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We have some 77 Million baby boomers in the U.S., yet somehow about 25 Million of them have a net worth of less than $4,000, excluding the equity in their homes! (Source: Age Wave)

Does this data tell us that some of these folks will need to tap that equity at some point for retirement income?

Enter stage left:  The Reverse Mortgage  (Referred to in this article as “R.M.”).  Lets explore:

R.M.’s used to typically be a last resort for the “little old lady” who needed some cash for a caretaker and to stay in the home for a few years before passing.  And she would usually get a raw financial deal from the bank in the process.  But today, Boomers (Who just started turning 65) are increasingly considering these “backward” loans to pay debts and/or provide “Bridge funding” for their early years of retirement.

An R.M. is simply that:  the polar opposite of a traditional mortgage.  A lender pays a certain amount of monthly income to a homeowner and this loan is re-paid when the house is sold.  In 1990 the average age of an R.M. borrower was 76.  Today it’s 73. (The minimum age to qualify is 62)

Here are 3 important considerations:

1) It’s a Non-Recourse loan:  You can’t owe the lender more than the price of the house – even if the loan eventually outstrips it.

2) It can bridge gaps:  As touched on earlier, one can take a reverse mortgage in order to defer social security payments so the payout increases.  A couple on the fence about downsizing can pull some cash via an R.M. to buy a few years to decide, then repay the loan when they sell.

Sounds good so far so what’s the real problem?

3) They are still too expensive!:  Lets be clear:  Banks don’t offer these loans because they are moralists!  Closing costs can approach $20,000 or more and, as usual with any type of financing, the pink elephant in the room is your interest rate.  Rates on R.M.’s typically run higher than on traditional loans.  And because you are not making payments, the loan grows as interest is assessed and accrues.

Still, as the mammoth size Baby Boom generation continues to migrate through retirement – with so much equity in their homes – I imagine that R.M.’s will continue to evolve, improve and become more competitive.  So keep them in mind.  But as always, buyer beware!  Do your due diligence and consult advisors you trust that know this stuff before getting involved.

Any questions or thoughts about The Real Problem With a Reverse Mortgage?  Please comment below or click here.

From 1980 to 2010, the population over age 90 tripled. 

And it is expected that this demographic will quadruple over the next 40 years.  (Source:  Census Bureau study, “90+ in the United States”)  Advancements in public health, food science, sanitation, pharmacy and medicine are extending our lifespan (for better or worse).

Will you be one of the 90+?

If you are, it will help if you are a smart saver/investor in your working years.  But you will still face the daunting task of “reversing course” and figuring out the best way to spend down what you have accumulated in your retirement and 90+ years.  You also may need to decide whether you need Long Term Care Insurance (LTCI), expensive estate planning and how to fund Grandchildren’s education…among other decisions.

Many folks may want to consider professional advice in sorting through all of these details, but choosing a financial advisor can be a head scratching journey.  Here are 5 questions to ask any financial advisor before hiring them:

1) Are you registered as an investment advisor?  If yes, then the advisor owes you a  ”Fiduciary duty” which is a fancy way of saying he or she must put your interests ahead of theirs, in all matters.  Investment advisors who are not fiduciarys are held to the lesser “Suitability standard”

2) How will I pay you for your services?  This should be put in writing.  The 3 basic methods of payment to advisors are; flat or hourly fee , percentage of portfolio – often referred to as assets under management (AUM) or commissions paid per transaction.

3) What is your overall investment philosophy/approach? Listen carefully to this answer!

4) What firm has custody of the funds?  Who will be sending me trade confirmations and monthly statements?  This only applies if your advisor is supervising your assets

5) How will I benefit from hiring you?  Listen carefully to this answer as well!

As fiscal ”self-reliance” becomes the norm, hiring the right advisor is critical.  Like law and accounting, financial planning is an area where good advice may be “priceless”.  That is, of course, if you hire the right advisor.

We were given two ears and one mouth for a reason; asking smart questions will reveal if a potential advisor is a good fit for you and your family.

Any questions or thoughts about the 5 Questions Smart Investors Ask Their Advisors?    Please comment below or click here!

It’s been said that “History repeats itself”.  And I believe it was Churchill who said “The further back you look, the further forward you see”.  Others have claimed “the only thing new is the history you don’t know”.  All of that might be true.  Studying the past and history may indeed provide us with clues as to what will happen in the future.  Yet one area where this is certainly NOT the case is Mutual Funds and short term time horizons.

