Retirement Planning - Textbook

run out of money. Few people voluntarily walk away from proper medical treatment, but doing so may become a requirement without sufficient healthcare cover and available savings. Depending on the health issues, surgery, hospitalization and recovery costs can run into lakhs of rupees. Even relatively smaller health issues can cost many thousands of rupees. This also is a good reason to build a financial cushion into the retirement budget Wealth Transfer Wealth Transfer is the transfer of wealth or assets to next generation /beneficiaries upon the death of the client through financial planning strategies that often include wills, estate planning, life insurance, or trusts in a tax efficient manner. Transfer of assets to next generation should be smooth and without any legal hassles to be faced by siblings in case proper will is not written. Estate planning is transfer of assets to beneficiaries in a smooth way. Clients with dependents will want to make arrangements to address the dependents’ on-going needs. This is especially true with minor children, but also pertains to spouses, parents, siblings, and adult children (and anyone else who may be a dependent). Special needs dependents often require extra preparation to ensure plans for their on-going care are in place. Broadly speaking, this aspect of estate planning can be categorized as people planning. The people-planning process helps to address dependents' financial needs as well as providing peace of mind. Clients will want to provide a guardian for their minor children and will want to ensure their aging parents have the financial resources necessary to provide for their needs. These goals can also extend to the client so that he or she has proper care in the event of incapacity. While finances certainly enter the picture, the primary focus of these goals is taking care of those who are important to the client, including him or her, and those for whom the client has a legal or moral responsibility. Clients also want to ensure their property is properly distributed. As is true when caring for children, this goal has a strong financial aspect. Following are a few ways this can be illustrated. Property inherently has financial value. Considerations might include ensuring the financial values are evenly distributed among children (or distributed in whatever way is consistent with client goals). The state also may demand payment of taxes related to the property distribution. The distribution itself may require payment of expenses to transfer the property. Also, the client normally wants to have some control over who gets his or her assets and under what circumstances. This includes the individual’s desire to support various philanthropic or charitable causes. Efficiency and effectiveness are also objectives. Clients want to ensure that assets will be distributed efficiently and without unnecessary legal or financial implications. Clients often want to ensure their assets are appropriately protected from creditors. Depending on the situation, a person’s assets may be frozen or seized in the event of legal action. The client’s lack of CFP Level 2: Module 1 – Retirement Planning - Global Page 45

negligence may not do much to protect those assets from legal liability. Typically, individuals can take measures to lawfully protect assets through tools such as trusts, certain insurance contracts, offshore arrangements, and wills. Financial distribution goals include wanting to ensure assets retain as much value as possible while going through the estate distribution and management process. This could include keeping a business healthy and on-going. It might focus on providing maximum benefit for a surviving spouse or other family members. Keeping transfer and distribution costs as low as possible is almost always a goal. Where applicable, this would include minimizing relevant taxes. Personal Incapacity During old age many clients become incapacitated and need to plan for that possibility. As is true when thinking through the potential incapacity of others, clients may need the services of a guardian to take care of themselves, and a conservator or administrator to take care of their financial concerns. For obvious reasons, this is something best arranged prior to the time of need. Some jurisdictions allow for an individual to provide a power of attorney that authorizes someone to act on behalf of the individual. A power of attorney is a written document that provides the person receiving the authority (i.e., agent, or attorney-in-fact) with broad general authority or more specific limited authority. A general power of attorney typically ends when the principal (i.e., the person executing the authority) becomes incapacitated or dies. A durable power of attorney is often a better choice, because the agent’s authority endures throughout the principal’s period of incapacity. The agent’s authority may be immediate, or may only begin when the principal becomes incapacitated (i.e., a springing durable power of attorney). Given the potential authority of the agent, the principal should exercise care in deciding applicable limits and make professional referrals as needed. A client may also want to use a living will (where allowed). A living will or similar, typically is revocable, meaning the individual can change or terminate it. A living will’s primary purpose is to allow the individual to identify what kind of medical care — especially in the area of life-sustaining care — they want in the event of incapacity and inability to make those decisions. An individual may also choose to use other healthcare-related documents (e.g., medical proxy; durable power of attorney for healthcare). Regardless of the title, and whether or not a specific document can be used in a given situation, the idea is the same — to provide advanced directions so others know what the individual wants to have happen in the event of incapacity. Incapacity would also likely create the need for funding. This, too, should be addressed in the preparation process. Sometimes, insurance may provide a solution, but other times assets should be appropriately allocated. One possible solution for this is to create and fund a revocable living trust. The trust documents can provide for the individual’s care when needed. Since it is a trust, the documents CFP Level 2: Module 1 – Retirement Planning - Global Page 46

can be fairly specific as to the way in which funding is provided and care is given. The person creating the trust (i.e., grantor) will need to fund it so money is available when needed. Since it’s revocable, the grantor could terminate the trust if necessary. Remember to always work with a qualified legal professional. Philanthropy Many people wish to give back to society and it is a positive goal. People for whom philanthropy or charitable giving is important often begin this practice early in life. However, in many cases, the individual may not have as much money as he or she would like to support the preferred level of giving. Often, as they work through the wealth transfer preparation process, clients may find they are able to do more than they previously were able. Philanthropic efforts can include gifts while the donor is living as well as bequests provided at their death. Depending on the jurisdiction, both gifts and bequests may provide some tax benefits to the donor, and these should not be ignored. However, for many people, any tax benefits are secondary to their desire to give back to their family or community in some way. Obviously, this is a personal decision, and there is no right or wrong answer as to whether, or how much, someone should give. Many clients want to share some of their financial well-being, and the financial advisor can help them do so. The client may simply give a gift to an organization or individual. Amounts can vary from very small to entire estates. The amount doesn’t matter as much as the act of giving. Of course, for some, the amount matters very much, because they want to do great things with their money, such as create scholarships or endowments; build hospitals or schools, and the like. While interacting with clients, financial advisors should ascertain clients’ philanthropic or charitable giving wishes. This is true throughout the client engagement, but becomes very important at the time of wealth transfer. One good way to learn how a client feels about giving is to ask. It is also simple that one or two questions on charitable-giving goals can be included in the initial discovery process. It is also a good idea to check in on this area throughout the client-advisor relationship. First on the wealth transfer list of goals is taking care of the client’s personal needs. It’s likely that retirement expenses, including medical expenses, will be higher than anticipated. A wealth transfer program that does not take this into account may run the risk that the client will run out of money. Many wealth transfer programs use strategies that involve removing the client’s ownership rights in an attempt to remove the assets and cash flow streams from the person’s taxable estate. While this may be a worthwhile endeavour, the financial advisor must exercise care to keep enough assets to meet on- going needs under the client’s control. In some jurisdictions, methods exist to effectively remove an asset from the client’s estate and also provide an on-going cash flow stream, and this may be a CFP Level 2: Module 1 – Retirement Planning - Global Page 47

reasonable course of action. The point here is not to choose one good strategy. Rather, it is to remind you to keep the client’s entire financial picture in mind when exploring wealth transfer strategies. Let us take an example to understand retirement planning Question Your client Aruna wants to retire 25 years from now with the inflation-adjusted equivalent of Rs.45, 00,000 additional annual a incomes. Payments at the beginning of each year. As you and Aruna b discuss her retirement, you agree to plan for 30 years of inflation- c adjusted income in retirement. Annual inflation is stable at 2.9 per d cent, and Aruna’s portfolio is earning six per cent annualized. Aruna Correct Answer wants the entire amount in place at the beginning of her retirement. Explanation How much will she have to save at the end of this and every year for the next 25 years to meet her goal? Distractor #1 a Distractor #2 b 31,87,590 49,27,500 50,76,009 33,78,741 D Step 1: What is Rs.45,00,000 in today's rupees worth 25 years from now? Mode = END, P/Y = 1,C/Y=1 N = 25, I = 2.9, PV = -45,00,000, PMT = 0, CPT FV = 91,95,955.96. Step 2: To maintain purchasing power, the negative impact of inflation must be addressed. ((1.06/1.029) −1) ×100=3.01263. Step 3: Determine the amount needed to fund the next 30 years of Aruna’s inflation-adjusted retirement income payments. Mode = BGN, P/Y = 1, N = 30, C/Y=1 I = 3.01263, PMT = 91,95,955.96, FV = 0, CPT PV = -18,53,73,000. Step 4. Mode = END, P/Y = 1, N = 25, C/Y=1, I = 6, PV = 0, FV = 1,853,73000, CPT PMT = -33,78,741 Calculator in BGN mode for step 4 Calculator in BGN mode for step 4. I = 3.01263 for step 4. Need to use nominal rate - everything has been adjusted for inflation already. CFP Level 2: Module 1 – Retirement Planning - Global Page 48

Chapter-3 Retirement Needs Analysis and Projections Learning Outcomes  Upon completion of this chapter, the student will be able to:  Identify the types of information to collect regarding a client’s estimated retirement expenses  Analyze financial goals and obligations  Calculate financial projections in retirement based on a client’s current financial position  Calculate amounts required to fund retirement cash flow needs  Analyze the impact of changes in assumptions on financial projections Topics  Longevity risk, inflation and the impact on retirement cash flow needs  Goal classification and funding  Fixed and terminable  Fixed and permanent  Variable and terminable  Variable and permanent  Goal development  Establishing goals and timelines  Determining goal priorities  Selecting and administering long-term investment portfolios  Risk, return and implications for retirement planning Introduction We have understood setting goals and objectives along with general considerations about healthcare, lifestyle objectives, financial conditions and targets. We will now understand retirement needs analysis and projections. It is very important to remember that any projections are little more than educated guesses. Financial advisors need to do a lot of research while making assumptions but it is also true that there is not one person who can accurately predict exactly what the future holds economically, CFP Level 2: Module 1 – Retirement Planning - Global Page 49

financially and personally. As a financial advisor, you should help clients understand this truth so they keep the needs analysis and projection process in perspective. It also means that you shall do a lot of research and spend time to accurately predict return from various products and about economy. Financial advisor also needs to understand that needs analysis is a valuable part of retirement planning. It does mean that you should build a financial cushion into your projections to provide some level of flexibility and responsiveness to situations and events that are almost certain to impact a client’s retirement at some point during that period. You should also be as careful and exacting as possible as you gather information, analyze and use it, along with proper research, to make financial projections and develop strategies to allow the client to support retirement needs. Longevity Risk, Inflation and the Impact on Retirement Cash Flow Needs We have understood by now risk of longevity and inflation so far. Both these factors influence retirement cash flow requirements. However, we have not yet explored the degree to which living longer in an inflationary environment can have an impact on retirement needs analysis. Longevity and Changing Assumptions We know that people are living longer than ever before. Assumptions that a financial advisor and client make regarding the client’s longevity will have a big impact on the retirement plan. In the last chapter, we worked through a retirement cash flow funding calculation, where the number of years in retirement played a key role. In years past, many retirement plans were built on the assumption of a 20-year lifespan after the person entered retirement. So, an individual who retired at age 65 would plan for 20 years of retirement cash flow, until he or she reaches age 85. Based on a first-year retirement cash flow need of Rs.5, 00,000, the person would require a fund of Rs.74, 25,837. Return of 7% and inflation of 3.5% is assumed throughout the period. 20 N 3.3816 I (Real rate of return) 5,00,000 PMT {0 FV} P/Y=1, C/Y=1 PV Solve = 74,25,837 [BEG] CFP Level 2: Module 1 – Retirement Planning - Global Page 50

