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Three Detailed Income Strategies for Retirement

by Flexo on September 26, 2009

in Investing

Earlier this week, I reviewed common financial rules of thumb and offered a quick evaluation of how each rule would likely perform if accepted by an individual as the final word. One of these was the rule that convinces retirees they will be financially secure if they withdraw 4% of their nest egg for income one year and continue withdrawing the same amount adjusted for inflation each year.

Walter Updegrave has a much more detailed strategy for retirees who would like to make their money last from age 65 to 95 and beyond. He offers three alternatives that one can follow depending on their assets and their needs in retirement.

Three strategies for retirees

The first strategy is for retirees who have enough income from Social Security and pensions to cover basic expenses and who are confident in their ability to manage their portfolio.

For those in this situation the 4% withdrawal rule has a chance of succeeding — having your money last 30 years — 77% of the time. If you need more income than 4% would provide, you’re risking not having enough to last that long. For example, someone retiring today with a $1 million nest egg could withdraw $40,000 that first year. But if you’re 33 years old like me, you better plan on having much more than $1 million when you retire; thanks to inflation, an income of $40,000 thirty years from now will probably not be sufficient.

In order to maintain a 4% withdrawal rate, according to the article, is to maintain a portfolio of 50% stocks and 50% bonds. And by the way, a bad year in the stock market could wipe you out.

The second strategy offered by Walter Updegrave is for retirees who need more income for basic expenses than is provided by Social Security and pensions or who do not want to subject their portfolio to as much risk as required in the first strategy.

Take part of your nest egg and purchase a lifetime immediate annuity. This will provide you with steady paychecks for the rest of your life. According to the article, recent annuities pay out 8%, so you would only need $500,000 to make that $40,000 income mentioned earlier. These are most beneficial for people who live longer because money is pooled with other investors. Those who die earlier help fund the incomes of those who survive in retirement longer. The problem with annuities is your money is often locked inside them, and you can’t get it if you need it without paying steep penalties.

Walter Updegrave also offers a third strategy for retirees who need more income than Social Security and pensions provide but want access to more of their money. In addition to a portfolio of stocks and bonds, and an immediate lifetime annuity, add a variable annuity with a guaranteed lifetime withdrawal benefit to the mix.

Variable annuities are flexible but they are also expensive. Rather than 8% like the lifetime immediate annuity above, a 65 year old is likely to receive a 5% return. It is not rare for these accounts to charge a fee of 3% of your account balance each year. The author suggests that the optimal mix between these products and investments would be 25% of your portfolio in variable annuities, 25% in immediate annuities, and the remaining 50% in the diversified portfolio of stocks and bonds.

The problem with annuities

The sale of annuities, particularly variables annuities, is riddled with problems. These are very popular products for salespeople because they make a lot of money for the companies that sell them. It’s not rare for salespeople to misrepresent the product. Often customers are not given the full information regarding withdrawal penalties.

Here’s an example of an 86-year-old man who was pressured into buying a product he did not understand and would never benefit from. Dateline investigated annuities salespeople and found more deception in the industry. Ben Stein, however, credits variable annuities for making his parents rich, though it might be important to note that a Ben Stein’s long-time working partner is Phil DeMuth, a registered investment adviser (salesperson) who benefits financially when more people are convinced that annuities are good products.

How to make your money last, Walter Updegrave, Money Magazine, September 23, 2009

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A Report Card for Financial Rules of Thumb

by Flexo on September 23, 2009

in Personal Finance

I’m not a big fan of “rules of thumb.” These are bite-sized nuggets of wisdom masquerading as advice, designed to apply to a mass audience. At best, they cant point someone in the right direction, but at worst, rules of thumb can erroneously send people on the wrong path or can mistakenly instill a false sense of security. This is a good example of why the best financial advice is specifically tailored to an individual or a family.

Rules of thumb satisfy the human desire for knowledge on a stick, like fast food for the brain. They are easily repeatable and retweetable, and they invite a minimum of critical thinking. But it would be unfair to suggest ignoring all rules of thumb. Some are better — more accurate for a larger number of people — than others. But it’s important to determine which ones apply to your situation and which one’s are not relevant.

Here are some of the more popular rules of thumb targeting personal finances, often repeated by gurus and writers targeting a wide audience.

Rules of thumb

You should save 10 percent of your income. Grade: B-.

This rule of thumb is not specific. It is not clear whether 10 percent should be counted before or after taxes. Saving this percentage of your gross income, a larger sum than the same percentage of your “take-home” income, would be preferred. This rules of thumb also does not specify whether your 401(k) or other investments are included or if this only refers to savings not invested or spent.

I can’t say that saving 10 percent is a bad idea. This is a good starting point; in fact, putting this portion of your income away without touching it will put you far ahead of the “average” American. Many people, however, will need to save more, some significantly more, than 10 percent in order to meet their goals. This rule of thumb, ingrained in the minds of many people who have read books suggesting this amount, can convince someone than 10 percent is enough.

Your emergency fund should be large enough to replace 3 to 6 months of your income. Grade: D.

Again, this is a good starting point, but your income is not related to the size. Your emergency fund should be allow you to afford your non-discretionary expenses while you work to replace your income. Determining the right size for your emergency fund requires measuring your monthly expenses, judging the stability of your income, determining what you would be willing to do to replace that income, considering how much it might cost to relocate in an emergency, and seeking expenses to cut.

The economy and the job market — how long it might take you to find a new job — should be a consideration as well. A better rule of thumb might state that the size of your emergency fund should be enough to cover necessary expenses for the number of months equal to the unemployment rate. For example, if the unemployment rate in your state is 10 percent, your emergency fund should be large enough to cover 10 months’ worth of expenses.

