax frameworks that would apply on top of federal
income taxes. Some states with income taxes do offer relief for certain types
of retirement income, such as Social Security benefits or pension payments. For
states with income taxes, these same principles will apply as with federal income
taxes, and the advantages of strategic tax planning can be even greater.

To figure out what marginal tax rates apply to income, we
must consider the tax filing option. The five filing options in the United
States are:

1.      Single

2.      Married
Filing Jointly

3.      Married
Filing Separately

4.      Head
of Household

5.      Qualifying
Widow(er) with Dependent Children

Our discussion will focus on the single or married filing
jointly options, as these are likely the most relevant for retirees. The filing
option does not affect the tax rates, but it does affect the income brackets on
which the tax rates are applied. The current structure for marginal tax rates was
created by the Tax Cuts and Jobs Act (TCJA), which was passed in December 2017.
The tax rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Exhibit 10.1 shows the tax rates and the taxable incomes to
which they are applied for singles and those married and filing jointly in 2021.
These taxable income thresholds represent the tax brackets for federal income
taxes. This system has applied for taxable income since 2018. Each year the thresholds
for each tax bracket tend to get adjusted upward slightly to account for
inflation. The equivalent tax brackets for married individuals filing jointly
are higher than for singles. This accounts for the larger household size. In most
cases, the tax thresholds for couples are double those for singles. The tax
filing status is based on marital status and family situation at the end of the
tax year, but one exception is that it is possible to file as married filing
jointly for a final time in the year of a spouse’s death.

Exhibit 10.1

Federal Income Tax Brackets and Rates in 2021

Tax Rate for Taxable Income Over:

Tax Rate

Single Individuals

Married Filing Jointly

10%

$0

$0

12%

$9,950

$19,900

22%

$40,525

$81,050

24%

$86,375

$172,750

32%

$164,925

$329,850

35%

$209,425

$418,850

37%

$523,600

$628,300

This tax regime will remain until 2026, when taxes are
scheduled to revert to their pre-TCJA levels. The tax rates and brackets were
higher before, and it is a common belief that tax rates are currently as low as
they will ever be. Therefore, it is a good idea to anticipate a larger tax
burden in the future to fund the growing government debt.

Exhibit 10.2 provides details about what the tax rates and
tax brackets would have been in 2018 before and after the TCJA. This is the
regime set to resume in 2026 with inflation adjustments made to the numbers. This
exhibit reveals the impact of inflation in the comparison between the higher
tax brackets from 2021 to their 2018 values. That difference is accounted for
solely by the three years of inflation adjustments in 2019, 2020, and 2021, compared
to 2018. As for the previous law set to resume, the tax rates applied to
different income levels were mostly higher, and these will also surely be
adjusted for inflation when they are re-introduced as scheduled in 2026.

These exhibits provide the marginal tax rates applied to
various tax brackets. The taxes due and the effective tax rate are determined
by adding up the taxes paid for each portion of income up to its total level.
Effective tax rates can be much less than marginal tax rates. The typical way
to define effective tax rates is the total taxes paid divided by taxable
income. In retirement, though, we might consider other ways to define an
effective tax rate, such as taxes paid divided by total spending. This is because
spending is what retirees care about, rather than the precise definition of
taxable income. Many assets provide spending to retirees without increasing
taxable income. Making the adjustment to consider taxes relative to spending
may be a more meaningful way to understand the tax efficiency of a strategy.

Exhibit 10.2

Federal Income Tax Brackets and Rates with the Tax
Cuts and Jobs Act

Tax Rate for Taxable Income Over:

New Tax Brackets in 2018

Pre-TCJA Tax Brackets for 2018,

Set to Resume in 2026

Tax Rate

Single Individuals

Tax Rate

Single Individuals

10%

$0

10%

$0

12%

$9,525

15%

$9,525

22%

$38,700

25%

$38,700

24%

$82,500

28%

$93,700

32%

$157,000

33%

$195,450

35%

$200,000

35%

$424,950

37%

$500,000

39.6%

$426,700

Tax Rate

Married Filing Jointly

Tax Rate

Married Filing Jointly

10%

$0

10%

$0

12%

$19,050

15%

$19,050

22%

$77,400

25%

$77,400

24%

$165,000

28%

$156,150

32%

$315,000

33%

$237,950

35%

$400,000

35%

$424,950

37%

$600,000

39.6%

$480,050

Exhibit 10.3 shows how to calculate income taxes for a
single filer in 2021. The idea is that total income taxes due increase as
different tax rates are applied to different portions of the income. For
example, consider a single filer in 2021 with $164,926 of taxable income. This
is $1 into the threshold above $164,925, which is in in the 32 percent tax
bracket. Accounting for the lower tax rates before that point, the tax bill is
$33,603.00 for income below that bracket plus another 32 cents for the last
dollar of income. The total federal tax bill is $33,603.32. As a percentage of
taxable income, this is an effective tax rate of $33,603.32 / $164,926 = 20.4
percent. With the progressive tax code, the effective rate is generally the
same or less than the marginal tax rate. In this example, we are defining the
effective tax rate in terms of taxable income, but this is not the most
relevant consideration for retirees. When we know the total spending for the year,
we might also investigate the effective tax rate as a percentage of total
spending.

Exhibit 10.3

Federal Income Taxes Due for Single Filers in 2021

Tax Rate

Single Individuals

Taxes Due

10%

$0

$0

plus 10% of income over $0

12%

$9,950

$995.00

plus 12% of income over $9,950

22%

$40,525

$4,664.00

plus 22% of income over $40,525

24%

$86,375

$14,751.00

plus 24% of income over $86,375

32%

$164,925

$33,603.00

plus 32% of income over $164,925

35%

$209,425

$47,843.00

plus 35% of income over $209,425

37%

$523,600

$157,804.25

plus 37% of income over $523,600

Determining Taxable Income

To understand tax planning, it is also important to
understand how taxable income is determined and how it relates to total income
and adjusted gross income. These are different types of income as defined in
the tax code.

We start with total income. It includes
salary and wages, self-employment income, interest income, dividend income,
rental or other passive income, and short-term capital gains. Total income also
includes retirement specific income sources such as distributions from
qualified tax-deferred retirement plans, pension income, a portion of distributions
from non-qualified annuities, and a portion of Social Security benefits. As
well, qualified dividends and long-term capital gains also count as part of
total income, but they are subject to a different set of tax rates that we will
discuss momentarily. There are some other minor income categories as well. Other
issues for total income include that wages, salary, and self-employment income also
require payroll taxes to cover Social Security and Medicare, in addition to
income tax. As well, some bonds provide interest that is tax exempt, and interest
from Treasury bonds is subject to federal income tax, but not state or local
income tax.

From total income, we subtract any above the line tax
deductions to get to adjusted gross income (AGI). Common above-the-line
deductions include contributions up to limits made to tax-advantaged retirement
plans such as Individual Retirement Accounts (IRAs) and 401(k)s, but not their
Roth counterparts, contributions to Health Savings Accounts, the deductible
part of the self-employment payroll tax, and student loan interest deductions. There
are several other less common above-the-line deductions as well. Removing these
deductions leads to AGI:

Adjusted gross income = total income – above-the-line
deductions

The AGI is an important measure, as there are various
modified adjusted gross income measures (MAGI) based on AGI used to calculate
related taxes and subsidies such as the portion of taxable Social Security,
Medicare premiums, Affordable Care Act health care plan subsidies, and so
forth. The definition of MAGI varies for almost every application in which it
shows up in the tax code, but it generally involves adding a few items to AGI
that are not part of the AGI definition. The subsequent below-the-line
deductions we discuss can reduce taxable income but not AGI, and therefore do
not reduce exposure to these auxiliary tax issues. But one has some control
over AGI by contributing to savings plans that provide tax deductions or by
limiting distributions from accounts that generate taxable income.

From AGI, we subtract the below-the-line deductions to calculate
taxable income. Below-the-line deductions equal the larger of two options: the
standard deduction amount or the total of allowed itemized deductions. Subtracting
the larger of these choices leads to taxable income:

Taxable income = adjusted gross income – below-the-line
deductions

Taxable income is the amount used in the previous exhibits
to calculate the taxes due. The Tax Jobs and Cuts Act of 2017 raised the
standard deduction and removed exemptions. The standard deduction amount in 2021
is $12,550 for individuals and $25,100 for married couples filing jointly. An additional
standard deduction amount for those aged 65 and older or the blind is $1,700
for singles and $2,700 for married filing jointly.

If itemizing deductions can allow for values that exceed these
standard amounts, then itemizing will reduce taxable income. However, with the
increase in the standard deduction, fewer households will likely benefit from
itemizing in the future. As well, changes in the Tax Cuts and Jobs Act make
itemizing harder by reducing options.

First, the home
mortgage interest deduction has been modified. One may only deduct interest on
acquisition indebtedness – a mortgage used to buy, build, or substantially
improve one’s home - up to $750,000 for joint filers. For mortgages taken out
before December 15, 2017, the limit is $1,000,000 for joint filers. Keep in
mind, as retirement approaches, mortgage debt is less likely; those who have
mortgage debt typically plan to pay it off soon. As well, because a larger
portion of the payment is applied to principal as a mortgage gets closer to
pay-off, there is less to potentially deduct.

Next, a significant change also took place
with state and local taxes. Deductions for
state and local sales, income, and property taxes remain in place but are now
limited. The cap on claiming for all state and local sales, income, and
property taxes together may not exceed $10,000 for joint filers. As for
medical and dental expenses, the
"floor" is 7.5 percent of AGI in 2021. The portion of qualifying
medical expenses that exceeds 7.5 percent of AGI are the only deductible part
of those expenses that can count as an itemized deduction. Finally,
charitable donations are another important deduction category. Charitable donations are also only deductible
up to certain limits as a percentage of AGI.

A final note is that for high-income taxpayers
who itemize their deductions, the Pease limitations previously capped or
phased out certain deductions. Under the current tax law, these Pease
limitations no longer apply, but they could return along with personal
exemption phaseouts when the pre-2018 tax regime returns as scheduled in 2026.

We have discussed the categories for below-the-line
deductions. To be clear, they only provide value when their total exceeds the
standard deduction. If the standard deduction is larger than the itemized
deductions, then the itemized deductions do not have any impact and do not help
to reduce the tax bill. They are effectively wasted in this regard. This
creates room for some planning strategies such as deduction bunching that we
will consider in greater detail later in the chapter. This situation is the
first of several nonlinearities in the tax code we address in this chapter that
make planning more important. By a nonlinearity, I mean that the impact varies
in a way that is not a straight line. The nonlinearity for deductions is that
they have no impact when they add up to less than the standard deduction, and
that only the portion of itemized deductions exceeding the standard deduction
creates any real value to reducing taxes.

Payroll Taxes

There are a few more related issues to
consider. If you continue to work in retirement – in the form of salary, wages,
or self-employment income – you must pay payroll taxes. They are not
applied to other sources of total income. For salary and wages,
the tax is split between the employee and employer. It is 6.2 percent for
Social Security and 1.45 percent for Medicare. This totals 7.65 percent from
each. For the self-employed, the full amount must be paid by the individual, adding
up to 15.3 percent of these income sources. The portion of the payroll
tax that applies to Social Security is only charged on up to the maximum wage
base limit, which is $142,800 in 2021. The Medicare portion of the tax applies
to these income sources without a cap and there are additional surcharges at
higher income levels. Payroll taxes will continue to impact earned income if paid
work continues during retirement.

Taxes for Long-Term Capital Gains and Qualified
Dividends

As mentioned, special tax rates
apply for qualified dividends and long-term capital gains (LTCGs). Exhibit 10.4
shows the tax rates and tax brackets for these income sources in 2021. Capital
gains are realized when an asset is sold for more than its cost
basis, which is usually closely related to how much was paid for the asset
including its purchase price and any brokerage commissions. Regarding long-term
vs short-term capital gains, the difference is that long-term gains are for
assets held for more than one year and short-term gains apply for assets held
less than a year. LTCGs are taxed at lower rates, and they are only taxed when
realized. This is a benefit gained from holding the security for at
least a year. Mutual fund owners may find that their tax forms include capital
gains even when no shares were sold, because the underlying funds may be buying
and selling securities throughout the year.

Exhibit 10.4

Federal Tax Rates for Qualified Dividends and Long-Term
Capital Gains in 2021

Tax Rate for Taxable Income Over:

Tax Rate

Single Individuals

Married Filing Jointly

0%

$0

$0

15%

$40,400

$80,800

20%

$445,850

$501,600

Assets can suffer from capital losses as well as enjoy gains.
When losses and gains are realized, the method for determining taxable income
is that first any short-term losses offset short-term gains and any long-term
losses offset long-term gains. If there are net gains for both short-term and
long-term holdings, then each is added to taxable income accordingly. If one of
these categories has a net loss, then the short-term and long-term outcomes
offset each other. When the resulting value is positive, that income is taxed
according to whether it was the short-term or long-term gain that was larger. With
a net loss at the end, up to $3,000 of a capital loss may be deducted from
ordinary income in a given tax year. Any remaining capital loss can be carried
forward to deduct in future years.

If there are net gains, then we can consider how long-term
capital gains (as well as qualified dividends) are applied to the calculation
of taxable income. These preferential income sources are added to taxable
income on top of all the other taxable income sources. For example, suppose a
single individual has a taxable income of $42,000, which consists of $38,000 of
income sources taxed at regular rates and $4,000 of LTCGs and qualified
dividends. The $38,000 is taxed according to the tax schedule from Exhibit 10.3.
This individual is in the 12% tax bracket for that last dollar of income. The
remaining $4,000 is added on top of this amount and taxed with the tax schedule
in Exhibit 10.4. The first $2,400 is still in the 0% tax bracket and the
remaining $1,600 falls into the 15% tax bracket. Notice that a 0% tax rate
applies for taxable income amounts that are close to the top of the 12% federal
tax brackets. Even though the combined taxable income looks to place the
individual in the 22% federal income tax bracket, this is not the case after
separating out the income taxed at preferential rates, adding it to the top of
other taxable income, and then applying those preferential rates to this
portion of income.

Capital Gains Exclusion for Selling Home

While discussing capital gains, it is
worth mentioning another area that can impact retirees, which is the exclusion
of a portion of capital gains on the sale of a home when certain conditions are
met. Single individuals may be eligible to exclude up to $250,000 of long-term
capital gains on the sale of a home, and this can be up to $500,000 for
couples. A surviving spouse may also receive the full couple’s
exclusion for two years following a spouse’s death.

Qualifying for the full exclusion amount
requires meeting several tests. These include both an ownership and use test.
The ownership test requires being an owner of the property for at least two
years over the previous five years before the sale. The use test is similar in
terms of requiring using the home by living in it as the main home for at least
two years over the previous five years. For couples, the use test requires both
spouses to use the home while the ownership test only requires one spouse to own.
There is also an eligibility test stating that the exclusion may not have been
received for at least two years. There are exceptions to these rules including
a shorter time for the use test or being able to receive a partial exclusion if
forced to leave the home for unforeseen circumstances or due to a health or
cognitive issue that may involve the need to move to assisted living or a
nursing home. This ability to exclude potentially large capital gains on a home
sale is an important advantage of home ownership, though it is worth pointing
out that those incurring a loss on a home sale are not able to use that loss to
offset other gains.

Tax Diversification

We can now dive deeper into strategies for
obtaining greater efficiency from retirement distributions. We will start with pre-retirement
strategies designed to provide optimal preparation for
retirement. These include tax diversification and asset location.

Regarding tax diversification, investment accounts fall into three main tax categories: taxable accounts,
tax-deferred accounts, and tax-exempt accounts. As will become clear with the
discussion of planning, tax diversification will be a general goal for
retirees, as there are benefits to have some assets in each of these types of
account structures. This is beneficial because we do not know what future tax
rates will be and when we will experience events that could either lead us to
generate taxable income at low tax rates or be forced to generate taxable
income at high tax rates.

Taxable Accounts

Taxable accounts are standard brokerage accounts and bank accounts. They
are funded with after-tax money, meaning that taxes have already been paid on
any income before it is invested. Some important features of taxable accounts
include that ongoing taxes must be paid on interest and dividends as they are
received, as well as any realized capital gains from pooled investments like
mutual funds. Qualified dividends and realized long-term capital gains are
taxed at lower rates. As well, taxable accounts have a cost basis which can be
spent tax free. For legacy purposes, the cost basis receives a step-up at death
to match the value of the assets at that time, avoiding potential capital gains
tax for beneficiaries.

When selling shares, there are three options that may be
used to determine the cost basis of the shares sold. The average cost basis for
all shares can be applied, shares can be sold on a first in, first out basis
with the oldest shares being sold first, or one can specify which specific share
lots are being sold to better control the amount of capital gains generated. The
latter option provides the most flexibility to identify and control the amounts
of gains and losses, but it requires the most effort to keep track of all
purchases and reinvested interest or dividends.

Ongoing taxation on account growth is not an attractive
feature because taxes subtract from the value of the account and leave less for
subsequent growth. For a very simple example to illustrate this idea, consider
a $1,000 account that grows at a 5 percent compounded growth rate for ten
years. Consider a 20 percent tax rate on account earnings that can either be
applied on an ongoing basis or can be applied once to cumulative earnings at
the end of ten years. First, if there was no tax, the $1,000 would grow to $1,628.90
after ten years of 5 percent annually compounding growth. If a 20 percent tax is
applied to the growth just at the end of ten years, the post-tax account
balance would be $1,503.12. But if the 20 percent tax is applied annually to
earnings, the ending after-tax account balance would be just $1,480.24. The
impact would be larger as the length of the investment horizon increases, as
the investment return increases, or as the tax rate increases. Allowing for
tax-deferred growth is a valuable attribute.

Tax-Deferred Accounts

Tax-deferred accounts are qualified retirement savings accounts
such as employer-sponsored retirement plans and traditional Individual
Retirement Accounts (IRAs). Specifically, employer-sponsored retirement plans
include 401(k) plans for private for-profit employers, 403(b) plans that are
typically associated with educational institutions and other tax-exempt
organizations, 457 plans for state and local government employees and other
nonprofits, as well as the Federal Thrift savings plan at the federal
government level. Employer plans also include traditional defined-benefit plans
that structure benefits as an annuity payment to the participant. Defined benefit
plans also include profit sharing or cash balance plans. These plans are also
referred to as either employer plans or qualified plans throughout the book. As
for IRAs, this includes traditional IRAs as well as SEP or SIMPLE IRAs that can
function as employer plans but are structured more like IRAs in terms of their
options and rules. Some small employers may offer SIMPLE IRA plans instead of
401(k) plans. For the self-employed, options include SEP IRAs, a solo 401(k),
or a defined-benefit plan (though these are not common).

These plans are funded with pre-tax money, which means that money
invested in these accounts provides an above the line tax deduction to reduce
adjusted gross income for the year it is invested. Tax deductible contributions
are most common, but it is also possible in some circumstances to make
nondeductible contributions as well. Nondeductible contributions are treated as
cost basis in the plan and may be made to IRAs when income exceeds thresholds
for deductions, and some employer plans may allow for after-tax contributions
to be made as well. Life insurance cannot be held in IRAs, but it can be found
in some qualified plans.

Money, including both the deductible contributions and
account growth, is taxed upon withdrawal, generally at ordinary income tax
rates. Any nondeductible contributions from the accounts are treated as cost
basis and may be distributed without taxes. The ordinary income tax rates,
which are often higher, are applied to all taxable distributions, including what
would have been counted as long-term capital gains and qualified dividends if
the assets had been held in a taxable account.

Tax deferral has value. Allowing assets to grow tax free and
then paying once at the end, rather than chipping away at their compounding
growth potential by forcing ongoing taxes to be paid on the interest,
dividends, and gains, can frequently lead to greater after-tax values for the
assets. Though it depends on the assumptions, this is frequently true even
after considering that income which might have counted as qualified dividends
or long-term capital gains is forced to be taxed at ordinary income tax rates
when held inside of the tax-deferred account.

There are limits on contributions that can be made to these
accounts. These limits can apply both to the amount of the contribution and to
the income levels that will still allow for the deduction. In 2021, IRA
contribution limits were 100 percent of employment earnings up to a maximum of $6,000
with an additional $1,000 catch-up contribution allowed for those aged 50 and
older. One must have earned income in an amount at least equal to the
contribution. An exception is made for non-working spouses who are filing
jointly. They may contribute based on the working spouse’s earnings.

As well, the contribution only provides a tax deduction when
income falls below certain levels for those who are also eligible for a
retirement plan at work. If income exceeds these thresholds, the contribution
to the IRA can still be made, but it is not deductible. These phaseouts for
deductibility begin at modified adjusted gross incomes of $66,000 for singles
and $105,000 for couples filing jointly in 2021. If a person is not an active
participant in an employer plan but the spouse is, then the phaseout for the
non-active person begins at $198,000. For those not eligible to participate
with an employer retirement plan, the income limits do not apply.

As for retirement plans such as 401(k)s and 403(b)s,
employee contribution limits are $19,500 in 2021, with a catch-up total of
$26,000 for those who are 50 and older. Employers can also make contributions
of up to $38,500. These employer contributions may be provided independent of
any action from their worker, or they may be provided as a company match on worker
contributions that become available after meeting eligibility and vesting
requirements. There are no income limits.

If one can choose whether to contribute to an employer plan
or an IRA, there are a few issues to consider. The first detail to note is that
many employer-sponsored retirement plans will offer an employer match for a
portion of employee contributions. It is generally best to first contribute at
least enough to benefit from the full company match. Otherwise, this is free
money that will be left on the table. Beyond this, some employer 401(k) plans may
have high fees and limited investment options compared to IRA plans. As well, it
can be more difficult to tap into an employer plan while still employed. Some
may offer hardship withdrawals or participant loans, but not all plans have
this flexibility. This must be evaluated as part of the tax diversification
decision. When employment ends, options for retirement account assets include
potentially keeping them in the employer plan, rolling them over to an IRA, or
taking as a taxable distribution with possible penalties if done before age
59.5.

Tax-Exempt Accounts

Tax-exempt accounts include Roth IRAs, Roth 401(k)s, or Roth
403(b)s. They are funded with after-tax money, meaning that any income invested
in these accounts has already been taxed. The contribution limits are the same
as with tax-deferred accounts. Contributions are not tax deductible. However,
their great advantage is that no taxes are owed on qualified distributions from
the accounts. This protects investment gains from tax.

Roth IRA accounts do have income limits that may prevent
direct contributions. In 2021, the full contribution is allowed for singles
whose modified adjusted gross income is under $125,000 and for married filing
jointly cases with modified adjusted gross incomes under $198,000. Unlike with
traditional IRAs, these rules are not related to whether one is an active participant
in an employer retirement plan. Once incomes exceed these levels, Roth IRA
contributions are quickly fully phased out by MAGIs of $140,000 and $208,000,
respectively. When exceeding these limits, the IRS does allow what is known
colloquially as a backdoor Roth contribution. In this case, the individual
makes a nondeductible contribution to an IRA, waits a few days, and then
converts this amount to the Roth account. This approach works without a hitch
when any IRAs owned are otherwise empty before the contribution. Otherwise,
with other account assets, the pro-rata rules for the Roth conversion will
apply and the transaction will not be tax free. These pro-rata rules are
discussed later in the chapter.

Some employer plans may offer Roth versions. With Roth
accounts, Roth contributions are only available on employee contributions. The
employer contribution cannot be made to a Roth account.

There are no age limitations on making contributions to Roth
IRAs. One can always contribute any earned income up to the limits when incomes
are below the thresholds. With the SECURE Act passed in 2019, this is also now true
for traditional IRAs as well.

Choosing Between Tax-Deferred and Tax-Exempt
Accounts

An important part of tax diversification is that over time
it can be helpful to accumulate assets in a variety of account types to create
more flexibility about the sources of retirement spending as a control for taxes.
To plan for diversification, in any given year we must decide where to place
our savings. When deciding between tax-deferred and tax-exempt options, the goal
is to pay taxes at the time that one is subject to a lower marginal tax rate.
Tax-deferred accounts are most useful for those who may be in peak earnings
years and expect to be in lower tax brackets in the future. The idea is to get
the tax deduction today when the tax rate applied would be higher, and then pay
taxes on the distributions later at a lower tax rate.

Roth accounts have the opposite characteristic. Individuals
can pay taxes and contribute to Roth accounts today because they anticipate a
higher tax rate will be applied to their future distributions. For this reason,
Roth contributions can make sense for younger individuals who have not yet
reached their full earnings potential, as well as during years that taxable
income is unusually low. Roth contributions are also a consideration for those
who are worried that the tax code of the future could include substantially
higher tax rates than today.

The discussion here is about where to place new
contributions between tax-deferred and tax-exempt. This comparison of tax rates
now and in the future also applies to making Roth conversions for tax-deferred
assets. A Roth conversion triggers taxable income as a distribution, which is
transferred to a Roth account. This creates taxable income during the current
year but then allows subsequent qualifying Roth distributions to be made
without generating taxable income. The idea is to make Roth conversions when
the tax rate applied is relatively low compared to what it may be in the
future. This comparison also applies to the tax rates for beneficiaries who may
receive the retirement account as an inheritance.

To summarize, the conventional wisdom around choosing
between traditional and Roth accounts is that the choice does not matter if the
tax rate is the same both today and in retirement. If the tax rate will be
higher in the future, then contribute to the Roth IRA today or consider a Roth
conversion for existing tax-deferred assets, and if the tax rate will be lower
in the future, then contribute to the traditional IRA today and hold off on
making a Roth conversion.

Advantages of Tax-Exempt Accounts for
Retirement Income

There are a few reasons to consider contributing to the Roth
even if the tax rate is expected to be a bit lower in the future. First, since
the government technically has claim over part of the tax-deferred account, the
Roth allows its owner to obtain tax deferral on more assets. William
Reichenstein of Baylor University has described tax-deferred accounts as a type
of limited partnership in which the account owner really only owns (1-t)
percent of the account, and the government owns the other t percent of
the account. The t is the marginal tax rate at the time that funds are
distributed.

Rather than think of tax-deferred accounts as tax-deferred,
it is really the case that the portion of the account owned by the investor is
tax-exempt. For this portion, the owner experiences the full return and the
full risk. The issue is that the government is entitled to a share of the
distributions to be paid as taxes, and the owner of the account has some
discretion about when to take these distributions to minimize the portion of
the account that goes to the government.

Suppose someone contributing is in the 22 percent tax
bracket. She could contribute $1,000 of after-tax tax money to the Roth account
and have no current tax savings, or she could contribute $1,000 to the
traditional IRA and have $220 of tax savings. But the government will receive a
portion of the traditional IRA in the future, so the owner does not really
benefit from the full contribution amount. If the owner is still in the 22
percent tax bracket when the distribution is taken, then the owner receives 78
percent of the distribution after taxes are paid. To make up this difference, she
may invest the $220 of current tax savings in a taxable account, which is then
subject to ongoing taxes on its compounding growth potential. Investors do not
receive all the returns from assets held in taxable accounts because of this
ongoing need to pay taxes which, if paid from the investments, means that less
is subsequently retained to benefit from compounding growth. Together, this means
that even with a lower tax rate in retirement, contributing to the Roth and
having full access to the contribution and its growth could still provide net
benefits.

As well, in terms of tax diversification, Roth IRAs provide
benefits by giving access to contributions without penalty prior to age 59.5.
After age 59.5, distributions are tax free if the account has been open for at
least five years. Roth IRAs can also help to cover large, unexpected expenses
in retirement without triggering higher taxes as would be the case when pulling
from a tax-deferred account to cover an unexpected spending need. Traditional
IRA distributions count as part of adjusted gross income, as mentioned, while
Roth distributions do not show up as income at all in tax calculations. Roth
IRAs are also very efficient tools for providing legacy as they do not result
in taxable income for their beneficiaries.

While Roth accounts provide many advantages, a reason for
diversification relates to the possibility of future law changes. Roth
distributions will likely never be taxable, but Congress could enact reforms that
would reduce the value of Roth accounts. Two possibilities include adding
required minimum distributions (RMDs) for the accounts or including the
distributions in measures of modified adjusted gross income or provisional
income for determining other taxes such as on Social Security or triggering
higher Medicare premiums. With required minimum distributions, the Roth
distributions would not necessarily need to be spent, but they would have to at
least be reinvested into a taxable account and the assets would lose their tax
advantages. Already, Roth 401(k)s do have RMDs, but these can be avoided by
rolling the assets over to a Roth IRA before the year that one turns age 72.

As part of the tax diversification discussion, another
critical matter for qualified retirement accounts such as 401(k)s and IRAs is
that they will eventually be subject to required minimum distributions (RMDs)
that generate taxable income. Since the passing of the SECURE Act at the end of
2019, RMDs now begin at age 72 instead of 70.5. The CARES Act that was part of
the response to the global pandemic did temporarily remove the need to take
RMDs in 2020, but they are back in 2021. Roth IRAs do not experience required
minimum distributions during the owner’s lifetime, and this can be a very
valuable attribute for making tax-strategic distributions.

Having too much in tax-deferred accounts can provide an RMD surprise
by pushing people unexpectedly into higher tax brackets. This is the retirement
tax cliff. RMDs generate taxable income and cannot be avoided even when one has
no interest in spending these funds. This is a key reason to diversify and not
hold too much in qualified retirement plans.

Exhibit 10.5

Taxable Income Generated by Required Minimum
Distributions

IRA Balance

RMD @ 72

RMD @ 75

RMD @ 80

RMD @ 90

IRS Life Expectancy

25.6

22.9

18.7

11.4

$100,000

$3,906

$4,367

$5,348

$8,772

$500,000

$19,531

$21,834

$26,738

$43,860

$1,000,000

$39,063

$43,668

$53,476

$87,719

$2,000,000

$78,125

$87,336

$106,952

$175,439

$3,000,000

$117,188

$131,004

$160,428

$263,158

Exhibit 10.5 provides an idea about required
minimum distributions at different ages and for different account balances.
Approximately, having $500,000 in qualified plans will mean that RMDs remain
less than the standard deduction for married filing jointly couples until more
advanced ages are reached. This could be an important part of a lower overall
tax level in retirement. Besides tax diversification, this can be a
justification for tax bracket management and making Roth conversions especially
in the years before RMDs begin. Maintaining high balances in tax-deferred
accounts subject to RMDs can lead to a lot of taxable income later in
retirement that may exceed what is needed to support retirement expenses. Especially
as one ages and remaining life expectancies get shorter, the RMD percentages,
which are one divided by remaining life expectancies, increase. This triggers
more taxable income from a given account balance. Such distributions could be
reinvested into taxable accounts (as one cannot do Roth conversions on RMD
amounts), but taxes would have to be paid at higher rates than may have been
necessary with more careful planning.

Asset Location

The next important tax-planning issue is asset
location. In a similar manner to diversification between different account
structures, asset location addresses the issue of which assets should be held
in each type of account. Asset allocation addresses how to allocate the overall
financial portfolio between different asset classes like stocks, bonds, real
estate investment trusts, and so forth. Asset location addresses where
different asset classes should be held among taxable, tax-deferred, and tax-exempt
accounts.

Exhibit 10.6 ranks different assets in terms
of their tax efficiency. Determining the appropriate asset allocation should
always be considered before asset location, but once asset allocation is determined,
this exhibit prioritizes tax efficiency regarding asset location. All else
being the same, more tax efficient assets should be held in taxable accounts
and less tax-efficient assets can be held in accounts providing tax advantages.
This applies to the extent possible with the capacity constraints for each
account type.

Exhibit 10.6

The Spectrum of Tax Efficiency for Asset Classes

Most Tax Efficient

Taxable Accounts

Tax-Exempt Bonds

US Stock Index Funds

International Stock Index Funds

Cash

Actively Managed Stock Funds

Government Bond Funds

Corporate Bond Funds

Commodities

Tax-Advantaged Accounts

Real Estate Investment Trusts

Least Tax Efficient

Starting at the top, tax-exempt bonds should
always be held in a taxable account. They offer a lower yield because their tax
advantages make them more equivalent to taxable bonds on a net-of-tax basis for
those paying taxes on bond interest at higher tax rates. Placing tax-exempt
bonds in a tax-advantaged account would just lead to a lower return without any
offsetting tax benefits.

Next, stocks tend to lean toward
taxable accounts, especially index funds. They provide preferable tax treatment
for long-term capital gains and qualified dividends. Unrealized capital gains
also naturally receive tax deferral since taxes are not paid until assets are
sold. Taxable assets also provide a step up in basis at death, which eliminates
capital gains taxes for beneficiaries. They also provide the ability to harvest
losses to offset gains. And one can donate appreciated shares with the most
long-term capital gains to charities to obtain more tax benefits than just
donating cash. With capital gains taxes, the government partly shares the risk
of investing in equities in taxable accounts since capital losses reduce taxes.

For stocks, US stock index funds are listed first because
the dividend yield tends to be less than international stocks at present, which
will help to lower their ongoing taxes. Also, index funds are more tax efficient
because they involve less trading and asset turnover, resulting in less
realized capital gains on shares that one continues to own.

Next on the list is interest on cash holdings. This is
taxable, but cash tends to have low yields at present, so there may not be much
taxable interest.

Actively managed stock funds come next. They are less tax
efficient than index funds. Capital gains and losses reported by mutual funds can
differ from the change in fund value because it depends on sales of underlying
assets held in the funds. Active funds that trade more frequently will trigger
more taxes through these realized gains or losses on sales even when the fund
owner holds onto the shares. Active funds may also trigger more short-term
gains through their internal buying and selling, and these taxes are passed to
the owner of the fund.

Moving along, government and corporate bond funds are next.
More of their returns are generated through the payment of interest, and tax
deferral can help to avoid paying ongoing income taxes on that interest. This
can leave more in the account to remain invested and to grow.

Asset Location
in a Low Interest Rate World

As interest rates have fallen so low, one consequence
could be the shifting of some of the advice around asset location. Since they
pay so little in interest, bonds might also be held in taxable accounts with
minimal tax implications.

Finally, some asset classes like commodities or real estate
investment trusts are particularly known for tax inefficiency. They are good
candidates for tax-advantaged accounts.

Besides the issue of tax efficiency and placing assets into
taxable or tax-advantaged accounts, decisions must be made about the placement
of tax-advantaged assets between tax-deferred and tax-exempt accounts. When
deciding on an asset location between IRA and Roth IRAs, for instance, the suggestion
is to locate higher expected-return assets in the Roth accounts and lower
expected-return assets in traditional accounts. In this case, bonds would be
targeted first for tax-deferred accounts. A disadvantage of having stocks in
tax-deferred accounts is that their long-term capital gains and qualified dividends
that would have been taxed at lower rates, end up being taxed as ordinary income.
Instead, Roth accounts could be the place to hold less tax-efficient stocks
with high growth prospects such as small value, emerging markets, and so forth.
Such gains will not be taxed with qualifying distributions from the Roth. Holding
assets in this manner will also accommodate the withdrawal order sequencing
issue that we will address for retirement distributions as Roth distributions
will tend to happen later in retirement, facilitating a higher level of risk.

Exhibit 10.7 provides a summary of this asset location
discussion. Taxable accounts hold the most tax-efficient assets. Tax-deferred
accounts hold less tax-efficient assets with lower expected returns. Tax-exempt
accounts hold less tax-efficient assets with higher expected returns.

Exhibit 10.7

Asset Location Characteristics

Remember, asset allocation decisions comes first, even if it
means holding assets in accounts that are not necessarily suggested by our
discussion. For example, an individual portfolio may contain more bonds than
available capacity in tax-deferred accounts. This does not mean the amount of
bonds owned should be limited. Rather, it means owning bonds in taxable or
tax-exempt accounts as well. The guidelines we offer are meant as suggestions
in terms of where assets should be placed when the capacity is available, but
asset allocation should rank ahead of asset location in terms of deciding which
assets to own. When tax-inefficient assets are held in taxable accounts because
there is not enough spare capacity available in tax-advantaged accounts, there
are other financial tools that can provide additional tax advantages as we will
consider briefly in the next section.

Obtaining Tax Advantages for Taxable Assets

To summarize the tax diversification
discussion, there are three potential ways to obtain tax
advantages in the tax code:

1.      Receiving
a tax deduction for contributed funds, which reduces current taxable income.

2.      Gains
could accumulate on a tax-deferred basis.

3.      The
distribution of gains could be obtained free of additional taxes.

Tax-deferred and tax-exempt accounts provide attractive options
to consider before placing assets into a taxable account. The ongoing taxes for
a taxable account will chip away at its after-tax growth. But tax-deferred and
tax-free retirement plans have limits on how much can be contributed on an
annual basis. For those who exceed these limits, various financial tools exist
to obtain tax advantages for assets that would otherwise be held in taxable
accounts.

Exhibit 10.8 shows more about the three beneficial tax
properties and a more complete list of different types of assets that may
provide them. First, taxable brokerage accounts do not provide any of these
benefits. Qualified retirement plans provide a tax deduction and tax deferral.
Roth accounts provide tax deferral and tax-free distributions. The exhibit also
lists other potential options.

Exhibit 10.8

Tax Advantages for Different Types of Assets

Tax Deduction

Tax Deferral

Tax-Exempt

Distributions

Brokerage Accounts

IRA, 401(k), & Other Qualified Plans

Yes

Yes

Roth IRA, Roth 401(k)

Yes

Yes

529 Plans

Yes, in some states

Yes

Yes, for qualified education expenses

Health Savings Accounts

Yes

Yes

Yes, for qualified medical expenses

I-Bonds & E-Bonds

Yes

Tax Exempt Bonds

Yes, though interest is counted toward Social Security
benefit and Medicare premium taxation

Nonqualified Annuities

Yes

Cash Value Life Insurance

Yes

Yes, when structured properly

Education 529 Plans and Health Savings Accounts

Two additional tax vehicles for specific expenses include
529 plans and Health Savings Accounts (HSAs). 529 plans work similarly to Roth
accounts when used for qualified education expenses. They provide tax deferral
and tax-free distributions. And though they do not offer deductions for federal
income tax, some states do provide a deduction for state income taxes. Next,
health savings accounts are a special type of tax vehicle that can provide all
three tax benefits. This is a rarity. Health savings account contributions are
tax deductible, grow tax deferred, and can be distributed tax free for
qualified medical expenses. For other expenses, taxes must be paid along with a
20 percent penalty. At age 65, the penalty goes away when used for non-medical
expenses, but taxes will still be due, meaning the treatment is same as with an
IRA. To contribute to an HSA, you must be enrolled in a qualified high
deductible health plan. In 2021, the limits on HSA contributions are $3,600 for
individual health plans and $7,200 for family health plans. Those over 55 can
make a $1,000 additional catch-up contribution.

Fixed Income Assets with Tax Advantages

In the realm of fixed income, for individuals who have
filled their tax advantaged accounts and still seek more tax benefits on bond
holdings, additional options include I-Bonds or E-Bonds, and tax-exempt
municipal bonds. I-Bonds and E-Bonds provide tax deferral and I-Bonds provide a
real yield plus realized inflation. The interest on these bonds is taxed when
the assets are distributed. There are annual contribution limits for these
types of bonds. As well, municipal bonds pay interest that is not counted as
taxable income when determining total income. They do have an important caveat
for retirees though, as their interest is included in modified and provisional
income measures that are used to determine how much Social Security benefits
are taxed and whether additional Medicare premiums are required.

Nonqualified Annuities

Another major product category with tax advantages is the
nonqualified annuity, which offers tax deferral and can be incorporated into
financial plans in different ways. It is worth having a basic understanding
about how the taxes for annuities work when they are being used by households
as a source of ongoing spending during the owner’s lifetime. A great resource
for more in-depth treatment of annuity tax issues is John Olsen and Michael
Kitces’ book, The Advisor’s Guide to Annuities.

When it comes to basic tax treatment for annuities, we
distinguish between annuities held in nonqualified or taxable accounts, and
annuities held in qualified retirement plans such as IRAs and 401(k)s. As well,
we must distinguish between annuities that have been annuitized into a stream
of payments and annuities that remain in the deferral stage, which includes non-lifetime
distributions and lifetime distributions obtained through an optional guaranteed
lifetime withdrawal benefit.

Income annuities, including single-premium immediate
annuities and deferred income annuities, are already annuitized and provide the
ability to lock in income. Deferred annuities such as variable and index
annuities provide more flexibility because they are not annuitized. They offer
upside potential, the ability to annuitize within the contract, and many offer
an option to add a lifetime income benefit that will support guaranteed
lifetime distributions without annuitization.

In taxable accounts, the basic idea for annuities is that
distributions representing return of premium are not taxed, but distributions
representing any interest or gains through market growth or mortality credits
are taxed. Taxation occurs at the point of distribution rather than when
interest is earned, which allows for continued tax deferral for the underlying
annuity assets until distributions are made.

For income annuities and other annuitized contracts that
were purchased in a taxable account, meaning that they are nonqualified
annuities, the portion of payments representing interest and mortality credits is
taxed as income, and the portion representing the return of premium is received
tax-free. To determine how much of the annuity payment is classified as the
return of the initial premium, the IRS provides details for how long an
annuitant should expect to receive payments from the annuity. The portion of
each annuity payment considered to be a return of principal is the amount of
the premium payment divided by the total annuity income to be received during
the expected lifetime. This provides an exclusion ratio for the contract as the
portion of payments excluded from taxable income.

Once the full amount of premium has been returned as income
at the life expectancy, subsequent annuity income then becomes fully taxable
for the remaining lifetime. This process helps to defer some taxes to the
latter part of retirement after surpassing the IRS measure of life expectancy.
This concept also applies to deferred income annuities, as annuitized assets
grow tax deferred within the contract and then the exclusion ratio is applied
once payments begin. This also helps to defer tax payments into the future.

For immediate and deferred income annuities with lifetime
payments, income payments can begin before age 59.5 and are exempt from an
early withdrawal penalty. For period certain annuities that only pay for a
fixed period without a lifetime component, immediate annuities are also exempt
from the penalty, but deferred income annuities will trigger the penalty for
the taxable portion of the payments if they begin before age 59.5, unless there
is some other reason for the distributions to be exempt. We discuss early
withdrawal penalties later in the chapter.

This nature of taxation for annuitized annuity contracts can
be beneficial when combined with other strategies, such as Roth conversions,
that lead to generating more taxable income in early retirement to take
advantage of the exclusion ratio, so that there can be less taxable income from
other sources later in retirement when the annuity income switches to become
fully taxable.

Deferred annuities, meaning that the contract has not yet
been annuitized, also provide tax deferral for assets that would otherwise
experience ongoing taxation in a taxable account. But they have a different tax
structure as they do not apply an exclusion ratio. Both types of annuities will
provide the return of premium tax-free, but rather than having premium returned
as an ongoing part of the distributions, a deferred annuity is taxed on a
last-in-first-out (LIFO) basis. Any distributions from the deferred annuity,
either as guaranteed distributions through a living benefit rider or
unguaranteed distributions, are treated first as gains from the contract. The
original principal is received only when there are no remaining gains to be
taken. When a deferral period has been used, this pushes larger taxable income
distributions toward the early part of the contract distribution period, rather
than later like with the exclusion ratio for annuitized contracts.

This tax deferral is subject to the usual limitations the
government provides, which are that all subsequent gains, even long-term
capital gains, are taxed at ordinary income tax rates. This could be an issue
for variable annuities that invest in subaccounts with stocks and assets that
could have qualified for preferential tax rates outside of the annuity. For
this reason, it is best to locate less tax-efficient asset classes in the
variable annuity. A 10 percent penalty also applies for distributions taken
prior to age 59.5 if there is not an exception.

Tax deferral can be a powerful benefit for annuities in
taxable accounts. This tax deferral has motivated the use of annuities as
accumulation vehicles with a de-emphasis on their original purpose of providing
periodic distributions on fixed dates. If annuities are used for less
tax-efficient asset classes that mostly generate ordinary income rather than
long-term capital gains, then this tax deferral could provide net positive
value for the owner. A low-cost investment-only variable annuity has become a
popular tool and costs must be kept low so that the benefits of tax deferral
can exceed the annuity costs.

One other point that is relevant for deferred annuities is
that the IRS allows for 1035 exchanges. These rules prevent the creation of a
taxable event when exchanging a life insurance policy into an annuity, or for
exchanging from one annuity contract to another. This can provide a way to
switch to an annuity offering more attractive guaranteed income payments or
other features.

For example, if a variable annuity with a guaranteed
lifetime withdrawal benefit has experienced strong growth in its investments
such that the contract value is worth about the same amount as the benefit base,
it may be possible to exchange that variable annuity into a more attractive
annuity. Options could include a fixed annuity contract with better
annuitization rates, a fixed index annuity, or another type of variable annuity
with more attractive withdrawal benefits. This can occur without creating a
taxable event. This feature of the tax code only applies to deferred annuities
since annuitized contracts are not liquid and cannot be exchanged in such a
way.

Life Insurance

Finally, cash value life insurance can potentially provide
tax-deferred growth, tax-free distributions, and a death benefit free from
income tax. There are ways to access the cash value on a tax-free
basis through appropriately structured policy loans. After Roth contributions
are exhausted, permanent life insurance becomes the primary tool to obtain both
tax-deferral and tax-free distributions for after-tax dollars.

Among life insurance advocates, there are a
strain of supporters who focus a great deal on promoting the tax advantages of
life insurance to minimize taxes paid in retirement. In explaining their views
and approach to retirement income, these advocates first tend to focus on how
tax rates are presently at historic lows, and that one should expect much
higher tax rates in the future.

These advocates explain that you will be
better off paying taxes now at lower rates to avoid paying taxes in the future
at higher rates, which naturally leads to advocating for tools that support tax
deferral and tax-exempt distributions. Life insurance allows for practically
unlimited contributions, which can serve as an important tool for obtaining
additional tax-advantages for savings and wealth.

