Retirement Planning

Retirement is a modern concept. As recently as 1900 there was no such thing as retirement. Average life expectancy was around 47 and people essentially worked until they died.

Life expectancy at birth

Life expectancy today is nearly double that and spending 20 or 30 years out of the workforce in retirement is quite common.

Life expectancy at age 65

As recently as 1934 when Social Security was established and the retirement age was set at 65, the expectation was that very few people would live to collect and that those who did would collect only for a few years. Two generations later, American politics is facing the crisis that nearly everyone is expecting to retire and to collect retirement benefits for almost 20 years on average with an outstanding health care system pushing up life expectancy by 2 years per decade; the system is projected to run out of money in our lifetime if no changes are made.

So it's not surprising that society as a whole doesn't know how to handle retirement: it's never really been done before.

At the same time, corporate pensions are rapidly becoming a thing of the past. Even the largest and most stable companies like IBM are doing away with their pension plans, and plenty of other companies never had a pension plan to start with. The corporate pension system is being replaced by a system in which individuals must take of themselves.

personal savings rate

Taking care of yourself isn't a bad thing; it's what America is supposed to be all about. But most people are not prepared to do it because it sort of snuck up on us.

America as a whole is saving less than nothing. This is a pretty amazing statistic given the country's obvious affluence … and the truth is that the statistic isn't well understood even by the Bureau of Economic Analysis who publishes it; but the debt-to-income ratio has been growing for a long time and many people have simply not been saving for the future.

By now, pretty much everyone knows that they should not count on either government help or corporate programs to support them in retirement and the question is what to do about it. The answer, in a word, is PLAN. In a few more words, SAVE and INVEST. We're not concerned with society as a whole here, this is not politics; we're concerned about helping specific individuals. Namely, you.

Everyone's situation is different and needs careful, detailed analysis. This is particularly true because of the complexity of all the rules governing Qualified Plans and tax-deferred accounts, to say nothing of trusts and closely held businesses and so on. However, it is quite possible to get a very good idea of how much money you need to support yourself in retirement. There is an online spreadsheet you can fill in to do this. It won't be exact, but it will be close; and for many people, it will also be a shock.

If you click the link the online retirement savings spreadsheet will open in another tab or window:

Online Retirement Savings Calculator

The first things to enter are

• The number of years from today until you expect to retire, the Years TO Retirement, during which time you can save money
  
• Then, the number of years of retirement itself,
  the Years IN Retirement, which is the amount of time you will live off of your investments, at least partially
  
• How much you currently have invested, your Current Portfolio Amount
  
• The rate of inflation, 3% is a good estimate
  
• And then the amount you expect your investments to return every year; on average, pre tax

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Then enter what you expect to need from your investments every year once you retire. Use today's dollars, the spreadsheet will adjust for inflation.

• First enter the amount of money that you expect you will spend. Taxes are an expense to be included in this amount. The best place to start is with your current expenses.
  • If you stop earning wages, you won't pay FICA taxes, you may have paid off loans and mortgages and your kids will probably be independent, which will reduce your expenses.
  • On the other hand, you may be planning to go around the world on a private jet, which will increase your expenses.
    
  Whatever. Make your best estimate. There are lots of rules of thumb that say you can live off 60 or 80% of your pre-retirement income, but you know your own wants and needs best. And don't forget that later in life you may have very high medical expenses.
  

• Subtracted from that amount will be any outside sources of income. Social Security is inflation adjusted; most corporate pensions are not. Enter whatever outside sources of income you can reasonably expect during retirement.

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Given that input, the minimum portfolio size can be calculated. This is the amount of money you need in the bank on the day you retire.

There are four ways of looking at the amount of money you need.

1. First, you can plan to spend all of your money and have none left over when you die. Philosophically, there's nothing wrong with approach but if any of your assumptions are just a little bit optimistic, you'll find yourself with no money before you die, which is not a good plan.
   
2. Option number 2 is to plan to have the same dollar amount in your portfolio at the end of your retirement as when you start. This is a safer bet than Option 1, but inflation will take a toll.
   
3. So, Option 3 is the amount that you need in order to end up with the same amount adjusted for inflation.
   
   The problem with the first three options is that they just rely on the math of Future Value calculations, and they rely on your assumptions working out perfectly. Which isn't the way life is, particularly over 30 or 50 years.
   
4. Option 4 says, "How big must my portfolio be to allow me to withdraw 4% every year, adjusted for inflation, and not eat into it?"

   This is the highest hurdle but it is the one you should be shooting for. This is the punch line... (See Withdrawal Limits From A Fixed Portfolio )
   
   The link cites a study which looks at what happens to an investment portfolio when nothing is going in and an annual withdrawal is being made.
   If we assume that a good part of the investments are in the stock market, since that's the only way to beat inflation, then there will be times when the portfolio actually shrinks.
   
   When the markets go down, the amount of money gets smaller. And at the same time, you have to withdraw money to live.
   Put all of that into a simulator and the answer is that if you have a life expectancy of 30 years, then you really should not plan to withdraw more than 4% a year.

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Math Favors The Early Saver

The earlier you start saving, and the more consistently you save, the easier it will be to retire comfortably.

Consider these scenarios in which three people save $15,500 a year tax free (the current limit to employee contributions to a 401(k)). All three people earn 10% per year on their investments.

• Person 1 saves every year from ages 25 - 65
  • Total investment: $635,500
  • Amount at age 65: $7,561,703
    
• Person 2 saves every year from ages 25 - 35 and then stops saving but lets the investment grow
  • Total investment: $170,500
  • Amount at age 65: $5,012,046
    
• Person 3 waits until age 35 to start saving but saves every year afterward until age 65
  • Total investment: $480,500
  • Amount at age 65: $2,820,123

How does Person 2, the one who stopped saving at age 35 to raise a family or something, do better than Person 3 who started 10 years later but saved for 3 times as long? It's the power of compound interest ... by age 35, Person 2 had built up $287,233 and that amount, compounded, was too much of a lead for Person 3 to catch.

The lesson is obvious: start saving as early as possible, save every year and put away as much as possible. For Person 3 to retire with as much as Person 1, they will have to work another 10 years or else increase the amount they're saving.

The trend in America has been to start work later and to retire earlier than our parents. To do this and to retire comfortably requires greater savings. If a person wants to become a doctor, say, which will require them to stay in school, etc. until age 30 and they want to retire at age 60 with as much money as Person 1, they will have to save $41,561 every year, at 10% tax free.

The maximum employer_plus_employee contribution to a 401(k) plan in 2008 is $46,000 so it is theoretically possible to achieve this, but not easy. For one thing, you have to forego spending this much money every year for your whole working life and for another, you have to invest at 10%; if you invest the maximum, the lowest interest rate that will allow you to achieve your objective is 9.49%.

If you're tempted to withdraw more than 4% a year from your portfolio in retirement, please read: Withdrawal Limits From A Fixed Portfolio

These sorts of considerations lead all too many people to "reach for yield" or otherwise invest foolishly; risky investments are just that, however, and one bad year can wipe out a lot of exceptional ones. Achieving returns that are better than the return on the 10-year Treasury bond require being willing to take some risk, to diversify and to invest for the long term; a suggestion on how to set up an investment portfolio to support yourself in retirement can be found here: Asset Allocation and Portfolio Rebalancing

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That's the math. Math is important and we can't ignore it; but life is a whole lot more than math.

And retirement is a huge transition for everyone.

Very often people put aside financial planning because of the emotional stress caused by the difficult life transition that is retirement. Just thinking about the subject gives a lot of people agita, no matter how old they are. This is natural.; the fact is that everyone responds this way because being young and in the workforce with plans for the future is what everyone plans for and expects. It is why we go to school for 20 or more years of our childhood, to prepare to be a member of the workforce. Work and family are what define most people at a very deep emotional level. Retirement disrupts everything; and many people compound the stress by moving away from their home on top of it.

What happens to us when our role in the workforce is diminished or eliminated? This is a tremendously hard question that goes to the heart of ...

• our self worth,
• our self-definition
• our place in society.

Preparing for retirement is an act of complete self redefinition during a period in our lives when our physical capabilities are beginning to decline, no matter how hard we work to prevent this. Everything is new and everything is hard. And there's really no one to show the way because ours is the first generation to do this on a large scale. It's no wonder that financial planning takes a back seat. However, having one's finances in good order and well understood reduces fear and stress by replacing an amorphous unknown with a concrete known.

