Friday, January 9, 2015

Two Questions

How much income will you need in retirement?

Not an easy question. We don’t know the future of the economy. We don’t know how long we will live. We don’t know how much medical care we will require before we die. We don’t even know if we will be able to answer that question before events will answer it for us.

Still, it is a question that we must ask and answer.

The simple answer is 80% of your preretirement income. That would make you about average. Once you retire, you will no longer need to spend money on the daily commute, clothing for the office, lunch out with the guys, and since your taxable income will likely drop, you can expect a lower tax bill. Some states even give their retirees tax incentives.

The most frequent method of lowering your ongoing cost of retirement is by moving from a high cost/high tax area to a low cost/low tax area. The other obvious method of lowering your income requirement is tapping into your savings and investments.

It turns out that in spite of a lot of good words, people don’t really want to lower their lifestyle in retirement. In fact they are likely to want to reward themselves for a lifetime of hard work with a cruise or two or some other luxury.

So, be honest and tally up the numbers, including a few “nice to haves” that make like worth living. Be sure to include the cost of healthcare. If you don’t have health insurance (or Medicare) you don’t have a retirement plan. Old school financial teachers would add that you haven’t paid off your mortgage you don’t have a retirement plan. If you only have a couple of years left on a mortgage that you can easily afford, I wouldn’t let that be a show stopper, but no outstanding debt at retirement is a good rule of thumb.

What are your sources of income? For most of us that list would include some of the following:

Social Security
Dividend and Interest Income
Part Time Work

I would suggest that ideally, the total of these numbers should roughly equal your normal expected expenses. If you can cover the purchase of something like a new car with your regular retirement income without tapping your savings, I tip my hat to you.

To be honest, most of us will not be able to cover the cost of retirement with a pension, Social Security, and the equity from our primary residence. That three legged stool is broken forever. We are now responsible for building our own retirement nest egg using 401(k) accounts, Roth IRAs, and taxable investments.

Exhaustive academic and industry studies indicate that if you have a balanced portfolio of 50% equities (stocks) and 50% bonds (bonds, bond funds, certificates of deposit, cash, and savings accounts) there is a 98% chance you will not outlive your money if your annual draw does not exceed 4% of your total initial portfolio indexed to inflation. In our current bizzaro Zero Interest Rate Policy (ZIRP) world that relentlessly punishes savers and old people some pundits are lowering that number to 3%.

But for the sake of simplicity let’s use 4% in an example.

Charlie and Madge will have a combined retirement income of $3,000 a month. They are projecting monthly expenses that will run about $4,000 a month. That is $12,000 that will need to come out of savings in their first year of retirement.

$12,000 divided by 0.04 (4%) or multiplied by 25 (same thing) means that Charlie and Madge will need to have a minimum of $300,000 in retirement savings before they pull the trigger. Of course, if they continue to work, this will likely increase their retirement income and retirement savings.

The 4% draw question brings up a second important question that is rarely asked, “How much are you willing to loose in a single year?”

This is an important question because the answer will limit your investment strategy. In simple terms equities will return 7% - 7.5% a year over a sufficiently long period of time. However, there is a something on the order of a 1 in 12 risk that your equities could take up to a 50% loss in a single year. If you want that return over the course of your working and retirement lifetime (say 60 years?) you must be willing to accept that risk without getting out of the game.

Studies indicate that it is reasonable to expect a 3.0% – 3.5% return on less risky investments although that number is not as predictable as Siegel’s Constant for equities.

It is obvious that a 4% draw isn’t going to work with a 3.0% return.

Maybe Charlie and Madge might want to have a little more than $300K in the tank just so they can sleep better at night. A 4% draw will survive anything short of a 50 year storm, but one can expect a 50 year storm every 50 years. The problem is you don’t know the year in advance.

When I lived in Maryland, we were hit with two 30 year storms in a single year. That was pretty exciting. I watched the Monocracy River rise something like twenty feet to put the Highway 28 Bridge underwater, not once, but twice in a single year. A large portion of Point of Rocks, a nearby town on the Potomac River, went underwater, not once, but twice in a single year.

Now please, “Let’s be careful out there.”

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