SAFE INVESTMENTS FOR OLDER

ADULTS:

Like the tooth fairy, there is no such thing as guaranteed safe, low-risk investments. Financial advisors should know

the risks when advising their older clients. BY A ARON RUBIN, JD, CPA , CFP

[ f i n a n c i a l ]

THE GREAT MYTH

CSA JOURNAL 59 / SUMMER 2014 / SOCIETY OF CERTIFIED SENIOR ADVISORS / WWW.CSA.US PAGE 29

One of an older adult’s greatest fears is run-ning out of money (PR Web 2010). This well-grounded fear leads them to search for the ever elusive “safe investment.” With

many companies looking to capitalize on an ever-ex-panding senior market, there is no shortage of options that are presented as low risk. Financial advisors should know the risks when advising their older clients.

No investment—be it stock, mutual fund, or any other investment/insurance product—can be protect-ed 100 percent from potential loss. However, many brokers, insurance agents, and other professionals have made it their business to market their products as safe, especially to older adults. So it is no surprise that many investors think they can invest with absolute, existen-tial safety.

Many older investors stipulate that their prima-ry investing objective is safety. But safety is a fallacy. There are only choices and sacrifices. The job of any ad-visor is to help clients flesh out what upside potential (or downside limiting) choice works best for achieving their goals, and what they are willing to sacrifice to achieve these ends.

Components of RiskWhen clients want to discuss safety, they are pri-

marily concerned about three main concepts: volatility, inflation, and liquidity.

Volatility, or the upward and downward move-ment of the investment, is what most people think of when considering risk. The S&P 500 Index goes up and down and the results are reported daily on the eve-ning news. Sometimes the swings are wild. But stocks are not the only investments subject to volatility. Real

estate often has just as much volatility, but trends are not as easy to establish and publish as stocks, which are traded on an open market.

Inflation, or the decreasing value of a dollar, is a specter that many fail to fear sufficiently. We under-stand that the costs of goods and services tend to go up over time. But since inflation numbers, as measured in the United States by the Consumer Price Index (CPI), are published monthly, and generally without much fanfare, inflation’s risk is often underappreciated, espe-cially over the long term.

Liquidity is how easily (or not) an investor can sell an asset for cash. There can be multiple barriers (monetary and legal) to selling an asset, such as surren-der charges, sales charges, partnership agreement, or a small or illiquid marketplace. Tolerance for liquidity risk should be tied to an investor’s overall liquidity. Too often, investors place too much cash into an illiquid investment only to discover that they do not have suf-ficient funds in an emergency.

While investors have many choices for investment vehicles, many clients hold either stocks, bonds, mu-tual funds, or annuities, and many times, combina-tions thereof.

Defining SecuritiesStocks, bonds, and mutual funds, collectively re-

ferred to as securities, are in the same asset family. Stocks represent pieces of ownership of a particular company. Bonds are debt issued by a company or oth-er organization, including government entities, which promise to pay interest along with principal over a set period of time. Mutual funds bundle stocks and bonds. They have a stated goal or purpose, and a manager who selects the stocks to fulfill that goal or purpose.

How Stocks WorkWhen people think of the stock market, the word

that comes to mind most often is volatility, and with good reason. Investors were reminded of the market’s volatility in 2008 when the S&P 500 plunged nearly 40 percent (Dimensional Fund Advisors 2013). Indi-vidual stocks, in particular, are subject to a variety of risks. An individual company may fall behind the com-petition and go out of business (business risk), or per-haps get swept up in a government reform movement (regulatory risk). The currency of the country where they do their business may decline (currency risk).

To minimize the risk posed by individual stocks, many investors choose to diversify. While diversifica-tion does not guarantee gain or fully protect against the risk of loss, it can limit exposure to most risks aside from market risk. Market risk is the overall

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performance of the market, and is a powerful force as noted in 2008.

Mutual funds are a popular way to diversify. Buy-ing hundreds or thousands of individual stocks are cost prohibitive to most investors, so mutual funds can be a cost effective way of purchasing a wide swath of the stock market. Mutual funds have a variety of differ-ent flavors. Some are open-ended, meaning they are constantly taking in new money and purchasing more stocks or bonds. Some are closed-ended, and do not take any new money. Exchange Traded Funds are akin to a closed-end fund, and are traded like stocks with a premium or discount. This means the price an investor pays for the fund could be less than or greater than the underlying value of the stocks or bonds held inside.

One of the most important factors when assessing risk in a mutual fund is whether the fund manager is trying to pick the winners or trying to capture an overall market. From January 2009 to December 2013, almost 73 percent of U.S. Large Cap (S&P 500) active portfolio managers failed to beat their index, as did 71 percent of International Large Cap (S&P 700) active managers (Standard & Poor’s 2013). Investors would be wise to recall the SEC warning: Past performance does not indicate future results (SEC 2007).

How Bonds WorkBonds are guided by two main factors: maturity

and quality. Maturity measures the time until the bond comes due. The longer a bond has until maturity, the more sensitive it is to interest rate risk. As interest rates rise, the value of principal decreases. This is because a new bond investor can get a better interest rate in the open market rather than buying an old bond with a lower interest rate.

