Three Functions of Retirement Savings

OK. So you’ve built up this nice big pot of assets on which to retire. As you embark on the difficult quest of adopting a retirement spending plan—your scheme for determining how much you’re going to allow yourself to spend each year—your allowance, as it were—it’s helpful to consider the three main functions of that cache. Here they are in order of importance, at least for most people:

1. A source for your annual retirement spending. Duh.
2. A reserve for unanticipated emergencies.
3. An inheritance for your heirs, usually your kids.

Let me dwell on these functions in reverse order.

Inheritance. Not so important for most people. You’re struggling just to maintain your own lifestyle, so how can you give any weight to luxuries for the next generation? So function #3 is strictly on the back burner. But two points are worth noting.

First, at some point, if the pot is large enough, the marginal utility of spending another dollar on your standard of living is just not enough to outweigh the pleasure you’d get from leaving—or giving—something to your kids. Maybe you’d rather help them make a down payment on their first house than buy yourself that pearl-handled backscratcher you admired in the window at Tiffany’s.

Second, as discussed in March 20’s post, leaving an inheritance is an inevitable, if unintended, by-product of not knowing how long you and your spouse are going to live.

Emergency Reserve. Stuff happens. You plan to spend your assets roughly equally each year, but then the roof springs a leak. Or Bowser contracts canine chilblains. Whatever. Even if you do your financial planning perfectly, and your investments perform just as you project (which they won’t; I’m just making a point here) life will hit you with your own personalized pig bladder. So you need to keep a reserve for the inevitable unexpected. (Is it correct to call the inevitable “unexpected”? Probably not.)

Note, however, that your need for an emergency reserve shrinks with your shrinking life expectancy. One year older? That’s one less year of financial curveballs ahead of you.

Retirement Spending. The main function of that pot you’ve accumulated (the financial one; not the one hanging over your belt) is to provide a stream of spending for your indeterminate lifetime. While you don’t know how much you’re going to need for the future, you have a rough sense that it shrinks as you get older: fewer years left to spend on yourself; fewer years to get stung by crummy financial markets. So perhaps the percentage of assets that you spend should somehow—slowly and conservatively, but somehow—grow with the passing years. Maybe an 85-year old can prudently spend a bigger percentage of her assets than a newly superannuated 65-year old.

So those are the three main functions of your treasure trove. (What have I left out? Send me an email or post a comment.) Now the tricky part is to translate these generalizations into a scheme for spending your assets prudently. More to come on this—much more.

State Taxation of Retirement Distributions

How will your state tax your retirement distributions? That’s a cost which you will need to take into account as you set your savings goal.

Most states have their own income tax. A few states, like Florida, have no income tax. (What fuels their government? Sunshine? ) Of the states that do impose an income tax, many have chosen the expedient scheme of piggy-backing onto the federal income tax system by starting the state tax calculation with the income and deduction figures from your federal tax return, and then adding and subtracting a few adjustments from there. So in these states, if a dollar of distribution from a retirement account is taxable for federal purposes, it will be equally taxable for state purposes, at least initially. And in these states, if—as with a well-timed Roth IRA distribution—it’s not taxable for federal income tax purposes, then it won’t be taxable for state income tax purposes either.

Some states have enacted a special benefit for their senior citizens. New York, for example, exempts up to $20,000 of otherwise taxable retirement income from state tax. Thank you, New York!

Imagine this scenario, which is not atypical. You work all your life in a high tax state, like New York or California. During all those years you are earning contributions to retirement accounts which are not being taxed. Some contributions are made by your employer, and some are made by you (think 401(k)). These contributions have gone into the Tax Time Machine, as described in January 29’s post. Then you retire to sunny Florida—which has no income tax—and you start taking distributions from these accounts. “Wait a minute,” says the state of California, “you earned those dollars when you were working here. We want to collect some of that tax revenue, no matter where you live. We’re coming to get you!”

Can California do that? No, they can’t. They tried to, a number of years ago, and in response Congress passed a law making it illegal for a state to tax retirement plan distributions to residents of another state, even if the non-resident had earned the contributions while living and working in the taxing state. This law applies to tax-favored retirement accounts, like IRA’s and 401(k)’s, but it doesn’t apply to many non-qualified deferred compensation plans.

