Secure Your Retirement Income (Part 1)

Warning: This post has a heavy dose of math, and plenty of highly specific details relating to retirement income.

Disclaimer: The article below discusses certain investment strategies, some of which I am currently using in my personal portfolio and some of which I am not.  Do your own due diligence before making an investment decision.  It’s your money; you’re the best person to judge what is best to do with it.

Always live your life from a position of strength.  My goal for my family is to build a financial fortress for life, and then hand the keys over to the next generation so that they can continue to increase the size of our family’s financial empire.  As you grow older, nothing provides that position of strength better than knowing that your basic living expenses are covered for the rest of your life.  There are a number of ways to do that.  One of the easiest, but also most expensive, is to buy an annuity from one or several insurance companies.  In exchange for a large chunk of capital upfront (hundreds of thousands of dollars), an insurance company agrees to provide you with a monthly payment for either a set period of time or the rest of your life.  Some of these annuities can be indexed to inflation, but at a lower monthly payment.  Many people prefer not to buy an annuity for several reasons.  First, you have to give up a big amount of your nest egg with no guarantee you’ll get what you paid for.  If you die early on, that money is gone and cannot be passed on to heirs.  There is also the remote possibility that the insurance company fails, and the annuity is not honored.  Second, annuities are complex and come with high fees, often in the 2-10% range.  This is egregious, and the fact that insurance companies still get away with it in this day and age is incredible.  These fees exist due to the need for insurance companies to still employ salespeople for these products (and the corresponding hard sell that you receive when you buy).  That 2-10% is not staying in your nest egg and is not going towards a higher payout for you.

There is an alternative to annuities that allows you to “annuitize” your own portfolio, keeping the money in your pocket while also ensuring that you have enough to cover your bases.  This process is tedious, heavy in math, and takes a bit of time and effort to calculate.  It is also executed over a period of decades, and must be followed in order to be successful.

Due to the level of complexity, the concept of annuitizing your portfolio will be broken down into two posts.  Much of the first post is setup for the specific planning done in the second post.  Understanding the basics is important, so I would recommend reading this post first.  However, if the concepts of real versus nominal interest rates, or the basics behind US TIPS bonds don’t excite you, then feel free to just read the section on estimating your income needs and what social security can provide before moving on to the second post.  For everyone else, here we go!

Real versus Nominal

Understanding real versus nominal is an important concept to grasp.  Nominal means the actual amount without regards to inflation, such as for an investment return or an interest rate.  Real, on the other hand, is the after inflation amount.  Using real numbers, instead of nominal, makes understanding future dollar amounts much easier because it’s equivalent to thinking in today’s dollar terms.  $1 million today would be the equivalent of $2.4 million in 30 years, if inflation runs at 3%.  Trying to use future dollars makes planning very difficult.  $9 million seems like a huge amount of money, unless you’re talking about 50 years from now, in which case that’s equivalent to $2 million today at 3% inflation.  A large sum, to be sure, but not nearly the huge amount that $9 million seems.

Thinking in terms of real returns is important, since our portfolio must grow greater than inflation in order to grow real wealth.  US stocks have returned 10% over the last 30 years.  Inflation has returned a little over 3% over that time, equating to a real rate of return for stocks of about 7%.  You can use that same calculation for any return from any asset or for any interest rate.  We’re interested in securing our retirement income, which may be 20-30 years away with a retirement that lasts 30 years or more, so we have to be concerned with maintaining and growing wealth over 50-60 years.  If we want to create lasting family wealth, we have to think in terms of centuries.  Using real returns and real dollar values is the simplest way for our mind to comprehend.

While inflation impacts every investment, from real estate to stocks to bonds, there are few assets that can actually guarantee returning the rate of inflation year after year.  There are years, and even whole decades, where stocks do not keep up with inflation.  Over the long run they have, and that’s expected to continue but there is no certainty.  Inflation in moderate amounts tends to benefit asset classes such as stocks and real estate, but at extreme levels can cause problems.  On the other hand, bonds and other fixed income investments respond poorly to any inflation, because interest rates on those instruments are often fixed at a certain level (floating rate bonds do not have the same problem).  Mortgage payments with fixed interest rates are a great personal example. If inflation jumps from 2% to 10% per year, as the borrower and payer of the mortgage, you come out quite a bit ahead.  If the interest rate is below the rate of inflation and your paycheck is growing by the rate of inflation, your mortgage payment becomes a smaller and smaller percentage of your budget.

