As with most articles on my blog, this one started with a conversation with a friend. The friend recently turned 60 and is starting to seriously think about retiring from a professional position. He is thinking about a range of options: fully retiring at age 62, shifting to part-time with his firm and delaying retirement until 65 or 66, or continuing to work full-time until 65 or 66. From a lifestyle perspective, my friend would like to retire sooner, rather than later, but wants to feel confident about having enough financial resources for he and his wife to live comfortably throughout their retirement.
It may seem odd to start a discussion of financial planning for retirement with health insurance but Presidential executive actions to not enforce the requirement for mandatory insurance coverage and leave uncertain the fate of some insurance subsidies under the Affordable Care Act (ACA/ObamaCare) have already disrupted the individual insurance market. Republican proposals to repeal and replace ObamaCare are creating further uncertainty in the insurance market for individuals and, if enacted, are expected to significantly increase the cost of coverage for older, pre-Medicare age, individuals. One CNN report on the Senate bill as of June 27, 2017 shows the cost of ACA Silver Plan coverage increasing from $1,800 to $8,300 because the proposed Republican legislation allows insurers to adjust rates by age and reduces insurance coverage. Until things are settled in Washington, it will be very difficult for any individual contemplating retirement before age 65 (when Medicare kicks in) to determine if individual health care insurance will be available and at what cost.
The best advice for now for someone considering retirement is to work full or part time until age 65 in order to retain employer-based health insurance coverage or confirm that you can purchase coverage through your employer using COBRA benefits and retire up to 18 months before turning age 65. The Consolidated Omnibus Budget Reconciliation Act (COBRA) gives workers and their families who lose their health benefits the right to continue group health benefits provided by their group health plan for limited periods of time under certain circumstances such as voluntary or involuntary job loss, with the individual paying the full cost of insurance.
When considering how much savings/investments you will need for retirement there are two issues to consider.
- Will your savings/investments generate enough income to allow you to live comfortably and
- Will the income from your savings/investment last long enough if you have a very long life?
Generating Enough Income
Popular guidelines for retirement income suggest that you should have sufficient income to replace about 70% to 85% of your pre-retirement annual after tax income to live comfortably in retirement but some more recent thinking suggests your income needs will not decrease that much in retirement as travel and entertainment, recreation expenses will offset reduced income use for business clothing, commuting costs, etc. (See Kiplinger Article).
Rather than focusing on your pre-retirement income, I believe most of those contemplating retirement prefer to focus on pre-retirement expenses to determine if they will be able to afford the lifestyle to which they are accustomed when they retire. If you plan a major lifestyle change in conjunction with your retirement, like moving to a different community or buying a vacation home, you will need to adjust your expenses, and potentially your taxes, to account for these major lifestyle changes. Looking at actual spending, perhaps over a couple of years, with adjustments for any major lifestyle changes, should provide a solid basis for estimating your expenses in retirement.
The most widely used tool for determining the income that your savings/investments will generate is the 4% rule. As explained in a CNN Money article (CNN Money Article), “The basic mechanics of the 4% rule are pretty simple. You start with an initial withdrawal of 4% of savings and then increase the dollar amount of that first withdrawal by inflation each year to maintain purchasing power.
So, for example, if you have a nest egg of $500,000 and inflation is running at 2% a year, you would withdraw $20,000 the first year of retirement, $20,400 the second year, $20,800 the third and so on. This regimen results from research done in the early 1990s by now retired financial planner William Bengen. After testing different withdrawal rates using historical rates of return for stocks and bonds, Bengen concluded that 4% was the highest withdrawal rate you could use if you want your savings to last 30 or more years.
Some experts have suggested, however, that a 4% withdrawal rate might be too ambitious given today’s low bond yields and lower projected returns for stocks. For example, Wade Pfau, a professor of retirement income at The American College, says that retirees should probably limit themselves to an initial withdrawal rate of 3% or so if they want a high level of assurance (although not a guarantee) that their savings will support them for at least 30 years. For more on how much lifetime income one can expect to get through inflation-adjusted withdrawals, income annuities and other methods of creating income based on current market conditions, check out Pfau’s Retirement Income Dashboard (Pfau’s Retirement Dashboard).”
Many financial firms also offer retirement planning services, some of which use a range of alternative models to estimate retirement income needs. One I have used personally in the past is from TRowePrice at TRowePrice Retirement Planner.
