Post-Retirement Risks

2. Post-Retirement Risks • Longevity • Family issues • Health and long-term care • Business and public policy • Investment

3. 1. Longevity Risk • Outliving your resources • Problems created when death occurs • Death of a spouse • First-to-die life insurance

4. One Way to Plan? • Use life expectancy to plan • Many expect to outlive average • Many underestimate what is average • Add 5 or 10 years to the average life expectancy • Annuitize certain assets to provide lifetime income

5. Longevity Risk Source: Unisex Table V

6. Annual Percentage of DeathsPopulation of 65 Year Olds Life Expectancy Source: 2000 Individual Annuity Mortality table

7. Life Probabilities at Age 65 % Age Source: Society of Actuaries RP-2000 Table

8. The Uncertainty of Life • Highly uncertain variable • Consider probabilities based on certain ages • Not: “20 years at age 65” • But rather: “a 63% chance at age 65 that one spouse will live to 90”

9. Implications for Longevity Risk • More uncertainty • Order of death for a couple • Women tend to outlive men • Changes in life expectancy of survivor • Immediate financial needs • Overall capital needs • Flexibility: update longevity estimates as time passes

10. Managing Longevity Risk • Social Security • Annuities • Reverse mortgages

11. 2. Family Issues • Divorce and remarriage • Unexpected death of the retiree or an adult child with dependents • Job loss of the retiree, a spouse, or an adult child

12. Other Family Matters • Care of a grandchild or other dependent • Elder care for retiree parents • Paying for college while in retirement

13. 3. Healthcare and Long-Term Care Risks • Costs • Medicare, insurance premiums and coverage, prescription drugs, LTC • Geographic resources • Caregivers, facilities • Ability to live alone • COBRA • Advance directives • POAs, living wills

14. LTC Needs & Issues • Assisted living facilities • Average yearly cost: $28,548 • Nursing home facilities • Average yearly cost: $57,000 to $66,000 • Home health care • Average hourly cost: $18.12 • Trading premiums for expected benefits Source: MetLife 2003 Survey

15. Types of LTC Insurance • Indemnity policy – pays fixed benefit amount • Expense-incurred – reimburses for actual expenses up to a fixed amount • Integrated policy offers a total dollar amount toward different types of LTC services • Daily benefit amounts for nursing home care: $50 to $300 per day

16. LTC Policy Features • Definition of benefit triggers • Inflation protection • Coverages • ADLs • Adult day care • Assisted living • Nursing home coverage: at least 1 year of coverage • Coverage for Alzheimer’s • Respite care for the caregiver • Tax treatment: premiums qualify for 7.5% medical expense deduction

17. Housing Needs • Downsizing for early retirees • Relocation issues • Retiree expectations • Home as an asset • Natural disasters (e.g., earthquake or flood)

18. 4. Business & Public Policy Risk • Employer bankruptcy • Employee benefits reduced or eliminated • Insurer solvency • Employment risk • Physical ability • Job availability • Diversification • Employer stock concentrations • Annuity insurer diversification

19. Legislative Changes • Social Security • Later start ages for boomers • Medicare

20. Tax Rate Change Risk • Rate/rule changes • Income tax • Estate tax • Imagine making a retirement income plan in 2000 • Then EGTRRA 2001 • Sunset provisions Need to monitor proposals

21. Historical Income Tax Rates % Year 2004 top rate: 35%

22. Historical Income Brackets $ Year 2004 top rate: 35%

23. More Income Tax Rate Variables • “Assumed” lower tax rate in retirement • Match the tax bracket to the retiree’s income need • Bracket change due to death of a spouse • Lower expenses for the surviving spouse • From married filing joint to single

24. Married filing joint (MFJ) $70,000 = 25% income tax bracket If the surviving spouse needs only $50,000, then would be 15% bracket Single $70,000 = 28% income tax bracket If the surviving spouse needs only $50,000, then would be 25% bracket Change in Filing Status

25. The Best Tax Income • Capital gains • Which spends better: $1 of ordinary income or $1 of capital gain income? • The challenge: overcoming the “I don’t want to spend principal” mindset

26. Ordinary income tax $142,857 1% interest annually ($1,428.57) Lose 30% ($428.57) to ordinary income tax $1,000 left after taxes Capital Gain Tax Same $142,857 grows by 1% to $144,286 Sell $1,428.57 after one year Lose 15% ($214.29) to capital gain tax $1,214.28 left after taxes An “Ordinary” Illustration

27. 5. Investment Risk • Inflation risk • Interest rate risk • Market risk

28. Inflation Risk • Not of major concern right now • How you define it matters • Any fixed income stream is exposed • Interest in products with cost of living adjustments is low at present

29. Historical Inflation Rates by Year Source: Bureau of Labor Statistics

30. Rolling Period Historical Inflation Rates Source: Ibbotson Associates

31. Defining Inflation for a Retiree • One rate: CPI • By expense type • Healthcare • Food/utility • Home value • College • Others

32. Inflation by Components of CPI Source: Bureau of Labor Statistics

33. When Do You Want Your Risk? Source: Nick Murray, The New Financial Advisor. Used with permission. For broker/dealer use only.

34. Strategies for Handling Inflation Risk • Control expenses over time • Certain resources are/can be protected • Social Security • I bonds • Variable annuities • COLA annuities • Real estate and/or REITs • Stocks

35. Interest Rate Risk • Fixed income assets exposed • Interest rates are currently low by historical standards • Reinvestment rate risk • Call risk • But low rates are good news and good timing for some income products

36. Historical Interest Rates Source: Federal Reserve

37. Market Risk • Retirees have a high degree of concern with short-term volatility • Investment return variability • Ibbotson 5-, 10-, 15- and 20-year rolling periods

38. 150% 5-year holding periods 125% 20-year holding periods 100% Compound annual return 75% 50% 25% 12.1% 10.2% 5.5% 3.8% 0% -25% -50% -75% Reduction of Risk Over Time 1-year holding periods 1926–2002 Smallcompany stocks Largecompanystocks Governmentbonds Treasury bills Each bar shows the range of compound annual returns for each asset class over the period 1926–2002. This is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. 3/1/2003. © 2003 Ibbotson Associates, Inc.

39. Spot the Pattern

40. Market Risk Going Forward • Future expectations • Equity risk premium • Predictions & debates

41. A Deterministic Quiz Q. If you had $100,000 averaging 6% per year, and you withdrew 6% per year, what would your balance be at the end of 10 years? a. $100,000 b. $71,531 c. $0 A. Depends on two factors: 1. Are there any years with negative returns? 2. When do the losses occur?

42. $100,000 in Hypothetical Investment with 1st Year Loss

43. Recovery Returns • Average RoR required to get back to $100,000 (while still making withdrawals) is 50% in 1 year 14.1% in 8 years 11% in 18 years

44. Lessons Learned • Returns aren’t linear in the securities markets • Major asset allocation changes (more price/market risk) may be necessary to make up for a bad year early in the distribution years

45. Retiring in Different Decades • Retiree has $500,000 portfolio in either • All stocks, or • All bonds, or • 60/40 stocks/bonds • 5% withdrawal first year, indexed for actual inflation • Some years are better than others…

46. 1960

47. 1970

48. 1980

49. 1990

50. More Lessons Learned • The sequence of returns matters—a lot! • Linear assumptions (x% per year for 25 years) are unrealistic and dangerous to a portfolio’s health • We can know the past with precision, but the future is unknown • Monte Carlo simulations