An ideal financial plan for these advocates
would involve having just enough saved in qualified retirement plans such as a 401(k)
that required minimum distributions do not push these taxable income amounts
above the level of standard deductions, then perhaps have some funds in taxable
investment accounts from which taxable long-term gains can be drawn without
pushing the tax rate out of the 12 percent level (which keeps the tax rate on
long-term capital gains at zero), and then taking other income as distributions
from Roth accounts or policy loans from life insurance. One could potentially
fund a quite sizable amount of spending power in retirement without having to
pay any federal income taxes.

Withdrawals from Tax-Advantaged Retirement Plans

There are two types of tax-advantaged
retirement plans we have described so far. First, tax-deferred accounts such as
IRAs, 401(k) employer plans, or solo 401(k) plans for the self-employed, allow
for a tax deduction on contributions up to a limit, tax deferred growth, and
then distributions are treated as taxable income. Tax-exempt accounts, such as
Roth IRAs, Roth 401(k) employer plans, and solo Roth 401(k) plans for the self-employed
do not provide a deduction on contributions, but they do provide tax-deferred
growth and tax-exempt distributions. The reality is that things can be more
complex than this simple overview, and these complexities are the focus of this
section. In this chapter we are focusing on tax issues during the lifetime of
the owner, and the next chapter will extend this discussion to inherited
accounts after the death of the account owner. This discussion will lay the
groundwork for better understanding tax-efficient retirement distributions.

Choosing Distribution Options from Employer
Plans

A first consideration with tax-advantaged
plans is what to do with assets accumulated in employer-based plans (defined
contribution 401(k), 403(b), 457 plans, or other defined-benefit pension plans)
when an employee leaves the firm. Subject to plan rules for what is allowed,
when individuals change employment or retire, they may rollover the lump-sum
value in the plan to another retirement account, they may keep the plan in
place with the previous employer, or they may decide to withdraw the amount as
a taxable distribution (which could also create a 10 percent penalty if under
age 59.5). When rolling over assets to another account, a direct transfer of
assets can be used as the simplest and most secure method. Employer plans are
required to provide a notice to participants noting that these direct transfers
or direct rollovers to another plan are allowed. With a direct transfer, the
plan assets are moved to another tax-advantaged plan such as an IRA. For
employer-based Roth accounts, the transfer may be to a Roth IRA. Transfers
could also go to Roth IRAs as taxable Roth conversions.

Indirect transfers are allowed, in which the
funds are provided to the participant, except for a 20 percent withholding
requirement, and then the individual is required to finish the rollover within
60 days to avoid having the amount become a taxable distribution. This would
also require replacing from elsewhere the 20 percent of assets that were
withheld. A direct rollover avoids the withholding that applies to an indirect
rollover and can be the safer approach to avoid any possibility for mistakes.

An important question then arises as to
whether it makes sense to keep the assets in the employer plan or to roll the
assets to another account. For defined-contribution plans, the employer plans
may have more limitations than IRAs, suggesting an advantage for a rollover.
This includes, first, the type of distributions allowed. Qualified plans
generally will not offer discretionary withdrawals. Distributions may be taken
through the form of different types of immediate annuities, as a lump-sum, or
as a series of installment payments. As for investment options, qualified plans
may have a more limited selection of investment funds offered within the plan
and may not allow deferred annuities or other financial products. The
investment options may also include higher fees than options available outside
the plan. IRA plans are generally much more accommodating both for the types of
withdrawals and investment options. Owners can take discretionary withdrawals
as desired and will not be limited by the list of options in the employer plan.
IRAs also provide much greater depth to the types of annuities that can be
purchased as well as greater discretion about the timing for the purchase
date.

For defined contribution plans, the starting
point is the lump-sum account value, but it may be possible to purchase some
types of annuities within the plan from private insurance companies. For those
interested in an annuity, it is worthwhile to compare pricing both in the plan
as well as with outside options available in IRAs. The employer plan may offer
more competitive institutional pricing on annuities, or it may be the case that
a better deal could be obtained through rolling the assets to an IRA and
purchasing the annuity there. One further consideration is that employer plans
must offer unisex pricing on annuities, which could give an edge to women who
live longer and may find higher costs with the gender-specific pricing used
outside the plan.

Many participants may find it worthwhile to
make rollovers of eligible distributions from their qualified plans to IRAs.
These eligible amounts include account assets except for any required minimum
distributions due in the year, 401(k) hardship withdrawals, or periodic
payments lasting for 10 years or more (including life annuities). A few reasons
not to make a rollover include that more cost-effective options are available
in the employer plan, or the potential to retain net unrealized appreciation
tax advantages (discussed later in this section). For those with after-tax
contributions in their employer plan, another idea relates to rolling over all
but these amounts to avoid the pro-rata rules around distributions that exist
in IRAs and will be discussed later in this section. We described how IRAs are
generally more flexible, but this is an area where employer plans have an edge.
They allow more flexibility about what is distributed, so that deductible
contributions and earnings can be earmarked for the rollover and only the cost
basis from after-tax contributions (if there is any) can be kept in the
employer plan and then distributed tax free or rolled over to a Roth account
without triggering taxes. IRAs do not provide this flexibility.

Defined Benefit Pension Plans: Lump-sum or
Annuity?

For those with defined benefit plans, an
important decision is whether to take a lump-sum distribution from the plan
(either as a taxable withdrawal or as a rollover to another plan) or to choose
an annuity option from within the plan. The standard form for the pension
option is a life annuity and any other distribution options provided will be
actuarially equivalent amounts, except in some cases where large employers may
subsidize benefits for early retirees by not making a full actuarial reduction
to an early payout. For married individuals, the default is a joint annuity
with survivor benefits, providing a smaller payment because it will last for
the lifetime of both individuals. The spouse must waive the right to a joint
pension if another option is chosen.

Many plan participants will decide to take a
lump-sum option as a rollover instead of an annuity. This decision should be
made carefully. Participants should determine whether there is a role for
annuity income in their retirement plan and what distribution options are
available from the plan. This includes determining whether the right type of
annuity is available and if the timing for annuity payments aligns. For
instance, if the participant wants deferral for when annuity payments begin,
this may not necessarily be an option provided by the plan.

If an annuity makes sense, and the plan offers
the right annuity for the participant, a further consideration involves whether
more income is available from the plan directly, or through a lump-sum rollover
and subsequent purchase of a commercial annuity in an IRA. The approach that
will offer the most income varies on a plan-by-plan basis and may also change
over time as changing interest rates can impact both the lump-sum amount from
the plan and the cost of annuity income outside the plan. One should also
consider the security of the annuity, comparing credit risk for the commercial
annuity with any risks in the employer plan and the protections provided for
defined-benefit pensions through the Pension Benefit Guaranty Corporation.
Couples might also consider a possibility for pension maximization strategies:
will it be better to take a joint life annuity from the plan or to take a
higher-paying single life option and use the difference to purchase life
insurance designed to protect the surviving spouse?

Another consideration involves whether the
pension decision impacts other benefits such as retiree health care insurance.
For example, choosing a single-life pension may eliminate retiree health care
benefits for a spouse, or choosing a lump-sum option may eliminate the
possibility of receiving retiree health care benefits from the employer. These
benefits could also be lost due to retiring early or deferring a pension. It is
important to also check carefully about whether the pension choice affects
other types of benefits and to include that information in your decision.

Finally, for those approaching retirement, it
is important to consider the timing of retirement and how that affects a contribution
credit for that year of work. Benefit amounts are often based on years of
service and a measurement of income. Receiving the credit for a year of service
could require a certain number of hours worked in the year or could require
employment through the end of the year. The potential value of the credit and
how much it would increase the value of a pension might make it worth delaying
retirement. In a related matter, it is important to consider how income is
defined for the purposes of determining the pension amount. This definition can
include whether it is base pay or total income including overtime or other
extra compensation, as well as which years of employment are counted in the
calculation. Depending on the formulas used, there may be incentives to
maximize income during certain key years of employment.

Required Minimum Distributions from Retirement
Accounts

For retirement plans providing tax deferral, such
as traditional IRAs and qualified retirement plans, the required minimum
distribution (RMD) rules are meant to ensure that the government will be able
to collect taxes at some point. There are different rules regarding RMDs for
the original owners and for beneficiaries. Here we describe RMDs during the
owner’s lifetime, and in the next chapter we will extend the discussion to
beneficiaries of tax-advantaged retirement plans with RMDs. Also, RMDs are not
required for Roth IRAs. They are required for Roth accounts in employer plans,
but the RMDs can be avoided by rolling those Roth accounts into a Roth IRA.
When Roth accounts do have RMDs, the amount must be distributed but no taxes
are due. The distributions could be reinvested in a taxable account if they are
not needed for spending. RMD rules also reflect only the minimum that must be
withdrawn, and individuals could always decide to withdraw more than the
required amount. Having RMDs in retirement without other taxable income subject
to withholdings could also create a need to pay quarterly estimated taxes.

As part of the SECURE Act from 2019, RMDs
begin at 72 for anyone who turns 70 on July 1, 2019, or later. Previously, RMDs
began at age 70.5.  In 2020, the CARES Act removed RMDs for that calendar year
as a response to the global pandemic. They are back as of 2021. Distributions
are required in each distribution year past the relevant starting age for the
account owner.

For the first year that an RMD is due, the
individual has until April 1 of the following year to take the distribution. In
subsequent years, the distribution must be taken by December 31 of the same
calendar year. Individuals who do wait into the new year to take their first
RMD would then have to take two RMDs in the same calendar year, which would
increase taxable income for the year.

For qualified plans where an individual
continues to work past age 72 and is not a 5 percent owner of the company, RMDs
for just that employer account can be delayed until the year that the
individual retires from that employer. This exception only applies for the
employer plan where the individual continues to work, but if that account
accepts rollovers, it may be possible to make rollovers to that account to
delay other RMDs.

Taking RMDs is a serious matter, as the
penalty tax applied for distributions not taken in their required years is 50
percent of the amount that should have been withdrawn in addition to the taxes
due on the distribution. This makes it very important to not skip RMDs.

The method for calculating RMDs for a given
year is relatively straightforward. RMDs are based on the individual’s age at
the end of the calendar year and the account balance on December 31 of the
previous calendar year. That account balance must include any indirect rollover
amounts that were initiated before December 31, even if the rollover was not
completed until the new year. Also, a deferred annuity with optional benefits
may need to add a valuation of those benefits to the contract value as a part
of determining the account value for the RMD.

There are three relevant life tables for
calculating RMDs. The most common one during the lifetime of the owner is the uniform
lifetime table (Table III). This table is for unmarried owners, married owners
whose spouses are not more than ten years younger, and married owners whose
spouses are not the sole beneficiaries of the IRAs. Table II is used for owners
whose spouses are more than ten years younger and who are the sole beneficiary
of the IRAs. This is a larger table providing joint life expectancies for all
combinations of ages 20 and older. The marriage situation for determining if
Table II can be used is based on January 1 of the year. If married on that date
and the sole beneficiary status is maintained for the year, then Table II can
be used for that year even if a divorce or spouse’s death happens in that year.
Finally, Table I provides single life expectancies and is used for some types
of beneficiaries of retirement plan assets. This table becomes more relevant
for the discussion in the next chapter about beneficiaries, but it is relevant
to just take note for now that the single life table provides smaller life expectancies
and higher distribution rates than the uniform life table.

A selection of RMDs is provided in Exhibit 10.9.
An additional note about this exhibit is important. We are currently undergoing
a change in the RMD tables with a new set of numbers available for years 2022
and later. I have chosen to provide information from the new 2022 tables in
Exhibit 10.9. If you happen to be taking a distribution for 2021, this exhibit
does not have the right information. The new tables note that people are living
longer, and the life expectancies are increased by approximately two years for
ages up until the early 70s, after which point the differences between the old
and new tables are less.

Exhibit 10.9

Life Tables for Requirement Minimum Distributions,
Starting in 2022

Uniform Lifetime Table

(Table III)

Single Life Table

(Table I)

Age

Life Expectancy

Distribution Rate

Life Expectancy

Distribution Rate

20

65

1.54%

30

55.3

1.81%

40

45.7

2.19%

50

36.2

2.76%

60

27.1

3.69%

70

18.8

5.32%

72

27.4

3.65%

17.2

5.81%

75

24.6

4.07%

14.8

6.76%

80

20.2

4.95%

11.2

8.93%

85

16

6.25%

8.1

12.35%

90

12.2

8.20%

5.7

17.54%

100

6.4

15.63%

2.8

35.71%

110

3.5

28.57%

2

50.00%

As noted, the uniform lifetime table is
commonly used for RMDs during the owner’s lifetime, with the exception noted
about when Table II is applied. Because the uniform table is constructed
assuming there is a spouse who is ten years younger than the participant, even
when the individual is single, this table does provide relatively conservative
RMD rates. As seen, at age 72 the rate is just 3.65 percent. This corresponds
to the old RMD distribution rate at age 70 for 2021 and earlier.

As an example, suppose it is 2022 and a
retiree’s IRA balance was $130,000 at the end of 2021. The retiree will turn 85
in November 2022. This individual is not married. What is the RMD for the year?
The relevant life expectancy is for age 85 from the uniform lifetime table, which
we can see in the exhibit is 16 years. The RMD amount is $130,000 / 16 = $8,125.
This amount must be distributed by December 31.

If an IRA account has non-deductible
contributions or other cost basis, RMDs do also apply to these amounts. But
only a portion of the RMD will be taxable. The pro-rata rules for determining
this are described later in this section.

Another important matter for RMDs is about
knowing when account aggregation rules apply if there are multiple retirement accounts.
These rules can be complicated regarding what types of accounts can be
aggregated. IRAs can be aggregated together as can 403(b) plans. If an
individual owns multiple IRAs, this person may determine the RMD for the
combined account balances and then take the distribution from only one of the
accounts if desired. About aggregating IRAs, this means only traditional IRAs,
not inherited IRAs or Roth IRAs. Also, I must emphasize that spouses cannot
aggregate their accounts. Each spouse needs to take their own separate RMDs from
their own separate retirement accounts. Also, other types of plans may not
allow aggregation. When aggregation is not allowed, RMDs would need to be taken
separately from each relevant account.

A plan of action for RMDs, then, is to make
inventory of all plans subject to RMDs, determine RMD amounts each year for
each account, determine which accounts may be aggregated to provide flexibility
for the account that the RMD is taken from, and then make sure that all RMDs
have been distributed by December 31.

Required Minimum Distributions from Annuities

Annuities can be owned in qualified retirement
plans such as employer plans and IRAs, as well as in Roth IRAs. With Roth
accounts there will not be taxes, and for tax-deferred accounts, annuity
distributions are taxed at ordinary income tax rates as they are received. This
is straightforward. The aspect that can get trickier relates to determining
RMDs for the annuity assets. The approach is different for annuitized contracts
and for deferred annuities.

For annuitized contracts, the RMD calculation
does not include any annuity premium or present value of payments. The annuity
income is accepted as covering the RMDs for the annuitized assets. At younger
ages, annuity income might be larger than the RMD that would have been required
for those assets, but the annuity income could be less than the RMD at later
ages. These differences are assumed to balance out over time, though, since the
annuity is treated as an accepted way to spend down the assets over retirement.

To be clear, in the early years, when the
annuity income is larger than the RMD would have been on the annuitized assets,
the retiree does not get to use the annuity income to cover the RMDs on other
assets remaining in the qualified plan. This could be viewed as a disadvantage
with a partial annuity strategy, as the retiree pays taxes on the annuity
distributions and the annuity distributions cannot be counted against any other
RMDs due on remaining assets, which could increase the overall taxable income
generated by the retirement accounts in those early years.

Though the tax treatment is relatively simple
for an immediate annuity in a qualified plan, there are problems with using a
deferred income annuity in a qualified plan when income is to begin past the
starting date for RMDs. Such a situation creates a technical violation for RMD
rules as annuity income covers the RMDs for the annuitized assets, but there is
no annuity income when that income is deferred for too long. In July 2014, the
Treasury Department created new regulations for qualified longevity annuity
contracts (QLACs) to help rectify this problem. Qualifying contracts for annuitized
premiums up to $135,000 or 25 percent of the combined balances held in
qualified plans, whichever is smaller, can now delay annuity income to age
eighty-five without violating the RMD rules. The total limit applies across all
plans and the 25 percent rule applies to each account, though IRAs can be
aggregated. Only deferred income annuities are eligible to be QLACs, not other deferred
annuities. RMDs for this portion of annuitized assets can be deferred past 72.

Not many 401(k) plans or other qualified
retirement plans that are set up by employers offer the ability to purchase
annuities. This may become more common in the future as the SECURE Act
simplified the process for employers to include deferred annuity options. For
those who do have this option, it is worth exploring whether the annuities
inside the employer plan may provide a better opportunity than annuities
outside the plan. Women can particularly benefit from the unisex pricing that
is required for annuities held inside employer retirement plans. If good
annuity choices are not available in the 401(k), then the common process after
retiring would be to rollover the 401(k) assets into an IRA and then purchase
the annuity inside of the IRA. When these steps are correctly followed, no
taxable events have transpired until distributions are received.

With deferred annuities in qualified plans, distributions
from the annuity are treated as taxable income when they are received. This is
the same as for annuitized contracts. It is important to emphasize that since
retirement plans already provide tax deferral, this is not a distinct advantage
of holding an annuity inside a qualified plan. There must be some other benefit
from the annuity, such as the desire to receive protected lifetime income, to
justify its placement this way. For lifetime income, a reason why the annuity
may be more attractive inside a retirement plan, despite already having the
benefit of tax deferral, is that taxable investment holdings may have embedded
capital gains that would trigger a large tax bill if sold to pay the annuity
premium. There is no 1035 exchange for moving assets from a taxable portfolio
to an annuity.

For deferred annuities, the contract value of the annuity
remains liquid, and RMDs are calculated on it. Unlike with annuitized
contracts, deferred annuities allow their distributions to be aggregated into
the overall RMD calculations. This can be a benefit at younger ages, when the
distribution from the annuity under a guaranteed living benefit may exceed the
RMD on the underlying contract value, so that part of the annuity income can
also be counted against the RMDs for non-annuity assets. In cases where the
contract value declines over time, this benefit could even increase further as
the annuity income may be much larger than the RMD on the smaller remaining
contract value. This can help to lower the need to take distributions from the
remainder of the IRA to cover RMDs, which could prove useful in managing sequence-of-return
risk.

However, there are complications related to this point
because the RMDs on a deferred annuity contract may not only be applied to the
contract value. RMDs may also be due on the present value of any living or
death benefits in the contract. Two simplifications provided about this are
that the actuarial value of these benefits can be ignored if they are worth
less than 20 percent of the contract value, and a standard return of premium
death benefit can also be ignored for these calculations. These requirements
can complicate taxes because it is necessary to obtain estimates for the
actuarial present value of the annuity benefits to determine the total RMDs for
the annuity.

This taxation matter also speaks to the value of not placing
all retirement plan assets into a deferred annuity. One potential calamity
could relate to an optional death benefit rider that only paid a death benefit
if the contract value exceeds zero. If the contract value is close to zero, one
might wish to stop taking distributions, but the RMD required on that death benefit
could exceed the remaining contract value and require a complete liquidation of
the annuity if there were no other assets that could be used to cover the RMD.
Having other IRA assets can be an important way to manage tax surprises related
to this complex aspect of calculating RMDs for deferred annuities.

Qualified Charitable Distributions

Another idea relates to Qualified Charitable Distributions
(QCDs) from IRAs. For IRA owners who are at least 70.5 (this age remains with
the SECURE Act, even though the start age for RMDs changed), QCDs allow for up
to $100,000 from the IRA to be distributed directly to a charity without any
tax consequences. QCDs are even allowed for amounts that would otherwise need
to be distributed as RMDs. The SECURE Act now allows for contributions to IRAs
for those still working past age 70.5, and the QCD annual limit is reduced by
the accumulated contributions made to traditional IRAs after 70.5.

The benefits for this strategy are significant – even though
there is no tax deduction, the amount of the donation does not count as income
but does count as that year’s RMD. For non-QCD donations, even if the donation
could be itemized, it shows up in the adjusted gross income because it is a
below-the-line deduction. This means that it could create vulnerability to the
auxiliary taxation issues related to AGI and MAGI (more on these later in the
chapter) that are determined before deductions are considered. For those who
are not otherwise itemizing, a non-QCD donation would not allow for a tax
deduction anyway.

In comparing a QCD with instead donating appreciated
securities from a taxable account, the appreciated securities donation can permanently
avoid capital gains on the donated securities. A tax deduction can be received
when itemizing. But for those waiting to receive a step-up in basis on the
taxable assets at death, the advantage of avoiding capital gains taxes through
the donation would be neutralized. Which approach is best does depend on
specific circumstances, but the QCD for tax-deferred accounts is a valuable
tool for making charitable contributions that is now a permanent part of the
tax code.

Early Withdrawal Penalties and Their Exceptions

Retirement plans are provided with tax
advantages to encourage retirement savings. As such, distributions that occur before
age 59.5 may be penalized with an additional 10 percent penalty tax applied to
the distribution amount in addition to any other income taxes due. There are
exceptions where early distributions can be made without incurring the penalty.
The situation becomes more complicated because different rules apply for
traditional IRAs, employer plans (except 457 plans), Roth IRAs, and Roth
accounts in employer plans. We cover Roth accounts in the next section. Section
72(t) of the tax code covers IRAs and employer plans.

Regarding exceptions, first, both traditional IRAs and
employer plans provide exceptions for the death of the participant. Beneficiaries
do not have to worry about early withdrawal penalties. Spouses have a unique
situation in which they can rollover the inherited account to their own IRA.
Doing so would remove the ability to avoid the penalty, but the penalty can be
avoided if the account remains in the name of the decedent. A surviving spouse
considering early distribution may keep the account in the name of the decedent
until age 59.5 when a rollover can be made.

Next, an exception is also applied for a participant’s permanent
disability. The disability exception is strict, as the individual must be
deemed as unable to engage in any substantial gainful activity for the
indefinite future. Third, distributions that add up to less than the taxpayer
unit’s deductible medical expenses for the year (qualifying medical expenses
that exceed 7.5 percent of adjusted gross income) are allowed without penalty.
These expenses do not have to be deducted if the standard deduction applies,
but they must just be deductible expenses. Fourth, up to $5,000 of expenses
related to a newborn birth or adoption are allowed. This is a new exception
created by the SECURE Act.

Finally, both types of accounts also provide an exception
for distributions that are deemed to be substantially equal periodic payments
(SEPPs) from the account as described by Section 72(t) of the tax code. The
rules around these payments are complex and must be considered carefully, as
modifying one’s scheduled distributions under these rules can lead to severe
additional penalties. Even though they are calculated as based on lasting for a
lifetime, the SEPP payments must continue for the longer of at least five years
or until reaching age 59.5. Then they may be changed or stopped. For example,
someone beginning a SEPP at 50 must continue it to 59.5, and someone beginning
at 58 must continue to 63.

Three methods are available for calculating SEPP payments:
the amortization method, the annuitization method, or the life expectancy
method. The amortization and annuitization methods lock in a number that must
be used precisely in subsequent years, while the life expectancy method is
similar to RMDs. The highest distribution amount is provided with the
amortization approach, and the annuitization approach may be close behind. Both
amounts will be fixed values. The life expectancy approach will lead to lower
and more variable amounts, as it updates each year for changing account
balances and distribution rates. For those wishing to reduce their
distributions, a one-time switch to the life expectancy method is allowed during
the time that the SEPP must continue.

The maximum SEPP amount will be available assuming the
highest account balance allowed (based on date used), the highest interest rate
allowed, and the amortization method for a single life. There is flexibility to
reduce the amount with assumptions for account balances and interest rates as
well as using a joint-life calculation. A separate IRA can also be carved out
and the SEPP can be applied just to this separate account as there is no need
to aggregate across IRAs.

In fact, carving out an IRA for the SEPP is generally a good
idea. The SEPP unravels if one accidently changes the payment amount, or
transfers funds in or out of the IRA. Carving out the separate account and
being very careful with it can help avoid violations. The penalty is harsh, as
in the year a distribution is modified, the 10 percent penalty on all past SEPP
distributions plus interest all become due in the current tax year.

Continuing with exceptions, traditional IRAs provide three
additional exceptions not found in qualified plans. Up to $10,000 can be used
toward the purchase of a home and the distribution must happen within 120 days
before the home purchase and used for the payment to qualify. For the home
purchase, it does not necessarily have to be for a first-time home buyer, as it
can be applied if a home has not been owned over the previous two-year period. The
$10,000 is a lifetime limit for this. Distributions up to the amount of
qualifying higher education expenses for the participant or eligible family
member can also be made without penalty. These distributions do not have to go
directly to the educational institution, so having eligible expenses in the
same year can allow for a penalty-free distribution of up to the amount. Third,
distributions to pay for medical insurance premiums when unemployed for oneself
and eligible family members are also allowed.

Finally, there is one additional exception for qualified
plans that is not available to traditional IRAs. If employment ended after age
55, then distributions can be taken from the one qualified account associated
with that employer without penalty. This is only allowed if employment ended
after age 55 though, so that the exception does not start at 55 for those who
ended employment at an earlier age. This exception may not always be useful as
many employer plans do not allow discretionary withdrawals.

Exhibit 10.10 summarizes these exceptions, including the
information for Roth accounts that will be discussed in the next section.

Exhibit 10.10

Exceptions for the Early Withdrawal Penalty

Exceptions

Traditional IRAs

Qualified Plans

Roth Accounts

Death of participant

Yes

Yes

Yes - Qualifying

Permanent disability of participant

Yes

Yes

Yes - Qualifying

Distributions less than deductible medical expenses for
the year (over 7.5% of AGI)

Yes

Yes

Nonqualifying- but no penalty

Substantially equal periodic payments

Yes

Yes

Nonqualifying- but no penalty

$5,000 of newborn expenses

Yes

Yes

Yes - Qualifying

$10,000 for first-time home buying expenses (must be
within 120 days of home purchase and used for payment)

Yes

No

Yes - Qualifying (for Roth IRA)

Distributions less than qualifying higher education expenses
for participant or eligible family members

Yes

No

Nonqualifying- but no penalty

Medical insurance premiums for unemployed participants and
eligible family members

Yes

No

Nonqualifying- but no penalty

Exception for employer plan if employment ends after age
55

No

Yes

No

Potential Penalties and Taxes on Roth
Distributions

We do think of Roth distributions as being tax
free (and, by association, penalty free). This is only completely true for
qualifying distributions. Beyond this, matters get more complicated. One
simplification to first note is that contributions to Roth accounts can be
distributed at any point without penalty or tax. Then we must determine if the
withdrawal is qualifying and therefore exempt from tax and penalty, or if the
withdrawal is nonqualifying but still exempt from penalty, or if the withdrawal
is subject to both tax and penalty. It is important to keep track of
differences for Roth IRAs built from new contributions, Roth IRAs
created from conversions, inherited Roth IRAs, and designated Roth accounts in
qualified plans.

Qualified distributions are not subject to penalty or tax. A
Roth distribution is qualified if it passes the five-year rule and meets
another triggering event. A first requirement for a Roth IRA distribution is
that at least five years have passed since January 1 of the first year that any
Roth IRA was set up with a contribution. There is aggregation with this
requirement, as the owner just needs to have any Roth IRA open for at least
five years before making a distribution. It is important to note, however, that
this requirement always applies no matter the age, which speaks to the
importance of at least opening a Roth IRA as soon as possible to get the
countdown started. Also, this aggregation does not apply for Roth
employer plans. With them, each plan must be opened for five years before their
distributions can become qualifying. An easy fix for this, assuming a Roth IRA
has already been opened for five years, is to first rollover the Roth account
to the Roth IRA and then take the distribution.

Assuming this five-year requirement is covered, we then look
for a further triggering event to make the withdrawal qualifying. The
distribution is qualified if the individual is at least 59.5 years old at the
time of the distribution, or if one of four exceptions are met with the same
criteria as described in the previous section about traditional IRAs: death of
the owner, permanent disability of the owner, the $10,000 exception for a
first-home purchase, or $5,000 for a newborn or adoption in the same year.

If these two requirements are not met, then the distribution
is nonqualifying. To understand the implications, we next keep track of what
the distribution represents as there are ordering rules for withdrawals. First,
for Roth IRAs, the first dollars distributed represent contributions. Contributions
can always be received on a tax-free and penalty-free basis even if they are
nonqualifying distributions. Once contributions are removed, we look to any
dollars in the Roth IRA representing Roth conversions. For any Roth
conversions, the taxed amount of the conversions is removed next. For these
amounts, no taxes are due, but the distribution is exposed to the 10 percent
penalty if it has been less than five years since the conversion took place,
the individual is under 59.5, and there is no other exception about
nonqualifying distributions that remove the need for a penalty. Once the
individual is over 59.5, there is no need to wait five years since the Roth
conversion to make a distribution, assuming any Roth IRA has been open for at
least five years. These exceptions are also related to the discussion about
traditional IRAs including for deductible medical expenses, substantially equal
periodic payments, qualifying educational expenses, or medical insurance
premiums when unemployed. Next, if there are any nontaxed amounts from Roth
conversions, representing the conversion of nondeductible contributions, these
are distributed without tax or penalty. Finally, earnings are distributed from
the Roth IRA. Nonqualifying distributions of earnings are taxed and are exposed
to the 10 percent penalty tax unless there is an exception for the same reasons
as just described for taxed conversion amounts.

This ordering for distributions is a bit different for Roth
accounts within qualified plans. Roth employer accounts are
subject to a pro-rata rule with proportional distributions from contributions
and account gains as reflected by their portions in the account. Contributions
are not subject to tax or penalty, but gains are. Also, as noted, Roth accounts
from qualified plans are also different because they do have RMDs and the
five-year rule about having the account open to make a distribution qualifying
applies to each account and not just when the first account was created.

Rollovers, Transfers, and Roth Conversions

Account owners may shift assets between
different types of retirement plans and IRAs without generating taxes. These
transactions are called rollovers or transfers. Usually, the term transfer is
used for a direct rollover, in which assets move directly from one account to
another. Rollovers can be direct or indirect, though, with indirect rollovers
being the case when the individual receives the funds and then has 60 days to
complete the rollover before it becomes a taxable distribution. For indirect
rollovers from qualified plans, there is a mandatory 20 percent withholding,
though this withholding does not apply to indirect rollovers from IRAs.
Generally, except for those seeking specific short-term access to the funds,
direct rollovers are encouraged to avoid any issues with not completing an
indirect rollover within 60 days and making the distribution fully taxable and
potentially subject to early withdrawal penalties.

Roth conversions are also allowed, in which
funds are transferred from an IRA or qualified plan into a Roth account. Roth
conversions are allowed from a traditional IRA or other plans like a SEP IRA or
a SIMPLE IRA (after two years), as well as employer and self-employed
retirement plans. Beneficiaries of qualified plans can also make a Roth
conversion, though this is not allowed for beneficiaries of IRAs. Roth
conversions are technically taxable rollovers and can be direct or indirect.
Conversions can be made by re-designating an IRA as a Roth IRA, by doing a
trustee-to-trustee transfer from an IRA or a direct transfer from a qualified
plan, or by doing an indirect rollover.

With conversions, income tax is paid on the
taxable amount of the conversion as though it is being withdrawn from the
account. For those younger than 59.5, there is no 10 percent penalty applied on
Roth conversion amounts. The amount of the taxable income is the fair market
value of the converted assets on the date of the conversion, which is
straightforward for most investments but can create complications for annuities
with additional benefits. The conversion deadline for a tax year is December
31. Indirect rollovers initiated before the end of the year and then completed
in the following year are counted as happening in the initiation year.

Partial rollovers, transfers and Roth
conversions are allowed if the distributed amount is eligible. The ability to
make partial conversions allows for better control over the tax situation and
is a key part of strategic Roth conversions. Eligible amounts include the
account balance except for distributions coming out as a series of payments
such as with a SEPP, required minimum distributions, hardship withdrawals, or
other corrective or deemed distributions. When there are RMDs, conversions may
only be done on amounts exceeding what must be distributed as an RMD.

In the past, Roth conversions could be
recharacterized or undone by October 1 of the following year. This was ended
with the Tax Cuts and Jobs Act in 2017. There were some planning opportunities
with recharacterization that may still be mentioned in older materials but are
no longer available. One was to convert different types of assets and then
recharacterize conversions of assets that subsequently lost value and keep the
conversions on assets that gained value. Another was to convert too much and
then recharacterize as necessary to fully control the tax bracket one sought to
manage. Since this is no longer possible, tax planning around tax bracket
management becomes more complicated, especially as one gets close to thresholds
that trigger jumps in Medicare premiums, as recharacterization is no longer a
relief valve to reduce taxable income.

Non-Deductible Contributions in IRAs and the
Pro-Rata Rules

We mentioned before that while employer plans
provide flexibility in controlling what is distributed between taxable amounts
and any cost basis, such flexibility does not exist with IRAs. Any cost basis
in IRAs, including nondeductible IRA contributions and after-tax contributions
to employer retirement plans that were rolled over to the IRA, must be
distributed using a pro-rata rule. They cannot be specifically chosen for a
distribution to reduce taxable income.

In a case where a person has more than one
IRA, the IRAs must be aggregated for applying pro-rata rules. These aggregation
rules do not apply to other types of retirement accounts. One cannot carve out
their nondeductible contributions into a separate IRA and then convert or
distribute them tax free.

Nondeductible contributions may exist when a contribution
is made to an IRA, but income exceeds the thresholds for making the
contribution deductible. They may also exist when a person made after-tax
contributions to an employer plan that they had subsequently rolled over to an
IRA. Such after-tax contributions may exist when the plan allowed it because
the individual was seeking additional tax deferral even after exceeding the
limits for deductible contributions.

For example, consider an individual who has
two IRA accounts. The first has $10,000 of nondeductible contributions and
$30,000 of deductible contributions and account earnings.  The second IRA has
$60,000 of deductible contributions and account earnings. This individual would
like to do a Roth conversion of $5,000 from the first IRA account. The
question: how much of this conversion represents taxable income?  The answer is
that the nontaxable portion is the $10,000 of nondeductible contributions found
in the accounts divided by the combined $100,000 balance of the two accounts,
or 10 percent. $500 of the conversion is tax-free and the other $4,500
represents taxable income. Again, the answer is not that $0 is taxable because there
is no option to just choose to convert the nondeductible portion, and the
answer is not that $3,750 is taxable because the nondeductible portion of that
first account is 25 percent of its value. Aggregating across the IRAs we see
that 10 percent of the account balances are nondeductible contributions and
that becomes the portion of the distribution that is not taxed. This issue
applies in the same manner for both distributions and Roth IRA conversions.

This issue is relevant for the backdoor Roth contribution
strategy that we mentioned earlier. If there are no other IRA accounts, the
nondeductible contribution to the IRA can be converted to the Roth IRA after a
few days without creating a taxable event. But if there were already IRA
accounts that had deductible contributions and earnings, then the pro-rata rule
applies, and a portion of the conversion is taxable. This provides a reason to
delay rollovers from employer plans when possible to preserve the option for
backdoor Roth contributions in the future.

These pro-rata rules do not apply to other
types of retirement plans. After-tax or non-deductible contributions can be
carved out from the rollover and then distributed tax free or converted to a
Roth account without taxes. This means that one may be strategic about when to
do rollovers and what to rollover.

Net Unrealized Appreciation on Employer Stock

One of the rare exceptions regarding distributions
from tax-deferred accounts being taxed at income tax rates is the possibility
for those who own employer stock in their retirement plan to have gains
on the stock taxed at long-term capital gains rates. This is called Net
Unrealized Appreciation (NUA). The NUA rules are complex, and it may or may not
always be a good idea to use this tax treatment depending on individual circumstances.

The long-term gains tax treatment is available if these
conditions are met:

·
The entire amount from the employer plan is distributed within
one year. The opportunity is lost with only a partial withdrawal or an
in-service distribution.

·
This distribution must follow a triggering event, which includes
reaching 59.5, dying, or ending employment.

·
The treatment is only relevant for the actual employer stock in
the plan from that employer.

·
The distribution can be divided between withdrawals and rollovers
to an IRA, but the shares of employer stock in which one is seeking NUA
treatment must be distributed and not rolled over.

·
The employer stock must also be distributed in kind as the shares
rather than taken as cash.

·
Any employer stock that is rolled over or sold and distributed as
cash loses the potential for this tax treatment.

For the employer stock that is distributed, income tax will
be due on the cost basis for that stock, based on its value when provided from
the employer and as determined by the employer. The gains on the stock will
then obtain long-term capital gains treatment when the stock is subsequently
sold. The net unrealized appreciation is this difference between the value of
the stock when distributed and its costs basis. For example, suppose employer
stock worth $100,000 is distributed and has a cost basis of $40,000. $40,000 is
taxed as income that year and the NUA is $60,000 that will be taxed at
long-term capital gains rates whenever it is subsequently sold. If the stock is
held longer, any subsequent gains above the NUA amount will be treated as
short-term gains if sold within a year from the distribution date and long-term
gains if held longer.

Is it a good idea to get this tax treatment for employer
stock, or is it worth sacrificing the tax treatment? The obvious benefit is
getting the lower tax rate on the stock’s gains, which of course is more
valuable the larger the gains are relative to the cost basis. With a large cost
basis and small amount of gains, the disadvantage of taking the distribution
and generating taxes may outweigh the small benefit of a reduced tax rate on
the NUA. Nonetheless, for those who otherwise want to take the distribution
now, this can be a good opportunity to obtain some tax benefit. And it is not
necessary to apply NUA treatment for all the employer stock, as the owner can
choose a portion to distribute and a portion to roll over. Only the distributed
portion receives the tax benefit.

There are disadvantages as well. First, if the distribution
is triggered because employment ends before age 59.5, then the cost basis that
is taxed during the year is also subject to the 10 percent early withdrawal
penalty when no other exception applies. The NUA is not exposed to this
penalty, but the cost basis is. As well, holding the employer stock means less
diversification and a relevant asset allocation question relates to whether the
investor is better off by diversifying away from the employer stock. Another
consideration relates to the idea that by taking the distribution, it changes
the composition of taxable assets and tax-deferred assets. These assets no
longer receive benefits from tax deferral and for younger people that loss may
outweigh any benefits.

To summarize, the best candidates for seeking the NUA
treatment are those who are close to retirement, who are seeking the
distribution anyway, and who have a large NUA build up. Younger individuals are
less likely to benefit from the NUA treatment as they face the 10 percent
penalty on the cost basis, lose opportunities for subsequent tax deferral, face
holding a less diversified portfolio, and may not have much NUA build up
anyway. The rules around NUA are complicated and it is worth discussing this
issue with an accountant for those who hold large quantities of employer stock
in their retirement plans.

Tax-Efficient Retirement Distribution Strategies

With the technical tax discussion complete, we next look at
how to source distributions during retirement in a tax-efficient manner. This discussion
is about withdrawal sequence ordering and tax bracket management. Most people
do not think about these issues, but your distribution strategy in retirement
and the resulting taxes you pay can have a significant impact on how long your
money lasts and how much you can spend, especially if you have taken care to set
up options and flexibility through tax diversification.

A basic guideline around withdrawal order sequencing is to
first consider any income you receive from Social Security, pensions, and so
forth, as well as any required minimum distributions you must take from
qualified retirement plans and other tax-advantaged accounts. Then the order of
spend down for covering remaining spending is taxable accounts, then tax-deferred
accounts, and then tax-exempt accounts. Taxable assets create a drag on returns
because taxes must be paid annually on interest and dividend payments. They are
spent first while tax-advantaged accounts are given more time to grow with tax
deferral. This guideline is directionally correct, but it can be further
refined for greater impact through tax bracket management and strategic Roth
conversions.

Tax Bracket Management and Withdrawal Sequence
Ordering

The ordering of taxable, tax-deferred, and tax-exempt, is a
reasonable starting point, but it is possible to do better. Taxes are
unavoidable, but what we really seek to do with tax planning for retirement
income is to pay taxes at the lowest possible tax rates to generate the most
lifetime spending and legacy power net of taxes from the retirement asset base.
This leads to tax bracket management to manage tax efficiency with the
progressive tax code. The planning potential can be greatest when significant
assets are held in tax-deferred accounts.

The objective is to try to fill up lower tax brackets with
taxable income and then potentially take from areas with better tax treatment
to fill any spending gaps without moving unnecessarily into a higher tax
bracket. As well, in cases where spending needs have been met while additional capacity
remains in a lower tax bracket, it may be worthwhile to fill that bracket with
taxable income and pay tax at lower rates to help avoid the possibility of
being pushed into a higher tax bracket in the future.

Each retiree’s situation is different in this regard,
but one threshold that creates a big advantage for strategic management is the
divide between the 12 percent and 22 percent tax bracket. That reflects the
biggest jump in tax rates, and in 2021 the taxable income levels where this
shift happens are $40,525 for singles and $81,050 for joint filers. These
thresholds are also quite close to where the tax rate for long-term capital
gains and qualified dividends jumps from 0 percent to 15 percent. For singles
this happens at $40,400 of taxable income and for married couples filing
jointly it is $80,800.

If there is spare capacity for taxable income in
a lower tax bracket after meeting spending goals, the idea is to fill up the
bracket with taxable income. In the early years of retirement, three options
for generating more taxable income include:

1) Spend less from taxable accounts and more
from tax-deferred accounts to cover the spending goal in a way that increases
taxable income toward the desired level.

2) Cover the spending goal from taxable
accounts, but then increase taxable income by doing Roth conversions with
assets from the tax-deferred account.

3) Generate taxable long-term capital gains by
selling and then immediately re-purchasing assets in taxable accounts,
especially when still in the 0 percent tax bracket for these preferential
income sources.

These ideas are for creating more taxable
income to fill up a particular bracket. But for those whose spending goals are
pushing them into a higher than optimal level of taxable income, this process
could work in the opposite direction where distributions from tax-deferred
sources could be reduced and replaced with spending from sources that do not
generate taxable income.

Exhibit 10.11 divides potential sources of retirement
spending by their tax treatment. There are sources that count as ordinary taxable
income using the income tax rates, sources that receive preferential tax rates,
and sources that do not count as taxable income and do not show up on the tax
return. Taxable income sources are the usual items we discussed before,
including any wages or earnings, distributions from qualified retirement plans
like IRAs, short-term capital gains, interest, dividends not qualified for
special tax treatment, pensions, rental income, and a portion of cash flows
received from nonqualified annuities and Social Security.

Exhibit 10.11

Tax Characteristics for Various Retirement Spending
Resources

Increases
Taxable Income

Taxable income
with preferential tax rates

Spending Sources

-- Not Taxable
Income

Wages, salary, and self-employment earnings*

Qualified dividends

Cost-basis of taxable investments

Qualified retirement plan distributions (IRAs)

Long-term Capital Gains

Roth IRA distributions

Short-term capital gains

A portion of nonqualified annuities

Interest

A portion of Social Security benefits

Dividends

Health savings accounts (qualified)

A portion of nonqualified annuities

Reverse mortgage proceeds

A portion of Social Security benefits

Cash value of life insurance (cost basis or loan proceeds)

Pensions

Benefits from long-term care insurance

Rental or other passive income

* Also subject to payroll taxes

The spending sources with preferential tax rates include
qualified dividends and long-term capital gains. Sources that can support
spending without generating taxable income include the cost-basis of taxable
investments, Roth IRA distributions, a portion of the income from Social
Security and nonqualified annuities, qualified distributions from health
savings accounts for medical expenses, proceeds from a reverse mortgage, and
partial surrenders of cost basis or policy loans from life insurance policies.

Strategic Roth Conversions

When one is generating more taxable income from tax-deferred
accounts to fill a tax bracket, the options are either to reduce other spending
sources and cover spending with these distributions, or to engage in Roth
conversions for these additional distributions. The Roth conversion approach
can often provide an edge in creating greater long-term benefits as will be
shown later with an example.

Roth conversions are accomplished by taking funds from qualified
tax-deferred accounts and transferring them into a tax-exempt account. This
triggers a tax payment on the amount of deductible contributions and account
gains that are converted. Ideally, the taxes would not be paid from the
distribution itself, but from other sources outside of the tax-deferred account.
This would especially be the case before age 59.5, as paying taxes on the
conversion from the tax-deferred account could trigger an additional 10 percent
penalty. The penalty does not apply to converted amounts, but it would apply to
any distributions that are not converted to the Roth, such as for paying the
tax.

By doing this strategically, the retiree can pay a lower tax
rate on the converted amount, and then have that money grow tax free in the
future. This can help to avoid paying higher tax rates on the assets in the
future, especially after required minimum distributions begin.

Roth conversions can be especially useful in years when
taxable income is low, such as years after work has ended but before Social
Security benefits have started, or in years with large tax deductions that
offset a higher adjusted gross income.

As well, Roth conversions could be used after a market
downturn to get more shares shifted over to the Roth at a “discount” without
generating as much taxable income. A concern with this would be if it is
necessary to pay taxes on these conversions from assets that have also declined
in value with a market downturn. This could be an opportunity for buffer assets
that have not declined in value to be a resource for paying taxes and obtaining
the conversion benefits without triggering sequence risk.

The SECURE Act passed at the end of 2019 further increased
the potential opportunities and value for Roth conversions. First, by raising
the start age for required minimum distributions from 70.5 to 72, there is more
opportunity and time to engage in Roth conversions before required minimum
distributions begin. Conversions can only be done on amounts that exceed the
RMDs. The SECURE Act also changed rules about RMDs for beneficiaries of
retirement accounts which may speed up the need for distributions. That could
more easily force beneficiaries into higher tax brackets, especially if they
are otherwise in their peak earnings years when receiving the inheritance. This
could guide toward greater use of Roth conversions when intergenerational tax
planning is considered, which is a subject explored more deeply in the next
chapter.

