It's a matter of trust

Most economists today consider business cycles to be credit cycles. In other words, they have to do with public confidence, or trust, in our economic infrastructure. When confidence is high, credit flows and economic activity increases. Eventually, confidence reverts to the mean and below, before repeating the cycle. More deeply considered, all economic activity has to do with trust. The story of the development of that trust from personal to infrastructural is the focus of this article.

I. Pre-scientific economics: Cooperation

The Beginnings of Commercial Activity

A do-it-yourself approach to life is inefficient and unfulfilling for most people, so people group together for mutual protection, shared resources, and companionship. People who live near one another, and who have a social relationship involving at least a minimal level of trust, may trade valuables with one another, or trade labor for valuable items, such as food and clothing.

Precious Metals

Bartering for goods and services has limitations, however. Finding someone who has what you want and wants what you have is chancy. However, certain items, such as gold and silver, possessed common appeal, due to rarity, durability and beauty. They became useful as exchange media, and as measures of value.

Economic Necessities: Food

Token Accounting

In ancient Sumeria, grain was stored for farmers in shared facilities. Clay tokens representing fixed values were given to farmers to certify ownership of fixed amounts of grain. While these tokens possessed no intrinsic value, they became acceptable for exchange among various parties, in addition to redemption at the granary.

Owners of these tokens commonly held them in sealed envelopes, with identification of owner and value on the outside. Eventually, the envelopes themselves became tokens of value, which improved efficiency of trade. Coins were heavy and subject to debasement (shaving, sweating and melting). Paper money was inexpensive and replicable.

Crop Loans

During the middle ages, the Lombard plains of Italy produced vast amounts of grain, and provided marketplaces for grain trade. While Christians were forbidden to charge interest, Jews were forbidden to own land. As a result, Jewish immigrants were willing and able to lend seed money to farmers, with the assurance of sharing the revenue from grain sales after harvest. Additionally, these merchant bankers were able to provide crop insurance to the farmers, as well as alternate grain supplies to wholesalers after a crop failure.
Eventually, this trade expanded to handling trades for others, as well as issuing bank notes for deposits. Today’s investment banks have extended their services to raising capital through public offerings of stocks and bonds.
Other monetary functions, such as money changing and pawn broking were left to less prestigious institutions.

Economic Necessities: Shelter

Value-added Goldsmithing

In 17th-century England, gold craftsmen had the safest storage facilities, since their materials were so valuable. As a result, their vaults came to be used for storage of precious metals. Goldsmiths issued notes to depositors, which they could redeem with the gold in their vaults, upon demand. These demand notes came to be accepted as a substitute for coins in everyday transactions. In the meantime, goldsmiths noticed that many deposits stayed in their vaults for a long time, and that not all deposits were withdrawn at the same time. They began to issue the demand notes to non-depositors as loans. The goldsmiths charged interest on the notes, which became profitable enough that the goldsmiths began to pay interest to attract more deposits.

Fractional Reserve Banking, with Land as Collateral

One of the important elements of these credit transactions, as instituted by John Law (the English goldsmith credited with popularization of fractional reserve banking), was the acceptance of the value of land as collateral, to expand lending far beyond that which was possible with only precious metals as collateral. The availability of home mortgages eventually made home ownership possible for members of the lower economic classes.

Military and Political Institutions need Money, too

The world’s first central bank is the Swedish Riksbank, which currently awards the annual Nobel Prize in Economics. The second central bank, and more relevant to this discussion, was the Bank of England. A group of wealthy bankers formed the Bank of England in 1694, in order to lend money to King William of Orange to fight a war with France. The Bank was allowed to accept private deposits and offer loans. It was also allowed to print money, and backed up the other English banks. The Bank of England was nationalized in 1946, and still acts as the nation’s central bank.

Among the central banks of today, the key role is to orchestrate national monetary policy with the purchase and sale of Treasury Securities (open market operations) and, to a lesser degree, affect the discount rate. Currency distribution (without the assistance of helicopters) and maintenance of international exchange rates are generally the responsibility of central banks. Central banks also set and enforce rules for commercial banks, having to do with capital, reserve and reporting requirements.

