Investing for a recession-proof, typical income retirement. Part 2: Dealing with missed goals
Nearly everyone misses — it’s not a disaster when you’ve planned for it
Introduction
Uncountable numbers of retirement planning articles promise to tell you how much investment assets you’ll need for your retirement. If there’s a single one that actually delivers on that promise, I haven’t found it. So I decided to write it myself. It turned out to be a longer article than I expected; this is Part 2.
Part 1: the median income lifetime investment goal
Part 2: options if you can’t meet the goal
Part 3: some ways to beat the goal
Part 4: tools to do your own planning
The original question from Part 1 was “How big does your retirement investment portfolio need to be in order to have an income that matches the median per capita income of a US resident? The answer: $14.2 million. Here’s where that number comes from. When combined with the median Social Security benefit of nearly $15,000, this amount gets you enough investment income to achieve the median U.S. per person income of $31,500, and provides enough growth to keep pace with inflation, and is as immune as possible to the fluctuations of gains and losses due to market fluctuations. It assumes, and these are big assumptions, that bond yields average 2.4%, inflation averages 2.0%, and investment management fees are 0.25%.
This is a large amount of money. It would put you close to the top 0.5% of Americans in net worth.
What if you can’t get there from here?
In Part 1 of this series, we divided a person’s financial lifespan into three stages. In stage 1, a working career lasting 30 years, investments go all-in on growth. Stage 2 is a ten-year transitional period aimed at preserving existing assets while still growing, and stage 3, retirement, is aimed at providing a stable income, protected from losing value due to inflation, fees, and taxes.
Unfortunately, even if you earn enough that you can invest 100% of the median salary, achieve 9% interest during life stage 1, and obtain 2% interest during life stage 2, you’ll end up with only about $6 million at the end of 40 years, according to MoneyChimp’s compound interest calculator.. And that’s before MIFT — value Minus Inflation, Fees and Taxes.
The advice of professional financial advisers is even more discouraging when you actually do the math. Just using Fidelity Investments, as an example — other advisers say similar things — they suggest that your portfolio at retirement should be 10x your salary for a typical retirement age and income, namely $315,000. This seems achievable, but it only works if the effective rate of return of your portfolio is more than 5%, meaning after the MIFT correction of subtracting inflation, taxes and Fidelity’s 1.5% management fees, you need an advertised rate over 11%. Eleven percent yield is totally unrealistic for any portfolio of income-oriented investments that preserves its principal indefinitely.
There are four major classes of things you can do to deal with this shortfall in asset growth potential
In the end, you’ll probably use a combination of these.
Tax deferred retirement accounts
Who wants to pay taxes if they can be legally avoided? There are many different kinds of tax advantaged retirement accounts, and you should contribute as much of your income into them as you can stand, and are qualified for. They vary in whether you pay taxes now but not later, or skip taxes now but pay later — it’s very hard to find ones that are totally exempt from taxes. The IRS lists 14 different types of retirement plans, in typical governmental detail. Nerdwallet has a simpler, but fairly comprehensive article listing the main varieties of retirement accounts, handy as long as you can ignore the “product placement” recommendation for IRA providers
Tax advantaged accounts are generally exempt from taxes on income generated inside them until the funds are withdrawn. This turns out to be important, because.it amplifies the effect of compounding on the growth of their value. Without internal tax exemption, compounding works by taking the income, subtracting taxes, and then reinvesting the remaining amount. Skipping the tax step in the cycle can turn a 5% yield into a 6% yield, which will have an enormous effect over 20 or 30 years, improving your outcome by more than 30% instead of by 1% in 30 years.
401(k) accounts, and 503(b) accounts if you work for a non-profit organization, have another advantage that is even greater. They allow an “employer match” contribution that doesn’t come from your paycheck, but is added directly to your retirement account without subtracting any of the deductions you see on your pay statement. The employer match contribution is another of the non-pay benefits that employers can offer without increasing your salary, such as healthcare insurance subsidies, health club memberships and fitness centers in their offices, parking or transit allowances in urban areas, and even more creative options. Those benefits can get quite creative — one company I worked for used to provide free car washes while you were at work, while other companies are famous for free gourmet food in the cafeterias. That company I worked for didn’t provide free meals, but it provided free soft drinks in the break rooms in addition to the traditional free coffee and tea.
