Saver’s Digest 3rd Quarter, 2011
This latest issue of Saver’s Digest: information on how to maximize your workplace retirement savings plan. Take a look at a PDF version here!
What’s Your Exit Strategy?
As you approach retirement, you’ll need a plan to convert your savings into a reliable stream of income.
As you approach your mid-fifties, you may find yourself thinking more seriously about when, where, and how you’d like to retire. That’s also the time when your approach to retirement investing should begin to undergo a gradual shift.
While accumulating savings remains a critical goal, it’s time to start thinking about how you will transform your hard-earned savings into a stream of income that will pay your bills during retirement. This involves taking inventory of your anticipated monthly and annual expenses for essential items like housing, food, and health care and comparing that number against your anticipated sources of income, such as Social Security payments, pensions, or annuities. According to the Social Security Administration, pension and Social Security benefits have typically provided only 41% of the average retiree’s income.
The rest comes from a combination of personal savings and earned income. As you begin planning your exit strategy from the workforce, be sure to consider the following risks to your retirement income plan:
Living to a Ripe Old Age
When Franklin Delano Roosevelt signed the Social Security Act into law in August 1935, retirement was a simpler, less expensive concept. Few Americans dreamed of owning retirement properties in Florida or taking expensive trips.
In fact, when monthly benefit payments began in 1940, there were only nine million Americans age 65 or older1 and life expectancies were shorter.
Fast forward 76 years and you can see why the Social Security system is facing financial challenges. Today, more than 38 million Americans are 65 or older, and many of us are living longer. An American male who has reached age 65 in good health has a 50% chance of living to age 85 and a 25% chance of living to 92. For a healthy woman, there is a 50% chance of living to 88 and a 25% chance of living to 942. Longer life expectancies mean your savings may need to help cover your retirement expenses for 20 years or more.
The Buck Drops Here: Inflation and Health Care
A quick trip to your local gas station provides a fresh reminder of how inflation can wreak havoc on your budget. But even a relatively low inflation rate can significantly reduce the purchasing power of your retirement savings. At a 3% inflation rate, a retiree with $72,000 of living expenses would need more than twice that amount—more than $150,000—to meet those same annual expenses in 25 years3.
The rising cost of health care is also likely to play a role in how long your savings last. A 65-year old couple retiring this year will need $230,000 to pay for medical expenses throughout retirement, according to a recent study4. Moreover, with the U.S. government struggling to reduce its budget deficit, potential reductions to Medicare could force you to shoulder a greater share of your future health care expenses.
If you are overly cautious and put all of your retirement savings in low-yielding fixed-income or cash investments, the purchasing power of your savings could actually decline over time. Therefore, to help protect yourself from rising prices, you may need to allocate a portion of your retirement savings to securities, (such as stocks or inflation-protected bonds), that have the potential to deliver a “real return” that outpaces inflation. Understand that this may create a more volatile portfolio. If that’s not something you can tolerate, you may need to revisit your spending plans, work longer, or save more before you retire.
Too Much Too Soon: Unsustainable Withdrawal Rates
The rate at which you begin cashing out of your retirement savings can also have a big impact on whether your money lasts. During the bull market of the 1990s, many retirees were able to withdraw 7%, 8%, or even more each year, while counting on rising stock markets to replenish the value of their retirement portfolios.
Stock market returns have lagged over the past decade, however, so your withdrawal rate may need to be much lower if you want your savings to last. How much lower? The calculation is a function of your age, your life expectancy, and your asset allocation, but numerous studies have shown that the risk of depleting retirement savings rises steeply at withdrawal rates of 5% or more.
This risk is magnified when a sustained market correction occurs during the early years of retirement. Therefore, it may be wise to establish a systematic withdrawal plan that automatically liquidates no more than 4% of your savings each year, especially during the first few years of retirement. You may be able to increase your withdrawal rate later on, but it’s better to err on the side of caution.
Another way to ensure you don’t outlive your savings is to elect to receive benefits in the form of an immediate annuity. Even if your workplace retirement savings plan does not offer annuity forms of payment, you may be able to roll over all or a portion of your assets to an IRA annuity that you buy from an insurance company, or purchase an annuity with your non-retirement plan assets.
When you buy an annuity contract, you provide a payment to an insurance company in exchange for regular income (e.g., monthly) for as long as you live. Although fixed annuities are useful for establishing a floor of income protection that will last throughout your retirement years, you give up control over your nest egg to an insurance company when you buy one. Annuity payments are usually not adjusted for inflation, and they may not be ideal if you die earlier than expected, encounter emergency expenses, or if you wish to leave as much as possible to your heirs.
For further protection, you may want to consider purchasing annuity contracts from several providers to spread your risk among different insurance companies and to maximize your state guaranty fund protection.
Moving from saving for retirement to living in retirement requires a fundamental shift in thinking. To ensure you don’t outlive your retirement savings, consider working with a financial adviser to develop a comprehensive retirement income plan that examines your expenses, your sources of income, and your investments. By revisiting your plan regularly, you can make sure you remain on track to meet your retirement expenses for years—and maybe decades—to come.
1. Social Security Administration at http://www.ssa.gov/history/lifeexpect.html.
2. Annuity 2000 mortgage table, Society of Actuaries. Figures assume a person is in good health.
3. U.S. Department of Labor, Bureau of Labor Statistics, Consumer Expenditure.
4. Fidelity Investments Retiree Health Care Costs Estimate, March 2011.
Follow the Money Trail
Tracking your spending habits can help you identify ways to boost your retirement savings. The federal government figured out a long time ago that the best way to get people to pay their taxes on time was through direct payroll tax withholding. After all, you can’t spend what you don’t receive.