Economic Necessities: Clothing

Textile Manufacture and the Industrial Revolution

In economics, whenever you think you have discovered a seminal event, there is always a precursor. Some events are critical, nonetheless. Richard Arkwright started the Industrial Revolution in 1771 by building a water-powered spinning wheel in Cromford, England. Arkwright improved the production of one of the three basic human necessities, clothing, by a multiple of 10, then 100. The series of events which led to this achievement are interesting, as well.

In 1733, John Kay patented a flying shuttle, improving the production efficiency of weaving. Demand for fiber increased, so fiber spinners had to find a way to work faster. Thomas Highs had provided a critical mechanism for stretching fiber before spinning it, to enable mass production. However, Highs was undercapitalized.

Richard Arkwright, having obtained (for lack of a better word) Highs’ technology, moved forward with a remarkable combination of business, financial and mechanical ingenuity. Arkwright raised capital and hired Highs’ technical expert, also named John Kay. He adjusted the machine to run on water power when he saw that human and horse power were insufficient. He was even smart enough to realize that he needed warm water year-round to power the water wheel. As a result, he relocated to remote Cromford, a full day’s travel from Nottingham, to find warm underground springs. Like Bill Gates, his vision and ambition (really, I need better words) were far beyond those of his peers, as was his business acumen. He initiated the industrial revolution by implementing mass production, highly productive employment of unskilled labor and continuous production processes.

The Malthusian Catastrophe

None of the above could happen without reasonably patient capital. Saving labor costs on spinning, which is only one of 8 primary steps in producing cloth, is valuable only on a massive scale. Thankfully, the scale has been enormous. As we have seen over the last 200 years, technological improvements, enabled by capital, have outpaced population growth to an extent unimagined by Thomas Malthus. Malthus was Dr. Doom 200 years before Nouriel Roubini. Like Dr. Roubini, he predicted the demise of civilization as we know it. Malthus’ reasoning was that population would grow faster than the farmers’ meager ability to provide more food, given the technology of his day. Hence, economics became known as the Dismal Science. Malthus didn’t anticipate the productive explosion resultant from redeployment of capital from agrarian to industrial uses.

Now, in 2009, we expect (and, indeed we possess) food, clothing, shelter and much more. Transportation, education and health care are available to members of all economic classes, and have come to be expected as basic necessities.

II. Economic Science: Observation and Analysis

Capitalism is not an idea; it is a series of observations

Political Economy-Philosophical Inquiry

Many early English capitalists, like Adam Smith and John Stuart Mill, were moral philosophers rather than government or business activists. They intended to improve upon Physiocratic and Mercantilist economics, which failed to address the improvement of the common good. They noticed that the people doing the back-breaking work were poorly rewarded. Using John Locke’s conception of the Labor Theory of Value, they advocated liberation of the masses from economic subjugation. Whereas the Physiocrats and Mercantilists used government to protect the interests of the wealthy and nobility, laissez-faire Capitalism offered economic opportunity to workers, by reducing government interference.

Outtake: Socialism

Karl Marx  argued, like Malthus, that workers had little opportunity, because the supply of workers  generally exceeded demand for labor. He insisted that violent revolution was necessary in order to progress from capitalism to utopian socialism. Violence overcame oligarchy, and awakened each person to his authentic being (remember, we are still in the age of economic philosophy; empirical analysis is coming next).

Political Economy-Mathematical Analysis

Three economists (William Steven Jevons in England, Carl Menger in Austria and Leon Walras in Switzerland) revolutionized economics in the 1870’s. Each, in his own way, said that the commercial value of a product or service is its market price, rather than the sum of its production costs. This rejection of the Labor Theory of Value led to a change in focus to more empirical observation and mathematical analysis, except in the case of the Austrians. The next 60 years of economic inquiry were largely devoted to these pursuits.

Government Policy: Fiscal Intervention

During the Great Depression, John Maynard Keynes (a non-violent Fabian Socialist) proposed a solution to cyclical business downturns. He suggested that governments spend money when confidence was low, making up the difference when a strong economy yielded higher tax receipts.

Government Policy: Monetary Intervention

Milton Friedman was concerned that government action to smooth business cycles would cause too much long-term damage. Instead, he proposed that business cycles were manageable by consumers and producers as long as government intervention didn’t exacerbate cyclical volatility. He cited government action, specifically monetary contraction as the primary cause of the Great Depression. He believed that business cycles would be less volatile with a steady money supply (up to 3% inflation is OK, too, he said).