Long-Term Capital Gains Harvesting

The third concept for generating more taxable
income as a part of tax bracket management is to harvest capital gains. This is
especially valuable when still in the 0 percent tax bracket for long-term
capital gains. Long-term capital gains could be harvested up to the top of the
0 percent bracket without generating taxable income. The assets could then be
immediately reinvested, resetting the cost basis to a higher level. Wash sale
rules exist when harvesting losses, which are rules about not purchasing a
substantially identical asset within 30 days of the date sold to allow the loss
for tax purposes. But there are no such rules for harvesting gains.

Pitfalls to Monitor When Generating More Taxable
Income

There are potential pitfalls regarding efforts to increase
taxable income as a part of managing taxes. These pitfalls make the process
more complicated as there is more to pay attention to than just the federal or
state income tax brackets. Taxable income can uniquely generate a need to pay
taxes on more of Social Security benefits and can raise Medicare premiums. It
can also trigger the net investment income surtax. After 2026, it may lead to
phaseouts for personal exemptions and itemized deductions. In special cases,
there could also be additional tax deductions and tax credits with
income limits that could be lost. For those retiring before Medicare eligibility,
taxable income could also impact the availability of subsidies for health
insurance coverage. Here we will emphasize a few of these key issues. Perhaps
the most important of these for typical retirees will be the Social Security
tax torpedo.

The Social Security Tax Torpedo

Having more income can uniquely generate a need to pay taxes
on Social Security benefits. Up to 85 percent of Social Security benefits can
be counted as taxable income. The rules for Social Security benefit taxation
create what is known as the “tax torpedo.” Once benefits begin, each $1 of
additional income from qualified plan distributions and the like will require
taxes on that income as well as taxes on up to 85 percent of a corresponding $1
of Social Security. Wealthier individuals may find that avoiding taxes on 85
percent of Social Security benefits is impossible, but those with relatively
more modest resources might be able to set into motion a plan that can reduce
or even completely avoid the tax torpedo for life, while following conventional
wisdom strategies could leave them mired in paying more taxes through the
torpedo. Presently around 50 percent of Social Security beneficiaries will pay
taxes on at least a portion of their Social Security benefits.

Exhibit 10.12 provides the details for determining how much
of Social Security benefits are taxable. The calculation is based on
provisional income, which is defined as modified adjusted gross income (MAGI) plus
half of the Social Security benefits plus any tax-exempt interest from
investments such as municipal bonds. Depending on the publication, this
provisional income measure may also be called the combined income or the total
income. As well, modified adjusted gross income can mean different things each
time it is mentioned in the tax code. In this context, it is generally the
components of adjusted gross income listed on the 1040 tax form before
including the taxable portion of Social Security benefits. This calculation is
what determines how much of the Social Security benefits are taxable, which
then allows for the calculation of AGI.

Exhibit 10.12

Social Security Benefits Taxation

Provisional Income

Taxable Benefits

Single Filers

Married Filing Jointly

Under $25,000

Under $32,000

0%

$25,000 - $34,000

$32,000 - $44,000

up to 50%

Over $34,000

Over $44,000

up to 85%

Note: Provisional Income = MAGI + 1/2 Benefit + tax-exempt
interest

The dollar values in Exhibit 10.12 were set in 1994 and this
is one part of the tax code that is not adjusted for inflation. Congress may
change these thresholds at some point, but they have been the same for a long
time. This means that over time more and more Americans will pay income tax on
their Social Security benefits unless they have built up large non-taxable reserves.
The upper thresholds for triggering taxation on 85 percent of benefits are
$34,000 for single filers and $44,000 for joint filers.

Calculating taxable Social Security benefits is complex because
of these loopy formulas. You do not know your AGI until you know how much of
your benefit is taxed, but you do not know how much of your benefit is taxed
until you know your AGI. The amount of Social Security benefits that are
taxable is calculated as whichever of these three calculations provides the
smallest amount:

1) 85 percent of Social Security benefits

2) 50 percent of Social Security benefits plus 85 percent of
the amount of provisional income that exceeds the second threshold ($34,000 for
singles and $44,000 for joint filers)

3) 50 percent of provisional income beyond the first
threshold plus 35 percent of provisional income beyond the second income
threshold

These three calculations can create results that may not be
intuitive. It also becomes difficult to connect taxable income directly to the
marginal tax rates because the results vary by amount of Social Security
benefits. There is not just one tax torpedo; its shape is different for
different amounts of Social Security benefits. To provide a sense about this, Exhibit
10.13 shows the taxable portion of Social Security benefits for couples who are
married filing jointly. The results are shown for different components of the
provisional income (Social Security benefits and everything else). Perhaps the
most counterintuitive outcome relates to how the taxable portion of Social
Security benefits can decrease as the Social Security benefit increases for different
levels of MAGI and tax-exempt interest. This is because the taxable portion of
the benefit is not growing as fast as the benefit in those cases where the 85
percent rate is playing a role.

Exhibit 10.13

Taxable Portion of Social Security Benefits

for Married Couples Filing Jointly

Combined Social Security Benefits for the Household

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

Modified Adjusted Gross Income + tax-exempt interest

$0

0%

0%

0%

0%

0%

0%

$4,000

0%

0%

0%

0%

0%

2%

$8,000

0%

0%

0%

0%

1%

5%

$12,000

0%

0%

0%

0%

5%

8%

$16,000

0%

0%

0%

5%

9%

13%

$20,000

0%

0%

5%

10%

14%

19%

$24,000

0%

5%

12%

15%

21%

24%

$28,000

5%

15%

18%

24%

27%

30%

$32,000

25%

25%

29%

32%

34%

36%

$36,000

45%

39%

40%

41%

41%

41%

$40,000

59%

56%

51%

49%

48%

47%

$44,000

85%

73%

63%

58%

55%

53%

$48,000

85%

85%

74%

66%

61%

58%

$52,000

85%

85%

85%

75%

68%

64%

$56,000

85%

85%

85%

83%

75%

70%

$60,000

85%

85%

85%

85%

82%

75%

$64,000

85%

85%

85%

85%

85%

81%

$68,000

85%

85%

85%

85%

85%

85%

$72,000

85%

85%

85%

85%

85%

85%

For Exhibit 10.13, the tax torpedo is at work in any case
that taxable Social Security benefits are greater than 0 percent and less than
85 percent. When the taxable portion is still 0 percent, a dollar of additional
income does not trigger tax on Social Security. Once the taxable portion
becomes 85 percent, then a dollar of additional income does not trigger more
Social Security taxes. But for the range in between, the tax torpedo is at work
as more income triggers not just taxes on that income but also taxes on more
Social Security benefits.

Exhibit 10.14 provides a visual illustration of the tax
torpedo for Social Security. In this example, we consider a single filer in 2021,
and the assumed Social Security benefit is $30,000. The exhibit plots the MAGI
plus tax-exempt interest against the marginal tax rate on $1 of additional
income. I will simply call this amount MAGI to avoid having to keep writing
“plus tax-exempt interest” every time as well. When the MAGI reaches $11,700,
the marginal tax rate jumps to 15 percent (this is a 10 percent federal tax
bracket and a trigger of 50 percent of a Social Security dollar becoming
taxable). It jumps to 18 percent at $18,334, 22.2 percent at $19,000, and 40.7
percent at $34,987. It then drops to 22 percent at $43,706. The MAGI of $43,706
is the point which serves as the upper limit of the tax torpedo with the
$30,000 benefit, as now 85 percent of Social Security is taxed. Subsequent
increases in taxable income do not also cause more Social Security taxation. With
this benefit, a MAGI of $43,706 represents an AGI of $69,206 with 85 percent of
Social Security added. With a standard deduction of $14,200 for single filers
over 65, this represents a taxable income of $55,006.

Exhibit 10.14

The Social Security “Tax Torpedo” for a Single
Filer in 2021

with a $30,000 Social Security Benefit

For tax bracket management, the MAGI of $43,706 becomes an
important threshold where there can be extra advantages to stay below it as
possible. Otherwise, once getting past this threshold, taxpayers then
experience a range where the marginal tax rate is back down to 22 percent.
Understandably, it can be very clunky to move this discussion back and forth
between MAGIs, AGIs, and taxable incomes, but at least I hope this discussion
has helped to provide a sense about how this tax torpedo can uniquely increase
marginal tax rates for retirees as income triggers taxes on itself as well as
on more of Social Security.

Social Security taxation creates a case for more than just
tax bracket management; it also can add greater after-tax value for delaying
Social Security benefits. If one is already retired at age 62, delaying Social
Security benefits to 70 could help to provide a foundation for making more Roth
conversions before Social Security benefits begin, which could then help keep
taxable income lower after age 70 so that Social Security then does not
experience as much of the tax torpedo. If Social Security is delayed until age 70,
then pre-70 taxable income is reduced. Those waiting to age 70 will have more
opportunity to conduct Roth conversions and realize long-term capital gains on
taxable accounts at lower tax rates. This will also help to reduce taxable
income later after benefits begin. Subsequent Roth distributions do not count
when determining how much of Social Security is taxable. Those with the
capacity to get a large portion of their IRAs converted to Roth accounts prior
to beginning Social Security could enjoy substantial tax improvements. Not only
will Social Security benefits be larger, but less, or at least a smaller
percentage, of those benefits count as taxable income. These strategies may
also help later in retirement to lower the amount of RMDs, to increase the
cost-basis for taxable accounts, and to create less pressure to make taxable
withdrawals to meet retirement spending needs. Social Security delay frequently
complements strategies to support more after-tax spending power.

The tax torpedo can apply for couples as well, and its
specific shape does depend on the level of Social Security benefits. The
torpedo has the biggest impact when it is adding Social Security taxes on top
of the 22 percent tax bracket, getting the marginal rate up to 40.7 percent for
a portion of income. If the old tax code returns in 2026, the tax torpedo could
impact the 25 percent tax bracket, which would amplify the marginal tax rate to
46.25 percent with Social Security’s impact included.

That is not even the whole story. These tax rates could be
even higher if there were long-term capital gains that further get pushed from
the 0 percent tax bracket to the 15 percent tax bracket as Social Security
becomes taxable. For this to be relevant, the household would need to still be
in the 12 percent tax bracket and in a range where a dollar of income is taxing
85 percent of a dollar of Social Security. If this also then pushes $1.85 of
long-term capital gains from the 0 percent to the 15 percent tax bracket, then
suddenly the marginal tax rate is 49.95 percent. With the tax rates scheduled
to return in 2026, the 12 percent tax bracket becomes 15 percent, which then
increases the overall marginal tax rate to 55.5 percent for this perfect tax
storm. Retirement tax rates will not always be lower in retirement, especially
when a dollar of income leads to tax on that income, tax on more of Social
Security, and tax on more of long-term capital gains or qualified dividends.

Increased Medicare Part B and Part D Premiums

Another part of the tax code that can create
tricky planning implications relates to how Medicare Part B and Part D premiums
are determined. This is known as the Income Related Monthly Adjustment Amounts
(IRMAA) for Medicare premiums. The level of premiums paid depends on modified
adjusted gross income, which in this context is defined more simply as adjusted
gross income plus tax-exempt interest. Note again, as with Social Security,
that while tax-exempt interest is not taxable, it can generate higher taxes on
other sources of income. An additional issue for Medicare, though, is that the
relevant measure of MAGI is from two years prior, which is what you have stated
on your prior year tax returns. For example, determining Medicare premiums in
2021 means using the MAGI from 2019 included on your 2020 tax forms. For those
starting Medicare at 65, this means that tax planning begins accounting for
impacts on Medicare premiums at age 63. For those experiencing life changing
events that lower current year MAGI relative to two years prior, which does include
retiring, it is possible to file a petition with form SSA-44 to have a smaller
premium applied. It is important to note that Roth conversions are not
considered as a life changing event and any higher premiums a Roth conversion
generates should be viewed as an additional tax.

Exhibit 10.15

Medicare Premiums in 2021 (Based on Income in 2019)

Single Filers

Modified Adjusted Gross Income

Married Filing Jointly

Modified Adjusted Gross Income

Part B Monthly Premium

per recipient

Part D Monthly Premium

per recipient

Combined Annual Amount per Individual

$88,000 or less

$176,000 or less

$148.50

$33.06 (base premium)

$2,178.72

$88,001 - $111,000

$176,001 - $222,000

$207.90

base + $12.30

$3,039.12

$111,001 - $138,000

$222,001 - $276,000

$297.00

base + $31.80

$4,342.32

$138,001 - $165,000

$276,001 - $330,000

$386.10

base + $51.20

$5,644.32

$165,001 - $500,000

$330,001 - $750,000

$475.20

base + $70.70

$6,947.52

Over $500,000

Over $750,000

$504.90

base + $77.10

$7,380.72

Note: The average base
plan premium (“base”) for Part D prescription drug coverage is $33.06 per month
in 2021, but it can vary between insurers.

Exhibit 10.15 provides the details for 2021
Medicare Part B medical insurance and Part D drug coverage. It shows the MAGI income
thresholds for a single and for a married-filing-jointly couple as the associated
monthly premiums and combined annual values. These are per-person premiums,
which doubles the cost for a couple who are both enrolled in Medicare. The
costs for Medicare can increase in quite noticeable ways at higher income
levels. And it is important to understand that these thresholds are firm. A
single person with a MAGI of $88,000 would experience annual premiums of $2,179.
With one more dollar of income ($88,001), the annual premium jumps by $860
dollars, representing an 86,000 percent marginal tax rate on that dollar. This
effect gets even larger at other thresholds, and with couples the premium jump is
multiplied by two. This is a more extreme type of tax torpedo, and those who
are using tax bracket management as part of tax planning should take care to
make sure that the MAGI does not exceed a particular threshold by even $1. Leave
yourself a buffer for surprises with tax projections that get you close to any
of these thresholds. Because these tax brackets are significantly higher than
with the Social Security tax torpedo, this issue will affect fewer retirees,
but it is important to monitor for Roth conversions.

Affordable Care Act Subsidies for Health
Insurance Before Medicare

Another issue impacting anyone who buys health
insurance through healthcare.gov or the state insurance exchanges under the
Affordable Care Act, including early retirees who are yet qualified for
Medicare, are the subsidies available for such health plans. Premium subsidies
are available for those whose modified adjusted gross incomes fall between 100
percent and 400 percent of the federal poverty levels, which vary based on
household size. Also, in some states, these percentage thresholds may be
different. For a two-person household, 100 percent of the federal poverty line
in 2021 is $17,420, and the 400 percent level is $69,680 in most states. This
is another case in which having $1 of additional income beyond the 400 percent
threshold could result in potentially thousands of dollars of lost subsidies to
help cover the cost of insurance, which can make this a very important matter. This
non-linear part of the tax code has been called the “subsidy cliff” due to the
steep drop in subsidies at the top threshold. This measure of modified adjusted
gross income includes AGI plus other categories like untaxed foreign income,
non-taxed Social Security benefits, and tax-exempt interest.

The
American Rescue Plan Act of 2021

The American Rescue Plan Act passed in March
2021 has temporarily changed the contents of this section for 2021 and 2022.
I have provided explanations for how things will be again in 2023, but
temporarily one does not have to be as cautious about the impacts of taxable
income on health care subsidies. There is no subsidy cliff at the 400 percent
threshold as now taxpayers are expected to cover insurance costs at up to 8.5
percent of their income even when exceeding this threshold, making subsidies
possible. For those facing the subsidy cliff, this may provide a short-term
opportunity to do more strategic tax planning.

The health insurance subsidy amount available is
based on a percentage of income one is deemed to be able to afford based on
income and the cost of the benchmark Silver insurance plan in the region where
one lives. The subsidy is the cost of the insurance plan exceeding the
percentage of modified adjusted gross income one is deemed able to pay. That
percentage ranges from 2.06 percent for those with incomes up to 133 percent of
the federal poverty line, up to 9.78 percent for those with incomes between 300
percent and 400 percent of the federal poverty line. An individual could still
choose a lower or higher cost plan, which would impact out of pocket costs
without impacting the subsidy. Plans range from bronze, silver, gold, and
platinum, in terms of the lowest premium cost and more co-pays and deductibles
with bronze plans, shifting to a higher premium and less additional costs with
other plans.

For those who may exceed the top poverty threshold,
it may be possible to reduce the modified adjusted gross income with tax
deductible contributions to employer plans or IRAs. Only above-the-line
deductions like this will help. This is a situation in which a strategic Roth
conversion could backfire as it reduces subsidy eligibility. At the other
extreme, an income of 100 percent of the poverty line is required to qualify
for the subsidy, which could generate a need to have more taxable income for
those who might have designed their plans well to avoid income sources that
show up in AGI. In this case, generating taxable income could be achieved
through Roth conversions, realizing capital gains on taxable accounts, or taking
other taxable distributions from retirement plans.

Net Investment Income Surtax

Another source of taxes that can be impacted by having
higher taxable incomes is the 3.8 percent Medicare surtax on net investment
income. It applies for those whose modified adjusted gross incomes exceed
$200,000 for singles and $250,000 for those married filing jointly. These
income thresholds are not inflation adjusted. They have been fixed since this
tax was created in 2013. I wish I could provide an easy explanation for how AGI
is adjusted to determine this version of MAGI. Alas, here is how the IRS
defines this MAGI in their FAQ on the topic:

For the Net Investment Income Tax,
modified adjusted gross income is adjusted gross income (Form 1040, Line 37)
increased by the difference between amounts excluded from gross income under
section 911(a)(1) and the amount of any deductions (taken into account in
computing adjusted gross income) or exclusions disallowed under section
911(d)(6) for amounts described in section 911(a)(1). In the case of taxpayers
with income from controlled foreign corporations (CFCs) and passive foreign
investment companies (PFICs), they may have additional adjustments to their
AGI. See section 1.1411-10(e) of the final regulations. (https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax)

Once this MAGI is determined by tax software or an
accountant, an additional 3.8 percent tax applies on whichever is less: the
modified adjusted gross income exceeding these thresholds or the net investment
income. Net investment income includes items such as capital gains, interest, and
dividends on assets in taxable accounts, as well as royalties, rents, and the
taxable portion of nonqualified annuity distributions.

As mentioned, this tax only becomes relevant when incomes
get up to the $200,000 range for singles and $250,000 for married filing
jointly, so it will not be relevant for many retirees. But when it applies, it
will add an additional 3.8 percent marginal tax rate to some components of
income. When the net investment income is smaller, this raises the preferential
long-term capital gains and qualified dividend tax rates by 3.8 percent.

Pushing Long-Term Capital Gains and Qualified
Dividends into Higher Tax Brackets

Another potential concern is that additional taxable income
can also push long-term capital gains and qualified dividends into higher tax
brackets as well, raising the effective marginal tax rate. This topic was
introduced at the end of the Social Security tax torpedo discussion, and it
exists more broadly. Long-term capital gains and qualified dividends have a
separate set of tax rates and tax brackets, and these income sources are added
on top of other income sources to determine their taxation. The impact is
largest when shifting this income from the 0 percent tax rate to 15 percent,
but the matter does apply more generally with the 20 percent tax rate and the
net investment income tax. Suppose $1 of income is generated in the 12 percent
tax bracket, which in turn pushes $1 of long-term capital gains from the 0
percent bracket to the 15 percent bracket. The effective tax rate on that
dollar of income, even though it was in the 12 percent tax bracket, is now 27
percent. Because of the unique properties and stacking of these income sources,
it is also important to consider how they are impacted when generating
additional income elsewhere.

Additional Medicare Tax

A related tax that passed in 2013 is an additional 0.9
percent surtax on wages and self-employment income that exceeds certain
thresholds. This tax is similar to the net investment income tax in terms of
how it is structured, but it applies to different types of income. It applies to
wages and self-employment income that exceeds the fixed thresholds of $200,000
for singles and $250,000 for married filing jointly. As this only applies to
income from working, it may be less relevant for retirees.

Alternative Minimum Tax

A complicated part of the tax code that still exists but
impacts fewer people since the Tax Cuts and Jobs Act of 2017 is the alternative
minimum tax. It is a separate way for calculating taxes, and it applies if the
calculations lead to a higher tax bill than with the standard tax code. For
retirees, the most likely way that one might incur the alternative minimum tax
is when taking large, itemized deductions. The need to manage the alternative
minimum tax in retirement is rare and beyond our scope here.

Other Considerations

If the 2017 tax code returns in 2026, this would likely
include a return of the personal exemption phaseout and Pease limitations on
itemized deductions for higher income individuals that were suspended by the
Tax Cuts and Jobs Act. For singles, in 2017, Pease limitations and the personal
exemption phaseout both began at an AGI of $261,500. For married filing
jointly, these phaseouts began at $313,800. Though this is not an issue at the
present, it is another factor whose practical impact is to raise marginal tax
rates by about 1 percent for incomes past these levels until the full phaseout
has occurred.

A final idea relates to maintaining some holdings in a
tax-deferred account later in retirement to possibly take advantage of large
deductible expenses such as late-in-life itemized medical expenses that fall
above 7.5 percent of AGI. One must be careful because larger IRA distributions
raise the AGI, which makes less of the health expense tax deductible, but at
the same time the deductions would reduce taxable income and possibly allow
such distributions to come out at a lower tax rate.

Other Planning Ideas

There are a few more tax planning ideas worth considering as
well. First, though we just considered pitfalls with generating more taxable
income as a part of tax planning, there are some reasons to further frontload
tax payments at the start of retirement. We also offer the idea of tax loss
harvesting as part of an ongoing strategy to offset gains and losses in the
taxable portfolio to increase the cost basis without generating tax. We then
consider deduction bunching and donor advised funds as ways to take advantage
of the ability to itemize tax deductions in some years.

Reasons to Further Frontload Taxes

Though there are pitfalls to monitor when generating more
taxable income, there are also reasons why it may be particularly advantageous
to frontload some taxes to the early part of retirement. The first reason
relates to the idea that there are many unknowns about public policy, including
a lack of visibility as to future tax changes. Many fear that Congress could
raise taxes in the future. With this view, retirees may wish to take more
advantage of the lower tax rates available now. We are in an odd period where
the presently legislated tax code has lower rates through 2025, and then the
higher tax structure from 2017 is scheduled to return in 2026 if Congress takes
no further action on this matter. With the costs of the global pandemic that
arrived in 2020, even more uncertainty is created about what could happen with
future tax policy.

The tax implications that accompany the death of a spouse in
retirement should be considered as well. In the year after the death takes
place, the household’s filing status will switch from married filing jointly to
single. To the extent that expenses may not fall as rapidly after the death of
a spouse, and as RMDs are not impacted by the size of the household, married
couples may plan to do Roth conversions more aggressively in anticipation of
this tax impact. Single filer status could lead to facing a higher marginal tax
bracket, a greater percentage of Social Security being taxed, and more
vulnerability to experiencing heightened Medicare premiums.

Another matter to further emphasize is that the early
retirement period may provide an opportunity to frontload taxes before Social
Security and Medicare begin. For those retiring by their early 60s, a
systematic tax planning strategy could be accompanied by delaying Social
Security to set in motion a plan that could subsequently avoid a large part of
the Social Security tax torpedo. We will have an example about this in the
following section. As well, before income becomes relevant for Medicare premiums,
which happens with income at age 63 for those starting Medicare at 65, one
could work on tax planning strategies that will avoid the need to pay higher
Medicare premiums. Remember, as well, the health insurance used prior to
Medicare may have premiums or subsidies based on taxable income levels that
would need to also be considered.

A further matter to consider relates to thinking about if
leftover assets will go to beneficiaries rather than being spent for retirement
expenses. The SECURE Act ended lifetime stretches for many recipients of inherited
IRAs. These beneficiaries will have to distribute the assets and pay taxes
during a ten-year window. When beneficiaries are adult children receiving
assets from their parents, this could end up leading to RMDs taking place
during the children’s peak earnings years, which could push up the marginal tax
rate paid on the inheritance. For retirees thinking ahead about bequeathing
assets, the tax bracket management problem for paying taxes at the lowest rates
includes comparing tax rates for the retiree against tax rates for the
potential beneficiary. Roth conversions by the retirees may allow for the taxes
to be paid at a lower rate. Beneficiaries would then receive Roth assets
instead, and though they will have to take RMDs from the inherited Roth, this
would not create taxable income for these potential peak earning years. These
legacy-related issues are explored in the next chapter.

Tax Loss Harvesting

For taxable accounts, tax loss harvesting can also be used
to raise the cost basis of taxable investments at times that do not trigger
additional taxes. Tax loss harvesting is a portfolio management technique
to systematically realize losses from the investment portfolio that can be used
to offset the gains from the portfolio, or to even offset some regular income. When
determining taxes around taxable gains and losses, short-term losses are
first deducted against short-term gains, and long-term losses are first
deducted against long-term gains. Then they are netted from each other. If
there is an overall loss, up to $3,000 of losses can be used to offset other
taxable income, and further losses can be carried forward to future tax years.
With tax loss harvesting, one must be careful about the wash sale rule, which
says that the loss cannot be realized if a substantially identical investment
is purchased within 30 days before or after the sale. After that time passes,
the same investment can be purchased, but otherwise one can look for something
that is similar to the asset sold for a loss.

Deduction Bunching

Another technique for tax management is deduction bunching.
With the increase in the standard deduction and limitations on some categories
for itemized deductions created by the Tax Cut and Jobs Act of 2017, it will be
increasingly difficult for taxpayers to itemize instead of taking the standard
deduction. The standard deduction wastes possible deductible expenses from the
perspective of their impact on reducing taxes: without itemizing, such allowed deductions
do not have any impact on taxable income. One must itemize to receive a
financial benefit for allowed below-the-line deductions such as charitable
giving.

This has led to the popularity of the bunching strategies. The
idea behind deduction bunching is to generate large deductible expenses in one
tax year to cover spending that would have otherwise been spread over several
years. This is done to exceed the standard deduction threshold in one year to
create a tax deduction for things like charitable giving, state and local
taxes, or medical expenses. This works by bunching deductible spending into one
year and skipping this spending in subsequent years.

For example, if you plan to donate $10,000 a year to charity
for each of five years, you may be in a situation where you do not exceed the
standard deduction in each of these five years. However, if you front-load your
five-year contribution into one year as a $50,000 gift, then you will be able
to deduct the $50,000 against your income in the current year. The amount that
exceeds the standard deduction would provide a true tax benefit, and then the
standard deduction can be used in the other four years. For those with state
and local taxes below the $10,000 limit and who live in places that allow it,
it may be possible to pay for two years of these taxes in one year when
otherwise eligible to itemize. Another idea is to focus these deduction
bunching strategies into tax years with unusually high taxable income to have a
bigger impact on taxes due. This higher income could be for natural reasons in
a particular year, such as the sale of a business, or it could be because of a
large strategic Roth conversion.

Donor Advised Funds and Other Charitable Tools

In recent years, donor advised funds have become a simple
and effective way to get assets transferred to charities using a deduction
bunching approach.  These funds can separate charitable planning from tax
planning for those who want to make charitable contributions, but who have not
figured out exactly how much should go to each of multiple charities. This also
helps to offset unexpected income near year end, as a donor can quickly shift
funds at the end of the year without having to figure out which charity should
receive the donation. It is important to note that this would not avoid the tax
torpedo for Social Security or Medicare premiums, because those are determined
by MAGI measures before this below-the-line deduction is taken.

When assets are moved to the donor advised funds, the full
tax deductions are available immediately for the current tax year. The funds
then grow tax free until they are distributed to qualified charities. Though
the funds must eventually be donated, there are no specific requirements about
when.

In addition to allowing for itemizing, this strategy can
also provide the benefits associated with donating appreciated shares instead
of cash. It is important to recognize that for those with appreciated shares in
their taxable accounts, it can be much more effective from a tax perspective to
donate appreciated shares rather than cash. The tax savings could then be
leveraged to provide an even larger gift, if desired. For instance, consider an
individual wishing to donate $30,000. By donating cash, and when itemizing
deductions, this contribution reduces taxable income by $30,000 if we ignore
the standard deduction. Suppose this individual also owns $30,000 worth of
shares in a taxable account with a cost basis of $10,000. These are appreciated
shares with unrealized capital gains of $20,000. By donating these shares
instead, this person gets the same $30,000 tax deduction PLUS there is no need
to pay capital gains taxes on the $20,000 of gains associated with a later sale
of these assets. By donating the appreciated shares, and then using the
available cash to repurchase those shares, we have erased $20,000 of taxable
capital gains from the investment portfolio. In practice, it can be a real
hassle for individuals to donate appreciated shares directly to charities, but
a donor advised fund can help facilitate this process. Assuming you itemize
your tax return, there are also AGI limitations for how much of a charitable
gift is deductible. It is important to work with an accountant when making a
large charitable gift to make sure it is structured in such a way that the full
tax benefits can be received.

For those with charitable inclinations, a
charitable gift annuity is another alternative. With charitable gift annuities,
a charitable organization receives the premium. In turn, the charity provides a
protected lifetime income. Charitable gift annuities will offer lower payout
rates than competitive commercial annuities (i.e. their money’s worth measures
will be lower) to better ensure that the average participant leaves something for
the charity. Charitable gift annuities provide the opportunity to receive a
charitable tax deduction for a portion of the premium in the year that the
premium is paid, which reflects an estimate of the amount that will eventually
be available for the charity after lifetime payments are provided. The premium
can also be paid with appreciated stock, but long-term capital gains tax may
then have to be paid on income received through the annuity. Charitable gift
annuities use unisex rates, which can be relatively helpful for longer-living
women. They may also help to satisfy concerns people have about dying early
with annuities, as one could view the charity as receiving the benefit in these
cases instead of an insurance company. The American Council on Gift Annuities
provides more information at their website, www.acga-web.org.

An Example for Tax Bracket Management

We can put these ideas together with an example that quantifies
how strategic tax planning and delayed Social Security claiming can increase
portfolio longevity in retirement. I have created an example for a 60-year-old
single individual who has just retired in 2021. She has $2 million of
investment assets, divided between $400,000 in a taxable account, $1.3 million
in a traditional IRA, and $300,000 in a Roth IRA. The cost basis for her
taxable assets is also $400,000. Her goal is to spend $95,000 a year in
retirement net of any federal income taxes and she lives in a state that does
not tax income. For Social Security, her primary insurance amount is $30,000 if
she claims at her full retirement age of 67. She will get $21,000 if she claims
at 62 and $37,200 if she claims at 70.

This example does not incorporate asset location issues and
long-term capital gains management, as I simplify investment returns to be 2
percent annually with no inflation. This implies that investments are held in
bonds and provide 2 percent taxable interest payments annually without
potential for capital gains or losses. While investment returns are simplified,
the full tax code has been built into the example. Taxes for 2021 to 2025 are
based on present law, and the 2017 tax code (with inflation adjustments through
2021) is used for 2026 and later.

Exhibit 10.16 summarizes the results for this example. It
shows five different strategies for this individual. The first is to claim
Social Security at age 62 and to follow the conventional wisdom for spending
down assets: take any RMDs, then spend the taxable portfolio, then the
tax-deferred portfolio, and then the tax-exempt portfolio. This strategy
supports 28.99 years of retirement spending, and the details are provided in Exhibit
10.17. It is the baseline. When the portfolio covers a fraction of the year,
that represents the percentage of the overall spending goal that can be funded
in the year.

Next, to show the value of delaying Social Security, if this
retiree claims Social Security at 70 and uses the same conventional wisdom
spend-down strategy, portfolio longevity increases by 1.86 years to 30.85
years. The remaining strategies in the exhibit also use Social Security
claiming at 70. The next strategy is to use tax bracket management at a
pre-determined level of AGI without using Roth conversions. I test various AGI
levels to manage and find that an AGI target of $60,000 provides the most
benefit for this example, with portfolio longevity of 32.82 years (see Exhibit
10.20). If we follow the same strategy and include strategic Roth conversions
as well, portfolio longevity increases to 33.54 years (see Exhibit 10.21). Coincidentally,
an AGI target of $60,000 also creates the greatest portfolio longevity with Roth
conversions. Finally, I provide an example of front-loading taxes to a higher
level in the early retirement years and then targeting a lower AGI level for
later in retirement. After several different permutations, I find that managing
AGI to $111,000 until age 70, which is the threshold just before a second layer
of IRMAA-related Medicare premium increases kick in for earnings starting at
63, and then switching to manage an AGI of $25,000 for age 70 and later (when
Social Security starts) can increase portfolio longevity by more than another
year to 34.62 years (see Exhibit 10.22). This is 5.63 years longer than
following convention wisdom on spenddown strategies and claiming Social
Security early. After raising the claiming age to 70, this more tax-efficient
strategy still adds 3.77 years of portfolio longevity to the convention wisdom tax
strategy. The topics described in this chapter can add significantly to the
longevity of retirement distributions.

Exhibit 10.16

Tax-Efficient Retirement Income for a 60-Year-Old
Single Retiree

Singles

Years of Longevity

Increase from (1)

(1) Conventional Wisdom,
Social Security at 62

(Taxable, Tax-Deferred, Tax-Free) [EXHIBIT 10.17]

28.99

---

Conventional Wisdom, Social
Security at 70

(Taxable, Tax-Deferred, Tax-Free)

30.85

1.86

Tax Bracket Management, AGI=
$60,000

Social Security at 70 [EXHIBIT 10.20]

32.82

3.83

Tax Bracket Management with
Roth Conversions, AGI=$60,000

Social Security at 70 [EXHIBIT 10.21]

33.54

4.55

Tax Bracket Management with
Roth Conversions

Manage 2nd IRMAA Threshold Through 2029,

then Manage AGI=$25,000

Social Security at 70 [EXHIBIT 10.22]

34.62

5.63

Married Filing Jointly

Years of Longevity

Increase from (1)

Bonus over Single Rates

(1) Conventional Wisdom,
Social Security at 62

(Taxable, Tax-Deferred, Tax-Free)

32.65

---

3.66

Conventional Wisdom, Social
Security at 70

(Taxable, Tax-Deferred, Tax-Free)

35.62

2.97

4.77

Tax Bracket Management, AGI=
$65,000

Social Security at 70

36.9

4.25

4.08

Tax Bracket Management with
Roth Conversions, AGI=$63,000

Social Security at 70

37.41

4.76

3.87

Tax Bracket Management with
Roth Conversions

Manage 2nd IRMAA Threshold Through 2029,

Social Security at 70

33.92

1.27

-0.7

As a further note, this exhibit also shows the five
corresponding strategies assuming that everything is the same except that the
discussion is about a married couple instead of a single person. The point for
including results for the couple is to demonstrate how much impact the
differing tax brackets between singles and couples can have on retirement
sustainability. For the different strategies, applying tax brackets for married
filing jointly could extend portfolio longevity by more than 3.66 years. This
does speak to the planning idea mentioned about how those who are married
filing jointly may seek more balance by frontloading taxes in anticipation of
an inevitable point when the surviving spouse will face the tax brackets for
singles. We can also note that the strategy for managing the second IRMAA threshold
for couples ($222,000) is too aggressive and results in worse outcomes. It
forces too much taxes to be paid early on, such that tax capacity is wasted
later in retirement.

Moving now to the specific lifetime patterns for different
strategies, Exhibit 10.17 provides the results for claiming Social Security at
age 62 and following the specific distribution strategy of spending taxable
assets first, then tax-deferred assets, and then tax-exempt assets. In this
case, she can meet her full spending goals for 28.99 years until just before
her 89th birthday. At this point her investment assets deplete and she
only has a $21,000 Social Security benefit to cover the rest of her life. I
show the details of this strategy to contrast it with more efficient spending
strategies.

In Exhibit 10.17, we can identify some of the inefficiencies
with the standard withdrawal recommendations. First, by only spending from the
taxable portfolio at the start, she wastes space in her tax brackets to trigger
taxes when tax rates are low. Her adjusted gross income in the early retirement
years consists only of the 2 percent interest payments being generated by her
remaining taxable assets each year. Her income does not even rise to the level
of the standard deduction until age 65, when her taxable assets deplete, and
she switches to spending from the tax-deferred account. Though she does not pay
taxes during the first 5 years of retirement, she is heading toward a bigger
tax bill later that will have a profound effect on her portfolio longevity.

From ages 65 to 81 her adjusted gross income is more than
$100,000 because she spends only from the tax-deferred account and Social
Security benefits. This inefficiency is leading her to have tax payments on 85
percent of her Social Security benefits between the ages of 65 and 82. In
addition, from ages 66 to 81 her Medicare MAGI (I assume no tax-exempt bonds so
this MAGI matches the AGI) exceeds the second Medicare threshold ($111,000),
which causes her Medicare premiums to increase by $2,164 per year from ages 68
to 84. Remember, Medicare premiums have a two-year lag related to income. I
include these IRMAA increases as part of her taxes. Her annual tax bill between
ages 68 and 82 is $23,670, which represents an effective tax rate of 24.9
percent of her $95,000 pre-tax spending goal. As discussed at the outset of the
chapter, this is a meaningful way to describe the effective tax rate in
retirement.

Later in retirement, after she depletes the tax-deferred account,
spending is sourced to the Roth IRA and Social Security. Her taxes eventually fall
back to $0 as her adjusted gross income is $0 starting at age 83. That year she
just has one more IRMAA adjustment to pay. Roth distributions do not create any
taxable income, and her Social Security benefits are not taxable at this stage.
While taxes are $0 as of age 84, the damage has already been done and there is
0 percent tax rate capacity being wasted by not having income to cover the
standard deduction.

One other harmful possibility that was not an issue with
this example is that required minimum distributions were never binding in terms
of forcing a higher distribution from the tax-deferred account than the retiree
otherwise wanted, but this could also be an issue for those whose IRA balances
are too high relative to their spending goals. This distribution strategy simply
missed opportunities to pay taxes at lower rates and ended up paying too much
tax at higher rates.

Exhibit 10.17

Outcomes for Claiming Social Security at 62,

Following Conventional Withdrawal Order Sequencing
Strategy

Remaining Wealth

Spending

Age

Taxable

Tax-Deferred

Tax Exempt

Taxable

Tax-Deferred

Tax Exempt

Social Security

60

$311,100

$1,326,000

$306,000

$95,000

$0

$0

$0

61

$220,422

$1,352,520

$312,120

$95,000

$0

$0

$0

62

$149,350

$1,379,570

$318,362

$74,000

$0

$0

$21,000

63

$76,857

$1,407,162

$324,730

$74,000

$0

$0

$21,000

64

$2,915

$1,435,305

$331,224

$74,000

$0

$0

$21,000

65

$0

$1,371,517

$337,849

$2,915

$90,681

$0

$21,000

66

$0

$1,302,389

$344,606

$0

$94,665

$0

$21,000

67

$0

$1,230,659

$351,498

$0

$95,860

$0

$21,000

68

$0

$1,155,649

$358,528

$0

$97,670

$0

$21,000

69

$0

$1,079,138

$365,698

$0

$97,670

$0

$21,000

70

$0

$1,001,097

$373,012

$0

$97,670

$0

$21,000

71

$0

$921,495

$380,473

$0

$97,670

$0

$21,000

72

$0

$840,302

$388,082

$0

$97,670

$0

$21,000

73

$0

$757,484

$395,844

$0

$97,670

$0

$21,000

74

$0

$673,010

$403,761

$0

$97,670

$0

$21,000

75

$0

$586,847

$411,836

$0

$97,670

$0

$21,000

76

$0

$498,960

$420,072

$0

$97,670

$0

$21,000

77

$0

$409,316

$428,474

$0

$97,670

$0

$21,000

78

$0

$317,878

$437,043

$0

$97,670

$0

$21,000

79

$0

$224,612

$445,784

$0

$97,670

$0

$21,000

80

$0

$129,481

$454,700

$0

$97,670

$0

$21,000

81

$0

$32,447

$463,794

$0

$97,670

$0

$21,000

82

$0

$0

$423,998

$0

$32,447

$48,110

$21,000

83

$0

$0

$354,791

$0

$0

$76,164

$21,000

84

$0

$0

$286,407

$0

$0

$74,000

$21,000

85

$0

$0

$216,655

$0

$0

$74,000

$21,000

86

$0

$0

$145,508

$0

$0

$74,000

$21,000

87

$0

$0

$72,938

$0

$0

$74,000

$21,000

88

$0

$0

$0

$0

$0

$72,938

$21,000

89

$0

$0

$0

$0

$0

$0

$21,000

90

$0

$0

$0

$0

$0

$0

$21,000

91

$0

$0

$0

$0

$0

$0

$21,000

92

$0

$0

$0

$0

$0

$0

$21,000

93

$0

$0

$0

$0

$0

$0

$21,000

94

$0

$0

$0

$0

$0

$0

$21,000

Exhibit 10.17 continued…

Age

RMDs

Roth Conversion

Adjusted Gross Income

Taxable Income

Taxable Social Security

Federal Income Taxes

60

$0

$0

$6,100

$0

$0

$0

61

$0

$0

$4,322

$0

$0

$0

62

$0

$0

$2,928

$0

$0

$0

63

$0

$0

$1,507

$0

$0

$0

64

$0

$0

$57

$0

$0

$0

65

$0

$0

$108,531

$96,581

$17,850

$19,595

66

$0

$0

$112,515

$100,565

$17,850

$20,665

67

$0

$0

$113,710

$101,760

$17,850

$21,860

68

$0

$0

$115,520

$103,570

$17,850

$23,670

69

$0

$0

$115,520

$103,570

$17,850

$23,670

70

$0

$0

$115,520

$103,570

$17,850

$23,670

71

$0

$0

$115,520

$103,570

$17,850

$23,670

72

$33,631

$0

$115,520

$103,570

$17,850

$23,670

73

$31,710

$0

$115,520

$103,570

$17,850

$23,670

74

$29,705

$0

$115,520

$103,570

$17,850

$23,670

75

$27,358

$0

$115,520

$103,570

$17,850

$23,670

76

$24,761

$0

$115,520

$103,570

$17,850

$23,670

77

$21,789

$0

$115,520

$103,570

$17,850

$23,670

78

$18,605

$0

$115,520

$103,570

$17,850

$23,670

79

$15,065

$0

$115,520

$103,570

$17,850

$23,670

80

$11,119

$0

$115,520

$103,570

$17,850

$23,670

81

$6,674

$0

$115,520

$103,570

$17,850

$23,670

82

$1,754

$0

$44,552

$32,602

$12,105

$6,556

83

$0

$0

$0

$0

$0

$2,164

84

$0

$0

$0

$0

$0

$0

85

$0

$0

$0

$0

$0

$0

86

$0

$0

$0

$0

$0

$0

87

$0

$0

$0

$0

$0

$0

88

$0

$0

$0

$0

$0

$0

89

$0

$0

$0

$0

$0

$0

90

$0

$0

$0

$0

$0

$0

91

$0

$0

$0

$0

$0

$0

92

$0

$0

$0

$0

$0

$0

93

$0

$0

$0

$0

$0

$0

94

$0

$0

$0

$0

$0

$0

As we shift to more efficient strategies, Exhibits 10.18 and
10.19 helps us identify how the AGI target choice impacts portfolio longevity. These
exhibits become the source of the strategies we consider in greater detail in
subsequent exhibits. The strategy we just described is represented as
“Conventional Wisdom, SS@62” in these two exhibits. We can contrast the conventional
wisdom approach to tax bracket management either as the source of retirement
spending (Bracket Manage) or to conduct strategic Roth conversions (Roth
Conversions). For these strategies, the level of AGI managed impacts portfolio
sustainability and the charts can be used to find the income level linking to
the longest sustainability.

Exhibit 10.18

Portfolio Longevity and Tax-Efficient
Distribution Strategies

Managing a Fixed Level of Adjusted Gross Income in
Retirement

In Exhibit 10.18, we consider a variety of fixed adjusted
gross income levels to manage and study portfolio longevity as we vary income targets.
Generally, allowing Roth conversions can support greater portfolio longevity.
The exhibit shows that for this example, using Roth conversions and managing an
adjusted gross income of $60,000 per year allows for the greatest portfolio
longevity. It is the sweet spot to provide the best balance for lifetime taxes.
Lower AGI levels will not be able to get enough moved to the Roth account and
can lead to too much later taxes. Higher levels mean moving assets to the Roth
account too quickly such that some of the lower tax bracket space is eventually
wasted by a lack of taxable income.

Exhibit 10.19 takes matters a step further to show how
managing to the $111,000 AGI level for the years before Social Security begins
and then managing to a lower subsequent level may support even better outcomes.
This front-loading of taxes reduces the impact of the Social Security torpedo
later in retirement, as by that time managing an AGI of $25,000 can support the
most long-term sustainability. Using the optimal outcomes from these two
exhibits give us the sources for additional examples to explain how tax bracket
management can improve portfolio sustainability.

Exhibit 10.19

Portfolio Longevity and Tax-Efficient
Distribution Strategies

Managing $111,000 of Adjusted Gross Income for
the First Ten Years

And then Managing a Fixed Level of AGI for the Rest

Exhibit 10.20 provides a more complete picture about how the
optimal “Bracket Manage” strategy plays out with a fixed $60,000 AGI target.
Compared to the previous strategy in Exhibit 10.17, this strategy adds 3.83
years of portfolio longevity by increasing Social Security benefits, shifting
income from the high-tax middle years of retirement to earlier and later years
when lower marginal tax rates apply, reducing the portion of Social Security
that gets taxed, and eliminating IRMAA-related Medicare surcharges until later
in retirement. Specifically, the strategy works by first sourcing spending gaps
from the tax-deferred account until the AGI target is reached, and then filling
the remaining need from the taxable account while assets remain and then from
the Roth account after taxable assets deplete. The taxable account now lasts
until age 69 since spending from it is slowed. This leads to taxes of $6,188
for the first five years, and then $7,483 starting in 2026 with the reversion
to the pre-TCJA tax code. Taxes then stay at this level until age 81 when an
RMD becomes binding for three years and forces more out of the tax-deferred
account. By age 84, the Roth account depletes and the subsequent greater
distribution need from the IRA pushes up taxable income from that point. Social
Security begins at age 70 with a benefit of $37,200, which helps reduce the
portfolio distribution need. This strategy keeps the taxable portion of Social
Security lower at 61.6 percent of benefits, until later in retirement when the
AGI is forced to increase as tax-deferred assets become the only available
investment resource in those later retirement years.

