Financial Frontlines®

This article was written by BG Gary G. Ottenbreit, Retired Brigadier General, Connecticut Army National Guard, and a new Life Member of MOAA. BG Ottenbreit is currently the District Manager for the Social Security Administration in New Haven, Connecticut, with more than 30 years of experience working in this agency.  This is his first blog post. These views are his own, and not necessarily the views of the SSA.

What is retirement? A century ago, it simply meant an event – when you opted to end your nine to five grind in the workforce. When a vast majority of the population found they could not afford that option, the government stepped in and passed the Social Security Act. Since then, the meaning of retirement has evolved into a ‘state of being’, an attainment of a certain age, financial stability. I believe that retirement has evolved sufficiently to be included as another step in one’s ‘life planning’.

As parents, we raise our children, educate them in preparation for life and then continue to offer support as we send them off into the world to make it on their own. We hope that sometime between their High School and College years they make their life plan. They make career choices, decide where to live, they may choose partners and/or raise a family and, yes, and if they are wise, begin to plan for their retirement.

For the purpose of this article, let us simply define retirement as that point in time when you are no longer in the work force. The funds you use to live your life are primarily income and not earnings. The goal, in retirement, is to maintain a life style that is equal to, or better than, the one you have grown accustomed to while you were working. It is not a question of if you will retire, but when, and planning for it will make the transition smoother. Retirement is a personal choice based on your ability to work, your choice to work or not, and your financial circumstances.

When conducting presentations, I often refer to Social Security benefit as the foundation. Social Security was designed to replace only one-third of your earnings. The other two-thirds should come from other sources; a pension from your employer, personal savings, investments, or other income. The combination of these resources will fund your retirement and if you planned correctly, sustain you as you move through them. However, the topic of this article is not Social Security – it is about how critical the savings portion is to your plan for retirement. Saving is the only building block that you can control.

A Social Security benefit and a company pension are subject to rules and predetermined formulas as are investment returns and rental income are subject to the current market value therefore, all are out of your control. However, you can control how much money you can save.

I have read articles from renown financial planners that recommend (retirement) planning a replacement rate of income for earnings at 70 to 80 percent. At retirement, to make your ‘nest-egg’ last, you should plan to withdraw only 4 percent a year. This is not an easy feat and certainly difficult to attempt to accomplish over a short period.

It is never too late to start planning for retirement. However, starting early means additional years of preparing and the less financially painful it will be to save. Saving smaller amounts, consistently over a long period, is easier than saving larger amounts of money over a short period. Just as important is tracking the growth of your retirement ‘nest-egg’. Review the year-to-date benefit projections from your retirement income instruments annually. [Analogy: You are reviewing Course-of-Actions and planning the battle.]

Waiting until mid-life to plan will probably extend the number of years you will need to work, force you to supersize your contributions and/or possibly cause you to alter your present and future lifestyle. [Analogy: The battle is half over and although you have not lost ground you have not gained any either.]

Waiting until you are within five years of retirement leaves you practically no room for improving your financial position. At best, you could rearrange your investment accounts and create a tax strategy. [Analogy: You are in retrograde.]

Visiting the Social Security website www.socialsecurity.gov can be helpful. There are many links and articles related to retirement planning. Two valuable requests that you can make online are the benefit estimate and the annual statement. The benefit estimate will not be exact, depending on how many additional years you will work, but it provides an excellent reference point. The Annual Statement lists your FICA wage by year, match the statement amounts against your pay stubs and/or tax returns for accuracy. Note: Later this year Social Security Administration will offer an Internet MySocialSecurity portal offering personalized service after the user registers with a self-selected username and password.

Contact the financial consultants from MOAA and/or USAA – I have and found them to be helpful. I stated earlier that it is never too late to start, however, the reverse is also true – it is never too early to start. Make sure that retirement planning is part of your children’s education.

Were you disappointed when Social Security Administration (SSA) decided to no longer mail annual earnings statements? Well, there’s great news!

SSA plans to resume mailing paper statements later this year for workers age 25 and older.

In February, SSA resumed mailing paper statements to workers age 60 and older, if they were not already receiving social security benefits.

Why is this important?

Well, for many of us (or family members) who are between the ages of 40-60 and not quite tech-savvy or receptive to accessing personal documents online, this is huge.

This statement provides annual social security earnings and benefits information. It includes estimates for disability and survivors benefits, making the statement an important financial planning tool.

Social Security benefits are based on average earnings over a person’s lifetime. Therefore, it is important to review this statement annual to ensure the information reported is accurate.  Inaccurate information could affect the benefits to which a person may be entitled.

SSA will continue to offer online access for working individuals ages 18 or older. To access statements online individuals will need to provide information about themselves that matches information already on file with Social Security Administration. For more information visit the SSA website.

The Roth Thrift Savings Plan Option will soon be available. Most agencies and services can begin accepting elections for Roth (after-tax) contributions on or about May 07, 2012. Your question might be “should I invest in Roth?” The answer may come down to whether you want to pay Uncle Sam now, or pay him later.

