Post-Retirement Tax Exemption for Investment Earnings

In yesterday’s post I extolled the virtues of the tax exemption in tax-favored retirement plans as the workhorse of retirement planning. Well, you say, that may be true for someone in his 30’s with plenty of time, but what about someone already in retirement? Doesn’t the miracle of pre-tax compounding of investment earnings cease once you’ve started to take distributions from your account? I respond, “No, Grasshopper, that tax exemption is the gift that keeps on giving.”

Consider the example of Ralph and Ed from Wednesday’s post, but let’s change the facts a bit. Instead of being in their 30’s, they are both age 67 and about to retire. They each have saved $6,000 from their final year’s salary. Ralph contributes his $6,000 to his employer’s 401(k) plan. Ed pays $1,800 of income tax on his $6,000 and puts the $4,200 balance in an ordinary taxable account. One more change to the facts. Both Ralph and Ed expect to be in the 30% tax bracket for the rest of their lives. Ralph expects to earn 7% (pre-tax) on his $6,000, and Ed expects to earn 7% pre-tax and net 5.3% after tax on his investment account. Each expects to live 29 years (good genes).

Here’s what the boys can expect to reap from the retirement planning they’re sowing. Using a financial calculator, Ed figures he can spend his $4,200 at the rate of $287 per year for the rest of his life. He’s already paid tax on the $4,200 and its investment earnings, so he gets to spend the whole thing. Fair enough.

What about Ralph, the wise one (the wide one)? Using the same financial calculator, he figures he will exhaust his $6,000 401(k) account at the rate of $489 per year. But he hasn’t paid tax on any of that yet. After paying a 30% income tax, Ralph expects to have $342 per year to spend. That’s 19% more than Ed. “How sweet it is!” thinks Ralph.

The point of this example is to illustrate that the chief tax benefit of tax-favored retirement accounts, their tax exemption, still has more work to do for you even after you have retired.

But wait! There’s more! What about after death? None of us really knows if there’s life after death, but I can report that there’s continued tax-exemption after death. Tax exemption is the gift that keeps on giving—to you, then to your spouse, and ultimately to your kids. That’s a subject for a future post.

Tax Exemption for Investment Earnings

In Wednesday’s post, we summarized the three main benefits of traditional tax-favored retirement plans. Of the three, which do you think is most important? Surprisingly, for most people, it’s the tax exemption on investment earnings compounding within your savings bucket. So powerful; so under-appreciated.

Let me recap the big three, chronologically.
• Deduction up front, giving you more to invest.
• Tax-exemption on investment earnings, allowing them to compound at a higher rate of return
• Tax bracket arbitrage, allowing you to pay income tax at your (presumably lower) post-retirement income tax bracket

Which do you think is most important? Most people like the deduction. It has a lot of surface appeal, because you immediately see the tangible result. You feel wealthier. Remember the example of Ralph and Ed from Wednesday’s post? Because of the deduction, wise Ralph had $6,000 to invest and Ed only had $4,200. The deduction is the sizzle that sells the steak. It’s easy to forget that the $6,000 comes with a built-in income tax liability that will bite back when you go to spend it in the future. Don’t get me wrong. It’s a good thing for sure. But not as powerful as the tax-exemption.

What about tax bracket arbitrage? Trading your high working year tax bracket for your low retirement year tax bracket? In yesterday’s post, we pointed out that for many people who are striving to get their Future Selves into the same standard of living as their Present Selves, tax bracket arbitrage is an illusion. They may well be in the same tax bracket—or even higher. And if it turns out to be a higher tax bracket, have they done their Future Selves a disservice?

Nosirree Bob! Because they still will have benefitted from the account’s intervening tax-exemption, the Mighty Mouse of retirement planning!

How powerful might that be? Again, remember the example of Ralph and Ed from Wednesday’s post. Ralph ended up with annual after-tax retirement spending of $2,790 compared to Ed’s $1,377. Let’s do a thought experiment. Let’s leave all other facts the same, but pretend Ralph’s account gets no tax exemption, so his account earns the same rate of return as Ed’s (5.3% during their working years, and 5.5% during their retirement years). Then Ralph’s annual after-tax spending drops from $2,790 to $1,475, a mere $98 per year more than Ed's. Our thought experiment shows that Ralph’s savings bucket’s tax exemption accounts for 93% of his benefit to be gleaned in real life!

So when you’re doing your planning, don’t make the mistake, as I so often see in the press, of focusing only on pre- and post-retirement tax brackets or the glamorous tax deduction. It’s the humble tax exemption, taking advantage of the miracle of compounding, that’s really doing the heavy lifting.

Tax-Favored Retirement Plans: The Tax Time Machine

In yesterday’s post, I summarized the income tax differences between saving in an ordinary taxable investment account and in a traditional tax-favored retirement account. I think it’s a good idea to step back a second and see what that implies about income taxes over your entire lifetime.

A traditional tax-favored savings bucket (an IRA, a 401(k) account, a 403(b) account) acts as your own personal income tax time machine. It shifts a piece of your salary—and the payment of income tax on that portion of your salary—from the Present You to the Future You. The deduction you get causes your annual savings to disappear from Present You’s tax return, and then just pop up on Future You’s tax return. Just like the DeLorean in Back to the Future!

And that has implications for your retirement planning. An astute commenter named Anonymous pointed out in a comment to January 21’s post that it’s a big mistake to fail to take into account income taxes when coming up with a savings target. And indeed it is. But if you do your saving inside a tax time machine, then in fact you are indirectly taking income taxes into account.

Remember the example of Ernie? Ernie started (in January 16’s post) by looking at his gross salary of $100,000 and subtracting a couple of expenses to see what he is currently living on. Included within his current standard of living are his state and federal income taxes. A lot less satisfying than food and vacations, for sure, but a living expense nonetheless. Let’s say they add up to $10,000. Since his planning is aimed at having Future Ernie enjoy the same standard of living, he can expect Future Ernie’s income tax expense to be roughly the same $10,000. The tax time machine will make that happen. So Present Ernie’s after-tax standard of living and Future Ernie’s after-tax standard of living will also be roughly the same. And that’s his goal.

For sure, there will remain some small differences between Present Ernie’s taxes and Future Ernie’s taxes. But they are likely not significant. For example, a portion of Ernie’s Social Security benefit is not taxed. And Future Ernie might not have a mortgage interest deduction. But these differences are likely not material.

So, like Ernie, you too can evade the awful, complex task of actually figuring out your present and future income taxes. But this only works if, like Ernie, substantially all of your retirement saving is expected to occur inside traditional tax-favored retirement accounts. That won’t be the case if for whatever reason your annual savings goal exceeds the amount you’re allowed to put into these types of plans. For example, if you get started saving late in life, or if you have a really high salary, or perhaps if your cheapskate employer doesn’t offer you a 401(k) plan. If a meaningful portion of your savings ends up in an ordinary taxable investment account or a Roth account, you’ll have to do some fancy footwork to deal with the income tax differences between the Present You and the Future You.

How do you make these adjustments to your planning? That’s another post altogether.

The Benefits of Tax-Favored Savings Plans

For most people, a traditional tax-favored savings plan will play the leading role in their retirement planning. You know: traditional IRAs, 401(k) plans, 403(b) plans. (Other types of savings buckets will be supporting actors—important contributory roles, to be sure, but no star on the door. These might include ordinary taxable accounts, Roth IRAs and Roth 401(k)’s, annuities, non-qualified deferred compensation.)

