Thursday, May 26, 2016

Retirement Rules of Thumb

For longtime readers of this blog, this will be pretty familiar material. However a recent Bankrate survey of replacement income in retirement indicates that 47 states currently fail to make the grade on replacement income. Only Alaska, Hawaii, and South Carolina get a passing grade. Alaska and Hawaii are peculiar situations involving unconventional life styles, state government programs and large retired military and government employee populations with unusually generous pensions. South Carolina has more folks with pensions than is common in the 48 continental states. When combined with low taxes and a low cost of living, South Carolina comes up a winner. In general high tax/high cost of living states appear at the bottom of the list and low tax/low cost of living states come closer to a passing grade. However, there are some surprises in the list.

Bankrate study: Seniors' incomes in 47 states don't go far enough

One of the retirement rules of thumb can be termed the 70% solution. Most financial advisors believe that in order to maintain your pre-retirement standard of living you will require at least 70% of your pre-retirement income. People do spend less in retirement, but not all that much less. Some experts think 80% is safer, but that is a pretty difficult goal for most of us to achieve. Shoot for 70% and then adjust your lifestyle to match your income.

Pensions, once the most important leg of the famous three legged stool of retirement income are almost a thing of the past. The military, government employees, and a few remaining union workers still get a pension, but state and local governments around the country are facing pension bills they can no longer continue to pay and today one of the Teamsters largest pension funds is on the verge of bankruptcy. Many other bankrupt union pension funds are now paid by The Pension Benefit Guaranty Corporation, an independent agency of the United States government. The recipients of these funds are only receiving a small fraction of what they were promised.

The good news is most of us still have a pension, Social Security, once the second leg of the stool. Let’s assume that a family earning a combined income of $85,000 a year can collect a total of $3,000 a month in Social Security benefits.

$85,000 dollars/year divided by 12 months/year multiplied by 70% = $4,958.33

In this simplistic example our couple still needs to replace $1,958.33 every month for the rest of their lives. Where is that money going to come from? The answer is retirement savings and home equity, the third leg of the stool that was once pretty much reserved for cruises to the Caribbean, membership dues at the country club, and trips to Europe. Today, most retirees will need that money for everyday expenses.

This brings up the second retirement rule of thumb, termed the 4% solution. Endless numbers of academic studies indicate that given an investment portfolio of 50% bonds, cash, and CDs combined with 50% in equities, a retiree can safely withdraw a number equal to 4% of the original amount adjusted for inflation in subsequent years and never outlive their money.

This means in order safely withdraw $1,958.33 every month our hypothetical couple requires an initial retirement nest egg equal to $587,499.

$1,958.33 dollars/month X 12 months/year divided by 0.04 = $587,499

If you can’t make 70%, there are other options. The most common is moving from a high cost/high tax state like Maryland to a low cost/low tax state like South Carolina. If the total cost of living in your new state is only 75% of the cost of living in your old state, your 70% replacement income is going to look a lot more like 93%. Maryland wanted me to go away, making room for somebody younger who can pay those high taxes for the next 30 years. South Carolina welcomed me with open arms, warmer weather, lower taxes, and much less traffic.

So how are you doing?

Danko and Stanley, authors of The Millionaire Next Door, have proposed a simple formula to calculate a reasonable value for net worth at a particular age with a given income. This formula produces bizarre results for people in their twenties. However for ages over forty, the results are pretty realistic when compared with actual averages.

Net worth = Age X Pretax Income ÷ 10


A couple about 50 years old earning a combined family income of $65,000 a year should have a net worth in the neighborhood of $325,000. If they have been paying on a mortgage for over 20 years and have been contributing to their 401K, this is fairly reasonable as an average number.

If you are near this target, you are considered by the authors as an average accumulator of wealth.

If your net worth is less than half your target, you are viewed as an under-accumulator of wealth.

If you have more than double this target, you are considered a prodigious accumulator of wealth and I tip my hat to you, sir.

While you should have started saving for retirement at age 22, all is not lost if you happened to get a late start. Whatever your age or financial situation, you can make decisions that will move you closer to financial freedom. Once the kids are out of the house and the mortgage is paid off, you are likely to be earning the highest income of your life at a time when your expenses have declined. Go into savings overdrive. You will be amazed at what you can accomplish in the next ten years.

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