However, the amount of anticipated life after retirement considerably affects the required fund. The amount needed to fund 10 years of retirement cash flow will be less and the amount required to fund 30 years after retirement will be more. While making assumptions about longevity of our clients, we need to be conservative; it means we need to assume a longer age, more inflation rate and less rate of return so that any deviation from assumption will be in the interest of investor only. Let us take an example and consider different longevity (different number of years after retirement.) Mr. Sameer is planning for retirement and he assumes that when he retires at age 65, he will require Rs.6, 00,000 in the first year . Rate of return is 10% p.a. and inflation rate will be 5%. How much corpus will be required if life after retirement is 15 years 20 years 30 years 15 years 20 years c) 30 years 15 N 20 N 30 N 4.7619 I (Real rate of return) 4.7619 I (Real rate of return) 4.7619 I (Real rate of return) 6,00,000 PMT 6,00,000 PMT 6,00,000 PMT {0 FV} {0 FV} {0 FV} P/Y=1, C/Y=1 P/Y=1, C/Y=1 P/Y=1, C/Y=1 PV Solve = 66,30,641 [BEG] PV Solve = 79,93,978 [BEG] PV Solve = 99,30,573 [BEG] Underestimating the life expectancy can become a major concern as we know required amount to be estimated will depend on assumed life expectancy. As we saw above, the difference between planning for a 10-year period and a 30-year period is substantial – around Rs.33 lakh. To make matters more difficult, once an individual stops receiving earned income the die is cast. For the most part, clients will not have additional money to add to their retirement fund. Investment earnings will certainly contribute, as will income from government and employer programs. However, the longevity factor included in calculations will have a (probably the most) substantive impact on the plan’s success or failure. As a result, this part of the planning process deserves special consideration and discussion between advisor and client. CFP Level 2: Module 1 – Retirement Planning - Global Page 51

As discussed earlier, it has to be conservative estimate or in other words, assume a higher life expectancy. Good financial advice adage is plan for the worst and work for the best. In this case, planning for the worst means including the longest reasonable lifespan for the client. Family history is a good place to start. Some families have historically high or low life spans. If every person in the family line has died by the time he or she reached age 75, and the client is of similar health, it might be reasonable to use that as a starting place for retirement planning calculations. Likewise, if most family members live into their 90s, that becomes a reasonable starting point. But if you plan for the client to live too long and reduce their annual income in anticipation of increased longevity, they may miss out on their desired quality of life and die with additional money they would have preferred to spend. An advisor may decide not to modify a client’s anticipated longevity, but might alter either the inflation rate or the investment return rate to lower retirement funding requirements. Clients often do not have a good understanding of historical inflation or investment return rates. Further, they usually do not understand how to forecast what those rates might be in the future. They depend on the advisor for guidance. Changes to inflation and return rates can have a big impact on required funding amounts. While planning for them, instead of assuming very high or very low life expectancy, they can do necessary changes in other assumptions. The logic is that the client should be happy with the way planner is planning as well as never short of money. We adjusted data inputs to illustrate that they could be saving enough to fund their entire retirement. They probably feel good about that, but not true. It is better to plan for a longer life expectancy using conservative inflation and investment return factors. Doing this may make it more difficult for the client to accumulate the desired amount. It may also result in having money left over if the client doesn’t live as long as anticipated, or investment returns are higher or inflation lower than anticipated. However, having more money than needed at the end of retirement is better than not having enough, as long as it doesn’t sacrifice the client’s quality of life. If we are going to err, let’s do so by allowing the client to have plenty of money during retirement, and ending life with the ability to leave a bequest to children or a charitable organization. We have assumed in our example the required amount in the first year after retirement as Rs.6,00,000 p.a. But we also know that during retirement, couple does not require 100% of the last spend, they require between 60-80% of pre retirement expenses. Financial advisor can discuss this with the clients. Some clients may not be interested in reducing expenses during retirement, so all the calculations should be done accordingly. CFP Level 2: Module 1 – Retirement Planning - Global Page 52

Inflation’s Impact One of the most important factors which can impact corpus requirement at retirement is impact of inflation along with life expectancy. There is a substantial difference between projections based on 4.5 per cent inflation and one that suggests much higher rates. This is relevant for two reasons. First, current inflation in most of the developed world is at the historically low end of the scale. We are using 3.5 per cent as a benchmark (Inflation is high in case of India), and inflation in some countries is closer to zero or even negative. This is known as deflation (or hypo-inflation). While it may seem like a good thing for consumers, over an extended period, it’s a bad thing for a country’s economy. Eventually, prices must increase or the economy moves into long-term stagnation. This often results in job-loss, business-closings, and a general malaise throughout the economy. The opposite situation – hyperinflation – can be at least as bad, because wages and overall personal income cannot keep pace with price increases. Currently, the worst inflation rate (in Venezuela) is greater than 400 per cent (Statista, 2017). While this is an aberration, a few countries have current rates of inflation in double-digits. Let’s look at a quick future value calculation to see the potential impact on a Rs.5, 00,000 annual goal over 30 years. 3.5 per cent inflation 30 N 3.5 I 5,00,000 PV P/Y=1, C/Y=1 FV = 14,03,397 7 per cent inflation 30 N 7I 5,00,000 PV P/Y=1, C/Y=1 FV = 38,06,128 10 per cent inflation 30 N Page 53 10 I 5,00,000 PV CFP Level 2: Module 1 – Retirement Planning - Global

P/Y=1, C/Y=1 FV = 87,24,701 A 6.5 per cent inflation increase (from 3.5 per cent to 10 per cent) over 30 years period results in an amount that is more than six times as much. At some point, inflation considerations have to include retirement funding sources. Government- provided funds often do not include much, if any, inflation adjustment. Most fixed annuities also do not have a way to adjust for inflation’s impact. If most or all client resources are fixed, inflation can have a much greater impact than when at least a portion of the funds are in vehicles that are responsive to inflation, such as equities. This is directly applicable to developing a retirement funding portfolio. To illustrate the point, consider the Rule of 72 (i.e., the time required for an amount to double when a fixed annual interest rate is applied). To use the rule of 72, divide 72 by the annual interest rate. At 3 per cent, it will take 24 years to double an amount At 3.5 per cent, it will take 20.6 years 5 per cent requires 14.4 years 7 per cent, 10.3 years 10 per cent, 7.2 years With seven per cent inflation, purchasing power cuts in half in 10.3 years, and at 10 per cent, it only takes 7.2 years. Meaning, if a client enters retirement with Rs.50,00,000 in their hand or long-term bucket, that they don’t plan on touching for 10 years, and inflation is 7 per cent per year over those 10 years, that Rs.50,00,000 will effectively only buy Rs.25,00,000 worth of goods and services after 10.3 years. At 10 per cent inflation, the same will happen after just 7.2 years. As a result, the retiree will experience a reduction in lifestyle. This is a good reason to suggest that a client save for retirement on their own, in addition to any government plan. It’s also a reason to include inflation-sensitive investment vehicles, like equities, in the portfolio mix. Many financial advisors suggest having at least 50 or 60 per cent of investment assets in some type of equity (e.g., stocks) or real estate for a large portion of retirement to help ensure the client’s assets and income at least keep pace with inflation. A Financial advisor should review inflation history in his country. What trends are forecasted by economists? Is the government making plans to impact inflation rates (either up or down)? These are all good considerations that will help you make correct projections. CFP Level 2: Module 1 – Retirement Planning - Global Page 54

Goal Classification and Funding Retirement funding has to be based on the goals defined by client. You cannot apply rule of thumb as every plan has to be customised as per the needs of investors. It is helpful to recognize that goals can be classified to help the advisor and client with developing a retirement budget. We will use four classifications to help with the process: Fixed and terminable Fixed and permanent Variable and terminable Variable and permanent Let’s explore each category more completely. Fixed and Terminable Fixed goal amounts do not change during the funding period. A fixed home mortgage is a good example of making payments that do not change throughout the loan term. When an individual agrees to a mortgage, the plan is often to time the mortgage repayment period so that it is paid off prior to, or early in, retirement. Of course, an individual could make extra payments during the mortgage term, but just considering a regular repayment amount over a regular repayment period, illustrates a terminable goal or expense. As a general rule, the fewer on-going payment commitments a person has during the retirement period, the easier it will be to fund cash flow needs. Payments for any loans that cannot be fully repaid prior to retirement will need to be included in the retirement budget. As the loans are retired related payments can be put to other uses, such as paying off additional on-going commitments. Fixed and Permanent Some goals keep going even after retirement. Related financial arrangements will also not end at retirement. The potential problem is that, while payments remain at pre-retirement levels, retirement cash flow reduces after retirement. In at least some situations retirement cash flow is greatly reduced from pre-retirement levels. One on-going financial commitment may not create a problem. However, if the client has several commitments that will not end during retirement the financial burden can overwhelm the retirement budget. This is a good reason to discuss entering into on-going financial commitments long before retirement is scheduled to begin. Quite a few retirement-related concerns involve lifestyle decisions, many of which are made prior to retirement. Purchasing a bigger, better house or car fits into this category. What can be done when a CFP Level 2: Module 1 – Retirement Planning - Global Page 55

client realizes that financial commitments exceed the ability to continue making required payments? There is no standard solution that works in all situations. Each case has to be considered on its own. However, it is possible that the client may have to sell the house and downsize to something more affordable. If finances are weak, the client may have to begin renting, which is often worse, because there is no opportunity for rental payments to cease, rather than pursue on-going home ownership. The expensive car may need to be sold and replaced with one that is less expensive. Perhaps the solution is to forego owning a car and instead use public transportation alternatives. The decision to sell a home, car, or other asset is not confined to people with limited financial resources. It can also be a proactive choice made by clients with reasonable resources, but want to improve their lifestyle options by reducing expenses. It is important to remember that most goals require money and have financial consequences. As such, it is important for the financial advisor to work with clients to review long-term goals and financial decisions as part of early retirement planning discussions. Fixed, permanent financial decisions have the greatest long-term impact on retirement planning and budgeting. Variable and Terminable Some of the long-term goals may have variable funding requirements as there may be some goals of shorter duration. When interacting with clients, financial advisors have the most flexibility in this area. For example, a client may want to fund a grandchild’s education. This is an example of a goal that is variable and terminable. Financial advisor can discuss about various expenses related to tuition, fees, housing and related costs. The costs will vary depending on the University and place also. On-going support for dependent children, aging parents or other family members is another scenario that may exist. Here, the expenses are going to be less certain than with education and the client may not know for how long the funding need will continue. Discussions around this goal can be thoughtful. The client will likely feel a sense of responsibility to support their dependents. Providing this support can involve a lot of expense if healthcare costs are included in addition to housing and other regular expenses. This is an area that requires careful consideration because of its potential to reduce retirement funds. Some of the clients may be willing to cut support for dependents. If possible, this is an expense for which the client can set aside a contingency fund and look into the possibility of insurance cover that can help pay expenses. If insurance cover is an option, the client may be able to help make premium payments prior to the time of need. If that’s not possible, having a discussion with the parents (again, prior to the time of need) about carrying beneficial insurance cover can provide a solution. CFP Level 2: Module 1 – Retirement Planning - Global Page 56

The whole arena of dependent care for children or other family members who have special healthcare needs is often financially and emotionally difficult. The advisor cannot do much to address the emotional issues, but supporting a sensitive discussion of the financial requirements along with possible solutions can be helpful. A good time to encourage this discussion is long before the need presents itself, and if there is never a need, the client will have that much more money to put toward other goals. Variable and Permanent Monthly household expenses are the best example of a funding need that is variable, but will continue throughout retirement. Although these expenses are permanent but will keep changing over time. Some of the changes will come as a result of economic fluctuations. Prices increase and decrease. Necessary services almost always increase in price over time. Food, clothing, utilities and similar expenses also generally increase in price. The client does have some control in this area, but no control over actual costs. This is why, when formulating financial projections, the advisor should always include a reasonable inflation factor. Inflation will be there throughout the life of a person. Funding Requirements Once we have set and defined goals, funding is one of the most important steps in the retirement planning process. Developing a budget is important throughout life’s stages, and it is the most important during retirement. Always remember, the assets with which someone begins retirement are only going to decrease as he is using money from these investments. In few cases, it may not happen as a person may have enough retirement corpus that he is only using return on those investments. Let me explain it with the help of an example: Mr. Khurana has Rs.2,00,00,000 as retirement corpus. He has invested 50% in equity and 50% in fixed income getting an average return of 10% p.a. The expenses in the first year after retirement are Rs.9,00,000 p.a. If you feed the values in CASIO FC200 V calculator to know, how many years the money will last, it will show error. You can try this because money will last even if he is alive 40 years after retirement and also leave enough legacies for children. Return @10% will give him Rs.20, 00,000 p.a. but he started spending Rs.9, 00,000 p.a. Although the inflation will increase the amount required buy the remaining amount of Rs.11, 00,000 (20, 00,000-9, 00,000) will also remain invested at @ 10%@ p.a. leading to increase in corpus. CFP Level 2: Module 1 – Retirement Planning - Global Page 57