Why are traditional tax-favored savings plans so important? Because the long-term tax benefits of these savings accounts are so great, it would be a blunder to fail to take advantage of them. First, a summary. Here’s how traditional tax-favored savings buckets compare to ordinary taxable investment accounts.


How important are the long-term tax benefits. Here’s an example. Ralph and Ed are friends and neighbors and are almost identical. They are both age 37, both plan to retire at age 67, and both expect to live to age 95. This year, each of them has $6,000 to save from their salaries. The only difference is that Ralph saves his $6,000 in a traditional 401(k) account and Ed saves his in an ordinary taxable investment account. Ralph and Ed are both in the 30% tax bracket while they are working, and expect to be in a 25% tax bracket after retirement. Each expects to earn 7% return on his investments, but in Ed’s case, because of income taxes on his investment earnings, he expects to keep 5.3% during his working years and 5.5% during his retirement years. Ed can expect his one-time investment of $4,200 (= $6,000 – 30% x $6,000) to result in a $1,377 annual after-tax stream of income during his retirement. Ralph can expect his one-time $6,000 investment to result in a $2,790 annual after-tax stream of income. Ralph’s is twice as large! All attributable to the tax advantages of the savings bucket Ralph chose.

There are other differences between Ralph and Ed. Ralph is fat, and Ed is thin. Ralph drives a bus, and Ed works in the sewer. But that’s not what’s important here. What’s important is that Ralph is taking advantage of a good idea, and Ed is making a blunder.

Adjusting for Inflation

In two recent posts, I discussed the necessity of taking inflation into account, and different ways to adopt a reasonable assumption about what inflation will be. (Not a prediction; just an assumption.) I guess it’s time to say something about how you go about doing that.

The easiest way to take inflation into account is to do it implicitly, rather than explicitly. Huh?

What I mean is best illustrated with an example. Let’s re-call Ernie. A couple of posts ago, we figured that Ernie needed to save for a target of $948,750. To arrive at that goal Ernie assumed his long-term rate of return would be 6%. But not really. He was hiding something (the scamp!). What he really assumed was that his nominal long-term rate of return would be 9% and that inflation would be 3%. His real (i.e., inflation-adjusted) rate of return was assumed to be the difference. Is 9% a reasonable assumption for a nominal earnings rate? For the time being, grant me that it is. So Ernie did in fact assume some inflation, but it was implicit, hidden in his 6% real rate of return.

In addition to making his arithmetic easier, using a real rate of return has another advantage. It keeps your numbers real (i.e., inflation-adjusted), so you can relate to them. If all goes as planned and projected, at retirement Ernie will have roughly $948,750 of purchasing power. He’ll actually have more than twice that in nominal dollars, but they’ll only be worth $948,750 in today’s dollars. The bigger nominal number has no sensible meaning; but you can certainly relate to the smaller real number because you have a feel for how far money goes today. (Actually neither figure carries any sensible meaning; what does have meaning is the $37,950 of annual spending that it will buy you. But that’s a whole other subject.)

In the example we constructed there’s another hidden implicit assumption. A few posts ago, we turned Ernie’s savings target into an annual savings goal of $11,426 (some of which is provided by his employer). Wait, you say, if he only saves $11,426 each year he won’t have enough at retirement after taking inflation into account. Good catch! But there’s this other hidden implicit assumption: That Ernie’s salary will increase with inflation. If it does, then when Ernie goes through this exercise next year, if all projections were to come to pass, his annual savings goal would increase by inflation, but it would remain the same percentage of his salary (11.426%). Ernie will have achieved his primary objective of having Future Ernie spending just as lavishly as Present Ernie, no more, no less. (This is the exact point made by an astute commenter to Wednesday’s post, some person named Anonymous.)

Is it reasonable to assume that your salary will increase with inflation? Ernie thinks it’s reasonable for him. What about you?

Projecting Inflation

Okay. So you’re planning your financial future and you know you’ve got to anticipate inflation. You know this because you’re observant and wise. Also because you read yesterday’s post. How much inflation will we see? Fagettaboutit. Nobody knows. You can’t predict it, you can only project it.

But that’s okay. You don’t have to be right in your projection; just be reasonable. Being the wise person that you are, your process includes a mechanism for annually updating your planning and projections based on reality—what really happened, not what you projected would happen. So next year, you’ll adjust for your inevitable failure to accurately predict the future, and effectively spread your error over the rest of your life. No, wait. Not “error;” that’s pejorative. Let’s call it “deviation.” No, that’s pejorative in a different way. Call it “dispersion.”

So what’s a reasonable assumption when it comes to future inflation? Here are a few options, any one of which is reasonable. Of these I prefer the first, since it presents a long-term average, and you’re planning for the long term.
• You can use inflation’s historical average. Between 1926 and 2008, inflation as measured by annual changes in the Consumer Price Index has averaged 3.01%.
• You can use the most recent rate of inflation. Between December 31, 2007 and December 31, 2008, the CPI has increased 0.09% (very tiny).
• You can glean the collective inflation predictions of many investors from the price of certain government bonds (called “Treasury Inflation-Protected Securities," or TIPS), which are designed to protect their owners from inflation. The rate of interest TIPS pay is generally lower than the interest rate payable on other government bonds with a similar maturity, and the difference represents, in a way, the bond purchaser’s prediction of inflation (as measured by the CPI) during that bond’s term. In fact, since interest rates on TIPS and other government bonds are set by an auction process, the difference in interest rate yields represents the collective inflation predictions of all government bond investors. As I write this, the most recently published spread between the yields on 20-year government bonds and TIPs is only 0.86%—not much. You can find the most recent interest rate yields for U.S. government bonds here (http://www.treasury.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml)
• Some financial institutions publish their predictions on their websites.

I don’t cotton to no predictions myself, and prefer instead to use a 3% inflation based on historical averages. It’s reasonable, and that’s all that counts. I’d be interested to hear your preferred approach to projecting inflation.

In any case, once you’ve settled on an inflation assumption to use in your projections, what do you do with it? That’s a subject for another post.

Inflation: The Phantom Menace

In the past I would occasionally review a Will somebody wrote in the 1950’s or 1960’s. It might include something like a stipend for a favorite nephew of $100 per month for life. A hundred dollars a month!? That’s not even carfare! This little story is not meant to illustrate Aunt Gotbucks’s cheapness; $100 per month was a pretty decent gift when she wrote the Will in 1955. Rather the story illustrates the long-term ravages of inflation.

Whether you’re in your working years or your retirement years, your retirement planning is inevitably long-term planning, and that means you have to take inflation into account. A number of commenters (all named Anonymous) have astutely pointed this out.

What is inflation, anyway? Like pornography, we all know it when we see it, but it’s notoriously difficult to define and measure. Generally, inflation is the rise in price for the same amount of stuff. One thing that makes it difficult to measure is that it’s different for everybody, depending on the sort of stuff you buy. Do you need education, rent, a new TV or health care? They have inflated at different rates. And stuff changes. How do you compare the cost of a slide rule to the cost of an HP12C calculator? A broccoli to a Big Mac? And it’s different if you live on a farm or in the city, the Northeast or the Midwest.

Nonetheless, the U.S. Department of Labor maintains an index which attempts to measure inflation (actually, multiple indexes). You can find them here (http://data.bls.gov/cpi/). Of course no index measures your personal rate of inflation, but it measures something.

Inflation is silent and it's sneaky. It’s out there, eroding the value of your assets. It’s happening. But the guy on the nightly news isn’t screaming about today’s increase in the CPI, the way he’s in your face about today’s drop in the Dow.

