Engineering Your Retirement

Simulating Retirement Investment Survival

2009-12-18T11:44:00.004-07:00

It would be wonderful if it were possible to run a computer simulation that would tell you exactly how much money you were going to need in retirement. Unfortunately, retirement investment survival is not a deterministic problem. It is a probabilistic problem. There are simulations, however, that can be used to great advantage in retirement planning.

In order to simulate your financial survival during retirement you need to model:
1) The size of your nest egg (how much will you have invested).
2) The real rate of return on your investments (ie. return minus inflation).
3) How much you will spend and when (a spending model).4) How long you will be retired (or equivalently, when will you die).

You have quite a bit of control on items 1 and 3. In contrast, you have virtually no control of item 4 (unless you are willing to take hemlock at a specific time). You can gain some insight into 4 by examining actuarial tables. This allows you to place probabilities on your longevity. Item 2 can be approached by examining historical rates of return on various investments and asset allocations.

The most simple minded way to approach retirement simulation is to assume a portfolio value, a fixed rate of return, a constant real spending model, and a longevity estimation. This data can be used in a spreadsheet or simple financial formula to determine how much money you need to retire. Unfortunately, this deterministic approach to retirement planning is not very accurate nor useful. Over a 30 or 40 year retirement period, average rates of return, average inflation, average spending, etc. are not good estimates of your actual financial performance. Fluctuations from year to year can be devastating.

One method that addresses the probabilistic nature of the retirement simulation problem is to use Monte Carlo analysis. A computer generates a random number that is used to establish an annual rate of return and annual inflation for a single year. Your assumed nest egg is then modified by the random rates, annual spending is subtracted, and the computer generates a second year's rate numbers. The process is repeated until an entire retirement sequence is created (30 to 40 years typically). The distribution of these rates is forced to be consistent with historical distributions. The multi-year retirement sequence is repeated hundreds or thousands of times and a probability of portfolio survival is computed. Although Monte Carlo methods are powerful techniques, when applied to the retirement investment problem they tend to be pessimistic because they do not account for the correlations between returns and inflation nor year-to-year correlations. An alternative method to deal with the retirement probabilistic problem is to use actual historical data. Data that describes stock returns, bond returns, real estate returns, inflation, etc since 1871 have been tabulated. The historical simulator simply uses this data in historical sequence to examine how a portfolio and spending plan would have survived over the hundreds of historical periods represented by these simulators.

You can gain free access to all three types of simulators at:http://www.golio.net/Chapter2.html
Basic input data and analysis results are also presnted.

Withdrawing from your IRA before age 59½ ?

2009-10-30T11:58:00.001-07:00

Many financial advisers and financial advice columns state that you cannot withdraw funds from your IRA without paying a penalty prior to the age of 59-1/2. Thanks to an important loophole in the IRA legislation, that’s not strictly true.

The loophole is known as a "72t exception". The name is derived from current tax law (Internal Revenue Service Code Section 72t). That section of the tax code states that you can avoid the 10% penalty tax if you take "substantially equal periodic payments." You have to use an IRS bulletin (Notice 89-25) to calculate what the IRS considers to be "substantially equal periodic payments". You must take those payments for a specific number of years (at least 5). The formula to compute acceptable payments is not simple, but if you need to access your IRA stash, it’s worth the effort (ie avoiding a 10% penalty) to compute your acceptable withdrawal rate. A web search for “IRS 72t calculator” will provide a number of online calculators to compute acceptable 72(t) withdrawals for your IRAs.

The IRS term “substantially equal periodic payments” is often abbreviated as SEPP. To take a series of SEPP from your IRA without penalty, you must withdraw money at least once a year, and you must keep taking withdrawals for five years or until you reach age 59½, whichever is longer. As an example, a 40-year-old would need to take withdrawals for twenty years (until age 59-1/2). Anyone over 54-1/2 years old would need to take them for five years (for 5 years which would be past age 59-1/2). Once SEPP is started, you cannot take unlimited withdrawals from your IRA for 5 years and a day. That’s a limitation for people who start SEPP after the age of 54-1/2. It means they can only withdraw their IRA funds consistent with SEPP rules until all 5 years of SEPP withdrawal have been taken. If SEPP withdrawal rules are not followed exactly, you face a 10% penalty and retroactive interest charges.

SEPP and 72(t) rules do not apply to a 401(k) account, but this technicality can be side-stepped if you rollover your 401(k) into an IRA. You need to consider all of the specific details of your 401(k) plan and rollover rules before you do this. Some company 401(k) plans allow more liberal withdrawal rules than those allowed by IRA regulations. Also, some company rollover rules are limiting. But the rollover strategy can be very valuable in many cases.

For more information see Section 8.3 at: http://www.golio.net/Chapter8.html

More on Higher Order Asset Allocation

2009-08-18T07:23:00.004-07:00

Consider the 60/40 – stock/bond asset allocation (AA) plan of my comments from March 6, 2009, “Fundamental Asset Class Definitions and Asset Allocation. First, it is important to understand that a simple 60/40 asset allocation plan is a very good plan that is very easy to implement. Historically, it will beat the performance of most other investors provided you use low fee investment instruments to construct the portfolio (ie low cost index funds or Exchange Traded Funds) and you consider a time frame of about a decade or more. Many investors would like to improve on the simple two asset class allocation by including a more sophisticated allocation analysis. There is no guarantee that consideration of additional asset classes will improve performance, so there is no optimum way to construct a more sophisticated asset allocation plan. But historical analysis can help to produce plans that would have performed better under certain economic conditions in the past. What follows are two examples of how to develop a more complex asset allocation plan.

An investor might start by observing that many broad stock market indexes are overweighted with large-cap and underweighted with small-cap stocks. That means that large companies are over-represented in the index as compared to smaller companies. By splitting the stock allocation in half, a second order allocation plan with three components is achieved. The new allocation includes 30% large cap stock, 30% small-cap index, and 40% bond. Introduction of small cap stocks in the allocation historically provides greater long-term returns but also introduces greater volatility (based on 130 years of US stock market history). If an investor is nervous and does not feel comfortable with increased volatility, the second order AA plan would not be advised. If the investor is more experienced and able to maintain the plan through small-cap downturns that may last several years, the second order plan is likely to result in greater long-term returns. Notice that additional appropriate funds must be identified and purchased for this more complex asset allocation plan. In fact, with each addition of a new asset class, additional funds must be used.

