Showing posts with label retirement plan. Show all posts
Showing posts with label retirement plan. Show all posts
Monday, July 3, 2017
Buy Your Retirement
If you're having trouble saving for retirement, think of it this way: your retirement is a purchase, and the more you spend, the more luxurious it will be. Retirement is a purchase--you're buying rest, relaxation, entertainment and time to do whatever you want. You may have to buy a fair amount of health care and other services such as lawn care, housekeeping and so on. But whatever the case may be, the more money you have for retirement, the nicer it will be. No need to think of saving as a sacrifice. You aren't giving up things up. You're simply spending for a better retirement instead of a bigger TV.
So, if you can't save for retirement, then spend on your retirement. It will be one of the smartest purchases of your life. For more, see
http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html,
http://blogger.uncleleosden.com/2010/11/how-much-do-you-need-for-retirement.html,
http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html,
and http://blogger.uncleleosden.com/2010/11/stress-test-your-retirement.html.
Thursday, May 4, 2017
The Truth About Housing Prices
Ten years ago, this blog predicted that housing prices, which had fallen sharply in the mortgage crisis of the mid-2000s, would not recover until 2024. http://blogger.uncleleosden.com/2007/09/when-will-housing-prices-recover.html. That prediction may have seemed preposterously negative to many. But real estate prices have meandered and stagnated since then. Although some markets have recently enjoyed brisk gains, many others remain sluggish and below their earlier peaks. Trulia, the real estate website, yesterday released a study that predicted real estate prices nationwide would not recover until 2025. https://www.trulia.com/blog/trends/home-value-recovery-2017/. Looks like my prediction of ten years ago was pretty accurate. While my analysis and Trulia's aren't directly comparable (I focused on nationwide average prices adjusted for inflation and Trulia used nominal prices unadjusted for inflation while measuring recovery in all housing markets nationwide), the basic conclusion is similar. It will take a shipload of time for housing prices to fully recover, and the mid-2020's may be when the housing market as a whole could once again start to accentuate the positive.
Housing historically has increased in value about 1% faster than inflation. Stocks have tended to average around 3% above inflation. Buy a house if you need shelter and can afford it. But pay off the mortgage, don't borrow against the equity, and save and invest in retirement and other accounts for your golden years. Some people who can't save money end up relying on their homes to finance retirement. But that's a much poorer choice (pun intended) than taking advantage of the greater potential of stocks and other financial investments. Your house is your castle. But it's not your best option for financing retirement.
Housing historically has increased in value about 1% faster than inflation. Stocks have tended to average around 3% above inflation. Buy a house if you need shelter and can afford it. But pay off the mortgage, don't borrow against the equity, and save and invest in retirement and other accounts for your golden years. Some people who can't save money end up relying on their homes to finance retirement. But that's a much poorer choice (pun intended) than taking advantage of the greater potential of stocks and other financial investments. Your house is your castle. But it's not your best option for financing retirement.
Sunday, May 1, 2011
Penalty-Free Early Withdrawals From a Retirement Plan
As the Great Recession rumbles on and on for just about everyone except those in the top 10% of income brackets, people are increasingly tapping into their IRAs. If you're not 59 and 1/2 or older, you'll pay a penalty of 10% of the amount withdrawn, on top of applicable federal and state income taxes. There is a way, however, to dodge the penalty: substantially equal periodic payments plans (SEPPs). These plans let you withdraw IRA funds without penalty, although regular federal and state income taxes will still have to be paid. SEPP plans can be complex, and you may want the assistance of a tax accountant or financial planner if you're going to use one. Here's a general picture of how they work.
A SEPP plan runs for a minimum of five years or until you reach age 59 and 1/2, whichever is longer. If you start a SEPP plan at age 57, you have to stick with it until you reach age 62. If you're younger than 54 and 1/2, the plan has to continue until you reach 59 and 1/2. So, if you start a SEPP plan at age 45, you'll have to stick with it for 14 and 1/2 years. If you don't stick with the plan and complete it, the IRS will assess a 10% penalty on everything you withdrew before the time you dropped the plan. Since you presumably instituted the SEPP because you were short of cash, that penalty could be painful.
During the time the plan is in effect, you get payments each year (which can be monthly, if the plan is set up that way). The distributions are calculated one of three ways: the amortization method, the annuitization method, and the required minimum distribution method. The first two are somewhat like what you would get from a commercial annuity purchased with the amount of money in the SEPP plan (although this is just an approximate description). You have a fixed amount that is paid out each year, and that amount never changes over the life of the plan. But, unlike a commercial annuity, this payment is not guaranteed and if the investment performance of your IRA lags, you could drain off the balance faster than you expected. (In fact, you can run out of funds before the plan is over; but the IRS won't penalize you for inability to complete the plan because of investment losses.)
The third method, required minimum distribution, is like the formula used for regular required minimum distributions from IRAs (i.e., those for people 70 and 1/2 or older). You take the SEPP account balance and divide it by the owner's life expectancy as estimated by the IRS. The resulting number is paid out. But the distribution has to be recalculated each year (using the owner's ever shortening life expectancy). So the required minimum distribution method is likely to pay out different amounts each year. It also tends to result in smaller payments than the first two methods. But the nature of the required minimum distribution formula means that you'll never run out of the money. You just won't know for sure how much you'll get every year--potentially more after a year of investment gains, and possibly less after a year of investment losses.
If you start with either the annuitization or amortization method, you can make a one-time switch to the required distribution method. This would be advisable if the original method is depleting your account balance faster than you feel comfortable with. Thus, you can reduce the impact that investment losses have on your account balance, but you'll get much lower periodic payments.
You can use some or all of the funds in an IRA for a SEPP plan. If you're going to use less than all the funds, transfer part of your IRA into a separate IRA that is used for the SEPPs. If your retirement money is in an employer sponsored retirement plan like a 401(k) or a 403(b), you cannot do a SEPP plan--it's allowed only for individually owned retirement plans. But if you're no longer employed at that employer, you can transfer the funds to an IRA and do a SEPP plan from the IRA.
A SEPP plan isn't useful for making one-time withdrawals, such as getting a downpayment for a car or house. It's a long term proposition, with a measured payout for each year of the plan. If you need a short term boost in cash flow, look elsewhere, or make the one-time withdrawal and pay the 10% penalty along with income taxes.
The amount you can take out at any one time through a SEPP plan is limited to whatever you can get per year under one of the three permitted methods of withdrawal. You can't use a SEPP plan to take out half the balance of your retirement account at once, or some other ad hoc amount that suits your needs at the moment.
Don't do a SEPP plan unless it's really necessary. You'd be burning up retirement resources earlier in life, which means your golden years may be less golden. Of course, sometimes life isn't kind and you need access to the money in your retirement account. The fact that a SEPP plan avoids the 10% penalty may be significant if you have to make long term withdrawals. For more information, you can visit the IRS website at http://www.irs.gov/retirement/article/0,,id=103045,00.html.
A SEPP plan runs for a minimum of five years or until you reach age 59 and 1/2, whichever is longer. If you start a SEPP plan at age 57, you have to stick with it until you reach age 62. If you're younger than 54 and 1/2, the plan has to continue until you reach 59 and 1/2. So, if you start a SEPP plan at age 45, you'll have to stick with it for 14 and 1/2 years. If you don't stick with the plan and complete it, the IRS will assess a 10% penalty on everything you withdrew before the time you dropped the plan. Since you presumably instituted the SEPP because you were short of cash, that penalty could be painful.
During the time the plan is in effect, you get payments each year (which can be monthly, if the plan is set up that way). The distributions are calculated one of three ways: the amortization method, the annuitization method, and the required minimum distribution method. The first two are somewhat like what you would get from a commercial annuity purchased with the amount of money in the SEPP plan (although this is just an approximate description). You have a fixed amount that is paid out each year, and that amount never changes over the life of the plan. But, unlike a commercial annuity, this payment is not guaranteed and if the investment performance of your IRA lags, you could drain off the balance faster than you expected. (In fact, you can run out of funds before the plan is over; but the IRS won't penalize you for inability to complete the plan because of investment losses.)
The third method, required minimum distribution, is like the formula used for regular required minimum distributions from IRAs (i.e., those for people 70 and 1/2 or older). You take the SEPP account balance and divide it by the owner's life expectancy as estimated by the IRS. The resulting number is paid out. But the distribution has to be recalculated each year (using the owner's ever shortening life expectancy). So the required minimum distribution method is likely to pay out different amounts each year. It also tends to result in smaller payments than the first two methods. But the nature of the required minimum distribution formula means that you'll never run out of the money. You just won't know for sure how much you'll get every year--potentially more after a year of investment gains, and possibly less after a year of investment losses.
