Challenge Pathway -Prep Book

GOALS & NEEDS The first step is to determine how much money a person needs today to fund his or her current lifestyle. A budget is a good place to start. Identify all outflows (inflows are not needed at this point, because we are looking at expenses only). Next, determine which categories will not likely continue into retirement. Some expenses may increase. Many retirees like to travel. While enjoyable, traveling adds to expenses. Some people begin or expand hobbies. Others may want to continue their formal education. A new business may be part of the plans, which will require start-up and ongoing funding. Healthcare expenses could also increase. Additionally, the individual may experience other expenses. DETERMINING IF CLIENT’S GOALS ARE REALISTIC There is an underlying consideration that should be in your mind as you explore retirement goals with a client. Are the goals and objectives realistic? Being realistic refers to the ability of providing funds that will support the goals. Unfortunately, there are times when the advisor has to let the client know that his or her goals cannot be achieved, given available time, cash flow and assets. As a result, the advisor and client will have to begin the process of working through what is, and what is not, possible. It’s one of the most difficult things an advisor has to do (and a good reason to work hard at encouraging the necessary lifestyle changes early in a person’s life). A primary step in determining the viability of a client’s goals is to take a good look at his or her current, and anticipated, financial situation. Current cash flow management is the first part of planning to fund retirement needs. International College of Financial Planning – Challenge Pathway Prep Book Page 297

From there, the financial advisor has to determine what funds are available to use in reaching future accumulation needs. As previously stated, part of the process may require lifestyle changes to modify spending habits. As a general rule, heading into retirement with little or no debt is a good idea. NORMAL EXPENSES & POTENTIAL EXPENSES Regardless of how simplistic it might seem, a reasonable next step is to determine a basic retirement budget. For some, this process is easy. Their retirement budget will be similar to their pre-retirement budget. Eliminate expenses directly related to employment, and they have a reasonable budget. Retirement lifestyle changes have significant potential for increasing retirement expenses. Here are some questions to explore with the client: -What does retirement look like to you? -How do you see yourself spending time in retirement? -How much do you plan to travel? -Do you plan to make major changes, such as starting a business, getting a degree, or remodeling your home? -What is it that you have always wanted to do, and now will have the time to accomplish? INFLATION Inflation, and its impact on purchasing power, are among the most significant factors to consider when doing a retirement needs analysis. The cost of a basket of groceries will just about double in 25 years with an average inflation rate of three percent. Without compensating for inflation, toward the end of the retirement period, a time when healthcare expenses can be expected to be at an all-time high, your purchasing power would decrease to around half of what it was at the beginning of retirement. Greater expenses coupled with diminishing cash flow (purchasing power) is not a recipe for a comfortable retirement. International College of Financial Planning – Challenge Pathway Prep Book Page 298

HEALTHCARE ISSUES The increased potential cost of healthcare as one ages is significant. Based as a percentage of GDP, healthcare expenditures in most territories approach or exceed 10% .Given global movements away from, or decreasing, government-provided social security benefits, covering these expenses should be part of the retirement planning discussion. Whether or not those forecasts match each client’s reality, or fully applicable in all territories, it’s clear that healthcare expenses have the potential to consume an increasing portion of a person’s retirement assets. What can be done to deal with the healthcare expense problem? The best option is to begin, early on, incorporating the need for increased healthcare funding into planning solutions. CAPITAL REQUIRED FOR RETIREMENT Using the real rate to determine the amount needed at the beginning of retirement (using a financial function calculator), the keystrokes are: (EXAMPLE) P/Y = 1 Mode = BGN 1. 25 N 2. 3.8835 I/YR 3. $100,000 PMT 4. 0 FV 5. CPT PV = $1,643,046 International College of Financial Planning – Challenge Pathway Prep Book Page 299

HIGH NETWORTH CLIENTS With greater amounts of assets come increased needs and opportunities. Most of this course is focused on helping individuals of average financial means achieve their retirement cash flow objectives. With this group, retirement needs primarily fit into the category of having enough cash flow to fund regular expenses along with any additional items unique to retirement. HNW individuals generally do not have the same concern. There will be exceptions, but generally, HNW individuals have enough money to fund all normal expenses. It’s important for the financial advisor to understand that even HNW individuals can struggle to match spending with available assets, leading to a potential cash flow gap. With many HNW individuals, part of the planning process must include answers to the question, “What should I do with assets I do not require to meet my retirement lifestyle needs?” Retirement Objectives HNW Cash Flow Gap When working with a HNW individual, one of the first objectives is to develop an accurate assessment of assets and typical expenses. A financial advisor should do an analysis to determine the degree to which available assets can support their desired lifestyle in retirement. If existing funds can fully support their desired lifestyle (along with enough margin to have a safety net), no changes may be necessary. However, it’s possible that assets will not support lifestyle, thereby creating a cash flow gap. When this is true, advisor and client will have to discuss adjustments to bring their target retirement lifestyle in line with available assets. One of the potential problems HNW individuals face is not understanding the need for assets to generate sufficient cash flow to support their retirement lifestyle throughout the rest of their lives. International College of Financial Planning – Challenge Pathway Prep Book Page 300

Balancing asset-generating cash flow with sustainable withdrawal/distribution rates is as important for this group as it is for everyone. HNW individuals face many, if not all, of the potential difficulties of all retirees: o They need to develop a plan to care for dependents – including elderly parents and children. - They consider philanthropic/charitable activities. o They need to help their children learn how to handle wealth responsibly. o In many cases, children of HNW parents (especially minor children) will be faced with large amounts of money that will require education to help them know how best to manage the funds. o HNW individuals, as with all clients, need to establish retirement cash flow targets. Establishing Retirement Cash Flow Targets There are some rules of thumb indicating that retirees will reduce spending in retirement. FPSB guideline may suggest that retirees need only 60 to 80 percent of pre-retirement cash flow. Others indicate higher amounts initially, but state that these amounts will decrease as retirement advances. It’s possible these suggestions are accurate. However, experience suggests otherwise. Evidence points to retiree spending being higher than expected. Healthcare costs can add significantly to anticipated expenses, as can things such as needing to make substantial home repairs, having to purchase a new vehicle or major appliance, or similar. Travel, and other leisure pursuits can also add to funding requirements. All of this points to the need to realistically assess and forecast (as accurately as possible) all financial factors. Changes made to any assumptions can have a big impact on funding requirements. International College of Financial Planning – Challenge Pathway Prep Book Page 301

