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| Determine how the real return from an investment compares to the real return hurdle. |
PART 2 of 7 Series:
THE ROAD OF RETIREMENT
The Process of Managing Retirement Income
Baby-boomer retirees may be particularly susceptible to the eroding effects of inflation, given that they will be less likely than past generations to have some form of pension that could be indexed for inflation.
This generation is relying more on savings accumulated in 401(k), 403(b), IRA, and after-tax savings accounts to support them in retirement. Unless these savings are prudently invested during retirement to allow the income stream to grow at a pace comparable with the increase in inflation, purchasing power will be diminished.
To illustrate this concept, let's use a simple hypothetical case of a retiree who has $1 million in retirement savings and has decided to spend the amount evenly over a 30-year period ($33,333 per year). The retiree also decides not to invest the money to ensure safekeeping. Over the next 20 years, at an average annual inflation rate of 3%, purchasing power drops by 42% to the equivalent of $19,010 per year; and if inflation runs at 4% annually, purchasing power declines by 52% to $15,821. Imagine retiring at age 62 and by age 82 only being able to spend the equivalent of $15,821 per year in today's dollars!
3 Basic Variables to Retirement
BABY BOOMER RETIREES ARE SUSCEPTIBLE TO THE ERODING EFFECTS OF INFLATION
There are three basic variables that a retiree needs to factor: the length of time to be spent in retirement; the initial spending rate desired; and a legacy, if any, that the retiree wishes to leave. Each of these variables is described below.
* Time Frame – the longer a retiree plans for their retirement to last, the more investment earnings are needed to support it. For retirement planning purposes, most advisors will use a minimum of 30 years, but in some instances 40 years may be even more realistic.
* Spending Rate – the first year's after-tax spending amount (say $40,000) divided by the total retirement savings (say $1 million) for a 4% initial spending rate.
* Legacy – how much of the initial retirement savings account is desired to be left as a gift to family members or charity upon the end of the retirement period.
Combining these three factors and preparing a simply cash flow model yields a real return hurdle (after the cost of inflation, investment expenses, and taxes) that must be achieved or exceeded each year to provide a retirement that will sustain itself for 30-40 years and beyond.
For a majority of the baby-boomers retiring in the coming years, most, if not all, of the retirement savings accumulated during retirement plus the future earnings on these savings will be spent over their planned retirement period. The concept of spending some, if not all, of the retirement savings to fund a retirement will be the norm, not the exception.
Retirement Return Hurdle
STARTS WITH IDENTIFYING EACH RETIREE'S UNIQUE COST STRUCTURE
For these retirees, a legacy amount will be available only if they do not use all their financial resources due to an unusually strong investment market or if spending amounts are actually less than planned. However, for those retirees who want to plan a legacy at the beginning of the retirement plan the real return hurdle would be required to provide for a sustainable spending plan, plus leave a legacy at the end of the 30-year plan. Needless to say, higher returns are required to achieve both objectives.
Planning for a 30- to 40-year retirement period makes preserving purchasing power of paramount importance.
Being able to see how the retirement plan variables relate to a real return hurdle is a great first step. Going through the process of identifying each retiree's unique cost structure, including inflation assumptions, investment expenses, and taxes, will determine how the real return from an investment compares to the real return hurdle needed to accomplish the plan.
Please note that any discussion related to average returns over a long period of time, such as a 30- to 40-year retirement, needs to be accompanied by a good understanding of the order in which returns are realized, called the "sequence of returns". For a retiree who is liquidating a small amount of their retirement savings each year to support the expenses, the order in which returns are realized is very important. We have addressed this sequence of return issue as a separate piece in this kit and it should be deemed as integral part of the discussion on preserving purchasing power.
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Disclosures:
Bonds are debt investments in which an investor loans money to an entity (corporate or governmental) which borrows the funds for a defined period of time at a fixed interest rate. Bonds are subject to certain risks including loss of principal, interest rate risk, credit risk, and inflation risk. The value of a bond will fluctuate relative to changes in interest rates; as interest rates rise, the overall price of a bond falls.
Government bonds, or Treasuries, are negotiable debt obligations of the U.S. Government, secured by its full faith and credit and issued at various schedules and maturities. Income from Treasury securities is exempt from State and local, but not Federal, taxes. Treasury bill data is based on a one-bill portfolio containing, at the beginning of each month, the bill having the shortest maturity not less than one month. Intermediate government bond data is based on a one-bond portfolio with a maturity near five years. Long-term government bond data is based on a one-bond portfolio with a maturity near twenty years.
A corporate bond is a debt security issued by a corporation. Corporate bonds are taxable and have more credit risk compared to Treasuries. The Citigroup Long-Term High Grade Corporate Bond index includes those issues from the Credit Index that have at least 10 years to maturity (long term) but exclude asset-backed securities and non-U.S. sovereign/provincial issues.
A stock is a share in the ownership of a company. As an owner, investors have a claim on the assets and earnings of a company as well as voting rights with the shares. Compared to bonds, stock investors are subject to a greater risk of loss of principal. Stock prices will fluctuate, and there is no guarantee against losses. Stock investors may or may not receive dividends. Dividends and gains on an investment may be subject to federal, state or local income taxes.
Standard & Poor's 500 Stock Index is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe.
