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Making Estimates for Retirement Planning
Readers recently submitted questions about financial planning for retirement to Doug Wheat, a certified financial planner with Family Wealth Management, based in western Massachusetts. Here is Part 1 of his responses; more will be posted on the Booming blog next Wednesday. (More than 100 questions were submitted, and regrettably not all can be answered on the blog.)
Q. My experience has been that retirement planners ask three questions, often somewhat obscurely: (1) How long do you expect to live? (2) How much income will you need to live comfortably in retirement? And (3) what do you expect the inflation rate to be? The math isn’t very complicated -- if I were confident of my answers to those three questions, I could figure it out myself and wouldn’t need a retirement planner. How about helping us figure out how to answer the three questions? —jrg, San Francisco.
A. By its nature retirement planning requires making plans without being able to know the future. You can, however, make reasonable assumptions and test them against historical data to determine the outcome with some confidence. The decisions you make in your preretirement and early retirement years set you on a path, but of course you will need to revisit your assumptions and adjust your path along the way. The Society of Actuaries estimates that for a married 65-year-old couple, there is a 45 percent chance of one person reaching age 90 and a 20 percent chance of one person reaching age 95. So it is prudent to plan on living a long time.
The best way to determine the income you will need to live comfortably is to first determine how much you are spending on your fixed and discretionary expenses today. Second, determine which expenses will continue in retirement, which will disappear and which will be new. For instance, your property taxes will continue, but your mortgage may disappear and you may have new medical insurance and travel costs. And don’t forget large periodic costs, like cars. No one knows what inflation will be. The Federal Reserve has a target annual inflation rate of 2 percent, but it is best to have inflation protection in some of your assets and income sources. Social Security is adjusted for inflation; some pensions and annuities are not.
Q. I have read that the rule of thumb is to withdraw 4 percent or 1/25 of your retirement funds each year. My guess is that this “rule” was developed when interest rates on “safe” investments (CDs, certain bonds, etc.) would support this level of withdrawal. However, with interest rates near zero (at least for now), it seems only equities have the chance to earn a sufficient return to support the 4 percent rule, but equities are risky for retirees. What is your advice on how to invest retirement funds, and is the 4 percent rule still applicable? —HonuCarl, Los Angeles.
A. The notion of a 4 percent safe withdrawal rate emanates from a 1998 academic study often referred to as the “Trinity Study.” In the study the authors from Trinity University provide historical evidence that if you begin withdrawing 4 percent of your accumulated savings your first year of retirement and increase that amount each year by the rate of inflation, you have little danger of running out of money over a 30-year period if it is invested in a balanced portfolio of stocks and bonds. For example, if you have $1 million at retirement, you can withdraw $40,000 the first year. Assuming the inflation rate is 3 percent, the second year of retirement you can withdraw $41,200. This strategy is appealing because it provides a steady cash flow while the value of your portfolio may be fluctuating. Updated studies through 2011 indicate that since 1926 there were no 30-year periods where you would have run out of money using this strategy (although if you retired in 1966 you would have come awfully close).
In a 2012 study, Wayne Pfau examined time periods of low dividend rates and high market valuations on withdrawal rates. He found that in those environments there may be reason for retirees to worry about the 4 percent rule of thumb.
In practice people may want to start with a 4 percent withdrawal rate and periodically adjust based on the current situation. A mix of stocks (equities) and bonds gives the best likelihood of success. If you are using a 4 percent withdrawal rate and the stock market booms, if you don’t re-evaluate you will be living more frugally than you need to. The opposite is true as well.
It’s also important to consider age. If you retire when you are in 50s, you will probably want to start with a lower withdrawal rate. If you are in your 80s, a higher withdrawal rate is certainly appropriate.
