A Secure Retirement Are you presently on target to retire safely? Are adjustments to your savings and investment strategies, large or small, required? In order for retirement minded consumers to avoid becoming another statistic amongst mistake plagued retirement strategies, a new perspective must be embraced. In a world where even the most seasoned pros lose money, consumers need to put themselves in a position to retire safely. Those who take the time to get a feel for the issues surrounding their retirement savings will have a much better chance of arriving at retirement safely. Generally speaking, some advisors may not be in tune with the needs of more moderate investors or savers, who are placing a bulls-eye on the goal of arriving at retirement safely. That sounds a bit odd with all of the attention being paid to baby boomers. How could those in the business of advising others about their finances, not be in tune with the needs of more moderate investors or savers? The “Educational Disclosure for the Consumer, Regarding Investing and Saving for Retirement”, is the name of our consumer protection model, and as you will see, it will bring relevant factors to the surface. This process will allow the consumer and the advisor to jointly view retirement issues with greater clarity. Such education and disclosure may have both fortunate and unfortunate consequences, as such clarity may leave those you trust feeling exposed, and a bit uncomfortable. Why? Because the recommendations of an advisor, a person you trust, may appear to be ill conceived, when applied to a consumer protection model. This consumer protection model takes the following seven elements into consideration: 1) Stock market risk, 2) retirement time horizons, 3) costs and fees, 4) simple, compound, and triple compounding of interest 5) “the practical math associated with investing”, 6) taxation of social security benefits, 7) and how all of these issues affect retirement income. Let's take a look at stock market risk first. If investor “A” buys low and sells high, making a profit, it must be understood that another investor is probably buying high, only to sell at a lower price in the future. Hence investor “A” is making a profit at the expense of investor “B”, because that is how it works. This occurs when investors buy individual stocks, bonds, mutual funds, or other investments. No one has a crystal ball, so we really don’t know what will happen in the stock market at any particular time in the future. Consequently, how can we possibly know who will be investor “A” or investor “B”? In regard to market risk, perhaps, we should concern ourselves less with making money in the market, as it is more important to understand what it means to lose money in the market, especially if you are mature in years. As we examine the issues, it is critical to tie the first four elements of our consumer protection model into the first half of our discussion: market risk, time horizons, costs and fees, and the practical math associated with investing. To illustrate this concept, we will provide an example that is sure to make you think. Pretend you invest $100,000 in the stock market. Next, presume that you suffer a 10% loss in the underlying stocks that make up your retirement portfolio, and that the average expense, cost, fees, etc, adds up to 3%. Your account is now down a total of 13%, thus you now have $87,000. Just to catch up and get back to your original $100,000, you will need a return of 17.94% the next year. Pretend you are lucky enough to get a 17.94% in your market sensitive investment the very next year, and now you are back to $100,000. I am going to throw you for a loop. What if you had a friend who had placed their savings in a fixed vehicle paying 5% interest? After 3 years, they would have $115,696. Assuming that your market sensitive investment has overall costs, expenses, fees, etc, adding up to 3%, what would your portfolio need in terms of a market return in the third year, to catch up to your friend? Would you believe 18.76%? Remember that market sensitive investments such as mutual funds, variable annuities, and professionally managed stock portfolios, have expenses, costs, and fees. In our example, the average costs, expenses, fees, etc, added up to 3%. So in our example, after expenses, when the market return was hypothetically 18.76%, you would keep only 15.76% of that lucky 18.76% of portfolio return in year #3, because you must consider the costs of being invested in the stock market. Consider, that you do not have to look very far to find a financial professional, a columnist, or an analyst, who speaks of “speed bumps ahead and even a correction of 10% or more”, at any particular time (Forbes February 12th, 2007: “Good, Not Great”, David Dreman). The critical point is that 10% losses in particular investments, or market indexes, are real. Now, what about the costs and fees we discuss here? Do not be so quick to think these fees are too high, that we are exaggerating, or that 3% is not legitimate. The average mutual fund is said to carry expenses averaging approximately 2%, in disclosed fees. Undisclosed costs, fees, and expenses, may bring that average higher. Variable annuities (market sensitive investments, not to be confused with fixed annuities), have disclosed fees ranging from approximately 2.25% to approximately 3% or higher. When one takes into account bid-ask spreads, or other costs within the “separate accounts”, this may bring the costs associated with this particular market sensitive investment even higher. This is an example of “the practical math associated with investing. If your portfolio loses 10% the first year, and you had costs, fees, expenses of approximately 3%, you need a 17.94% return in year 2 to get back to your original principal. Furthermore, to keep up with a simple 5% return, you will need an additional 18.76% return the in the third year! Say this aloud to yourself: “If my portfolio loses 10%, I will need 17.94% in the second year to get back to my original investment. Furthermore, to keep up with a simple, safe, 5% interest rate, I will need an 18.76% return in the third year”. We make