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August 1, 2003

What Kind of Retirement Do You Want?

We all know the process. Estimate how much is needed in retirement (which can range anywhere from 70% to over 100% of pre-retirement income), determine available income sources, and then calculate how much to save annually to reach those goals. As you go through this largely mathematical exercise, however, don't forget the most important part. You need to give serious thought to the type of retirement you want -- visualize what retirement will be like.

Retirement is no longer viewed as a time to slow down, but is now considered a new beginning in life. That means your current living expenses may have very little to do with your retirement expenses. To help you visualize your retirement so you can estimate retirement expenses, consider these questions:

  • When do you want to retire? Will you realistically have the resources to retire at that age?

  • Do you plan to stay in your current home, trade down to a smaller one, or move to a different city? If you plan to move, is the cost of living there more or less expensive than in your present city?

  • Will your mortgage be paid off by retirement? What about other debts?

  • Will you continue to work after retirement? If so, will you work part time or full time? Where will you work and how much can you expect to earn? Do you have any hobbies or interests that can be turned into paying jobs? Are you planning to start a business after retirement?

  • How will you spend your free time? What hobbies will you pursue? How much and where will you travel? How much will all these activities cost?

  • How will you pay for medical costs? Will your employer provide health insurance or will you need to purchase insurance to supplement Medicare coverage?

  • Do you have any medical conditions that are likely to impact your quality of life in retirement? What would you do if you became physically disabled? Would your spouse take care of you, would you move in with your children, or would you go to a nursing home? How will you provide for long-term-care costs?

  • How much of your income will be provided by personal investments, including 401(k) investments? Are you confident you can invest so those investments will last your entire retirement?

  • What would happen financially if your spouse dies? If you die, would your spouse be able to manage financially?

The Investment Sell Decision

For many investors, the only decision more difficult than which investment to purchase is when to sell that investment. Although there are no hard and fast rules, consider these general guidelines:
  • Compare each investment's performance to that of a similar investment or to the overall market. While a specific investment's performance will vary over time depending on the market cycle, consider selling any investments that lag in performance for an extended time.

  • Don't sell at the first sign of trouble, since it's not unusual for a company to go through a difficult period. But do review the fundamentals again to determine if there is a permanent change.

  • Realize that emotionally it is difficult to sell an investment at a loss. Many investors prefer to wait until the investment rebounds to at least a break-even point. However, the investment may never rebound to that level or may take a long time to do so. Only hold an investment if its future prospects are good.

  • Set high and low target prices to review an investment. You don't have to sell at that point, but you should thoroughly review it.

  • An investment's price can increase significantly in a short time. At that point, review its fundamentals again to decide whether it has the potential to continue increasing or if the price is just too high.

  • Resist the temptation to sell immediately following a market correction. Remind yourself that the market fluctuates and corrections are a normal part of that process.

  • Review all your investments at least annually. Read all information acquired during the year to help assess future prospects. Look for major changes that may indicate problems or signal a change in focus. Make sure investments still meet your financial goals.

  • Call for another opinion. Often, discussing your thoughts with someone else causes you to consider other factors or helps ensure that you have valid reasons for selling.

Calculating Your Life Insurance Needs

While life insurance can serve a variety of purposes, one of the most common is to maintain your family's standard of living in case you die. Thus, you need to purchase an appropriate amount of insurance to ensure your family is adequately protected. While many rules of thumb exist, such as five to seven times your annual income, don't rely on rules of thumb to determine your coverage. These rules don't take into account your individual circumstances, so they could leave you with an inadequate amount of insurance.

Your insurance needs will probably change over time. When you are a young, single adult, you may have little reason to purchase life insurance. As you start a family, your insurance needs will be greater, since other family members are depending on your income. As your children become independent, your insurance needs may decline. However, at that point, you may need life insurance for other purposes. For instance, you may want life insurance to help your family fund estate taxes. The estate tax is not scheduled to be repealed until 2010, and even then, will be reinstated in 2011 based on 2001 tax laws, unless further tax legislation is enacted. Business owners may want to use life insurance so the business will not have to be sold to pay estate taxes, or to provide a means for partners to buy out the deceased partner's heirs.