Q. I am very confused about what to do about long-term care insurance. Do you need to know where you will live when you retire, or are there policies that can be purchased in one state and used in another? Are there still such things as prepaid policies that you can pay off while you are still working? And are there any guarantees, or “insurance for the insurance”? That is, what if the company drops you, or the company goes under, or sells your policy to another company that goes under — do you lose everything you’ve already paid into it? And how much do they really cover? If you go into a nursing home, don’t you end up spending down all of your assets and ending up on Medicaid anyway? I’ve heard rumors that they don’t really cover all that much, once the time comes to actually collect. I understand that health care is a huge, huge cost when one is older, but are these plans really worth it? Are you really better off with one, given all the things that can go wrong? The last thing I want to do is to spend savings on insurance that won’t actually do me any good in the end. — E., Long Island.
A. Deciding whether to purchase a long-term care policy is one of the most difficult decisions a preretiree needs to make. Like many insurance products, long-term care insurance is insuring against a risk that you hope you never need but that if you do need it, you want to be sure it is there.
Long-term care companies are bound by state regulators to pay for care covered in their contracts. Indeed, the insurance companies have paid so much in long-term care benefits that Unum Group, Guardian, MetLife, Allianz and Prudential are not writing new policies because they are not profitable. There are no guarantees for long-term care insurance companies, but they generally have the ability to request rate increases if their costs increase, allowing them to continue paying benefits (sometimes price increases are substantial). You should know, however, that at least one long-term care insurance company, Penn Treaty, is in bankruptcy, and it is likely the policy holders will receive little in the way of benefits. Make sure you check the credit rating of an insurance company before you buy a policy. You can move from state to state with your existing long-term care insurance.
There is no right answer whether to purchase a long-term care policy. The question to ask yourself is whether you understand the financial and care risks associated with long-term care. If you understand the risks and can afford a policy, you then need to decide whether you are willing to accept the risks or insure against them. Long-term care is very expensive, and so are long-term care insurance policies. In my experience the people who purchase long-term care policies most readily are those who had parents with policies. That may be revealing.
Q. I find most retirement advice foolishness. I am 58, my parents each died in their 90s. They left no estate. My mom died of Alzheimer’s after five years of in-home care in N.Y.C., my dad died in a nursing home, bouncing between there and now-defunct St. Vincent’s. I have two kids who have yet to start college. My net worth together with my wife is nearly half a million dollars, and I am told by experts that it is not enough. Our system is sick and ridiculous if someone in my earning category (combined incomes nearly 200K) cannot adequately save for retirement. What changes in the current laws and government support would you recommend to remediate this awful state of affairs? —Bert Gold, Frederick, Md.
A. Financial planning advice is generally focused on helping people understand likely outcomes of their financial choices. Spending less than you earn, diversifying your investments, insuring against risks, preparing estate planning documents and reviewing your taxes may be boring and conservative but not foolish.
Having enough money saved for retirement is a function of both your total savings and how much you spend. If you spend $100,000 a year and have no other income besides Social Security, you will want to target more than $1.5 million saved for retirement assuming a 4 percent withdrawal rate. If you spend $50,000 per year, you might want to target $500,000 in savings. If you spend $100,000 per year but have only $500,000 saved at retirement, you will be forced to make a very dramatic change in lifestyle in retirement or face the potential of running out of money very quickly.
Saving enough money to maintain your current standard of living in retirement can take a very long time, and end-of-life care can indeed eat much or all of a potential inheritance. It’s not clear what you are spending your money on, but you may want to carefully reconsider all of your fixed and discretionary expenses and save as much as possible in retirement plans and I.R.A.s before your kids enter college. Avoid saddling yourself with college debt in the coming years and have a frank discussion with your kids about how much you can afford to pay for a college education. I see the total cost of both health care and higher education as the two issues that most urgently need to be addressed by public policy because they provide the most uncertainty for individuals. In my opinion the issue is the total cost of higher education and health care and not just how and by whom the cost is paid.
Q. Choosing when to draw Social Security is not as easy as it seems. The traditional advice from financial advisers is to wait until age 70 if at all possible, yet there are other views, including those from professional financial advisers, who say to take the money as soon as possible. Most of my friends started drawing at 62, even though they are in good health and were hit with a penalty. What do you advise and why? —Michael Hydak, Austin, Tex.
