The Bogleheads' Guide to Retirement Planning (21 page)

Then it slipped to AA+ a year later, and then it dropped three levels, literally overnight, in September 2008. On September 17, 2008, U.S. regulators seized control of the company.

Martin D. Weiss criticizes the other rating agencies for being too closely tied to insurers, while claiming that his own company, Weiss Research, is independent. In 1992, the
New York Times
said of Weiss that “life insurance companies do not like him much” and that “assigning low grades to large, well-known life insurance companies has become something of a trademark for Weiss Research.” Weiss Research ratings are available at no cost from
www.thestreet.com
.

What is an acceptable rating? Definitive answers are hard to find. Babbel and Merrill wrote in
Rational Decumulation
(
http://fic.wharton.upenn.edu/fic/papers/06/0614.pdf
) that “if a default is going to occur, it occurs on average about 25 years after the annuity purchase from an insurer with a claims paying rating of single-A at the outset.” In
The Guru Guide to Money Management,
authors Joseph H. Boyett and Jimmie T. Boyett suggest demanding an A or better from Best, AA or better from S&P, and a B or better from Weiss.

If the quotation says that you pay $168,418.26 and receive $1,000.00 every month, then you pay exactly $168,418.26 and you receive exactly $1,000.00 every month. But how much does the insurance company make? Somewhere between 2 and 15 percent.

Some researchers claim that in 1999 a typical retiree with average mortality prospects faced an embedded transaction cost of 5 to 20 percent if he or she purchased an individual annuity from a commercial insurance carrier. By 2006, researchers found the range to be much better, from 3 to 5 percent.

It is a misconception that companies with a higher financial strength rating charge higher premiums. Typically, the rating of the company does not influence the level of monthly payment. Last year, a set of quotations was obtained from a firm that specializes in immediate annuities from major companies. Seven quotes were obtained from companies with S&P ratings from AAA to AA-. The quotes for a premium paying $1,000 a month to a 62-year-old woman showed a spread of $18,580 between the low-cost provider at $151,620 and the high-cost provider at $170,200. The low-cost provider’s rating was in the middle of the pack.

Income from an SPIA will usually be taken into account by any means-tested programs, such as public housing assistance and Medicaid. The specific rules for such a situation might create conditions under which spending a sum of money to buy an SPIA would be less favorable than retaining the same sum as unspent assets.

Medicaid considerations vary from state to state and are beyond the scope of this book. An eldercare law expert must be consulted with regard to any specific situation. Various forms of annuities have figured in the legal battleground between individuals seeking ways to sequester assets from Medicaid and the authorities seeking to recover them. This much can be said:

Vanguard’s managed payout funds are relatively new, having been introduced in April 2008. These mutual funds are
not
annuities, and they offer no guarantee of income. Nor does Vanguard guarantee the safety of principal. So why are they being discussed in this chapter on immediate payout annuities? Because the funds have been the subject of great interest and some controversy on the Bogleheads’ forum, and they need explaining.

As mutual funds pay dividends and interest, you are given a choice to have that income distributed to you as the fund pays it or to reinvest the income by purchasing more shares of the fund or another fund. The managed payout funds are essentially mutual funds with a built-in automatic withdrawal strategy. Instead of paying out interest and dividends, they pay out a calculated amount based on a moving average of the three previous years’ return. Here are the basics:

Single-premium immediate annuities (SPIAs) are a valuable retirement planning tool because they provide a higher stream of income than any equivalently safe investment. Some experts suggest that they are underutilized. SPIAs are simple products that are easy to understand and compare. They are pure insurance products, without any investment plan mixed in. SPIAs do have drawbacks that need to be understood. One is that SPIAs provide more income for you at the expense of leaving a smaller legacy to your heirs. Another is the risk of insurer default, which is very hard to quantify. Financial strength ratings mean less than you would wish. Backup protection from state guaranty associations exists and is important, but it has limits.

The SPIAs are most useful to retirees whose savings are marginal. If you are planning your retirement, you should know that they exist, understand how they work, and evaluate what they can do for you.

Investing is simple if you follow a few basic principles: reduce your risk by widely diversifying your investments including a reasonable allocation between stocks and bonds, maximize your return by minimizing fees and expenses, and stick with your plan long enough to experience the power of compounding. Jack Bogle said it all in these few words: “Simplicity is the master key to investment success.”