Exhibit 10.20

Outcomes for Claiming Social Security at 70,

Managing $60,0000 Adjusted Gross Income (no Roth
Conversions)

Remaining Wealth

Spending

Age

Taxable

Tax-Deferred

Tax Exempt

Taxable

Tax-Deferred

Tax Exempt

Social Security

60

$358,813

$1,271,976

$306,000

$48,223

$52,964

$0

$0

61

$317,625

$1,242,568

$312,120

$47,415

$53,772

$0

$0

62

$276,438

$1,211,748

$318,362

$46,608

$54,580

$0

$0

63

$235,250

$1,179,488

$324,730

$45,800

$55,387

$0

$0

64

$194,063

$1,145,759

$331,224

$44,993

$56,195

$0

$0

65

$151,600

$1,110,507

$337,849

$45,435

$57,027

$0

$0

66

$109,138

$1,073,699

$344,606

$44,602

$57,860

$0

$0

67

$66,675

$1,035,307

$351,498

$43,770

$58,693

$0

$0

68

$24,213

$995,297

$358,528

$42,937

$59,525

$0

$0

69

$0

$954,003

$347,083

$24,213

$60,000

$18,250

$0

70

$0

$935,266

$325,274

$0

$37,076

$28,187

$37,200

71

$0

$916,154

$303,029

$0

$37,076

$28,187

$37,200

72

$0

$896,660

$280,339

$0

$37,076

$28,187

$37,200

73

$0

$876,776

$257,196

$0

$37,076

$28,187

$37,200

74

$0

$856,495

$233,589

$0

$37,076

$28,187

$37,200

75

$0

$835,807

$209,510

$0

$37,076

$28,187

$37,200

76

$0

$814,706

$184,950

$0

$37,076

$28,187

$37,200

77

$0

$793,183

$159,898

$0

$37,076

$28,187

$37,200

78

$0

$771,230

$134,346

$0

$37,076

$28,187

$37,200

79

$0

$748,837

$108,282

$0

$37,076

$28,187

$37,200

80

$0

$725,997

$81,697

$0

$37,076

$28,187

$37,200

81

$0

$702,346

$54,771

$0

$37,423

$28,000

$37,200

82

$0

$677,669

$27,603

$0

$37,965

$27,709

$37,200

83

$0

$652,170

$68

$0

$38,286

$27,536

$37,200

84

$0

$586,198

$0

$0

$77,466

$68

$37,200

85

$0

$518,814

$0

$0

$77,557

$0

$37,200

86

$0

$448,901

$0

$0

$78,715

$0

$37,200

87

$0

$377,589

$0

$0

$78,715

$0

$37,200

88

$0

$304,852

$0

$0

$78,715

$0

$37,200

89

$0

$230,659

$0

$0

$78,715

$0

$37,200

90

$0

$154,983

$0

$0

$78,715

$0

$37,200

91

$0

$77,793

$0

$0

$78,715

$0

$37,200

92

$0

$0

$0

$0

$77,793

$0

$37,200

93

$0

$0

$0

$0

$0

$0

$37,200

94

$0

$0

$0

$0

$0

$0

$37,200

Exhibit 10.20 continued…

Age

RMDs

Roth Conversion

Adjusted Gross Income

Taxable Income

Taxable Social Security

Federal Income Taxes

60

$0

$0

$60,000

$47,450

$0

$6,188

61

$0

$0

$60,000

$47,450

$0

$6,188

62

$0

$0

$60,000

$47,450

$0

$6,188

63

$0

$0

$60,000

$47,450

$0

$6,188

64

$0

$0

$60,000

$47,450

$0

$6,188

65

$0

$0

$60,000

$48,050

$0

$7,463

66

$0

$0

$60,000

$48,050

$0

$7,463

67

$0

$0

$60,000

$48,050

$0

$7,463

68

$0

$0

$60,000

$48,050

$0

$7,463

69

$0

$0

$60,000

$48,050

$0

$7,463

70

$0

$0

$60,000

$48,050

$22,924

$7,463

71

$0

$0

$60,000

$48,050

$22,924

$7,463

72

$33,436

$0

$60,000

$48,050

$22,924

$7,463

73

$33,836

$0

$60,000

$48,050

$22,924

$7,463

74

$34,383

$0

$60,000

$48,050

$22,924

$7,463

75

$34,817

$0

$60,000

$48,050

$22,924

$7,463

76

$35,266

$0

$60,000

$48,050

$22,924

$7,463

77

$35,577

$0

$60,000

$48,050

$22,924

$7,463

78

$36,054

$0

$60,000

$48,050

$22,924

$7,463

79

$36,551

$0

$60,000

$48,050

$22,924

$7,463

80

$37,071

$0

$60,000

$48,050

$22,924

$7,463

81

$37,423

$0

$60,642

$48,692

$23,219

$7,623

82

$37,965

$0

$61,645

$49,695

$23,680

$7,874

83

$38,286

$0

$62,240

$50,290

$23,953

$8,022

84

$38,820

$0

$109,086

$97,136

$31,620

$19,734

85

$36,637

$0

$109,177

$97,227

$31,620

$19,757

86

$34,133

$0

$110,335

$98,385

$31,620

$20,915

87

$31,174

$0

$110,335

$98,385

$31,620

$20,915

88

$27,561

$0

$110,335

$98,385

$31,620

$20,915

89

$23,632

$0

$110,335

$98,385

$31,620

$20,915

90

$18,906

$0

$110,335

$98,385

$31,620

$20,915

91

$13,477

$0

$110,335

$98,385

$31,620

$20,915

92

$7,203

$0

$109,413

$97,463

$31,620

$20,676

93

$0

$0

$0

$0

$0

$860

94

$0

$0

$0

$0

$0

$860

Though retirees may be wary about unnecessarily generating
more taxable income in the early retirement years, we have another example
about how short-term sacrifice with retirement income planning can lead to
long-term efficiencies. This strategy has smoothed taxes at a lower level
throughout retirement. Tax bracket space is not wasted by paying some taxes
during the earlier retirement years. Altogether, this strategy added 3.83 years
of portfolio longevity as compared to the baseline strategy. As well, even if
assets deplete, the retiree benefits from still having a Social Security
benefit that is 76 percent larger than when claiming at 62.

Next, in Exhibit 10.21 we allow for strategic Roth
conversions as part of tax-bracket management. The optimal AGI target is
$60,000 again, and this increases portfolio longevity by another 0.72 years
over the previous strategy. Roth conversion strategies tend to support the same
or better outcomes than simple bracket management. For Roth conversions, the
early retirement years consist of spending down taxable assets like in the
conventional strategy, but also generating more taxable income by converting
assets from the tax-deferred account into the Roth account to cover the target.
The first four years of retirement witness Roth conversions of more than
$50,000 per year. Roth conversions continue until the taxable portfolio
depletes. The additional taxes on the conversions are also funded by the
taxable account, which depletes it more rapidly.

At age 64, the taxable account depletes, Roth conversions
end, and distributions from the tax-deferred account are instead used to fund
retirement expenses up to the $60,000 AGI target. The remainder of spending is
covered by distributions from the Roth account, allowing for the AGI target to
continue being managed. This keeps taxable income lower. Again, 61.6 percent of
Social Security benefits are taxed during the middle period, which provides
additional tax relief relative to when 85 percent of benefits are taxed.

With the same pre-tax spending goal, the combined effects of
this strategy maintain investment assets until age 93. After assets deplete, Social
Security continues to provide $37,200 of annual spending. This example
highlights the value of tax-efficient retirement planning, as portfolio
longevity extends by 4.55 years relative to the first strategy. We moved away
from the conventional wisdom by first blending distributions from the taxable
and tax-deferred accounts while taxable assets remain, and then blending
distributions from the tax-deferred and tax-free accounts. This blending
process provides greater control over AGI and marginal tax rates.

As a final example, Exhibit 10.22 provides a case in which
taxes are even more strongly front-loaded into the early retirement years
before Social Security begins. This helps to better manage the Social Security
tax torpedo. Even though tax bills are higher in the early retirement years,
the strategy can increase portfolio longevity by more than a full year relative
to the previous strategy. This strategy allows the retirement spending goal to
be met for 34.62 years.

In this case, Roth conversions are used to manage a $111,000
AGI level for the first ten years of retirement before Social Security begins. As
I am assuming there is no tax-exempt interest from municipal bonds to be
counted, the AGI matches the MAGI used to calculate IRMAA-related premium
increases for Medicare. This AGI target is right at the level that accepts one
hike in Medicare premiums but just avoids the second hike. In practice, one
must be especially cautious about managing income around one of the Medicare
brackets, because going over by just $1 will trigger a substantial additional premium
hike.

This strategy allows for larger Roth conversions in the
early years of retirement until the taxable portfolio depletes at age 63. Roth
conversions exceed $100,000 for three years but are limited in the fourth year
by the small remaining balance for taxable assets. The spending is then sourced
to a combination of tax-deferred and Roth distributions to continue managing
the same AGI level through age 69.

At age 70, Social Security begins and a new AGI target of $25,000
is used for the remainder of retirement. Though the tax bill reaches $21,101
for ages 65 to 69, it is only $2,320 at age 70 and 71 and then never exceeds
$1,460 for the remainder of retirement. Required Minimum Distributions are
never binding to force more from the IRA than is desired for spending and
tax-efficiency purposes. This $1,460 tax number provides an effective tax rate
of 1.5 percent of the retirement spending goal for ages 72 and later, which may
seem shocking for someone who began their retirement with $2 million of
investment assets and is managing $95,000 of pre-tax spending. The reason this
strategy is so effective is because it worked to further reduce the Social
Security tax torpedo, as only 18.4 percent of Social Security benefits are
counted as taxable income throughout retirement. Portfolio assets last for 34.62
years until the retiree is almost 95 years old.  This is an increase of 5.63
years over the baseline, showing the real value that can be obtained for
retirement plans by combining a delay in Social Security with an aggressive
Roth conversion strategy in the early retirement years.

A
Caveat About the Results

Strategies that extend portfolio longevity
involved aggressively consuming the taxable portfolio to cover spending needs
and taxes on Roth conversions. This is partly due to the assumption that
portfolio returns are realized and taxed annually at ordinary income tax
rates. With preferential treatment for long-term capital gains and qualified
dividends, there may be reason to slow spending from the taxable portfolio,
as keeping some assets may allow for future distributions that can be taxed
at preferential rates, though that would also make more of Social Security
taxable. I aim to explore this further in my next iteration of research on
this topic.

Exhibit 10.21

Outcomes for Claiming Social Security at 70,

Managing $60,0000 Adjusted Gross Income (Using Roth
Conversions)

Remaining Wealth

Spending

Age

Taxable

Tax-Deferred

Tax Exempt

Taxable

Tax-Deferred

Tax Exempt

Social Security

60

$304,789

$1,270,896

$361,104

$101,188

$54,024

$0

$0

61

$207,673

$1,239,267

$425,373

$101,188

$55,928

$0

$0

62

$108,615

$1,205,025

$492,908

$101,188

$57,870

$0

$0

63

$7,577

$1,168,077

$563,815

$101,188

$59,851

$0

$0

64

$0

$1,130,238

$540,808

$7,577

$60,000

$33,611

$0

65

$0

$1,091,643

$508,312

$0

$60,000

$42,463

$0

66

$0

$1,052,276

$475,167

$0

$60,000

$42,463

$0

67

$0

$1,012,122

$441,358

$0

$60,000

$42,463

$0

68

$0

$971,164

$406,874

$0

$60,000

$42,463

$0

69

$0

$929,387

$371,699

$0

$60,000

$42,463

$0

70

$0

$910,158

$350,383

$0

$37,076

$28,187

$37,200

71

$0

$890,544

$328,640

$0

$37,076

$28,187

$37,200

72

$0

$870,537

$306,462

$0

$37,076

$28,187

$37,200

73

$0

$850,131

$283,841

$0

$37,076

$28,187

$37,200

74

$0

$829,316

$260,767

$0

$37,076

$28,187

$37,200

75

$0

$808,086

$237,232

$0

$37,076

$28,187

$37,200

76

$0

$786,430

$213,226

$0

$37,076

$28,187

$37,200

77

$0

$764,342

$188,740

$0

$37,076

$28,187

$37,200

78

$0

$741,811

$163,764

$0

$37,076

$28,187

$37,200

79

$0

$718,830

$138,289

$0

$37,076

$28,187

$37,200

80

$0

$695,390

$112,304

$0

$37,076

$28,187

$37,200

81

$0

$671,480

$85,800

$0

$37,076

$28,187

$37,200

82

$0

$647,093

$58,765

$0

$37,076

$28,187

$37,200

83

$0

$622,217

$31,190

$0

$37,076

$28,187

$37,200

84

$0

$596,844

$3,063

$0

$37,076

$28,187

$37,200

85

$0

$533,839

$0

$0

$73,473

$3,063

$37,200

86

$0

$465,408

$0

$0

$77,557

$0

$37,200

87

$0

$394,427

$0

$0

$78,715

$0

$37,200

88

$0

$322,026

$0

$0

$78,715

$0

$37,200

89

$0

$248,177

$0

$0

$78,715

$0

$37,200

90

$0

$172,851

$0

$0

$78,715

$0

$37,200

91

$0

$96,018

$0

$0

$78,715

$0

$37,200

92

$0

$17,649

$0

$0

$78,715

$0

$37,200

93

$0

$0

$0

$0

$17,649

$0

$37,200

94

$0

$0

$0

$0

$0

$0

$37,200

Exhibit 10.21 continued…

Age

RMDs

Roth Conversion

Adjusted Gross Income

Taxable Income

Taxable Social Security

Federal Income Taxes

60

$0

$54,024

$60,000

$47,450

$0

$6,188

61

$0

$55,928

$60,000

$47,450

$0

$6,188

62

$0

$57,870

$60,000

$47,450

$0

$6,188

63

$0

$59,851

$60,000

$47,450

$0

$6,188

64

$0

$0

$60,000

$47,450

$0

$6,188

65

$0

$0

$60,000

$48,050

$0

$7,463

66

$0

$0

$60,000

$48,050

$0

$7,463

67

$0

$0

$60,000

$48,050

$0

$7,463

68

$0

$0

$60,000

$48,050

$0

$7,463

69

$0

$0

$60,000

$48,050

$0

$7,463

70

$0

$0

$60,000

$48,050

$22,924

$7,463

71

$0

$0

$60,000

$48,050

$22,924

$7,463

72

$32,502

$0

$60,000

$48,050

$22,924

$7,463

73

$32,850

$0

$60,000

$48,050

$22,924

$7,463

74

$33,338

$0

$60,000

$48,050

$22,924

$7,463

75

$33,712

$0

$60,000

$48,050

$22,924

$7,463

76

$34,096

$0

$60,000

$48,050

$22,924

$7,463

77

$34,342

$0

$60,000

$48,050

$22,924

$7,463

78

$34,743

$0

$60,000

$48,050

$22,924

$7,463

79

$35,157

$0

$60,000

$48,050

$22,924

$7,463

80

$35,586

$0

$60,000

$48,050

$22,924

$7,463

81

$35,845

$0

$60,000

$48,050

$22,924

$7,463

82

$36,296

$0

$60,000

$48,050

$22,924

$7,463

83

$36,559

$0

$60,000

$48,050

$22,924

$7,463

84

$37,037

$0

$60,000

$48,050

$22,924

$7,463

85

$37,303

$0

$105,093

$93,143

$31,620

$18,736

86

$35,121

$0

$109,177

$97,227

$31,620

$19,757

87

$32,320

$0

$110,335

$98,385

$31,620

$20,915

88

$28,790

$0

$110,335

$98,385

$31,620

$20,915

89

$24,963

$0

$110,335

$98,385

$31,620

$20,915

90

$20,342

$0

$110,335

$98,385

$31,620

$20,915

91

$15,031

$0

$110,335

$98,385

$31,620

$20,915

92

$8,891

$0

$110,335

$98,385

$31,620

$20,915

93

$1,747

$0

$24,061

$12,111

$6,412

$2,180

94

$0

$0

$0

$0

$0

$860

Exhibit 10.22

Outcomes for Claiming Social Security at 70,

Managing $111,0000 Adjusted Gross Income for the
First Ten Years,

And then $25,000 of AGI for the Rest (Using Roth
Conversions)

Remaining Wealth

Spending

Age

Taxable

Tax-Deferred

Tax Exempt

Taxable

Tax-Deferred

Tax Exempt

Social Security

60

$293,098

$1,218,642

$413,358

$112,649

$105,253

$0

$0

61

$184,058

$1,133,476

$531,164

$112,649

$107,391

$0

$0

62

$71,960

$1,044,365

$653,568

$113,509

$109,589

$0

$0

63

$0

$952,032

$737,479

$71,960

$111,000

$0

$0

64

$0

$857,853

$749,669

$0

$111,000

$2,509

$0

65

$0

$761,790

$759,459

$0

$111,000

$5,101

$0

66

$0

$663,805

$769,444

$0

$111,000

$5,101

$0

67

$0

$563,862

$779,630

$0

$111,000

$5,101

$0

68

$0

$461,919

$790,019

$0

$111,000

$5,101

$0

69

$0

$357,937

$800,616

$0

$111,000

$5,101

$0

70

$0

$346,576

$773,825

$0

$18,157

$41,964

$37,200

71

$0

$334,988

$746,499

$0

$18,157

$41,964

$37,200

72

$0

$323,168

$719,504

$0

$18,157

$41,103

$37,200

73

$0

$311,111

$691,969

$0

$18,157

$41,103

$37,200

74

$0

$298,813

$663,883

$0

$18,157

$41,103

$37,200

75

$0

$286,270

$635,235

$0

$18,157

$41,103

$37,200

76

$0

$273,475

$606,014

$0

$18,157

$41,103

$37,200

77

$0

$260,425

$576,209

$0

$18,157

$41,103

$37,200

78

$0

$247,113

$545,808

$0

$18,157

$41,103

$37,200

79

$0

$233,536

$514,799

$0

$18,157

$41,103

$37,200

80

$0

$219,687

$483,170

$0

$18,157

$41,103

$37,200

81

$0

$205,560

$450,908

$0

$18,157

$41,103

$37,200

82

$0

$191,152

$418,001

$0

$18,157

$41,103

$37,200

83

$0

$176,455

$384,435

$0

$18,157

$41,103

$37,200

84

$0

$161,464

$350,199

$0

$18,157

$41,103

$37,200

85

$0

$146,173

$315,277

$0

$18,157

$41,103

$37,200

86

$0

$130,577

$279,658

$0

$18,157

$41,103

$37,200

87

$0

$114,669

$243,326

$0

$18,157

$41,103

$37,200

88

$0

$98,442

$206,267

$0

$18,157

$41,103

$37,200

89

$0

$81,891

$168,467

$0

$18,157

$41,103

$37,200

90

$0

$65,009

$129,911

$0

$18,157

$41,103

$37,200

91

$0

$47,789

$90,584

$0

$18,157

$41,103

$37,200

92

$0

$30,225

$50,470

$0

$18,157

$41,103

$37,200

93

$0

$12,310

$9,554

$0

$18,157

$41,103

$37,200

94

$0

$0

$0

$0

$12,310

$9,554

$37,200

Exhibit 10.22 continued…

Age

RMDs

Roth Conversion

Adjusted Gross Income

Taxable Income

Taxable Social Security

Federal Income Taxes

60

$0

$105,253

$111,000

$98,450

$0

$17,649

61

$0

$107,391

$111,000

$98,450

$0

$17,649

62

$0

$109,589

$111,000

$98,450

$0

$18,509

63

$0

$69,450

$111,000

$98,450

$0

$18,509

64

$0

$0

$111,000

$98,450

$0

$18,509

65

$0

$0

$111,000

$99,050

$0

$21,101

66

$0

$0

$111,000

$99,050

$0

$21,101

67

$0

$0

$111,000

$99,050

$0

$21,101

68

$0

$0

$111,000

$99,050

$0

$21,101

69

$0

$0

$111,000

$99,050

$0

$21,101

70

$0

$0

$25,000

$13,050

$6,843

$2,320

71

$0

$0

$25,000

$13,050

$6,843

$2,320

72

$12,226

$0

$25,000

$13,050

$6,843

$1,460

73

$12,195

$0

$25,000

$13,050

$6,843

$1,460

74

$12,200

$0

$25,000

$13,050

$6,843

$1,460

75

$12,147

$0

$25,000

$13,050

$6,843

$1,460

76

$12,079

$0

$25,000

$13,050

$6,843

$1,460

77

$11,942

$0

$25,000

$13,050

$6,843

$1,460

78

$11,837

$0

$25,000

$13,050

$6,843

$1,460

79

$11,712

$0

$25,000

$13,050

$6,843

$1,460

80

$11,561

$0

$25,000

$13,050

$6,843

$1,460

81

$11,324

$0

$25,000

$13,050

$6,843

$1,460

82

$11,111

$0

$25,000

$13,050

$6,843

$1,460

83

$10,800

$0

$25,000

$13,050

$6,843

$1,460

84

$10,503

$0

$25,000

$13,050

$6,843

$1,460

85

$10,092

$0

$25,000

$13,050

$6,843

$1,460

86

$9,617

$0

$25,000

$13,050

$6,843

$1,460

87

$9,068

$0

$25,000

$13,050

$6,843

$1,460

88

$8,370

$0

$25,000

$13,050

$6,843

$1,460

89

$7,631

$0

$25,000

$13,050

$6,843

$1,460

90

$6,712

$0

$25,000

$13,050

$6,843

$1,460

91

$5,653

$0

$25,000

$13,050

$6,843

$1,460

92

$4,425

$0

$25,000

$13,050

$6,843

$1,460

93

$2,993

$0

$25,000

$13,050

$6,843

$1,460

94

$1,296

$0

$15,265

$3,315

$2,955

$331

I conclude this example with Exhibit 10.23, which could
serve as the guiding emblem for this book. It tracks remaining wealth in
retirement for the longest surviving strategy from Exhibit 10.22 against the
baseline strategy from Exhibit 10.17. This image shows the tradeoff between
short-term costs and long-term benefits for the two strategies. We described
how delaying Social Security to 70 and aggressively making Roth conversions
allows for retirement assets to last 5.63 years longer while meeting the same
pre-tax spending goal, as compared to a strategy in which Social Security is
claimed at 62 and assets are spent in order from taxable, tax-deferred, and
then tax-exempt accounts. The exhibit shows how obtaining these long-term
benefits requires short-term sacrifice, as the tax-efficient strategy will lag
with its remaining wealth for the first 17 years of retirement. For the largest
early gap, the baseline strategy supports $286,283 more at age 69, as the
long-term winning strategy has been spending investment assets faster to cover
missing Social Security benefits and higher tax bills. After age 70, the trend
reverses. The crossover happens at age 77 when there is about $840,000 left
with both strategies. The more efficient long-term strategy provides the
largest advantage at age 88 with $323,057 left when the baseline strategy runs
out of assets.

Exhibit 10.23

Portfolio Longevity and Tax-Efficient Distribution
Strategies

Comparing Wealth for Two Retirement Distribution
Strategies

For someone who is more focused on the short-term, the
baseline strategy could have appeal. Legacy values will be larger if death
happens before age 77. But age 77 is before life expectancy so that there is
more than a 50 percent chance that life will continue to an age where the
efficient strategy performs better. As well, in both cases legacies will be
relatively large with an early death. If death happens at 69, the baseline
strategy provides $1.44 million of legacy. But the $1.16 million remaining with
the efficient strategy is still quite large. Retirees might focus more on the
legacies with a longer retirement, where dollar values are less, and each
dollar of legacy can have a bigger impact. For instance, with death at age 88,
one strategy provides $323,057 of legacy while the other provides $0. For those
living beyond 88, reverse legacies may come into play as retirees outlive their
assets and come to rely on the support from others. A case can be made for
either strategy, though I would suggest serious consideration should go to the
strategy creating the most long-term benefit. It is important to consider these
trade-offs when thinking about the right approach.

Action Plan

This chapter has shown how the progressive nature of the tax
code makes planning important. Strategies that keep taxes in mind can
dramatically improve retirement asset sustainability. The action plan for this
chapter consists of accumulation strategies for the pre-retirement years
followed by tax-efficient distribution strategies during retirement.

o
While still in the accumulation phase, retirees can take many
steps to prepare for tax management in retirement.

o
Understand the basics of the tax code in terms of values for tax
brackets, how marginal tax rates work, how taxable income is determined, and
the differences between ordinary income tax rates and preferential rates for
long-term capital gains and qualified dividends.

o
When saving for retirement, build tax diversification for the
asset base by saving with taxable, tax-deferred, and tax-exempt accounts.

o
Understand how to choose between saving in tax-deferred and
tax-exempt accounts based on whether the marginal tax rate will be higher now
or in the future, and after considering the advantages of having some assets in
tax-exempt accounts.

o
Work through asset location decisions to position assets based on
their tax efficiency and long-term growth prospects.

o
Determine whether there are other ways to obtain tax advantages,
such as with education 529 plans, health savings accounts, tax-advantaged
bonds, nonqualified annuities, and life insurance.

o
With a strong base built in the pre-retirement years, additional
strategies can help with tax management during retirement.

o
Understand the rules for taking distributions from tax-advantaged
retirement plans, including required minimum distributions, early withdrawal
penalties, rules for qualified distributions from Roth accounts, making rollovers
and conversions, and managing net unrealized appreciation on any employer
stock.

o
Understand withdrawal sequencing strategies based around managing
adjusted gross income and using strategic Roth conversions.

o
Identify the impact of the various retirement pitfalls when
generating taxable income, including the Social Security tax torpedo, heightened
premiums for Medicare, the loss of subsidies for health insurance, the net
investment income surtax, and the impact of pushing preferential income sources
into higher tax brackets.

o
Also consider the benefits of front-loading taxes in retirement, including
the potential to improve the eventual tax situation for a surviving spouse or to
manage future tax increases.

o
Consider tax-efficient strategies for charitable giving,
including qualified charitable distributions, deduction bunching for gifts,
donor advised funds, and charitable gift annuities.

Further Reading

Olsen, John L., and Michael E. Kitces. 2014. The
Advisor’s Guide to Annuities, 4th Edition. Cincinnati: The National
Underwriter Company.

Piper, Mike. 2019. Taxes Made Simple: Income Taxes
Explained in 100 Pages or Less. Simple Subjects.

Reichenstein, William. 2019. Income Strategies: How
to Create a Tax-Efficient Withdrawal Strategy to Generate Retirement Income.
Retiree Inc.

Chapter 11:
Legacy and Incapacity Planning

As we discuss various facets of retirement
income planning, this chapter turns toward how to properly prepare you and your
family for end-of-life issues. We first discuss how to get your finances organized.
This will certainly be helpful during your own lifetime, but we discuss it here
specifically to help guide those you love. You will better understand your
finances and how the different pieces fit together. And you will also have your
financial affairs collected in one place with easy access for those who need it
after an emergency. Often there is one member of the household who manages the
family finances, and obvious problems can arise when that person is no longer
able to continue these tasks following either incapacity or death. During a
stressful time, family members who do not understand the financial picture will
experience even greater stress and may be prone to making mistakes or falling
victim to financial abuse in ways that could quickly overturn the benefits created
through years of careful planning. This process will help to prepare family
members to take control.

We need to address how to prepare your family
for managing the household finances. Taking time to properly prepare
instructions and explanations around these matters, and to collect the relevant
documentation so it is accessible to those who need it, is key to making these
transitions as smooth as possible. This involves collecting and organizing your
personal and family information, contact information for professionals and
service providers you work with, insurance information, medical history, and
details about various financial accounts and other assets.

After describing how to get organized, we
shift to a discussion of estate planning issues. Estate planning begins with the
process of tracking and organizing assets. As part of that process, take a
careful look at how each asset is titled and whether beneficiary designations are
included. This is important because asset titles and beneficiary designations
always take precedence over whatever is stated in a will. But creating a will
is a vital part of this process as well, as it indicates how you would like
your property to be disbursed upon death. As a part of creating a will,
consider whether the creation of a trust would be a useful tool for managing the
estate. Other aspects of an estate plan include deciding on both a financial
power of attorney and on advance health care directives to help manage your
finances and health care in the event of incapacity. Who can make medical and
financial decisions for you if you are unable? One may also want to provide
final wishes, which can include matters such as funeral arrangements, lists of
who should be contacted, messages to family members, words of wisdom, and so
forth.

When assigning different powers and roles, be
sure to discuss the roles and responsibilities with those who will be asked to act
in the event of your incapacity or death. You can make everyone’s situation
easier by working to make sure that your wishes are known and to develop
agreement and acceptance around your choices. Your family will thank you for
having everything organized for them as it will avoid countless hours of
additional hassle during already stressful periods.

After addressing these preparations, we
continue the discussion regarding tax-efficiency and tax-planning
considerations as it relates to legacy. The tax planning discussion of the
previous chapter explained matters related to sustaining a spending objective
for as long as possible by maximizing retirement spending after-tax efficiency.
Naturally, greater tax efficiency will be correlated with providing a larger
legacy because there is less chance of spending all available resources as a
part of managing longevity risk. But legacy was not a specific objective in the
previous chapter. This chapter continues by explaining how decisions may change
if supporting a legacy goal is an explicit part of retirement planning, or as
it becomes clear that a retiree will not be spending all available assets and there
will be a legacy to coordinate. Tax planning for legacy includes updates to
withdrawal ordering decisions and managing estate taxes, as well as understanding
required minimum distribution rules for various inherited tax-deferred assets. Estate
taxes are possible, but currently the exemptions exceed what most families need
to worry about. Nonetheless, estate tax rules could change in the future, and
this chapter will introduce a few concepts to contemplate with estate planning
professionals.

I must emphasize that I am not providing legal
advice in this chapter, or anywhere else in this book. The matters discussed here
are particularly sensitive to legal considerations, and state laws do vary
widely on how these decisions should be made. While I attempt to explain the
main issues for you to think about, developing a personalized estate plan
should occur with the guidance and advice of a qualified estate planning
attorney knowledgeable about the laws in your state. My hope is that this
chapter will leave you better prepared to understand your options and to make
the decisions needed when working with a professional.

Getting Your Financial House in Order

Getting your finances organized is important for
both you and those who depend on you. It is also important for when you may
depend on others in the event of cognitive decline or other impairments or
illness. It is important so that family members know where things are and what needs
to be done. For instance, there is little use in paying life insurance premiums
if no one knows about the policy after your death. This section provides a
summary for a topic on which entire books have been written. Three books that I
found valuable for those seeking a deeper dive into getting your affairs
organized include Sally Balch Hurme’s Checklist for My Family, Tony
Steuer’s Get Ready!, and Melanie Cullen’s Get It Together. While
I attempt to provide a summary of what you need to consider, you may wish to
consult an additional resource for more comprehensive explanations about how to
build and store a complete set of documents and instructions.

Personal Information, Family History, and
Financial Information

Getting organized first involves getting your
key personal information and documents gathered and stored in a safe and
accessible place. A checklist of personal items in this category include:

o
Birth certificates

o
Adoption papers

o
Marriage license

o
Prenuptial agreement

o
Divorce documentation

o
Immigration or citizenship documents

o
Social Security cards

o
Military DD-214 service record

o
Driver’s license (copy)

o
Health insurance cards (copy)

o
Passports

As well, in terms of priority, very near the
top of your to-do list should be organizing your emergency contacts and
important medical details. Who needs to be contacted and what information
should be quickly accessible in the event of emergencies? Important
considerations include:

o
Who to contact after emergencies

o
Contact information for close friends and neighbors

o
Medical and health information, list of current medications and
dosages, allergies, blood type, immunization records, doctors and physicians,
and medical history

o
Employer details: who to contact at your employer, availability
of paid time-off, available employer benefits

o
School and day care contacts if children are attending

o
Pets: contact information for veterinarian, details about who
should care for pets

Most individuals will work with a variety of
financial and medical professionals that may need to be contacted. It is
important to provide the names and contact information for any of these
professionals:

o
Financial advisor

o
Attorney

o
Estate plan attorney

o
Insurance agent

o
Banker

o
Accountant

o
Trust officer

o
Executor

o
Guardian

o
Power of attorney for finance

o
Power of attorney for health care

o
Family physician and other relevant medical professionals

Some of these details, such as emergency
contacts and medical information, should also be kept in your wallet or purse.
Speaking of what you may carry in your wallet or purse, maintaining a separate list
of credit cards or other items contained therein can be helpful in the event
these items become lost or stolen.

Your
Online Life

As more
of our lives move onto the internet, it is worth taking the time to build and
maintain a list of your online accounts that includes the website URL for the
login page, username, password, security question answers, and basic details
about the account such as if automatic payments have been set up. Ideally
this file will be password protected as well, but it is important that the
right people can obtain access when necessary. This file can include all of
one’s online life, including bank accounts, brokerage accounts, retirement
plans, insurance, credit cards, as well as utilities, social media, streaming
television, and shopping sites.

Though of less immediate priority, other financial
details should be collected to ease the tasks of anyone assigned to help. Without
a stack of paper bills, the convenience of using automatic bill payment for
yourself can be a hindrance for others to unravel if you have not provided clear
instructions about how payments are structured. In addition to knowing how to
pay your bills, some of these items will also include online accounts requiring
usernames and passwords. Cross-checking this bill payment list with the
budgeting process efforts described in Chapter 3 can help to ensure that
nothing important is missed. Considerations here include:

o
Utilities: electricity, heating/fuel, water, sewage, telephone,
etc.

o
Service providers: electrician, plumber, handyman, housekeeper,
lawn service, roofer, snow plowing, car repair, security system, babysitter, home
health agency, etc.

o
Ongoing expenses: anything with reoccurring bills or automatic
bill payment, such as magazine subscriptions, gym memberships, season tickets,
cell phones, cable and streaming TV, internet, retail memberships like Costco
or Amazon Prime, etc.

o
Credit cards and debit cards: a list of cards, annual fees,
website and login information, account numbers, expiration dates, rewards
programs, and automated bill payments.

In addition, basic biographical details that
you may wish to collate and share with family members or others include:

o
For yourself, spouse, and children: name, legal name changes,
address, phone number, email, birth date

o
Education and degrees

o
Employment history

o
Military service

o
Past residences

o
Awards

o
Membership organizations (professional, religious, political, trade
unions, veterans, civic rights, educational, fraternal, hobbies, etc.)

o
A booklet or other written or recorded materials to provide
family members that details the events of your life, your values, your
interests and passions, words of wisdom, and other remembrances. This is also
known as an ethical will.

Furthermore, collecting information about your
family’s medical history could prove useful to help other family members with
prevention, diagnosis, or early treatment for various hereditary conditions.
This type of information is often asked when visiting a new medical facility.

Regarding family, for those with an interest
in genealogy, it may also be fun to include a family tree and lists of
relatives, family history documents or news clippings, as well as a collection
of family photos and videos with descriptive comments about who is featured, and
where and when they were taken. If this information is not identified on the
photos or in the filenames, it will eventually be lost to coming generations.
Though such details are not needed for the estate plan, it might be something
that you wish to consider organizing at the same time.

Assets and Liabilities

We next describe the information needed to
access the relevant accounts related to constructing the household’s net worth
statement. For various asset and liabilities, information needed by others
includes firm names, contact information, website, username and password,
account numbers, account owners and title information, account types, and
beneficiary details. In collecting this information, it is important to review
how accounts are titled and if the beneficiary designations are up-to-date and
appropriate. Titling for bank accounts involves knowing who has ownership, who
has access, and what happens in the event of the owner’s incapacity or death. With
bank accounts, there may also be ATM card numbers and pin numbers to monitor.
You may wish to provide further instructions about what you want done with various
assets or liabilities and such matters should also be formally addressed within
your estate plan.

While this is by no means a comprehensive
list, potential assets or benefits to gather include:

o
Bank accounts – checking, savings, money market, CDs

o
Credit union accounts

o
Savings bonds (series, denomination, serial number, issue date)

o
Treasury Direct account

o
Brokerage accounts

o
IRAs, Roth IRAs, and other individual retirement plans

o
401(k), 403(b), and employer-based qualified retirement plans

o
Social Security statement and benefits

o
Executive deferred compensation or other benefits

o
Pensions

o
Veteran benefits

o
Workers’ compensation

o
Business interests, stock options, contracts

o
Royalties – copyrights, trademarks, patents

o
Education savings accounts (529 plans)

o
ABLE accounts for children and young adults with disabilities

o
Health Savings Accounts

o
Real estate: home, second residences or vacation homes,
time-shares, investment properties, farmland, etc.

o
Real estate rental contracts related to long-term care, such as
an assisted living facility or continuing care retirement community

o
Vehicles, including cars, trucks, boats, planes, RVs, etc.

o
Uncollected legal judgments

o
Other property you expect to receive from others

o
Collectibles inventory, including receipts and appraisals

o
Significant special possessions with documentation including
photos or video recordings

o
Jewelry, antiques, artwork

o
Reward and loyalty programs: credit cards, airlines, hotels,
rental cars, etc.

o
Storage units

o
Digital assets: email, ebooks, music, videos, blogs, Facebook, LinkedIn,
Twitter, etc.

o
Crypto-currency accounts

Meanwhile, liabilities related to debt
holdings include:

o
Mortgage

o
Home equity line of credit

o
Reverse mortgage

o
Vehicle loans

o
Student loans, including those for others on which you co-signed

o
Personal loans

o
Lawsuits or claims against you

o
Credit card balances

o
Money borrowed informally from others

We can also view taxes as a liability, and
there are a variety of tax records to keep organized, including past returns
and supporting documents for:

o
Federal income taxes

o
State income taxes

o
Property taxes

o
Other local taxes

To organize this information, you may wish to
maintain separate folders or sections for each account and then refer to a
master index list of accounts in the main letter of instructions to be used by
others.

Business
Ownership and Succession

Owning a business can create some unique
complications for estate planning. Questions to consider include succession
planning for who will run the business, whether the estate will have
sufficient liquidity to protect the business and keep it operating while also
covering other estate expenses, and how to bequeath or sell one’s stake in
the business at the highest possible valuation. Keeping a business outside of
the probate process may be important and ownership by a living trust is one
method to handle this.

Insurance Policies

Households also generally hold a variety of
insurance policies. It is important to collect information about each insurance
policy, including the company name, policy number, insurance agent contact
details, website, username, password, policy amounts and other benefit or
beneficiary details. This will ease the process of filing claims. It is worthwhile
to also conduct an insurance review to make sure that the right types of
policies and coverage are held, that the beneficiary designations on any
policies reflect current wishes, and that unnecessary policies are terminated
to save on premiums. Potential insurance policies to get organized include:

o
Life insurance

o
Annuity contracts

o
Long-term care insurance

o
Disability insurance

o
Health insurance

o
Medicare coverage (Medicare Advantage, Medigap, Part D)

o
Dental insurance

o
Vision insurance

o
Property insurance – homeowner or renter insurance

o
Vehicle insurance

o
Umbrella insurance

Regarding life insurance, in addition to
standard policies, life insurance may also be provided through employers and
some credit cards may offer life insurance benefits if death happens during
travel paid for with the credit card. To be complete with updating records
about available insurance policies, it is important to keep any of these
additional possibilities in mind as you want to ensure that nothing is overlooked
by your heirs.

Organizing and Storing Information and a Letter
of Instruction

The purpose of collecting and organizing these
documents is to simplify life for those who will need it as a part of managing
your incapacity or death. Your family or other professionals will need to have
convenient access and explanations about your household finances. Be clear
about where they can find the necessary documents and who should be contacted. You
want to help them avoid overlooking anything. The next matter is deciding where
to keep this information and to provide an accompanying letter of instructions
and guidance.

Important documents could be kept in a binder
or storage box with paper copies and stored in a safe and accessible place, as
well as having electronic copies on a flash drive or stored in a secure account
on the cloud. The originals should be kept safe in the event of a fire or
flood, such as in a secure safe or fireproof box.

A safe deposit box at a bank is an option for
important documents and valuables that may not be needed immediately in an
emergency, but it should not be where you keep everything. There are mistakes
that can happen with a safe deposit box that include making it hard for the
needed individuals to access it. A safe deposit box is not the right place to
keep a will or advanced directives, as this may hinder access to these
documents when they are needed. For any safe deposit boxes, make sure that the
core information you make available includes its location, box numbers, and the
location of keys or other means of access. Make sure that those you intend to
be able to access it will be allowed by the bank.

As for distinguishing what should be kept
where, items that you may wish to keep in a home safe to provide for quicker
access include:

o
Household net worth statement listing all assets and liabilities,
as well as information on ownership and beneficiary designations, asset values,
and cost basis

o
A list of ongoing bills, as well as automatic payment details or
whether payments must be made manually

o
A list of websites, usernames, passwords for important accounts

o
Insurance policies

o
Your will

o
Durable financial power of attorney documentation

o
Advance health care directives

o
Documentation for trusts

o
Passports

o
Social Security cards

o
Access instructions for your phones, computers, tablets

o
Safe deposit box details and content inventory

Meanwhile, items that are appropriate for your
safe deposit box include:

o
Copies of items in home safe

o
Copy of financial instructions

o
Personal documents: birth, adoption, marriage, divorce

o
Financial documents (non-emergency)

o
Household inventory

o
Collectibles

o
Jewelry

o
Family photos

o
Computer back-up files

For anything kept behind a lock, including a
digital lock on an electronic device, it is important to make sure the lock
combinations or other information is accessible. Something that may be
forgotten but is highly important is how to access and unlock smartphones,
tablets, and other computers that may contain important details for the family.
It is also important to provide instructions for disarming home and vehicle
alarms.

Along with collecting these items and
documents, you will likely want to create a letter of instruction that explains
everything needed for managing the household finances. The letter can include
explanations for how to find everything we have described as well as
summarizing the key information that needs to be known for a smooth transition.
You may include suggestions about asset allocation, withdrawal order
sequencing, or other helpful advice that could improve financial outcomes. This
letter should be kept very secure and should be updated at least annually. Here
is an example for a table of contents you may wish to use when organizing your
letter of instructions:

1.      Overview
and Key Instructions, Including People to Contact

2.      Secured
Places and Passwords

3.      Letters
to Loved Ones

4.      Biographical
Information

5.      Health
Care Directives

6.      Durable
Power of Attorney for Finances

7.      Final
Wishes

8.      Will

9.      Trusts

10.   Insurance Policies

11.   Bank Accounts

12.   Service Providers and
Automatic Bill Pay

13.   Credit Cards and Debts

14.   Brokerage Accounts and
Retirement Plans

15.   Social Security and
Government Benefits

16.   Real Estate, Vehicle,
and Other Real Property

17.   Employment History

18.   Business Interests

19.   Taxes

20.   Memberships and Other
Miscellaneous Items

As you collect this information and create your
letter, make sure your family knows how to find it. Of course, having things
organized in one place does not help if no one knows where to look. At the same
time, having all this information gathered in one place can create a real
security risk if this information falls into the wrong hands. It would be quite
dangerous to keep the full passwords alongside everything else, and only a few
key individuals should know how to connect the two pieces needed for this full
access. You could instead include a code about how different passwords are
organized, and then include the actual passwords in a separate location. You
might also handwrite passwords on your letter after printing it, so the
passwords are not included in the electronic version. The goal will be to
balance having the information accessible when needed, but not so accessible
that it leads to identify theft. Finally, for some less important documents you
may decide whether to provide printed paper copies or just digital copies. Make
sure that your letter clarifies the locations (both physical and digital) where
you keep everything discussed here.

Components of an Estate Plan

Now that the financial picture is organized, estate
planning is the process for determining how to manage and distribute one’s net
worth upon death. For ease of discussion, we will also mix in issues for
incapacity planning as well, since there is a large overlap about what needs to
be done.

Estate planning will help you and your family
members be prepared. It involves developing answers for three questions about
distributing assets – to who, when, and how? You want to design mechanisms that
will accomplish your goals in a tax- and cost-efficient manner. This process
includes properly titling assets and making beneficiary designations,
maintaining a will and other related instructions, determining whether there is
a role for trusts, identifying an agent with financial powers of attorney,
creating advance health care directives, and providing final wishes.

Some of these tasks can be accomplished on
your own, while others include more complex legal issues that will benefit from
professional advice. Working with the right professionals, rather than trying
to accomplish everything in a do-it-yourself manner, will become important
especially for the matters addressed in this chapter.

Everyone has a default estate plan, even if it
means dying without a will and having property distributed by the state. Before
going further, you might assess the outcomes of your current estate plan. Have
you identified your assets and liabilities and organized them so they can be
found and understood by others? Do you understand how your relevant property is
titled or registered? Do you know the beneficiary designations you have made
for relevant assets? Do you know what will happen to your finances and who will
decide about your health care if you are incapacitated? Do you know what
property will be subject to the probate process after death? Do you have a
will? Do you have any trusts, and have they been properly executed and funded?
Have you made your final wishes known? Does the distribution of your assets
under your current plan accomplish what you intend, or could there be big mistakes
related to unequal distributions, mistaken distributions (such as to someone
you have divorced), distributions to those unready or unable to handle
immediate full receipt, unnecessary costs, or other unintended consequences?

Goals that we outline in this section include:

·
Identify the entirety of your assets and debts

·
Determine your wishes for asset disbursement: to who, when, and
how? What is the right breakdown between providing for heirs and for charitable
causes?

·
Clarify that assets are titled and beneficiary designations are
made in the ways you intend

·
Provide survivors with sufficient assets for their lifetime as
well as for covering expenses while the estate is in probate

·
Simplify the probate process as much as possible to reduce fees
and maintain privacy

·
Minimize estate taxes (if applicable) and manage estate
distributions with other tax consequences in mind

·
Ensure that financial and health care decisions are handled as
you wish if you become incapacitated

When it comes time to settle your estate, the
first step is to identify the entirety of your assets and debts. This is
everything we have been describing in the previous section, and by going
through this process and providing these details you will surely make things
much easier (and less expensive) in the future. Your estate executor will only
need to double-check your work and make sure everything has been accounted for
and there are not outstanding issues to be resolved, rather than trying to
undergo a full forensic investigation about what you owned and owe. Assets can
then be divided between those in your probate estate and those which can be
distributed outside of the probate process. As well, asset values can be assessed
for estate tax purposes.

