Sep 19, 2012
by Cathy Mendell, RFA of Elevatino Capital Strategies
Funding a 30-year retirement will take financial planning prowess as you juggle the effects of inflation, distributions, taxes, asset allocation and expenditures. Are you up to the task?
George Forman, the boxer-turned-spokesman for portable grills, may have best summed up the retirement conundrum facing baby boomers, “The question isn’t at what age I want to retire, it’s at what income.” The amount you’ll need each year to maintain your desired standard of living is the most critical variable to identify in the retirement planning process. No rule of thumb will suffice. If you are like many boomers, your spending will not drop significantly at retirement. In the beginning, you’ll be fulfilling the many dreams and desires you postponed during your career and child-rearing years. Later on, the cost of health care will become a significant factor in determining your income needs.
How Long Will You Need It?
Longevity is perhaps the greatest challenge for boomer retirement planning. Most boomers seriously underestimate their life expectancy. Perhaps this is due to a misunderstanding of what mortality age really means. In fact, half the population will outlive their life expectancy. When the mortality table tells us that a 65-year-old man has a mortality age of 82, it means that half of all men who are 65 today will die before age 82, and the other half will still be alive.
Another frequent misunderstanding about mortality age is the statistical increase in mortality age that occurs when calculating joint mortality. A male age 65 has a 50 percent chance of living to age 82. A female age 65 has a 50 percent chance of living to 85, but as a couple, they have a 50 percent chance of one of them living to age 92. In fact, as a couple, they have a 25 percent chance that one of them will still be alive at age 97. A worker retiring early at age 55 may need to generate more than 50 years of retirement income. This is the basis for the new definition of long-range planning.
The Double Bite of Inflation
The increased longevity that boomers can expect contributes to the serious risk of inflation, which is the long-term tendency for money to lose purchasing power. This has two negative effects on retirement income planning. It increases the future costs of goods and services that retirees must buy, and it potentially erodes the value of their savings and investments set aside to meet those expenses. Even at a modest inflation assumption of three percent annually, the effects of inflation over a half century of retirement could be devastating. In prior generations, inflation was not such a worry, since retirees were not expected to live much more than five or ten years past the age of 65.
In fact, when the Social Security retirement age of 65 was enacted in 1935, the average mortality age for a man was 64.
The Planning Process
Explore any and all sources of guaranteed income available when retirement begins. Social Security, pensions, annuities, and any other income sources must be quantified as to how much, from what source, and for how long. Pay careful attention to whether benefits index with inflation or continue to a surviving spouse. Develop three cash-flow models — both spouses living, husband dies, wife dies — to identify any gaps in cash flow that need to be addressed by additional savings or insurance.
Next, inventory all assets that will be used to generate retirement income. This is where the traditional financial planning tools are needed to project future values and income streams from various types of assets. Be alert to the differences in taxation during distribution among various types of assets. Retirement accounts will generate less spendable income than investment accounts, because of the taxes due on distributions from retirement plans.
The Risks Involved
Life insurance and long-term care insurance should also be evaluated as part of any retirement plan. These policies can be expensive, and they may not be necessary if you have significant assets. However, they can provide an important safety net in the absence of such assets, so ask your advisor to review your insurance needs.
Asset Allocation: Between a Rock and a Hard Place
The double whammy of longevity and inflation creates an asset allocation dilemma for boomers. The old adage of subtracting a person’s age from 100 to obtain the optimal percentage of equities just doesn’t hold for a four-decade retirement portfolio. Invest too conservatively, and your money may not grow enough to last your lifetime considering the erosion of long-term inflation. Invest too aggressively, and you run the increasing risk of outright capital loss drastically reducing assets and potentially running short of money. We believe that it is vital for boomers to take appropriate steps in planning their retirement with prudent low-risk investments that will provide them with the income they need in retirement.