In fact, it’s usually the opposite.  Let’s explore:

The short term performance of a mutual fund, or any investment for that matter, tells us very little about what will happen over the next block of time.  If  anything, it tells us the trend will probably reverse itself !  Check out this clever chart which I recently found in Mark Hebner’s entertaining little book “Index Funds” :

How much do you love it?

This chart tracks the top 10 Mutual Fund Managers in 2005 and how they fared in the 5 subsequent years.  ProFunds UltraJapn INV had the best performance of all mutual funds in 2005.  Then in 2006 it slipped to 2,320 place.  Finally, investors in this fund found themselves all the way at the bottom in 2007 when the fund slipped to 6,744 out of 6,765!  The data shows other examples of fund performance that sharply declined.

This occurs because the performance of a mutual fund is often a function of the random rotation of its style (going in and out of favor) and/or sheer luck.  Then the phenomenon is fueled by the media and advertisers putting extra attention on and touting what has performed well in the recent past.  That’s usually when all the “performance chasing” dollars start pouring in. One can only imgaine how much was invested in the Ultra Japan fund after its stellar performance in 2005.

But don’t buy it:  Because it’s one area where history usually won’t repeat itself.

Any questions or comments about Being Fooled by History?  Please comment below or click here.

The whole concept of retirement is changing.

In the past, retirement was sort of a “one time, one size fits all” event;  The retirement party, a gold plated wristwatch gift, then banishing off to a condominium in the sun for 7,9 years of bridge and bingo.  Think “On Golden Pond”… with Norman Thayer played by Henry Fonda swaying in his rocking chair.  Today, most retirees have different lifestyles. Many are working (part-time), are active in their communities, travelling, learning, volunteering et cetera.

Financially, in the past, aging Americans would rely mostly on Social Security and Pensions for retirement income.  Not so for some of todays and most of tomorrows retirees. The next wave will need to be more fiscally “self-reliant” in retirement.  Here are some key points to consider in that context:

Your Withdrawal rate:  The thoughtful financial advisor William Bergen first put forth the 4% rule in a 1994 article.  His thesis asserted that retirees who withdrew 4% of their portfolios each year – adjusting for inflation - should be able to make their funds last 30 years.  He “backtested” to show this has proved sound for every 30 year period since the 1920′s.. including the periods that overlapped the great depression. (In my practice, we will often go as high as 5%)

Your Depletion order:  Retirees (hopefully) will have different “buckets” of investments to draw on to replace pensions.  These include Tax-deferred investments (401-K, 403-B, IRA et cetera), taxable accounts and tax – free accounts including Roth IRAs or municipal bonds.  In what order should one spend down these accounts?  While each case is different, the depletion order that usually makes the most sense is:

1) Taxable 2) Tax – deferred 3) Tax free

Your Social security:  My assumption is that social security will be there for you – in full – if you are over around age 35.  If you are younger, it’s harder to tell.  In any event, the only decision we have direct control over is simply when to begin taking benefits.  The first step is to determine your full retirement age.  Currently if you were born after 1938, it’s age 65.  If you were born after 1960, it’s 67.  If you are in between, it’s in between.  For example, if you were born in 1957, your full retirement age is 66 years, 6 months and so forth.  From this point you can choose a reduced benefit earlier (as early as age 62) or an increased benefit later (as late as age 70).  Increasingly, I am advising retirees to delay benefits, but it’s probably a good idea to sit down with your accountant and/or financial advisor to weigh the options based on your circumstances.

Retirees have come a long way since On Golden Pond was made in 1981.  For many, it’s an opportunity to explore opportunities that weren’t available in their working and child rearing years – assuming they stay healthy…. and are prepared financially!  And planning your withdrawal rate, depletion order and timing of social security are 3 steps in the right direction!

Any questions or thoughts about Rethinking Retirement?    Please comment below or click here!

The origins of the concept of life insurance, as we know it, can be traced to ancient Rome.  Caius Marius, a Roman military leader, creates a burial club among his troops in approximately 100 B.C,  so that in the event of an unexpected death of a club member, other members will pay for the funeral expenses (Romans believed anyone who was improperly buried would become an unhappy ghost!)

And while we have come a long way since the days of ancient Rome, some things remain the same.  And one of them is a basic need for Life Insurance.