Liquidity is usually not a problem for securities. Most securities are traded on an exchange. The most famous exchanges are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ). Secu-rities listed on larger exchanges are most often quite liquid. Some smaller securities are traded over the counter (OTC), and are not traded as heavily. Such securities can have a high cost of sale since there are not as many willing buyers and sellers trading as often.

Inflation risk is also less of a concern with securi-ties. Stocks are probably the best hedge against infla-tion (Siegel 2011). As inflation creeps up, individual companies raise their prices, which in turn raise profits and raises the stock price.

Bonds do not have the same inherent protection. Since the interest rate is usually fixed, as inflation goes up, the interest rates remain the same. So inflation can ruin

a large bond portfolio by reducing buying power. Mutual funds, depending on the stock to bond mix, have similar reactions to inflation as their underlying securities.

What Older Investors Need to Know About Securities

The pitfall that older adults should try to avoid is getting overly concerned about yield. Yield is of-ten expressed as a percentage, and measures the cash flow (rate of dividends and interest) against the price of the underlying security. Many believe that strictly collecting yield is the best way to fund retirement so as not to have to sell the underlying security, but still getting cash flow. But hunting for yield in the stock market may result in thinly diversified portfolios and heavy weighting to certain sectors (e.g., utilities, en-ergy), which exposes the investor to additional risk. High-yield bonds are often long term and/or low quality, both dangerous, and even more so when used in tandem.

An alternative method that can also provide a cash flow is a synthetic dividend approach. Under this phi-losophy of investing, investors use capital gains (and pay the capital gains tax) to supplement yield. As the portfolio grows, appreciated stocks are sold, and cash is collected and paid out as retirement income. So what happens in a down market? If cash is managed such that there is a one to two year cushion, a downturn can be mitigated by not replenishing cash during the bad year (or two), and waiting for the recovery to start before making trades again, if possible.

In sum, older adults need to pay particular attention to their stock-to-bond allocation. With fewer years to make up for market losses, and generally more reliance

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on income from the portfolio, having too much in the market can be dangerous. At the same time, keeping pace with inflation and withdrawal viability must be balanced. Before making investment decisions, older investors should have discussions with their financial advisors about their ability to withstand major market downturns, and in that same vein, plan for the worst-case market scenario.

How Annuities WorkAnnuities receive a lot of attention from older

adults since they are considered safe by many standards. Qualified annuities also allow for tax deferral, though withdrawals are taxed at ordinary rates to the extent there are gains. Annuities are contracts made between an investor and an insurance company. Typically, there is an accumulation period where the money the inves-tor places with the insurance company grows, either by set rate or variable rate. Then there is an annuitization period where the investor receives payments. Since an annuity is a contract, there is a tremendous amount of flexibility and creativity. The main varieties of annuity contracts include fixed, variable, and equity indexed.

A fixed annuity has a set interest crediting rate, for instance 3 percent annually. Terms can range in length from three to ten years. While there is no real volatili-ty risk, these types of annuities are subject to inflation risk. Like bonds, the longer the term of the annuity, the greater the inflation risk. Fixed annuities end up look-ing a lot like bank certificates of deposits (CDs), but with stiffer penalties for taking the money out early.

With a variable annuity, an investor is basically choosing a mutual fund type investment vehicle. The main differences between a traditional mutual fund and a variable annuity can be found in the riders that ac-company the contract. A rider is a feature of an annuity contract that is meant to alleviate some kind of risk. For instance, some riders have a guaranteed death benefit, or lifetime income benefit. These riders have a cost, howev-er, and can significantly eat into returns (Douglas 2013).

An equity-indexed annuity marries the fixed an-nuity and the variable annuity. This type of contract credits interest based upon the performance of an index—for example, S&P 500 and Russell 2000. In most cases, investors are protected from downside risk, but are capped on their upside potential. For instance, while investors may have a floor of 0 percent, they may only be able to capture a maximum of 6 percent an-nually in an up market. This can be a good thing in a year like 2008 when the S&P lost 37 percent, but not so much in years like 2013 when the S&P returned almost 30 percent.

Risks Inherent to AnnuitiesThe major sacrifice for annuities is liquidity. Most

annuities contain some kind of surrender charge. A sur-render charge is a period of time where, if the investor wants to pull money out of the account, they must pay the issuing company a percentage of the investment. Surrender periods can range from three to ten years, and usually start at around 8 percent, declining over time.

Annuities are subject to credit risk. Investments are backed by the full faith and credit of whichever insur-ance company has your money. They are not FDIC or SIPC insured. If the insurance company goes under, the investor is stuck with whatever the State Guarantee Fund is willing to pay. (AnnuityAdvantage.com 2014)

Finally, annuities also tend to be expensive. Wheth-er from the mortality and expense fee in variable prod-ucts, or the opportunity cost for equity indexed annu-ities investors pay a premium for the privilege of throw-ing volatility risk onto the insurance company.