Trade-offs Necessary to Meet Retirement Objectives Financial advice often requires compromises. Few people have all the financial resources needed to put all parts of a financial strategy into place at the same time. This is one reason why advisor-client relationships often last for decades. Many of the compromises require making lifestyle changes to have the money to achieve goals. This is often true when planning for retirement. Balance The word balance in this context means the ratio of time spent accumulating wealth versus the time that wealth is spent. Today we see shorter accumulation and longer expenditure/distribution phases because of increasing longevity, prosperity and early retirements. This means individuals are under pressure to create enough financial resources during shorter working years to fund longer and more active retirement years. Complexity Personal savings behaviors are significantly affected by: -Increased family responsibilities that may span several generations -The shift from defined benefit to defined contribution retirement plans In the family structure, increased longevity has created more financial responsibilities for individuals who are sandwiched between children (or grandchildren) in college and aging parents (and/or grandparents). The expenses of added family responsibilities often affect these individuals’ ability to save for their retirement, and may require them to use portions of their existing retirement assets to pay for family members’ educational, caregiving, health and medical needs. We can identify three distinct phases within retirement: International College of Financial Planning – Challenge Pathway Prep Book Page 302

1. Active: Typified by increased leisure-time activities, such as travel; 2. Passive: Usually accompanied by a “settling down” with less travel and a greater awareness of end-of-life issues; and 3. Final: Often a time of decreased wellness, resulting in increased medical expenses. Most Important Period A growing number of advisors maintain that the five years before and the first five years after retirement begins may be the most important in determining a retiree’s overall retirement comfort. In many situations, people have the highest earning levels just prior to retiring. This, coupled with the fact that many major expenses, such as purchasing a home, have been taken care of, provides a time when saving and investing can be especially strong. The five years preceding retirement should be a time of saving as much money as possible and the five years following should not be a time of excess spending. Rather, new retirees should exercise prudence during this period as they determine appropriate spending levels based on accumulated assets. Lifetime Security Although it is possible to create what is sometimes called a synthetic annuity, unless there is an actual lifetime cash flow guarantee, the individual cannot be certain he or she will have enough cash flow to last a lifetime. Unless an insurer issues the investment, and includes a mortality charge based on actuarial analysis, the investor will not have a lifetime cash flow that is guaranteed. “Guarantee” is the key term, and it’s the strongest benefit offered by an annuity (or other insurance company-issued guaranteed-cash flow contract). The lifetime cash flow guarantee is not free, but as long as the issuer remains solvent, the guarantee is good. If the underlying retirement funding goal is to have enough money to last throughout retirement, why not just put all the individual’s money into an insurance company annuity product? Some people do International College of Financial Planning – Challenge Pathway Prep Book Page 303

make that choice, but it’s not always the best option. Cost is one consideration (the mortality and expense [M&E] charges can get rather high). Loss of flexibility is another big concern. Guaranteed Annuities An annuity has the potential to be a good option, but does it qualify as the best or only option? For most people the answer is no. The loss of flexibility is the primary reason not to use an annuity as the sole retirement-funding vehicle. Any solution involving annuities would have both cost and flexibility penalties that diminish its desirability for many retirees. Do annuities still have potential application? Yes, and the key is in annuitizing a portion of an otherwise-invested portfolio. Rather than think in terms of “either, or”, an advisor might consider a regular investment portfolio “and” an annuity. If an individual annuitizes a portion of the retirement portfolio, that portion will provide cash flow at a guaranteed rate, regardless of what the non-annuity investment market does. When to annuitize is a good question. The answer depends on the individual situation. Generally, waiting beyond the initial period of retirement makes sense. The one caveat to that being, if a retiree is extremely nervous about future cash flow, and is uncomfortable considering any sort of investment portfolio, annuities may provide a solution. It won’t likely be the optimal solution, but it may provide a desired comfort level. For most other people, there seems to be little reason to purchase an annuity early on. Let the portfolio continue to work and generate the desired cash flow. Maintain flexibility and the option to make changes as the need arises. Then, as the individual travels further into retirement, placing some portfolio assets in an immediate annuity may make a positive addition. International College of Financial Planning – Challenge Pathway Prep Book Page 304

Target Date Funds A target date fund is a collective (pooled) investment scheme (e.g., mutual fund or trust) designed to provide a changing asset mix to match the investor’s life stage. Many investment companies offer such funds, and all share a similar (but not identical) framework. The concept is simple. Rather than the individual being concerned about determining an appropriate asset allocation, and then gradually shifting the percentages of stock and bonds, the fund does it all. The fund’s investment manager determines an initial asset allocation. The allocation then automatically adjusts as the investor ages. During the holding period, the fund remains diversified and professionally managed. Simplicity is perhaps the greatest benefit of target date funds. The investor only has two choices to make: the company to use, and the desired retirement date. Simple, however, does not always mean better, and target date funds present a few potential problems. Some of these funds come with higher than average fees, which can include fees for the target date fund along with underlying mutual funds, and which can cut into investment returns. A bigger potential problem is the glide path used to modify the asset allocation. This is a problem with two parts. 1. First is the initial allocation between equities and fixed cash flow securities. 2. The second concern is the tapering process used to shift the bias from equities to fixed cash flow. This problem is not limited to target date funds, and would be somewhat of a concern any time you use a standardized approach. There is simply no substitute for individualized solutions based on an individual’s specific situation and goals. International College of Financial Planning – Challenge Pathway Prep Book Page 305