In most cases, Insurance covers you for something that might – or might not – happen.  With life insurance, your insuring against something that is certain to happen.  I can assure you this:  If you don’t go before age 65, you will definitely go after age 65!  Here is an orderly way to approach the topic:

1) Assess your need:  Life insurance was designed to fill a need.  Simply consider your financial situation and the standard of living you want to maintain for your dependents if you are not around.  Then make sure you have enough insurance that – at a reasonable rate of return – would generate enough lifetime income (inflation adjusted) to continue that standard.

2) Choose the type of policy:

• Term Life:  Provides only a death benefit without “cash value” and is available for set periods of 10, 15, 20, 30 years.  Term life offers you the least expensive cost per $100o of coverage purchased.

• Universal life (UL):  This type of plan offers greater flexibility than either whole life or term.  After your initial payment, you can reduce or increase both the amount you are funding and the benefit amount.  It does have a “cash value”  but it is typically less than whole life.  Some UL’s can be structured like term; configured at the time of purchase to provide a level death benefit and level premiums that are contractually guaranteed. The reasonable cost and flexibility has made UL my personal favorite in most cases these days.

3) Review and revise:  Your situation and needs will obviously change over time, hence this is not a static process.  Sit down with your advisors every 3-5 years to consider whether adjustments to your Life Insurance plan are necessary based on your current situation.

Please understand:  Researching and purchasing Life Insurance is no fun!  The application process is paper intensive, can take 30-60 days or more (I’ve seen it take a year!).  Physical exams are typically required and expect probing regarding; your foreign travel, health history, lifestyle, finances and family.

The whole process can feel both inconvenient and intrusive…

But ignore it at your own peril.

Any questions or thoughts about Ignoring Life Insurance?  Please comment below or click here.

Interest rates are low.

As of this writing the 10 year treasury is yielding a mere 2.00% and it appears rates will stay low for a while;  in a very unusual move, the Fed has vowed to keep its key benchmark interest rate near zero through mid 2013.  And while we can debate whether or not  this is good for our economy, it certainly seems to create a dilemma for retired (or semi-retired) investors that are looking for investment income for their portfolios.

Or does it?  Could it be that the Journalist Walter Lippman was right when he said “What everyone knows often isn’t worth knowing”?  Is it possible that the best way for a retiree to invest for income in a low yielding world is….not to!

When Americans were retiring at age 65 and living for 7, 9 years playing shuffleboard and bingo – with full social security and a rich pension – maybe investing just for income made sense.  But like Dorothy said to toto “I don’t think we’re in Kansas anymore”.  Many retirees will live 20, 30 years or more without a pension - and in that world what matters more than income or yield is Total Return (income plus appreciation).

So first the retiree figures out how much Total return is required from their investments (on top of SS and pensions) to pay for gasoline, groceries, clothes, travel, rent or mortgage, healthcare, postage stamps et cetera – Make sure to adjust for taxes and inflation because there will always be taxes and these items will be costing more each year.  This leads to the appropriate asset allocation (mix of stocks bonds and cash) that will provide her with the best chances of generating the required income.

This isn’t just theory…I have used this approach with several retired clients taking periodic distributions from their portfolios and it has held up just fine – even through the unparalleled crash of 08.

The percent of your portfolio allocated to Bonds should be diversified and high quality.

But don’t just go searching for “income” in your retirement portfolio in a low yielding world.  It’s an outdated method of retirement investing … And today it’s fools gold.

Any questions or thoughts about Investing in a Low Yield World?  Please comment below or click here.

Incredibly, as private colleges keep paying their top executives millions of dollars each year, they continue to hike tuition prices for their students.  For example, Vanderbilt University paid its chancellor, Nick Zeppos, 1.9 million in 2009 (That’s enough money to send 43 students to that school) while their tuition jumped 4.3% that year.  The total cost to attend Vanderbilt now stands at $41,332.

While we can debate whether Mr. Zeppos – and other executives – deserve such compensation or whether a college education is even “worth it” anymore, tuitions continue to rise.  And there appears to be no immediate relief in sight.  ”College will probably continue to get more expensive” says Sandy Brown author of the college board report which can be found here.

So if funding a child or grandchild’s education is one of your financial goals, we need to plan accordingly.  Lets explore:

•  Funding from income or existing assets:  Some investors may be fortunate enough to have enough excess income to simply pay for college costs directly.  Others may have accumulated adequate investments.  Problem solved!  (Remember that direct payments to educational institutions do not count towards your annual gift tax exclusion or lifetime exemption… so in these situations paying the tuition directly is smarter than doing so through a gift to a child)

• Pre-funding in advance with an investment plan:  For investors that don’t anticipate have enough excess income, planning in advance for this future liability is essential.  And the earlier you begin, the better!  Basic assumptions can be established including anticipated cost of college and assumed inflation rate (5%-6% is reasonable).  By factoring in the years until the child will attend, we can then “back in” to how much needs to be invested each month or year to stay on track by using a reasonable return assumption on your investment.  Regular investments can then be made into mutual funds or ETF’s (exchange traded funds) either directly or via a “529″ plan.

