A few weeks ago I took an extension class at UCLA called, "Your Transition to Retirement: Creating a Lifelong Income" taught by Paul Heising, MBA, CFP. Here's the course description from the catalog:
This course is ideal for those who are recently retired and those concerned financially about whether or not they will be able to retire some day. Unlike other retirement planning courses that focus solely on the accumulation of assets, this course also covers the transition from accumulation to the distribution phase and identifies critical financial strategies so you don't outlive your money. Key planning areas covered include identifying the most common mistakes that retirees make and how to avoid them, determining the income you will need in retirement and where it will come from, a review of withdrawal rate strategies based on recent academia studies, and creating a lifelong income so you won't outlive your money. Participants leave the class with a clearer understanding of how to analyze their options and successfully manage their own transition from accumulation to distribution. This course also includes many examples of real life retirement and investment situations.There were only about eight of us enrolled, which illustrates just how shamefully ignorant most people choose to remain about their future. Did I learn anything? Yes, lots. Would I make any changes to the investment lessons I already published? Not really--there is a big difference between the accumulating stages of investing which I covered in these lessons and drawing an income from your investments.
It would take much more than a single blog post to cover everything that was discussed in class so I'll just hit on some of the highlights that I found interesting.
The most common mistakes people make when it comes to retirement planning:
- Underestimating how long you will live in retirement.
- Not recognizing the impact of inflation on reducing your purchasing power.
- Investing too conservatively relative to your income needs.
- Excess withdrawal rates and point-in-time risk.
- Not understanding tax planning and how it can be a benefit.
- Overlooking health care issues and costs.
- Not understanding the importance of estate planning.
So how do you plan for retirement? First of all plan to be retired for a long time. There are charts and tables drawn created by actuaries that show statistics like two thirds of all humans who have reached the age of 65 are alive today and if you are a 65 year old female your life expectancy is 85 but a woman who is 85 today will likely live to over 92. No one knows how long they will live and most of us don't really want to think about it too much but to be on the safe side, plan on living 7 years or more beyond your life expectancy. Even if you wait until 65 to retire, we're talking about spending 30 years in retirement. Considering early retirement? Plan for 40, 50 years in retirement or even longer.
As you age your money will be worth less because of inflation. The rate of inflation varies from year to year. I remember some years where we had double digit inflation and people bought things now because they knew that the price would only go up if they waited. Annualized from 1914 through today inflation grew at a rate of 3.29%. Using the Rule of 72 that means that the cost of living doubled every 21.88 years.
Investments should stay ahead of inflation and this brings up the subject of real rate of return. Historical rates of return for an all stock portfolio average out to 10.3% per year, intermediate treasury bonds have returned 5.1% and a blend would of course be somewhere between the two. However, inflation eats away at the earning power of the portfolio so stocks real rate of return drops to 6.8% and treasury bonds to 1.75%.
It would make sense to try and maximize your return within your risk comfort zone but many people tend to invest for retirement too conservatively. Not only is it difficult to accumulate enough to retire, the funds will run out quickly. The consequences are outliving your money, having to reduce your spending, return to the workforce or trying to make up for it by taking on more investment risk during retirement than is prudent.
That brings up the point of excessive withdrawal rates and point-in-time risk. Ideally your withdrawal rate will be enough to cover your lifestyle, keep up with inflation and either run out when you die or maybe leave a little something for your heirs. Point-in-time risk can't be predetermined unless you know which direction and how far stocks and bonds will be going in the future, in other words you will only know you retired at the wrong time when you run out of money! Let's say your investments drop 50% as has happened many times in history. Your portfolio would have to gain 100% just to get back the where you started but let's say you decide to take a 4% withdrawal rate, which is pretty standard, you'll need a 132% increase to recover.
At this point the prospect of ever retiring may seem pretty slim, but using computer modeling and historical stock market returns an initial investment in 1972 of $200,000 in an all stock portfolio with an initial withdrawal rate of 7% and adjusted to keep up with 3% inflation would last over 30 years. The initial withdrawal would start at $14,000 and by 2005 the annual withdrawal would increase to $37,133 and the total withdrawals for the life of the investment added up to $838,405. What did this portfolio in was the dot-com bust of 2001, a bear market which it never recovered from. Reducing the withdrawal rate from 7% to 5% and keeping up with 3% cost of living increases on the same $200,000 all stock portfolio would start you out with $10,000 (in 1972) and by 2011 you would be taking out $30,748 per year and still have plenty left over. In fact despite the 35 years of withdrawals the portfolio would have grown to $2,448,813 in 2011.