Retirement Value Tree Lifestyle Objectives: Retirement Planning During Life’s Stages Page 306 Broadly speaking, people can be said to move through three life stages : 1. Accumulation phase (to about age 30)  First job/career  Paying off debt  Begin saving & investing  Marriage and children (for some) 2. Consolidation phase (generally age 30 to 60) -Home purchase -Marriage (for some) -Children -Children’s education -Peak earning years -More investable income International College of Financial Planning – Challenge Pathway Prep Book

Lifestyle Objectives: Retirement Planning During Life’s Stages 3. Retirement phase (generally age 60+) -Cash flow typically ends or is significantly reduced -Portfolios typically reallocated to a more conservative approach -Portfolio distributions -Wealth transfer -Long-term care issues WEALTH TRANSFER Eventually, all clients pass away. Financially, they may do so with few, if any, remaining assets. It is not uncommon for people to come to the end of life with most of their money gone, and increasingly dependent on government-provided benefits and family generosity. However, it’s equally true that a sizeable number of people leave behind some amount of financial assets. When this is the case, the question becomes what to do with what remains. Clients with dependents will want to make arrangements to address the dependents’ ongoing 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 ongoing care are in place. Broadly speaking, this aspect of estate planning can be categorized as people planning.Clients also want to ensure their property is properly distributed. As is true when caring for children, this goal has a strong financial aspect. Efficiency and effectiveness are also objectives. Clients want to ensure that assets will be distributed efficiently and without unnecessary legal or financial implications. International College of Financial Planning – Challenge Pathway Prep Book Page 307

PERSONAL INCAPACITY Clients can 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. PHILANTHROPY Giving back is a positive goal for any part of financial life, including wealth transfer. International College of Financial Planning – Challenge Pathway Prep Book Page 308

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. Each of the tools we have already discussed (e.g., outright gifts, trusts, life insurance, and wills) may be used for this purpose. Financial advisors should discover clients’ philanthropic or charitable giving wishes. This is true throughout the client engagement, but perhaps especially so when considering wealth transfer. One good way to learn how a client feels about giving is to ask. Professional Skill 301 Gives attention to what clients and others are saying and takes time to understand the points being made Retirement Needs Analysis and Projections Longevity Risk, Inflation & the Impact on Retirement Cash Flow Needs 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. A 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. 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. International College of Financial Planning – Challenge Pathway Prep Book Page 309

The amount of anticipated longevity significantly affects the required fund. Longevity factor included in calculations will probably have 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. The amount of anticipated longevity significantly affects the savings required. Changes to inflation and return rates can have a big impact on required funding amounts. The amount of anticipated living expenses also has a big impact. 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. Inflation’s Impact on a Retirement Plan One of the threads running through the longevity section is the potential impact of inflation. There is a substantial difference between projections based on 3.5 percent 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 percent as a benchmark, and inflation in some territories is closer to zero or even negative. Inflation’s Impact: The Rule of 72 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 percent, it will take 24 years to double an amount (72/3 = 24)  At 3.5 percent, it will take 21 years (72/3.5 = 20.57)  5 percent requires 14.4 years (72/5 = 14.4)  7 percent, 10.3 years (72/7 = 10.3)  10 percent, 7.2 years (72/10 = 7.2) International College of Financial Planning – Challenge Pathway Prep Book Page 310

The other way to look at this is through the lens of reduction in purchasing power. With seven percent inflation, purchasing power cuts in half in 10.3 years, and at 10 percent, it only takes 7.2 years. Goal Classification and Funding Funding targets have to be based on client goals. By now you should understand that rules of thumb are not a substitute for calculations based on funding actual goals. It’s 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: 1. Fixed and terminable 2. Fixed and permanent 3. Variable and terminable 4. Variable and permanent 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. 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 ongoing commitments. Fixed and Permanent Some goals and related financial arrangements will not end at retirement. The potential problem is that, while payments remain at pre-retirement levels, retirement cash flow often does not. In at least some situations retirement cash flow is greatly reduced from pre-retirement levels. International College of Financial Planning – Challenge Pathway Prep Book Page 311

This is a good reason to discuss entering into ongoing 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 house or car fits into this category. Variable and Terminable Some long-term goals have variable funding requirements, as do many that have a shorter duration. When working with clients, financial advisors have the most flexibility in this area. For example, a client may want to fund a child’s or grandchild’s education. This is an example of a goal that is variable and terminable. Ongoing 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. 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 Ongoing living expenses may provide the best example of a funding need that is variable, but will continue throughout retirement. One of the budgeting keys is recognizing that these expenses, while permanent, will change 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. International College of Financial Planning – Challenge Pathway Prep Book Page 312

Goal Development Having arbitrary financial goals is less helpful than having specific goals 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: 1. A defined purpose 2. A specific timeframe 3. 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. For example, an investor who plans to make a down payment on a house six months from now would want to keep that money in an asset with minimal risk, like a six-month certificate of deposit or money market account. Longer time horizons (e.g., Buckets 2 and 3) can allow for investments that, though they will fluctuate in value, offer increased appreciation potential. Using 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) International College of Financial Planning – Challenge Pathway Prep Book Page 313

Doing this will help the financial advisor make appropriate recommendations as to how to allocate financial resources to best achieve the goals. Generally, a goal is considered to be broader or more global, while an objective tactically supports the goal. Another description identifies a goal as an overarching principle that guides decision making, while objectives are specific, measurable steps that can be taken to meet the goal WHAT ARE SMART GOALS SMART Goals are:  Specific  Measurable  Attainable  Realistic or Relevant; and  Trackable or Time-bound WHAT INFORMATION IS NEEDED 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.)  The age at which the client wishes to retire  The client’s desired retirement lifestyle HOW ARE GOALS DEFINED They would require a determination of how much money would be required to fund the desired lifestyle.  Available financial resources Page 314  Government or employer-provided pension  Money already accumulated International College of Financial Planning – Challenge Pathway Prep Book