Recently, political economy debates have centered on the differences between the views of Keynes and Friedman. The finer points of their respective arguments are well-publicized and beyond the scope of this article. However, they agree on this: governments can help the real economy only marginally.

III. The Real Economy: Not an Ideal

The amount of money in circulation, multiplied by the frequency of its use, with certain adjustments, measures our mutual cooperation. U.S. GDP, a related measure, is over 3 times the amount of the next highest country (Japan), and makes up of 25% of world GDP, though we have only 4.5% of the world population. We are extraordinarily productive, and it is critical that we continue to produce the goods and services desired by consumers worldwide.

Our worker productivity is very high, compared with the rest of the world, for a variety of reasons. One of the most important advantages the U.S. has is plentiful capital to improve production and distribution efforts. This capital is less plentiful today than it was a year ago, due to the financial delevering of the last year. This brings out the importance of equity investment, as debt capital has become rarer.

Capitalism: Exploitation or Enhancement of Labor?

To paraphrase Richard Nixon, we are all Capitalists now (I’ve wanted to say that for 6 pages). You see, I love commerce. I am so excited about wealth creation. Capital, innovation, specialization and distribution have made our lives more comfortable, safe and enjoyable than those of our forebears.

Having witnessed Celine Dionne’s rendition of the theme song to “Titanic”, I thought of the honor it must be to deliver such inspirational artistry to appreciative audiences. In my own career as a financial planner, I am honored to share in the commercial accomplishments of Western culture, in the same manner in which she shares in the delivery of beautiful music.

You should feel the same way. You provide the strong, patient, reliable capital which our civilization needs to prevent a Malthusian catastrophe. You are the benefactor of laborers and consumers, and deserve to be paid well for your contribution. I am confident that you will be rewarded, as has been the case since the dawn of the Industrial Revolution.

We at Porter Kickham REALLY appreciate your interest in a subject so fascinating to us. We hope that this presentation complements your appreciation of economics, and that you are able to put it to good use in your private endeavors and arguments around the dinner table.

Michael J Kickham, CFP®     Registered Principal

These times demand that you manage your money with sound fundamentals in mind. Most people think that investing is about buying stocks and watching the price of their assets go up from the moment they buy. That’s for amateurs and gamblers. Marked to market pricing is not what you are after, and if you chase it, you’ll see your wealth dissipate. Sound fundamentals make for sound investments.

If you plan to retire and live from the income your savings can generate, your primary concern in the capital markets involves purchasing earnings streams. By selecting portfolio managers who can choose good companies with solid expectations of growth, you're more likely to own investment opportunities which may turn out to be tomorrow's industrial powerhouses. But that all takes place in the background.

Financial Independence is Your Primary Concern

That’s what retirement is all about. The concerns of making a living day after day don’t concern you anymore. When you declare your financial independence (“retirement is so last century") your days revolve around the things you want them to, and not around questions of money and finance. The end result of good retirement planning delivers a stream of income for you and your family that allows you to move on with the really important parts of your life: travel, visiting family and friends, good books and good endeavors.

Five key principles have guided Porter Kickham over the last 30 years of financial practice. We’re sure you’ll agree that they should be good for the next millennium.

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“Begin with the Goal in Mind”

Let’s begin to make crystal clear what you want out of your life’s work. If you are near retirement or retired, the best truly is yet to come. Tell us about your family and what you want for them. Let’s make a plan to take care of your spouse, your children and your grandchildren. Life is one successful encounter with risk after another. We need to plan together for the best way to confront them in an affordable, rational manner.

“Before acting, seek understanding”

You need to be heard. You need to talk out your hopes and dreams, as well as your concerns about the future. We need to hear it. Financial planning is not about winning some football game where points accrue year after year. Sound planning makes clients feel relaxed and in control of their future, and the future of their family.

“Leave no assumption unchallenged. Let nothing pass unsaid”

Our guiding principle is to understand your unique position in the world. Each person comes to the table with their own ideas, prejudices and myths about what the capital markets can do for them and how they should behave as investors. We’ll examine your thoughts about the market so that we can interact on a level playing field of understanding and knowledge.