It’s slow, building over time. Changes in stock values can be large and swift (these days sickeningly so). Inflation is slower. 2% one year; 4% another. But its cumulative impact over the course of your life will be large.

And it’s inevitable. There have only been 12 years during the 95-year period between 1913 and 2008 when the cost of living declined—only two since the beginning of World War II—and the most recent year that occurred was over 50 years ago, in 1955. (There were a few months in 2008 when the CPI dropped, but it increased slightly over the calendar year.)

I know what you’re thinking. Everybody is now worrying about deflation, not inflation. Yes they are. And the puppet-masters at the Fed and elsewhere in Washington will be doing everything in their considerable power to turn deflation back into inflation. That $2 trillion we’re currently adding to the national intergenerational debt will certainly support the effort. So from a planning perspective, you’d better count on inflation.

Individually, we can’t do anything to affect inflation. But as we plan our financial futures, we certainly should take it into account. I assure you I have done so in the examples I’ve spun in this column so far, and I will continue to do so in the future.

So how do you take inflation into account? That’s a subject for a couple of future posts. Right now I’ve got to go cash my monthly $100 check and buy myself a nice new tie.

Truing Up Your Savings Goal

Let’s say you’ve been a good boy or girl, and you’ve gone through a sensible process of figuring out how much you should save out of your current salary. Just like the example of Ernie from Thursday's post. And, like Ernie, after your first pass you find you’re saving too little or too much. You’re cheating Future You to benefit Present You (saving too little); or you’re cheating Present You to benefit Future You (spending too little). What do you do next? Well that depends. It depends on which of the following five categories you find yourself in. I’ll list them from luckiest to unluckiest.

Wealthy. You find you’re saving more than enough to keep the Future You living the lifestyle of the Present You, and you have no desire to increase your standard of living. You would get no real pleasure out of doing so. Congratulations, either you’re wealthy, or you’re on your way to wealthy! Start working on your estate plan.

Matched. The amount you need to save to provide for the Future You is actually less than the maximum amount your employer matches in its 401(k) plan; but you could make good use of an increase in spending nonetheless. Maybe you would change your razor blades more frequently. Or start buying the frozen vegetables with the sauces built right in. Whatever. Now you’ve got a tough choice. Do you plump up Future You at the expense of Present You, just to get that employer match, 25%, 50%, whatever it is? My own opinion is that you do. It’s generally smart to go for that instant return on investment. There are so many uncertainties in life anyway, you are bound to encounter future events that cause a drop in Future You’s lifestyle. Why not just get a jump on your saving on your employer's nickel.

The Middle. The amount you’re saving toward, your savings target, is based on your current spending rather than trying to avoid dropping below your personal poverty level. (Remember the Two Multipliers?) Then you should increase (if you’re saving too little), or decrease (if you’re saving too much) your annual saving. By how much? You’ll have to do some fancy arithmetic to figure that out, since your current spending level is determined in part by how much you’re saving. But that mare’s nest is a subject for another post.

Personal Poverty Level. Your savings target is based on keeping the Future You from dropping below your personal poverty level. This describes the situation in which Ernie finds himself in the example from Thursday's post. Then you should just increase or decrease your annual saving to the amount determined on your first pass. Saving more will be hard, but at least the arithmetic is easy.

Under Your Poverty Line. Your savings target is based on keeping the Future You from dropping below your personal poverty level, but if you increase your annual savings to avoid that, then the Present You would drop below your personal poverty level. You’re screwed! It’s time to rethink your standard of living or how you define poverty.

Lots of Good Little Retirement Planning Ideas

I have reluctantly concluded that there are no great ideas when it comes to retirement planning. There’s only two categories of ideas: (i) bad ideas to be avoided, and (ii) modestly good ideas. But good ideas, as modest as they may be, add up. Accumulate enough of them and you’ve got something.

One modest idea to be added to your planning comes from a commenter named Anonymous—“An Actuary”. (Why are so many commenters named Anonymous?) He or she points out that when you add to savings from your paycheck every pay period, you can expect that your effective rate of return will go up a tad compared to adding a lump at the end of every year. And that the formula included in Wednesday’s post implied a once-a-year contribution at the end of every year. Anonymous the Actuary astutely points out that it’s reasonable to expect retirement savings to be added in little dribs and drabs throughout the year.

That’s a good idea! To be treasured! Assume that you add to your savings every pay period. (i) That’s a closer fit to most people’s reality. (Although you might take your savings from an annual bonus, in which case Ernie’s approach may be a closer fit.) (ii) You get your money working for you sooner; that means more work being done by the financial markets and less by you. (iii) You can justify a modest increase in your spending. Nothing wrong with that.

How much of an increase? Anonymous the Actuary figures $317 per year, which is 2.8% less saving and more spending. You can add HBO to your cable package! Thank you, Anonymous. Not a huge increase in lifestyle, but definitely worth taking advantage of, especially when added to other modest retirement planning ideas. A little less investment expense here, a smidgen more investment return there, a dash of tax saving perhaps. It eventually adds up to something really meaningful.

A slight digression on Anonymous the Actuary’s arithmetic. In calculating the savings, Anonymous assumed that the total return for the year would still aggregate 6%, even after taking into account semi-monthly compounding of returns. A different way to look at it is to assume that a reasonable projection for investment returns is 0.25% per semi-annual pay period. Then Ernie’s required savings for the year drop by $597, or 5.2%. So which is more reasonable? That depends on how Ernie came up with his 6% assumption to begin with. But that’s a subject for another post.

Two other commenters—also named Anonymous—raised issues about taking into account inflation and income taxes. Both good points, which I need to address in other posts. But I can only absorb one good idea per day.

Your Employer’s Contribution

Yesterday’s post illustrated the example of someone in his working years saving toward a retirement goal. But maybe there’s a third leg to your two-legged stool. Maybe your employer is helping with your retirement saving by contributing to your retirement plan. They might not be helping you with any of the decision-making (how much to save, how to invest it), but at least they might be helping with some of the dollars.

In yesterday’s example, Ernie figured he needed to save $11,426 of his $100,000 annual salary. Let’s add another fact: Ernie’s employer sponsors a 401(k) plan, and has consistently made annual contributions to it. In fact, his employer has said that it will match 50 cents on the dollar of its employees’ contributions, up to a maximum employee contribution of 6% of salary. Employees may contribute more, but only the first 6% of salary will get matched.

So Ernie figures he’ll contribute at least $6,000 (= 6% x $100,000) and his employer will contribute $3,000 (= 50% x 6% x $100,000). Ernie’s savings burden is reduced to $8,426 (= $11,426 - $3,000). Alright! That’s only 8.4% of his salary, an acceptable burden.

In this example, Ernie’s employer historically matched 50% of the first 6% employee deferral. That’s a typical employer matching scheme, but by no means the only one. Your employer’s match may be 25 cents on the dollar, or may be capped at 8% of your salary. Or maybe your employer doesn’t provide a matching contribution, but has historically made contributions for all employees, varying with its annual profits. Or maybe your employer doesn’t provide any contributions whatsoever (the cheapskates!). Or maybe they have provided matching contributions in the past, but this year announced a temporary suspension in light of the crummy economy.

