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What I Learned at Retirement Income School . . . and How It Can Benefit You - Michael M. McDonough, Inc.
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What I Learned at Retirement Income School . . . and How It Can Benefit You

What I Learned at Retirement Income School . . . and How It Can Benefit You

Multifaceted risks abound, the planning horizon is unknown, and complexity is escalating in a dynamic and rapidly changing environment. My deep dive into the tools, tactics and processes of retirement income planning can help you recreate a reliable paycheck.

Today’s retirees face challenges on several fronts in their quest to avoid outliving resources and meet legacy objectives. Risks stem from economic and market uncertainty, inflation, diminished social safety nets, significant and escalating healthcare costs, and low current interest rates. These and other issues must be confronted amid relentless complexities of everyday life, often as our mental and physical abilities are in decline. An effective retirement income plan is needed to maintain a desired lifestyle for what for most will be decades in retirement; it can profoundly impact the quality of our lives.

Specialized knowledge, experience and education – and the right tools and processes – are needed to guide clients through healthcare, housing and lifestyle choices, and apprise them of options for monetizing assets over a retirement horizon of unknown duration.

Many of my clients are either ‘on-deck’ to retire within five years, or already retired. This cohort is generally drowning in information yet starving for knowledge, and shares broad concerns revolving around their kids, their parents, their health and the health of their spouse. They want to shed stress and gain the confidence derived from greater clarity and understanding. Informed clients can better assess alternatives to integrating risk mitigation with the strategies, products, and estate issues of the retirement income plan.

Income planning is at the core of retirement planning and retirees are looking for a reliable process to recreate a paycheck. Desire to help clients negotiate the high-stakes ramifications inherent in retirement compelled me to earn the Retirement Income Certified Professional (RICP) designation from The American College. My digital learning experience included lectures via the internet, case studies, technical material from a variety of sources, and nearly 800 pages of study guide notes over three rigorous courses.

So . . . what exactly did I glean from the curriculum? For starters, how to help clients determine an optimal retirement age and Social Security claiming strategy.

Beyond a deep dive on sources of retirement income and considerations for initial and on-going plan management, the RICP curriculum explored determining the best health insurance options, retirement housing decisions, and tax-efficient strategies for withdrawals from qualified retirement plans and IRAs. Considerable attention was devoted to the implications of aging, including long-term care needs, and the many research-based approaches to help ensure retirement income lasts a lifetime.

One emergent theme: the constructive impact working longer – even if for only an additional year – has on retirement security. The retirement horizon needing funded is reduced . . . which helps to defer the Social Security start date . . . which increases a guaranteed, inflation-protected lifetime income stream . . . which can have profound survivor planning implications. Even where the spouse with the higher Social Security lifetime benefit has a diminished life expectancy deferring claim initiation may be warranted since a surviving spouse gets the larger of their own or their spouse’s benefit.

Optimizing the Social Security Claiming Decision

More than half of all recipients accept a materially reduced amount by claiming Social Security as early as possible (age 62). This is a costly mistake for many (not all) couples as it saddles a surviving spouse with a lower benefit for the balance of his or her lifetime. While the claiming decision is nuanced, betting on dying young can be a poor gamble since losing means living a long life with too little income.

Many question the sustainability of our Social Security system and whether it will be around for them. Nothing is certain, but the odds are good that it remains in effect for several more decades, likely in a form not dramatically different than today’s. The sooner corrective measures are implemented the more impact they’re likely to have. The proverbial wisdom resonates: a stitch in time saves nine.

Social Security’s value is significant, and coordinating an optimal claiming strategy needs to be part of a comprehensive retirement income plan. Every case is unique and demands a personalized analysis. My firm’s emersion into social security education has led to sophisticated optimization software which considers all scenarios in generating a recommendation.

Medicare

Misperceptions on Medicare abound, and missteps can be costly. It is far from free, by no means covers everything, and comes with no maximum out-of-pocket limitations. Enrollment deadlines are important. Miss the initial enrollment at age 65 and, unless covered through employment, you’ll pay an additional 10% of your premiums for every year you were late, an annual penalty for the rest of your life. Similarly, enroll late for Medicare Part D (prescription drug coverage) and pay another annually penalty for the rest of your life. Look for private Medigap coverage (pays for most of the gaps in Medicare, such as deductibles, copays, and coinsurance outlays) outside of “open enrollment” and risk losing your right to be covered irrespective of pre-existing condition(s).

Medicare is not free, your out-of-pocket expenses are not limited, and it does not cover some important, basic items including potentially budget-busting custodial long-term care.”

