Financial planners ALL tell a version of the same story. A moderately prosperous couple, not quite retirement-age empty-nesters, wants to leave the workaday world. Do we have enough money, they ask, to see us through our senior years?
That depends on the comforts and lifestyle they want, the planners say, and on just how long they'll live in retirement -- which, of course, no one can know. Most folks understand that those huge stock market gains are history and have tempered their expectations. What clients don't often realize is that life expectancy has even a greater impact on the adequacy of a nest egg. In planning today, it's prudent to assume that a healthy 60-year-old will make it to 90 or even 95. The money that seemed sure to see someone to 80 or 85 then falls short. The inescapable conclusion: The price we pay for living longer is working longer.
Take John and Linda Porter, a fictitious couple who want to retire a year from now, when he's 60 and she's 59. They have a combined annual income of $200,000, money in 401(k)s, individual retirement accounts, and a taxable investment account. We also assumed they would make $500,000 in tax-free profit by selling their house. (Federal tax law provides a $250,000 capital gains exclusion per person when you sell a house in which you've lived for two of the past five years.) They plan to move into a retirement home in North Carolina that they own and on which they still have a $100,000 mortgage. Depending on whether they pay off the mortgage, their nest egg comes to a not-too-shabby $1.3 million if they don't -- or $1.2 million if they do.
We asked four financial planners to assess the Porters' prospects. Their answer: The Porters could count on annual income of $60,000 to $90,000 in current dollars, indexed 2.5% to 3% for inflation, for up to 37 years of retirement. That amounts to 33% to 45% of their pre-retirement earnings, far short of the 70% to 100% planners say is needed to maintain your pre-retirement lifestyle.
The differences in income estimates depend on many factors, only some of which the Porters can control. The couple has made two decisions: when to stop working and where to live. Other controllable factors, on which the planners generally agreed, were that they should start taking Social Security as early as possible, when each turns 62, and should pay off the mortgage on their retirement home. The Social Security benefit -- indexed annually for inflation -- will account for $16,200 of their income if John starts at 62 and an additional $10,800 from Linda a year later. That's 25% less than each would receive by waiting until their full retirement age of 66. But, says Jean Sinclair, a planner in La Jolla, Calif., if the Potters did wait until 66 to receive Social Security, it would take them 12 years to reach the "breakeven point" when they would make up for the Social Security income lost between ages 62 and 66.
Three of the four planners recommended that the Porters use $100,000 of the house-sale profit to pay off the mortgage on the retirement home. The rationale: The value of the tax deduction on the mortgage interest would wane as their income falls and those monthly payments are increasingly devoted to principal.
BIG BITE
Besides social security, the Porters' only other income will come from their investments. The advisers suggested rolling the 401(k) money into a traditional IRA (with no tax consequences) because it gives them more control and investment options. They also recommended putting the remaining $400,000 from their house sale into their taxable investment account.
Early retirement takes a big bite out of anyone's capital. Social Security won't kick in for a few years, and Medicare doesn't begin until they turn 65. That means the Porters might have to cover $600 to $800 a month in medical insurance for five or six years. People who wait until they get Medicare before retiring might not have such high costs.
So how long will the money last? Suppose the Porters' portfolio earns a 7% average annual rate of return. At a 7% withdrawal rate, it will last 20 years, according to a table used by Deena Katz, a financial planner in Coral Gables (Fla.). Drop the withdrawal rate to 6%, and the money should last 25 years, and at 5%, 36 years.
All these figures can differ significantly depending on the planners' assumptions. Steve Merkel, a financial planner in Coconut Grove, Fla., figured on 2% inflation, not 3%. So even with a 5% withdrawal rate and a 4% return on assets, he figures that in 35 years, when John turns 95, the couple would still have nearly $749,000 in their account. That would still be roughly $375,000 in current dollars, assuming a 2% inflation rate.
All of the advisers recommended the Porters allocate 60% of the portfolio to stocks and 40% to bonds or divide the portfolio evenly between stocks and bonds. To minimize risk, they suggested investing in mutual funds and creating a "laddered" bond portfolio -- a strategy of buying short-term bonds that mature in 1, 2, 3, 4, and 5 years, reinvesting the proceeds in the five-year bonds as each group matures. None of the counselors thought buying a fixed-income annuity now was a good idea. Harry Scheyer, a planner in Marlton, N.J., said interest rates are too low to lock in a long-term investment, even one that offers an inflation adjustment. He suggested the Porters reconsider an annuity in 10 years, when their lifestyle is more settled and their needs more predictable.
TAX STRATEGIES
The porters can improve their situation with some savvy tax planning, too. Guy Holman, a financial planner in Denver, suggests the couple vary the asset allocation within the different accounts. He recommends that they invest both their taxable account and their Roth IRA funds 100% in stocks. Holman also says the taxable account should be managed to generate long-term gains, which will be taxed at just 5% if the Porters can keep their taxable income to the 15% marginal tax bracket and 15% if their income is higher. The gains in the Roth IRA won't be taxed because the Porters already paid tax on the money. Holman would invest funds in a traditional IRA -- which is taxed as income when withdrawn -- of 80% fixed-income securities and 20% stocks.
Making your money last depends mostly on devising a financial plan and sticking to it, reviewing the plan at least once a year, and correcting it when necessary. Katz suggests retirees withdraw a little less than what they think they'll earn, such as taking 6% if you're making 7%. That provides some buffer against a turndown in the market.
Can the Porters plan on retiring in 12 months? Sure, if they're willing to live on $60,000 at first. But Scheyer says the best strategy for the Porters would be to make an up-front "adjustment" by continuing to work for a few more years. That would allow them to keep their employer health insurance, put more money aside, and possibly boost their future Social Security benefits.
It's probably not what they want to hear. But the strategy would give them a better shot at cushier golden years.
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