I’ve seen some disturbing data points recently:
- 78 percent of American workers report living paycheck to paycheck. This became very visible during the recent government shutdown.
- 40 percent of Americans said they couldn’t cover a $400 unexpected expense without going into debt. That number jumps to 60 percent for a $1,000 expense.
- A record 7 million Americans are 3 months delinquent on their car loans.
- In 2018, student loan debt hit $1.46 trillion and $166 billion of that is seriously delinquent. Both record highs.
- People in their 60s with student loans owe an average of $33,800 in student debt. They owe $86 billion total which is a 161% increase since 2010.
- People over 60 owed $615 billion in credit cards, auto loans, personal loans and student loans as of 2017. That’s an 84% increase since 2010 and the biggest increase of any age group.
- The percentage of bankruptcy filers older than 65 is higher than it’s ever been.
Whatever the reasons, we’re spending too much, saving too little and living on the bleeding edge of financial insecurity. Sure, everyone on Facebook looks like they’re #LivingTheirBestLife, but peer behind the curtains and there’s trouble. To make matters worse, all of this is happening at a point in time when the economy is in relatively good shape, unemployment is at multidecade lows and the stock market is near all-time highs. What happens if/when we have another recession?
I’m going to spend the next several posts discussing these worrisome trends and talking about how you can overhaul your expenses, save more and improve your retirement security. Today, however, I’m just giving you a friendly reminder. The general idea behind retirement is to reach a point of financial independence where work is optional. If you’re not on track for financial independence, you’re doing it wrong. Stay tuned over the next few weeks and I’ll give you some practical ideas on how to get there.
Qualified Charitable Distributions
Once you reach age 70 ½ you need to start taking required minimum distributions (RMDs) from your IRA each year. There’s a simple formula to determine how much you need to take. Then you just withdraw the money and—here’s the important part—pay the taxes. Until recently, there was no way around those taxes. Then Congress changed the rules to allow people to make tax free charitable donations directly from their IRAs and count those donations toward their RMDs. These are called Qualified Charitable Distributions (QCDs). Here’s how they work.
If you have an RMD due, rather than having the money distributed to you, instruct the IRA trustee to send the money directly to a qualified charity. The distribution will count toward your RMD and the IRS will exclude it from your taxable income. You can exclude up to $100,000 per year. If married and you file a joint return, your spouse can exclude an additional $100,000.
These distributions are particularly appealing after the recent tax law changes. The standard deduction was raised considerably, which means many people will no longer itemize and deduct their giving. The QCD allows you to still get a tax benefit for your charitable giving even if you don’t itemize.
A few things to keep in mind:
- You must be at least 70 ½ to make a QCD.
- The QCD must be a distribution that would have otherwise been taxable.
- The distribution must go directly to the charity. If you distribute it to yourself and then give it to the charity, it counts toward your RMD, but it does not count as a QCD.
- QCDs are excluded from your taxable income, so you can’t double dip and also claim them as a charitable contribution on your tax return.
- You can make a QCD for up to $100,000 even if your RMD is less than that.
- A QCD cannot go to a private foundation or donor-advised fund.
A few weeks ago, I gave you six ways to make your nest egg last. It’s an important topic, so here’s a seventh: Dynamic Spending. There’s a growing body of research that shows it can significantly extend the life of your portfolio. What is it and how does it work?
In retirement, like in your working years, your budget will include both fixed and discretionary expenses. Fixed expenses are things like food and your mortgage. Discretionary expenses include things like travel. In retirement, many of your fixed expenses are gone. Your house and cars are likely paid off. The kids are out of college. You’re no longer saving. Fixed expenses make up a smaller portion of your budget than ever. Your discretionary expenses are another story. Most retirees have a long list of travel, hobbies and other things they want to do.