 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 Selecting and Administering Long-Term Investment Portfolios Perhaps the biggest issue today, and looking forward, is increased longevity. 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. We can conclude from this that retirement portfolios must be structured to, at the least, keep pace with inflation. This means incorporating equity exposure. Risk, Return and Implications for Retirement Planning As a financial advisor, you will need to gain an understanding of a client’s risk profile, including their risk tolerance (i.e., how much volatility can he or she tolerate). 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. In addition, 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. Types of Investors The following descriptions can help advisors better understand their client's risk profile by breaking down investor's into 4 different types. International College of Financial Planning – Challenge Pathway Prep Book Page 315

Portfolio Risk Decisions Available time and funding requirements influence portfolio risk decisions. 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. 3 FACTORS THAT MAKE A PERSON’S RISK PROFILE Risk tolerance (i.e., how much volatility can he or she tolerate). Willingness to take on risk. Risk capacity (i.e., the ability to sustain a loss and still achieve investment goals). Ability to take on risk. Goal time horizon. Potential Sources of Retirement Cash Flow Increased longevity provides more opportunity for retirees to run out of money. The solution to proving adequate cash flow and protecting against running out of money is either to accumulate large sums or to keep as large a portion of accumulated assets as possible invested, while gradually liquidating amounts needed to provide cash flow. International College of Financial Planning – Challenge Pathway Prep Book Page 316

The longer-term investments can help offset purchasing power problems related to increased longevity. For our purposes, we will assume a portion of accumulated assets will remain invested throughout much of the retirement period. What is Cash Flow? Cash flow can come from dividends and interest, along with resources generated from the sale of assets, including liquidating investment principal. Cash flow provides a more broad-based source from which to generate payments to the client. For our purposes, we will focus on the broader measure of cash flow but will periodically use the income term when deemed appropriate. The sections below outline the various types of retirement plans that can be source of cash flow. Pension Funds Broadly speaking, there are two primary types of pension plans: 1. Defined Benefit (DB) and 2. Defined Contribution (DC) Defined Benefit (DB)  Defined benefit plans promise to pay a specified benefit to qualified retirees.  Often, DB plans do not require any contributions from individuals. Accounts are fully funded by the sponsor (e.g., government and/or employer).  Some territories 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.  Defined benefit plans guarantee a retirement income benefit, usually based on earned income and years of employment. The exact definition and plan parameters may be different among various territories, but the basic principles will be similar. Benefits, and the contributions necessary to provide them are determined by actuaries, and often updated annually. International College of Financial Planning – Challenge Pathway Prep Book Page 317

 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.  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.  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. Defined Contribution (DC)  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.  Usually, DC plans require participants to contribute to the plans. In fact, without participant contribution, it’s possible the individual will not accumulate any money in the plan. Defined Benefit Plans: Important Terms and Considerations 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. 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. International College of Financial Planning – Challenge Pathway Prep Book Page 318

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. Vesting 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. Payment may not come until the participant reaches age 65, but it will be made at that time. 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, 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. 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. Types of Mandatory Defined Benefit Retirement Income Programs PENSION 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. International College of Financial Planning – Challenge Pathway Prep Book Page 319

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. 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. What Are Defined Contribution Plans? 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. International College of Financial Planning – Challenge Pathway Prep Book Page 320

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 Defined Benefit vs. Defined Contribution 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. 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. Types of Defined Contribution Plans 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: 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. Government-mandated or collectively bargained guaranteed return: Primarily used in Germany and Belgium. Insurance contracts provide stated returns on participant savings. International College of Financial Planning – Challenge Pathway Prep Book Page 321

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. Personal pension brokered markets: Primarily used in the Czech Republic and Israel. Participants use account balances to purchase individual pensions through brokers. State insurance model: Primarily used in Morocco and Pakistan. Participants pay into state-sponsored insured funds. Some Downsides to Defined Contribution Plans Defined Contribution (DC) plans provide a plan into which participants can make contributions (along with employers and the government) that can be used to create a retirement cash flow stream. However, the 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. In addition, 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. 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. International College of Financial Planning – Challenge Pathway Prep Book Page 322

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. Individual Retirement Plans 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. 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. 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. Plans may be voluntary or compulsory and may be designed either to integrate with DB/DC plans or function on a stand-alone basis. International College of Financial Planning – Challenge Pathway Prep Book Page 323

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. 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. As with the other areas, participants and their financial advisors should carefully review 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. 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. Annuities are simply another investment option, one that, in some territories, International College of Financial Planning – Challenge Pathway Prep Book Page 324

provides tax benefits. However, annuities continue to offer, as one of their most valuable options, the possibility of a lifetime income stream. 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. 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. LIFE ANNUITIES A life annuity is an annuity that provides a guaranteed lifetime income. For example, if you buy a life annuity for $100,000 at age 65 with an income of $500 per month, you get your $100,000 back by age 82. If you live past 82, you will still receive $500 a month as long as you live. As the table below shows, the longer one lives, the more income the annuity provides. In most cases, life annuity income payments stop when a person die and no money goes to their estate or a named beneficiary. However, some annuity providers may offer the following options so that payments continue to be made after death:  A joint and survivor option, where the income payments continue as long as one of the annuitants is alive International College of Financial Planning – Challenge Pathway Prep Book Page 325