There are two distinct types of contributory retirement savings in 401(k) type plans, like the TSP, or IRAs – traditional or Roth. Traditional plans allow you to delay the payment of income taxes (payroll taxes – FICA and Medicare – must still be paid) on your contribution to a qualified retirement account. Uncle Sam provides an incentive to save for retirement by allowing us to postpone the tax due on those funds until we receive them. The funds are deposited into your account before federal and state, if applicable, income taxes are imposed. The funds we contributed, plus the employer match, if any, and any growth within the fund will then be taxed at our marginal tax rate upon receipt.

We may begin a penalty-free withdrawal from these tax-advantaged accounts at age 59.5. Minimum distributions are required beginning at age 70.5. This tax deferment is significant. If you believe that your tax rate in retirement will be lower than it is now, then a traditional TSP may be for you. However, many military folks will be in higher tax brackets once they lose their tax exempt allowances and their ability to claim legal residence in an income tax exempt state. Making a Roth contribution while still serving may be a smart thing to do.

No one can predict with certainty what tax rates will do in the future, of course. Let’s just agree that there is pressure to increase taxes, and that pressure is unlikely to dissipate with so many Baby Boomers entering their retirement years. Uncle is going to want to collect the taxes he’s postponed for so long.

Our other choice is the “pay Uncle Sam now” election, or Roth. There is no immediate tax break with Roth TSP contributions. The break comes later. Since all contributions to a Roth TSP are made after-tax, later withdrawals, including all growth, are tax-exempt.

Many financial planners encourage their clients to set up a stream of taxable and tax-free dollars to use in retirement. Roth contributions are a great way to do this. If you’re currently serving military, you know that you already receive a significant tax break through your allowances, primarily BAH and BAS. Can you afford to pass up another break now to receive one later? Many of you can.

What other ways can you use to receive tax-free dollars in retirement? Roth IRAs are another investment you can make. But Roth IRA contributions begin to phase out for singles making $110,000 and for couples at $173,000, and are proscribed at $125,000 and $183,000 Modified Adjusted Gross Income, respectively. Sounds like a lot of money, but with a military pay and a working spouse, or military retired pay and a good second job, many retirees bump up against those limits. The Roth TSP or 401(k) contributions have no income limits.

A few cautions. Employer matches must be applied to a traditional 401(k). That’s not an issue for military folks, but someday it might be. It is a big part of the equation when you’re in a job with an employee match – those funds can’t go into a Roth 401(k).

If you open a Roth, or split your contributions between a traditional and Roth TSP, the annual contribution limits still apply ($17,000 in 2012, plus a $5,500 catch-up contribution if you’re age 50 or more). You don’t get another bite at the apple just because you opened another account. Any employer match you might receive does not count toward these contribution limits.

Uncle Sam has given you a choice. You can pay him now or later, so do your homework and make your decision.

Detailed information on the Roth TSP is available on the TSP website.

Do you have cash value in a life insurance policy or a commercial deferred annuity and own a long term care policy? If so, it may be possible for you to use the money in your life insurance or annuity to pay for your long term care insurance without paying taxes on the life insurance or annuity withdrawal.

Normally the withdrawal of funds from life insurance cash value or a deferred annuity triggers a taxable event. The portion of the withdrawal that’s considered the ‘gain’ is taxable as ordinary income.

Section 1035 of the Tax Code has always allowed tax-free exchanges of entire life insurance and annuity policies; even tax-free partial payments between life insurance policies and annuity contracts. However, now an enhancement to Section 1035 took effect on 1 Jan 2010 that added long term care policies to the mix.

This means money from the cash value in life insurance policies or deferred annuities can be withdrawn and used to pay premiums of long term care insurance without causing a taxable event.

Keep in mind, we talking tax code here so there are catches. There are so many different types of life insurance, annuities and long term care policies that not all of them qualify. Only your insurance provider, or possibly your financial advisor, knows for sure. Retirement accounts don’t qualify—annuities within an IRA or an annuity form of pension plan.

If your policies are eligible, the transfer must be worked between the two insurance companies. They know the process and paperwork and the transaction has to be a direct transfer from one company to the other.

Besides U.S. Code Title 26, Section 1035 of the tax code, also see IRS Internal Revenue Bulletin, 2011-36, Sept 6, 2011. Your long term care insurance provider will probably be your best bet for information and action.

Part 1    Part 2

ALLOCATION–Managing Your Portfolio

Allocation, the mix of stocks, bonds and cash (among other things) you have in your investment account.  An illustration of an allocation is 80% stocks, 15% bonds and 5% cash.

Over the long haul, 10+ years, stocks (TSPers: C, S, I funds) outperform bonds (F fund) and bonds outperform cash (G fund).  Stocks are more volatile than bonds and bonds more than cash.  So put those stats together and you get greater returns over time with stocks but the ride will be much more volatile.