That type of budget—low fixed, high discretionary—is ideal for dynamic spending rules. As the name implies, dynamic spending is simply adjusting your spending each year based on how your portfolio is doing. You establish rules that give you a raise when times are good and cut back a little when times are tough. The adjustments don’t need to be large to be effective and, as we saw earlier, spending adjustments are easier in retirement because a larger portion of your budget is discretionary.
How it works.
Vanguard did some research in this area and found evidence that dynamic spending rules can greatly improve success. What they tested was a hybrid distribution strategy that was basically a percentage withdrawal of the previous year’s portfolio value with adjustments based on certain rules. They would allow the spending to adjust each year based on year-end value, but would limit it to a ceiling and a floor. This allows your spending to rise as high as the ceiling when times are good and adjust downward as far as the floor when times are bad.
Let’s look at a quick example. Assume a $1 million portfolio and a 4% withdrawal rate, so the first-year distribution is $40,000. Now for next year, they would calculate a ceiling and a floor 5% above and 2.5% below that $40,000. So the ceiling is $42,000 and the floor is $39,000. Now let’s assume we have a big up market and the portfolio value is $1.1 million. 4% of that would now be $44,000. That’s above the ceiling, so you limit your withdrawals to $42,000. What if instead the portfolio had a bad year and it dropped to $900,000. 4% of that is $36,000. That’s below the floor, so you take the floor amount of $39,000. Basically, you’re giving yourself a raise during good times or taking a pay cut during bad times, but you are limiting each by predetermined amounts. This strategy had a 92% success rate vs. the 78% success rate of just taking a dollar amount grown by inflation. That’s a huge jump, all because you set a few simple rules that help ensure you don’t overspend (and risk running out of money) or underspend (and risk not living to the full).
“Will my money last?” That’s the biggest concern for most retirees. What can you do to stretch your retirement dollars for as long as possible? A recent article in the Journal of Financial Planning (JFP) analyzed six factors and the role each played in portfolio longevity. (Determinants of Retirement Portfolio Sustainability and Their Relative Impacts, by Jack C. DeJong Jr., Ph.D., CFA; and John H. Robinson). Let’s take a look at each:
Initial withdrawal rate
The less money you take from your portfolio each year, the longer it will last. No surprise there. What is somewhat unexpected, however, is that the withdrawal rate that is considered “safe” is shrinking. Thanks to lower assumed bond rates, the long held 4% rule should probably be renamed the 3% rule for those who need their portfolio to last 30 years. That’s one conclusion reached by the JFP article and it is backed up by other studies from respected researchers like Michael Kitces and Wade Pfau. So if you anticipate a long retirement, and you think bond rates will stay near their historic lows, it’s probably a good idea to dial back your initial withdrawal rate. If, however, you saved more than needed, retire later or have health issues that shorten your retirement (e.g. 20 years instead of 30) the 4% rule will likely hold.
The Fed’s decade long experiment with low interest rates has been great for borrowers, but terrible for retirees. Generating income is harder than ever. When the initial research was done for the 4% rule, mean bond rates were around 5-6%. Now they are much lower. Lower returns mean your portfolio won’t last as long. It looks like rates will stay low for the foreseeable future. Plan accordingly.
Retirees typically invest in both stocks and bonds so they can balance out the need for growth with the need for stability. What’s the right mix? Several recent studies seem to suggest that dialing up stock exposure a bit (say from 60/40 to 70/30) might help improve portfolio longevity. Before taking that advice, however, I think there are three important considerations. First, what is the likely future return of stocks? The studies assume a lower return for bonds, but assume future stock returns will be similar to past stock returns. When stocks are as richly valued as they are now, however, future returns are generally lackluster. Second, how will you respond in the face of increased volatility? The studies assume that retirees will calmly ride out any increased volatility from the higher stock allocation. That flies in the face of what we know from both behavioral finance studies as well as the long running Dalbar study on investor behavior. Volatility often causes people to do the wrong thing at the wrong time. Third, how much return do you need? If you haven’t saved enough, it can be tempting to swing for the fences and heavily overweight stocks. If you nest egg is adequate, however, it might make more sense to swing for singles and doubles rather than risk striking out. The takeaway from all this? Don’t take the added risk unless necessary. And if you decide to increase your stock allocation, wait for a good opportunity, such as after a market correction. Stocks will be cheaper and bonds will likely have rallied.