Aristotle said that Well Started Is Half Done and Woody Allen observed that 80% of life is showing up. If you get your financial house in order, you will have a much easier time of dealing with everything else that may be going on in your life; and the earlier the better.

For any individual, there is a lot more analysis required to make sure we get everything right. Furthermore, there's a lot more to Financial Planning than just Retirement Planning. But this should have given you an appreciation of the magnitude of the issues that you face and have given you an idea of what needs to be done to ensure that you are on the road to financial independence. Because ultimately, that's what we're trying to do here.

A detailed look at the investment process can be found here:

Asset Allocation and Portfolio Rebalancing

http://www.philadelphia-reflections.com/blog/1373.htm

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Asset Allocation and Portfolio Rebalancing

http://www.philadelphia-reflections.com/blog/1362.htm

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January is the month for rebalancing

All investors should rebalance their portfolios from time to time. Rebalancing will automatically ensure that you buy-low and sell-high and it will ensure that your portfolio does not drift away from your preferred asset allocation. If you are subject to capital gains taxes, however, you should not rebalance more often than once a year (unless something goes wildly askew as commodities did in mid 2008).

Investors who live off the cash generated by their portfolio, in whole or in part, should keep up to 5 years' needs in cash; at a maximum withdrawal rate of 4% per year, this means that up to 20% of an investor's total portfolio will be set aside to provide cash. This cash portion of the portfolio will grow and shrink with the market: when the market is good and the 80%+ of the portfolio is growing, capital gains should be taken to increase the cash pool; when the market is falling, the cash pool will shrink as cash is withdrawn so that sales are not required to provide cash.

In up years and down, the non-cash portion of the portfolio should be rebalanced.

2008 was particularly painful and investors may not even want to look at their portfolios, to say nothing of rebalancing them. But that understandable instinct is wrong ... in the long run, an investor who sticks to a mechanical rebalancing program in the face of all the buffeting of the market will get by far the best performance.

If we take the model portfolio suggested by "Asset Allocation and Portfolio Rebalancing" with a fairly standard asset allocation, the chart below shows how investors should rebalance the $738 that remains of the $1,000 portfolio they hypothetically began the year with.

			2008 Performance				After Rebalancing
		Allocation	Start	Performance	End		NewAmount	Change	% change
Intermed Govt Bonds	IEI	15%	150	13%	169		111	(58)	(34%)
TIPs	TIP	15%	150	(1%)	149		111	(38)	(26%)
Commodities	DJP	10%	100	(37%)	63		74	11	18%
REITs	VNQ	10%	100	(37%)	63		74	11	17%
Emerging Mkts	VWO	10%	100	(52%)	48		74	26	55%
Asia Developed	VPL	10%	100	(35%)	65		74	9	14%
Europe Developed	VGK	10%	100	(45%)	55		74	19	33%
US Total Mkt	VTI	20%	200	(37%)	127		148	21	17%
		100%	1,000	(26%)	738		738

This says

• Sell 34% of IEI
• Sell 26% of TIP
• Buy 18% more DJP
• etc.

It should be noted that a portfolio decline of 26% is much better than the declines of the broad equity indexes and of course these figures do not take the cash portion of the portfolio into consideration which dampened the decline further (and dampens the increases in good years, too; but people inevitably suffer more on the downside.)

• (31%) for the FTSE 100
• (34%) for the DJIA
• (39%) for the S&P 500
• (43%) for the FTSE Asia Pacific
• (54%) for the MSCI Emerging Markets Index

In an "ordinary" year, many investors would scream that a 30% allocation of the non-cash portion of the portfolio to Treasuries was far too high; this year, of course, everyone wishes they had been 100% allocated to them (we have not recommended any US Corporate bonds or foreign bonds of any sort). The fact that knowing these things ahead of time is impossible is the reason we argue for very broad diversification combined with portfolio rebalancing.

Without rebalancing, this model portfolio would enter 2009 with 44% allocated to Treasuries and that is probably too much for this hypothetical investor (presuming that the allocation shown was the result of careful thought about their risk tolerance ... this year being the one in which that tolerance was really tested.) The fact that Treasuries were good to us this year almost certainly means that they will not do as well next year.

http://www.philadelphia-reflections.com/blog/1555.htm

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The Cause of the Subprime Crisis

http://www.philadelphia-reflections.com/blog/1437.htm

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Retirement Planning Video

http://www.philadelphia-reflections.com/blog/1443.htm

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Insurance

Insurance is a good-news/bad-news story. On the one hand, "pure" insurance is very important and a very useful part of a person's financial plan. On the other hand, the insurance industry in the United States is a bit of a throwback to the days when financial services and utilities were heavily regulated.

The situation in the insurance industry today is somewhat like AT&T before telecommunications deregulation: AT&T was a regulated monopoly which prohibited competition, limited innovation and set uncompetitive prices. Had AT&T not been deregulated and broken up, it is very unlikely that we would have cell phones or the Internet.

The insurance industry for individuals and small businesses in the United States is actually 50 mini industries (plus a few more for territories like Puerto Rico). The National Association of Insurance Commissioners provides standardization, but the type of coverage you can buy and its cost is determined state by state. In each state the legislators, the regulators and the insurance companies decide among themselves what to allow and what to charge.

• If you register a car in a particular state, for example, you can buy insurance for it only in that state; and from state to state the differences in auto policies are significant, for the same driver and the same car, for no better reason than that there is different regulation.
   
• Health insurance is probably the most egregious example ... in many states it is essentially impossible for an individual to buy health insurance because the state legislators and regulators have put up so many obstacles; the availability of Health Savings Accounts varies widely for the same reasons.
   
• Some states impose as much as a 5% tax on insurance premiums, others none. And so on.

Nonetheless, insurance is very important and it is usually possible to buy insurance that suits the needs of your situation at an affordable price. It's just made difficult by the fact that insurance planning differs so much from state to state and by the fact that information about fees and the operation of the policies is very difficult to get or to understand once you do get it.

What I mean by "Insurance, per se" is insurance that insures you against a risk and does not attempt to serve another purpose as well, such as investment or tax avoidance.

A typical person's insurance opportunities fall into five categories: "pure" insurance, health insurance, social security and the investment & estate planning aspects of life insurance. Annuities are also part of the insurance industry.

The fundamental idea behind insurance is that if a group of people who face a similar risk get together and pay a small amount into a pool, those few of them who face a loss can be covered from the pool.

If you don't have a loss, you get nothing for your premium but you are willing to pay it because you know that you can collect if you ever do have a loss which might otherwise bankrupt you.

Over the past century or so in the United States, the Insurance Industry has worked with Congress and the Courts to create tax advantages for itself which have been used to create so-called "variable products" that are sold as investments similar to IRAs and other tax-advantaged savings accounts.

I talk about these products in another presentation. Here, I want to discuss just insurance that helps people to protect themselves from risks. We might call this "old fashioned" insurance. But whether old fashioned or not, this sort of pure insurance is a very important part of everyone's financial planning.

Pure insurance for individuals consists of the following:

1. Term life insurance
2. Homeowners insurance
3. Auto insurance
4. Liability ("umbrella") insurance
5. Disability income insurance

In each case, you hope the loss (early death, fire, car crash, lawsuit, disabling accident) doesn't happen but because the cost of the loss is so high you are willing to pay something every year to cover yourself in case it does happen.

Sometimes a minimum level of insurance is required by a lender for a mortgage or the like, but that is for the lender's benefit, not yours, so I don't include it here.

In general, the best advice is

1. Get a policy with a high deductible and an inflation rider, to keep the premium low and to ensure that the coverage keeps up with inflation
    
2. Behave in ways that reduce your risk, like seatbelts and keeping paint cans out of the house; and don't make claims for every little thing
    
3. Review the policy every few years.

Most people are inadequately covered:  either too much or too little.

This is an area that is easy to forget once you've made the initial step because most people don't face losses very often, but it is wise to review the details carefully to ensure that you are adequately covered at the lowest cost.

The losses covered by pure insurance can be catastrophic and it is important to be sure that you are protected.

Group insurance, provided by an employer, is well worth considering because the qualification process is often easier than for individual insurance and the premiums may be lower. Group Life is frequently offered and many employers offer group health and disability insurance.

On the other hand, group insurance coverage may not be sufficient, which may drive you to consider supplementing it with individual insurance; plus you need to consider the value of independence: being tied to an employer because of insurance coverage or being unable to qualify later in life when you leave an employer are serious considerations.