 A guarantee option, where income payments are continued to a beneficiary or your estate if you die within a specific amount of time  A cash-back option, which provides a one-time payment to a beneficiary or estate if a person dies before receiving a specific amount of money (usually the amount you paid for the annuity)  These options can be combined, but each additional feature will lower the amount of the income payment. Life annuities also come with a list of pros and cons. Pros  Provides guaranteed income payments for as long as you live  No risk of outliving your income  One can add a joint and survivor option to transfer payments to a spouse/partner  Other options can be added to provide money to the beneficiary or estate upon death Cons  A person may pass away before receiving all of the money back  Adding extra options (such as those that provide payments to a spouse upon death) usually means a lower regular payment TERM CERTAIN ANNUITIES A term-certain annuity is an annuity that provides guaranteed income payment for a fixed period of time (term). If a person dies before the end of the term, the beneficiary or estate will continue to receive regular income payments, or receive the balance of the regular payments as a lump-sum. The table below shows that a regular income payment will usually be lower when one buys an annuity with a longer guaranteed payment term. In addition, the longer the annuity term, the more money the annuitant or beneficiary will make on the original $100,000 investment. International College of Financial Planning – Challenge Pathway Prep Book Page 326

The pros and cons include: Pros  Provides a guaranteed income for a set period of time  Beneficiary or estate will receive any remaining benefit if annuitant dies before the end of the term Cons  Annuitant may live longer than the term of annuity, meaning he or she could stop receiving income before death FIXED ANNUTIES Annuities may be fixed or variable, and the two options are quite different. A fixed annuity contract is preset. A fixed annuity payment period may be immediate or deferred, but either way, the amount is fixed in the contract. 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. One big problem with fixed annuity payments is that they are fixed. The guaranteed pay out amounts are a two-edged sword. On the one hand, the annuitant can feel secure (assuming ongoing 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. A variable annuity may provide a solution, in that, depending on investment returns, annuity payments may keep pace with inflation. VARIABLE ANNUTIES A variable annuity is an annuity where the annuity provider invests your money in a product with a variable return, such as equities. International College of Financial Planning – Challenge Pathway Prep Book Page 327

The pros and cons include: Pros  Offers a fixed income plus potential extra income linked to market performance  May earn more money than a non-variable life annuity if the investments backing the variable portion of the annuity performs well Cons  Regular income is harder to predict. Annuitant may earn less money than a non-variable life annuity if the investments backing the variable portion performs poorly  Variable annuity contracts can have a lot of fees. While annuities, like most investment options, can serve a valuable function, advisors must exercise caution to determine whether related fees are appropriate or excessive. INDEXED ANNUTIES Indexed annuities (IAs) 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. Indexed annuities offer some of the growth potential of the stock market with the downside protection of as 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. DEFERRED ANNUTIES 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). International College of Financial Planning – Challenge Pathway Prep Book Page 328

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 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. Annuities: 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 then be used 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, regardless of whether money remains in the account or not. Below are the different payment options. International College of Financial Planning – Challenge Pathway Prep Book Page 329

Joint (and survivor) Payments 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 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 Fixed amount annuity payments are made in a fixed amount (e.g., 1,000 pesos) for as long as the principal (and earnings) last, after which all payments stop. Refunds 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. International College of Financial Planning – Challenge Pathway Prep Book Page 330

Retirement Cash Flow, Withdrawal Projections and Strategies Sources of Cash Flow in Retirement One of the first things we should clarify is the subtle difference between income and cash flow. Income in retirement is generated by dividends or interest. That’s not a problem, but it does present a limitation. Some clients may also have passive income from real estate, the sale of a business or elsewhere. Cash flow, on the other hand, can come from dividends and interest, along with resources generated from the sale of assets, including liquidating investment principal. Cash flow provides a more broad- based source from which to generate payments to the client. For our purposes, we will focus on the broader measure of cash flow but will periodically use the income term when deemed appropriate. Increased longevity provides more opportunity for retirees to run out of money. The solution to proving adequate cash flow and protecting against running out of money is either to accumulate large sums or to keep as large a portion of accumulated assets as possible invested, while gradually liquidating amounts needed to provide cash flow. The longer-term investments can help offset purchasing power problems related to increased longevity. For our purposes, we will assume a portion of accumulated assets will remain invested throughout much of the retirement period. Portfolio Distribution Strategies – Converting Capital Growth to Cash Flow Generation How much should be in each bucket? Depending on the client’s situation, the number of years and amount going into each bucket can, and should, vary somewhat. Risk profile also comes into play as does the individual’s specific spending parameters. Some advisors add another bucket between numbers two and three, and sub-divide those buckets into three to five and five to ten year periods. In that scenario, the final bucket continues to hold long-term International College of Financial Planning – Challenge Pathway Prep Book Page 331

investments. Regardless of the exact approach, over time, most of the client’s assets are often held in bonds and conservative investments. This reduces potential growth, but it also decreases overall risk level and increases ongoing cash flow. Bucket #3 can hold stocks, high-yield bonds, real estate, options and commodities (for clients with a higher risk profile), and other higher return assets. As the individual spends money from Bucket #1 each year, assets equivalent to $100,000 can be liquidated from Bucket #2 and moved in the first bucket. A corresponding amount can be moved from Bucket #3 to Bucket #2. Assets in the second and third buckets will continue growing and the individual should not be in danger of running out of funds. This assumes that a cushion has been built in for emergencies, extra medical expenses and other financial surprises. Retirement Distribution Rates Beyond the Buckets The bucket system is one approach to retirement cash flow. For it to work well, relatively large amounts of assets are required. Not everyone accumulates large retirement funding accounts, but they still have to live in retirement. Several researchers have suggested approaches that may be more appropriate for a broader group of retirees. A four-percent distribution rate is a common conservative recommendation, designed to provide cash flow and maintain some level of funding throughout retirement. This means that a retiree with $100,000 in assets would have to live on around $4,000 annually. The exact withdrawal amount will depend on investment results each year, but four percent does not provide much money for those who have accumulated a relatively smaller fund. International College of Financial Planning – Challenge Pathway Prep Book Page 332

