Financial Literacy Test for Retiring Couples

 Answer Key

1. The correct answer is B. Only 38% of survey respondents answered this question correctly. This question reflects the 4% safe withdrawal rule that has been highly publicized and discussed in the press. The 4% rule is based on research that looks back at investment returns in the 20th century in the U.S. The research indicates that if you retire with $1,000,000, you could afford to take a withdrawal of $40,000 (4%) in the first year of retirement, increase it for inflation each year, and sustain that income stream for 30 years. The rule is good to know as it begins to help retirees understand how much can be safely withdrawn each year. It dispels the common misunderstanding that if the average return on the portfolio was 7%-8% then that amount can be withdrawn each year. Because of the ups and downs of the market, the sustainable withdrawal amount is much less than the average return on the portfolio. The rule also is a quick way to get a sense of just how much income can be provided by a lump sum amount. For example, $1,000,000 under this rule only generates $40,000 of inflation-adjusted income. The research is based on historical returns and many question whether it is sustainable going forward. It is also just one of many factors that should be considered in determining how much can be withdrawn in retirement.

2. The correct answer is A. Only 45% of survey respondents answered this question correctly. A life annuity pays the annuitant for as long as he or she lives. Taking a portion of a portfolio and purchasing an annuity ensures that even if the portfolio is depleted, the annuity will continue to pay out monthly benefits. Deferring Social Security benefits to 70 (which increases the annuity payments) and electing a life annuity option with a pension at work are other ways to increase guaranteed lifetime income.

3. The correct answer is B. Only 34% of survey respondents answered this question correctly. The timing of good/bad investment returns does matter, and this is one of the uncertainties faced in retirement. This risk is referred to as sequence of returns risk. Significant negative returns occurring at or near retirement have a much bigger impact on whether portfolio withdrawals will be sustainable throughout retirement than if they occur well before or well after the retirement date. The primary strategy for addressing this risk is to reduce portfolio risk—especially during the 5-year period prior to and after retirement. Reducing risk can mean reducing the allocation to stocks and moving more toward bonds, or buying deferred income annuities that start at or after retirement begins.

4. The correct answer is B. Only 14% of survey respondents answered this question correctly. One of the most popular annuity options today when purchased at a younger age to accumulate assets for retirement is the deferred variable annuity with guaranteed lifetime withdrawal benefits. This is a complex product, and unfortunately some who own it do not fully understand its terms. The product combines the opportunity to benefit from the returns on the underlying investment choices, while the guarantee provides minimum income payments for a single or joint life (for a couple) in case the policy underperforms. The guarantee is a specific payment based on contract terms (this is why A is incorrect). B is correct as the guarantee ensures lifetime payments even when the investment account is depleted. C is incorrect as the investment account will vary depending upon investment performance. D is incorrect as investment alternatives will include both equities and fixed income investments.

5. The correct answer is D. 84% of survey respondents answered this question correctly. Minimum distributions must be made from an IRA for the year in which a participant attains age 70½. However, the first distribution can actually be deferred to the following April 1st. It is important to understand these rules as failure to meet the required minimum distribution rules can result in a penalty of 50% of the amount that was supposed to be distributed!

6. The correct answer is A. 64% of survey respondents answered this question correctly. All distributions from a Roth IRA for an individual who is at least age 59½ and has had the account for 5 years will be tax-free.

7. The correct answer is A. 59% of survey respondents answered this question correctly. There is some disagreement about how well stock investments protect an investor from inflation. But as compared to traditional bonds and CDs there is little disagreement that stock investments are superior. Another option is Government bonds called Treasury Inflation-Protected Securities (TIPS).

8. The correct answer is D. Only 18% of survey respondents answered this question correctly. This fact points out that the majority of Americans will need long-term care at some point in their lives. The odds are so high—everyone needs to consider that this is an issue that is likely to affect them.

9. The correct answer is B. 59% of survey respondents answered this question correctly. Many people are not aware that Medicare does not typically pay for costs of nursing care. There is an exception for those needing skilled nursing care after a 3-day (or longer) stay in a hospital. In this case, skilled nursing care may be provided for up to 100 days.

10. The correct answer is A. Only 34% of survey respondents answered this question correctly. Investors often think of bonds as low-risk investments. They forget that the value of bonds varies depending upon the relationship between the interest rate paid by the bonds and the interest rates available in the market. When interest rates are rising, the market is offering higher interest rates on new bonds than the existing bond holdings, reducing the value of the existing bonds. In retirement income planning, sometimes individual bonds are purchased to provide income needs. If the interest and principal of the bond is going to be spent to meet income needs, the price variation of the bond is less important. In this case, what is more important is that bonds can provide specific income with certainty for a predictable cost.

11. The correct answer is C. Only 10% of survey respondents answered this question correctly. Small company stock funds carry more risk, which means that performance varies a lot from year to year. But on average, to compensate for that risk, returns are generally higher. From 1926 through 2012, small-cap stocks averaged an annual return of 12.28% compared to 10.08% for large cap, according to Morningstar Ibbotson data.

12. The correct answer is A. 58% of survey respondents answered this question correctly. Price to earnings is one of those indicators that investors keep a close watch on as it is an indication of whether the stock is a good value.

13. The correct answer is C. 55% of survey respondents answered this question correctly. One factor in determining when to choose Social Security benefits is life expectancy because this affects total benefits provided under the system. Delaying to age 70 is a good idea if the higher benefit is paid for a long time, as in this case. This is tricky though, as most people do not know how long they will live. And for a married couple, the larger benefit is paid for the joint lifetime—so the couple’s joint life expectancy should be considered when thinking about this question. Another way to look at the claiming question is how you can improve your retirement security. Deferring Social Security can do this as deferring “buys” more lifetime income that will receive inflation protection.

14. The correct answer is A. Only 43% of survey respondents answered this question correctly. Choosing the life annuity provides a specified benefit amount for life, essentially guaranteeing income to meet basic needs. On the flipside, it eliminates the possibility of growth in income, flexibility to change strategies, or leaving the asset to children. The annuity provides certainty and simplicity. Even though the lump sum may better meet these other goals, it presupposes that the retiree has the skill to make the right investment decisions and understands all the factors relevant in choosing how much can be withdrawn each year.

Important Disclosures For This Content

It is important to understand that everyone’s situation is unique and not all strategies and methods mentioned in this book may be appropriate or suitable for every individual. We suggest that you consult fully with your financial, tax, and legal advisors on pursuing a strategy that is uniquely tailored to your particular needs.

All information included is from sources believed to be accurate as of the writing of this book. Please conduct your own long-term care insurance planning review with qualified professionals before making your own decisions. Not everyone will qualify for insurance-based products, such as long-term care and life insurance. The cost of these products is in part a function of your individual health profile.