these points in an attempt to help consumers be honest with themselves, when it comes to market sensitive investments. When an advisor utilizes this consumer protection model, they are promoting an individual’s responsibility when it comes to saving and investing for retirement. Time horizons are a simpler issue to discuss. As we grow older, generally speaking, more of our money needs to be in conservative, safer, investments or savings products. Be careful here, because a strict stock market oriented advisor may use a formula which has been developed by a stock market oriented industry. Many advisors have been trained to use “100 minus your age”, as a method of determining the net sum of your assets that should be in stocks, the remaining balance placed in something more conservative, perhaps in bonds. Today the industry has changed that formula, and routinely uses “120 minus your age”. This formula is now in vogue. Relative to one’s age and time horizon for investing and saving for retirement, do you believe there is a better way to figure out how much money you should invest in the stock market, versus how much money you should have in safer, savings products? Are you presently on target to retire safely? Consider the following exercise, or click here to contact me, and I will run the calculations for you. Step #1 – Write down how much money you have accumulated thus far. Step #2 -Separate IRA, Pension, and any other qualified savings plans (savings that are pre-tax, or have not yet been taxed), from your non qualified savings (savings that are post tax or have already been taxed). Step #3 -Write down the number of years you expect to continue working. Step #4 – Write down the amount of your annual contributions, including the employer-match portion of retirement savings, again separating your qualified versus your non- qualified savings. If you are no longer working, there are no contributions and no employer match. Step #5 -Write down your hypothetical, or estimated rate of return, 5, 6, 7, 8% etc, you would presume to be earning on your money. You now have enough information to figure out approximately how much money you will have when you retire, in both qualified and non-qualified accounts. Knowing how much money has accumulated in qualified versus non-qualified accounts is important when it comes time for distributions or monthly income. Step #6 -How much will you need in retirement? First, you must consider how much money you spend today. No one knows for sure, as this is not an exact science, but most financial advisors believe that you will need somewhere between 80% and 100% of your current income in retirement. For example, if you need $4,000 a month today to cover your living expenses, you will need approximately $3,200 to $4,000 when you retire. Step #7 -The next thing you need to do is factor in rises in the cost of living, the impact inflation will have on your monthly expenses. So, if you were to retire five years from now and factor in 3% inflation, you will need between $38,400 and $48,000 to cover your living expenses for the year. Each and every year thereafter, you should factor in an increase in the cost of living, hence, an increase in your annual living expenses. The point is, if your annual living expenses are presently $40,000, and inflation is averaging 3%, 10 years from now you will need $53,756. Do not let these numbers scare you. Keep in mind that a thorough look at retirement budgets may reveal significant changes in expenses. You may or may not have a mortgage. You may spend less in many areas. However, you may be likely to incur greater medical expenses. Aside from these budget changes, one thing is likely to be constant -inflation. After inflation, your nest egg is affected by taxes, the costs of managing your savings and/or investments, alongside the safety of your investments. You should know that two of the most important factors affecting retiree's savings are #1-safety and #2-cost. Step #8 - After you are finished with all of your calculations, where do you stand? Are you on target? Do you have a surplus? Do you have a deficit? If you are dead on, meaning that you are expected to have exactly the amount of retirement savings to maintain your standard of living, congratulations! Since you are expected to arrive precisely on target, you have to figure out what that means. If you are conservative now, and you remain conservative, you may have a high probability of arriving at retirement safely. If you deviate, and begin taking risks by investing in more volatile investments in hopes of achieving significant gains in the stock market, and things work out for you, terrific. If you take some risks, and experience losses in your market sensitive investments, you may come up short of your retirement target and your lifestyle in retirement will suffer. If you are fortunate to have more than enough money to retire, and you are presently conservative in your portfolio allocation, you may be able to sit back and enjoy a smooth ride into retirement. If you are presently more conservative, and believe it is time to remove some of the risk in your current asset allocation strategy, you could reposition some of your assets to safer vehicles, and feel comfortable knowing you are still very likely to have what you need at retirement. If you know you are taking some market risks presently, and you continue to ride out the ups and downs of the market, you may be lucky, and you may not. The upside is that you are in a position that 99% of the population envies, and you are more prepared to accept risk with a portion of your assets than others. What if you are estimating a deficit and you are not ending up where you need to be? You could take some chances, and move money into more volatile stocks or funds that have some upside potential, in hopes of buying low and selling high. If you are lucky, you may arrive at your target. However, you know that you are also capable of experiencing losses with such a strategy. Is there a better alternative? You could begin to systematically save, and budget yourself into the target range and beyond. This discussion seems to make perfect