Tag Archives: christine benz

Your Back-Of-The-Envelope Financial Plan

We do a lot of financial planning with fancy software for clients at RIA Advisors. We think a financial plan is the basis for someone having a successful financial life. But sometimes you don’t need a fancy computer program with a lot of bells and whistles to get started. There are only a few things you have to know about planning for retirement. And if you do your own back-of-the-envelop calculations, that may spur you to see an advisor and get a more detailed plan in place.

Work Backwards From Income Needed

Strangely enough, it helps to start backwards. So the first thing someone planning for retirement should think of is how much of an annual income they’ll need. There are rules of thumb including one that says 80% of your income in your last working years is adequate. Nobody really knows for sure though, so you should spend some time thinking about that. Keep in mind that an amount of income you think is adequate today will likely be more in the future because of inflation. We’ll address that below.

Nest Egg Required To Generate Income

Once you come up with that required income number — and, by all means, it can be a range instead of a precise number — you can use it to figure out how big of a nest egg you’ll need to generate income on top of Social Security and any other pensions you anticipate receiving. The old rule of thumb in financial planning is the 4% rule, which states you can take 4% from your assets the first year in retirement and then increase that by 4% of the initial withdrawal amount each successive year. (So if you take out $10,000 the first year of retirement, you can take out $10,400 the second year, $10,816 the third year, and so on.) If you’re very close to retirement (a year or two away), it might be better to cut that withdrawal rate to 3.5% now. If you’re very conservative, you can even cut it to 3%. Remember the 10-year U.S. Treasury is yielding around 2.7% currently. Also, stocks are trading at high prices relative to past earnings, and that usually means future returns will be muted. So a balanced portfolio (roughly half stocks half bonds) is unlikely to deliver more than 4% annualized, and may deliver less over the next decade. It probably won’t deliver the 7% annualized that it has in the past and that many financial planners cavalierly tell their clients.

So let’s say $10,000 isn’t enough, and you want more like $35,000 per year to supplement Social Security and any other pensions you might have, when you retire at 65. In that case, you’ll need to have a nest egg of $1 million. The formula for figuring that out using our 3.5% rule is $35,000 = .035*nest egg. In other words, take the annual income you need and state mathematically that it equals 3.5% or .035 times the nest egg or pile of money you’ll need to have.

If you need your assets to generate $70,000 per year in the first year of retirement – double the amount of annual income in our first example — you’ll need a $2 million nest egg – double the nest egg in our first example. If you need $17,000 or $18,000 of annual income – half the amount of income in our first example, you’ll need a $500,000 nest egg – half the amount of the nest egg in our first example.

If you’re far from retirement, and you think you need a certain amount of money, given what it can buy today, you should compound that “nominal” amount by something for inflation. So if you’re, say, 20 years from retirement, and you think you’ll need $35,000 of income from your assets in retirement, it might be reasonable to compound that $35,000 by 3% per year to come up with the number of dollars you’ll need 20 years from now. Nobody knows how much inflation will run over the next two decades, but 3% has been a decent rule of thumb. It turns out that $35,000 compounded by 3% every year for 20 years amounts to around $63,000. That means it will take $63,000 in 20 years to buy what $35,000 buys now. It also means you’ll need a nest egg of  $1.8 million in 20 years to generate that $63,000 of income using the 4% rule adjusted down to 3.5%.

Savings Required To Produce Nest Egg

Finally, now that you have a handle on how big your nest egg needs to be, you can figure out how much to save to get there. Any online financial calculator, such as this one, will let you put in a number of dollars already saved, future annual savings, and an estimated rate of return to get a future value estimate of your nest egg.

If you’re within a decade of retirement, you should count on modest returns. Check out a recent article by Morningstar’s Christine Benz on how some well-respected investors are saying financial markets won’t deliver robust returns for the next decade or so. If you’re two decades or more from retirement, go ahead and plug in 6% returns from a global balanced portfolio.

To recap, if you want a back-of-the-envelop financial plan, start backwards with how much annual income you’ll need from your assets. You’re really trying to solve for an income number in retirement. Then figure out how much capital is required to generate that amount of income safely. Then figure out how much money you need to save to build that nest egg or pile of assets.

It’s true there are other things involved in retirement planning, including questions about when someone should take Social Security, whether and how to buy supplemental healthcare coverage, how to leave a legacy to heirs, etc… And a good financial advisor can help you with these things. But, if you want to get a head start, train yourself to start thinking about the first three parts of financial planning – income needed, nest egg needed to generate the income, and amount of savings needed to build the nest egg.

