Retirement Income Planning Done Right (part 2)
This is a follow-up post to Retirement Income Planning Disasters (part 1) ----
Last month I wrote a post titled "Retirement Income Planning Disasters" - and got quite the reaction. Some people loved it, others were infuriated. I guess that's what happens whenever you tackle an issue very personal to people. Those that were upset largely didn't like that I showed how many people purchase investment products without doing proper planning, and when those products aren't the right ones, find themselves with little flexibility or opportunity to fix the mistake.
That's reality. I see it happening all the time.
Usually it's because financial salespeople are more motivated by making a quick commission and much less interested in doing real work for the money. It's sad, but the faster we recognize it happens, and learn the proper steps for good planning, the less likely it is to happen to us.
Bill and Susan Doe had saved well, lived modestly, and had reasonable retirement goals. However, because critical issues like individual components of their budget weren't itemized for inflation, and the products they used didn't really work as they were proposed, The Doe's ended up with a shortfall in their retirement years.
It shouldn't have happened, but it did.
Here's the screenshot of their retirement income plan being "stress tested" for 30 years:
As you can see, they didn't come up too short, but short nonetheless. In this post we'll walk through the proper way to determine income needs, and test some additional ways for them to reach their goals with the highest degree of probability.
Step 1: Proper Retirement Income Needs Projecting
The first thing that needs to be done when building a retirement income plan is determining what realistic needs are. I did this in the last post by showing a table illustrating the various expenses Bill and Susan will have for the next 30 years. Here's the table as a refresher:
[table id=15 /]
The reason we itemize the key areas of income needs is because each has a different inflation rate.
For example, if Bill and Susan have a mortgage that will be paid off in 10 years - then we know that their "Housing" budget will be higher, but with little inflation for the first 10 years; then be lower but with a higher inflation rate during the last 20. This is because during the years the mortgage is being repaid most of that expense is fixed. It does not go up. However, once the principal and interest payments are done the only remaining "Housing" expenses are taxes, upkeep, utilities, etc. Those items do go up each year.
The same is true for "Medical" expenses relative to "Living" expenses. Medical expenses traditionally have a much higher inflation rate than other expenses, so they should be illustrated as such.
Most planners/individuals use a generic total inflation rate, like 3.5% when forecasting income needs. That could be under or over compensating for inflation - so it's very important to drill down with as much precision as possible to get it right.
I also broke down the fixed income sources for Bill and Susan along with each income sources inflation rate. That table is here:
[table id=16 /]
When we merge these tables together we get a pretty clear picture of what Bill and Susan's fixed income versus income needs looks like:
[table id=17 /]
This is what the base of their Retirement Income Plan should be based from
Step 2: Risk Management Analysis
During retirement there are really 3 risks that can completely derail a Retirement Income Plan.
Medical expenses - namely Nursing Home/Assisted Living
In Bill and Susan's initial plan they covered item 2, but didn't think about items 1 or 3. Plenty has already been written (ad nauseam) regarding the expenses of Long Term Medical Care costs. See here and here for some examples. Yet this is a commonly overlooked item when building a Retirement Income Plan.
For those unfamiliar, Long Term Care expenses are not cheap. I've personally seen people pay $10,000 per month to take care of one person, though the range can vary significantly. There are really only two ways to be prepared for such expenses:
Self insure - by having more than enough income/assets
Purchase insurance - or have an income that adjusts for Long Term Care costs if applicable
In Bill and Susan's case we know they aren't covered for this risk because their initial plan failed even without the possibility of additional medical costs. The way we properly plan for this expense is to determine the cost of insurance and see if we can get the retirement commensurately higher with the cost of insurance, without the risk of running out of money. After all, if you run out of money Medicaid would kick in and pay those costs, though not always for the facility retirees prefer.
Warning: Long Term Care Insurance is not cheap. And some people will not qualify if their health is poor. All the more reason to do proper planning while you can.
Lawsuits are another risk that are commonly ignored. While we don't ever plan on getting sued, it's not uncommon if in a car accident, or if someone gets seriously injured while on your property. And to boot, it's an easy and low-cost type of insurance to have. The easy way to cover this risk is by purchasing an Umbrella Liability Policy. Fairly large policies can be purchased for very low relative costs, often time obtaining $1,000,000 of coverage for as little as a few hundred dollars per year.
Like the Long Term Care Medical costs ideally we like to see if retirement income can be increased to cover this insurance while still maintaining portfolio principal throughout retirement.
In our Retirement Income Planning Done Right scenario we will assume the following:
Long Term Care Insurance can be purchased for $4,000 per year
A Liability Umbrella Insurance policy can be purchased for $500 per year
This effectively raises our income need by $4,500 per year.
As for the risk of a Stock Market Crash...
The easiest way to avoid this is to build a plan that does not need stocks. This will be possible for some people, while others will need better long-term returns in order to meet their income needs. Doing proper planning we first test using no stock or stock fund investments and if we cannot meet long-term needs slowly introduce small allocations of stocks until income needs can be met. This might mean having just 5-15% in stocks/stock funds, which is actually a very conservative allocation with minimal risk involved.