All of that variability leaves you with the burden of projecting (not predicting, projecting) how much your employer will contribute in the future. If you take the conservative approach, and project no help from your employer, then the Present You will have to save more and spend less. And if your employer then in fact makes contributions, the Future You will be able to reduce his contributions and increase his spending. Or, conversely, if you assume your employer will continue to contribute, but it does not, the Future You will have to increase his rate of contributions and take a cut in take-home. I say go with the odds and make your savings decision based on your assessment of the most likely scenario.

So now Ernie thinks he has his annual savings goal—$8,426 per year. Not so fast, Grasshopper. If you will remember back to last Friday’s post when we invented Ernie, one of the givens we started with was that Ernie was saving $6,000 per year. Now he figures it should $8,426 per year. Which is it? Maybe neither. But that’s a subject for a later post.

Your Annual Savings Goal

In yesterday’s post, I kind of left my friend Ernie hanging because I had to go. I was using Ernie as an example to illustrate how someone in his working years might turn a retirement target into a savings goal. It’s time to take another step.

A recap. Ernie, who earns $100,000, has established a future retirement savings target of $948,750, of which $321,890 is expected to be taken care of by his prior savings. That leaves him $626,860 to save out of his salary. Ernie wants to be equally fair to Present Ernie and all Future Ernies, so he plans to spread that burden over his 25 remaining future years of work.

He could just divide the $626,860 by his 25 remaining years, but that would be, in effect, assuming that his savings do none of the work for him. That’s not realistic. As bad as we all feel about last year’s (and yesterday's) financial markets, it’s not reasonable to assume that will continue indefinitely. I hope. Instead, Ernie recalls yesterday’s reasonable assumption that over the long run, his assets will earn about 6% per year. That’s not a prediction; it’s just a projection.

Ernie projects he will need to save $11,426 per year for the next 25 years, which is 11.4% of his salary. How did he do that? Here are a couple of ways.
• You can use a financial calculator.
• You can use the following formula, where “F” is the future value of the amount you need to save ($626,860); “r” is the assumed rate of return (6%); “N” is the number of years of saving (25); and “Pmt” is the amount of annual saving you’re trying to determine.

Pmt = F * [r/([1 + r]^N – 1)

• You can use an Excel spreadsheet.

Are you doing all your retirement savings on your own, or is your employer contributing something? If your employer historically has made a contribution to your retirement plan, it might be reasonable (there’s that word again!) to project that it will continue to do so. That requires another step. But that’s too much for one day. To be continued.

The Fruits of Your Assets

A few posts ago, I discussed the establishment of a savings target. So how do you turn that target into a savings goal for the year? I’m glad you asked.

Remember the example of Ernie? He had established a target. He wants to have $948,750 saved by his retirement. Let’s add two facts: Ernie is 25 years away from retirement, and has already accumulated $75,000 in a 401(k) account. Good for him! Because that $75,000 will do part of the work for him, reducing the burden on Present Ernie and Future Ernie. Thank you, Past Ernie.

Ernie wants to do a projection of how much of his $948,750 target he can expect his $75,000 to cover. First he needs an assumption about what rate of return he might expect. There’s no way to know that, but it’s not so important that his assumption be right. It won’t be. Not even Ernie can predict the future. Rather, it’s only important that it be reasonable. He can (and should and, by golly, will) make mid-course corrections every year to make up for his inevitable failure to predict the future. So what’s a reasonable assumption? For illustration purposes I will use 6%. In a future post I will describe the myriad factors that go into that assumption, but for now, grant me that it’s reasonable.

Ernie projects that, in 25 years, with an investment return of 6%, his $75,000 will be worth $321,890. How did he do that? There are lots of ways to do that sort of financial projection.
• You can use a financial calculator.
• You can use this formula, where “A” is your current assets ($75,000); “r” is the assumed rate of return (6%); “N” is the number of years to go (25); and “F” is the future value of your assets:

F = A * (1 + r)^N

• You can use an Excel spreadsheet.

Lots of ways to get there. The important thing is that Ernie’s prior savings are going to do 34% of the work for him, leaving him with a net target of only $626,860 to save for out of his current and future salary. So how much should he save? That’s for another post, because I gotta go.

Ah, Youth!

I wish I were the Benjamin Button of retirement planning. I wish I could start my career armed with a lifetime of knowledge and wisdom. But that’s just a fantasy. Like expecting Benjamin Button to win the best picture Oscar.

When you’re fresh out of school, starting on your career, you have two huge assets that you’ll never have again.

The first is time. It erodes. If you’re 25, you might have a 40-year working life ahead of you. But next year, you have 39 years to go. And so on. Not even Superman can stop that inevitable erosion. And time is very valuable indeed when it comes to retirement savings. Because time permits the financial markets to do most of the work of saving for your retirement. The less time you have, the more you have to save out of your own pocket at the expense of your current pleasure. Let’s face it. Foregoing spending part of your current earnings is hard work. Youth has the advantage of shifting more of the burden to the markets.

Here’s a simplified example. (Since today is Martin Luther King day, I'll use "Martin" as an example, in his honor.) Martin has a $50,000 salary. He begins saving at age 25, planning for retirement at age 65. Expecting no contribution from his employer (the cheapskates!), he calculates a reasonable saving percentage to be 8% of his salary. Over the course of his 40-year working career, and then a 35-year retirement, he projects that his contributions will account for only 2.67% of his aggregate distributions. Investment earnings will provide him with the other 97.33%. Thank you, financial markets!

But now imagine that Martin starts saving at age 40, with 25 years to go until retirement. Then Martin figures he will have to save a whopping 20% of his salary to build up a suitable retirement fund. His own contributions are projected to account for 6% of his aggregate distributions, essentially doubling the savings work he has to do, and reducing the contribution of the financial markets. (Caution: Don’t be scared. For the sake of simplicity, these two examples do not take into account Social Security benefits. Taking that into account would meaningfully reduce Martin's required savings percentage. I’ll address that in a later post.)

So the luxury of time and its effect on the miracle of compound interest is one valuable asset.

The second major asset only available to the young is the ability to set your standard of living. Imagine you are fresh out of college and starting your first job. Chances are they aren’t paying you a large salary, but whatever it is, it’s likely a whopping step up compared to the resources you had available to you as a student. And if you start putting aside 4%, 6%, 8%, whatever, of your salary, you won’t miss it. Your net take-home will still be a big step up from your student years. This is your first, maybe your last, and undoubtedly your best, opportunity to establish your standard of living. It may be the only time in your life you can begin saving and not suffer a drop in your standard of living. Taking that haircut won’t ever be this easy again.

A Tale of Two Multipliers

In a comment to Wednesday’s post, Anonymous made a very good point. He or she said that it’s hard to adjust your standard of living. Indeed it is. Very hard. Which is what people like about a spending plan that will very likely not require them to have to do so.

Which is why it is a good idea to have a sense of where your personal poverty level lies (as recommended in yesterday’s post). Because it’s your personal poverty level that pretty much defines the spending you can’t realistically drop below. Think of it as the level at which you join the Nation of Whiners. Above that level, and you could adjust, as unpleasant as that might be. So when you’re working, and trying to determine a retirement savings target, you should actually have two targets in mind. One is based on the Present You’s current spending level, and one is based on your rough estimate of your personal poverty level. You can afford to use a realistic approach toward saving up the first target. But you should be very cautious—even pessimistic—about saving up the second target.

Here’s an example. Remember Ernie from Friday’s post. He had figured that he needed his future retirement savings to provide him with an income of $47,950. Adding projected Social Security would give him a retirement income of $65,950, which is comparable to his current lifestyle (which you may recall was $86,350, before adjustments). To translate that $47,950 into a savings target, he multiplied it by a reasonable multiplier, one that is likely to give him a sufficient war chest; he chose 17. His tentative target was $815,150 (= 2517 x $47,950).