Please feel free to contact us with your financial planning needs.

Morningstar’s Christine Benz On Return Forecasts

Baseball Hall of Famer and sage, Yogi Berra, once said, “It’s tough to make predictions, especially about the future.” But, as Morningstar’s Christine Benz notes, plugging in a return forecast is necessary for financial planning. Without it, it’s impossible to know how much to save and for how long. In this spirit, Benz has collected asset class return forecasts from large institutional investors and Jack Bogle, who is virtually an institution himself.

Because the forecasts are longer term, they are worth contemplating even if you can’t take them to the bank. Nobody knows what the market will do this year or next year. But it’s at least possible to be smarter about longer term forecasts. When you start at historically high valuations for stocks, such as those that exist now, it’s reasonable to assume future 7- or 10-year returns might be lower than average. In fact, the S&P 500 has returned less than 5% annualized (in nominal terms) since 2000 when it had reached its most expensive level (on a Shiller PE basis) in history. That’s only half of it’s long term average.

Below are the forecasts in table form and in bar chart form as Benz reports them. Some are nominal, and some are real; we’ve indicated which kind after the name of the institution.

At least two of the asset managers’ forecasts — GMO and Research Affiliates — take the Shiller PE seriously. That metric indicates the current price of the S&P 500 relative to the underlying constituents’ past 10-year real average earnings. When that metric is low, higher returns have tended to result over the next decade. And when it has been high, low returns have tended to result. Currently the metric is over 28. It’s long term average is under 17.

Investors should take all forecasts with a grain of salt. But when valuations are as high as they are now, it seems prudent to lower expectations.

You Are Different This Time

You don’t always see a respected member of the financial commentariat argue that it’s different this time. But that’s almost what Morningstar’s Christine Benz has done in an excellent recent article.

What Benz means is that you’re different now than you were during past market cycles. More specifically, you’re older now than you were during the last market debacle, so you have less time to recover from another one if it should occur. That might not mean much if you were 10 in 2008 and 20 now. But it means a lot if you were, say, 50 in 2008 and 60 now or even 45 in 2008 and 55 now. If you’re five to 10 years from retirement, the risk of encountering a period when bonds outperform stocks is high enough – and dangerous enough to your retirement plans — so that you should reduce stock exposure.

The Math Is Different in Distribution

And, if you’re retired and withdrawing from your portfolio, the “sequence-of-return” risk – the problem of the early years of withdrawals coinciding with a declining portfolio – can upend your entire retirement. That’s because a portfolio in distribution that experiences severe declines at the beginning of the distribution phase, cannot recover when the stock market finally rebounds. Because of the distributions, there is less money in the portfolio to benefit from stock gains when they eventually materialize again.

I showed that risk in a previous article where I created the following chart representing three hypothetical portfolios using the “4% rule” (withdrawing 4% of the portfolio the first year of retirement and increasing that withdrawal dollar value by 4% every year thereafter). I cherry-picked the initial year of retirement, of course (2000), so that my graphic represents a kind of worst case, or at least a very bad case, scenario. But investors close to retirement should keep that in mind because current stock prices are historically high and bond yields are historically low. That means the prospects for big investment returns over the next decade are dim and that increasing stock exposure could be detrimental to retirement plans once again. In my example, decreasing stock exposure benefits the portfolio in distribution phase, and that could be the case for retirees now.




The Psychology Is Different In Distribution

But it isn’t just that stock prices are high and that bond yields are low now. Benz argues that your mindset is likely different too. “Even if you sailed through the 2007-2009 market meltdown without undue worry or panic-selling, the next downturn could prove more visceral if retirement is closer at hand and starting to seem like a realistic possibility. It’s not fun to see your portfolio drop from $500,000 to $225,000 when you’re 45. But it’s way worse to see your $1 million portfolio drop to $500,000 when you’re 55 and beginning to think serious thoughts about the when and how of your retirement. The losses are the same (in percentage terms); the ages are different.” In other words, your proximity to retirement could make you sell at the bottom more than it might have a decade ago.

Sure, everyone probably needs some stocks in their portfolio in retirement. Returns from cash and bonds may not keep up with inflation, after all. But stock returns might fall short too. And if stocks do lag, they probably won’t do so with the limited volatility that bonds tend to deliver, barring a serious bout of inflation. So, if you’re within a decade of retirement, it may be time to think hard about how much stock exposure is enough. The answer might be less than you think for a portfolio in distribution phase.