How to raise clients' living standards — smoothly over time.
The stock market may be a wild and crazy ride, but it's generally (about 70 percent of the time) an uphill one. The trouble is, market averages lie. Where one ends up capital accumulation-wise depends not just on the market, but on the extent of one's spending along the way. Seems obvious, but too often spending is ignored in discussions of investment performance. For example, when we talk about market returns — “the S&P 500 did this-and-that over this-and-that period” — we assume every penny of income was reinvested over time.
Portfolio holdings must, of course, be geared to the client's situation. For young clients, with safe jobs, this seems like a terrific time to invest in equities via low-cost domestic and international index funds. It's hard to believe the market can drop further, but, then again, there's the experience of the early 1930s where it dropped — only to drop some more. By January 1, 1932, a dollar that had been invested on January 1, 1929 was worth only 47 cents in real terms. But by New Year's Day, 1937 it was up to $1.31. In 1937 it fell to 83 cents and took until the end of the War to surpass $1.31. By 2005, that dollar invested in 1929 was worth $105 adjusted for inflation. Today, well, better not say.
For older, retired clients, this is the time to establish an absolute floor under their standard of living. Doing so requires being able to accurately calculate their sustainable living standard, by which I mean discretionary spending per household member adjusted for economies in shared living. It may also require doing unorthodox moves, such as selling risky assets to pay off (or down) a mortgage.
The focus on clients' sustainable living standards is the hallmark of an “economics life-cycle, consumption-smoothing” approach to financial planning. For older clients I'd recommend constructing a safety-first plan which has them investing simply in long-term TIPS (Treasury Inflation-Protected Securities). I'd then try to optimize the plan. Many studies I have done over the years simply involve taking Uncle Sam's best offer. For example, a consumption-smoothing program we have developed at my company, Economic Security Planning, shows that, in general, clients who can wait until age 70 to take Social Security will generally be able to sustain a living standard that is 5- to 10-percent higher in each and every year for the rest of their lives (age 100 is the program's default value). The reason is that Social Security is, in effect, selling, at the margin, annuity insurance at very favorable rates. [For an alternative view on this, see page 67.]
Economists, such as me, are pro annuities (assuming they are inflation indexed and purchased from reliable counterparties.) Why? Annuities are complex, true, but they do very clearly show clients the need to plan as if their actuarial table will correctly predict their actual life expectancies — for the simple reason that, well, they might. Annuities also allow clients who are not too risk averse to take something of a gamble on their lifespans by spending relatively more when they are young. So, the spending pattern, not the planning horizon, is what is adjusted for longevity risk.
For married couples, waiting to collect one's retirement benefits can also permit the lower-earning spouse to collect spousal benefits for “free” once that spouse has reached his or her full retirement age. Doing so requires the higher-paying spouse to apply for retirement benefits upon reaching full retirement age and then to suspend collection. ESPlannerPRO, software that my company created for financial professionals, calculates free spousal benefits automatically. By “free,” I mean that the collection of spousal benefits won't affect the amount of retirement benefits the low-earning spouse ends up receiving. For some couples, this can amount to as much as $60,000 in extra income.
Clients who are already collecting Social Security have the option of repaying, on a tax-deductible basis and with no interest charged, all the benefits they received in the past and then reapplying for higher benefits. Such Social Security “start-overs” can make lots of sense for clients in their late sixties or early seventies, particularly if they a.) started collecting benefits at age 62, b.) might live to ripe old ages, and c.) have the cash to cover the repayment. How much sense, exactly? Well, the case study posted at esplanner.com shows a middle-class couple aged 70 with $200,000 in regular assets and $400,000 in retirement accounts, experiencing a 22 percent rise in their living standard. For the couple, repaying and reapplying for Social Security is equivalent to finding $220,000 lying on the street.
Convert — And Profit
Another option is converting one's IRA to a Roth in 2010, when there will be no limitation on doing so. In a recent case study, we considered a typical middle-class, 58-year old couple. We generated a 2.5 percent permanent increase in their living standard by having them convert $300,000 out of their $820,000 retirement assets to a Roth. The living standard increase rises to 5.2 percent if Uncle Sam raises tax rates by 30 percent starting in seven years.
