How your grandparents retired, why your parents never will and if they do; how you’ll be picking up the tab. Part 3.
In the first two parts of this series, I gave you an in-depth look at retirement strategies from previous generations. I explained the pros and cons of each of the strategies for different generations and how each effected the following generation. I showed you the difference between defined-benefit plans and defined-contribution plans. I also illustrated how the shift from pension plans to 401(k) plans has left our upcoming retirees extremely underfunded and unprepared. In this final article, I will provide some useful tips to help you navigate your financial ship towards success and have enough income to truly enjoy retirement.
Step 1 — Chase a rate of savings, not a rate of return.
If you remember from the last article, one of the major issues with defined-contribution plans is that they focus solely on amassing a large sum of money and that money is tied to market performance and volatility. This strategy enables individuals to focus more on taking risk to earn growth on their money instead of focusing on saving their way to retirement. I want to illustrate why saving your way to retirement is far more realistic than “growing” your way to retirement and also, far safer. I am going to use the same 30-year-old from the previous article, who earns $100,000 a year to illustrate my point. All of the variables will be the same as before. The subject will earn a 3% wage increase and will also receive a 3% match from his company for the 3% she(he) is saving. We are going to assume that the retirement age is set at 65. If over 35 years, this individual were to earn 6% net of fees (6% net of fees is somewhere closer to an 8% rate of return), they would have $1,032,912. If they were to earn 8% net of fees over that same time, they would have $1,555,504. In this scenario, where you are consistently hoping for growth, you lose more and more control of your money as you continue to chase higher rates of return in the market. Your retirement strategy isn’t a strategy at all, it’s a prayer that you can earn a linear return of 6–8% compounded for 35 consecutive years. I can’t predict the future, but I can tell you, that the scenario that I just described has never happened in the history of our markets.
We can’t control markets, but we can control our habits and savings should become a habit sooner than later. In the following illustrations I am going to assume that we will only earn a 4% rate of return, net of fees. The only variable that will change here is the percentage of money that will be saved. You can see immediately, that in this strategy we are taking more control of our future and taking less risk in the market. I recommend that all of my clients work their way up to saving 15–20% of their earnings. A savings rate of 20% is a rate that I would consider optimal. Now, let’s take a look at what saving 10% annually and earning a 4% rate of return would do for this individual. Over the same 35-year span, we would have amassed a total of $1,177,516! With less market volatility and more personal control, we already surpassed the previous savings strategy that earned a 6% rate of return. It becomes staggeringly better at a 15% savings rate and a 20% savings rate where the totals come out to $1,766,273 and $2,355,031 respectively! There is no reason to take excessive risk and battle the volatility in the market, when you can simply change the way you view savings and adjust your habits.
Step 2 — Become an asset specialist, not generalist.
Let’s say, hypothetically, you were told by your Physician that you had a brain tumor and it would require surgery to be removed. Would you tell your General Physician to do the operation or would you ask for a Neurosurgeon to do the operation? You would obviously ask for the Neurosurgeon! If we have specialists for every other aspect of our lives, why do we treat our finances any different? It’s unfair and unrealistic for you to expect your nest egg to provide for all of retirements varying needs. If your only strategy was putting money in your defined-contribution plan for 35 years and using a certain percentage of that asset to live on, you’re asking your money to be a generalist, not a specialist. You’re expecting that asset to hedge against inflation, provide income, pay for increasing healthcare costs, hedge against market risk, pay for lifestyle, provide money for gifting, hedge against longevity risk (outliving your savings) and provide a legacy for following generations. I could keep going, but I think you get the gist of it. Of all of the risks I mentioned, I want to focus on longevity risk with you. Longevity risk, or the risk of extending life expectancy and thus outliving assets, only exaggerates all of the other risk. It takes all of the risks and amplifies their effects as you continue to outpace life expectancy. One strategy to hedge against longevity risk is to make sure that your portfolio is armed with guaranteed income that also keeps pace with inflation. An annuity with a Cost of Living Adjustment rider comes to mind when protecting against longevity.
