CHAPTER TEN
INVESTING FOR RETIREMENT

WE’RE GETTING OLDER,
BUT ARE WE GETTING WISER?

IN 1900, 4 percent of Americans were age 65 or older. In 2000, 13 percent were 65 or above. By 2030 the Census Bureau projects that the figure will increase to 20 percent. This demographic trend will have well-documented negative effects on our social security system as the baby boomers begin to reach retirement age in 2010. Many argue that this trend will also create a volatile environment for the stock market as funds are spent or shifted to safer investments as people get older.¹

Corporate stocks are the investment of choice for retirement plans. As a matter of fact, over 50 percent of the value of traded U.S. equities is now held in retirement accounts, and this number is growing. We trust and count on the market to help us accumulate a sufficient sum to allow us to retire comfortably.

We used to depend heavily on traditional pensions for our retirement income. The employer would provide a guaranteed retirement benefit based on a formula that factored in the number of years of service and salary. After twenty-five or thirty years of service, the employee would receive a reasonable retirement income to help supplement social security.174 Most employers set aside money for this liability and took on all of the investment risk. However, there were a few bad apples.

After seven years of congressional debate, President Ford signed the Employee Retirement Income Security Act (ERISA) in 1974. Tragic tales of pension benefits wiped out by bankruptcies, mergers, and unsavory business practices prompted the laws, which stipulated that companies with pension plans had to follow certain basic rules, including actually setting money aside for pensions. Corporations have lots of flexibility in interpreting the rules, as described in chapter 3. The law also allowed individuals who were not in a traditional pension plan to set up their own retirement savings account with special tax benefits. This marked the beginning of the Individual Retirement Account (IRA).

In 1982 the Internal Revenue Service launched a public policy campaign to encourage people to save for their own retirement through before-tax payroll deductions called 401(K) plans. In a separate ruling the IRS liberalized the IRA rules to allow individuals to contribute up to $2,000 per year, including employees already in corporate pension plans. These initiatives were the main triggers to the explosive growth of the mutual fund industry. At the market peak in 1999, upwards of 75 percent of the $1.8 trillion that workers held in 401(K) accounts was invested in equities.

Today, the statistics and trends are sobering: more than 50 million workers—about half the workforce—have no pension coverage whatsoever. They have neither a traditional, employer-run pension plan to provide checks after retirement, nor a personal tax-deferred savings account such as an IRA or 401(K) plan. For small businesses, where only 25 percent of workers are covered by some sort of retirement plan, the problem is particularly acute.²

To make matters worse, over 50 percent of America’s workers that have a 401(K) cash out when they change jobs—rather 175than rolling those savings over to an IRA or another 401(K)— and therefore pay taxes on the proceeds as well as a 10 percent tax penalty for withdrawing the money before age 59-1/2.

Even those who are setting aside money for retirement are doing a poor job of it. From 1983 to 1998, when the S&P index rose an astounding 774 percent, the most fortunate retirement savers—those ages 47 and over with $1 million or more in net worth—saw their retirement wealth grow by only

44 percent.³

Sources of Retirement Income

The main sources of retirement income are social security, benefits from pensions, retirement savings, and other investments.

• Social security—As many a retiree will desolately attest, it is almost impossible to make ends meet on a social security check alone. It should be viewed only as a supplement to retirement income. If you were born after 1937 and plan to retire with full social security benefits at age 65, you’ll find that you may have to wait as long as age 67 to receive full benefits. This change was put into place to help strengthen the system.
• Pensions—This is a benefit provided by certain businesses where the employer, not the employee, makes the contributions. This type of plan is being used less and less as employees are encouraged to save and provide for their own retirement. Only 22.3 percent of the workforce is covered by a traditional pension plan, about half the percentage covered in 1975.⁴
• Retirement savings—This area includes accumulated savings from payroll deduction plans such as 401(K)s (for profit entities), 403(B)s (educational and certain nonprofits), and 457s (government). Profit-sharing plans, money purchase plans, IRAs, and Roth IRAs fall 176in this category along with many other lesser-known salary deferral plans. Nonqualified deferred annuities also fall into this category.
• Other investments—These include securities and assets not specifically allocated toward retirement. Personal assets would fall under this category along with the value of the personal residence. Your home can be a source of retirement income, usually as a last resort, through such things as creative sale and leaseback transactions, and reverse mortgages.

