Managing Your Money in Retirement


 

 


This afternoon I got into a conversation with a friend about money management in retirement.  He has the opportunity to take a pension as an annuity, or to take a lump sum and invest it himself and was wondering about which path was better.  He also has a couple of different 401k funds.  He was wondering if he should go to a financial planner, or just invest himself.

One thing about personal finance is that it is just that – personal.  The right answer for you depends on your financial situation, plans in retirement, and risk aversion.  If you are in great financial shape with way more money than you need, you can take more risk since you could take a big market drop without getting into trouble.  If you are planning to sit around the house in retirement and are scared of the prospect of losing any money, you might invest the money very conservatively and give up better returns in exchange for stability and predictability.  So there is no right answer for everyone.

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Personally, I have a great deal of experience and knowledge about investing, having invested for the last 30 plus years.  I was investing during the 1987 crash where the Dow Jones Industrial Average fell 25% in one day.  While it was quite a shock to see your stocks fall by 25%, or even get cut in half in a single day, I held on and saw prices recover to pre-crash levels within about a year.  I also was investing through the dot-com bust in 2000 (and shorting some dot-com stocks and oil refineries) and the housing bust in 2008 (and shorting some thrifts and housing lenders).

I’ve learned from this experience that things can go really badly in a short amount of time and that sometimes it seems like everything is going to zero.  I’ve also learned, however, that things usually turn out OK if you just hold on, at least if you hold onto a set of mutual funds or a whole basket of stocks.  Sometimes with individual stocks, they do go down and never go back up again.  These experiences have taught me both that volatility can be scary and that sometimes the best course of action is just to turn it all off and do other things since doing nothing is better than doing something.  They have also taught me that I do have strong nerves and can weather a downturn without freaking out and going into all cash.

 

 

Based on this experience, I will handle my own investing when I retire and use the markets to provide the income I need.  I know how to allocate the funding to provide the right amount of diversification and income at the right times.   I also plan to have way more in my retirement accounts than the minimum I need so that I can invest more aggressively without worrying about a big market drop affecting my lifestyle.

For other people, an annuity may make sense since it takes away the worry about finding needed income.  An annuity provides guaranteed income for a specified period of time.  The best types of annuities to buy are the plain-vanilla types where you give them a specified amount of money and they provide you with a specified income.  The other types where you can make additional returns based upon the performance of the stock market are just too complicated.  Realize that the returns you’ll receive will be far less than market returns since the insurance company needs to protect themselves for the years where the markets decline since they guarantee that you can’t lose money.  This means you’ll make 5% when the stock markets are providing 15% returns.  You’re better off just using an annuity for income and then investing some of your money in index funds for stock market participation.

The main issue with annuities is that they have a lot of fees attached, and those fees are often difficult to sort out.  Annuity salesmen are like whole life salesmen, using all sorts of jargon to sell you a really overpriced product.  This is why you want to keep it simple.  You’ll also want to ask three or four different providers how much monthly income you’ll get over a specified amount of time if you provide them a specified amount of money and compare the answers.  For example, if you have $500,000 to give them for an annuity that will start paying immediately and pay you until you die, ask each provider how much you’ll receive each month.  The one who will pay you the most per month, for the same amount invested and the same term, will be charging the lowest fees.  If they won’t give you a straight answer on what they’ll pay, move onto another provider.

                  

 

On the question of whether to invest yourself or hire a professional financial planner, I obviously plan to handle things myself since I know what I’m doing and really how little maintenance it takes to manage your money when you’re doing it right.  Really, less is more when it comes to investing.  I will still use other professionals like CPA’s, however, to help with the tax planning since that is an area that changes often.

Really, you could do very well on the investing side simply following three rules-of-thumb:

  1.  Invest your age minus 10% in bonds, and the rest in stocks.
  2. Invest in low-cost, diversified, index mutual funds.
  3. Take no more than 3% of the value of your portfolio out in any given year.

The first rule causes you to protect a portion of your portfolio from the wild ride that stocks can offer by tempering it with bonds.  As you get older and have less time to recover from a big stock market crash, you buy more bonds.  The second rule makes sure you spread out your money over the whole market (a total market stock and bond fund can be used to ensure this) and also to limit fees by investing in index funds.  The third rule makes sure you don’t take more out of your portfolio than it can replace while also keeping up with inflation.

