When you entered your 50’s you likely began to pay more and more attention to your long-term retirement savings, like your 401k. 401k’s are emblematic of a range of retirement saving accounts across American for private sector workers. Every day, week or month you nervously log into your account to check your balance. You also conscientiously inspect your quarterly earnings statement mailed to your home four times a year. You see your contributions posted, inspect your company’s match and pray the market has gone up.
Trying to make up for lost ground, you are likely taking advantage of the IRS catch-up provision allowing workers over 50 to deposit into their 401k’s an additional $6,000 per year in pre-tax earnings. You feel encouraged but you still wonder if your 401k is going to do the job.
You may ask yourself the following questions:
- Am I on track to reach my retirement goals?
- Am I ahead or behind?
- Will my 401k be big enough when I retire?
- Once I do retire, how does this account convert to income?
- How do I know I have enough so I don’t run out before I pass?
- Should I be taking more or less risk?
These are good questions; however, you are not asking the right question!
You should be asking yourself:
“When was the last time you hired someone to do a job?”
Now, this may seem like an odd question. Trust me and follow along… You are likely not a business owner or ever had to “meet a payroll,” so this question might be rather peculiar. But seriously, when was the last time you hired someone to do a job? You do this every day when you purchase goods and services in the marketplace!
Consider your cell phone service? You scan the available cell carriers, compare your needs and expectations with a vendor’s rate plans, service areas, features, and benefits and basically hire who you perceive to be the best to do the job. We make these types of buying decisions every day, some more significant than others. The decisions could range from a shop to service your automobile to a pest control company to handle the bugs at home. Hopefully, these relationships go well, but if not, we fire them and switch to someone else who can do the job to our expectations.
About 10 years ago my wife Susan and I embarked on a complete makeover of our home. The home was built in 1961 and needed an entire renovation. The project was so significant that we were forced to move out for 12 months while the house was completely gutted, added on to and rebuilt. With four kids ranging from 8 to 17, it was a huge undertaking. A year before we began, we spent months drawing and redrawing plans to guide the project. This proved to be the most important step!
By the time the renovation was complete, we had engaged a range of sub-contractors. With each relationship, we set expectations, gathered bids, selected vendors, and materials, managed those expectations and inspected each final outcome. When a problem arose we found ourselves huddled around the plans to clarify expectations and managing the project back to our original design. The project was so significant we hired a general contractor to help us along the way. The endeavor was not without its twists and turns, disappointments and surprises. In retrospect, advanced planning and hiring the right people was the key.
Building or renovating a home can be a rewarding experience, but so is preparing for one’s retirement. You could live in retirement for a third of your life! Unfortunately, most Americans spend more time preparing for a two-week vacation than preparing for their golden years. Since most American’s in the private sector “hire” a 401k, IRA, or investment account to do the job, I must ask you,
“What job are you hiring your 401k to do?”
This probably sounds rather odd because you don’t remember making a buying decision with your investment account. Upon starting work, a person from human resources or the company owner told you about the plan. You instinctively knew it was important to save, so you signed up. And besides, they said they would match part of your contributions, all of which would be pre-tax.
- But, what job did you hire that 401k for?
- What’s its objective and how well can it do the job?
- When you stop working you’re going to need income other than Social Security, right?
- And you want that income to last until you kick the bucket, correct?
- The whole idea is to not run out of money, right?
But running out of money is only part of the expectation, you want enjoyment in retirement!
- You want enough income to live the retirement lifestyle of your choice, correct?
- You want to maintain your pre-retirement standard of living, right?
- Given all options, you would also want optimal, wouldn’t you?
So, will your 401k deliver? Can it do the job?
If you are like most Americans, their eyes glaze over at this point. It’s like that time I walked into the great room of my completely torn apart house to see my contractor and foreman looking up into the open attic with a puzzled look on their faces. I asked what was wrong and they said, “We are wondering how this roof is being held up because none of this was done to code.” That was not a happy day!
USA Today recently reported (2/13/2014) that Fidelity Investments, the nation’s largest 401k provider, clocked the average 401k balance for pre-retirees over age 55 at $165,200. Let’s just assume at age 65 this balance is $300,000. Conventional wisdom used to say that you could withdrawal 4% of that asset for income each year with a reasonable expectation that you wouldn’t run out of money. Today, research suggests the percentage is closer to 3%. Read the Wharton Business School, Morning Star, Harvard Business Review and Wall Street Journal reports/articles in the Learning Center of my Website (mckellpartners.com). You can even Google, “Say Good-bye to the 4% Rule” to get more educated.