(What’s a non-qualified deferred compensation plan? It’s a kind of retirement plan only available to highly paid employees. If you’ve got one, you know what it is.)

So as you do your planning, and project your tax costs, pay a bit of attention to your state’s taxing scheme.

Predicting Income Tax Rates

Can anyone predict the future of our income tax rates? David raised that issue in a comment to April 27’s post. I guess the correct answer is, yes you can predict future income tax rates; just not accurately.

In that regard, income tax rates are just like any other unknown variable that affects your retirement planning. How will your investments perform? How long will you live? What will Polident cost? You make your best guess and project from there. Then you stress test. You change your assumptions to see how that affects your projections.

My crystal ball is just as cloudy as yours, but I expect income tax rates will have to rise to pay for new health care initiatives, the recent stimulus plan, the unrecovered costs of bailing out the financial system, and the rest of the $10 trillion national debt that has accumulated since 1791.

A good starting point for projecting future income tax rates is to look at President Obama’s proposal. Right now it’s a little short on detail, but one feature would increase the highest marginal tax rate from 35% to 39.6% for incomes over $250,000 (over $200,000 if single). It would also increase the long-term capital gains tax rate and dividend tax rate to 20% for the same taxpayers. The phase-out of personal exemptions and itemized deductions would be reinstated, effectively tacking on a hidden tax rate of about one percentage point to high income people’s nominal tax rate. And the tax benefit of itemized deductions would be capped at something like 28%.

An aside about that last potential change. It sure sounds like it’s going to add a huge amount of complexity to an already overly complex Tax Code. And how will it interact with the Alternative Minimum Tax? Under one scenario, people who live in high-tax states like New York and New Jersey, whose deductions are already wiped out by the Alternative Minimum Tax, might not be adversely affected by this new wrinkle. But residents of no-tax states like Florida and Texas will. Maybe Treasury Secretary Geithner, in his spare time, can think of a way to get a similar revenue impact without adding undue complexity. Perhaps just add a point or two to the highest tax bracket.

The likelihood of higher future tax rates really turbo-charges the idea of converting your IRA to a Roth IRA in 2010.

Your Teenager’s Retirement Saving

Teenagers. Ya gotta love ‘em. It’s like having your own personal Linda Blair around the house. As long as you’ve got to get yourself and your kids through the high maintenance teenage years, you might as well impart some good habits along the way. Like acceptable hygiene. And retirement saving.

When they get that first summer or after-school job, they are going to have a lot of discretionary income—a lot compared to what they need and are used to. So there’s no better time than the teenage years for them to begin the saving habit—setting aside a portion of their working income in a savings bucket of one kind or another. Saving is like playing baseball or doing crossword puzzles or lifting weights or playing guitar—the more you do it, the better you get at it. It becomes second nature. So there’s no better time for a person to learn how to save than when she has her first taste of discretionary compensation.

You might even encourage your kids’ saving habit by subsidizing it. Maybe give them a dollar for every two they put away in a savings bucket, so they can continue to enjoy some of the consumption benefits of their hard-earned income. It’ll be like your own family matching contribution.

So what’s the best kind of savings bucket for a teenager? That’s a no-brainer. It’s the Roth IRA! Teenagers don’t have much income (except for Miley Cyrus) so they usually meet the qualification rules for contributing to a Roth IRA, as described in February 4’s post. And for a teenager, the tax cost of foregoing a deduction (had they instead contributed to a traditional IRA) is very small; maybe even zero. Then the dollars they put aside—and every dollar of investment earnings for the next 70 or 80 years—is totally tax-free. What a deal!

Now don’t you wish you were a teenager again so that you could start your own Roth IRA? When I was a teenager there was no such thing as IRA's or Roth IRA's. Or electricity. Or the wheel.

Ed Slott’s Retirement Planning Advice

This is hard to believe, but I saw a TV show about retirement planning. Not only that, but it was two hours long. Not only that, but it was on a PBS station. Not only that, but it was shown as part of their annual pledge drive to get you to send them some dough. You’d think they would show reruns of Simon and Garfunkel in Central Park from 25 years ago; but, no, instead it was a lecture by noted authority Ed Slott on securing your retirement. (Thanks to my friend Denis who alerted me to the show, so I could DVR it and skip over the pledge parts.)

