I recently attended the Garrett Planning Network conference near Denver, CO.  What a nice break from the Texas summer heat!  One of the sessions highlighted an issue many of us are dealing with right now: frame of reference risk.  

We usually think of investing risks as external events that could impact performance.  But frame of reference risk refers to the possible negative impact on investing performance of something we might do to ourselves!

Think about what your frame of reference is.  For most of is, it's the US stock market.  It's the Dow Jones or the S&P 500.   But then think about what's in your portfolio.  Hopefully, it's a lot more diversified than just the US stock market.

When the US stock market is doing poorly (like during 2007 - 2008 or the early 2000s), you're really happy to be diversified.  You're hearing horrible reports on the news about how the Dow is down 10%, 20%, or more. You're looking at your portfolio, and it's down, but not that much.  So you feel wise, and you're happy to commiserate with your friends about the market's performance and your diversification strategy.

But now think about what we've been living through over the last 6 years. Or in the second half of the 1990s.  The US stock market has been going gang-busters.  US stocks were the top performing developed market country for the last 2 years in a row.  And how is your diversified portfolio doing now?  Less well.  If it includes some bonds, some international stocks, and possibly some other diversifiers, those holdings have been a drag on your performance.  So when you hear another stellar report about the the S&P 500 or the Dow, you feel a little sheepish.  It's one thing to have your diversified portfolio under-perform for 1 year or 2 years, but when it becomes multiple years in row, it becomes a little hard to take.

And this is what frame of reference risk is.

It's the risk that we might abandon our diversified portfolio strategy at exactly the wrong time because we just can't stand to not do as well as the benchmark against which we're judging ourselves.  It's human nature to compare.  And human nature to want to act on that comparison.

But this is a time when we need to let science and history be our guide.  Remember back to those that abandoned their diversified strategy in the late 1990s and went all-in to US stock just before the dot-com bubble burst.  Their portfolios were massively damaged.  

So we need to be aware of our own frame of reference and how it can be a risk to our portfolio.  And the next time you're tempted to make a change in your portfolio because the US stock market is doing better than one of the laggards in your holdings list, remember that staying diversified over the long term is the best way to manage risk and protect yourself against market downturns.  You will not usually make the most money in any year, but over time you will enable your portfolio to best support your financial goals by sticking with your strategy.

As life expectancies increase, longevity risk--the risk of outliving retirement savings--is a concern for a growing number of people. In response, recent federal regulations created qualified longevity annuity contracts (QLACs), which are accessible through employer-sponsored plans, such as 401(k)s and IRAs.

 

What is a QLAC?

  

A QLAC is a type of longevity annuity that is held in an employer-sponsored plan such as a 401(k), 457(b), or 403(b) plan, and in IRAs. The premium paid to a QLAC is held for a number of years until distributions begin later in life, such as age 80. There are specific requirements and restrictions that apply to QLACs, including:

• The QLAC must generally be payable over the retiree's lifetime or over the lifetimes of the retiree and a beneficiary, and the interval between payments can be no longer than one year
• The QLAC must provide that payments begin no later than the first day of the month following the participant's 85th birthday, although an earlier starting age may be selected
• No more than 25% of any individual plan account balance may be allocated to a QLAC (including the value of the QLAC), and the value of all the retiree's IRAs are treated as a single plan for purposes of applying the percentage limit
• The total amount of all QLAC premiums paid by all retirement plans and IRAs over the participant's lifetime may not exceed $125,000, adjusted for cost-of-living increases, although inadvertent overfunding can be remedied if done in a timely manner
• QLACs may not include "cash out" or surrender provisions, and a QLAC may not be a variable annuity or an indexed annuity, nor can a QLAC be held in a defined benefit (pension) plan, Roth IRA, or Roth 401(k)

Potential QLAC benefits

• QLAC balances during deferral are not included in calculating RMDs, reducing the amount of required distributions and the income tax bite associated with those distributions
• The amount and starting date of future QLAC distributions is predetermined, allowing a retiree to more accurately calculate how long income from retirement savings may need to last
• A QLAC may provide cost-of-living adjustments to potentially increase the income stream
• A QLAC death benefit may include a return of premium

Potential QLAC drawbacks

• QLACs are not liquid, have no cash surrender value, are generally irrevocable, and are not subject to growth potential during deferral years
• Retirement plan sponsors may not allow for the purchase of a QLAC within their retirement plan
• Funding a QLAC with a portion of a retirement account reduces the account balance available to provide income during the years before the QLAC distributions begin
• No payments will be made to a QLAC beneficiary if the annuitant dies before the payment start date, unless the contract owner has purchased an optional death benefit