Layer Cake William Bengen, CFP, who was an early proponent of the four-percent withdrawal, did additional research to suggest an alternative approach that would potentially generate more cash flow. Bengen’s more recent work suggests building a layer cake. The various layers are modifications—special situations—that may affect withdrawal amounts. Bengen continues to suggest a base withdrawal rate of 4.15 percent. However, some more conservative individuals, especially those wanting greater security, may want to reduce the initial withdrawal rate back to four percent or even further in some situations. On the other hand, those who are willing to accept more risk and more uncertainty by incorporating additional layers may be able to increase the initial withdrawal rate to more than seven percent. The factors or layers Bengen suggests are:  Withdrawal scheme (foundation layer)  Asset allocation  Success rate (degree of confidence)  Rebalancing interval  Super-investor (normally capable of better-than-average returns)  Desire to leave a legacy  Time horizon Bengen focuses on four fundamental assumptions that must be determined for each individual. Tax status of the portfolio: is it tax-advantaged or not? Time horizon: For how long does the individual expect to need cash flow? Asset allocation, and How is the portfolio is rebalanced. Page 333 International College of Financial Planning – Challenge Pathway Prep Book

Another key factor is the required success rate—that is, the degree of confidence that everything will work and the money will last. More Equities; More Cash Flow? Other researchers have built on Bengen’s work over the succeeding years. Part of the problem they have tried to solve is the degree of equities required to produce desired cash flow, compared with the inherent desire for increased portfolio safety. Building on some of Bengen’s research, Jonathan Guyton, CFP, wrote about possible ways to expand cash flow possibilities. Guyton’s work suggests that, based in part on the portfolio percentage devoted to equities, it may be possible to increase the safe initial withdrawal rate to as much a 6.2 percent. If an individual is willing to incorporate greater amounts of equities into his or her portfolio, it may be able to produce a higher, sustainable distribution rate. Someone who is willing to increase equities to 65 percent might be able to have an initial withdrawal rate around five percent. By increasing equities to 80 percent, the initial withdrawal rate might increase by another percentage point to around six percent. Guyton’s work also requires withdrawal rate freezes based on poor market returns. This means that there is no inflation-adjusted withdrawal rate increase following a year in which the portfolio experiences a negative return. The obvious reason for this is an attempt to build sustainability into the retirement portfolio, while maximizing annual withdrawals. Additionally, inflation-related increases are capped at six percent, even if actual inflation rates are higher. This would potentially have a negative impact on purchasing power, but is necessary to maintain the portfolio in keeping with the two confidence standards. International College of Financial Planning – Challenge Pathway Prep Book Page 334

The Equity Conundrum Notice that the studies of both Bengen and Guyton suggest that increasing portfolio equity percentages (to a point) can have a significantly positive impact on initial withdrawal rates and subsequent withdrawals, as well as overall portfolio sustainability. If Bengen and Guyton are right, how do we balance their approach against what others suggest as a more reasonable approach, in which equity investments are greatly reduced? Part of the answer lies in the size of the retirement portfolio. If an individual has a sufficiently large portfolio, he or she can afford to significantly reduce equity exposure in retirement. A four percent withdrawal on a portfolio of $2 million, will provide the client with an annual cash flow of $80,000, enough to provide many people with a comfortable retirement lifestyle. The larger the asset pool the client can accumulate, staying consistent with his or her goals and risk profile parameters, the greater flexibility there will be in withdrawal percentage requirements. Unfortunately, as we have identified, a sizeable number of clients will not accumulate the amount of money needed to be as conservative with their retirement portfolio as they may desire. What can the advisor suggest for these clients? This is where the work by Bengen and Guyton provides assistance. By carefully maintaining equity investment exposure during retirement, an individual may be able to increase withdrawals without compromising portfolio sustainability. It may be worthwhile to think in terms of additional segmentation by dividing the portfolio into 4 different pools. Lifetime income: this pool is designed to provide guaranteed income for life. All capital will be depleted by the time of death. Any source, such as annuities, that can provide a guaranteed income stream fits into this pool. International College of Financial Planning – Challenge Pathway Prep Book Page 335

Preserved capital: this pool is a traditional investment portfolio holding stocks, bonds, and any other appropriate securities. This, too, is designed to contribute to cash flow for the retiree’s life. However, unlike the first pool, the retiree likely does not plan to fully deplete all capital, and plans to leave any remainder to heirs or other beneficiaries. Medical reserve: we have discussed the potential impact medical expense can have on a retiree’s cash flow. This pool is a fund that can be reserved to meet excess medical costs that may occur as the retiree ages. In addition to portfolio assets, this pool may include long-term care or other insurance to cover medical expenses. Capital consumption: this pool is set aside to provide additional cash flow by drawing down capital. Since cash flow will be generated not only by interest payments, or other income-generating investments, but also by depleting principal or capital, this pool can have a large positive impact on cash flow (recognizing that when the money is gone, there will be neither earnings nor cash flow generation). There are actually two pool categories in this section: Impact of Taxes on Retirement Cash Flow Income taxes can produce a significant drain on retirement cash flow. Benefits from retirement plans are often fully or partially taxable when received. The amount of taxation is important to retirees, because it determines the net benefit they receive. As a simple example, there is a significant different between a $1,000 monthly benefit with no taxation and a similar benefit taxed at 25 percent. The 25 percent tax results in a net benefit received of only $750, which may result in the retiree not being able to meet expenses. Generally speaking, taxes on retirement benefits tend to be lower than those on regular earned income, because income is lower, putting the individuals into a lower tax bracket, but they still can significantly impact overall cash flow. Retirement cash flow, what can clients do to control or reduce taxation? International College of Financial Planning – Challenge Pathway Prep Book Page 336

