Get With The Plan: November 27, 2011

Johann and Charlotte, in their 60s, want to spend their retirement with family and friends, and maybe a little travel on the side. Nothing extravagant.

Future bills are on their minds, though. They want to make sure they can afford their retirement.

“I’m especially concerned about paying for medical if I retire before age 65. I have medical while working but no retiree medical,” says Johann, 62. “I would like to retire at 63 or 63 ½. What’s the best way to use our assets to generate enough income?”

The couple, whose names have been changed, have saved $365,000 in 401(k)s, $391,500 in IRAs , $85,000 in a brokerage account, $127,300 in Certificates of Deposit, $46,000 in savings and $1,000 in checking.

Johann is eligible for a monthly pension at age 63, and Social Security benefits of $1,700 a month that same year. Charlotte is already receiving her Social Security.

The Star-Ledger asked Michael Gibney, a certified financial planner with Highland Financial Advisors in Riverdale, to help the couple manage their plans as they near retirement.

“They have over 50 percent of their retirement assets invested in cash or cash equivalent instruments which are earning a minimal return and, over the long run, will not keep pace with inflation,” Gibney says.

This kind of allocation will have an impact on their ability to achieve their goals, he says.

Gibney said he found their current retirement portfolio is almost 90 percent invested in fixed income assets which can be a good source of income, but will not provide the capital appreciation required to keep pace as their cost of living increases.

Gibney notes the couple say they have a low tolerance for risk, which is quite apparent in their current allocation.

“However, they may be avoiding one risk and accepting another,” he says. “By this I mean they will avoid the `market risk’ associated with being invested in the stock market, but they will acquire the risk of losing purchasing power.”

Inflation has a historical average of rising 3 percent a year, and the couple’s cash and fixed income investments won’t keep pace.

For example, Gibney says the average annual total return of the Barclays Aggregate Bond fund – which includes government and corporate bonds – over the past 10 years has been about 2.3 percent. In general terms, inflation of 3 percent means any item purchased for $1,000 this year will cost you $1,030 next year. Based on the return of bond index, they would only have $1,023 over 10 years if they use only fixed income as their investment vehicle.

“This can have a negative effect on their ability to reach their retirement goals,” he says. “Fixed income is an essential part of a well-diversified investment portfolio when used in proper proportion to all other asset classes.”

That means Johann and Charlotte need diversification to increase the annual returns of their investments while actually decreasing the overall risk of the portfolio. Gibney recommends more asset classes, and to optimize the portfolio for their time horizon and given that they are very conservative investors, an allocation of 50 percent fixed income securities and 50 percent equities would make sense.

Currently, Johann is contributing 10 percent of his salary, or $7,200, to his 401(k). Because he is over age 50, he can contribute a total amount of $22,000 a year, and Gibney recommends he shoot for that amount.

In the couple’s favor is their modest budget. They have a monthly cash surplus of about $1,400, which leaves more than enough extra for Johann to boost his 401(k) contributions.

Gibney says if the couple made no changes at all, they’d have a 93 percent probability of success, but their “safety margin,” or the amount of money Gibney projects will be left at the end of the plan, is below what he would normally consider acceptable.

“This is a symptom of asset allocation,” he says. “With the recommended changes to their investment allocation, the probability of achieving their retirement goals increases to 99 percent, but more importantly the value of their `safety margin’ increases 10 times over.”

Next, Johann’s pension. He has several different payout options, including: a single life annuity, which would pay $1,430 monthly during his lifetime but nothing for Charlotte; a joint and survivor annuity option, which would pay a reduced amount for Johann’s lifetime and then either 50, 75 or 100 percent to Charlotte upon Johann’s death; an annuity with 120 payments guaranteed, which pays for Johann’s lifetime, or a minimum of 10 years to Charlotte should Johann die first.

The most interesting option, Gibney says, is the 50 percent lump sum with the remainder in a monthly annuity. Johann could take half the account value – $107,000 – and use any of the other annuity options for the rest of the money.

Gibney recommends they take this option, investing the $107,000 in tandem with his recommended allocation, with the 100 percent options for 120 annuity payments for the remainder.

Under all these circumstances, Gibney says, they can afford for Johann to retire in a year, and they can afford the medical insurance premiums until he’s eligible for Medicare at age 65.

They can also afford to spend $5,000 a year on travel.