sense, perhaps a lot more sense than the random stock market oriented industry strategy of allocating your assets according to “120 minus your age”. But just talking about it, without taking any action, will not give you any sense of control over where you are likely to end up at retirement. So, regardless of whether or not you are dead on, and you are expected to have a surplus, or you appear to be in a deficit situation at retirement…its decision time! How safe do you want to be? How much risk are you really willing to take? Are you willing to budget yourself into a healthy retirement account? It is one thing to be a risk taker when you are young, but it is something else to be a risk taker when you are older, when you have a shorter time horizon, and hence a shorter time to recover from market losses. Mature folks with a shorter time horizon, who decide to place a significant portion of their nest egg in market sensitive investments, need to understand that they are essentially “going to the casino” with their rent or mortgage money, or the retirement savings they will need in retirement. Where do you presently stand? As we get into more detail, remember we are talking about those approaching retirement, or those that are already in retirement. People in this situation do not have their entire working careers ahead of them, which would be accompanied by years of employer and employee contributions into a retirement plan. As previously mentioned; A) you areon target, B) you are in a surplus situation, or C) you are in a deficit situation. Let's take a look at your options under each scenario: SCENARIO A If you are on target and you are still working and contributing X number of dollars into your retirement plan, you are in great shape. The unknown, just to keep it simple, is the assumption that you will remain gainfully employed, and that you will continue to make your contributions, and that you will also continue to receive the employer match for your 401k. Let’s be optimistic, so we won’t talk about any other “unknowns”. However, the stock market is full of the unknown, and by nature, is risky. Stock market volatility is something of which you need to be aware. You need to know what it means to lose money in the market. If you can afford to be more conservative and still arrive on target, it could mean serenity. If such serenity is truly possible, you may want to avoid risk, volatility, and avoid the stock market altogether. Of course you may be inclined to stay invested and accept risk. This strategy may have gotten you where you are today. With continued success, along with a little luck, you could very well exceed your retirement target. A surplus of retirement savings could lead to true golden years for you. But what if you experience losses? What if you have $100,000 in a mutual fund, and the average stock in the fund loses 25%? Well, the market would have to come back by 33%. If you add in 3% in hypothetical costs/fees, etc, now the market needs to come back by 39%. Why 39% when you only lost 25%? Because now you have less money working for you, and you must consider the effect of the costs, the fees associated with mutual funds, variable annuities, and cost and fees of a professional money managed account. Notice I said just to get back what you originally had. If you were trying to keep up with a hypothetical 5% return, meaning if you did not have a 25% loss, and instead your $100,000 grew by 5%, you would have had $105,000. Now in order to stay on target, to maintain that 5% yield, you now need a 46% return, so that you don’t fall behind your retirement target. If that hypothetical situation does not make perfect sense to you, that is because you do not have a working understanding of “the practical math involved with investing”. And don’t forget that those in retirement, or those approaching retirement, do not have the long investment horizons they had when they were 35 years old. If you are 60, and you plan on retiring soon, you may have only 5 or 10 more years to accumulate and to contribute to your nest egg. You may not have the time to make up for market losses. SCENARIO B After all of your number crunching, you are ahead of schedule. You could do nothing, assuming you are earning a moderate, safe return, and retire with a surplus. You can live a little extravagantly, but still within your means. You could also carve out the percentage of your nest egg that is considered to be in excess of your target, and invest that portion in stocks-securities (market sensitive investments) which may provide above average returns, along with the potential for above average losses. Once again, consider the shorter time horizons of retirees, or those that are approaching retirement. Even if you are ahead of your retirement savings target, danger still lurks in market sensitive investments. Wouldn’t it be nice to relax, to sleep peacefully, and to enjoy the lifestyle in retirement that is afforded by you being ahead of target? Additionally, there is no reason we all can’t reduce our risks, and trim some fat from our expenses, which alone could catapult us into the good life. SCENARIO C If you are lagging behind your retirement target, there are still many things you can do to improve your situation. One of those things is increasing your risk in the hope that you happen to pick the right stock or mutual fund. You could get lucky, but you should not count on that. Most people find that a thorough examination of their expenses will reveal genuine cost cutting opportunities. Some of the luxuries may have to go. Compare insurance coverage and cost, start using coupons at the grocery store and the dry cleaners. Buy nothing unless it is on sale. Stop buying or leasing new cars every 3 years. Make smart, cost efficient vacation choices. Take the money you’ve saved, and direct it towards your retirement plan. The point is, you may have to start cutting now! Now, this was a pretty simple exercise. Everyone falls into one of those three categories; 1) on target, 2) ahead of target, or 3) behind target. Those who are wealthy, and those who are significantly ahead of target, can invest and take chances in the