June 1, 2011

Investing - To Panic or to Splurge: That Is the Question

By the Investment Strategies Committee and the Elder Law Committee

This article provides commentary between Bruce Mann, chair of the Investment Strategies Committee, and Walter Burke, chair of the Elder Law Committee.

Bruce Alan Mann: As senior lawyers try to plan retirement, they often look at many different planning tools. One of the most popular ones is the retirement projections that are found on many investment house and mutual fund websites. What should an attorney who is not overly familiar with finances or investments know about these retirement projection tools?

Walter T. Burke: These websites can be helpful provided that you proceed with some caution. Because most of these sites project out 20 or 30 years, the compounding effect of the initial assumptions become staggering in the later years. Therefore, you must make sure that the basic parameters that are being used are reasonable for your own circumstances. If you are a very cautious investor, you should not be counting on your investment returns projections to be 8% to 10% over 20 to 30 years.

The three biggest assumptions that must be carefully considered are the following: (1) rate of return, (2) rate of inflation, and (3) taxes.

The projected rate of return should be reflective not only of your current investment portfolio but also how you would anticipate it would change in the upcoming years. Traditionally during senior lawyers’ working years, the stock to bond proportion is usually 60/40, gradually shifting to 40/60 as they approach and start retirement, and generally shifting to a higher bond percentage as they become older. In the current economic climate, projecting 6%, 5%, and 4% for those three base assumptions would not be out of line. Assuming decades-long performance of 9% to 12% would require a significant amount of risk (as well as luck), and would certainly not be a good foundation upon which to build.

Conversely, if your investment portfolio is very conservative and consists primarily of CDs and Treasuries, then a rate of 4% in this economic climate would be too high.

The retirement projection you use should also take into account a reasonable rate of inflation. If the site doesn’t take that into account, don’t use any of the information on the site. Find a more credible one. Also acknowledge that for senior lawyers, inflation does not necessarily affect them the way that inflation affects the general population. Many senior lawyers have no mortgage or have a relatively low fixed-rate mortgage, have little or no credit card debt, and are not trying to fund college education for offspring. These are three huge problems for the general population, and inflation ravages all three. Conversely, senior lawyers often have investment funds that can profit from an inflationary period. Therefore, while you should not ignore inflation, you should also not assume that inflation will impose huge burdens on all aspects of your financial life.

The retirement projection you are using should take into account taxes. It should be able to project qualified retirement plan funds at zero tax rates during the accumulation phase while your taxable funds should be growing at an after-tax rate. Keep in mind that once you start to distribute or draw down your qualified retirement plan funds, then they become taxable regardless of whether they were characterized as interest, dividends, or capital gains. It all becomes taxable income.

Know your tax rate. Do not assume 35% when you may be in a 25% bracket, and you should not look at distributions taxed at 15% when your tax rate is really 25%. Also, do not forget Social Security, which has portions taxed and portions not taxed, when you’re doing your projections.

BAM: What are some other things a senior lawyer should consider when using retirement plan projections?

WTB: The projections should be able to take into account not only monthly and annual distributions, but also the deduction of principal in the amount and in the year that you determine that it would be appropriate. For instance, if in the year after you retire you plan to take an exotic vacation costing X thousand dollars, your chart should be able to factor in the result of deducting X from principal. If in year five of your retirement you’re planning to sell your primary residence and buy a smaller residence and you will then have an additional

$100,000 of capital, then your projection should reflect that infusion into principal.

BAM: What is another underlying assumption that a senior lawyer might choose to question?

WTB: Most of these sites take as an absolute truth that you should always maintain the same amount of principal. If your object for retirement planning is to leave the absolute maximum amount possible to your heirs while you yourself maintain the most modest lifestyle that you possibly can, then that is fine. However, many people wish to enjoy their retirement years as well as leave something to their heirs. Therefore, one should not be afraid to intelligently use both income as well as some principal to enjoy their retirement years. While you certainly do not want to live your last years in abject poverty, you also certainly do not want to have abundant funds and nothing but regrets about having money but not the health or the loved ones with which to enjoy it.

BAM: We have heard much about the 4% rule in retirement planning. What exactly is it?

WTB: It is one of the many “rules” that attempts to simplify a complicated area, financial planning for retirement, and simplify it so that it is easily understood. It postulates that if you withdraw 4% of your retirement assets every year, then with a projected modest amount of returns you would never touch your principal.

BAM: With a well-diversified portfolio over time, a 4% rate of return does not seem unreasonable.

WTB: I agree, however a portfolio that is primarily invested in CDs and Treasuries in the current economic climate will not produce 4%. In addition the 4% is meant to represent the purchasing power of 4% adjusted upward for inflation, not merely a static 4% withdrawal.

BAM: Are there other nuances that may affect the 4% rule?

WTB: Yes, the timing of when you withdraw the money has a bearing on the overall rate of return. For example, over time the principal you end up with will be affected depending on whether or not you withdraw the 4% on the first day of the year, you stagger withdrawal over 12 months, or you wait until the end of the year and then withdraw the money.

BAM: In order to achieve a 4% rate of return over time, I think it would be necessary to invest in a diversified balance portfolio of stocks and bonds. What happens if the market goes down? Does that not affect the 4% rule?

WTB: It certainly does, and that is why it is important in your financial planning to anticipate such a possibility and invest accordingly. In order not to have to pull money out when the stock market may be down, you should consider keeping some of your funds liquid so that you would not be adversely impacted by the vagaries of the stock market. For instance, you could keep 3 months of retirement withdrawals in a money market account and ladder CDs of from 3 to 6 months as well as utilize a short-term bond fund so that effectively you have approximately one year’s worth of savings or retirement withdrawals liquid so that if the market should go down, you would still have liquid funds ready and not be forced to sell in the down market. Conversely, on a more optimistic note, if the stock market was up, you would want to sell some of the appreciated securities to take profits off the table and rebalance your portfolio. In this way, you maintain a constant withdrawal rate to a large extent insulating yourself from the down markets and profiting from the up markets.

BAM: You indicated that certain economic statistics should be taken with a grain of salt when dealing with retirement projections. Are there any other statistics that attorneys should be aware of?

WTB: Yes, the assumptions about longevity and retirement ages are not really applicable to attorneys as a group. Currently, the average life expectancy of an American is 78.4 years. This includes the entire spectrum of Americans, including those who did not have the advantage or access to health care, had physically demanding or dangerous jobs, suffered from chronic illnesses without medical support, and often drank and smoked in excess. For the most part, attorneys have had the advantages of having a nonphysically demanding job, access to good health care, and the education and ability to understand the ramifications of bad behavioral choices. Therefore, the longevity projections for attorneys as a group is significantly higher than 78.4 years.

In addition, the average retirement age in America is 62. For many attorneys, particularly senior lawyers, that retirement age is dramatically pushed back to a later date. These are some of the reasons why it is vitally important to tailor your retirement projections to your own family history as well as your current medical condition and your own retirement goals.