Since stocks, real estate, and bonds have all had periods of underperformance relative to inflation, how can we help ensure that we keep up without risking our principal?  There is, in fact, one investment that does just that.

US TIPS

US Treasury Inflation Protected Securities, or TIPS, are bonds issued by the US Treasury that are linked to the rate of inflation.  Assuming you believe that the US government can’t and won’t default on its debt, TIPS are a risk-free investment that will perform at least as well as inflation.  As an aside, the US government can’t default on its debt due to financial reasons and those who tell you so are wrong.  The US issues debt in the US dollar, so the government could always just print more to pay it off.  That does not mean that the government can’t willfully default (like what almost happened in 2011) or that there may not be some technical default.  For example, there was a computer glitch in the 1970s that caused interest payments to be delayed for a day (technically a default, but investors were not fazed).  Not defaulting on its debt will be my working assumption for the US government.

US TIPS have a real interest yield, and an inflation component that is measured by the Consumer Price Index for All Urban Consumers (CPI-U, or hereafter, CPI).  This index is published by the Bureau of Labor Statistics, and is supposed to represent a basket of goods for the typical urban consumer.  The CPI will never be a perfect representation for your personal spending habits.  However, over time, it should be at least representative of your spending increases, within reason.  For lack of any better measurement, we’ll use this as our assumed rate of inflation.  Both the coupon and the principal of the bond increase by inflation through time.  For example, if you buy a five year TIPS bond at $100 and inflation increases 20% cumulatively over the next five years, your bond will pay out $120 at maturity.  Additionally, your semi-annual coupon payments will increase with inflation throughout those five years.

Measuring the rate of return for a US TIPS bond is straightforward.  If you buy a TIPS bond with a 1% real yield, and inflation is 3% next year, you’ll receive a 4% return.  Your principal will increase by 3% to match inflation and your coupons will increase as well since they are calculated off of the new, inflation adjusted principal.  The math is that simple and is one of the reasons that TIPS are a great addition to a retirement account.  They have terrible tax consequences (you have to pay tax each year on the principal increase even though you don’t get it until maturity) but they are useful in ensuring a minimal amount of money available at retirement.  Annuitizing part of your portfolio to secure your retirement income relies heavily on the use of TIPS bonds for these reasons.

The Assumptions

Like any model or scenario analysis, assumptions matter.  A lot.  In order to determine how much money we need our portfolio to generate in retirement, we have to make some conservative assumptions.  There’s really no good reason to be aggressive.  At best, you’re correct and you have marginally more money in your portfolio.  At worst, you delay retirement or live like a pauper because you run out of funds.  Remember to live life from a position of strength.  Conservative assumptions help.