Another AA alternative would be to partially replace the small-cap fund with a Real Estate Investment Trust (REIT) investment. REIT returns have been weakly correlated to large cap stock returns in recent years, but tend to exhibit less volatility than small-cap funds during most periods of time.

Further sophistication of the allocation plan can be added by differentiating between value and growth funds. Both the large-cap and small-cap portions of the stock investment can be further split to include large-cap value and small-cap value funds to complement the general large-cap fund and general small-cap fund. The additional weighting of value stocks in the stock portion of the portfolio has historically both decreased volatility and increased long-term return (although not in every historical period). The resulting third order allocation plan includes as many as six components: 15% general large-cap stock, 15% large-cap value fund, 10% general small-cap stock, 10% small-cap value fund, 10% REIT, and 40% short-term bond.

Starting again with a first order 60/40 – stock/bond AA, an alternative asset allocation example can be developed. An investor might decide to split the general stock allocation into large-cap domestic stock, international stock, and small-cap domestic. Over some periods, international stocks have shown low correlation to US-based stocks. The inclusion of 15% to 25% international stock in a portfolio has helped produce both greater returns and reduced volatility during these periods. A second order asset allocation plan designed to address this might include 20% large-cap domestic stock, 20% international stock, 20% small-cap stock, 20% short-term bonds, and 20% intermediate term bonds. In this example, the bond asset allocation has also been sub-divided to provide stability over shorter periods of time.

Both of the above second order asset allocation plans can be rationalized and neither can be proven to be “optimal” for the future. Still other plans can be developed based on examination of alternative subdivisions of the general stock/bond asset classes and historical correlation and volatility data. Before subdividing the general stock/bond allocations and adding an asset class, you should understand what that asset is, the cost of owning it (fees), the risk it brings to your portfolio, and how it may correlate with the other assets in your plan. Adding asset classes without this basic understanding can hurt rather than help your investment portfolio. The number of assets in an investment plan is not an indication of sophistication. If you don’t understand an investment, don’t buy it. An investor that maintains the simple first order stock/bond allocation has historically outperformed most other investors. This is often done with as few as two market-tracking index funds. The simple stock/bond allocation plan, when coupled with a reasonable spending model and regular saving, will get you to a comfortable retirement.

More on Asset classes and Investment Options: http://www.golio.net/Chapter5.html

More on Asset Allocation (see Section 6.2): http://www.golio.net/Chapter6.html

Some material is from Golio, Engineering Your Retirement, Wiley, 2006. (see http://www.golio.net/)

Bond Basics

2009-06-02T05:55:00.003-07:00

A bond is a loan for which the investor is the lender. They are like IOUs. When you purchase a bond, you are lending money to the government, a company, or some other organization. Bonds are sold in fixed increments, normally $1000. The organization that sells a bond is known as the issuer. Like other loans, there is an amount borrowed (face value or par value). There is an applicable interest rate (coupon rate), and a specified time when the bond must be paid off (maturity date). Bond maturities can range from days to decades. The bonds that typical individual investors purchase have maturity dates that are years to decades in length. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months, although quarterly or monthly payments are sometimes specified. Because the cash flow from them is fixed, bonds are also known as fixed-income securities. On the maturity date, the face value of the bond is returned to the bondholder.

(Example: You buy a bond with $1000 face value, 5% coupon rate, and 5 year maturity date. Purchase of the bond costs you $1000 plus any sales fees. Every six months – as specified by the bond -- you are paid $25 in interest payments. Five years from the date of purchase, you get your $1000 purchase price back.)

Long-term investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods (25 years or longer), the stock market has always beat bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have part (but not all) of their portfolio invested in bonds.

Bonds are debt while stocks are equity. This distinction means that equity holders are owners of a company while bondholders are creditors. Legally, the creditors (bondholders) have a higher claim on assets. In case of bankruptcy, a bondholder will get paid before a stockholder. An organization’s bonds carry less risk than their stock certificates. Since the bondholder is taking less risk, he or she almost always receives lower returns. The relationship between risk and reward (ie. higher reward requires taking greater risk) is the underlying principle for all investments.

Not all bonds carry the same risk. The more risky the bond investment, the higher the coupon rate of the bond. Companies sometimes default and fail to pay back bonds. Large, stable company bonds tend to pay less than those of small, volatile companies. Government bonds are the least risky and also tend to pay the lowest rate.

Time is also a factor in bond risk. A bond that matures in 30 years is much less predictable, and therefore more risky, than a bond that matures in 1 year. For this reason, longer time to maturity is usually associated with higher interest rates. Bond investors should consider underlying risk before investing in a bond.

How does an investor evaluate bond risk? -- Bond ratings can be useful in evaluating the default risk of bond issuers. Bond ratings are developed and published by two major rating organizations in the United States: Moody’s, and Standard & Poor’s (S&P). These ratings are similar to a report card on the issuer’s stability. The highest grades are awarded to the government since they are the closest thing to a risk-free investment available. Large, blue-chip firms tend to receive fairly high ratings because of corporate stability. Financially unstable companies receive low ratings.

Moody’s Ratings in order from least to most risk are Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. S&P ratings (low to high risk) are AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Bonds with ratings of higher risk Ba or BB are referred to as junk bonds. These bonds offer high yield, but at greater risk.

A bond can be sold before its maturity date. When bonds are sold like this, it is on the secondary market. The price of such sales can fluctuate from the face value. If a bond is bought at face value, the yield is equivalent to the coupon rate of the bond. If the bond is purchased at a price greater than face value, the payments remain fixed, providing a yield less than the coupon rate. Similarly, a bond purchased at below face value will produce a higher yield than the coupon. The yield to maturity (YTM) is the return an investor will receive from a bond purchased on the secondary market at a price different than the face value. YTM can be larger or smaller than the bond coupon. Bond prices and bond yields are inversely related.

