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Managing wealth with professional strategies The Decision Decade A funny thing happens in many households a few years before retirement. Money appears! It’s a perfect storm of sorts as one or more of the following happy milestones is reached: The nest is finally empty. The mortgage is paid off. College tuition is done. The last wedding bell has rung. This harmonic convergence of final payments can result in a seeming jackpot of additional cash flow – the well-deserved payoff for all those years of financial and familial responsibility. With perhaps tens of thousands of extra discretionary dollars in hand, even the most frugal saver may be tempted by big-ticket purchases. And those fifty-somethings who resist the urge for an Audi TT (or a three week summer getaway to Provence or a second home in the mountains, or, or…) may respond to the extra cash in another way: retiring earlier. Splurge or save? Retire early or go the distance? These are two of several important choices that comprise the Decision Decade – the five years or so before and after officially retiring. While it may not seem so at the time, the financial and lifestyle decisions made through this key period can deeply influence the quality of retirement that follows. In our two previous articles we examined the basic math of retirement – how much should be in savings and investments to fund a full and satisfying time of financial independence – and the fundamentals of smart investing. In this third piece to the puzzle, we explore the Decision Decade, with an eye on making smart choices at the end of one’s career and during the first stages of retirement. So many choices; so much time
Like most decisions, these have no magic answers that perfectly apply in all situations and for all people. However, it’s important to recognize that any choice has consequences, and the consequences of these particular decisions can be dramatic and long-lasting. Let’s take a look at each. Spend or save? But is this kind of spending a smart choice? This is a math problem that can only be reliably solved by projecting cash flows needed for retirement and comparing them to projected sources of income once the paychecks end. As we’ve discussed in previous articles, few people take the time to make these projections, and the few who do are generally surprised by the numbers, and not in a positive way. Like it or not, maintaining a comfortable lifestyle through a long retirement is expensive. Furthermore, even modest contributions to investment accounts can grow into serious money over several decades. Let’s assume there’s $20,000 of extra discretionary income available each year starting at age 55. While it would not be difficult to exhaust that cash with a few choice purchases, investing it for retirement could generate a windfall when it is needed most, twenty or thirty years down the road. Stashing away the surplus each year until age 60 ($100,000 total) and achieving an annual return of 5% more than the inflation rate would produce approximately $290,000 at age 80, when other savings may be running low. Continuing this practice another five year, to age 65, generates more than $520,000 by age 80, enough to fund another 10-20 years of comfortable retirement. The power of compounding is, inevitably, too powerful to ignore when pondering the splurge versus save decision. Retire early? Retiring early works counter to this goal at both ends of the equation – prematurely ending deposits into the top of the bucket and simultaneously starting the relentless drip. Adding five or more years to retirement spending, while cutting off new savings at likely the highest earning stage of one’s career is not a decision to be made lightly. To allow this move, many must accelerate savings through the earlier career years, accept a lower standard of living in retirement or supplement income through a new career in retirement. Social Security starting when? Determining whether to take smaller payments, and more of them, or fewer, larger payments is an optimization problem that can only be solved correctly when one’s age at death is known. Of course, few people know this important data point at the time when they must decide whether to take or defer Social Security payments. Life expectancy charts only provide averages – meaning almost all individuals live longer or less long than the number on the chart. Most of our clients have planned and invested sufficiently that Social Security acts only as a mild supplement to portfolio income. With this in mind, we generally advise clients to start collecting payments as soon after retirement as possible and investing the proceeds rather than gambling on a longer than average life expectancy. We will be pleased to review and explain your choices as they approach. What can we withdraw? This four percent figure is a helpful guide in determining how much money must be in one’s portfolio at retirement. A couple needing $40,000 from savings during each year of retirement needs $1 million at the start of retirement to withstand four percent annual withdrawals to keep up with inflation. Decisions are cumulative Proof in numbers The following chart shows when the money runs out based on three possible courses of action:
 (assumes 3% inflation and 8% annual return) As the chart demonstrates, the results vary widely based on the couple’s Decision Decade choices:
It is interesting to note that spending the extra $20,000 each year for five years results in a zero balance ten years sooner than the no-splurge option (comparing yellow to pink). Individual answers Regardless of the specific choices made, knowledge and forethought in this area are invaluable. We look forward to discussing your own Decision Decade at your convenience. These discussions can be particularly valuable for individuals who have considerable time before retirement, as understanding the variables well in advance facilitates positive lifelong saving and investing habits.
