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Retirement Special Issue

Your Next Managing Partner

Succession Planning Strategies: Dos and Don'ts.

 Table of Contents

December 2007 Issue | Volume 33 Number 8 | Page 38
Features

Transitions: Retirement and Succession

That Magic Number: Divining the Monies You Need for Retirement-And More

Everyone's looking for "the number" of dollars they need to have at retirement. Although there is no predictable number that applies to everyone, there are, fortunately, imprecise rules of thumb to help.

Everyone is looking for “the number” of dollars they need to have at retirement so that they don’t run out of money before they die. Indeed, there is a best-selling book titled The Number: What Do You Need for the Rest of Life and What Will It Cost? In it the author, Lee Eisenberg, spoke to “wealth gurus, life coaches, financial advisers, everyday investors and many others to explore the secrets of The Number.”

Unfortunately, there is no predictable number for everyone, or even for any one particular person. Life is not an exact science. We don’t know how long we will live; how the investment markets will perform in the future; what our health trajectory and future medical expenses will be; what future inflation rates will be; or what the tax laws will be 10 or 20 years from now, among many other imponderables. In short, as Yogi Berra should have said, “Predicting things is hard, especially when it involves the future!”

The moderately good news is that often when things are not susceptible to precise calculation, there are imprecise rules of thumb to help.

The 4 Percent Assumption

A common rule of thumb is that one can safely spend no more than 4 percent of one’s investment assets per year in retirement. There are two different ways to derive this number:

  1. If you want to live off only the earnings of your assets, preserving principal for your children or other bequests, 4 percent is often a reasonable estimate of average earnings on your portfolio net of inflation (i.e., 7 percent average earnings less 3 percent average inflation).
  2. If you are willing to spend all of your principal, a 4 percent rate would allow for about 25 years of spending once you start, without consideration of earnings. For example, if you retired at age 65 and earned nothing on your principal thereafter, you would run out of money at about age 90. Because assets sensibly invested do earn long-run returns at some positive (after inflation) rate, such returns would allow for a margin of safety in case one lived beyond age 90.

Thus, the simple approach would be to divide one’s desired annual retirement spending by 4 percent to ascertain the number of dollars needed by retirement to live in the style desired. For example, if you think you need $125,000 per year to cover living expenses and taxes in retirement, using the 4 percent rate means you would need $3,125,000 to retire.

There are many refinements that can be made to the foregoing formula. Fortunately, the fuzziness of the assumptions and calculations is not much of a problem on the upper side of a prudent or acceptable range for “the number.” In other words, people should save and invest as much as they comfortably can for retirement because, arguably, you cannot have too great a margin of safety in this matter.

Because the math involved is simple, and because the uncertainty of the assumptions needed does not justify great precision, retirement planning (or at least estimating “the number”) is something one can begin to do by oneself.

When the Time Comes: Withdrawal Strategies

There is also a bit of an art to post-retirement withdrawals, involving matters such as what types of accounts to withdraw from first and whether and how to vary the withdrawal rate over time. For that reason, some feel more comfortable paying to annuitize all or a part of their retirement income.

You should consider taxes in determining your strategy. All withdrawals from assets within a retirement plan will be subject to ordinary income rates, including capital gains realized on those assets. Capital gains on assets held outside the plan will be subject to a much lower rate. For this reason, you should consider holding assets producing capital gains outside of your retirement plan.

There are, of course, other pieces to the planning puzzle. They include adequate medical and other insurance; housing appropriate for your planned lifestyle; and activity and lifestyle considerations to keep you happy, motivated and fulfilled. Many books and other materials on retirement planning offer advice on these matters. You may need to consult experts in the various fields, such as insurance agents, tax accountants, real estate agents and estate planning lawyers, particularly in the implementation phase of your planning.

Investing During Retirement

Typically retirement is not the sudden cliff it once was, when most women were housewives and most men spent their entire careers with one large employer and were handed a gold watch and a pension at age 65. Today both spouses often work and may retire at different times. People live longer now and are likely to live dramatically longer in good health in the future. In many cases, people work for smaller firms or are self-employed and don’t retire at traditional times, choosing to continue to work (full-time, as a consultant or part-time). What is and is not retirement have begun to blend together.

Similarly, investment during retirement may be little different than before retirement, and abrupt shifts in strategy are usually not necessary. Let’s look at some fundamentals.

Retirement portfolios and securities. In “olden times,” when people retired they bought bonds. More recently there has been a rule of thumb that the percentage of bonds in one’s portfolio should be equal to one’s age, or the percentage of stocks should be 100 minus one’s age. These days, the rule of thumb seems to be for the percentage of stocks to be 120 minus one’s age.

But what are “bonds” these days: collateralized debt obligations, Treasury strips, ARM mortgage-backed bonds, synthetic bonds, swaps, convertible preferreds? And, for that matter, what are “stocks:” large cap, small cap, micro cap, growth, value, ADRs, foreign regional or country mutual funds, closed-end funds, equity REITs, sector ETFs, index funds using a hundred different indexes? Just as retirement lifestyles have gotten more complicated, so have securities and investing in them, and that is a topic for another discussion. Nonetheless, just as retirement requires preconsideration and reconsideration, post-retirement investing requires the same, though it often doesn’t require dramatic changes in investment posture.

Total return, not income. The investment management field evolved, perhaps 40 years ago, to the point of looking at investments from a “total return” standpoint. Current income (whether dividends from stocks or interest from bonds) and capital appreciation (of both bonds and stocks) are considered equally. A dollar of one is as green and useful as a dollar of another. Instead of focusing on arbitrary differences between and among types of securities, the risk and return characteristics of all securities are equally quantified and considered.

Thus, the distinction between principal (including capital appreciation) and income has become blurred. One can live on a dollar of stock capital appreciation as easily as on a dollar of bond interest—perhaps more easily since the appreciation is generally taxed at a lower rate (capital gains) than the interest (ordinary income). Barring some very unusual circumstance, investors (retired or not) should be focused on total portfolio return (and accompanying risk) rather than being sold “income”-producing financial “products.”

Longer time horizons. A final factor to note is that individuals sometimes invest with not only their own time horizon in mind, but their children’s and grandchildren’s as well. The names of the owners of the money (whether in trust or not) may change, but the money (more or less of it) goes on. Time horizon is often the main determinant of asset allocation. If children or grandchildren are a significant consideration, your investment time horizon may stay long into or even throughout your retirement.

Making the Magic Last

You can’t know in advance exactly what your “number” will be. Because there are so many uncertainties, a rough estimate will probably have to do. Decide what you think you might need to spend annually after you retire—beyond what you’ll get from social security and what any pensions (whose investments you don’t control) may pay you. Divide that number of annual dollars by 4 percent. The result is a reasonable guess at what it will take to make the peanut butter and jelly last to the end of the sandwich. The bottom line is that just as portfolios get managed and reevaluated during the part of life before retirement, so too must they be managed and reevaluated during the retirement years.

About the Author

M. John Sterba, Jr. is a member of the New York bar, author of Fundamentals of Personal Investing (ABA, 1997) and Chairman of Investment Management Advisors, Inc. in Manhattan.

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