You can withdraw 4 percent of your nest egg in retirement to provide yourself an income while keeping enough invested to last indefinitely. Grade: C.

The 4 percent “safe withdrawal rate” relies on a number of dangerous assumptions. First, the funds from which you take the 4 percent must be invested completely in a diversified selection of stocks, like the S&P 500. As we’ve seen recently, beginning retirement while completely invested in stocks in a year where the stock market is down can be disastrous to financial health. Secondly, in assumes the stock market will perform 5 percentage points higher than inflation. That’s a reasonably good estimate when you look at the stock market on average, but there is rarely an average year. The stock market performs significantly better in some years and significantly worse in others.

The rule of thumb is not detailed enough to explain, but 4 percent is the withdrawal rate for the first year only. The withdrawal in every subsequent year should increase by the rate of inflation. For example, if you withdraw $40,000 from your $1,000,000 in the first year, and in the second year your nest egg increases to $1,001,000 after a year where inflation was 3%, your withdrawal in the second year should be $41,200 (3% more than $40,000) rather than $40,040 (4% of your new balance).

To find the percentage of your portfolio that should be invested in stocks, subtract your age from 100. Grade: F.

According to this rule, once you are no longer a minor the most you’ll be invested in stocks or stock mutual funds is about 80 percent. Someone retiring at age 65 would have a portfolio only 35 percent invested in the stock market. This directly contradicts what would be necessary to make the 4 percent safe withdrawal rule of thumb a reality. And for most people, the calculation using 100 just simply won’t cut it in order to grow wealth over the long term.

There’s more to consider. Suze Orman has a massive net worth compared to most people, and can therefore afford to play it safe by investing almost all of it in bonds. Stocks are riskier, and she and other people with significant net worth do not have to take on as much risk as what is found in the stock market to provide more than enough income for the rest of their life. Not only that, but significant wealth in a less risky investment helps ensure there will be an estate to leave to family or charity at the end of life.

The rest of us must take on the risk of the stock market in order to provide the best chance of building wealth in the long term. And the amount of risk needed for us is a higher percentage than the result of subtracting your age from 100. Perhaps 130 or 140 would be a better figure to use.

To retire comfortably, you will need to have an income of 80 percent of your maximum pre-retirement income. Grade: C.

Although it’s common to believe your needs, and therefore expenses, will be less in retirement, reality shows that this is not always the case. It is safer to assume that your expenses will be 10 percent higher in retirement. Keep in mind that health care costs will most likely rise dramatically as you age. And with people living longer than ever, those expenses will last for many years.

Once size does not fit all. Rules of thumb are good starting points, but don’t fall into the trap of believing you are safe if you follow these rules. Do you know of any other rules of thumb deserving a thrashing?

Photo: John Leach

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Take This Rule of Thumb Quiz

by Flexo on January 11, 2008

in Financial Advice and Advisers

I often rail against “financial rules of thumb” for their overly simplistic view of what are often complex situations. There is far too much potential for snappy catchphrases to lead people to refuse to think and evaluate situations on their own. Rules of thumb don’t take into account individual circumstances and even the most popular ones are simply incorrect.

Kiplinger asks about the usefulness of twelve financial rules of thumb, particularly when some can be harmful if blindly followed. What do you think? Which “rules” are true and which are false?

# You should always close credit card accounts you no longer use. (See How to Best Handle Old Credit Card Accounts.)
# Save and set aside an emergency “rainy day” fund to cover at least three months’ worth of your expenses. (See Always Be Prepared: The Unexpected Job Loss.)
# The percentage of stock in your portfolio should equal 100 minus your age.
# Always go with a fixed-rate mortgage — especially when interest rates are rising.
# Save 10% of your income each year.
# Buying a car is always cheaper than leasing.
# A Roth IRA is better than a traditional IRA.
# Never buy a house that costs more than 2.5 times your annual income.
# Make sure your own retirement savings are on track before you save for your kids’ college education.
# If you carry a balance, you want a credit card with a low interest rate.
# If you need life insurance to protect your family, your coverage should equal eight to 12 times your annual income.
# With a nest egg of $1 million, you can retire comfortably. (See Does This Number Impress You?)

Some of the answers may surprise you. Leave your thoughts in the comments or take the quiz at Kiplinger.com. Also, take a look at 25 Rules to Grow Rich By.

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Retirement Income Rule of Thumb Debunked

by Flexo on November 27, 2007

in Planning

To retire comfortably, you’ll need to have an income of 80% of your maximum pre-retirement income.

That’s a common rule of thumb you hear trumpeted by financial planners. Unfortunately, it’s not accurate. It may give someone planning their retirement a basis for thinking about creating income during those years, whether from part-time work or income-producing investments, but it can also provide a false sense of security.

“The Mole” is an undercover financial planner who writes for Money Magazine, and he has a better way at looking at retirement needs. It promises to be more accurate. He believes that if you have to estimate something, you should estimate your expenses first, and work backwards from there.

Clients often come to me with this same question, and I can’t answer it without knowing how much they are spending. Some clients making $100,000 per year are only spending $50,000, while others are earning $110,000 and getting further in debt. So you should really ask, What percent of my current annual expenditures should I expect to spend in retirement?

Typically, unless they make drastic lifestyle changes, retirees will spend the same, if not more, than they did before retirement. The Mole suggests estimating your full expenses and adding 10% to that figure. Now you’ll need a way to come up with that income in retirement.

Taking this approach would certainly inspire me to come up with ways to cut back expenses. Perhaps I will move to an area with an extremely low cost of living. Perhaps I should do any world traveling now while I have a steady income.

It’s not all bad. Once you’ve retired, you don’t have the “expense” of saving aggressively for retirement, so more of your income will be available for your expenses.

Retirement – How Much You’ll Really Need [Yahoo Finance/Money Magazine]

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