Of course, it’s hard to convey lots of good little ideas in a two-hour mass-audience TV show, but he did an excellent job of summarizing the big picture:
• Know where you stand;
• Educate yourself about your options;
• Get good advice;
• Take the long view;
• Take action in small consistent steps.

You’ve got to agree with him on these recommendations.

Not surprisingly, Mr. Slott turns out to be a big fan of the benefits of Roth savings. His take on it is that with the amount of borrowing we do as a society, and the concomitant deficits we’re running, tax rates are bound to increase, so it will turn out to be a bargain to pay your tax obligation on your retirement accounts now, when tax rates are at historic lows, before they inevitably rise to dig us out of the hole we’ve gotten ourselves in. It’s hard to argue with his logic.

Buried in Ed Slott’s big picture was a small-picture idea that I thought was pretty clever. I’ll use tomorrow’s post to pass it along.

Retirement Weights and Measures

Yesterday’s post had some good stuff buried in it. (If I may be so immodest.) Its main thrust was to explore how much of your recent stock market losses you might be expected to make up with an additional year of work. But an important underlying predicate needs to be highlighted: Money is meaningless.

Whoa! Money is meaningless?

By that I don’t mean “the moon and the stars are for everyone,” or anything like that. Rather, I mean that a pile of bucks is simply too abstract for us. We can’t grasp its value. We need to find personal equivalencies—our own individual metric system of weights and measures—to translate a large savings bucket—or a large loss in a savings bucket—into what it means for us personally.

Take Ernie for instance, from yesterday’s post. He suffered a $430,000 loss in his $1,200,000 retirement savings bucket during the recent Unpleasantness in the financial markets. What does that mean? What are its equivalencies?

Money Equals Allowance. Ernie found that, for him, based on where he is in life (the cusp of retirement), $430,000 equals $17,000 of annual retirement spending; allowance if you will.

Money Equals Lifestyle. Ernie might take the next step and mentally tote up the adjustments in his lifestyle he would have to make to fill a $17,000 gap in his budget. Dinners out; vacations; how frequently he changes his razor blades; perhaps moving to a less expensive home. Whatever. (Me? I used to like to buy the books I read; now I use the library. Other adjustments as well.)

Money Equals Future Years. If Ernie were not on the cusp of his retirement, and was planning to work anyway, he could project how many years of average investment earnings it would take for his savings bucket to grow back to its pre-Unpleasantness value.

Money Equals Past Years. If he wanted to, Ernie could comb through his account statements and count how many years back he’d have to go before his savings buckets were as low as they’ve recently gotten. Knowing that might be important to Ernie. There’s a lesson in there somewhere.

Money Equals Expectations. It might be instructive for Ernie to go back over his past few years’ annual statements to see how his expectation for his future retirement fluctuated with the ups and downs of his savings buckets. Which year’s expectation was the most realistic? It’s human nature to focus on the very highest, thereby ratcheting up our expectation for the future. But then we are left bemoaning the inevitable drop in expectation. Was our highest expectation ever the most realistic? Likely not; but it’s the one we measure against.

Money Equals Work. Ernie projected that it would take about four more years of working, at a time he was ready to retire, to make up his $430,000 loss.

Money Equals Peace of Mind. Ernie feels more financially vulnerable than he did a year ago. I don’t know how to measure that. Perhaps he can count the number of additional pharmaceuticals he now takes to be able to sleep at night. Or perhaps his new-found fear of losses has caused him to adjust his asset allocation to one that’s less equity-oriented; one that trades off higher projected allowance for greater stability.

How do you translate your money into something you value?

Income: A Four Letter Word

The word “income” should be outlawed. Or if not outlawed, at least treated with same disdain and awkward silence that might greet an ethnic slur or the word “groovy.”

“Income” means so many different things—some precise, some vague and ill-defined—that its use can’t help but engender miscommunication. You mean one thing when you say “income,” I take it as something completely different, and—presto—miscommunication.