Inflation mutes your investment returns and diminishes your purchasing power. For retirees, low inflation is better and will help portfolios last longer. You can’t control the inflation rate, but it’s helpful to know what it is. We’re currently in a prolonged period of low inflation around 1-2%. That can help improve portfolio longevity and offset the lower expected returns discussed earlier.
Investment expenses act as a headwind against returns, so it’s important to a) keep them as low as possible and b) make sure the people you hire are adding value. In a large study on the value of advisors, Vanguard concluded: “Left alone, investors often make choices that impair their returns and jeopardize their ability to fund their long-term objectives.” This type of behavior often leads to “wealth destruction rather than creation.” Vanguard suggests that advisors can help add value if they “act as wealth managers and behavioral coaches, providing discipline and experience to investors who need it.” Specifically, they say to look for an advisor who can help with things like asset allocation, security selection, behavioral coaching and distribution strategies. According to Vanguard, those things are worth about 3% per year in net returns. In other words, a good adviser creates value, but has reasonable fees. The JFP article found that portfolio longevity is greatly improved when expenses are limited to around 1%, but diminish significantly when expenses rise beyond 2 or 3%.
Distribution strategies come in lots of different flavors, but the goal is usually the same: turn your assets into an income. The JFP article tested 4 different withdrawal strategies: a) spend stocks first, b) constant allocation, c) simple guardrail and d) spend bonds first. Most of those are self-explanatory except the guardrail strategy. With that strategy, withdrawals are taken proportionally from stocks and bonds with one exception. No withdrawals are made from stocks following a down year. Most retirees use the constant allocation strategy (draw from asset classes proportionally and rebalance each year), but the study found that the two strategies with the highest success rate were spend bonds first and the guardrail. Both strategies reduce the likelihood that you’ll have to sell assets for a loss during the early years of retirement which, not surprisingly, will help your money last longer.
When planning for retirement, you need to make a lot of assumptions. How long will you live? What will your investment returns be? How much income will you need? When it comes to that last one, most people just estimate their first year of retirement expenses and then adjust that amount higher each year to account for inflation. This seems like a logical strategy. It’s predictable. It provides a steady income. It gives you a raise each year to account for rising costs. There’s just one potential problem. New research shows it’s not how the typical person spends money in retirement.
New spending research
David Blanchett, Michael Finke and other academics have studied how spending changes throughout retirement and what they found might surprise you. Rather than starting at a certain amount and then moving higher with inflation, people spend more in their early years and then gradually decrease spending as they get older. This trend typically continues until later in life at which point healthcare costs cause spending to rise again.
Why is this important? First, your retirement plan is driven by assumptions and perhaps the most important assumption of all is how much you need to spend each year in retirement. If you have that number wrong, your plan won’t be as accurate as it could be.
Second, most people, planners and software assume a static rate of spending in retirement that needs to increase every year with inflation. If that’s not correct—and real spending gradually decreases instead—then we’re overstating the cost of retirement. That means you might be able to retire sooner, retire with less or take a higher distribution rate. Here’s an example to show you what I mean.
In his research, Blanchett found that a household that needed $50,000 in income at age 65 would decrease real spending by about 15% by age 80 and 20% by age 85. Let’s assume you retire needing $50,000 in income and you plan on getting half of that from Social Security and half from portfolio withdrawals. Even if your spending goes down, your Social Security won’t, so any spending reductions can be used to reduce portfolio withdrawals. So if you want to decrease total spending by 20%, then you can decrease your withdrawals by 40%. That means less strain on your portfolio which, as mentioned earlier, means you might be able to retire sooner than expected, retire with less, or spend a bit more early in retirement when you’re healthy and active, knowing that you’ll decrease spending later.
