Q. How should single payment, immediate annuities be considered in a retiree's portfolio?   Due to their cash-like risk, should they replace a large share of cash and short term bonds in the design of the investment portfolio?  

---D.K., by e-mail

A. Lifetime annuities, where you exchange your principal for a guaranteed monthly income for life, should be considered as fixed income investments in your portfolio of financial resources. Because the monthly income is considered to be both interest and return of principal the monthly payments are likely to be higher than any yields you could find in the fixed income markets.

This does not mean they should replaced fixed income investments altogether.

Why?

Simple. A life annuity offers monthly payments, but no liquidity. You can't sell your lifetime annuity to raise cash the way you can redeem a CD or sell a Treasury note. As a consequence, it would be unwise to have a portfolio that was 50 percent stocks, 50 percent lifetime annuity.

A better strategy would have a portfolio that holds equities, fixed income, and annuities. You can view the equities and annuities as the long term power sources of the portfolio and the fixed income holdings as a buffer against bad markets or personal disasters.

  

Q. My wife and I have been using a fee based financial planing group.   They charge approximately 0.75% annually on the total portfolio of tax deferred and taxable accounts.   If we plan to take out no more than 4% of our portfolio annually, would you adjust that down to 3.25% to allow for the management fee or is it reasonable to assume that their management gains me at least an additional 0.75% and stay with 4% of my portfolio.   We have been with this group for five years and are reasonably pleased with their management and our total returns.

A second question is, as we get closer to retirement, how is it best to make withdrawals-monthly, quarterly? And do you draw down the taxable accts first and then the tax deferred?  

---J.M., by e-mail

A. You need to take that a step further. You annual withdrawal rate should include three items: what your financial planning firm charges, the annual cost of any underlying investment such as a mutual fund, and (finally) the money you intend to withdraw for your personal use. What all three withdrawals have in common is that they come from the return your money is earning.

Money management is a service that is done for a fee. It is something you may not want to do. It could be something you may not be able to do. Either way, if we have someone else do it, we should expect to pay for the service.

The question is, how much should we pay? Money management may, or may not, add return to your portfolio--- just as a haircut may or may not enhance your appearance. While some money managers earn their keep and add value equal to or exceeding their fees and expenses, decades of research shows that most don't.

Over the 15 years ending December 31, 2005, for instance, the average return of all large blend domestic equity mutual funds trailed the S&P 500 Index by 87 basis points, indicating that their average annual expenses of 1.19 percent weren't completely recouped through wise decisions. Funds in the same group with annual expense ratios of at least 2.00 percent a year trailed the S&P 500 Index by 2.47 percent a year, a loss that was actually greater than their average expense ratio of 2.24 percent.

This is why I have harped so much on paying attention to expenses. The same expenses that slow the growth of your nest egg while you are accumulating it become even more important when you retire.

In retirement, we have a very basic choice to make. We can help the money managers pay their bills, or we can pay our own bills. Since the maximum safe withdrawal rate is 4 to 5 percent, high management expenses can easily take half of your retirement income.

  

Q.   At what level of net worth would you consider it reasonable to drop health insurance? At some point those households with significant wealth (but not more than $10 million) would be better off investing those premiums and assuming the risk themselves.

---G.P., by e-mail from Houston

A. Health insurance is different from most other forms of insurance in that the liability we face is can be so enormous. For that reason, a wealthy person might always buy health insurance but would buy policies with larger and larger deductibles.

Let's do a comparison. When you insure your car with a $100 deductible, you pay a premium that will protect you from a loss that is no greater than the value of the car. Even a luxury car, however, would be a small loss relative to the kinds of bills a major illness can create. So when we insure a car we insure ourselves against losses that would be a hardship. We can control that with the size of the deductible.

People with limited incomes and assets, for instance, should have low deductible policies because they can't afford losses. A person who earns $200 a week can be derailed by a $500 bill and should probably take a $100 deductible. A person who earns $2,000 a week, however, can afford a $500 loss.

Many people who have income and assets own older cars and may decline to buy collision insurance because they can afford a loss of, say, $5,000 or $10,000, if it occurs.

With health insurance, however, we are always dealing with losses that can be much, much greater. That's why you'd raise the deductible and lower the premium--- but you wouldn't drop the insurance.