If you start with either the annuitization or amortization method, you can make a one-time switch to the required distribution method. This would be advisable if the original method is depleting your account balance faster than you feel comfortable with. Thus, you can reduce the impact that investment losses have on your account balance, but you'll get much lower periodic payments.
You can use some or all of the funds in an IRA for a SEPP plan. If you're going to use less than all the funds, transfer part of your IRA into a separate IRA that is used for the SEPPs. If your retirement money is in an employer sponsored retirement plan like a 401(k) or a 403(b), you cannot do a SEPP plan--it's allowed only for individually owned retirement plans. But if you're no longer employed at that employer, you can transfer the funds to an IRA and do a SEPP plan from the IRA.
A SEPP plan isn't useful for making one-time withdrawals, such as getting a downpayment for a car or house. It's a long term proposition, with a measured payout for each year of the plan. If you need a short term boost in cash flow, look elsewhere, or make the one-time withdrawal and pay the 10% penalty along with income taxes.
The amount you can take out at any one time through a SEPP plan is limited to whatever you can get per year under one of the three permitted methods of withdrawal. You can't use a SEPP plan to take out half the balance of your retirement account at once, or some other ad hoc amount that suits your needs at the moment.
Don't do a SEPP plan unless it's really necessary. You'd be burning up retirement resources earlier in life, which means your golden years may be less golden. Of course, sometimes life isn't kind and you need access to the money in your retirement account. The fact that a SEPP plan avoids the 10% penalty may be significant if you have to make long term withdrawals. For more information, you can visit the IRS website at http://www.irs.gov/retirement/article/0,,id=103045,00.html.
Thursday, March 3, 2011
How to Avoid Running Out of Money in Retirement
The fear of running out of money may be the biggest financial dilemma for most retirees. There's no perfect solution to the problem. But plenty of people have long, enjoyable retirements and leave something behind for their heirs. So the problem isn't insurmountable. Here are some ideas.
Build up your Social Security and pension credits. Whatever Congress and the President do to reform Social Security, they won't abolish it. It will be there in one form or another when you retire. Working as long as possible to maximize your benefits ensures a lifelong stream of inflation-adjusted payments. While Social Security won't cover more than the basics, life is easier when you have the basics covered. If you're fortunate enough to have a pension, work as long as you can to boost your pension payments. Working longer, although not as much fun as shuffleboard, is one of the best ways to make sure you're as well prepared as possible for retirement.
Save. The more you save, in retirement accounts or otherwise, the better off you will be in retirement. Non-savers, by definition, have already run out of money, and poor savers will quickly fall into the abyss. It's important to have a pool of cash available for big expenses like assisted living and other medical bills. If all you have are comparatively small streams of payments like Social Security and perhaps a pension, and you need to go into assisted living, you'll have effectively run out of money even though you're still getting a monthly income.
Pay down debts. Ideally, you should have no mortgage and little or no other debt by the time you retire. Debt, and its accompanying interest expenses, are negative savings. Some financial advisers will conjure up scenarios where you supposedly might be better off with a mortgage or some other debt. But debt involves risk, and the recent financial crisis and Great Recession amply demonstrate that risk can easily lead to losses. Financial stability is very important for a comfortable retirement, and debt destabilizes.
Invest conservatively. The older you get, the less time you have to recover from investment losses. Keeping some money in assets with potential for appreciation, like stocks, is a good idea because of long term risks of inflation. But be cautious about investing in stocks and other volatile assets. Perhaps a third of your portfolio might prudently be kept in stocks. As you get older, that proportion should shrink so that you don't get walloped by the stock market when you're 83.
Consider an annuity. It's easier to establish a budget if you have a predictable monthly income. An immediate annuity can provide either a fixed monthly payment or one that rises with inflation. (The latter is costlier, but you get additional peace of mind.) Annuities are issued by insurance companies, and they can go bankrupt. If you want the benefits of an annuity, consider buying two, each for half the amount you want to invest, from different insurance companies. Both should have solid credit ratings. With two different insurers, you diversify your risks.
Be cautious with variable annuities. They tend to have high expenses and varying (as the name indicates) payments. That uncertainty of payments may, for some, defeat the purpose of an annuity.
Note that annuities lock up the capital you invest in them, meaning you can't get access to it. All you can get are the payments. You'll almost surely need some liquid assets during retirement, for medical expenses and large items like cars. Never spend more than half your savings on annuities. Indeed, given the limitations of annuities, spend only the minimum amount needed to give you the peace of mind you're trying to secure.
Think about long term care insurance. Although increasingly expensive, long term care insurance gives you hundreds of thousands of dollars of buying power if you have to go into assisted living or have other major similar needs. Long term care insurance helps to preserve your savings (which may be important if you have a spouse or partner whose financial security you wish to protect). In addition, if you want to avoid a nursing home that accepts Medicaid patients--some feel that such nursing homes provide lower quality services--long term care insurance could be essential to affording a more exclusive facility.
Work part-time. Okay, working isn't exactly what you had in mind for retirement. But it allows you to spend less of your savings while you're able to work. If and when you reach the point where you can't work, you'll be glad you worked as long as you did.
Build up your Social Security and pension credits. Whatever Congress and the President do to reform Social Security, they won't abolish it. It will be there in one form or another when you retire. Working as long as possible to maximize your benefits ensures a lifelong stream of inflation-adjusted payments. While Social Security won't cover more than the basics, life is easier when you have the basics covered. If you're fortunate enough to have a pension, work as long as you can to boost your pension payments. Working longer, although not as much fun as shuffleboard, is one of the best ways to make sure you're as well prepared as possible for retirement.
Save. The more you save, in retirement accounts or otherwise, the better off you will be in retirement. Non-savers, by definition, have already run out of money, and poor savers will quickly fall into the abyss. It's important to have a pool of cash available for big expenses like assisted living and other medical bills. If all you have are comparatively small streams of payments like Social Security and perhaps a pension, and you need to go into assisted living, you'll have effectively run out of money even though you're still getting a monthly income.
Pay down debts. Ideally, you should have no mortgage and little or no other debt by the time you retire. Debt, and its accompanying interest expenses, are negative savings. Some financial advisers will conjure up scenarios where you supposedly might be better off with a mortgage or some other debt. But debt involves risk, and the recent financial crisis and Great Recession amply demonstrate that risk can easily lead to losses. Financial stability is very important for a comfortable retirement, and debt destabilizes.
Invest conservatively. The older you get, the less time you have to recover from investment losses. Keeping some money in assets with potential for appreciation, like stocks, is a good idea because of long term risks of inflation. But be cautious about investing in stocks and other volatile assets. Perhaps a third of your portfolio might prudently be kept in stocks. As you get older, that proportion should shrink so that you don't get walloped by the stock market when you're 83.
Consider an annuity. It's easier to establish a budget if you have a predictable monthly income. An immediate annuity can provide either a fixed monthly payment or one that rises with inflation. (The latter is costlier, but you get additional peace of mind.) Annuities are issued by insurance companies, and they can go bankrupt. If you want the benefits of an annuity, consider buying two, each for half the amount you want to invest, from different insurance companies. Both should have solid credit ratings. With two different insurers, you diversify your risks.
Be cautious with variable annuities. They tend to have high expenses and varying (as the name indicates) payments. That uncertainty of payments may, for some, defeat the purpose of an annuity.
Note that annuities lock up the capital you invest in them, meaning you can't get access to it. All you can get are the payments. You'll almost surely need some liquid assets during retirement, for medical expenses and large items like cars. Never spend more than half your savings on annuities. Indeed, given the limitations of annuities, spend only the minimum amount needed to give you the peace of mind you're trying to secure.
Think about long term care insurance. Although increasingly expensive, long term care insurance gives you hundreds of thousands of dollars of buying power if you have to go into assisted living or have other major similar needs. Long term care insurance helps to preserve your savings (which may be important if you have a spouse or partner whose financial security you wish to protect). In addition, if you want to avoid a nursing home that accepts Medicaid patients--some feel that such nursing homes provide lower quality services--long term care insurance could be essential to affording a more exclusive facility.
Work part-time. Okay, working isn't exactly what you had in mind for retirement. But it allows you to spend less of your savings while you're able to work. If and when you reach the point where you can't work, you'll be glad you worked as long as you did.
