April 2004
Today's record low interest rates are a huge benefit for both consumers and businesses but, at the same time, they create quite a hardship for those who are paying the price - income-oriented investors. Of course, we can all understand the obvious reasons for the Fed following their unprecedented low cost money policy and it has, in fact, helped blunt the serious effects of the bursting of the stock market bubble. Mortgage rates are at unheard of lows, corporate America is getting the stimulus of cheap credit and consumers are feeling no pain as their houses appreciate in value. But where does it leave conservative retirees who are stuck earning paltry returns on their money and how is it helping those whose primary concern is to not run out of money in their retirement years? Current yields are extremely low and taking more risk to reach for extra yield is, well, a risky endeavor. Today's interest rate policy is likely the right one to get the economy going - but it comes at a cost to many - both to current retirees and to those on the eve of retirement.
Do We Have Enough Money To Retire?
By far the most often asked question posed to us is, "Do we have enough money to retire?" It is an emotionally charged question that can be answered relatively accurately given the right information. But the devil lies in the details and the assumptions that are made can alter our answer immensely. Every investor has a unique set of objectives and most do cite the common goal of enjoying a worry-free retirement. However, some hope to leave a lot to their kids or charity while others simply aim to satisfy their desires to their fullest and leave nothing to spare. That is big distinction and it does change our recommendation tremendously.
Our answers in this article attempt to generally address the question of how much money is enough. Please note that nothing substitutes for analyzing your unique circumstances with a trained professional prior to making any long-term decisions about retirement. Consider that free advice - not a commercial.
With Social Security's long-term solvency questioned - at least under the current setup - and with the first of the baby boom generation approaching retirement, looking realistically at what level of sustainable income you should expect your portfolio to produce is becoming a very important thing to consider. The stock market's gains of the past two decades - in our opinion - cannot be counted on to make up for the lack of retirement savings. The only realistic solution is to (a) develop disciplined spending habits, (b) consider delaying full retirement for some time and (c) consistently investing what you have managed to save responsibly. A combination of these has been - and always will be - the cornerstones of building and maintaining a successful retirement.
Plan A: Don't touch the principal - and keep up with inflation.
On one end of the spectrum - using the assumption that you want to have as much money (adjusted for inflation) at the end of your life as have at the beginning of retirement - you will need to sacrifice some spending along the way.
One very important factor in determining the sustainable spending rate is the path of future investment returns. The spending is the easy part and very predictable - for example, you take out $50,000 the 1st year, a bit more the next and so on - but the investment returns in your early retirement years can seriously alter how long the spending can last.
Bad returns in the early years - along with steady spending - can lead to a deterioration of principal awfully quickly. This is a lesson many have sadly learned over the past four years. So, under these assumptions, we recommend limiting your spending to 3% or less of your total portfolio value annually. This spending rate is designed to leave some investment returns on the table to replenish what inflation will surely eat over time and will help create a small cushion for any investment return disappointments.
Plan Z: Die broke - and forget the rest.
On the other extreme - using the assumption that you aim to die broke - your biggest worry will be how to properly time your spending with your breathing. It doesn't sound like an easy task - and our expertise in the "stop breathing" realm is thankfully limited. Nonetheless, if this is the objective, we feel that establishing a spending rate of greater than 3% is completely justifiable. The difficulty lies in the timing - but insurance products, namely annuities, can solve the problem completely. The cost for this income certainty for rest of your life can come at great expense - but this solution fits some circumstances very well. However, in most situations - for those who don't need to rely on the aid of an insurance product - establishing a 7% spending rate will likely leave a little left over to be safe, especially when considering the utilization of what is often substantial, untapped home equity.
Plans B to Y: The Goldilocks Approach
Of course, spending somewhere between 3% and 7% is a reasonable compromise of assumptions that balances the desire to leave a large estate behind with the need to reduce money-related stresses in your later years. No money manager, financial planner or broker knows exactly how the investment future is going to unfold and no client knows their eventual date of demise. Ironically, it should not be forgotten that the worst case scenario - living a long, long time - is the scenario of primary concern. So, in the end, we advise erring on the side of conservatism and establishing a spending rate of no more than 4% of your portfolio's value - the less the better.
Today's accommodative interest rate policy and the 2000-2002 stock market decline certainly dented the financial lives of both those already retired and those considering it in the near future. The stock market made things tough enough and now yields on bonds leave very little to be desired. Nonetheless, we strongly discourage extra risk taking - by reaching for extra yield in lower quality bonds, long term bonds and especially leveraged bond funds. We equally caution against trying to make up for lost financial ground by repeating the critical investing mistake of relying on momentum and hope over value and patience. Making up for past losses by investing in bad companies at high prices or committing your capital for 10 years or more for a mere 3% more in yield is a great recipe for more disappointment - but this time with even less time to make it up. In the end, it is important to maintain investment patience, learn to tune out the market's extraneous babble and, perhaps most importantly, establish a sustainable spending plan before pulling the trigger to retire. Retiring isn't the goal - remaining retired is!
Jason P. Tank, CFA
jason@frontstreet.com