Sometimes group insurance has a conversion option allowing you to retain the insurance after you leave an employer. This is often not the most cost-effective way to get continuing life insurance, but individual health insurance may not be available any other way and you should look into the requirements for continuing your group health insurance even if you are not expecting to leave because having health insurance is so important.

Group life insurance has two features you should be aware of: first, any premiums paid by the employer for death benefits above $50,000 are treated as income to the employee; second, death benefits paid to the employee's beneficiary become part of the employee's Gross Estate. Furthermore, if the employer's plan is not portable and you want coverage after you leave for any reason, you are likely to pay higher premiums because you are older and you may have to take a medical exam to qualify.

It is well worth taking the trouble to understand the rules of your employer's group policies and to investigate the options available to you as an individual. Call a local insurance agent and ask for advice.

The best way to approach pure insurance is to sit down and list all the areas in your life that are at risk, to methodically work through all of your needs and then to investigate your options with the help of a reputable insurance agent, of whom - in these areas - there are quite a few.

This may seem a boring nuisance, but it is always well worth the time and most financial planners will start here when helping their clients because the effect of a loss which could well be catastrophic is often so easily protected against with a little planning.

Increasingly, the Internet is facilitating the creation of discount pure insurance companies in competition to the insurance companies who have commissioned agents.

While the cost of agent-sold insurance is higher because of the commissions, you need to consider the fact that major losses have a significant emotional component and doing business over a number of years with a person in your neighborhood whom you know and who will offer to help is more than just a sales pitch. For pure insurance, choosing a good agent can be as important as choosing a good policy.

Term Life Insurance is insurance that provides a lump sum amount to your beneficiary if you die. The word "Term" in term life insurance means that the insurance policy terminates. The policy only covers you for a year or a few years.

This is the way all so-called "pure" insurance works: your auto insurance usually has a term of a year; there is permanent homeowners insurance in Pennsylvania where it was invested by Ben Franklin, but it is quite rare elsewhere.

If you still want life insurance coverage after the policy terminates or expires, you have to buy a new policy, and almost always at a higher price because as you age your chance of dying increases.

The purpose of life insurance is to protect your dependents from financial catastrophe in case you die.

In general, for people without special needs, the need for "pure" life insurance is a short-term need during the period in which they have dependent children.

Low-cost term life insurance that is not renewed once the children are gone is usually the best option. The purpose is to provide an amount of money in the event of your death so that your family can maintain their lifestyle and attain financial goals such as financing a college education. If you are diligent about saving, you will build up an investment portfolio over time. The need for life insurance is likely to decline as your portfolio grows to a size that can support your family; as you approach this point, you will be better off investing the insurance premiums rather than buying insurance with them.

Term insurance, like all pure insurance, only lasts for the policy term and then lapses if it is not renewed. The cost of term insurance goes up every time you renew even if you keep in good health because the number of deaths goes up as the people in the pool get older and their mortality rate goes up.

There is a such a thing as "permanent" life insurance that does not require renewal, but really the only meaningful difference between permanent and renewable-term life insurance is the fact that permanent life insurance policies provide for a level premium that is too high initially for the insurance cost and the difference is put into a fund (called the "cash value account") that is used to offset the higher premiums in later years.

There are two variants of permanent life insurance, whole life and universal life. The twist offered by universal life is a higher interest rate on the cash value which may allow for lower premiums later on, plus an option to have the death benefit increased by any excess cash value in the account at death (which is called "Option B").

The level premiums and the cash value of permanent life insurance may seem an attractive alternative to term life insurance, but you can do better financially if you have the discipline to buy a renewable term life insurance policy plus an index or even a money market fund with the premium difference in the early years.

And, anyway, most people shouldn't get permanent life insurance at all. The need isn't permanent.

The point to remember, the point to stress, is that most people have no reason to own life insurance after their children have become independent. Life insurance is not something that most people should own for life. The need for it goes away at around the time the premium starts to really ramp up.

Of all the pure insurance types, term life insurance is often the least well understood. Not because term life insurance per se is particularly difficult to understand, but because it's "Life Insurance".

For centuries there was only term life insurance. That's all there was. Then in the mid 1970s, largely because of favorable tax treatment, the product began an explosive transformation that continues to this day ... creating a myriad of heavily marketed investment products in which the insurance component is largely incidental.

Let me say that again: life insurance that is sold as an investment actually tries to minimize the insurance part, the insurance is incidental. The advantage of these products is their tax advantage, which is a legislative issue, created by insurance industry lobbyists and has nothing to do with insurance.

But the pure insurance of term life remains a valuable tool for personal financial planning, and the price of term life insurance has been driven down dramatically through the pressure of information & competition brought on by the Internet, primarily, and to a lesser extent because of increased longevity.

This graph shows how term life insurance rates have fallen as a result of the Internet and also as a result of the fact that people are living longer (3 years longer for every decade since the Second World War in America). The amounts represent the cost per $1,000 of coverage at different ages.

The data is drawn from the IRS which uses it to impute income to people who receive life insurance from their employers.

The top dashed blue line was valid from 1955 to 2001. Essentially, life insurance rates didn't change for 46 years.

By 2001, however, rates had been driven down dramatically, as you can see by the lower red line, in some cases by over 75%.

This chart simply carries the data out from age 51 to 100. What is most telling about this chart is that in 1955 rates were not quoted beyond age 81, whereas by 2001 the chart was carried out to 100.

These charts should not be used to estimate your own actual policy cost; you can go online to a hundred sites to do that and life insurance agents will be happy to talk to you if you are young and healthy. Or old and rich.

But the charts are representative and they do illustrate (a) the fact that the cost of life insurance rises as you get older, (b) prices have fallen dramatically and (c) they show the populations' increasing longevity.

From the standpoint of the opportunity cost of the insurance policy premiums, the best deal for term life insurance is a single-premium policy with a term equal to the period of need (in other words, one 20-year term policy if you expect to need life insurance for 20 years, rather than two 10-year term policies). Single-premium term policies are unusual and the next-lowest opportunity-cost option is a level-premium policy.

What this means first of all, is buy a policy that covers the entire period that you will need it.

And, second, pay the premium all up front if you can find such a policy; if not, then the next best is a policy for which the premium charged is the same every year for the entire term. This second choice is called level premium.

It should be mentioned that life insurance can play a very large role in estate planning. There are two aspects worth mentioning here:

1. If you own a policy on your own life, the full amount of the death benefit will be included in your estate. Either your spouse or a trust can own the policy to ensure that it doesn't bulk up the value of your estate (on which taxes will, eventually, be due above a certain - ever-changing - exclusion amount).
    
2. The second thing to know is that, because of its special tax treatment, life insurance can sometimes be used to provide the money to pay estate taxes.

Both of these statements gloss over a great deal of complexity ... estate planning requires specialized advice. But you should at least know that the issues exist.

Pure Insurance, which is insurance that protects against catastrophic loss, includes Term Life Insurance and

• Property and Liability insurance
   
• Automobile insurance
   
• Disability Income insurance

Health and Long Term Care insurance are covered separately because they are so different from the other forms of pure insurance. Health Insurance in America is available almost exclusively from large employers, which causes a number of problems; and Long Term Care insurance is quite new.

Variable Life Insurance and Annuities, while sold by Insurance companies, are not really insurance at all and are therefore also covered separately.

The primary consideration with homeowners insurance is to make sure the property is covered at full replacement cost, with a deductible high enough to defray the premium cost, and that the coverage amount increases at least at the rate of inflation.

The alternative to full replacement cost is actual cash value, which is the depreciated value of the house. Do not insure your house for Actual Cash Value; anything less than full replacement cost is tantamount to no insurance at all if you ever have a major loss.

Older homes constructed with materials and techniques no longer in common use are best covered at "functional" replacement cost, which would use asphalt for slate on the roof, plastic rather than copper pipes, and so forth. Unless you live in a historic monument that must be restored exactly and you can afford the premium cost of doing so, functional replacement cost is perfectly adequate.

Expensive personal property is not adequately covered by a standard homeowners policy, and as you get older you accumulate more and more valuable property. If not "scheduled" and explicitly covered for their correct value you will lose nearly the whole amount of any possessions lost or damaged. It's worth a quick glance at the standard schedule for personal property to convince yourself that the standard coverage is almost nil.

Finally, most homeowners policies provide a small amount of liability coverage. It is a good idea to increase it to the maximum as sort of a "deductible" for your umbrella policy because it is not at all expensive and it's hard to have too much liability coverage in our litigious society. In fact, many umbrella policies require higher homeowners liability coverage.

