Like any profession, the investment industry has its own vocabulary, which can be confusing and often off-putting.
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But as you near retirement, it’s worth your while to become familiar with this specialized language. Not only will you be better equipped to communicate your needs, but you can be sure those needs are actually met.
Here are a few terms that are important for you to know:
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1. Fiduciary.
When you’re paying for advisory services, it should be clearly stated that your financial professional is working in this capacity. A fiduciary must act in the best interests of his client and avoid any conflicts. For example, he can’t make recommendations that produce higher commissions for himself or his firm.
The best-interest standard doesn’t apply to every aspect of financial planning, however. You may wish to hire a dual-licensed or hybrid adviser who also can sell you insurance products or mutual funds. Do your research and ask questions about licenses, certifications and compensation.
2. Interest rate risk.
Conservative investors often buy bonds because they think they’re playing it safe, but fluctuating interest rates can pose a risk. If rates rise, bond prices typically fall. Talk to your adviser about further diversifying your portfolio mix.
3. Sequence of returns risk.
Too many years of negative returns at the start of your retirement can substantially damage your nest egg – perhaps to the point where you won’t recover the loss – and reduce the amount you’ll be able to withdraw over your lifetime. This is a major concern for today’s retirees, many of whom are counting on their investments to provide most of their retirement income.
Unfortunately, it’s simply a matter of timing and something over which you have little control – which is one more reason why you perhaps should consider reducing your portfolio’s risk by the time you hit the retirement “red zone,” the 10 years before and after retirement.
4. Risk tolerance and risk capacity.
You’ve probably read a bit about risk tolerance, and hopefully you’ve talked about it with your adviser. It’s basically your emotional ability to withstand losses to your portfolio without panicking.
Risk capacity is a bit different: It’s your ability to take a loss without it affecting your lifestyle. Or it could be your need to take a bit more risk in order to grow your nest egg so that it meets your financial needs. It’s useful to know both your tolerance and capacity to avoid making knee-jerk decisions during market fluctuations.
5. Annuity.
Annuities are contracts offered by insurance companies that give you a stream of regular payments in exchange for a premium. Retirees like them because they can provide predictable income for the rest of their lives. With employer pensions disappearing, that’s an appealing option.
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Annuities, in general, have gotten a bad rap because people think that when you die, the insurance company gets to keep your money. But that isn’t always the case. There are several types of annuities, and the fees and penalties vary considerably. An annuity isn’t as flexible as some other investments, so you wouldn’t want to put everything you have into one. But they can perform an important role in your retirement plan, and are extremely important to know about in detail.
6. Expense load.
Anytime you’re looking at an investment, you should take into account the costs that come with buying and maintaining it. Those expenses are often hidden or buried deep in the jargon in the paperwork you receive.
Mutual funds, hedge funds and variable annuities have some of the highest expenses. That doesn’t mean they’re all bad, but it does mean you’ll need to be vigilant in making sure your investment is performing, because expenses can eat away at returns. Insist on the full disclosure of all fees, and discuss with your adviser the fund’s performance vs. its benchmark.
7. Required minimum distributions (RMDs).
These mandatory yearly withdrawals start in the year you turn 70½. Generally, you have to take RMDs from any retirement account in which you contributed tax-deferred assets or had tax-deferred earnings, such as 401(k)s and IRAs. If you don’t, you’ll face severe penalties. Although your adviser probably will let you know when it’s time to start, the burden is on the investor to get it done.
8. Roth IRA.
Unlike a traditional IRA, the money you contribute to a Roth retirement account has already been taxed, so when you retire and start withdrawals, the money – and any potential growth in the account – may be tax-free.
You can withdraw your contributions at any time without paying taxes, and once you turn 59½ and have had a Roth at least five years, your earnings would be tax-free as well. So, if you think your taxes (or all taxes, in general) will be higher when you retire, it’s worth considering adding a Roth to your portfolio. One final consideration: If you converted a regular IRA to a Roth IRA, you can’t take out the money penalty-free until at least five years after the conversion (with some exceptions).
9. The 4% rule.
This is one of the most misunderstood and misapplied terms in the investment world. That’s probably because it’s a rule of thumb, not an actual equation for retirement success. The theory is that you should withdraw 4% of your retirement-date portfolio value, adjust this amount for inflation in subsequent years, and sustain withdrawals over 30 years using a diversified portfolio of stocks and bonds.
There’s been much debate about whether the rule (which was developed in the 1990s) is still valid today. Many experts believe 4% may be too high, considering modern-day market fluctuations and longer lifespans.
Finding an adviser who can translate and help you navigate your way through the investment world will make retirement easier and more enjoyable. But you’ll have even greater financial confidence if you know the language yourself and can be sure you’re making the most of your hard-earned savings.
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Kim Franke-Folstad contributed to this article.
Investment advisory services offered through Brookstone Capital Management, LLC (BCM), a registered investment adviser. BCM and Fritts Financial, LLC are independent of each other. Insurance products and services are not offered through BCM but are offered and sold through individually licensed and appointed agents.
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