“Plan a Legacy”

You don’t need to make your kids rich when you die, but you can plan now so that those you care about will not be saddled with an awful mess when you are gone. Frankly, we’ve found that the best gifts you can give to your children and grandchildren aren’t monetary. They are composed of diaries, gifts, moments and time together. Let’s plan your time and your use of your wealth so that you leave a lasting legacy and truly help the next generations become all they can.

“Plan for Goals, not Balances”

Money in an investment account is useless. A balance steadily rising in a bank account is meaningless. Goals, dreams and people give meaning and importance to money, because it is what wealth can do for you, and for your loved ones, that is vitally important. That’s what makes money come alive.

If your broker has ever called you to pitch a specific stock or a mutual fund run by his company, you’ve experienced sell-side investing. If you’ve ever gone online to look up research reports, you’ve looked over sell- side research. Welcome to the world of retail investing.

As the name implies, retail investing relies on advertising, cache and glamour in order to move product to consumers. For investment bankers and for too many stock brokers, stock is a product. Like retail stores, various wirehouses sold the product to customers (there is no such thing as a retail client, is there?)

At the turn of this century, retail investors naively gobbled up these research reports. They assumed that unbiased researchers developed the information in them by looking at various aspects of each company and its prospects for the future. It wasn’t until well into the fall of the dot com’s that the public woke to the reality that these reports were sales literature. Scandal struck Wall Street as personal emails from these researchers showed that they personally considered the touted stocks to be worth much less than their glowing reports purported them to be.

An initial public offering creates the product. After that, anyone can trade it in the secondary market. The creators and "servicers" of stock product constitute the “sell-side." The sell-side is composed of a group of players, listed here with their respective roles:

• Investment bankers: Bring the company public.
• Analysts: Write research reports and make recommendations including upgrades and downgrades.
• Market Makers: Agree to trade the stock continuously at any price, profiting from the bid- ask spread.
• An investment bank may perform all of these functions under one roof.

The Sell-Side Bias is to Sell Stock to You

The sell-side, obviously, sells stock. Higher stock prices best serve the interests of the sell-side brokerages. Stock brokers employed by the brokerage tell compelling stories as a way of standing behind their product, but they offer no guarantee. If you get into the stock early enough, their sales prowess may appear to coincide with your best interests.

As with any product salesman worth his salt, the sell-side agent will service and support her product. Since stock certificates don’t have moving parts, the support consists of analysis and ratings of the stock she has sold.

You may begin to see a bias towards "pushing" stock. However, this is where the financial services industry differs from other industries. Your stock broker and all the other players mentioned above have no real control over how well a company performs. No matter how good the ratings or how compelling the sales story, the stock price will eventually reflect the true performance of the company. So a stock can only be held up for so long before it must stand on its own.

Investment Banks Sell, Retail Investors Buy

Retail buyers, like individual investors, sometimes take large blocks of stock in aggregate. But the buy-side players, like mutual fund and pension managers, make the largest price moves possible. (For a more in depth discussion of Buy-Side Intelligence, see the article in Institutional Standards [Link])

Sell-side analysts present as positive a picture as possible for stocks their investment banks have brought to market, through their brand of analysis and research publications. They ostensibly work to envision the future and bring to market new stocks, as well as support existing stocks that will benefit from that vision.

In an ideal world, every stock that an investment bank brings public becomes profitable and stable in the long term. The bright future predicted by the analyst comes to pass and everyone wins.

Ultimately, the sell-side bias is countered by a desire for a good reputation. A firm that continually pushes low quality companies is quickly known as such. But a firm whose sales pitch actually turns out to be accurate generates loyalty from the buy-side customers.

Some Spectacular Sell Side Results

A state investigation of Merrill Lynch's stock analysts revealed that its analysts regularly used words like "crap," “junk," "disaster," and "dog" to privately describe stocks that Merrill recommended to their clients. The language appeared in subpoenaed emails, along with 100,000 pages of documents showing that Merrill Lynch encourages its analysts to give favorable stock recommendations. These favorable recommendations helped Merrill obtain more investment banking deals.