Every investor dreams of finding the next Google before the stock sky-rockets in value. Putting all your eggs in one basket and hitting the jackpot is one of the quickest ways to get rich. Unfortunately, it is also one of the quickest ways go broke. That investment you expect to skyrocket could also plummet, becoming the next Enron or Lehman Brothers. Diversification—or spreading your assets across a variety of different types of investments—eliminates the risk of a total loss and lowers the risk of a large loss.

The reason for diversifying is fairly simple. By including different investments that have different types of risks in your portfolio, the portfolio should be less volatile than if you put all your money in one type of investment with one type of risk.

Diversification creates a risk-reduction advantage because the returns on each unique investment tend not to be perfectly synchronized. That means the investments in a well-diversified portfolio generally do not move in the same direction at the same time or by the same magnitude. Each investment in the portfolio responds uniquely to changes in the economy. Accordingly, if you own several different investments with different risk profiles, a decline in one investment may be offset by a rise in another. There are times when all investments move in the same direction at the same time, but those periods are rare in financial history.

Specific risk is the risk that comes from fluctuations in the price of a particular stock, whereas systematic risk is the fluctuation in price that is attributed to the entire asset class. For example, having money invested in a few individual stocks or bonds exposes you to specific risk. If one company does poorly, your entire investment does poorly. The more stocks you have in a portfolio, the more the portfolio sheds specific risk and takes on the characteristics of systematic or market risk. Risk in this sense is defined as the variation in return from one period to another.

If you are unlucky enough to own only a few stocks and they all do poorly, it can result in devastating losses to your investment portfolio. But the more stocks you own, the greater the chance that you will have some that go up to offset losses from those that are losers. Diversification reduces the risk of a large loss. Even in the terrible stock market of 2008, there were firms that did well and saw an increase in their stock price. In the end, the market did better than many individual stocks on the market, particularly financial stocks.

The solution for diversifying away the specific risk of a stock is simply to hold as many stocks as possible. Two stocks are better than one. Four is better than two. And ultimately, the widest diversification possible is simply to own every asset in the particular market. A total-market stock fund, for example, offers the most diversification for the equity asset class.

Owning a large number of stocks lowers the specific risk of any particular company, but it will not protect you from the systematic risk of the entire stock market. To reduce the risk of a market, investors should consider diversification on two levels. The first level is to reduce specific risk by diversifying among many different investments of one particular asset class, such as U.S. common stocks. The second level in diversification is to reduce the systematic risk of asset classes by spreading investment across different asset classes, such as stocks and bonds. Stocks and bonds often act differently during different economic conditions, and asset class diversification can help your overall portfolio against the systematic risk of a particular asset class.

Volatility in the stock market is an inherent risk that can’t be eliminated by owning more stocks. But that risk can be tempered by owning different asset types. Having part of your portfolio in assets that have potential for high returns and another part in investments that produce more stable returns helps protect your overall portfolio from the ups and downs caused by any single event.

Diversification among asset classes lowers risk and means potentially higher returns in the long term. This is efficiently done using mutual funds and exchange-traded funds. However, simply holding many funds does not guarantee diversification. You can hold several blue chip U.S. stock funds that do little to increase your diversification because they all invest in the same companies. A better allocation would be between stocks, bonds, and cash.

Here are three major classes that can then be subdivided:

There are times when all asset classes advance and times when all of them retreat, but over the long run, they tend to not be perfectly correlated. Since it isn’t possible to know which asset will do best at any particular time, holding a variety of asset classes that move differently moderates the effects of any one asset class and is protection against any single plummeting asset in your portfolio. A well-diversified portfolio should be diversified within asset classes so that specific risk is effectively eliminated and diversified across asset classes so that the risk of the portfolio is consistent with your risk tolerance.

Everyone wants to identify a few investments with the greatest opportunity for growth coupled with the least downside risk. But good individual assets meshed together do not always make a good portfolio. Something can go wrong with a few of the investments, and then the entire portfolio performs much worse than the market. Rather than focusing on a few individual investments that appear to have above-average risk-reward characteristics, modern portfolio theory is all about building a broadly diversified portfolio with acceptable risk-reward characteristics for your situation.