•  A 529 plan is an education plan operated by a state or educational institution – named after section 529 of the IRS code in 1996.  Such plans offer tax benefits not available elsewhere.  While contributions are not deductible - your investment grows tax deferred and distributions come out federally tax free (The tax treatment was made permanent with the pension protection act of 2006).  Further, states may offer some tax breaks as well, such as an upfront deduction for part or all of your contribution… you should research which benefits you will receive for investing in your own states plan here.

• Scholarship programs: Here is a silver lining in this cloud.  While many of us joke around about scholarships when we pay for our children’s sporting activities, the odds of this occurring are probably greater than you think.  Fewer than 12% of private college students pay those schools’ high sticker prices.  Fully 88% of all freshmen at private universities received scholarships to reduce their costs, according to a recent survey by the National Association of College and University Business Officers.  Private college students receive, on average, $15,530 in scholarships and federal tax benefits, reducing their average net cost to $26,700, the College Board found. Maybe those tennis lessons will pay off!

Any questions or thoughts about College Education Costs? Please comment.

In the first of this three part series we  introduced the concept of biases which comes from the new and exciting field of behavioral economics.  (At least it’s exciting to me)  The first bias we discussed was  mental accounting which is the habit of coding and categorizing economic outcomes.  In part two of this series, we looked at loss aversion, the tendency to prefer avoiding losses to acquiring gains.  Now it’s time to consider a third bias, one that is my personal favorite:

Despite the common cliché, hindsight is not really 20/20.  In fact without corrective lenses we might be close to legally blind as we look back at events and believe we knew it was going to happen all along – even if we were utterly in the dark at the time.

Friends, welcome to the world of hindsight bias.

According to about.com, this refers to the ”tendency people have to view events as more predictable than they really are”.

This innate flaw continues to haunt us in Politics, Science, Sporting events and of course….. economics and finance.

It goes like this:

It’s the fall of 2001, shortly after 9/11, a  guy tells himself “Nothing will be the same ever again” because “This time it’s different” - So he abandons his financial plan.  Then the market rallies 15% by 2003 and what does that same guy say now?  ”I knew stocks were a great bargain after 9/11!”

Stephen Dubnir, co author of Freakanomics called this tendency “The folly of predictions” in a recent hilarious podcast where he mocks economic and political pundits by replaying recordings of all their wrong predictions… which can be found here:

http://www.freakonomics.com/2011/09/14/new-freakonomics-radio-podcast-the-folly-of-prediction/

Jason Zweig author of  Your Money and Your Brain writes that when it comes to making modern day investment decisions, our search for patterns leads us to assume that order exists when it often does not!  We are biologically inclined to want to believe that the future can be foretold when it rarely, if ever, can.

Mr. Zweig, half kiddingly, writes that if rodents and pigeons knew about the stock market, they might be better investors than most humans.  Why?  Because they seem to stick within the limits of their abilities to identify patterns – giving them a sort of “natural humility” in the face of random events.  Humans, however, are a different story!

Any questions or thoughts about hindsight bias?  Just click here!       

In the first post of this series, we introduced the concept of Biases which comes out of the field of behavioral economics, which is sort of a hybrid of neuroscience, economics and psychology that might help us to understand what drives investor behavior.

We reviewed the bias labeled ”mental accounting” and how it affects us in everyday life.  In this post we will look at another bias that can lead us to making poor decisions without even realizing it:

Loss aversion

A fellow we’ll call “Joe” orders a robotics kit from an electronics web site which looks like it costs $20.00.  But after checking his bank statement, he notices he was charged $28.40.  Boy is Joe upset… so he calls the company but can’t get anyone to help him.  Then Joe goes to his credit card company to challenge the charge but it’s not that simple, because it’s considered a “mischarge”  he needs to fill out several forms.  Long story short:

3 hours of time spent for an $8.40 refund.

The next day, he is approached to complete a survey; takes about a half hour and the company will pay him 20 bucks.  ”No way, says Joe, it’s not worth my time” !!!

