by Joe Hearn | Aug 9, 2011 | Asset Allocation, Debt, Retirement, Risk
As I’m sure you’ve heard by now, S&P downgraded U.S. debt one notch last Friday from AAA to AA+. Aside from the short-term angst in the markets, how will the downgrade affect those of us planning and saving for retirement? Here are three likely consequences from the downgrade as well as steps you can take to minimize the impact on your plans. Note: Just a friendly reminder—nothing on this site should be considered investment advice for your specific situation.
Expect increased volatility—This is the first time in history that our country’s debt has been downgraded from AAA. Expect continued volatility in both the stock and bond markets as traders and investors digest the news and react accordingly.
To protect your assets and maximize your returns over time you should meet with a trusted adviser to make sure that your asset allocation is appropriate based on your risk tolerance, goals, and time frame.
Also, for those at or near retirement, increased volatility means increased sequence risk. What is sequence risk? Stock and bond returns aren’t linear, and sequence risk is simply the risk that you will receive lower (or negative) investment returns in the early years once you start drawing money for retirement. Early negative returns greatly increase your odds of running out of money.
One way to minimize sequence risk is to have a year or two of withdrawals sitting in cash. If you retire just prior to a bull market, you can pull income from your growing investments. If you retire on the cusp of a bear market, you can take withdrawals from your cash. That way you won’t be forced to sell investments in a down market in order to fund retirement.
Expect higher interest rates—In an ironic twist of fate, the world responded to the downgrade of U.S. bonds by buying—you guessed it—U.S. bonds. That’s because (ratings be damned) the U.S. bond market is still the most liquid, transparent bond market in the world and investors still flock to it in times of trial.
All of that buying pushed prices higher which sent interest rates lower. Don’t expect that to last, however. Just as a person with a low FICO score can expect to pay higher interest rates to borrow money, the U.S. Government can expect to pay higher rates if bond investors perceive it to be a greater credit risk.
That’s bad news if you’re a borrower (think higher mortgage rates), but good news if you’re a lender (think higher dividends on your bond portfolio). Interest rates are at generational lows. Consider the downgrade the canary in the coal mine that they’re eventually going higher. To minimize risk and increase cash flow in retirement, set a goal to retire debt free.
Expect higher taxes—If rates go up, then the U.S. will be spending more of your tax dollars on interest payments. That’s an expense that they can little afford. In fiscal 2010, the U.S. government spent $3.456 trillion, but only had $2.162 trillion in tax receipts. That’s a deficit of $1.294 trillion. Similar deficits are projected for years to come.
To get its fiscal house in order, the government has two primary tools: cut spending and raise taxes. We all saw what a difficult time Congress had making even modest spending cuts during the debt ceiling debate. Even if they could agree on cuts that eliminated 100 percent of discretionary spending (i.e. non-military and non-entitlement), the budget would still be deep in the red. What does that mean? At some point down the road we can expect higher taxes.
How can you prepare for that? As you work on your retirement budget, assume that things like income and capital gains taxes will be higher than they are now and save enough to cover the added expense. Also, different states have different tax burdens. Some states tax Social Security and pension benefits while others do not. Sales and property taxes also differ greatly from state-to-state. As you consider where to retire, don’t forget to consider how your income, property, and purchases will be taxed during retirement. Finally, if you have some time to go before retiring, consider putting as much as possible into your Roth IRA and Roth 401(k). Distributions from those accounts during retirement are free from federal tax.
With so much uncertainty, it’s easy to get discouraged. A quick review of history, however, shows that we have always had times of volatility and uncertainty. The key is to manage through them by recognizing the challenges you face and doing everything you can to meet them head on. Do that and when times get better (which they inevitably will) you will be well positioned to benefit.
Thanks for reading. Touch base if I can ever help.
Joe
by Joe Hearn | Jul 12, 2011 | Debt, Distribution Planning
It’s almost impossible to open a newspaper these days without reading about your retirement “number.” That is, the amount of money you need to set aside to fund your retirement years. While important, the “number” is only one way to skin the proverbial cat. What if I told you that you could slash 20-40 percent off the amount you need to save without reducing your standard of living in retirement? Would you be interested?
