Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer (2016)

Part III. PLANNING FOR THE INEVITABLE

Chapter 12. FINANCIAL INDEPENDENCE: The New Retirement

WHY do I need to read this chapter?

The topic of retirement strikes at the heart of Enough. And more than most, because it directly addresses the fear of not actually having, well, enough. In chapter 6, we took a look at where you stood according to Fidelity’s retirement index. In this chapter, we’re going to go further.

I’m going to give you more individualized guidance for how to view retirement (and saving for retirement) for future retirees who are currently in their 20s, 30s, 40s, and 50s, as well as those who are glimpsing retirement on the not-too-distant horizon. We’ll conclude with a Retirement Stress Test for investors who want to get an initial indication if they are ready to retire. What’s more, I’ll offer two “silver bullets”—ways that you can give your personal retirement plan a boost if you’re starting to think you’ll never be ready. Think of it as your own personal bailout plan.

Commencement

What comes to mind when I say the word “RETIREMENT”?

The most common answer I get to that question is also the word’s simplest definition: “Not working.”

But is that really all retirement is? Not doing something? Do we really want to define the last thirty years of our lives—give or take—as being dedicated to the absence of activity?

Another couple of the most common responses I get are “freedom” and “doing whatever I want.” But does that mean today—and for the majority of your adult lifetime—you’re operating in bondage? Doing something that you don’t want to do?

No.

In the words of the eminent philosopher, Ty Webb—Chevy Chase’s character in the not-Oscar-nominated classic, Caddyshack —“This isn’t Russia.” You’re not imprisoned today, and be sure that when you wake up, you are in complete control of your day, every day.

When we graduate from high school or college, the occasion isn’t referred to as retirement (from learning), but as commencement. Something new. What if we viewed retirement not as the end of something, but the beginning? Or better yet, as the continuation of a life well lived?

Retirement … at Twentysomething

Commencement is not hard for twentysomethings to envision, but retirement is. Every semester I taught the “Fundamentals of Financial Planning” at Towson University, I asked for the students’ gut reactions to the word “retirement,” just as I did from you. Would you believe that most of the soon-to-be accountants and financiers had a generally negative impression of the concept?

The top two reasons:

1. They have visions of hot, humid, early buffet dinners in rural Florida.

2. They consider the notion of traditional retirement to be out of their reach.

They hear that pensions are gone and Social Security is in trouble. They see their parents struggling to realize their own retirement goals. They think they’re going to have to work forever.

Retirement seems just too far off for twentysomethings to reflect on seriously. How ironic, then, that their distance from retirement is also their advantage. Time is on their side.

Consider for a moment two future retirees—Jill is 20 years old, and her cousin, Jack, is 30. Always the early bird, Jill starts saving for retirement right out of the gate, investing a healthy $10,000 each year beginning at age 20 for 10 years. Then she stops investing. Jack decided to “live a little” and waits to begin saving until his 30th birthday, but he dedicates himself to saving $10,000 every year until his presumed retirement age, 70. Jill invests for only 10 years while Jack dedicates himself to investing for 40 years.

If each earns an annual average of 8 percent on their investments, which of them has more money to show for it at age 70?

· $3,147,136 (Jill)

· $2,590,565 (Jack)

How could that be possible? Jill invested only $100,000 to Jack’s $400,000, but she ends up with $556,571 more than Jack at age 70. That is the story of compound interest. That is the benefit of getting a head start.

Of course, you might not be able to invest $10,000 per year beginning at age 20, but the point is to invest whatever you can as early as you can. Let the money work for you over time.

What about the grandfatherly wisdom of investing 10 percent of your income each year? Will you be okay if you just save 10 percent of your income for retirement every year? Probably, but there’s a catch.

Let’s say Jill began her career at age 22 with a starting salary of $50,000. She worked for 45 years, retiring at her Social Security Full Retirement Age of 67. She received a 3 percent raise annually and saved 10 percent every year, earning an annual average of 8 percent on her investment.

In this case, Jill would retire with $3,038,996 in retirement savings and a final year’s salary of $183,573. According to the Fidelity retirement study (chap. 6), she’d need to have eight times her salary at age 67. She doubled that. Jill might reasonably expect to withdrawal 4 percent of her portfolio’s balance in retirement, or $121,560, in year one.

