Retirement Planning Rules of Thumb are Likely Off-Target

retirementnumbersWhat’s your “Number”? You know, that elusive amount of investment assets you need when you stop working so that you don’t run out of money in retirement.

Barron’s ran a series of articles Saturday on retirement which included rules of thumb for calculating your number. “Conventional wisdom” would have you take 75% of your annual working income, subtract your social security and pensions expected in retirement and then multiply the result by 25 to get “your number.”

Here’s a simple example. Household income of $120,000. Social security expected to be $30,000, no pension. 75% of income is $90,000. Subtract $30,000. The result is $60,000. Multiply by 25 and the number today is $1,500,000. It will keep increasing with inflation. Easy calculation. But likely off-target. Here’s why:

First, using 75% of your current income as your expense level for all of retirement could be way off. You may have mortgage payments that will exist for only a few more years into retirement. You might still have children at home at retirement time for which education costs will be incurred. And, at some point, the kids might leave home and reduce your expenses. You might currently only be spending half your paycheck and investing the rest. For business owners and salesman, expenses in retirement could be higher because previously company-provided benefits now have to be paid personally.

Also, expenses in retirement change over the years. Typically spending declines when folks reach their late 70s or early 80s. And, then with medical costs, expenses could ramp up significantly if people live into their 90s. Furthermore, a married couple will likely not die on the same day, particularly if there is an age difference. Expenses of one person for part of the retirement period will typically be less than expenses for two people.

Second, the use of multiplier of 25 is based on a “safe withdrawal rate” of 4% each year. The concept is that since expenses will increase with inflation, if the portfolio earns 7% and you withdraw 4% the first year, then your principal grows 3% which means you can draw 3% more in year two (due to inflation) without breaking the bank. Furthermore, this 4% number is an after-tax amount. So, for example, if the funds you accumulate are all traditional 401(k)/IRA funds, then every retirement withdrawal will be subject to income tax. If we assume a 25% income tax rate, your withdrawal rate just went down to 3% and your multiplier just went up to 33.33.

Third, you may have other assets that should be included, for example if you have equity in your house. At some point, your house could be sold, downsized or you could consider a reverse mortgage. In each cases, these funds would reduce your “number”.

Here’s a better way to do retirement planning:

  1. Instead of using income, use your actual expenses as a starting point. On the first day of retirement, what will your expenses likely be? If some expenses will drop off in a few years, put those in a separate column. If you have wants and wishes in retirement, for example travel or a second house, show those separately for each item, number of years of payments, etc.
  2. Using actuarial tables modified by family and personal longevity likelihood, calculate the number of years you (and your spouse) will likely live.
  3. Identify before retirement what your annual additions to your investment portfolio will likely be and separate it between qualified plans and taxable amounts.
  4. Review your risk profile and determine your likely asset allocation while you are working and after retirement.
  5. Prepare a year by year analysis of your financial retirement plan, while you are working and during retirement. For each year, this will show the beginning investment portfolio, investment additions, post retirement income, investment earnings, income taxes, expenses during retirement and ending portfolio value. And, of course, inflation needs to be incorporated into the calculation as well.
  6. Then use a Monte Carlo or similar simulation. It incorporates all of your data in a random order to account for the uncertainty and performance variation and produces thousands of scenarios of possible outcomes. The result- the likelihood of “success”, i.e. having enough money for your lifetime.
  7. Stress test your plan for such items as early death or disability, social security being reduced or eliminated, long-term care costs, etc.
  8. Regularly (at least annually) review the above assumptions and see if you are still on plan or if revisions are necessary.

I’m sure that the above seems overwhelming. It doesn’t need to be. There is good software available to help in the calculation and illustration of the above. We use MoneyGuidePro and, of course, we expedite the process of our clients. If you’re not working with us, you might attempt to do this calculation on your own.

It will take more time than the simple calculation that some use to find their “number.” However, it certainly will provide a more accurate target for you for the future and give you greater peace of mind about your finances. After four decades of doing this for clients, I can assure you that the process is well worth the investment.

An Apple Watch and Then What?

apple_watchLast week, Apple unveiled two new iPhones and a wearable device, the Apple Watch. It’s a really neat device. I don’t need a new watch, but I think I want or at least wish, I had one.

Barron’s Tiernan Ray describes it as “gorgeous.”  “Pictures don’t do justice to how light, thin, and comfortable to wear it is.”  It will tell time, connect to your iPhone to give you updates of texts, let you send messages by speaking, remind you of appointments and show directions on a map.  Furthermore, the Apple Watch is supposed to become a mobile wallet, replacing credit cards at retail locations.  In addition, the watch will have third-party apps, one of which can turn it into a “fit bit” for monitoring physical activity.  Of course, the big thing is that the watch is part of Apple’s ecosystem, a combination of software, services, data and business partners, with everything working with one another.

It’s amazing what technology and Apple have come to in the last three decades. In 1984 Steve Jobs presented the new Macintosh computer. The iPod was introduced in 2001 and iTunes Music Store in 2003. The first iPhone was available in June, 2007; the first iPad in January, 2010. We’re now up to the iPhone 6 for which Apple received 4 million pre-orders in the first 24 hours after it was announced on September 12th. Of course, Apple is not alone. Samsung, Google and Xiaomi (in China) and others are all part of this fantastic technology burst.