As long as a person has a job and earns an income, there is always the potential to increase financial assets. Once work (for pay) ends, the asset base does not get bigger, except for whatever is added from investment returns. After considering all this, we can begin exploring the amount required to fund a client’s retirement, and also any changes in goals that might result from the funding determination. Let’s assume a client, who wants to retire in 30 years, has an annual budget today of Rs.5,00,000. We are in an economic environment where eight per cent is a reasonable long-term (e.g. 20-plus years) investment return, and inflation averages three per cent. If we are also able to assume that the client’s basic budget will not change (which is unlikely, but OK for this example), except for inflation, how do we determine the amount needed to fund the client’s retirement cash flow needs? We do this with a three-part calculation: 1. Inflate the current cash flow amount for 30 years to determine the first year’s retirement cash flow need. This step uses the rate of inflation only. 2. Calculate the amount needed at the beginning of retirement (i.e., not today) to fund the inflation-adjusted cash flow required for the client to maintain purchasing power throughout the anticipated retirement period (in this case, let’s use 25 years). This step uses the real (i.e., inflation-adjusted) rate of return, and is almost always calculated as an annuity due (i.e., in BEGIN mode on financial calculators). 3. The third step can be either solve for a (PV) lump sum amount or (PMT) annual payments needed today to accumulate the retirement fund. As this step only involves the investment return, we will use the investment, or discount rate. Given our scenario, what is the first year’s retirement cash flow amount, and how much would be needed at the beginning of retirement to allow the individual to maintain purchasing power over the 25-year retirement period? The following steps allow us to determine the amount.  30 N 3 I  5,00,000 PV  P/Y =1, C/Y=1  FV = 12,13,631 CFP Level 2: Module 1 – Retirement Planning - Global Page 58

The client’s annual budget today is Rs.5, 00,000, which will be Rs.12,13,631 (rounded) in 30 years. If the client’s annual cash flow need does not change, in 30 years he or she would need Rs.12, 13,631in the first year after retirement to have the same lifestyle as today. How much money would the client need to accumulate by the beginning of retirement (At the time of retirement 30 years from now) to fund 25 years of inflation-adjusted cash flow?  25 N  4.8544 I(Real rate of return)  12,13,631 PMT 0 FV  P/Y=1 C/Y=1  PV Solve = 1,81,99,865(BEG) The client must have a fund of around Rs.1,81,99,865 in 30 years to provide the desired retirement cash flow. How much will the client have to save to reach that goal? The process to calculate a lump sum needed today or periodic annual payments over the next 30 years is the same with one difference – whether you solve for PV or PMT.  30 N 8 I (Rate of return) 0 PMT  1,81,99,865 FV  P/Y=1, C/Y=1  PV = 18,08,654 Or for payments  PMT = Rs.1,48,757[BEG] The client would need to either deposit Rs.18, 08,654 today, or agree to make annual level payments of Rs.1, 48,757. That amount of annual savings may seem high at the beginning, but is less likely to seem so high in the future (especially with regular salary increases). Even so, most clients will not be able to save that exact amount every year. It may be more realistic to begin with a smaller amount and increase it annually as income increases. What does the client envisage doing during retirement? If the individual were to continue working in some capacity and earning a cash flow, he or she might be able to offset the required investment. CFP Level 2: Module 1 – Retirement Planning - Global Page 59

Let’s change the scenario and say that the client wants to fund their grand children’s education but has not yet accumulated any money to put toward the goal. Let us take an example to understand this We can work with a four-year tuition amount of Rs.5,00,000 (future cost i.e., when tuition payments begin). To accumulate the money to pay for tuition would only will require an additional Rs.  30 N 8 I  5,00,000 FV  P/Y=1, C/Y=1  Solve for PV = 49,688 Of course, if the tuition amount is stated in today’s terms, rather than the cost upon reaching retirement, we would have to inflate the tuition amount over the next 30 years, with the required amount changing to Rs.12, 13,631.  30 N 3 I  5,00,000 PV  P/Y=1, C/Y=1  Solve for FV = 12,13,631 Doing a quick present value calculation on that amount means the client must deposit an additional Rs.1, 20,607 today to have enough money to fund the future tuition.  30 N 8 I  12,13,631 FV  P/Y=1, C/Y=1  Solve for PV = 1,20,607 We can easily see the impact changes can make in the amounts required to fund future retirement- period goals. As an advisor, you will need to consider the various changes to develop a retirement plan. Keep in mind, too, that it’s better to keep assumptions conservative, because you would rather the client accumulate a little more money than needed instead of not enough. Also remember that there is no way to accurately predict the future, so you should review earnings rates, inflation amounts, and all CFP Level 2: Module 1 – Retirement Planning - Global Page 60

other inputs each year. Making changes annually will be easier than waiting five or ten years to make changes – especially if the required amounts have increased substantially. Also, don’t forget about additional expenses, such as those for healthcare. If we were to add the anticipated amount needed based on the Fidelity study, we would need an additional $260,000 in today’s dollars. You can expect the amount to change, but it is not clear whether it will increase or decrease (the amount periodically has gone in both directions). Let’s look at the planning we have done to evaluate it for reasonableness. Remember, we have not included any government-provided or other benefits, nor have we taken into account any amounts the client may already have accumulated. Both of these items can help reduce the client’s funding requirements. This would be good, because if we add the health-care costs to the original amount needed, plus money needed to fund the inflated tuition costs for grandchildren, the client would need to accumulate a larger amount to fully fund retirement cash flow needs. When we include additional expenses for travel and other goals, the funding requirement will further increase. We will make an assumption that the client does not have the money available to fully fund their retirement needs. The real question is whether the client has the discretionary cash flow to meet the required annual funding amount. That amount could be difficult for some individuals. If so, what path would you suggest for the client? We will explore possible answers to this question below. Insurance and Other Benefits We need to consider insurance and other benefits that can impact retirement planning. First, some employees may be getting government guaranteed pension income; some employers also give the benefit of pension. We discussed previously about the financial advice rule; “Plan for the best, but develops strategies in case the best doesn’t happen”. Where government or employer benefits are concerned, this means an advisor should be cautious when helping a client plan for retirement, because the advisor cannot guarantee the anticipated benefits will be available when needed. Even when the benefits get paid, the recipient never knows whether they will continue, or at what level they may be paid in the future. As a result, good planning should not ignore potential benefits, but neither should it depend 100 per cent on them being available. The client and advisor should discuss this, and together determine the degree to which they feel comfortable including government / employer benefits, and at what level. In situations where the individual has few years remaining prior to retirement and has not saved enough money to fund any sort of lifestyle, depending on potential benefits may be the only real option. CFP Level 2: Module 1 – Retirement Planning - Global Page 61

Insurance can also play a part. Part of good financial advice is to consider how you might use different types of insurance or other products, such as annuities. An advisor cannot simply consider the potential benefits, but must also compare them to their cost. Working through a cost-benefit analysis is a good process. Health or medical (including long-term care) insurance and annuities are the two primary products that come to mind for retirees. Life insurance may or may not be valuable, depending on things such as outstanding debts (e.g., home mortgage), need for estate planning purposes, taking care of dependents: parents, children living at home, or those with special needs requiring on-going care Health insurance –Is an important part of good planning. Even when the government or an employer provides some benefits, many people find they are more comfortable with at least a supplemental benefits policy. Such a policy can fill the gaps in government and other programs. At the same time, be careful not to have the client duplicate benefits and pay for something that he or she doesn’t need. As always, careful analysis pays. Example Question We know that people are living longer than ever before. Assumptions that a financial advisor and client make regarding the client’s longevity will have a big impact on the retirement plan. Your client has a first-year retirement cash flow need 20 years from now of $75,000 (future value that has already been adjusted for inflation 41,526 PV in today's dollars). This will be paid out of the account at the beginning of every year. Your client also wants their retirement income fund amount to be fully funded upon retirement. Assuming an investment return rate of 8% and inflation at 2.5%, what is the difference in the investment fund inflation- adjusted amount required if the longevity assumption moves from retiring for 25 years to retiring for 35 years? The purchasing power of the $70,000 has to be maintained. a $154,028 b $73,485 c $162,292 d $79,363 CFP Level 2: Module 1 – Retirement Planning - Global Page 62

Correct C Answer Step 1: Q is asking inflation-adjusted retirement cash flow. ((1.08/1.025) Explanation −1) ×100=5.36585. Step 2: Calculate amount needed in fund for 25 years Longevity Mode = BGN, P/Y = 1, N = 25, I/Y = 5.36585, PMT = 75,000, FV Distractor #1 = 0, CPT PV =1,074,047. Step 3: Calculate with longevity at 35 years: Mode = BGN, P/Y = 1, N = 30, I/Y = 5.36585, PMT = 75,000, FV = 0, CPT PV =1,236,339.37 Step 4 Calculate the difference: 1,236,339 - 1,074,047 = 162,291.95 a Calculator in END mode for steps 2 & 3 Distractor #2 b Calculator in END mode for steps 2 & 3 & I/Y = 8 for steps 2 & 3 Distractor #3 d I/Y = 8 for steps 2 & 3 Goal Development Client goal should form the foundation of every engagement between client and financial advisor. We have discussed various retirement goals. Now, we want to review goal development, and then look into how a client can prioritize goals. Financial goals need to be specific that are tied to specific life cycles. Not only does this help identify financial priorities, but it can further define associated time lines and help establish more realistic and effective financial goals. Well defined goals share three characteristics:  A defined purpose  A specific timeframe  A monetary amount Establishing Goals and Timelines The investment time horizon is the period available until money is needed for a financial goal. A financial goal with a high degree of certainty and a short time period requires a focus on capital preservation, and therefore a selection of assets that remain stable in value (most likely interest- bearing instruments). The money in this category fits well into Bucket 1. CFP Level 2: Module 1 – Retirement Planning - Global Page 63

For example, an investor who plans to make a down payment for a house six months from now would want to keep that money in an asset with minimal risk, like a six-month bank fixed deposit, flexi deposit account or liquid fund of a mutual fund. Longer time horizons (e.g., Buckets 2 and 3) can allow for investments that, though they will fluctuate in value, offer increased appreciation potential. For example, if the investment goal is accumulating Rs.1 crore for retirement 25 years from now, investments with higher long-term expected returns i.e. equity either directly or through mutual fund route will be appropriate. Investment once done needs to be monitored and reviewed regularly. SMART Goals Goals should be considered in relation to each other, because many (if not most) will have an impact on the others. Goals could be:  Short-term (two years or less)  Intermediate-term (from two to ten years)  Long-term (more than ten years) (These tenures are as per global standards) Categorisation of goals as per time horizon will be useful as it will help the financial advisor make appropriate recommendations as to how to allocate financial resources to achieve the goals and to see that right amount of money is available at right time to meet goals. Goals need to be SMART .  Specific  Measurable  Attainable  Realistic or Relevant; and  Trackable or Time-bound How would a financial advisor turn a client’s wish for a comfortable retirement into a SMART goal? After having advisor and the client’s initial communication, the advisor would have to ask some clarifying questions. What information does the financial advisor need to develop a useful retirement planning goal?  The client’s current age and status (i.e., single, married, etc.) Page 64  The age at which the client wishes to retire CFP Level 2: Module 1 – Retirement Planning - Global

 The client’s desired retirement lifestyle This would require a determination of how much money would be required to fund the desired lifestyle.  Available financial resources  Government or employer-provided pension  Money already accumulated  Discretionary funds available for application to meet this goal  Competing goals and uses for available funds  Anticipated longevity (how long should we plan for the retirement period?)  Expected rates of return and inflation This will also require an understanding of the client’s risk tolerance and any investment-related limitations Let us understand some SMART goals. Specific: The client wants to maintain same lifestyle in retirement as she is maintaining now, except for the possibility of moving into a beach house. She is 40 years old and, even though she really enjoys her work, wants to retire at age 65. Longevity runs in her family, so she wants to plan to live in retirement for 35 years. Measurable: Current annual living expenses = Rs.4, 50,000; annual inflation is expected to average 4.5 percent, and her portfolio rate of return should average 9.00 percent. The inflated equivalent of Rs.450, 000 in 25 years is Rs.13, 52,446. That’s the first year’s cash flow requirement. If we were going to carry out the process, we would need to determine the amount needed to fund the inflation- adjusted annual cash flow throughout the entire retirement period. Without going through the calculations here, the client would require a portfolio at the beginning of retirement valued at slightly more that Rs.2.53 crore. Attainable: The client has already accumulated Rs.5, 00,000, which will grow to Rs.43, 11,540 by age 65 (at 9 percent per annum). Assuming no pension benefits, this leaves her with having to accumulate Rs.2.09 crores. The client can easily afford the required annual contributions of Rs.2, 26,500, so her goal is attainable. CFP Level 2: Module 1 – Retirement Planning - Global Page 65