Wednesday, January 26, 2011
Hope For the Financially Lost
Financial plans can be blown up because of job loss, illness, elderly parents who need support, or bad investments. Some people simply can't save. Whatever the situation, there remains hope for the financially lost to have at least a decent retirement.
Boost your benefits. Work as long as possible to build up Social Security and, if available, pension benefits. This is especially important for those that can't save. Even if you aren't working, delay taking Social Security benefits as long as you can (unless you're 70 or older). Delaying Social Security increases benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_02.html.
Stay together. Couples generally are better off than singles, because they can pool their resources. Even if their only resources are Social Security benefits, a couple are usually better off together than individually. Of course, togetherness isn't always possible. When it is, there are financial, as well as other, benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_03.html.
Get a job with a pension. Government, law enforcement, military and educational jobs usually offer a pension or other retirement plan. Although pension benefits in many state and municipal jobs are being adjusted to meet fiscal realities, they will still be better than nothing. Not everyone is cut out for these lines of work. If you find a private sector job with a pension, then try to stay there long enough to accrue meaningful benefits. For those who can't save, a pension is golden. You just have to work long enough to vest; saving isn't necessary. If you need assistance figuring out if the amount of pension benefits your employer promises is correct, contact the American Academy of Actuaries at http://www.actuary.org/palprogram.asp. They'll give you up to four hours of free help. If you think your benefits are too low, contact a regional pension counseling project for free assistance. http://www.pensionrights.org/counseling-projects.
Buy a house and pay off the mortgage. Buy a house, pay off the mortgage, and don't borrow against the house until you retire. This strategy will build equity in a piece of real estate that you can add to your Social Security benefits (and pension benefits, if any). Even though strategic defaults have become fashionable, the unfashionable may have an advantage in the long run.
None of these strategies will finance a yacht. Remember that it's never too late to save, even if you're living on just Social Security. Cash is sublime when times are tough.
Boost your benefits. Work as long as possible to build up Social Security and, if available, pension benefits. This is especially important for those that can't save. Even if you aren't working, delay taking Social Security benefits as long as you can (unless you're 70 or older). Delaying Social Security increases benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_02.html.
Stay together. Couples generally are better off than singles, because they can pool their resources. Even if their only resources are Social Security benefits, a couple are usually better off together than individually. Of course, togetherness isn't always possible. When it is, there are financial, as well as other, benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_03.html.
Get a job with a pension. Government, law enforcement, military and educational jobs usually offer a pension or other retirement plan. Although pension benefits in many state and municipal jobs are being adjusted to meet fiscal realities, they will still be better than nothing. Not everyone is cut out for these lines of work. If you find a private sector job with a pension, then try to stay there long enough to accrue meaningful benefits. For those who can't save, a pension is golden. You just have to work long enough to vest; saving isn't necessary. If you need assistance figuring out if the amount of pension benefits your employer promises is correct, contact the American Academy of Actuaries at http://www.actuary.org/palprogram.asp. They'll give you up to four hours of free help. If you think your benefits are too low, contact a regional pension counseling project for free assistance. http://www.pensionrights.org/counseling-projects.
Buy a house and pay off the mortgage. Buy a house, pay off the mortgage, and don't borrow against the house until you retire. This strategy will build equity in a piece of real estate that you can add to your Social Security benefits (and pension benefits, if any). Even though strategic defaults have become fashionable, the unfashionable may have an advantage in the long run.
None of these strategies will finance a yacht. Remember that it's never too late to save, even if you're living on just Social Security. Cash is sublime when times are tough.
Wednesday, November 17, 2010
Stress Test Your Retirement
With stocks going nowhere for the past ten years or more, we now understand that retirement planning involves more than seeking the highest returns. Risk has to be managed. Savings must be protected. This is especially so as one grows older. With fewer working years left, those who have living memories of seeing or wearing leisure suits should think about downside risk as well as upside potential. It's a good idea to stress test your retirement.
A stress test would estimate how well your finances would look in adverse circumstances. There are different ways to do this, and some can become quite complex. There is no magical formula or golden number(s). Much depends on your appetite for risk, your life expectancy and your retirement goals. Let's start with individual factors.
1. Stocks. Assume a 50% drop in the stock market. That's not an unrealistic assumption since stocks dropped a bit more than that at their worst point in the 2008-09 financial crisis. They could drop like that again, notwithstanding every assurance from Wall Street and high ranking government officials. What impact would that have on your finances? If the answer is too much for your comfort level, then reduce your exposure to stocks until you feel comfortable.
2. Bonds. Assume a 20% loss of your taxable bond portfolio. This would be a very large loss for bond holdings, but could happen if the Fed has to raise interest rates sharply in order to combat inflation. (Indeed, the Fed's ongoing quantitative easing program--the purchase of Treasury securities with printed money in order to lower interest rates--has anomalously resulted in increased interest rates, suggesting bond investors expect inflation from the QE.) What impact would a 20% drop in your taxable bond holdings have on your equanimity? If the answer isn't conducive to equanimity, dial back your bond exposure.
3. Municipal Bonds. Assume a 20% loss in the value of your muni bond portfolio. This, too, would unusually large. But the growing crisis over state and municipal deficits, and the possibility that interest rates may rise because of or in spite of the Fed, could produce significant muni bond losses. How would this affect your sense of financial security? If you don't like the answer, trim your muni holdings.
4. Money Market Funds and Similar Products. As we know from the 2008-09 financial crisis, money market funds can go under. Less well-known similar products, most notoriously auction rate securities, may be less safe than money markets. Assume a liquidity crisis for your holdings of money market funds and other short term investments. What would you do if you couldn't get to these assets? If the answer is ugly, transfer your liquid assets to money market funds that invest only in U.S. Treasury securities, or to bank or credit union accounts and CDs that are fully insured by the federal government. Don't mess around searching for incremental increases in yield. Make sure your liquid assets are truly safe (because they may not be liquid otherwise).
5. Insurance Products. Insurance products are subject to the creditworthiness of the insurance company. Insurance companies make mistakes. If, like AIG, they make big enough mistakes and put the international financial system at the edge of the abyss, they will be bailed out by the government. But most insurance companies can't put the touch on taxpayers like that. Try to figure out how much you could salvage from your annuity or other insurance products if the insurer goes belly up. You might have to research the law of the state where the insurance company is chartered for the coverage provided by its guaranty association for life insurance. (One place to start is the website for the national umbrella organization for these associations, called the National Organization of Life & Health Insurance Guaranty Associations,
http://www.nolhga.com/.) The amount of coverage may be between a maximum of $100,000 to $500,000, depending on the state. If that limit spurs major heartburn, either avoid making a big investment in insurance products, or look to boost the non-insurance portion of your portfolio. Be cautious about exiting insurance products you've already bought, because the insurance companies may whack you with painful termination fees. But pay those fees if your exposure to insurance products makes you queasy.
6. Pension. Let's say your employer goes bankrupt and ditches its pension plan. Can you live with the reduced payments you might end up with? Figuring out how much your pension might be reduced in such a circumstance could be difficult and the stress test might have to be done with just an approximation (factoring in the limitations in coverage from the Pension Benefit Guaranty Corp., if applicable; see http://www.pbgc.gov/workers-retirees/benefits-information/content/page789.html). You could try assuming your pension payments turn out to be half of what you expected. Then, increase your current savings a lot because the loss of half a pension would be painful for just about anyone.
7. Social Security and Medicare. Social Security and Medicare will not disappear. They will be here as long as the Stars and Stripes fly. Of course, some modifications will surely be made, particularly in light of the recent mid-term elections. These modifications won't give you a warm glow. Assume your benefits are reduced by 15%. If that would increase your antacid budget, save more.
8. Health Insurance. If you're under 65, consider the impact of losing your health insurance. (Just about everyone 65 or older has Medicare coverage.) If you're in a group plan, research the cost of buying replacement coverage (which would be an expensive individual policy for most people). Then save more. If the health care reform of 2010 survives Republican attack in 2011 largely intact, you'll probably be able to get good coverage. If the 2010 health insurance reform is significantly cut back, you could be in a tight spot.
9. House. If your home is part of your retirement finances, consider the impact of a 25% drop in its value. Many homes have dropped more than that in the past few years. Don't think it can't happen again. Factor in the mortgage, home equity loan(s) and other liens on the house. If a 25% loss would ruin your day, save more.
