Make It Last – Ep 60 – How Should You Invest Your “Mid-Term” Bucket in Retirement?

This episode is continuation of a discussion from episode 59 where Victor discusses different retirement distribution strategies, including using short-term, mid-term, and long-term investment buckets. This show unveils how you should invest your mid-term bucket.

Make It Last with Victor Medina is hosted by Victor J. Medina, an estate planning and certified elder law attorney and Certified Financial Planner™. Through his law firm and independent registered investment advisory company, Victor provides 360º Wealth Protection Strategies for individuals in or nearing retirement.

For more information, visit Medina Law Group or Private Client Capital Group.

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Victor Medina:  Everybody, welcome back to Make It Last. I am your host, Victor Medina. I’m so glad you could join us here this Saturday morning at 7:30 AM. It is June 23rd, and I’m excited to be here because this is part two of a show that I started last week.

Now, if you didn’t listen to part one and you are listening to this show as a podcast, I want you to hit pause. I want you to go back to last week’s show. That’s episode 59. Listen to that show and then kind of catch up with us.

But if you’re listening live on the radio, you don’t have the opportunity to do that and you’re trying to figure out, “Should I keep listening?” and the answer is yes. Because I’m going to recap a little bit of what we did last week so that this week is exciting for you and entertaining and informative, and all the things that you need in order for this to be a great show.

What did we talk about last week? Last week, we talked a little bit about why just pulling out a set amount from your retirement every year was such a bad idea. Last week, I covered what the news media has often told you you should be doing in retirement, which is taking out four percent every year.

Taking out four percent, four percent, four percent. Now, the reason why they did that is actually based off of a study a long time ago that said that if you did that over a certain market performance, then you couldn’t run out of money. It presupposed a bunch of stuff that isn’t really the case these days.

What we showed last week is that your money is at risk in retirement to a sequence of returns. When you look at how the market might perform in retirement, there’s really only three things that it can do. It can go up, it can go down, or it can stay the same.

We don’t know what your money’s going to be doing at any particular time. In other words, in your retirement, when you finally pull the trigger and you say, “That’s it. I’m done working. I now have my nest egg from which I am going to live,” when you do that, you don’t know what the market’s going to be doing next.

You know generally that markets go in cycles, but you don’t know this year, this month whether the market’s going to be up or down or stay the same. Because you can’t predict what’s going to be going on, you are at risk to having a bad sequence of market returns.

That’s like a term of art. When we, as advisers, talk about sequence of returns, we know what we’re talking about. We know that we’re talking about a sequence of market returns. We understand the shorthand about what that means for how it affects your retirement portfolio.

Now, with people with tons and tons of money, they may not have to worry about this as much because they’ve got always some that’s going to be able to be sold if they need the money.

If you have a limited retirement, if you are looking at what you’ve got and say, “This is all that I have and I’m not sure if I’m going to make it at the end,” then the sequence of returns is really important for you.

The sequence of returns basically says that, if you have a series of downturns early in the performance of what the market does in your retirement, early in your retirement, it is going to vastly impact how long your money lasts, because essentially what you’ve done is…

You think about the markets as a rollercoaster, kind of going up and down and up and down. You took out money when the rollercoaster was at the bottom, which means that you didn’t get to ride it as it grows back up again. Therefore, you lost out on some of the performance that you needed there.

Of course, because you took it out of there when it was down and then started taking out again as it was going up and even took it out more as at the height basically impacts how much your money is going to last.

Last week, I sort of teased what the solution for that was, which is that you should be thinking about your investments more as a time segments. You should think about investments that you have for the short term, investments that you have for the mid‑term and investments that you have for the long term.

Investments in the long term, those are pretty easy. That should be your diversified portfolio that’s meant to grow at seven percent over the long haul, yadda, yadda, etc. That’s your “set it and forget it,” kind of the portfolio that you had as you were ramping up to retirement, as you were accumulating assets. That’s what you’re going to want in the long‑term bucket.

In the short‑term bucket, you essentially want something that is liquid or close to liquid because you’re going to be using that money.

