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Will You Outlive Your Retirement?
Copyright (c) 2007-2012 Bill Garrett
Today, Americans are living longer than ever. During the twentieth century life expectancy in America increased from age 47 to age 77. Longer life spans present problems for retirees, however. Assuming some rate of inflation, you will need an ever- increasing income to maintain your standard of living.
The Question is: "Will you have enough saved to last throughout a twenty or thirty year retirement?"
Social Security
Social Security was designed as a pay-as-you-go plan, i.e., retired workers collect benefits funded by workers still paying into the system. Today, the system's ability to maintain current benefit levels is in jeopardy. It is apparent that your financial security in retirement is to a great extent dependent upon your personal resources.
Four Risks to Your Retirement
There are four major risks to your retirement: Long-term Care Expense, Inflation, Investment Risk, and Withdrawal Rate Risk. Any could threaten your retirement security. Understanding how to counter them may be vital to your financial future.
Long-term care
Middle America needs to be concerned with the high cost of long-term care. Statistically, 40% of retirees are expected to incur long-term care expense. The cost of 24-hour care in or out of the home is so high that it poses the single greatest threat to the average retiree's financial security. The most practical method of dealing with this risk is through long-term care insurance. There are no government programs to handle the full cost. Even if you are in your 50's it makes sense to consider purchasing a policy to keep the premiums down.
Inflation
Since 1926 inflation for Americans in the workforce has averaged 3% a year. However, largely due to increased medical cost, the Consumer Price Index for the Elderly (CPI-E) has averaged 3.38% over the last twenty years. If you don't plan for at least the higher rate you might be under-funded.
So, how do you guard against inflation? One way is by investing in the stock market. This may sound risky but there are ways to reduce the risk, which will be covered later.
Let's look at the historical returns of various investments since1926: large cap stocks have averaged 10.4% and small cap stocks 12.7% a year. Long-term U.S. Government bonds have averaged 5.2%, and Treasury Bills have averaged 3.72% compared to Inflation's average 3.03% during the same time period. After taxes only stocks substantially outpaced Inflation.
Investment Risk
Investing Too Conservatively
Many retirees stay away from the stock market preferring to invest in interest-bearing investments like bonds or Certificates of Deposit (insured by FDIC). Here's an example of the risk inherent in these instruments:
Example 1: You have $1,000,000 invested in twenty-year interest investments paying $50,000 a year. Inflation is averaging 3.38% (CPI-E). At that inflation rate in twenty years $50,000 will buy only half what it did twenty years before.
Investing Too Aggressively
On the other hand, having your money in the stock market can be dangerous, especially if you are systematically selling shares for income.
Example 2: You have $1,000,000 invested and are taking $50,000 a year for income. The market goes down. You remain invested. Assume that three years later your investments have lost 15% a year and your portfolio is now worth $485,500. To recover, assuming a 10.4% annualized return and taking $50,000 a year out, will take 48 years! That return is what the S&P 500 Index has averaged since 1925.
Today's longer retirements have greatly complicated the withdrawal phase of retirement. It is apparent that a successful investment strategy in retirement is crucial. Decisions made today may have serious unforeseen long-term consequences so it is important to have a sound withdrawal plan in place. This means it must be both flexible, prudent, and still provide long-term returns adequate to offset inflation.
Withdrawal Rate Risk
How fast you take money from your savings is the third risk factor to contend with in retirement. What is a safe rate? Probably a good target is 4% or less. We have seen in Example 2 what can happen if the market drops while taking withdrawals. You have to sell more investments because they are worth less in a down market. That's how systematic withdrawals work against an investor.
A Solution
You can no longer depend on the old buy and hold approach when in retirement. You may now be wondering if there is a solution. Actually, there is. Your income needs to come from investments not exposed to the stock market. Interest-bearing instruments and those offering guaranteed income and/or protection of principal could be used for income. You will need to have enough invested to provide income for at least ten years. Invest the rest of your money in growth until you have earned enough to create another ten-year income stream. Then repeat the process. Although simple in its approach, a retirement income plan is anything but simple.
Once you decide how much income you want from savings you must determine how you will invest for income. One way is to invest in investment grade bonds with varying maturities up to ten or twelve years. Income will come from interest on the bonds and principal as each bond matures. By consuming principal and interest less money is needed to generate income thereby leaving more for long-term growth. For shorter periods you might use money market and CDs. Fixed annuities and some of the new breed of variable annuities that provide guaranteed income without having to Annuitize work very well, too. Remember to always keep an emergency fund available for unexpected major expenses. This method of staggering bond maturities is called "laddering".
The rest of your savings then goes into a well-diversified growth portfolio. Mutual funds are probably best for most people. Don't make the mistake of assuming a few mutual funds will adequately diversify your holdings. It depends on what they are. If you don't know a lot about selecting mutual funds get professional help from a fee-based or fee-only financial planner. The bond ladder allows your growth investments enough time to help reduce market risk.
Where people can get into trouble is when they must sell investments that are more exposed to market volatility such as one year holding periods. In the last eighty years the market has lost money about 31% of the time over rolling one-year periods. It has lost money only 3% of the time over rolling ten-year periods. Of course, the past does not predict the future of markets but it can illustrate how long holding periods can help reduce investment risk and that's exactly why we establish the bond ladder.
This new methodology can work. You will have to allow for inflation and understand how to properly invest for this to work. It is designed to provide a dependable rising income throughout retirement and flexibility to handle unforeseen expenses so you can have a retirement without wondering, "Will I outlive my retirement?"
1. Source: "Social Security and the Consumer Price Index for the Elderly," Federal Reserve Bank of New York, 2003. Data represented from 1984-2001.
2. Results of 2006 Capital Markets, "Stocks, Bonds, Bills and Inflation 2007," Morningstar.
3. Ibbotson and Associates, "Stocks, Bonds, Bills and Inflation", 2006.
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Bill Garrett is a practicing Certified Financial Planner(tm) in Brentwood, TN specializing in retirement income planning and portfolio management. His trademarked WealthSpring(tm) retirement income system is designed to provide reliable inflation adjusted retirement income for decades. To find out more visit http://www.GarrettFinancial.com. Securities Offered through Securities America, Inc., Membe FINRA/SIPC, Wm. B. Garrett, CFP(tm), CCPS, a Registered Representative. Securities America, Inc. is not affiliated with Garrett Financial, LLC.
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