You are fortunate if you are in a position to receive both social security and a noncontributory pension because the old-style pensions are becoming rare. For investment retirement planning, we will concentrate here on retirement savings— money specifically allocated for retirement—which usually receives favorable tax treatment. We’ve already seen that 50 percent of active workers have no retirement plan. Those who do usually have a 401(K) or 403(B) plan.

The Protected Investor and the 401(K)

Most people who have made provisions for retirement own two major investments: their house and a 401(K) or other retirement savings account. A house can stabilize living costs and give inflation protection. The 401(K) and other salary deferral plans are great ways to save for retirement, and investors should take advantage of them to the maximum extent possible. Money set aside for retirement via payroll deduction is exempt from federal and sometimes state income taxes. Some employers match contributions up to a certain percentage. This is a valuable employee benefit that should be taken advantage of, even if the match is with company stock. Take the security if it’s free, but as a risk-averse investor never direct 401(K) contributions into company stock unless you plan to sell the stock as soon as the company allows. 177

About 2,000 U.S. companies offer their own stock as an investment option in these plans in addition to mutual funds. Some of these corporations—including many large employers such as Coca-Cola, Proctor and Gamble, and (formerly) Enron —have essentially forced 401(K) participants to invest in company shares by issuing them as the employer’s matching contribution. A survey by the Employee Benefits Research Institute showed that 18.6 percent of the average 401(K) plan balance was held in the employer’s stock in 2001. For companies with more than 5,000 employees, the figure was a whopping 25 percent.¹ That even defies traditional diversification strategies of not putting more than 5 percent of investments in one company’s stock.

Even without a matching contribution, the 401(K) is an excellent retirement savings tool if used properly. The earnings on the investments accumulate tax deferred. Taxes are paid when you draw funds out at retirement.

The big challenge for a protected 401(K) investor is selecting investment options that provide a reasonable opportunity for growth without risking principal. The employee cannot select investments outside of those provided in the plan by the employer. The employee may have many investments to select from, but they usually consist of variations of stock funds, bond funds, and money market funds. Money market funds are low yielding but usually safe. Bond funds can perform well at times but can actually lose money during periods of rising interest rates, when the value of bonds decreases. The risk with stock funds is certainly self-evident.

The risk-averse investor is left with very few attractive choices. A money market or ultra-short bond fund may be the best available option. Some employers offer a guaranteed interest option through an insurance company that pays an attractive rate compared to the money fund. Very few offer protected market-linked alternatives.

According to the Bureau of Labor Statistics, the average 178employee stays with his or her employer for a little under three years. One strategy for the risk-averse investor is to roll over the accumulated value of the 401(K) to a self-directed IRA upon termination from the current employer. Be sure to establish the IRA before the money is requested so that the funds can be directed to the new trustee. The self-directed IRA can provide a whole array of protected products, including market-linked CDs, notes, and equity-index annuities.

Approximately 95 percent of 401(K)s offer loans to participants. Research indicates that about 18 percent of 401(K) holders borrow money from their 401(K).⁵ It’s generally not a good idea to borrow money designated for retirement, but some people seem unable to invest for a long period of time. If the loan provision in a 401(K) is used, then upon termination of employment, the money should be transferred to the new employer’s 401(K). Loans are not available on IRAs.

There is an advantage to borrowing money from the 401(K) for a down payment on a first house, but cashing in or borrowing money from retirement funds for a big-screen TV is another story. You should be aiming to accumulate a minimum of ten times your last annual working salary in retirement funds by age 65 in order to generate a target of 75 percent of your accustomed income over the last twenty years of life expectancy. For example, someone accustomed to making $50,000 a year should have at least $500,000 accumulated at retirement. The average retiree in 2002 left the employer with approximately $115,000 in his or her 401(K).

It’s critical to start saving as early as possible for retirement. Even if you can only save a small percentage of your income, it will grow tax deferred and be compounded over time. A solid foundation will be developed that you can add to in increasing amounts over the years.