Some people treat their homeowners insurance policies like an ATM to cover relatively minor expenses. In the long run, you're better off paying for smallish items out of pocket to keep the premium at a level that won't motivate you to insure for less than 100% replacement cost with an inflation rider.

It's always important to bear in mind that insurance is intended to cover the infrequent major loss and nothing else.

Auto insurance rules vary greatly from state to state, as does the cost.

The generalization that applies everywhere, however, is that the fundamental purpose of automobile insurance is to protect you from liability, not to cover the cost of repairs.

Many states require you to carry some minimal level of uninsured motorist coverage in case you are involved in an accident with someone without insurance; very often underinsured motorist coverage is not required, but it is a very good idea to get a rider for this purpose.

Some states are "no fault" which means that if you are involved in an accident, you are reimbursed by your own insurance company directly. Then, behind the scenes, the two insurance companies settle up between themselves and the driver judged to be at fault will be penalized by higher premiums.

A common but very unattractive alternative in other states is the tort system that requires you to hire a lawyer and sue the other driver yourself to recover damages.

You are well advised to have much more than the minimum level of liability coverage in any jurisdiction. Liability insurance is your only protection against an aggressively litigious system. All too many people, lawyers and plaintiffs, live off of liability suits; protect yourself from this with liability insurance.

Most people know to refuse coverage by rental car companies because their own auto insurance will cover them and this is usually good advice but a few items are worth keeping in mind:

1.  Your collision coverage may not cover the extent of the damage and the rental car company retains exclusive control over the repairs

2.  You policy will pay the depreciated value of the car if it is totaled, but many rental car contracts specify that you must replace their car with a new one.

3.  During the period until the rental car is back on the road, the rental car company will charge you (via the credit card you gave them) an amount that they feel reimburses them for lost revenue. You can be sure your policy does not cover this and you can also be sure that you have a lower estimate of their lost revenue than they do.

Your homeowners and auto policies will provide a minimal amount of liability insurance, but not nearly enough. You should carry the maximum liability coverage offered in those other policies, and also get an umbrella personal liability policy for many millions of dollars.

A common rule of thumb is to get an umbrella policy for an amount equal to your net worth. There's no particular rationale for this and ordinary umbrella policies max out well below a high net worth individual's requirement by this rule; my rule of thumb is to get as much as the insurance company will give you. If you feel you are likely to be a target for any reason, you should consider special liability coverage.

Liability awards are made by a court system that is capricious and wholly unpredictable.

An umbrella policy will cost, roughly, one hundred dollars per million per year and it is money well spent, not only for the coverage in the event that you are sued for any reason (other than intentional harm) but also because it covers all legal expenses which often rival the awards themselves.

Umbrella policies often also provide auto coverage outside of America, which is usually excluded from regular auto policies; rules governing foreigners involved in accidents abroad are often very harsh, so this is a handy thing to have. (Better yet, hire a local chauffeur).

Disability insurance is often offered by employers as an employee benefit but it is worth looking into the coverage on your own if the coverage is not sufficient. Also, employer disability insurance is sometimes paid for with pre-tax dollars, in which case the benefits are taxable; if paid with after-tax dollars, the benefits can be tax free.

Fewer people buy disability income insurance than life insurance, sometimes expecting to rely upon worker's comp, social security or a successful lawsuit. Disability income insurance is also not as aggressively marketed as life insurance, to which a disability rider may sometimes be added, but disability is more likely than premature death and because of ongoing medical and rehabilitation expenses, disability can be a much greater financial burden.

The deductible of a disability policy is called the "elimination period", which is the period of time that must elapse after you have been medically certified as disabled before benefit payments begin. The length of the elimination period, the length of the coverage period (whether for a set number of years or until retirement age) and the percent of income that is replaced are all options to be investigated.

Investment & Estate Planning With Life Insurance

The attraction of life insurance as either an investment or an estate-planning tool arises from favorable tax treatment:

1.  Life insurance death benefits are income-tax exempt

2.  If the insured is not the policy owner, the death benefits are estate-tax exempt

3.  Cash value (investment) accumulation is income-tax deferred

4.  Tax-free return-of-premium withdrawals from cash value are allowed after 10 years

5.  Essentially-permanent tax-free loans of accumulated cash value are allowed under certain circumstances

 Variable Universal Life Insurance

A Variable Universal Life (VUL) insurance policy is basically a term life insurance policy with an IRA attached. That's a bit glib but it conveys the concept. The reason Variable Universal Life insurance policies are sold is because they are tax shelters. If they weren't tax shelters, there would be no reason whatever to buy them.

For a VUL policy to be a pure tax shelter, the entire premium would go into the tax-deferred investments. The IRS frowns on this, however, and has established very complicated rules to the following effect:

1.  The cash value (investment) cannot exceed a certain % of the death benefit

2.  The premium also cannot exceed a certain % of the death benefit

 Furthermore, since the ratio of cash value to death benefit is a function of market performance, you may find yourself facing a huge assessment in order to avoid negative tax consequences or a lapsed policy simply because of a decline in the stock market.

A VUL that fails the IRS's tests becomes a "Modified Endowment Policy" (MEC) which will always reduce its attractiveness below the threshold used to justify the policy in the first place. Ordinary income taxes will be due on all gains, all at once.

In other words, a VUL policy must be more life insurance than tax shelter and the cost of the life insurance coverage is effectively an additional fee since it is the tax shelter that is of interest, not the insurance (if all you want is life insurance, buy a term policy: " it's much cheaper). Somebody has to keep track of these things, so one of the first questions to answer when looking into purchasing a VUL is who that person will be, how much this special service will cost and how vigilantly it is performed.

Life insurance is a contract, not a security. This means that once you enter into it, you're stuck with it. Aside from the nether world of viatical agreements (in which terminally ill people can sell their death benefits) and 1035 tax-free exchanges (complicated and expensive) once you start paying into a life insurance policy you have to play by their rules to ever get any value out of your investment. VUL is viewed as an investment but you need to keep in mind that the money isn't "yours" except under narrowly prescribed rules.

The safety of your investment depends entirely upon the strength of the insurance company, many of which have gone out of business over the years " at a rate of roughly 50 "- 100 per year. Some states maintain guaranty funds, but you shouldn't count on their protection. A. M. Best rates the credit worthiness of insurance companies and should be consulted. "There are no guarantees, only guarantors" is a clever way of saying that a guarantee is no good if the person making the guarantee goes broke.

Finally, these policies always have very high fees, which are not always fully disclosed, and the investment choices offered for the cash value account (mutual funds called "separate accounts") are controlled by the insurance company and always perform poorly compared to equivalent high-quality index funds.

For some people under some circumstances, the special tax treatment may more than offset these deficiencies and make a VUL policy a viable portfolio choice.  Like municipal bonds, they become more attractive when income tax rates are high. But if ever there was a need for "caveat emptor" it is here. Ditto annuities, discussed below, that are essentially life insurance policies turned inside out, paying until you die rather than when you die.

The basic pitch for why a Variable Universal Life insurance policy is a good lifetime investment is the following:

1.  A young single person in their first job needs no life insurance but they should certainly start investing as soon as they can. To start this process they can take out a small amount of insurance coverage in a VUL policy and pay as much more than the minimum premium as they can, investing the excess in the tax-deferred equity funds of the "separate account".

2.  After marriage, they can add a rider for the new spouse or otherwise convert to joint (1^st to die) coverage. Continue funding the equity investment accounts to the maximum extent feasible.

3.  After the first child, increase the amount of insurance coverage and convert the equity investment account to a money market. If the funding and tax-deferred growth in prior years was sufficient, the tax-free investment returns will fund the minimum premium required to keep the insurance policy in force, thereby reducing the family's expenses while providing insurance coverage when it is most needed.

Had the family not funded a VUL in the years prior to this, they would have to pay for term life insurance to protect themselves in their most vulnerable years.

4.  After the last child is out of the home, reduce the amount of insurance coverage, convert the investments back into equities and resume funding the investment accounts.

5.  At retirement, take a series of tax-free policy loans to supplement retirement income, being careful that the policy neither lapses nor converts to a MEC (which requires constant vigilance on the part of the insurance company since an individual can't possibly know when they're at risk). The conversion to income can also be accomplished by converting to an annuity but that would eliminate the last step, plus annuity payments are taxable.

