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Sustainable income.

Creating a sustainable income portfolio and maintaining it is a challenge. Many things change along the way. Uncertainties and assumptions complicate the task, as advisors and individual investors must balance portfolio stability and volatility in order to meet future liabilities. Furthermore, portfolio withdrawals and/or additions will affect the portfolio and investment plan over time. The shift from accumulation to the distribution phase of investing requires new thinking about risk and risk measurements within your portfolio.

Protecting and extending an investor's portfolio must go beyond an investment plan to include a thorough search for an investment manager with an excellent record of risk control. A thorough analysis of downside protection and results over time, coupled with a detailed evaluation, can tell a lot about an investment manager's strategies and performance.

Risk Transfer

A structural shift is changing the landscape of retirement and disability. Traditionally Social Security, defined benefit retirement plans, and company-provided disability insurance gave retirees and people with disabilities a financial safety net. Institutions bore the costs and risks of providing lifelong retirement and disability benefits, and retirees and people with disabilities received checks in the mail.

Today; the long-term viability of Social Security is in question, with dedicated sources of government revenue inadequate for financing the benefits promised to current and future retirees. At the same time, a growing number of companies--even those with healthy balance sheets--are freezing their defined benefit plans and replacing them with 401(k) plans, or 403(b) plans for nonprofits and governments. Most companies now provide long-term disability insurance as an optional benefit with the costs paid for by the employee. As a result, personal savings are becoming the primary source of income for many current and future retirees. With this structural change of responsibility comes the transfer of two critical risks from institutions to individuals: (1) investment and (2) longevity.

Retirement and Disability

A constant concern for investors before and after retirement is investment risk. But a number of other variables add to the uncertainty of the distribution phase. Advisors must make multiple assumptions--about time horizon, investment returns, withdrawal rates, inflation, and taxes--each of which can have significant ramifications if oversimplified or underestimated. They must also decide which accounts, and which asset classes, to liquidate first in retirement: qualified or nonqualified accounts, annuities, business interests, trusts, stocks, or bonds? Advisors must also help clients with a realistic budget with realistic lifestyle choices.

Longevity Risk

If a husband and wife are 65 years old, the probability that at least one of them will live to age 90 is about 50% (according to the Society of Actuaries RP-2000 table). With each passing decade, as medical advances extend life expectancy rates, those probabilities will continue to climb. Longevity risk--the chance of living longer than expected--must be recognized, managed, and incorporated into all retirement income planning.

Spending Risks

Many retirees and folks with disabilities underestimate what their spending patterns will be. According to a 2006 study by management consulting firm McKinsey, nearly half of retirees said they had miscalculated their retirement spending needs. In addition, spending habits change over the course of a long retirement or disability. We also have to calculate inflation into our future expenses. Those of us who are disabled know the additional expense of life with a disability. Withdrawal rates, therefore, do not remain constant. They fluctuate across active, inactive, and infirm phases of life.

Tax and Inflation Rates

There are no "expectancy tables" for future tax rates, so advisors must use current assumptions. While inflation rates seem more predictable, they are by no means certain. According to the U.S. Bureau of Labor Statistics, the rate of inflation for seniors over the last 20 years has exceeded the broad-based CPI by up to 1% per year, influenced primarily by healthcare costs. Future costs are difficult to estimate due to rapidly changing technology and medical advances.

Faced with these risks and uncertainties, investors and advisors must plan the more complicated distribution phase with care and precision. Accumulation-phase assumptions are no longer sufficient.

Average returns, which are useful in accumulation-phase planning, are less meaningful when cash outflows become a key model assumption. The math changes at the beginning of the distribution phase and will probably continue to change over time, based on spending patterns.

Asset Management

Asset diversification is an integral part of successful investment planning for the accumulation and distribution phases. In the accumulation phase, a well-diversified portfolio can help reduce volatility, enhance compounding effects, and build wealth. With patience, discipline, and the luxury of time, investors can generally withstand shorter term declines and meet their accumulation goals.

The difference in the distribution phase is that regular portfolio withdrawals can possibly compound losses. The management of the slow-and-steady approach of the accumulation phase suddenly gives way to the more complex calculations based on the compounding effects of withdrawing money on a regular basis in up and down markets.

Clearly, the margin for error narrows in the distribution phase. A portfolio generating an income stream cannot tolerate significant declines before capital is exhausted. Besides the severity of a decline, other factors that influence its impact are whether it is a rapid or protracted decline and how long the portfolio takes to fully recover.

Based on the S&P 500, seven major declines have occurred since 1970. Some have lasted days; others, months. Measured in calendar years, the S&P 500 has posted a negative one-year return in about one out of every four years. But measured from market high to market low, significant declines have been erratic in frequency, duration, and recovery time. An investor taking regular withdrawals primarily from equities could not recover from many of these declines. Yet investors facing 20-30 years of retirement are likely to face a number of major and minor market declines.

The Distribution Phase

Planning for the distribution phase must reflect this shift from long-term investing and accumulating, to models based on multiple assumptions and distribution of savings. While risk in the accumulation phase is often summed up by volatility, the central focus in the distribution phase becomes shortfall risk, or the risk of outliving your money. Aside from the uncertainties of retirement, several investment factors can contribute to successful management of shortfall risk.

In conclusion, during the distribution phase of managing money in retirement or while disabled, it becomes important to constantly monitor your situation with a financial professional. You must pay close attention to the importance of downside risk protection and measurement, along with the returns in the portfolio.

While many investment managers do well during bull markets, the more skilled managers prove their skill in more difficult market conditions. The right asset allocation of non-correlated assets, along with rebalancing on a regular basis, and using various portfolio measurement tools will help prevent outliving your investment portfolio.

Find an advisor you feel comfortable with and confident in for this type of critical financial planning. As always, do not hesitate to contact me with any questions you may have.

Contact: dan.jones@raymond / Danlones / 800-657-8969/610-771-0316 / 771-0125 (fax).
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Title Annotation:MONEY talks
Author:Jones, Dan
Publication:PN - Paraplegia News
Date:Sep 1, 2007
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