The probate estate includes everything that
will be distributed according to your will, if one exists, or otherwise according
to state law. Assets falling outside of a will and the probate estate include
assets with joint ownership and right of survivorship, assets owned by a trust,
or assets with beneficiary designations. The taxable estate are the assets
counted to determine federal and state estate taxes. Your trust estate included
assets you have included in your trust. After thinking about general goals
regarding how much to provide to family, friends, and charity, it is time to
structure the plan.

The Titling of Assets

Though it may not feel like estate planning,
an essential component of planning happens when you decide how to title or
register the ownership of assets as you proceed through life. This includes financial
assets such as bank or brokerage accounts, and real assets such as homes and
vehicles. You have different options available for defining asset ownership,
and you may want to revisit what you have done in the past to make sure it is
what you intend for the present and future. For those who are married, the
defaults for asset ownership also depend on state laws and whether you are in a
common law or community property state. The titling or registration of assets
refers to the process of documenting how the asset is owned, and this can include
options for how to disburse the asset in the event of the owner’s death. These decisions
always take priority over anything stated in a will or trust document, and so
it is important to be careful with these titling decisions along with
beneficiary designations.

To re-emphasize this point, since it is so
important, it does not matter what you say in a will or trust if you have not
also formally updated the asset titles to be aligned with what you want to have
happen in your will or trust. As a part of getting your affairs in order, you
can review and update ownership as appropriate. There are numerous options.

First, assets can be owned individually
without reference to how they will be disbursed upon death. For such assets,
the probate process will determine the asset’s fate, either as documented by a
will when one exists, or by the state’s probate laws. Certain relatives such as
spouses may have rights that supersede the will, but otherwise this is the only
type of ownership that would allow a will to take over and handle the asset disbursement
at death as part of the probate estate.

There are other ways to title assets that will
allow them to avoid the probate process by outlining who receives the property
upon an owner’s death. Assets can be held jointly with one or more other
individuals, for instance. If an asset is owned jointly with right of
survivorship, then when one owner dies, his or her share of the asset
automatically transfers to the surviving owners. The last surviving owner
becomes the sole owner of the asset.

This type of titling may be a natural default
for spouses. However, there could potentially be problems if there are children
from previous marriages that an individual would like to receive a portion of
the asset. A will cannot redirect what the account title indicates; the living
spouse would receive the full asset value and instructions from the deceased
spouse’s will to have a portion of the asset go to those children may not be
obeyed.

People sometimes think to add a child as a
joint owner to a bank account to help manage household finances, but there are
risks to choosing this titling option. These include that the child then has
full ownership and will essentially inherit what is left, that this ownership
change constitutes a gift that could have tax implications, and that creditors
for the children will be able to go after the account. As well, particularly
with real estate, any step-up in basis that may be allowed at death will not
take place. Having a younger owner could also complicate attempts to use a
reverse mortgage. Alternatives to joint ownership include allowing the child to
be a signer on the account without having ownership (called a convenience
account), moving the account to a trust in which the child is a trustee, or
providing the child with control over the account by acting as an agent through
a durable financial power of attorney.

Another option for titling an asset is called joint
ownership in common. In this case, joint owners own portions of the asset
and may maintain rights over their share of ownership, such as to sell or
bequeath it, that do not require agreement among all owners. In the context of
estate planning, the important distinction for ownership in common is that the
share of the asset owned at an owner’s death is transferred to the deceased
owner’s estate rather than to surviving owners. This avoids having the last
surviving owner become the sole owner of an asset, and it may be a popular
option with vacation homes owned by a larger family with multiple siblings.

For states with community property laws
(Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington,
and Wisconsin), real assets purchased during a marriage are automatically
titled as ownership in common shared equally between the spouses. Each spouse
can use a will to assign ownership of their share of the asset upon death.
Another possibility is ownership in common with rights of survivorship, in
which when one spouse dies, his or her share automatically transfers to the
surviving spouse.

Other ownership options include the
possibility of adding transfer at death (TOD) or payable at death
(POD) provisions to the account title. These work in the same manner as
beneficiary designations. The beneficiary is not an account owner but will
receive the asset upon the owner’s death outside of the probate process. A TOD
option can be especially useful with real assets such as a home or vehicle. This
option is also commonly available for bank and brokerage accounts. Again,
having these provisions in place overrides whatever may be stated in a will and
keeps the asset out of probate.

For real estate, another option to consider is
to create a life estate for a property. This allows one to sell a
property, likely at a discount, while maintaining the right to continue living
in the property until death. This could be another way to free up some home
equity to be used within a retirement income plan.

A final option we consider is to title
property to be transferred to and owned by a trust. A trust can be drafted
calling for ownership of the asset, but it is important to follow through with updating
the title so it can be transferred to the trust. We describe trusts in more
detail later.

Beneficiary Designations

Related to how some accounts and real estate
are titled, certain types of assets will pass directly to stated beneficiaries
outside of what is indicated in a will. These are accounts with beneficiary
designations. It is important to make sure that beneficiary designations are up
to date and account for life changes, such as births of children or
grandchildren, deaths of existing beneficiaries, marriages, divorces, or other
changes in relationships, and that these are aligned with what you want to have
happen with your will or trust. If an asset has a beneficiary designation
assigning it to person A while the will includes directions to assign the asset
to person B, it is person A who will receive the asset.

Beneficiary designations are available for
different types of financial accounts including life insurance policies,
annuities, IRAs, company retirement plans, deferred compensation plans,
pensions, education savings accounts, and other transfer-on-death securities
accounts. Often beneficiary designations are made as accounts are opened without
much thought or coordination over the years, and so it is worthwhile to include
a complete beneficiary designation review as part of your planning and to
create a list of all assets along with their beneficiary choices. Maintaining a
list of all your assets along with their beneficiary designations or ownership
titling could prove invaluable to uncovering mistakes.

When making beneficiary designations, there
are a few types of beneficiaries to identify. First are primary beneficiaries.
When alive, primary beneficiaries are the first in line to receive the assets.
There can be multiple primary beneficiaries, in which case the assets are
divided among them in the shares specified on the designation form.

Contingent or secondary beneficiaries can also
be identified. This is who is next in line only if all primary beneficiaries are
deceased before the original account owner or otherwise disclaim their right to
receive the assets. Contingent beneficiaries do not maintain any rights once
the account has passed to a primary beneficiary, as the primary beneficiaries
can then decide on their own subsequent beneficiaries as desired.

There is also another type of beneficiary called
a successor beneficiary. The successor would become the beneficiary for
anything left after a primary or contingent beneficiary has received the asset
and then later has died. The original account holder could attempt to add a
successor beneficiary. The choice for a successor beneficiary may not always be
enforceable, but it is a way to at least indicate one’s wishes. Usually instead
of the original owner identifying a successor beneficiary, the new primary or
contingent beneficiary will be able to decide about their own primary or contingent
beneficiaries for the asset after it is received.

It is also important to note that minor
children, such as children or grandchildren, cannot own more than a de minimus
amount of financial assets. One should appoint a guardian or create a trust to
oversee the assets until the children reach the “age of majority” in their
state. Trusts can also serve as beneficiary designations, and this can provide
a way to fund a trust intended for minor children after death.

If there are no living beneficiaries, either
because no one was named or the beneficiaries have already died, then the
assets will pass to the estate and be subject to the probate process to be distributed
through the will.

As part of your beneficiary review, you can help
those implementing your estate plan by creating a list within your broader instructions
that provides the information about the ownership and beneficiaries for each
account. Record the beneficiary names and contact information, Social Security
number, primary or contingent status, and share of the account to be received.
Having this information collected in one place will also help with determining
a more strategic plan for bequeathing assets.

Creating a Will

Upon death, your financial affairs will need
to be settled. Preparing a will allows you to provide your input and desires into
the process. A will is a legal document outlining how to transfer property and
assets after your death. It will guide the probate process and it covers what
are known as probate assets. Probate assets refer to any assets subject to a
will or to state intestacy laws if no valid will is available. Preparing a will
involves deciding on a plan of action and preparing a legal document for how
you wish to have your probate estate distributed after your death. It includes
three major items:

·
Identifies an executor to manage the probate process

·
Identifies how probate property will be distributed to
beneficiaries

·
When relevant, designates a guardian for minor children

Not all assets are probate assets. Assets that
are jointly owned with rights of survivorship, have valid beneficiary
designations or payable on death provisions, or are held in a trust or life
estate will pass to their beneficiaries without becoming a probate asset that
is directed by the will. For those who can effectively manage the titling and
beneficiary process for their assets and accounts, or who have positioned most
assets within a trust, the remaining assets to be covered by the will in the
probate process could be quite small. Even if careful to move assets outside the
probate process governed by a will, the will may still be important as a backup
to account for anything else that you may have missed, and it is needed if you
care for minors. Relatedly, a pour-over will serves to redirect property into a
trust at death, though such property directed by the will to a trust is still treated
as part of probate first.

The probate process can have downsides. Heirs
may be restricted from receiving their inheritance for a significant amount of
time, such as a year or more for complicated estates. Probate can also be
expensive when accounting for various court and attorney fees. Probate is also
public, reducing the level of privacy available to the estate. For small probate
estates, different states may provide workarounds to avoid the time and costs
associated with large estates. Otherwise, as noted, steps can be taken to keep
most assets outside of the probate process through property titling,
beneficiary designations, and use of trusts.

The probate process is run through a court to
determine your will’s validity and identify who is charged with settling your
affairs. The will names an executor who is to carry out the wishes of
the deceased person by managing the estate and its distribution. This could be
a spouse, sibling, adult child, or other relative or friend. It could also be a
professional, such as an attorney, a bank employee, or a professional
fiduciary. Being an executor can be a significant undertaking requiring
organization, honesty, assertiveness, and interpersonal skills.

When relevant, arrangement can be made to pay
the executor for their services from the estate assets. However, if the
executor is someone who will be receiving most of the assets as an inheritance
anyway, it can be better to avoid receiving payment that would count as taxable
income. These instructions can be included in the will and any professional
executor will expect payment.

The executor’s tasks including contacting
heirs, cataloguing the assets, having relevant assets appraised to determine
their value, paying bills, settling debts, settling business affairs, posting
notices, notifying relevant parties of the individual’s death, filing tax
returns, closing out accounts, canceling subscriptions and other ongoing
expenses, and then distributing remaining property to heirs in accordance with
the will. The will can be specific in terms of identifying who receives specific
items or assets, or assets can be distributed on a percentage basis. Beneficiaries
of the will can include individuals as well as institutions.

If you have not identified an executor, then
the probate court will appoint an administrator to carry out these tasks. Not
having a valid will means dying intestate, and then state law will govern the
process for how assets are distributed. State laws vary and are based on trying
to guess what an owner’s desires would be. The order for distributing assets
would typically follow spouse, children, parents, siblings, and so forth to
find the next of kin, until the first people on the list can be identified. If
no next of kin can be identified, the state will typically keep the property.
Cases where state intestacy laws may lead to different outcomes than you intend
include if you have charitable intentions, wish to make unequal distributions
between heirs, wish to disinherit someone, or have other tax planning
considerations with respect to the estate.

The will is also the only place to appoint a
guardian to care for any minor children, such as children or grandchildren in
your care. The guardian is a person designated to act as a representative to
oversee personal affairs and finances, including caring for minors until they
reach the age of majority. Guardians can be named in a will or be appointed by
a judge if necessary. Having the courts manage this process will be costly and
time consuming with respect to limitations a court appointed property guardian
would receive. Minors cannot inherit assets, so trusts or custodial accounts should
be created to manage any probate assets meant for them until they are old
enough to receive it. Such a trust can be set up and funded as part of the will
and only comes into being after your death.

Creating a will can be done on one’s own with
online tools and software, but it is worthwhile to also work with an estate
planning attorney to review the documentation and make sure that everything
conforms with state law so that your wishes can be met as intended. The will
should be signed and dated with the number and types of witnesses and notary
needs as required by your state. After completing your will, you need to make
sure that it is easy for your executor to find the original copy.

A will should be updated every several years,
or after any changes in family circumstances or tax laws. A codicil can be used
to amend your will without starting from scratch. Codicils should be arranged
and executed professionally, as directly editing your will could result in it
becoming invalid. While codicils are an option, the fact that they must be
executed in the same way as a will means that it may be just as simple to redo
the will with the change. The old will and its copies can then be destroyed.

In the context of the will, you may create an
additional letter of instruction to the executor of the will. While not having
legal authority, the letter can provide more details about your wishes. This
can include how to divide personal possessions of lesser financial value (but
perhaps greater emotional value) that would not necessarily be included in a
will, desires about your funeral or memorial service, and other aspects we will
cover in the final wishes section. You might also state your intentions about
how you wish certain property to be used, such as for family members to keep
the vacation home instead of selling it. Since this is not a legal document, it
is less formal and can be changed easily. It is also not legally enforceable,
and you should include a note in the letter that you understand it is not legally
enforceable to help prevent any potential challenges to your will. Just be sure
to sign and date the document so that people can determine the most recent
version to use, and it will be helpful to discard older versions to reduce potential
confusion.

A Role for Trusts in Distributing an Estate

Trusts can be a particularly complex subject that
benefit from receiving professional advice to determine their efficacy as well
as in guiding their creation and management. A trust provides a way for a
trustee to hold the legal title to property for a beneficiary. Not everyone
will need a trust, though it is also the case that trusts are not just for the
ultra-wealthy. Trusts have lots of potential uses outside of estate tax
management.

There are two general reasons one might
consider for creating trusts: to provide greater control over the process of
distributing an estate while also avoiding probate, especially if there are
minor children involved as beneficiaries, and to help reduce estate taxes. In
this section we focus on the first consideration, which is using a trust to
manage an estate when the estate is not large enough for estate taxes to be a
concern. This means we will discuss revocable trusts here, which can be changed
during the lifetime of their grantor. Later in the chapter we will look
creating an irrevocable trust to help manage estate taxes.

It is possible to create trusts in a do-it-yourself
manner, but there are many potential pitfalls and unanticipated outcomes. It is
important to also speak to professionals about the best approach to take and to
make sure the documentation is legally valid and will have the intended
effects. I aim to help you become an educated participant in these discussions.

Some examples of cases where a trust may be
helpful in achieving planning goals not directly related to reducing estate taxes
include:

·
Worries about asset management after your incapacity

·
Probate is avoided for assets held in a living trust at death,
which can reduce costs to the estate and maintain privacy

·
Beneficiaries are minors and unable to inherit assets directly

·
Control disbursement of assets to beneficiaries who may not be
responsible enough to manage full receipt (spendthrift trust)

·
Own real estate in different states and want to avoid the probate
process for those states

·
Married more than once with children from previous marriages

·
Protect assets from the beneficiary’s creditors

·
Protect assets for children in the event your spouse remarries

·
Protect assets from children’s spouses in the event of their
divorce

·
Provide for a special needs family member in a way that does not
impact eligibility for government benefits (special needs trust)

If you determine that a trust will be a
helpful part of your estate planning, an important decision is whether to use a
living trust or a testamentary trust. A living trust is set up and funded
during one’s lifetime, while a testamentary trust is set up and funded after
death through the provisions outlined within your will. A living trust may also
call for the creation of new trusts at death.

With any type of trust, there are several key
parties to keep in mind. A grantor creates the trust and shifts
ownership of property to it. The trust then assumes legal ownership of property
it receives. Assets held in a trust may be referred to as the trust property, trust
assets, or trust principal. The grantor also determines a trustee to
manage the property of the trust and determines how and when the trustee will
transfer that property and any income or other considerations it generates to
the trust beneficiaries. The trustee serves as a fiduciary working
toward the best interest of the grantor and beneficiaries. Beneficiaries are
those who receive benefits from the trust and who may eventually fully inherit
the trust assets. Life estate or income beneficiaries may have a limited
interest in the trust property that lasts for a fixed period or until that
beneficiary dies, and final beneficiaries are those who will ultimately receive
trust property after the terms for income beneficiaries have ended. A corporate
trust is a bank or trust company that is chosen to serve as the trustee.

A living trust, which also goes by the names
of revocable living trust, or a settlor, grantor, or donor trust, provides a
framework for transferring your property to a trust while alive so that it can be
managed by a trustee other than you in the event of incapacity as well as
including provisions for what happens at death. A revocable living trust can be
designed either for one person or to be shared between spouses to manage both
co-owned and separately owned property. With a living trust, the grantor,
trustee, and beneficiary can be the same person, and a successor trustee can be
identified to take control if the original trustee (i.e. you) is incapacitated
or dies. A secondary beneficiary can also be added for when the primary
beneficiary (i.e. you) is deceased, and the grantor (i.e. you) can design the instructions
for how to disburse assets to various successor beneficiaries and over what
time frame.

A revocable living trust allows the grantor to
modify the trust and remove property or revoke it entirely while alive and
maintaining mental capacity. The grantor continues paying taxes on trust
property as though he or she is still the owner of the property in the trust,
as a revocable living trust is not registered as a separate legal entity.
Living trusts generally change from revocable to irrevocable upon the death of
the grantor. With living trusts, assets remain as part of the grantor’s estate,
and so when used by themselves do not reduce potential estate taxes. A
revocable living trust may be understood as an invisible or passthrough entity
in this regard. This is different for irrevocable trusts, which we will discuss
later.

A living trust is created with a “declaration
of trust” that names the creator as the trustee. Property can then be
transferred to the trust which you can still manage and fully control as the
trustee. You may also identify yourself as primary beneficiary during your
lifetime, with secondary beneficiaries to subsequently inherit the assets outside
of probate after your death. Your will may also direct additional probate assets
to be transferred to the trust upon your death. A successor trustee is also
named who then takes over management when you are no longer willing or able to
continue self-management as trustee. An independent method of determining
incompetency for a successor trustee to take control can be included, such as
the determination of two physicians.

To summarize this process, we can think of
three phases for a living trust. During the first phase the grantor is alive
and has mental capacity. The grantor serves as the trustee and beneficiary of
the living trust. The second phase is if the grantor loses capacity. Then the successor
trustee takes control of management for the benefit of the grantor who is still
the beneficiary of the trust. The third phase is when the grantor dies. Then
the successor trustee manages the trust for the disbursement of assets to its
secondary beneficiaries.

A wide variety of assets and property can be
shifted to a trust. Options include bank accounts, brokerage accounts, real
estate, vehicles, and so forth. In many cases, a choice can be made about
whether to shift assets to the trust during one’s lifetime, or to use
beneficiary designations, transfer-on-death provisions, or a will to move the
assets to the trust at death. Two advantages of transferring during one’s
lifetime is so the successor trustee could manage the assets during times of
incapacity, as well as helping to keep assets out of probate before transferring
to the trust in cases where the assets would go through probate first.

When determining assets for a living trust, a
few additional comments are relevant for IRAs and other qualified retirement
plans. First, they cannot be owned by trusts during the owner’s lifetime, so
placing these assets in a trust can only be done through a beneficiary
designation at death. As well, it may not be wise to use a trust as a
beneficiary for retirement accounts, especially if your spouse is alive. This
will eliminate the benefits a spouse can receive from inheriting these assets
and may even lead to the poor treatment that non-person beneficiaries obtain
for required minimum distributions. The inherited account may need to be
drained within five years unless the trust is set up in a specific way. This is
covered further later in the chapter.

For distributions, the value of a trust over a
will and probate is that more detailed instructions can be provided about the
post-death distribution process. Assets do not have to be disbursed all at
once, which can be helpful for managing disbursements to those who are minors,
who are adults but may not be mature enough to receive everything at once, or
to provide other creditor protections for beneficiaries. Instead, the living
trust can call for the creation of irrevocable trusts at death to help manage the
distribution process for trust assets. With a will, the probate assets are
fully disbursed to the beneficiaries at the time that probate business has been
handled and the process is closed.

Trust for minors, such as children or
grandchildren, can spell out that assets are not available until a chosen age
that can occur well past the age of majority, except for allowed expenses like
education, medical needs, and living expenses approved by the guardian. These
trusts can be established as a testamentary trust through the will, or as part
of a living trust that is designed to become an irrevocable children’s trust
after death.

These trusts could be set up as a single
trust, or each child could receive a separate trust. With a single trust, one
may have “sprinkling” provisions that provide discretion about the distribution
of trust income and property in a non-equal way between beneficiaries. For a
simple example, if the trust supports education expenses for multiple children
facing different education costs, the grantor may not necessarily want offsets made
elsewhere for those with higher education expenses. The grantor may also want
provisions for a spendthrift trust that are designed to stop beneficiaries from
squandering trust assets or to protect the assets from the beneficiary’s
creditors.

As well, this type of property control
provided by a trust can be useful for those who have been married more than
once. The grantor may wish to balance concerns for supporting a surviving
spouse while also providing an inheritance to children from previous marriages.
A trust can be designed so that the surviving spouse is a life-estate beneficiary
of a trust, with rules defining the amount and type of support received during
the survivor’s lifetime, and with any remaining property then being directed to
final beneficiaries defined by the trust creator when that surviving spouse
dies. Surviving spouses may be able to receive income generated by the trust,
be able to use property owned by the trust, and may be able to invade principal
of the trust in certain situations such as for health care expenses. With this
approach, a surviving spouse can receive support from a trust without owning or
having control over it. The trust becomes irrevocable after the grantor’s
death.

Having a living trust does not override the
need for a will, and of course a will is necessary to direct the creation of a
testamentary trust. But even if most of one’s assets are held in a living
trust, a will can provide backup for any other loose ends or property not in
the trust. For example, a pour-over will simply gathers up any remaining assets
at death and calls for them to be transferred into the trust. A will is also
necessary if you wish to name your own executor or a guardian for minor
children.

A living trust provides support for three phases
of life: when the grantor is alive an able to be in control of trust assets,
when the grantor is incapacitated and needs someone else to manage the trust
assets, and when the grantor has died and would like to direct the trust assets
to beneficiaries. A testamentary trust, on the other hand, only serves this
final role as the trust only comes into effect through the will as part of the
probate process. Assets held in a living trust do not become part of the
probate estate since they are already owned by the trust instead of the
individual who died, which is one of the main advantages of a living trust over
a testamentary trust. A living trust is also helpful for those who are worried
about their will being tested by unsatisfied potential heirs.

A living trust could be compared to having
granted a “financial power of attorney” for trust assets to the successor
trustee. Then the successor trustee would be like the “executor” for the trust
assets at death, as both roles involve managing the distribution of assets. You
will probably want to name the same person as the successor trustee for living
trusts, the agent with financial power of attorney, and the executor for the
estate. For each role, you should also name an alternative to serve as backup
if your first choice is not available or unwilling to serve the role.

There are potential risks or downsides to keep
in mind about living trusts. These include potential costs, as creating and
maintaining a trust can be expensive. Another disadvantage of a trust over a
will relates to your creditors who would otherwise only have a fixed amount of
time to lay claim to probate assets. Also, placing one’s home in a trust can
impact property taxes and Medicaid eligibility and these types of matters can
be reviewed by a qualified accountant in addition to an estate planning
attorney. Testamentary trusts are usually less expensive and do not require
maintenance since they are not created until death. However, assets that will
be used to fund the trust may be included in the probate process if they do not
have other ways to be transferred outside of probate.

Creating a trust involves more than just
creating its legal documents. It is also necessary to re-title or update beneficiary
designations for any assets that are meant to be held in the trust. You must
engage in the work to retitle assets and transfer the ownership of assets you
want to be owned by the trust, as the desires expressed by creating a trust do
not override the legal ownership rights created in the titles of assets you had
intended to be held by the trust. The trust is just an empty shell if you do
not follow through with the process to fund it. This point does get forgotten
in the real world. As well, remember that property owned by the trust is no
longer legally owned by you and is not part of the probate process. Though this
does not have significant implications during your lifetime, a practical
implication is that a will cannot override trust documents when the property
has been transferred to the trust. We return to the topic of trusts later in
the chapter to cover their uses with managing estate taxes.

The Financial Power of Attorney

The power of attorney is a legal process in
which a principal (you) can delegate the decision-making authority over your
affairs to an agent or attorney-in-fact. An important part of planning is to
identify agents to handle your financial and medical affairs in the event of
your incapacity. We first consider the financial power of attorney. It is
important to clarify that this power is meant to apply to incapacity during
one’s lifetime; it ends at death when the executor of the estate would take
over this control. This provides an alternative to placing assets into a living
trust where a successor trustee plays the same role for the trust assets.

The alternative to identifying agents to have
these powers is to go through the potentially costly and cumbersome process of
having a court-appointed guardian or conservator to handle your affairs if you
have been deemed incompetent and become a “ward” of the state. The guardianship
process is called living probate, and it is something you will likely wish to
avoid by creating the appropriate legal documents in advance. Identifying an
agent with this power in advance not only to reduces stress and potential
fighting among family members, but it also allows the principal to be in
control of the process and choose the person and the specific duties and
responsibilities they are empowered to perform.

A power of attorney can be made general to
manage all financial affairs in the same manner as its creator. Courts may
interpret the power of attorney narrowly to help protect the principal from
abuse, so you may wish to be specific about the types of powers to include. This
can include managing investments and real estate, paying bills, managing
insurance contracts, collecting debts, engaging in lawsuits, applying for government
benefits, making gifts, hiring caregivers, signing tax returns, managing
digital assets, operating a small business, and creating, funding, or revoking
living trusts. You can limit any of these powers if you wish.

Two types of powers of attorney are durable
and springing. A durable power of attorney begins as soon as it is
signed, with control handed over for the remainder of one’s lifetime unless it
is canceled. To create a durable power of attorney, some states may require
language to also include that the power stays in effect if one is
incapacitated. This is an important point, because the common law traditions
from which the power of attorney originates did not allow the agent to act when
the principal became incapacitated, but the entire point of having this power
is that the agent be able to act at the time of incapacity. Make sure you have
created a durable power of attorney with this detail about incapacity spelled
out as necessary in accordance with your state’s law.

Another option is to create a springing
power of attorney, which delays when it goes into effect until some triggering
event happens such as a physician identifying that one has become
incapacitated. This may sound more attractive, but having a durable power of
attorney in effect does not mean that one loses control of their financial
affairs at the present. It only means that now two individuals have legal
authority to handle the affairs. A power of attorney can also be changed or
even revoked at any time while the principal maintains his or her capacity.

Choosing an agent for the power of attorney
can be complicated. It should be someone both trustworthy and experienced at
managing financial matters, though the person does not have to be a financial
professional. It is also best for the agent to live nearby as many tasks may
need to be accomplished in person. You may also name an alternative agent as
well to be covered for any reason that your primary agent is not able to
fulfill the role. To simplify matters, your financial agent can be the same
person as the executor for your will, the successor trustee for any living
trust, and your health care agent (discussed in the next section). Because of
the vulnerability it creates, you need to feel completely confident that the
individual can be trusted. The starting point would be to choose one’s spouse for
this role for those who are married, unless there are valid reasons to choose
someone else such as another close relative or friend. It is also possible to
have a professional serve in this role and be compensated, such as a lawyer or
banker you work with. If you cannot think of anyone to play this role, it may
be best to allow the guardianship process to play out with court supervision if
the need ever arises.

You can create a financial power of attorney
on a do-it-yourself basis for a low cost using online tools such as those found
at nolo.com, but it is a good idea to have an estate planner review to make
sure what you have created conforms with your state laws and has been properly
executed so that it will work as intended. This is especially important if you
are worried that a family member will challenge your decision. Your agent will
need to know how to find the original copy as well. You will also want to inform
your key financial institutions that you have authorized an agent to act on
your behalf and make sure these institutions will honor it. They may have
additional paperwork for you to complete. Regarding bank accounts, it is
important to also set up the power of attorney with the bank by filling out in
advance the authorization forms and signature card for the agent with the power
of attorney. This does not make the agent into an owner of the account, but the
individual will have authorization to pay bills and make other distributions.
Otherwise, the bank may not be willing to honor actions taken by the agent with
these powers.

Advance Health Care Directives

Advance health care directives are documentation
for making health care decisions when a person is unable to make such decisions
on his or her own. This includes a living will and a health care power of
attorney. When you are unable to communicate your wishes related to medical
treatment, your advance health care directive can be helpful in outlining the
types of treatment you may or may not want. This can help family members and
health care providers to better meet your wishes when you cannot communicate
them.

Creating these documents will avoid the
slower, costlier, and more cumbersome process of having a legal guardian
appointed to make these decisions at the time of your incapacity. Such an
individual would then be following state laws in absence of understanding your
preferences for care, leaving you without input into the process.

The portion of the advance health care
directive outlining your wishes is the living will. It provides details
about the types of medical treatment you wish to receive. This can include
whether to receive life-prolonging treatments such as intravenous nutrition, resuscitation,
the use of respirators, and a statement about the quality-of-life you find
acceptable. Of course, many people may not really know what types of decisions
might need to be made with end-of-life care. Different groups have created
helpful materials to outline the potential types of decisions to be made as
well as the implications of different choices. In the further reading section,
I have included helpful materials from the American Bar Association.

The advance health care directives can also assign
a health care power of attorney to an agent who can then make these health care
decisions on your behalf. As with a financial power of attorney, you can
provide guidance and instructions about how broad the power of attorney will
be, but generally you may want to allow authority for all health care decisions
to address whatever issues are not covered by the living will. It can be
especially useful to have an advocate for communicating your wishes to medical
professionals. This power is always springing in the sense that you will be
asked to make your own decisions when possible, and the agent only steps in when
you are not capable. Of course, defining when you are capable can be subjective
and you may include instructions for this.

Choosing someone you
trust is critical. That person should meet several criteria, including
availability to help in the future, a willingness to carry out your wishes,
ability to meet your state’s criteria for who can serve in this role, and an ability
to act as an assertive advocate as needed. You should avoid naming a committee,
and you may wish to avoid naming your child. You should also identify a
successor agent if your primary agent is not available when needed. It is
important to have conversations with these individuals and to provide written
explanations so that the person is best equipped to fulfill your wishes around
medical care and when to stop attempts to prolong life. You and your proxy
should agree on what you view as an acceptable quality of life. At what point
would you be willing to let go, or do you want to be kept alive at all costs
even without realistic prospects for recovery. How do your personal values or
religious beliefs affect this? Does your agent understand your wishes and is
willing to respect them?

The Health Insurance Portability and
Accountability Act (HIPAA) tightened privacy rules around health care records.
HIPAA restricts access to information about health care except to the patient
or those who have been granted access. As a part of developing your advance
health care directives, you should fill out the additional HIPAA paperwork
needed to grant access to key family members, the health care power of
attorney, the financial power of attorney, and/or the trustee under a living
trust.

After creating this documentation, it is
important to share it with your chosen agent and with your health care
providers. You should also make sure your agent knows how to find the original
version. You may also include a card in your wallet indicating that this
documentation exists and providing contact details for the agent. You can also
take comfort in knowing this document can be amended or revoked while you
maintain your decision-making capacity.

This advanced directive can be prepared without
a lawyer in many states. This service may also be included as part of an
overall package when working with an estate planner. For those seeking a
do-it-yourself approach, the AARP provides a list of state-specific advanced
directive forms. This information is at www.aarp.org/advancedirectives.
States have different laws; make sure to use the right documents and advice.

Final Wishes

A final part of your estate plan includes more
personal items that you wish to communicate to family and friends, including
documentation and instructions about your final wishes. You may identify who
should oversee funeral arrangements, information on whether a burial plot is
owned, or a funeral has been pre-paid, desired funeral home and service
locations, and details such as who should speak or what songs should be played.
With final wishes, these are the main details to include:

o
Letters written to be given to friends and family

o
An ethical will or other personalized messages

o
Desires for organ or body donation

o
Obituary details

o
Burial or cremation choice and location of final resting place

o
Documentation about any pre-payment made for funeral or burial

o
Plans and ideas for funeral and memorial services

o
Items to be destroyed

o
Other people to contact

o
Pet care

Wills,
Living Wills, and Ethical Wills

Three types of “wills” are described in this
chapter. Each describes something quite different. A will is a legally
binding document that describes how an individual would like their probate
assets to be disbursed upon death. A living will outlines your wishes
regarding your health care, which can be followed in the event of your
incapacitation. An ethical will shares your beliefs, values,
inspirations, life lessons, favorite memories, expressions of love and
gratitude, and other personal communications with your family after your
passing. It is comparable to letters prepared for families and friends, and
it provides another option for how you may wish to communicate with loved
ones.

Tax Planning with Legacy and Estate Considerations

With the basic components of an estate plan in
place, we now shift our attention toward tax issues related to legacy. First,
we consider important matters for tax-efficient retirement distributions with a
legacy in mind when estate taxes are not an issue. Then we explain how estate
taxes work and describe different strategies to help manage them related to
gifting, life insurance, and trusts.

Tax-Efficient Retirement Distributions with
Inheritance in Mind

We now shift to a discussion of taxes and
legacy when estate tax is not a concern because asset levels are below the estate
tax exemptions. We described tax-efficient retirement distributions in Chapter
10 as the process of using tax-bracket management and strategic Roth
conversions. Tax-efficient distributions generally involve spending from a
blend of taxable and tax-deferred assets first, and then from a blend of tax-deferred
and tax-free assets once the taxable accounts have been depleted. When
considering how to position financial assets also for inheritance, we include:

·
The step-up in basis available for taxable assets at death means
that bequeathing appreciated securities can avoid capital gains taxes compared
to if those assets are sold during one’s lifetime.

·
Tax-bracket management should also incorporate the marginal tax
rates that heirs will pay on any inherited assets.

·
When multiple heirs face different tax rates, the inheritance can
be designed to improve efficiency by having unequal pre-tax inheritance amounts
that are equalized after tax payments to provide more after-tax value for all
recipients.

Addressing these matters in order, an
important aspect of the tax code is that capital assets receive a step-up in
basis at death. This means that the cost-basis for determining taxes is reset
to the fair market value of the asset at the time the owner dies. This is
relevant both for taxable assets held in brokerage accounts as well as for real
estate and other related assets that track a cost basis for tax purposes. As
for exceptions, annuities and retirement plan assets do not receive a step-up
in basis. For assets experiencing large appreciations, the step-up in basis can
imply a huge reduction in potential capital gains taxes. Sell the asset while
alive and capital gains taxes are due; leave it for an inheritance and those
capital gains taxes disappear. Joint ownership of assets such as real estate
can eliminate the possibility of receiving a step-up in basis at death, though
for community property a complete step-up may be possible at the death of
either owner. Losing the potential for a step-up in basis can create a costly
tax mistake for appreciated assets.

To consider a simple example, suppose you have
a long-held mutual fund in a taxable brokerage account worth $100,000 with a
cost-basis of $40,000. You could sell it to cover retirement spending and then
pay long-term capital gains rates on the $60,000 of gains. However, if you
instead leave this asset for heirs, its cost basis resets to the $100,000 fair
market value at the time of death. If then sold at this price, there will be no
capital gains taxes to be paid by the heirs.

This possibility speaks to the idea that it
may not always be wise to fully spend down taxable assets first. In some cases,
as legacy planning becomes realistic, it may prove wise to hold on to some highly
appreciated taxable assets so that their embedded capital gains can avoid
taxation when inherited. As for a related point, some assets may experience
losses and be worth less than their cost basis. It might be wise to sell those
assets while alive to receive a tax deduction on the losses that would be lost
at death when there is a step-down in basis.

The next point relates to the marginal tax
rates paid on distributions from IRAs and other tax-deferred retirement plans.
We spoke in Chapter 10 of reducing the marginal tax rates paid through
tax-bracket management and strategic Roth conversions. Taxes must be paid at
some point, and the strategy is to trigger taxable income when the tax rates applied
to that income are relatively low. The extension to consider here is that when
these IRA assets are inherited, tax-bracket management also extends to include
the marginal tax rates paid by the account beneficiaries.

Peak earnings years often happen at around age
50, and this age may also coincide with when beneficiaries are inheriting IRAs
from their parents. The SECURE Act speeds up the process for many
beneficiaries to take required distributions, allowing for ten years to fully
distribute an inherited tax-deferred account and pay taxes on the proceeds.
This eliminates the previous ability to stretch distributions from inherited
accounts over one’s lifetime (we discuss this further later in the chapter). With the SECURE Act’s ten-year window on distributions, beneficiaries
may increasingly be forced to take distributions during peak earnings years
and, therefore, at higher marginal tax rates. The implication is that the
advice to pay taxes when the tax rates are lowest might increasingly suggest
Roth conversions to retirees who may be in lower tax brackets than their
beneficiaries.

It is also quite possible that multiple
beneficiaries may be in different tax brackets. Perhaps one adult child is a
high earner facing high marginal tax rates while another adult child has a more
modest income and faces lower tax rates. A desire to be fair might suggest
dividing all accounts equally between the two children. But a more
tax-efficient approach would be to lean toward leaving taxable accounts and
Roth accounts to the high earning child and leaving IRAs to the low earning
child. This way, lower tax rates can be applied to the IRA distributions.

One can also consider what is meant by “equal”
inheritances. Should the amounts be equal before tax or after tax? In this
scenario, the low earner will be stuck paying taxes on IRA distributions while
the tax bills will be less for the high earner receiving assets that are not
taxed. This speaks to providing a larger monetary amount to the low-earning
child such that after taxes are paid, the inheritance values will be more
equalized. When strategizing in this way, it is worthwhile to explain to your heirs
what you are doing so that they do not view it as unfair and understand that
this can lead to a larger after-tax inheritance value for each of them than a
simple equal splitting of each account value. We generally view monetary amounts
in gross terms rather than in the more relevant after-tax terms, and that thinking
can lead to less after-tax value for beneficiaries.

This concept is complex and is worth providing a simple
illustration. An estate consists of $100,000 in an IRA and $100,000 in a Roth
IRA. Two adult children will be the beneficiaries of these accounts. One child
will be in the 37 percent marginal tax bracket while the other child will be in
the 12 percent marginal tax bracket. First consider if these accounts are split
evenly between the children, with each receiving $50,000 from the IRA and
$50,000 from the Roth IRA. The $100,000 pre-tax values will not be the same
after taxes. For the high tax child, the after-tax value of the inheritance is
$81,500. This consists of $50,000 from the Roth IRA and $31,500 net-of-taxes
from the IRA. For the low-tax child, the after-tax inheritance is $94,000 after
paying 12 percent taxes on the IRA component. The combined after-tax
inheritance value is $175,500.

But consider a different distribution. The high-tax child
receives an inheritance of $94,000 from the Roth IRA, while the low-tax child
receives the $100,000 from the IRA and $6,000 from the Roth IRA. As the low-tax
child received $12,000 more than the high-tax child, this may not seem fair.
But consider the after-tax impact. The high tax child still has $94,000 after
taxes. The low-tax child has $88,000 from the IRA after paying 12 percent taxes
and $6,000 from the Roth IRA, for a total of $94,000. They both received
$94,000 after paying taxes, for a combined after-tax value of $188,000. This is
$12,500 more combined after-tax inheritance than in the case where accounts
were split equally. Even though the pre-tax inheritance values were not equal,
both children should be understanding of the situation once the after-tax implications
are made clear.

A final variation on this applies to those with charitable
intentions as part of their legacy and who own a variety of account types. IRAs
and other tax-deferred accounts may be the best suited for charitable
donations. IRAs carry embedded income tax requirements for their distributions that
qualified charities do not have to pay. Roth IRAs and taxable assets with a
step-up in basis will then be better suited for receipt by individuals. As a
related point, it would not make sense to engage in Roth conversions for assets
that you intend to donate to a tax-exempt charity.

Estate Taxes

The other wrinkle with estate planning is the existence of estate
taxes, which are applied to the value of the assets an individual owns at
death. These taxes exist at the federal level as well as in some states. Currently,
most people will not need to worry about paying federal estate taxes. In 2021,
the estate tax exemption for an individual is $11.7 million. Since 2011, unused
exemption amounts can be passed to a US citizen spouse, using a concept called
portability. To take advantage of this portability between spouses, an estate
tax return (IRS Form 706) must be filed within nine months of an individual’s
death, even if no estate tax is otherwise due. This process effectively doubles
the exemption to $23.4 million for a couple in 2021. Estate taxes are due only
if the net value of the estate exceeds these exempt amounts. An estate tax
return must be filed if the gross value of the estate exceeds the thresholds,
even if the net value after deductions is less. For asset values exceeding the
exemptions, estate tax rates range from 18 percent to 40 percent. The 40 percent
rate applies on any amount of the taxable estate above $1 million.

If these exemption levels seem unimaginably high for your
potential estate, and you otherwise live in a state that does not have estate
taxes, you may be thinking to skip ahead to the next section. But estate taxes
are still something to be aware of, as the exemptions and other rules could be
changed by Congress in the future. In fact, even the current exemption amounts,
which adjust annually for inflation, are set to be expire after the 2025 tax
year like other provisions of the Tax Cuts and Jobs Act of 2017. Current law
has the exemptions set to be cut in half starting for deaths in 2026. But Congress
can change the estate tax laws at any time, and the exemptions could possibly
be made much lower. As recently as 2001, the individual estate tax exemption
was $675,000, and it was still only $2 million in 2008. If Congress decides to
return to these levels as part of a tax reform package, you may suddenly be in
a situation where estate taxes become relevant. You may want to be ready to
revisit these issues should the exemption amounts ever be lowered to levels
that could impact you.

Thus, it is worth understanding how estate taxes work. These
taxes are due on the net value of the estate. The gross value of the estate is
the total value of all assets owned by the deceased. There are several
deductions available to determine the net value. First, there is a marital deduction
for any portion of the estate bequeathed to a surviving spouse who is a US
citizen. As well, a charitable deduction is available for all property left to
a tax-exempt charity. Deductions are also available for funeral expenses,
expenses for settling the estate, claims against the estate, and a percentage
of state or foreign estate or inheritance taxes. An annual gift tax exclusion
is also available prior to death and will be discussed further in the next
section. Lifetime gifts made above the annual exemptions are added to the
estate, and any gift taxes already paid are deducted.

Income taxes are not paid on the value of the estate by
those who receive it. The exception is when beneficiaries receive retirement
plan assets or annuities that were provided with tax advantages and still
require taxes on their required distributions. As well, if inherited property
then generates further income or gains, then the new owner becomes responsible
for those taxes. If the estate is large enough that estate taxes are paid on
the value of retirement accounts, then it is possible for the beneficiary to
receive a pro-rata deduction on the income taxes due for their distributions to
offset the estate taxes paid. Nonetheless, the embedded income taxes due on
retirement accounts like IRAs can make them great assets to leave to charities
as part of the estate plan, as this avoids both income and estate taxes for
these assets.

Residents of some states may also find
themselves exposed to state-level estate or inheritance taxes. Estate taxes are
imposed on the estate, while inheritance taxes are imposed on individual
beneficiaries. For inheritance taxes, the tax rate can differ by the type of
beneficiary, with close relatives often receiving lower rates. Some states have
deduction thresholds matching federal levels, while others have lower
thresholds. States with an estate tax include Connecticut, Hawaii, Illinois,
Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island,
Vermont, and Washington, as well as the District of Columbia. As well, states
with an inheritance tax include Iowa, Kentucky, Nebraska, Maryland, New Jersey,
and Pennsylvania. Maryland is the only state with both estate and inheritance
taxes.

Gifting

Aside from taking advantage of exemptions and
deductions, the general concept of estate tax planning involves trying to
remove assets from the estate at current valuation levels so that any
subsequent appreciation takes place outside of the taxable estate. This is the
idea guiding strategies around gifting, life insurance, and irrevocable trusts,
which we now consider in turn.

Gifting can play an important role in reducing
the size of a taxable estate and probate is avoided for gifts made during one’s
life. Gift decisions are often made for personal reasons unrelated to taxes,
and gifting strategies are only relevant when the gifts do not threaten the
sustainability of a retirement plan. When other aspects of the retirement plan
are set, one may also find value in providing gifts while alive to enjoy seeing
their receipt, rather than waiting to leave everything as an inheritance.

As well, the gift tax exemption can be quite valuable. Assets can be permanently removed from the estate for valid gifts of up
to $15,000 per recipient in 2021. Recipients who may trigger gift taxes include
individuals and non-charitable organizations. Gifts made beyond the exemption
level in a tax year are taxable for the giver and a gift tax return (IRS Form
709) must be filed. The gift tax is not immediately due, as it instead works to
reduce the exemption amount for the estate by the taxable portion of the gift. Actual
payment of gift taxes begins once taxable gifts exceed the estate tax
exemption. This may still help to reduce eventual estate taxes by taking
property and its subsequent appreciation out of the estate.

Even just taking advantage of the gift
exemption each year can add up over time. This exclusion is per individual
giver. A couple could jointly gift $30,000 to one recipient before reaching the
exemption limit. And if a couple makes that gift to five individuals each year,
that is $150,000 removed from the estate without creating tax. This process can
be repeated annually. Other gift exemptions are also available for the full
amount of a gift to a spouse, a gift of tuition or eligible medical expenses
that are paid directly to the institution or provider, or gifts to
political organizations and qualified charities. Educational 529 plans also
have a special provision that allows up to five years of the gift-tax exclusion
to be taken at one time for a large gift of up to $75,000. One might consider
paying education expenses for grandchildren, or perhaps taking the entire
family on a vacation.

Assets that are better suited for gifting
include those with a high cost-basis and limited embedded capital gains, assets
with strong appreciation potential for the future, and assets that produce
large amounts of income, which could be gifted to someone paying taxes at lower
marginal tax rates. The idea of gifting assets that are expected to appreciate
is to freeze the value of an asset at its current level so that any subsequent
appreciation occurs outside of your estate. Relatedly, there may be value for
individuals in higher income tax brackets to gift income-producing assets to
those in lower tax rates to reduce the tax rate on that income. This
consideration may not work for gifts to minors, though, as income generated by
those assets is generally taxed at the same higher rates as for irrevocable
trusts.