The base contribution to a 401(k) account has been capped at about 60% of the median income for several years now, with an extra “catch up” contribution of $6000 allowed if you’re over 50 years old. The employer contribution can be anything they choose, and it is also capped, but at a level nearly twice that of the employee contribution. Financial Samurai has a nice chart showing how these contribution caps have developed over the years. So if you choose your job carefully, your employer may nearly double your own direct retirement contribution.
Increasing the rate of your employer’s contribution could be an important point in your next salary negotiation, since the employer can deduct their contribution, and it’s not counted as taxable income for you. Not only is it free money, but it’s tax-free free money.. You should do everything you can to take advantage of this gift, even if it means living frugally while maxing out your retirement contributions.
If you start early with a job with good retirement benefits, and contribute the maximum allowed for 40 years, and your employer adds the maximum that they’re allowed, and you compound 6% growth for the first 30 years and 2% recession-resistant growth for the next 10 years, you’ll end up with something over $6 million to fund your retirement. That’s not as much as you’ll probably need, but it puts you far ahead of most Americans.
Higher risk income sources yield higher returns
There have been 9 recessions in the past 50 years. In two of the most recent four of them, the S&P 500 stock index lost nearly 50% of its value, and took as long as 11 years to recover. If your income was derived from investments in stocks, you would have had to live extremely frugally for quite awhile. This makes stocks a “high risk” investment category.
There are many ways to divide investment vehicles into categories of risk management strategies. Some of those strategies have a risk amplifying property that is extremely dangerous to the economy as a whole when a large fraction of investors all use the same method. Here’s a list of risk categories that don’t have that kind of self-amplifying property, ordered from highest risk to lowest risk. It doesn’t include some of the highest risk investments, like “junk bonds”, options and derivatives, which are used by professional investors with lots of money to invest, and who can tolerate losing equally huge amounts.
As you go from the lowest risk category, Treasury bonds, to the highest risk category, the yields go up, but the likelihood of missing the expected yield and even providing a loss, also goes up. You might be lucky and avoid a miss on that expectation, but over the duration of your retirement the chance of bad luck will go up proportionally.
If you have a target income level, such as the median annual income that we’ve been using as an example, and a given amount of principal, such as the $6 million that you might have accumulated by devoting the vast majority of your working income into retirement investments, you can make a chart of your estimated income in each risk-yield category, review it step by step from lowest risk to higher risk levels until your estimated income matches your target income, and focus the bulk of your funds into index funds in that category. That chart will look something like the one below.
I’m not showing the chart with actual numbers because our goal is stable, risk-free income, not accepting more risk. It’s not hard to make that chart yourself if you’re interested, using the MoneyChimp calculator mentioned above. Don’t forget to include the MIFT correction.
In theory, you may be able to obtain lower risk and higher yields by distributing your investments across more of the risk categories, and then frequently rebalancing the proportions in each category, but unless you do all the accounting work yourself, the investment management fees are likely to overshadow the relative gains of this more sophisticated strategy.
Surviving with reduced income
If you have to do this, you’re by no means alone. The median balance in 401(k) retirement accounts of people aged 65 and over is about $69,000. (As always, beware of averages, which overweight high values and give a false impression of the actual distribution of values.) Invested in “risk free” treasury bonds yielding 2% interest, this will provide you with less than $80 per month after the MIFT correction. If you’re in this class your living expenses will have to come nearly entirely from Social Security. You may as well invest that balance in a stock market index ETF, and consider the irregularly varying, but higher yielding dividends produced by the ETF as unbudgeted bonus income. Then when growth takes the balance above its value at the time of your retirement you can skim off some of the principal for a second bonus. Thankfully, Social Security is indexed for inflation.
Why focus on dividends? Businesses have five types of things they can do with their profits:
- They can keep the profits and spend the money on activities that grow their own business which leads to even more profits in the future
- They can keep the profits and spend the money on higher executive pay and higher employee pay. When unions are weak and skilled employees are easy to obtain, for instance from developing countries with large populations of educated workers such as India and China, managers can pay themselves higher salaries and bonuses without harming their businesses
- They can invest the money just like anyone else who has cash, and let the magic of market returns and compound interest grow their future profits
- They can spend the money buying back their own shares, which decreases the supply of shares and thereby raises the share price, making the remaining shareholders happy.
- They can return the profits to shareholders in cash, as dividends.
From a national perspective, only reinvesting profits in their own business adds to productive capacity — all the other options are “zero sum” that pass money around in circles without adding any value. If the country is lucky, some of the companies that receive the cash investments will reinvest that cash in their own development, raising the total national value.