Funding a Comfortable Retirement In our earlier article, Understanding the Math of Retirement Planning: Find your “turn around point” and other key measures, we used a simple metaphor for the finances of retirement. We describe a bucket, with savings going in the top and retirement expenses dripping out the bottom. Based on this framework, successful planning means sufficiently filling the bucket so that a long and happy retirement never runs the bucket completely dry. In this follow-up article, we explore the savings and investment process – the steps necessary to fill the bucket to the top. As discussed in the previous article, sources of retirement cash flow may include pensions, Social Security and real estate, but here we will focus on the funding source where the individual has the greatest control – the long-term accumulation of assets through savings and investment. Simple, yet challenging Let’s consider the central tenets of smart investing. While most of these ideas will sound familiar, we find that few investors consistently follow all of them. Invest early and often The practical importance of early and frequent contributions can’t be ignored. As Table 1 indicates, workers who make even modest contributions through their 20’s, 30’s and 40’s gain a formidable advantage on those who wait until the end of their careers to get serious about retirement investing. Getting an early start is one of the easiest steps in retirement investing.
(1) All returns are annualized and not guaranteed. Accept the advantage Spread the wealth We all diversify in other aspects of life. For transportation we use not only shoes, but also bikes, cars, trains and airplanes. Our diets include carbohydrates, fat and protein. A balanced investment diet is critical as well. A well-formed portfolio includes allocations to domestic equities, fixed income, foreign equities, emerging market equities and real estate. By investing in these distinct asset classes, investors benefit from upward moves in a variety of market and economic conditions, and are protected from severe losses when individual classes fall. The result over many years is improved total return with less volatility. The importance of diversification is well-documented; one of the most often quoted research findings is that asset allocation has a much greater impact on investment results than selection of investments within each class. This is the core of Modern Portfolio Theory, generally considered the most important advance in investing of the last century. Nonetheless, most investor portfolios are concentrated in US large cap stocks. Some investors also hold treasury bonds or limited positions in foreign securities. But very few portfolios include intentional allocations to all core asset classes. Why is asset allocation so important for individual investors? Wouldn’t it be more advantageous to concentrate investments in asset classes most likely to outperform other classes? Yes, it surely would…if one could only predict which classes would outperform. Chart 1 below, which ranks the recent performance of various asset classes, indicates just how difficult that task is. The checkerboard pattern proves that performance is essentially random. Even the most experienced security analysts and economists cannot reliably predict which classes will lead the pack. For individual investors the effort is doomed to fail. Chart 1
Stay in balance These changes can severely alter the diversification characteristics of a portfolio. A surge in foreign equity markets, for instance, could increase the concentration in that class from 20% to 30% of portfolio value. Failing to rebalance allocations in this case would leave the investor overexposed to foreign stock performance and underexposed to opportunities in other classes. Rebalancing is necessary to bring the allocations back in line. A disciplined rebalancing strategy keeps a portfolio healthy. But for many investors, it is a counter-intuitive approach to managing a portfolio. It means selling securities that are doing well and buying more of underachievers. It’s selling high and buying low, which is hard to argue with, but human instinct often tells us to do the opposite – invest more in classes that have done the best and abandon weaker classes. As a result, many investors are slow to rebalance or avoid it altogether. Failure to rebalance robs the investor of the full advantages of diversification, and ultimately hinders the risk/return characteristics of the portfolio. Control costs The investment industry does a good job of obscuring the impact of costs. Most mutual fund investors, for example, have no idea how much investment return is sacrificed to expenses each year. The growth of index funds, which have much lower costs than actively managed funds, indicates greater awareness in this area, but the problem persists. The bottom line is clear: one percent is something to worry about. As Table 1 indicates, the difference between an 8 percent annual return and 9 percent over 30 years is more than $26,000 per $1,000 annual investment. Rigorous control of costs is essential. Don’t try too hard Passive investment, which tracks, rather than attempting to beat, benchmarks, wins for two main reasons. First, expenses. By minimizing management fees, and by eliminating the transaction costs of “strategically” buying and selling securities, a precious percentage point or two is saved each year. Secondly, picking winning securities is just plain difficult. The clearest evidence of this is the rarity of actively managed funds beating benchmarks year after year. A huge year is typically followed by weakness. Trying to beat the averages is statistically proven to be a losing proposition. But the good news is that more and more investment vehicles are available that track the benchmarks with very little lost to expenses. Even real estate is now widely indexed, making it possible for individuals to allocate a portion of assets to diversified real estate investments. Lessons for investors