Two important factors that we can control in saving for retirement are both the amount of money we sock away and 179the amount of time the money is invested. Another factor in determining how much we’ll have at retirement is the rate earned on the investments. Most of us give up control of this factor by investing in unprotected equity mutual funds in a 401(K). All it takes is one bad year to wipe out years of accumulation. For example, let’s say you achieve a 10 percent return over ten years on a $10,000 yearly retirement investment. If in year eleven the market drops by 40 percent, all of your gains of the previous ten years are lost. You end up with less money than if you had put it under the mattress.

Market- or Equity-Linked Investments in the 401(K)

Market-linked certificates of deposit as well as equity-linked notes are usually purchased in a brokerage account. Each has a minimum investment of $2,000 to $5,000. This makes it difficult if not impossible to purchase these kinds of securities in your typical salary deduction 401(K) plan. However, there is a way to overcome this obstacle if the employer offers a self-directed 401(K).

As mentioned earlier, the self-directed 401(K) can allow employees to purchase any security, including individual stocks, bonds, mutual funds, CDs, and so on. Only about 10 percent of employers currently offer this option to their employees. On the one hand, the plan sponsors have a fiduciary responsibility to provide diversified investment alternatives in their employees’ 401(K) plans. On the other hand, the employer has the fiduciary duty of prudence in the selection and retention of investment choices.⁶ Many smaller professional firms in which most workers are fairly high net worth investors use self-directional 401(K)s. A lot of these employees are interested in riskier strategies such as trading stocks. However, these plans can be used for protected, conservative strategies too.

Plan sponsors can and should limit the range of investments available in self-directed accounts. If investments are limited to 180FDIC-insured CDs and other insured or very safe alternatives such as AAA rated government-backed securities and insured equity-linked notes, then the employer is properly handling their fiduciary responsibility. This gives their risk-averse employees some viable options to choose from, while not allowing unlimited investment options—including the purchase of high-risk stocks, which may not be suitable for accumulating money for retirement.

A self-directed 401(K) will cost each participant between $25 and $100 in additional administrative fees. It really isn’t cost effective for the employee until this charge becomes a reasonable percentage (less than 1%) of total investments placed in this option. Because of this additional cost and the fact that CDs, notes, and government-backed securities are not suited for payroll deduction due to minimum investment requirements, the employee should only participate in the self-directed 401(K) option with $10,000 or more.

When offered in a 401(K), equity-index annuities can be purchased in increments as low as $100 per month. Unique guarantees and provisions, such as the annual reset, make equity index annuities attractive retirement investments.

In order to offer employees the additional choices of a self-directed account and equity-index annuity along with the standard fare of mutual fund options, the employer may need the services of a third-party administrator to allow more flexible investment choices. The additional fees for a custom plan are reasonable given the level of service provided. Employees are happier with the greater quality of investment options, and employers gain from providing a better benefit to employees. In addition, the employer as a fiduciary is prudently carrying out their responsibilities by providing protected investment options for risk-averse employees.

Employers may have other programs besides the 401(K) that are attractive to the risk-averse investor. This includes certain types of employee stock purchase plans. 181

Employee Discount Stock Purchase Plans

Most publicly held corporations offer a package of benefits, including health, retirement, 401(K), and employee stock purchase plans. Some of the stock purchase plans are well suited for the risk-averse investor, and the employee should participate to the maximum extent allowed by the employer. However, the protected investor should completely avoid holding employer stock and dispose of it immediately after purchase.

The employee stock purchase plan allows employees to purchase company stock at a discount. A typical plan allows employees to apply up to 10 percent of their gross salary toward the purchase of employer stock. At the end of a designated period, the money is used to purchase stock at a discount based on the lower of either the beginning or ending price (usually three or six months).

What makes this attractive to protected investors is that once the purchase is made they may sell the stock if they so desire. And that’s exactly what the employee should do—sell immediately. Once the stock is in the name of the employee it becomes an unprotected investment and is subject to the usual risks associated with all other stocks.

The percentage return on this employee benefit can be substantial. For example, if the stock went from $50 at the beginning of the period to $40 at the end of the period, employees would pay $34 a share for the stock (85% of $40) assuming a 15 percent discount. If employees sold the stock immediately, they would have made $6 per share, or 17.6 percent. Assuming that this was for a six-month period and the money was put in the plan equally over six months, the annual rate of return works out to over 70 percent!