While it may sound too good to be true, that is exactly what you can do by entering retirement debt free. To see why, let’s look at an example. Imagine two couples, the Drakes and the Palmers. They’ve been friends for years and live next door to each other in a small community in Oregon. The couples, both in their mid-sixties, plan on retiring next year, so they sit down with their respective advisers and calculate how much they’ll need.
The Drakes outline their retirement budget and determine that, in addition to Social Security, they will need $5,000 per month or $60,000 per year. Approximately $1,300 of that is for their mortgage and $400 is for a car payment. Assuming a withdrawal rate of 4 percent, the Drake’s adviser tells them they will need a nest egg of $1.5 million to generate the income they need ($60,000 ÷ .04).
The Palmers expect their retirement expenses to be nearly identical to their friends the Drakes with one big exception: they have no debt. Ten years ago they set a goal to enter retirement debt free. They paid extra on their mortgage each month and resisted the urge to buy expensive new cars. As a result, rather than $5,000 per month they only need $3,300. Assuming a withdrawal rate of 4 percent, their adviser tells them that their “number” is $990,000.
So even though they are planning nearly identical retirements, the Palmers can generate the cash flow they need with nearly half a million less than the Drakes, simply because they have no debt.
Cash flow during retirement
During retirement, your portfolio takes over the job that the payroll department handled during your working years, namely to send you a paycheck every month. As we saw in the example above, debt makes that task much more challenging. It cuts into your cash flow and increases the risk that you will outlive your money.
Even so, more people are following in the footsteps of the Drakes than ever before. According to the Joint Center for Housing Studies at Harvard University, more than 60 percent of people aged 55-64 have mortgage and home-equity debt. Funding retirement is difficult enough without handicapping yourself with liabilities. Here are three steps you can take to make sure your debt retires when you do.
1) Commit
Paying off your house and other debts takes time and requires a serious commitment. It might even mean putting your retirement dreams on hold. Getting into debt is easy, but getting out of debt means adjusting your lifestyle and choosing to live below your means so that you can allocate the excess to your creditors. If married, discuss the plan with your spouse so that you can hold each other accountable and work together towards a common goal.
2) Develop a plan
Once you’re committed to the idea of retiring debt free, it’s time to develop a plan. Make a list of all your debts, including credit cards, car loans, mortgage debt, and school or business loans. Next look at your budget and see how much you can allocate towards deleveraging each month. Some say you should start by paying off the loans with the highest interest rates. Others say you should start with your smallest loans and pay those off first so you can build momentum by seeing quick progress. Choose whichever you think would work best for you. As you pay things off, use the money you were allocating toward that loan and apply it to the next loan on your list.
When you get to large loans like your house, contact your lender and ask for a payoff amortization schedule so you can track your progress. Don’t be tempted by the thought of holding on to your mortgage interest deduction. Congress is considering eliminating this tax break in order to close the budget gap, but even if they don’t, it may not provide you much benefit in retirement. You’ll likely be in a lower tax bracket and mortgage interest is front loaded, so the deduction shrinks over time.
These arguments aside, it’s questionable whether paying interest to get a tax deduction is a benefit in the first place. Let’s say you pay $20,000 in mortgage interest in a given year and you’re in the 25 percent tax bracket. Deducting $20,000 from your income would save you $5,000 in taxes. Only in America does it make sense to spend $20,000 in order to save $5,000. How much better would it be to pay your mortgage off, send Uncle Sam the extra $5,000 in taxes, and pocket the remaining $15,000?
3) Outline your retirement budget
Once you’ve cleaned up your balance sheet and are ready to move into retirement, develop a detailed retirement budget that matches your income with your expenses. This will help you keep a reign on your spending so you can stay debt free.
As you can see, debt is inherently limiting at a time when most hope for greater independence and opportunity. Eliminate it and you will gain the freedom, flexibility, and peace of mind that so many see as the hallmarks of a great retirement.
Note: I first published this article at www.fpanet.org.