The amount of life insurance you need depends on your current net worth, the lifestyle you want to provide for your family, and your personal circumstances and desires. To calculate that amount, consider these items:

  • Determine how much income your family needs every year, factoring in the effects of inflation. Don't forget to include amounts to pay for college educations for your children or for any debts you want to pay off, such as your home mortgage.

  • Total your assets and other sources of family income. Include any benefits your family may be entitled to under pension plans and Social Security. If your spouse doesn't work now, consider whether he/she would work if you died and how much he/she could reasonably earn.

  • Based on how long your family needs this income, your expected rate of return on the proceeds, and other factors, you can then determine how much life insurance you need.

  • Since your insurance needs will change over time, assess your insurance coverage periodically, especially after major events in your life. The birth of a child or a large salary increase can drastically alter your insurance needs.

Do You Need Disability Insurance?

You probably have life insurance so that, in case you die, your family won't be left without a means to help support themselves. But have you considered how your family would cope if you were unable to work for a lengthy period due to illness or injury?

Only 30% of workers currently have some form of disability insurance (Source: Dow Jones News Service, January 31, 2003). Many ignore this coverage, hoping they won't be affected by a disabling injury or illness. However, between the ages of 45 and 65, approximately 50% of all individuals will suffer a disability lasting at least three months (Source: Knight Ridder Tribune Business News, March 1, 2003). One out of seven workers will suffer a disability lasting five years or longer (Source: CNBC, 2003), with the average disability lasting 12.7 months (Source: Knight Ridder Tribune Business News, October 13, 2002).

You should consider disability insurance if your current assets won't support you until age 65. To see if this is the case, take time to review your available options. Determine how much you need monthly to pay essential expenses and what income sources you would have if you couldn't work. Review the following questions to determine if you have adequate coverage in this area:

  • Will Social Security provide disability benefits? The criteria for benefits are very strict -- you must be unable to work at any job, expect to be completely disabled for at least one year, and have contributed to the Social Security system for a sufficient length of time. Approximately two-thirds of claims are initially denied (Source: Kiplinger, 2003). Even if you do qualify, benefits tend to be modest. Your annual Social Security Statement indicates what disability benefits you can expect.

  • Does your employer provide disability insurance? Many companies provide short-term disability insurance which covers 100% of your salary for three to six months. Long-term disability insurance is typically less common and less generous than short-term plans. Policies frequently have strict definitions of disability, pay no more than 60% of your base salary (bonuses and profit sharing generally aren't included in benefit calculations), pay benefits for only two to five years, and don't provide cost-of-living adjustments.

  • Do you want to use other personal assets for a potential disability? You can access Individual Retirement Accounts (IRA's), annuities, or 401(k) plans without penalty if you are disabled. But first decide whether you want to risk depleting your retirement fund or children's college fund due to a long-term disability.

  • How much of your income should disability insurance replace? You should ensure that your available resources and benefits from disability insurance equal at least 60% of your pre-tax salary. Many insurers limit coverage from all disability policies to 60% to 70% of your salary to provide an incentive to return to work. Make sure the total of your employer-provided insurance and individual insurance does not exceed the maximum benefits that will be paid or you could end up paying for coverage you can't receive. Insurers typically require documentation of income and may have a limit on the maximum monthly benefit they will pay.

  • Are there any significant differences between employer-provided insurance and individual policies? You have little choice in the benefits offered by your employer, while an individual policy can be tailored to your needs. The most significant difference, though, is the tax treatment of any benefits. If premiums are paid by your employer, benefits are taxable. If you pay premiums, benefits are tax free. This will have a significant impact on the amount available to pay your bills.

  • What provisions should you look for in a disability policy? There are several provisions you should pay special attention to, including:

    The definition of disability. There are three basic types of coverage -- own occupation, any occupation, and income replacement. Own occupation pays benefits when you can't work at your specific occupation. Many professionals, such as doctors and lawyers, opt for this coverage. However, due to substantial claims, this coverage is now more difficult to obtain. You may only be able to find own occupation coverage for up to 24 months, with the policy then converting to any occupation coverage. Any occupation coverage means you must be unable to work at any occupation for which your training and education would be suited. Income replacement policies pay the difference between what you were earning before the disability and what you are earning now. Income replacement coverage may provide the best balance between costs and benefits.