You can’t have it be tied up in either an investment that is illiquid, that’s hard to get out of or an investment that’s really designed to perform over the long haul, because, if you have the short‑term bucket tied up in one of those two things, you’re either at risk for the sequence of returns or you have what we call a liquidity risk or risk of taking it out.

Liquidity risk actually means a couple of different things. It’s not only whether or not the contract is something that ties up your money but it also is a practical liquidity risk, like, could you actually come out of your investments and not affect the rest of your retirement? That’s a form of a liquidity risk.

If you have stocks that are meant to be held for the long term and perform over the long term, then you have a form of liquidity risk because for practical purposes you can’t use that money when you want to use that money. The short‑term bucket should really be liquid stuff.

That leaves us with the mid‑term bucket and what I teased that we were going to be talking about today.

For a long time, that mid‑term bucket were safer investments in the form of bonds. Bonds we thought would hold their value and pay a predictable amount of interest. We knew that that mid‑term bucket was going to be something that was reliable if we could hold bonds. It would help us keep that safe.

A couple of things have happened since then. The first has to do with the fact that the interest rate that bonds are paying out is low, it’s not great. The other thing is that because the interest rates are low, it means that the value of the bond is risky.

It’s risky that it will go down because if interest rates go up, that is to say, if what the bonds will pay out today be as less than what they will pay out in the future, when the interest rates go up, then that means that the value of the bonds for today is going to go down.

If you’re holding those [indecipherable 6:42] bonds, they’re going to be worth less. In effect, if they’re worth less that means that they’re very risky. We don’t have as much value in there, and we may need that money.

What’s the answer to the mid‑term bucket if bonds aren’t right? Well, my answer in the way that we design a retirement portfolio is that we recommend that that mid‑term bucket be in a fixed indexed annuity.

A fixed indexed annuity is a very specific kind of investment that I’m going to walk you through so that you understand as much as all of our clients understand about this investment because it can be scary to get involved with an investment that you don’t know a lot about and, by the same token, the annuity is not a simple investment. It is important that you learn something about it if it’s going to become part of your investment portfolio.

Why is the fixed indexed annuity the right decision for a mid‑term bucket? The answer has to do with the reason why that mid‑term bucket exists. The mid‑term bucket exists largely so that we can ensure that that money is there, outside of the sequence of returns risk, to be used to fill the short‑term bucket as it’s consumed.

All right? Hope that makes sense for you. If the short‑term bucket is what we’re going to spend, we’re going to run out of that money. We’re going to need the mid‑term buckets to fill the short‑term bucket. Because we’re going to be drawing money away from the mid‑term bucket, it cannot be subject to sequence of returns risk.

As we were talking about before that’s the thing that destroys your retirement. Not in the long run, not at the end of a retirement run, but if the sequence is down in the short time and we can’t predict what’s going to happen.

Victor:  I’m going to talk to you about the fixed indexed annuity, but I’m running up against the break. Let’s take a quick break, when we come back, I’ll describe the fixed indexed annuity so that you understand why it’s the right investment for that mid‑term bucket and whether it is right for you. Stick with us, we’ll be right back on Make It Last.

Victor:  Welcome back to Make It Last. I’ve been talking to you about retirement income strategy. Specifically this bucketing or time‑segmenting strategy. Really, what we’re talking about is how to fill that mid‑term bucket. Basically, if there’s three periods of time, short, mid and long term, what’s in the mid‑term bucket?

I told you that the answer, the way that I do my planning is fixed indexed annuities, so I’ve got to describe what they are. Stick with me because I’m going to just hop in the wayback machine. We’re going to talk about what an annuity was in the past and how it’s developed, talk about what a fixed indexed annuity is and why it fits for our planning.

We know a lot about the way insurance companies work. Insurance companies are very, very good at understanding actuarial tables, the risk of somebody dying early. They exist essentially to transfer the risk of somebody dying early onto their books.

They can pool money in a way that helps them pay that out as a good business, but also helps transfer the risk from people who can’t bear it. That’s basically the way insurance is. Insurance is when you have to transfer the risk of something expensive happening when it’s unlikely to happen.

