This is the tale of two Retirees.
They are very typical retirees, really. And their finances are identical to one another. But there is one major difference: Only one seeks outside council from a Retirement Strategist, while the other retiree is certain there is nothing complicated about retiring. After all, he’s done pretty well for himself thus far.
But the problem with “not knowing” is that we just don’t know how much we don’t know.
Meet your retirees: They go by the names of Tom and Ned. Tom remains teachable as retirement approaches and seeks specialized council, while Ned is just not well informed. Ned is a smart guy, and he does his math; it’s just that Ned isn’t aware of all of the components needed for his equations.
At the point of retirement (say, age 66), there are still dozens of ways to mess up a previously “well planned” retirement. This article will focus on just a few very common stumbling blocks. For now, we’ll illustrate the cost of making just 3 poor decisions. The subjects are:
- The right time to start social security.
- Which pension settlement option to select.
- Managing the risk associated with your life’s savings
Let’s set the stage. It’s retirement day, January 1st 2000:
Our two retirees both appear to be in great shape. In fact they…
- Have always earned exactly the same wage, saved exactly the same amount of money, at exactly the same time, in precisely the same accounts. Therefore, they have precisely the same amount of money in their IRAs and 401ks. ($450,000)
- Have no debt.
- Are in great health at retirement. They expect to live a while.
- Have a monthly income need (including very reasonable entertainment and modest travel) of $6,000.
- As husband and wife, may take social security (respectively) worth $2,400/$400 at age 66 or $3,635/$544 at age 70. However, only Tom will dig deeper and find that he could exercise a “file and suspend” option.
- Will enjoy the same pension, with the same pension settlement provisions, as follows:
Each retiree is married. Each will enjoy a full pension benefit for life of $2,500. Each is offered an optional reduced pension. This means if the retiree is willing to accept just $2,000 (vs.. the full benefit of $2,500), the pension plan will provide, in the event of his death, $1,500 per month, for life, to his surviving spouse. This benefit is available only to the named surviving spouse, and ceases at the death of the surviving spouse. There is no benefit to children. However, if she should pre-decease him, the retiree must continue through life with a reduced benefit ($2,000 vs. $2,500), even though his wife no longer lives. He cannot assign this $1,500 survivor benefit to anyone else. Sadly, the retirees will indeed lose their respective spouses. It will be unexpected (at spouse’s age 70), just 4 years into retirement.
Other Study Assumptions
We will follow each retiree’s path through December 2012, utilizing historical S&P returns, with a retirement date of January 1, 2000. We will assume for this study that the COLA (cost of living adjustment) in the pension and the increase in annual Social Security benefit will match inflation. Spouses will pass at age 70. Retirees will live to age 90.
We will use today’s Social Security formulas.
Ned’s Retirement Decisions:
- Social Security: Ned and his wife decide to take Social Security immediately, at age 66. Their incomes are set at $2,400/400 respectively. But just 4 years into retirement, Ned’s bride passes at age 70. Ned will lose his wife and her Social Security benefit. The total Social Security income paid out for the household will be $710,400.
- Pension Election: Ned accepts a reduced pension ($500 reduction) so that he can care for his wife if something should happen to him. This $500 per month adds up to $72,000 in lost wages over a 12-year period. At that time, his lovely wife pre-deceases him. Unfortunately, Ned must continue to pay $500 per month, with no beneficiary to boot, until his death at age 90. Total lost wages $144,000. Ouch.
- Risk vs. Reward: True to form, where investing is concerned, Ned continues his pre-retirement “growth” mindset even as retirement begins. After all, the market is soaring! And there seems to be no end in sight. His Financial Advisor, a lifelong friend, fails to discuss many important retirement issues with Ned. This includes shifting from “growth” mode to “income/preservation” mode. Though initially Ned has plenty of savings to support his lifestyle, he leaves his nest egg at risk. Ned doesn’t realize that we are about to be chopped off at the knees on Wall Street as the price-to-earnings ratios correct. Terrorist threats and political pressures take their toll, as well. Investor confidence declines. Oil prices move forward. Ned experiences significant decline from 2001-2003 (approximately 47%!). Nonetheless, he must continue to take from savings even to support his lifestyle. To complicate matters, his wife will pass next year and he will lose another $4,800 per year that he was counting on. Though he sees some market recovery in the mid 2000’s, he is hit once again with a 38.49% decline in 2008! Ned no longer speaks much to his friend and financial advisor, who had advised Ned to simply “buy and hold, and stay the course.”
