Reducing downside potential can be accomplished by “seeking alpha” —an estimate of the return expected from a portfolio of investments in relation to the return of the overall market when both are adjusted for non-systematic risk (risk that can be reduced through diversification such as owning stocks in a variety of companies or industries, or having a mix of investments or securities).
This strategy can be useful to those who wish to simulate the returns of a given index but want to add a level of protection from the alpha (by investing in risk-free securities), or for those who wish to take on additional risk by taking positions exposing them to non-systematic risk, by choosing individual stocks. The return on a portfolio with an alpha of, say, 1.25 percent could be expected to be 1.25 percent higher than the return of the market over the course of a year, as one example.
‘Catching Up’ Before Retirement
One of the easiest ways for people over the age of 50 to “catch up” is increasing their contributions to tax-qualified retirement arrangements. Those who are 50 and older can contribute an extra $1,000 per year to traditional or Roth IRAs and an extra $6,000 per year to 401(k), 403(b) and 457 plans. Also, keep in mind that contributions can be made for spouses as well.
Another tool to set aside additional money for health care and retirement is a health savings account (HSA). An HSA is an option for those with a high deductible health-care plan.
Among the benefits of an HSA: allowing the unused balance to roll over from one year to the next; ability to accumulate tax-deferred investment earnings on account balance; at age 65, HSA money can be used for any expenses, not just health care, without an additional federal tax; distributions will be taxed as ordinary income. The money remains untaxed after age 65 when used for qualifying medical expenses, including Medicare Part B premiums.
Protecting Against Certain Risks
One solution to help protect a portion of clients’ retirement savings against certain risks is non-qualified annuities. Non-qualified annuities can provide tax deferral; reduce interest rate risk (some annuities); protect against market volatility (some annuities); may generate guaranteed income for life reducing longevity risk, and may include death benefits for beneficiaries. It’s important to note that guarantees on these contracts are backed by the financial strength and claims-paying ability of the issuing company.
It’s also critical to clarify that non-qualified annuities are not a suitable solution for every situation. Some clients may find liquidity an issue. Although rare, others may already have enough guaranteed retirement income. Some individuals may be at an age where it no longer makes sense to purchase a non-qualified annuity since it is a long-term vehicle. Be sure to consider these factors before recommending a non-qualified annuity for your client’s portfolio—but also remember that implementing an annuity strategy appears to work better when done sooner, rather than later, so clients shouldn’t delay in exploring this option.
Cash value life insurance is another vehicle that is used to help protect against risk. It can provide the primary need for death benefit protection for beneficiaries. In certain cases it also offers potential supplemental retirement income, helps provide a level of protection against market volatility, helps diversify retirement income hedges against inflation when using cost of living riders (which may be optional and at an additional cost) and may provide tax-advantaged loans or withdrawals. (Policy loans and withdrawals will reduce the available cash value and death benefit and may cause the policy to lapse, or affect guarantees against lapse. Withdrawals in excess of premiums paid will be subject to ordinary income tax. Additional premium payments may be required to keep the policy in force. In the event of a lapse, outstanding policy loans in excess of unrecovered cost basis will be subject to ordinary income tax. Tax laws are subject to change and your clients should consult a tax professional.)