We all know that, in a financial crisis, more than one asset class may go sour at the same time. Estimate the combined impact of such a morass. One thing that is certain is we will have another financial crisis like 2008-09. When is anyone's guess. But an enduring lesson of 2008 is that there are no new paradigms in the world of investments and finance. Sooner or later there will be another financial crisis. Those that prepare for it will probably do okay. Crisis deniers surely won't.
Where is there safety? Money market funds that invest solely in U.S. Treasury securities for one. Bank and credit union accounts and CDs that are fully insured by the federal government are another. See http://blogger.uncleleosden.com/2010/07/safe-investments.html. Longer term U.S. Treasury securities will be paid in full upon maturity, but are subject to interest rate risk during their terms. Gold and silver may look attractive at the moment, but their values have historically been extremely volatile. Invest in commodities at your peril.
If you don't like the results of your personal stress test, save more. That, more than anything else, will strengthen your finances. A diversified portfolio is prudent (stocks and bonds can help with your long term financial needs). But diversified doesn't necessarily mean high risk. Having 20% in stocks and 30% in bonds, with the rest in safe assets, may be as diversified as some people want to get, especially those over 70. All the nice looking statistics and charts that financial planners can generate about long term gains don't mean diddly if we're stuck in one of the decade long or longer time periods when financial assets sag. Allocate your assets in the way that facilitates sleep. You'll sleep better for it.
A stress test would estimate how well your finances would look in adverse circumstances. There are different ways to do this, and some can become quite complex. There is no magical formula or golden number(s). Much depends on your appetite for risk, your life expectancy and your retirement goals. Let's start with individual factors.
1. Stocks. Assume a 50% drop in the stock market. That's not an unrealistic assumption since stocks dropped a bit more than that at their worst point in the 2008-09 financial crisis. They could drop like that again, notwithstanding every assurance from Wall Street and high ranking government officials. What impact would that have on your finances? If the answer is too much for your comfort level, then reduce your exposure to stocks until you feel comfortable.
2. Bonds. Assume a 20% loss of your taxable bond portfolio. This would be a very large loss for bond holdings, but could happen if the Fed has to raise interest rates sharply in order to combat inflation. (Indeed, the Fed's ongoing quantitative easing program--the purchase of Treasury securities with printed money in order to lower interest rates--has anomalously resulted in increased interest rates, suggesting bond investors expect inflation from the QE.) What impact would a 20% drop in your taxable bond holdings have on your equanimity? If the answer isn't conducive to equanimity, dial back your bond exposure.
3. Municipal Bonds. Assume a 20% loss in the value of your muni bond portfolio. This, too, would unusually large. But the growing crisis over state and municipal deficits, and the possibility that interest rates may rise because of or in spite of the Fed, could produce significant muni bond losses. How would this affect your sense of financial security? If you don't like the answer, trim your muni holdings.
4. Money Market Funds and Similar Products. As we know from the 2008-09 financial crisis, money market funds can go under. Less well-known similar products, most notoriously auction rate securities, may be less safe than money markets. Assume a liquidity crisis for your holdings of money market funds and other short term investments. What would you do if you couldn't get to these assets? If the answer is ugly, transfer your liquid assets to money market funds that invest only in U.S. Treasury securities, or to bank or credit union accounts and CDs that are fully insured by the federal government. Don't mess around searching for incremental increases in yield. Make sure your liquid assets are truly safe (because they may not be liquid otherwise).
5. Insurance Products. Insurance products are subject to the creditworthiness of the insurance company. Insurance companies make mistakes. If, like AIG, they make big enough mistakes and put the international financial system at the edge of the abyss, they will be bailed out by the government. But most insurance companies can't put the touch on taxpayers like that. Try to figure out how much you could salvage from your annuity or other insurance products if the insurer goes belly up. You might have to research the law of the state where the insurance company is chartered for the coverage provided by its guaranty association for life insurance. (One place to start is the website for the national umbrella organization for these associations, called the National Organization of Life & Health Insurance Guaranty Associations,
http://www.nolhga.com/.) The amount of coverage may be between a maximum of $100,000 to $500,000, depending on the state. If that limit spurs major heartburn, either avoid making a big investment in insurance products, or look to boost the non-insurance portion of your portfolio. Be cautious about exiting insurance products you've already bought, because the insurance companies may whack you with painful termination fees. But pay those fees if your exposure to insurance products makes you queasy.
6. Pension. Let's say your employer goes bankrupt and ditches its pension plan. Can you live with the reduced payments you might end up with? Figuring out how much your pension might be reduced in such a circumstance could be difficult and the stress test might have to be done with just an approximation (factoring in the limitations in coverage from the Pension Benefit Guaranty Corp., if applicable; see http://www.pbgc.gov/workers-retirees/benefits-information/content/page789.html). You could try assuming your pension payments turn out to be half of what you expected. Then, increase your current savings a lot because the loss of half a pension would be painful for just about anyone.
7. Social Security and Medicare. Social Security and Medicare will not disappear. They will be here as long as the Stars and Stripes fly. Of course, some modifications will surely be made, particularly in light of the recent mid-term elections. These modifications won't give you a warm glow. Assume your benefits are reduced by 15%. If that would increase your antacid budget, save more.
8. Health Insurance. If you're under 65, consider the impact of losing your health insurance. (Just about everyone 65 or older has Medicare coverage.) If you're in a group plan, research the cost of buying replacement coverage (which would be an expensive individual policy for most people). Then save more. If the health care reform of 2010 survives Republican attack in 2011 largely intact, you'll probably be able to get good coverage. If the 2010 health insurance reform is significantly cut back, you could be in a tight spot.
9. House. If your home is part of your retirement finances, consider the impact of a 25% drop in its value. Many homes have dropped more than that in the past few years. Don't think it can't happen again. Factor in the mortgage, home equity loan(s) and other liens on the house. If a 25% loss would ruin your day, save more.
We all know that, in a financial crisis, more than one asset class may go sour at the same time. Estimate the combined impact of such a morass. One thing that is certain is we will have another financial crisis like 2008-09. When is anyone's guess. But an enduring lesson of 2008 is that there are no new paradigms in the world of investments and finance. Sooner or later there will be another financial crisis. Those that prepare for it will probably do okay. Crisis deniers surely won't.
Where is there safety? Money market funds that invest solely in U.S. Treasury securities for one. Bank and credit union accounts and CDs that are fully insured by the federal government are another. See http://blogger.uncleleosden.com/2010/07/safe-investments.html. Longer term U.S. Treasury securities will be paid in full upon maturity, but are subject to interest rate risk during their terms. Gold and silver may look attractive at the moment, but their values have historically been extremely volatile. Invest in commodities at your peril.
If you don't like the results of your personal stress test, save more. That, more than anything else, will strengthen your finances. A diversified portfolio is prudent (stocks and bonds can help with your long term financial needs). But diversified doesn't necessarily mean high risk. Having 20% in stocks and 30% in bonds, with the rest in safe assets, may be as diversified as some people want to get, especially those over 70. All the nice looking statistics and charts that financial planners can generate about long term gains don't mean diddly if we're stuck in one of the decade long or longer time periods when financial assets sag. Allocate your assets in the way that facilitates sleep. You'll sleep better for it.
Sunday, November 7, 2010
How Much Do You Need For Retirement?
A pretty simple way to estimate how much money you need for retirement is:
1. Calculate how much annual income you want (or need) in retirement, using current dollars.
2. Subtract the amounts of Social Security benefits (including your spouse's benefits, if you're married), and pension income, if any, you (and your spouse, if married) expect.
3. Multiply by 30; we'll call the result your nominal target.
4. Adjust for inflation between now and your anticipated retirement age, by multiplying 1.03 by itself the number of times equal to the number of years until your retirement (i.e., 1.03 to the exponential power equal to the number of years until your retirement), and next multiplying the resulting number by the nominal target.
The number you end up with is your inflation adjusted target. Here's an example.
Let's say you'd like the inflation adjusted equivalent of $50,000 (in current dollars) a year for retirement. Your estimated Social Security benefits are $15,000 a year. You're lucky enough to have a pension that will pay $10,000 a year when you retire. Subtracting $15,000 and $10,000 from $50,000 leaves $25,000. Then multiply $25,000 by 30, getting $750,000. We assume inflation will be 3% a year (that's the approximate average annual inflation rate since World War II). We'll also assume you have 20 years to go before retirement. Multiply 1.03 by itself 20 times (that would be 1.03 to the 20th power, exponentially speaking). The result is about 1.8061, which you multiply with $750,000, getting $1,354,500 as your approximate inflation adjusted target.
