So many theories – What’s the reality

How many times have you read a headline that fairly screams “retirement crisis” or some variation on that theme.  I often get the question – Am I saving enough? Or, How much should I be saving?  There are number of handy rules of thumb that can point people in the right direction but each requires a bit more understanding than simply a percentage or a dollar figure.

Let’s begin with a better understanding of where to start.  If you look at your paycheck the first number we need is your “net pay” which is how we will form our baseline.  Take that number and multiply it by the number of paychecks you receive each year then divide that by 12 for your monthly baseline cash flow.  That’s pretty simple math and it gives us something we can start to work with (a bit of a simplification, yes, I completely agree).  Rule of Thumb #1 – the higher that number, the more you should be saving.  Why is this?  For starters, Social Security is going to cover a higher percentage of a lower monthly amount than a higher amount. 

Let’s run through an example:  Let’s say your annual salary is $65,000.  Depending on your tax and insurance deductions (let’s leave your retirement savings out of it for now), your take home might be something in the range of $43,500 or $3,630 a month.  On the other hand, let’s say your annual salary is $95,000, your monthly take home might be something closer to $5,300.  If the average Social Security is $1,540/month, then you can quickly see that $1,540 covers a bigger chunk of $3,630 per month than it does $5,300 which means the higher earner needs to save more to make up the difference.

The next step is to consider whether or not you have a pension (and yes, there are still plenty of those floating around out there).  If you do have access to a pension and you are the lower earner in the above scenario, then you don’t need to save nearly as much as the higher earner does who might not have access to that pension.  This leads me to Rule of Thumb #2 – if you don’t have access to a pension, the more you should be saving.  Of course, having a pension isn’t fool-proof and you may want to be saving more to insulate yourself from the risks associated with non-government based pensions but that’s now a matter of choice rather than baseline survival.

So now we have some idea of how much we need and what structured resources we might have available so let’s turn to what we should be saving.  You’ll often hear “you should be saving 10% (or 15%, or 20%) of your income” or “you need to save up 10x your salary.”  That give us Rule of Thumb #3 – Target 10% of your salary since it is an easier equation to work with.  That being said, don’t forget that if you are receiving a matching contribution from your employer that counts towards your 10%.  If your income is higher and you don’t have a pension, you should be thinking about saving a higher percentage.  If you want to retire before your Social Security Full Retirement age, ditto.  If you want to retire before you are Medicare eligible or earlier, double ditto.  If you are getting started later in life, want to retire before you are Medicare eligible, and have a healthy income, perhaps consider couch surfing for a while so you can catch up on your retirement savings.

But what about all those “what’s your number” ads? So here’s the challenge with those – what’s the time frame leading up to that “number?”  What life expectancy is being use in that calculation?  What’s rate of return on your assets?  What rate of inflation is being used for your expenses?  All of your expenses, or is a different rate being used for your medical expenses?  What rate of inflation is being used on the Social Security benefits?  Rule of Thumb #4 – f you are using one of the many computer formulas available on line, make sure you understand how they are calculating what you need to save to make your “number.”

Of course, all of this starts with the making sure you have a good handle on your cash flow, have your non-housing debt eliminated (or under control), and are considering a retirement lifestyle roughly equal to your current lifestyle.  Here you have Rule of Thumb #5 – If you aren’t sure where to begin, begin at the beginning.  Start saving 1% of your pay (net or gross, your choice) and put a note in your calendar for three months later.  This lets your budget adjust for 3 months.  When that three months is up, increase your savings by 1% and mark your calendar out three more months.  Repeat this process until you’re saving at least 10%.  Can’t find 1% (or whatever you need)?  Come on in and I’ll help you find it (full & fair disclosure, my version of what you need in life is probably going to look different than yours….).

So there you have it – a solid five Rules of Thumb to bring some perspective to your long-term savings plan.  Draw yourself a little hand-turkey (remember those from kindergarten), label the fingers, and post it on your fridge as a reminder on how to secure your future.  And who said money isn’t fun!

The 4% Rule – Retirement Fact or Fiction?

Many of my retired clients have mentioned that the working part of their lives was much easier than the retirement stage and I’m reminded of a t-shirt my husband would wear that said “Old age ain’t for sissies.” One of the most pressing questions I hear is “how do I determine a comfortable draw from my portfolio that ensures there is money left over when I am unexpectedly drawing breath at age 95?”  Enter a gentleman named William Bengen who postulated, in 1994, that a retiree could draw 4% from their assets, increasing their distributions by inflation each year, after rebalancing their portfolio annually.  Sounds like solid advice…and Swiss Cheese is still a cheese.

Let’s start with what that portfolio looked like back in 1994. Mr. Bengen did his calculations based on a portfolio that contained just two asset classes—intermediate Treasury bonds and large-cap stocks. Intermediate Treasuries were paying an enviable 5.92% in 1994 compared to 1.29% for those same issues right now. In his favour, the inflation rate when he did his research was 2.56%. That’s not terribly far off from our current non-medical inflation rate, although he didn’t account for the increasing amount an older person spends on medical expenses as they age. Another cheesy hole—this is based on a ~25 year draw so you have a choice: don’t retire early or don’t live too long.

All that number-crunching aside, there was a huge flaw in Bill’s strategy—annual rebalancing. While strong statistical data is hard to come by, years ago, the stat often quoted was that less than 15% of people rebalanced their portfolio annually. Anecdotally, I can tell you that the majority of people who swing through my office haven’t rebalanced their portfolio in several years and there’s a good percentage who have rarely, if ever, rebalanced their accounts. Rebalancing annually means every year, not just the years you feel like it and absolutely rebalancing during the years you don’t want to even open the envelope.