 

For others, it makes sense to use a financial planner, but you need to be careful because there are a lot of bad financial planners out there.  Many simply take a short course on the products offered by their company and then spend their time selling you those products.  Even if you want to use a financial planner, it is better to at least have a basic knowledge of retirement investing before you go so that you can see if the person you’re dealing with knows what they’re doing or if they’re just trying to sell you something.  Buy and read a couple of books, and start to read articles in The WallStreet Journal and, of course, The Small Investor to learn what you’re doing.  You’ll also want to find a fee-only planner, who charges you by the visit or by the hour instead of charging you when you buy products from him/her.  You don’t want them to have an incentive to sell you things, other than knowledge.

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Simple Ways to Invest in your 401k


Congratulations – you are now a pension fund manager.  There is only one person in your pension plan, but that person is very special – you.  If you are working for a company with a 401k plan, ready or not, you are now the manager in charge of your pension plan.  Do it well and you’ll come out way ahead of where you would have in a traditional pension plan.  Do it poorly, and it will be a long, cold retirement.  Unfortunately, you can’t sue the pension plan manager for mismanagement, so take a few minutes to learn at least the basics.  It really isn’t very hard (believe it or not).

Interested in learning how to invest in individual stocks?  A SmallIvy must-read is JD Spooner’s Do You Want To Make Money Or Would You Rather Fool Around?

The dirt simple method:

The easiest method of investing your 401k assets will provide a reasonable return – better than a traditional pension plan – and take only a few minutes one time to implement.  Here’s the recipe:

  1.  Look through your 401k investment options and look for a target date retirement fund.  These will normally include words like “target” in the name and have a year in their title.  For example, the Vanguard Target Retirement 2020 fund is one of these funds.
  2. Find a fund with a date near your retirement age.  For example, if you’re 20 today, pick one 50 years into the future, so either a 2070 fund or a 2065 fund.
  3. Direct all of your investments into this fund.
  4. Go off and have a cold beverage of your choice.  You’re done.
  5. Look at your statements maybe every five years or so.

Why this works:  A target-date fund automatically shifts investments as you age, going from more aggressive investments when you’re young to more conservative investments when you’re older.  Theoretically, the fund managers should just take care of everything for you, which is why they’re called one-decision funds.

Why you can do better:  Unfortunately, one-decision funds are not always set up optimally.  (Notice that I didn’t say they were set up “wrong.”  I said, “not optimally.”)  Investing in one is far better than putting your money in the money market fund where it will lose money each year if you include inflation in your calculations, but you will not get the returns you will get by allocating the funds optimally on your own.  These funds also vary in their investment allocations by fund company, with some being too conservative and some being too aggressive.

                           

Great beginner investment guides.  


The simple but not dirt-simple method:

If you want to get better returns, but still not spend much time or learn very much, do the following:

  1.  Figure out your allocation between growth investments and income investments.  Do this by setting your income allocation equal to your age minus ten, and your growth allocation equal to 110 minus your age.  For example, if you’re 25, your income allocation would be 25-10 = 15% and your growth allocation would be 110 – 25 = 85%.
  2. Invest your income allocation in a bond fund that covers as much of the market as possible.  For example, the Vanguard Total Bond Market Fund, which invests in bonds that come due over a variety of time periods, would be appropriate.  If you were 25, you would set up your 401k to put 15% of your contributions into the bond fund.
  3. Invest the rest in a broad market stock fund.  For example, the Vanguard Total Stock Market Fund, which invests in all kinds of different companies, would be appropriate.  A twenty-five-year-old would put 85% in the stock fund.
  4. Go off and have your favorite frosty beverage.
  5. Look at your statements every five years to see how you’re doing.  Adjust your holdings as needed as you age to keep your age minus 10 in bonds and 110 minus your age in stocks.  For example, at age 30 you would have 20% in the bond fund and 80% in the stock fund.  You would need to both move money between funds and change how new investments are invested.  Many mutual funds have online tools to do this in a couple of clicks.