market, because they may be able to afford the risk. Others may not be able to afford taking the same amount of risk. The financial services industry is generally market oriented. Typically, the standard operating procedure, and the position of many financial advisors, is that people should be invested in the market to keep up with inflation. This idea of investing in the stock market to keep pace with inflation is “True”, but only when the stock market treats you well, but “False”, when you experience market losses, driving your account values down. Savings choices can remove risk, yet still provide a moderate, safe return on your nest egg. Consider that many advisors have a long-term perspective when it comes to the stock market, even though a retiree may be thinking short term accumulation, and then distribution, turning their nest egg into a dependable income stream. In regards to the financial industry’s metric of “120 minus your age”, and the dividing up of your nest egg, simply amongst stocks, bonds, and cash equivalents, bonds deserve our attention as well. Consider that bonds are also market sensitive investments. Stocks and bonds go up and down with the economy, and are affected by the money supply and interest rates, and other economic influence. The idea of placing our retirement savings in bonds, when our time horizons are shorter, when we do not plan to hold onto these bonds until maturity, in essence makes bonds market sensitive. This means that if you want to cash in bonds today that do not mature for 10 more years, you have to offer your bonds to the marketplace and see what you can get for them. As interest rates change, so does the value of a bond, and the longer the term of the bond, the greater the change in value. I am not going to discuss bond ratings in detail at this time, but changes in bond ratings will also affect the value of your bonds, when bond ratings go down, or up, that changes the market value of your debt instruments, your bonds. If you need to access your savings, and you are tied up in bonds that must be sold, there will be a market value adjustment of the bond, plus a service fee, a cost you will incur to sell your bond. The market value adjustment may be positive or negative, depending on the direction of interest rates, and you may receive more than you paid for the bond, or less. So, if you need liquidity in retirement, think about whether or not bonds sound appealing to you. Also, if you own bond mutual funds, you indirectly own bonds and the same forces apply, plus additional costs and fees. If you want access to your savings and you must liquidate a bond mutual fund, you will receive what the market bears. Unless you are buying a 10 year, 20 year, or 30 year bond, and plan on holding the bond until maturity, and it is issued or backed by the federal government or some state agency, you really cannot call it safe. Some bonds are backed by the full faith and credit of the federal government or the state. However, municipal bonds have risk as experienced in Orange County, California. Also, bonds may be tax inefficient for many people with provisional income that places them close to the thresholds for taxation of Social Security Benefits. Corporate bonds certainly have risk, as one can see by the devaluation of Ford and GM bonds. This is all relevant to the idea of “120 minus your age”, being divided amongst stocks and bonds. Let’s discuss the taxation of Social Security benefits in tandem with distribution of savings. This is an issue that is often ignored by many, who suggest seniors place their savings in CDs and by many advisors when it comes to retirement planning. The federal government has afforded certain IRS advantages to tax-deferred annuities, and to ignore them may be harmful to the general public and especially retirees. Where is the plan for distribution of savings? Where is the income plan? Random withdrawals of investment accounts, or liquidations of mutual funds, transferred to savings or checking accounts at a bank, is not the same as having a solid income plan. Placing your savings in a CD is not risky, but it can be tax inefficient. Keeping your money invested in the stock market, accompanied by random liquidations, may be both risky and tax inefficient as well. There are simple planning methods to consider, which will enable you to avoid 1099 income, maintain safe growth, and have steady, and perhaps even increased monthly income. What good is it to receive $5,000 in interest income per year, generated from a $100,000 CD at the bank, if you pay 28% in federal taxes, 3% in state taxes, and the 1099 income causes you to be taxed on 85% of your Social Security Benefits? Consider that you may have $5,000 coming in the front door, but you may have approximately $7,200 going out the back door. Imagine beginning the year with a $100,000 deposit in a CD at your local bank, and at the end of the year, having only $97,000. It sounds counterintuitive, doesn’t it? We all need to pay attention to 1099 income when receiving Social Security Benefits, which may push us into being taxed on 85% of our Social Security Benefits. Advisors can reposition 1099 income producing investments into tax deferred savings products.  Your Social Security benefit can be taxed at the rate of 0%, 50%, or 85%. How much tax do you want to pay? An advisor can engineer an income plan which may reduce the tax you pay on your social security benefits, perhaps down to a 0% tax. The longer a consumer remains in a tax inefficient situation, the greater the losses mount, year after year. Advisors and consumers must keep retirement goals in mind throughout the planning process. An income plan that is safe and dependable is achievable. A retirement spending plan is just as important as a retirement savings plan. I suggest that a retirement estimator be used to get a diagnosis of one’s retirement savings status, just as a physician would run various tests before they treat the patient. Are you on target, are you ahead of schedule, or are you behind? You then apply some common sense, taking one’s financial profile into consideration, and then apply some reality to the situation. |