You’re unlikely to die early, but you dying early is very, very impactful. It has a catastrophic effect. Because the damages on you dying early are so great, you would transfer that risk over to somebody that could better bear it. That’s the insurance company.

For a long time, that was just life insurance. Put the money together. Not as many people are going to die early as we thought. We’ll pay out the claims for the people that do. We’ll have some profit. Then, basically, that’s the business.

So insurance companies said, “Look, I think we can do one thing better than that. Instead of waiting to pay out when they die, since we know how long most people live and where they are on the range of a life expectancy, how likely it is for many people to live or die for any length of time, what if we gave them the money that we were going to pay out at their death?

“Why don’t we give it to them as an income stream? What if we can predict how much money they’re going to get?” By the way, it’s going to end up being more money than they would be entitled to if they just pay it out on their own.

The way that the insurance company is able to do that is a very cold technical term called “mortality credits.” Mortality credits are basically the money that I was going to pay somebody who died early. I’m going to pay that money to people who keep living for a longer period of time.

I’m going to transfer those mortality credits. I didn’t have to pay those people when they were early. I’m going to pay it when they’re gone. That’s basically an annuity.

An annuity is a structured income payment. You hear about annuities in a lottery winning. You can either take it as a lump sum or as an annuity. An annuity is guaranteed payments for life. That’s what an annuity is.

The insurance companies after that said, “Look, we’ve got a better deal. What if we don’t pay the income to you immediately, but we’re going to allow you to increase how much that amount would be, if you defer when you take it.”

What they’re going to say is, “OK, don’t take the income right now, turn it on later. Turn the income on later, but the longer you wait, the more we will pay you out as a guaranteed number.” That’s what we would call a deferred annuity. We’re deferring it to a later point in time.

You might think to yourself, “How are you going to give me more money in that account by waiting?”

The insurance company says, “Look, we are going to invest this money in these government treasuries to pay out for 30 years. We’ll share some of that with you. We will credit some of that onto your account. Basically, the longer that you hold off, the higher that account’s going to be. How’s that deal sound to you?”

Some people took that deal. They deferred the annuity. The balance of what they put in the annuity increased, grew bigger. They might or might not have turned on that income later in life.

Then the insurance company added an additional layer to that. What they said was, “Listen, instead of crediting you the interest that we would have done, you know, as a share arrangement with what we got for the investments, what if we did something else with that money?”

You say, “OK, what do you want to do with that money?” Insurance company says, “What I’m going to do with that money is we’re going to buy options to participate in an index.” The amount of the options, how much we put at risk in there is going to depend on what the cost of those options are.

“Rather than you getting credited this interest for the entire time, what if we bought the opportunity to participate in an index? We did that with your money,” you know, “the amount that we would have credited.”

In that arrangement, your money is not being invested in the index. This is not the same as putting your money in an S&P 500 index. Your money is not being invested there. It’s the interest that is going to buy options to participate in that index.

I’m throwing a lot of words on you, but I want you to understand that your money doesn’t go anywhere. Your money is not at risk. What’s at risk is the fact that you spent the interest that you would have gained on these options. What’s the worst thing that can happen?

The worst thing that can happen is that those options are worth nothing to you. That you invested in the options, but they’re worthless because the index went down. It didn’t perform at all. If that’s the worst‑case scenario, your balance on file with the insurance company went nowhere. It stayed exactly the same because you didn’t put your money at risk.

If you didn’t put your money at risk, is that a safe investment for that mid‑term bucket? The answer’s yes. In that mid‑term bucket, one of the things that we needed to ensure is that any potential investment we had had no downside risk. If we needed to pull money out, we didn’t want to pull it out of a reduced account, an account that had gone down.

Is it starting to make sense to you? That way, it meets our first requirement of that mid‑term bucket, which is make sure that that balance is as safe as possible with the potential for it to grow.

What can it grow and how it works I’m going to explain in the last segments. It will be one of those rare shows where I take all three segments to talk to you about something. This is important if you’re going to learn what you need to know about fixed indexed annuities in these 30 minutes that we’ve got with you.