The company refused to admit misconduct, paid a nominal fine of $100 million (their approximate earnings for a single day) and in spite of the investigations, continued to see business soar.

The National Association of Securities Dealers (NASD) filed charges against top telecommunications analyst, Jack Grubman. The suit is in response to the increasingly strong evidence that Salomon Smith Barney "traded" favorable analyst reports for investment banking business.

Specifically, the NASD investigated evidence that indicates quite clearly that Mr. Grubman gave positive research reports on the communications company Winstar, despite the fact that the company was in serious financial trouble. These misleading reports artificially inflated the stock prices of Winstar and companies like it, damaging hundreds of investors.

In response to these claims, Citigroup Inc. has allocated $1.5 billion to cover legal related expenses, but nevertheless reported a net income for 2002 greater than any other company in the world.

''Not a bad performance when you consider what we had to face,'' said Citigroup CEO Sanford Weill to reporters.

Credit Suisse First Boston and Frank Quattrone

During the IPO (Initial Public Offering) boom, Credit Suisse First Boston was the top underwriter of technology IPOs. Under star tech banker Frank Quattrone, they underwrote $6.08 billion worth of IPOs on 62 separate issues. In 1999 and 2000, Credit Suisse First Boston earned more than $700 million in fees alone for helping bring technology companies public.

Investigators allege that Credit Suisse First Boston underwriters helped create a frenzy as to which favored customers would get access to the high tech IPOs. This deceptive hype inflated the after- market price paid by individual investors. Then, just as small investors were rushing in to buy the new stocks, insiders and favored customers were selling so that the small investors suffered huge losses when the stocks collapsed. It is also alleged that certain underwriters gained profits from the IPO boom not only through the bloated fees they charged for their services in making the companies IPOs, but also by conducting kickback schemes with their favored customers.

Most of the investors we work with describe themselves as “conservative.” If you agree with that assessment, you likely use it to express your feeling that it’s better to be safe than greedy in pursuing wealth. Care in selecting proper investments supersedes any attempt at market beating returns. Wealth preservation, in the form of spending power conservation, becomes the primary goal.

UPIA is a Guide for Conservative Investors

Academic and practical research over the last century has produced a body of knowledge that institutions use to deliver returns with safety. Such institutions include insurance companies, pensions and large trusts. These organizations have the responsibility to care for hundreds or thousands of beneficiaries by delivering steady income over long periods of time. You can use the same methods in your own portfolio. The rules and guidelines for the process have been codified in the Uniform Prudent Investor Act (UPIA) which is the legal standard for handling family wealth and small trusts. You can expect the highest level of service from your advisors if you treat your own retirement nest egg as if it were a trust.  In order to observe such care and to honor the wishes of a conservative investor, we have developed a methodology for financial planning not usually available to individuals.

3 Layers of Portfolio Management

You may choose a very high level of service and management that delivers three distinct layers of management when placing your money in the capital markets:

The first line experts choose the stocks in which to invest according to an Investment Policy Statement (IPS) that allows us to categorize their funds according to style (Large Cap, Small Cap, etc.). Within each of the fund styles, individual managers have the responsibility to diversify and monitor their own performance. Most individuals make the mistake of choosing funds based on performance reporting by companies such as Morningstar and Lipper.

The second line of managers are Certified Financial Analysts. They monitor performance according to AIMR standards and make sure that costs and fees are reported correctly as well. This management level is responsible for determining if there is excess return over the correctly attributed index, and whether any excess is due to luck or manager skill.

The Institutional Advantage

Porter Kickham monitors and maintains due diligence on the level 2 managers and provides a third layer of management by assigning assets to 13 different sub asset classes designed to exhibit covariance and to capture Equity Risk Premium across the globe.

These steps effectively eliminate some of the most common and most insidious obstacles to success when pursuing financial independence. When you consult with us, we’ll provide you with a plan that allows you to compare your choices with a variety of advisor services which include index investing with fee-only compensation.

You can miss a lot of important details if you insist on bottom line answers to everything in life. But with that risk in mind, it’s fair to say that consistent, inflation adjusted, lifelong income is the goal of retirement planning.