The entire bond market can be categorized along a dual continuum. The classifications that apply to bonds are maturity and credit rating. Conventional maturity classifications are long (greater than 10 years), intermediate (4 to 10 years) and short (less than 4 years). Credit rating is the Moody’s or S&P’s credit rating as discussed above. As an example, a U.S. treasury bond with a 20 year maturity would be classified as a long-term, low-risk bond, while a bond from a financially struggling small company with a 3 year maturity would be a short-term, junk bond.

In addition to the maturity and credit rating, bonds can be divided into US or foreign debt. Non-US bonds can be further classified either as emerging or as developed country debt. Bonds can also be classified by the business sector of the company.
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adapted from Engineering Your Retirement, Golio, Wiley, 2006. http://www.golio.net/EngineeringYourRetirement.html

Fundamental Asset Class Definitions and Asset Allocation

2009-03-06T04:36:00.007-07:00

Asset allocation (AA) focuses on managing investment risk while accepting that an investor is not likely to be able to predict what will happen next in the markets. An asset allocation plan involves choosing the asset classes that will comprise the plan and setting target percentages of the overall portfolio that should be invested in each class. Studies show that the asset class choices for an investor are the primary indicator of both performance and risk when considered over long periods of time. The actual specific investments within those asset classes are far less important. An AA plan requires periodically (typically once per year) rebalancing the portfolio as one asset class outperforms another. Rebalancing maintains the portfolio risk at a fairly constant level.

What is an asset class? The most fundamental distinction of asset classes is stocks vs. bonds.

A bond is a loan for which the investor is the lender. They are like IOUs. When a bond is purchased, the buyer is lending money to a government, company, or other organization. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months. The interest rate is fixed by the terms of the bond. If the company performs astronomically well, the bond still only pays according to those terms. It does not pay more. On the other hand, bonds pay the terms of the bonds regardless of poorer than expected company performance (unless the company goes bankrupt). Investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods, the stock market has always beaten bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have at least part of their portfolio invested in bonds. Bonds can be subdivided into multiple asset classes. A bond is classified by it’s duration, it’s risk (as determined by Moody’s or Standard and Poor’s rating system) and by country of origin. For example one bond might be an international, long-term, Moody’s Baa bond while another is a US, short-term, Moody’s Aaa bond. You can learn details about bond rating systems in Section 5.1: Wikipedia Bond Credit Rating: http://www.golio.net/Chapter5.html An asset class can also be defined using any or all of these distinctions.

Stocks are a certificate of ownership in a company. As a stockholder, you are not personally liable for company debts or mismanagement -- even if you are a shareholder of a company that goes bankrupt. On the other hand, your participation in earnings has no limit. While you can lose no more than 100% of your investment, you can earn more than 10,000% on your stock if the company is very successful. For the greater risk of owning stocks, the investor demands greater returns. This is the reason that throughout history stocks have outperformed other investments over the long term. Stocks can be further distinguished by the size of the company selling the stock. Large companies are large-cap stocks. Small companies are small-cap stocks and medium sized companies are mid-cap stocks. Stocks can be classified along a second continuum as either growth or value stocks. Using these two classifications subdivides the stock asset class into 6 other possible asset classes. When a distinction between US companies and international companies is added, we end up with 12 possible asset classes. For example a company’s stock might be an international, large-cap, value stock while another stock is a US, small-cap growth stock, etc.

An asset allocation plan can be developed based simply on the stock/bond distinction. An AA could establish a target allocation of 60% stock and 40% bond for their portfolio. A reasonable rule-of-thumb for determining stock allocation is to compute (100 – [your age]) as a target stock percentage. Thus a 40 year old would choose a 60/40 stock/bond allocation. An investor who is comfortable with more risk might use (110 – age) while a conservative investor might choose (90 – age) to compute a stock target. Such a plan isn’t complete until the investor decides how he/she will own stocks and bonds. An investor can choose to pick individual stocks and bonds through a brokerage house, or buy them through mutual funds. For an individual, diversification is most easily achieved by choosing mutual funds. A very good first order asset allocation plan could be based on only two mutual funds: 1) A broad stock market index fund, and 2) a broad bond market index fund. Historically, for periods of at least two decades, an investor with an asset allocation plan with only these two, low cost index funds would have outperformed over 80% of all other investors.

Investors may be able to improve on the above fundamental asset allocation plan by using the more refined divisions of stocks and bonds as asset class definitions. The 60% stock allocation, for example, might be broken down into 40% US stocks and 20% international stocks. Further subdivisions that consider the growth-value and/or size continuum can also be applied. Bond class definitions can similarly be applied. In addition, real estate and/or commodities can be added to the target asset classes.

Not all asset class distinctions are useful to an investor. Adding more asset classes without understanding correlations between those assets does not help a portfolio in terms of risk or reward. In other words, more asset classes is not necessarily an indicator of a more sophisticated investor.

For more on asset allocations, refer to http://www.golio.net/Chapter6.html Section 6.2.

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Asset Allocation vs Market Timing

2009-02-15T05:57:00.002-07:00

The underlying, fundamental principle that describes investments is that greater return comes with greater risk. The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. A U.S. Treasury bond, for example, provides lower return than a corporate bond. The reason for the difference in returns is that the risk of a corporation going bankrupt is higher than the risk that the government goes bankrupt. The corporation has to pay a higher rate than the government to entice investors to buy their bonds rather than government bonds. The risk-return continuum that applies to government and corporate bonds also applies to stock, mutual fund, real estate and commodity investments. All investment choices need to consider an individual’s comfort level with risk and his/her requirements for reward.

Investment strategies can be classified along a continuum between asset allocation and market timing. Asset allocators are investors who focus first on managing risk by maintaining fixed percentages of their portfolio in various asset classes – each associated with that class’ risk. For example, a simple asset allocation plan might be to keep 30% of investments in US stock market investments, 30% in international stock investments, and 40% in short-term bonds. A pure asset allocation strategy would involve establishing a portfolio with this mix of investments, then periodically (once a year, for example) re-balancing the overall portfolio to maintain the asset classes at the same levels. Asset allocators accept that they cannot predict what the markets will do and choose instead to manage risk.