I continue to find the 4% rule works well provided you maintain a portfolio that includes stocks as well as presently low yielding bonds and have adequate cash reserves to stay invested through market downturns. But one common mistake many pre-retirees make is failing to adjust pre-tax retirement income when comparing it to post-tax retirement expenses. While some retirement income is tax sheltered and some state’s do not tax certain retirement income, be sure to remember that most of your retirement income will be subject to Federal, state and local income tax, even Social Security, and typically taxes are a big enough expense that it will be worth consulting a financial planner or your tax accountant to make sure you get your post-retirement tax calculation right.
Assuring Enough Income For A Long Retirement
A 65-year-old woman has a 68% chance of living to 80 and a 28% chance of living to 90. And a 65-year-old man has a 58% chance of living to 80 and a 17% chance of living to 90.2 (BLS Spending Patterns Of Older Americans). And these are averages for the entire population. A physically fit, more affluent senior who enjoys better medical care and diet than average and is less likely than average to smoke can expect to live longer than the above statistics suggest. As a result, a healthy, affluent baby boomers retiring today should assume 30 – 40 years of life in retirement – living to age 95 or 105 if retiring at age 65.
Assuming you are not spending beyond your means and have sufficient savings under the 4% rule to pay for your post-retirement expenses, there are two primary risk areas that might cause a retiree to outlive their savings:
- A large unexpected expense, most likely the cost of institutional care for yourself or your spouse for a prolonged period, or
- A significant market downturn from which your savings are unable to recover.
Long-term care insurance can protect you against much of the risk of prolonged institutional care but the ideal time to purchase such a policy was when you were in your 50s. It may be cost prohibitive to purchase such a policy at or near retirement age. My wife and I have policies through Lincoln National Life Insurance Company that we purchased when I was 53 and my wife 52. These used a lump-sum up-front payment to purchase as annuity that pays the premiums for a long-term care insurance policy while also offering a death benefit if the LTC insurance is not used. The mechanics of this are complicated but I like the idea that the payment amount was locked in at the beginning. If you do not have long term care insurance, you may want to build an additional cushion into your retirement savings to “self-insure” against this risk. Setting aside $150,000 to $200,000 when you retire that will grow with inflation, which is enough to cover up to 24 months in an assisted living facility, should provide reasonable protection against you or a spouse requiring institutional care in the future (See The Cost of Care and other posts on this blog for more information on the cost of care, what Medicare, Medicaid and the VA will pay for and the cost of institutional vs. at-home care).
My preferred method for guarding against the adverse impact of a market downturn is to have a larger than recommended cash component to my savings/investments that will allow me to draw cash in lieu of stock principal for more that a year in the case of a significant market downturn and to use Social Security in lieu of a commercial annuity product to assure long-term income. Many financial planning websites will recommend an annuity to assure continuity of income into very old age. While an annuity purchased from a financially sound and reputable company can assure long-term retirement income, the combination of high up-front fees and current low interest rates make commercial annuities less attractive to me, although I am using one in conjunction with my LTC insurance policy.
For a senior with a sufficient savings / investment portfolio to be able to afford retirement, I believe Social Security offers the most attractive option to create the type of guaranteed income that an annuity offers. Social Security pays an inflation-adjusted retirement benefit for as long as you live. A Social Security benefit for someone who contributed the maximum to the system retiring in 2017 at age 66 (Full Retirement Age) is $2,687 per month but will rise to $3,538 per month if you defer collecting Social Security benefits until age 70. And this higher benefit will continue to grow with inflation over time. If you have sufficient savings to be able to defer collecting Social Security Benefits until age 70, I believe Social Security offers the most cost-effective way to create a guaranteed annuity-like investment stream for your very old age.
A CNN Money asset allocation model suggest a mix of 65% bonds, 20% large cap stocks, 5% small cap stocks and 10% foreign stocks for someone 3 -5 years from retirement with a medium risk tolerance and some flexibility about when income is received CNN Money Asset Allocation Wizard. This is consistent with the financial maxim that the percentage of bonds in your portfolio should equal your age.
However, T Rowe Price’s asset allocation model recommends 50% – 65% stock, 25% – 35% bonds and 5% – 15% short term liquid assets for someone about to retire at age 65. Within the stock portion of the portfolio, TRowe recommends 15% – 19% international/global stocks, 7% – 10% U.S. mid/small cap stocks and 28% to 36% U.S. large cap stocks. Within the bond portfolio, TRowe recommends 5% – 7% international bonds, 2% to 4% high yield bonds and 18% to 24% investment grade bonds TRowePrice Asset Allocation Tool.