Or worse, even within the quiet confines of your own mind, using an ill-defined concept of “income” can lead to the capital crime of sloppy thinking.

Consider all the different meanings of income. Imagine you have a $5,000,000 pot of assets to retire on. Pretty nice thought, eh? You could live quite comfortably off that. Let’s say you decide to use the 4% Plan as described in January 13’s post (which I don’t particularly care for, but at least the arithmetic’s easy). So you pull out $200,000 to spend. What is your income?
• If that $5,000,000 is in a traditional IRA, and you take a $200,000 distribution, your tax accountant would say you have $200,000 of income. She’s thinking taxes and gross income.
• If you tell your accountant you have made $100,000 of non-deductible contributions to the IRA, she might say you have $196,000 of income. She's still thinking taxes, but now she’s thinking taxable income.
• If instead that $5,000,000 is in a trust Grandma left you, and the trust’s investments yielded, say, $100,000 of interest and dividends, your trustee would say you’ve gotten $100,000 of income and $100,000 of principal. He’s thinking traditional accounting income.
• If the trustee was a bit more modern, and applied his newfangled powers to redefine trust income, he might instead say that the entire $200,000 is income. He’s thinking modern trust accounting income.
• If you’ve decided to spend $200,000 because that’s the largest annual amount you think the pot will sustain for your whole lifetime, you might think that $200,000 is your income. You’re thinking of sustainable spending as income.
• If the $5,000,000 is in a managed investment account, which grew $400,000 in value during the year (not 2008 obviously), your investment advisor might say you had $400,000 of income, irrespective of how much you have chosen to spend. He’s thinking of investment performance as income.
• If, to get your allowance converted to cash, you had to sell $200,000 of appreciated stocks originally costing $50,000, your accountant might say you’ve got $150,000 of income. Again, being tax-oriented, she’s thinking of realized capital gain as income.
• If you took the whole $5,000,000 and bought an annuity paying you $300,000 per year for life, your insurance agent might say you’ve got $300,000 of income. She’s thinking of the annual annuity amount as income.

Eight different meanings of income, all valid within the appropriate context. But what really counts? Ask your grocer or your mortgage lender or your cable company. They just want to be paid in cash. They don’t care whether it’s income in any sense of the word. Really, income just doesn’t matter.

My, How the Little Things Add Up

In a number of prior posts I’ve discussed some ideas for making your retirement savings go further. For the most part, each idea is a modestly good idea, but taken together, they can add up to a great idea. Huge! And that’s today’s task—to put it all together with an example. The results are amazing and heartening.

Consider Wally Cleaver. He’s grown up now. In fact, he’s age 40, with a family and everything. To date, Wally has saved $50,000 in a taxable investment account. Wally has analyzed his many savings options. He thinks of them as creating many different futures—Wally Worlds, if you will. Wally projects how much each additional good idea, layered on top of the others, will add to his annual after-tax retirement spending. All of his projections are shown in real, inflation-adjusted dollars, to keep them meaningful. And all in after-tax dollars, as well, because you can't spend money that goes to the government. The assumptions that went into Wally’s projections are shown in the chart below.

Wally World One. $6,320 per year.
Wally does nothing special and continues to invest his existing savings in an ordinary taxable investment account. He projects that his $50,000 of savings will eventually, at age 65, buy him a retirement of $6,320 per year. A nice start.

Wally World Two. $7,268 per year.
Wally decides to do the hard thing—to forego some spending this year and add $7,500 to his investment account. (In fact, he postpones a planned cross-country trip with his wife and kids to a Disney-esque amusement park.) Giving up some luxuries hurts, but it adds $948 to his annual retirement spending. That’s after-tax and expressed in today’s dollars. Foregoing the pleasures of consumption is the hard part. It gets easier from here.

Wally World Three. $7,950 per year.
Instead of adding $7,500 to his taxable investment account, Wally makes a $10,000 pre-tax elective deferral to his employer’s 401(k) plan. It costs him the same $7,500 as in Wally World Two because he is in the 25% tax bracket. Just by contributing his savings to the right bucket, Wally has increased his future after-tax retirement spending by another $652 per year. Way to go, Wally!

