Tuesday Oct 09, 2018
Chapter 1 - "Why It's Different Over 50"
Tuesday Oct 09, 2018
Tuesday Oct 09, 2018
In this episode, podcast host and author of “Control Your Retirement Destiny” covers Chapter 1 of the 2nd edition of the book titled, “Why It’s Different Over 50.”
If you want to learn even more than what there is time to cover in the podcast series, you can find the book “Control Your Retirement Destiny” on Amazon.
Or, if you are looking for a customized plan for your retirement, visit us at sensiblemoney.com to see how we can help.
Chapter 1 – Podcast Script
Hi, I’m Dana Anspach, the founder and CEO of Sensible Money, a fee-only financial planning firm that specializes in helping people transition into retirement. I’m also the author of the books Control Your Retirement Destiny, and Social Security Sense.
My passion for helping people make the best retirement decisions possible is what led me to write Control Your Retirement Destiny and I’m honored by the incredible 5-star reviews it has received. I wrote it because I wanted people to see what a real retirement plan looks like – and the book spells it all out, step by step.
Today, I’m thrilled to bring to you this podcast where we will discuss highlights from the book. In this episode, I’ll be covering Chapter 1 of the 2nd edition of the book titled, “Why It’s Different Over 50.”
If you want to learn even more than what we have time to cover in this podcast series, I encourage you go to Amazon.com and search for Control Your Retirement Destiny. Or, if you are looking for a customized plan for your retirement, visit us at sensiblemoney.com to see how we can help.
Let’s get started.
So, why is it different over 50? Sure, your joints ache more, and you can no longer read menus, but, do the financial aspects of life change too?
In many ways, yes, they do.
Think of it like this…
Imagine you’re planning for a road trip. This road trip has two phases.
The first phase is the accumulation phase. This occurs during your working years where your focus is on saving for retirement. You have a set point in time you are saving for – a destination you want to reach by a specific age.
The second phase is the decumulation phase of the road trip. This will be the point in time where you will “live off your acorns”. You have a lot more flexibility in this phase, but also, a lot more unknowns.
Let’s look at each phase more closely.
First, the accumulation road trip.
Assume for this portion of the road trip, you’re not going too far, only about 300 miles.
Your gas tank holds 18 gallons and you didn’t have an electric car, so you only get about 20 miles per gallon.
Taking 18 gallons x 20 miles per gallon, you can estimate you’ll get about 360 miles per tank. Since your destination is 300 miles away, it’s pretty easy to figure out you can get to there on one tank.
This type of calculation is simple and easy to do. When you’re young and actively saving for retirement, this type of calculating helps you figure out how much to save.
For example, if you’re age 40, and you want to save $1.5 million by age 65, how much do you need to put away each year?
The answer is about $24,000 a year – that is assuming you earn about 7% a year on your investments.
This type of math is relatively easy to do using a spreadsheet or a financial calculator. It’s easy because you plug in specific data, such as 25 years and a 7% return.
Now, let’s start the second part of your road trip – the decumulation phase – and see how the math gets harder.
As you start the decumulation phase, here are some of the questions you have.
How long is your road trip going to be?
What terrain will you be driving over?
What will the weather be like?
Are they any gas stations along the way?
What will the price of gas be?
These are all unknowns.
Let’s break these unknowns into four risk categories.
- The first category is called “Longevity Risk”. You don’t know how long you’ll live. So you don’t know how many total miles you’ll be driving. Instead of knowing it is 25 years until you reach age 65, now your road trip could be 20 years, thirty or even 40 years.
- The next risk category is called “sequence risk”. This has to do with the unknown market returns. For example, we all know that city driving takes more fuel than highway driving. But with this road trip, you don’t know what conditions you’ll encounter. This risk impacts you when you are accumulating too. But while you are younger you have time to recoup from mistakes, or from a period of time with below average investment returns. As you get closer to retirement, a bad sequence of returns, or several years in a row with poor returns, can cause a result that you didn’t see coming.
- This next risk category is “inflation risk”. What will the price of gas be as you travel along? Will prices rise over time, and if so, by how much?
- The last challenge you have is rationing your supplies. This is a risk retirees face called “overspending risk.” Suppose you pack your favorite snacks, but you go on a binge early on the trip and gobble them all up? Now, you don’t have enough for the tail end of your trip.
To feel comfortable transitioning into retirement, you need a plan in place to account for these unknowns.
In this podcast on Chapter 1 of Control Your Retirement Destiny, I’m going to provide an introduction to each of these four risks; longevity risk, sequence risk, inflation risk, and spending risk.
- LONGEVITY RISK
First, longevity risk. When you run a projection, you must start with an assumption about how long you might live. You can guess, or you can use science… sort of. Science works well for engineering when you’re working with known factors – like gravity.