It makes you wonder. We’ve come so far in the last couple of decades. What will the next 20-30 years hold?

I think a great place to start to get some answers would be Ray Kurzweil, an American author, computer scientist, inventor, futurist and director of engineering for Google. You may not know his name but his writings were the inspiration for the 2013 hit film “Her” starring Scarlett Johansson as the “Siri” lady who develops a relationship with a human.

Mr. Kurzweil started his first software company in his sophomore year at MIT. Since then, he has started several other companies and invented the first print-to-speech reading machine for the blind. WSJ describes him as a “restless genius.” Forbes calls Mr. Kurzweil the “ultimate thinking machine.”

He thinks the day will come when our brains will be connected to the cloud. “Nanobots” (microscopic robots) will one day travel to our brains through our capillaries. Computers the size of blood cells in our neocortex (grey matter in the brain) will connect to the cloud wirelessly the way iPhones do today. He added, “I don’t see a significant difference whether technology is inside your brain or whether my brain is directing my fingers. We will just make it more convenient by connecting it into our brains.”

Mr. Kurzweil sees a future where humans live indefinitely. It won’t happen overnight, we need to do three things first. One, stay healthy much longer. Mr. Kurzweil takes 120 vitamins daily, drinks green tea and exercises regularly. He contends that his “real age” is in the 40s though he was born in 1948. Second, we need to reprogram our biology. This started with the Human Genome Project. This includes stem-cell research and 3-D printing. Third, when we implant nanobots in our bodies, they will act as an extension of our immune system, identifying and destroying pathogens our own cells can’t. The 2030s will be a “golden era” according to Mr. Kurzweil. We’ll have a revolution in medicine with technology replacing human parts.

Obviously, this is all pretty amazing stuff. Mr. Kurzweil plans to be around to see whatever the future holds. His goal is to live indefinitely. His backup plan is to cryogenically preserve his body. But, he says, “My goal is not to need the backup plan.” As we always say at DWM, no one can predict the future. However, Mr. Kurzweil’s vision is certainly quite eye-opening.

So, I’ll get my Apple Watch now. And maybe put in a pre-order for some nanobots for delivery in a couple of decades. It’s a wonderful time to be alive.

Save the Date!

Emmetts squareDWM’s Annual Palatine Client Seminar

Tuesday, October 21, 2014, 4-6 pm

Emmett’s Brewery, 1st Floor Banquet Room

110 N. Brockway, Palatine, IL 60067

* Late October Charleston Client Seminar- To Be Announced 

Liquid Alternatives: Clarifying Some of the Recent Press

We’ve seen some bad press lately about liquid alternatives saying that in general these new funds have not proven themselves. It’s no coincidence that this comes at a time when the equity markets are at all-time highs after a 5 year bull run. This bad press is unwarranted.

Many of these articles fail to point out exactly why alternatives are a necessary part of one’s portfolio. They are there as a diversifier to the rest of your portfolio; the zig to the zag. This diversification comes in quite handy when equity returns decline, volatility increases, and interest rates rise. All of which could happen sooner rather than later.

It wouldn’t make any sense if alternatives were up say 20% in a year stocks were up 20%. If so, those two asset classes are totally correlated. Alternatives best trait is being non-correlated to other asset classes, be it stocks and/or bonds. Frankly, expectations of alternatives are probably too high for most people. Our expectations for alternatives (as a group) would be around 6-8% per annum. But more importantly, our expectations for alternatives is that they won’t be down dollar for dollar when equities have a 10% or worse correction.

And that’s the real beauty. By using alternatives and avoiding a blow-up like many hard-core equity investors did in 2008, you don’t have a huge hole to dig yourself out of.

Investors should know that alternatives come in two categories:

  1. Alternative strategies – that utilize traditional asset classes (stocks and bonds) in non-traditional ways. Examples: Long/Short Equity, Long/Short Fixed, Market Neutral
  2. Alternative assets – non-traditional asset classes (anything that’s not a stock or bond). Examples: Real Estate, Infrastructure, Commodities

*Some alternative funds combine both strategies and assets. Examples: Managed Futures, Multi-Strategy, Fund of Funds.

Alternatives are typically used for four major reasons:

  1. Reduce Volatility
  2. Generate Income
  3. Increase returns
  4. Address A Specific Risk

Most alternatives may only align with one of the four objectives above. Very rarely will an alternative be able to do all of that. For example, infrastructure is really just a “generate income” play. Whereas Market Neutral isn’t necessarily increasing returns or generating income but there to reduce volatility and limit max drawdown. The table below shows how different these alts can be.

Liquid alts

That being said, you need to know what you own to invest in this area. As a portfolio manager, DWM seeks to understand the risk/return profile, market exposure, correlation to traditional asset classes and the manager skill and experience before we make an addition to our Liquid Alternatives Model. We also identify how one fund correlates (or hopefully doesn’t correlate) with the other funds within the model. We think our model blends the above objectives in a optimized way to benefit our clients’ portfolios. We’ve been working with “liquid alts” for a decade now and they have proven to be quite beneficial for us and our clients.

In conclusion, the bad press we see every once in a while on liquid alts is not warranted and typically comes from the misunderstanding of what can be a complicated area. We hope this article has provided some education. For further information on alternatives, don’t hesitate to contact us.