The most obvious solution is to place assets into non-taxable savings/investment vehicles. Many territories have vehicles with earning that are not subject to income tax. Some retirement plan distributions have no income tax, while others are taxed, but on a reduced basis. When building a retirement portfolio, the financial advisor and client should consider the future taxability of asset location – within or outside of retirement accounts. Distributions from these may be fully taxed, partially taxed, or tax free. There is an old piece of guidance related to choosing investments that is worth repeating, “Don’t let the tax tail wag the investment dog.” This means that tax implications should be kept in perspective, while other/greater factors rise to the top of the consideration list. When planning retirement distributions, this guidance is especially prudent. Greater consideration should be given to maintaining investments that produce especially good cash flow and liquidating those that are underperforming or simply not as useful a part of the overall retirement portfolio. While it’s true that tax implications must be factored into the overall plan, they should be secondary to broader portfolio and cash flow considerations. Remember, work with qualified tax professionals or provide referrals to qualified tax professionals. Do not provide advice outside of your expertise or that you are not licensed to deliver. Recall Professional Skills: DIFFERENCE BETWEEN INCOME & CASH FLOW Income is generated by dividends or interest. That’s not a problem, but it does present a limitation. Cash flow, on the other hand, can come from dividends and interest, along with resources generated from the sale of assets. International College of Financial Planning – Challenge Pathway Prep Book Page 337

Cash flow provides a more broad-based source from which to generate payments to the retiree, and is preferable to use in retirement planning. Increased longevity provides much more opportunity for retirees to run out of money. The solution to proving adequate cash flow and protecting against running out of money is either to accumulate very large sums or to keep as large a portion of accumulated assets as possible invested, while gradually liquidating amounts needed to provide cash flow. The longer-term investments can help offset purchasing power problems related to increased longevity. International College of Financial Planning – Challenge Pathway Prep Book Page 338

The Characteristic India Demography, Family and the Retirement Preparedness A young India with low old age dependency ratio Pros- Better economic growth, rise in women joining the workforce, increased avenues for fiscal income and expenditure, increase in savings rate, overall enhancement in the standard of living Cons- The number of jobs and the skills required to consistently remain beneficial to the economy will be a challenge WHAT IS SOCIAL SECURITY A government led program that provides assistance to its citizens through the nil or inadequate income phase, providing them with monetary benefits for their survival and sustenance. FEATURES OF SOCIAL SECURITY Important aspect of one’s later life where due to age or health reasons, one is not able to work anymore. helps also in times of untimely death, disability, loss of job, sabbaticals or a temporary gap in employment. India’s Social Security Program Employee Provident Funds, Employee Pension schemes, Employee Deposit Linked Insurance Schemes, Gratuity Act, Health benefits under the Employees State Insurance Act, Workmen’s Compensation Act, Maternity Benefits Act, etc. With constraints on the government’s spending power and the magnitude of the population, increasing funds available for social security measures becomes difficult. So, citizens need to plan and save for themselves. International College of Financial Planning – Challenge Pathway Prep Book Page 339

A typical Indian Family - Three generations living together is still more common But with nuclear family getting more traction, it is important to do retirement planning in advance. Retirement is one of the last priorities of Indians. The average marriage age for Indians has gone up to 27-30 years. Late marriages have compounded the problems of savings and spending - Buying a house/car, travel, medical expenses, children’s education, marriage, parental health and medical care pushes out the entire life cycle of one’s basic objectives to the age of 50-55. By this time, the individual is closer to retirement. Inability to save enough during working years often leads to a diminished quality of retired life. It is up to an adviser to raise his client’s attention and provide data-driven guidance- to balance the current needs of the family with the future needs of their own. Pension Reforms in India Old Age Social and Income Security (OASIS) Project The year 1999 – was the International Year of Older persons and marked the beginning of project OASIS for India. The word OASIS stands for Old Age Social and Income Security. Project purpose- To provide the government with recommendations to create and modify policies and gather resources around the safety and security of its senior citizens. Objectives of OASIS included - To ensure old age needs for medical care, nursing assistance, food security, shelter, protection against exploitation etc. To ensure need based maintenance of parents and senior citizens, revocation of transfer of property by senior citizens in case of negligence by the relatives, penalties and legal implications for abandonment of senior citizens, establishment of old age homes, provision of medical facilities and availability of security for senior citizens and the protection of life and property. Key policy recommendations as part of the OASIS project report were –  To limit early withdrawals on retirement funds  To ensure better financial and portfolio management of these corpus funds for superior returns International College of Financial Planning – Challenge Pathway Prep Book Page 340

 To ensure better customer service so as to be more accessible to the end user  To expand the coverage of the existing systems to reach more workers  To make the defined contribution schemes more accessible, efficient and better for the user. Pension Scenario – State Governments, Autonomous Bodies and Unorganized Sector Pension is defined as monetary credit provided by the employer, regularly to an ex-employee once he/she retires from active service due to age, mental or physical health conditions. There are two types of pension schemes - Defined Benefit Schemes & Defined Contribution Schemes. Defined Benefit Schemes The Government of India paid pension to all its employees under the CCS (Centralized Civil Services Pension Rules 1972) if their joining date/appointment date was before 1.1.2004 and the employee has completed 10 years of qualifying service. Private sector employees had no such pension. Defined Contribution Schemes For employees appointed post 1.1.2004, the National Pension System, (NPS), became applicable. Defined Benefit Schemes – features o The eligibility of the pension amount is determined on the basis of tenure and salary history o Contributions are made by the employer during the employee’s working tenure o The pay-out to the employee post retirement is reasonably consistent and not linked to the pension fund’s performance. o The pension received is taxable as “salary” o The commuted pension is tax exempt to a certain prescribed limit. International College of Financial Planning – Challenge Pathway Prep Book Page 341