But Ernie really needs to take a second step. He can afford to be reasonable about saving for his current standard of living, but he has to be unreasonably conservative about saving for his personal poverty level. He simply couldn’t stand entering the Nation of Whiners, and he’s willing to take any reasonable steps to avoid going there. So Ernie searches his soul. He asks himself how low his spending can drop below $86,350 without being too painful. After some thought, Ernie figures he could adjust his spending by $10,000, down to $76,350. That would mean, after Social Security and other adjustments, his retirement savings would have to provide him with $37,950 (= $47,950 - $10,000) to support his bottom line lifestyle. So he has to be unreasonably cautious about saving up that amount.

How do your translate that caution into a savings target? By using an unrealistically conservative multiplier; 25 instead of 17. So his alternative target is $948,750 (= $37,950 x 25). He has to save up the greater of the two target amounts, $815,150 or $948,750. Bummer.

It’s worthwhile to remember what these two different multipliers represent. The cavalier multiplier (17) gets you to a retirement level that is likely to be similar to your current lifestyle, but which may require the Future You to be flexible about making those difficult spending adjustment if things don’t go as expected. The conservative multiplier (25) gets you to a retirement level that is damn likely to never drop below your personal poverty level.

There are a lot of implied decisions behind these two multipliers, and your multipliers may well be different. But that’s a subject for another day.

The Relativity of Wealth and Poverty

How do you know if you’re wealthy? How do you know if you’re poor? It’s all relative. (Please stay with me a minute, because this does relate to retirement planning.)

Let’s start with wealthy. Are you wealthy if you have (A) $1 million? (B) $10 million? (C) One billion dollars? My answer is “(D) None of the above.” Like Humpty Dumpty, I am going to exercise my privilege of defining the words I use the way I want to define them. And I choose to define “wealthy” with a functional definition: A person is wealthy if he has so much money that during his (and his spouse’s) lifetime he can’t reasonably expect to productively spend it all on his own pleasure. He’s forced to give it away (to his kids, his favorite charities) either during his lifetime or at death. That’s wealthy.

“Wait a minute,” you say, “you’ve snuck in a word there. What do you mean by ‘productively’”? Humpty Dumpty returns. By “productively” I mean you wouldn’t get any meaningful pleasure out of increasing your consumption. You’re spending lavishly enough, to the point where you’d rather give it away than spend more on yourself. That’s wealthy. By this definition, few people are wealthy; most of us can find pleasure in ratcheting up our lifestyles. There's always gold-plated faucets and such. But those who are wealthy can be found in all economic strata, from CEOs and hedge fund managers to teachers and bakers.

What about poverty? What is your personal poverty level? Again, like wealth, it’s relative. I define your personal poverty level (as Humpty Dumpty tells me I may) as that spending level that would make you so miserable, you would not voluntarily take any measurable risk of dropping below it.

Here’s a f’rinstance. Remember Ernie from yesterday’s post. He earns $100,000 per year, of which he spends $86,000 per year. Let’s say Ernie’s financial planner tells him that at his savings rate, his likely available retirement spending is $86,000. Ernie’s pretty happy with that, since that’s his current standard of living. But imagine that his financial planner goes on to say that while that’s his likely future retirement spending, there’s a meaningful possibility it will be $76,000. Now Ernie has to think about that. How bad would that be? What little luxuries would he have to give up? Maybe he could deal with that. What if it were $66,000? $56,000? $46,000? At what level would Ernie step up and say, “Whoa! That’s too low. I can’t stand that risk. I’m willing to ratchet down my spending today to shrink that meaningful risk of having to live below that level tomorrow.” That’s Ernie’s personal poverty line. And it’s different for everyone, depending on the lifestyle they have become accustomed to, and the depth of their commitment to that standard of living.

It would be useful to have a sense of your own personal levels of wealth and poverty. Not, of course with precision—just a rough idea. Because knowing the boundaries of what you must have and what you can’t use will help you settle on what risks you can’t afford to take.

Your Savings Target

When it comes to saving for retirement during your working years, you need a target—some amount that when you’ve saved it up, you can feel confident in giving up your source of income if that’s what you want to do. How much is enough? Unfortunately, unless you put some thought into this question, the answer will be there’s never enough; you’re doomed to be a wage slave for the rest of your life. To be freed from the bonds of financial slavery, you should have a numerical target in mind.

Coming up with your target is a complicated process, but you can start with a tentative step, and build and hone from there. So here it is, your first step: Start by determining your current annual allowance—now, during your working years. Then make a few adjustments. And then multiply it by a suitable multiplier. And that’s your target. What could be simpler?

First, your allowance. Remember the goal of retirement planning, the principle that you want Future You to live just as comfortably as Present You, no more no less. Your current salary that you live on is a pretty good starting point. It sort of defines your standard of living. An example is helpful. Consider Ernie, who earns $100,000 salary. Present Ernie wants to plan for Future Ernie to live the $100,000 life.

Next some adjustments. Ernie does not live on the full $100,000. There’s two common adjustments that disappear when he retires. The first is Social Security and Medicare tax, which he never gets to spend. And which he will cease paying when he retires. So Ernie can reduce his tentative $100,000 spending goal by 7.65% (the combined FICA tax rate) down to $92,350. The second is retirement saving. Let’s say Ernie contributes 6% of his salary ($6,000) to his employer’s 401(k) plan. So he’s not living on $92,350; he’s living on $86,350. His target is shrinking. It’s looking more attainable.

Then there are some common expense adjustments. Now Ernie pays his mortgage every month. That’s a big component of his living expenses. Ernie checks his statement and realizes his mortgage will have been paid off before his projected retirement date. That’s an expense that will disappear—$24,000 per year in Ernie’s case. (Just the principal and interest; not the escrow for taxes and insurance, which goes on forever.) Ernie’s commuting expenses are another adjustment; in his case $2,400 per year. But expense adjustments can go both ways. Ernie’s employer now pays for his health insurance. While he anticipates Medicare eligibility at age 65, he also anticipates a cost of supplemental insurance at $6,000 per year. After taking these adjustments into account, Ernie’s target has shrunk to $65,950.

But wait! There’s more! Ernie has been paying into the Social Security system which will provide up some of that $65,950. He goes to the Social Security website, and uses the wonderful calculators there to project his annual Social Security benefit, which he finds will be $18,000. If his employer had sponsored a traditional pension plan, he would further adjust for his projected pension benefit, but alas that is not the case. Nonetheless, Ernie’s target has shrunk to $47,950 per year.

Final step, Ernie multiplies that by a suitable multiplier. How much of a multiplier? Is it 25? Or 20? Or 17? That depends on the spending and investment plan he intends to adopt when he gets to his intended retirement age. But that’s a subject for another post. For the sake of discussion, let’s say his multiplier is 17. Then his savings target becomes $815,150.

Now Ernie has a concrete goal. He has a plan! Ernie is very happy.

The Roth 401(k) Hidden Contribution

It’s January and people’s thoughts have turned to, what? Football? No. The inauguration? No. 401(k) contributions? Yes!

For 2009, your maximum 401(k) elective deferral is $16,500, and if you are at least age 50 by the end of the year, another $5,500. If you are one of those people (and there are at least 6 or 7 of you out there) who are planning to contribute the maximum, and would contribute more if you were allowed to, you can. Maybe. Sort of.