Wally World Four. $8,398 per year.
Wally increases his 401(k) deferral to the maximum $16,500. But he doesn’t decrease his spending by more than the $7,500 of Wally World Two. Rather, as described in February 8’s post, he spends $4,875 from his taxable savings account (shrinking it to $45,125). Because of the tax deduction, it only costs him $4,875 to increase his 401(k) deferral by $6,500. And doing this adds $448 to his retirement spending. Here’s something worth noting: The last two steps combined added more to Wally’s projected retirement spending than did his painful and heroic effort to save $7,500. And they didn’t require any further spending reductions! Oh, happy day! But wait; there’s more!

Wally World Five. $8,722 per year.
Wally has read January 15’s post and decides to make the $16,500 deferral on a Roth basis. The loss of a deduction costs him $4,125 of additional taxes (further reducing his investment account to $41,000). But it has a long-run tax benefit, which increases his projected after-tax retirement spending by an additional $324. Hey. Why not?

Wally World Six. $8,919 per year.
After reading February 15’s post, Wally decides to take another $5,000 out of his investment account (reducing it to $36,000), and use it to open a $5,000 IRA. He has read February 14’s post and has concluded that the contribution won’t be deductible to him, but he finds it to be a worthwhile step nonetheless. In fact, he projects it will add another $197 to his annual retirement spending. And, again, without breaking a sweat.

Wally World Seven. $9,217 per year.
Wally decides to expend some effort to lower his investment costs for his (now three) savings buckets, as described in yesterday’s post. He finds he is able to shave his expenses by a modest 0.1% (10 basis points, in investment world jargon). Wally projects that this modest savings will increase his after-tax retirement spending by another $298 per year. Not a huge amount, but he’ll take it.

Wally World Eight. $9,630 per year.
Wally has read February 12’s post, and decides to do some future spigot planning. When he gets to retirement, instead of spending down his three savings buckets proportionately (as was assumed in prior Worlds), he plans to spend them down in the order that will optimize his annual after-tax spending. He projects that doing this will increase his after-tax spending by another $413. It’s money for nothin’!

Wally World Nine. $10,636 per year.
Wally decides to go further and engage in asset location planning (after reading February 13’s post). He projects that by cleverly allocating his stocks and bonds among his three savings buckets he can increase his retirement spending by another $1,006 per year compared to investing his three savings buckets in the same stock/bond proportion. Cool!

Wally World Ten. $10,967 per year.
What! Yet another world? Yes. Wally has read February 10’s post, and, seeing that he has adjusted gross income of less than $100,000, he realizes he can convert his new $5,000 traditional IRA to a Roth IRA. (And in Wally’s unusual situation, he pays no income tax to do so. The value of his IRA is equal to his after-tax contributions, and he only has to pay income tax on the difference, which is zero.) He projects that this step will increase his retirement spending by another $331. Free money!

Now just look at the aggregate results. Struggling to save $7,500 added $948 per year to Wally’s future retirement security. But just being clever about how he arranges his savings, adds even more: another $3,698. That’s a four-fold increase! Who knew?!

The Illusion of Probability

Did you spot the fallacy in yesterday’s post?

Here it is: It is misleading of me—and frankly of the whole financial profession—to assign probabilities to levels of confidence. How do you know that it’s 50% probable that you’ll be able to spend this amount or that? Nobody knows the future. And nobody even knows how to assign probabilities to the future. Nonetheless, I will continue to do so, because it serves a useful purpose.

I think I better explain myself.

When you flip a coin, you don’t know what the outcome will be—heads or tails. But at least you know that it’s 50% likely to be heads. You have some certainty about your uncertainty. But with financial matters, we don’t even have that. We can pretend to assign probabilities to various outcomes, e.g., “the stock market is 50% likely to return 9% or more over the long-term.” We might glean these false probabilities from the market’s historical performance. Or we might glean them from sophisticated modeling employing Monte Carlo simulations (which are, at bottom, based on historical performance). But the fact is that the financial markets simply don’t follow the same neat laws of probability as coin flips do.