Organized sector employees – Central government employees Appointed and joined before 1.1.2004 o Eligible to receive pension under the Central Civil Services 1972 rules. o Minimum number of years of qualifying service was 10 years o Can commute up to 40% of the pension amount as lump sum o The remaining amount will be amortized into installments called monthly pensions. o On death, arrears are payable to the eligible family member - spouse, dependent son/daughter, Divorced daughter. The formula for commutation is as below Commuted Value of pension = 40% x Commutation factor x 12 New Pension Scheme later on became the National Pension System: In 2009, the National pension System was opened up to all citizens along with government employees. Features of the NPS -  The Scheme allows subscribers to regularly contribute in the NPS  On retirement, he can withdraw a partial sum and convert the rest of the amount into an annuity  Any Indian Citizen between the age of 18 and 60 years can join NPS, including NRIs.  Most banks are points of service, and even offer this account opening facility online via their websites. NPS has Tier-1 and Tier-2 accounts -Tier 1 is mandatory, gives tax benefit and does not allow withdrawal. On retirement, 40% to be compulsorily converted to annuity. - Tier 2 is voluntary, no tax benefit on investment or withdrawal and early withdrawals are permitted. International College of Financial Planning – Challenge Pathway Prep Book Page 342

Organized sector employees– private sector employees Workers in the private sector do not get a pension from their employers in India. Other avenues for retirement savings o The Employee provident fund o The Employees’ Pension Scheme o Superannuation funds Government – Decisive shifting away from Defined Benefit Schemes GRATUITY  Eligible to receive gratuity on completion of 5 years with the organization.  Benefit paid under the Payment of Gratuity Act 1972.  Does not require any contributions from the employee.  Can be paid earlier on disability or death of the employee Gratuity calculation for Government employee - Maximum tax exempt can be Rs. 20 lacs Gratuity = ((Basic Pay+ DA) x 15 days x No. or years of service) / 26 Gratuity calculation for Non -Government employee - Maximum tax exempt amount can be Rs. 20 lacs 15 x Last drawn salary x No. of years of service /26 Mandatory contributory system Employee Provident Fund  Employees and employers contribute equal amounts to the EPF  The accumulated amount with interest can be withdrawn on retirement or resignation  EPF enjoys the E-E-E category of exemptions under Income Tax Act 1961. International College of Financial Planning – Challenge Pathway Prep Book Page 343

 The amount accumulated is immune from attachment by a court of law in case of legal liabilities.  The fund can be withdrawn prematurely for the following reasons - o Purchase or construction of house/land, repayment of housing loan o Financing of an insurance policy for the member o Illness or marriage in the family o Natural calamity o Physical handicap Employee Pension Scheme  Social security program for Employee Provident Fund Organization (EPFO) members  Provides for private sector employees to receive pension after retirement  Only employers contribute to the EPS at the rate of 8.33% of the employee’s monthly salary  Employee can avail pension even if he becomes permanently and totally disabled  Pension is an annuity payment and is fully taxable  Pension is payable to the employee’s widow/dependent children, after his death  Early pension can be opted for after age of 50 but completion of at least 10 years of service  Pensioner/widow needs to submit life certificate every year to the bank manager to continue receipt of pension. Formula to calculate eligible amount of pension - Pension = Pensionable salary (average of the last 12 months) x Pensionable service / 70 Pensionable service is the period for which the contributions have been received Retirement Products in India Provident Fund Provident fund is a special benefit scheme generally prescribed, administered and guaranteed by the central government for its working class citizens.. Its main purpose is to help employees compulsorily International College of Financial Planning – Challenge Pathway Prep Book Page 344

save a part of their salary every month so that this accumulated sum can be used post-retirement or disability. There are two types of Provident funds in India - Employee Provident fund and Public Provident fund Employee Provident Fund Scheme run by the Central government of India Set up under the Employees’ Provident Fund Scheme 1952 Employee contributes a monthly sum from his salary to the fund and the employer contributes an equal amount Fund becomes available for withdrawal on retirement or death of the employee and other listed special circumstances Employee Pension Scheme A social security program provided by the Employee provident fund organization (EPFO) Provisions for private sector employees to receive pension once they retire Only the employer contributes to this fund to the extent of 8.33% of the employee’s monthly salary Fund becomes drawable for pension only on retirement/permanent disability Defined Contribution Plans – Institutional Framework and Investment Architecture Defined contribution plan is where the Employer and/or the employee both contribute regularly to a retirement fund meant for the employee’s later age needs. International College of Financial Planning – Challenge Pathway Prep Book Page 345

The Employee Provident fund in India is a type of a Defined Contribution Plan. Institutional Framework  EPFO is entrusted with the task of accumulating, managing and dispensing monies from the Provident fund accounts  Governed under the Employees’ Provident Funds & Miscellaneous Provisions Act, 1952.  The central board of trustees is appointed by the government of India  The board is assisted by the EPFO via its 135 offices across the country. Investment Architecture When an employee joins an organization, his account is opened with the EPFO. Existing account from previous employer is transferred to new employer. The contributions from both the employer and the employee are deducted at the end of every month and transferred to the EPFO account. The registration and management of accounts on EPFO is completely online On retirement or exiting from an organization, the employer applies to the EPFO on behalf of the employee to withdraw or transfer his funds to the next employer. EPF Falls under the EEE- Exempt-Exempt-Exempt category. Withdrawals for emergency, marriage or education are exempted from Tax. Interest accrued on amount accumulated in also exempted. Contributions to EPF is exempt under 80© subject to a limit of 1.5 lacs. Universal Account Number (UAN)  12 digit code allotted to every member of the EPFO  Used to identify the employee’s account with the EPFO – as a reference number for all contributions and service related issues.  Issued by the Ministry of Employment and Labour under the Government of India  Remains the same throughout lifetime, is portable and can be moved to another employer International College of Financial Planning – Challenge Pathway Prep Book Page 346