As for less useful assets for gifting, appreciated
assets that are eligible for a step-up in basis at death are not as suitable
for giving away while alive. The gift would sacrifice the potential step-up in
basis and elimination of capital gains at death. Conversely, gifting property
with embedded losses would mean losing the ability to deduct those losses for
yourself first, and there would be a step-down in basis at death. One might
sell assets with losses, take the deduction, and then gift the value of those
assets.

The issue of asset appreciation can become a
source for mistakes. For example, someone might consider adding a child as a
joint owner on the deed to one’s home for personal reasons unrelated to taxes.
This action would allow the child to eventually become the homeowner without
going through the probate process. However, there can be negative consequences
to this decision. First, the child’s consent is now needed for any actions
related to selling the home or opening a mortgage or home equity loan on the
home. The home could also become entangled in any proceedings related to the
child getting divorced, sued, or entering bankruptcy. As well, adding the child
to the deed counts as a gift of the home value to the child, which could
trigger gift taxes. It will also mean that the child does not receive a step-up
in basis on the home value upon your death and so may be exposed to greater
capital gains taxes on a subsequent home sale. The gifting may also be penalized
and delay the process of gaining Medicaid eligibility for long-term care,
whereas home equity may otherwise be an excluded asset for Medicaid
eligibility.

As for other issues, some gifts must be made
at least three years before death for the gift to be allowed to reduce one’s
estate. This can be an issue with life insurance, as the cash value of the gift
is typically much smaller than the value of the death benefit. If death happens
within three years of gifting a life insurance policy, then the gift is not recognized,
and the death benefit is added to the estate. But after three years, the gift
is allowed and only the cash surrender value is treated as a taxable gift. This
provides a way to leverage legacy assets to get them outside the reach of estate
taxes. For example, suppose a life insurance policy with a cash surrender value
of $100,000 and a death benefit of $1 million is provided as a gift in 2021.
Should that individual survive for three more years, the taxable portfolio of
the gift ($85,000) is all that impacts the estate. However, the estate would
grow by $1 million should the giver die within that three-year period. It may
be useful to note that the three-year rule does not apply to gifts made from a
living trust.

To qualify for the gift tax exclusion, the
gift must have a “present interest,” which means that it is immediately
available for the recipient to use. Gifts to irrevocable trusts may not meet
this requirement. For minors, such as children or grandchildren, who are not
legally able to receive gifts of value, the gift tax exclusion is still
available if certain conditions are met. These include that the gift is
retained in a proper child’s trust, in a custodial account conforming to the
requirements of the Uniform Transfer to Minors Act (UTMA) or Uniform Gifts to
Minors Act (UGMA), or in a 529 Education savings plan. The custodian manages
the assets for the minor’s benefit and the account control transfers fully to
the child at the age of majority. For UTMA and UGMA accounts, the gift must be
made available outright when the minor reaches the age of majority, which is
between 18 and 21 in most states. The “present interest” rule can also be met
by creating a “Crummey” trust which makes the gift immediately available, but
if it is not accepted within a limited time then the gift becomes owned by an
irrevocable trust. When comparing trusts to UTMA accounts, trusts can have
multiple beneficiaries, different tax treatment, and the ability to defer the
distribution of assets beyond the age of majority.

Selling an asset for less than its fair market
value can also be counted as a gift. Gifts can also complicate Medicaid
eligibility for long-term care benefits. Gifts or transfers at less than fair
market value during the previous five years can impact Medicaid eligibility by
creating a penalty period before benefits begin. This is an area in which a
knowledgeable estate planner can help identify allowed ways to transfer assets.

Life Insurance

Life insurance can provide a tax-efficient way
to support legacy goals in the estate plan. Life insurance can be used to pay
final expenses, to cover estate taxes or unpaid debts, to fund business
continuation agreements, or to provide financial support to a spouse or other
beneficiaries. Beneficiary designations can be used to
keep the proceeds out of probate, which can help the death benefit become
quickly available to support immediate liquidity needs. Life
insurance can provide an important way to create liquid assets for paying
estate taxes or final expenses so that illiquid assets do not need to be sold
for this purpose. The death benefit will not be subject to
income taxes, and irrevocable life insurance trusts (ILITs)
can be designed to keep the proceeds of a life insurance policy outside of an
estate to avoid estate taxes. The smaller cash surrender value of the policy at
the time of the trust creation becomes the gift amount. As well, the death benefit for life insurance provides a method to meet a legacy
goal using risk pooling and tax advantages that is distinct from preserving
investment assets for this purpose. This can allow the retiree to potentially
enjoy a higher standard of living in retirement, while also ensuring that
assets have been earmarked to meet the legacy goal.

A life insurance policy can also be gifted to
an individual or organization. This also has the same effect of freezing the
value of the policy for the estate at its current cash surrender value rather
than the larger death benefit it will eventually provide. Gifts of life insurance
do have to meet the same three-year rule described previously. As well, if you
are using the policy as part of your retirement income strategy, which requires
keeping control to borrow against the policy or take other actions, then the
IRS would not recognize the gift for estate tax purposes. That is because the
IRS requires giving up any retained interest in an asset for it to be accepted as
a completed gift. An advantage of using an ILIT over gifting a policy is that
the trustee may better manage premium payments or may prevent the beneficiary
from cashing out the policy before your death.

Life
Insurance for Retirement Income

Aside from estate planning, permanent life
insurance can also play a role in retirement income strategies. Permanent life insurance with cash value providing stable growth can
serve as a volatility buffer for the investment
portfolio (whole life insurance joins cash reserves and reverse mortgages as
the three types of buffer assets). It can provide a source of funds to
support legacy, liquidity, and even long-term care if a rider is added for
that purpose. With the support of a death benefit as backup for the annuity
premium, the retiree may also feel more comfortable using an annuity with
lifetime income protections as part of a retirement plan. Another use of permanent life insurance is as a supplemental source
of retirement income. To be effective, the policy must provide net benefits so
that the tax-advantages of life insurance contribute more value than the
insurance costs of the policy. If tax rates increase in the future, this
would increase the relative advantage of life insurance. As well, when viewed
as an investment, life insurance cash value can provide an attractive
alternative to holding bonds in a taxable investment portfolio. In addition
to tax deferral and the potential for tax-free distributions, premiums are
invested in the insurance company’s general account, which can provide advantages
by holding higher-yielding fixed-income investments relative to what a
household can obtain on its own by accepting more maturity, credit, and
illiquidity risk. Using life insurance as part of a retirement income plan is
discussed in much greater detail in my book, Safety-First Retirement
Planning.

A Role for Trusts in Managing Estate Taxes

Our earlier discussion of trusts focused on
avoiding probate and controlling the distribution of property after death. For
estate taxes, those matters are not mutually exclusive as trusts can be
designed both to manage estate taxes and control trust property. But now the
focus is directed toward estate tax issues rather than property control issues.
The basic idea for this section is that irrevocable trusts can be used to
provide gifts at their current value such that any subsequent asset
appreciation or income generation occurs outside of the estate and is not
counted as part of the taxable estate. Revocable trusts do not have any impact
on reducing estate taxes because assets held in a revocable trust are included
as part of the grantor’s estate. Revocable trust assets are still controlled by
the grantor, so they do not count as taxable gifts. Revocable trusts may create
irrevocable trusts at death to control the disbursement of assets. But for
estate taxes, this discussion is about creating irrevocable trusts during one’s
lifetime to gift assets, or in some cases to create irrevocable trusts at death
to take better advantage of personal estate tax exemptions. This discussion of
irrevocable trusts and estate taxes introduces basic concepts. You should seek
professional legal guidance to determine the appropriateness of these
approaches and to draft the legal documentation to create an irrevocable trust
provided that is the optimal approach.

Irrevocable trusts are permanent and cannot be
changed once created. Unlike revocable trusts, they become independent legal
entities with their own tax IDs, tax rules, and tax filing requirements. The
trust pays taxes and holds ownership of its assets once they have been
transferred. Property cannot be returned to the grantor, and the grantor cannot
serve as a trustee for the irrevocable trust if the goal is to keep assets
outside the estate. This is necessary to ensure that the property has truly
been gifted away from the estate and to be compliant with gift tax rules. Grantors
can be income beneficiaries of the trust with rules defining how much access is
available to trust assets and income.

As separate legal entities, irrevocable trusts
face their own set of tax rules. For those who are living when transferring
property to the trust, that property is treated as a gift and is subject to the
gift tax. As noted, taxable gifts are offset against the estate tax exemption.
This becomes the main point of these strategies: to transfer property out of an
estate when it may be valued at lower levels to reduce the subsequent taxable
estate. For instance, if property is gifted to a trust when it is worth $1
million, and that property is worth $2 million when the grantor dies, this
strategy allows for $1 million to be counted when determining estate taxes. If
property is transferred at death, the whole $2 million is counted as part of
the taxable estate.

When an irrevocable trust generates income
from trust property as part of its ongoing operation, trust income tax rates
apply for any income that is retained at the end of the tax year. The tax rates
on trust income quickly escalate, with a top marginal tax rate of 37 percent
already applying to retained trust income above $13,050 in 2021. If the trust
instead distributes that income to its beneficiaries before year end, then it
instead becomes part of the beneficiary’s income tax return.

An important type of irrevocable trust that
can be designed with estate tax management in mind is an AB disclaimer trust.
Before portability of the personal estate tax exemption became available for
spouses, these trusts were popular for married couples who expected to be
subjected to estate taxes. Now this design is less necessary for married
couples, but it still may be used for those who are not married, who are
subject to state-level estate taxes, or who are worried that the portability of
the deduction may be eliminated. The objective of an AB disclaimer trust is to
keep the property of the first-to-die individual out of the estate of the
surviving individual in this joint set up. When the first individual dies, an
existing joint living trust is split into Trust A and Trust B. Trust A is an
irrevocable trust for the deceased individual’s assets and Trust B is the
separate revocable living trust for the survivor. That survivor is a life
beneficiary of Trust A, which means that the survivor can receive trust income,
use trust property, and spend trust principal if it covers basic needs through
a standard “health, education, support, and maintenance” clause. For the trust
to work for its intended estate tax purpose, the survivor cannot have full
access to or ownership of the property in Trust A. When the survivor dies, the
remaining property in Trust A goes to its final beneficiaries as had been
defined by the first-to-die individual, but the goal was not necessarily to save
property for those final beneficiaries. Property in Trust A is part of the
deceased individual’s estate used to take greater advantage of that individual’s
estate tax exemption. The disclaimer aspect of the trust allows the survivor to
have control over which property is kept outright by the survivor and which
property is disclaimed by the survivor and therefore goes into Trust A. Disclaiming
property means it is never owned by an individual and does not become part of
that individual’s estate.

A second similar type of trust is a qualified
terminable interest property (QTIP) trust. Its basic setup is comparable to an
AB Disclaimer Trust, though a QTIP trust is only available for married couples.
The basic difference for this trust is that it uses the marital deduction for
estate taxes to delay the payment of estate taxes until the second spouse dies.
When the first spouse dies, the trust property is exempt from estate taxes by
passing it to the spouse, and the remaining property is included in the second
spouse’s estate to be taxed at that time. The surviving spouse has access to
money and property in the trust, but does not have outright ownership, and
remaining trust property will go to the final beneficiaries after the surviving
spouse has also died. This can be useful for those in second marriages to
support a surviving spouse while also ensuring that some assets will also go to
children from a previous marriage. The tradeoff involves determining just how
much the life beneficiary (surviving spouse) can use, as controls against too
much use will better protect property for the final beneficiary. A QDOT trust
can play a similar role for married couples in which one spouse is not a US
citizen.

Irrevocable trusts can also be used in the
context of giving to charity and can provide both income and estate tax
benefits. A Charitable Remainder Trust (CRT) provides an annual payment to an
income beneficiary (typically you or a family member) during his or her
lifetime or for a set number of years and then the remaining property is passed
to the charity as the final beneficiary. Income payments are either defined as fixed
amounts (annuity trust) or as a fixed percentage of remaining assets (unitrust).
A Charitable Lead Trust (CLT) works in the opposite way by providing
distributions to a charity for a specified period and the remainder is then
available for other beneficiaries (typically you or a family member). These
trusts are irrevocable, can be used with eligible tax-exempt charities, and are
often set up during one’s lifetime to take advantage of income tax deductions
for the charitable donation. The IRS uses tables to estimate the portion of the
donation that will remain with the charity as opposed to being returned as
payments to the income beneficiary. An income tax deduction for the donated portion
can then be spread over a five-year period and is subject to limitations on the
percentage of one’s adjusted gross income that can be donated for a tax
deduction. Appreciated assets can be used to set up these trusts to avoid
capital gains taxes as well, though a portion of payments received back will
return some capital gains to you. The trustee is typically the charity, but you
or someone else might serve as trustee if the charity allows this. Assets in a
CRT are no longer part of your estate once they go to the final beneficiary.
Charitable gift annuities, which we discussed in the previous chapter, are streamlined
and standardized forms of CRTs.  CLTs do require income taxes to be paid on the
distributions to charities, which can offset the value of the tax deduction,
but this approach may still be attractive to avoid capital gains taxes on
appreciated assets.

Charitable
Giving after Death

When charitable giving is an important goal,
besides the obvious questions of whom to give to and how to balance the
desires between family and charity, important questions for givers include
when to give and with what assets. In this and the previous chapter we
discuss tools for giving when alive to obtain income tax deductions in
addition to reducing the subsequent size of the taxable estate. Many may
prefer to give while still alive once they feel the gifts are affordable and
will not disrupt their retirement sustainability. Charitable giving after
death is still possible and it will reduce the size of the taxable estate for
those whom estate taxes are a consideration, even though income tax
deductions are no longer possible. But even for the vast majority who will
not pay estate taxes, charitable giving may be a goal and coordinating it
properly can help to save on taxes. With their embedded income tax
liabilities, we noted that IRAs and retirement plan assets can be great
candidates for charitable giving, because tax-exempt charities will not have
to pay income taxes. One might even use life insurance policies to replace
the value of the IRA assets as a gift for family members, with the
possibility that the income tax savings from not paying taxes on IRA
distributions could help to fund the life insurance premiums.

The discussion of CRTs also has a parallel set
of trusts when the final beneficiary is not a charity. These include Grantor
Retained Annuity Trusts (GRATs) that pay fixed amounts, and Grantor Retained
Unitrusts (GRUTs) that pay fixed percentages. These are irrevocable trusts that
maintain some ability for you to use trust property for a set period as an
income beneficiary before the property goes to the final beneficiary. During
the period you use the property, you remain as a trustee. A downside for these
is that if you die before your period of use has ended and before the trust assets
have been transferred to the final beneficiary, then the estate planning
benefits about removing the asset from the estate are lost. Even though the
trust is irrevocable, you have a retained interest in the trust while serving
as the income beneficiary. You must outlive the period of property use to have
the trust assets valued as a gift from the time the trust was established,
which is a disadvantage if the trust property had further appreciated in value
since that date. The value of the gift is adjusted downward from the amount of
assets placed in the trust to estimate the value of your retained interest in
the same manner as with CRTs and the gift tax exclusion is not applicable at
the time of the trust creation. These trusts are also established so that any
income and capital gains from the trust are taxed to you as the grantor, even
though the trust is a separate legal entity.

A related type of trust is the Grantor
Retained Income Trust (GRIT). These are designed to provide use of the
property, such as living in a home, rather than to provide income generated
from the trust property. GRITs are now generally used as qualified personal
residence trusts (QPRTs) to own a personal residence for a specific number of
years and to provide use of the home to the grantor during that time. After that
time, the property’s title passes to the remainder beneficiaries. The original
grantor might remain in the house after that time if a fair market rental value
is paid to the beneficiary who serves as owner.

For another example, Irrevocable Life Insurance
Trusts (ILITs) are an option to help keep a life insurance death benefit out of
the estate for the purpose of determining estate taxes. Though life insurance
death benefits are not exposed to income taxes, they do become part of the
taxable estate. The ILIT provides a way to remove the policy from the estate by
transferring its ownership to an irrevocable trust. This may be useful in cases
where you do not wish to gift the policy directly to another person. There are
many rules that must be met to ensure the estate tax benefits are received,
including that you cannot be the trustee or otherwise have any decision-making
control over the policy. As noted earlier, the trust must be in place for at
least three years before your death for it to be effective in keeping the death
benefit out of your estate. The policy may still require premium payments, and
there are a variety of techniques that can be used to pay premiums that do not
imply retained control over the policy from the IRS’s perspective.

Other types of complicated trusts are also
available to help manage estate taxes. These include generation-skipping trusts
which treat one’s children as income beneficiaries and grandchildren as final
beneficiaries to avoid a second round of estate taxes from having to be paid by
the grandchildren when the children die. This skipping ability only applies up
to the level of the generation-skipping transfer tax exemption, which is
currently the same as the personal estate tax exemption amount. There are other
options as well, as the limits relate to the creativity of estate planning
professionals and their abilities to convince the IRS that the efforts to
reduce the estate’s size are legitimate.

Required Minimum Distributions for Inherited Assets

In this section, we continue the discussion of
tax issues related to legacy by extending the discussion of required minimum
distributions during one’s life to what happens after the death of the original
owner. Beneficiaries of IRAs and other qualified retirement plans and annuities
will face required distributions from these assets. The SECURE Act from
December 2019 changed how these rules work, creating many possible scenarios
for any embedded income tax liabilities in these accounts that remain after the
death of the original account owner.

RMDs on Inherited IRAs and Qualified Plans

Upon the IRA account owner or qualified plan
participant’s death (which, to simplify the language, I will refer to as
“owner” from this point forward), IRAs and retirement plan assets will pass to
the beneficiaries indicated on the account beneficiary forms, or to the estate
(or what the plan documents otherwise require with qualified plans) if
beneficiaries are not otherwise listed. Required minimum distributions for
beneficiaries work differently than for the original owners. The nature of the
rules used depend on the type of beneficiary, on whether the death happens
before or after the owner had reached the required begin date for
distributions, and on whether the death took place before or after January 1,
2020. Exhibit 11.1 provides a summary of these details. We also note that if
the beneficiary has details about non-deductible contributions that had been
made to the IRA, then it is not necessary to pay tax on that portion as was
also the case during the owner’s lifetime.

I will walk through the process to explain the
details in Exhibit 11.1. The first step is to identify the required minimum
distribution in the year of the owner’s death. If the owner dies before April 1
in the year after reaching the RMD starting age (this is the required beginning
date), the RMD is not due and the first set of rules in the exhibit is applied.
If the owner has already made that first payment before dying, then nothing
happens. The payment is not refunded, and it does not shift the beneficiary to
the bottom half of the exhibit. The RMD starting age was 70.5 in 2019 and
before, and it is now 72.

Exhibit 11.1

Required Minimum Distributions (RMDs) for Inherited
Retirement Plans

Owner or Participant Dies before Required Beginning
Date for RMDs

Type of Beneficiary

Death took place in 2019 or earlier

Death took place in 2020 or later (SECURE Act)

No RMD in the year of owner's death. In subsequent
years:

Spousal beneficiary

Spouse may rollover or otherwise treat the account as
his or her own, such that RMDs are based as though the spouse is the owner;
Spouse may leave in name of decedent and distribute using the single life
table (annually updated) beginning when owner would have turned 70.5.

No changes, except RMD start age is now 72.

Non-spousal beneficiary

Lifetime stretch: RMDs based on smaller of
beneficiary's age and owner's age at end of the year in the year following
death using the single life table (fixed).

End of lifetime stretch. Now a 10-year rule, except
for "eligible designated beneficiaries"

Non-person beneficiary (estate, charity, some trusts)

5-year rule

No changes

Owner or Participant Dies after Required Beginning
Date for RMDs

Owner's same RMD in the year of death (must be paid
by beneficiary if not paid yet). In subsequent years:

Spousal beneficiary

Spouse may rollover or otherwise treat the account as
his or her own such that RMDs are based as though the spouse is the owner;
Spouse may leave in name of decedent and base RMDs on smaller of
beneficiary's age and owner's age at end of the year in the year following
death using the single life table (annually updated).

No changes

Non-spousal beneficiary

Lifetime stretch: RMDs based on smaller of
beneficiary's age and owner's age at end of the year in the year following
death using the single life table (fixed).

End of lifetime stretch. Now a 10-year rule, except
for "eligible designated beneficiaries"

Non-person beneficiary (estate, charity, some trusts)

RMDs based on owner's age at end of year of death
using the single life table (fixed). Some trusts may be able to be set up to
use single life expectancy (fixed) of beneficiary.

No changes

Once we get past the required beginning date,
the regular RMD for the owner is due as usual by December 31. If the owner has
not made the RMD for the year yet, beneficiaries need to make sure they
complete this task by December 31 to avoid the large 50 percent penalty tax on
the distribution amount. A death in December, for instance, with everything
else going on for the family, becomes one more matter to get addressed quickly.
Though waiting until the end of the year provides the most tax-deferral
potential, individuals may wish to take their RMDs earlier in the year to
protect their families regarding this matter.

In the year after the death takes place,
matters diverge as based on the date of death and type of beneficiary. And
there may be multiple beneficiaries, in which case the RMD rules will be linked
to the beneficiary with the least favorable RMD status.

The process for determining RMDs is to first
identify all beneficiaries of an account at the owner’s death. Then we look
toward determining whether any of the beneficiaries cease to have an interest
by September 30 of the following year. A beneficiary could cease to have an
interest by receiving their full payout or by disclaiming their benefit. Non-person
beneficiaries such as the estate, charities, and some types of trusts, will
receive the least favorable RMD status by needing to apply a five-year rule to
distributions. To avoid that impacting other beneficiaries, a charity or other
non-person beneficiary could receive its full payout by the following September
30 and cease to be a beneficiary at that point.

With multiple beneficiaries, the RMD rules for
the beneficiary with the least favorable treatment (i.e. the shortest
distribution period) are applied to all beneficiaries. Younger individuals
could be hurt by the rules for an older beneficiary, and every person could be
hurt by the presence of a non-person beneficiary. The account could be divided
into separate accounts with one beneficiary per account, which may work, for
instance, if multiple children are beneficiaries. This would also allow each
beneficiary to use a different asset allocation and distribution strategy. See-through
trusts may also be used to avoid applying the non-person treatment to all
beneficiaries. More on this in a moment.

There are three types of beneficiaries to
consider. The spouse is first. Spouses receive the most favorable treatment
which make them a natural beneficiary choice for retirement accounts. In
addition, for employer plans the spouse must be the beneficiary and needs to
specifically waive this protection for the owner to choose a different primary
beneficiary. The spousal right does not automatically apply for IRAs, except in
community property states.

Next are non-spousal beneficiaries. These are
people who represent anyone other than the spouse. For this category, the
SECURE Act also creates a subset of “eligible designated beneficiaries.” Rights
are more limited for non-spousal beneficiaries, such as they can only use
direct rollovers into inherited IRAs, whereas spouses have more flexibility. Finally,
there are non-person beneficiaries. Technically, a non-person beneficiary means
that there was no designated beneficiary. These include the estate, charities,
and some types of trusts. Regarding trusts, proper structuring can be used to
provide treatment more along the lines of the non-spousal beneficiary. These
are pass-through or see-through trusts that meet various requirements under
state law, including that the trust is irrevocable and has a list of clearly defined
beneficiaries that can be provided to the IRA custodian by October 31 in the
year following death. Even in this case, the beneficiary with the worst RMD
treatment will be applied for all beneficiaries.  A master trust may also
create sub-trusts for each beneficiary to use the separate rules for each as a
non-spousal beneficiary.

Regarding these types of beneficiaries, first
consider if the owner dies before the required beginning date for RMDs. Spouses
have flexibility about their choice at this point. One option is to simply
treat the inherited account as their own, or to roll it over into their own
IRA. For spouses doing this, the account is subsequently treated as his or her
own account and the RMD discussion reverts to the previous chapter about how
RMDs work for the original owner.

Another option for spouses is to leave the
account in the name of the decedent and then take RMD distributions using the
single life table beginning when the owner would have reached the age that RMDs
begin. In the exhibit, this is referred to as single life table (annually
updated). The annually updated aspect refers to the same idea as how RMDs are
calculated during the owner's lifetime. Each year a new life expectancy factor
is used based on the individual's age in that year. An important difference,
though, is that the single life table is used here unlike the uniform life
table during the owner's lifetime. This distinction was described in Chapter 10.
This single life table has shorter life expectancies and higher distribution
rates than the uniform life table used during the lifetime of owners. The
single life table draws down the account faster and will lead to larger RMDs
and more taxable income. As for deaths in 2020 and later, the SECURE Act did
not change the treatment for spouses. The only difference for spouses is that
the RMD starting age is now 72.

The next group is non-spousal designated
beneficiaries. In other words, people other than the spouse. In 2019 and
earlier, when the owner died, non-spousal beneficiaries could stretch the RMDs
over the beneficiary’s lifetime. This “lifetime stretch” rule worked by
identifying the beneficiary’s age at the end of the year following the year of
the owner’s death. Usually, we think of the beneficiary as younger, but technically,
the RMDs are based on the smaller age of the beneficiary and owner. That age is
used to find the life-expectancy from the single life table. This life
expectancy is then fixed, with the terminology in Exhibit 11.1 of “single life
expectancy (fixed).” In this case, the life expectancy is not updated each year
with the life table, but instead one is subtracted from the fixed life
expectancy each year until the remainder gets to zero. At that point, the
account is fully distributed through RMDs. This will deplete the account faster
than with annual updating.

The SECURE Act removed this lifetime stretch
for deaths happening in 2020 and later. Instead, there is now a ten-year rule.
The new ten-year rule is not technically an RMD in terms of specific amounts
being taken in each calendar year. The rule only requires that the full account
value be distributed by December 31 in the year with the tenth anniversary of
the owner’s death. For instance, if the death happens in October 2021, the
account will need to be depleted by the end of 2031. This ten-year window can
speed up the process for distributions, reducing the attractiveness of
inherited retirement plan assets, but it does at least provide flexibility
about how much is taken each year as there is no ongoing RMD during the ten
years. If desired, the full amount could be taken in the tenth year. Planning
around seeking lower tax rates on distributions can help with developing
strategies for how to distribute during this ten-year window.

The SECURE Act also creates eligible
designated beneficiaries who can potentially apply the old rules for a lifetime
stretch instead of the new ten-year window. These include the spouse, disabled
or chronically-ill individuals, beneficiaries who are not more than ten years
younger than the owner, and minor children of the owner. When any of these
beneficiaries dies, the subsequent beneficiary will face a ten-year window. As
well, when minor children reach the age of majority, the ten-year rule applies
to them starting at that point. One final change is that before the SECURE Act,
when a non-spousal beneficiary died, their new successor beneficiary would
continue using the same remaining fixed life expectancy. Under the SECURE Act,
these individuals would now shift to a ten-year window.

Regarding non-person beneficiaries, the
non-person beneficiary has a five-year window to take distributions in
situations where the owner had not yet reached the required beginning date. The
five-year window applies the same flexibility about when to take distributions
as was described for the ten-year window. Only having five years to deplete the
account is the least favorable treatment applied. The SECURE Act did not change
this rule for non-person beneficiaries.

An additional point can be made about assets
from qualified plans. Plan sponsors may require that all beneficiaries use the
five-year rule instead of whichever rules they might have otherwise been
eligible to use. It is important to check the plan documents regarding this
point. This problem can be avoided through a rollover into an inherited IRA.

Next, we consider the situation for
beneficiaries when the owner died after the required beginning date for the
RMDs. As noted, the usual RMD for the owner must be taken in the year of death
as though the owner was still alive. Then, in the following year, the situation
varies by type of beneficiary.

We start with spouses. For spouses, the rules
are the same as when the death took place before the required beginning date.
Except, since we now know that the owner passed the required begin date
already, that would begin the lifetime stretch in the following year when the
spouse left the account in the name of the decedent. The SECURE Act keeps this.

As for non-spousal beneficiaries, the rules
are mostly the same. With deaths before January 1, 2020, the lifetime stretch
applied in which RMDs are based on the smaller of the beneficiary's age and
owner's age at end of the year in the year following death with the single life
table (fixed). The SECURE Act did change this, replacing the lifetime stretch
with the ten-year rule except for some types of eligible designated
beneficiaries as noted earlier. For any successor beneficiaries, the same rules
applied as mentioned when the owner died before their required beginning date
on RMDs. Before the SECURE Act, successor beneficiaries continued using the
same fixed life expectancy, but in 2020 or later they switch to using the
ten-year rule.

Non-person beneficiaries take distributions
based on the remaining single life expectancy (fixed) of the owner based on his
or her age at the end of the year of death. This value then reduces by one in
each subsequent year, so the first RMD in the following year does use that
calculated amount less one. As noted, switching from the uniform to single life
table will increase the RMDs. The SECURE Act did not change these rules for
non-person beneficiaries. With trusts, there are possibilities to structure the
trust in a way that RMDs are applied more in line with non-spouse persons
rather than with non-persons. That could support a switch to using the life
expectancy of the beneficiary instead, which would help if the beneficiary is
younger and is an eligible designated beneficiary or is otherwise able to
switch to the ten-year rule.

We should make a further caveat about
pass-through trusts that could follow the person beneficiary rules. There was
some panic after the SECURE Act passed as many trusts have provisions to
distribute only the RMD amount to an income beneficiary, which was designed for
the lifetime stretch rules. When the treatment for the beneficiary changes from
a lifetime stretch to the ten-year rule, this could lead to a very large
distribution made just in the tenth year, potentially generating a very large
tax bill and high marginal tax rates. Estate attorneys were scrambling to
update trust documents to avoid this outcome and you may wish to check any
older trusts you have to see if this is an issue.

RMDs on Inherited Roth IRAs

For inherited Roth IRAs, beneficiaries do have
required minimum distributions. These distributions follow the same rules as
just discussed for inherited tax-deferred retirement assets. The difference, of
course, is that the distributions are not taxable. They are qualified distributions
triggered by the death of the owner. They can simply be reinvested in a taxable
account at the time of distribution, and they do not add to the adjusted gross
income of the beneficiary. Their relevance, then, is just the timetable created
in which subsequent asset growth is no longer tax-deferred and tax-free for the
beneficiary.

With taxes not being paid, for cases when the
ten-year rule applies, it would generally make sense to simply wait until year
ten and then withdraw the entire Roth account value when the distributions were
not otherwise needed for spending purposes. This would provide the most
tax-deferral. The asset value could then be reinvested in a taxable account. As
we described before, the reductions to the ability to use a lifetime
stretch triggered by the SECURE Act increases the value of receiving an
inheritance as a Roth instead of a traditional IRA. The new ten-year stretch
period can force faster and larger distributions for beneficiaries when they
may be in their peak earnings years, and this can trigger higher marginal tax
rates than the retiree may have needed to pay with Roth conversions. With the
ten-year window, forced distributions from an inherited Roth IRA may be more
favorable than forced distributions from an inherited IRA for those
beneficiaries in peak earnings years. This will make Roth conversions more
popular in the future.

A
Caveat for Inherited Health Savings Accounts

In Chapter 10, we noted the incredible role
that health savings accounts (HSAs) can play for providing tax deductions,
tax-deferral, and tax-free distributions for eligible medical expenses. There
is a caveat for this if the accounts are inherited. When going to a spouse,
there is no problem. The spouse can treat the account as his or her own. But
for other non-spouse beneficiaries, the account ceases to be an HSA. It
behaves like an inherited IRA with a one-year window. The entire account
value must be distributed to the non-spouse beneficiary in the year of the
owner’s death, such that the entire account value becomes taxable income in
one year. This suggests an importance for HSA owners to use their accounts to
cover eligible medical expenses and to avoid targeting the assets to be part of
legacy.

Taxation Issues for Inherited Annuities

Inheriting an annuity can create tax
complications for beneficiaries. Annuities share characteristics with inherited
IRAs as they are exposed to both estate and income taxes and have rules for
required distributions by beneficiaries. At a very superficial level, the rules
treating inherited retirement plan assets and inherited annuities are similar.
But the rules do have important differences and there are many specific
complications for annuities that go well beyond what we present here. Those
with tax questions about inherited annuities should seek further guidance from
a tax professional. We only cover the issue with broad strokes.

We have four basic scenarios to consider that
involve whether the annuity is held in a qualified retirement plan or whether
it is a non-qualified annuity purchased using taxable assets, and whether the
contract has been annuitized or whether it is still in the deferral stage.
Because rules around annuities held inside of qualified retirement accounts
require taxes to be paid in the same manner as with other plan assets, we will
focus the discussion on non-qualified annuities. There are also additional
complications if the owner and the annuitant for an annuity contract are not the
same person, as this can trigger different outcomes for whether the beneficiary
receives the annuity when the annuitant dies or when the owner dies. Tax rules
also vary based on when the annuity contract was created, with different rules
for before and after dates that often fall in the 1980s. For this section, we
will describe the rules in general terms for contracts created in the past
thirty-plus years. These contracts are owner driven. In any case, due to the
complexity of these tax rules, which could fill an entire book (see further
reading by John Olsen and Michael Kitces), I must emphasize again the
importance of consulting with a professional when inheriting an annuity.

Owner-driven
contracts and Annuitant-driven contracts

As a reminder from Chapter 5, the owner of
an annuity makes decisions about it. The annuitant is the individual whose
mortality is used to drive payments from mortality-based annuity contracts.
If the owner and annuitant are the same individual, then the death of that
individual will clearly pass any remaining annuity proceeds to the
beneficiary. The problem is determining when the proceeds go to the
beneficiary if the owner and annuitant are not the same person. If the
contract is annuitant driven, then the beneficiary receives the contract
proceeds when the annuitant dies, even if the owner is still alive. That
might surprise the owner who would not necessarily expect to lose control of the
death benefit. If the contract is owner driven, then the beneficiary receives
the contract on the owner’s death, even if the annuitant is still alive. This
might also be a surprising outcome to an annuitant. Annuitant-driven
contracts were more common before 1985, but since that time owner-driven
contracts are the norm. Much of this problem can be solved by having the
owner and annuitant be the same person.

But this issue can create complications with
jointly-owned annuities. When we described a GLWB providing a joint lifetime
income to a couple owning a deferred annuity, the natural expectation for the
couple is that payments would continue to the surviving spouse upon the death
of the first spouse. It is important that the insurance company designs the
contract carefully to ensure this happens by identifying each spouse as the
sole beneficiary in case the death of an owner triggers the passing of the
contract to the beneficiary. A secondary beneficiary could then be added to
receive any remaining death benefit after the deaths of both owners.

For estate taxes, the relevant idea is that
the value of the annuity provided to a beneficiary is included in the deceased
owner’s estate. For annuitized contracts, this would include any lump-sum cash
refund payment. If the death benefit is structured as a series of payments,
such as period-certain, installment refunds, or a remaining payment based on
the life of an annuitant, then the estate value would be equivalent to the cost
of purchasing a similar payment structure from an insurance company at the time
of the owner’s death. For deferred annuities, the value of the annuity death
benefit would be included in the estate.

Inherited non-qualified annuities are also
subject to income taxes, and these assets do not receive a step-up in basis at
death. Like Roth IRAs, nonqualified annuities are not subject to required
minimum distributions during the lifetime of the owner. The basic idea is that
for annuitized contracts, payments will continue under the terms of the
contract using an exclusion ratio, and that these pre-defined distributions
will satisfy distribution requirements for the beneficiary. A portion of the
payments will be classified as taxable income, while a portion continues to
reflect the return of premium.

As for nonqualified deferred annuities, there
are five possible options to guide required distributions that vary based on
the type of beneficiary (spouse, non-spouse person, and non-person) and rules
of the insurance company. These possibilities include receiving as a lump-sum,
distributing over five years from the date of the owner’s death, annuitizing
the contract, stretching the contract out over a fixed life expectancy, and
having a spouse who is the sole-beneficiary stepping in and treating the
contract as his or her own. Spouses have the best option available to take over
as owner and then do not have to worry about required distributions. Depending
on the rules of the insurer, non-spousal beneficiaries may have to use the
five-year rule, may annuitize the contract, or may use the lifetime stretch
based on their fixed life expectancy that does not annuitize the contract and
maintains flexibility to take out more than the minimum. This latter option is
based on private letter rulings from the IRS that do not give universal
authorization and is not accepted or used by all insurance companies. It is
also not impacted by the SECURE Act, which removed this option for inherited
IRAs. Non-person beneficiaries (such as estates, trusts, or charities) have up
to five-years to take distributions. Deferred annuities continue to use the
last-in first-out tax rules in which any contract gains are removed as taxable
income before removing non-taxable principal, though private letter rulings
have also been used to allow the lifetime stretch approach to also apply an
exclusion ratio. For beneficiaries choosing the annuitization option, that
would also trigger the use of the exclusion ratio for taxation. These matters
are especially complicated, but I hope this introduction can give you a basic
idea about the relevant issues.

Action Plan

As a review for the chapter, an action plan
that incorporates the key aspects of legacy and incapacity planning includes:

o
Collect personal information

o
Create an inventory of household assets and liabilities

o
Account numbers

o
Values

o
Ownership details

o
Existing beneficiary designations

o
Whether asset will be part of the probate estate

o
Assemble information on all insurance policies

o
Assign a durable financial power of attorney

o
Create advance health care directives

o
Living will

o
Health care power of attorney

o
HIPAA releases

o
Decide how assets should be distributed: what, to whom (family,
friends, charity, others), and when

o
Write a will

o
Identify executor

o
Implement asset distribution plan

o
Identify guardian for minors in your care

o
Create and fund trusts to meet potential goals including
incapacity planning, avoiding probate, managing property distribution at death,
providing asset protection, and reducing estate taxes

o
Identify trustees

o
Ensure ownership and beneficiaries of assets are updated to
include trust

o
Review completely all ownership titles and beneficiary
designations to ensure they are aligned with your goals and other estate
planning documents such as wills and trusts

o
Decide and share final wishes

o
Create letter of instructions for family members, executor,
trustees, and attorneys-in-fact to help simplify their process as much as
possible by describing your whole financial situation and providing your wishes
about a course of action

o
Store these documents safely and let the relevant individuals
know how to access the information when they need it, as well as discussing
matters with those individuals and providing them with copies of appropriate
documents

o
Discuss your plans with family members so that everyone knows
what to expect and potential conflicts are managed regarding your intentions,
the disbursement of assets, access to key documents, and the roles and
responsibilities of each person

o
Review your estate planning at least every several years to see
if updates are needed. Certain life triggers that should prompt reviews sooner
include:

o
Significant changes to household balance sheet

o
Changes in family: births, deaths, marriages, divorces

o
Move to a new state

o
Changing relationships or death of individuals holding key roles
in the estate plan

o
Changes in law and tax code that impact the plan

Further Reading

American Bar Association. 2020. Tool Kit for Health Care
Advance Planning. [https://www.americanbar.org/content/dam/aba/administrative/law_aging/2020-tool-kit-hcap.pdf]

Clifford, Denis. 2020. Plan Your Estate. 15th
Edition. NOLO.

Cullen, Melanie. 2018. Get It Together: Organize Your
Records So Your Family Won’t Have To. 8th Edition. NOLO.

Hurme, Sally Balch. 2015. Checklist for My Family: A
Guide to My History, Financial Plans, and Final Wishes. American Bar
Association.

Olsen, John L., and Michael E. Kitces. 2014. The
Advisor’s Guide to Annuities, 4th Edition. Cincinnati: The National
Underwriter Company.

Steuer, Tony. 2019. Get Ready! A Step-by-Step Planner
for Maintaining Your Financial First Aid Kit. Alameda, CA: Life Insurance
Safe Press.

Chapter 12:
The Non-Financial Aspects of Retirement Success

Much of this book focuses on retirement finances. But finances
are only one component for achieving retirement success. Equally important is
crafting a plan to manage your retirement transition in a way that allows you
to flourish and enjoy these years. Improved finances can help lay a foundation
to make a great retirement possible. But if other non-financial aspects of
retirement have been neglected, then having more money is not going to create a
satisfying life.

It is important to cultivate a proper balance between work
and other life pursuits, investing in your life as well as your career. If work
is all that matters in your life, then retirement can mean death. For some, the
proper balance can easily include working in retirement. Work and retirement can
be compatible, as retirement is more about a state of mind.

Retirement is associated with having financial independence
so that you can do what you want with your time. You do not have to be
compelled to do certain things by a need to earn income. If working is what you
want to do, then that is fine, but retirement provides a sense of freedom and
flexibility to change your mind and do the things that bring you the most life
satisfaction.

When looking beyond finances, a study by Merrill Lynch and
Age Wave identified seven life priorities for retirees: Health, Home, Family,
Work, Giving, Finances, and Leisure. Finances, which we cover throughout the
book, are just one of these seven considerations. Home was also the topic of Chapter
9. This leaves five priorities for us to explore in this chapter: health,
family, work, giving, and leisure. In this chapter we shift the question from “how
can we efficiently fund our retirement goals?” into “what will I do in
retirement?”

To provide more context, there are two general styles of
books about retirement planning: those mostly focused on the financial side and
those mostly focused on the non-financial side. Many of the non-financial books
were written by recent retirees who developed a passion for sharing their
experiences with navigating the day-to-day personal aspects of retirement by
writing a book about it. I would suggest that if you are seeking a deeper
exploration of the issues discussed in this chapter, you might also read Mike
Bellah’s The Best is Yet to Be, Don Ezra’s Life Two: How to Get to
and Enjoy What Used to Be Called Retirement, Fritz Gilbert’s Keys to a
Successful Retirement, and Ernie Zelinski’s How to Retire Happy, Wild,
and Free. This chapter benefits from their experiences.

Money has value, but only up to a point. Planning
on how to have a fulfilling and satisfying retirement lifestyle may only be
tangentially related to finances. Once getting your basic life
expenses covered, which is often possible to do with just a Social
Security benefit, other aspects become more important. These
include having purpose and passion, strong relationships, and a healthy
lifestyle. The non-financial aspects may end up being more important
than the finances, as people have a capability to adapt to their financial circumstances.

No matter income levels, people tend to report that they
would feel very satisfied with 40 percent more income. But while further
increases can lead to temporary satisfaction, we quickly return to our baseline
satisfaction levels. That is why having 40 percent more continues to be the
target. If not careful, this can put us on a hedonic treadmill where one needs
more and more just to continue feeling the same. It is an attitude that is
important to avoid. Money is often not the solution to dissatisfaction with
retirement.

The financial and non-financial sides must strike a balance
and can reinforce each other, as creating a stable financial situation is meant
to provide the time and resources to focus on the non-financial considerations
that make life worth living. Enjoying better health, stronger relationships, a
sense of worth, and opportunities for fun make it easier to provide enough focus
on work to build up the finances and to save on potential retirement costs.

Since this book is mostly about finances, another type of
analogy may be helpful. With the financial side, the question becomes how to
best position our resources to avoid running out of money during retirement.
There are other types of non-financial assets that we also wish to avoid
depleting, such as physical health, mental health, friendships, relationship
with a partner or spouse, and maintaining a sense of purpose and satisfaction
with life. With finances, we discuss things like asset allocation, Social
Security claiming, whether to use an annuity and so forth, to create
sustainability and efficiencies. But we also need to make sure to “invest” our
time and energy into the non-financial aspects as well.

Exhibit 12.1 summarizes the types of changes
that one can expect in retirement. Some of these may seem obvious, but it is
worth identifying them to ensure they are not overlooked. For each change, the
response could be viewed as positive or negative depending on your perspective,
background, and attitude. Your feelings are legitimate either way. As well, some
changes could initially be negative but gradually change to become positive, or
the change could start out positive but then gradually become more negative.
The objective of this chapter is to identify issues that could be negatives and
to find ways to transform them into something positive to create the conditions
for a better retirement.

Exhibit 12.1

Lifestyle Changes for Retirees

Retirement Change

Positive Response

Negative Response

Lose Work Identity and Sense of Purpose

Identify activities or goals that create purpose and
passion for retirement to forge a new identity and become who you truly wish
to be

Loss of work identity with no alternative interests
can lead to depression and worsening health

Increase in Unstructured Time

Opportunity for new pursuits and interests, to be
spontaneous, and to focus on health, hobbies, passions, and relationships

Lack of structure and focus leads to boredom and
results in increased television watching, internet surfing, or other passive
activities

Change in Routines

Focus on developing new routines to provide any
needed structure to your days

Retirement is a life transition with the loss of
habits and routines that can create great stress and reduced life
satisfaction

Increased Time with Spouse

Opportunity to re-connect and pursue common interests
as well as respect a separation for individual pursuits

Time together leads to greater conflict and worsening
relationship with potential for grey divorce

Reduced Social Connections Through Work

Use additional time as opportunity to build and
enhance relationships

Increased social isolation and loneliness risk
depression and worsening health

Health and the Aging Process

Recognize aging as a natural part of life and
maintain positive outlook, while also exercising and pursing activities to
support physical and mental health

Less active lifestyle and worsening health status
creates a negative feedback loop with stress and depression causing further
physical and mental health decline

It is important to also address the emotional and quality of
life aspects of retirement. Think about what you will do in
retirement before you get there. Retirement happiness does extend beyond
just having your financial situation under control. Adequate retirement
finances are only part of the story for a successful retirement. We begin by
discussing how to find a purpose or passion that will get you motivated to get
up in the morning and getting going with the day. Then we look at the
relationship between work and retirement, ways to strengthen relationships, and
promoting an active and healthy lifestyle.

Finding Your Purpose and Passion

Retirement brings freedom to spend your days in a very
different manner than before. A retiree is no longer required to
be at work, performing work-related tasks. For successful retirements,
this freedom will serve as a blessing and opportunity to become your true self.
For unsuccessful retirements, this freedom may reflect a loss of routine and
purpose that will become a curse. Creating a plan to manage the newfound
freedom of retirement may ultimately determine whether a retirement is successful
or unsuccessful. Unless work will be part of your retirement, you need to
cultivate a life outside of work (activities, interests, relationships) before
you get there.