Your main goal when entering retirement should be to have a diverse portfolio with assets placed strategically throughout to provide for all of the needs I mentioned prior and also to protect against all of the risks that are at hand. An annuity is a good specialist to fight against longevity, but what about providing income and still having the ability to leave a legacy behind? I believe that one of the biggest mistakes individuals make when planning their retirement, is allowing their life insurance to lapse as they reach retirement or not having a permanent insurance product in place to provide for legacy. Our ability to spend down our assets in retirement is a direct reflection of our enjoyment in retirement. All too often, retirees are left living a modest retirement due to the fear of running out of money too soon and also out of the fear of not providing a legacy for their families. Both of the aforementioned fears are very real, but can easily be hedged against by placing a permanent insurance product in your portfolio. This one strategy can be a multifaceted tool for you. It can provide money in the form of cash value for you and your spouse, should you spend down all of your assets and it can also leave behind a large legacy for your family, while still allowing you to have had a fulfilling life during your retirement years.
Utilizing just the two aforementioned strategies will unlock your ability to do something that most retirees never get to do, spend their money! Most retirees are forced to live very frugal lives due to the lack of planning in place for them. With their assets being generalists, these individuals don’t have the luxury of taking random distributions or spending down their money, out of the fear of running out too soon. To paint a clearer picture for you, I want to introduce you to the “4% rule”. The rule states that in order for a retiree to safely withdraw money from their asset and keep that asset intact, they can only draw 4% of their account value! That is only $40,000 pretax on an account that has $1,000,000 of principal available. That also doesn’t take into account any type of market correction or any emergency that might arise during your retirement years. So that lifelong trip to Iceland that you’ve wanted to take, the family vacation with the grandkids to Disney, the golfing trip with your friends to a world class golf resort or that Norwegian cruise that you’ve always envisioned, none of those will come to fruition because you didn’t have a plan and you’re afraid the money won’t be there when you wake up.
Step 3 — Prioritization, systemization and crushing procrastination.
It’s no secret that our nation’s people do not do a good job saving for their future. More than half of our country couldn’t come up with the funds to cover a $2,000 emergency should it arise. The issue at hand, isn’t that people don’t know how to save or don’t have the money to save. The issue is, they don’t make saving money a priority. Most people have their financial priorities backwards. They will fund lifestyle and unnecessary expenses, before ever considering saving for the future. If they do have any savings, its usually in the defined-contribution plans that we touched on earlier. Money not accounted for in your life will always find a place to go, most of the time, that path never leads to savings. I recommend that people view savings as a monthly expense. Every month, you will pay your savings expense just like you pay your mortgage. I always have my clients start with a number that is challenging, yet realistic. Once the individual has been paying their savings expense for a few months, we push the envelope a little and increase the savings expense. This savings expense doesn’t have to be invested in anything as you begin your journey. The goal here is to create a habit, the habit of saving. You may not realize this, but tomorrow will continue to show up, so you need to make a change today. Even if you don’t have ability to save 20% immediately, start now, start small, and build your way up. Pushing off your savings continually can have an astronomical effect on your overall asset value. Think back to our example of the person who makes $100,000 with a 3% annual wage increase. This time they are going to earn a 5% rate of return and save 10% on an annual basis. What we will be exploring now, is how impactfull it is to have a longer savings horizon. If this individual started saving later in life and only had 20 years to save under the stated guidelines, they would have a total of $444,773. If they had 25 years to save, they could accumulate a total of $678,603, quite a difference for only an extra 5 years. Add another five years to that and we are looking at a total of $994,707! Starting ten years earlier in life more than doubles your asset value! I urge you to take control of your financial future and start saving now. You owe it to your future self.
If you need any guidance, please feel free to reach out to me or your current financial professional.