It would seem that the answer to maintaining a life-long income is to invest only in stocks and don't be greedy with the withdrawals but it isn't that easy. Starting a withdrawal plan right at the beginning of a long and deep bear market is risky. How much risk are you willing to take? You won't really know until your portfolio is down 50%, 75% or even 90% as has happened in past bear markets. It is difficult to stomach these declines and stay fully invested. Many investors panic and sell right at the bottom, their portfolios never recovering. A way of smoothing out the bumps of the stock market is by adding bonds to the portfolio. A stock/bond portfolio mix is a bit more difficult to model but assuming that the bond portion of the portfolio earns a fixed rate of 4%, a 60/40 stock/bond mix of $200,000 starting in 1972 with a 5% withdrawal rate and 3% annual cost of living increase would not be drained by 2011. The portfolio would still have $309,267 left over, much less than the all stock portfolio but with a lot less fluctuation in value. In addition, in order to keep the portfolio balanced you will be withdrawing from the portion of the portfolio that is performing the best for that year. For example, in a stock bear market you'll draw from the bond portion. If the stock portion drops significantly then funds should be transferred from the bond portion to the stock portion to keep the target stock/bond mix. This will automatically force you to buy low and sell high, which is exactly what you want to do.
Another factor to throw into the problem is taxes. Stocks and bonds will pay out taxable dividends. You will be taxed on these dividends even if you don't withdraw them so it would make sense to shelter as much of that income from taxes as possible. In addition, if you have a choice of adding to a tax free or tax differed account like an IRA or 401K, it is probably a good idea, especially for the bond portion of your investments. Exactly how to figure out what works best is beyond the scope of these basic investing lessons but I will say that I have converted all of the retirement accounts that I had control over into a single Roth IRA. I've also got a pension from the trade union I belong to and of course there is Social Security but I don't have any say so over how that money is invested. In fact, I don't even factor those funds into my retirement equations because there's no guarantee that there will be anything left by the time I'm eligible.
Right now my biggest obstacle for taking an early retirement is health care. It isn't that my wife and I have any serious health issues, it is because insurance is very expensive in the U.S. and being under covered can be very risky to our finances. In fact it is the main reason that I continue working--to collect my union health benefits. Although we covered several options in the class, none of them seem as cost effective as putting in just enough hours to qualify for a good group health plan. Until, that is, Medicare eligibility kicks in. Again, this subject is a bit beyond these investing lessons.
Finally, estate planning. Ideally, your investments run out right at the time of your death but if that's not the case it is much better to have some left over instead of the other way around. If you want to leave anything to your heirs you'd better look into drafting up a will and possibly moving some major assets like your home into a trust. Like the last few points covered, this is also beyond these investment lessons but it is worth mentioning in case your investments outlive you.
Is it possible to invest enough to eventually live comfortably or are we commended to working the rest of our lives? It depends on your definition of living comfortably. Some people work only a few years and retire in their 40's or even their 30's, others struggle until they are forced out of the workforce in their 60's and 70's with no savings. Someone who learns basic principals of investing and puts them into practice should be able to accumulate enough investments that will provide enough of an income to live off of the investments for a lifetime.
Just to make sure I got the concepts of creating a lifelong income, I created a few spreadsheets and experimented with some what-if situations. Although taking a larger percentage along with a bigger risk of say 7% from a 100% stock portfolio, if the stock market doesn't cooperate and you fall into the trap of a bear market early in your retirement there is a good chance of running out of money. Your chances of avoiding lots of anxiety by living frugally and drawing between 3% to 4% of a balanced portfolio. How you balance it of course is very individual but let's say that if the portfolio is made up of 50% stocks and 50% bonds, deciding whether to draw from the stock or bond portion of the portfolio becomes very easy. There's no need to constantly re-balance. Simply draw from stocks when they outpace the bond portion of the portfolio and from bonds in the years they outpace stocks.
Overall the lesson learned from the UCLA class was that not only it is possible to fund your own retirement but with the current state of Social Security, company and union pension plans, it is probably the only way to guarantee a lifelong income. Note that the goal of investing isn't to be able to live a luxurious lifestyle. In fact living frugally not only helps when you're saving for retirement, it is imperative in order to create a lifelong income.