6.  If converted to 2^nd to die and transferred to an irrevocable life insurance trust (at least 3 years before the 1^st to die), the policy can pass to the family's heirs free of gift, estate and income taxes either providing a legacy directly or else providing the money to pay the taxes on the rest of the estate (bearing in mind that the cost of insurance becomes very high as you move into your 70s and beyond: see the charts in the section on term life insurance).

This is a fairly attractive story, one that has appealed to many people. The first VUL was introduced in 1985, however, so it's too soon to have actual experience with the full lifecycle in practice.

A fundamental issue to bear in mind about life insurance is that its cost goes up very steeply as you age: a $1,000,000 5-year term policy would cost a 25 year old in the neighborhood of $400 per year but might cost a 70 year old $15,000 per year " 38 times more " and an 80 year old could expect to pay upwards of $60,000 per year. This rapid escalation of cost must be borne, from whatever the source, if the policy is not to lapse and become worthless.

The whole story hinges on the net after-tax value produced by the investment account. The key word is "net" because:

1.  Your premium payment is reduced by state premium taxes and any front end loads the insurance company charges

2.  The cost of the insurance, which rises with age, reduces the amount of the remaining premium payment that can actually be invested. The cost per $1,000 of the life insurance in a VUL is higher than in a term life insurance policy because fewer such policies lapse.

3.  Many policies also have back end loads, known as surrender charges

4.  A VUL policy itself has administrative and other expenses

5.  The expense ratios of the separate accounts are higher than other mutual funds

6.  The tax advantage is a function of both

a.   The individual's marginal tax rate, which tends to vary considerably throughout life as the amount of taxable income changes

b.  The general level of taxes in the economy, which at the time of this writing is quite favorable making tax-advantaged investments in general less attractive

The math to determine whether the net benefit is positive is complex and must be done separately on every policy considered since every policy is different, which tends to discourage comparison shopping. Since so many variables are at play over the entire period of a family's lifetime, even the most sophisticated analysis is at best an estimate. Ben Baldwin's excellent book, The New Life Insurance Investment Advisor, devotes a separate chapter to the problem of figuring out if a VUL is a good investment, and it ends inconclusively. The fact that computer programs perform these analyses quickly does not improve their accuracy.

Very often, a buyer's motivation is the insurance policy's characteristic of "forced saving". Many people know they should save but they also know about themselves that the desire to consume for today always wins out over the need to save for tomorrow. This rationale actually shows a level of maturity but if at all possible, alternative tax-advantaged opportunities should be taken fully before considering a VUL:

a.   401(k) or other employer provided (and matched) savings plans

b.  IRA

c.   HSA

d.  529

Given the current tax environment, a taxable discount brokerage account which supplements the other tax-deferred accounts with low-cost index funds will often provide a much better long-term return than a VUL. However, it does seem likely that the US government debt is going to rise significantly to fund Social Security, Medicare and the general increase in the role of government in American society. Therefore, the likelihood of increased taxes in the future seems high, which will make all tax sheltered opportunities more attractive than they might be today; it will also make them more expensive, so the best time to consider them is when tax rates are low.

Annuities

While there are many options available, annuities, like life insurance, essentially have a "pure" form and a tax-sheltered investment form.

The pure form of an annuity is a Single-Payment Immediate Annuity, possibly with an inflation rider, which will pay a fixed stream of taxable income for life in return in return for a lump-sum payment. The return on investment of such an annuity is not as good as the long-term return of a diversified investment portfolio, but it is guaranteed for life. It is very comforting to many people to have their basic expenses covered in this way and it is often well worth giving up some theoretical return for peace of mind.

The issue is getting such an annuity at the least cost: no-load annuities from Berkshire Hathaway and USAA are worth looking into if the security of a life pension is something you're interested in.

A hybrid option is an Inter Vivos Charitable Remainder Trust, a sort-of a do-it-yourself annuity which gives whatever money is left at your death to a designated charity (rather than to an insurance company as in the case of an annuity). Broadly speaking, an Inter Vivos Charitable Remainder Trust operates like this:

1.  You give a lump sum gift to the trust, designating a charity to be the recipient of the funds at your death. You get an immediate one-time charitable tax deduction.

2.  You retain the right to invest the funds inside the trust, and the investment activities of the trust are tax exempt.

3.  The trust is required to distribute an amount not less than 5% but not more than 50% of the value of the trust to you (or other beneficiaries) every year. These distributions are taxable.

This description glosses over quite a few details that must be well understood before establishing such a trust, but is should give a feel for why such structures are very attractive to many people.

A Variable Deferred Annuity (VDA) is the tax-deferred investment vehicle.

To invest in a VDA, you pay premiums that go into one or more of the mutual funds offered by the annuity company. There are two phases: accumulation, during which you put money into tax-deferred investments, and liquidation, during which time you receive taxable annuity payments. "Annuitization" is the conversion from accumulation to liquidation.

In fact, a majority of existing VDAs have never annuitized, apparently because people are content to allow the principal to grow tax free. However, VDAs are not efficient vehicles for transferring wealth to non-spousal beneficiaries because they must arrange for a taxable payout of the value within the VDA within one year of the annuitant's death.

As with VUL, the only appeal of a VDA is as a tax shelter. Variable annuities are notorious for their fees, which in most cases more than eliminate whatever benefit the tax deferral provides. Vanguard and Fidelity offer no load VDAs, however, if a VDA seems to be of interest.

There is a huge debate about Social Security funding brought on by the fact that there are more retirees than the system anticipated and they are living much longer than expected.

Social Security is called the Third Rail of American politics because it is so sensitive. Let's ignore the politics and just talk about the facts.

First of all, Social Security has been a huge success. It was intended to supplement the income of retirees, disabled people and their families to keep them out of poverty. It has done this quite well and therefore is a much beloved program.

Second of all, if demographics and taxes remain as they currently are, Social Security will start paying out more than it takes in around the year 2040, technically it will be bankrupt.

Those are facts and I don't believe they are worth arguing about. Furthermore, I think there is an obvious conclusion we can draw from these facts, namely that the system will not fail. The Baby Boom generation simply will not allow their elected officials to do anything but support the system. Period.

Lots of people say that they don't expect to receive any Social Security benefits because the system is in trouble. Well, that's just nonsense. Every person in America who has contributed to the system (via the so-called FICA taxes) will collect Social Security benefits.

They will; they just will.

Obviously, some changes must be made to prevent the system from going bankrupt and the only useful changes are to either increase the money going in or to decrease the money going out. Or both. Both of these choices are taxes and both are already happening.

Since the Greenspan Commission in the early 1980s took a look at this problem, the taxes on wages have been increased and the age of eligibility has been pushed out.

The tax on wages is a direct tax on workers and the increase in the age of eligibility is an indirect tax on retirees. In both cases, people have had to give up some money to the government, and that's called paying taxes.

The Greenspan Commission pushed off the day of reckoning to 2040 and some new commission will push it out even further. This new commission will do it the same way the Greenspan Commission did, by raising taxes.

This is a fact. Everything else is politics.

So, as a current or future Social Security recipient, relax: you will get paid and, in fact, you will get more than the generations who preceded you. You will just have to pay a little more up front and have to wait a little longer at retirement.

The one caveat I would add to this is that the populist pendulum swings back and forth in Washington and the burden of the inescapable tax increases may be skewed toward higher net worth individuals.  But even so, I stand by my prediction that everyone who has paid into the system will receive benefits at retirement.

When most people think of Social Security, they think of retirement benefits. In fact, the Social Security Administration oversees six broad benefit plans.

First is retirement for which people initially become eligible at age 62 with reduced benefits which increase about 8% per year if retirement is delayed up to age 70.

Disability Benefits covers people of any age who have paid into the system who have a severe physical or mental ailment.

Family benefits provide support to certain members of the families of either retirees or disabled persons.

Survivor benefits go to the families of eligible workers who are deceased.

Medicare provides hospital and medical insurance coverage to retirees or to people who have received disability benefits for two years or more. I cover Medicare in another presentation.

Supplemental benefits are available to retired or disabled persons who also qualify for Medicaid and food stamps.

Except for the Supplemental Benefits, the money for Social Security comes out of taxes on wages, the non-deductible, non-refundable taxes that appear on a W2 form, below the Federal income tax withholding line.

The so-called FICA taxes are a total of 15.3% of a person's wages, with 12.4% of the first $97,500 going to Old Age, Survivor and Disability Insurance - OASDI is the acronym - and 2.9% of total wages going to Medicare.

The employer pays half and the employee pays half. This applies to W2 income employees as well as self-employed persons.

