How to generate income in retirement

Most people spend their careers saving and accumulating funds so that one day they can retire. But when retirement finally arrives, a whole new process begins.

Economists call it, “the decumulation phase.”

This is the process of turning saved or invested assets into regular income.

Decumulation is an entirely different animal than accumulation. Paying regular bills by slowly liquidating investment shares can be an extremely complicated task to undertake.

  • Which stock (or fund shares) should you sell first?
  • Should you sell shares of a stock that is up or a stock that is down?
  • Should you sell an average of all the stocks you own?
  • Should you be selling shares of some other investment such as a bond fund?

I often think of the challenges of decumulation when I am at the grocery store and see very senior people doing their shopping.

(OK…if that makes me some kind of economics/financial nerd, so be it. There is a serious human side to this story.)

I think to myself,

“Does this person now have to go home, log in to his or her online brokerage account, and sell shares to pay for those groceries?”

I also often wonder,

“What if this person is alone and has lost his or her spouse?”

What if the spouse who is now gone was the one who “took care” of the money?

What’s left is someone at a very delicate and vulnerable senior age – who is likely intimidated or even downright afraid – forced by necessity to manage an extremely complicated and difficult task, just to pay for basic things like groceries.

Yikes…

There is a better way.

There are products designed to generate and distribute income more smoothly. These products generally “pool” funds in order to distribute income steadily and predictably over time.

  • Funds of this general type date back to the Roman Empire when individuals were paid an annual stipend called an “annua.”
  • Roman soldiers received such stipends in exchange for military service.
  • Participants would make a single payment to the fund and receive payments each year until they died.
  • Other funds of this type – called tontines – were used during the middle ages by kings and lords to finance the cost of frequent military campaigns.
  • The first annuity used in America was established in Pennsylvania as a retirement fund for pastors in 1759.
  • Lotteries today use similar mechanisms to distribute prize money to winners. After an initial lump sum is contributed, funds are paid out evenly over a number of years.

Converting savings into income can be a very complicated process, but it doesn’t have to be.

After a certain age, for mercy’s sake, it really shouldn’t be.

Don’t leave your spouse trying to manage a “do-it-yourself” decumulation plan.

Learn how annuities can help convert savings into guaranteed, worry-free income and make the decumulation process a whole lot easier.

Try this simple method to calculate how much income you may need in retirement.

If you would like to contact me to discuss whether annuities may be suitable in your situation, I can be reached by email or through my Cincinnati, OH insurance agency, McCarthy Stevenot Agency, Inc., at 513-891-9888.

What if everyone bought the same hot stock?

Conventional wisdom suggests that the stock market is the destination of choice when it comes to laying the groundwork for future financial security and building personal wealth.

Since the rise of the 401(k) in the early 1980s, tens of millions of people have officially become stock market investors. Critics of the status quo worry that public awareness about the risks associated with stock investing needs to be improved.

Generally, I agree.

As such, I have been writing about some of the risks related to stock market investing that I feel people should know more about.

A few of the topics I have covered so far are,

In this post, I focus on two issues that serve as underpinnings for the often futile pursuit of so-called “hot” stocks or other over-hyped trends in investing.

These are the “fallacy of composition” and the “bandwagon effect.”

Fallacy of Composition

Fallacy of composition refers to circumstances in which something that is true for a “part” may not necessarily be true for the “whole.”

For example, if one person stands up at a baseball game, he or she can get a better view. But, if everyone stands up, no one gets a better view.

Similarly, if only a few people bet on a particular horse at the racetrack, they can win big. But, if everyone bets on the same horse, the payoff will be small.

The same logic can be applied to investing.

A share of stock is essentially a claim on a company’s current or future earnings. If a company has a finite amount of earnings, its current stock price may represent a very good value for a certain population of investors.

But, if everyone were to buy the same stock, the fortunes could change.

First, the stampede of new demand would likely drive up the share price.

Sounds like good news, right?

