Retirement income shortcuts not always best route

The simple retirement maxims are often a poor fit for your clients' specific goals and circumstances

Jan 29, 2013 @ 9:44 am

By Dune Thorne

Retirement planning
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When faced with thorny, complex problems, we all want simple, easy-to-understand solutions.

That is especially true when those difficult issues are emotionally charged.

For example, trying to sort out your various retirement goals and developing an investment plan to achieve them is complicated enough. But add on the fear of financial insecurity, and the result can be paralyzing.

So it is understandable when people rely on simple retirement maxims to get past their insecurities and fears. Unfortunately, those adages are often a poor fit once you have examined your specific goals and circumstances.

Here are a few of the most common retirement-planning shortcuts that may work in some cases but may not always serve you well.

Shortcut: The investments in your retirement account should track your progress toward retirement: an aggressive stance in your youth, a more conservative mix as you get closer to retirement age. This fairly logical concept is based on the potentially false assumption that your retirement account is actually going to be used primarily to fund your retirement. However, the account may actually serve an entirely different goal. In a comprehensive financial plan, you are likely to develop multiple goals — retirement, wealth transfer and charitable giving — and each of these goals can be targeted by locating certain types of accounts in specific wealth structures.

If you are retired, your goal for a retirement account may in fact be to generate income. In that case, a conservative posture may make sense in order to protect your principal. But what if the ultimate goal for the account is to build assets to pass to your children? In that case, you would likely be better served by maintaining a growth posture in that account throughout your retirement years in order to maximize your children's eventual inheritance. Additionally, you might choose to use a Roth individual retirement account. Because Roth IRAs don't require you to take minimum distributions, they are ideally suited to an investment strategy targeting long-term growth throughout your retirement. What if your family has charitable goals in mind? Traditional IRAs and 401(k) accounts are tax-efficient for retirement purposes but very inefficient when it comes to estate taxes (after estate taxes are paid, your children will still pay ordinary income taxes on future distributions). For this reason, 401(k)s and traditional IRAs are good candidates to pass to a charity in your estate plan, as the charity will be exempt from paying taxes on distributions. Given enough forethought about your family's charitable-giving strategy, this account could be designated for a specific charity and then invested according to the charity's investment goals, as opposed to family considerations that would cease to be relevant.

Shortcut: High-growth investments should be held in retirement accounts because they are tax-deferred, and income investments should be held elsewhere. This may make sense before your retirement years, but once you begin taking required distributions, you pay ordinary income tax on these distributions (at least for non-Roth retirement accounts), often at a higher rate than capital gains taxes. Put more simply, if your returns in a retirement account this year are all capital gains and you take a distribution from that account in the same year, your distribution will still be taxed at the higher ordinary income tax rate, obviously an undesirable outcome. In this scenario, as you transition into your retirement years, it might make more sense to hold taxable bonds in your retirement account, where you will pay ordinary income taxes on interest as you normally would, while holding your equity investments in personal accounts that will be taxed at lower capital gains tax rates. Although this sounds counterintuitive after a lifetime of instructions to the contrary, it often makes sense. Again, it is essential to engage in regular planning discussions so that you can understand how the changes in your life circumstances provide a clear map to logical changes in your portfolio positioning.

Shortcut: “Set and forget” a bond portfolio to generate retirement income. Sometimes, all the planning in the world can't protect us from fundamental market shifts that challenge long-held investment assumptions. Many retired couples have spent their entire lives investing in bonds to generate income, but because yields are so low, they are gravitating toward bonds that carry significantly increased risk for only a small amount of additional income. These actions leave their portfolios vulnerable to loss of principal — the exact opposite of what many investors expect from a bond portfolio. Given today's yields, retirees may need to consider much more creative — and perhaps less liquid — strategies to generate income.

This is a particularly stark example of how dangerous it can be to settle for simple solutions to complex problems. Of course, it is tempting to look for a “set and forget” solution for your portfolio during retirement, but in our work with clients, we don't think that retirement is some sort of finish line in terms of investment planning. Instead, the transition to retirement should be accompanied by more, rather than less, strategic-planning work, as this period of time is often marked by significant evolution of your lifestyle, and your estate and charitable goals. Structuring one's portfolio, locating assets in the right kinds of accounts and trusts, and watching your mix of investments are all critical activities leading up to and persisting in retirement. In the end, there are no simple solutions. Rigorous and disciplined planning is the only real way to truly get past our fears and achieve the security that is so important to all of us.

Dune Thorne is a wealth manager at Brown Advisory Inc.

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