Published July 08, 2013
You are preparing to retire. Maybe you retired 5 years ago. You have a plan. You have a budget. You have guaranteed income streams such as social security, pensions, or rental income. You supplement this income with withdrawals from your nest egg, or you plan to do that before too long. You try to pay attention to tax rates and the various loopholes available to keep tax liabilities down.
Sometimes retirement feels pretty good. Still, there is uneasiness. Why? There is one big problem, the elephant in the room, “the unknown.” The unknown can come in a variety of flavors. The problem is that every flavor is something you don't care for. You can put all the ketchup in the world on a cardboard box, and it will still cause some indigestion. Let's talk about a few "unknowns" that have recently become "known.” This is why annual reviews are so important.
Remember that what you don't know really CAN hurt you.
Meet the new "known."
The 4% Rule
Years ago, back when your folks were retiring (say, early 1990's), we in the financial planning industry liked to do calculations that assumed you could reasonably plan on about an 8% rate of return. We would plan on withdrawing no more than about 4%, and you would be fine! Throughout the 90's, this model held true. The 1990's enjoyed market returns unlike any other decade in history. We were invincible. No turning back. Damn the torpedoes and full steam ahead!
Enter the following decade however, and things have changed quite a bit. As price-to-earnings ratios became "out of whack," there was just one way to get them back into “whack.” That's right, a correction. The first correction lasted 3 years, beginning around year 2000. The 2nd began in November of 2007 and lasted just one memorable year with a near 58% decline.
What a roller coaster ride it's been, so much so that Texas Tech Financial Planning professor Michael Finke wrote an article stating that, “the 4% rule is dead.” His new number, 2.8%! Blame it on whatever you like. A 2.8% withdrawal rate! Believe me; this puts a damper on the retirement party like wet towel on a single match. Time to re-visit the budget and see what we can live without.
Sequence of Return
I hate to break it to you, but traditional securities portfolios in retirement work well only if you receive positive returns during the first full 1/3 of retirement WITH NO SIGNIFICANT SETBACKS. This has to do with what we call "Sequence of Return." Rather than WHAT rate of return you earn, "sequence of return" is nothing more than, WHEN you earn the rates that you earn.
Think of it this way, if you are retired and need current income from your savings, you might be tempted to employ the 4% rule mentioned above. However, if your nest egg is cut in half early on in your retirement (remember 2008?), you will suddenly be pulling a full 8% of your savings. This is just not advisable or supportable. It's a slippery slope that leads right to your kids' place. You'll be standing there with your hat in your hand. At that age you’ll likely have neither the time nor energy to look for a job. Now that's just bad timing.
Note: During pre-retirement years, sequence of return is not mathematically relevant. When you do the math, it doesn't matter WHEN the good years or bad years come. You will end up with the same future value whether the bad years happen early, or later on. Therefore, it is not discussed much by advisors that service investors of various ages. Once you are retired however, sequence of return is both powerful and potentially devastating.
The Black Swan
There is a term in the financial planning industry known as a "Black Swan". It refers to an unforeseen event, which causes instability, or lack of confidence in the market. It could come in the form of a terrorist threat, the bankruptcy of a large company, an industry, or even an entire country. Regardless, we try as an industry to foresee these events. Try as we might, they can blindside us and set a well-planned retirement back on its heels.
Increasing Tax Rates
Now here is a popular topic. Regardless of your political persuasion, most of us would rather keep our dough in our own pocket. However, with our U.S. debt load, it's not likely. Qualified plan distributions are now topped out at (as of 2013) a whopping 39.6%. Back in 1950’s the top marginal Federal tax rate was 91%. To think that tax rates won't exceed 50% during your retirement years maybe a bit naive.
Low Bond Yields
Warren Buffet was quoted as saying that, "bonds should be issued with a warning label.” I would add that they may be hazardous to your wealth. Drop these like 3rd period French. In this low rate environment, the current undesirable low rate will only be followed by a reduction in value as rates move forward. Why? Because no one is going to want to buy your low-rate bond when they can go out and find a higher yielding one. You will have to discount the selling price to reflect this, known as “selling below par.” How fast can values decline? A good rule of thumb is a 10% reduction in market value for every 1% increase in prevailing rate. That might leave a mark.
It looms. Like a buzzard watching a dying calf in the desert. Currently, the Fed, in its attempt to avoid a deflationary trend, is pumping currency into the economy. This is known as monetary inflation. It ordinarily precedes real inflation. Inflation is when you have to pay $15 for a $10 haircut that you used to pay $5 for, back when you had hair. Nonetheless, the cost of milk, bread, eggs, hamburger, building materials, energy, etc. will increase in this environment. Better get ahead of the curve. Worried about that 60% stock portfolio? Well, if the American Institute for Economic Research (AIER) is correct when it forecasts that double digit inflation is imminent, stocks and stock funds will NOT be the best place to park.
So, where do I go, Joe?
Again, be advised that neither stocks nor bonds fare very well in inflationary times. Therefore one begins to consider saddling up a horse of a different color. In this environment, we want to seek vehicles that have historically taken advantage of these inflationary trends. They exist. You just have to look in places that not everyone is looking. We can help with that. The writer encourages you to seek the advice of an independent adviser. One who is free from an employer/employee relationship, and who specializes in retirement issues. Retirement Planners who function daily in these matters view the world through what I call, “Retirement Goggles.” We focus on safe money management as we seek to supplement relatively "guaranteed" income streams such as pensions, rental income, and social security.
Will Rogers was quoted as saying, "The best way to double your money is to fold it over and put it back in your pocket." I suppose he may have been referring to the idea of minding your own expenses. Nonetheless, safe money management and well informed decision- making is crucial at this stage of the game. Decisions made today WILL determine your destiny.