By the end of 2012, Ned’s nest egg will erode to just $161,412. Even with no inflation, it is very unlikely that his savings will last another 12 years, a sad state of affairs indeed. Ned will live to see age 90, but his life savings will not. Ned will pass away leaving no inheritance for his children. Total capital lost $450,000.
Tommy’s Retirement Decisions:
1. Social Security: Our friend Tom is a teachable guy. He seeks counsel from a “Retirement Strategist” and then decides to “File and Suspend” his own Social Security benefit, and begin his wife’s benefit at age 66. This causes his wife’s Social Security income to increase immediately from $400 to $1,200. Later, his own Social Security benefit will begin at $3,625 (a 32% increase over his age 66 offer) when he finally begins taking his Social Security at age 70. Until age 70, Tom makes up the difference in his income need by temporarily taking income from his retirement savings. Therefore, at age 70, Tom and his bride will potentially enjoy $4,825 per month combined Social Security income. However, Tom will lose his wife and her Social Security Income at age 70. He will enjoy only his own $3,625 Social Security Income. His household Social Security income throughout retirement will still be $841,000.
2. Pension Election: Tom elects to take his “Full Benefit” pension ($2,500), and purchase a $275,000 universal life insurance policy from a well-known carrier, and pays $600/month to provide for his spouse. In year 4, Tom will lose the love of his life, but since he owns his life insurance, he has the right to cancel his universal life policy and ask for the cash value to be paid to him. His “cash back” is $15,998. Total out of pocket for Tommy (amount paid less return of cash value) is $12,812. He will pay no premiums from age 70-90, and will enjoy his full $2,500 pension.
3. Risk vs. Reward: Tom discovers (through careful calculation) that he doesn’t need to stay in risky investments in order to enjoy his pre-determined retirement lifestyle, even with inflation. He now knows he has plenty of savings, and even a 4% return on this savings is adequate. So why risk it? Tommy moves the bulk of his retirement monies into “safe haven” positions. This includes such traditional vehicles such as bonds, CDs and annuities. He also places a modest amount (just $50,000) of his savings into a very simple S&P 500 index fund. This mutual fund may not be the most explosive, but Tom knows large companies are historically the most solid, and most of the 500 companies pay dividends. Although he does experience some decline in his portfolio during the downturns of 2001-2003, and again in 2008, he need not panic. He has plenty of savings from which to derive income until his mutual funds recover. His new Retirement Strategist suggests that he withdraw from the mutual fund only when he feels that market conditions are ripe for withdrawal. He never sells at a loss. Tom’s CDs and annuities average about 5.25% during this time period. Surprisingly, Tom’s mutual fund actually retards his overall growth, averaging just 1.841% from 2000-2012. Nonetheless, Tom’s portfolio value in year 12 exceeds $560,000. If history repeats itself in the following 12 years, his children will inherit approximately $825,000.
The drumroll please…
Retirement Summaries, at ages 78 (year 12) and 90*:
Age 78, year 12
Account Value, Year 12: Ned - $161,412 Tom - $561,363 (+399,951)
Age 90, end of plan
Total Social Security Received: Ned – 710,000 Tom – $841,200 (+131,000)
Net Outlay for Survivor Benefit: Ned – $144,000 Tom – $12,812 (+131,188)
Inheritance at age 90: Ned – $0 Tom – $827,355 (+827,355)
The two retiring men are both intelligent. They both saved well and enjoyed the same pension and the same Social Security options. Just a few key decisions caused a world of difference in personal lifestyle, emotional stress, and eventually an inheritance to children.
*Note that the vast difference in values reflects a combination of poor choices of one of our retirees. D Bryant Retirement Strategies strongly encourages the reader to seek an advisor who understands the complexities of post-retirement financial matters.