Medicare does not cover most dental care, eye exams relating to glasses, hearing aids, dentures, cosmic surgeries, acupuncture, and home modifications related to disabilities. Importantly, it does not cover custodial long-term care, the cost of which can be prohibitive. The importance and complexity of Medicare requires specialization, which is why my team collaborates with a dedicated Medicare specialist.

Income Tax Planning and Tax-Efficient Investing

Income tax planning is important in retirement for less-than-obvious reasons, including what some refer to as “stealth taxes,” or less visible governmental levies, many of which reference taxpayers’ modified Adjusted Gross Income (AGI; line 37 of the Federal Form 1040). Additional levies tied to modified AGI impacting retirees include taxation of their social security benefits, phase out of deductions and exemptions, and the amount paid for Medicare.

You should be cognizant of ‘stealth taxes’ and how your income tax return drives them. They are not likely to go away anytime soon.”

The importance of managing your tax posture via prudent retirement withdrawal strategies, tax-efficient investing, and other measures is seen in Medicare Parts B & D premium determination rules. Eclipse modified AGI of $85,000 (single filers) and $170,000 (married-filing jointly) by even $1.00 and you’ll incur the additional income- related adjustment amount. Hit the highest (of four) modified AGI thresholds ($160,000 and $320,000) and you’ll pay more than triple the base premium rate for Parts B and D – an additional outlay of more than $4,000 per person (per year). Clients should know they can petition the SSA for reconsideration of this AGI-driven Medicare penalty due to a change in life circumstances (retirement, reduced work schedule, divorce, death of spouse, amended return) when current year income is below the threshold income for the year used to calculate the premium [two years earlier; i.e. 2016 AGI drives any additional 2018 premium].

Non-itemizers should consider the “qualified charitable distribution” (QCD) technique for their contributions. A QCD entails a direct distribution from the IRA of someone 70.5 or older to a qualified charity. The distribution / contribution counts toward taxpayer’s annual required minimum distribution and yet is excluded from his / her taxable income. Such tax treatment is preferable to the alternative of taking a taxable IRA withdrawal and separately gifting money to charity, even if taxpayer itemizes his / her deductions as it depresses the modified AGI potentially driving stealth taxes. Stealth taxes aside, a QDC still enhances post-tax economics to a non-itemizer’s charitable giving.

Long-Term Care Needs

Long-Term Care (LTC) includes a broad range of skilled, custodial, and other services provided over an extended period in various care settings, due to chronic illness, physical disabilities, or cognitive impairment. Alzheimer’s and dementia are the leading reasons for needing LTC. Care settings can include day care centers, nursing homes, assisted living facilities, and the patient’s home. LTC is often provided by loved ones in the home, a solution which can be (generally is) stressful and challenging to the care provider (often female) on several fronts including degradation of caregiver’s own health – and income.

Odds of a person needing LTC during his/her lifetime are all over the place, and the resulting statistics often reflect how the question is framed. The “National Medicare Handbook” estimates 7 out of 10 in the US will eventually require LTC services (for some period). Meanwhile, a healthcare actuary and LTC specialist I work with believes approximately 1/3 of humans have some form of Alzheimer’s gene which symptoms will eventually emerge if we live long enough. When pressed for odds that a LTC insurance policy would pay off, he placed probability of a healthy 65-year-old male and female needing care for more than 90 days (the standard policy elimination period) at approximately 28% and 40%, respectively. Thus, his odds of “at least one of a couple” needing LTC services after 90 days: 1 – (.72 x .60) = 57%.

Genworth’s June 2017 survey showed the annual median nursing home cost in Pennsylvania exceeded $120,000 and $111,000, respectively, for private and semi- private rooms. At the same 4% compounded rate of inflation PA experienced over the past five years, those annual costs would grow to $263,000 and $243,000, respectively, in 20 years – when today’s 60 – 65-year old’s may require care.

Options for paying for LTC services include self-funding, governmental programs, LTC insurance, and charity. Self-funding entails consuming personal resources, which can conflict with your legacy objectives. The main governmental program paying for LTC is Medicaid (welfare for the indigent) – not Medicare, since Medicare was not designed to cover LTC needs and, in fact, provides only limited coverage for some post-acute care services under strict eligibility requirements. Medicaid picks up the tab for 64% of the nation’s nursing home residents. Some believe it has become a middle-class program as many undeserving-not-poor ‘game the system’ by legally circumventing entitlement rules; this ‘open secret’ is often abetted by elder care attorneys. With the Medicaid system fiscally challenged and buckling under the weight of demographic realities, my guess is loopholes are closed and Medicaid becomes much less exploitable in the years to come.

