Get With The Plan: October 16, 2011

Bob, 67, and Janis, 64, are worried that their Social Security and their pensions — which will no longer have cost-of-living increases — will mean their expenses will soon exceed their guaranteed income. The couple, who have been retired for three years, are wondering if they have to change their investment strategies and/or their retirement budget. Bob and Janis also love to travel, but they’re afraid — like everything else — costs will only go up.

“For now, we are able to budget travel, but as we age, we know we will have to rely on escorted trips and more costly, less exerting travel plans,” Bob says.

The couple is also wondering if they should convert their traditional IRAs to Roth IRAs, hoping they can pass enough of their estate to their two grown children, hopefully without tax consequences, to help them jump ahead in this continued tough economy.

Bob and Janis, whose names have been changed, have saved $384,000 in IRAs, $88,800 in mutual funds, $18,200 in a brokerage account, $30,000 in a money market and $38,600 in checking.

The Star-Ledger tapped Michael Green, a certified financial planner with Wechter Feldman Wealth Management in Parsippany, to help Bob and Janis improve their retirement plan.

“Bob and Janis’ living expenses are currently less than their after-tax pension income and Social Security,” Green says. “The recent loss of cost-of-living adjustments for New Jersey state pension recipients is the kind of unforeseen setback that makes pre-retirement planning incredibly important.”

Green says while the couple can cover all their expenses today, they will eventually need to tap their nest egg.

“Fortunately, Bob and Janis saved enough during their working years to achieve their financial goals today,” he says.

But they can do even better. Green says if they implement his recommendations, they’ll increase their plan’s probability of success from 88 percent to 96 percent.

The couple is currently adding approximately $800 per month to their checking account, but they’ve already saved enough for an emergency fund and for some near-term major purchases. Instead, Green suggests they add this extra savings to a taxable investment account for higher returns.

Janis’s required minimum distributions will begin in 2018, at which time the couple will still have a surplus. Green says they should use the RMDs to save more, because by 2020 they’re projected to draw on their taxable accounts to supplement their income. By 2031, they will begin to draw on tax-deferred assets in excess of the RMD amount.

Bob was interested in converting his IRA to a Roth IRA. Green says the analysis is a mixed bag because their overall financial plan has a high probability of success without the conversion.

“The tax costs upfront can be painful, but tax free growth, shelter from future tax rate increases and reduced estate taxes tip the scale in favor of a partial conversion,” Green says. “It is recommended that Bob convert his IRA to a Roth IRA in 2011 or 2012 and fund the tax bill from taxable investments.”

Green says it’s not a good idea for Janis to also convert her IRA because paying the tax bill on both conversions would deplete their taxable joint accounts.

The couple has a managed investment portfolio made up of 75 percent in fixed income, 20 percent equities and 5 percent cash, and they also have several separate cash accounts. On the surface, Green said, the portfolio appears to be conservative, but a closer look shows otherwise.

“Fifty percent of the managed portfolio is allocated to high yield bonds. High yield bonds offer a degree of portfolio diversification, but lower quality issuers are at greater risk than their investment grade counterparts during economic downturns,” Green says. “High yield bonds can be significantly more risky than investment grade bonds, with default rates ranging from 1.1 percent up to 16 percent based on a Moody’s Investor Services study.”

And, Green says that interest rates are at historically low levels, posing a long-term risk to bond funds when rates eventually rise. Interest rates and bond prices move inversely; bond values decrease when interest rates rise. This means bond funds may be poised for capital losses down the road.

As such, Green recommends the couple limit their allocation to high yield bonds and increase their equity exposure by rebalancing the portfolio to 50 percent fixed income, 40 percent equities and 10 percent cash.

A review of the couple’s insurance shows they have enough life insurance to care for the surviving spouse should something happen to one of them, and they also have long-term care insurance policies. The long-term care policies pay out a daily benefit that is below the current average cost of long-term care in New Jersey, Green says, so in the event that one of them needs care, their ability to cover the daily benefit shortfall will ultimately depend on the length of time care is needed and the assumed reduction of joint living expenses.

The couple’s current estate size means they won’t have to pay federal estate taxes, but they would be exposed to the New Jersey estate tax, which kicks in at $675,000 of assets. Bob’s Roth IRA conversion would reduce estate taxes — the account would be subject to the tax but the overall estate would be smaller because of the taxes paid when the conversion is done. The Roth would also give a tax-free inheritance to their heirs.