If you have no pension, which is the case for most Americans, you'd subtract your $15,000 Social Security benefits from $50,000, getting $35,000. That figure multiplied by 30 yields $1,050,000. Multiply by 1.8061 to account for inflation, and your target becomes $1,896,400.
Note that your target number is in future inflation adjusted dollars. Since most people's incomes tend to keep pace with inflation, reaching the target isn't quite as hard as you might think. You can use this target without having to think about investment options or diversification strategies. Tired of stock market volatility? Slick financial advisers make you nervous? Don't want to invest in derivatives contracts or no money down real estate deals? That's okay. Save in CDs and money market accounts if you want. Work a second job, or drive the same car for 20 years. Don't splurge on a McMansion and learn the virtues of home cooked meals. Inherit the money, win the lottery, or get it any other way that's legal. It doesn't matter how you get the money, so long as you have enough.
This formula is just an approximation, and is meant to give you a ballpark sense of where you need to go. We assume that you're retiring in your early 60s (most people do so around age 62). That's why we use a multiplier of 30--many financial advisers would use a multiplier of 25, but they're assuming retirement at age 65 or later. The multiplier of 30 also helps account for the fact that most pensions are not increased for inflation, so they lose value over time. We also assume that once you've accumulated the needed total, you invest it in a conservatively diversified portfolio during retirement. If you want to stick with all CDs in retirement, you should use a larger multiplier, like 35 or 40. Of course, this money isn't for your kids' college expenses or other non-retirement uses. That has to be saved in addition to your retirement money.
It isn't easy to save for retirement. Then again, nothing worthwhile comes easily. Most people go through life and then retire on whatever they have available when retirement time rolls around. Even if you can't imagine how you'd ever hit your target, starting to prepare is the first step in ultimately being prepared. Many folks would be happy to accumulate half their target. But they have to start saving to get there. The worst thing you can do is nothing. For more on retirement, see
http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html, and http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html. Good luck.
1. Calculate how much annual income you want (or need) in retirement, using current dollars.
2. Subtract the amounts of Social Security benefits (including your spouse's benefits, if you're married), and pension income, if any, you (and your spouse, if married) expect.
3. Multiply by 30; we'll call the result your nominal target.
4. Adjust for inflation between now and your anticipated retirement age, by multiplying 1.03 by itself the number of times equal to the number of years until your retirement (i.e., 1.03 to the exponential power equal to the number of years until your retirement), and next multiplying the resulting number by the nominal target.
The number you end up with is your inflation adjusted target. Here's an example.
Let's say you'd like the inflation adjusted equivalent of $50,000 (in current dollars) a year for retirement. Your estimated Social Security benefits are $15,000 a year. You're lucky enough to have a pension that will pay $10,000 a year when you retire. Subtracting $15,000 and $10,000 from $50,000 leaves $25,000. Then multiply $25,000 by 30, getting $750,000. We assume inflation will be 3% a year (that's the approximate average annual inflation rate since World War II). We'll also assume you have 20 years to go before retirement. Multiply 1.03 by itself 20 times (that would be 1.03 to the 20th power, exponentially speaking). The result is about 1.8061, which you multiply with $750,000, getting $1,354,500 as your approximate inflation adjusted target.
If you have no pension, which is the case for most Americans, you'd subtract your $15,000 Social Security benefits from $50,000, getting $35,000. That figure multiplied by 30 yields $1,050,000. Multiply by 1.8061 to account for inflation, and your target becomes $1,896,400.
Note that your target number is in future inflation adjusted dollars. Since most people's incomes tend to keep pace with inflation, reaching the target isn't quite as hard as you might think. You can use this target without having to think about investment options or diversification strategies. Tired of stock market volatility? Slick financial advisers make you nervous? Don't want to invest in derivatives contracts or no money down real estate deals? That's okay. Save in CDs and money market accounts if you want. Work a second job, or drive the same car for 20 years. Don't splurge on a McMansion and learn the virtues of home cooked meals. Inherit the money, win the lottery, or get it any other way that's legal. It doesn't matter how you get the money, so long as you have enough.
This formula is just an approximation, and is meant to give you a ballpark sense of where you need to go. We assume that you're retiring in your early 60s (most people do so around age 62). That's why we use a multiplier of 30--many financial advisers would use a multiplier of 25, but they're assuming retirement at age 65 or later. The multiplier of 30 also helps account for the fact that most pensions are not increased for inflation, so they lose value over time. We also assume that once you've accumulated the needed total, you invest it in a conservatively diversified portfolio during retirement. If you want to stick with all CDs in retirement, you should use a larger multiplier, like 35 or 40. Of course, this money isn't for your kids' college expenses or other non-retirement uses. That has to be saved in addition to your retirement money.
It isn't easy to save for retirement. Then again, nothing worthwhile comes easily. Most people go through life and then retire on whatever they have available when retirement time rolls around. Even if you can't imagine how you'd ever hit your target, starting to prepare is the first step in ultimately being prepared. Many folks would be happy to accumulate half their target. But they have to start saving to get there. The worst thing you can do is nothing. For more on retirement, see
http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html, and http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html. Good luck.
Thursday, October 28, 2010
The Cash Balance Pension: a Retirement Plan for the Future?
It's hardly a secret that retirement plans and retirement planning are a mess. Traditional defined benefit pensions can be costly to fund properly and all too often have proven to be underfunded. Employers battered by the recession sometimes abandon their plans, leaving beneficiaries with only the payments guaranteed by the federal Pension Benefit Guaranty Corp. These plans are going the way of the dinosaurs.
Newer defined contribution plans like 401(k)s are much less risky for employers. But the risks are dumped on beneficiaries, who are at the mercy of high expenses, Wall Street induced economic crises, flash crashes and other financial market volatility, and limited numbers of often unattractive investment options. It's almost impossible to predict the benefits one will receive from a defined contribution plan, and funding an account is more an act of faith than planning for retirement. The average defined contribution plan account is worth somewhere near $70,000. When you think about it, that's a lot of money to put in a black hole.
Both employers and employees want something better. Oddly, a runt of the retirement planning litter called the cash balance pension may provide an answer. It's an amalgam of not entirely attractive features. But it may prove workable in an uncertain world.
The cash balance plan annually credits a dollar value to each employee's account. The amount credited is usually a percentage of the employee's compensation. The accumulated balance in each employee's account is paid interest (at a fixed or variable rate, as specified by the plan), which is compounded annually. Employee accounts gain value over time from annual credits and the compounding of interest. Upon retirement, the employee generally has a choice between receiving the account value as a lump sum, or using it to buy an annuity (which would provide monthly payments). If an employee leaves the employer before retiring, he or she retains the accrued value of his or her cash balance account and can remove the money from account.
The cash balance plan is a compromise. The employer guarantees the growth of account balances up to the point of retirement or termination of employment. Then, the employee is responsible for deciding what to do with the account after retirement: either withdraw a lump sum and personally invest it at market risk, or take an annuity that provides monthly payments. The employer can fund the annuity through a contract with an insurance company, largely relieving the employer of the burdens of guaranteeing years and perhaps decades of retirement benefits. (However, the employer remains legally liable for the annuity payments and bears the risk of the creditworthiness of the insurance company.) Cash balance pensions are guaranteed by the Pension Benefit Guaranty Corp., so there is federal backing for employees' benefits.
The advantage to employees is that the employer takes on the costs and risks of funding the cash balance plan until the employee retires. The formulaic nature of the cash balance plan makes it easier for employees to predict how much they'll have upon reaching retirement age, and thereby facilitates financial planning. Employers benefit from the same predictability, making it easier to fund and manage the plan. Small businesses also get large tax deductions from cash balance plans.
Are cash balance plans a win-win? Not necessarily. They have a poor reputation stemming from litigation over early iterations of these plans, when employers converted from traditional defined benefit pensions to cash balance plans in ways that left longtime employees feeling shafted. Some cash balance plans have been attacked in court for alleged unlawful discrimination against older workers. Because cash balance plans can be structured to give older employees lower benefits than traditional defined benefit plans, they are disfavored by many workers.
But pension plans are voluntary, and an employer doesn't need to offer any kind of pension. Many don't, substituting 401(k) plans and all the risks they present to workers. Other employers offer nothing, leaving employees to limited self-help measures such as IRAs. A cash balance plan has the somewhat dissatisfying quality of a compromise. But it offers a degree of certainty and predictability to both employers and employees. Many employers want to offer pensions plans as a means of recruiting and retaining employees, yet don't want the burdens of traditional defined benefit pensions. The cash balance plan may be a way for employers to have such a recruiting tool, and for employees to predictably accumulate retirement benefits in amounts they'd never save on their own.
