The New Math of Retirement
This previously published article is part of 12 Days of Wealth Managment: The Year in Review.
There have long been certain metricsfinancial planning assumptionsthat advisors have used in order to structure their clients' portfolios to achieve a comfortable retirement. While the future has ever been unknowable, these assumptions seemed to stand the test of time. Unfortunately, biology, markets and politics have conspired to invalidate those assumptions. Today, the retirement planning script has been rewritten, and almost none of these beloved planning metrics hold true anymore. They've been replaced with new numbers that advisors must begin to integrate into their planning now, or risk leaving their clientseven their wealthiest oneshigh and dry in their Golden Years.
New Math Challenge: Longer Lifespan = Longer Retirement
People are living longer, meaning assets need to last longer, too. In 1970, American men could expect to live to an average of 67.1, women to 74.7, according to the Centers for Disease Control. By 1995, those numbers were 72.5 and 78.9 respectively. In 2010, the numbers were 76 for men, 81 for women.
But those numbers are life expectancy from birth. For those already 65, life expectancy today is actually 17 more years for men and 20 for women, making the average life expectancy for the newly Medicare-eligible 82 for men and 85 for women. And thanks to better health care, lifestyles and living standards, a 65-year-old man today has a 30% chance of living to 90and a 65-year-old woman has a 40% chance of reaching 90, according to research by Ron Gebhardtsbauer, an associate professor of actuarial science at Penn State University. In addition, a 2011 report by the Census Bureau says that a person at 90 statistically has a further life expectancy of almost five years.
But will all these nonagenarians have any money left? According to the Employee Benefit Research Institute, the average wage earner today will need $900,000 to fund his or her retirement. You might think these figures mean that only the lower, middle and mass affluent classes need to worry. But Michael Greene, senior vice president for business development and group financial planning at Ameriprise Financial Services says that "it turns out everybody, at just about every income level, has the same fear of running out of money."
Greene says that even a couple with $1 million in retirement assets worries about maintaining their lifestyle. If they don't have an increasingly rare pension and if their expenses get out of balance, "it's time for a hard conversation." He cites a client who had $10 million in assets and was spending $1 million a year. "That won't work," Greene says.
New Math Solution: Cut Back
For your clients who are already close to retirement, there is only so much you can do to address this new planning metric. You can't acquire more money for them once they're in or near retirement, and you can't dramatically, nor efficiently, increase the rate of return without piling on unacceptable levels of risk. For your near- or in-retirement clients, the only way to address the possibility of the blessing of a long, long life is to cut back on spending.
"Cutting back on spending by 10% is something you control," Greene says. This could mean doing things like "switching your car from a Lexus to a Nissan," or even selling a second home, with little actual impact on lifestyle. "When the kids are grown, many people find they don't want to go to their vacation homes," Greene says.
Richard Bone, senior vice president for investments with Raymond James in Chicago, says cutting back on spending can often be the simplest way to make a predictable difference in the sustainability of assets. But it can be painful telling clientswho spent a lifetime amassing a significant nest eggthat they should forego some things if they want their funds to last.
"People with assets in the under-$250,000 range often seem to have an easier time scaling back," Bone says. For people with higher incomes and larger savings, the idea of cutting back can be harder, "because their expectations for retirement are higher."
Greene adds that addressing the expense side of a retirement plan is not just hard for clients. "Cutting spending is not something advisors want to hear. They see one big pot and end up putting enormous strain on themselves and the client in a downturn," he says.
Several experts stressed the importance of holding cash in reserve. Shannon Reid, director of retirement solutions for Raymond James, suggests setting aside enough cash so that, with Social Security, annuity and other income, clients' base expenses for "one, two or even three years" are covered. Christine Benz, director of personal finance at Morningstar, doesn't go that far, but recommends having sufficient cash and income to cover basic needs for a year. "You don't want to have to sell in a down market to pay your bills," she says.
New Math Challenge: Slow Market/ Higher Expenses
With the Dow repeatedly setting new highs this year, and the S&P up about 19% through July 31, equities might look better than they have in years. But the old investing mantracreate a diversified portfolio and let the "magic of the market" grow one's assetsis losing its mojo. Many analysts are cautioning clients now that even equities are unlikely to perform as well as in days past.