Realistic: Based on her continuing to earn at the same general rate, with no unanticipated large expenses, and assuming she follows through with annual contributions, and that both inflation and her rate of return meet expectations, the goal is realistic. Time bound: Given that the financial advisor and client know the amount required at age 65 and the periodic payments needed to fund that amount, the goal is trackable/time bound. Annual reviews would allow client and advisor to determine the degree to which the plan is on track and any adjustments needed. The retirement goal of a client will look like this “The client wants to retire in 25 years at age 65 and wants to have an annual cash flow in retirement that is the inflation-adjusted equivalent of her current annual cash flow. The retirement cash flow period will last for 35 years.” The goal statement would not include the financial particulars (e.g., the inflation-adjusted annual cash flow or portfolio amount needed at retirement). However, to determine whether the goal fits the SMART criteria, the advisor would need to evaluate each of those details. As a result, it may be that the initial goal would need to be modified somewhat, based on funding requirements and the client’s ability to satisfy them. The discovery process needs to be robust so that financial advisor is able to get a greater understanding of the client’s desires, it would be easy for the goal to be expanded.  As we complete the SMART goal process, we included several steps in the process required to determine whether the goal will be achievable.  After identifying the client’s general wishes, we focused on quantifying the goal statement with both financial constraints and timeframes.  Then, we checked existing resources and determined whether additional resources would be needed.  If the financial advisor were to take the next steps in the process, he or she would need to consider potential strategies, along with any potential funding constraints or limitations.  Then, the financial advisor would make recommendations for the goal-achievement strategy, and advisor and client would then work to implement the strategy.  The advisor would round out the process by regular review, with possible adjustments based on economic and personal changes. Determining Goal Priorities We have understood how to help clients determine retirement goals. One question an advisor can ask that can be helpful when trying to determine goal priorities is: “What does a fulfilling or satisfying retirement look like to you?” CFP Level 2: Module 1 – Retirement Planning - Global Page 66

Retirement is different for different people as we have discussed in earlier paragraphs. Can you imagine about you, how retirement means to you. For me it is lot of traveling, helping society with money and knowledge. 1) The first step in the goal-prioritization process is discussing and determining how the individual views retirement. How does he or she hope to shape the retirement period. Within this discussion, the advisor should help the client understand the need to build a strong financial foundation. An individual’s financial foundation usually includes items such as sufficient types and amounts of health insurance cover, adequate savings – especially emergency funds, enough money to meet monthly living expenses and on-going debt repayments if any (although debt should have been paid off before retirement), focused savings for large purchases. 2) For many retirees, a secondary level of goal priorities includes items such as education funding for grandchildren, saving for a house, funding for a wedding (or more than one), money to start a business, or for other large goals. Funding the client’s ideal retirement may fit into this second priority level, or it may stand on its own. The retirement funding category can be misleading, because it can incorporate many existing goals. For example, financial security goals will continue throughout the retirement period. These can include things such as insurance premium payments, having enough money to live independently throughout retirement, money to cover potential emergencies, etc. The primary difference in funding these goals is that during retirement, no new work-related income is being generated. This may not have much impact on funding goals if the individual has sufficient assets to produce their desired cash flow. However, for many retirees, with the exception of investment earnings (e.g., rental receipts, stock dividends, bond income), new sources of cash flow are limited. This can impact goal achievement and prioritization. The best time to prioritize goals and make plans to fund these goals is much long before retirement begins. If we accept that the foundational goals already mentioned automatically have top priority, all remaining goals have to be prioritized in a secondary position. How can this be accomplished? Even an excellent discussion between the client and financial planner will not prevent inadequate financial resources from obstructing goal achievement. This means that within the prioritization process, the client must allow the one or two most important (non-foundational) goals to rise to the top of the list. CFP Level 2: Module 1 – Retirement Planning - Global Page 67

When asking clients what a fulfilling retirement looks like to them, it will be important for the advisor to allow enough time for the clients to reflect and carefully consider the answer, and understand that it may change as retirement gets closer. This may mean suggesting the clients think this through on their own time and return with an answer. One way to consider the question is to turn it around and ask what would make for a negative retirement experience if it was missing. As an example, if the client wants to travel to see grandchildren annually, what difference in their satisfaction would it make if they could not do the traveling? Sometimes there is value in taking away options to help clients recognize what is most important to them. It can also be helpful to frame the decision in the context of asking, “If money was not a concern, and you had all the required financial resources, what would you like to achieve? ”This type of conversation can be difficult for some clients, and some advisors, too. It may open areas the individual has kept closed for many years. A good financial advisor will recognize this possibility and proceed accordingly. Eventually, as we have seen, goals must be funded. This means that without funding goals are unlikely to be achieved. Some clients will have such limited financial resources that their ability to achieve goals will be reduced to those in the financial foundation. For others, especially when planning begins early enough, there will be enough money to achieve at least one additional goal in retirement perhaps several. As a financial advisor, one of the top goals should be helping the client accumulate enough funds so he or she can achieve as many high-priority goals as desired. To do this will involve building an investment portfolio. We will look at this next. Selecting and Administering Long-Term Investment Portfolio We need to first review some key factors in determining optimal retirement investment (cash flow) portfolios. As we have discussed earlier also, people today are living longer, longevity is increasing. While the percentage of increased life span seems to be slowing in some areas and increasing in others, it is clear overall that people are living longer. This must be factored into any long-term retirement planning. Whether it remains level, increases, or decreases, we can be certain that inflation will continue to be a factor. As we have seen, the loss of purchasing power due to inflation can be the cause of considerable difficulties for retirees with a three per cent inflation rate, over 24 years; the cost of living comes close to doubling. This means that a Rs.5, 00,000 annual budget today will need to be Rs.10, 00,000 in 24 years, with no increase in purchasing power. We can conclude from this that retirement portfolios must be structured to, at the least, keep pace with inflation. This means incorporating equity in the portfolio. Equity provides growth to the portfolio and debt gives stability. CFP Level 2: Module 1 – Retirement Planning - Global Page 68

However, with equities comes volatility and when structuring a portfolio, especially for someone close to retirement, you have to consider volatility, and choose asset allocations accordingly. Asset allocation is one of the most significant factors in portfolio success. A mostly fixed-income/cash- based retirement portfolio is rarely the best idea for most people. While investment risk discussions often focus on market risk, especially for retirees, loss of purchasing power represents an equally, if not more significant risk. This being the case, most retirement portfolios should include equities or real estate investments that keep pace with inflation. The percentage will vary based on client goals and risk profile. For our purposes, let’s suggest a 65 per cent equity allocation at the beginning of retirement, recognizing that this percentage may need to be adjusted based on current economic and market conditions, and the individual’s risk profile. We have earlier discussed about bucket strategy. The portfolio also needs to allocate from one to three years’ worth of cash flow/budget requirements to a cash or cash equivalents bucket (i.e., Bucket #1). This will fund each year’s withdrawal needs. It would also be prudent to allocate a percentage of assets to an emergency fund. This money should also be held in cash equivalents or at least something stable and liquid. How much should be allocated to an emergency fund? That will vary from person to person. We do not have to cover regular expenses from this fund, so there should just be enough to cover any emergencies, such as repair of laptop, LED, need to fly to another country for a family emergency, without negatively affecting the overall retirement portfolio. What’s the best way to invest funds in the equity allocation? As you know, not all equity investments are equal. For example, a significant difference exists between buying 100 shares of a new start-up company stock and 100 shares of Toyota, Siemens, Sinopec Group, or Alibaba. Further, there is a big difference between buying shares of those four companies directly, and holding them in a mutual fund or other collective investment scheme. Let us assume Sameer is among the many people for whom owning equities in the form of mutual or exchange-traded funds (ETFs) makes the most sense (for this example, we will not include options, commodities, or direct ownership of real estate). Let’s build a portfolio (Bucket #3) around shares of funds, recognizing that, depending on the individual and the size of the portfolio, direct ownership of company stocks (or other securities) can be a viable option. The real question for Sameer is what types of funds are most appropriate? This question refers to options such as index or non-index (i.e., passively or actively managed), domestic, international, global, large-cap, mid-cap, small-cap, emerging markets, growth, value, growth and value, etc. There are 44 Mutual Funds (AMC’s) in India having variety of schemes to choose from. The bigger problem is deciding what percentage of the various categories to use, and then selecting the actual funds within each category. CFP Level 2: Module 1 – Retirement Planning - Global Page 69

As Sameer’s financial advisor, what allocation would you suggest? Is there enough information to do more than a basic allocation? Recognizing that we could discuss actual allocations for days, we will use the following asset classes:  Large-cap domestic  Small-cap domestic  Broad-based international (Few schemes of MFs investing in US markets)  Emerging markets (international) (Not available in India as of now) REIT (real estate investment trust) (Not available in India as of now) Let’s also assume that the list moves from lowest market risk to highest (realizing that the REIT category is somewhat of an outlier). How would you determine the percentage of each asset class for Sameer’s portfolio? Further, would you recommend keeping it the same throughout retirement, or would you shift the allocation over time? Since we are looking at a portfolio during retirement, the overall market-risk level needs to be considered in that context. While we have agreed on a 65 per cent equity exposure (in this example), we should bias that exposure to the lower end of the risk spectrum. At least part of that exposure might include dividend-producing assets. However, because the other looming risk is the loss of purchasing power, and Sameer may live for another 30 years or more, we should allocate some portion of the equity portfolio to more risk- aggressive assets. In addition to large-capitalization domestic equities, Sameer could benefit from international assets (both large and small cap) to help diversify any purely domestic risk. Also, it could be good to include a small percentage of REIT ownership for diversification and potential cash flow generation (when available) Sameer’s long-term equity portfolio allocation might look something like this: (As per Global content), it will vary in India.  Large-cap domestic: 50 per cent  Broad-based international (large and small cap): 25 per cent  REIT: 10 per cent  Small-cap domestic: 7.5 per cent  Emerging markets (international): 7.5 per cent This portfolio is designed to provide growth and income, along with reasonable domestic and international diversification. The small-cap and emerging-markets exposure is significant, but not too CFP Level 2: Module 1 – Retirement Planning - Global Page 70

great for the initial retirement portfolio allocation (around 15 per cent of the equity, and 10 per cent of the total portfolio allocation). This higher-risk allocation should give the portfolio extra growth potential, which may be needed to offset higher periods of inflation. The REIT exposure amounts to around 6.5 per cent of the total portfolio allocation, with the remainder (35 per cent) of the portfolio invested in fixed income. This is only one example of a potential retirement portfolio. However, this sample allocation can serve as a starting point for thinking about how to initially invest the client’s retirement portfolio. Regardless of the starting point, the question becomes, should the initial allocation remain the same throughout retirement or should it be changed over time? In India, many of the options discussed as per global standards are not available, we suggest financial advisors to create a portfolio as per the time horizon and risk appetite of investors. If you feel more exposure to equity than desired by client should be done, make your client understand the importance of more equity in the portfolio. In India, most of clients wish to deposit the entire retirement corpus in debt which provides fixed income. As we all know, impact of inflation cannot be ignored while planning for any goal and retirement is amongst the most important goals. Variety of schemes with different objectives is available in mutual funds. Financial advisor can select the best schemes out of many better performing schemes for their clients and keep monitoring the retirement portfolio once every 6 months and if need be rebalance by selling non performing schemes. As a young investor may be 100% of retirement investment in equity and as age increases, slowly keep shifting money to fixed income and at retirement, keep around 30-40% in equity, rest in debt. Equity portion will again vary as per risk appetite of investors. Education the clients about risk and return can help investors increase their risk appetite. You would probably agree that the allocation should not remain constant throughout retirement. As Sameer moves closer to the end of his life, cash flow needs—including those for healthcare expenses— will likely increase, requiring a greater allocation to income-producing investments (e.g., high-dividend equities and fixed income). Additionally, from a psychological standpoint, many, if not most, seniors grow more conservative and fearful as they age. The fear is based on reality. They are no longer generating new income, and they need to have confidence that their existing asset base will last as long as they do. This usually results in a gradual decrease in their risk-tolerance threshold. By the time Sameer reaches age 75 or so, he might be more comfortable with an allocation closer to 20 per cent equities / 80 percent fixed income. Over the following 10 years, he may want to continue reallocating the portfolio to a more conservative, cash flow-generating mix. Sometime in his final decade, Sameer may want to adjust his portfolio allocation to nearly 100 per cent in fixed income CFP Level 2: Module 1 – Retirement Planning - Global Page 71