There are some important ways that you can incorporate this new spending research into your planning.
Make a Core/Discretionary budget: Not all spending changes equally during retirement. Certain core spending on things like food and housing will be with you throughout retirement and are more likely to increase with inflation. It is your discretionary spending—such as travel and entertainment—that will likely decrease as you move through retirement. To better predict how your spending will change, make a budget that itemizes core spending (e.g. grocery money) and discretionary spending (e.g. travel or a new car).
Shrink core expenses: Once you know how your spending breaks down, get rid of as much core spending as possible before entering retirement. Housing is the largest retiree expense and more and more people are retiring with mortgage debt. This is especially easy to justify in a low rate environment. But the downside of servicing a mortgage in retirement is that you’re not servicing it from your paycheck, you’re servicing it from your investment portfolio. If your portfolio drops, you still need to pay your mortgage. That means selling into weakness and increasing your odds of running out of money. Core spending is riskier because there’s little flexibility. Discretionary spending, however, tends to decrease as you move through retirement and you can adjust it if necessary (e.g. postpone your vacation if the market drops).
Rethink your distribution rate: In Blanchett’s research, he found that a 4% initial withdrawal rate over 30 years under the constant spending model has the same approximate probability of success as a 5% initial withdrawal rate if spending changes as discussed earlier (assuming $50,000 in initial spending). If you can take 5% instead of 4%, then you would need 20% fewer assets when you retire. For example, a 4% withdrawal from a $1,000,000 portfolio gives you the same dollar amount as a 5% withdrawal from an $800,000 portfolio.
Stay healthy: Obviously you can’t prevent all illness, but do everything you can to be healthy. This will improve your odds of a long, active retirement and can delay or even eliminate some of the health costs that cause spending to rise later in retirement.
Insure against rising costs: You might be asking, “Why do health costs rise later in retirement? Doesn’t Medicare cover those expenses?” Medicare covers a lot of things, but with very few exceptions, long-term care—where you need help caring for yourself—is not one of them.
What are the chances you’ll need this type of care? Seventy percent of the people who reach age 65 eventually require some form of long-term care. Those are good odds. It reminds me of the time I picked up a rental car in Dublin. I found out the car was a stick, the steering wheel was on the right, you drive on the left, and the place we were going only had single lane roads. The guy behind the counter asked <insert Irish accent> “Are ya gonna be wantin’ the insurance today then?” “Yeah,” I said. “Better give me everything you got. There’s a good chance you won’t be seeing that car again.” The lesson? Insure against bad things that are likely to happen.
Enjoy life: There’s a good reminder embedded in the research we’ve been discussing. If spending decreases as you move through retirement, then for whatever reason, the typical retiree is doing less—either by choice or necessity—at 75 than at 65 or at 85 than at 75. If you retire at 65 and stay healthy and active until 75, then you’ve got 10 years to do everything you’ve been putting off for the last 40. That’s not much time. Be ready to hit the ground running when you retire. Yes, that means the early part of your retirement will be a little more expensive, but if incorporate this new spending research into your plan with the help of a competent adviser and the results hold up, then you should be in good shape.
This week is National Retirement Planning Week, so I thought it would be good to give everyone a quick reminder of what it takes to get ready to retire. Sure, saving enough money is important, but retirement is more than just a math problem. There are plenty of other things involved as well. With that in mind, I made a handy retirement readiness flow chart that will give you an idea if you’re ready to retire or if you still have some work to do. To see the chart, just click on the image below.
If you find yourself on the “No” side of the chart and you’ve still got some work to do, visit the Archives Page where you’ll find dozens of articles on every topic mentioned in the flow chart. A few additional free resources you might find helpful are A Brief Guide to Retirement Bliss and the Financial Checkup Checklist.
Thanks for reading and touch base if I can ever help.