Retirement Planning for the Middle-income Household, One Step at a Time – Part II

John J. Hohn and dog Jessie

In Deadly Portfolio: A Killing in Hedge Funds, Matthew Wirth and Morrie Clay work with wealthy people with large sums set aside for retirement planning. As pointed out in the first article in this series, that is not the case for the middle-class American household.

In the first post, we accomplished two important initial steps. First, a visit to the Social Security web site projected the amount of income a retiree can expect from Social Security depending upon retirement. Second, a life span expectancy calculator determined the period of time that income would be needed.

We concluded the completion of the Flexible Retirement Planner (FRP) questionnaire in this post. If you have read the first post, do it now.

The first posting covered an explanation of the first column of entries requested by the FRP. The second column also requires explanation.

Taxable Portfolio Value calls for entry of all the funds invested that are not held in a tax deferred account like an IRA, Roth-IRA, 401(k), 403(b) plan or an annuity. Include any funds that have been set aside in a savings accounts, savings bonds, credit union shares, and  brokerage firm or mutual fund company accounts. Enter the total for all such accounts regardless of the spouse’s name on the account.

Tax Deferred Portfolio Value calls for the entry of all funds held in tax deferred accounts like an IRA, Roth-IRA, 401(k), 403(b), or an annuity. The sum entered should include all the funds held by both spouses and all jointly held accounts.

Tax Free Portfolio Value calls for the entry of all funds held in non-taxable accounts. Tax-free investments are municipals bonds issued by the state, county, or city governments.

Taxable Annual Savings asks for an amount the retiree can set aside each year in an account other than a tax deferred account as explained in the preceding paragraph. Be cautious with this computation. Wishful thinking will result in later disappointment. If you have set up a budget program to capture the monthly expenses of the household,  you know how much is available for savings every month. Be conservative. If you can set money aside while you are still working, enter that amount even though you do not anticipate being able to save after retirement. You will need to run the FRP with a revised lowered amount when you retire.

Tax Deferred Annual Savings asks for the amount the retiree or retirees in the household will be setting aside in tax deferred accounts like an IRA, Roth-IRA, 401(k), 403(b) or an annuity. Include the amount matched by your employer, if any. Input to the calculation will be cut off on the date of your retirement earlier in the questionnaire.

At the top of the third column, enter your investment style. This gets tricky because it is very subjective, and we are often dependent upon circumstances to define our choices. Seven possible choices are provided, the last one being custom which lies outside the scope of this article.

Choosing among the remaining six investment styles should be guided by only a few variables. First, how close you are to retirement? If you are just months away or already retired, be as conservative as you can. You will be able to recalculate the projections many times, so if the first calculation does not work out, use the next most conservative style.

The mix of asset in each style is limited to domestic stocks, bonds, and international stocks. More choices may be available for your actual portfolio, but this site has limited the selection to these three classes.  We are wise to work within them. Notice that the allocation to stocks, both domestic and international, increases as the level of risk increases.

If you have several years to retirement, a level of moderate to above average risk is a suitable choice. The allocation in a portfolio can be changed anywhere at any time. In fact, it should be changed as retirement draws nearer. Notice that the aggressive style allocates 93% of the holdings to stocks. A very risky choice.

A previous posting discussed standard deviation. As the level of risk increases the standard deviation also increases. This web site calculates it for the respective risk levels. Note that the standard deviation is less than the average return at the lower two levels but greater than the average return at the upper three levels.

The investor also needs to choose his or her personal tolerance for risk in mind. I found that most clients did not know their risk tolerance. They knew that they didn’t want to lose any money but they never worked out what would be an acceptable level of risk. After discussing risk tolerance, some found they could accept losing as much as 15% in any given year as long as prospects over time were very promising to do better. Others balked at the thought of losing even 5% regardless of the long-term prospects.

Would you bet $1,000 on 10% chance of winning $20,000? How about a 90% chance of winning $1,500? Questions of risk tolerance need to be framed in this manner. As reward increases, so also does the risk.

Choices also depend upon prevailing market conditions, yet another subject for a later post. A good choice for the investor who does not want to deal with changing market conditions would be a mutual fund managed so as to change the funds holdings in response to changing market conditions. The task of reading, interpreting and adjust the holding in the fund to the market is then delegated to the fund manager.