It is a simple statement to make, but it is extremely
important to recognize that being able to retire to something,
instead of retiring from something, is a key starting point to
retirement success. Retiring because you have grown tired of working, without
having a clear idea about what you are going to do with your time after
retiring can lead to depression and a lack of fulfillment for many new
retirees. Not everyone is able to retire on his or her own terms, and we must
consider the important distinctions between voluntary and involuntary
retirements, but in either case you must find motivation to start each day.
This is about understanding your passions and interests to create the best retirement
experience.

Retirement offers the time and opportunity to do what you
want and what you love. Finances can facilitate, but they are only part of the
story. Retirement is a time in life designed to fulfill dreams. You want to
find ways to spend time that will keep you engaged and feeling good while
providing you with a sense of purpose and accomplishment. The
hours of the week previously spent with work will need to be redirected. The
novelty of retirement can wear off quickly in the absence of engaging
activities.

The need to find a new purpose or passion in retirement may
not become evident at the beginning of retirement. There can be a honeymoon
phase early on as you enjoy your newfound freedoms to sleep in and not need to
adhere to a specific schedule. As well, there may be a list of activities, such
as specific trips or home renovation projects, that keeps you occupied for even
the first year of retirement. But at some point, treating retirement as an
extended vacation will grow tiresome for most retirees. The thrill of being
retired will gradually wear off. There will need to be something else beyond
simple leisure. If you do not know what that something will be, then you will
need to figure it out. Ideally, planning for what you want to do in retirement will
begin long before the time that being retired is your reality.

Before retirement, think carefully about your life dreams so
you are better prepared to transform those dreams into reality with the time
and opportunities afforded by retirement. You can begin this brainstorming
process now. You may do a lot of daydreaming as you read through this chapter.
What do you view as a perfect retirement? How would you spend a perfect day and
a perfect week? What will you do and experience? Where will you be? How will
you feel? What resources would it take to ensure this can happen? Try to map this
out on a schedule or calendar to make it more concrete in terms of where the
hours will go.

George Kinder identified similar thought exercises as part
of his development of life planning. He says to imagine that at the start of
retirement, a doctor informs you that you have five years left to live. The
nebulous potential of living 30 to 40 years in retirement is shortened in a
concrete way. What would this news do to your focus in retirement? What would
you want to do, to accomplish, to see, to say, and to be during these final
years? Even further, suppose the doctor informs you that you have just 48 hours
left to live. In this case, what hopes and dreams can you let go, what would
you wish you had accomplished or experienced, and what regrets would you have?
Naturally, thinking through these matters can help to create a priority and
emphasis to guide your actions in retirement. Make sure to do the things you
identify as most important and make sure you will not have regrets about things
left undone. We never know just how long our health and life will last, and
though on the financial side we must plan for the possibility of a long
retirement, it is the non-financial side where we also need to plan for the
possibility of a short retirement. We need to prioritize what matters most
and work from there.

How will you know what you want to do in retirement? An idea
that Ernie Zelinski offers in his retirement book is to create a get-a-life
tree. This is a mind map where you list out as many brainstorming ideas as you
possibly can. The idea is to work from the center of the page by branching off
at least three general concepts to which you link your ideas. One way to
organize this is to identify things that interested you in the past, things
that interest you now, and things you have considered doing. There could be
sub-branches as well, such as for different types of physical activities,
different trip destinations, or different types of classes that interest you.
It is important to include all the main areas within this for a happy
retirement, such as relationships to strengthen, activities that fulfill your
purpose, and activities to keep you healthy. This brainstorming can prove
valuable to clarify what will make your retirement a success.

Write down any dreams that cross your mind. Think about what
gives you a feeling of “being in the zone,” where you are focused on completing
a goal and feel a sense of accomplishment afterward. Not everything you list must
be realistic or affordable. But having a complete list will allow you to then
focus on an action plan regarding what is truly the most important to you and
for what can truly be accomplished. As a part of this, revisit your childhood
dreams. With such dreams, if it is something you have put off doing for 50
years, recognize that you might not be likely to start, but there could be
something from your childhood that can again capture your interest and heart.

Ernie’s book lists hundreds of possible activities, but this
brainstorming may work better if it comes from your own thoughts, as that may
suggest it is something you will truly follow-through with rather than just
being something that sounds nice. To give just a brief overview to get your
thinking started, there may be hobbies or interests that you wish to re-devote
yourself to in retirement, or there could be new activities that you have
dreamed about and finally have the time to pursue. Examples may include playing
a musical instrument, learning a new language, reading classical literature,
playing a favorite sport, spending more time with friends, playing a more
active role at civic or religious organizations, sitting in on college courses,
creating art, cooking new recipes, committing to an exercise regime, writing a
book, or maintaining a blog or website. You may also want to fulfill certain
travel experiences, such as RV trips, international trips, cruises, staying at
a cabin in the woods, or seeing different oceans, mountains, and cities. Figure
out what truly matters to you, and what you have always wanted to do but never
had the right opportunity to make it happen. As a side benefit, this process of
planning and anticipating events can be just as important to creating life satisfaction
as actually experiencing the event itself.

Defining legacy can also be an important part
of determining your purpose. We considered the financial aspects of legacy
planning in Chapter 11, but there are many other non-financial aspects of legacy
as well. How would you like to make the world a better place? Possibilities include
passing down family values to grandchildren, supporting worthy causes with your
time, mentoring young professionals in your industry, tutoring children, writing
a memoir or a recipe book, and so forth. You may volunteer with your time as
well as your money. To consider your charitable intentions, you might think
about where you have given in the past, where you wish to volunteer your time,
and what you would like to change or preserve in the world. In addition to
injecting passion and purpose, volunteering can create social connections which
helps to improve health and life satisfaction in other ways as well.

When it comes to purpose and passion, for many individuals
approaching retirement, it is entirely possible that continuing to work or
coping with the loss of work will be an important part of the retirement
landscape. Individuals whose lives revolve around work will have a hard time if
retirement means not working. Work can be an important part of your purpose or
passion, and we explore this further in the next section.

The Relationship between Work and Retirement

In the popular view, the key act that defines retirement is
leaving work behind for a life of leisure. But there are many life changes
related to stopping work, and so this version of retirement may not be best for
everyone. Changes include the loss of work identity, the increase in unstructured
time each day, and the loss of daily routines and structure associated with work.
The purpose and identity provided by a career can disappear
quickly after leaving. The social connections, camaraderie, responsibilities,
income, structure, routines, and status provided through work will need to be
replaced in other ways. This is especially true for those whose personal
identity is closely linked to their careers and whose retirements may not have
started voluntarily. If possible, try a test run of
retirement before leaving work. Ideally you could try this for at least a month,
but even if it is only a week, try as best as you can to avoid anything work
related and see how you feel about the increased free time and lack of
structure and whether retirement might be best for you. Retirement does not
have to mean stopping work entirely.

An important additional consideration is the
possibility that you might not be able to work for as long as you planned.
Surveys consistently find that about half of retirees ended up retiring sooner
than they had anticipated, as discussed in Chapter 2. These estimates were
created before the global pandemic in 2020, which has also forced countless
individuals into an early retirement. Retiring early was voluntary for some, but
more common reasons include retiring due to poor health, involuntary job loss,
or needing to provide care to other family members. Involuntary retirement can
be traumatic for both the financial and non-financial aspects of life.

There is potential for any of the lifestyle changes
associated with the end of work to create depression and stress for new
retirees. The Holmes-Rahe Life Stress Inventory identifies 43 stressful life
events and ranks “retirement from work” as the tenth most stressful event on
their list. With a 45 point-score, the act of retiring gets one about a third
of the way toward a score that suggests a 50 percent chance for a major health
breakdown within the next two years. The loss of work identity
and daily structure, as well as a paycheck, can create stress and requires adjustments.
If retirement begins involuntarily, then it may be associated with
“major personal injury or illness” (ranked 6th), “being fired at
work” (ranked 8th), or “major change in the health or behavior of a
family member” (ranked 11th). These events compound the stress of
retirement.

Retirement is a stressful event because it involves change
and new patterns. It is an end but also a beginning. The natural
changes that accompany retirement can trigger uncertainty and stress as new
ways of living are adopted. Not everyone is equally equipped to manage these
transitions. While on this topic, moving can also
be stressful, and moving at the start of retirement can compound this stress,
and so you might not rush a move, or another major life change right at the start
of retirement.

It is worth dwelling more on some of the
negatives of leaving work. First is the impact of losing one’s work identity.
Many new retirees may feel a sense of loss as an important aspect of their
identities is tied up with their work. Retirement can naturally disrupt this
part of identity. The title shown on one’s business card can be very important.
Giving up that title can create a real sense of loss and even trauma. New
retirees can feel as though they have lost power, status, and respect, changing
overnight from somebody important into a nobody. Work also provides a
routine and structure. It can be scary to deviate from these routines. This sense of loss can easily lead into depression. Retiring can be a
mistake in situations where losses to prestige and stature cannot be recovered.
The psychological stress and sense of loss related to retiring can lead to
depression, addiction, and declining health.

It is important to recognize that these are normal feelings.
The sense of loss is valid, and the response is important. Are
you able to find new challenges and opportunities to replace the psychological
benefits from work? If possible, try not to think about losing a work identity,
but to focus more on what you can become. Retirement provides an opportunity to
reimagine your identity and to reinvent yourself.

Traditional retirement may not be best for
everyone. For some it may be best not to leave work. For others, after
the initial honeymoon period of retirement has past, the best decision may be
to return to some type of work. This can be a bigger issue for those whose work
ends involuntarily. Having a job may be necessary for mental
health even if the finances are otherwise under control. If what you do is who
you are, then it can make sense to simply not want to retire from who you are.
That is the sense where retirement is more about the freedom to do as you wish,
and so working can provide a sense of purpose while having financial
independence can give a sense of being retired at the same time. You do not
have to feel compelled to leave work just because you reach a particular age or
meet a wealth target. You still have the freedom to decide that you would like
to keep working, understanding that it is what you want to do and not because
of economic necessity.

As we consider our interests and habits, an
important step in the transition toward retirement is to consider your
relationship with work. It can be too limiting to think that retirement always
means the cessation of work. Some individuals will want to retire and never
look back. Some individuals will want to keep working. Some will be excited to
retire but soon find themselves wanting to go back to work once the initial
exhilaration of retirement has passed. Some will plan all along to continue
working but in a different capacity. It is important to understand that work can
provide a source of enjoyment, a sense of purpose, a way to stay active and
involved, a way to develop social connections, a way to maintain routines, and
a source of additional spending money.

Some people enjoy working and do not wish to
stop, at least not entirely. There is no judgment. You will not receive a call
from the retirement police if you decide to return to work. It is fine to do
what brings you fulfillment. For some, work can be an important part of one’s
identity, and losing this can be quite difficult. In addition to the obvious
monetary benefits, working can also provide a sense of importance, status, and
self-worth, social interactions, and routines and activities to get through
each day. The social engagement and activity of work can be good for one’s
health. Those who have reached financial independence have more flexibility to
make decisions about these issues. One may decide to leave work entirely, to
just cut back on hours, to switch to a completely unrelated field, or perhaps
to become more active with volunteer work as an alternative.

Working
and Retirement Finances

Though I am trying to keep financial
considerations out of this chapter, it is worth recognizing that continued
work is one of the most powerful ways to improve the sustainability of a
retirement income plan for those who may be falling short. Working longer
allows for more savings, and for existing savings to grow for longer before
being tapped. Because wealth is at its largest, hopefully, in the
pre-retirement years, the compounded returns from investments before
distributions begin can have a huge impact on the number of dollars available
for retirement. And then, as one works longer, the subsequent retirement
period will be shorter and easier to fund. Working longer may also make it
easier to enjoy the benefits of deferring Social Security and it may help
increase benefits from any other employer pension plans. Working longer also
maintains more options for managing a market downturn. For those receiving
health insurance through work, these benefits may also help manage retirement
costs. Stanford University released a study in 2018 which showed that working
3-6 months longer has an equivalent impact as increasing one’s savings rate
by 1 percent for 30 years. Even working for just one additional month has the
same impact as a 1 percent increase in the savings rate for the last 10 years
before retirement. Many of these advantages can also be realized through
part-time work in retirement, which reduces the pressure to take
distributions from investments in the early retirement years. Those who are
thinking that they may wish to work longer before retiring can also take
comfort in knowing the benefits this will have for their finances.

To better understand the connections between retirement and
work, Lynda Gratton and Andrew Scott describe three types of intangible assets
in their book, The 100-Year Life. Intangible assets are aspects of our
lives that extend beyond financial wealth. First are productive assets, such as
skills, knowledge, and investments in human capital. Second are vitality
assets, which include aspects of mental and physical health, such as family and
friends, personal fitness, and mental well-being. Third are transformational
assets. These relate to having options to make changes or adjustments in life,
such as a broad network of contacts and an openness to new experiences. All
three categories of intangible assets are important for transitioning into a
successful retirement. It is not about accumulating financial assets alone.

We can think more broadly about work. Retirement
as the end of working may be antiquated. It may be
better viewed as achieving financial independence such that one no
longer feels compelled to engage in a certain type of work because of financial
concerns. In this framework, retirement does not necessarily mean retiring from
work. It just expands the opportunities available to find a new balance that
allows for even more emphasis to be placed on the non-financial aspects of
life. And it is important not to ignore these non-financial aspects while still
working; you need to “invest” in them as well or your satisfaction with
retirement could be at risk. As lifespans increase, there will more time and
opportunities to achieve this balance in different ways.

This discussion about balancing work and
retirement is relatively new in human history. Even the concept of retiring
completely in one’s 60s may turn out to be a unique circumstance of the late 20th
century. For most of human history, retirement did not really exist. People
worked until they no longer could, and if still alive but physically unable to
work, they may have spent a few final years in the care of family members.
Suddenly, then, with the expansion of pension systems and improved longevity, a
more enjoyable 10-to-15-year retirement became possible.

With the prosperity created after World War
II, there was a growth in motivations to retire and enjoy leisure activities at
the end of life. Employers facilitated this through defined-benefit pensions as
an employee benefit that pooled longevity and market risk for their retired
employees. Now as traditional pensions decline in availability and as 10 to 15
years of retirement change into the possibility of 30 to 40 years, the burden
of saving enough to fund retirement may be too great for many individuals to
manage. As people continue to live longer, the concept of retirement may
change. Retirements may evolve to incorporate work in different ways. On the non-financial
side, 30 to 40 years is also a long time to fill up with purely non-work
activities.

People quickly shifted from not living long
enough to have much worry about funding retirement, to living too long and
being unable to save enough to drop completely out of the workforce. For those
falling behind, continuing part-time work, or maintaining the option to return
to the work force are also important building blocks for retirement income.

Lynda Gratton and Andrew Scott write in The
100-Year Life that as longevity improves people may find themselves working
into their 70s or 80s. But they describe how changes to our traditional model
of retirement may make this idea less potentially shocking than it seems. As
people live even longer, lives will shift away from the three phases of
education, work, and retirement, into a more dynamic and multi-state process in
which breaks may be taken throughout life to rest and to learn new skills with
the possibility of having multiple different careers. Working until one is in
their 70s or 80s will be hard if there is no time to balance work with the
non-financial considerations of life, which may lead to taking short
“retirement” breaks throughout life and perhaps even start new careers after
each break. Those already at retirement age today may be at the start of these
trends, as we do already see many cases of having an “encore” career in
retirement.

Even when earning income no longer is a
primary motive for working, many people choose to return to work, perhaps after
the honeymoon phase of retirement has concluded. For those in retirement,
voluntarily wanting to work is more common than needing to work for the money.
Many people simply find that they enjoy working, and they miss the aspects of
life that work provided. Working in retirement could be full time or part time,
and it could be paid or voluntary. Returning to the same employer could be done
on a part-time or temporary basis, as a consultant, or in other ways dreamed up
with the employer. Returning to the same full-time work is not necessarily
needed to obtain the social aspects and sense of accomplishment that one had
with their work. As well, qualifying for Medicare at age 65 means there is no
need to stay bound to a full-time career for the purpose of obtaining health
insurance.

A first possibility is a phased retirement.
Phased retirements are formal arrangements with your current employer to allow
a shift from full-time to part-time work. It is still uncommon for employers to
have these employment models in place, but those with valuable skills may be
able to create a suitable arrangement that can combine the best aspects of work
with an increase in leisure time and opportunities to pursue non-work interests
as well. While phased retirements imply a temporary transition into retirement
with the same employer, holding a bridge job or other temporary position
provides another possibility to support a gradual transition to retirement.

Another possibility is to develop an encore
career that may be more related to personal satisfaction than to making money. You
may wish to consult in the same industry where you built your career and have
developed strong professional skills. But encore careers could relate to
something entirely different. Pursuing a new line of work could relate to an
interest or hobby. You might serve as a mentor or teacher. You might provide
leadership to a non-profit organization.

The encore career could be a way to unleash
your entrepreneurial spirit. Perhaps you have assembled a portfolio of investment
properties to manage. You might even want to take advantage of opportunities in
the gig economy, setting your own hours for a task that will provide some
income as well as a broader range of social connections. You may also wish to
engage in seasonal work, which allows for a clearer delineation between time for
retirement and time for work. Seasonal jobs could also relate to one’s
interests, such as working in a national park or other vacation destination. Volunteer
work could be another outlet if the goals for work relate more toward pursuing
passions than to the need for financial remuneration. There are many
possibilities available.

For those interested in continuing to work,
there are important steps to take to better ensure the marketability of one’s
skills. This can involve keeping up to date with new technologies and acquiring
new skills. As well, maintaining work networks can be an important way to keep
current with potential opportunities. As well, though many near retirement will
find it hard to replace work lost to the pandemic, there may be some
opportunities that emerge. As remote working becomes more common and accepted,
this may fit into the retirement lifestyle more easily as it will be
increasingly possible to continue with some types of work from anywhere, such
as while traveling in an RV. Geography is not a constraint.

Strengthening Relationships and Social Connections

Maintaining social connections and having a network of
social support in place is an important aspect of retirement. Loneliness can
create negative health and cognitive impacts and can shorten lives. For those with partners or spouses, a lot more time may be spent
together after retiring. As well, as children grow up and leave the home, there
may be new strains for a couple to manage their newfound time together. Beyond
the household, retirees have fewer naturally occurring ways to be socially
connected. Greater effort will be needed for social interactions in the absence
of work. These are issues to address before retiring.

For social relationships, an important starting point is the
relationship between spouses. Spousal relationships can change dramatically
with the increased amount of time spent together after retirement. New strains
can develop as well during a transition period where one member of the couple
retires while the other continues work. A stay-at-home spouse can also be
impacted by having their routines changed with a retired spouse now at home all
day. Spending more time together can have positive or negative impacts
depending on circumstances.

Relationship strains are a real risk at the start of
retirement. Grey divorce is on the rise. Couples may tend to grow apart over
time. Childrearing may have bonded them with common purpose, but this is no
longer a consideration once the children have grown. As well, spouses are less
financially dependent on each other, and spouses may have different visions
about retirement that become irreconcilable.

Communication between spouses will be important. Spouses may
need to reacquaint themselves. Spouses need to understand each other’s dreams
for retirement and to find common ground on how both sets of dreams can be
achieved. Further issues for discussion including retirement timing, finances,
changing roles, ideas about spending time together as well as time apart,
thoughts about social life and how outgoing each spouse wishes to be
(especially if moving in retirement), other family obligations, where to live,
where and when to travel, legacy plans, and end-of-life care.

Don Ezra describes a simple Venn diagram illustrated in
Exhibit 12.2 that I found to be a very insightful way to approach the impact
that retirement can have on the relationship with one’s spouse. What do you want
from retirement? What does your partner or spouse want from retirement? Which
aspects can be accomplished together? Which aspects are separate? How can the
couple work together to make sure that each spouse’s independent goals and
dreams also receive sufficient attention?

Create a shared vision for retirement and then figure out
which aspects overlap to be done together as a couple, and which aspects may be
done separately as individuals. Each circle represents an individual in the
couple. For the parts of the circles that do not overlap, this reflects time
and activities spent apart from one another. The middle overlapping part is
where to list the time and activities that will be spent together. How much of
the circles overlap can vary, but it is important to at least have a sense that
both spouses are comfortable with the portions spent alone and the portions
spent together.

Exhibit 12.2

Time Management for a Couple

There are many other relationships with family and friends
for retirees to also consider. Retirees need to feel a sense of community and
belonging. Friendships can provide continuity in life to help manage negative
life events such as the death of loved ones or the development of health
problems. But it can be more difficult to maintain connections after retirement,
especially those flowing from work.

A helpful way to plan for social connections is to maintain
and update a friends list, identifying friends, family, co-workers, or other
connections that remain important in retirement. You can identify the strengths
of these relationships and think about which relationships you may like to
strengthen further. Think about how you can reach out and strengthen these
relationships starting now. Perhaps you could arrange weekly meetups for a meal
or other socializing. Do not wait until after retiring to get started on this.
It is an area where you may think that having more time available after
retiring will make it possible to fill in gaps and fix problems that develop
during the working years. But neglected relationships are not always easy to repair.

It does seem like a lot of the books about the non-financial
aspects of retirement were written by extroverts. Not everyone will have an
easy time making new friends at this stage of life. Those who may have been
devoted to their work may enter retirement without many friends and may have
lost the skills for finding new friends. This may also impact decisions around
moving in retirement, as some may find it more difficult to create new social networks
at this stage in life. As well as actively seeking to reach out to new
neighbors, perhaps joining organizations designed around a common interest or
investigating the potential for making connections at an active adult community
could be helpful.

On these points, the global pandemic and its need for social
distancing have changed aspects for how people connect. New technologies have
made it easier to keep in touch remotely, when in-person meetings would create
greater risk. But these technologies over the longer term could increase
isolation by providing more remote monitoring that reduces need for human contact.
These possibilities include health monitors, driverless cars, and smart homes. For
many, a digital connection will have less value than in-person connections. As
well, social media and the internet enhance addiction risks with algorithms
designed to keep you scrolling, reducing the strength of real-world
connections. Loneliness can worsen health and lead to an early death. Retirees
must fight this rising tide to maintain their personal relationships.

Healthy and Active Lifestyle

Though more time may be available each day,
retirees also need to make greater effort to be active and to engage in a
healthy lifestyle. There will be fewer naturally occurring opportunities for
physical and mental activity without taking the initiative to make things
happen. Falling into the trap of spending too much time watching
television is a risk. As well, though the idea of declining health
can be overblown, it is the case that the natural aging process can lead to
reduced mobility and declining vision, hearing, and cognitive skills, among
other possibilities. Recognizing and adapting positively to these natural
changes is important for ongoing health.

There is an important distinction between mortality and
morbidity. Mortality regards the length of life, while morbidity refers to
health during life. As people live longer, are they doing so in good health, or
do they experience more years of bad health? The objective of a healthy and
active lifestyle is to better support the conditions for a longer and
healthier life.

It is not too late to improve health habits through diet and
basic exercise, even if these are areas that you have been neglecting. Benefits
from exercise and diet can arrive quickly. But that is not an invitation to
continue to procrastinate on health matters. Invest in your health, including
exercise, nutrition, sleep, and preventative care. Work on maintaining your
health before you retire so that you will still have as much of it as possible after
retiring. Do not wait until retirement to begin an exercise regime. This is
another topic where the idea that retirement will provide the extra time needed
to accomplish items on your to-do list may not be the case. Matters could get
worse without making the necessary initiative and effort.

Exercise does not have to be overly strenuous to yield
powerful benefits. Frequent moderate exercise that focuses on distance rather
than speed is fine to get the basic health benefits of exercise. Work to get
outside and engage in activities like walking, biking, or swimming. Having simple daily exercise routines can also be important for mental
health. A daily exercise routine can be a source of structure in
retirement that may help replace the structure that had been provided through
work.

Exercise can also apply to one’s mind. Exercising the brain may
help to maintain cognitive abilities. Not providing challenges for your brain
can cause it to atrophy in the same way that a lack of exercise can lead to
physical decline. Ways to stimulate your brain include writing, reading,
studying a language, attending classes, playing word games, playing a musical instrument,
volunteering, and seeking new experiences.

As well, taking care of health means getting appropriate
health screenings and taking advantage of other preventative care benefits
through Medicare or other health insurance. Seek treatment to help with any
reduced functions related to vision, hearing, or other matters. It is important
to remember that aging does not automatically lead to illness and dependency,
and though a degree of physical decline is inevitable, staying fit and active
can help prolong the healthy portion of one’s life. Focusing on health can
create positive reinforcements to have more energy and motivation to be
successful with other aspects of retirement.

Mental health is another important aspect of retirement.
Retirement can create many pitfalls that can lead to depression, loneliness,
addiction, and even suicide. This may especially be the case when retirement is
triggered by poor health, involuntary job loss, or a need to provide care to a
partner or aging parents. Those who retired before they were ready may go
through a grieving process. These can be stressful events. Retirement
can intensify stress and increase feelings of depression, and it is important
to have strategies to help manage these feelings. There is always a risk for
negative life events, and this continues for retirees who may be subject to age
discrimination, illness, or the loss of a friend or loved one.

Even beyond these stresses, part of the difficulty of a
retirement transition is that much of the popular culture presents it as a
wonderful time in life with walks along the beach and spending happy time with
grandchildren. An important component of retirement satisfaction relates to the
expectations for retirement one has developed beforehand. Those whose experiences
do not live up to these expectations may feel a sense of isolation and feeling
that something is wrong with them. It is important to understand that it is
very common to have mixed feelings about retirement, either right away or with
a delay after the honeymoon portion.

It is tempting to think that retiring will provide the time
needed to solve existing problems, but it is also possible that the extra time
provided by retirement can make existing problems worse. Retirement does not
necessarily solve lingering or ongoing issues. Procrastination can still occur,
and retirees may feel even more guilty about not getting things done after
retiring. This can intensify feelings of uselessness and not having anything
interesting to do.

Understand that transitioning into retirement can take time
and energy. It is okay if things do not click right away, though it is
important not to let negative feelings become overwhelming in a way that makes
it hard to improve one’s situation. This does not all have to be negative. On
average, mental health and life satisfaction tends to improve with age once
people get to their 50s. Older individuals have more life experiences to help provide
resilience for coping with negative events. Retirement can also provide more
opportunity to focus on religious faith and spiritual health. Experience and
wisdom grow with age. Being optimistic about aging can help manage some of the
potential downsides related to cognitive and physical decline, and it is
important to try and maintain a positive outlook.

Retirement Spending – Ants and Grasshoppers

This chapter has emphasized that having a balanced life
portfolio is just as important as a balanced financial portfolio. For seeking a
life balance, it is worth revisiting the old parable of the ants and the
grasshopper. In the context of retirement, ants are those who tend to over save
and underspend. They may become overly prepared for retirement, and their
innate focus on preservation may make it difficult to fully enjoy their
retirement years. Grasshoppers, meanwhile, tend not to worry about the future.
They may not have sufficient savings for retirement, though they may be able to
adapt their finances and be okay overall.

Readers of this book will have a natural tendency to be
ants. Saving and preserving wealth may be a source of satisfaction, but ants
may still worry about whether they are striking the right balance between
enjoying the present and feeling comfortable about the future. This is a
reminder for ants that there is more to retirement than finances, and it is
important not to neglect these non-financial aspects of life. Investing in a
more diversified “portfolio” of life experiences can lay the foundation for the
most overall satisfaction with retirement.

Action Plan

Quality of life in retirement is an important topic existing
side-by-side with finances. The focus on the financial side of retirement
implicitly assumes that the personal and psychological aspects of retirement
have been addressed elsewhere. However, it is important to make sure these issues
have indeed been addressed. Retirees seek purpose and satisfaction. These are
key steps to guide the way:

o
Find purpose and passion to guide your retirement

o
Identify expectations for a good retirement life

o
Retire to something, not from something

o
Identify fulfilling activities to replace work identity

o
Develop leisurely interests while still working

o
Prioritize your activities to make sure the most important items
get accomplished while you have time and health

o
Consider your legacy beyond financial gifts

o
Strike the right balance with work

o
Understand the importance of your work identity

o
Buy into retirement as a new lifestyle and new identity

o
Maintain your skills and networking to create flexibility

o
Consider whether work will play a role in your retirement

o
Prepare for an unexpected jolt into an early retirement

o
Strengthen your relationships with others

o
Reconnect with spouse and identify retirement dreams

o
Focus on friendships and other relationships

o
Engage in activities to maintain social ties

o
Promote an active and healthy lifestyle

o
Develop exercise routines and a healthy diet

o
Keep your body and mind active

o
Take care of physical and mental health

o
Have appropriate expectations for gradual decline

o
Focus on spiritual and religious needs

o
Build structure into your day as needed to feel comfort

Further Reading

Bellah, Mike. 2019. The Best is Yet to Be:
Discovering the Secret to a Creative, Happy Retirement. Canyon, TX:
BestYears Press.

Ezra, Don. 2019. Life Two: How to Get to and Enjoy
What Used to Be Called Retirement. Don Ezra Consulting Services.

Gilbert, Fritz. 2020. Keys to a Successful Retirement:
Staying Happy, Active, and Productive in Your Retired Years. Emeryville,
CA: Rockridge Press.

Gratton, Lynda, and Andrew Scott. 2016. The 100-Year
Life: Living and Working in an Age of Longevity. London: Bloomsbury
Information.

Zelinski, Ernie. 2019. How to Retire Happy, Wild, and
Free: Retirement Wisdom You Won’t Get From Your Financial Advisor.
Edmonton: Visions International Publishing.

Chapter 13:
Putting It All Together

We have worked through the important decisions
for navigating a successful retirement. To review, these include:

o
Determine your retirement income style

o
Assess exposure to various retirement risks, including choosing
your planning age and discount rate

o
Quantify your financial goals (your budget, legacy, reserves) and
assess your preparedness with the funded ratio

o
Understand strategies for sustainable spending from investments

o
Understand strategies using annuities with risk pooling

o
Develop a claiming strategy for Social Security

o
Manage health care and Medicare decisions

o
Plan for long-term care risks

o
Decide about retirement housing and housing wealth

o
Build tax-efficient retirement distribution plans

o
Create plans for legacy and incapacity

o
Prepare for the non-financial aspects of retirement

o
Find your purpose and passion

o
Understand your relationship with work

o
Strengthen social relationships

o
Maintain a healthy and active lifestyle

Now it is time to fit these pieces together into an overall
planning approach to achieve financial and non-financial success in retirement.
In this chapter I organize the previous discussions into an integrated series
of steps to be prepared for your best retirement. It is time to implement
and monitor your retirement plan. The simple act of proactively planning
for retirement can improve satisfaction and happiness. Risks become less nebulous,
and comfort can be taken knowing you have a plan in place.

Getting Started Now

Some readers may still be twenty years away from retirement.
Others may be just on the precipice. Some may have retired several years ago.
In addition to everyone facing different circumstances and situations, it is
not possible to provide a universal checklist that applies equally for
everyone. What I aim to do in this chapter is to organize retirement planning
steps as best I can under the basic assumption that the reader is still several
years away from retiring. As you work through the tasks of this chapter, please
keep in mind that it may be necessary to make some adjustments in the ordering
of these tasks, and some matters may not be relevant or may have already been
accomplished. In this section we address some initial steps as one begins the
transition toward retirement.

Organizing your Finances and Preparing Estate
and Incapacity Plans

The legacy and incapacity planning discussion in Chapter 11 provides
an important initial step for retirement planning. Not only does it help with
risk management for your family if you tend to be the one who manages the
finances, but it also provides you with the opportunity to get your finances
organized. This becomes very important when taking a subsequent step to
determine your funded ratio for retirement. If you have procrastinated on
developing your estate plan, it is important to get started on this as soon as
possible. The action plan for legacy and incapacity planning
includes:

o
Collect personal information for family members

o
Create an inventory of household assets and liabilities

o
Account numbers

o
Values

o
Ownership details

o
Existing beneficiary designations

o
Whether assets will be part of the probate estate

o
Assemble information on all insurance policies

o
Review whether each policy is still needed

o
Review whether some insurance need has not been fulfilled (life
insurance, health, long-term care, disability, homeowner, vehicle, umbrella)

o
Ask insurer for in-force illustrations on life insurance policies
to assess the current situation

o
Assign a durable financial power of attorney

o
Create advance health care directives

o
Living will

o
Health care power of attorney

o
HIPAA releases

o
Decide how assets should be distributed: what, to whom (family
friends, charity, others), and when

o
Write a will

o
Identify executor

o
Implement asset distribution plan

o
Identify guardian for minors in your care

o
Create and fund trusts to meet potential goals including
incapacity planning, avoiding probate, managing property distribution at death,
providing asset protection, and reducing estate taxes

o
Identify trustees

o
Ensure ownership and beneficiaries of assets are updated to
include trust

o
Fully review ownership titles and beneficiary designations to
ensure they are aligned with your goals and other estate planning documents
such as wills and trusts

o
Decide and share final wishes

o
Create letter of instructions for family members, executor,
trustees, and attorneys-in-fact to help simplify their process as much as
possible by describing your whole financial situation and providing your wishes
about a course of action

o
Store these documents safely and let the relevant individuals
know how to access the information when they need it, as well as discussing
matters with those individuals and providing them with copies of appropriate
documents

o
Discuss your plans with family members so that everyone knows
what to expect and potential conflicts are managed regarding your intentions,
the disbursement of assets, access to key documents, and the roles and
responsibilities of each person

Planning for How to Claim Social Security

Choosing your Social Security claiming strategy is a key
part of building a retirement income plan. The benefit application can be done
online, by phone, or in person at a Social Security office. Though Social
Security claiming is just one step in building a retirement income plan, the
value of lifetime Social Security benefits can dwarf many other retirement
assets. Thought and care are needed to determine how to claim Social Security
in the most effective manner for the household. Here are key steps to take:

o
Obtain your updated Social Security Statement at ssa.gov

o
Check your statement’s earnings history for accuracy and understand
the assumptions used for estimating your benefits

o
future covered earnings

o
economy-wide wage growth and inflation

o
Familiarize yourself with the basic claiming philosophies

o
Collect the relevant information for making a claiming decision

o
Benefits from your earnings record: spouse & dependents

o
Your eligibility for benefits from other’s earnings records:
spouse, ex-spouse, survivor

o
Role of earnings test, windfall elimination provision, government
pension offset, disability benefits

o
Availability of resources to support delayed claiming

o
Dependence on Social Security as reliable income

o
Risk tolerance

o
If you already claimed and regret this, identify possibilities
for suspending benefits

o
Use software to calculate the optimal claiming strategy and
compare with other options

o
Build a strategy to support deferring benefits when applicable

o
Identify how to meet spending goals before benefits begin (portfolio
distributions, part-time work, reverse mortgage, life insurance, period-certain
annuity, bond ladder)

o
Consider tax planning opportunities while deferring

Tax Planning Steps

The progressive nature of the tax code makes tax-planning strategies
important to sustaining retirement assets. When you still have the opportunity
in the pre-retirement accumulation years, there are steps you can take to prepare for tax management in retirement:

o
Understand the basics of the tax code, including marginal tax rates
and tax brackets, how taxable income is determined, and the differences between
ordinary income tax rates and preferential rates for long-term capital gains
and qualified dividends

o
Build tax diversification for the asset base by saving with taxable,
tax-deferred, and tax-exempt accounts

o
Understand how to choose between saving in tax-deferred and
tax-exempt accounts as based on whether the marginal tax rate will be higher
now or in the future, and after considering the advantages of having some
assets in tax-exempt accounts

o
Work through asset location decisions to position assets based on
their tax efficiency and long-term growth prospects

o
Determine usefulness of other ways to obtain tax advantages, such
as education 529 plans, health savings accounts, tax-advantaged bonds,
nonqualified annuities, and life insurance

Retirement Housing Decisions

Housing decisions are also very important for
retirement planning. The following action plan relates to making the right housing
decisions:

o
Identify the aspects of retirement housing that are most
important

o
Begin thinking about housing options in advance of retirement and
determine whether a move will be part of your plan

o
Conduct trials in any new area to make sure it is the right
decision

o
Make housing decisions in anticipation that physical and mental
impairments associated with aging will impact your needs

o
Understand how housing decisions could be impacted by long-term
care needs and how moving becomes more difficult with age

o
Consider how frequently you want to move and at what point you
want or need to consider a last, permanent move. When you reach the point where
the current or next home is likely to be permanent, assess the following
factors:

o
The home is affordable and the home-related costs, as well as how
they may change with age, are budgeted

o
The home is near family, friends, or a social network that can
help prevent growing isolation at later ages

o
The home provides an agreeable climate with the right blend of
activities and opportunities to have an enjoyable retirement lifestyle

o
The home is in a location that supports any desired work or
volunteer opportunities

o
The home is accessible to health facilities and long-term care
opportunities

o
The community provides diverse transportation options

o
Home renovations are done to support aging in place

o
For those owning an eligible home, consider whether to
incorporate a HECM early on as part of an overall strategy rather than treating
it as a last-resort option

Assess your Financial Situation for Retirement

The next steps relate to getting a big picture
view for how you will approach retirement planning and whether you have
sufficient funds to meet your financial goals, or whether you are at least on
track with projected future income included. Working toward this, it is quite
important to first have a sense of your retirement income style. You can assess
this on your own, or you may take up my offer to use the Retirement Income
Style Awareness® tool. You aim to:

o
Understand the factors to identify retirement income preferences
and how they interact to define retirement income styles

o
Determine your RISA Profile, which is your preferred style for
generating retirement income

The next matter is to assess your risks for
retirement income. The amount of assets required to fund your financial
goals in retirement depends on how long you live, your investment returns, and
your exposure to various shocks. You will want to choose a
planning age and a discount rate as an assumed investment return. Greater
conservatism for your assumptions is suggested for those with a Distribution
mindset and a preference for Back-Loading. You will also want to think about
your exposure to different types of retirement shocks. Begin thinking
about your retirement risk exposure:

o
Obtain longevity estimates using a tool such as the Longevity
Illustrator [www.longevityillustrator.org]

o
Those with a front-loading preference may prefer to use numbers
closer to the 25th percentile of outcomes

o
Those with a back-loading preference may prefer numbers closer to
the 10th percentile of outcomes

o
Market and sequence-of-return risk

o
Understand your comfort level with market risk as it relates to
your retirement income style

o
Decide on reasonable net-return assumptions for your retirement
portfolio. The starting point is the current yield on long-term Treasury
Inflation-Protected Securities

o
Assess exposures to various retirement spending shocks and other
surprises. As part of this assessment, consider the potential costs or impacts
that these risks could create:

o
Long-term care risks

o
Health care and prescription costs

o
Inflation

o
Death of a spouse

o
Unexpected family-related financial responsibilities

o
Divorce

o
Changing public policy and tax rules

o
Business risk for annuities and pensions

o
Excess withdrawal risk

o
Frailty and declining cognitive abilities

o
Financial elder abuse

o
Changing housing needs

o
Forced early retirement and reduced earnings capacity

Two of the largest spending shocks for retirement relate to
long-term care and health expenses. You will want to settle on estimates about
additional desired reserves to manage these shocks. Those with a true liquidity
preference will wish to be more explicit about setting aside specific reserve
assets for these risks. These are the key steps related to long-term
care:

o
Identify the long-term care options and costs in your community

o
Consider how other budgeted expenses, such as travel, may be
reduced if long-term care is needed

o
Decide where you would like to receive care. Are CCRCs a
consideration?

o
Understand what your default plan of care will be if you do not
take further action. This includes taking an inventory of what you have:

o
Traditional long-term care insurance policies

o
Permanent life insurance with long-term care benefits

o
Family members and friends who may be willing and able to help
without creating too much burden

o
Reserves earmarked to cover long-term care expenses

o
The level of countable assets that would be spent before reaching
Medicaid eligibility in your state

o
Identify the potential to self-fund long-term care expenses and
the impacts this could have on other family members

o
Identify a reasonable amount of reserve assets to set aside as a
funding source for long-term care

o
Is this amount realistic?

o
How will it be invested?

o
Do family members understand and accept the obligation if you are
expecting them to provide care?

o
Determine whether Medicaid may be unavoidable as part of your
long-term care plan. Consult with an elder-law attorney to assist with Medicaid
planning as needed

o
If interested to offset some of the spending risk related to
self-funding, explore a variety of options to include traditional long-term
care insurance or hybrid approaches

o
Will your health allow you to qualify for coverage?

o
How much of the long-term care spending risk would you like to
offset through insurance?

o
How much of the risk can you afford to offset?

o
Will you pay for coverage with investment assets or through the
exchange of existing insurance policies?

o
How much would the coverage lower your need to hold reserves for
self-funding while still feeling comfortable?

o
When considering insurance, determine what makes the most sense
regarding the tradeoffs between premiums and the periodic benefit amounts,
total coverage, inflation adjustments, and elimination period

o
Traditional long-term care insurance may appeal to those who can
obtain tax deductions for premiums, may use a partnership plan to provide
further asset protection for Medicaid, and wish to include inflation protection
riders

o
Hybrid policies may appeal to those seeking stability for premium
amounts, protections for the use-it-or-lose-it aspect, have health issues that
make it hard to qualify for traditional insurance, and have existing insurance
available that could be exchanged to these policies

o
Provide family members with your written plan for long-term care
so they can easily implement it if you are cognitively impaired. The plan
includes details about sources of care, sources of funds, insurance policies,
and any professionals who may be available to answer questions, such as a care
coordinator provided by an insurance policy

Health expenses are also a major component of
retirement spending. Precise expenses can be hard to estimate and become more
uncertain through health spending shocks not covered through insurance. The
action plan for health care in retirement relates to finding the appropriate
health care and prescription drug coverage and having a plan to cover health
care related expenses. At this stage:

o
Develop estimates for a baseline health care budget, how it may
grow, and potential cost shifting from other categories

o
Make sure you have budgeted for dental, vision, hearing, or other
types of health-related needs that may not be covered by your insurance choices

o
Decide how much in reserves you want to set aside to help with
higher than anticipated expenses

o
Review the “Leaving employment” section if you are transitioning
away from employer-based insurance before Medicare eligibility

Now we can look more directly at providing an
overall determination of your funded status by calculating the funded ratio of
assets to liabilities. The following action items summarize the key steps for
quantifying your goals and assessing your retirement preparedness:

o
Estimate the Four Ls of retirement: longevity, lifestyle, legacy,
and liquidity

o
Collect data on spending over the previous few years

o
Use past spending and analyze what will change in retirement to
develop a baseline retirement budget

o
Organize the retirement budget as essential longevity expenses
and discretionary lifestyle expenses

o
Project how spending needs may evolve

o
Determine legacy goals

o
Assess exposure to spending shocks to determine a target for
reserves

o
Build a retirement balance sheet by collecting household finances
and determining all assets and liabilities, including the present value for
income and expenses that happen in the future

o
Choose a planning age and conservative discount rate to apply to
the funded ratio calculations, and then calculate the funded ratio

o
Take special care to also note the level of funded ratio with
reliable income for longevity goals, along with other categories of the RIO-Map.
For styles other than total return, seek to fill gaps in reliable income
(annuities, bond ladders)

o
In situations where a plan is underfunded, consider taking one or
more of these steps to ensure a reasonable funded ratio:

o
Delay retirement or otherwise add a greater role for work

o
Reduce projected future spending goals

o
Those with styles that de-emphasize the role for market growth and
use more conservative assumptions will generally find an improved funded ratio
with annuities

o
Reassess the role for home equity in the plan

o
Assume a higher discount rate (with caveats about risk)

A Note about Online Retirement Calculators

There are many online retirement calculators
intended for use by do-it yourself individuals. I have not discussed them for
three reasons.

First, I simply prefer to do my own
calculations and have not spent much time investigating other options.

Second, I hold the view that the funded ratio
method is good enough for most situations. Once you have made the effort to
estimate your budget, your Social Security strategy, your collection of assets
and liabilities, and a way to estimate taxes, then a simple spreadsheet to
calculate the relevant present values to create a funded ratio tells you what
you need. There is not much need to also worry about Monte Carlo simulations
and the probability of plan success. The equivalent for success rates with the funded
ratio would be to increase the discount rate above the level of TIPS yields,
which will imply a chance of underperformance for your assets relative to the
discount rate and, therefore, a risk of failure. But if the assumed discount
rate is a conservative number that you are comfortable with, then this is
enough. There are fixed return assumptions that correspond to probabilities of
success, so a funded ratio without all the other complexities can work
effectively. If you use average historical stock returns for your funded ratio,
recognize that this will correspond to a probability of success that is under
50 percent. Moving closer to bond yields will imply a greater success rate.

The third reason is that there are countless
calculators available, and it is hard to know which one to choose. Several
studies have attempted to enter the same user inputs into different calculators
and have found widely divergent results in terms of whether the plan is
expected to work. At least for calculators that do not also make complete
guesses about your spending goals (by using a simple replacement rate on your
salary) and Social Security benefits, the two most important factors that
explain these differences surely relate to the underlying assumptions about
market returns and longevity. Some calculators may assume that bonds will earn
5 or 6 percent returns with even higher returns for stocks, or that retirees
will die by 85. These calculators will report high success rates. But the
assumptions are questionable.

Many of these calculators represent black
boxes, as it is not always easy to know what is being assumed about underlying
variables such as market returns, inflation, spending goals, how spending
adjusts over time, Social Security decisions and benefits, other income sources
outside of investments, the use of annuities, the role of the home, household
composition, tax calculations at the federal and state level, the retirement
age, asset allocation, asset location, investment fees, withdrawal order
sequencing, legacy goals, planning for contingencies, and accepted risk for
investment depletion.

I think a funded ratio analysis can allow for
more control over these variables. Estimating taxes is hard, but at least a
simple spreadsheet can provide more control over cash flows related to
retirement assets and liabilities. Assuming a conservative effective tax rate on
your spending should get you in the right direction for tax estimates. Any lack
of precision with this assumption should be more than offset by the greater
control you have with the other assumptions for your plan. Anyway, I do not
think that many of the online calculators available to consumers are doing
sophisticated tax planning either. Calculators which do not allow you to control
your planning inputs could provide misleading outcomes based on incorrect
guesses.

