The current American dream is to retire early and indulge in your passions. There are a multitudes of websites, books and media experts telling people how to do this. Some advocate staying in cash and CDs, others in all stocks and the Rich Dad, Poor Dad contingent who believes in real estate as the road to wealth.
Whatever your belief or comfort zone is when it comes to investing, there are two things that you need to take into account while planning for your retirement: 1) inflation / deflation and 2) life’s surprises.
Here is one case study of an actual couple and their outcome from in investing in fixed income for safety and security:
Baby Boomer Couple Retired Early
Jan and Norm Packard (not their real name) retired at 50 with $1 Million in Southern California fifteen years ago. They were middle class, had decent paying jobs and had saved aggressively. They decided to retire early at 50 since they had hit the magic $1 Million mark that everyone talked about. They had almost paid off their house at the time and with only 5 years left, they spent $28,000 to pay off the remaining balance.
Seniors for Hire - courtesy Kodama
They had built their nest egg by saving and investing in stocks. At the early retirement, they switched completely to laddered CDs and bonds. This meant that they bought bonds and CDs that would mature at different times so that they would have something to renew every three years. At the time, they were getting 5-8% returns on their CDs and bonds and had a $65,000 annual income. Both were too young for Social Security so they were dependent on their investment income.
Jan and Norm had to scale down their living expectations since they were making $125,000 as a couple before retirement. They were able to do this and had a good time traveling on budget around the world and enjoying life in general. However, each year, there was something that would exceed their budget and eat a little away at their principal.
One year it was replacing the roof on their 35 year old house. This cost them $20,000 and they had to take $15,000 out. Another year it was surgery and health issues for Norm which cost another $10,000 from their investments.
Another of the reasons that they had to tap their principal was the fluctuation in their income. When interest rates are down, their income dropped along with it because the fixed investments that they buy pay substantially less and they were locked in on the CD and bond rates for several years.
When Jan and Norm reviewed their portfolio last year, their principal had gone down to $475,000. Their income from their bond and CD portfolio was $20,000/year. They had been tapping the principal every year to live on for the last 10 years. They were intending to take another $55,000 out this year. They had $300,000 of the bonds coming up and were looking at rates of 2% which would reduce their income further to a total of $12,000/year for the next 3 years.
At the rate that Jan and Norm were going, they will be out of money by the time they are 71-74 years old.
They both qualified for Social Security this year which would supplement their income but there was a hitch. Because they both retired so early, their Social Security checks were a lot less than they had anticipated. It looked fine 15 years ago but now, it’s not at the level they want.
Due to fear about loss of savings, Jan and Norm decided to stay in bonds and CDs with the assumptions that their income will increase when interest goes back up and they won’t have to continue to tap their principal.
The reality
- Insufficient planning for a long life – The Packards retired without ever thinking through the fact that they have 50 years of generating their own paycheck to plan for. In fact, they admitted that they went by the standard of $1 Million and quit their jobs as soon as they hit that. In addition, neither ever really thought about how long they might live. Their whole focus was on retirement and enjoying life.
In 1995, $1 Million was a lot of money. Houses in the premium areas of Orange County, CA were selling for $200,000. Jan and Norm didn’t do a cash flow analysis to identify their expenses. There were costs such as health care premiums that went up dramatically and offset the savings from clothing purchase for work and commuting costs. In fact, at the time, not too many dental plans were available for individual purchases so there were several thousands of dollars in expenses in some years for dental care.
- No hedge for inflation – They didn’t think about inflation. Most normal people don’t. That’s a word that someone typically does not run around thinking or factoring in.
Inflation is simply the rate that the things you buy are going up in costs while your ability to buy the items are going down. Over time, everything will cost you more money. However, your money will not increase in value at the same rate. The easiest example is a car. I bought a deluxe Toyota Camry for $14,000 in 1990. When I looked at replacing my car in 2003, it was $24,000. Today’s price for a stripped down deluxe model is $32,000.
Your money simply buys less and less every year so your savings needs to grow in value to offset that loss of buying power. Most industrial countries try to maintain inflation between 2-3% a year.
- Did not cut back enough on expenses – When their income got hit by lower interest rates, the Packards did not reduce their standards of living immediately to live within their means. They continued to travel and simply tapped their principal. When you’re in retirement and not working, your income is fixed. You have to always live within your monthly paycheck or less.
- Making assumptions does not guarantee success - Hope is not a valid strategy for retirement. You have to plan for the worst and you have to plan for today. Never assume anything because no one knows what or when things will change.
- Not locking in rates – This is a tough one. No one can predict the future so the practice of laddering the bonds and CDs made sense because if interest rates go up, the Packards were not stuck with lower rates. When they retired, interest rates were being raised continuously. The Federal Reserve Chairman at the time, Alan Greenspan, raised interest rates six times back to back in 1996 and broke the back of the recovery for a short time. They had no warning or premonitions that interest rate would be artificially depressed for years to generate growth.
Don’t get me wrong, the Packards were worried about their future. They were upset about the reduction in their income. They were slowly making changes in their spending habits. They decided not to travel as heavily since 2007. They know that they need to make changes but were uncertain what to do. They even consulted new advisers.
However, there was a disconnect between what their perceptions were and reality. Even though their savings had been reduced to $475,000, Jan and Norm felt sort of okay. They were in better shape with that pot than a lot of their friends who were still working. This gave them a belief that they were fine. They were comparing themselves to other people instead of looking at only their reality.
In retirement, you have to be ruthless to survive. You have to make instant decisions about spending money such as cutting out extras immediately when your income is reduced. There is no margin for error when you are not working. It is best to look only at your case and not compare to anyone else. Their living expenses are different and you can’t see all the details. It also doesn’t matter what someone else’s retirement is like. Yours is the only one that matters.
If you choose to have only fixed income in retirement, your entire life needs to be planned around that investment choice. You have to understand that your savings will be reduced little at a time and it’s a race between death and money running out. There’s risk in every type of investments, equities have their downside too. The key is to recognize the risks and have emergency plans ready to go if the worst happens.
People have been trained to focus on savings and building a nest egg but very few talk about how to live in retirement without outliving your income. This area is more important than anything that you have done while you were working. While working, you have time and youth to fix mistakes. After retirement, you have set paths and options that are limited by your savings. At 75, if you have to go back to work as a senior, there are fewer choices.
Readers: What kind of resources should be available to help people in retirement?
© 2010 MoneyandRisk.com all rights reserved