But as we discussed, this road trip has a lot of unknowns, so when it comes to this type of planning, it’s really a scientific guess. Or, the term I love, that one of our clients shared with us, … a SWAG… or Scientific Wild A** Guess. (Can I say that on a podcast? I sure hope so!)
To SWAG longevity risk – the unknown factor of how long your road trip is, it is best to start with mortality tables –– These are the types of tables that insurance companies use and that the government uses when figuring out how much in Social Security they will pay out over time.
We’ll start with data from 2014 mortality tables. If you’re curious, you can find these tables and associated research on the Society of Actuaries website.
First, let’s look at singles.
For a single female, age 60, –how likely do you think it is she’ll live to 85? Would you be surprised to know there is a 60% chance? - (64% white collar only)
Male – age 60 – A male age 60 has a 51% likelihood of living to 85 - (58% to white collar)
Those are high odds. Many people make decisions about money with an off-hand comment such as “well, I might not live that long”. That’s like betting against the odds!
Not only do people routinely underestimate how long they’ll live, many married couples make decisions based on their own life expectancy, as if they were single. What they need to do is look at their joint lifespan.
If you’re married, how likely is it one of you will live to 85? The odds go up to 80%! 85% when looking at just the white collar data set.
What about the likelihood that one of you will live to 90? There’s a 58% chance – which goes up to 65% for white collar folks.
I’d play to those odds in Vegas any day. Wouldn’t you?
So doesn’t it make sense that you should align your finances to take advantage of those odds?
What do you think the 85-year-old… you will wish the 50-year-old you had done?
What about the 90-year you? What do you think they’ll wish the 60- year old had thought about?
The types of decisions I’m talking about aren’t just “save more and spend less.” There are more complex decisions to make – decisions that help reduce the risk of outliving your money.
For example, one decision that can have a big impact on protecting you against the risk of outliving your money is the decision as to when you start Social Security. Your Social Security benefits are inflation adjusted and you get a lot more per month if you start benefits at a later, age rather than as soon as possible.
And if you’re married, you must learn how Social Security survivor benefits work. Many couples have one person who made the majority of the income. All too often that person starts Social Security benefits at a young age, and thus severely curtails the survivor benefits available to their spouse.
There are many financial tools to consider when looking at how to protect your retirement income for life.
You have to be open minded and willing to learn how things really work. This isn’t always easy.
The bias against some financial tools can be so strong that when I mention them, you’d think I’d said a four-letter word! What are tools the illicit such strong responses? Things like Reverse mortgages and annuities.
These products can be great financial tools when used in the right situation. It’s sad that many of these tools are marketed in such a cheesy way that people refuse to consider them.
In conclusion, when it comes to longevity risk, the unknown length of your road trip, be open minded and evaluate financial decisions such as
- When you begin Social Security
- Use of a reverse mortgage
- Purchasing an income annuity
To protect the older you, it can also make sense to consider…
- Working a little longer
- Using investments that are most likely to keep pace with or outpace inflation
- SEQUENCE RISK
Next, let’s talk about sequence risk, or to use road trip vernacular, what we’ll call “the gas mileage question.”
As we discussed, it would be difficult to calculate how many miles per gallon you were going to get if you didn’t now whether you were going to be driving mostly highway miles, or city miles.
When planning for retirement the unknown conditions are your market returns. There’s something called The Retirement Red Zone – considered to be the last 10 years of working and the first 10 years of retirement. What if your Retirement Red Zone occurs during a time where the economy is booming? Or what if it is during a recession? These things make a big difference – and you need to know your plan will work either way.
To study how much investment returns can vary, let’s look at two historical examples.
First, safe investments. Certificates of Deposit or CDs, issued by banks, are considered a safe investment.
In 2001, you could earn over 6% interest on a 3-month CD. If you were planning for retirement, you might have naturally made the assumption that 6% interest was realistic. For every $100,000 you had in CDs, you assumed you’d have $6,000 a year of interest income to spend.
Fast forward to 2011 – and that same 3-month CD was paying less than 1/3 of 1%. Your $6,000 of income had dropped to $300 a year. Ouch.
Well, if CDs didn’t provide consistent income, what about the stock market? The Standard & Poors 500 Index, commonly referred to as the S&P 500, tracks the collective performance of the stock prices of five hundred of the largest U.S. based companies.
From 1926 to 2017, a 92 year time span, the S&P 500 averaged just over 10% a year ( 10.2%)
Looking at a more recent time period, 1995 to 2017 The average annual compound return was also just over 10% ( 10.1%)
I start by using averages, because financial literature often uses averages to illustrate the historical performance of an investment. And most people use past returns to choose investments and set expectations for the future.
