Readers recently submitted questions about financial planning for retirement to Doug Wheat, a certified financial planner with Family Wealth Management, based in western Massachusetts. Here is Part 1 of his responses; more will be posted on the Booming blog next Wednesday. (More than 100 questions were submitted, and regrettably not all can be answered on the blog.)
Q. My experience has been that retirement planners ask three questions, often somewhat obscurely: (1) How long do you expect to live? (2) How much income will you need to live comfortably in retirement? And (3) what do you expect the inflation rate to be? The math isn't very complicated -- if I were confident of my answers to those three questions, I could figure it out myself and wouldn't need a retirement planner. How about helping us figure out how to answer the three questions? -jrg, San Francisco.
A. By its nature retirement planning requires making plans without being able to know the future. You can, however, make reasonable assumptions and test them against historical data to determine the outcome with some confidence. The decisions you make in your preretirement and early retirement years set you on a path, but of course you will need to revisit your assumptions and adjust your path along the way. The Society of Actuaries estimates that for a married 65-year-old couple, there is a 45 percent chance of one person reaching age 90 and a 20 person chance of one person reaching age 95. So it is prudent to plan on living a long time.
The best way to determine the income you will need to live comfortably is to first determine how much you are spending on your fixed and discretionary expenses today. Second, determine which expenses will continue in retirement, which will disappear and which will be new. For instance, your property taxes will continue, but your mortgage may disappear and you may have new medical insurance and travel costs. And don't forget large periodic costs, like cars. No one knows what inflation will be. The Federal Reserve has a target annual inflation rate of 2 percent, but it is best to have inflation protection in some of your assets and income sources. Social Security is adjusted for inflation; some pensions and annuities are not.
Q. I have read that the rule of thumb is to withdraw 4 percent or 1/25 of your retirement funds each year. My guess is that this “rule†was developed when interest rates on “safe†investments (CDs, certain bonds, etc.) would support this level of withdrawal. However, with interest rates near zero (at least for now), it seems only equities have the chance to earn a sufficient return to support the 4 percent rule, but equities are risky for retirees. What is your advice on how to invest retirement funds, and is the 4 percent rule still applicable? -HonuCarl, Los Angeles.
A. The notion of a 4 percent safe withdrawal rate emanates from a 1998 academic study often referred to as the “Trinity Study.†In the study the authors from Trinity University provide historical evidence that if you begin withdrawing 4 percent of your accumulated savings your first year of retirement and increase that amount each year by the rate of inflation, you have little danger of running out of money over a 30-year period if it is invested in a balanced portfolio of stocks and bonds. For example, if you have $1 million at retirement, you can withdraw $40,000 the first year. Assuming the inflation rate is 3 percent, the second year of retirement you can withdraw $41,200. This strategy is appealing because it provides a steady cash flow while the value of your portfolio may be fluctuating. Updated studies through 2011 indicate that since 1926 there were no 30-year periods where you would have run out of money using this strategy (although if you retired in 1966 you w ould have come awfully close).
In a 2012 study, Wayne Pfau examined time periods of low dividend rates and high market valuations on withdrawal rates. He found that in those environments there may be reason for retirees to worry about the 4 percent rule of thumb.
In practice people may want to start with a 4 percent withdrawal rate and periodically adjust based on the current situation. A mix of stocks (equities) and bonds gives the best likelihood of success. If you are using a 4 percent withdrawal rate and the stock market booms, if you don't re-evaluate you will be living more frugally than you need to. The opposite is true as well.
It's also important to consider age. If you retire when you are in 50s, you will probably want to start with a lower withdrawal rate. If you are in your 80s, a higher withdrawal rate is certainly appropriate.
Q. I am very confused about what to do about long-term care insurance. Do you need to know where you will live when you retire, or are there policies that can be purchased in one state and used in another? Are there still such things as prepaid policies that you can pay off while you are still working? And are there any guarantees, or “insurance for the insurance� That is, what if the company drops you, or the company goes under, or sells your policy to another company that goes under - do you lose everything you've already paid into it? And how much do they really cover? If you go into a nursing home, don't you end up spending down all of your assets and ending up on Medicaid anyway? I've heard rumors that they don't really cover all that much, once the time comes to actually collect. I understand that health care is a huge, huge cost when one is older, but are these plans really worth it? Are you really better off with one, given all the things that can go wrong? The l ast thing I want to do is to spend savings on insurance that won't actually do me any good in the end. - E., Long Island.
A. Deciding whether to purchase a long-term care policy is one of the most difficult decisions a preretiree needs to make. Like many insurance products, long-term care insurance is insuring against a risk that you hope you never need but that if you do need it, you want to be sure it is there.
Long-term care companies are bound by state regulators to pay for care covered in their contracts. Indeed, the insurance companies have paid so much in long-term care benefits that Unum Group, Guardian, MetLife, Allianz and Prudential are not writing new policies because they are not profitable. There are no guarantees for long-term care insurance companies, but they generally have the ability to request rate increases if their costs increase, allowing them to continue paying benefits (sometimes price increases are substantial). You should know, however, that at least one long-term care insurance company, Penn Treaty, is in bankruptcy, and it is likely the policy holders will receive little in the way of benefits. Make sure you check the credit rating of an insurance company before you buy a policy. You can move from state to state with your existing long-term care insurance.