Employers have applied this same concept to retirement savings. By allowing you to defer a portion of your salary directly into your workplace retirement savings plan, you are in effect “paying yourself first,” before other expenses swallow up your entire paycheck.
While many people take advantage of salary deferrals to build a retirement nest egg, most of us could (and should) be contributing more. On average, Americans have been saving about 5% of their personal income in recent months. That rate may seem low, but it’s actually a big improvement over a few years ago, when the savings rate was virtually zero. However, it pales in comparison to the 1980s and earlier periods, when Americans routinely saved 10% or more of their disposable income.
If you’re looking to ramp up your savings rate, the first item to examine is your spending. This includes big-ticket items such as your mortgage or rent payment, as well as seemingly insignificant purchases, such as your daily dose of caffeine or those magazines you can’t resist at the checkout counter. Once you know where you’re spending your money, you can rein in impulsive or unnecessary purchases and start saving more.
To get started, first choose a method to track every dollar you spend. This can be as simple as a notebook and a pen, a spreadsheet, or you can use personal finance software.
No matter which method you choose, the key is to track every expenditure over the course of at least one month, but preferably two or three months (and longer if you choose). By tracking expenses over a longer period, you’ll capture infrequent expenses that occasionally pop up, such as car repair bills. Group your spending into categories, such as utilities, groceries, restaurant meals, clothing, entertainment, insurance, etc. It also helps to sort between discretionary and non-discretionary expenses, as discretionary expenses are the first place to look for savings.
Once you have tracked your expenses — and yes, that pack of gum should be included — a picture will begin to emerge. You may be amazed to learn just how much you spend on restaurant meals, music downloads, or ice cream sundaes each month. Armed with this information, you can then become more mindful of your spending and identify areas where you can easily cut back.
For example, home-brewed coffee and a travel mug could save you hundreds of dollars a year. Planning your shopping trips can cut your gasoline bill. If you’re a smoker, adding up your monthly cigarette bill could provide the motivation to finally quit. You might also examine your monthly cable and cell phone bills to see if you can negotiate better deals.
The final step is to put your newfound spending discipline to work for your future by increasing your salary deferral rate. If, in the process you also cut back on junk food or cigarettes, you may also enjoy a healthier lifestyle in the long run.
Learn The Lingo
Expense Ratio
Many factors, including the economy, interest rates, and of course, the performance of the financial markets, will affect the returns you earn from your mutual funds. But investors often overlook the impact that fees and expenses can have on their fund’s performance.
You can compare fund expenses by looking at a fund’s expense ratio. This number reflects the fund’s total annual operating expenses, expressed as a percentage of a fund’s assets. Some funds also charge what’s known as “12b-1 fees” to compensate brokers and advisers for marketing and selling their fund shares, as well as performance fees that pay a bonus to the management team if the fund outperforms its benchmark index.
According to mutual fund research firm Morningstar®, the average expense ratio for a domestic stock fund that invests in large company stocks is 1.45%. That means for every $1,000 you invest in the fund, $14.50 out of the fund’s returns will be paid to the fund each year.
That may not sound like much, but as your balances grow larger, these amounts also grow larger. Fees are paid right out of your fund’s earnings, so the higher a fund’s expense ratio, the more challenging it will be to beat market indexes or category averages. Therefore, it’s wise to consider a fund’s expenses ratio before you invest.
Market Timing is No Answer for Market Volatility
The stock market’s recent roller-coaster ride has been difficult for some investors to stomach. According to recent figures from the Investment Company Institute (ICI), investors have been pulling money out of stock mutual funds in recent weeks and piling into money market funds.
Despite warnings about the folly of making wholesale changes to retirement savings during times of extreme market volatility, many investors find it difficult to contain their emotions. This sometimes causes them to sell their stock mutual funds in a panic, often at or near market lows. If you are in this camp, remember that, while pulling your money out of the stock market may help you rest a little easier tonight, emotional reactions to market volatility may lead to sleepless nights in the future.
Why? Because when the market recovers, your money will be sitting in cash, earning low yields. Eventually, you will have to choose the right time to reinvest in stocks. If you wait too long for the “all clear” signal, you may miss most of the stock market rally and invest your money just in time for the market’s next down cycle.
When your retirement savings are tied to the fate of the stock market, it’s perfectly reasonable to be concerned. However, that doesn’t mean you should dismantle your portfolio for some temporary psychological relief. Studies have demonstrated that time in the market, not market timing, is the key to long-term success.
In fact, since 1926, the stock market (as measured by the S&P 500 Index) has had positive returns in 61 out of 85 calendar years. That’s a success rate of nearly 72%. Many of these gains have occurred during relatively concentrated periods. If you’re hiding out in cash when the market rallies, your long-term results will likely trail the market averages. So, as difficult as it may be, resist the temptation to bail out of your stock mutual funds when the going gets rough.
Of course, if your personal financial circumstances or long-term goals have changed significantly, then it makes sense to revisit your asset allocation. Just be sure you’re doing it for the right reasons.
The information in this publication is not tax or financial advice. Please review the provisions of your plan and consult with a financial or tax advisor on these and other tax and financial planning matters.