A. The number of people collecting Social Security at age 62 has steadily declined over the last 20 years as more people work to older ages, according to the Center for Retirement Research at Boston College. Still, more than 46 percent of people collect Social Security at age 62. Most people start taking Social Security at age 62 because they need the money to meet their living expenses – it is not a choice. Some people decide to collect because they are worried about dying young and not getting what they are due. However, if you can pay your living expenses without Social Security, you are in good health and you are married, it is generally financially beneficial to wait to collect. If you begin collecting at age 62 rather than at your full retirement age, your monthly income may only be 75 percent of the amount you would receive at age 66. If you wait until age 70 to start collecting, you receive delayed retirement credits that further increase your monthly payment.
To make a decision it may be helpful to determine at what age you “break even” if you delay taking Social Security. That is, if you forgo Social Security income for four years, how long will it take you make that money back. Depending on the circumstances, the break-even age is often between age 78 and age 81. If you believe you will live longer than your break-even age, it is quite likely that delaying Social Security would be financially beneficial. You can also think of delaying Social Security as investing in a guaranteed inflation-adjusted annuity with very attractive rates of return.
For married couples there are some more complicated decisions that depend on each of your work histories, but since the largest benefit is passed to the surviving member, there is another reason to delay.
There is a common misconception that you need to be collecting Social Security to be on Medicare. That is not true, but because Medicare cost is typically deducted from your Social Security check, Medicare will send you a quarterly bill if you are not collecting.
Q. How does one find someone like yourself to be advised by but not necessarily sold to? — Gail, Denver.
A. Two national organizations of “fee-only” financial advisers are the National Association of Personal Financial Advisors (www.napfa.com) and the Garrett Financial Planning Network (www.garrettplanningnetwork.com). You may want to ask potential advisers if they are a fiduciary – putting the needs of clients before their own.
Q. Maybe you could share your thoughts on investing in bonds. Basically, retirees like myself have three choices: (a) put their retirement savings in ultrasafe money market accounts, which are paying only one-quarter of 1 percent; (b) put their savings in the stock market, possible losing a healthy hunk of it; and (c) bonds, particularly bond mutual funds, currently paying around 3 percent. The obvious choice would seem to be (c) -- bond mutual funds, particularly intermediate-term index funds offering steady dividends and low volatility. “NOT SO FAST!” say the financial gurus. “Why would anybody invest in bonds in 2012, with interest rates at historic lows? Interest rates are bound to rise in the future, and then your NAV will really get whacked.” What are your thoughts? Maybe you could mention the role of the “Average Duration” of a bond mutual fund. Also, the potential loss of several years of healthy dividend income, if you elect to keep your money in money market accounts, waiting for the interest-rate risk to go away (when interest rates rise). After all, given Fed policy, interest rates could be low for quite a while. —ibisbill, Maryland
A. There is no doubt that savers are being hurt by the Federal Reserve’s actions to keep interest rates low. In essence savers are being forced to take risk with their savings in order to generate investment income. That is risk that many retirees would prefer not to take. People have been predicting interest rates are going to rise since the Federal Reserve announced its quantative easing program more than three and a half years ago. Rates have only gone lower. We don’t pretend to have the answer whether rates are going to rise. But rising rates are of course a risk, and we would suggest diversifying to limit the effect of that risk. That means having both short-term bonds and intermediate-term bonds. We also like owning individual bonds that don’t have the same interest rate risk. That being said, the long-term outlook for bonds is to barely keep pace with inflation, so you may actually be losing value if you are spending all of the interest.
Most retirees are going to want a large percentage of bonds in their portfolio to maintain stability but will need to have some growth from stocks and other investments to help keep pace with inflation. Mutual funds of high-quality dividend-paying stocks are a good place to start. Some high-yield bond exposure may also be appropriate. To help people become comfortable with the accompanying volatility, we suggest that retirees consider how many years of cash flow they have in safe investments like bonds. With many years of cash flow in safe investments, people can think less about the ups and downs of the stock market. This helps them sleep better at night and avoid selling in a market downdraft.
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