Although retirement planning is a holistic endeavor, your main concern is likely maintaining your present lifestyle without having to earn any more income. That’s the place to start. Logically then, the first task is to make a best guess at the income number you want to spend each year in order to calculate the kinds of returns you’ll need. If you have a great deal of wealth and few material needs, your requirements will be different from those who will plan to live an extravagant lifestyle for the next few decades. No matter which road you choose, it all starts with this number. The next constraint will be to make sure that this number is sustainable given the market volatility and the kind of wealth you've already acquired.

Retirement Spending Plan is the Place to Start

Surprisingly, few people have a written budget, although it’s easy to get one if you use one of the many inexpensive software packages available on the market. So while it’s likely that you don’t have your finances all together on a hard drive, you should consider how much time and money you’d save if you did. Tax preparation takes a few clicks of a mouse. You won’t wonder “where did all that money go?” And if anyone else has to help you with finances later on, when you may find yourself sick or disabled, the process will be much easier for your spouse or your children.

"Best Guess"  Retirement Income for Initial Planning

The next best thing to a written spending plan is to simply base retirement needs on current take home pay. Our objective is to see what’s needed in order to replace that. Before we accept that as a final number, we look at what payroll deductions are presently being made that may need to be replaced once you quit working. The most common issue is health insurance, but some people have things like Christmas clubs, which allow them to have lump sums at the end of the year. On the other hand, the payroll deductions that won’t be necessary anymore are those having to do with retirement savings.

What is an Annuity?

The popular press paints them as one of the greatest scams of the century. Yet, the growth in popularity and inflows has increased over the last ten years. When an investor uses the annuity contract correctly, he can avail himself of services and safety unavailable elsewhere.

Annuity contracts provide an agreement between you and a large institution, like an insurance company. In some cases, the company may promise you a lifetime of cash flow that you cannot outlive, subject to the insurance company’s solvency, of course. Additionally, other guarantees might provide you with life insurance and protection for your spouse. In some cases, the contract might afford you protection in the event of a nursing home stay and replace the need for a long term care policy.

Fixed Annuities Offer Guarantees

Fixed Annuities guarantee you a fixed rate of interest over a fixed period.
Annuity rates vary with macroeconomic factors and the best annuity rates may change quickly. Fixed contracts provide in the constancy of income stream. The risk lies in the threat of inflationary erosion of your spending power.

Equity Index Annuities Limit Losses and Gains

Equity Index Annuities provide an asymmetrical return agreement.
Based on the SP500 Index, you get paid either an interest rate near the current “risk free rate” level or you get paid an interest rate equal to the rise in the SP Index over a fixed period. However, if the index rises above a certain “ceiling”, you may not participate in further increase. Liquidity issues may decrease the effective return on your money, as some companies require an extended payout period in order for you to receive the full benefit possible with the contract.

Variable Annuities May be Least Understood and Most Complex

These agreements call for expertise on the part of the advisor in order to make the agreement an effective instrument for retirement planning, it’s most frequent use.

Variable Annuity Pros and Cons:

Liquidity may decrease to 10% per year during the “surrender period.” Penalties may apply on withdrawals greater than ten percent in any one year. Most retirees plan to withdraw 5% or less, so except for a severe emergency, this may not create an issue for a particular investor.

Commissions for these products are said to be high, however the insurance company pays the representative from its own funds, not yours. Management, mortality and expense fees range from 2.25 to as much as 4%, depending on the level of guarantees superimposed over the basic annuity vehicle.

Retirees May Defer Taxes

Investors don’t pay taxes on appreciation until the money is withdrawn and, at that time, may be in a different tax bracket than during their accumulation phase. However, the IRS treats the withdrawals as ordinary income, not as capital gains or dividend income.

The return on a variable annuity contract depends entirely on how your advisor constructs your annuity. Inordinate volatility may produce wild swings in value and available income. Too little return risks performance which does not preserve spending power over the next few decades. Your advisor must properly allocate the sub-accounts to reflect a Prudent asset allocation among equity benchmarks; he may not be qualified to do this. On the other hand, some annuity companies provide your advisor with analytical services that might cost over $100,000 per year if performed by a private party or smaller business.

In order to get the best variable annuity contract, you need to have a thorough analysis of the contract details, expenses, fees and services. Of the more than 1,400 annuity contracts available right now, we have found only a handful that provide enough service to make the costs low enough to compete with a fee-based arrangement.