Newer defined contribution plans like 401(k)s are much less risky for employers. But the risks are dumped on beneficiaries, who are at the mercy of high expenses, Wall Street induced economic crises, flash crashes and other financial market volatility, and limited numbers of often unattractive investment options. It's almost impossible to predict the benefits one will receive from a defined contribution plan, and funding an account is more an act of faith than planning for retirement. The average defined contribution plan account is worth somewhere near $70,000. When you think about it, that's a lot of money to put in a black hole.
Both employers and employees want something better. Oddly, a runt of the retirement planning litter called the cash balance pension may provide an answer. It's an amalgam of not entirely attractive features. But it may prove workable in an uncertain world.
The cash balance plan annually credits a dollar value to each employee's account. The amount credited is usually a percentage of the employee's compensation. The accumulated balance in each employee's account is paid interest (at a fixed or variable rate, as specified by the plan), which is compounded annually. Employee accounts gain value over time from annual credits and the compounding of interest. Upon retirement, the employee generally has a choice between receiving the account value as a lump sum, or using it to buy an annuity (which would provide monthly payments). If an employee leaves the employer before retiring, he or she retains the accrued value of his or her cash balance account and can remove the money from account.
The cash balance plan is a compromise. The employer guarantees the growth of account balances up to the point of retirement or termination of employment. Then, the employee is responsible for deciding what to do with the account after retirement: either withdraw a lump sum and personally invest it at market risk, or take an annuity that provides monthly payments. The employer can fund the annuity through a contract with an insurance company, largely relieving the employer of the burdens of guaranteeing years and perhaps decades of retirement benefits. (However, the employer remains legally liable for the annuity payments and bears the risk of the creditworthiness of the insurance company.) Cash balance pensions are guaranteed by the Pension Benefit Guaranty Corp., so there is federal backing for employees' benefits.
The advantage to employees is that the employer takes on the costs and risks of funding the cash balance plan until the employee retires. The formulaic nature of the cash balance plan makes it easier for employees to predict how much they'll have upon reaching retirement age, and thereby facilitates financial planning. Employers benefit from the same predictability, making it easier to fund and manage the plan. Small businesses also get large tax deductions from cash balance plans.
Are cash balance plans a win-win? Not necessarily. They have a poor reputation stemming from litigation over early iterations of these plans, when employers converted from traditional defined benefit pensions to cash balance plans in ways that left longtime employees feeling shafted. Some cash balance plans have been attacked in court for alleged unlawful discrimination against older workers. Because cash balance plans can be structured to give older employees lower benefits than traditional defined benefit plans, they are disfavored by many workers.
But pension plans are voluntary, and an employer doesn't need to offer any kind of pension. Many don't, substituting 401(k) plans and all the risks they present to workers. Other employers offer nothing, leaving employees to limited self-help measures such as IRAs. A cash balance plan has the somewhat dissatisfying quality of a compromise. But it offers a degree of certainty and predictability to both employers and employees. Many employers want to offer pensions plans as a means of recruiting and retaining employees, yet don't want the burdens of traditional defined benefit pensions. The cash balance plan may be a way for employers to have such a recruiting tool, and for employees to predictably accumulate retirement benefits in amounts they'd never save on their own.
Wednesday, February 10, 2010
The Nine Lives of the Dollar
With feline quickness, the dollar has again pulled out of its latest nosedive. Greeks came bearing gifts, in the form of a Euro bloc debt crisis, and investors worldwide suddenly found the greenback in their hearts. Two and a half months ago, the dollar was trading at more than $1.51 per Euro. Today, it closed below $1.38 per Euro. That's close to a 10% gain (approaching 50% on an annualized basis). We're not suggesting that you jump into the currency markets. But if you're an American, your passbook savings account just enjoyed a pop in Euro terms.
Late last year, many predicted the imminent transfer of the dollar to hospice care. These days, the dollar is dancing up a storm in swanky nightspots with an endless stream of partners. There's nothing like a good old fashioned financial crisis to put the pep back in the greenback's step.
The Chairman and governors of the Federal Reserve Board are probably sleeping better, as a strong dollar portends lower inflationary risk and widens their latitude to continue monetary accommodation. The administration is likely breathing more easily, since a strong dollar attracts capital to the mountains of Treasury securities that will have to be sold soon to finance the burgeoning federal deficit. Exporters are not pleased. But reality is that the government sector of the economy is more important these days than the private sector. Although that's a very big long term problem, no more than three or four people in America are focused on the long term, while the unemployed and everyone else are wondering about today, tomorrow and next week.
Wall Street is pleased, if only because the recent volatility of currencies and the stock market, and divergence in the bond markets (corporate debt is down, Treasuries are up), provide profit opportunities. Big money is made by the big banks when asset prices soar and swoop, and churn the stomachs of investors. Volatility creates trading opportunities for returns above long term market averages. In order to cash in on these trading opportunities, the big banks have to convince you, dear reader, to be a short term investor who trades in and out. That gives them commission income and market making profits. Fastidious, disciplined long term investors who know that .300 hitters hit a lot of singles and not so many home runs, and therefore don't trade a lot, are not ideal customers for the Street, even if they impudently become personally prosperous. (See http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html.)
Legend tells us there are risks when Greeks come bearing gifts. A bailout for Greece is reportedly in the works. If so, the burden will fall mostly on Germany, the economic engine of the European Union. France will contribute a high five but not too much money. The Dutch will frown and dourly push a few Euros into the pot. The Germans will probably insist on stiff terms for Greek fiscal reform, and pretend not to hear sardonic asides about jack boots, Panzers, and aspirations for continental domination. The Euro bloc bailout will probably feel ragged, begrudged and fraught with political risk (such as rejection by the Greek government due to internal opposition). Other financially troubled nations in Europe may also look to Bonn for a bailout. The burdens of bailouts could slow down Europe's recovery, which might in turn hinder America's recovery. The dollar may yet again lose its shine.
Late last year, many predicted the imminent transfer of the dollar to hospice care. These days, the dollar is dancing up a storm in swanky nightspots with an endless stream of partners. There's nothing like a good old fashioned financial crisis to put the pep back in the greenback's step.
The Chairman and governors of the Federal Reserve Board are probably sleeping better, as a strong dollar portends lower inflationary risk and widens their latitude to continue monetary accommodation. The administration is likely breathing more easily, since a strong dollar attracts capital to the mountains of Treasury securities that will have to be sold soon to finance the burgeoning federal deficit. Exporters are not pleased. But reality is that the government sector of the economy is more important these days than the private sector. Although that's a very big long term problem, no more than three or four people in America are focused on the long term, while the unemployed and everyone else are wondering about today, tomorrow and next week.
Wall Street is pleased, if only because the recent volatility of currencies and the stock market, and divergence in the bond markets (corporate debt is down, Treasuries are up), provide profit opportunities. Big money is made by the big banks when asset prices soar and swoop, and churn the stomachs of investors. Volatility creates trading opportunities for returns above long term market averages. In order to cash in on these trading opportunities, the big banks have to convince you, dear reader, to be a short term investor who trades in and out. That gives them commission income and market making profits. Fastidious, disciplined long term investors who know that .300 hitters hit a lot of singles and not so many home runs, and therefore don't trade a lot, are not ideal customers for the Street, even if they impudently become personally prosperous. (See http://blogger.uncleleosden.com/2009/11/techniques-for-retirement-saving.html.)
Legend tells us there are risks when Greeks come bearing gifts. A bailout for Greece is reportedly in the works. If so, the burden will fall mostly on Germany, the economic engine of the European Union. France will contribute a high five but not too much money. The Dutch will frown and dourly push a few Euros into the pot. The Germans will probably insist on stiff terms for Greek fiscal reform, and pretend not to hear sardonic asides about jack boots, Panzers, and aspirations for continental domination. The Euro bloc bailout will probably feel ragged, begrudged and fraught with political risk (such as rejection by the Greek government due to internal opposition). Other financially troubled nations in Europe may also look to Bonn for a bailout. The burdens of bailouts could slow down Europe's recovery, which might in turn hinder America's recovery. The dollar may yet again lose its shine.
Wednesday, January 13, 2010
IRAs and 401(k)s Aren't Retirement Plans. But a Roth Conversion May Help Your Estate Plan.