So, who's eligible? Currently, you are probably eligible.

Anyone who paid FICA taxes for ten years on $4,000 per year adjusted for inflation is eligible and is "fully insured". Adjusted for inflation means that the amount was smaller in previous years; each year the amount you must earn in each quarter is adjusted upwards for inflation.

This probably means that anyone listening to this presentation is eligible as a "fully-insured" participant. The only broad class of people who might not be eligible are certain government employees with an equivalent pension.

The rules are complicated and guaranteed to change, so here's what you do:

go to ssa.gov or else call 1-800-772-1213

and request a copy of your benefits statement. The Social Security Administration is supposed to mail a copy to every eligible person every year around the time of their birthday but if you've misplaced your most recent copy, just get another one.

If you haven't looked at your statement recently, look at it now and make sure all the information is correct. If it isn't, start raising a fuss until whatever is wrong is fixed.

The next thing to do is to decide when to start receiving retirement benefits. This depends entirely on how long you expect to live.

If your family has a short life expectancy and/or you are not in such great shape yourself, take it early. You can start receiving a reduced benefit at age 62. You will receive less per year than if you wait, but you may receive more in total if you are not in good health.

The age at which you can receive full retirement benefits is called the "full retirement" age. The Greenspan Commission recommended making this age later than 65 for younger people and this table shows the ages of eligibility; it's actually broken down by moth, so as you get close you will want to look up your specific case on your statement.

Broadly speaking, if you live more than 12 years beyond full retirement age, you will receive more money by waiting until then.

In fact, your benefit will increase 8% per year more than that if you wait until age 70; less, if you were born before 1943, the idea being to provide people with an incentive to delay.

How much will you get? Well, here again, the calculation is so complex that the only way to really get a handle on this question is to look at your Social Security statement.

However, for talking purposes, for people reaching their full retirement age in 2007, in other words for those people born in 1941 choosing to wait until they are 65 years, 10 months old to receive retirement benefits, the national average is a bit under $17 thousand dollars per year and the maximum is just under $26 thousand dollars.

The amount is indexed for inflation every year to keep up with the rising cost of living.

You won't get rich on this amount of money and as the politicians struggle with fixing the system the numbers may change; nonetheless, this is a very comfortable amount of money you can add to your retirement income calculation.

When you think that during the Depression, elderly people were literally starving to death, this is a very generous safety net that America provides to its elderly citizens.

This is why the system is so much beloved and that is why politicians suggest changes to it at their peril.

All of which adds up to why I don't think it's going away. This is a democracy, and when tens of millions of the Baby Boom generation, who protested the Vietnam War and changed so much of our society are looking forward to receiving Social Security benefits,  well, what they want, they will get because that's how the system works.

Finally, there's the question of whether you can work and receive Social Security retirement benefits.

If you decide to receive benefits prior to full retirement age and you earn outside income, your benefits may be reduced. The earnings limitation for people who choose to retire early was $12,960 in 2007. Earn more than that and your retirement benefits will be reduced $1 for every $2 earned above that amount.

Following full retirement age your benefits are not reduced by any other income you receive.

However, if your Modified AGI, the bottom line on the front of your 1040 tax form with a few additions, plus 50% of your retirement benefits exceeds certain levels, then between 50% and 85% of your benefits will be subject to tax.

Medicare is a Federal insurance program that covers health care costs for people aged 65 and up. Some people with disabilities, others with renal disease are eligible earlier than 65 and for low income beneficiaries dependents can sometimes be covered, but for the most part, this is health care coverage for Seniors; for people 65 and older.

Medicare is partly funded through a 2.9% tax that is levied on wages as part of FICA along with the rest of Social Security. But Medicare also has deductibles, co-pays and premiums for some of its coverage, so Medicare is not free coverage.

In general, eligibility rules are the same as for Social Security in that you must be fully insured, meaning - essentially - that you must have paid into the system for at least 10 years during your working life. Most people qualify and so are eligible.

Medicare is part of the Social Security program. The Social Security Administration sends out a pamphlet to every person covered by the system every year at around the time of their birthday which contains information about your eligibility and benefits.

If you don't have a current copy, go to

SSA DOT GOV

And request a new one.

Medicare has two useful websites of its own run by the Center for Medicare and Medicaid Services which is part of the US Department of Health and Human Services, and often goes by the initials, CMS.

MEDICARE DOT GOV

Contains a lot of very useful information about the program in general, and

MyMedicare DOT GOV will allow you to look up specifics of your own participation.

By and large, eligibility for Medicare begins at age 65, whether you are still working or retired.

It is a good idea to have your plan for what type of Medicare and other insurance you will want complete well before your 65^th birthday because it is complicated and you really have only six months after your 65^th birthday to apply without penalty.

So plan ahead.

Medicare's deductibles and co-pays are based on a concept of Benefit Period, rather than on a calendar year as is common with individual health insurance policies.

A Benefit Period begins when you enter a hospital or nursing home and ends after you have been discharged for 60 consecutive days. There is no limit to the number of Benefit Periods and each one is distinct.

The chart shows the charges as of 2007 for coverage under Part A, which we'll get into more later. If you enter a hospital, there is a $992 dollar deductible but none for a nursing home.

After 20 days in a nursing home, you have a co-pay of $124 dollars per day up to day 100 when the benefit runs out. Medicare does not cover long-term care. It is often a very good idea to have your own individual Long Term Care policy because if you need to remain in a nursing facility for more than 100 days, Medicare pays nothing. Medicare was not intended to provide long term care and all-too often people run through all their assets paying for long-term nursing care and then must rely on Medicaid, the health insurance program intended for very low-income people.

In a hospital, a $248 dollar-per-day co-pay kicks in at day 61 and lasts until day 90.

For hospital care, there is a lifetime allotment of 60 "reserve days" that can be drawn upon only once with a co-pay of $496 dollars per day.

Thereafter, you must rely on other forms of insurance, although 150 days, which is roughly 5 months, is a very long time to spend in a hospital and the chances are good if you are in the hospital that long, you will have to be discharged into a nursing facility.

You have two choices when considering Medicare: the original program which consists of Parts A, B and D; and the Medicare Advantage program, called Part C, which acts rather like an HMO or PPO.

Part C, Medicare Advantage is somewhat more restrictive than the Original Medicare in choosing which doctors to vast and so forth, but it is often less expensive and may have more options.

In the original Medicare, part A is the basic coverage provided as part of Medicare; the other parts are optional, extra cost choices.

Part A covers inpatient hospital, skilled nursing care services, home health care and hospices.

For a fully-insured person, there is no premium for Part A, although there are deductibles and co-pays.

Part A limits hospital stays to 90 days per spell of illness with a lifetime reserve of an extra 60 days. Nursing home coverage is limited to 100 days per spell of illness.

Spells of illness or benefit periods must be separated by 60 consecutive days not in a facility. The deductibles and co-pays are indexed for inflation and were shown in the previous section for 2007.

Part B covers physicians, outpatient services, equipment and rehabilitation.

Part B is optional and in 2007 requires a payment of $93.50 per month premiums which are deducted directly from Social Security retirement benefits, if any. The premium is higher for people with incomes over $80,000 on a sliding scale up to $161.40 per month, in 2007.

There is also a $131 deductible and a 20% co-pay. If you don't signup for Part B within six months of becoming eligible for Medicare at age 65, the cost goes up 10% if you subsequently decide to join Part B.

Part D is Prescription Drug coverage. To be eligible for Part D, you must have signed up for Part B, also. However, enrollment is restricted to November 15 to December 31, so careful planning is required.

Part D has a $32 dollar per month premium, a $265 dollar deductible and a 25% co-pay up to $2400 dollars.

You are responsible for 100% of the costs between $2401 dollars and $5451.25, after which there is a co-pay of 5%. The part for which you are responsible for 100% is often called the donut hole.

Finally, Medigap Insurance is offered by private insurance companies to pay for donut holes and other areas that are not covered by Medicare and sometimes also to pay for the deductibles and co-pays.

It is usually a good idea for most people to get some form of Medigap insurance but careful research is required because there are many choices as well as unscrupulous operators.

Medigap policies are standardized to the extent of coverage but not as to cost, so first you must decide which of the standardized coverages you want and then you must shop around for the best cost.

Medigap policies usually require you to be enrolled in Part B and Medigap does not cover prescription drugs, so you need to consider whether you will also enroll in Part D.