There’s only one problem with the 10 percent annual savings rule, but it’s a big one: life doesn’t always do what we want it to. It might be easy to save 10 percent when you can live happily off Ramen noodles and canned tuna at age 22. It may be even easier if you’re a young married couple with two incomes at age 25. But what happens after you start piling up responsibilities? When your income decreases and your expenses rise after the miracle of birth generates a new dependent? When you have three kids and two of them are in college at the same time?

Life is variable, and so is your ability to save. For this reason, I recommend you aim to save 15 percent to 20 percent of your household income pre-kids, getting a great head start. Anticipate your savings rate may recede into the single digits in your peak expense years. Then, once you’re an empty nester, you should be able to back-end load your retirement savings in your peak income years as you head toward retirement.

In short, you can dramatically increase your chances of financial success in retirement—and drastically reduce your savings workload in the middle stages of your career—by getting off to a great start in your twenties. Here again, we see the benefit of automating the Nudge default system (chap. 8). If you start your adult life saving 15 to 20 percent of your income, your chances of maintaining a high savings rate are that much higher as the Rider trains the Elephant (chap. 3).

… at Thirtysomething

At age 30, Fidelity suggests you should have one-half of your current salary saved, and a full year’s worth of pay by age 35. If you saved like Jill, you’re likely ahead of the game, but what about Jack? He has some catching up to do. How about you? Will the 10 percent rule still apply if you start later?

With an estimated salary of $63,000 at age 30, if you saved 10 percent each year until you were 40, you will have amassed $110,906. Not bad, but $53,500 short of Fidelity’s goal. If you remain dedicated to saving 10 percent every year, the news gets better, however. By age 67, if all of our assumptions hold true, you’ll have $1,940,555 saved—a little over 10 times your final salary of $177,273. You pass the Fidelity test, but you may be flirting with danger in your future reality. After all, a lot could change between now and then.

The big issue to contend with in your thirties is the initial financial shock of child-rearing. If one parent stays home to be with the kids, you’ll obviously see your income decrease. But even if you maintain two sources of income, you’ll still see a meaningful chunk of income ceded to a childcare provider. Anticipate this challenge in your retirement planning.

What if you’re behind in your savings and struggling to put away enough going forward? First, I’d remind you of the third guarantee in financial planning (chap. 8), failure, and its counterpart, grace. If you’re behind in your savings, the next step forward should be to forgive yourself and rebuild the Elephant’s self-confidence. Save as much as you can now. Hopefully at least as much as your employer will match in your 401(k) or equivalent retirement plan. Then dedicate yourself to saving a significant portion (like 50 percent) of every raise or bonus you get until your savings rate approaches where it needs to be to fund a comfortable future.

A meaningful effort will help you feel the comfort of Enough even if you don’t yet have enough.

… at Fortysomething

So you’re old enough to have finally purchased the house and made it a home. You’ve molded your children into fine readers and artists, as well as gifted piano, soccer, and lacrosse players. You’re on the board of the local YMCA, you support the PTA, and you normally make a contribution to the offering plate when it’s passed at church.

How about your retirement plan—how is that progressing? Do you have an inherent tendency that makes saving easy, or is it more difficult? You’ll recall from chapter 7 that each of us has a saving personality on a continuum spanning a wide spectrum.

By the time you’re into your forties, it’s likely that your retirement savings is reflective of your cash flow personality.

Most educators in the realm of personal finance take aim solely at those on the left side of this continuum as if more is always better. But is it possible that you could actually save too much for retirement? Absolutely. I’m not demonizing any particular level of net worth, but you may be socking away as much as humanly possible for your future to the detriment of your (and your family’s) present. Many advisors, driven by their economic bias to manage your money, will use the save-for-your-family’s-future guilt trip to wrench more of your dollars into accounts they can oversee.

Of course, most of us are actually more inclined to lean in the direction of the spendthrift than the hoarder. It’s easy to overvalue the present because we can see, touch, and feel it today. And fortysomethings have so many pressing concerns demanding attention and funding, it’s only natural for deferred gratification to take a backseat. So my call for balance between your future and present plans should not be received as permission to underestimate the importance of saving for the future. The reality is that you should have three times your current salary saved by the time you reach age forty-five. And four times your salary when you reach your fiftieth birthday, according to Fidelity. That requires a concerted effort.