Why it works:

When you invest in stocks, you make money when the company grows and eventually pays a dividend.  Because you’re depending on the growth of the company, returns are more sporadic than they are with things like a bank account that pays a predictable interest rate.  When companies do grow, however, the rate of return is much higher than it is with interest-bearing assets (because you’re taking on more risk).  Over long periods of time, if you invest in a lot of different stocks, you’ll get market returns which have averaged between 10 and 15% over the last 100 years when assets are held for long periods of time (like 25 years).  As you get closer to retirement, you shift to interest-bearing assets like bonds and real estate that have a more predictable return, which helps reduce the severity of declines, but which return less.  You therefore start out mostly in stocks when you’re young and can afford to go through a big market decline since you can wait for good times to return (plus, you have little money invested), and then shift to bonds when you get older to reduce the volatility (how much your portfolio value goes up and down) since you need more security at that point in your life.

Why you can do better:  

Only looking at your portfolio every five years and adjusting your investments will mean that your allocations may get a little skewed until you finally adjust how the money is invested.  For example, if stocks do really well but bonds lag, you may end up invested in a larger proportion of stocks than you should be, which means you’ll get hit harder during a stock market decline than you would be if you had the right amount of bonds.

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The slightly harder than the simple method for those who can turn off Netflix for an hour a year

Rebalancing, which is what you’re doing when you adjust the amounts invested in stocks and bonds in step 5 of the Simple Method, should really be done about once per year, but no more often than twice a year. To improve your returns a little more with the simple method, instead of looking at your portfolio only every five years and rebalancing, rebalance once per year.  Keep in mind while it is very unlikely that you’ll see a decline in your portfolio over a five-year period, you may very well see one over one year.  Just realize you’re able to buy more shares with the money you have when prices go down and stay the course.

Why it works:

By rebalancing once per year, you automatically sell what did well during the last year and buy what did poorly.  This means you’re taking profits when things go up and are likely relatively expensive (and therefore may decline in price or just not go up as fast during the next year), and buy things when they’ve gone down in price and are on sale.  You only want to rebalance once a year or so since doing so too often will mean you may sell at the beginning of a big rally.  Stocks and bonds tend to have what is called momentum, meaning that when they are going up, they tend to keep going up for a while and vice-versa.  Rebalancing too often will mean you’ll miss this momentum.

Why you can do better:  

Investing in the whole US market in stocks and bonds is good, but adding other kinds of assets can improve your returns even more.  In addition, by skewing your investments towards other asset types, like small stocks which have more room-to-grow than big companies, you can get a little better return.

In the next post, we’ll go into some ways to get that little bit extra out of your 401k portfolio if you’re willing to just do a little more.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Figuring Out How Much Money You Need to Save for Retirement


Hopefully, you’ve heard the 4% rule, where you can withdraw about 4% of your retirement portfolio the first year of retirement and then increase that amount for inflation each year.  You can then figure out how much you’ll need to save up by 1) figuring out how much you’ll each year for living expenses, 2) guessing that you’ll get about $15,000 per year from Social Security so subtracting $15,000 per year from living expenses, then 3) multiply the difference by 25 to find the total amount needed (multiplying by 25 is the same things as dividing by 4%).  If you want to be really safe, multiply by 25 or 30 to reduce the chance you’ll burn through your portfolio early.  Oh, and also add $400,000 to the total for a couple ($200,000 for a single) for medical expenses.

So, if you’re a couple and want $50,000 per year for living expenses.  The calculation would look like this:

Income needed = $50,000 – $15,000 = $35,000

Retirement money needed = 25*$35,000 + $400,000 = $1,275,000

If you wanted to be safer, you would take a 3% withdrawal rate instead of 4%, so you would multiply by 30 instead of 25:

Retirement money needed = 30*$35,000 + $400,000 = $1,405,000

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I would actually recommend trying to have extra money saved up so that you could invest the extra fully in stocks, which have a larger return than bonds, while you invest the money you really need about 50-50 in bonds and stocks.  (This mix of stocks and bonds is right at retirement – you would add more bonds as you got older to reduce the effects of a stock market decline, roughly keeping the bond percentage equal to your age minus 10%.) Because stocks average about 12% per year, you could withdraw about 8% per year from this extra money and have a good chance of getting 15-25 years of extra income that you could use for fun and giving.  The extra 4% you would earn would allow the funds to keep up with inflation.   For example, with an extra $1M, this would be:

Extra money = $1,000,000* 0.08 = $80,000 per year

Total Income = $35,000 (main account) + $80,000 (extra account) = $115,000

Because this is extra money, if you had a couple of years where stock market returns were low or even negative, it would just mean that your extra money would decline a little.  You could also choose to not take 10% (or not take anything at all) if there is a decline and wait a year or two for the market to recover, which it usually does, then continue to take withdrawals at 10%.  That is why you can take the risk of being fully in stocks.  If it runs out in 10 years, you’re still covered by your main account.

Having the extra money also helps protect you should you see a big market decline early in your retirement.  If the market drops 40% the first year you retire like it did in 2008, you could shift some of the money from your extra portfolio into your main portfolio to provide enough income for daily expenses.  While it is mainly for extra income, saving up more is also an insurance policy against market declines.  (Note that while the stock market fell by 40% in 2008, the bond market actually rose, so having a 50-50 mix of bonds and stocks would have meant your account would only be down by 15-20% and you might have been able to just wait a year for the stock market to recover without adding to your main portfolio.)

 

                  

These funds will typically be in a 401k or an IRA.  If you have a traditional IRA or 401k, where you will be taxed at ordinary income rates when you withdraw money, you’ll need to take taxes into consideration.  You can figure that you’ll pay about 15% taxes on the withdrawals (20% if you want to be safe), so you should increase the amount you need by 15-20%. To figure out how much you need to save for retirement, just take your retirement money needed amount and multiply by 1.15 or 1.20:

Assuming 15% taxes and a conservative, 3% withdrawal rate:

Retirement money needed with taxes = $1,405,000 * 1.15 = $1,615,750

Assuming 20% taxes and a conservative, 3% withdrawal rate:

Retirement money needed with taxes = $1,405,000 * 1.20 = $1,686,000

If you are using a Roth IRA or 401k, because the taxes are taken out before you put the money into the account, the withdrawals are tax-free.  This means you only need to save up the original $1.4M, not the higher amount.

I know it seems like a lot of money, and it is.  We’re talking about $2.7M in a traditional IRA or 401k if you want to have enough for expenses plus extra money coming in each year, which is probably more money than many people expect to see in their lifetimes.  The good news is, if you start early, it really isn’t all that difficult to amass such a sum.  That is the beauty of compounding.  Here’s how it works:

You can assume a return of about 8% after inflation if you invest fully in a diversified set of stock mutual funds.  If you start investing at age 20, right when you start your first job, you’ll only need to put about $260 per month away to reach $2.7 M by age 70.  If the stock market does even better, you might have $4M, or you might be able to retire at 62 or 65 instead of waiting until age 70.  The beauty of investing in a 401K or IRA, as opposed to the old-fashioned pension plan where the employer decides when you can retire, is that you can flex things based on how the market is doing.  If you have a good market from the time you’re 60 to 65, you can retire early.  If things go south, you can stay on a few more years and let things rebuild.

 

Want all the details on using Investing to grow financially Independent?  Try The SmallIvy Book of Investing.  

 The best plan is to sign up for the company 401k (if they offer one) or start an IRA as soon as you start working and start putting money away before you get used to the extra income.  If you start out making $50,000 per year, put away 10% into the 401k plan, which would be about $420 per month.  Hopefully, your company will match part of your contribution, so you might end up putting $600 or more away each month.  If you do so, you’ll have about $4.4M at age 70.  At age 65 you’ll have more than $3M, so you could retire a bit early.

If you wait until you’re 30 before you start putting money away, you’ll still have about $2M at age 70.  Wait until you’re 40, and you’ll only have $880,000 at age 70, so you’d need to work until you’re 75 or 80 before you could retire securely.  This is assuming that you don’t get laid off or have health problems that force you to retire.  Starting early is the best way.

Have a burning investing question you’d like answered?  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.