In contrast, market timers focus first on return. Buy low; sell high is the goal of the market timer. Market timing is a seductive strategy. Engineers who are used to optimizing performance understand that maximizing yield must involve picking equities and bonds when they are underpriced and selling them when they are overpriced. Unfortunately, this is easier said than done. In order to successfully time the market, the investor must 1) identify a bargain correctly before anyone else has done so. Once others identify the bargain, the market will immediately increase the price until it is priced appropriately. 2) buy the bargain at the right time. 3) sell the bargain at the right time. If a market timer misses on any of the above tasks, they can completely eliminate their profit advantage.

Countless studies have looked at various investments strategies and compared the resulting performance. Over periods as short as 5 years, most asset allocators outperform market timers. As the time period gets longer, the performance advantage of asset allocation grows. For periods of 2 or 3 decades, only a small fraction of market timers are comparable to pure asset allocation strategies.

Visit my site at http://www.golio.net/

Investing Basics

2009-01-31T17:48:00.009-07:00

When it comes to investing, people don’t agree on anything. Investors disagree on what to buy, when to buy it, and how long to hold it. Some trade individual stocks or bonds, others only invest in mutual funds. There are disciples of real estate, commodity traders . . . you name it. Some investors believe in using a pure asset allocation strategy. They maintain specific target percentages of their portfolio in specific asset classes (X% stock, Y% bond, Z% real estate,. . .) regardless of what the markets do. Other investors try to time the market (buy low, sell high). Regardless of what method they use, most investors believe that their method is best and every other investment style is inferior.

But here’s the truth. The "best" method to use is one that you understand and can live with. Trying to emulate the success of someone else probably won't work for you unless you have the exact same knowledge and temperament that they have. Here’s another fact: Most investors who think they have the best method are fooling themselves and are almost certainly underperforming the markets.

For the vast majority of successful investors, the key to asset accumulation is to 1) Live Below Your Means (LBYM), 2) Invest regularly, and 3) Let time in the markets work its magic. Obsession about trying to beat the market is more likely to hurt your chances of success than to help you. If you avoid throwing your money at get-rich-quick schemes, invest regularly, and follow a few simple guidelines, the choices of what specifically to invest in are less important than many investors fear.

The simple guidelines:

1) Diversify. Don’t put all your investments in a handful of stocks, for example. Index funds are a great way to do this. They diversify investments across an entire market index.

2) Minimize Fees. If you buy mutual funds you should be looking at the expense ratio (expenses/assets expressed as a percentage). Different mutual funds will have expense ratios that vary from as low as 0.15% to over 4%. Countless studies have shown that over periods of a few decades or longer, fees are the single best predictor of which funds will do best. Higher fees mean poorer performance. It’s that simple. If you buy stocks or bonds directly, look for discount brokers. Fees matter.

3) You don’t have to beat the market to get rich. Timing the market is hard. Despite what your neighbors, colleagues or broker may tell you, the vast majority of people do not beat the market. And the longer the period of time you consider, the fewer the number who actually do. The truth is that your neighbors, colleagues and broker probably spend too much money, have too much debt, and don’t have a clue how their portfolio really did against the market. If you invest in index funds, you will (by definition) match the markets (minus fees). If you put your money in low fee index funds and let time do its magic, you can achieve the nest egg you need to retire. You have better things to do than read corporate 10K forms, study charts and call your broker. If you do choose to try to time the market, you will need to understand your greed/fear levels and control them well as your investments rise and fall. Invest in a good program that will keep track of your returns and be honest with yourself. Studies show that most people who invest this way dramatically overestimate the actual performance of their portfolios.

4) Understand your risk tolerance. Your investments are at risk. Regardless of how you have chosen to save (stocks, bonds, commodities, annuities, houses, or buried in a jar in the back yard) there is a chance you could lose all or part of your investment. The underlying principle that drives investment results is that there is a direct relationship between risk and return. Greater investment risk brings greater potential returns (long term). The underlying cause for this relationship is that investors expect to be compensated for taking on additional risk. It is hard to understand risk and its effect on comfort until an investor actually experiences significant declines in their portfolio. Risk tolerance before a market decline is like courage before a battle. Until it is tested, it is difficult to distinguish someone who is brave from someone merely showing bravado. Establishing your appetite for risk involves gauging the potential impact of a major loss on both your portfolio and psyche. You need to make sure you have balanced your high flying investments with enough less volatile investments to let you sleep at night in the event of a catastrophic market crash.

For more information go to: http://www.golio.net/Chapter6.html

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How much do I need to retire?

2008-05-03T05:40:00.006-07:00

Asking this question is a little bit like asking, “How much gain does an amplifier need?” or, “How much gas does it take to get to Tucson?” Without defining many other details, the questions can’t be discussed intelligently. But if enough other information is specified, you can come up with a reasonable estimate.

For retirement, people can use historical simulations or monte carlo simulations and examine how various investment portfolios (stock/bond allocations) would have performed over time. Such simulations include spending habits and inflation and can look at history and performance distributions in the US since 1871. (If you try to go back further than 1871, it’s hard to find useful and complete data.)

The short answer to the retirement question is that you will need investments (or present net worth of your investments if you have pensions, etc.) equal to about 25 times your current annual spending in order to survive the worst 30 year period in retirement history in the US. If you retired at the worst time in US history but withdrew only 1/25th of your investment portfolio that first year, then increased that withdrawal each year by the annual inflation rate, you would have been able to survive for 30 years without ever decreasing your lifestyle. There are a lot of assumptions about stock/bond allocations, rebalancing your investments, the future being no worse than the worst case past, etc. in that answer. But the answer gives a good first guess at your retirement needs. Notice that (1/25) is 4%. This general rule of thumb is sometimes referred to as the 4% Safe Withdrawal Rate (SWR) or the 4% rule.

