October 2005

Asset “Option Plays” for Managing Retirement Risks

One of the most fundamental shifts that most people need to make as they transition into retirement is a shift in emphasis from opportunity management to risk management.  One reason for this, of course, is that after retirement most of us have much less opportunity to replenish assets that are lost as a result of encounters with one of the many risks that threaten them.

A risk-managed approach to retirement identifies various threats to assets and develops strategies for dealing with these threats.  The most significant threats include: taxes, inflation (and conversely, recession), investment losses, and health care/ long-term care risks.

Many of my favorite strategies for managing risks in retirement can be compared to option plays in football.  The quarterback (you) takes the ball (the assets) and runs toward the defensive end (the threat).  The quarterback does not do this alone; he is accompanied by a running back out to his side, who provides the risk management option.  If the defensive end (the threat) commits to tackling the quarterback, the ball (the assets) is pitched out to the running back who then accelerates around the end, thus successfully managing the risk.  On the other hand, if the end commits to tackling the running back, the quarterback keeps the ball and turns upfield, also successfully managing the risk.

Taxes

Taxes represent an almost universal threat to assets in retirement.  One type of tax that should not be underestimated is the estate tax because the tax rate is approximately 50%.  Currently, there is great uncertainty about the federal estate tax because of the proposals that it be repealed altogether.  In the wake of Hurricane Katrina, federal budget expenditures are expected to soar.  As a result of the increased government spending, the likelihood of a repeal of the estate tax in the near future is diminished.  This leaves in place the current so-called phase-out of the estate tax.

In the absence of a repeal of the estate tax, the current law will continue to provide a so-called phase out of the estate tax by virtue of a phased-in increase in the estate tax exemption.  The current exemption of $1.5 million per person is scheduled to increase to $2 million on January 1, 2006, and then to $3.5 million on January 1, 2009.  It is scheduled to become unlimited (no estate tax at all) on January 1, 2010 for one year before dropping to $1 million on January 1, 2011 (thus bringing the estate tax back with a vengeance).

Traditional estate planning strategies often took the form of formulas that were written into wills and trusts to ensure that the full exemption amount would be diverted into a family trust with the balance going to the surviving spouse or to a marital trust for the surviving spouse.  Leaving such formulas in place now represents a new threat to the surviving spouse, albeit not quite as significant a risk as the estate tax itself.

Is there an “option play” to help manage these estate planning risks?  One such strategy is for the will or trust to leave the assets to the surviving spouse along with a right to “disclaim” them into a family trust.  This gives the surviving spouse the option of disclaiming to the family trust just enough assets as are needed in order to minimize the estate tax, under whatever rules are in effect at the time, very much like the option play in football.

Inflation, Recession, Stagflation

Another risk to assets in retirement is the current uncertainty as to what is on the economic horizon.  Will it be inflation, recession, or stagflation (a word brought back from twenty-five years ago that describes an economy in which prices rise faster than economic growth).  One way to meet this uncertainty is with highly liquid investments that maintain your ability to adjust as the economic future becomes more certain (if it ever does).  Another way to do it is with less-liquid alternatives that guarantee minimum returns.  Examples of the liquid approach are portfolios consisting of low-cost, diversified index funds and exchange-traded funds.  Such portfolios should include multiple asset classes such as large and small cap U.S. stocks, international and emerging markets stocks, more tangible assets such as precious metals, and a healthy dose of inflation-adjusted bonds issued by the U.S. Treasury and other highly rated municipal bonds or highly rated issuers.  Examples of the less-liquid, more-guaranteed alternative approach are equity-indexed annuities from highly rated insurance companies. These guarantee a floor return, usually annually, but will provide a higher return based upon the performance of a selected stock market index.  Although usually accompanied by penalties for early liquidation, these annuities can preserve flexibility within them, such as a prospective annual choice of guaranteed floor rate.  Although most of the equity-indexed annuities that are sold involve extended periods of liquidation penalties such as ten years, shorter terms also can be found.

Heath Care/ Long Term Care Costs

Another risk to assets in retirement is the increasing possibility that many of us will need help with daily living and that the government will not have the resources to be able to help us.  Even though the federal government has promised citizens retirement income through social security and medical insurance through Medicare, it has never promised to provide us with assisted living facilities, rest homes, or nursing homes.  Help with daily living and even skilled nursing care is provided only through needs-based government programs such as Medicaid.  If the government will not be available to help you face the risks of needing expensive help with daily living, what other strategies can be used?  First and foremost, long term care insurance coverage should be obtained, if you can qualify for it and are young enough for it to be affordable.  Long term care insurance is classic risk-management insurance.  You should think of it just like auto and home insurance.  Get it before a health issue arises that prevents you from being able to do so.  If you are already in a circumstance that prevents you from qualifying for long term care insurance, get the help of a qualified insurance professional who can help you obtain an alternate form of insurance that can be used in lieu of long term care insurance.  How does long term care insurance help to keep your options open?  There are many ways.  For example, by including both home health, and assisted living benefits it can keep open your option of staying home or moving to an assisted living facility when they need for help arises.  Additionally, if you ever require an extended period of skilled nursing care, it can provide a few years (e.g. five years) during which you can receive this care in a self-pay status without necessarily depleting all of your other assets.  This could become extremely important if Congress ever passes the five year waiting period for Medicaid that it is considering.  Finally, a growing number of long term care insurance policies are offering return-of-principal features that pay in the event that you die without having received all of the long term care benefits.

Conclusion

The key to managing risks in retirement is to keep your options open.  Identify the threats, assume that you will encounter them, and be prepared with strategies that will thrive no matter what, or with strategies that will at least soften the blow of negative events.