Investment Strategy

06/18/04 - Outliving Your Retirement Savings

By: Investor Solutions

Would you believe that several studies have shown that between 40 to 60 percent of pre-retirees (within the next five years) have not done any retirement income planning? For those that have, many are still trying to recover from the stock market bust of 2000-2002. Millions of baby boomers will consider retirement over the next decade. Financially, will they really be ready to retire? While longer life expectancies are on the rise and inflation is veering its ugly head, it looks like we're headed for a rapidly mounting retirement income crisis for millions.

Well, here's the good news, statistically, your chances of living longer have increased. On average, people are living at least 18 years beyond age 65, and possibly much longer. Many think they are saving plenty through 401(k) plans, IRA's, and other savings vehicles. However, the tough reality to this is that evidence has shown that many of these nest eggs will not provide the adequate income needed to fund a full retirement. Some studies have shown that you should be saving up to 17 percent of your income for retirement, while others have shown a savings rate of over 20 percent. No matter how you look at retirement or your current savings- increasing medical costs, longer retirement periods, periods of inflation, and volatility of the stock market and interest rates are all obstacles that you are likely to face during your golden years.

Although life longevity is a major factor when planning for your retirement income, a 2003 MetLife survey found that only 27 percent said longevity was a major retirement issue, while 41 percent identified inflation.[1] However, in another study conducted, only 23 percent thought they would not outlive their money! As a starting point, many financial planners use the concept that you will need 70 to 80 percent of your pre-retirement income in your retirement years. Many retirees are under the assumption that they can withdrawal up to 10 percent of their retirement assets each year during retirement and still come out ahead, but your probability of success is greatly reduced at any rate above 4 to 5 percent. In the years past, a 6 to 7 percent withdrawal rate during retirement might have held up, but with the recent volatility of the market and turbulent economic conditions ahead a 4 percent draw from retirement assets may seem more reasonable. A more sophisticated approach used by financial professionals (instead of the guessing game) in helping pre-retirees with all this withdrawal rate madness is use of a Monte Carlo Simulator.

A Monte Carlo simulation is a mathematical tool that offers a way to evaluate a retirement portfolio to see if it will last a lifetime. You input a sum representing the client's financial assets, the income they need in retirement, a projected return and risk measure, and the number of years the client will need it. The software will then run through 10,000 simulations, projecting 10,000 separate retirement outcomes, if it works 7,500 times, you can expect a 75 percent probability that you will not run out of money. While we gloat when we see client simulations with 100 percent probability of success, realistically it's up to the client to maintain a withdrawal discipline during the retirement years to make the plan actually work. Typically, it's the first few years of retirement that are the most difficult. Clients tend to spend more money during that period, and naturally it then throws them off the plan.

So what can you do to improve your odds of success? First, you should utilize your financial planner's services and have him/her run a Monte Carlo Simulation for your situation. If your simulation dictates a greater savings need, evaluate your retirement plan options. If you're saving in a company 401(k) plan and your employer matches your contribution, make sure to defer enough to qualify for the entire match. Next, look to your Roth or Traditional IRA are you making the maximum annual contribution for both you and your spouse (in 2005 the annual contribution increases to $4,000 plus a $500 catch-up for those age 50 and over). If you're having a hard time finding the lump sum to fund the IRA, put yourself on "automatic". The easiest way to stick with a savings plan is to make it automatic, that's why most 401(k) and other employer sponsored plans are the centerpiece of most retirement assets.

Most importantly, stick to well constructed asset allocation that is tailored to your risk and return objectives. If you don't currently have one, it should be at the top of your list. It's easy to forget that investors' worst enemies are often themselves. Concerning the types of investments or the mix between equities and bonds to chose, that's up to you and your advisor. When Nobel laureate Daniel Kahneman (Nobel Prize for economics in 2002) was asked what he and other behavioral finance theorists thought of supporters of index and passive investing versus stock pickers, he replied "Many of us are very skeptical about stock picking. Even if there are a few people who can do it, most of those who claim they can do it certainly cannot."[2] Smart investors are turning to passively managed securities which are benchmarked to the various indexes within their asset allocation. Modern Portfolio Theory is a proven model that matches risk versus return in order to achieve the highest return. By investing in securities with lower costs, lower volatility, and access to the entire global market, you'll have a superior chance of improving your returns.

As human beings, we tend to feel a need to take action in our portfolios as forecasts on the economy and other national events occur, thinking that we know how markets will react to those events. We tend to listen to those in the media and the gossip around the company lunchroom. Natural behavior will implant a temptation in you to follow a hot stock pick or a thriving sector of the economy. Stick to your plan, adding a systematic investment to your retirement plan now can lead to a prosperous and worry-free retirement. As a disciplined saver, investing in the equity markets is a long-term decision; the only way to reach your goals is to stick to the game plan. For those of you without a plan, it's time to get in the game.

[1] On Wall Street, "The Looming Retirement Income Crisis" June 2004

[2] Financial Advisor Magazine, "Clients Misbehavin", June 2004