comprised of short-term bonds and cash equivalents. Remember though, neither Sameer nor anyone else knows exactly how long they will live. If all of a client’s planning focuses on only 25 or 30 years in retirement, and they actually live for 40 years, they could be in financial distress at life’s end. This advanced planning and scenario testing is where the value of financial advice and client’s working with a financial advisor comes in. We cannot create “best” portfolio-allocation plan. The optimal retirement portfolio allocation for each client will depend on their individual needs, goals, risk tolerance and time horizon. Instead, we have looked at creating an overall flow and built a potential foundation for a sustainable retirement portfolio. Each individual’s situation will determine optimal investment allocations to meet their retirement goals. Risk, Return and Implications for Retirement Planning Before making strategy for investing to accumulate retirement corpus, financial advisor needs to gain an understanding of a client’s risk appetite. Risk Profiling is very important part of planning process as asset allocation will depend on client’s risk appetite. As the individual approaches and enters the retirement period, risk capacity (i.e., the ability to sustain a loss and still achieve investment goals) and time horizon may become even more important than risk tolerance. As an extension of this process the advisor must explore some general considerations about investments and their risk-adjusted return potential. Then, the task becomes combining the two areas to determine whether the individual’s return expectations are consistent with their risk tolerance. This must also be compared with the client’s risk requirement, or the necessity of earning a minimum return to support retirement cash flow goals. Portfolio construction and asset allocation decisions will likely be at least a little different prior to retirement than within the retirement period. People tend to develop a more conservative risk tolerance as they progress through retirement. Also, their risk capacity generally decreases, because they need to ensure continued availability of funds and cannot afford as much volatility as they may have in preceding decades. If a client has enough funding for his comfortable retirement, there is no need to take excess investment risk. There is no need to incur greater volatility in an attempt to increase available funds. Most clients will not be in this situation and will need to at least explore the possibility of increasing portfolio risk in an attempt to increase investment return. Remember that there generally is no way to increase investment return to any degree without also increasing investment risk. Also remember that increasing risk is not a guarantee of increasing return. Doing so just opens the door to potential increases. CFP Level 2: Module 1 – Retirement Planning - Global Page 72

The average person investing for retirement and in retirement will likely require accepting an increased level of investment risk. If we embrace the bucket concept in retirement and place enough money in the first cash bucket to fund around two years of cash flow, it will be a little easier for clients to accept an increased level of risk for the third bucket (longer term investments). Prior to retirement, accepting portfolio risk is almost mandatory if the client is going to accumulate enough money to fund retirement goals. The degree to which this is true will depend largely on the amount the client needs to accumulate and the timeframe in which to do so. We can illustrate this using return averages for different asset classes. Over the 20 years from 1997 to 2016, here are average annual returns for a few asset classes (Blackrock, 2017). Cash 2.30 per cent Fixed Income 5.30 percent REIT 11.04 percent Large cap value stocks 8.30 per cent Int’l stocks 4.20 percent Small cap stocks 8.20 percent Depending on the resource consulted, you can find variations on historical return figures, but the preceding list will serve our purposes. The list is ordered according to relative risk levels (although you can find different ordering in various lists). Notice that REITS have a return greater than the stocks, but often are considered to be less risky. Part of the reason is that different asset classes exhibit different returns over different time periods. Another part of the reason has to do with the type of real estate the REITs hold. When a fund holds actual properties, there is always the potential to sell the properties and recover lost funds. This is less likely with any type of stock (although a company could sell assets in liquidation). When we developed a portfolio for Sameer, we used the following allocation:  Large-cap domestic: 50 percent  Broad-based international (large and small cap): 25 percent  REIT: 10 percent  Small-cap domestic: 7.5 percent  Emerging markets (international): 7.5 percent The question you have to ask as a financial advisor is whether this allocation is appropriate, and if so, during retirement, pre-retirement or both? Further, as we mentioned above, how should Sameer’s portfolio be adjusted as he ages? The answer to the first question is yes, the portfolio is at least potentially appropriate before, as well as during, retirement. The answer to the second question CFP Level 2: Module 1 – Retirement Planning - Global Page 73

hinges of how long Sameer lives, how much money he has accumulated relative to retirement funding requirements, his risk tolerance and to what degree does Sameer become more risk averse over time. If a client starts investing early, investing even a small amount per month and taking adequate amount of investment risk will lead to accumulation of huge corpus. May be the client does not wish to take more risk but he has more surplus available to invest which when invested at moderate rate of return can accumulate so much corpus that his retired life can be taken care of perfectly. A can invest Rs.6,00,000 p.a. for next 25 years at a return of 10% p.a. (moderate risk), he will be able to accumulate Rs. 6,49,09,059 (6.49 crore) that is fair enough amount to take care of his needs. B is having a surplus of Rs.300000 p.a., if he invests at a return of 14.25% p.a. he will be able to accumulate the same amount Rs.6,49,09,059 You can see how available time and funding requirements influence portfolio risk decisions. This fact will have to enter into discussions with the client around goal achievement realities. Sometimes, as we have seen, the client will not be able to accumulate the required amount of money within the available timeframe, given the amount of investment he or she can make. Other times the client can probably accumulate the funds, but only by assuming a relatively higher degree of risk. These decisions continue throughout the retirement period. Recall the potential problems associated with increased longevity and inflation. If the client is unwilling to accept a moderate risk level during retirement, he or she may have to accept a lower standard of living, because funds will be depleted over time. The financial advisor should educate clients about the different types of risk, including purchasing power, and the potential impact on portfolio development considerations. We now have a fundamental understanding of retirement goals, their development and portfolio funding solutions. In the next chapter we will look at sources of retirement cash flow, many of which are provided by the government and do not require personal savings and investments. CFP Level 2: Module 1 – Retirement Planning - Global Page 74

Chapter-4 Potential Sources of Retirement Cash flow Learning Outcomes Upon completion of this chapter, the student will be able to:  Identify details to collect of a client’s potential retirement cash flow sources  Analyze retirement benefits provided by the government  Analyze retirement benefits provided by employers  Explain how annuities are used to provide retirement cash flow Topics  Pension funds  Government-sponsored  Defined benefit plans  Employer-sponsored  Defined contribution plans  Types of non-pension employee retirement benefits  Individual retirement plans  Annuities  Types of annuities  Settlement and pay out options Introduction Ancient Roman Emperor Augustus (from 27 BC until AD 14) wanted to guarantee the loyalty of his soldiers. To help ensure this, he offered a pension to people in the army with at least 16 years of service. Payment was to be in cash or land at a rate of 12 times their annual salary. As a result, military wages and pensions absorbed half of Rome’s tax revenues. The emperor would not be the last person to underestimate the cost of providing retirement benefits (The Economist, 2016). This problem is still continuing around the world today and is largely the result of defined benefit pension plans. We all know longevity has increased and return on investments has fallen down resulting in greater difficulty funding the guaranteed retirement benefits. CFP Level 2: Module 1 – Retirement Planning - Global Page 75

In this chapter we will explore some of the retirement benefits provided by governments and employers, along with ways in which annuities may be used to fund retirement cash flow. Pension Funds There are two primary types of pension plans: defined benefit (DB) and defined contribution (DC). Defined benefit plans promise to pay a specified benefit to qualified retirees. Defined contribution plans do not guarantee a retirement benefit. They provide a sum of money which the retiree can use to fund retirement cash flow based on amounts the individual has contributed, employer contributions, and investment return rates. Often, DB plans do not require any contributions from individuals. Accounts are fully funded by the sponsor (e.g., government and/or employer). Usually, DC plans require participants to contribute to the plans. In fact, without participant contribution, it is possible the individual will not accumulate any money in the plan. Some countries offer fully-funded DB plans (sometimes also known as a social security program) while others have a combination of DB and DC plans, with both government funding and private/individual funding. We will look at government-sponsored pensions first and then those offered through employers. Government-Sponsored Just as Emperor Augustus provided a government-funded pension for people in the military, most countries provide some level of pension payments to citizens. The Organization for Economic Cooperation and Development (OECD) has produced a report on OECD and G20 national pension indicators for the last 10 years (OECD, 2016). The latest publication indicates significant pension reforms among many of the 42 countries covered in the report. OECD states that “the last decade has been a period of intense reform . . . with governments changing key parameters of their retirement income systems and, in some cases, proceeding to overhaul the design of pension schemes, often scaling down the ambition of public pensions and giving a larger role to funded DC retirement provision” (OECD, 2016, p. 9). Increasing the minimum retirement age to as high as 67 (occasionally higher) has been one of the major revisions in several territories (countries). These changes point to the problems we have identified of increased longevity and decreased investment returns. Unfortunately, increasing the age at which an individual can receive full retirement benefits does not also automatically increase the individual’s ability to continue working. Sickness and injury often force workers to step out of the workforce before they might otherwise desire to do so. Although many plans provide some level of benefits related to participant’s health, this has a potential impact on workers’ pension benefits, especially when they cannot continue working until reaching the increased retirement age. At the same time, a larger number of workers seem to be deciding to work CFP Level 2: Module 1 – Retirement Planning - Global Page 76

for more years. This is largely due to a combination of decreased pension payments and the hope of greater income through increased employment earnings. Many public pension systems are pay as you go (PAYG) models. A PAYG model funds the pensions of retired people using contributions from those who are currently working. With more workers living longer and fewer younger workers paying into the system (largely due to decreased birth rates in many territories), many PAYG systems are experiencing some level of financial distress. Defined Benefit Plans Defined benefit plans guarantee a retirement income benefit, usually based on earned income and years of employment. When most people think of traditional pension plans, they are considering DB plans. The exact definition and plan parameters may be different among various countries/territories, but the basic principles will be similar. Benefits and the contributions necessary to provide them are determined by actuaries, and often updated annually. The DB plan’s guaranteed retirement benefit is at its core. That guarantee gives retirees an increased confidence level about how they will live during retirement, because they know the amount they will receive each month. They also know whether the amount will increase over the years as inflation causes purchasing power to decrease. Assuming the provider (e.g., government or employer), along with the pension plan, remains solvent, the retiree will have a base income on which to live. He or she may want to supplement the amount provided, but at least the foundational amount will be provided. DB plans may be public (i.e., social insurance or social security) or private (i.e., employer-sponsored), or a combination of the two. DB benefits usually are built around a formula that delivers a fixed amount or percentage benefit based on the worker’s salary and years in the plan. Plans may consider all annual income amounts or just the latest or highest paying years. For example, a plan formula may provide a benefit based on two per cent of the final year’s salary times the number of years in the plan. If a worker participated in the plan for 30 years and had a final salary amount of $100,000, the annual benefit would be two per cent of $100,000 times 30 or $60,000. Another option might provide something like $200 per month for each year of service, up to 25 years, for a total of $5,000 per month. Plans may also use modified formulas. Regardless of the formula used, all DB plans specify the amount the worker will receive at retirement. The amount may remain level throughout retirement or it may be adjusted periodically to compensate somewhat for the effect of inflation. CFP Level 2: Module 1 – Retirement Planning - Global Page 77

