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Creating a Well-Balanced Retirement Plan



Elements of a well-balanced retirement plan: protection of principal, liquidity, growth, insurance. Remedies to common concerns and the flip sides of these crucial topics.


OK, I am going to let you in on a little secret.  There is no perfect investment or financial product for retirement (anyone who tells you otherwise is ill-informed or, as we say in the profession, have a “conflict of interest”).  Each advantage of a financial product usually has an equal and offsetting disadvantage – rarely in today’s financial marketplace do you get something for nothing.  A good financial strategy understands these tradeoffs and strikes a balance, based on your individual circumstance and preferences.

Here are some concerns you will encounter without a doubt when creating a retirement income plan and their “yin yang”:

3. Concerns & Remedies

Concern 1: How do I protect my principal?

Many of us worry about losing our initial savings, or initial investment.

Remedies: Make low-risk investments, such as investing in money market funds, treasury bonds, and CDs.

Advantages:   Low-risk investments protect your principal with higher confidence and can serve as “dry powder” in turbulent market conditions, allowing an investor to buy into depressed markets in times of economic distress.

Disadvantages:   Low-risk investments generate low investment returns (in fact, most low risk investments today have a return close to 0.00%) which puts your long-term income at risk, making it difficult to keep pace with inflation, and preventing you from participating in the benefits of a bull market, resulting in a lost opportunity, too.

Concern 2: How much liquidity is right?

Liquid assets: What you have in bank accounts, brokerage accounts, and other assets that can be readily exchanged for cash.

Illiquid assets: Real estate, artworks, cars, fancy technology, family businesses – things that are bought and sold infrequently, have a limited number of potential buyers, may take a long time to sell or may require hiring and paying a broker to sell on your behalf. Immediate annuities are another example of an illiquid asset; once they are purchased you generally cannot get your principal back other than waiting out the income benefits.

Advantage of illiquid assets: Helps rein in out-of-control spending habits by making it less difficult to monetize; opportunity for large returns if they can be held for the long term.

Disadvantage of illiquid assets: If you need to exchange them for cash quickly, you may be forced to sell them at a deep discount.

Disadvantages of highly liquid assets: little investment payoff, because they have to be readily available as cash anytime, and cannot be invested in the long-term, and dangerous, as home equity loans or credit cards encourage your spending to go through the roof, to your detriment, leaving you living beyond your means.

Remedies:  Keeping an amount of highly liquid assets available to meet near term income needs, diversifying illiquid investments so that you are not forced to sell a large “chunk” of asset at one time in a bad market for that particular type of asset, continually managing the mix of liquid/illiquid assets over time by gradually converting illiquid assets into liquid assets, and only holding an amount of illiquid assets that you are sure can be held for a long period of time with high certainty.  In certain situations, you may be better off getting a loan and using the illiquid asset as collateral (such as a home equity loan) instead of selling the asset – this allows you to continue to hold on to the asset for a longer period, potentially benefiting from future appreciation of the asset, and avoid potentially significant transaction costs.  But you will need to make sure you have the resources to repay the loan.  Finally, you may want to consider owning illiquid assets that can generate cash income, such as a family business, real estate (that you can rent), and immediate annuities.

Concern 3: How do I make sure my investments grow?

Growth is crucial for several reasons; it generates cash for your income needs in the later years of retirement (which may be 50 or 60 years from today), and it helps your portfolio keep pace with inflation over the long term, preserving its purchasing power.

Growth-oriented investments:  Equity-related investments (stocks, and mutual funds and exchange traded funds invested in stocks), real estate, and long-term, high-yield bonds can provide opportunities for long-term growth.

Disadvantages / Caveats: Investments with high growth potential can also be highly volatile, so if you need to liquidate a growth asset in the near term you risk selling it at a depressed price, resulting in a permanent loss.

Remedies:  As you invest in growth assets, you should invest only in an amount you’re sure you won’t need in the near future as cash; your growth portfolio should be well diversified (which will keep volatility to a minimum); and be sure to periodically rebalance the portfolio so that the proportion in growth investments is appropriate.

Concern 4: How is insurance part of my retirement plan?

Why is insurance valuable? First and foremost, it helps you avoid catastrophic financial loss.  Second, it transforms a risk from a highly uncertain and unpredictable cost (that is, the risk you are insuring) to a more certain and known cost (i.e. insurance premiums).  This gives you more peace of mind and financial flexibility.

Remedies: Long-term care insurance covers certain costs should you become incapacitated; annuities can help cover you in case you live beyond your life expectancy; health insurance can provide protection against surprise health costs; and even put options can be viewed as a form of insurance against future investment losses.  Insurance allows you to better manage and finance the risk of a “big event”, so you don’t need to keep as many assets liquid and conservatively invested to provide for these potential costs. This means you can use the funds to invest in higher return growth investments, making a better provision for your long term needs.

4. Disadvantages of Investment Insurance

Disadvantage 1: Insurance is only as good as the creditworthiness of the insurance company, which can change over time.  While most insurance companies are financially strong and subject to strict regulatory requirements, there is always a risk that a given company may not be able to meet its obligation to its policyholders.  This is particularly worrisome with insurance that involves prefunding (for example, premiums paid in a given year provide both current and future protection).

Disadvantage 2: Insurance can also be expensive – the greater the risk that you transfer to an insurance company, the more you will have to pay them to take it.  Certain forms of insurance, such as annuities, can also result in diminished liquidity and control over your assets.

Disadvantage 3: Of course, there is always the risk that you pay for insurance that you end up not needing—but peace-of-mind and control are part of a well-balanced retirement plan.

Remedies:  If the cost of insurance is a concern, consider reducing the proportion of the risk that you insure by using a high deductible or deferral period; you can protect against credit risk on annuities by purchasing smaller annuities from multiple insurance companies over a period of time.


5. Conclusion

As you can see, there is no clear, unambiguous solution of how to allocate your retirement capital to achieve the right balance of growth, capital protection, liquidity, and insurance.  This can make planning intimidating and appear somewhat chaotic – how can you start to get your arms around these issues and gain some control?

The best way to assess your right balance is through the use of a good financial model that can assess how your portfolio will perform across stress scenarios that make provisions for each class of risk.

One word of caution

Did we miss any important “yin and yangs”?  If so, please post them below for the benefit of your fellow reader!

Posted by

John Bevacqua on October 12, 2011

Filed Under

Income Strategies

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Each advantage of a financial product usually has an equal and offsetting disadvantage – rarely in today’s financial marketplace do you get something for nothing. A good financial strategy understands these tradeoffs and strikes a balance, based on your individual circumstance and preferences.


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