In his eye-opening book, The (Mis)behavior of Markets, the eminent mathematician (and some-time economist) Benoit Mandelbrot totally debunks the illusion that market prices bear any resemblance to coin flips. Rather than following the same neat laws of probability, markets follow their own logic. Millions of people buying and selling, each motivated by their own needs, opinions, and prejudices, create a turbulence that can’t be explained by the same rules that govern coins and dice. See 2008 for an example.

(By the way, Mandelbrot has earned his credibility. He is one of the founders of chaos theory, and the discoverer of the “Mandelbrot set.” Should you happen to get a case of the visual munchies, gaze at a picture of the Mandelbrot set for a while. You can see an animation of it in Wikipedia here. Scroll down to the heading labeled "Zoom Animation.")

So if we can’t legitimately assign probabilities to financial outcomes, why did I do that in yesterday’s post? And in January 14’s post? What kind of double-talk is this? I think assigning fake probabilities serves a useful purpose. It provides a basis for comparison. We can all agree that “50% confident” is better than “25% confident.” But just don’t fall for the illusion of precision. I can’t legitimately say that “50% confident” is twice as confident as “25% confident.” The numbers are just not that meaningful.

Your Number

Everyone wants to know, “What’s my Number?”

How much do you need to accumulate in order to retire securely, to cut your lifeline to the main source of your income? A couple of years ago, Lee Eisenberg wrote an excellent book called The Number. In it he asks you to think about the tough issues you have to wrestle with before you can even think about arriving at an answer. One of the main purposes of this column is to take the next step, to go beyond the broad issues raised in the book and to (gradually) give you the tools to arrive at your Number.

The first thing you have to realize is that the savings you need to accumulate—your Number—will really buy you two distinct things: the dollars to meet your standard of living, and security that there’s enough remaining to last your and your spouse’s lifetimes. For shorthand, let’s call them “Consumption” and “Confidence.” Every penny you add to the pot can buy you more Consumption or more Confidence, but not both. A glib financial planner might ask, “What would you rather do? Eat better or sleep better?” (Financial planners learn that question in Chapter 1 of the Junior Woodchuck Guide to Financial Planning.)

A quick diversion. There’s actually a third thing that goes hand in glove with Confidence, and that’s an inheritance for your children or favorite charities. The less you spend on Consumption and instead allocate to Confidence, the more you increase the likelihood and size of your kids’ inheritance. So to be more accurate, the dichotomy is not between Consumption and Confidence, but between Consumption and Confidence/Kids. I think most of us are struggling to earn a decent retirement, and are not particularly motivated to grow their kids’ inheritance. Nonetheless, that becomes an inevitable by-product of increasing your Confidence. Think of it as their unintentional inheritance.

What makes it so hard to come up with your Number is your need to figure out where you sit on the Consumption-Confidence matrix. It’s relatively easy to get a handle on Consumption. You sort of know how much you’re spending—the cost of your lifestyle. But Confidence is another dimension altogether. What does it mean to say you’re 50% confident? 75% confident? 99% confident? 100% confident? (No, forget 100% confident. There’s no such thing.)

And are you really so self-aware that you can focus on alternative hypothetical standards of living? I want to be 99+% sure of a $50,000/year standard of living; 75% confident of a $60,000/year standard of living; and 50% confident of a $70,000/year standard of living. If you’re a genius of self-awareness, you can come up with more and more ever-finer Consumption-Confidence goals. Each one will (eventually, with enough tools and work) translate into a savings goal. And then your target—your Number—is the largest of the goals you’ve been able to think of.

Can you spot the built-in fallacy in today’s post? For the answer, see tomorrow’s post.

Projections, Predictions, Assumptions

Yesterday’s post talked about the need to do a new projection every year as a way of constantly adjusting your planning to reality. Makes sense. But . . . what’s a projection? Here’s the transcript of an actual recorded conversation between Kwai Chang Caine and Master Po.

Caine: “What’s a projection, Master Po?”
Po: “It’s an educated guess about the future, Grasshopper”

“And do I get this guess from a Magic Eightball? Or from the wind?”
“No, Grasshopper, it’s an educated guess. No fingers in the wind. You start with the facts—the things that are real. To that you add assumptions about the future—how long you will live, what your investments will earn, how much your salary will be—such things as that.”