Mark Robertson, founder and managing partner at Manifest Investing, using projections from research firm Value Line, predicts an annualized 4% total return for equities markets over the next four years based on market values on August 2, 2103. That's well below the last century's 10%-11% annualized return. In general, analysts also predict increased volatility, with some warning of the potential for another crash.
"Even seven years ago, you could buy 7% bonds and live on the interest," says Michael Poppo, managing director of wealth management at UBS Financial Services. No more." Treasury rates have ticked up a bit, but Poppo says they are still at "a 60-year low" and could linger there if the economy stays sluggish.
This new economy means the standard assumption that a 4% annual withdrawal rate could provide for clients through retirement no longer works. Neither does a second crucial assumption, that retirement income should be equal to about 70% of pre-retirement income in order to maintain a client's standard of living.
"We have to question that 4% assumption," says David Blanchett, head of retirement research at Morningstar Investment Management. He says that withdrawal rate would only give clients a 50% chance of their assets lasting 30 years. A 2.8% annual withdrawal rate is more realistic, he adds.
Dean Deutz, senior manager of wealth management initiatives at RBC Wealth Management in Minneapolis, says that 70% figure is also too low to provide a comfortable retirement. "Most of our clients are spending 100% of what they spent before retiring, sometimes 110% or even 130%."
New Math Solution: More Savings/More Risk
For people in their 30s or 40s, preparing for a slow-growth market and a more expensive retirement means stepping up their savings rate. "Saving 3% per year, which has been the silly default rate, is not going to get you the assets you'll need," Greene says. "We need to talk with those younger clients about establishing a sustainable savings rate, instead of about a sustainable withdrawal rate. Three percent isn't nearly enough."
For clients already in or approaching retirement, the new reality means adjustments in investment strategy. Gone are the days of shifting assets into safe, low-risk bonds as retirement arrives. Today's retirees are looking at falling short unless they increase their risk profile, advisors say.
UBS's Poppo suggests buying preferred shares of financial institutions. These, he says, pay 7% dividends and later convert to floating-rate preferreds with floors of 3.5% to 4%, paying LIBOR plus 75 basis points. Most such issues are for large global banks and he argues risk is low. Poppo also likes master limited partnerships in the U.S. energy sector, REITs, "very high dividend-paying" stocks, especially in the tech area, emerging market bonds and "diversified high-yield paper."
Poppo says there are "vehicles available today you couldn't even find four years ago. You're seeing them appear now because of the demand of our aging population."
Such investments do entail some increased risk over bonds or annuities. "But it really depends on what you're comparing it to," Poppo says. "If you were to buy 30-year bonds and rates went up, your bonds would go down in value substantially."
"People these days need to be willing to take some increased risk," agrees Raymond James' Reid. "It's not your parents' pension-based retirement anymore." She suggests buying a deferred immediate annuity to provide guaranteed income beginning at age 80.
Carla Masselink, senior vice president for investments with MKS Wealth Advisors of Raymond James in Holland, Mich., agrees with the need for many clients approaching retirement to adjust their risk tolerance upward. "We're bullish on the market, so we're looking at income-oriented equities, which do better than 10-year Treasuries and traditional fixed income markets," she says. Like Poppo, she also likes REITs, both health care and commercial, MLPs and preferred financial sector stocks.
Morningstar's Benz takes a more cautious view. "Income-centric portfolios can be kind of funky," she says. "Junk bonds, MLPs, convertibles and REITS are not good quality assets." While suitable as a small portion of client portfolios, she favors shorter duration bonds to provide stabilization for equity investments.
"People have become allergic to tapping their principal," she adds. "I think they need to shift from trying to generate income and to think in terms of total return, where you sell equities that have done well, harvesting your capital gains to add to your income in the good years."
New Math Challenge: Disappearing Health Care Safety Net
Twenty years ago, Medicare covered most bills, and insurance, hospitals and drugs were cheaper, too, with Americans spending an average of $3500 per year on medical care, according to the U.S. Department of Health and Human Services. For a generation of people, many of whom worked for a single company for decades, company-sponsored retirement health insurance plans eliminated much of the worry and planning surrounding retirement medical issues.