I believe thinking about and consciously deciding on an asset allocation for your retirement savings/investment portfolio is one of the most important things an investor should do with their portfolio on an annual basis. Many financial publications and mutual fund companies offer asset allocation models and it may be helpful to consider several and understand what is driving them to help you make a good asset allocation decision for your own portfolio.
My own allocation is a bit closer to the TRowePrice model with 51% equities including a small amount of alternative investments, 32% bonds and 17% short-term cash-equivalent investments. My bond allocation includes a significant amount of tax-exempt municipal bonds and, in my mind, the higher allocation to cash offsets the potential market risk of a larger allocation to equities while allowing me to benefit from dividend yields that are in many cases higher than bond yields and from potential stock price appreciation over time. My stock portfolio includes a healthy dose of individual income producing stocks, exposure to Real Estate Investment Trusts (REITs) through an index fund and some individual stocks and a managed bond portfolio in which I own individual bonds rather than bond funds. I see a real advantage to owning individual bonds over a bond fund because, absent a default, you can hold individual bonds to maturity and protect your principal while the value of a bond fund can fluctuate with market conditions and the actions of other fund investors.
As my bio under “The Blogger” heading above indicates, I worked for 15 years as a stock analyst with Legg Mason and Stifel Nicolaus and was recognized seven times as a Wall Street Journal All-Star analyst. While I have the skills to manage my own investments I work with a full service investment advisor at Stifel, Nicolaus & Company to manage my portfolio and in recent months have shifted from a commission based to fee based compensation structure as Stifel, like many other firms, has implemented the fiduciary rule.
The focus of many investors today is on minimizing investment fees and purchasing low cost index funds or exchange traded funds (ETFs) over using full service advisors and owning actively managed funds or individual stocks. Understanding and minimizing the fees on your investment portfolio is important and there is a lot of investment analysis that passive investments have outperformed most active managers and individual stock pickers. However, I continue to see value in a full service advisor and a degree of active management, particularly if you have a larger amount of investments.
The key advantages I see to a full service advisor/active management include:
- Keeping all or almost all your investments in a single place. This makes it much easier to understand and monitor your asset allocation and will be extremely helpful to your spouse and other surviving relatives if you die or are incapacitated. Some low-cost brokers and funds companies offer a broad enough array of investment options and can provide some advisory services over the phone or in person in the event of a death or impairment but not the same personalized attention as an experienced broker or fee advisor in my view.
- Index funds may do less well in a more volatile market. We are approaching 10 years of unprecedented low interest rates and market stimulus from central banks throughout the world. In this low-volatility, interest/stimulus driven, broad-based post-downturn stock market rally passive investments have outperformed. But with index funds and the entire market more highly valued and influenced by a relatively small number of mega-market-cap stocks, like Apple and Amazon, will index funds continue to outperform when and if the market and investors are tested by a significant correction and increased volatility? I can’t predict the future, but believe there is a case to be made that the underlying assumptions that have allowed passive investments to outperform may change and again create an opportunity for value-based investing and active management.
- You may need an active manager to buy individual bonds. As noted above, because owning individual bonds provides greater principal protection than a bond fund, I prefer to own individual bonds. The only practical way to do this may be to work with an active bond manager because buying bonds as individual, particularly tax-exempt issues, can be difficult. In addition, I want to hold individual bonds through a single account with my other investments for administrative convenience and to keep down overall fees.
- A good advisor can save you from yourself. Much has been written in recent years on the psychology of investing. One of the most difficult things for even experienced investors to do is to keep one’s nerve when the market is selling off and potentially even buy on dips. An experienced and trusted advisor can help you keep your nerve in a market downturn and help protect you against following the herd. A good advisor can also protect you against being lazy in a good market by periodically adjusting your asset allocation and culling your portfolio in a tax-efficient manner.
I hope these ideas for evaluating and managing your financial resources for retirement are helpful and will be happy to respond to questions and comments.
I formerly worked at Legg Mason Wood Walker, Inc. and at Stifel Nicolaus & Company, Inc. and previously had some of my investment portfolio with T Rowe Price Investment Services, Inc. I do not currently receive and do not expect to receive in the future remuneration from any of these companies.