Three Numbers You Must Know to Build Your Finances
by Paul Adams
Hello, and welcome to Sound Financial Bites. My name is Paul Adams, your host and president of Sound Financial Group. It’s great to have everyone with us today. Today we’re going to learn something unique that people don’t talk about or only periodically talk about. This is the three numbers that every person doing any degree of planning must memorize. These are numbers that you need to know because they are the fulcrum behind so many of your financial decisions and incorrect assumptions.
What disaster often looks like for people financially is the slow and eroding situation or financial security that they have. Sometimes it happens all at once. But many times it’s just like slow bleeding; people don’t notice it over time. Today is financial philosophy, and as many of you know, all we want to do by bringing this podcast is serve our existing clients to do our best, to give them a source of well-grounded financial knowledge. Things that are grounded n the disputable math and independent scholarships so that they can continue to grow in their knowledge. We believe it’s our job to educate clients throughout our relationship with them so that they get the greatest potential possibility of making the best financial decisions for themselves and for their family.
I’m going to give you the three numbers. They’re not going to be hard to memorize, they’re not long numbers but they are critical numbers for what’s important to you in your future. Those three numbers are: 4, 65, and 95. Now, 4 is 4%, 65 is age 65, and 95 is age 95. Now, this is really the preview of a conversation I’m going to have with a group of ambitious business professionals that are part of two different conferences I’m going to be speaking at soon. These are all people are, for the most part, $250,000 and up in annual income. In some cases, they have paid tens of thousands of dollars to be in rooms to learn from surreal leaders in the business community. They learn about how to build better careers, and businesses. But as they build better careers and better businesses, what are they doing with the new income and cash flow that they have? These conversations are all financial mechanics. One of the fundamental underlying things that should really be behind every decisions.
As your income goes up over time, believe it or not, you’re more than likely to pay more attention to your health. These people are doing their best to make sure that their weight is where they want it, that they’re fit, and that they’re eating a non-inflammatory diet. So for those people, and maybe for many of you, you plan on not only having financial success over time, but being more healthy. Yet, having more financial success and better health over time can actually be the biggest breakdowns to your current financial practices. Let me explain.
If you retired and you’re relatively unhealthy — hardened arteries, enormous heart disease, maybe even a family history of some problems — ut not doing anything that care for those things, then you die at age 70, it doesn’t take that much money to retire. Every year we go through retirement, it takes less money to retire if we’re closer to our mortality. People may say, “Well, I want $100,000 a year of income or $200,000, or $400,000 a year of income in my retirement, but I’m only going to live three years.” Well, that’s not that hard to build. But for many people how long they’re going to live is basically forever. What I mean by forever is there’s no real statistical deviation between living a very very long time in retirement and having enough money to live forever. We really have to have a lot of money built up and in savings because if we’re going to be healthy when we get there, we’re going to live a much longer period of time.
The second part is our increased income. As our income increases, it’s actually going to be harder to build a level of wealth that we want to build in retirement. The higher your income is, the more likely you’re going to be surrounded in a network or ecology of people that are also high-income earners, who are also more likely to be big spenders. They might not necessarily ‘big spenders’ or doing crazy stuff, I just mean somebody puts a couple of Altis or Lexus in the driveway, they’re buying new cars every 4-5 years, they’re posting their amazing vacations to Facebook. None of that stuff is bad necessarily, but we’re more likely to have people around us who are putting us in the position where their spending is going to draw us into more spending.
The higher our lifestyle is, the more it’s going to take to be able to have enough income to one day retire. If what you want to do is become a world-class saver of setting aside 20% of your gross income, in an another post, I will ground that for you about why 20% of your gross income is really the minimum that we should be at. We’re going to do a wealth coronation account part two, why you need to be able to set that money aside consistently, 20% for building assets. If we’re now setting aside 20%, then we’re not going to have the ability to have a likely amount of capital at work to replace the other 80% that was being spent or consumed in some way.
So as you make more money, it becomes more tempting to not set aside the 20% and you now need a larger pile of money to get the job done, which is pay all your expenses that you want to have when you get to age 65 and beyond. Now, many people say that living expenses drop in retirement. Well, they might. I guess that’s possible. But do you want that to have to be the case? So many people say, “I’m going to be okay because the mortgage will be paid off,” or, “The kids will be moved out of the house”. Yet, that is probably going to happen well before the day you decided to punch out and reach financial independence. For the sake of our conversation today, we’re going to say that is 65. But for many of you, especially our clients in the strategy, stop having to work for money much earlier.
When you make more money, it takes more money on the pile of capital at work that you have in old age, to produce the income that you want. Well, how much is that pile have to be? That brings us to our first number: 4, 4%. When we’re taking money from our assets for the sake of consumption, we can do all kinds of great things in our financial lives with money. We can keep it moving around on our balance sheet, we can build velocity with our money, we can put a down payment on a rental property, or pay for a rental property cash. That rent could then go to a mutual fund or a portfolio of investments. How we would prefer to have people do it was a portfolio of passive structured investments, academically allocated, globally diversified portfolio, the rents could go right into that portfolio.
