Tools of the Trade
A doctor uses x-rays, EKGs, and other tests to do his job. A financial advisor, on the other hand, should check things like the asset allocation in retirement accounts and personal investment accounts, expense ratios, commissions and fees for mutual funds and exchange-traded funds (ETFs), amount and type of life and disability insurance, employee benefits derived from employment, etc.
One frequently misunderstood term in retirement planning is the “funded ratio,” which points to whether we are on track for the retirement lifestyle we hope to achieve. The funded ratio is comprised of the income-producing assets we have today, plus the annual amount we are investing at a reasonable rate of return (net of inflation), divided by the total assets we will need at retirement to sustain our desired retirement income.
It sounds complicated, but a good advisory team can calculate it easily, explain it in understandable terms, and – most important – monitor our progress as we move toward retirement and beyond. Most financial planners have computer programs where they can plug in numerous variables to make the appropriate calculations.
Online tools may be adequate for basic calculations, but they have limitations. The output of such a program is only as good as the input. If you deviate from standard inputs, you run the risk of being misdiagnosed, particularly because they often use a one-size-fits-all approach. In many cases, these programs simply miss meaningful differences between people.
Bob and Betty Jones
Bob and Betty Jones are both age 50 and hope to retire in 15 years. They have two concerns:
- What will it take to be able to retire with the essentials of an acceptable lifestyle?
- What will it take to be able to retire and enjoy the things they really want to do?
They believe their “have to have” lifestyle will require an annual income of $25,000 on top of Social Security. They think a “comfortable” lifestyle will call for $50,000 in addition to Social Security. Both of these estimates will need to grow with inflation.
Bob has a modest pension of $6,800 from his company starting at age 65, but it is not indexed for inflation. The company switched to a 401(k) years ago.
According to a recent survey by the Employee Benefit Research Institute, only about 3% of those working in the private sector have a pension. Like Bob, unless you work for the government, your employer likely converted to a 401(k) or similar program long ago. This won’t guarantee a certain amount of income; they are basically tax-deferred savings plans. As Bob and Betty realized, it is up to them to save and then invest wisely so they have enough to retire comfortably.
They currently have a total of $265,000 in 401(k)s, IRAs, and personal investments. They are adding $6,000 a year to their portfolio. Let’s look at the funded ratio for both their have-to-have and comfortable lifestyles to find out if they are on track. As we do this, keep in mind that there are unknown factors to consider:
- A realistic estimate of the rate of return on their assets. We assume 7% net of expenses. Studies show that a balanced portfolio of 60% equities and 40% fixed-income has delivered 7% over rolling periods of 10 years since 1926.
- Will they retire into an up or down market? Consider the poor devil who retired on January 1, 2008 into the great recession market, versus the lucky guy who retired just one year later January 1, 2009, into the recovery market. This risk can be addressed with what we call a “shock absorber liquid portfolio.” This means having two or three years of annual expenses in cash and near-cash accounts so you don’t have to sell assets from your core portfolio when markets are down.
- What will inflation do to their buying power? We assume a 4% rate of inflation, but actual inflation should be used to update their plan annually.
- Are their investments diversified and allocated to reflect their tolerance for market volatility? Has the volatility of markets in the past few years changed their thinking?
- How long will they live after retiring? Oddly enough, living a long life is perhaps the biggest risk facing retirees.There is always the chance that Bob and Betty could each live to age 120, but for this analysis, we will assume age 95. If your family has a history of longevity, you need to take that into consideration. Just as other assumptions should be periodically be monitored, so should their health and any breakthroughs in medicine that could extend their lifespans.
One obvious question then should be: Is age 65 the appropriate retirement age? Unless you have accumulated enough money to afford the luxurious lifestyle mentioned earlier, we don’t think so. Considering the loss of work-related benefits including medical, dental, and life insurance, there are many reasons to defer retirement. Many retirees have changed careers and are enjoying new careers doing what they want in a less stressful environment.
Another factor to consider is whether they will free up any money by moving from their family home to a less expensive place. Has that prospect changed since the recession drove housing prices down? Do they really need a new car every three years? Could they increase their savings rate by eating out just twice a week instead of their usual three times?
By forgoing one $60 dinner out every week, Bob and Betty could save an extra $3,120 every year. Investing this at a real return of 3% would give them another $53,309 at age 65. You will see below that something as simple as this will make quite a difference in your retirement lifestyle.