One of the best examples I’ve seen of properly balancing money and life comes from a good friend of mine (and financial planning colleague). He is living with and battling Cystic Fibrosis, a disease that attacks the lungs and leaves those so afflicted with a life expectancy of 37.4 years. My buddy is married with two beautiful children and turns forty this year. He’s forced to be focused on the future for his family’s sake (and hopefully for his sake as advances in medicine push toward a cure for CF), but he also recognizes the absolute necessity of getting the most out of every single day.

Tomorrow is surely coming, but it’s promised for none of us, and our retirement planning should reflect that dichotomy.

… at Fiftysomething

The fifties are a transition decade for most retirement savers. At the front end, you’re holding on for dear life, attempting to survive life’s most expensive stretch—the kids’ college years. But then, one day dawns empty nest-hood. Hopefully.

This is an important stage at which to take stock of your retirement readiness. Where do you stand? Are you behind schedule? If so, don’t panic—let’s see how bad it really is.

At 50, our friend, Jack, has $388,487 in retirement savings—3.5 times his $110,500 salary. Fidelity wants him to be at four times his salary. He’s close enough to this goal that if he continues to save 10 percent of his income, and the market treats him reasonably well, he’ll enter his next decade on track for retirement.

However, what if Jack had the same level of savings, but he was three years older and making more money—say, $150,000. Then, at age 55, he’d have only 2.5 times his current salary, half of what Fidelity recommends at that age. But watch this: If he bumps his savings rate up to 20 percent—a savings rate he can afford now that the kids are (mostly) independent—he’ll catch up to Fidelity’s retirement savings recommendations by the time he reaches 67.

The moral of the story? There’s still time to catch up in your fifties if you dedicate yourself to saving in your peak income years.

Retirement Stress Test

Once you’ve moved into your sixties, you’re officially in the retirement home stretch. But please don’t misread me. I don’t want you to stop working. I just want you to be able to stop working in case you want to—or need to for health reasons.

At this point, I want you to work because you want to, not because you have to. That’s the definition of financial independence.

Let’s see how close you are to this milestone with a simple Retirement Stress Test. You’ll recall from the previous chapter that the three-legged stool of retirement is composed of three different potential income sources:

· Pensions

· Social Security

· Personal Savings

In order to complete the stress test, all you’ll need is a recent statement for each. Adding your expected income from any pensions and Social Security will indicate your amount of fixed income. Since these numbers are typically formatted as monthly income, multiply each by 12 to arrive at an annual expected income from fixed sources. If, for example, you’re expecting $1,200 per month from pensions and $2,300 of combined household Social Security income, you’d have $42,000 of fixed income. Not a bad start.

($2,300 + $1,200) x 12 = $42,000

Now, let’s take a look at your personal savings. In order to determine a rough estimate of how much income you could reasonably expect to take from your retirement savings buckets—like 401(k) plans and IRAs—multiply the sum of your aggregate retirement savings by 4 percent, or .04. For example, if you have $400,000 in a 401(k), $525,000 in a Traditional IRA, and $75,000 in a Roth IRA, we could reasonably expect your savings of $1,000,000 to generate $40,000 of annual income.

($400,000 + $525,000 + $75,000) x .04 = $40,000

If we add the fixed income sources to the reasonable annual withdrawal amount from your personal savings, we can estimate annual income of $82,000. If $82,000 is greater than your annual income needs, that’s a good sign.

Mind you, your assets are not guaranteed to outlive you just because you passed the retirement stress test. A more detailed analysis, which takes into account taxes and market volatility, is a must. But at least you’ve passed the first test.

What if you failed the test? What if you know your income needs are higher than the stress test estimates you’ll be able to support? Simply put, there are really only two options: You need to spend less money or make more. If you are behind, here are two retirement planning “silver bullets” that could help you get on track.

Silver Bullet #1

The first retirement silver bullet may be the most powerful: move to a lower cost of living area.

This maneuver is especially impactful when contrasting areas with the highest cost of living to those with the lowest. According to www.bestplaces.net, an online resource estimating the cost of living in areas across the country, the median home price in Chevy Chase Village, an idyllic Washington, DC, suburb in Maryland, is $1,493,400. Additionally, the cost of living is 252 percent higher than the United States average. Alternatively, the median home price in economically battered Detroit is $35,700. There, the cost of living is 26.70 percent lower than the United States average.

But if that comparison appears all too convenient and unrealistic, consider this contrast: Baltimore suburb Parkton, Maryland, boasts a median home price of $439,300 and a cost of living 52.10 percent higher than the United States average. Meanwhile, Knoxville, Tennessee, the lovely home of the University of Tennessee, has a median home price of $109,200 and a cost of living 19.30 percent lower than the national average. And it’s on the water and doesn’t snow as much.