Let’s do the math and see if your 401k can do the job…
$300,000 times 3% means $9,000 a year in pre-tax annual income or $750 per month. Add the average Social Security check of $1,300 and you have a bank-breaking $2,050 a month. Does this meet your “golden years” expectations? Is this getting the job done in your mind? My guess this falls way short of expectations!
But you aren’t average! You have accumulated $1,000,000, $2,000,000 or $3,000,000 in retirement assets. Congratulations! That means given $2,000,000 in assets you can live on $60,000 a year in pre-tax income. This is still disappointing even after Social Security, especially when you have been earning $400,000 a year!
Who wants to take that kind of income decrease in retirement?
Unlike any time in recent American history, there is so much that today’s pre-retirees are simply unaware of when it comes to planning a successful retirement. Today’s pre-retirees are facing a much different landscape than their parents or grandparents, especially those in the private sector. We refer to this as a “YOYO Retirement.” In other words, “you’re on your own!”
Those who work in the public sector are largely covered by government pensions (a guaranteed form of income for the rest of your life; that sounds nice, doesn’t it?). However, for those in the private sector including business owners who often look to the sale of their businesses to support them in retirement, pensions simply aren’t a part of the average retirement package anymore.
So, what’s the default path most professionals and private sector workers take? They pursue what I refer to an Assets-Only Retirement.
They do what you are doing. They accumulate assets in a 401k type pre-tax plan and/or other investment type vehicle(s). This approach alone is incomplete and is fraught with three serious pitfalls. Remember, retirement preparedness is not solely about accumulating a large asset by retirement age. Rather, it’s more about crafting an efficient and optimal income stream that will last your lifetime.
Although these may seem similar, they are two completely different objectives and in practice yield vastly different results. Because we live in a YOYO (remember, you’re on your own!) economy, many are simply confused about how to effectively create an adequate retirement income streams. And so, most pre-retirees today default to pursuing an “Assets-Only Retirement.” As noted, there are 3 serious pitfalls to this strategy, rather than focusing on developing a robust lifetime income stream. These pitfalls lead to less than optimal income in retirement.
Here is why an Assets-Only Retirement falls short.
Pitfall #1: Actuarial Science – Defined Benefit Pension Plans incorporate actuarial science, but Defined Contribution Plans, like a 401k, IRA or private investment 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. To improve income and mitigate longevity risk faced in retirement, the key is to incorporate actuarial science back into one’s planning.
Pitfall #2: Constant vs. Fluctuating Return – The main problem during the distribution or spending phase of retirement is withdrawing income for living expenses in a fluctuating return environment. To garner growth, assets typically remain at risk in the market during the spend-down phase. Many 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.
This describes an inherent risk called sequencing of returns and must be understood if assets are left in the market to produce income for retirement. This adverse effect of this risk is not faced in the pre-retirement phase of life so many are caught off guard. An adequately funded, non-market correlated volatility-type buffer can be beneficial to combat this risk, potentially bolstering retirement income by 30-50% or more. Unfortunately, most are unaware of how to effectively position this remedy.
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? We covered this topic earlier in the article. 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?
What are the ramifications of these three pitfalls?
The bottom line is your 401k Plan or investment account by itself will not do the job! Oh, it can provide income in retirement, but way below what it could produce if positioned properly. By itself, the terribly low 3.0% income rate is not a feasible solution as it will be difficult for most families to build sufficient assets to enjoy a “happily ever after” retirement. Remember the $2,000,000 example?
Can you see why pursuing an Assets-Only Retirement is a problem?
The good news is that pre-retirees if they catch it in time, can overcome all three pitfalls of an Assets-Only Retirement. When properly designed in the accumulation phase of life, one can potentially increase retirement income by 30% to 50% or more, without spending any more money or taking on additional risk. This can be accomplished through an integration of both investments and actuarial science. Understanding this positioning could mean thousands more in additional retirement income and a greater sense of control over one’s financial future.
To get started, you must get educated on the topics of longevity risk, sequencing of returns, withdrawal rate risk, the importance of actuarial science, anticipated cognitive decline and the confusion between constant vs. fluctuating interest rates. This may sound like alphabet soup, but these are important concepts to understand when considering whether your 401k plan will do the job or not.
With over 11,000 baby boomers retiring each day, many are beginning to realize that their defined contribution plans might not be up for the job. We work with pre-retirees every day to fix this problem. Call McKell Partners for a no-cost or obligation consultation.