Types of mandatory, retirement income programs include the following (Social Security Administration, 2016): Flat-rate pension: Uniform amount or one based on years of service or residence but independent of earnings. Earnings-related pension: Based on earnings. It is financed by payroll tax contributions from employees, employers, or both. Means-tested pension: Paid to eligible persons whose own or family income, assets, pension income, or a combination of these fall below designated levels. Flat-rate universal pension: Uniform amount normally based on age, residence and/or citizenship but independent of earnings. Provident funds: Employee or employer contributions are set aside for each employee in publicly managed special funds. Benefits are generally paid as a lump sum with accrued interest. Occupational retirement schemes: Employers are required by law to provide private occupational retirement schemes financed by employer and, in some cases, employee contributions. Benefits are paid as a lump sum, annuity or pension. Individual retirement schemes: Employees and, in some cases, employers must contribute a certain percentage of earnings to an individual account managed by a public or private fund manager chosen by the employee. The accumulated capital in the individual account is used to purchase an annuity, make programmed withdrawals, or a combination of the two and may be paid as a lump sum. Some plans base qualification on accumulating a minimum number of points. Each year contributions, based on a reference salary, are converted into points. Pension benefits are based on the number of points accrued. Points may also be accrued for periods of unemployment. Points are assigned a current value, which in turn, is used to determine a pension benefit. The number of pension points a person can accrue annually may be limited by regulation. Also, early retirement may cause a point reduction, which also reduces monthly benefit payments. Researching the systems that use points reveals a number of variables in how they are credited, accrued and applied. However, each system adds pension points and multiplies them by a pre-determined value so they can be converted into pension payments. Please note that employees are not responsible for investment results in DB plans. Regardless of what investments earn, the plan guarantees the benefit. This may mean the government or employer (whichever is sponsoring the plan) may have to increase plan contributions, but it should not impact CFP Level 2: Module 1 – Retirement Planning - Global Page 78

the retiree’s benefits. Also notice that years of service frequently are part of the retirement benefit determination formula. This is likely to mean that employees with fewer years of service will automatically receive lower benefits during retirement. Fewer years of service (or plan participation) may result from ending working years sooner than normal or starting to work later than normal. It may also indicate that sometime during life the worker stopped working for a period. An example might be when a parent left the workforce to raise their children. Or, in the case of employer-sponsored DB plans, it could be a job or career change into the company in a client’s later working years. While some territories compensate for this by providing a regular benefit, others do not, and reduce retirement benefits correspondingly. There are two additional terms we need to define. The first is eligibility and the second is vesting. Employer-sponsored DB plans (and DC plans, too) require a minimum period before the worker is eligible to participate in the plan and begin accruing benefits. Often, this period is only a year or two, perhaps also requiring a minimum participation age (e.g., 21). Some plans may also include a requirement for a minimum number of hours to be worked during the year (e.g., 1,000). This requirement effectively eliminates workers who are seasonal or only work on a part-time basis. Prior to eligibility the worker does not begin accruing benefits. Vesting is the point at which accrued benefits belong to the individual. A participant may be fully vested after a year or two, or perhaps not for five to 10 years. Being vested does not mean the worker can actually receive the benefits immediately. That may have to wait until a specific age or numbers of years have passed. Vesting does mean that, whenever benefits can be paid, they will be due the participant. If the participant has accrued a vested benefit of $10,000, he or she will be paid the $10,000. As we indicated, payment may not come until the participant reaches age 65, but it will be made at that time. Sometimes vested benefits are given to the participant at any time when he or she terminates employment. The rules vary by plan and by territory, and may sometimes include a requirement for minimum years of participation. For example, a plan may require at least 10 years in the program before fully vesting. If a participant has fewer than the minimum required years, he or she will likely receive a reduced level of benefits. Cash Balance Plans: Defined benefit plans sometimes are structured as cash balance plans. These plans generally conform to the DB concept, but are set-up a little differently. A cash balance plan remains a DB plan, but it also shares aspects of a DC plan. As a result, a cash balance plan promises a pension benefit that is stated in terms of the accrued account balance. As a general description, a cash balance plan credits a participant’s account with an annual pay credit, which is based on a percentage of compensation. Additionally, the account has an interest credit, which can either be fixed or variable, CFP Level 2: Module 1 – Retirement Planning - Global Page 79

and often is linked to an index or other conservative asset type. Investment risks continue to be borne by the employer, rather than the participant. Pension benefits are based on the age at retirement and the account balance. Accounts are sometimes called hypothetical accounts because they do not reflect actual contributions or investment returns. We should insert a cautionary note at this point. Even though DB plans promise to pay a specific retirement income benefit, there is no guarantee the full benefit will be paid. Recent years have seen more than one territory undergo significant financial distress. Although almost all territorial governments attempt to maintain pension and social insurance programs, deep enough financial stress may prevent them from doing so. Employers may also undergo significant financial difficulties resulting in pension benefit defaults. Most territories have programs designed to prop up such default, but consider what might happen if both the employer and the government were experiencing significant financial difficulty at the same time. We bring this up as a reminder to encourage clients to do as much of their own retirement planning as possible. If they were to accumulate enough money to fully fund their retirement, and their government pension also came through, what would be the downside? Certainly, they would have saved and invested money that they could have put to other uses during their working years. At the same time, during retirement, they will have more money to achieve any goals that require funding. They will be able to enjoy an increased standard of living, give money to charitable organizations and leave money to children and grandchildren. Contrast that scenario with one in which the client did not save for retirement because he or she was depending on government- provided benefits, but those benefits either were not paid or paid, but greatly reduced. Once a person begins living in retirement, it’s too late to start saving. Another reason to save money for retirement has to do with the age at which a person wants to retire. As mentioned, territories are increasing the minimum age at which full retirement benefits can be claimed. It’s becoming more common for the minimum age to be close to 66 or 67. If a client wants to retire before the minimum age allowed by the government, what can be done? If the worker has not saved any money for retirement, the answer likely is nothing . . . continues to work more years or accept a reduced benefit based on an earlier retirement age. On the other hand, if there are adequate funds, the individual can retire when desired using money he or she has accumulated to provide full retirement cash flow. Then, the retiree can begin receiving government benefits when they become available. Though, the only negative consideration to having too much money accumulated is that some programs reduce government-provided benefits when an individual has too much other income. If this is true in your territory, you will want to modify recommendations accordingly. We have been covering DB plans as if no participant contribution is required. While this may be true insofar as a requirement to make specific contributions, most plans do require some level of contribution (e.g., especially from employers, but also from participants). This often comes as a form of taxation, where individuals and/or employers are required to pay taxes to support pension plan CFP Level 2: Module 1 – Retirement Planning - Global Page 80

benefits. For example, the Pay As You Go models which are funded by taxes and contributions from the current work force. An increasing number of DB plans are being supplemented by DC plans (e.g., hybrid plans). In other situations, DB plans are going away and being supplanted by DC plans. Governments sometimes offer both types of plan or just one or the other. Employer-sponsored retirement plans can be DB, DC or a combination, but are increasingly only DC plans. We will continue our coverage by looking at employer- sponsored DC plans next. Employer-Sponsored Defined benefit plans may have the longest history, but defined contribution and hybrid plans are overtaking them in application. One reason for this is the relative expense and complexity of most DB plans. A DC plan provides for and specifies contributions rather than benefits. Where DB plan participants know the retirement benefits they will receive, those in DC plans do not. They can know their account balance, but not the benefits that balance may provide. Benefits are determined by participant contributions, employer (or government) contributions and investment returns. Unlike DB plans, in most cases, participants are responsible for making investment decisions, and have to accept the results. DC plans are usually set-up so that each participant has an account, rather than all participants participating in one omnibus account maintained by the government, plan provider or employer[26]. Some plans convert accumulated amounts into pension payments while others simply provide the account balance and allow the participant to determine withdrawal amounts and timing. Whether or not the government contributes to the plan, it will almost certainly enact and enforce rules to oversee the plan and protect participant accounts. The types of DC plans, tax benefits and regulations vary from one territory to another, but the overall purpose and structures are similar. We can categorize DC plans into five categories (SSGA, 2015). 1. Open-architecture, broad-investment choice: Primarily used in US, UK, Ireland and Australia. The provider offers a large range of funds from which employers and employees can choose. 2. Government-mandated or collectively bargained guaranteed return: Primarily used in Germany and Belgium. Insurance contracts provide stated returns on participant savings. 3. Government- or state-approved provider: Primarily used in Chile and New Zealand. Employees have some degree of investment choice. Also used in Thailand, Hong Kong and Mexico. In these plans employers choose a licensed provider who then determines participant investment choices. 4. Personal pension brokered markets: Primarily used in the Czech Republic and Israel. Participants use account balances to purchase individual pensions through brokers. 5. State insurance model: Primarily used in Morocco and Pakistan. Participants pay into state- sponsored insured funds. CFP Level 2: Module 1 – Retirement Planning - Global Page 81

Financial advisors working with multi-national companies and clients, who may live in multiple territories, should be aware of the potential plan differences. Multi-national employers generally want as much plan similarity as possible in the various territories in which they have employees. This is true, in part, to ease administrative issues and also because employees may move between territories as they continue working for the organization. Some areas, especially Europe, have been considering and implementing actual cross-border plans (Allianz Global Investors, 2013). However, a client’s DC plan in territory A may be fundamentally different from one held in territory B. Plan differences tend to revolve around the plan structure (as identified in the list above), as well as local regulations, employment law, tax implications, investment options, fiduciary responsibilities and plan benefits. The superannuation plan in Australia provides an example of one well-recognized and well-structured plan having several contribution options. Australian super plans require payment into the pension fund directly either on a pre-tax or after-tax basis (http://www.australia.gov.au/information-and- services/money-and-tax/superannuation). Notional Accounts: Most DC plans require actual contributions into separate accounts. However, four OECD territories – Italy, Norway, Poland and Sweden – have notional accounts (OECD, 2016, p. 124). China and Russia also use notional accounts in combination with defined contribution plans. According to OECD, notional accounts record contributions in the individual accounts and then apply a rate of return to the balances. The term notional comes from the practice of accounts existing only on the books of the managing institution. When the participant retires, the accumulated notional amounts are converted into a pension payment stream, based on life expectancy. These plans may be called notional defined contribution (NDC) plans. Each territory may have multiple types of DC plans. As an example, the U.S. has target benefit, money purchase, profit sharing, cross-tested, 401(k), several stock-based and stock option-based and Keogh plans. The U.K. has money purchase, executive pension, group personal, master trust (e.g., NEST, NOW pension), Self Invested Personal Pension (SIPP), Small Self-Administered Schemes (SSAS) and Stakeholder pension plans (Gov.UK, 2017). The exact nature of each plan is not important for our purposes, but knowing the variety that exists is worthwhile. You probably have more than one pension plan type in your territory, too. DC Plan Downsides The biggest downside of DB plans is the cost and administrative complexity. The upside is that participants have a guaranteed retirement income stream. DC plans offer greater variety, lower costs and less administrative complexity than DB plans, but the plan type also has a number of potential downsides. The biggest downside is related to its very nature. DB plans provide a defined retirement benefit. DC plans provide a plan into which participants can make contributions (along with employers and the government) from which they can create a retirement cash flow stream. However, the CFP Level 2: Module 1 – Retirement Planning - Global Page 82

retirement cash flow is not guaranteed in most territories. Plan participants normally are responsible for making investment decisions. This can result in larger or smaller accounts even when contributions are of the same amount. When receiving retirement cash flow, DC plans usually do not control the amount or percentage a retiree can withdraw. This is great when it comes to flexibility and freedom of choice. However, it may also result in the retiree running out of money at some point during retirement. Most plans offer several investment options. While this is potentially beneficial, it also can produce participant concerns and questions. Often, when there are many options, participants get confused about how to invest. This may lead to them being vulnerable to those who suggest an investment scheme that does not benefit the participant. Usually, fewer investment options are preferable to too many. Even the fact that participants often can choose the degree to which they contribute is a potential problem. When times are tough and finances are low, people may choose not to contribute when given the option. This will help current cash flow. However, at retirement, it will also mean less money has been accumulated, resulting in lower than desirable cash flow levels. Some territories are addressing this problem by making contributions mandatory from both the employee and employer. DC plans sometimes offer ways to get some or all plan funds before retirement. Participants may access funds by taking a withdrawal or making a loan. Loans are supposed to be repaid, but withdrawals do not have to be. Even when a loan is repaid, the money was not producing any investment return while it was out of the account. Of course, this is also true of withdrawals. The biggest downside remains the lack of retirement cash flow certainty. Low contribution amounts and poor investment returns can combine to create a retirement cash flow environment that is less than satisfactory. From a public policy standpoint, this may result in people entering the public welfare system, because they do not have enough money to fund living expenses. As a financial advisor, you can provide a great service to clients by showing them how much they should contribute and the investment return to be targeted so they can achieve a retirement cash flow benefit on which they can live. Additional funding is nice, but not necessary. Having enough money on which to live should be considered mandatory. Types of Non-Pension Employee Retirement Benefits We will not explore this information in great detail, but you should know that some plans in many territories/countries provide non-pension retirement benefits. Healthcare probably is the biggest non- pension benefit. This can include regular medical benefits, extended care (long-term care), specialized, such as dental and eye care, along with other ancillary benefits. Sometimes benefits are provided directly by the government, paid for by taxes. Other times, employers offer extended benefits to retired employees. When employers provide the benefits, they may fund them through existing CFP Level 2: Module 1 – Retirement Planning - Global Page 83