It's easy to think of IRAs and 401(k)s as retirement plans. They're not. IRAs and 401(k)s are retirement accounts. They serve as tax shelters to delay taxation of the money contributed to them. However, the amounts that you are allowed to shelter have no particular relationship to how much money you need for retirement. The IRS limits on contributions to IRAs ($5,000 in 2009 or $6,000 if you're 50 or older) and 401(k)s ($16,500 in 2009 or $22,000 if you're 50 or older) are simply the amount you can shelter from taxation. In both the saving phase and the withdrawal phase of your retirement planning, don't confuse tax issues with financial planning. Here's why.
Saving. How much you need to save for retirement may be more or less than the amounts the tax code lets you shelter. You should base your saving rate on a prudent estimate of your life expectancy. That is more easily said than done. Life expectancy is influenced by family history, your personal habits and diet, your occupation, the availability and quality of health care, and a host of other factors. If you dabble with life expectancy calculators on the Internet, you're likely to get a range of estimates as wide as 15 or so years. That's a big difference from a financial planning standpoint. Make the best estimate (meaning most accurate) you can of your life expectancy. Then add 10 years to account for medical advances. The resulting lifespan is probably a pretty safe assumption for financial planning purposes. Save in aftertax accounts if the amount that you can shelter in 401(k)s and IRAs isn't enough.
If all this number crunching is painful, then follow a simple formula: if you save 15% to 20% of your pretax earnings over the course of a 30 to 40 year career and invest it in a diversified portfolio, the amount you save plus Social Security will probably let you have a retirement lifestyle pretty close to what you enjoyed while working. For more details, see http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html.
Withdrawals. Once you reach the age of at least 59 and 1/2, you can start making withdrawals from your retirement accounts. At the age of 70 and 1/2, you are required to begin making withdrawals, whether or not you want to. The IRS has no objections if you withdraw your savings faster than required; they get more taxes upfront that way. But at 70 and 1/2, the process of minimum withdrawals begins. The exact amount of your minimum withdrawal will depend on IRS formulas designed to increase sales for antacid manufacturers. But the important point here is that the amount you're required to withdraw may or may not be safe for you to spend. If you have a longer than average life expectancy, save some of the aftertax portion of the withdrawal. Remember that the IRS withdrawal formulas are tax rules, not financial plans.
Avoid withdrawals with a Roth Conversion. One step that may simplify your retirement planning would be conversion of your IRA(s) to a Roth IRA. Traditional IRA accounts may be converted to Roth IRAs in 2010 without any income limitations (which were a problem in the past for many people). Conversion requires paying current income taxes on the amount converted, and you have to consider whether you're prepared to do that. There are lots of arguments why conversion will or won't save you taxes. How this analysis turns out could depend on tax legislation that remains to be adopted in 2010 and you may want to delay the decision whether or not to convert until later this year. But if you don't think you'll need your IRA assets, conversion to a Roth will let you avoid mandatory withdrawals altogether. That way, you can pass the entire account onto your heirs. Paying taxes now, but then letting the account grow on an aftertax basis could provide your heirs with quite a tidy sum. They'll have to make minimum withdrawals, but the withdrawals are tax-free and the remaining balance continues to grow tax free. Thus, converting a traditional IRA to a Roth can be an effective estate planning tool.
Saving. How much you need to save for retirement may be more or less than the amounts the tax code lets you shelter. You should base your saving rate on a prudent estimate of your life expectancy. That is more easily said than done. Life expectancy is influenced by family history, your personal habits and diet, your occupation, the availability and quality of health care, and a host of other factors. If you dabble with life expectancy calculators on the Internet, you're likely to get a range of estimates as wide as 15 or so years. That's a big difference from a financial planning standpoint. Make the best estimate (meaning most accurate) you can of your life expectancy. Then add 10 years to account for medical advances. The resulting lifespan is probably a pretty safe assumption for financial planning purposes. Save in aftertax accounts if the amount that you can shelter in 401(k)s and IRAs isn't enough.
If all this number crunching is painful, then follow a simple formula: if you save 15% to 20% of your pretax earnings over the course of a 30 to 40 year career and invest it in a diversified portfolio, the amount you save plus Social Security will probably let you have a retirement lifestyle pretty close to what you enjoyed while working. For more details, see http://blogger.uncleleosden.com/2009/07/simplest-financial-plan-of-all.html.
Withdrawals. Once you reach the age of at least 59 and 1/2, you can start making withdrawals from your retirement accounts. At the age of 70 and 1/2, you are required to begin making withdrawals, whether or not you want to. The IRS has no objections if you withdraw your savings faster than required; they get more taxes upfront that way. But at 70 and 1/2, the process of minimum withdrawals begins. The exact amount of your minimum withdrawal will depend on IRS formulas designed to increase sales for antacid manufacturers. But the important point here is that the amount you're required to withdraw may or may not be safe for you to spend. If you have a longer than average life expectancy, save some of the aftertax portion of the withdrawal. Remember that the IRS withdrawal formulas are tax rules, not financial plans.
Avoid withdrawals with a Roth Conversion. One step that may simplify your retirement planning would be conversion of your IRA(s) to a Roth IRA. Traditional IRA accounts may be converted to Roth IRAs in 2010 without any income limitations (which were a problem in the past for many people). Conversion requires paying current income taxes on the amount converted, and you have to consider whether you're prepared to do that. There are lots of arguments why conversion will or won't save you taxes. How this analysis turns out could depend on tax legislation that remains to be adopted in 2010 and you may want to delay the decision whether or not to convert until later this year. But if you don't think you'll need your IRA assets, conversion to a Roth will let you avoid mandatory withdrawals altogether. That way, you can pass the entire account onto your heirs. Paying taxes now, but then letting the account grow on an aftertax basis could provide your heirs with quite a tidy sum. They'll have to make minimum withdrawals, but the withdrawals are tax-free and the remaining balance continues to grow tax free. Thus, converting a traditional IRA to a Roth can be an effective estate planning tool.
Thursday, July 9, 2009
The Simplest Financial Plan of All
A very simple financial plan--the simplest of all, in fact--is to save a significant percentage of your income. If you save about 15% to 20% of your pretax earnings, work for 30 or more years, and invest in a reasonably well-diversified portfolio, you'll have a good chance of maintaining your pre-retirement standard of living during your golden years. It's not easy to save this much. But if you can, you'll probably build a good-sized portfolio while keeping your standard of living under control and sustainable in your golden years. If you save a smaller percentage of your pretax earnings, like 5% or 10%, you'll have to make some cutbacks in retirement (although you'd still be better off than most Americans).
One advantage of the percentage of earnings approach is that you won't need to fuss around with calculators that give you seemingly impossible retirement targets in the millions of dollars and which need to be revised every year or two to account for inflation. Any reasonable estimation of your needed retirement savings will result in a figure in the high hundreds of thousands or in the millions. These numbers seem so intimidating and impossible that many people don't even bother to start saving. That's a mistake. Forget about the seemingly impossible dollar amount and instead focus on saving a percentage of this year's income, then next year's income, and so on. After a few years, saving becomes easier and your wealth will grow visibly.
Another advantage of using a percentage of your earnings as a saving target is that you won't have to budget specific expenses. You can spend as much as you like on lattes, clothes, cars and whatever, so long as you save the requisite percentage of your earnings. You can still indulge and spoil yourself in some ways, even excessively, provided you feed the retirement savings. No need to input each day's expenditures into your PC, or debate whether chocolate is an extravagance or a necessity. Anything goes, as long as you fund your retirement adequately.
Saving isn't easy. But a simple financial plan will make it easier.
If you want a more detailed explanation of why the percentage of earnings method works, keep reading. But . . .
Warning, Alert, Danger: Math lurks below.
The simplest financial plan of all is based on a straightforward idea: the more you save, the less you spend today and the less extravagant your current lifestyle. Because you have a less expensive lifestyle, you’ll need less money to maintain that lifestyle in retirement, yet will have more resources today to save for a nice retirement. In other words, by controlling your spending today, you leverage your ability to save for a comfortable retirement. If you’re a really good saver, you’ll have the means to provide for a retirement that involves little or no reduction of lifestyle.
Look at the numbers. If you’re spending 100% of your current income, you’ll save nothing for retirement, and have just Social Security benefits. Get used to eating dog food.