Before I take a break, I want you to really latch on to this idea, that when you buy this fixed indexed deferred annuity, you give that money to the insurance company. The insurance company manages, essentially, the risk by keeping your money safe but taking the interest credits that you would have otherwise had and using it to buy options in an index that it’s tracking.

Victor:  If you’ve got that much, congratulations. [laughs] You’re ready to be an advisor.

When we come back from the break, I’ll actually show you how the indexing works so that you see that it’s not magic, and you understand what the tradeoffs are. Then we’ll get through that. We’ll really understand why it’s perfect for that mid‑term bucket. All right? Let’s think about this. We’ll be right back on Make It Last.

Victor:  Welcome back to Make It Last. I’ve been talking today about fixed indexed annuities and specifically why fixed indexed annuities are the right investment for your mid‑term bucket.

Now, when we took a break, I taught you that this fixed indexed deferred annuity was essentially safe money that you had traded with the insurance company so that they would give you the opportunity to participate in the index. Now, how does that work? Strap in. You ready?

We know about indices.

Victor:  We understand an index because we hear about it all the time. If you’ve heard about the S&P, that’s an index. Now, it’s not the only index. In fact, it’s not the index that we use most of the time when we’re talking about one of these fixed indexed annuities.

The reason is because it can be very volatile. Even though it is returned great over the long haul, it can be volatile in retirement. We don’t like it in retirement. I want you to just focus on the S&P because you understand the way that that works.

The S&P is essentially a representation of the overall stock value of the 500 largest US companies ‑‑ the S&P 500. Great. That index at any point in time could be up or down, depending on the growth of the index. Now, I’m going to use a made‑up number so that we can track it.

Let’s say that the value of the index that you’re tracking is 1,000. Not $1,000. That’s the value of the index. Just 1,000. That’s a round number. Let’s say that it’s worth 1,000 today. A year from now, as I said to you like any investment, that could be up, down, or stay the same.

Let’s use a 10‑percent swing. Let’s say that a year from now it’s either going to be at 1,100, so it’s up 10 percent, 1,000, didn’t go anywhere, or 900, basically gone down 10 percent. It can do any one of those things.

If you bought options to participate in the index, and it’s at 1,000 or 900, those options are worthless to you. You’re not going to exercise them. They’re not worth anything. Just let them go. Now, your money is safe because your money didn’t go down 10 percent. It’s just that those options were worthless.

We know that as a bottom run this fixed indexed annuity basically is the safest investment that you can be in because it can’t ever go down. We’re going to talk about liquidity risk in a second, but just stick with me. The value of that account can’t go down.

If it goes up that 10 percent, your money is going to get credited some amount. How much it gets credited depends entirely on what method the insurance company is using to credit that money to you.

They’ve got three options. I want you to write these down. They can either give you a cap, a straddle, or a participation rate. Now, a cap is basically a ceiling. Let’s say that the cap is four percent. On this index it went up 10, but because your cap is 4 you just get 4.

The way that the cap works is that the first amount up to the top of that ceiling is all yours. If it makes one, you get one. If it makes four, you get four. If it makes six, you get four. Got it? It’s not going to go any higher than the cap.

The straddle essentially is that amount that you have to get over. You have to straddle over that before you start to make any money. Let’s say that the straddle amount is 1.5 percent. That means the first 1.5 percent is the insurance company’s money. Anything above that is yours.

In that first scenario with the cap, above that four percent, that was the insurance company’s money. They took that. On the straddle, it’s an uncapped crediting strategy because, once you get over the straddle, all the rest of the money is yours.

If the index goes up just one percent, that is all the insurance company’s money. If it goes up 2.5 percent, the first 1.5 is the insurance company’s, and the next 1 percent is yours. If it goes up 10 percent, the insurance company got 1.5. You got 8.5. Make sense? Good.

The last one is a participate rate. A participation rate is basically sharing it in a proportion. Let’s say that you’re 80/20. You get 80. The insurance company gets 20. If that index goes up 10 percent, you get 8, the insurance company gets 2.