accounts established for this purpose or from the employer’s general account. Often benefit payments are provided on a hybrid basis by combining private with public/social insurance (government) benefits. Employers have been offering financial wellness benefits, too. Financial wellness refers to an individual’s overall financial condition. It can include savings, investments, debt, various types of insurance cover, funding tools (e.g., college, housing, etc.) and similar. Often, these benefits are being offered to existing employees, and some employers are extending the offer to retirees. Financial wellness can also include income tax and estate distribution guidance, both of which can be especially beneficial for retirees. Retirees may receive life insurance and death benefit payments, also. Benefits may include specific monthly payments to spousal and dependent children beneficiaries. Sometimes the employer provides an actual life insurance policy to the retiree. Usually, the retiree has made periodic premium payments, supplemented by the employer, over a period of time. At retirement, the policy becomes the full property of the retiree. Additionally, retirees may receive legal services, university tuition payments, transportation fees (e.g., public transportation), athletic facility access, and others. It’s difficult to identify all possible benefits, so you may want to explore the options in your territory. Individual Retirement Plans So far, we have focused on employer- and government-sponsored retirement benefits. In addition to these, individuals may be able to contribute to non-occupational individual retirement plans. Of course, anyone can save money in an account targeted to provide cash flow during retirement. In this section we will refer to those accounts that offer some degree of tax benefits, either during the contribution period, the distribution period, or both. Not all territories offer these plan types, but among those that do so in some form are: Bulgaria Canada Costa Rica Malaysia Singapore U.K. CFP Level 2: Module 1 – Retirement Planning - Global Page 84

U.S. Several Eastern European, Scandinavian and South American territories (https://www.ssa.gov/policy/docs/ssb/v66n1/v66n1p31.html) Plans may be voluntary or compulsory and may be designed either to integrate with DB/DC plans or function on a stand-alone basis. They also have various names in each territory. For example, in Canada, you might see a Registered Retirement Savings Plan (RRSP) or Retirement Savings Plan (RSP). The UK has several types of Individual Savings Accounts (ISAs), while the US has traditional and Roth Individual Retirement Accounts (IRA). These are some examples, and plans in other territories go by different names. Each plan type shares a few similar characteristics, including tax deferral and regulatory limits and requirements. Individual retirement savings plans almost always provide some degree of tax savings. This is done to encourage individuals to use the plans to save money for the future. Some of the plans also allow for tax and/or penalty free withdrawals for certain pre-retirement expenses, such as purchasing a home or paying tuition or medical expenses. These retirement savings plans can provide tax-free or tax- deferred growth within the plan and initial deposits may be made on a tax-deferred basis as well. Plans also normally have annual contribution limits – whether or not the initial contribution has specific tax benefits. Contribution limits also may include specific account-type limitations. For example, UK ISA plans have four sub-plan types with each type having specific contribution limits. There is also a limit of the total amount that can be contributed to all plan types in a year. What types of investments can you use? That varies as well. Some accounts only allow cash, while others allow money to be invested in shares, stocks, annuities, and other options. Some plans limit certain asset types, such as real assets, commodities, option contracts, and similar. Plans that allow for stock/share investments often do not tax the growth (capital gain). When more than one provider offers plans, participants may be able to transfer from one account to another without tax implications. Usually, there are rules on how this may be done and how often. Also, it may be possible to make a temporary withdrawal, use the money, then re-deposit in the account without having to pay tax or penalties. As with the other areas, participants and their advisors should carefully review relevant regulations to ensure they do not inadvertently run afoul of requirements. It may be possible to incur on going penalties or even invalidate the plan by not following relevant regulations. Flexibility and control is another characteristic of many individual retirement savings plans. Plans provided through the government and employers often limit options around investments, beneficiaries, pre-retirement access to funds, vesting, contribution amounts, and perhaps other areas. Individual accounts usually provide the ability to bypass some or all of these limits. However, as we CFP Level 2: Module 1 – Retirement Planning - Global Page 85

have seen, they come with their own limits, but those normally are less onerous than with government and employer plans. Question Broadly speaking, there are two primary types of pension plans: Defined Benefit (DB) and Defined Contribution (DC). Which of the following statements is most likely correct? a Defined benefit plans promise to pay a specific retirement income benefit, and there is a guarantee that the full benefit will be paid. b Where defined contribution plan participants know the retirement benefits they will receive, those in defined benefit plans do not. c Defined contribution plans are usually set-up so that each participant has an account, rather than all participants participating in one omnibus account maintained by the government, plan provider or employer. d Unlike defined contribution plans, in most cases, defined benefit participants are responsible for making investment decisions, and have to accept the results. Correct Answer C Explanation Defined contribution plans are usually set-up so that each participant has an account, rather than all participants participating in one omnibus account maintained by the government, plan provider or employer. Distractor #1 a Even though DB plans promise to pay a specific retirement income benefit, there is no guarantee the full benefit will be paid. Distractor #2 b Where DB plan participants know the retirement benefits they will receive, those in DC plans do not. Distractor #3 d Unlike defined benefit plans, in most cases, defined benefit contribution participants are responsible for making investment decisions, and have to accept the results. CFP Level 2: Module 1 – Retirement Planning - Global Page 86

Annuities Annuities have been used as part of retirement funding for many years. They are an investment option rather than a retirement plan type, but because they provide some unique benefits, we are covering them separately. Before governments opened the door to various retirement plans, many people used annuities to provide cash flow during the retirement period. Annuities have a history going back to the Roman Empire (Ritchie, 2017). From the beginning, annuities represented an agreement between a buyer and seller whereby the seller promised a stream of payments for a period of time (or life) and the buyer agreed to make an up-front payment. Sellers, of course, were interested in making a profit, and buyers were looking for a level of long-term financial security. Sellers wanted to have a way to estimate how much money they would have to pay, so they developed early versions of actuarial tables to measure and predict life expectancy. Annuities have gone through many revisions and iterations over the years, including French tontines, which provided lifetime payments in return for an up-front payment. This is similar to how a regular annuity functions, but with tontines, as one of the purchasers dies, the accounts were divided among the survivors. Today, annuities are developed and sold by insurers, who employ actuaries to do what actuaries have always done – determine life expectancy of one or more groups of people. The life expectancy tables are a major component of determining required funding and payment amounts to annuitants and beneficiaries. Early on, annuities were considered conservative options, especially as they offered income guarantees. Today, while some of that approach continues, annuities may be less conservative and offer several more options than those that existed previously. In today’s world, annuities are simply another investment option, one that, in some territories, provides tax benefits. However, annuities continue to offer, as one of their most valuable options, the possibility of a lifetime income stream. In a time value of money context, an annuity is a stream of payments. We can apply that concept to the annuity product. At its core, it was (and remains) designed to provide a stream of regular payments to the annuitant (i.e., the owner/beneficiary and recipient of the payments). An annuity’s function is to spread invested capital and earned interest over a period – such as the life of the annuitant. Actuaries and mortality calculations enter the picture to determine, based on age, and sometimes gender, the amount of each periodic payment to the annuitant. When the capital and interest turn into an income stream, the contract is said to be annuitized. Annuities do not have to be annuitized over the lifetime of the annuitant. Payments can be structured to last for a specified period, such as 10 or 20 years. In fact, many of today’s annuities do not have to CFP Level 2: Module 1 – Retirement Planning - Global Page 87

be annuitized at all. Unlike with their original iteration, annuity owners may simply make withdrawals at those times when they want to add some income to their cash flow. We should note that some jurisdictions, notably those offering tax-deferred earnings, might require that withdrawals, in specified amounts, begin by a certain age. Further, depending on the contract, either the insurer or the government may assess taxes, surrender charges and penalties against withdrawals. Let’s explore some details regarding annuity types, funding and pay out options. Types of Annuities Immediate Annuities Immediate annuities are those where a single sum is deposited and payments to the annuitant normally begin one benefit period after the contract is issued. The annuity payments are either a fixed amount (immediate fixed annuity) or an amount that varies with the unit value of the underlying fund (immediate variable annuity). An immediate annuity (annuitization) most often is purchased because the buyer wants to begin receiving a stream of regular periodic payments that are guaranteed by the insurer to last for some pre-specified period of time, generally the remaining life of the beneficiary(s) or some other pre-selected time frame. Two very important considerations exist when contemplating annuitization. First, annuitization is generally irrevocable. Once payment begins, no option exists to reverse the decision and retrieve the principal. The second consideration is the erosive long-term effect of inflation on purchasing power; inflation at four per cent per year halves purchasing power in a mere 18 years. This substantial risk cannot be ignored by the advisor; clients should always be alerted to this risk and presented with the option of inflation-adjusted payments. Deferred Annuities Deferred annuities allow for payment of either a single sum (single-premium deferred annuities) or a series of payments over a period of years (fixed or flexible-premium deferred annuities). The accumulation period begins once the first premium payment is received and the contract is issued. This period lasts until the time when the funds are removed from the contract under an annuity option. The policy owner normally has the option of making occasional withdrawals, receiving periodic (i.e., annuity) payments under one of several possible annuity options, or taking a lump-sum cash payment. Annuity payments begin at the date stated in the contract, although generally the annuity start date can be changed by the policy owner at any time before annuity payments begin. The amount of the payments depends on several variables, including the amount invested, the return earned on that CFP Level 2: Module 1 – Retirement Planning - Global Page 88

amount, the age of the annuitant when payments begin, and the period for which payments are guaranteed. Payments consist of both principal and interest. Annuity payments can be based on the life of one person or on the lives of two or more people. An annuity contract issued on two lives, where payments continue in whole or in part until the second person dies, is called a joint and last survivor annuity. An annuity issued on more than one life, under which payments stop upon the death of the first person, is called a joint life annuity. While withdrawals may be permitted if funds are needed prior to annuitization, they may be subject to tax or other penalties (depending on the company and jurisdiction). The issuing insurance company may impose penalties (called surrender charges) on annuity distributions. Surrender charges normally do not last throughout the entire contract period. Instead, they normally decrease over a period of years until they are eliminated. After the first year, investors often can withdraw a percentage of the annuity’s value without incurring a surrender charge. Because of possible penalties and tax considerations, individuals should consider whether an annuity is the best option for their money and their goals. Once the annuitant selects an annuity income option and payments begin, the annuity account is more or less frozen. At this point the owner has used the amount accumulated in the annuity to purchase an annuity payment stream from the insurance company—so any amount previously accumulated in the annuity no longer belongs to the owner (it was “sold” to the insurance company for the income stream). When someone says the funds in an annuity are “annuitized,” he or she is referring to this purchase. Some companies are making changes to annuities that allow for increased distribution (pay out) flexibility. Fixed Annuities Annuities may be fixed or variable, and the two options are quite different. In the same way that a whole life insurance contract is fixed, meaning pre-set premiums, cash values and death benefit, a fixed annuity contract is pre-set. A fixed annuity payment period may be immediate or deferred, but either way, the amount is fixed in the contract. Contracts almost always vary by company, so even though we can identify basic or core contract types and benefits, it is highly likely that individual insurers will offer variations. Also, we are talking about base contracts. Insurance contracts and annuities often provide options (i.e., riders, endorsements or additional features) that modify basic coverage. As an example, we may identify that a basic fixed annuity contract provides for level payments throughout the contract period. However, the annuity may also have an option that provides for inflation (e.g., cost-of-living) adjustments. These additional coverage options and guarantees almost always increase a contract’s expenses. As such, you should do a cost-benefit analysis to determine which options, if any, you should recommend. CFP Level 2: Module 1 – Retirement Planning - Global Page 89