As shareholders, we want either higher stock prices or larger dividends. When a stock is sold, it’s taxed as capital gains, at a lower rate than the proceeds from dividends, which are taxed as ordinary income. To produce the highest income you’d want to invest in “growth stocks” whose profits are returned when they are sold later. But growth is volatile and unpredictable, and in retirement we’re looking for stable income above all. For cultural and historical reasons, companies strive to pay dividends reliably, and will even maintain dividend payouts when times are bad and share prices are collapsing.
To obtain the highest dividend yield, you can either scour the listings of stocks for dividend details, and invest in the ones that have the largest dividends at the lowest share price, or you can let a low-cost manager do that tedious work for you. The “dogs of the dow” provides a simple top-10 list of stocks with the best dividend to price yields, but that list contains a number of failing companies whose yield is high precisely because everyone is selling their stock, which drives the price per share down, and the yield per share up.
You can distribute the risk of this kind of loss while still obtaining the higher yield and greater stability of “dividend stocks”by investing in a dividend oriented ETF. A low-cost, managed ETF will also save you the work of rebalancing your portfolio as stock prices vary and they move into and out of the list of best dividend performers. Reuters has an analysis of more detailed aspects that you should consider when choosing a dividend ETF, and lists the biggest funds in this category.
Living off the principal
My grandfather had a rule for retirement investments: “never spend the principal”. It’s a good rule to start with, but doesn’t get to the miracle of compound growth. And since nobody lives forever, once you’ve reached retirement age, it may make sense to start liquidating small fractions of your principal according to a schedule that will have you run out of money at the same time that you run out of lifespan.
The most popular rule of thumb for using this method with your investments is called the 4% rule, which was devised by William Bengen in 1994. Bengen wanted to create a withdrawal strategy that could make the retirement portfolio last for up to 50 years, while being robust to the kinds of crashes that had occurred in the years preceding his article. His analysis concluded that the best withdrawal rate was between 4% and 5% of the total principal each year, and counterintuitively concluded that the best portfolio contained as much as 70% stocks.
Bengen made his study more than 25 years ago, and since then analysts have found many problems with it, so today if you search for “4% retirement rule” most of the articles you find are about what’s wrong with it. The chief difficulties are that while it accounts for inflation, it doesn’t account for taxes and fees, and that it’s excessively sensitive to market conditions during the early part of your retirement period. Robert Pagliarini provides a discussion of the 4% rule that shows why once you’ve retired, you can’t tolerate any investments that risk losses to the value of your principal. If you’re unlucky enough to retire during a downturn, like the coronavirus recession that’s occurring as this essay is being written, your income can be severely reduced for the rest of your life, even if you follow a plan that would provide comfortable returns if the market were acting in its “average” manner.
If you have 401(k) or 503(b) or IRA tax-advantaged retirement accounts, the IRS forces you to follow a similar, but more complicated plan. Starting at age 72, account holders are subject to “required minimum distributions” that vary as you get older, according to an opaque actuarial schedule that attempts to predict how long you will live. The IRS doesn’t attempt to account for whether you are in good health or ill, or whether you have good or bad genes for longevity. Their schedule starts near 4% at age 72, but grows to require nearly a third of the remaining principal to be withdrawn annually should you reach the remarkable age of 110. Charles Schwab provides a RMD calculator that shows how the RMDs and principal will evolve over the years, but it doesn’t do the MIFT correction, of course. Remember that returns from this type of account are tax-free as long as they are rolled over to stay within the account, but they are taxed as ordinary income when the required withdrawals occur.
Rising expenses with age. The IRS rules increase your mandatory withdrawals as you get older for essentially actuarial reasons, that is, to reduce the tax-advantaged amount remaining in your account to near zero by the end of your lifespan. As the number of expected remaining years of life reduces with age, the proportional amount of withdrawal increases. At the same time, your expenses are likely to go up. Aging bodies require more medications and medical treatments to maintain health and activity levels. At some point, many of us will enter assisted living facilities, where housing, food, and assistance with basic activities are provided by professionals instead of by family members, and these services come with substantial costs. Medicare provides coverage for many of the medical needs, but it contains well-known gaps and arcane exceptions just at a time when diminishing mental facilities make it difficult for many people, possibly including your future self, to navigate its bureaucratic maze.
You’ll need an extra cushion in your retirement fund to cover these rising expenses, yet most popular retirement planning advice fails to take them into account. And the size of annual withdrawals from that cushion is likely to grow with time. It would be a terrible tragedy to run out of money just when your needs are greatest.
Next — Part 3: some ways to beat the lifetime investment goal