If you are interested in running historical or Monte Carlo simulations to analyze your own situation, go to: http://www.golio.net/Chapter2.html

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Fees and 401(k) or 457(b) Accounts

2008-04-13T07:12:00.008-07:00

Common advice offered to investors is that they should contribute to available tax-deferred plans (like 401ks and 457bs) before investing in after tax accounts. In most cases, this is good advice. It is especially advantageous when company matching contributions are available. If your employer is providing matching funds to your tax deferred accounts, then when you fail to contribute, it is like voluntarily giving up salary. Make sure you get all the matching funds you can get or you are effectively taking a cut in wages.

Even if matching funds are not involved, tax-deferred plans are often better investments than contributions to an after tax account. Consider the following cases:

CASE #1 (After tax contributions):
Contribute $3000 per year to an after tax account for 30 years.
Then withdraw $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns 7% per year return with an expense ratio of 0.2% (typical of low-cost index funds)
Assume the pre-retirement tax rate is 28% and the post-retirement tax rate is 18%.
Withdrawals are tax free (since youve already paid tax on the money when you invested).

CASE #2 (Tax deferred account):
As in case 1, contribute $3000 per year to a tax-deferred account for 30 years.
Then, identical to case 1, withdraw the $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns at a rate identical to case 1 -- 7% per year return with an identical expense ratio of 0.2% (typical of index funds)
Assume the pre-retirement tax rate is 0% and the post-retirement tax rate is 0% (Consistent with 401(k) and 457(b) regulations).
Withdrawals are taxed at 18%.

CASE #1 describes typical numbers for a taxable index fund account while CASE #2 describes numbers that might apply for a 401(k) or 457(b). Of course every individuals experience and tax situation is different.

At the end of 30 years, the tax-deferred account of CASE #2 would be worth ~$295,000 while the after tax account of CASE #1 would be worth ~$208,000. Tax deferred treatment is worth ~$87,000.

Once the withdrawal phase is started (years 31 to 60), the taxable account has an advantage since withdrawals do not count as income and so are not taxed. Despite this advantage, at the end of year 60, the tax-deferred account is valued at ~$1.8M while the taxable account is valued at only ~$1.2M a $600,000 advantage to tax-deferred accounts.

But what happens if the 401k account is burdened with high fees? Using identical assumptions for the two cases except assuming the CASE #2 tax-deferred account expense ratio is 1% rather than 0.2% results in the complete annihilation of the tax-deferred advantage. With a 1% expense ratio, the tax-deferred account grows only to ~$256,000 in 30 years (an advantage over after tax saving of only $48,000). But even that slight advantage is lost entirely during the withdrawal phase. For higher expense ratios, a tax-deferred account is actually a bad investment when compared to the low-fee, equivalent returning fund in a taxable account.

Fund expense ratios as high as 1%, or even 4% to 5%, are not unusual. With only a 2.1% expense ratio on the tax-deferred mutual fund, all advantage is lost even in the 30 years of the contribution phase. During the withdrawal phase, this tax-deferred account would lose over $500,000 compared to after tax saving of CASE #1. It pays for investors to keep their eye on expenses. If your employer isnt offering matching funds and offers no low-fee mutual funds in their plan, you might be better off investing your money in a taxable account.

Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html

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Tax Efficient Withdrawal Strategy in Retirement

2008-02-21T15:47:00.008-07:00

You may not currently have a retirement withdrawal strategy, and if you are still in the accumulation phase of your career, you might not need to put too much advanced thought into that strategy. When the time comes to enter the withdrawal phase of your financial life, however, it makes a difference what order you withdraw your funds. The primary issue for most retirees is to keep an eye on taxes. Taxes can potentially be the largest controllable expense a retiree faces. Withdrawing assets tax-efficiently as you manage your retirement is one simple way to save money over the long run.

Basic withdrawal advice is fairly straight forward:

- Educate yourself on your options and legal requirements. You should know, for example, what the minimum age for withdrawal without penalty is. You should also know that if you hold onto your tax-deferred accounts for long enough, the government will require you to take withdrawals. You cannot withdraw money from most tax deferred plans (like 401(k)s, 403(b)s, IRAs, etc) prior to age 59-1/2 without incurring significant penalties. If you are planning early retirement, you need to identify what source of funds you will use prior to that age. There are exceptions for certain kinds of withdrawals, and there is a tax loophole known as 72t withdrawals that get around the penalties – but the laws are very restrictive and specific about how to do this. If you hang onto your tax-deferred account for too long, the law forces you to withdraw a required minimum distribution (RMD) and suffer the tax implications of that withdrawal. RMDs are applicable at age 70–1/2.

- Your goal should be maximum growth. This involves different things depending on your personal situation but in general you want to draw down according to this priority list:

Before Age 70½
1. Taxable assets.
2. Tax-deferred assets (such as those in traditional IRAs and employer-sponsored retirement plans).
3. Assets in tax-free Roth IRAs.

After Age 70½
1. RMDs from qualified retirement accounts.
2. Taxable assets.
3. Tax-deferred assets.
4. Assets in tax-free Roth IRAs.

- Take other tax considerations into account. You might benefit from selling assets that have lost money from your taxable accounts – taking the tax deduction for the loss. Your decisions should not be based on simple minded tax minimization. Instead you should focus first on achieving sustainable growth. It is important to manage risk by rebalancing your portfolio if it becomes too heavily invested in a particular asset or asset class.

Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html

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How Long will I Need to Fund Retirement?

2008-01-29T06:16:00.008-07:00

One of the first issues a retirement planner has to deal with is answering the question, "How long will I need to fund my retirement?"

Of course the answer to this question is, "As long as you live." And how long will you live? Although most of us don't know the answer to that question, insurance companies are very aware of the distribution of longevity of the overall population. We can use that information to help define the probabilities that we live for X years longer.

If you have no significant others, heirs, or dependents, you can estimate the length of time you need to fund retirement using uniform lifetime tables like those available in Chapter 1 Section 3 (Annuities):
http://www.golio.net/Chapter1.html

Some longevity calculators use perturbation analysis to estimate how personal habits and diet impact longevity. There are several links to various types of longevity calculators under Section 1.3 at the url:
http://www.golio.net/Chapter1.html

Knowing how much longer the average person your age will live is better knowledge than nothing, but there are still important problems that knowledge does not address.