A legitimate Medigap policy must state that it is a Medicare Supplement Policy. Except for the three states of Massachusetts, Minnesota and Wisconsin, all Medigap policies must offer 12 standardized coverage options called Plans A thru L. They do not need to offer all of them, however.

The MEDICARE DOT GOV website has a booklet on choosing a Medigap policy and it is well worth your time to read it, perhaps more than once.

The best time to buy a Medigap policy is in the Open Enrollment period which is during the six months after your 65^th birthday and after you have enrolled in Part B. You really don't have much time, so you are well advised to know exactly what you want to do before your birthday so that you can be as efficient as possible.

During this open enrollment period you are guaranteed Medigap coverage and you are guaranteed to get the standard rates. If you wait beyond this period you may be denied coverage or charged considerably more than the standard rates for pre-existing conditions.

Finally, Part C is like an HMO or a PPO and is the alternative you have to the original Medicare plan of Parts A and B.

Medigap insurance is not an option under Part C, so you must assure yourself that you are comfortable with all that is provided by the program itself.

In summary, I would advise you to begin researching your numerous options long before your 65^th birthday;

First of all because they are complicated

and second of all because you really only have the six months following your 65^th birthday to enroll in all of the health care plans that will cover you for the rest of your life.

MEDICARE DOT GOV has publications that provide a good place to start and the Social Security Administration has lots of people to help if you avail yourself of the opportunities.

Will Medicare change between now and when many people reach 65? Yes, very likely, but the better informed you are, the better you can adapt to any changes that come along.

Is Medicare running out of money? Yes, technically it is; and at a rate that makes the Social Security problem look quite small in comparison.

But that does not mean you won't be covered; you will be. There will inevitably be changes to the system but it simply will not fail.

Once you reach 65, or perhaps a little older for younger folks, your health coverage will largely be in the hands of the US Department of Health and Human Services, and it well behooves you to prepare yourself in advance for this.

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http://www.philadelphia-reflections.com/blog/1396.htm

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World Finance, Columbus Day 2008

Prime Minister Gordon Brown

With voters watching three weeks before the 2008 American presidential election day, finance ministers and their political masters met to decide a basic question: dare they risk disaster to save the existing system, or play it safe by sacrificing small banks to rescue big ones? That is, guess if the situation is so bad only strong rowers can be allowed in the lifeboat, or whether things are really manageable enough to try to save everybody but at the risk of worse consequences for failure. For example the credit default swap mystery; there are $60 trillion notional value insurance policies in existence to cover $20 trillion of bonds. Is that massive double-counting, or an actual disaster so severe it makes every other consideration trivial? Answer quick, please, the ship looks like it might sink. At first it seemed strange a Labor government in England would propose saving only the strong, until you realize that Prime Minister Brown is protected from his Left, while the Democrats in America want to use a fairness argument to win their election. A Republican lame-duck president must do the deciding, a man who has been shown to be both a tough politician and a fearless gambler; playing things safe is not his style. The Dow Jones average soared a thousand points in a day's trading on the prayer that things were finally under control. But take a look around.

Little Iceland and Switzerland are proud to house some enormous banks. But if those banks approach failure, their homeland treasuries are far too small to bail them out.

On the other hand, little Hungary has a negligible banking system, so Hungarians commonly borrow money from foreign banks. The national currency devalued by half in this crisis, so most Hungarian mortgages doubled in price. Reserve systems based on national governments suddenly look obsolete.

Try another approach. Little Ireland went ahead and guaranteed all deposits in its financial institutions. Money from England and the rest of Europe immediately poured in to enjoy that guarantee, forcing other grumpy nations to match the unwise Irish offer. There's a sense that nations are losing control of their affairs.

Europe consists of 27 nations, of which fifteen are in the Euro zone. There's a common currency and a constrained central bank, but can this gaggle of geese possibly agree on concerted action in this crisis? America was once in this situation under the Articles of Confederation, but even after almost losing the Revolutionary War, George Washington was nearly unable to get the colonies to form a union. Even after this experience, the Southern Confederate States later adopted the same system of a central currency without a central government and really did lose their war.

Are we to infer from Prime Minister Brown's attitude toward banks that he might soon suggest ditching little nations in order to save bigger ones?

www.Philadelphia-Reflections.com/blog/1525.htm

http://www.philadelphia-reflections.com/blog/1525.htm

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Financial Institutions of the Future

Things which normally dominate newspaper front pages, like presidential elections and World Series baseball, are now found back among the brassiere ads displaced by the stock market, credit market, banking and investment crisis of 2008. However, like the wake of a ship at sea, the past could be pointing to the future. Contemplate all the mighty financial institutions which have simply vanished.

It may even be trivial to say that Lehman Brothers and Bear, Stearns have disappeared. The fact is every investment banks has disappeared.

And that's not all by a long shot. Savings and Loans have disappeared. Small commercial banks, and even most of the pretty big ones have disappeared. We may soon be left with half a dozen major banks, and no lesser ones. Commission-based stock brokerage is now a rarity. Insurance? Well, the longevity increase of thirty years over the past century gave life insurance an enormous unearned windfall; when that flattens out, will such institutions still prosper? Individual corporate stocks are quickly vanishing into the homogenized soup of index funds, just as securitized debt was digesting home mortgages before the current uproar. The ranks of stock analysts are thinning out; it no longer matters much if they have a conflict of interest with nonexistent investment banks and stock brokers. All of this disappearance of institutions is in the recent past, and it mostly isn't coming back. Perhaps hedge funds and private equity companies will take over, but it is really too soon to say if they will survive, either.

Credit cards have been over used and abused; that can be corrected. But the credit card system is supported by exorbitant fees charged to participating merchants; the card industry could easily disappear if the merchants devise a way to escape this private taxation; merchants universally wish to do so. The currency version of money is trying to disappear as fast as practical ways can be devised to measure value and transactions electronically. The remorseless pressure behind reducing all transactions to electronic form is created by the greatly reduced cost of it. And that pressure is magnified by electronically speeding up transactions; the faster money turns over, the more its virtual size increases. The converse of course is that a slow-down reduces its size. Like a giant tuna, the money supply dies of lack of oxygen if it slows down.

It can be seen in retrospect that banks are dying because everybody else stole their products by providing cheaper alternatives, mostly with computers. In the process, the national economy gets more uniform, less dependent on local agencies. Something of value has been lost, of course, particularly the local assessment of the capabilities and requirements of local customers; somehow, that seems to be expendable. But one thing, perhaps two, cannot be dispensed with.

For fifty years, we have grown accustomed to the idea that the electronic records of our institutions are accurate. That's definitely not so. Even a reliable firm makes a myriad of errors in its many transactions, catches them with redundancy and cross-checks, and presents the cleaned-up product once a month or maybe even once a day. But even though the illusion of flawlessness is maintained for the customer as much as humanly possible, it is not inherently flawless. Systemic breakdowns will always expose uncorrected flaws caught in process, while disincentives are created by this one-sided system to spend money perfecting and refining its quality control. It's better than the old manual systems, of course, but its flaws are constantly exposed by the remorseless external pressure to do things faster, in bigger volume, in greater complexity. We approach the point where every individual needs to maintain a duplicate computer system to verify his accounts. Individual telephone bills, for example, require the aid of a computer to explain what another computer produced, brokerage transactions need computerized counterparty challenge to expose hidden fees and costs. We all know how lack of transparency brought securitized mortgages to their knees. We will soon learn that the meaning of credit default swaps defies even expert comprehension. The mysteries of university tuition discounts, hospital insurance and even supermarket discounts cry out for safeguards to generate transparency. It may be true that even billionaires like Warren Buffett do not bother to check the accuracy of all accounts presented to them, trusting the fairness of the counterparty. But that does not contradict the need for balance. Institutions of independent public accounting are surely going to make an appearance in the future, telling people what they have and what they are paying for.

The other component which seems to be missing in our transaction system is a well-developed and widely available profession of financial advisors, equipped with electronic tools to provide their badly needed services affordably and accurately. Not only do agents and advisers need some tools, they need the political power to force high-handed vendor systems to permit universal customer verifications; the hooks and portals to their private systems need to be developed to make this system workable, and that will not be willingly forthcoming. But they must be provided, because any independent advisor/auditors need to be subject to constant reverse-confirmation if we are to escape creating a gigantic imperfect-agency problem. But the fact remains that a vendor is not an agent of the customer; his ultimate duty is only to provide an arms-length transaction with transparency. It is the customer's duty to secure his own verification system. When that occurs, it will become part of the third party duty to consent to safeguards against his own imperfect agency. But that's for later. At the moment, independent auditors of the sort needed, scarcely exist.

