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Turbulent Times Series Part 3: Mistakes Outside Investment Portfolio Can Impact Retirement Savings

by Darren L. Zagarola, CFP ® , CPA, PFS

As published in The Princeton Patch , August 24, 2012

Part 3 of 3 of the Turbulent Times Series

There is a common perception that as long as you have a strong understanding of your current income and expenses, as well as a properly diversified portfolio, that you have a sound financial plan for retirement. Few things in life are that simple. Many of my clients and students at the Princeton Adult School are surprised to learn that common mistakes and oversights outside of their investments -- such as unexpected expenses and poor estate planning -- can have a significant impact on their financial independence. It is for this reason I advocate a comprehensive financial plan that considers all aspects of your financial lives, including tax planning, insurance planning and estate planning as a complement to investment planning.

As I have written about in my previous columns, understanding your living expenses (cash outflows) is a significant part of understanding what your needs will be in retirement. Most people project their anticipated living expenses for retirement based on their recent outflows and some factor of a reduction of expenses after retirement. In most cases, the reduction of expenses does not materialize. In fact, most people experience increased expenses upon retirement. Key expenses that might be overlooked when planning for retirement center around insurance costs, including healthcare, life insurance and long-term care costs. By omitting these additional expenses in a retirement cash flow projection, individuals can understate their cash outflows and the amount required from their portfolio to meet their long-term needs.

While working, most people receive subsidized medical and dental insurance benefits. Once retired, this cost is now theirs alone to pay. The cost of private medical coverage can be significant, especially for those not yet age 65, prior to Medicare eligibility. There are also costs for those on Medicare, such as Medigap insurance and private prescription drug coverage. In addition, the inflation rate for healthcare-related expenses, estimated to be greater than 7 percent, is much more significant than for durable goods (less than 3 percent). Although healthcare costs cannot be controlled, they need to be factored into future expenses in any retirement plan projection. Some people may have company-sponsored group life insurance benefits while employed. Although they might be convertible to private policies at retirement, the cost is often significantly more than what is currently being paid. How can these costs be controlled in retirement while still protecting your family's financial future in the event of your premature death? If life insurance is needed, consider obtaining guaranteed term private life insurance while healthy and working, which would reduce the cost of future premiums. Simply put, guaranteed term means the premium amount will remain constant over a certain term period (usually 10-, 20- or 30-years). In this case, expenses are increased prior to retirement while one is earning income, but over the long-term, insurance costs will be fixed throughout retirement. An additional benefit of term life insurance is that once it is no longer deemed needed, payment of the premium can be stopped, allowing the policy to lapse. For comparison, the cost of a $500,000, 20-year guaranteed term policy for a 50-year-old is approximately $1,000; whereas a 65-year-old will pay $4,500 for the same policy.

Long-term care costs can be a significant burden to the success of your retirement. First, you must understand that long-term care is custodial, not medical. Custodial care covers care when someone needs help with physical or emotional needs over a long period of time. The cost of care, whether in a facility or at home with the assistance of skilled nurses and aids, can have a significant impact on an investment portfolio. Should care be needed because of a stroke or other ailment, for example, it may not be ideal to take money out of an investment portfolio to pay for the related expenses; especially during a down market. As it relates to long-term care costs, there are two basic choices: self-insurance and long-term care insurance. Self-insuring long-term care needs means funding any potential costs with your own investments. This can have a significant impact on a portfolio in a short period of time once the care is needed. Obtaining long-term care insurance transfers the risk to the insurance company for a fixed cost. The key, as it relates to controlling one's retirement, is the fixed cost of the policy premium allows for proper planning and budgeting.

What might be the most significant and is definitely the most certain expense that could derail retirement is the estate tax. Currently, individuals can pass up to $5 million to a non-spouse without incurring a Federal Estate Tax. Remember, all assets passed to a spouse are tax-free on the first spouse's death. This exemption is scheduled to decrease to $1 million in 2013. The current Federal Estate Tax rate is 35 percent, but will increase to 55 percent in 2013. In addition to the possible Federal Estate Tax, there is also a State Estate Tax. The New Jersey exemption is $675,000; the Pennsylvania exemption is $1 million. Therefore, while an estate may not be taxable for Federal purposes, it may be for State purposes. Proper estate planning can assist you in controlling the amount of tax due. Even in cases where individuals take all the right pre-retirement financial planning steps - including investing early and diversifying their portfolio - outside factors can put their retirement savings at risk. Knowing what these factors are allows for risks to be minimized.

There are many things you will learn about me as I continue with this column. First, I feel very passionate about comprehensive financial life planning. Second, I believe in fee-only financial planning and do not sell products. Third, I believe that a financial plan is specific to each individual and by having a financial plan in place to meet your individual goals you will be able to exercise a significant amount of control over your financial independence. And from my experience, most people without a financial plan report feeling out of control about their retirement and financial independence.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk and other factors. Securities sold or redeemed prior to maturity may be subject to a substantial gain or loss. In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default. International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Over time you may earn a lower return from a bond ladder than you would from holding only long-term bonds, i.e. bonds that mature in 10 or more years. Liquidity may suffer under a laddered arrangement. Access to principal requires selling a bond, or not reinvesting the proceeds upon maturity which will break the ladder, shortening your portfolio's average maturity and reducing the income it generates. Please note that individual situations can vary. Information presented here should only be relied upon when coordinated with individual professional advice.