My next cheesy hole has less to do with Mr. Bengen’s calculations and more to do with people’s interpretation of his rule of thumb. You’d be surprised how many people layer their own interpretation on this mathematical theory and “feel” that it shouldn’t have to include taxes (boy, are those taxes inconvenient). On a $500,000 post-tax portfolio, 4% is $20,000 (let’s ignore that whole capital gains nonsense). To pull that same $20,000 from your $500,000 pre-tax portfolio, you have to pull at least $24,100, which is now closer to 5% of the portfolio, more than 20% more than the recommended draw. When you are building that retirement cash flow, make sure that you adjust your work based on what you have in your post-tax account and what you have in your pre-tax accounts (and no, we aren’t going to talk about Roths…. it’s been a long week)

I’m not saying that targeting a 4% draw is a bad thing. I love the idea of a structured stream of income since it makes my life a whole lot easier helping people build strong balanced portfolios with that goal in mind. I‘m just saying that what some talking heads call rules, I call guidelines and everyone needs to make sure they take into account as many variables as possible when they come up with the goals we are working towards. If you want to pull more than 4% in the early years of retirement, I hope you have a cash flow put together that has you spending a lot less than 4% in your later years. If you are in a higher tax bracket and all your money is pre-tax, your cash flow should be built on a lot less than 4% after tax.

If you are thinking of leaving a legacy for your kids, if there is an age difference of more than a couple of years between you and your partner, if one of you is the picture of health and one of you isn’t, then I would seriously reconsider becoming too enamoured with the 4% theory. In fact, there are mathematicians who are now saying a more realistic draw is closer to 2.5% (although I think that’s a little on the miserly side myself). As with so much of what we talk about, having a better understanding of what you have, what your resources can, and can’t, do, and setting some realistic (and somewhat flexible) expectations goes a long way towards helping you create a consistent, annual stream of income in retirement.

Shoring Up That Wobbly Retirement Stool

Whether you are standing on it, sitting on it, or hiding underneath it, a stool is only as stable as the number of legs supporting it and that’s no different than our retirement plan. If you think of your retirement plan as a stool, it needs those sturdy legs. And since it isn’t as much what you save as it is what you keep, the tax treatment of each of those legs is what creates that stool’s strength. No matter what stage of life you are in, these principles really apply to everyone thinking about retirement so here it goes…
Leg #1: The Pre-Tax Leg
This is the leg everyone focuses on and the one that makes our government happy since they now know there will tax revenue for many, many years to come. This is going to include everyone’s 401(k) / 403(b) / 457 / SEP / SIMPLE, and plain ole’ IRA plans. You put the money in now (either from your paycheck, by way of a company contribution, or simply making a personal deposit), take a tax deduction for the year, and let those dollars build and build, tax-deferred, until age 72 when the IRS says “thanks for the memories, where’s our dosh…” 
Leg #2: The Partial Tax Leg
When Social Security was first established, it was tax-free but thanks to President “lower taxes” (but only for some people) Reagan, Social Security is now up to 85% Federal taxable (it’s still tax-free in some states). Here’s a fun challenge—take too much from Leg #1 and you run the risk of making more of Leg #2 taxable, effectively decreasing your available cash…talk about conundrums. Here’s a fun fact—the average person collecting Social Security gets back everything they contributed in less than 10 years. As someone who identifies with the younger generation, I have very mixed feelings about that particular flaw in the formula.
Leg #3: The Post-Tax Leg
Have cash in the bank, in a money market, or under the mattress? That’s a #3 leg. Money in an investment account? Ditto. How do we know the difference between this leg and other legs? If you take money from this leg, the taxes are called “capital gains” whereas the taxes on other legs are called “income taxes.” While both taxes are somewhat manageable, managing “capital gains” taxes is much, much easier than managing “income taxes”
Leg #4: The No-Tax Leg
Wait, What? There’s a leg where I won’t pay any taxes??? Yup, under certain circumstances and like a truffle, not the easiest to find and use. It’s called a Health Savings Account and it allows you to deduct the contributions from your current year taxes, invest those dollars tax-deferred, and take the proceeds out cash free. Of course, in order to use this account, there are challenges worthy of a medieval knight but yes, the prize at the end is not only a slain tax-dragon but a lovely golden goose laying tax-free eggs in retirement.
Leg #5: The Mystery-Tax Leg
While many people consider anything including the words tax, financial, and investing to be a mystery (but not any of you because I know you faithfully absorb these weekly emails), there is one type of retirement vehicle that does have the air of mystery about it and that’s the Roth IRA. Established in 1997 by Senator Roth, the theory goes that you put the money in AFTER paying taxes and let it sit there for a specified period of time, then, when you take it out, the government won’t tax the earnings. Of course, this would mean that the Senators of today could balance more than a Venmo account and a handful of uppers so I’m sure none of you are surprised that there have already been several bills presented to Congress to tax the earnings on these accounts the same way Social Security is taxed. We’ll call this the “balsam-wood leg” and wait & see.
As you look at your retirement (whether you are in the throes of it, can see it floating on the horizon, or it rests somewhere in the hazy future), adding as many legs as possible to your retirement stool puts you in charge of your retirement tax picture, which means you keep more of what you have.