If you spend 95% of your pre-tax earned income (we count taxes as spending because you don't save the taxes you pay), and save 5% in a 401(k) account—adjusting your contributions upward annually for inflation--you’ll have a decent sized nest egg after 30 years. If we assume annual investment gains of 7% compounded, you'll have enough at age 65 to start withdrawing an amount equal to about 19% of your average annual pre-retirement income. (This assumes you're drawing down 4% of the initial value of your retirement assets per year in retirement, which is about as much as you'd want to withdraw if you don't want to outlive your money.) You can use an Internet financial calculator like Money.cnn.com's (http://cgi.money.cnn.com/tools/savingscalc/savingscalc.html) to do these calculations. Adding 19% of your working years' annual income to your Social Security benefits may not sound like a lot, but it’s a damn sight better than zero.
If you're middle class, Social Security could amount to about 30% of your pre-retirement income. With another 19%, you'd retire on a total of 50% or so of your average annual pre-retirement income.
If you save 10% of your earned income in a 401(k) account for 30 years and get 7% returns compounded annually—again adjusting your contributions annually for inflation—you’ll end up with enough in retirement assets to provide about 38% of your average annual pre-retirement earned income, starting at age 65 (assuming a similar 4% annual drawdown). But your standard of living will be based on 90% of your earned income, so you’d be withdrawing enough for 42% of your average annual pre-retirement living expenses. (This is because 38% of 90% is 42%.) In other words, a little restraint in your lifestyle today leverages your ability to save and to maintain your current lifestyle in retirement. Add the 30% or so that Social Security would provide if you're middle class, and you'd retire on about two-thirds of your average annual pre-retirement income.
Using the same assumptions, if you save 15% of your earnings each year, then you'd be able to withdraw about 57% of your average annual pre-retirement income during your golden years. Because you'd have been living on 85% of your income, the withdrawal would approximate 67% of your average annual pre-retirement spending. If you're middle class, add 30% or so for Social Security, and you would be able to spend about as much each year in retirement as you did, on average, before retiring.
If you can save 20% or 25% of your earned income per year, you could actually end up with more lifestyle in retirement than you had while working. Let the good times roll.
It’s important to note that these numbers are for your average annual earnings over the course of your life. Your average annual income for your entire working life will probably be lower than the income levels you enjoy in your 40’s and 50’s, since many people start off with lower incomes early in their careers and see their incomes rise over time. If this has been true for you and you want to maintain the lifestyle to which you’ve become accustomed in your 40’s and 50’s, save a higher rather than lower percentage. At least 20% of your earned income would be a good idea. We also don't count investment earnings saved, since that is embodied in the compounding of earnings that leverages the growth of your savings.
What’s the right level of saving? That’s for you to decide. Each of us has a point where the trade-off between saving and current spending feels right. It won’t be the same for everyone. Pick a point along the continuum that makes you comfortable, and stick to the savings plan. Some people want or need to spend a lot now, and are willing to accept a modest retirement as the price. Others want to be prepared for the future as much as possible, and their personal sweet spot would be farther along the continuum toward a modest lifestyle now and a higher level of savings. If you want to avoid a drop in your lifestyle in retirement, and you have 30 years to build a retirement portfolio, save 20% or more of your current earnings. While 15% has a good chance of getting you there, 20% is a safer number in case investment gains are lower than historical averages during the next 30 years (which is quite possible since go-go years in the stock market--like the 1990s and 2000s up to 2007--are often followed by long periods of below average performance). Also, if you have fewer than 30 years to go before retiring, save more, like 20%, if you want to avoid a drop in lifestyle during your shuffleboard years.
One advantage of the percentage of earnings approach is that you won't need to fuss around with calculators that give you seemingly impossible retirement targets in the millions of dollars and which need to be revised every year or two to account for inflation. Any reasonable estimation of your needed retirement savings will result in a figure in the high hundreds of thousands or in the millions. These numbers seem so intimidating and impossible that many people don't even bother to start saving. That's a mistake. Forget about the seemingly impossible dollar amount and instead focus on saving a percentage of this year's income, then next year's income, and so on. After a few years, saving becomes easier and your wealth will grow visibly.
Another advantage of using a percentage of your earnings as a saving target is that you won't have to budget specific expenses. You can spend as much as you like on lattes, clothes, cars and whatever, so long as you save the requisite percentage of your earnings. You can still indulge and spoil yourself in some ways, even excessively, provided you feed the retirement savings. No need to input each day's expenditures into your PC, or debate whether chocolate is an extravagance or a necessity. Anything goes, as long as you fund your retirement adequately.
Saving isn't easy. But a simple financial plan will make it easier.
If you want a more detailed explanation of why the percentage of earnings method works, keep reading. But . . .
Warning, Alert, Danger: Math lurks below.
The simplest financial plan of all is based on a straightforward idea: the more you save, the less you spend today and the less extravagant your current lifestyle. Because you have a less expensive lifestyle, you’ll need less money to maintain that lifestyle in retirement, yet will have more resources today to save for a nice retirement. In other words, by controlling your spending today, you leverage your ability to save for a comfortable retirement. If you’re a really good saver, you’ll have the means to provide for a retirement that involves little or no reduction of lifestyle.
Look at the numbers. If you’re spending 100% of your current income, you’ll save nothing for retirement, and have just Social Security benefits. Get used to eating dog food.
If you spend 95% of your pre-tax earned income (we count taxes as spending because you don't save the taxes you pay), and save 5% in a 401(k) account—adjusting your contributions upward annually for inflation--you’ll have a decent sized nest egg after 30 years. If we assume annual investment gains of 7% compounded, you'll have enough at age 65 to start withdrawing an amount equal to about 19% of your average annual pre-retirement income. (This assumes you're drawing down 4% of the initial value of your retirement assets per year in retirement, which is about as much as you'd want to withdraw if you don't want to outlive your money.) You can use an Internet financial calculator like Money.cnn.com's (http://cgi.money.cnn.com/tools/savingscalc/savingscalc.html) to do these calculations. Adding 19% of your working years' annual income to your Social Security benefits may not sound like a lot, but it’s a damn sight better than zero.
If you're middle class, Social Security could amount to about 30% of your pre-retirement income. With another 19%, you'd retire on a total of 50% or so of your average annual pre-retirement income.
If you save 10% of your earned income in a 401(k) account for 30 years and get 7% returns compounded annually—again adjusting your contributions annually for inflation—you’ll end up with enough in retirement assets to provide about 38% of your average annual pre-retirement earned income, starting at age 65 (assuming a similar 4% annual drawdown). But your standard of living will be based on 90% of your earned income, so you’d be withdrawing enough for 42% of your average annual pre-retirement living expenses. (This is because 38% of 90% is 42%.) In other words, a little restraint in your lifestyle today leverages your ability to save and to maintain your current lifestyle in retirement. Add the 30% or so that Social Security would provide if you're middle class, and you'd retire on about two-thirds of your average annual pre-retirement income.
Using the same assumptions, if you save 15% of your earnings each year, then you'd be able to withdraw about 57% of your average annual pre-retirement income during your golden years. Because you'd have been living on 85% of your income, the withdrawal would approximate 67% of your average annual pre-retirement spending. If you're middle class, add 30% or so for Social Security, and you would be able to spend about as much each year in retirement as you did, on average, before retiring.
If you can save 20% or 25% of your earned income per year, you could actually end up with more lifestyle in retirement than you had while working. Let the good times roll.
It’s important to note that these numbers are for your average annual earnings over the course of your life. Your average annual income for your entire working life will probably be lower than the income levels you enjoy in your 40’s and 50’s, since many people start off with lower incomes early in their careers and see their incomes rise over time. If this has been true for you and you want to maintain the lifestyle to which you’ve become accustomed in your 40’s and 50’s, save a higher rather than lower percentage. At least 20% of your earned income would be a good idea. We also don't count investment earnings saved, since that is embodied in the compounding of earnings that leverages the growth of your savings.
What’s the right level of saving? That’s for you to decide. Each of us has a point where the trade-off between saving and current spending feels right. It won’t be the same for everyone. Pick a point along the continuum that makes you comfortable, and stick to the savings plan. Some people want or need to spend a lot now, and are willing to accept a modest retirement as the price. Others want to be prepared for the future as much as possible, and their personal sweet spot would be farther along the continuum toward a modest lifestyle now and a higher level of savings. If you want to avoid a drop in your lifestyle in retirement, and you have 30 years to build a retirement portfolio, save 20% or more of your current earnings. While 15% has a good chance of getting you there, 20% is a safer number in case investment gains are lower than historical averages during the next 30 years (which is quite possible since go-go years in the stock market--like the 1990s and 2000s up to 2007--are often followed by long periods of below average performance). Also, if you have fewer than 30 years to go before retiring, save more, like 20%, if you want to avoid a drop in lifestyle during your shuffleboard years.
Good luck.
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