Since I’m sure Jill isn’t behind on her retirement saving, let’s picture Jack and his wife living in Parkton, trying to figure out their plan for retirement:

In Parkton

· Their home is now worth $500,000.

· They have a $200,000 mortgage (from college costs and home improvements).

· They need $100,000 of income to cover annual expenses:

o Their mortgage principal and interest payment (a $200,000 loan at 5 percent for 15 years) is $19,000 per year.

o Without a mortgage, their income need is only $81,000.

· Jack took a pension lump-sum offer. They now have total retirement assets of $800,000. At 4 percent, they could reasonably expect to take $32,000 of income from personal savings.

· With an additional $18,000 from Social Security, they can reasonably expect a total of $50,000 in retirement income, only 50 percent of their estimated need.

In Knoxville

· They were able to purchase a comparable home for $200,000, mortgage free.

· The additional $100,000 in net proceeds from the home sale brings their retirement nest egg to $900,000, capable of producing annual income of $36,000.

· According to cost of living ratio, it would require only $45,360 in income in Knoxville to feel like the $81,000 they want to live comfortably in Parkton.

· With an additional $18,000 of income from Social Security, their $54,000 in annual income now represents 119 percent of their estimated need.

If you find yourself in a retirement planning pickle, I’m not suggesting you read this and hammer a for-sale sign into your yard. Cost of living should not be confused with quality of life, and if your geography and proximity to friends and family is where you derive the most joy, it’s not my suggestion that you have a financial duty to uproot. But, if you’ve reached a retirement planning dead end and find yourself without options, and a yearning for a refreshing change of pace, there is no question that transplanting your financial life to a lower cost of living area can transform a bleak retirement plan into a surprisingly comfortable one.

Silver Bullet #2

You do still have another option, and much as Silver Bullet #1 was summed up in one word—move—so too is Silver Bullet #2—work.

It’s not what you think. If you’re one of the many who’ve dutifully labored for a lifetime, largely motivated by some point in the future when you’d be able to dance your way out of your office never to return, I’m not intending to obliterate that daydream. In fact, the only way this second silver bullet will work is if you’re able to find—or create—a vocation that gives you as much or more joy than being fully retired.

And this isn’t just advice coming from your financial planner but also your doctor, as Anne Tergesen illuminated in her 2005 Businessweek cover story entitled, “Live Long and Prosper. Seriously.”1 She quotes Dr. Jochanan Stessman, head of the geriatric and rehabilitation department of Hadassah-Hebrew University Medical Center, as saying, “There’s a strong argument for continuing to work throughout life.”

This doesn’t mean you have to work full-time, nor does it mean that you should be doing work that drains you. This is your license to create your dream job and begin to plan a phase of life we’ll call pseudo-retirement. You’re working enough to keep your mind and body functioning at high levels, with enough income to reduce your need to tap your nest egg.

Let’s look at this in the context of our hypothetical retiree from Silver Bullet #1:

With two incomes, Jack and his wife are currently making $175,000 in income, $75,000 more than they need. But they’re burned out and want to retire—yesterday. Unfortunately, if they take their early Social Security benefit at their current ages and rely on their nest egg to fund the remainder of their $100,000 income need, they’ll be pulling 10.3 percent out of their personal savings. That’s an unsustainable withdrawal amount and could sink their retirement ship before it even sets sail. Here’s the recommended course of action:

1. At age 62 …

· They begin to plan their dream job, while contributing $50,000 of their $75,000 in excess income to their nest egg.

· They aggressively pay down their mortgage with $15,000 per year of excess annual income. Dial back the aggression in the portfolio and lower the rate of return expectation to 5 percent.

2. At age 66 …

· They transition to their dream jobs, accepting lower pay—$100,000—for full-time jobs they more fully enjoy.

· They stop saving for retirement but delay taking Social Security, allowing future income to grow.

· Their mortgage has been paid down to $94,093. Cease extra principal payments.

· They allow their nest egg—now $1,187,911—to grow, conservatively invested to earn 5 percent per year.

3. At age 70 …

· They scale back to part-time work at their dream jobs.

· Their mortgage balance is now $31,062.

· They take their Social Security benefit, now at $30,927. With part-time income of $50,000, total current income is $80,927.

· The nest egg is now up to $1,436,620.