Another way to reduce this risk is by using a Tactical Asset Allocation for the stock/stock fund portion of an investment allocation. You can read more about Tactical Asset Allocation here.
Step 3: Stress Test (then re-test, then re-test)
In the image I showed in the previous post you can see an example of a Retirement Income Plan Stress Test. It essentially shows a best case, average case, and worst case scenario of whether or not a retirement income plan will work or not. In Bill and Susan's case all three (best, worst, etc) failed. They basically had no chance of living 30 years and not completely depleting the cash value of their portfolio. Bill and Susan relied heavily on annuities, which have picked up significantly in popularity the past 10 years. So while they may have depleted their portfolio, they would still have had guaranteed income for life.
Their initial plan was great at guaranteeing income, it just wasn't quite enough, nor provided enough flexibility for some of the non-portfolio risks retirees face.
When doing stress testing it's usually smart to start like the Doe's did. Using just guaranteed investments and eliminating market risks. Though, in my opinion, they should have also considered some safe alternatives like short-term high quality bonds, CDs, or maybe even a very small allocation to growth investing (like stock/stock funds via TAA).
As a recap, this was the way they invested their money in their initial retirement income plan:
[table id=14 /]
Since we know this didn't work, let's take a look at another way they could have allocated their funds and see how that would have worked.
Stress test of Portfolio Option 2:
[table id=18 /]
The only change we're initially testing is if Bill and Susan do not use a second annuity, and instead just use a diversified bond portfolio as a replacement. Some folks have been filled with scare tactics regarding bonds as an investment. They're told "bonds will go down when interest rates go up," or "you don't want to buy bonds when interest rates are at historic lows."
These arguments are only partially true. The reality is that the best time to buy bonds is when interest rates are high. That's pretty obvious. But history tells us that bonds (when managed correctly) are still very good investments when interest rates are low and then rise. For example, since 1928 the worst average annual return from bonds when held for at least 10 years occurred from 1943 to 1953. Over this time period bonds returned an average annual return of 2.39% (source: IndexFunds.com). When looked at over 30 years (the Doe's retirement time horizon) the worst average annual return is 5.58% from 1982 to 2012. As for risk, so long as a bond holder has held for 24 months they have never lost money and the worst ever 12 month time horizon was a loss of 1.94% (1994).
Hopefully that clears up all the misguided baloney floating around about how "risky" bonds are. It's all relative. When done well, properly diversified, laddered, etc - bonds have historically been a relatively safe way to get modest returns without stock market risk.
All that said, let's see how it changes the Stress Test:
Wow - what a difference just a small change makes.
In this example we were able to create the additional income to prevent catastrophic risks, meet all other retirement income needs, and still maintain a high probability of $300,000 to $800,000 being left for heirs/charity/etc.
Stress test of Portfolio Option #3
At this point we could feel pretty satisfied and conclude that Option #2 is the way to go. But what if Bill and Susan want to see one more option with as much guaranteed about their retirement as possible? Easy, we just run another Stress Test.
In this scenario we decide we'd like to find an additional $10,000 of guaranteed income beginning at age 70. To do this we look at all insurance company income guarantees and find that if Bill and Susan invest $98,982 today, they will be assured an income of $10,000 per year no matter how long they live starting in 8 years (age 70). So we simply deduct that amount from Susan's IRA and see if it still works:
Unfortunately, this doesn't quite work out.
Lesson learned - trying to get too much guaranteed income doesn't allow the Doe's to have a solid, fighting chance of meeting their retirement income needs.
Conclusions on Retirement Income Planning
Probably the thing that jumps out the most when doing analysis like this is the following:
Never implement an investment plan if it hasn't been tested to work.
Too often planning is linear and assumptions too generic. Getting detailed about income needs, income sources, and testing (vigorously) the various options you have as an investor, is the best possible way to enjoy a high quality retirement free from worry about finances.
It's also important to understand that sometimes even well thought out plans take time to work. In our scenario #2 - which worked the best of the 3 scenarios tested, there would be some years that weren't perfect. This is because for the Doe's, they had to take some risk. Even though it was about the minimal possible risk, it still would have the potential for a year or two to be slightly negative. That's the tradeoff in achieving long-term goals...you must be willing to commit long-term in spite of short-term deviations.
Do you have a plan? Has it been thoroughly tested? Need a little help?
[warning - self-serving comments coming ;)] For my clients I always test our investment process indiscriminately. I'm a bit of a computer geek - and this type of testing, testing, testing - is very natural. But if you read this, and wonder - "Hmm, will my plan work? Do I even have a plan? Could I be doing something smarter/better?" Well, feel free to reach out. I'm happy to provide a little guidance if you think it would be helpful.
To get in touch just use the Contact Me page. It's secure, confidential, and nobody will hound you. Just simple feedback via email.
I hope all my readers find this helpful. If not, or if you see errors, or if you have questions - just use the Comment area below this post (you need to scroll down just a bit).