  

Q. My wife and I are in our mid to late 20's and are on track to accumulate over $3 million in our retirement accounts by age 60. My plans are to eventually switch that money out of our growth and value oriented mutual funds and stocks into tax-free municipal bond funds so that our investment income is federally and state-tax free. Any opinions on this plan?

---N.K., by email from Dallas

A. When I was in my twenties I made similar calculations and plans about what I would do when I was 60. Reality, both market and personal, intervened. Trust me, it will for you as well. That's the way it is and we should build our portfolios accordingly.

There are two problems with investing 100 percent of your money in tax-free bonds as you approach retirement. First, you'll have no protection from inflation and your portfolio will start to wither and die the moment you convert it to bonds.

Second, the rules for the taxation of Social Security benefits require that you must include tax-free bond interest in the measure of income. As a consequence, your tax-free income will induce the taxation of your Social Security benefits. Worse, by the time you are in your sixties, it is a lead pipe cinch that virtually all of your Social Security benefits will be subject to taxation. (For more on this subject, check my website or read "The Coming Generational Storm", coauthored with economist Laurence J. Kotlikoff).

The alternative is diversification of both portfolio assets and types of accounts. Young workers, in particular, should pursue tax efficient investing in taxable accounts and investments in Roth-IRA accounts. Withdrawals from Roth-IRA accounts are tax-free.

  

Q.   I told one of my best friends that I as considering buying a universal life policy as a retirement investment. I get a policy, pay the principal at about 8 percent interest, and after 5 years I can withdraw my principal tax free. After my principal is depleted, I can withdraw my interest earnings as a loan, again tax free. He told me to contact you for your opinion as he had heard of this type of investment and knew there was some risk in it.

What advantages or disadvantages can you tell me about this investment?

---L.P., by email from Dallas

A. There are many good uses of universal life policies and, yes, it is possible to make large enough payments into the policies that the earnings on your cash value may eventually eliminate the need to pay additional premiums. This should not be confused with thinking of the policies as a riskless source of income for the rest of your life.

In the '80s one of the favorite sales techniques for selling these policies was called "the disappearing premium" in which you were told that if you paid premiums for about 7 years you would accumulate enough cash value that you would never have to pay a premium again.

Those policy projections were based on the high interest rates prevailing when the policies were sold. By the time seven years had gone by interest rates were down sharply. People learned they might have to put in five, seven, or ten more years of additional premiums. It made a real mess of peoples' lives.

The same could happen to you. The 8 percent return projection may not materialize and you'll have to pay in more premium money.

Worse, since the policy continues to generate charges for life insurance benefits, the cost of the insurance starts to reduce the return that can be distributed out of the policy.

If your life insurance sales agent has only walked you through the blue sky assumptions in the policy, I suggest you ask him to walk you through some dark sky assumptions like much lower returns.

The worst possible result with these policies is that you can borrow out the policy earnings tax-free but interest charges reduce the accumulated cash value to the point where you are asked to pay additional money into the policy. The policy will lapse if you don't pay in the additional money. Then all the income borrowed becomes taxable.

Does that really happen?   Yes, it can.

  

Q. A financial advisor recently told a friend that no one should retired unless they have at least $1 million in financial assets and no real estate mortgage. I am 66, a recent retiree, and have about $900,000 in financial assets. I also have income from two pensions of $2,000 a month, Social Security of $1,400 a month, and annuity payments of $3,000 a month. My home is almost paid for and valued at about $170,000. I have no debt except two car payments. I am considering selling my present home and buying another where I would have a $150,000 mortgage.

Does this seem reasonable to you and what do you think about the $1 million and no mortgage? If this is accurate, I would think very few people in this country could ever retire.

---F.S., by email from Richmond, TX

A. The size nest egg we need in retirement depends entirely on the standard of living we hope to maintain once we stop working. That $1 million figure is the same kind of nitwit assumption as the accounting firm financial planners who think everyone makes at least $300,000 a year because those are the only people they consult with. Whatever the visible affluence of America it remains that most people have modest incomes and modest savings, before and after retirement.

With $5,000 a month in pensions and annuity payments you have the income equivalent of a $1 million bond portfolio in addition to your $900,000 nest egg. Since you have so much fixed income, it is entirely reasonable for you to have a fixed mortgage. Basically, the $150,000 mortgage you expect to have will 'neutralize' or offset a portion of your pension and annuity income.

Having the mortgage will allow you to add the equity from the house you sell to your financial assets, giving you a better hedge against inflation.

Bottom line: You're in great shape.