What Older Investors Need to Know About Annuities

When looking at annuities as an investment op-tion, seniors must be very careful. With plenty of an-ecdotal evidence of annuity salesmen overreaching older adults, states like California have set up special laws and notifications to protect them (Aviva Investors 2013). Too often, clients want to unwind an annuity, but cannot afford to take the surrender charge hit.

Advisors should make sure their clients pay close attention to the riders and what they end up costing. Unfortunately, insurance policies are often written and presented in such ways that the expenses are very diffi-cult to decipher. When in doubt, get a second opinion from an advisor who does not receive a bulk of his or her revenues from selling annuities, but still has a good understanding of how annuities work.

How to Pick an AdvisorWith all of the choices that are available to investors,

Older investors should have discussions

with their financial advisors about their ability

to withstand major market downturns, and

plan for the worst-case market scenario.

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it is very difficult for them to make sense of their op-tions. This is where having a trusted financial advisor can really make a difference, even though there is al-ways some cost involved, whether it be an annual fee or commission. There are many types of financial advisors: registered investment advisors (RIAs), brokers, and in-surance agents.

RIAs are not locked into working with any particu-lar investment firm. Under regulatory obligations, they have a fiduciary responsibility to act in the best inter-est of the client, and are not employees to a brokerage house or insurance companies. RIAs may also lack name recognition since they tend to be smaller firms.

Brokers work within a larger organization. They do not have a fiduciary duty, but are subject to the Suitability Rule. So long as a product is suitable (not necessarily the best) for their clients they are not vio-lating any duty to their client (Steiner 2012, FINRA 2014). Of course, ethical brokers always put their cli-ent’s interests first. Brokers also have more access to commission products, although many charge a fee for management.

Life insurance agents can be helpful advisors when considering their products, which are basically life in-surance and annuities. But it’s important to understand that they have no fiduciary responsibility to their clients in regards to investments.

Typically, they are also part of a larger broker (State Farm and Allstate both have their own brokerage houses). Insurance agents get paid almost exclusively on commission, and often have a duty of loyalty to their parent companies.

Selecting an advisor is as much, if not more so, a process of the heart than of the head. Older adults need to be aware of financial advisors who guarantee rates of return. Many times these guarantees are linked to a rider or are only for a limited time. It’s also im-portant that seniors not get caught up on the brand. Being associated with a well-recognized firm or insur-ance company is not an indication of advisor quality. Of course, the most important axiom remains in place: If it sounds too good to be true, it probably is.

ConclusionGiven the absence of safe investments, older in-

vestors should be working with a fiduciary financial advisor. So long as the advisor understands the cli-ent’s tolerance for fluctuations in value, need for li-quidity, and consider inflation risk, a portfolio can be constructed that maximizes potential reward for the client’s chosen level of risk. With a good, long-term portfolio in place, a senior can gain confidence in a more secure financial future. •CSA

Aaron Rubin is a CPA, CFP, and member of the California Bar Association. For twenty-five years, the Werba Rubin firm in San Jose, California, hasserved high net worth families in the Bay Area. Contact him at arubin@werbarubin.com, or visit www.werbarubin.com.

■ References

AnnuityAdvantage.com. 2013. “State Guarantee Funds, Liability Limits.” http://www.annuityadvantage.com/stateguarantee.htm. Accessed March 5, 2014.

Aviva Investors. 2013. “Compliance Update, New California Disclosure Requirements for Senior Citizens.” February 22, 2013. http://www.d-u-s.com/PDF/Aviva_CA+Compliance+Update.pdf. Accessed May 27, 2014.

Douglas, Christine. 2013. “Why Pay More for a Variable Annuity Rider?” USA Today, April 12, 2013.

FINRA (Financial Industry Regulatory Authority). 2014. “Suitability: What Investors Need to Know.” www.finra.org/Investors/ProtectYourself/BeforeYouInvest/p197434. Accessed May 21, 2014.

PRWeb. 2010. “Senior Fear Factors: What Aging Americans Fear the Most.” March 24, 2010. www.prweb.com/releases/GMM_Frailty/03/prweb3761844.htm. Accessed May 27, 2014.

Security and Exchange Commission (SEC). 2007. “Mutual Funds: A Guide for Investors.” Office of Investor Education.(http://www.sec.gov/investor/pubs/sec-guide-to-mutual-funds.pdf, Accessed May 27, 2014)

Siegel, Jeremy J. 2011. “Stocks: The Best Inflation Hedge.” Kiplinger, June 9, 2011. http://www.kiplinger.com/article/investing/T052-C019-S001-stocks-the-best-inflation-hedge.html, Accessed May 27, 2014).

Standard & Poor’s. 2014. “Indices Versus Active Funds Scorecard (SPIVA), Year End 2013.” (http://us.spindices.com/resource-center/thought-leadership/spiva/). Accessed May 27, 2014.

Steiner, Shayna. 2012. “How the fiduciary standard protects you.” Bankrate.com, June 19, 2012).

2013 Matrix Book, Dimensional Fund Advisors. NOTE: This is a book of data that does not have online access. Please refer to DFA at www.dimensional.com.

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