Much can be gained by searching to correct the flaws of the past whose significance is suddenly apparent. With a stroke of genius, the 2008 reforms of the Bush administration offered a government guarantee of safety for bank accounts which pay no interest. The light finally dawned that businesses use banks for settling up accounts and are more or less indifferent to the interest paid on deposits. When there is a bank panic or a run on a bank, deposits are shifted from bank accounts to Treasury bills in order to find safety; that's now unnecessary. If a bank account pays no less interest than a Treasury bill and is just as safe, why move it? Under the traditional system, deposits seeking safety depleted the loan capacity of the bank and erected a barrier to recovery from the slump that often caused the problem. Why didn't we think of this before?

One of the sources of panic in 2008 was the enormous size of credit default swaps, several times larger than the entire American stock market, many times larger than the national debt. How could we allow such a vast over-insurance to occur? But as some appreciation of the large amount of credit swapping with foreign nations began to grow, things calmed down. If that should unravel the mystery, it is certainly far easier to determine the proportion of international swapping than to set up detailed accounting reports for $60 trillion of default insurance, particularly when the record-keeping intermediaries suddenly go bankrupt.

As soon as the calamity of mortgage-backed securities made its appearance, hands were wrung that originating banks were not required to retain a piece of the mortgage. It seems sensible to impose this requirement on the only party in the chain with the opportunity to evaluate and screen the risks, face to face. So, we can probably expect legislation with the effect of requiring originating institutions to retain "a piece of the action". The principle may need to be extended into other areas, as well. Investment banks until fairly recently were partnerships, not corporations. The capital of an investment bank was supplied from the personal resources of the partners, who usually retired at quite an early age rather than retain big risks without actively coping with the constant pressures of hands-on oversight. Investment banks found they could not raise enough capital from rich partners who were constantly tempted to cash out, so they incorporated and sold stock to the general public. The consequence was the managers were placed in the position of taking big risks with other people's money, and able to pay themselves huge salaries without the constant snooping of rich partners at the next desk. For the time being, investment banking has been totally absorbed into other institutions, but the culture shock of mixing risk takers with risk avoiders will surely lead to something else. Like originating banks with mortgages, the originators of IPOs need to acquire some personal risk of their own, because their essential innovations will always race ahead of the imagination of underpaid plodding regulators. Instead of making a game of outwitting the regulators, investment banking must place much more reliance on the examples within their midst, of rich young kids turning themselves into paupers by assuming the wrong risks.

While we are wallowing in the idea of reconfiguring world finance to avoid the mistakes of the past, some thought should be given to goals. Alan Greenspan was able to win every argument with his reputation of guiding the economy through eighteen years without a major recession. Now that we have resigned ourselves to a return of the business cycle, maybe we should ask whether it is wise to go eighteen years, or even five years, without a correction. Some of this has to do with election cycles, so it isn't easy. But perhaps we have learned that perpetual prosperity is a mirage, small frequent readjustments are better.

http://www.philadelphia-reflections.com/blog/1526.htm

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Forbidden SNL Clip

NBC pulled the original of this Saturday Night Live video from their Web site and replaced it with this edited version.

NBC deleted the section in which Herbert and Marion Sandler described swindling their clients and ultimately Wachovia. The original video had a caption that described the couple as "People who should be shot." Furthermore, the actor portraying Herbert Sandler said "And thank you Congressman Frank as well as many Republicans for helping block Congressional oversight of our corrupt activity."

Herbert and Marion Sandler sold Golden West Financial Corp to Wachovia in 2006 for $24 billion, precipitating Wachovia's failure and eventual sale to Wells Fargo.

http://www.philadelphia-reflections.com/blog/1552.htm

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Philadelphia City Controller

Alan Butkovitz

The Right Angle club was pleased to hear the City Controller, Alan Butkovitz, give us an insider's view of the municipal finances, but was a little startled to hear how badly the national banking crisis has affected our city. While of course the city does a lot of things, its present finances can be summarized as mainly consisting of two things: the pension system and the management of police/fire/corrections.

Mayors of this city for several decades have been following the national pattern of government to transfer its deficits to the pension funds of the employees. That has the effect of shifting the cost of present operations into the far future, and avoiding present confrontations by promising even more generous pension benefits in the future. Over time, the future gets closer and closer; to a large degree it is right now. Pension funds are largely independent organizations, supposedly receiving current contributions to be invested for future distribution. That requires an assumption about how much investment growth will be achieved in the meantime, now set by the Philadelphia Board of Pensions at 9%. That's not impossible to achieve in some medium-term intervals. But it's optimistic, even inconceivable, for long-haul investing; over periods of thirty or more years, most experts say that 4% is about all anyone gets. More to the point, 9% is particularly unachievable right now, in the present crash of national financial markets. That's bad enough, but repeated shortfalls in contributions to the fund have left it funded at 53% of the calculated requirement to pay the pensions of the future, even using the unrealistic 9% return assumption. A few years ago, Mayor Rendell worried about the underfunding and brought it up to 70% with a billion-dollar bond issue. Unfortunately, the crash in the markets has brought it right back down to 53% again. So, it's fair to say the pension fund is a couple of billion dollars short, even if you accept a 9% income accumulation -- which you probably can't, but at least it brings the pension fund to 70% funding in forty years. Call it four billion dollars short, just to be conservative, since it is presently admitted to be two billion. That isn't Mayor Nutter's fault, but it's sure his problem; and if it gets worse, it will be seen as his fault.

The other expense item of note includes 42% of the budget in the police, fire and prisons systems (education is handled separately through the school board). If you fired all those people, or they quit, we wouldn't have a city, we would have a jungle. But the Controller describes all three as terribly mismanaged, with the local police stations in a deplorable state of disrepair and degradation, bathrooms you wouldn't think of using, and so on. The fire department has only a minor number of fires to fight, perhaps four or five hundred a year, but it includes the emergency rescue services which respond to a couple hundred thousand calls a year. The rescue people report to the firemen, and there is social friction between the two, working to the disadvantage of rescue. It costs about $500 to respond to a call, and it isn't entirely satisfactory to send a fire truck to help someone with a heart attack. The Controller had a number of horror stories about administrative mismanagement in this area. As far as prisons go, everybody knows prisons are bad places, and ours are no exception. Confrontation with the unions is definitely in the future for the Mayor, and the city is going to be in pretty bad shape if he doesn't win some arguments.

That's the expense side of the municipal budget; the revenue side is equally gloomy. The offhand comment was that real estate taxes could double without bringing the pension system under control for twenty years. If our taxes are significantly higher than neighboring cities, or even just the same as in cities with superior uniformed services, it will be hard to attract and hold business taxpayers, causing municipal finance to spiral downward. Along the course of this patter-song it isn't exactly reassuring to learn that it now takes the City 21 days to process a check, and that absenteeism in some departments runs to 20%. We've heard a lot of denunciation of Mayors Giuliani and Bloomberg in New York, but their absenteeism runs 3% because investigators are sent to the house of an absentee, who is subject to court martial if he isn't home.

Somewhere in this nightmare lurks the hidden migration of the unionized workers. Starting with Mayor Rizzo or even earlier, the uniformed services were the main political support of the Democrat political machine. Quietly, they have moved out to the suburbs where the schools are better and the taxes are lower, and it is now said that 70% of union workers live (and vote) outside the city limits. The unions talk tough, bluffing through the uncertainty when their membership can no longer provide the votes to be so fearsome. To some degree, their weakening political power is augmented by using their pension funds to provide construction loans for new commercial real estate. Some of that political clout is used up by the need to get zoning variances and tax abatements for the projects. A lot of these power shifts are hard to assess from the outside, but a trend is clear.

The controller didn't mention it, but the city is not only a pension investor in bonds, but also an issuer. Interest rates are about as low as they can get while the Federal funds rate is nearly zero, so there is only one direction they can go in the future -- sooner or later they will go up. By the iron law of bond financing, the value of the underlying principle will then go down. That could provide an opportunity to buy them back at lower prices, or it could break the city's financial back financing higher interest payments. However, for the pension fund side of things, exactly the opposite is true. Maybe Hizzoner can tap-dance around these dangers and opportunities, but most mayors would have trouble pronouncing the words.

It's part of the job description for the controller to be a pessimist. But the most you can make of this mournful dirge is to hope he is completely wrong.

http://www.philadelphia-reflections.com/blog/1591.htm

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