I do plan to eventually compare various
retirement calculators to see if I can find one that I feel comfortable
suggesting to do-it-yourself retirees. Until then, I suggest using the funded
ratio. You might then compare your funded ratio with other online calculators to
double-check your results. I personally just use the funded ratio approach.

Retirement CARE AnalysisTM: Product
& Asset Allocation Decisions

So much of the focus for retirement income rests on the idea
of a “safe” withdrawal rate for retirement, which is especially tied into
probability-based approaches. I tend to be quoted in the media with a number in
the ballpark of 2.8 percent. But recently Bill Bengen (the founder of the 4
percent rule) suggested that 5 percent is a more reasonable estimate when
inflation is low. The problem with estimating withdrawal rates is that they
depend on so many underlying assumptions, as we explored in Chapter 4. How long
should the funds last? How much risk of depletion is acceptable? What is the
asset allocation? What are the assumptions about future market returns? Will
spending keep pace with inflation or otherwise decline over time? Does the
lumpiness of real-world spending negate the usefulness of thinking in terms of
withdrawal rates? Is there any flexibility to adjust the distributions in
response to market performance? Are there buffer assets to coordinate with
portfolio spending? Is there desire to build in a safety margin for assets to
preserve something for contingencies or legacy? How important are these
distributions in the overall plan? This makes it hard to have an underlying
baseline for the conversation.

More broadly, any estimate for a withdrawal rate does have a
one-to-one correspondence with an underlying fixed market return. The specific
connection depends on the details about future portfolio distributions and how
that impacts sequence risk. If you are seeking a high enough probability of
success when using a volatile investment portfolio, at some point your plan may
be assuming an underlying market return that is less than TIPS yields. However,
Monte Carlo based financial planning software does not report the results in
this way, so the detail gets obscured. I have tried to make this book less
technical, but the underlying mechanics of this issue I did explore further in How
Much Can I Spend in Retirement?

Withdrawal rates can be fraught with peril, as it does seem
to be difficult to understand how a “safe” withdrawal rate must assume a low
underlying investment return. Because of the complex underlying relationships
between market returns and withdrawal rates, I have concluded that it will be
easier for individuals to think about their plans in terms of a market return.
That return is then reflected in the discount rate used for the funded ratio.
Rather than debating about a “safe” withdrawal rate, just focus on whether your
discount rate will be based on bond yields alone, or whether you are
comfortable including some degree of risk premium into it. Then, with your
chosen discount rate, is your plan sufficiently funded?

This viewpoint is still not widely shared. Heated debates
about withdrawal rates have continued since the concept gained recognition in
the 1990s. People want to know what the right withdrawal rate is for their
plan. So, to help manage one’s thoughts about this decision, I now turn to the
Retirement CARE AnalysisTM. This analysis pre-dates the Retirement
Income Style Awareness®. It provides a set of considerations to guide
decisions around withdrawal rates, asset allocation, and the use of annuities. How
aggressive should spending and asset allocation be in your retirement income
plan? Would you like to use an annuity and how does this impact your decisions
about asset allocation and withdrawal rates? This framework is based on Capacities,
Aspirations, Realities, and Emotions. Exhibit 13.1 provides the factors to keep
in mind.

First are capacities, which relate to the idea of risk
capacity. Risk capacity is the ability to experience portfolio losses
without suffering a major life setback or a major reduction to your standard of
living. How important are the withdrawals from your investment portfolio to your
overall standard of living in retirement? The less that lifestyle is impacted
by market downturns, the greater is the capacity to bear financial market risk.
Risk capacity can diminish rapidly at retirement to the extent that work
becomes less of an option to respond to risks. The investment horizon is shorter,
the ability to generate new income sources reduces, more liquidity may be
needed for unplanned expenses, and alternative options to reduce expenses or
change lifestyle may decline with increasing age.

There are four factors that can increase risk capacity.
These include having more spending covered through reliable income resources (Social
Security, pensions, annuities, individual bonds) that are not exposed to market
downturns, being flexible with spending so that cuts can be made in response to
a market downturn without overly hurting the living standard, having a higher
funded ratio such that there is greater discretionary wealth which can
experience losses without impacting goals, and having more reserves to protect
from the need to sell assets at inopportune times to cover expenses.

The funded ratio speaks to whether a retiree
even needs to take risk in retirement. Those who are funded when TIPS
yields are used as the discount rate do not require risk. They have won the
game and can stop playing if they wish, to avoid the risk of losing their successful
funded ratio. When plans are underfunded, a discussion can then proceed about
whether it is acceptable to add risk with a hope of achieving a better funded
ratio through investment growth while accepting the risk of falling further
behind as well.

Next are aspirations, which relate to your goals for
spending and legacy. With the funded ratio, the specific withdrawal rate from
investments is not so important, but much of retirement planning is still based
around the concepts for finding a “safe” withdrawal rate. Naturally, your
choice for withdrawal rates will relate to what it takes to meet your goals. A
starting point for the withdrawal rate decision is to first determine what rate
would satisfy your overall lifestyle goals. You do not need to use a higher
withdrawal rate than what is needed to cover your spending. In some cases, you
might decide to accept greater risk by using a higher withdrawal rate than
deemed “safe” if there are important spending needs it will cover. How your
future spending patterns will link to inflation is also important, as is a
desire to preserve investment assets for legacy goals.

Exhibit 13.1

The Retirement CARE Analysis™

CAPACITIES (Resiliencies)

Reliable Income

What proportion of your spending goals are covered
through reliable income sources from outside the investment portfolio that
will not be diminished by market downturns?

Spending Flexibility

Is it possible to reduce portfolio distributions by
making simple lifestyle adjustments without significantly harming your
standard of living?

Funded Ratio

Are there sufficient assets to meet retirement goals
without taking market risk? Is there excess discretionary wealth, or are you
underfunded with respect to goals?

Availability of Reserves and Exposures to Spending
Shocks

How much exposure is there to large and uncertain
expenses? What insurance policies or other reserves are available to manage
these shocks? Are there reserve assets?

ASPIRATIONS (Goals)

Lifestyle

What is the retirement budget? How does it change
over time? How closely connected is it to consumer price inflation?

Legacy

What are the legacy goals? How important is legacy,
relative to other goals?

RETURNS (Assumptions)

Capital market expectations

What are reasonable market return assumptions for
different asset classes and inflation to guide simulation of the retirement
income plan? How are returns impacted by investor behavior, fees, taxes, and
investment vehicle choices?

EMOTIONAL COMFORT (Constraints)

Traditional risk aversion

How much short-term portfolio volatility can you
stomach before it affects your sleep and leads you to panic and change course
if markets are down?

Longevity risk aversion

How fearful are you about outliving your investment
portfolio? Greater concern means more longevity risk aversion, implying that
one should choose a higher planning age.

Financial tool aversion

Are you willing to consider different types of
retirement tools, such as annuities and reverse mortgages, or are some tools
simply nonstarters for you?

Susceptibility to behavioral mistakes

When it comes to investing and long-term planning for
complex situations, how prone are you to making a variety of behavioral
mistakes? Will you be able to stick to your financial plan?

Financial plan complexity

What is the acceptable degree of complexity and
involvement needed to manage your finances? Do you enjoy the planning
process, or would you prefer to outsource management to others? Would you
prefer more simple set-it-and-forget-it types of solutions?

Financial savvy of all household members

How is financial planning knowledge and savvy distributed
among household members? What is the degree of vulnerability of others in the
household if the more financially savvy member experiences cognitive decline
or an unexpected death?

The third category is returns. These
are your capital market expectations, or your assumptions about net portfolio returns
and inflation. Net returns are important and are determined as gross returns
less the impacts of fees, investor behavior, and investment vehicle choices. Taxes
could also impact your net returns, or you may account for them separately. With
the funded ratio, you begin with TIPS yields and decide whether you are
comfortable assuming a higher net return. With traditional Monte Carlo based
financial planning tools, you make your best guess about average market returns
and their volatility, and then test your plan with randomized return
simulations and calibrate a desired probability of success to manage downside
risks. Either approach uses market return assumptions to estimate your plan
feasibility. Your choice for assumptions is important. Naturally, the higher
your assumed returns, the easier it will be for your plan to work, with the
caveat that assuming higher returns also entails accepting greater risk that
those returns will not be met.

The final category is your emotional comfort with different aspects
of planning. Your comfort represents potential limitations regarding your
planning and is often related to behavioral factors. The first of these is
traditional risk aversion, or, conversely, risk tolerance. How much short-term
market volatility can you stomach before it starts affecting your sleep with
undue stress or causes you to panic and sell stocks after a market downturn? Risk
tolerance implies comfort in managing your portfolio volatility and being
able to “stay the course” and not panic after a market drop. It represents a
willingness to use a more volatile asset allocation.

In this behavioral context, risk tolerance is defined in its
traditional way regarding short-term portfolio volatility. But it is important
to recognize that true risk tolerance is different for retirees. Risk tolerance
in retirement relates to how well one can deal with the prospect of reducing
their spending. Being more aggressive in this case means understanding and
accepting that lifestyle may have to be reduced if things go poorly.
Aggressiveness can be manifested both by spending at a higher rate and by using
a more aggressive asset allocation. For those with greater risk tolerance,
spending well above the "safe” withdrawal rate could be perfectly
acceptable.

For those with less risk tolerance, spending conservatively,
investing more conservatively (without overdoing it), and considering annuities
as protected income sources are all alternatives. For the Accumulation vs
Distribution factor, risk-averse retirees will accept a strategy with lower but
more stable spending over retirement, compared to a strategy that might support
higher average spending, but with greater volatility and more occasions for
annual spending to dip to uncomfortably lower levels. Risk aversion links to
the Distribution preference. The more risk averse will prefer the lower average
but less volatile spending path, while those with more flexibility and risk
tolerance might be willing to accept the higher average but more volatile
spending path.

Nonetheless, though traditional accumulation-based risk
tolerance may not be important at this lifestyle level if short-term downturns
do not impact spending, it is still an important behavioral constraint on
choices. If someone is not comfortable with short-term portfolio volatility,
then none of these broader considerations matter.

A second emotional constraint is longevity risk aversion. How
worried are you about outliving your assets? How strongly do you wish to avoid
spending reductions in the event you live well beyond your life expectancy?
Those with a preference for Front-Loading have lower longevity risk aversion.
They use a higher withdrawal rate and more aggressive asset allocation because
they want to focus more on the present and worry less about reduced spending in
the future. A preference for Back-Loading implies higher longevity risk
aversion and a lower spending rate.

The third constraint is aversion to certain retirement
income tools. How willing are you to consider various retirement income tools,
such as annuities or a reverse mortgage? If the thought of using such tools
strikes you negatively on an emotional level, then such options can simply be
non-starters for your planning purposes. It may be fruitless to try and
convince you otherwise. In the end, you need to be comfortable with your
choices.

Next is your susceptibility to making behavioral mistakes that
could harm the long-term prospects for your financial plan. Can you stick to
the spending and investment objectives for your financial plan without
arbitrarily changing course? Probably the most damaging behavioral mistake made
by real-world investors is succumbing to the greed-and-fear cycle that causes
someone to buy into the market at its peak and sell out at its lows. This
natural cycle happens thus: when markets are doing well, investors get excited
and pour more money into the market with the hope that this trend will continue
indefinitely. But it usually does not. Investors on the sidelines may become
jealous of neighbors’ gains and may worry that they are missing out, leading
them to pile in at the market peak. It is tough to rebalance to your strategic
asset allocation that matches your risk tolerance when markets are rising,
because this requires you to sell shares of the biggest gainers. Do you have
the discipline to stick with your plan?

Conversely, sometimes markets plummet, as we saw most
recently in February and March 2020. Investors get nervous, and some, after
seeing significant declines, become scared enough that they start selling off
holdings. Staying the course is an even greater challenge if you are
experiencing cognitive decline. Unfortunately, downturns also call for rebalancing
to your strategic asset allocation, which would require buying assets with
falling prices, rather than selling them. This is also a challenge, both
emotionally and intellectually. Unfortunately, investors in financial markets
tend to do the opposite of what happens in most other markets: they buy more
when prices are high and sell when prices are low. This causes returns to drag
behind what a “buy, hold, and rebalance” investor could have earned. The 4
percent rule assumes that investors do stick with a “buy, hold, and rebalance”
strategy. Those more susceptible to behavioral biases should reflect on the
implications this will have for portfolio returns and net sustainable spending.

A further issue of emotional comfort relates to financial
plan complexity. Can your plan run on autopilot or be facilitated by a trusted
financial professional, or does it require ongoing complex decision-making on
your part? It is important that retirees find manageable approaches.

Finally, how financially savvy are different members of your
household? Would surviving household members be able to carry on financially if
you were incapacitated due to illness or death? This also has implications for
strategy choices, asset allocation decisions, and withdrawal rates.

The Retirement CARE Analysis provides a way to begin
thinking about an appropriate personalized withdrawal strategy in retirement.
It provides the details for how to decide on the aggressiveness of both
spending and asset allocation within a retirement income plan. It also helps to
identify the role that annuities can play within the plan. A more conservative
retiree will generally experience fewer reliable income sources
outside the investment portfolio to help cushion the impact of market
volatility on lifestyle, less flexibility to make spending reductions because
spending goals are fixed and rise with inflation, fewer reserves, buffer
assets, or insurance policies to help cushion spending shocks, a desire to
build in a margin of safety for the financial plan, and greater worry and
stress about short-term market volatility and about outliving your retirement
assets.

Meanwhile, a more aggressive retiree will tend to fall in
the opposite direction on these matters, highlighting the highly personal and
complex nature of determining asset allocation and withdrawal rates for
retirement. Retirees need to consider carefully about the threat to their
quality of life should they happen to deplete their investment portfolio at
some point while still alive. With a sufficient base of reliable income, those
who tend toward relative frugality may find that it is reasonable to go ahead
and occasionally splurge a bit without feeling guilty about it.

The Retirement CARE Analysis also helps with thinking about
annuities. For income protection and risk wrap retirement income styles,
annuities can also provide a tool to improve plan funding by providing
additional risk pooling. The lower your discount rate and the higher your
planning age, the better an annuity with lifetime income will look in your
plan. This is because the annuity income stream will have a higher present
value, and therefore you will see a larger asset on your balance sheet. As you
increase the discount rate or lower the planning age, an annuity will begin to lose
its attractiveness. As a series of future cash flows, its present value
declines and there are less assets on your balance sheet. The caveat, though,
is that a higher discount rate or lower planning age creates risk.

Whether you find this risk to be worrisome is a personal
matter that relates to your style. Probability-based versus safety-first determines
whether you are more comfortable basing your retirement income on market growth
or on contractual protections. Market-based approaches also tend to be
correlated with front-loading and accumulation preferences, while safety-first
preferences are more aligned with back-loading and distribution. Either
approach has merit if it is the right approach for you.

Not everyone will need or want an annuity. For
some, it will not fit their style. Others may already have plenty of lifetime
income through Social Security and traditional defined-benefit pensions. The
action items for determining whether and how to include annuities within your
retirement income plan include:

o
Your RISA Profile suggests that your preferences align with
income protection and risk wrap strategies

o
You have an income gap in which there is not enough reliable
income to cover your longevity expenses

o
Your risk tolerance limits your comfort with stocks in
retirement. The case for annuities is stronger for those with less stocks

o
You have greater longevity risk aversion. Concerns about
outliving retirement assets lead to more relative benefits from annuities as
the alternative is to spend even less from investments

o
You view annuities as a replacement for bonds and are comfortable
using a higher stock allocation with remaining investments

o
You seek protection from making behavioral mistakes with your
investment portfolio, you lack self-control for spending, or you find investments
intimidating

o
Choosing a joint annuity can also help to protect less
financially savvy family members

If you do decide that an annuity may be
worthwhile, then additional considerations include:

o
Learn about the features and mechanics of different annuities

o
Determine the income gap you are seeking to fill and decide
whether the amount of assets needed to fill that gap with annuities is
reasonable. Decide on a premium amount

o
Take your time with making this purchase decision: consider
various options and make sure you understand them, discuss with family members,
and only include benefits that you intend to use

Planning for the Non-Financial Aspects of Retirement

Quality of life in retirement is an important topic existing
side-by-side with finances. The focus on the financial side of retirement
implicitly assumes that the personal and psychological aspects of retirement
have been addressed. However, this is not always the case. These are key steps:

o
Find purpose and passion to guide your retirement

o
Identify expectations for a good retirement life

o
Retire to something, not from something

o
Identify fulfilling activities to replace work identity

o
Develop leisurely interests while still working

o
Prioritize activities to accomplish what is most important

o
Consider your legacy beyond financial gifts

o
Strike the right balance with work

o
Understand the importance of your work identity

o
Buy into retirement as a new lifestyle and new identity

o
Maintain your skills and networking to create flexibility

o
Consider whether work will play a role in your retirement through
phased retirement, consulting, a part-time position, starting a new business, or
an encore career

o
Prepare for an unexpected jolt into an early retirement

o
Strengthen your relationships with others

o
Reconnect with spouse and identify retirement dreams

o
Focus on friendships and other relationships

o
Engage in activities to maintain social ties

o
Promote an active and healthy lifestyle

o
Develop exercise routines and a healthy diet

o
Keep your body and mind active

o
Take care of physical and mental health

o
Have appropriate expectations for gradual decline

o
Focus on spiritual and religious needs

Determining Whether to Seek Financial Planning Help

Retirement requires making complicated
decisions that can benefit from the guidance of various financial professionals.
A financial planner can coordinate these interactions to ensure a
consistent strategy. Other professionals who may be part of your team include
accountants, elder-law or estate planning attorneys, insurance agents, Medicare
specialists, reverse mortgage originators, and long-term care coordinators.

As for financial planners, not everyone will wish to have an
ongoing engagement. Another aspect of the Retirement Income Style Awareness
process that I described in Chapter 1 investigates your preferred
implementation style for retirement planning. We found two factors that prove
to be quite instructive about the preferences for working with a financial
advisor. These include your self-efficacy for implementing your retirement
plan, and your degree of perceived advisor usefulness. Those with high
self-efficacy believe they can be successful with personally implementing the
steps outlined in this book. These individuals will not procrastinate, will
view themselves as having the resolve to overcome behavioral hurdles, and can
cope with the natural stressors of aging. Though not conclusive, the fact that
you have made it this far into the book suggests you may have high
self-efficacy for retirement income. But it is okay if you feel overwhelmed. Meanwhile,
perceptions may vary about whether financial advisors provide value beyond
their fees.

Exhibit 13.2

Financial Implementation MatrixTM

High
Perceived Advisor Usefulness

Low
Retirement Income Self-Efficacy

Delegator

[Low Self-efficacy

& High Perceived Usefulness]

Collaborator

[High Self-efficacy

& High Perceived Usefulness]

High
Retirement Income Self-Efficacy

Validator

[Low Self-efficacy

& Low Perceived Usefulness]

Self-Directed

[High Self-efficacy

& Low Perceived Usefulness]

Low
Perceived Advisor Usefulness

For the Financial Implementation Matrix in Exhibit 13.2, we
find four quadrants that combine these two sets of attitudes and preferences.
Starting in the upper right are individuals with high self-efficacy and high
perceived advisor usefulness. These are collaborators who value working
with an advisor and intend to be active participants in their planning process.
In our initial RISA study, we found that 19 percent of respondents were
collaborators. The lower-right quadrant identifies individuals with high self-efficacy
and low perceived advisor usefulness. This is the self-directed or
do-it-yourself community, representing 34 percent of respondents. These
individuals are confident in their abilities to implement their plan and do not
see any reason to pay an advisor for these services. Some self-directed
individuals may view personal finance as a hobby.

The lower-left quadrant includes individuals with low
self-efficacy and low perceived advisor usefulness. These are validators
who will aim to implement the plan themselves but may seek an occasional second
opinion as they are generally unsure about both themselves and advisors. Rather
than seeking an ongoing advisory relationship, these individuals might prefer a
one-time plan or may seek specific advice at key decision points. Overall,
though, they will assume ownership of their plan even though they do feel less
comfortable about it. Our survey identified 13 percent of respondents as
validators. Finally, the upper-left quadrant includes those with low self-efficacy
and high perceived advisor usefulness. These are delegators who are most
likely to seek a traditional ongoing financial planning relationship with an
advisor. These individuals do not feel confident about implementing their
financial plans and believe that a trusted advisor can be of benefit to obtain
a better retirement outcome. Among our respondents, 34 percent were delegators.

With retirement, it is important to consider how declining
cognitive skills associated with aging will make it increasingly difficult to
self-manage your investment and withdrawal decisions. As well, for households
where one person handles money matters, surviving household members will be
especially vulnerable to making mistakes when they outlive the family financial
manager. Developing a strong relationship with a trusted financial planner can
help with both matters. Beyond this, not everyone wants to work with an advisor.
The rest of this section provides a bit more background for those who want to
learn more about financial planners.

Though the financial services profession is highly regulated
at both the state and national levels, use of the terms financial advisor or
financial planner as job titles is hardly regulated. Regulation generally
focuses on the nature of business activities rather than job titles. Pretty
much anyone can use these terms without any further oversight about training,
competency, education, or qualifications. Financial designations have developed
to train advisors and to signal quality. Well respected general planning
designations include the CFP and ChFC, and for retirement-specific training
there is the RICP, RMA, or CRC. Finding advisors with these designations can
help as a starting point.

Generally, those calling themselves financial planners or
advisors represent one of three types: registered investment advisors, stockbrokers,
or insurance agents. When investigating an advisor, you will want to examine their
credentials, complaint records and other background details, as well as the
advisor’s fit with your preferred style.

Among different types of advisors, there are three types of
compensation models used:

o
Fee-only: only paid through fees from the client, which could
involve paying a percentage of the assets managed, paying fixed fees for
planning services, or paying an hourly rate for advice

o
Fee-based: paid through a mix of fees from clients as well as
commissions from selling financial products

o
Commissions: paid through commissions earned on selling financial
products such as loaded mutual funds or insurance policies

With the debate about fees, fee-only advisors have held
themselves out as the “good guys” by not having a conflict of interest in their
recommendations since they only receive fees from their clients. But to the
extent that many fee-only advisors charge their fees as a percentage of assets
under management, this reduces incentives to recommend insurance products which
the advisor could not collect fees on. Such advisors tend to be more aligned
with total-return and time segmentation styles as they build investment
portfolios and charge on the assets they manage. Annuities and other insurance
fell outside their business models because they could not be paid for
suggesting such products and they might lose control over some of the assets
covered by their fees. This matter is being remedied partly with the growth of
fee-only insurance products that do not compensate through commissions. But
more broadly, if you are willing to accept that there are multiple legitimate
retirement income styles, and that not everyone is best served with
total-return or time-segmentation strategies, then fee-only advisors who live in
this narrow world may not be appropriate for everyone.

Nonetheless, fee-only advisors are more likely to provide
comprehensive planning opportunities than other types of advisors. There are
exceptions, so it is important to inquire and discuss further before committing
to an engagement. Some fee-only advisors simply focus on investments, and there
is still a popular perception that a financial advisor is mainly tasked with
such a role. But a good comprehensive fee-only financial planner should assist
their clients with eight core planning areas: investments, taxes, debt
management, education planning, retirement planning, estate planning, insurance,
and household budgeting. Those charging an ongoing assets-under-management fee
will also generally provide portfolio management, while other fee-only
approaches such as one-time plans or hourly rates may involve the presentation
of recommendations that the client would them implement on their own.

Next, fee-based advisors may have more potential to serve
different retirement styles by having the ability to incorporate both
investment management and insurance solutions within the same firm. Nonetheless,
there is always a danger with commissions. Advisors who do not serve as
fiduciaries may base their product recommendations more on personal
profitability than on what is best for the client.  Commissions lend themselves
to abuses and it is good to be skeptical about advice provided when commissions
are at stake. But in an ideal world, commissions can be an attractive
compensation model that costs less to the client over time than paying an
ongoing percentage of assets under management.

As well, purely commissioned advisors may be fine to work
with when you have done your homework and know the specific product that you
want. Though non-commissioned insurance products are growing in popularity,
some products are still only available to be sold through a commission-based
advisor.

Returning to the three types of advisors (registered
investment advisors, stockbrokers, and insurance agents), traditionally only
the registered investment advisors were required to serve as fiduciaries for
their clients, at least when they are wearing their “investment advisor” hat.
The fiduciary standard of care requires investment advisors to act in the best
interests of clients and disclose any material conflicts of interest to clients
for the advice they provide. Regulations are changing to require more types of
advisors to also make decisions in the best interest of their clients.

Many advisors are registered dually as investment advisors
and as brokers or agents. This is how they become fee-based instead of fee-only
or commission-only. In such cases, it may not always be clear when advisors are
wearing the hat of a fiduciary, and when they are making recommendations under other
requirements. You are always welcome to ask questions about how an advisor is
compensated.

As well, if you are specifically seeking a comprehensive
planner, there are some questions you might ask to get a sense about the
breadth and depth of their advice. First, simply ask questions and see if the
advisor is patient and provides answers in a straightforward manner. You might
also ask about the assumptions used in their planning projections (or whether
they are even creating a plan for you, rather than just selling products). As
well, potentially a good litmus test for an advisor is to simply ask about
reverse mortgages. Some firms still prohibit their advisors from discussing
them, which suggests a lack of emphasis on comprehensive planning.

Are you working with a comprehensive financial
planner who does more than just manage investment portfolios and can help you
to implement good financial planning decisions? A comprehensive planner can
support your effort to make and coordinate key retirement decisions and will do
much more than just designing investment strategies that aim to “beat”
the market. A good planner can serve as a sounding board for ideas and as a behavioral
coach to help avoid making rash decisions and to overcome inertia or biases. A
good planner can also help you manage incapacity risk and provide a resource to
help transition other family members into taking control of the finances. A
good planner can help to free up time for you to better enjoy your retirement
years. Finally, a good advisor who is also right for you will be comfortable
with serving your preferred style for implementing your retirement income
strategy and will not try to pigeonhole you into a different style that the
advisor views as better. A financial advisor can be cost-effective for those
who do not see personal finance as a hobby that they enjoy spending time and
energy to handle, those who may experience inertia when it comes to implementing
and updating their plan, and those who worry that other family members may not
be able to handle taking over the reins.

Decisions at Specific Ages or Moments

Next, we consider items that connect to specific inflection
points. First, we look at important ages with retirement planning and then
consider key decisions when leaving employment and reaching Medicare
eligibility.

Some Meaningful Ages

o
Age 50: catch-up contributions allowed for retirement plans

o
Age 59.5: End of early withdrawal penalties for retirement plans

o
Age 62: Earliest age for Social Security claiming

o
Age 62: Eligible borrowing age for HECM reverse mortgage

o
Age 65: Medicare eligibility

o
Age 66 to 67: Full retirement age for Social Security

o
End of earnings test

o
Possibility to suspend benefits to earn delay credits

o
Full survivor and spousal benefits are available

o
Age 70: End of delay credits for claiming own Social Security

o
Age 70.5: Qualified charitable distributions from IRAs are
allowed

o
Age 72: Required minimum distributions begin

Leaving Employment

Leaving employment is a key milestone. For some, retirement
will be voluntary. Others will experience an involuntary retirement after job
loss, health problems, or the need to care for a family member. For those with
the option, a phased or partial retirement may be possible. Those
seeking to learn more about new possibilities for working in retirement may
visit websites such as Encore.org. The following action items are
important when approaching your date for leaving work.

o
Meet with human resources to get an accurate understanding about
employer benefits and other decisions to be made

o
Pension decisions

o
Retirement health benefits

o
Inventory of other employer benefits

o
Defined-benefit pensions: lump-sum or lifetime income choices

o
Timing retirement to obtain an additional pension credit

o
Identify distribution options for the pension

o
Analyze need for additional reliable income

o
Compare to annuity options if lump-sum goes to IRA

o
Consider credit risk of employer and whether pension is fully
covered by Pension Benefit Guaranty Corporation

o
Determine if pension choice impacts other retirement benefits
such as retiree health insurance

o
Assess risk tolerance for investing a lump-sum amount

o
For lifetime income, consider tradeoff between joint lifetime income
and higher income for single recipient

o
Defined-contribution plans: rollover to IRA or keep in plan

o
Compare investment options and fees in plan and IRAs

o
Determine value of having more discretionary control over
withdrawals in an IRA

o
Compare annuity options in and out of employer plan

o
Consider if rollover will disrupt plans for Roth conversions
through pro-rata rule on non-deductible contributions

o
Determine opportunities for net unrealized appreciation

o
Actions that may be easier before leaving employment

o
Obtaining a mortgage may be easier if still employed

o
Consider paying off existing mortgage before retiring

o
Obtaining a home equity line of credit may be easier

o
Take advantage of health insurance benefits such as getting exams
or other preventative care

o
Coordinate personal emails that go to your work address to go to
a personal email address

o
Opportunity to consolidate accounts when rolling over

o
Work toward one IRA and one Roth IRA per spouse

o
Consolidate bank and brokerage accounts to simplify

o
If retiring before Medicare eligibility:

o
Consider how to obtain health insurance and what healthcare costs
you will face until reaching Medicare eligibility age

o
Coverage may be available through an employer, a spouse’s plan,
the Affordable Care Act marketplace, other private insurance, retirement health
insurance, a healthshare plan, or COBRA

o
Make sure that spouses and dependents have coverage if you are
retiring and leaving your employer plan

FIRE
Movement: Financial Independence Retire Early

The FIRE community is growing in popularity. These folks
focus on achieving financial independence and retiring early.
Much of the discussion in this book can also apply to younger retirees, but
there are a few additional considerations. First, the 4 percent rule was not
designed for early retirees as it was calibrated to just 30 years of
retirement. Early retirees must manage a longer retirement horizon, which
suggests using both a lower withdrawal rate and higher stock allocation. This
also suggests a need for more flexibility to adjust spending over time and to
make cuts if the portfolio is not performing as expected. Early retirees
should also make careful plans for health care with the recognition that they
are on their own until qualifying for Medicare at 65. Finally, early retirees
may emphasize strategies for drawing from retirement accounts without
incurring the early withdrawal penalties or otherwise have sufficient taxable
assets to get them through age 59.5 before needing such distributions.

Tax Planning Opportunities After Employment

Depending on your retirement age, a window of opportunity may
open after retiring with some lower income years before Social Security and required
minimum distributions begin. For those who have built a strong base in the
pre-retirement years, this can provide an opportunity to deploy strategies for
tax-bracket management and tax-efficient distributions:

o
Understand the rules for taking distributions from tax-advantaged
retirement plans, including required minimum distributions, early withdrawal
penalties, rules for qualified distributions from Roth accounts, making
rollovers and conversions, and managing net unrealized appreciation on any employer
stock

o
Understand withdrawal sequencing strategies based around managing
adjusted gross income and Roth conversions

o
Identify the impact of the various retirement pitfalls when
generating taxable income, including the Social Security tax torpedo, heightened
premiums for Medicare, the loss of subsidies for health insurance, the net
investment income surtax, and the impact of pushing preferential income sources
into higher tax brackets

o
Consider reasons in favor of front-loading taxes in retirement,
such as how that will help the eventual tax situation for a surviving spouse or
to create the opportunity to better manage future tax increases

o
Consider tax-efficient strategies for charitable giving,
including qualified charitable distributions, deduction bunching for gifts,
donor advised funds, and charitable gift annuities

o
Be mindful of cost-basis and capital gains tax for portfolio
changes

Reaching Medicare Eligibility

As you reach the Medicare eligibility age:

o
If you would like professional assistance, identify an
independent broker specializing in Medicare to guide you

o
If you or your spouse is still actively employed, determine
whether your employer health insurance can be counted as primary insurance
after you reach age 65

o
If Medicare will become your primary insurance, plan for timely
Medicare enrollment to avoid penalties and a lapse in coverage

o
Read Medicare and You booklet at Medicare.gov

o
Choose Original Medicare or Medicare Advantage

o
Choose a Part D drug plan, drug coverage through Medicare
Advantage, or coverage through other secondary health insurance with creditable
coverage

o
With Original Medicare, decide whether to purchase a Medicare
supplement plan or whether other secondary retirement health insurance can play
this role

o
Determine whether there are any impacts from Medicare decisions
on any of your other employer benefits

o
If you are considering switching from secondary coverage to a
supplement later, determine if you will potentially be eligible for a special
enrollment period at some point to provide access to some plans without
underwriting

o
Use Plan Finder tool at Medicare.gov/plan-compare

o
Make sure that your spouse and dependents have coverage if you
are switching your coverage to Medicare

o
Enroll in Medicare online, by phone, or at your local Social
Security office

o
Open account at MyMedicare.gov to keep track of your Medicare
claims and obtain information about your coverage

o
Medicare personnel are available 24 hours a day by phone

for counseling (1-800-633-4227), and you can also talk to knowledgeable
volunteers through the Medicare Rights Center (www.medicarerights.org) and your
state’s State Health Insurance Assistance Program (www.shiptacenter.org)

Ongoing Monitoring and Adjustments

This section is intended for those who are already retired
and have worked through the steps from the previous sections. I have attempted
to provide a month-by-month list of annual activities to keep your retirement
plan updated. There is flexibility to adjust this calendar of activities, and not
all items may be relevant. This organization is based on placing activities when
they make the most sense, or otherwise spreading activities throughout the year
in cases where the timing does not matter.

January

o
Gather account balances and asset values at year end to update
your household net worth statement.

o
Use online tools to finalize household spending from the previous
year. Add spending to your ongoing budget numbers and adjust your future
retirement budget as needed based on what you learned with your past year’s
spending. Make note of any surprises that should be used in plan updates.

o
Make a final estimated tax payment for the previous year as
needed. (January 15)

o
Take note of what your RMDs will be for the year as a starting
point for tax bracket management.

February

o
Check annual credit reports. (www.annualcreditreport.com)

o
Revisit your financial instructions documentation and make any
needed updates.

o
Obtain updated Social Security statement. (usually available in
mid-February)

March

o
Review legacy goals.

o
Revisit estate planning steps to make any necessary updates.

o
Outside of this annual review, be mindful of other life events
that could trigger a quicker response for estate planning documents:

o
Significant changes to the household balance sheet

o
Change in marital status, births or deaths, family relations

o
Open or close important financial accounts or policies

o
Move to a new state

o
Changes to tax or estate laws

o
Change in relationship with those serving key roles

o
Review estate plan and associated documents, asset titles, and
beneficiary designations.

April

o
Prepare and submit tax return for the previous tax year.

o
Pay estimated taxes. (April 15)

o
Review your discount rate and update your funded ratio analysis.

o
Consider any planning adjustments based on funded ratio update.

o
Appropriateness of overall funded level

o
Appropriateness of funding for reliable income and longevity
expenses

o
Adjustments to assets or liabilities

o
Possibility for making gifts when becoming more overfunded or
more potential to be exposed to estate tax

May

o
Review asset allocation and rebalance portfolio. Include
decisions about re-filling buffer assets or upcoming spending with time
segmentation strategies.

o
Make sure your emergency fund is sufficiently funded.

o
Schedule annual opportunities to use preventative care benefits
with health insurance.

June

o
Pay estimated taxes. (June 15)

o
Review insurance policies. (life, homeowner, vehicle, umbrella)

July

o
Ponder your passions, activities, and relationships to find areas
for improvement.

o
Review physical activities and diet to maintain a healthy
lifestyle.

August

o  Reconnect
with important players in your estate plan: executor, trustees, those with power
of attorney, etc.

September

o
Pay estimated taxes. (September 15)

o
Update your assessment about housing decisions and the ability to
age in place.

o
Review local long-term care facilities and options, and review
for any updates to your long-term care plan.

October

o
Revisit health insurance decisions for the Medicare open
enrollment period lasting from October 15 to December 7.

o
Update health care budget and reserves based on recent spending
and health care usage

o
Update your list of prescription drugs to use with testing for
the best personalized prescription drug plan during each open enrollment

o
Review choices for Part D prescription plan, Medicare Advantage,
Original Medicare, and supplements (be aware of underwriting with supplements)

o
When relevant, review annual decisions and coverage options for
employer open enrollment season.

November

o
Review asset allocation and rebalance portfolio.

o
Revisit asset location, withdrawal order sequencing, and
tax-planning decisions.

December

o
Charitable giving plans: RMDs or QCDs, contributions to donor advised
funds

o
Make sure that any RMDs have been taken by December 31.

o
Make any desired gifts for which you wish to benefit from the
annual gift tax exclusion.

o
Engage in any strategic Roth conversions or other tax planning to
manage your taxable income at the desired level for the year.

Avoiding Mistakes

Many things can go wrong with retirement planning.
A significant mistake could unravel years of hard work. To conclude, I highlight key pitfalls to summarize the book’s lessons.

Investment Decisions

o
Using an inappropriate asset allocation for your risk tolerance
or risk capacity

o
Letting emotions take control and drive asset allocation changes
during periods of market volatility, and related behavioral mistakes

o
Assuming too high of return for your portfolio

o
Believing that higher-cost investments must be better

o
Assembling investments piecemeal without an overall strategy

o
Using an excessive number of accounts or funds

o
Holding concentrated positions, especially in your employer stock

o
Falling victim to a sales pitch for an investment product without
understanding clearly about the role it will play in your plan

o
Missing deadlines for making required minimum distributions

o
Being overly exposed to losses if interest rates rise

o
Not being emotionally prepared for multiple bear markets
through-out your retirement

Distribution
Policy Statement

In the investment world, investment policy statements are
common to help investors understand and stick to their investment plan. A
distribution policy statement can apply to retirement income. You can create
a written statement about your targeted asset allocation, investment funds to
use, asset location goals and withdrawal order sequencing, your fund review
and rebalancing process, and allowed withdrawal rates to be used over time or
spending rules for when adjustments should be made in response to portfolio
performance. Though such a statement is not a legal contract, writing these
details down may be helpful in managing behavior and in avoiding excessive
distributions or spontaneous portfolio changes. Such a document can provide
an important defense against potentially unwise decisions.

Insurance Decisions

o
Purchasing annuities or life insurance in a haphazard manner
without a clear plan for how the policies fit into your plan

o
Lacking needed insurance or carrying unnecessary insurance

o
Falling victim to a sales pitch for an insurance product

o
Forgetting to pay a premium and unintentionally lapsing on an
insurance policy

Social Security Decisions

o
Not testing your claiming decision with software

o
Missing out on eligible dependent, ex-spouse, or survivor benefits

o
Thinking that the act of retiring means you must also claim

o
Being overly excited to have both spouses claim at 62

o
Finalizing divorce just before ten years of marriage

Medicare Decisions

o
Not understanding that Medicare becomes the primary payer for
health coverage upon reaching the age of eligibility except for those who can
maintain coverage through active employment (by yourself or a spouse) at a firm
with at least 20 employees

o
Not understanding that if you do not have primary coverage by law
after turning 65 and do not enroll in Medicare, you may find yourself without
health coverage and may have to wait up to 15 months to begin coverage during a
general enrollment period

o
Not understanding that Medicare coverage is based on individuals
and does not provide benefits to younger spouses or dependents

o
Not realizing that Medicare enrollment is not automatic if you
are delaying Social Security past age 65

o
Not enrolling at least in Parts A and B for those with secondary
coverage through other health insurance

o
Not understanding that using only Medicare Parts A, B, and D can
lead to significant exposure to uncapped medical expenses

o
If you have secondary coverage that provides primary coverage for
other family members, be careful about making decisions that could have
unintended consequences as based on the rules of your health plan

o
Making decisions based solely on which option has the lowest
premiums or deductibles, rather than considering the full costs of various
options

o
Assuming that Medicare is set-it-and-forget-it and not reviewing your
options during each year’s open enrollment period

o
Not recognizing that outside of the initial enrollment period and
somewhat with special enrollment periods, applications for Medicare supplements
will be underwritten and potentially denied

o
Thinking that Medicare will cover long-term care needs

Tax and Estate Planning

o
Lacking an estate plan

o
Lacking a plan for incapacity

o
Having out-of-date beneficiary designations

o
Forgetting to fund your trusts

o
Creating unequal or unintended inheritances

o
Paying unnecessary costs and taxes for estate distribution

o
Missing important strategies to save on taxes

o
Not filling up zero percent tax brackets with taxable income

o
Donating cash instead of appreciated securities

o
Doing Roth conversions for funds you will otherwise donate

Non-Financial Aspects

o
Thinking you will figure things out with the extra time after
retiring

o
Lacking a purpose and passion for retirement

o
Not communicating with your spouse about your retirement vision

o
Not considering how important work is to your identity

o
Engaging in too many passive activities: television, internet
surfing

o
Using retirement funds to start a new business based on a hobby

o
Neglecting your health and avoiding preventative care

Opportunities for Further Engagement

As we
finish, please let me outline a few ways to continue engaging together as you
prepare for your best retirement. First you can visit www.retirementresearcher.com
and sign up for our weekly newsletter with our latest articles, invitations to
webinars, Q&A sessions, and more. The newsletter arrives to your inbox each
Saturday morning.

I created Retirement Researcher as a blog in September 2010.
As it developed beyond a blog over the years, I have tried to maintain the
original mission: RetirementResearcher.com provides independent, data-driven,
and research-based information about retirement income planning. The website is
geared toward providing unbiased information about building efficient
retirement income strategies and endeavors to bridge between the various
retirement income styles.

Our most recent
innovation regarding this bridging is the Retirement Income Style Awareness I
described in Chapter 1. If you are interested to obtain your RISA Profile as an
initial step toward retirement, you can sign up without cost at www.risaprofile.com/guidebook.

As well, returning to the topic of financial
implementation preferences discussed in this chapter, we are working hard to
provide support that works for everyone. For self-directed retirees, we now
have the Retirement Researcher Academy membership site. It empowers
members with a clearinghouse of knowledge that provides an extension to
these contents.

For those who are collaborators, validators, or delegators,
Retirement Researcher also provides opportunities to work with its sister firm,
McLean Asset Management. McLean offers various one-time planning options
for validators that do not require commitment for ongoing wealth management.
These range from undertaking a Funded Ratio Analysis and discussing it
with an advisor, engaging in a reliable income analysis, a base financial plan,
or a comprehensive one-time financial plan. As well, for collaborators and delegators,
McLean offers traditional financial planning relationships that includes
portfolio management with ongoing comprehensive planning and update
meetings. I can help you arrange an introductory call to learn more about these
options (wade@retirementresearcher.com).

Finally, I am also a Professor of Retirement Income at The
American College of Financial Services and the director for the Retirement
Income Certified Professional® (RICP®) designation. It is
a three-course sequence intended for financial professionals wanting to learn
more about retirement income.

The door is opening to a wonderful phase of life. I wish you
all the best for your retirement! Thank you for reading, and I hope you now
have the skills needed to make the retirement you want.

Make an Author Happy!

If you found this
information helpful, I would truly appreciate it if you left a brief review
of the book at your favorite book retailer. Perhaps you could mention the
most useful item you learned. As the book is self-published, it can be a
challenge to get the word out to a wider audience and every review helps to
get this information in front of more readers. Thank you!

The
Retirement Researcher’s Guide Series

The Retirement Researcher’s Guide Series
includes four volumes. This book provides an overall investigation of
retirement income planning. For most readers, this may be sufficient. The other
three volumes offer a deeper dive into specific aspects of a retirement income
plan. These books are available at most major retailers. I can also arrange
discounted bulk orders for any of the four volumes in this series. Please
contact me directly about bulk orders at wade@retirementresearcher.com.

Safety-First Retirement
Planning

A deeper
exploration of strategies for those with income protection and risk wrap
styles.

How Much Can I Spend in Retirement?

A deeper
exploration of strategies for those with total return and time segmentation
styles.

Reverse Mortgages (2nd Ed.)

A deep dive on
reverse mortgages and different roles they can plan in a retirement plan.

About the Author

Wade D. Pfau, PhD, CFA, RICP® is a professor of
retirement income and the director of the Retirement Income Certified
Professional® (RICP®) designation program at the American
College of Financial Services in King of Prussia, Pennsylvania. He also serves
as a principal and the director of retirement research for McLean Asset
Management. He is the founder of Retirement Researcher, which is an educational
resource for individuals and financial advisors on topics related to retirement
income planning.

He holds a doctorate in economics from Princeton University
and has published more than sixty research articles in a wide variety of
academic and practitioner journals. His research has been discussed in outlets
including the print editions of the Economist, New York
Times, Wall Street Journal, Time, Kiplinger’s, and Money magazine.

Wade is a past selectee for the InvestmentNews Power
20 in 2013 and inaugural 40 Under 40 in 2014, the Investment Advisor 35 list
for 2015 and 25 list for 2014, and Financial Planning magazine’s
Influencer Awards. In 2016, he was chosen as one of the Icons and Innovators by
InvestmentNews. He is a two-time winner of the Journal of Financial
Planning Montgomery-Warschauer Editor’s Award, a two-time winner of the
Academic Thought Leadership Award from the Retirement Income Industry
Association, and a Best Paper Award winner in the Retirement category from the
Academy of Financial Services. Wade served for four years as a coeditor of the Journal
of Personal Finance.

Wade is a contributor to Forbes and an Expert
Panelist for the Wall Street Journal. He has spoken at the
national conferences of organizations such as the CFA Institute, the CFP Board,
the FPA, NAPFA, and the Academy of Financial Services.

He is also author of three other books
in the Retirement Researcher’s Guide Series: Reverse Mortgages: How to
Use Reverse Mortgages to Secure Your Retirement, How Much Can I Spend in
Retirement: A Guide to Investment-Based Retirement Income Strategies, and Safety-First
Retirement Planning: An Integrated Approach for a Worry-Free Retirement.

Twitter: @WadePfau

Website: RetirementResearcher.com