1) You don't care about the average person, you care about you. Although the average 50 year old will live another 33.7 years, ten percent of them will live another 47.3 years. If you planned to retire at age 50 and fund only 33.7 years, you could get really hungry and uncomfortable during the next 10 or 20 years. Being one of the fortunate people who live long lives could seem like something other than a blessing if you didn’t plan for it.

2) If you want to plan for your spouse or other dependents, you are more concerned with joint life expectancy. On average, a 50 year old will live for 33.7 years, but if there are two 50 year olds, on average at least one of them will live another 40.4 years. If you plan your and your spouse's retirement based on uniform lifetime expectancies, make sure you die first. The last 6 or 7 years could get uncomfortable for the survivor.

The best link I have found to look at joint life expectancy is the Vanguard Joint Life Expectancy Calculator. You can find a link to it under Section 1.3 of the url:
http://www.golio.net/Chapter3.html

This calculator gives you probabilities that two people of same or different ages live X years longer. For retirement planning purposes, this is pretty useful.

You can get the official government joint and last survivor tables from a few places online. These tables are necessarily very long. You have to scroll through a lot of pages to find the one that has both you and your joint survivor’s ages in a top row and 1st column. Also, this tells you the 50% probability only. As mentioned, for retirement planning, you might want to plan for better than the 50 percentile problem.

IRS publication 590 includes a joint and last survivor table in Appendix C, Table II. For the IRS form, this table is not used unless spouses are separated by more than 10 years of age, but the data you are interested in is available in the table. The same government table that covers joint life expectations for ages 0 to 115 can also be found in the document available in Chapter 1 Section 1 (Publication 590 IRAs):
http://www.golio.net/Chapter1.html

The joint life tables start on page 104 of that document and continue to the top of page 126. To use any of these tables you need to find your age along the top row and your joint survivor’s age along column 1. The number in the intersection is the life expectancy from the present (ie. one of you is likely to live that many more years).

Use of the longevity tables described above helps provide guidance regarding the length of time your retirement plan should target.

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Family Equivalence Scale

2008-01-18T06:11:00.003-07:00

The US Bureau of Labor Statistics (BLS) has developed an estimate of how family size and type affects budget. You can use their estimates to evaluate cost of living changes along a typical family life cycle. All estimates are normalized to the costs for a family of four (two adults and two children). All other budget entries represent the normalized funding required for the specified family to maintain an equivalent lifestyle to the base family.

Family Type--BLS Normalized Family Budget
Single Adult--0.360
Two Adults--0.600
Two Adults, One Child--0.820
Two Adults, Two Children--1.000
Two Adults, Three Children--1.116
One Adult, One Child--0.570

For a single young person prior to marriage the cost of living is 36% that of a normalized family of four. The cost of living for a married couple increases to 60% of the normalization base. When one child is added, the family budget is at 82% of the base. A second child puts the family at base budget level. A third child places the couple at 111.6% the cost of a family of four. For cases not shown in the table, the equivalence family budget can be roughly approximated using the expression:

E = [(A + pK)^F]/2.751

where A is the number of adults in the family, K is the number of children, p=0.92 and F=0.75.

The USBLS equivalence scale indicates how difficult it is for a family to grow, maintain a lifestyle threshold, and continue to save for future retirement. If you hope to maintain a constant lifestyle, your family of three (two adults and one child) requires a 36.7% higher budget than a married couple with no children. If you (and your working spouse if he/she works) earn a salary increase of 5% over inflation per year, your income does not reach a level to support a first child until you’ve worked for more than 7 years. To achieve an income that would support a second child at the same standard of living would take an additional 4 years on the job.

A single engineer who wants to marry, or a couple that desires children have other options. You can choose to lower your lifestyle and carry on with family plans. You can choose to invest less money toward retirement, maintain your standard of living with family additions, and work more years before retirement. You can do a combination of both. When going from single to married, a couple consisting of two wage earners might easily exceed the required 66.7% income increase implied by the table simply by combining salaries. Although two cannot live as cheaply as one, two wage earners can live a more comfortable lifestyle or can save more toward their long-term goals.

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Planning a Retirement Budget

2008-01-08T07:25:00.003-07:00

Once I learned a minimal amount about investments, risk and inflation, I came to believe that the biggest unknown facing the retirement planner (at least this retirement planner) was trying to predict the budget they would need in order to support a satisfying retirement.

The first step in getting a better grip on this is to understand how much you are spending today and on what. A lot of affluent technical professionals make enough money that they don't track expenses very well if at all. That’s the reward for all that hard work studying math and science in college. You don’t have to budget. But the absence of an accurate expense record makes this problem even tougher. If you know how much you spend today on each aspect of your life, you can go down the list and estimate whether you are going to spend more or less on that item in retirement. Finally, you can estimate how much more or less you expect to spend.

Here's a starting list for expense tracking from the US Bureau of Labor Statistics:
- FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
- HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
- APPAREL (men's shirts and sweaters, women's dresses, jewelry)
- TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
- MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
- RECREATION (televisions, pets and pet products, sports equipment, admissions);
- EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
- OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses.

One advantage of using a list that conforms to the USBL list is that you can monitor inflation rates by spending category more easily. This allows you to estimate your own personal rate of inflation relative to the published CPI-U. Many people feel that the inflation rate they experience is very different than CPI-U because their purchases do not conform to the category mix used by the Bureau.
If you have a thorough understanding of what each category and sub-category costs you today, you can start to make a pretty good estimate of how much you might spend in retirement. Go through the categories one at a time.

The FOOD AND BEVERAGE category may not change much in retirement if you think your eating habits will remain the same. On the other hand, if you dine out a lot today because you’re too busy to prepare food and do dishes, you might reduce this category by quite a bit in retirement. Or maybe you want to spend more time dining at gourmet restaurants and expect this expense to rise.

HOUSING, utilities and home insurance may not change much unless you are planning on moving from your current conspicuous McMansion to a smaller retirement home. If so, make sure you capture that savings in your estimates.

APPAREL expenses may decrease a little since you won’t have to dress for the office.

TRANSPORTATION costs are likely to change significantly – either reduced because you can eliminate an expensive commute, or increase because you plan on traveling extensively when you retire.