  1. The Retiree: The person planning for retirement is currently 46 years old and will retire at age 67.  Starting next year, they hit the 20 year countdown.  This person’s annual spending is $50,000 (typical annual spending, not including things like college tuition or other large expenditures), and that number is expected to grow at a real rate of .50% (if inflation is 3%, their spending grows at 3.5%).  They’ve had a good career and earn an above average but not fantastic salary.  Between their contributions and their employer’s contributions to their retirement plans, they currently have retirement accounts totaling $600,000 and can put away 80% of the annual contribution limit ($14,400 in 2017, as the cap is $18,000).  The cap goes up by the same .50% real rate each year.  Beginning at age 50, they can do catch-up contributions of $6,000 per year above the current cap, but because money is tight, it takes them three years to get to the 80% level they’ve been doing.  Like most of us, there is no pension available from their employer.  The portfolio is invested in a “risky portfolio” of 80% stocks (S&P 500 or MSCI ACWI) and 20% bonds (Barclays Aggregate).
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  2. Rates of Return: Stocks have historically earned a 6-7% real rate of return through time.  A broad combination of corporate investment grade and government bonds (the Barclays Aggregate Index) has earned about half that amount.  We are currently in the third most expensively priced stock market in history, and bond yields are the lowest they have been in over half a century.  While I think both stock and bond returns will disappoint over the next 10+ years, our model is for 20 more years of a career and 30 years of retirement.  Conservatively, let’s assume that stocks and bonds return roughly 2/3rds of their historical average.  This equates to a 4.5% real return for stocks and 2% real return for bonds.  Modeling a “risky portfolio” of 80% stocks and 20% bonds equates to a real portfolio return of 4% (80% x 4.5% + 20% x 2%).  For simplicity, I’m going to assume we earn 4% each year, which will be wildly different from what actually happens.  However, at least for this model, the timing of the return matters only a small amount.
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  3. US TIPS: US TIPS bonds will factor heavily into the annuitization process. The US government currently has TIPS bonds available out to year 2047, and they generally issue a new 30 year TIPS bond in February of each year.  Since we’re assuming our individual is 46 years old and retiring at age 67, the first year of cash needed from their portfolio is not until 2039.  I will assume that the US government will continue to issue 30 year TIPS bonds and that their real yield will match what the 30 year bonds earn today, .90%.  If inflation averages 3.0% over this timeframe, the bonds will return 3.9%.

Estimating Your Spending Needs

Recall that our example person currently has $50,000 in annual spending needs and that this number is estimated to grow at .5% in real terms (today’s dollars).  There will be no substantial changes before retirement.  In order to estimate the annual spending needs in the future, we have to begin to do some math.  The formula for this one is pretty straightforward.  The first year of retirement begins at age 68, or in 2039, 22 years from now.  In order to calculate our estimated spending on that date, we use the following formula:

Formula: Current Spending * (1+annual rate of increase) # of years

Example: $50,000 * (1+.005)22 = $55,799

Recall that .50% translates into .005 on a calculator (just like 1% is .01 or 20% is .2).  As an alternative, you can also use the future value, or FV, function in excel or on a financial calculator.  We have to do this for each year of retirement.  Let’s assume that our retiree kicks the can at age 93, which is in 2064 or 47 years from now.  For that last year of retirement, assuming our retiree is still spending at a similar rate, their total spending needs would be: $50,000 * (1+.005)47 = $63,208.  In total, this individual’s annual spending pattern, using today’s dollars, grows from $50,000 per year today to nearly $65,000 by the time they pass away.

Social Security

If you live in the United States and have been working and paying payroll taxes, then you will be eligible for Social Security benefits once you retire.  Social Security benefits are guaranteed by the US government and are indexed to inflation.  Interestingly, Social Security is indexed to the CPI-W, which is a subset of the CPI-U and is specific to Urban Wage Earners and Clerical Workers.  Importantly, while although the CPI-W has increased at a modestly lower rate than the CPI-U over time, they have been nearly identical (since 1970, it’s 4.31% vs. 4.25% per year).  For the purposes of this article, I’m going to assume that they grow at the same pace, meaning that Social Security benefits increase at a real rate of 0% (the increase matches the rate of inflation).

In order to determine how much you need to generate from your portfolio, you need to find out your estimated payment from the Social Security Administration (SSA).  The SSA has a pretty user friendly website where you can go and find out your estimated benefits.  SSA uses the average of your top 35 earnings years to calculate your payment, but so long as you have 10 working years (40 quarters minimum), then you are eligible for some level of benefit.  For our retiree, let’s use $2,500 per month, in today’s dollars.  If you are married or living with someone else, then you have to find out both people’s benefits.

Since our retiree’s spending is increasing at more than inflation, the social security check will cover less and less of the budget through time.  This is okay, so long as it is planned.  For our retiree, the expenses versus social security income looks like this:

Since we’ve mapped out this retiree’s spending versus social security, we can begin to figure out how to ensure that there is enough income throughout their retirement.  This is the annuitization process, and will be covered in detail in Part 2.  Following this method will ensure the retiree covers their basic expenses, while still having enough of a portfolio left over to help with having a little fun or to hand an inheritance down to the next generation.

Keep building my friends.

Read Part 2 here.

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