    Noncancelable or guaranteed renewable. Noncancelable means you can renew the policy every year at the same premium. Guaranteed renewable means you can renew the policy every year, but the premium can increase as long as it is not done in a discriminatory manner. Either provision will ensure the policy can't be canceled due to medical problems.

    Waiting period before benefits begin. If you have other resources to rely on for the short term, such as sick leave, personal savings, or short-term disability coverage, you can increase the waiting period to reduce premiums. Waiting periods can range from one week to two years, but the most common option is a 90-day delay in benefits.

    Length of benefits. Disability insurance is designed to protect your financial situation in the event of a serious disability, so coverage should last for the long term. You can obtain lifetime benefits, but you may only need benefits until age 65, when presumably you could receive Social Security and other retirement benefits.

    Residual benefits. With this provision, you can go back to work on a part-time basis and still receive partial benefits.

    Cost-of-living adjustments. This rider increases your benefits in line with inflation. An additional coverage clause allows you to obtain additional coverage without a medical exam.

Dealing with the Possibility of Lower Investment Returns

When designing an investment program, your expected rate of return is a critical element in determining how much to periodically invest to meet a future goal. Since no one can predict future returns, the expected rate of return is typically estimated based on an analysis of past returns for various investments. So what return can you expect in the future for stock investments? The average annual return for the Standard & Poor's 500 (S&P 500) for the period from 1926 to 2002 was 10.2%*, but you don't want to simply use that return without determining whether it is a reasonable return for the future.

A starting point for making that assessment is to look at the equity risk premium. Since stocks are generally considered more volatile than bonds, investors typically expect a higher return. This excess return is called the equity risk premium. Although there are many complicated methods of calculating this premium, a simplified approach calculates the difference between total returns for large-company stocks and long-term government bonds.

For the period from 1926 to 2002, that difference was 4.7%.* However, the annual equity risk premium fluctuated significantly during that period. For the near future, many market analysts question whether the equity risk premium will approach the historical average of 4.7% for several reasons. First, even though price/earnings (P/E) ratios have declined, they still remain at high levels. Since corporate profits are not expected to increase as rapidly in the future, P/E ratios may not go back to previous levels. Second, a significant portion of the equity risk premium results from dividends, which are at historically low levels. Third, the current bear market may have shaken investors' confidence in stocks. Lower-than-expected returns in the future may further erode that confidence. If that happens, investors' preference for stocks may stay dampened, bringing the equity risk premium down.

If the equity risk premium does decrease in the future, total returns will be lower than historical returns. Only time will tell if that assessment is accurate. However, it is probably prudent to consider a lower return for investment programs than historical returns would indicate. To compensate for potentially lower returns, consider the following strategies:

  • Take a fresh look at your financial goals. Reevaluate your goals, how much you need to reach them, and how much you should be saving annually based on lower expected returns.

  • Save more of your income. If you can't count on returns to provide growth in your portfolio, you should compensate by saving more of your income. That may mean you'll need to work overtime or take on a second job to provide additional income. Another strategy is to reduce your living expenses and save the reductions.

  • Invest in a tax-efficient manner. Taxes are often a significant investment expense, so using strategies to defer the payment of taxes may make a substantial difference in your portfolio's ultimate size. Utilize tax-deferred investment vehicles, such as 401(k) plans and individual retirement accounts, which defer the payment of taxes until withdrawal. Or emphasize investments generating capital gains rather than ordinary income. Minimize turnover in your portfolio, so unrealized capital gains can grow for many years.

  • Consider other investment categories. Investors have typically allocated their investment portfolio among cash, bonds, and stocks. With the prospect of lower returns in stocks, you might want to consider other categories, such as real estate.

  • Don't concentrate your investment portfolio in one category. The one major lesson to learn from the recent stock market volatility is that it is risky to concentrate your portfolio in one category. Diversify so when one asset class declines, hopefully other asset classes will be either increasing or not decreasing as much.

  • Evaluate your portfolio's performance annually. That way, if returns are lower than you targeted, you can make adjustments to your strategy to compensate for these variations in return.

* Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future performance.


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