“Options for paying for long-term care services include self-funding, governmental programs, LTC insurance, and charity. The days of legally circumventing Medicaid entitlement rules are likely numbered.”

The plan for LTC is most effectively addressed far in advance. Proactivity is rewarded on two fronts: it is easier to save over a longer period, and it affords access to more planning solutions. Long term care insurance (LTCi) can be a highly effective alternative, but it can only be purchased while we are still young and healthy enough to qualify.

Beyond the peace of mind at point of claim LTCi provides, several financial benefits to using traditional LTCi as an alternative to self-funding exist. Significant coverage in the event of a LTC need can quickly recoup the money paid into the policy. The benefits received from a tax-qualified LTCi policy are generally received tax-free. In contrast, self-funding may require liquidating assets which trigger a taxable event or entail sub-optimal timing.

Tax benefits to business owners can be particularly attractive. Similar to group health insurance, LTCi can result in the ‘holy trinity’ of tax treatment: deductible to the business, no imputed income to the employee or owner (insured), and no income to the insured upon receipt of benefits. Coverage for spouses of employees receive the same tax advantages. [Self-employed and 2% or greater owners of tax conduits may have premium deductibility limited to the age eligible premium limits]. The opportunity can be further enhanced by discounted group pricing and the ability, via executive carve-out arrangement, to legally discriminate as to which employees receive the benefit.

Myriad LTCi solutions are available in today’s marketplace. Options range from plans providing pure LTCi coverage after a brief elimination period to plans allowing access to a life insurance death benefit to fund qualifying LTC needs (via an optional rider), to annuities with optional riders providing a leveraged benefit to pay for qualifying care.

Both life insurance-LTCi hybrids and annuity-LTCi hybrid solutions feature income tax free liquidity for qualifying LTC needs, and both effectively obviate the “use it or lose it” concern integral to most insurance. Tax-deferred gains inside an annuity can potentially permanently escape taxation if such an annuity were to be exchanged (tax- free) to an annuity containing a LTC rider, with eventual withdrawal driven by a qualifying LTC need.

In addition to assuring legacy objectives are efficiently met, life insurance can help with premortem morbidity planning. While the insured is still living, the tax-free death benefit can be accessed (via rider) to cover a qualifying LTC need. To the extent the LTC peril has been addressed, client has more latitude for planning to pass wealth to loved ones. Certainty and tax advantages augur for life insurance as an efficient way to address legacy desires, and its death benefit is exempt from Pennsylvania’s Inheritance Tax (generally triggered at or near dollar-one of estate value) whether or not held by trust.

Three Principal Retirement Risks:

While the Society of Actuaries has identified 15 unique retirement risks, three principal ones relate to longevity, inflation and market volatility (sequence of returns) risks. In addition to mitigating Longevity Risk, Inflation Risk and Timing Risk, a robust retirement income plan must often overcome hurdles such as lack of a pension (or other reliable long term income sources), low interest rates, and obstacles unique to each client’s situation.

  • Longevity risk is the potentially adverse economic consequence of a long life. Longevity magnifies many retirement risks and amplifies the risk of outliving one’s savings. Humans have never lived as long as we do today, as the Society of Actuaries placed odds at nearly 50% of one spouse of a couple, both age 65, living to age 95 based on 2010 mortality tables. Living a longer life means income is needed for more time, which entails longer exposure to the impacts of inflation and market forces, and can lead to additional health issues, including the potential for a financial independence-threatening need for long-term care.
  • Inflation risk relates to the concept of purchasing power – how much our money buys. Dubbed the “invisible tax,” inflation risk is the risk that rising prices could threaten your future standard of living. The compounded effect of inflation over longer periods is deceptively powerful and different types of expenses tend to inflate at different rates. The inflation rate for healthcare costs, for instance, has historically increased at a greater rate than ‘general’ inflation, while the increasing share borne by consumers (deductibles, copays, etc.) amplifies the burden. Hence, the planning imperative to understand the linkage between health and wealth.