The way to indirectly increase your 401(k) deferral is to contribute your elective deferral on a Roth basis instead of a traditional pre-tax basis. With a Roth contribution, you get no tax savings up front, but you can arrange for all distributions to be tax-free. And you can also arrange for a future rollover to a Roth IRA where there are no required distributions during your or your spouse’s lifetime. Not at age 70-1/2. Not ever for as long as you live.

The first question you need to ask yourself is whether this avenue is open to you. The bad news is that Roth 401(k) contributions are only available if (a) your employer maintains a 401(k) plan or 403(b) plan, and (b) the plan has been amended to allow Roth contributions. This new type of contribution is sometimes called a “Designated Roth Contribution,” and it’s been available since 2006. The good news is that if your plan offers it, it’s open to you regardless of your income. Roth 401(k)’s differ from Roth IRAs which are only available to people with modest income.

You may not exceed the $16,500 limit by making both pre-tax and Roth 401(k) contributions. You can split your contribution between the two types, but you can’t exceed the $16,500 limit in the aggregate. If that’s the case, then how can you contribute more than $16,500? Read on.

The reason is that by foregoing the tax saving of the traditional pre-tax contribution, you effectively increase the value of your contribution by your tax rate. More accurately, for someone who is in a combined (federal and state) income tax bracket of 30%, the value of a $16,500 Roth 401(k) contribution is roughly equivalent to a pre-tax elective deferral of $23,571. Where did that number come from? It’s equal to $16,500/(1 – 30%). That’s 43% more!

There’s a lot of particulars that will affect how much more a Roth 401(k) contribution is worth to you, but that formula gives you a pretty good rule of thumb. For example, the benefit is reduced if you are in a lower tax bracket after retirement. And the benefit is increased if you have meaningful savings to live on outside of a retirement plan. For a bit more on how and why a Roth contribution is worth more than a pre-tax contribution, see the Position Paper on this subject posted on the Brown Brothers Harriman website.

Bottom line, though, is that if you’ve hit the 401(k) maximum, you should think about the Roth deferral as an end-run around the cap.

What Else Is Wrong with 4%?

In yesterday’s post I opined as to what I fundamentally disliked about the 4% Plan for determining your retirement allowance. Now here’s another thing. Four percent may well be the wrong number.

First, a recap. The 4% Plan is a spending plan you might adopt as you embark on your retirement. You spend 4% of your retirement assets, and then increase that annually with cost of living adjustments. The fundamental flaw in this plan is that for many people it gives up too much of an affordable lifestyle in exchange for more certainty as to your allowance from year to year.

But there’s another problem. It appears that 4% is too small a percentage! In a lapidary article appearing in the Journal of Financial Planning, David Blanchett and Brian Blanchett point out a flaw in the literature that has been hiding in plain sight. Perhaps your initial spending percentage should be 5%. It very much depends on your age and your tolerance for uncertainty.

Their argument goes something like this. The financial planners who zeroed in on 4% basically did two separate analyses to get there. First, they analyzed how long a retirement fund ought to last. To be conservative, they chose a long period, e.g., one that no more than 15% of 65 year old couples would survive (30 years). Then they analyzed, for a given investment strategy (60% equities, 40% bonds), what withdrawal rate (4%) would result in a high probability (95%-96%) of lasting the entire period. But the flaw in that reasoning, as pointed out by the authors, is that for the 4% withdrawal rate to fail during the couple’s lifetimes, two unlikely events would have to occur simultaneously: a really long life and a really bad investment period.

So the authors refigured the probability of both events occurring, and concluded that a 4% withdrawal rate does not carry a 4%-5% risk of failure, but rather a 0.7% risk of failure, i.e., running out of money before running out of heartbeat. To ratchet up to a 4%-5% risk of failure, the initial withdrawal rate should be 5%, a 25% increase in spending from your retirement assets. That’s a pretty substantial leap in lifestyle: Outback Steaks instead of McDonalds; the Caribbean instead of Rockaway Beach; whatever.

Of course 99% confidence is better than 95% confidence. But at what price? Is the incremental certainty worth the cost? Only you can make that judgment. But the important thing is that the underlying trade-offs not be hidden from you.

So maybe the 4% Plan should be the 5% Plan. As I said in yesterday’s post, I don’t care for the 4% Plan. And for the same reasons I don’t care for the 5% Plan. I think many people are better off giving up the quasi-certainty of either approach and getting a (likely, but variable) higher standard of living in exchange.

What do you think? If you had $1 million, would you rather have a mostly unvarying $50,000 standard of living, or a varying $60,000 standard of living?

What’s Wrong with 4%?

When the Personal Financial Planning column of your newspaper’s business section does an article about spending your assets in retirement, it will invariably mention the “4% Plan.” I don’t particularly care for the 4% Plan. Here’s why.

First, what is it? The 4% Plan is one plan for spending your accumulated assets in retirement. When you are done working and about to embark on your retirement, you add up all your retirement assets—your IRA’s, 401(k) accounts, savings accounts and the like—and multiply the total by 4%. That’s your allowance for the next twelve months. Then, after a year has passed, you increase your allowance by the prior twelve months' rate of inflation, and that becomes your next year’s allowance. And so on until both you and your spouse have passed on.

The 4% Plan has a lot to be said for it. It’s simple. It gives you certainty as to your standard of living from one year to the next. If you invest your assets wisely, you have a high probability that your assets will not be depleted before you pass on. And it's a plan. All good.

But it has a built-in flaw. Because it’s designed to carry a high probability that you will not outlast your assets, that necessarily means there’s a high probability that your retirement assets will build up and up and up. And then as you move into your seventies, eighties, and nineties, you likely will have more than enough to afford a meaningful increase in your allowance. Your nineties are a hell of a time for a raise. Where was that raise in your sixties when you could have put it to better use?

The flaw in the 4% Plan is that it fails to adjust to the reality of your changing assets. When it comes to your allowance, there’s a trade-off between certainty and size. And size matters. It essentially defines your standard of living. If you can accept fluctuations in your annual spending, your initial allowance can prudently be greater than 4%. Maybe 6% (but that’s a subject for another post). The more flexibility you have to turn your back on a portion of your spending if circumstances warrant, the greater the amount of spending you can prudently allow yourself. Another way to put that is: the less you must spend, the more you may spend. It’s Zen-like, isn’t it.

The Hallmarks of a Good Plan

Last week I wrote about the need for a Saving-Spending-Investment Plan. Fair enough. But what does such a plan look like? Allow me to conceptualize a bit, and list the characteristics of a good plan. Then in future posts, I can get more specific.

A good plan should be reasoned, flexible, individually-tailored, reality-based, long-term, self-adjusting, incremental, affordable. Let me translate these virtuous sounding words into something a bit more concrete. Here’s what I mean.
• Reasoned. Your plan should be designed to achieve your goal. Since your goal ought to be to equalize your spending over your life, don’t try to save your entire retirement fund in your last five working years.
• Flexible. Life is going to throw you curve balls. So your plan should be flexible enough to accommodate the unexpected. For example, don’t invest too large a percentage of your funds in an investment that doesn’t give you access to principal.
• Individually-tailored. There are plenty of statistics that can distract. Maybe the average working person retires at age X. But you may be planning to retire at age Y. That will change the calculus.
• Reality-based. You’ll have to make lots of assumptions: how much your assets will earn, how long you will live, what your tax rates will be, etc. Don’t be too optimistic or too pessimistic in your assumptions. Just try to be realistic.
• Long-term. The assumptions you employ in executing your plan should be long-term, since you’re planning for the long term. A typical family goes through a 40-year working career, and then transitions to a 35 (or more) year retirement. Your equities may have lost 40% in value in 2008, but that’s not a realistic assumption for a 75-year plan. In both good times and bad, this too shall pass.
• Self-adjusting. Since your assumptions will inevitably turn out to be wrong, your plan should include a mechanism for periodically—at least yearly—adjusting to rude reality. You’re making projections, not predictions.
• Incremental. And your adjustments to reality should be smooth. If your equities lost 40% in 2008, don’t try to make up for the loss in one year. You still have to eat. Your plan should be designed to spread unusual losses, and windfalls, over the long run.
• Affordable. Attune your annual saving (or spending) goals to your own economic circumstances, not the lifestyle you’ve read about in a magazine. You’re not Prince Charles.

