Top 5: Retirement Spending MisconceptionsMonday, July 19th, 2010 by Cass Chappell, CFP®
When I meet with a prospective client for the first time one of my first questions of them is about retirement. I am curious to know how they anticipate living off their nest egg. It’s important not to “coach” them at this point. I want them to tell me what they are thinking, not what they think I want to hear. The five responses below are some common misconceptions about retirement.
#5. Buy bonds and live off the interest
Unless you are extremely wealthy, this won’t work. The two main reasons:
- Interest rates fluctuate and may not generate enough income (e.g. as of today (7/16/2010), the 30 year note yields less than 4%).
- The amount of interest that the bonds generate cannot keep pace with increasing withdrawals. In other words, income needed in retirement generally increases with inflation while the interest on bonds is fixed.
While bonds can and should play a key role in any retirement portfolio, we do not recommend exceeding a 40% allocation to fixed income holdings as the equity portion of any retirement account is likely to be the major source of asset growth and inflation protection.
#4. Increasing fixed income allocation as you get older
The “Rule of 120” is a bad rule. It should go the way of the rotary phone. This rule holds that an investor’s fixed income allocation should match 120 minus their age. For example, a 70 year old should have 50% of their portfolio in fixed income investments (120 minus 70 equals 50). The thinking is that as one gets older, portfolio losses are more destructive to their financial freedom. Generally, fixed income is considered to be safer and less likely to incur losses.
In reality, fixed income investments can have sharp declines. Also, people are living much longer than before. A retiree, aged 65, has a high probability of living to age 95. For that reason, one must look at a retirement portfolio with a long term view….even if the investor is “older.”
The “Sustainable Withdrawal Ratio” is something that we ingrain into our client’s heads. It is part of every financial plan we create and part of every quarterly review we perform.
William Bengen, in his landmark article in the 1994 issue of The Journal of Financial Planning, demonstrated that portfolios with 60% in fixed income had a much higher rate of failure than portfolios with 40% in fixed income. For this reason, we target a stock / bond ratio of AT LEAST 60/40 and no more aggressive than 75 / 25. Our recommendation would be the same whether the client was 80 or 60 years old.
#3. Increasing distributions due to good investment returns
Thinking that good results will continue indefinitely, or conveniently forgetting lessons learned in the bad years, can really lead to some trouble. For many, a major purchase (almost always a luxury purchase) is sure to follow a “nice year in the market.” How many investors bought a bigger house, an investment property, a boat, or another “toy” because 2003 through September 2007 saw such great market returns?
The 18 months that followed are powerful reminders that portfolios will ebb and flow. Good years only serve to offset the down years that are sure to follow.
#2. Assuming you will spend less
Now that you aren’t going to work each day, you will probably spend MORE. There are several studies out there that show spending increases for the first several years of retirement. After all, now you have the time to do all of the things you love and travel to all of those “one day” destinations.
#1. Under-estimating how much you need
One of the big insurance companies has a commercial that has each investor carrying around their “number”. It’s the amount of money they will need to have saved in order to retire confidently. It’s one of my favorite commercials.
Most people are shocked to find that you need a nest egg 22 times as big as your first withdrawal. For example, to make an initial withdrawal of $44,000 and have those withdrawals last for 30 years, an investor would need 1 million dollars. This is consistent with the “Sustainable Withdrawal Ratio” of 4.4%.
A good advisor can add more value in this situation (retirement distribution planning), than any other area of financial planning.