The personalized estimate of post-retirement, two-spouse, out-of-pocket healthcare expenses I favor was developed by an interdisciplinary team of physicians and actuaries. The resultant, year by year, cumulative lifetime cost estimate is illuminating . . . and generally disturbing. Research conducted by Fidelity Benefits Consulting estimated a 65- year-old couple retiring in 2015 with Original Medicare will need an average of $245,000 to cover medical expenses throughout retirement, up more than 11% from their retiring in 2014 estimate. Other estimates, such as provided by the Employee Benefit Research institute, are decidedly higher. Out of pocket costs track health status, and the longer one lives the more medical care they require, so that requiring care later rather than sooner allows inflation more time to compound to our detriment. Costs can vary considerably, amplifying the need for realistic planning and the financial incentive to get and stay healthy.

  • Market volatility is challenging enough in the ‘accumulation phase’ (pre-retirement), as it is the principal catalyst for investors’ behavioral bias to buy high and sell low. Volatility comprises an additional, insidious, and important risk unique to the post-retirement period (‘decumulation phase’) known as the “Sequence of Returns Risk,” or Timing Risk. Portfolios are susceptible to more rapid depletion when they are funding withdrawals at a time of market decline. Thus, Timing Risk is picking a bad year to retire – like 2000 or 2008, just when stock prices are poised to fall. As a reminder, this advertisement in the London Financial Times fairly represents the clairvoyance and market timing ability of the greater Financial Advisory complex:

          “The Clairvoyant Society of London will not meet Tuesday because of unforeseen circumstances.”

While today’s synchronous global expansion is proceeding apace, our domestic stock market as a percentage of GDP is approaching its dot-com bubble peak valuation and we’re in the ninth consecutive year without a meaning stock market correction. The world is awash in global debt including an underappreciated pension crisis. Little risk is priced into global bond markets even as the world’s central banks must eventually unwind unprecedented quantitative easing (QE), a profoundly important macro process having no precedent. If the massive QE brought much higher asset prices with benign volatility, little inflation and low interest rates, what will its reversal bring? No one knows and there is but one certainty: market risks will always be present.

Financial planning objectives and factors of an economic, investment, behavioral, and health nature are often more correlated than is apparent. As an example, consider the following. Fundamental to retirees’ housing decisions is where to live. As income from employment goes away, funding real estate (property) taxes often rises in significance in residency decisions relative to federal (if not state) income taxes. Local sales taxes can be another consideration. Meanwhile, pensions of every stripe (corporate, federal & municipal governments, overseas obligors, etc.) are dramatically underfunded. Capacity to meet these obligations and certain post-retirement healthcare promises is insufficient, and corporate leaders and politicians continue to “kick the can down the road” by deferring appropriate (timely) action. Leaders appear to believe, rightly or wrongly, that they must choose between (i) openly discussing realities and options to rectify the underfunding and (ii) keeping their jobs. Faced with obligors reneging (haircut to pensioners) or taxpayers shouldering the burden, compromise is a likely outcome, which means both material benefit cuts to pensioners and tax increases to property owners. Thus, in evaluating costs of living in various locations, it may be prudent to consider both current and future local tax burdens as the inevitable compromises play out.

Worthwhile Links

Here’s a vignette exploring the three aforementioned key retirement risks and a practical approach to managing them: WWW.MMCDONOUGH.INCOMEFORLIFEMODEL.COM.

Here’s a brochure illuminating how a time segmentation strategy to retirement investing – dividing wealth into separate “buckets” – helps reduce key risks: https://app.box.com/s/fi6mvr69t56g6724kr9ip2q03t0cdo8r.

“Both the movie and the brochure communicate clearly and provide a solid return on your time.”

Other Issues Examined

Beyond the aforementioned, the RICP curriculum went into detail on a host of additional considerations: retirement portfolio construction and integrating various approaches for converting assets into income; wealth protection issues; ethical issues; Federal and civilian military benefits (presently undergoing revision); and planning for executive benefits. It also examined several techniques for closing ‘income gaps‘ (shortfalls) such as integrating home equity into a retirement income plan, including use of reverse mortgages.

A plan for creating retirement income should try to anticipate and mitigate major risks to the extent possible. Converting savings into sustainable income for one or two lives requires good decisions in an increasingly complex and uncertain world, a challenge exacerbated by persistently low interest rates and ostensibly elevated asset prices. With proper guidance, however, the job is not insurmountable.

Retirees’ reward for developing and implementing the right retirement income plan and process goes beyond the direct, high-stakes financial ramifications inherent in retirement. The more subtle yet important ancillary benefit is in having less stress, more confidence, and the satisfaction of successfully addressing another life challenge. 

Michael M. McDonough, RICP®, AIF®, CPA (inactive)
Michael M. McDonough, RICP®, AIF®, CPA (inactive)
michael@mmmadvisory.com