What have I left out?

Social Security Reform. Again.

I intend for this column to be about self-help: How to deal with the financial world as it is, to make the best of it. The Two Legged Stool was not conceived as a political or policy forum. But forgive me if I occasionally stray, as I do today. I’m weak. I feel compelled now and then to take off my financial planner’s hat and put on my citizen’s hat.

Last week President-Elect Obama said he would be looking critically at both Social Security and Medicare as long-term sources of budget deficits. Which gives me an excuse to add my own two cents to the Social Security debate.

The concept, promoted by President Bush, of turning our Social Security benefits into individual accounts is a terrible idea. We already have that, in spades, with the large-scale abandonment by the private sector (and increasingly by the governmental employment sector) of traditional salary-for-life type pension plans (called defined benefit plans by the professional pension community). They have largely been replaced by individual account plans, such as 401(k) plans, where we already have the ability to build up large individual accounts. We don’t need to abandon the only—relatively modest—defined benefit plan most of us have. Diversity in all things, including the types of pensions we accumulate.

But according to the latest report from the Social Security trustees (http://www.ssa.gov/OACT/TRSUM/index.html), the Social Security Trust Fund is going broke. It is projected to be depleted by 2041, at which point Social Security taxes are expected to cover only 78% of projected benefits. Something must be done. My own personal favorite ideas for closing the gap are:
• Invest part of the Trust Fund in stocks. Virtually all private sector pension plan trustees invest a portion of their trust funds in stocks. Why shouldn’t the Social Security system do the same? Are all these trustees being imprudent? Of course not. To the contrary, the Social Security system is imprudent by design in limiting its investments to low-return Treasury securities.
• Invest part of the Trust Fund in corporate bonds and other private sector fixed income securities. The Trust Fund can then earn a premium over the meager return it gets on Treasury bonds. And today, more than ever, the private sector can use a large new source of credit.
• Gradually increase the retirement age. The Social Security system simply was not designed for today’s longer life expectancies. Increasing the retirement age by a couple of years is fair to all. This can be done gradually so as not to unfairly disrupt the expectations of those now nearing retirement age. That’s how we did it in 1983, the last time we “permanently” fixed Social Security.
• During your retirement, your Social Security benefit is indexed to changes in the cost of living. That’s fair and should be continued. But during your working years your benefit is indexed to average increases in wages—a historically more generous index. To save the system, benefits should be indexed, during both working and retirement years, just to changes in the cost of living and not to changes in average wages.
• To generate more tax revenue, increase the taxable wage base, which is currently capped at $106,800 in 2009. I suggest it be increased to $200,000. To be fair, a new tier of benefit should be added for those paying taxes based on the higher amount, but at a lower percentage than the current highest tier to preserve the progressivity of the system.

I love the Social Security system. I think Social Security is a great achievement in social security. But it needs to be made actuarially sound, and that requires everyone to give a little. What’s your favorite fix?

One Plan. Two Plans. Or Is it Three Plans?

You might say to yourself, “I think I’ll save 8% of my paycheck each month. That seems about right.” Or if you’re already retired, you might say, “I think I’ll spend 5% of my savings this year. That seems reasonable.” Well, where did those numbers come from? A Magic Eightball? Or did they just spring into your head in some divine Eureka moment? You need a plan—a reasoned, flexible, affordable, individually-tailored, reality-based, self-adjusting scheme. One that turns your financial goal into something concrete, a single number actually. If you’re working, that number is how much you should save this year; if you’re retired, that number is how much you should draw out of savings.

Maybe that’s two plans—a savings plan and a spending plan. No, wait, it’s more like two phases of a single plan—a Saving-Spending Plan!

You also need a plan for investing your savings, both during the accumulation (working) phase, and during the spending (retirement) phase. So you also need an Investment Plan to guide that part of the process. But wait! How you invest depends intimately on how much of your investments you’ll be spending, and when. So maybe we’re talking about a single plan: a Spending-Saving-Investing Plan!

Whatever. Whether it’s one plan, two or three, the important thing is that you have a well thought-out procedure for planning your retirement.

Why? What’s so important about a plan? First, it will protect you against chintziness—saving too much and robbing yourself of a more luxurious, but nonetheless affordable, lifestyle. Second, it will protect you against profligacy—spending too much to the detriment of your future self. Third, it will protect you against reaction—investing unwisely—buying high and selling low in response to current (and fleeting) events.

Our capacity for fooling ourselves is boundless. A plan helps guard against our own worst instincts.

Two Degrees of Freedom

Let’s face it. Your life is beyond your control. Way beyond. You’re buffeted about by people, institutions, and mindless powerful forces that seem to conspire to make you jump this way and that, when all you want to do is just amble in one direction for a while.

It’s certainly like that in retirement planning. When you think about it, it turns out you have just two degrees of freedom—two main tools at your disposal to affect your retirement planning: (1) where you draw the line between spending and saving; and (2) how you invest your retirement funds. Two big dials to turn, and that’s it.

The rest is outside your control: How much will your employer help with your retirement? Not up to you. Will the stock market go up or down? Not within your control. Will your income tax rates go up or down? You get no say in that. Will your roof spring an expensive leak? That’s up to the gods.

Certainly, you have other small tools that can enhance your economic well-being. For example, you can carefully titrate how much you distribute from your IRA each year to minimize the long-term tax cost. Or you can wisely decide between a traditional or a Roth IRA contribution. Or you can cleverly select which of your savings buckets should house your stocks and which should house your bonds. Making smart decisions will help—and certainly should be done. But the benefit to be gleaned from them is relatively small compared to the two big enchiladas: where you set your savings/spending dial, and where you set your investment dial.

You adjust your spending/saving dial during your working years by determining how much you will contribute to your retirement savings…which of course leaves you with less to spend on your standard of living. And you adjust the same dial during your retirement years by determining how much you will withdraw from savings, which, when added to your other available resources, like Social Security, determines your lifestyle.

You adjust your investment dial mainly by determining what percentage of your assets will be in stocks and what percentage will be in fixed income investments. For the most part, that’s it. Oh, you can certainly fine-tune the dial by carefully selecting among various subcategories of investments—U.S. stocks vs. international stocks; treasury bonds vs. corporate bonds; or index funds vs. a professionally managed portfolio; Microsoft vs. General Electric. But the big decision is reflected in how far up or down the equity/fixed income scale you’ve tuned the dial.

How do you set these dials? That requires a plan. And that’s a subject for another post.

Meanwhile, I wonder what you think. What are the big decisions within your control that affect your retirement standard of living?

Savings Buckets vs. Investments

I don’t know if you’ve seen the papers, but 2008 was, financially, a pretty crummy year.