Then again, maybe not…

  • New investors buying the higher priced shares end up paying more for the same proportional share of the company’s overall earnings.
  • If the company’s stock was formerly priced at $50 and paid a dividend of $3.00 per share, the yield would have been a respectable 6%.
  • However, if demand drives the price of the stock to $100 and the dividend per share remains the same $3.00, the yield now becomes only 3%.
  • New investors pay twice the original share price to get half as much yield in return.
  • New investors also bear the risk that the stock price may fall due to the perception that shares have become overvalued.

The point is, what may have begun as a good deal for some, can end up becoming not nearly as good a deal after everyone (or a sizeable population) gets involved.

The Bandwagon Effect

The bandwagon effect refers to incidences where demand for a stock, commodity, or other investment is driven by social pressures such as, “everyone else is buying it.”

In such cases, people are moved to act because they feel societal pressure and/or the fear that if they do not act, they will miss out on an opportunity.

When combined, fallacy of composition and the bandwagon effect can serve to drive prices of stocks or other investments to remarkably high and unsustainable levels.

In general, the later a person arrives to the party, the more he will have to risk, the less he will stand to gain, and the greater the likelihood he will lose.

Mother knew best

It turns out, your Mom knew a little something about the about fallacy of composition and the bandwagon effect when she told you,

“Just because everyone else is doing something doesn’t mean that you should do it too.”

Sage advice for both life and for investing…

The next time you see the masses chasing the latest hot stock or other investment trend, exercise caution.

Just because everyone else appears to be getting involved, doesn’t necessarily mean it’s the right thing to do.

Click here to learn the MOST important secret to retirement success.

So what do you think?

  • Have you ever seen a situation where what was good for a few was not necessarily good the whole?
  • Do you believe the bandwagon effect has had an impact on current U.S. stock prices?
  • Do you think stocks today are properly valued or out of line?
  • Can the fallacy of composition be applied to participation in the market as a whole?

The Risk of Sequence of Returns

For years we have heard it repeated over and over from the financial sector – and their willing allies in academia and the media – that investing in stocks will provide us the best possible returns over time.

In a recent post, I pointed out that one of the problems with this conventional wisdom is how one defines “over time.” Depending on when you invest, how long you stay invested, and the time frame in which you need your money back, can have a dramatic impact on your actual results.

But the difficulties don’t end there…

The risk of Sequence of Returns

This problem relates to the “sequence” or the order in which a person receives his or her investment returns while withdrawing funds from a portfolio during retirement.

It is an enormous concern, though few people have any idea it exists.

It is both uncontrollable and unpredictable, and, depending on how it plays out, it can lead to a the early depletion of person’s retirement fund.

Here’s how it works.

Consider the following three numbers:

-13, 7, 27

Add them up and you get 21.

Divide 21 by 3 and you get an average of 7.

This is called an “arithmetic average.” Similarly, the oft quoted “7% inflation adjusted rate of return including dividends on stocks over time” is an arithmetic average.

You can add the three numbers above in any “sequence” you like and you’ll still get a total of 21 and an average of 7.

-13 + 27 + 7 = 21. (21 divided by 3 = 7)
7 + -13 + 27 = 21. (21 divided by 3 = 7)
27 + 7 + -13 = 21. (21 divided by 3 = 7)

But, here’s the rub…

The order in which those numbers appear as “returns” in a person’s portfolio can have a major impact on how long his or her portfolio lasts during retirement.

Let’s take the same three numbers: -13%, 7%, 27%, and apply them in different orders as rates of return on a portfolio that is funding systematic withdrawals – just as would be the case for someone funding his or her retirement.

  • We’ll start with a $100 nest-egg and take $10 out of the portfolio each year to pay bills.
  • We’ll run two sequences, both with 7% average returns
  • The only difference between the two scenarios is the sequence or the order in which the returns are achieved.

In Sequence One, the order of returns will be: -13% in year one, 7% in year two, and 27% in year three. The returns will continuously repeat for a running average return of 7%.

