Financial Makeover: Smart Retirement

Dec. 9, 2002 -- I would like to be able to retire at some point in my life. My family always had money and I "felt" I would be able to depend on that income. The money did not materalize. I feel like it is a hopeless situation to even start looking at a financial goal and I will have to depend on my "teacher retirement."

With investing for retirement, some of the biggest challenges may come when your goal is right around the corner. The sooner and more thoroughly you plan for these potential issues, the better prepared you'll be able to enjoy your golden years. The 403(b) tax sheltered annuity that Lola and a lot of teachers have, may be the best place for you to be.

It is important that you develop an appropriate asset allocation strategy. Traditionally, people believed that, as retirement approaches, they should shift most of their money out of stocks and into bonds because bonds provide principal protection and pay current income.

Today, with longer life expectancies, as an investment professional I generally recommend that people keep a good portion of their assets in stocks throughout retirement. People can draw income from stock mutual funds by establishing a Systematic Withdrawal Program.

For retirees who elect this option, as an investment professional, I will recommend an annual percentage rate for their withdrawals, such as 6 percent. If retirees' stock holdings rise in value at a higher rate than their withdrawal percentage, retirees can continue to realize principal growth, even while using their stock investments for current income.

While every stock investor is worried about the next market downturn, it is important to note that over 30 years a person could live through as many as five or six market cycles.

Stock-Heavy Portfolio

For people retiring, I don't recommend the traditional 60 percent stocks, 40 percent bonds split, I usually suggest a heavier weighting in stocks. If they're conservative and worried about risk, I recommend conservative stock funds, such as utility funds and growth and income funds.

It is important to select the accounts that you will withdraw from first. It's common wisdom that retirees should withdraw from their taxable accounts first. It's better to postpone distributions from tax-favored investments such as 401(k)s and IRAs — the thinking goes — so that you as the retiree can continue to benefit from the deferral of taxes on their earnings.

But that blanket advice is too simplistic to address the myriad issues people getting ready to retire have to consider, Lola needs to meet with her investment professional and tax advisers to do some tax planning and to talk about what her goals are for leaving money to their children or relatives. Lola, with her investment professional's help, might discover she'll be in only the 0 percent to 15 percent tax bracket when she retires.

In 2002, Lola if she is retired and is 65 or over, and if she does not itemize deductions on her tax return, she would be in the 15 percent tax bracket or maybe the 10 percent tax bracket. She needs to check with her tax adviser. When Lola withdraws money from 401(k) s or 403(b)b and IRAs, her withdrawals are taxed at their ordinary income tax rate.

Defined contribution plans, such as 401(k)s, have become popular in recent years. But many people retiring today still have the more traditional pensions, known as defined benefit plans. Unlike 401(k)s, the traditional pensions offer retirees a guaranteed monthly benefit that is usually based on their years of service and final salary.

As Retirement Nears

When their retirement date draws near, people with traditional pensions must decide how they want to take their plan's benefits. A few defined benefit plans allow retirees to take lump-sum payments. Retirees can take the money as cash and pay taxes immediately, or roll the money into an IRA. Lump-sum payments are a popular choice among the plans that offer them because they give retirees more freedom in how to handle their money. But many defined benefit plans don't allow lump-sum payments.

Instead, they require retirees to "annuitize" their benefits. When annuitized, the pensions convert to a guaranteed monthly payment usually for the remainder of the retiree's life or for the remainder of the retiree's and his or her beneficiary's life.

Lola needs to scrutinize her choices. While the single-life annuity pays the highest monthly benefit, since Lola is not married, she will not select the choice that most retirees' select a joint annuity, because they want to protect their spouses, this happens especially when the spouses don't have their own pension. I recommend that people carefully review their options with their adviser before making a decision. If the reduction in the monthly benefit, from the single-life to the joint annuity is too great, someone might do better by taking the single-life annuity and using the difference to buy a life insurance policy.

If Lola were still married and retiring, for example, she might have the option of taking a single-life annuity that would pay a $4,000 monthly benefit for the remainder of her life. The 50 percent joint-and-survivor available from his plan might offer a $3,000 monthly payment while she was alive and a $1,500 monthly payment to his wife after she died.

In that case, I might recommend the retiree take the single-life annuity of $4,000 per month, live on $3,000 per month, and use $1,000 a month to pay the premiums for a substantial life insurance policy. That way the spouse will be protected when the retiree dies. The spouse won't get any more money from the pension, but the spouse will receive the proceeds of the life insurance policy.

The spouse could invest the tax-free proceeds in mutual funds. If it were a substantial enough policy, she could withdraw from her investment an amount that would give her income each year equal to the amount she would have received from the joint annuity.

Living off the investments might even enable the spouse to increase their monthly withdrawals each year to keep pace with inflation. With the annuitized benefits, that's not possible because the monthly payment stays the same throughout the retiree's and spouse's lifetimes.

If the money invested from the policy grows faster than the spouse's annual withdrawal rate, the principal would continue to grow. There could then be something to leave for the couple's children. When the spouse dies with a joint annuity that doesn't have a period certain, benefits stop and the children don't receive anything.

But this strategy — taking the single-life annuity and buying insurance — is worth considering only when there's a substantial difference in the monthly benefits paid under the single-life and joint-annuity options. It's also a strategy available only to those who are healthy. Those with a major physical illness may not be able to buy life insurance, or a policy could be prohibitively expensive.

Discovering all the money issues you'll have to consider as retirement nears may feel overwhelming. But these are issues investment professionals deal with routinely. With my long-term clients, whose needs I know well, I can recommend a payout option after about 15 minutes of number crunching. In fact, many of the choices retirees face can be reduced to simple math. When clients see the numbers, their choices often become obvious. If you chart the right course with your advisers, then you may be able to step onto the long-sought-after shores of retirement with grace and ease.

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Jesse B. Brown is president of Krystal Investment Management, a financial advisory firm in Chicago. For a free trial copy of his monthly electronic newsletter, e-mail, or write to him at Three First National Plaza, PMB Suite 14042, 70 West Madison, Chicago, IL 60602. He is the author of the books Investing in the Dream — Wealth Building Strategies of African-Americans Seeking Financial Freedom and Pay Yourself First: A Guide to Financial Success. His Web site is