Fixed annuities are generally more appropriate for conservative individuals, and those who want a guarantee of future income. Deposits are invested in the company’s general account and provide a low, guaranteed return. The return paid on a fixed annuity is a potential downside. Remember the basic investing rule: low risk usually results in low returns. This holds true for annuities. In fact, if an advisor sees a fixed annuity offering overly high returns or pay outs, he or she should be suspicious and investigate how the high returns are being generated. Chances are good that the insurer is using hedging techniques (not always a bad thing) or increasing risk levels in some way that may not be appropriate for a client. Peace of mind is the biggest value of fixed annuities for many individuals. Some people are willing to forego higher returns and higher income payments in favour of a guarantee. However, others are not so willing, and for them, a variable contract may be appropriate. A deferred fixed annuity is a savings account that earns a fixed rate of interest for a time specified by the insurer. After that period, the insurer establishes a new rate. A bailout provision is an annuity contract provision in which the company agrees that if any new rate established by the company is below the rate specified in the provision, money in the contract can be withdrawn without a company- imposed penalty. Not all contracts offer a bailout provision. The insurance company typically guarantees both principal and interest in a fixed annuity. Assets backing fixed annuities stay in the company’s general account and are subject to creditors’ claims in the event of insurer financial difficulty. Variable Annuities One big problem with fixed annuity payments is that they are fixed. The guaranteed pay out amounts is a two-edged sword. On the one hand, the annuitant can feel secure (assuming on going insurer financial viability) in knowing exactly how much money will be coming in each month. That very security, however, often creates problems. A fixed payment never changes, but cost of living almost always does. As previously discussed, market risk is not the only type to note. Especially for those who live long, maintaining purchasing power can be a risk that is as big, or bigger. With any amount of inflation, the cost of an item tomorrow will almost certainly be greater than today’s cost. The same is true for all inflation-sensitive expenses, and if all the annuitant’s payments are fixed, eventually he or she may begin to struggle financially. A variable annuity may provide a solution, in that, depending on investment returns, annuity payments may keep pace with inflation. If we can compare a fixed annuity to a whole life insurance policy (minus the life insurance part), we can compare a variable annuity to a variable (or VUL) life contract. The variable annuity accumulation account invests in owner-chosen mutual funds, or their insurer equivalent. This means that variable annuities are securities, and must be treated as such (including observing all licensing-related requirements). CFP Level 2: Module 1 – Retirement Planning - Global Page 90

All annuities, other than those with immediate annuitization, have two primary periods. During the accumulation phase, the owner makes deposits into the annuity (or one deposit, with a single- premium annuity). In a fixed annuity, these deposits go into the general fund and earn whatever rate has been contractually guaranteed (plus any excess, if applicable). This is not what happens with a variable annuity. Variable annuity deposits purchase accumulation units, and are invested in whatever fund or funds the client (annuity owner) has selected. For example, assume the cost of an accumulation unit is $100 and the owner deposits $100. He or she would have purchased one accumulation unit. If the deposit were $500, the client would have purchased five units. When the time comes to annuitize, the initial annuity payment amount would be determined based on the number of accumulation units in the contract. From that time on, as the value of each unit (now called an annuity or payment unit) increases or decreases, annuity payments would raise or lower in response (more on this later). The value of each accumulation unit varies, just as the value of each mutual fund share varies, based on market returns. Some annuities offer minimum earnings guarantees, but such guarantees always come at a price, which must be weighed against the benefit provided. As is the case with variable life insurance policies, some contracts offer just a few investment alternatives, while others may offer hundreds of options. Investment options have all the same type of expenses as with any mutual fund, including those related to investment management and distribution. Additionally, all annuities have expenses related to the actual annuity contract. These include administrative charges along with mortality-related expenses. Some contracts may have sales charges, and if so, they are usually of the contingent-deferred or surrender variety. That is, if the owner withdraws money from the contract within a set period following the original purchase (e.g., 10 years), the insurer may deduct a percentage from the withdrawal as a way of recapturing sales charges. Some contracts, but not all, allow minimum withdrawals without assessing a sales charge. Typically, surrender charges eventually fall away. A financial advisor should be aware of the period and amount of any surrender charges and advise accordingly. Most contracts allow the owner to move money from one investment option to another, but the number of times this can be done annually may be limited, and fees sometimes accompany the transfers. If you are getting the idea that at least some variable annuity contracts can have a lot of fees, you are correct. While annuities, like most investment options, can serve a valuable function, advisors must exercise caution to determine whether related fees are appropriate or excessive. Also, when trying to calculate annuity investment returns, you may see a sizable difference between gross and net returns – especially in the contract’s early years. Focus on the client’s need, as is true with any investment option, to weigh benefits against expenses, and carefully consider whether to use or recommend annuities accordingly. CFP Level 2: Module 1 – Retirement Planning - Global Page 91

The annuity phase or pay out period follows sometime after the accumulation phase. In the case of fixed annuities, payments will be fixed and clearly identified at the beginning of the pay-out period (remember that some contracts offer inflation adjustments). Variable annuity payments are not fixed, and only the initial payment will be identified. We should mention that it’s always possible that the client will want to liquidate the contract and receive all available funds in a lump sum. This pay out may or may not be taxable (at least in part), depending on regulations in the jurisdiction, and the type of contract. Assuming the client elects to have a payment stream, the insurer would convert accumulation units to annuity or payment units. All the same distribution options apply to variable contracts as are available with fixed annuities (e.g., single life, joint life, period certain, etc.). The client often has the option to opt for a fixed pay out or one that is variable. Sometimes, both options can be applied to part of the contract’s value. Since the variable pay out option is a big part of the rationale for variable annuities, most people choose this path. The payment amount of each annuity unit reflects the annuitant’s age, and sometimes gender, life expectancy (just as with fixed annuities), pay out option (e.g., single life, period certain, etc.), and investment return. That last item is what causes each payment to vary. Sometimes payments are guaranteed for a period, but if not, each payment will rise or fall as the value of the underlying investments does the same. For this reason, annuitants cannot accurately predict the amount of each payment they would receive. At the same time, assuming solid investment performance, the annuitant should be able to count on at least the potential that payments would keep up with inflation. Remember, the number of annuity units does not change, but their value does. This may be re-calculated on a monthly, quarterly, semi-annual or (often) annual basis. Indexed Annuities Indexed annuities (IAs) offer some of the growth potential of the stock market with the downside protection of a guaranteed annuity. These products are fairly sophisticated, so both financial advisors and their clients should have a firm understanding of these annuities before adding them to a portfolio. Further, there are several variables in these products, which can make comparisons difficult. Many regulators have issued warnings expressing concern over the complexity of and potential problems associated with IAs. Indexed annuities have characteristics of both fixed and variable annuities. They usually provide a guaranteed minimum interest rate and an interest rate tied to a market index. They typically are linked to a benchmark (such as the S&P 500), which provides the growth potential in these accounts. The participation rate determines how much of the underlying index’s gain will be applied to the account value. For example, if the participation rate is 90 per cent, and the S&P increases by 10 per cent in a period of time (called the index interval, which can be 1, 5, 7, or even 10 years), the annuity’s account value would increase by 9 per cent (90 per cent of the 10 per cent increase). Some annuities CFP Level 2: Module 1 – Retirement Planning - Global Page 92

also may have a rate cap, which will limit the amount of growth that can be applied to the account value for a given interval. There are different methods of measuring the change in the underlying index. The percentage change method measures the percentage change in the index from the beginning to the end of the index interval. Only the index’s starting and ending points matter; market fluctuations in between are ignored. In those intervals when the index declines, no gain is credited to the account. The ratchet method (also called point to point) locks in the gain credited to the account each policy year. The index value at the end of one policy year becomes the starting value for the next policy year. The spread method subtracts a fixed percentage (such as two per cent or three per cent) from the index’s percentage change in a given interval. If the index grew by 30 per cent over a three-year interval and the insurance company used a two per cent spread, the account would be credited with a 28 per cent increase in value. In terms of downside protection, assume the S&P 500 declined 10 per cent over a given index interval. In this case, the annuity’s account value would remain unchanged from its starting point for that interval. While the annuity owner did not earn any interest or have any gain during this period, neither did the account lose money due to the market’s drop. This downside protection can be very appealing to a client who wants to participate in the market’s gains (to a limited degree) while avoiding market losses. The idea is that the account value in an indexed annuity will not decline unless the owner takes a withdrawal. The timing of a withdrawal can have a significant impact on the participation rate. The ideal situation would be for the annuity owner to only take withdrawals immediately after the participation rate (for a given interval) has been credited to the account. Once the participation rate has been credited to the account, the increase in account value is locked in and guaranteed into the next index interval. So, you can see that a withdrawal in the middle of a participation rate interval could minimize the growth potential of the account for that period of time. One final note: as mentioned above, regulators are giving IAs extra scrutiny. They are concerned that these products may be too complex, that IAs are not being adequately described (with adequate disclosures) to potential clients, and that there is too much opportunity for abuse. Settlement and Pay out Options Annuity payment options are essentially the same as life insurance settlement options. In both cases, lump sum payment is the option most commonly used. This gives the beneficiary all the funds at once. These can be used then for any purposes and serve a valuable cash flow function. When beneficiaries choose to receive regular payments in lieu of a lump sum, the life income option is most frequently chosen. This option will make payments during the life of the beneficiary. At death, all payments stop, CFP Level 2: Module 1 – Retirement Planning - Global Page 93

regardless of whether money remains in the account or not. As an example, assume an account has $100,000 and the beneficiary has chosen a life income (or single life) payment option. If the beneficiary dies after receiving payments of $20,000, the remaining $80,000 will stay with the insurer. There is no recourse. This is why this option is seldom recommended, except possibly for situations in which only one individual is involved, and he or she does not wish to leave a bequest to anyone. In addition to life income, annuities also offer other options: Joint (and survivor) – payments continue during the lifetimes of both annuitants, after which they terminate. Joint payments may remain level during both lifetimes, or may be reduced (e.g., one-half) following the death of the primary annuitant. If the annuity has a survivor option (certain jurisdictions only) any amount of the basis (i.e., capital plus earnings) that remains after the deaths of the annuitants will be paid to a beneficiary. Period certain – annuity payments continue for at least a minimum number of years (e.g., 10). Depending on the contract terms, payments may end once the set number of years has passed, or may continue for the remaining lifetime of the annuitant. If the annuitant predeceases the period certain, remaining funds go to a beneficiary. Fixed amount – annuity payments made in a fixed amount (e.g., 1,000 pesos) for as long as the principal (and earnings) last, after which all payments stop. Refund – depending on the pay out option chosen, the contract may allow for a refund of any remaining money (principal plus earnings) left in the contract at the end of the annuity period (i.e., when the annuitant dies). Where included, the total of payments will be calculated, and if less than the total amount of principal and earnings in the contract, the remainder will be paid to a beneficiary. As an example, if the principal is $100,000, and total payments add up to $80,000, the beneficiary will receive the remainder of $20,000. However, if total payments are more than $100,000 (in this example), the beneficiary will receive nothing, as the original principal has been fully distributed. Some contracts may allow for variations on the primary options listed above. Further, it may be possible to allocate some of the capital to more than one pay out option. Finally, the preceding annuity option list refers to annuitization, not periodic withdrawals. Withdrawals, where allowed, enable the owner to receive money from the contract without changing the contract’s structure, and keep annuitization options open. It’s easy to see why annuities have a long history as part of many retirement planning packages. It should also be fairly easy to understand why, at least with some applications, financial advisors and their clients should exercise a degree of caution when implementing this option. This may be more or less true in various territories depending on potential penalties, regulatory limits, and tax implications. In this chapter we explored some of the retirement benefits provided by governments and employers, along with ways in which annuities may be used to fund retirement cash flow. The ultimate purpose of CFP Level 2: Module 1 – Retirement Planning - Global Page 94