Having helped hundreds of people with their financial lives, I have gained a unique perspective over the years. I have worked with retirees who have prepared well for retirement, and unfortunately many who have not. This has driven me to work with pre-retirees helping them increase their retirement readiness. Unfortunately, today’s pre-retirees are facing a much different retirement landscape than their parents or grandparents. Those who work in the public sector are largely covered by government pensions, but not so for those in the private sector including business owners who often look to the sale of their businesses to support them in retirement.
What is different about today’s retirement landscape?
- Americans are living longer. Pre-retirees today need to plan for a potential 30+ years in retirement.
- A longer retirement means a more of a watchful eye on inflation.
- The prospect of a long-term catastrophic illness is real. These expenses can devastate an estate and so preparing for this potential is essential for financial peace.
- Medical costs are skyrocketing. Pre-retirees should anticipate paying a far higher percentage of their healthcare expenses than their predecessors. Why? Because government entitlement programs like Social Security and Medicare are struggling. Basic demographics and the cost of these programs demand it.
- For private sector workers the existence of Defined Benefit Pension Plans has plummeted in the last 30 years with Defined Contribution Plans (401k’s) taking their place. News Flash! These two instruments are not the same!
Most Americans in their 40’s and 50’s are simply unaware, uneducated and ill prepared for what awaits them. Most go to work and come home every day not understanding the magnitude of the problem that will face them in their supposedly “golden years.”
The first step to prepare in this new environment is to save more! For many, if you are not saving at least 15% of your gross income, then you must rearrange your priorities. With 10,000 baby boomers retiring every day, the USA Today recently reported that, “The retirement income deficit, meaning the difference between what people have saved for retirement, and what they should have saved at this point, is a staggering $6.6 trillion.”
Although saving more is essential, retirement preparedness is not solely about accumulating a large asset by retirement age. Rather, it’s more about crafting an income stream that will last your lifetime. Although these may seem similar, they are actually two completely different objectives and in practice yield vastly different results.
Confused regarding how to craft a retirement income stream, most pre-retirees default to pursuing an “assets only retirement.” This approach means one is likely accumulating money in some form of after tax or pre-tax savings like an IRA, 401k, 403b, 457 with the goal to live off that asset in retirement. Consistently, a business owner typically plans the sale of their business at retirement to produce the assets necessary to live on later. Millions of American’s, not covered by some sort of pension plan, fall into these groups.
There are three serious pitfalls to an “assets only retirement” strategy versus focusing on the development of a lifetime income stream. The former strategy will likely not provide the income one will need in retirement, but could provide much more if properly structured. Here is why an “asset only retirement” falls short.
Pitfall #1: Actuarial Science – Defined Benefit Pension Plans incorporate actuarial science, but Defined Contribution Plans (401k, 403b, 457) do not. In short, pensions provided lifetime guaranteed income with lifetime survivorship benefits available to a spouse. Defined Contribution Plans by themselves lack this important financial power. The key is to get actuarial science back into one’s planning.
Pitfall #2: Constant vs. Fluctuating Interest Rates – The main problem during the distribution or spending phase of retirement is withdrawing income for living expenses in a fluctuating interest rate environment, since assets typically remain at risk in the market during the spend down phase. Most assume we live in a constant interest rate environment. We do not! Depleting assets for living expenses in a down market can be devastating to one’s retirement nest egg.
Pitfall #3: Withdrawal Rate Risk – Understanding Pitfall #2, do you know the appropriate percentage you can safely withdraw from your retirement asset and be assured you won’t run out of money? Extensive research has been conducted by some of the best economic minds to determine this percentage. A January 21, 2013 research paper by MorningStar titled “Low Bond Yields and Safe Portfolio Withdrawal Rates” concluded “a 4% initial withdrawal rate has a 50% probability of success over a 30 year period.” I don’t like those odds, do you? Goggle the Wall Street Journal article by Kelly Greene entitled, “Say Goodbye to the 4% Rule.” Conventional wisdom has dictated a 4% withdrawal rate, but current research suggests 2.8% to 3.5%.
What are the ramifications of these three pitfalls?
A 3.0% income rate is often not a feasible solution as it will be difficult for most families to build sufficient assets to enjoy a “happily ever after” retirement. For example, a $1,000,000 nest egg only yields a paltry $30,000 of annual retirement income! This income is woefully short of most expectations.
To make matters worse, Rodney Brooks reported (USA Today, 2/13/2014) that Fidelity Investments, the nation’s largest 401(k) provider, clocked the average 401(k) balance for pre-retirees 55 and older at $165,200. “Houston, we have a problem!”
The good news is that pre-retirees can overcome all three pitfalls of an “assets only retirement” strategy, by being more strategic and focusing on retirement income planning. Properly designed, one can increase their retirement income by 30% to 50% or more, capture a lifetime contractual guarantee (actuarial science) and do so without spending any more money! Is this possible? Absolutely! Take 30-40 minutes of your time to understand how. Get on the road to financial peace!