By FPA member Frank C. Boucher, CEBS, CFP®
Last Updated: December 5, 2011
Someone once said, “Everybody wants to go to Heaven, but nobody wants to die.” Something similar may be true for new retirees. Everybody wants to stop working, but nobody wants to give up that paycheck.
For years, workers have been hearing about how important it is to save as much as possible as early as possible. Americans weren’t saving enough. They weren’t investing properly and unless they changed their evil ways, they were going to work until they died.
It turns out that accumulating retirement assets may have been the easy part. Spending those assets seems to be a lot harder. Our bipolar equity markets are unnerving at best and interest rates are at historic lows. Add the apparent inability of governments to get their fiscal houses in order and it’s little wonder why retirees are frustrated and maybe a little bit scared. Now that they have a nest egg, figuring out how to spend it is a new and challenging obstacle that needs to be solved in order to enjoy a financially peaceful retirement.
What about annuities?
Immediate annuities provide a stream of income that can’t be outlived. They are the next best thing to the old fashioned defined benefit pension plans that so many long for. Many retirees are seeking out annuities to provide the steady reliable income that they covet. But annuity prices are linked to interest rates. Recently, a 70-year-old woman asked for an annuity quote that would pay $2,200 a month for life and 20 years certain. The insurance company came back with a price of $424,000. If she dies before age 90, the contract will pay out $528,000. That’s a return of 1.10 percent for 20 years. If she lives to 95, the contract will pay $660,000 resulting in a 1.79 percent return. Does anyone want to tie up money for 20 years for a 1.10 percent return or even 25 years for 1.79 percent? The answer is probably not. Are immediate annuities still a good retirement vehicle? Yes, just not right now.
What about the four percent rule?
Some smart people have conducted extensive research to determine how much a person may draw from retirement assets and have those assets last through retirement. They looked at historical rates of return and inflation and made assumptions regarding asset allocation and the duration of retirement. Without getting into all of the details, the magic number seems to be about four percent. In other words, a new retiree can withdraw four percent of their assets in the first year of retirement, adjust that amount each year for inflation, and the assets will last 30 years. This is good work that deserves applause, but like most things in financial planning, it relies on assumptions which may or not come true. It also assumes that humans are rational non-emotional beings who will do exactly as expected year after year. Thankfully, they are not. What a dull world that would be!
What to do?
Before cutting that retirement party cake, soon-to-be retirees should figure out their spending needs and make sure they have the income and assets to cover them. This has been stated many times, but it can’t be over emphasized. Write down all expenses and don’t forget the “special’ expenses that don’t happen every day like vehicle and home repairs and those special vacations. Take the time to do this right and run the numbers or hire a pro to help. This isn’t a budget. It’s a spending plan and it’s healthy. Above everything else, financial success in retirement is all about managing cash flow.
The next step is to figure out how much money is needed in each of the next three years. This money should be invested in something where the principal won’t fluctuate like a money market fund or certificates of deposit. Remaining funds should be invested in a diversified portfolio of mutual funds that will provide the desired balanced asset allocation.
Every year, repeat this exercise and liquidate enough money from long-term investments to fund the new third year and rebalance long-term investments. If those long-term investments are in the “dumps,” then delay this step until the following year when investments recover. Just remember that delaying a year means that two years of expected expenses will need to be liquidated.
This strategy is simple and flexible and it forces retirees to review their spending and investments each and every year. It allows for spending adjustments and helps avoid the need to sell assets in an unfavorable market. Is it a “forever” strategy? That’s unlikely. Remember, times change and retirees must expect to change with them. Financial planning is a process as opposed to an event and retirees who understand that and prepare to be flexible will find this special time much less stressful and a lot more fun.
FPA member Frank Boucher, CEBS, CFP®, operates Boucher Financial Planning Services in Reston, Va.