While the fundamentals of smart investing are, for the most part, easy to understand, applying them on a do-it-yourself basis is hard work. Setting appropriate asset allocations demands a strong understanding of asset classes, and an honest appraisal of personal goals and constraints. Minimizing the impact of taxes requires knowledge of constantly changing tax codes. Finding high quality, low cost investments takes time and research. Rebalancing demands attention and discipline. We are well prepared to help investors create and execute an investment plan that maximizes the opportunity for a comfortable retirement. Our approach is centered on the investor’s long-term goals, never on the day-to-day or hour-by-hour fluctuations of the market. As always, we remind our clients that filling the retirement bucket takes a long time, so we encourage you to begin the process right away. © Mark Smith, 2006 – Understanding the Math of Retirement Planning The English language provides us a vocabulary of a quarter million words, give or take. But we really only have one word for “retirement.” It’s not nearly enough. The days of the stereotypical rocking chair retirement, if they ever existed, are long gone. Retirements now come in every imaginable shade of gray, red, yellow and green. Some people happily abandon the working world at 55; others continue to work in some form until the day they die. Some dive headlong into golf, travel, volunteer work or artistic expression; others are content to hang out with grandkids. Some thrive for decades; others struggle with illness – their own or a spouse’s. Because retirement years can be spent in so many different ways, making concrete financial plans is complicated, demanding a careful look at many choices and variables. How much money will I need? When can I afford to retire? How should I invest my savings to generate the cash I will need after the last paycheck clears? Inevitably, it’s a lot of questions, and a fair amount of math. To be sure, the math of retirement planning is complex and intimidating. Nonetheless, breaking down the issues and understanding how the math works are important first steps in creating rationale, achievable financial strategies. The material that follows explores many of the key issues of retirement planning. It is not intended to answer every question on the subject, but to introduce the most important planning elements. We look forward to discussing any of this material with you as you consider your own retirement options and preparations. Money in; money out
How much cash flow will I need at retirement? Through our experience working with clients of varied income levels, we encourage plans that aim to generate 100 percent of pre-retirement spending levels. So a couple spending $100,000 in the years leading up to retirement should plan to generate that same $100,000 each year to support a healthy and happy retirement. This figure must be adjusted for one very important variable – inflation. Even small annual inflation rates result in huge changes in what a dollar will buy over a 20-40 year retirement. For instance, a three percent annual inflation rate means that $100,000 of expenses in the first year of retirement would cost $243,000 in the thirtieth year of retirement. This assumes that all of expenses grow at the same rate, which we know is not true. Reliably predicting the individual inflation rates for various expense categories is impossible, nonetheless, we must include reasonable assumptions about inflation as we forecast cash flow needs. Should I self-insure? So some medical costs, potentially huge sums, must be paid out-of-pocket by retirees or be covered through insurance premiums. In particular, prescription costs and long term care costs should be factored into the analysis of cash flow requirements – either as fairly predictable insurance payments, or as potentially large and unpredictable outlays. We advocate insuring against risks that cannot otherwise be managed and suggest that potential health care costs be thoughtfully examined as retirement expenses are evaluated. How long will retirement last? In general, each generation lives longer than the one that precedes it. Life expectancy at birth in 1950 was 66 for males and 71 for females. By 2002, these figures had increased to 74 and 80, respectively2. And life expectancy changes with age as well. For example, additional life expectancy for a person who reaches age 65 is 16 years for males and 19 years for females. This means that at birth, males have a life expectancy of 74. However, if they reach age 65, life expectancy increases to 81, an increase of seven years. For couples, of course, the relevant life expectancy is that of the “second-to-die,” which is greater than it is for either separately. Of course, all of these figures are actuarial averages. How long each individual lives depends on medical history, risk factors and imponderables such as accidents. And making financial plans based on the average is very dangerous – because 50% of a given population lives longer than the average. A more prudent planning horizon is the life expectancy of the “top 20%” – the 20% of the population that lives the longest. Planning for this best-case outcome means only a one-in-five chance of outliving one’s assets. The table below, using data from a 2004 report from the Center for Disease Control, indicates the additional life expectancy for the top 20% after reaching various ages between 55 and 70.