MEDICAL CARE is a very important category to consider. If you are retiring with a paid medical insurance benefit from your ex-employer, consider yourself extremely lucky. That will help keep this cost manageable. If not, plan on an insurance expense that will rise more than the inflation rate every year. This is a tough cost to gauge with our current medical situation in the U.S.

A RECREATION budget is clearly very important to most retirees and possibly the most difficult to anticipate. Prior to retirement I knew exactly what I was spending on recreation, but that did not help me much when it came to planning that budget for retirement. While working, I only had weekends and vacations to spend any serious time on recreation. How much more time would I need to devote to this category to create a satisfying retirement? While working, I often spent money on recreation/travel services in order to save my precious, but limited vacation time. In retirement, I can choose to do many things more slowly (and less expensively). Because I planned on traveling a lot, I broke out VACATION & TRAVEL as a separate item. I looked at several different kinds of trips I make: 1)day-long field trips, 2)camping trips, 3)road trips (travel to sites and stay in low-cost accommodations) and 4)city visits (air travel, city hotel rates, rental cars, etc). Then made an estimate of how often I thought I would want to make each type of trip, and budgeted accordingly. I then split the vacation & travel sub-budget into appropriate categories: mostly TRANSPORTATION or RECREATION.

You can continue through the remainder of the items in a similar fashion. For each category that you think might change significantly, you need to estimate the expected change. If you have the figures on your current spending by category, that’s not too difficult. When I was in doubt, I would simply guess that a 10% perturbation on the current cost was a good guess. Being an engineer, I over estimated my cost increases and underestimated my cost savings by a little. On the other hand, so far I’ve traveled a lot more than I thought I would in retirement.

Some people recommend using some simple rule-of-thumb guessing for your budget. For example, you might read that you will spend 80% as much in retirement as prior to retirement, or that you should plan to need 70% of your pre-retirement take-home pay to live off in retirement. I don't think it is wise to approach the problem this way. Those rules certainly didn't work for me – not even close.

For those who have not yet developed a detailed accounting of where their current spending is going, you may want to check out the url: http://www.golio.net/Chapter3.html
Scroll down to Section 3.3 and click on “download all excel spreadsheets”. There are also several other budget tools available through that page.

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Fees matter . . . a lot.

2007-12-17T05:13:00.020-07:00

Minimizing cost is critical to achieving long-term investment success. Unlike future performance of your investments, costs are predictable and controllable. Countless studies and mathematical analyses have shown that higher costs do not lead to higher returns. Dollars spent on management fees, trading costs, and taxes are dollars lost to the investor. Market rewards are finite and investment expenses come off the top before the investor gets their share. Smart investors should be concerned with finding investment products, with low fees.

In one recent study of mutual fund performance (Financial Research Corporation, 2002, Predicting Mutual Fund Performance II: After the Bear) the predictive value of several fund metrics were examined. The possible indicators of future returns that were examined included: a fund’s past performance, Morningstar rating, alpha, beta, as well as expense ratio. It turns out that the fund’s expense ratio was the most reliable predictor of its future performance. In other words, low-cost funds delivered better performance. This was true for all of the periods considered by the study.

John Bogle, Founder and Former CEO of the The Vanguard Group talked about another study when he spoke in 2003 to the Society of American Business Editors and Writers. The study quantified the relationship between the total costs of equity funds and their returns by looking at the returns of 803 diversified U.S. equity funds. Using the Morningstar database, each of the funds investment returns along with its costs were compared. The average expense ratio for these funds was 1.3%, and their average portfolio transaction costs were estimated at 0.7%, for a total of 2.0%. The funds were then divided into quartiles by cost (fees). The results included these important facts:
-The high-cost quartile of funds, with all-in expenses of 3.4%, provided an average annual return of 6.8%.
-The low-cost quartile, with expenses of 1.0%, provided an average annual return of 10.2%, earning an advantage of 3.4 percentage points per year.
-On a fund-by-fund basis, the inverse correlation between cost and return was remarkable: minus 0.60%.
-Funds with the highest costs also assumed the highest risks, generated the highest turnover, and produced the poorest tax-efficiency.
-Funds with the lowest cost had an even greater advantage in risk-adjusted return and an amazing advantage of 4.0% per year in after-tax return.

Fees as they impact returns are also the subject of an article by Nobel Laureate, William Sharpe: The Arithmetic of Active Management in Section 6.2( http://www.golio.net/Chapter6.html). Here’s what Sharpe concludes:
If "active" and "passive" management styles are defined in sensible ways, it must be the case that
(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.
As an individual investor, how can you reduce fees? Using a low cost mutual fund provider should allow you to assemble a portfolio with an expense ratio on the order of 0.20%. Fixed income investment (bond) requirements for your portfolio can be satisfied using a short to intermediate term US Government bond fund. An S&P500 or Wilshire 5000 index fund can be a good choice for the stock portion. Other low cost index funds can provide further diversification if desired.

The average mutual fund has an expense ratio of about 1.30%. Fees of this magnitude result in significant drag on your portfolio performance. The figures and analysis below provide an estimate of how much can be gained from using low fee funds rather than average or high fee funds.

The figure labeled “Effects of fees while saving” considers an investor that invests $2500 per year for 40 years and earns 7% per year on the total investment. The 5 curves illustrate the effect of fees on the portfolio value. Fees of 0.2% are typical of low cost index funds. Managed funds average over 1% fees. Some managed funds have fees as high as 5%. Over a 30 year investment period, the cost to an investor investing in funds with a 1% fee is over $32,000 compared to the investor using mutual funds with a 0.2% fee. Compared to an ideal “no fee” return on investments, the investor gives up over 16% of the gains on his/her own money over this period of time. The investor takes all of the risk, but pays over 16% of their gains to the mutual fund company.

At the end of 40 years, 1% fees have cost the mutual fund investor over $93,000 compared to the low cost investor. The investor has now paid almost 30% of his/her investment gains to the mutual fund company.