Welcome to the weird world of loss aversion

Loss aversion is an error in our brains that makes us feel like rabid animals to avoid a small loss.  According to Wikipedia, it refers to people’s tendency to strongly prefer avoiding losses to acquiring gains.  In fact, we prefer avoiding loss about twice as much as acquiring gains (Kahneman and Tversky 1979)

To illustrate:  When given a choice between getting  $1000 with absolute certainty OR having a coin toss chance of winning $2500, most will go with the sure $1000.  But the 50/50 chance of  $2500 is a better choice (The mathematical equivalent is $ 1250)

Marketers understand loss aversion when they tout the “Trial period” or “Money back guarantee” attempting to calm our innate fear of loss.

But no where does loss aversion show up more than it does in the world of investing, as investors, time and time again sell investments that have increased in value too quickly to “lock in the profits” and hold on to the losers way too long… to “avoid a painful loss”.

But it shouldn’t matter!  The decision to sell an investment that has decreased in value should have nothing to do with the price paid (as they say:  the investment doesn’t  knows what you paid for it).  It’s worth what it’s worth, regardless of your cost basis.

To avoid the effects of loss aversion creeping into the Sell decision, it can be framed as follows:  If I were starting with new cash, would I make this investment today?  If not, you should sell it, regardless of the price paid.

How has loss aversion affected you?

Any questions or thoughts about loss aversion.    Just click here!       

Quick:

If John F. Kennedy had not been assassinated, how old would he be today?

Got your answer?

Think of your final answer before you continue reading.

Got it.  OK good.

If you are like most people, your spontaneous first guess was that JFK would have been 75, 77.  After the adjustment you may have ended up at 80, 85.  It’s unlikely you would have guessed the correct answer (94) or older.  The reason most of us guess wrong here is because we are answering this question intuitively.  without the data, we form a picture of Kennedy’s boyish face and youthfulness.  It’s hard for us to feel him being 94.

 While intuitive behaviors can be good for many areas of our lives, they can be dangerous when it comes to financial and investment decisions.  Psychologists refer to these intuitions as biases and in this and the next 2 posts we will explore 3 biases that have been labeled:  Mental Accounting, Loss aversion and the status quo bias.

Mental Accounting:

This concept was first coined by Richard Thaler and attempts to describe the process whereby people code, categorize and evaluate economic outcomes.

Say you are headed to the movies possibly to see Lost in Translation with Bill Murray or a remake of Raging Bull with Robert Dinero.  As you enter the theater you reach into your pocket and much to your dismay, you realize that you lost your ticket!  If you still want to see the movie, you will need to shell out another 10 bucks.  Would you do it?

Let’s reconstruct that scenario:  What if you didn’t buy the ticket in advance but when you reached into your pocket you realize that you dropped a ten dollar bill on the metro!  You’re disappointed, but are you more likely to shell out another 10 to see the movie, relative to the first scenario?

Research says YES.

Psychologists found that only 46% of those who lost an actual ticket would be willing to buy the replacement whereas 88% who lost an equivalent amount of cash would.

That, my friends, is ‘ Mental Accounting” – which has enormous consequences in everyday life and affects how we save, spend and invest.  It impacts how we deal with losses and windfalls as we walk around with ” running tabs”  that represent different accounts between our ears.

Losing the ticket and buying a second one is akin to taking $20.00 out of our ” entertainment account” whereas lost cash is not charged to that account… in our heads.

But that makes no sense because ten bucks is ten bucks!   We just don’t think of it that way which is why economic models of human behavior (biases) are often wrong.

Mental accounting, which some describe as a built-in mental “Handicap” can affect us in lots of areas:

• Tax Refunds:  May be placed in the “windfall” or “found money” account and spent frivolously
• Safety Capital:  The opposite of the windfall.  It’s money we “can’t afford to lose” so we invest it too conservatively.
• Sale Items:  If an item is priced substantially lower than we are used to seeing it, it goes in the “bargain account” and we may be tempted to even if we don’t need it.

Let’s be clear:  The dividing line created by our biological inclination to create separate mental accounts is just an illusion.  And it’s often a hurtful one because it violates the most basic rule of economics which states:

 Money is fungible or interchangeable.

The decision to see the movie should have nothing to do with whether you lost cash or a ticket.  The spending of the tax funds should not relate to where it came from and buying an item should have nothing to do with whether it’s on sale or not.

But it does….

How has mental accounting affected your financial decisions?

Any questions or thoughts about Mental Accounting?  Just click here!