Ten percent sounds great. If you earn 10% a year, your money doubles almost every 7 years.
But in the book The Black Swan, author Nassim Taleb uses a line I love. He says, “Don’t cross a river if, on average, it is 4 feet deep.”
By nature, an average is composed of times where returns were higher, and times where they were lower. Take the time period that has become known as The Lost Decade as an example.
The Lost Decade, 2000 – 2009, The S&P 500 had a negative return of .9 – or a loss of about 1% a year over that ten years.
All was not lost, however, depending on how you invested. The S&P 500 represents the performance of only 500 large cap stocks. If you used a globally diversified portfolio of stock index funds, with exposure to many other asset classes and to stocks across the globe, you averaged 5.4% a year over The Lost Decade. (DFA Global Equity Index 5.4%)
Still, that’s a far cry from the long-term average of 10% that you might have been expecting.
Averages can be dangerous by giving you misleading expectations.
They can also be dangerous when used in software programs and when planning for retirement. I’ll talk through an example to explain why.
From 1973 – 1982, the S&P 500 averaged 6.7%. Not a bad return. Let’s assume its 1973 and you are using an online retirement calculator. Of course, those didn’t exist then, but just humor me for the sake of leaning.
You plug in 6.7% for your expected return. The software assumes you earn 6.7% each year. You start with $100,000 and tell the software to withdraw $6,000 per year. It shows you that at the end of the 10 years, you should still have $109,000 left. You think that’s great, especially considering the fact that you took out $60,000 along the way. You retire based on this plan.
Unfortunately, what really happened, is in 1973 the stock market went down the first few years. This means when you withdrew the $6,000 you had to sell some shares at a loss. Although the market recovered, you had less shares available to participate in the recovery.
So, although the software said you should have $109,000, remaining at the end of the decade, what you ended up with was $83,000. That’s a $26,000 difference between what you thought you would have based on a calculation, and what reality delivered.
How do you plan for such varying conditions? Well, when engineers build a bridge they don’t build it for average weather. They test for extremes. You have to do the same thing when planning for retirement. You test your approach to see if it works over bad economies, as well as good ones.
You can also build in contingencies. For example, assume you like to travel. Spending extra on travel might work fine as long, as you get average returns. But you know if a recession should materialize, your contingency plan will require you to travel less or give up travel for a few years. Building in contingencies give you flexibility in your planning.
Another option is to segment your investments into what is needed for different legs of your trip.
For example, picture having safe investments to fuel the first 10 years of your journey and growth investments to fuel years 11 and beyond. The technical term for using this approach is asset liability matching, and I’ll cover it in Chapter 5 on investing.
- INFLATION RISK
The next thing to consider on your road trip is the unknown price of gas, or inflation risk.
When I was in elementary school, I lived in St. Louis, Missouri. Actually Chesterfield, which is a suburb of St. Louis. It was the early 80’s and I used to ride my bike to the nearest Schnuck’s Grocery store to buy my favorite candy bar, a Reese’s Peanut Butter Cup. It cost a quarter. today
The price of gas provides another great example. In the 1990’s the price of a gallon of gas ranged from $1 - $1.30. Today, it hovers about $3.00 a gallon.
So, we know inflation is real. Prices do rise.
The standard rule of thumb in financial planning projections is to assume a 3% inflation rate, as this has been the long-term historical average.
Inflation is measured by what is called the Consumer Price Index (or CPI) , which tracks the collective prices of a basket of goods and services.
In recent history, 1990 – 2017, inflation has actually been less than 3%, 2.4% as measured by the Consumer Price Index.
Over that time, prices of some goods have come down, while prices of some services, such as health care, have gone up.
Inflation does NOT impact all things and all people equally. Believe it or not, in retirement, most of you will not need your current level of spending to continue to go up at the same rate as inflation.
For example, assume you enter retirement with a mortgage payment of $1,500 a month. Your mortgage has 12 more years. This is a fixed payment. Your mortgage will not go up each year with inflation. Your insurance and taxes will though.
Or, early in retirement you may have children who still need financial assistance. That expense is likely to go down later.
This is why, once again, I don’t like using averages. If you tally up your expenses, and grow them by 3% a year, and save enough to support that goal, you might actually be over-saving. Now, granted, not a lot of bad things happen by saving too much. Still, many people who develop a custom plan realize they can retire earlier than they thought.
To determine how inflation really impact retirees, research studies examined retirees and how they spend money over time.
My favorite research paper on the topic is called Estimating The True Cost of Retirement, written in 2013 by David Blanchett. David is the Head of Retirement Research at Morningstar.
The research shows:
- Spending is at its highest when retirees are in the 60 – 65 age range
- Then it slows down, with those same retirees spending a lot less as they enter the 75 – 85 age range.
