Karen Goodfriend
Karen Goodfriend
Retirement Plan Strategies After the Financial Crisis

What now?

July 22, 2010
by Karen Goodfriend, CPA, PFS

Many people have been reassessing their retirement plans in the nearly two years since the drama of the financial crisis unfolded with Lehman Brothers filing for bankruptcy and AIG facing the possibility of a similar fate.

During the latter part of 2008 and early 2009, financial doomsday scenarios seemed plausible and anxiety levels were high. While our economy is much more stable today, we often find our clients — and ourselves — justifiably concerned about the financial future.

There remains a sense of financial uncertainty, which makes it harder to plan for the future, yet it’s now more important than ever to develop a proactive retirement strategy.

Consider the following:

  • Those who are unemployed or fear losing their jobs may wonder how long they will go without a source of compensation. These individuals and those who plan to make job changes will wonder what their career and income level will look like in the future.
  • The economic outlook shows many positive trends, although the rate of growth is uncertain, and possible setbacks remain. The magnitude and pace of economic growth will influence the future wealth of individuals and the financial health of businesses, large and small.
  • To what degree will inflation erode purchasing power? Although not a near-term issue, the prospect of higher inflation in the long term is quite possible.
  • Will your client’s assets — real estate, business, investment portfolio — support their lifestyle?

Half Full vs. Half Empty

Uncertainty tends to make individuals anxious and investors risk averse, both of which are rational responses. However, the adjustments the financial environment made to the economy — and the resulting impact they had on individuals — can be viewed with some positive perspective.

The crisis and recession served as a wake-up call to consumers and created an opportunity for better financial education. The U.S. consumer savings rate was disturbingly low before the crisis and has since improved. Today, frugality is “in.”

Individuals have the opportunity to learn from past mistakes and become more successful investors going forward. In one decade, we have seen the bursting of two major bubbles: tech stocks and real estate.

These two very different investments have common denominators of behavioral traps to which individuals easily succumb, namely emotion. Before the crisis investors were caught up in counterproductive thought patterns, such as overestimating their investment acumen and ignoring the risks.

Without the benefit of learning from experience or professional guidance, many investors were overly optimistic about the upside and underestimated the downside.

Others made similar mistakes by letting fear be their guide, and they overreacted pessimistically. They bailed out of long-term investment strategies at inopportune times during a downturn.

How to Plan and Prepare

Planning under the cloud of uncertainty. Uncertainty makes it that much more difficult to rely on particular assumptions, i.e., investment returns, inflation, Social Security income and future medical expenses. However, uncertainty is no excuse for not planning. Rather, it means a more rigorous process is required, which involves financial planning for a range of potential outcomes.

Investors have very little control over some uncertainties, such as economic growth, political decisions governing tax policy and entitlements (Social Security and Medicare). However, with these and other uncertainties, an individual can make proactive decisions to positively influence their own financial outcome.

For example, more likely than not, there will be pressure to reduce entitlements and raise taxes to cut the U.S. budget deficits. The increasing number of aging baby boomers creates additional strain on the ability to fund Social Security and Medicare. The political system will determine who will be affected and how. By nature, this process is unpredictable.

Clients with higher incomes and wealth are most likely to be impacted. For today’s planning purposes, it’s reasonable to assume higher tax rates, reduced Medicare and Social Security benefits, or tax surcharges on these benefits.

CPAs and financial advisers can help clients defer or accelerate income to the most advantageous tax years and take advantage of tax-efficient investing; and maximize qualified plans, deferred compensation arrangements, IRAs and Roth conversions:

Prepare for the likelihood of higher inflation. In the short term, inflation is of little concern, and deflation remains a possibility. Most experts that see inflationary trends as likely are not anticipating anything close to the magnitude of the 1970s in the long term. When planning for retirement, consider how particular expense categories typically have different inflation rates. Medical expenses and post-secondary education have chronically experienced a high rate of inflation — six percent or more — and this pattern could continue. It’s important for individuals to look at their own expense profile and review how they will be impacted by inflation.

Revisit established retirement beliefs. Rather than target a traditional retirement age of 65, baby boomers and others should rethink their retirement age from several perspectives:

  • Most likely, they will be healthy enough to work well beyond age 65.
  • Longer life expectancies require a larger nest egg to retire.
  • For those contemplating working into their 70s or beyond, taking a more fulfilling career path — whether an interesting job or improved lifestyle — can create an increased psychic and financial payback during the extended work years. For example, consider a 60-year-old earning $100,000 per year at an administrative job she’s anxious to leave. She’s waiting until age 65 retire, yet she would be better off financially to switch to a more creative and desirable job earning half that amount and working until age 75. Not to mention that by making the career change, she would likely be happier with her lifestyle during her remaining work years.

New viewpoints for a new era of investing. The 2008 and 2009 market decline heightened consumer awareness of the inherent risks of investing. Some may have thought they had a stronger tolerance for risk than they actually experienced. Some clients may be reacting emotionally and are now reluctant to invest in the stock market. Others may continue to be attached to concentrated investments they are familiar with, such as their company stock or real estate, and are inadequately diversified. It’s important for professional advisers to gain a clear understanding of these attitudes and relate them to the client’s goals.

Professional advisers can serve a critical role in helping clients navigate the traps of being driven by emotion. The outcome of such discussions, along with the recognition of specific goals — retirement, charitable giving and estate planning, should determine the appropriate investment strategies to accommodate each goal.

Additionally, conversations about risk should incorporate the possibility of unexpected results. The recent financial crisis serves as a good example of how unanticipated events can have severe, negative impacts on investment results. The concept of such events occurring is sometimes referred to in portfolio theory discussion as “fat tails” or “black swans.” The point is to acknowledge that risk can’t be neatly quantified and investment returns can’t be consistently predicted statistically using a normal distribution. Advisers and clients should recognize this and may be more conservative in their approach through contingency planning and gravitating toward investments with less risk exposure.

The visibility of Madoff and other scandals serves as a reminder to clients and the profession of the importance of objective due diligence and transparency of investment products and vehicles.

Proactively plan for Social Security and Medicare benefits. Although it may seem simple on the surface, planning for Social Security can be an intricate process. There are some well-known strategies to maximize benefits (waiting until age 70 to take benefits and continuing to work longer) and little known ones (“file and suspend,” which maximizes the receipt of spousal benefits) that can make a measurable difference for some, especially over a long lifetime. Selection of one’s own strategy will depend on variables, such as life expectancy, the age of each spouse and future income. Therefore, it’s important to review multiple scenarios specific to the situation.

Similarly, it’s important to plan for Medicare benefits. With all the options and complexity, it’s easy to want to avoid this. For most individuals, it’s worth the time and effort to assess their own expected medical expenses and compare various plans. In California, various nonprofit organizations offer counseling and education at no cost.

Protect one from the unexpected. While statistically unlikely to occur, certain unpleasant life events can have a devastating financial impact and derail what might otherwise be a secure retirement. Examples include death or disability of an income-earning spouse or the need for extended long-term care. It’s important to have a game plan in case these likely situations occur rather than assuming they won’t happen to you or your clients.

Securing life, disability or long-term care insurance or, for some, the accumulation of extra savings are all means to guard against the financial consequences of such occurrences.

No shortage of economic issues can impact personal finance. Some people may choose to worry; others will take action and prepare for the future. In my experience, those with a solid plan find peace of mind.

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Karen Goodfriend, CPA, PFS is a principal at KK Wealth Advisers LLC.