“So these assumptions, they are my predictions for the future?”
“No! No predictions! We are Shaolin priests, not charlatan fortune tellers!”

“Thank you for correcting me, Master. I am humbled by your wisdom. And where do these assumptions come from?”
“You must glean them from the world as you see it. You can take them from history. Or from indicators if you like. Or from reputable experts. Whatever source is rational and readily at hand.”

“Can I take them from different sources in different years?”
“Bad idea, Grasshopper. That is a prescription for fooling yourself. And a Shaolin priest, above all else, never fools himself. Try to avoid switching sources. Be consistent in the source for each of your assumptions”

“So this annual prediction . . . no, projection . . . it is my educated guess as to the most probable outcome for the future?”
“Close, Grasshopper. Not the most probable. But rather, the expected outcome. The probable center of all possible outcomes.”

“I think I understand, Master. But I must ask one more question if I may.”
“Knock yourself out, Grasshopper.”

“You said I could find reasonable assumptions from history if I choose, such as average returns on stocks or bonds. But Master Kan has taught me that history is no predictor of the future. So how is that a reasonable basis for making a projection? Or projecting an expected outcome?”
“That’s a tough one. We Shaolin masters think long term. And we believe that certain historical long-term tendencies are likely to reassert themselves in the long-term future.”

“That still sounds like double-talk to me. No disrespect intended, Master.”
“Shaolin masters do not engage in double-talk, Grasshopper. Now go out and preach the ways of peace. And beat up some bad guys with your stick.”

Your Annual Date with Reality

Get real. Really. At least annually, get real.

Whether you’re in your working years or your retirement years, the main challenge of retirement planning is figuring out an appropriate amount to save (in your working years) or to spend (in your retirement years). Actually, the main challenge is then sticking to your budget. But the main planning challenge is figuring out this amount. The amount you come up with is bottomed on projections about the future, which will most assuredly not come to pass. They’re just guesses after all. Reality and your projections diverge a little bit more every day.

These divergences come from all over the place. They come from outside your personal life, such as the financial markets (was it a better than projected year for stocks, or worse?); and from events unique to you—an unexpected bonus, a surprise leak in your roof.

So the method you’re using to come up with your saving or spending amount had better have a built-in mechanism for periodically adjusting to cold reality. If you don’t, one of two things will happen. If things go worse than you projected, you will gradually pauperize yourself. If things go better than projected, you will gradually build up an inheritance for your children (the worthless good-for-nothings!) at the expense of the more comfortable lifestyle you could have treated yourself to.

How often should you recalculate? At least annually. You could do it more frequently, like monthly, but you’d drive yourself crazy. Your saving/spending amount would bounce up and down with the same sort of volatility as you see in your 401(k) statement. You’d be seasick in no time. Or you could do it every five years, but then your adjustments would be vertiginous. Annually seems about right. Pick a month, and then set aside some time for your annual review. I don’t like December for this task—too much other stuff going on. January or February seem about right. A good time to be inside; not much else happening then (unless you celebrate President’s Day bigtime); early enough in the year to adjust your elective deferral to your 401(k) plan.

The benefit of annual adjustments is that they will be small in relation to the size of actual events. The younger you are when it happens, the smoother the adjustment. That’s because you have a whole lifetime to make up for (or revel in) the large unexpected loss (or gain).

Here’s a f’rinstance. Remember Ernie from January 21’s post. He had $75,000 in his 401(k) plan, and projected an annual savings goal of $8,426 over the next 25 years. Let’s say instead of earning 6% as projected, his 401(k) account lost 33% of its value, dropping to $50,000 (sound like 2008?). When Ernie refigures his annual savings goal the following year, all other things being equal, it will work out to $10,776 per year for the next 24 years. That’s a $2,350 increase in required saving to make up for a $25,000 loss. It will pain Ernie to reduce his current spending by that amount, but it won’t devastate him.

If you’re in retirement, your adjustment might be more dramatic. That’s a subject for another post.

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.

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.

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.

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?