The data shows, for example, that a 70 year-old female has a one-in-five chance of surviving 23 years or more. Stated in the negative, 80% of females who reach 70 will die before they reach the age of 93. While many factors affect longevity, we recommend that financial plans be made based on optimistic life expectancy projections such as the top 20% data discussed above. How will I pay for retirement? Financial assets typically derive from some or all of these sources:
Let’s consider these individually: Employer provided pension plans or “defined benefit” plans, provide a monthly payment over some or all of one’s retirement. Once the crux of retirement financing, these plans are increasingly rare, and some pension funds are collapsing before fulfilling their promised payments. When they operate properly, the employer funds an account based upon a promised percentage of past wages. Then, at retirement, the retiree selects a payment period – either a fixed period or for life. If the retiree passes away, payments to the spouse can continue at some decreased rate. As the stability of these plans has become a major concern, any future pension holder should learn as much as possible about the mechanics and financial soundness of the employer’s plan to determine the expected cash flows from this asset. Employee defined contribution plans include typical 401k and profit sharing plans. With these, the employee is responsible for selecting contribution amounts and investment directions. Some employers match employee contributions. In these plans, there are no guaranteed benefits, only a payout of accumulated assets upon request or as a rollover to an IRA. These plans typically offer investment options that vary widely in risk and expected return, so investment decisions should be made carefully. Ideally risk levels should decline as retirement approaches, but must be high enough in earlier years to allow higher average returns. Real estate may include the family residence and/or rental properties. Selling the family residence and downsizing to a simpler residence suits many retirees. For others, a reverse mortgage can produce liquidity to fund retirement. Rental properties can be liquidated at retirement, or can be a source of fairly predictable free cash flows. Business assets can be quite volatile, both emotionally and financially. Business cycles, changing technologies and changes in management can dramatically influence the operating income and ultimate value of a business. When an entrepreneur retires, it cannot be assumed that the business will continue to thrive and produce the same level of income to the owner. Likewise, selling a business can be a long and complicated process, one that may or may not yield the proceeds that the seller might expect. And passing a business on to another generation is risky as well. Studies indicate that only 35 percent succeed in the next generation3. We encourage that business assets be evaluated conservatively. Social Security remains in the headlines today, with a future that is anything but certain. We recommend that individuals planning for retirement remember that Social Security was always meant to be a supplement, not the full means of retirement funding. We expect it will continue as a reliable supplement for individuals now in their 50’s. The picture is less clear for younger workers. Inheritance can lighten the financial burden in some families. In very affluent families or those that have clearly established trust funds, inherited wealth can be included in financial projections. In all other cases, we recommend that individuals discount or exclude expected inheritance proceeds from retirement planning calculations. Many factors can put an inheritance at risk, so we suggest that it not be relied upon until the assets are actually received. Savings and investment returns comprise the category where individuals exert the most control. Funds from this source depend on individual decisions – spending/savings levels and investment decisions – and on the investment markets. We’ll take a much closer look at investment decisions shortly. How much do I need to generate through investments?
If this retiree forecasts cash flow needs of $100,000 per year, that leaves a $40,000 burden that must be supported by withdrawal of savings and investments. Using this $40,000 figure, we can estimate the size of the investment account needed to support withdrawals of this size. Assuming a 4% annual withdrawal, the investment account should hold $1,000,000 at the start of the retirement. While not guaranteed, there is a high probability that this sum, properly invested, would continue to provide $40,000 per year (adjusted for inflation) for 30 years. In this simplified example, the turn around point – the moment when assets are sufficient to support the desired retirement without continuing to work – is the time at which investments equal $1,000,000 and the expected retirement length is 30 years. Obviously, this turnaround point is based on a number of assumptions that should be carefully made and periodically re-evaluated. For instance, if retirement should continue for more than 30 years for one or both spouses, or if the withdrawal rate increases, it is likely that investments will be depleted more quickly. If actual pension or Social Security benefits fall short of expectations, retirees must replace that income with additional savings. And if investments return lower than historically-predicted returns, savings will last for fewer years. What does this all mean for me? We encourage individuals to start playing with the numbers as early in their careers as possible. Projecting cash flows needs in retirement and evaluating investment strategies of varying risk and return characteristics clarify the important variables that will ultimately dictate the standard of living that can be enjoyed during retirement. True, a variety of assumptions must be made to predict a turn around point. This uncertainty may discourage some people from beginning the process. In our view, the uncertainty is exactly why becoming familiar with the relevant variables – as early as possible – is so important. The better the understanding of the variables, the greater the opportunity to create an effective retirement plan. We are happy to help you explore these important issues and share the sophisticated planning tools now available. The first step into this arena is the hardest, but the most important. “A vision of retirement without action in merely a dream What are you going to do? 1 Benchmarking Retirement Income Needs, AON Consulting and Georgia State University. ©Mark Smith, 2006 – Solutions for Wealth Management, LLC
1605 N. Convent Bourbonnais, IL 60914 Phone (815) 935-6636 Fax (815) 935-0360
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