The advantage of converting is subtle. Normally, we'd expect there to be a lifetime tax increase from paying taxes earlier than necessary; for example, we'd expect tax deferral plus the prospect of lower future tax brackets to make waiting to pay taxes the right move. But in this case, things are different thanks, in large part, to the taxation of Social Security benefits and the fact that Roth withdrawals aren't counted as part of adjusted gross income. Hence, withdrawing from a Roth, rather than from a taxable account late in life, triggers much less taxation of Social Security benefits than would otherwise be the case.
Taking Uncle Sam's best deal is not the only way to raise clients' living standards. Putting your clients into inflation-indexed annuities can go a long way toward calming their nerves and raising their living standards. Buying annuities means, of course, less left over for children if one dies relatively young. But clients who want to take care of their children are probably best served by making gifts to those children now and then annuitizing their remaining resources. This reduces the risk of your clients' running out of money due to exceptional longevity and ensures that their children will not need to bail them out.
Get Rid Of That Mortgage
Another potential way to try to raise your clients' living standards is to encourage them to pay off their mortgages. Using regular assets to pay off or pay down one's mortgage balance generally makes very good sense. If your client is holding Treasury bonds with the same maturity as her mortgage, selling the bonds and using the proceeds to pay off the mortgage represents a pure arbitrage opportunity. The bonds will invariably pay a lower rate of return than the interest rate paid on the mortgage. Having your client pay off her mortgage using bonds (the interest of which is itself taxable) will, if anything, reduce her taxes on balance. This is clearly true of clients who are taking the standard deduction or having their mortgage deductions limited under the income tax, which is something the Obama administration is advocating.
There is, of course, the inflation factor to consider in paying one's mortgage off (or down). If inflation goes up, clients who hold onto their mortgages get to pay with watered down dollars. But there is another possibility, particularly in this environment: Inflation drops or even goes negative. In this case, your clients' real mortgage payments go up, not down. So the inflation factor makes holding a mortgage a risky security. But if the regular assets that would otherwise be used to pay off (or pay down) the mortgage are being invested in equal maturity Treasury bonds, the inflation risk they bear is the opposite of that generated by the mortgage. Hence, the bonds plus the mortgage amounts they could pay off represent, in combination, a riskless asset whose return can be raised by selling the bonds and using the proceeds to pay off the mortgage.
Clients may protest that it is important to own other investments (stocks and bonds other than Treasuries) and to pay off the mortgage at a later date. For such clients one might want to raise the following hypothetical: “Suppose we use a portion of your regular assets today to pay off your mortgage, so that tomorrow you have no mortgage and less invested in risky securities. Would you, tomorrow, want to borrow money to invest in risky assets? If the answer is no, then we need to pay off your mortgage today, because right now you have effectively chosen to borrow to speculate on the market.”
What about clients with no mortgage? When should they start withdrawing from their retirement accounts and which accounts should they tap first? From the case studies we've considered, it appears that waiting as long as possible to start retirement account withdrawals and then taking money first from tax-deferred accounts and second from Roth accounts, provides the highest living standard, in general. I say in general, because each household is different in large numbers of ways and even small differences can matter a lot for these decisions.
Yet another question economics-based planning can help resolve is whether to take one's pension in a lump sum or as an annuity. Assuming the pension is not inflation-indexed, the annuity option will be best if future inflation is expected to be low to moderate. But if expected inflation is high, which certainly seems the case given the extent to which the Federal Reserve is printing money, it will be best to take the lump sum rather than get paid one's pension in watered-down dollars.
This partial list of ways to safely raise your clients' living standards makes clear that financial advice goes far beyond simply investment advice. Compared to a regular financial plan, the decisions referenced above can potentially raise clients' living standards by a quarter or more. That's a huge gain, and such an optimized safety-first living standard plan may be one clients can actually follow.
— Laurence J. Kotlikoff is a professor of economics at Boston University and co-author of Spend ‘Til The End.
On May 14, Prof. Kotlikoff will appear on “Coffee Break,” Registered Rep.'s new webinar series appearing every other Thursday. In his 30 minute webinar presentation, hosted by Rep. Editor-in-Chief David Geracioti, Prof. Kotlikoff will describe the “economics-based, consumption-smoothing” approach to financial planning and provide examples of ways to safely (and yet materially) raise your clients' sustainable living standards. For more, please go to RegisteredRep.com and click on the CoffeeBreak button on the homepage.