Charitable Gift Annuities may make sense for investors who want to leave some of their estate to a charity or cause. Essentially, such contracts allow for an estate planning function to manage the value of your portfolio and the distribution plan. Many aspects of the annuity contract take care of certain estate planning functions, saving you the headache and expense of attorney’s fees as well as providing convenience for your benefactors.

Retirement planning  is complicated.  That's because most people don’t want to sit on a porch staring into the sunlight on Golden Pond.

Today’s 65 year old has lots of life left and that may be the root of several of the problems that you’ll encounter if you want to plan retirement for yourself in the face of a lump sum option from your pension plan.

#1  Ignoring Inflation

Ignoring inflation: Sure, you’re aware of inflation. While it had been silent for a number of years before 2000, the rising price of gas in the last half of 2008 brought the point home for everyone who had a car or had to get somewhere. Even if gas prices moderate, the point is that inflation is generally unstoppable. It’s the price of progress and it’s certain to be a part of the US government’s plan to reduce its growing debt.

If you are considering a pension payout that doesn’t grow with inflation, you’re taking a huge risk. If you have other  savings that do grow, and if your needs are very simple, the fixed amount may make some sense to you. If the monthly figure sounds pretty good, take away a third of it. That’s going to be the purchasing power you’ll have 10 years from now if inflation continues at 3%. In 15 years, it’s close to half as much. Does 50% of that figure sound good to you?

#2  Ignoring the Cost of Health Care

Most experts like to use 3% as an average figure for inflation. But averages are awful for real planning purposes. Consider that healthcare costs have risen more than 5% per year. All but the very healthiest retirees take several different prescriptions. That expense will likely continue to rise as will the cost of any type of doctor visit or surgical intervention. The lure of the monthly payout figure is that you ignore the fact that you’ll need more in later years, and if you have an emergency, you’ll not have access to larger sums.

#4  Underestimating Life Expectancy

This mistake is hard wired into your brain, so it’s difficult to see beyond it. In fact, you likely have several conflicting opinions about it. On the one hand, you know you’ll die. On the other hand, just like a teenager in the 1960’s who didn’t trust anyone over 30, you’re probably thinking that you’re unlikely to see 90. But if you’re 65 now, you have a 50% chance of living past 84. IF you’re married, one of you has a 50% chance of living past 90.

Tie this to the inflation issues we talked about in the last section, and you can see that making mistakes about both of these issues together can have bas consequences that add up quickly.

#5  Ignoring Early Retirement Subsidies

If you’re considering early retirement, your employer may throw in an offer to cover your health care needs until Medicare kicks in. You need to add this into the number. When you shop around for health care coverage, you may be surprised to find that the offer of insurance to a 50 something year old is worth over $10,000 per year.

Health insurance cost is probably the major stumbling block for most people who want to retire early. Given that they will have a few years before Medicare kicks in and before Social Security income starts, the burden prevents most people from quitting their jobs much before their early 60’s.

#6 Misunderstanding Annuity Guarantee Benefits

The monthly pension check form your company is guaranteed by the Pension benefit Guaranty Corporation. That’s a government sponsored entity that guarantees pension checks in case your company goes bankrupt or you plan runs into serious difficulties. Health plan benefits are not covered.

For 2009, the maximum guarantee on a single life plan is %4,500 per month. In order to see what the PBGC does not cover, go here.

There are some issues coming down the road for the PBGC if things go south in the economy for an extended period of time. The government does not fund the corporation; workers who have pension plans fund it. And the number of subscribers is dwindling. For a discussion of what the PBGC might face in the future, go here.

#7 Using Retail Investing Options

Planning for a nest egg to last for several decades in the face of changes, emergencies tragedies and new priorities represents a challenge for which you have no training. If you decide to take a lump sum payout, you’ll need professional help investing it.

Trading stocks is not so easy that a baby in a high chair can do it. “The face of the independent investor” is often wrinkled and frowning.  Get professional help. No matter what you see on television, DON’T TRY THIS AT HOME.

Use a Certified Financial Planner. These men and women have spent years to get their marks and likely have many years of experience handling just the obstacles that are new to you.