4. At age 72 …

· The mortgage is now paid off, reducing their income need by $19,000 per year.

· Their Social Security benefit is now $32,176 (assuming 2 percent inflation per year).

· Their nest egg is now $1,583,873. Four percent income is now $63,354.

· Their income need with inflation considered is now $98,738.

· Their Social Security plus 4 percent portfolio income is $95,530, giving them enough income to live comfortably.

Please remember that working part-time in retirement does not represent failure. It represents a new reality. As a culture, we’re retiring earlier and living longer than our predecessors. This puts more pressure on our income generation and necessitates an evolved retirement strategy.

Also consider that the purpose of retirement is not necessarily to not work but to do the work of your choosing. As Confucius said, “Choose a job you love, and you will never have to work a day in your life.” Maybe you’ve never had the chance to put that wisdom to the test. Ironically, there’s no better time than in retirement.

Reducing Retirement Stress

What’s the rush, anyway? In addition to research that finds work good for your health, the Harvard School of Public Health concluded that rushing into retirement is bad for it. In the ongoing US Health and Retirement study, they discovered that “those who had retired were 40 percent more likely to have had a heart attack or stroke than those who were still working.”2

Why is this planned utopia one of the most stressful events in life, consistently ranking up there with public speaking—and fear of death?3

Change. Fear of the unknown. A diminished sense of purpose. A decrease in human interaction.

For this reason, I recommend that anyone planning to retire—regardless of their financial wherewithal—do so with deliberate consideration and planning.

Consider the following process.

Preparing for Retirement

1. Think about it. Considering the magnitude of the retirement decision, isn’t it interesting that it’s usually the Elephant driving this decision—not the Rider (chap. 3)? This phase of retirement planning is intended to get the Elephant and Rider working together on this big project. To get the juices flowing, Carol Anderson of Money Quotient, the nonprofit research group specializing in the many behavioral elements in personal finance, suggests considering which of these statements apply to you:

· I’m counting the days until I can retire.

· I expect my retirement to be very different from what my parents experienced.

· I don’t want to retire “cold turkey.”

· I worry about not having enough money when I retire.

· I wonder what I am going to do with my time when I retire.

· I worry that Social Security will not be available when I retire.

· I haven’t thought much about what I want to do when I retire.

· I like being productive and would like to continue working after I retire.

· I’m worried that my health will fail when I retire.

· I have a clear vision of how I will invest my time and energy when I retire.

2. Plan for it. Now let’s start moving into the realm of the practical. What would life actually look like in retirement? Not the first week, but the thirty-first. What’s the typical week in retirement for you? Write out your ideal week as well. Sunday through Saturday, what would you be doing morning, afternoon, and night?

3. Practice it. Now, put your planning to the test. Take a week of vacation (or two if you can manage it) and live out your typical, ideal week in retirement. Kick the tires.

One of the best ways to reduce the stress of retirement is to phase into retirement in stages. Even if you can “afford” not to, work part-time at first and use the balance of your time to pursue the activities that will eventually consume all of your time. If you do retire “cold turkey,” remember that life is not a two-act play—backbreaking work followed by a passive retirement. Your adult life is (at least) a three-act play, and you’re just beginning the second act. It’s not until Act Three when life may take on characteristics more like a “traditional” retirement picture.

Recognize that retirement is a major life transition. As with any of these major milestones—marriage, parenthood, the loss of a loved one—the best insurance from crumpling under the weight of change is to enter it as a whole, healthy, and fulfilled being. The optimal way to reduce the stress of retirement, therefore, is to enter it with Enough.

1. If you view retirement as a magic pill that will deliver all of your hopes and dreams, it’s likely to disappoint.

2. With the disappearance of corporate pensions and the fear of losing Social Security retirement benefits, twentysomethings feel as though they’re on their own when it comes to retirement—and they might be right. But time is on their side.

3. If you start early, a linear 10 percent savings plan is likely to result in retirement success—but remember, life isn’t linear. Kick-start your financial future with a higher savings rate out of the gate. It will help make up for what will likely be decreased savings in midlife.

4. Each decade of adulthood comes with its own unique retirement planning challenges—be ready to address them.

5. If you failed the Retirement Stress Test, there are really only two ways to improve your situation: decrease your expenses or increase your income.

6. Despite its utopian promises, retirement is one of the most stressful transitions you’re likely to endure in life. Reduce this stress by retiring in stages and through thoughtful, deliberate planning.