I know some of you bond people will call me on the issue of bond returns over the last few decades.  But as I discussed in my last post, that was due to a unique situation where the planets aligned for bonds during that period of time and those days are over.  Now we revert back to normal.

A better return over the long term with lots of ups and downs in the short term, it’s a perfect environment for averaging down into stock funds.  Taking the long view, you’ll be glad every time that stocks drop because each dip is a chance to rake in more shares before the next higher advance up the stock chart.  Notice the chart below with the performance of various asset classes over time and the levels of volatility.

The Importance of a Big Picture View

A big picture view is critical to serious investors.  We humans tend to focus on current events.  And the media reinforce a short-term view.  Managing by current events kills investor returns.  Big picture wise, you can see from the chart below how the down periods (peach colored areas) don’t last long enough to buy as many shares as you would like to buy.  Technically, even when viewing the scary period of the 1920s and 30s, the market hit a bottom and started up again.  So even though the market is down from a previous high, all the shares bought on the way down and at/near the bottom provide a very quick profit.

The DOW industrial index was up 72% of the time going back to 1896.  Think about that; you only had 28% of the time to accumulate wealth in down markets.  Think of the world’s history since 1896.  Up 72% of the time in light of some very bad periods of history.

For those who question the “averaging down” strategy, they usually point to how it doesn’t work in down markets.  Granted, if you only evaluate the strategy during the period Oct 2007 to Mar 2009, it doesn’t work.  But after what I’ve explained, how likely is that? Or how likely is it that the markets take a cataclysmic dive and never come back up?  If they did, nothing else would matter.  A possible concern could be a short-term period where there’s a dive in the market and you don’t have the time to recover above your average costs.  Again this is for a short-term investor.  If you’re a short-timer, you should use other strategies anyway.

How about you folks who prefer to be safe and conservative?  See how much potential wealth you sacrificed and how much more you’ll have to contribute to make up for returns you won’t get?  And this chart doesn’t factor the eroding impacts of taxes and inflation.  What’s your return in bonds and cash after taxes and inflation?

Manage your portfolio using your allocation.  People a long ways from retirement should be heavy stock people.  People closing in on retirement, inside 10 years, want to shift gears.

Younger investors want and need the volatility in combination with the greater returns to build wealth.  Younger folks are accumulators of wealth; that’s your mission.  The value of your account is not an issue at your point in time.  The accumulation of shares is everything.  Lots of ownership creates wealth.

More “seasoned” workers and investors need to start the shift from share accumulation to the protection of account value.  When you retire, that money has to be there.  You don’t want to be one of those folks who get close to retirement and the stock market dumps causing your nest egg to crack.  If your portfolio is too stock heavy and the market dips, down goes the account value and now you’re faced with a lower standard of living or working longer.  Not pleasant choices.

Here’s how to manage your portfolio and make your allocation work for you.  The following chart is based on actual situations.

The S&P500 index bombs out 48% between September 2008 and March 2009.  You see how different allocations reacted to the 48% drop in the pie charts.

Younger folks.  The 80/20 portfolio dropped 38%.  Excellent!  Tell your buds your portfolio dropped 38% and you love it and catch their reaction.  You’re accumulating wealth as the market drops.  Your friends won’t be because they’ll be taking action to stop the bleeding.  Don’t feel pressure to follow the herd.

Seasoned folks.  You’re protecting value with a 40/60 split.  You still went down but it’s a more reasonable amount.  Actually, you could have protected more value with fewer stocks but you have a balancing act to keep in mind.  You’ll be retired a long time; 20, 30, 40 years.  Your accounts still have to grow and have to offset taxes and inflation to ensure you don’t run out of money.  So you can’t totally shun stocks.  Stocks provide the ability to grow your money over time and offset the impacts of taxes and inflation.

That’s it.  Stop trying to time the market by guessing when to buy or sell shares of specific funds in your account.  No one knows when it’s the best time to buy or sell and you have better things to do in your life.

We have one more strategy to discuss, rebalancing.

REBALANCE–Buy Low; Sell High, Like You Mean It

Rebalancing is a simple concept.  You have a set allocation.  Over time the stock and bond markets go up and down.  Eventually, your allocation will get out of balance.  Say your allocation was 80% stocks, 15% bonds and 5% cash.  As the markets rise and fall, your account may come to look like this, 70/25/5.

Just ask your 401k or TSP provider to “rebalance” your account back to your established allocation of 80/15/5.  To put your allocation back in original shape, the plan administrator will have to sell bonds funds.  The bonds are at 25% and they should be at 15%.  Technically that means you have a profit in your bonds.  You sell the bonds which is selling high; a good thing.  The stocks are down from 80 to 70%.  The profits from the sale of bonds will be used to buy stocks.  The stock are down at this point so you will be buying low; another good thing.  Now your allocation is back to normal.

Do this annually.  Each time you do it you will be buying low and selling high.  Something we can’t do on purpose.

See Part 1      See Part 2