Even a decade ago, the cost of a year in a nursing home was just $48,000, a National Institutes of Health study says. But given our increasing longevity, abandonment of retiree health benefits by most major corporations, soaring medical costs (6%-7% on average per year, according to the Bureau of Labor Statistics) and political threats to Medicareand with long-term hospitalizations and catastrophic illnesses looming like a shadow in every aging person's mindhealth care is suddenly a top issue in retirement planning.
Fidelity Investments estimates the average couple retiring in 2013 will spend about $220,000 on medical care. That $220,000 includes premiums for Medicare Plan B (doctors) and D (prescription drugs), as well as copays, deductibles and non-covered expenses like hearing aids and dentistry. Meanwhile, the HHS estimates 70% of retirees will need to spend an average of three years in long-term care. According to a study by Nationwide Insurance, about half of that care will be provided in the person's home, at a current cost of about $40,000 a year. Over one-quarter of retirees will need nursing home care at a current cost of around $90,000 a year (predicted by that same study to hit $265,000 in 2030). Costs vary by state, but can easily be double or triple that for assisted-living or tonier homes with private rooms.
New Math Solution: Long-Term Care Strategy and Good Health
The fear of a crippling health care crisis, over and above the staggering costs of health insurance, has made long-term care insurance a popular product. Clients can buy long-term care insurance, but Morningstar's Blanchett warns advisors, "Companies can cancel or keep raising their premiums, and you have to look carefully at the issuer to make sure they'll still be around when you need them." It's also a lot of money to lay out if the client ends up not needing it. (See "Long-Term Scare")
Raymond James' Masselink suggests a long-term care policy like the MoneyGuard policy she bought for a client from Lincoln Financial. That policy, she says, offers $162,000enough to cover a year or two in a nursing home or a longer period of in-home careat a cost of $5,000 a year for 10 years. If the client ends up not needing it, he or she can recover the $50,000 principal, or it becomes a death benefit for the client's beneficiaries.
Blanchett warns against over-budgeting for nursing home care. Most people don't spend years in a nursing home, but end up there only at the end of life, and then for less than two years (with up to 100 days of that covered at least partly by Medicare, if it is considered rehab from a hospitalization). Medicare will also pay up to 60 days a year (up to 37.5 hours per week) for in-home "episodic" care, such as speech or physical therapy, or other kinds of skilled care, as long as a doctor certifies a patient is housebound and the care is medically necessary.
Reid, like most other advisors, also stresses the importance of Social Security. She suggests maximizing that benefit by delaying taking it until the maximum age of 70.
"For every year after full-retirement age, you get an extra 8% in benefits," Raymond James' Reid says. "That's probably better on average than you can do in the equity markets, and it's a monthly payment that is adjusted for inflation each year" through retirement.
Alicia Munnell, director of the Center for Retirement Research at Boston College, says that waiting until 70 to maximize Social Security benefits is "the best single investment a person can make." And reaping that investment is not just for those of meager means.
"Even our high net worth clients are concerned about maximizing Social Security," reports Theresa Fry, manager of IRA and retirement planning at Benjamin F. Edwards & Co. "It's almost like a rite of passage."
The truth is that Social Security is not small change even for a high earner. This year, the maximum benefit for someone who started collecting benefits at 70 is $40,200 for the year. That means a two-earner family could be collecting an inflation-adjusted $80,400 this year. Depending upon how other new math metrics affect your client's portfolio in the coming years, the additional income generated by delayed collection of Social Security could prove a meaningful one.
The bottom lineespecially for wealthier clients whose basic retirement expenses are coveredappears to be that retirement is not a crisis, but it requires care, close periodic consultation, a willingness to pare expenses when markets slump and the ability to take on a bit more portfolio risk than planned. And stay as healthy and as fit as possible.
Meanwhile, Blanchett suggests not over-saving and over-cutting expenses for worst-case scenarios. "The worst thing you could do would be to end up at 90 with a huge pile of assets and lots of things that you wanted to do but couldn't afford to do. Instead of trying to eliminate all your risk, try to maximize your happiness."