It could even get better. If the stock price went from $40 to $50, employees would pay $34 per share but immediately sell at $50 for a $16 profit per share, or 47 percent gain. On an annual basis the actual return in this example is over 180 percent. And this is without gambling.

I have to reiterate that the stock must be sold immediately after purchase to realize these gains without any exposure to market risk. The only way employees would be at risk is if the employer went bankrupt during the accumulation period. If this is even a remote possibility, don’t participate in the plan.

I’ve met with hundreds of people over the years who had this kind of plan as an employee benefit and didn’t participate. Most of those who did usually didn’t put in the full amount possible and ended up holding the stock as a long-term investment. Participation in these plans is something you have to find a way to do, even if it means delaying the payment of higher-interest debt. You can use the proceeds from the stock sale as a lump-sum payment toward the debt later.

Government-Backed and Private Mortgages

Mortgages are frequently used as part of the fixed income component of a retirement plan. U.S. government-backed mortgage securities usually pay attractive interest compared to other safe income-oriented investments. A government agency guarantees interest and principal, which gives these investments the highest possible credit rating.

An investor in this type of security doesn’t have to worry about whether the interest and principal will be paid, but there is a concern about the timing of the principal payments. When interest rates go down, people refinance their mortgages, and you may get the principal of your investment back sooner than you would like. The money comes back, and you then have to reinvest in a lower interest rate environment. The opposite is also true. When rates go up it may take longer than you would like to get your principal back, so you may miss opportunities to reinvest at higher rates. A good financial adviser can purchase mortgage-backed securities that minimize these risks, which the financial industry calls prepayment and extension risk. These investments go by names such as Ginnie Mae (Government183 National Mortgage Association), Fannie Mae (Federal National Mortgage Association), and Freddie Mac (Federal Home Loan Mortgage Corporation).

One way to minimize these risks is to control the mortgage process yourself. You can write in prepayment penalties that will help offset the annoyance of getting the principal back faster than expected. In addition, you could put in a “balloon” provision, which makes the whole mortgage come due in a certain period of time, to control extension risk.

With a private mortgage you are depending on the value of the real estate to back the mortgage for security against credit risk, instead of a government-backed guarantee. The protected investor will want the owner to have significant equity in the property before making a loan. There must be enough equity to provide the investor with adequate security should the value of the property drop significantly.

There are lots of creative things you can do with private mortgages. But it’s an active investment that requires you to do some things that you wouldn’t be concerned with in a government-backed mortgage security. You have to record liens, collect checks, do tax reporting, and so on. You also have to be good at evaluating risk.

Private mortgages are often written between family members. This usually works to everyone’s advantage. However, you do have to be concerned with what you, as the investor/lender, would do if your relatives default on their payments. Do you put up with it? Foreclose? This kind of thing can cause battles between family factions and may be more than you would want to deal with.

ALLOCATING RETIREMENT SAVINGS

The time-honored precepts of asset allocation, diversification, and a long time horizon remain worthy concepts for the risk-averse investor. The big difference between protected investment 184management and the traditional administration of investments is that common stocks and equity mutual funds are excluded from consideration because they can generate negative as well as positive returns.

Asset Allocation

The process of asset allocation helps the risk-averse investor to decide how to divide money between protected equities, fixed income, and cash. The traditional rule of thumb for asset allocation is that the percentage in equities should be 100 minus your age. For example, if you are 30 years old, 70 percent (100 - 30) should be in equities. If you are 65 years old, 35 percent should be in equities.

The selection of a particular allocation is as much an art as a science, but the general concept is that when we are young we seek potential growth of the principal and are able to incur higher risk, so more is allocated to the equity component. As we age and eventually need income from our investments, the allocation is shifted to bonds, other safe fixed income investments, and cash. There is no correct magic answer, but you will find lots of opinions on the subject. In an article written for Newsweek by financial columnist Jane Bryant Quinn, a section entitled “Roadmap for Retirement” suggests the 401(K) allocations shown on the next page.