The final fields that need to be filled on the first page of the questionnaire, again, are somewhat subjective. Annual Retirement Income asks for income expected from part-time work, work in the home, gifts or other sources of income. Also, expected dividend and interest income should be entered here. Do not enter social security or annuity payments here. They will be entered on a second page.

Retirement Income Start Age is a companion field to the one immediately above it. Enter year the retiree will start earning additional income.

Annual Retirement Spending calls for an estimate. If you have a household budget, this should be a relatively figure to come up with. Expenses do not drop off that much after retirement. Retirees tend to travel more and spend more money on leisure activities. Be realistic. Better to over estimate than under estimate.

Spending Policy asks for how disciplined the household will be at staying within the budget for annual spending. If you plan some extraordinary purchases like a car or a boat or an ocean cruise, do not enter it here. Provision will be made for the out of the ordinary items later. Again, this is a subjective field. You should know you own spending habits.

Notice in the upper right hand corner of the questionnaire page is an icon for “Additional Inputs.” Click on it and the program will display another page with two separate areas that request additional data. We are going to postpone dealing the first block calling for additional returns, inflation, and taxes. Your results will be very meaningful without tampering in this area. We will explore it in a later post.

The second block is another matter. It is very important. Each input field has a drop down menu indicated by the arrow. Look at the menu. The first item is social security. You calculated this on the Social Security web site, in the first blog post on this topic. Enter that amount. Then complete the other remaining fields as required. Start Year offers several options. If you retire before your social security starts, specify either the age at which you want social security to start. Set the End Year at the default value of “End of Plan.” If there are two wage earners retiring at different times in the household, make a separate entry for each.

Once the social security income is entered, click on the arrow to see the rest of the drop menu for this input block. If you expect to collect a pension in addition to social security, enter it next. Again, the Start Date should coincide with the year the monthly pension payments begin. With most pensions, retirees are asked to choose a payment plan. The default choice is usually lifetime payments for the retiree only. Thus, in the event of the retiree’s death, all payments cease. Other options may include the lifetime of the retiree’s spouse or a time certain period, usually a ten-year certain period, after the death of the retiree. The stop date should be set to coincide with whatever payment option has been chosen.

In fact, it would be idea if the simulation could be run to help with the payment option decision.

Payment options are usually favor the employer. If a pension can be rolled over into an IRA in a lump sum, it is usually better for the retiree and the retiree’s family because the funds will remain in the retiree’s estate upon the death of the last beneficiary. This topic will be discussed in a latter posting.

If you are to collect pension payments, you need to determine whether the annual amount will be adjusted for the cost of living, or cola. If so, choose the second option where cola is specified. The amount will then be increased with inflation in succeeding years of the plan.

Miscellaneous Income is an open field that can be used for a variety of reasons. Input here can include rental income from seasonal or year-round rental properties, annuities, royalties, patents, etc. If any are subject to  cost of living increases, choose the cola entry field.

Earlier we mentioned that special expenses should be entered at some point in the simulation questionnaire. This is the place for that. College Expenses and Travel Expenses are specified. Enter estimates for the years that they occur. Several entries can be made for each, if necessary. Other Expenses can be used for planned purchases of major items like an automobile or replacing household appliances. If the expense is incurred in one year, set the start date and the end date for the same year. If payments for the item are to be spread out over several years, enter the start date for the year that the purchase is made and pro rate the amounts over the number of years that payments are planned and set the end date in the year when the last payment comes due.

All of the entries will appear in the area to the right of the input fields. The first column is captioned Enabled with a ballot box. Checking the ballot box includes the line item in the simulation. Removing the check from the ballot box excludes the line item. This is a very convenient feature and comes in handy once you begin running the simulation as it provides for discretion on the inclusion of optional items.

The final column is caption Taxable Percent. Obviously, this applies to income items. Income tax rates typically drop in retirement. The program, therefore, is calling for the rate that you anticipate once you retire.

OK. All done for now. Return to the first page of the questionnaire by clicking the Done icon at the bottom of the page for the Additional Inputs. Once there, look in the upper right hand corner for the Run Simulation icon and click on it. The program may take a while to crunch the numbers and array the data. We will discuss the results in a subsequent blog posting.

Do not be disappointed in the outcome. It is far better to know than not know even when the news is less than what you wanted to hear. Play with the inputs. See what changes can be made to change the results. This is just the beginning of the planning process. There is much more to follow.

Congratulations on taking the first steps.