You can’t choose which indexing strategy you would like without understanding that the insurance company sets what that indexing strategy is going to be. You may want a participation rate, but they don’t have it available. You may want a straddle, but they don’t have it available. The straddle and the participation rates are the only ones that are uncapped.

Now, I said before that, when we talked about different indexes, I don’t like the S&P for what we do in our practice. The reason for that, it is too volatile. It can go up or down. If it goes down, it goes down really sharp. That’s not a great retirement‑planning index.

I want something that is volatility‑controlled so that I’m not trying to hit home runs with it but that I get the opportunity to get the performance that I liked in the bonds. I’m looking for about four to five percent a year. If I get that, I think it’s going to be great.

If I get that on the index, it’s not guaranteed. Absolutely not guaranteed. It could be the year with a zero. It’s almost like a ratcheting effect. When you get up to a certain level, you stay there. Then you ratchet above that because your money can’t ever go down in this.

From a mid‑term bucket, coming on full circle, it’s a really great choice because it means that money’s going to always be there. It means if it does anything, it goes up or stays the same, but it can’t ever go down. If I take money out of that, I’m not taking out of it while it’s down on the rollercoaster. I’m withdrawing money where it’s either standing the same or it’s gone up.

One question that comes up with annuities is liquidity. How can you get at your money? It is a fair question because annuities typically come with surrender charges. If we know that there’s safety, there’s growth, and there’s liquidity in any investment and that our annuity gives us safety and it gives us growth, the question is how badly does it compromise liquidity?

The answer depends entirely on the kind of annuity that you purchase, what the product is from the insurance company, because you have ones that are very restrictive. I don’t like them. Don’t like them at all. You’ve got ones that go out 15 or 20 years’ worth of surrender charges and super‑high percentages. 12‑15 percent in surrender charges.

Those are not great, but there are annuities that allow you to take out 10 percent a year. That’s not bad if I’ve got a 10‑year annuity and I know that I’m going to be using that money in the mid‑term bucket for 10 years and taking out 10 percent. Really matches my planning strategy because it fills that short‑term bucket in equal installments, allows me to keep working with that money.

By the way, you see the way the numbers work. If I allocated 40 percent into this mid‑term bucket and I take out 10 percent a year, that’s my four percent without the downside risk. Is that making sense to you guys? Hope so. Hope so. All right.

Some allow us to take 10 percent, but what if you don’t want to make 10 percent on it? Products can allow you to take 20 percent the next year. They have products that allow you to take the entire amount after the fourth year, after the second year.

There’s no cut‑and‑dry definition for what this annuity can do. It is dependent entirely upon the product, the insurance company, and the way that it’s designed, which is why you absolutely need somebody who is essentially a fiduciary in your corner working with you to plan this strategy out.

If you rely on the salesperson to do it, they’re going to jam you with a product that is no good because it pays them a lot. Somebody who’s a fiduciary is going to structure this so that they are in fact making it what is in your best interest for your planning.

That’s the reason why this fixed indexed annuity works in the mid‑term, because properly designed in place it will be an investment that holds its value and never goes down. Then also is able to help you fill the short‑term bucket as you are using this money in retirement. That’s it. That’s the end of the show. [laughs] That’s how I’ve explained it.

If you have any questions specifically about this, of course you can email the show. You can drop a comment anywhere that you can find us. You can contact the law firm or my financial firm and ask us questions directly if this is interesting to you. One of the things I would love for you to do is actually share this episode with a friend.

If you have liked this, go on into the podcast version on iTunes or on Spotify. Take the link and share it with a friend. Say to somebody, “Look. I found the way that you should be doing your retirement in the mid‑term bucket. You got to listen to this show. This guy knows what he’s talking about.” Then share it with them. That’s been it. All right.

I’m going to join you next week, and we’re going to keep talking about this stuff. I hope you enjoy this two‑part retirement‑income show and topic for it.

Victor:  This has been Make It Last where we help you keep your legal ducks in a row and your financial nest egg secure. With that tagline said, I’ll catch you next Saturday. Bye‑bye.