Because of the many factors that come into determining asset allocation, this age-based chart is for illustration purposes only. I feel that this chart may be too aggressive in the earlier years and too conservative in the later years. Regardless of how the ultimate allocation is made, the protected investor will use market and equity-linked investments in place of stocks. Bonds will primarily be AAA rated and insured. Also, bond maturities will be laddered out over time to help deal with interest rate risk—the risk that future rates will be higher. When interest rates go up, it causes bonds to go down in value. If interest rate risk is properly dealt with, then low-185interest-earning cash equivalents such as money markets can be kept to a minimum.

SAMPLE AGED-BASED
ASSET ALLOCATION7

* Risk-averse investors will use protected investments in lieu of stocks or mutual funds.

Diversification

By using diversification we reduce risk. Too much money in one particular investment can be a recipe for disaster if that investment goes sour. The risk-averse investor, using only protected investments, can also benefit from diversification.

Once the proper asset allocation is decided upon, we then seek out the specific investments that are suitable for our retirement fund. For example, in the equity portion we will select from market-linked CDs and notes as well as equity-index annuities. Buying multiple CDs and notes based on different indexes and terms makes sense. The performance of even the most popular indexes can vary widely during certain periods. For example, there are times when larger companies like those found in the S&P 500 and Dow indexes will perform better than smaller companies represented in indexes such as the Russell 2000. Remember that the calculation of interest on some MCDs is based on a point-to-point method, while others are based on a quarterly average. Participation rates and caps will also vary between CD issues.

The policy date for an equity-index annuity with an annual reset is critical because this is the month and day used for determining the new beginning index for the following yearly period. If the starting indexes are low, there is a better chance of receiving an attractive interest return for the following year. Since we can’t predict the future, it makes sense to diversify the policy dates and use different indexes and methodologies for calculating the interest. Once you have accumulated a reasonable amount with one insurance company, see if there are other insurance companies that offer a complementary equity-index annuity with different terms. For example, one company may offer a point-to-point interest methodology, while another uses a daily average. One method may be better than the other depending on how the market moves during the period.

Long-Term Time Horizon

If we didn’t focus on the long term, we would only consider cash equivalents such as money market funds and short-term CDs as suitable investments. Having a long-term time horizon allows us to invest in three- to seven-year market-linked CDs 187and notes. As noted earlier, equity-index annuities have surrender penalties and terms as long as fifteen years. For risk-averse investors, having a long-term outlook doesn’t mean we buy into the concept that the market is always the best place to be and always comes through for us in the long run. It means that we believe the market will be volatile in the future and will have both bullish and bearish periods, and that we’re satisfied with sharing in the gains of the up markets while avoiding the pain in the down markets.

AN ONGOING PHILOSOPHY

The market-linked investments used for our retirement accounts assure that our nest eggs will remain intact while still allowing us to participate safely in stock market gains. These products fit an overall philosophy of personal risk management that keeps us in control of the principal value of our investments. If we lose command of our principal, the attainment of our financial goals becomes dependent upon factors beyond our control. We become gamblers with our savings, and as we’ve seen earlier in this chapter as well as in Chapters 1 and 2, most of us are likely to make poor decisions that reduce our potential returns, even during the good times.

If we maintain an ongoing regimen of keeping our personal expenses under control relative to our income and use the difference to pay down high-interest debt first and then consider protected investments within our retirement savings, we have a good shot at reaching our long-term goals. These goals commonly include financial independence—the ability to retire without having to worry about money.

We have to stay focused on our strict definition of risk and not be taken in by the many investments that are advertised as safe or conservative without proper due diligence of the true risk. For example, a $100,000 thirty-year zero coupon government bond, purchased to yield 5 percent, will cost approximately188 $23,100. If interest rates jump to 7 percent, the bond will be worth only $13,100, a drop of 43 percent. An advertisement for this bond may focus on the fact that this is a AAA rated government bond. The credit risk is small, but the interest rate risk in this type of investment is huge.

How you plan for retirement and choose the appropriate retirement investments can result in tremendously different lifestyles after leaving the workforce. Unless there are radical changes in the way we save and invest, as many as 20 percent of retiring baby boomers will be living in abject poverty, completely dependent on government assistance. Studies show that only half of the workers between ages 47 and 64 plan to be collecting even 50 percent of their current income at retirement. Many will have far less.