And the worst part of it was having to watch the TV newscasters interview ordinary Americans about their financial woes. Well, that and the 25% drop in our 401(k) accounts.

On one newscast, the designated ordinary-American-with-financial-woes made the following statement: “If a Roth IRA is such a good idea, how come mine is worth so much less than what I put in?” The interviewee, to his discredit, failed to note the distinction between his investment—which dropped in value—and the type of savings bucket in which it was housed, in this case a (totally innocent) Roth IRA.

So let’s get this important distinction straight. As you save for your retirement, there’s really two decisions you have to make: Into what type of savings bucket should I contribute my savings? And what investments should I buy with the contents of that bucket? If the ordinary-American-with-financial-woes had understood that distinction, he still would have lost money, but at least he wouldn’t have embarrassed himself on national TV.

There are a lot of different ways to characterize savings buckets. The taxonomy of savings buckets can be as complex as that of the invertebrates. One way to characterize savings buckets is by their tax attributes. From that perspective, there are basically five types of savings buckets (with lots of sub-categories and variations). They are:
• Traditional tax-favored retirement account (such as a traditional Individual Retirement Account or 401(k) account)
• Roth tax-favored retirement account (such as a Roth IRA)
• Taxable investment account (such as a bank savings account or ordinary brokerage account)
• Annuity (such as a deferred variable annuity or an immediate annuity)
• Non-qualified deferred compensation account (available only to highly paid executives)

For most people, the first two are the most important. Why? Because most of us find it hard to save, and if we are limited in our saving, it usually makes sense to put our scarce dollars into the savings bucket offering the greatest tax advantages. And that would be the first two. Of course every savings bucket has its own set of rules to consider—contribution limitations, investment restrictions, distribution requirements, and tax characteristics—which I will save for another posting. For now, I just wanted to note the distinction between the receptacle, and the investments with which you fill it. Just in case you’re the next ordinary-American-with-financial-woes on the nightly news. (I certainly hope not.)

The Goal of Retirement Planning

To plan wisely, you’ve got to have a well-articulated financial goal.

My starting point for articulating a retirement planning goal is that the Future You should be just as comfortable as the Present You—no more, no less. Does the Future You deserve anything less than the lifestyle to which the Present You has become accustomed? I think not. And if you fail to plan, the Future You will rightfully be steamed at the Past You (which is now the Present You) for being so damned selfish, for living so high on the hog without even a thought for the You to come.

On the other hand, you don’t want to save too much either. Why deprive the Present You of the perquisites of an affordable lifestyle just so the Future You can live in greater luxury? Who died and made him king? Particularly since part of the time, the Future You will be elderly and presumably less able to enjoy some of the finer things—like travel, skiing and chewable solids. No, the goal here is to be like Goldilocks and to get your spending-saving balance just right (as best you can within the rather unforgiving limits of uncertainty), so that you enjoy a consistent standard of living, one that neither declines precipitously nor spikes vertiginously when you shift from working to retirement.

What does that mean? How do you turn that rather abstract and facile formulation into something more concrete—a dollar-denominated financial goal that you can aim at and plan for? I will cover that in future posts, but for now I would just like to suggest the guiding principle that the Present You and the Future You are equally deserving sentient beings.

I would also like to point out that the process differs a bit depending on where you’re currently sitting.

If you are just now embarking on, or already in, your retirement years, then presumably your available resources are set. There’s no more additions coming into your retirement war chest (other than investment earnings); just a lot of outgo. So the principle of equality leads to an exercise in establishing a spending plan that parcels out those resources over your and your spouse’s remaining lives, so your standard of living is roughly the same for the rest of your lives. In short, to determine an allowance for yourselves—one based not on the standard of living you wish you had, nor on the standard of living you enjoyed while working, but rather on the standard of living your now-cast-in-stone resources will allow. And then to find a way to live within that allowance.

If you are still in your working years, then the principle of equality leads to an exercise in setting aside some amount annually from your current salary, leaving you the same amount to spend every year, such that when you stop working you will have built up enough of a financial war chest to continue the lifestyle you got used to during your working years.

Of course there are lots of big and little adjustments to make in these processes that are unique to you. In future posts I will go over some of the more common ones. But I hope you agree with the basic principle. Both of You—Present and Future—deserve the same standard of living, neither one to be preferred over the other. The concept of discounting the future, while okay for future cash flows, has no place in setting both You’s standard of living.

I’d be interested to hear if you agree.

Introducing a New Retirement Planning Blog

Welcome to The Two Legged Stool. I am so glad you stumbled upon—or, even better, were referred to—this brand new blog.

The Two Legged Stool is all about financial planning for retirement. It is a place to explore the really tough financial issues facing all of us. While I’m working, how much should I save? When I’m retired, how much should I spend? How do I invest my funds along the way? What are the best savings vehicles for me? Simple enough questions; no simple answers. The Two Legged Stool will be a forum—to raise planning questions, to suggest answers, to share experiences, ideas and opinions. My first goal is for these posts to be concise, cogent, clear-eyed, insightful, unbiased, thought-provoking, far-sighted, accurate, and helpful. That’s my job. Your job is to add your voice and view for the benefit of the entire readership, to tell me where I’m wrong, to add your opinion and perspective, to share your experience, to react.

Why “The Two Legged Stool”? Traditionally, retirement is supposed to be built on a three-legged stool: personal savings, a governmental component (Social Security), and an employer-provided pension. But the third leg is disappearing (and the second leg is looking a tad wobbly). The traditional pension plan for life is largely becoming a thing of the past—like the VCR and the Walkman. According to the Center for Retirement Research at Boston College (crr.bc.edu), only 38% of private sector employees who are covered by an employer retirement plan are accruing a traditional pension, down from 83% in 1980. Even if your employer has replaced its pension plan with a 401(k) plan or something like it, that just leaves you with a souped-up savings account. You’re still largely making your planning decisions on your own, balancing on a two-legged stool.

As individuals, we have to decide how much to save, how to invest it, how much to spend. These are difficult—perhaps impossible—challenges even for the most experienced financial professional. So how are we supposed to make these decisions? After all, we’re mail carriers, doctors, construction workers, shoe salesmen, lawyers, teachers, Indian chiefs; we’re not practiced in the black arts of financial planning. The Two Legged Stool is (or will become) a good place to start to lift the fog of indecision and to zero in on answers. So, if you are located somewhere between your first job and the grave, stay tuned.

Who am I; and why should you care what I have to say? My name is Martin Silfen, and these are my qualifications:
• I am retired.
• I have professional bona fides. I spent my entire career steeped in retirement planning. For 21 years I practiced law (primarily in Atlanta), specializing in retirement planning and estate planning. For eight years, I worked in the investment world, providing retirement planning (and other financial planning) advice to individuals throughout the country.
• I have written and spoken extensively on the subject, primarily for the professional community. That includes two books, now, sadly, out of print: The Retirement Plan Distribution Book (1999, National Underwriter Company), and The Retirement Plan Distribution Advisor (2002, National Underwriter Company). For eight years I served as Retirement Planning columnist for Personal Financial Planning, a professional financial planning journal, also, sadly, no longer published. For two years I wrote a Q&A column for BenefitsLink.com, the country’s leading website for employee benefits professionals.
• I am unbiased, clear-eyed, and wise.

Please let me hear from you. Tell me when I’m wrong. What specific topics should I cover? Let’s have a dialogue. We’re on our own, but we’re in this together.