Then a certain amount of the portfolio every year could actually be getting dripped off every single year to build the asset class of whole life insurance on somebody’s balance sheet. Like $1 that we paid for a rental property in cash or even a down-payment on rental property enough for it to be a positive cash flow, might potentially be able to get three things done in our life. That money is moving around in our life and we’re doing our best to keep that money flowing. Yet, when we put money in just one place and it needs to get something done like pay for our groceries, then the velocity of that money sort of stops in our lives. We don’t get any additional uses on that dollar. This is key. The 4% distribution in retirement is really crafted around the idea that we’re going to take money out and that money is going to go off our balance sheet. We’re not going to have anymore uses of the capital.
If you have a portfolio of residential or commercial real estate, or a basket of mutual funds, or a passive structured portfolio, the most that we should be taking off that portfolio every year for the sake of consumption is 4% a year. Now, why is that? It’s because when we take money out in retirement, the portfolio itself is going to rise and fall. As the portfolio itself rises and falls, if we take out the average rate of return, then we’re going to be accelerating the erosion of our capital in those down years.
Let’s look at it as just a simple portfolio, in this case I’m going to use purely the Standard & Poor’s 500. There’s two brothers, just five years apart in age, and both getting near retirement. One of them has $1 million and he retires at age 95. They held almost exactly the same career path, just five years difference in them and he retired age 95 and he says, “I don’t want an advisor, I don’t want any help. I’m going to put all my money in the S&P 500 which has averaged 11% in some change since the beginning of time. I’m going to take out 8% a year from this portfolio because I think it’s going to do better than that.” He begins taking out $80,000 a year.
The rates of return in the S&P 500 for its total return in ’95 was 37%; in ’96 it was 22%, ’97 it was 33%, ’98 it was 28%, and in ’99 was a 21% rate of return. He gets to the end of five years, he’s taken out $80,000 every year in income, and there’s still $2.6 million of investments. He went from $ million to $2.6 million, despite taking out $80,000 a year. His younger brother getting ready to retire comes to him and says, “Hey I notice you stayed in the same neighborhood when you retired and you seem to take some vacations, and life is good. What should I do?” Older brother says, “It’s so easy. All you have to do is put all your money in the Standard & Poor’s 500, take out $80,000 a year, and it just works. Look at me I’ve got $2.6 million now.” This is why when somebody else says, “My experience is,” or “My opinion is including your advisors, we need to back-out of that conversation long enough to go check the math and the scholarship.”
When the younger brother retires at 65, he takes out $80,000 the first year, except the market that year, the S&P 500, dropped 9.1% and he lost his $1 million. In 2001, it went down 11.9%. In 2002, it went down 22%, he’s now down to $456,000. Good news in 2003, it’s up to 28%. The problem with being up 28% in 2003 is that it’s 28% positive return on $456,000. So the portfolio barely rebounds by less than $30,000 that year, once the withdrawal has taken into account. In 2004, that portfolio did 11.01% at S&P 500.
So in this hypothetical story, this person now has $448,000 and still wanted to take $80,000 a year. That’s just doesn’t work. When we’re taking out money, we need to take out a small enough amount of money that when those downturns happen, they’re not accelerating the erosion of our capital. Now incidentally, it’s also not super wise to be 100% equities as a retiree. One of the things that we want to be able to do when we are doing our distribution planning is not only have buckets of money for the different horizons of time that we’re looking at, but also make sure that we have a portfolio that’s the appropriate amount of volatility for our distributions. So that’s why 4% a year.
If we take out more than 4%, we increase our risk of running out. 4% does not guarantee that we won’t run out, but it massively increases the statistical likelihood that we won’t run out over a 30 year period of time, according to things like the trinity study and running Monte Carlos scenarios which is common financial software that the advisors have.
In commercial and residential real estate, you might be able to buy a piece of real estate that is going to have an 8% cap rate. The 8% cap rate is supposed to take into account the vacancies, repairs, and everything else. You have 8% cash flow after all that stuff, and the answer is, maybe you do. But that 8% cap rate might be dividing the repair of the roof over 20 years. It’s probably dividing the vacancy rate possibility over 10 or 20 years over time, and then giving you a component of it. You’ll be empty for two or four weeks every year, and it’s giving you a part of that, but that doesn’t change your personal experience if that property is vacant for a year.
I think enough of us have driven by areas where people obviously own these commercial buildings, and they’ve stayed vacant for quite some time. It’s that individual that if they’re using for income, they can’t take that money. It might be cash flowing it, but some of that money needs to go in the reserves and then the other 4% consumed so that we increase the safety and sustainability of that portfolio. That means whether it is the portfolio of investments, whether it’s real estate or other, what I would call book value or promise-based assets. Things like safe vehicle CDs or life insurance cash values, or certain types of guaranteed annuities.
But wait…there’s more?!
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Paul Adams is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. PAS is an indirect, wholly owned subsidiary of Guardian. Sound Financial Group is not an affiliate or subsidiary of PAS or Guardian.
This podcast is meant for general informational purposes and is not to be construed as tax, legal, or investment advice. You should consult a financial professional regarding your individual situation.
Guest speakers are not affiliated with Guardian or PAS unless otherwise stated, and their opinions are their own. Opinions, estimates, forecasts, and statements of financial market trends are based on current market conditions and are subject to change without notice. Past performance is not a guarantee of future results.