The figure labeled “Effect of fees in Retirement” illustrates how fees affect a retiree during the distribution phase of investment history. The figure assumes a retiree starts retirement with a $1M portfolio, spends $45K the first year and adjusts this spending upwards by 3% per year to match inflation. The unspent portfolio is assumed to earn 7% return per year. The investor who is invested in mutual funds with 0.2% fee survives over 40 years in retirement. At a 1% fee level, the retiree runs out of money in year 34. An investor using mutual funds with a 4 % fee runs out of money in year 22.

The road to investment success is improved when expenses are minimized. Your portfolio performance is driven primarily by
- your saving rate,
- your asset allocation and
- amount of time in the market.

Personal values and frugal living drive your saving rate. Asset allocation is a matter of establishing your personal risk-return comfort level. Time marches onward for all of us. This leaves little or no reason to diminish your returns through commissions and fees. Even a 1.00% management fee costs a lot in terms of reduced nest egg and retirement income. Spending the small amount of time required to learn about financial markets and managing your own retirement assets should reap significant rewards.

More about investment instruments and mutual funds: http://www.golio.net/Chapter5.html

Information on developing your own investment allocation plan: http://www.golio.net/Chapter6.html

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How do you define retirement?

2007-12-12T05:01:00.005-07:00

I was recently discussing retirement planning with a group of engineers and asked if they could help me with an informal “show of hands” poll to determine how long before they planned to retire. Before I could even start the poll, someone asked, “What do you mean by “retirement”? People laughed, but it wasn’t a facetious question. In fact, it’s a very good question and one that each person needs to answer before they start retirement planning.

When does retirement start? A few decades ago, people worked full time until they stopped. But today, according to surveys more and more people are looking at retirement as a process rather than as an event. Some studies indicate that as many as 90% of Baby Boomers want to continue to work beyond conventional retirement age. Rather than stopping full-time work abruptly, we see a trend toward either working part time or cycling between periods of work and periods of pure leisure. Still other workers are planning to leave a high-pay, high-stress career for a low-stress labor of love. These people plan to work until their mid-50’s or 60's, then transition to part time or temporary work (possibly a change of career) then retire completely. They are planning a “transitional retirement”. The only problem with this view of retirement is that it makes the point when retirement begins difficult to define, and that presents a retirement planning challenge.

Retirement planning is complicated further by the fact that people don’t have the same ideas about how they want to spend their time in retirement. Some people want to travel the globe. Some want to sit on their porch in their rocking chair. Some want to cultivate family and friends while others hope for solitude. Some anticipate involvement in causes as a volunteer while others hope for peaceful seclusion.

Here's some background history on retirement age/lifestyle. Prior to the Social Security Act of 1935, most people were not able to retire until they became too frail or sick to work. Since then, the average age of retirement has dropped monotonically every year until very recently. Between 1950 and 2000, the average age at retirement dropped from about 67 years old to under 62. About 60% of Americans over 65 consider themselves completely retired. It is no accident that the age when Social Security benefits are first available corresponds exactly with the average age of retirement. According to the US Bureau of Labor Statistics, nearly half of all seniors would be below the poverty level without social security.

Retirement trends among technical workers do not vary that much from those of the general population. According to the National Science Foundation, engineers and scientists with BS or MS degrees quit working full-time at an average age of 62. Those with a Ph.D. do not stop working full time until age 65. It is interesting that the number of technical workers who work only part-time increases for all degree earners between the ages of 55 and 65 – transitional retirement.

Of course no one vision of retirement is right or best, but regardless of the vision, surely one goal they all have in common is the need to achieve a level of financial independence. Financial independence provides freedom for wage slaves. What one chooses to do with that freedom – recreation, leisure, volunteer, part-time work, or change of career – is entirely up to them. Even if you choose to die in your cube, financial independence makes certain aspects of the job easier to take.

Retirement planning tools available at: http://www.golio.net/Chapter2.html

What to do in retirement ideas: http://www.golio.net/Chapter7.html

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Live Below Your Means

2007-12-10T20:09:00.003-07:00

In the absence of generous, reliable pension benefits, all successful retirement plans depend on your ability to develop a portfolio of investments that will fund your retirement lifestyle. For most affluent technical professionals, this means that successful retirement planning begins with learning to live below your means (LBYM). If you get this component of retirement planning correct, the rest will fall into place. If not, no advice will help you. Exceptions to this rule are lottery winners and recipients of large inheritances. Unfortunately, I know of no way to guarantee you win the lottery or are born into wealth. The critical impact of LBYM principles on retirement planning is easy to understand. You will never have any money to invest if you spend it as fast as or faster than you earn it. So the LBYM principle is required before any investing can take place. If you do live by this principle, then you are either investing regularly or burying money in jelly jars in your back yard. Be sure to practice the former and your retirement plan will stay on track. You might be concerned about exactly how you allocate your investments, but these issues are neither as complex nor as critical to the ultimate goal as many inexperienced investors believe. Instead, the optimum investment portfolio is as much a matter of personal comfort as it is a specific set of investments. As long as you've learned the LBYM principle and make regular investments, you are likely to find efficient investment vehicles that will insure a safe and successful retirement.

There are two major components of LBYM: 1) maximizing means and 2) living frugally relative to those means. The first component is related to career path and job choices while the second is related to spending and living habits. Both are important. Even more important, however, is the realization that the LBYM principle is only a means to an end. If the achievement of an LBYM lifestyle and comfortable retirement requires that you become a miserly curmudgeon, you have missed the point. It is possible to put too much emphasis on either of the components above. Ruthlessly driving your career to ever-higher salaries may not be satisfying or comfortable for you. Similarly, an obsession with the cost of every luxury or comfort item may keep you from enjoying life. Balance is the key to an LBYM lifestyle and a happy and successful retirement.

Although the LBYM principle is simple and obvious, violation of it appears to be the major cause of failed retirement plans. It is not always as easy to apply as it appears. For many, it seems impossible. In a consumer-oriented world with advertisers encouraging us to buy something at every turn, it is not surprising that many become materially focused.

For more information on LBYM practices, visit http://www.golio.net/Chapter3.html
Many of the urls listed on this page provide articles, tips and web tools to help you develop an LBYM plan.

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