- As retirees near age 85+ , spending tends to increase again, primarily due to health care needs.
This spending pattern is often described as the “Go-go years, slow-go years and, no-go years.”
- The research paper concludes that many retirees may need approximately 20% less in savings than the common assumptions would indicate.
- And that retiree expenditures do not, on average, increase each year by inflation
This research went even deeper and segmented retirees into three groups. Those who spend about $25,000 a year in retirement, $50,000 a year and $100,000 a year or more.
Inflation has the biggest impact on lower income households.
That makes sense – when you’re on a tight budget, price increases on basics such as food and gas have a big impact. Inflation has a much lower impact on households spending $100k or more in retirement.
The research concludes that “When correctly modeled, the true cost of retirement is highly personalized based on each household’s unique facts and circumstances.”
I see this first hand with the work we do with clients. We build in inflation raises in our projections. But as our clients reach their 70’s and we offer their annual inflation raise, they often tell us they don’t need their monthly withdrawal to go up. They’re perfectly comfortable on what they are already getting.
In conclusion, Averages can be quite misleading when it comes to market returns, and when it comes to the impact of inflation.
When planning for retirement you want to customize your spending assumptions and the impact of inflation to your financial circumstances. Using a rule of thumb, such as inflating all expenses at 3% a year, may result in over-saving for retirement.
- OVERSPENDING RISK
The last topic to introduce you to in Chapter 1 is Overspending Risk. This is the risk of spending too much too soon.
When I think about overspending risk, the movie The Martian, with Matt Damon, pops up in my mind. In the movie, he has to carefully ration his food. If he doesn’t ration his food, he’ll run out of food too soon and die before the rescue team can get to him.
In retirement, if you take out too much money too early in retirement, you increase your risk of running out of money early. That’s why you have to plan for big expenditures like auto purchases and major home repairs. Many people forget to include these items when they are figuring out how much they’ll need in retirement.
Another problem that occurs - if your investments do well early in retirement, it’s easy to take out the excess and spend it. This may seem reasonable at the time.
But remember how averages work. If you are in the middle of a time period where things are doing really well, you have to take some of the gains, and set them aside for the inevitable period of time when investment returns will be below average. This is how you ration your supplies as you travel on the retirement road trip.
If you don’t have a way to measure how much you can safely take out, and how to account for big ticket items, you can easily spend too much too soon.
Another thing that catches people off guard in retirement are taxes. Take the popular 4% rule as an example. The 4% rule says that you can safely withdraw 4% of your portfolio each year, and reasonably expect to have it last for life.
Let’s talk through an example. Using the 4% rule, you would conclude for every $100,000 you have invested, you can withdraw and spend $4,000 a year. That works, except if that $100,000 is all in a Traditional IRA, 401k or other tax-deferred retirement plan. The money you withdraw from traditional retirement plans will be taxed. If you’re in the highest tax bracket, after taxes, you might have only $2,400 of the $4,000 available to spend.
Simple rules of thumb can be great to use when you are age 40 and planning for retirement 20 to thirty years away. But once you are within 5 years of your retirement age, they are not an effective way to determine what you can actually take out and spend each year.
Rules of thumb do not account for taxes, and even if you try to account for it with an estimated tax rate, such as 20%, in reality, your taxes in retirement may be vastly different than your neighbors. And your taxes are likely to vary from year to year.
Taxes depend on the source of income. While Roth IRA withdrawals are not taxed, 401k withdrawals are. And while some people pay no taxes on Social Security benefits, others will pay taxes on 85% of the benefits they receive. You need a customized plan to accurately project how much you’ll pay in taxes in retirement.
So, let’s review what we discussed.
When you get ready to transition into retirement, it’s like heading out on a road trip where…
- You don’t know how long you’ll be traveling. We call this longevity risk – the unknown factor of how long you’ll live.
- You don’t know what type of driving conditions you’ll encounter. We call this sequence risk – the idea that you could retire into a bad economy or a good one – and you need your plan to work either way.
- You don’t know the future price of gas. This is inflation risk. Research shows the traditional assumptions used in the financial planning industry may be overestimating what you’ll actually need.
- You have to have a way to ration your supplies. This is overspending risk. Use too much too soon, and you could run short later in your journey.
There is a way to account for these challenges. It starts by looking at your household finances. Then, you learn how to align the pieces to work together. We start this journey in Chapter 2, where we begin to follow Wally and Sally, a couple getting ready to retire. We look at how they can most effectively put together a plan.
Thanks for joining me for Chapter 1 of Control Your Retirement Destiny. To learn more, get a copy of the book on Amazon, continue through the podcast, or, to work with a professional retirement planner to put together your own customized plan, visit us at SensibleMoney.com.
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