In Sequence Two, the order of returns will be: 27% in year one, 7% in year two, and -13% in year three. The returns will continuously repeat for a running average return of 7%.

Let’s see what happens…

Sequence #1

Sequence Number 2

Sequence Two ends up yielding 44% more income than Sequence One (i.e. $168.37 versus $116.81) and lasts five years longer.

This happens with exactly the same $100 nest egg, exactly the same rate of withdrawal, and exactly the same long-term average rate of return.

The only difference is the unpredictable and uncontrollable sequence of returns.

These examples show that a difference in the order of returns – notably, more negatives in the early years just before or just after retirement begins – can have a dramatic impact on how long a person’s retirement money will ultimately last.

Click to learn more about how to overcome the risk of sequence of returns and guarantee you never run out of income in the future – regardless of how long you live or what the markets do.

So, what do you think?

  • Have you ever heard of the risk of “sequence of returns” before?
  • With tens of millions of people in 401(k) type plans that may be affected by this concern, why don’t we hear more people talking about it?
  • Does the example above illustrate the concept clearly enough?
  • What other issues does becoming aware of this risk bring to mind? (I’ll tell you one – women are the most at risk because they live substantially longer than men…)

Email me your thoughts or comment below.

The accidental rise of the 401(k)

Did you know that the 401(k) was never intended to be the primary vehicle to cover people’s retirement? In a cascade of unintended consequences, following no serious public policy debate on the issue, many Baby Boomers now find themselves at a destination in which they were never intended to arrive.

Take a look at this Marketplace article published in June 13, 2013. It features an interview by reporter Scott Tong with Ted Benna, widely considered to be the father of the 401(k):

Father of modern 401(k) says it fails many Americans

A few quotes and observations from the article,

  • Benna says, “…the 401(k) was never intended to cover everyone’s retirement.” Further, he observes that the current system is too complicated and incurs sizeable and unseen fees.
  • Per Benna, “Hey, if I were starting over from scratch today with what we know, I’d blow up the existing structure and start over. What I’m talking about isn’t 401(k). I’m talking about the way investing is done.”
  • The rise of 401(k) plans was accidental. In the past workers had company pensions and Benna was in the business of helping run such plans. In the 1970s, business owners were looking for ways to gain bigger tax breaks.
  • In 1978, Congress passed a hardly noticed add-on to the tax code in Section 401. It was a paragraph denoted with the letter “k.” It represented a tax break that allowed workers to put away cash on the side.
  • Added to this concept was the idea to allow a “match” or incentive to encourage workers to save more. Benna suspected the idea would take off. And it did.
  • In the early 1980s, with big companies leading the way, the new plans were offered in droves. Before long, even companies that never before had any type of retirement plan, were offering the new option.
  • Companies also started ditching what were perceived to be costlier traditional pensions plans – i.e. plans that offer a defined benefit at retirement, say 70% of a worker’s final salary payable for life.
  • Thus, the door was opened, on a completely serendipitous and unintended basis, to the DIY retirement era. Responsibility and risk for making plans a success was transferred from employers onto individual employees.
  • Another unintended consequence was that plans caused increased levels of stock ownership. Benna observes, “Unfortunately, the worst thing that happened with this wretched market is too many had the highest stock ownership that they ever had at the wrong time.”
  • During the mid-1990s bull market, participation in 401(k) type plans rose to 30 million Americans. In spite of this rise in popularity, roughly half of workers in America today still have no retirement plan.
  • Studies suggest that the typical middle class household as only about ten percent of the funds needed for retirement.
  • Benna never meant for this concept to become a do-it-yourself system that would replace traditional pension plans. But now, “This is kinda the whole enchilada…It’s not good, but it’s reality.”
  • The idea was “…simply a financial product that took off.”

So what are your thoughts? Should it bother anyone that such a major piece of piece of public policy happened essentially by accident? I suppose many good things got started that way. Is this one of them?  What are things people can do to make up for the shortfalls they are finding with their 401k plans? What have you tried?

Let me know your thoughts by email or in the comments below.