Archives for March 2011

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Planning for Uneven Retirement Spending

Jim writes in to ask:

“I’m 58 now and planning to retire in the next couple years. After much reading, I’ve decided that I’m comfortable using a 4% starting withdrawal rate, which means I need to have saved 25 times my annual expenses.

The thing is, I expect my expenses to change over time. Approximately 3 years into retirement, I will finish paying off my mortgage. And once I reach age 70 I’ll begin collecting Social Security, which will further reduce the amount I’ll have to withdraw from my portfolio each year.

How do I account for those changes when calculating how much I need saved before I can retire?”

Situations like Jim’s are pretty common, due to the fact that many investors retire before they begin taking Social Security. So I thought it would make sense to work through it to provide a framework for other readers who have similar plans.

How About Some Actual Numbers?

First, let’s make up some numbers to use. Ignoring inflation for the moment, let’s assume that Jim plans to withdraw the following amounts from his portfolio:

  • $55,000 per year for the first 3 years,
  • $40,000 per year for the next 7 years (assuming his mortgage payments totaled $15,000 per year), and
  • $30,000 per year for the remainder of his life (assuming Social Security provides $10,000 of income per year).

So how much money does Jim need saved before he can retire?

Mental Accounting Tricks

I often find that a little mental accounting makes things easier to understand. Try thinking of Jim’s spending needs as distinct segments:

  • $30,000 per year, plus
  • $10,000 per year for 10 years (from age 60-70, before claiming Social Security), plus
  • $15,000 per year for 3 years (for the final 3 years of his mortgage).

Given that Jim wants to use a 4% starting withdrawal rate, funding the $30,000-per-year need would require $750,000 of savings (because $30,000 ÷ 0.04 = $750,000).

From there, we can just add the remaining numbers:

  • $100,000 to fund 10 years of $10,000 per year, and
  • $45,000 to fund 3 years of $15,000 per year.

So, in total, Jim could retire once his savings reach $895,000.

Accounting for Interest

In actuality, Jim can retire with slightly less than $895,000 due to the fact that he can earn interest on the money that will go toward funding the final 3 years of mortgage payments.

And if Jim expects his savings to outpace inflation, he can reduce his savings goal a little further to account for the above-inflation interest earned on the money that will fund the $10,000 of annual spending prior to claiming Social Security. (I’m assuming that, in contrast to the mortgage payments which are a fixed nominal amount, this $10,000 per year will increase with inflation–hence the need to earn interest above inflation in order to reduce the savings target.)

Multiple (Mental) Portfolios

As to the question of how to actually invest the money, I think it can be helpful to continue with our mental accounting. Think of it as three separate portfolios:

  • A $750,000 portfolio, invested in keeping with whatever asset allocation you think is appropriate for a typical retirement portfolio.
  • A $100,000 portfolio, invested very conservatively (nominal Treasury bonds or TIPS, for example).
  • A $45,000 portfolio, invested in something with zero risk (CDs, savings, etc.).

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Vanguard Review: Why I Invest with Vanguard

Over the last few years, I’ve had accounts at just about every brokerage firm you can name–Schwab, Fidelity, Vanguard, ETrade, Scottrade, TradeKing, and a whole list of others.*

And over the last year, I’ve consolidated everything at Vanguard.

To be clear, Vanguard is not the only reasonable choice. Low-cost, diversified portfolios can be built just about anywhere these days. So, while my own portfolio consists of Vanguard index funds, I’d be perfectly happy with this portfolio of commission-free ETFs at Schwab, for example:

  • Schwab U.S. Broad Market ETF
  • Schwab International Equity ETF
  • Schwab Short-Term (or Intermediate-Term) U.S. Treasury ETF

…or this index fund portfolio at Fidelity:

  • Spartan Total Market Index Fund
  • Spartan International Index Fund
  • Spartan Short-Term (or Intermediate) Treasury Index Fund.

So Why Do I Use Vanguard?

I prefer Vanguard because of their unique ownership structure. You see, Vanguard is owned by the mutual funds it runs. (This is in contrast with other brokerage firms and fund companies, which are owned by third-party shareholders.)

Believe it or not, this isn’t just trivia. It has important ramifications.

Low Costs

First and most obviously: It makes their funds very inexpensive. All of Vanguard’s services are provided “at cost” to investors. And why wouldn’t they be? The investors essentially own the company.

Cost Reduction (rather than Profit-Maximization)

Second, it means that Vanguard is always looking for ways to reduce costs even further. Contrast this with other brokerage firms, and you see a big difference.

For example, discount brokerage firm Zecco became known for offering commission-free trades to people with accounts of $25,000 or more. They recently announced, however, that they’re ending that program completely. Tough luck to everybody who opened accounts for exactly that reason.

With Vanguard, you don’t have to worry about bait-and-switch tactics like that. You don’t have to worry about them roping you in with a low-cost promotion, then jacking up prices to increase their profit margin (because, again, there is no profit margin).

Elimination of Conflicts of Interest

Finally, Vanguard’s unique ownership structure means that the information investors receive from them is not polluted by conflicts of interest.

As a contrasting example, with my account at Schwab, I frequently received emails (as well as their quarterly On Investing publication) that encouraged me to seek above-market returns by trading individual stocks or selecting actively managed mutual funds. I daresay it’s not a coincidence that frequently trading stocks and investing in high-cost funds happen to be strategies that are more profitable for Schwab than buying and holding index funds.

My experience was similar with other brokerage firms: They consistently encourage their clients to use investment strategies that are most profitable for the brokerage firm, regardless of how likely those strategies are to be successful for the investor.

At Vanguard, it’s different. I don’t agree with every piece of information they put out, but at least I don’t have to worry that they’re trying to get me to do something just because it’s more profitable for Vanguard.

*I do not recommend having accounts at several places. I did it for business purposes — so that I could write intelligently about several different companies — rather than investment purposes. As an investment decision, it makes little sense.

How Much Should I Save Per Year?

The question in the title is one I’m asked quite frequently. Unfortunately, I never feel that I’m able to give a satisfactory answer. Easy-to-follow instructions like, “invest 10% of your income” are popular, but I think they’re rather problematic.

The amount you should invest per year depends significantly on your plans and circumstances. To get even a ballpark figure, there’s a whole list of questions that need to be answered.

How Much Will You Need (per year) in Retirement?

  • How will your retirement spending compare to your pre-retirement spending?
  • Will you have a pension?
  • Will there be a stage of semi-retirement during which you’ll have income from a job or business?

The more you expect to spend in retirement, and the less of that spending that will be satisfied via wages or a pension, the more you need to save now.

How Much Will You Need (in total) to Retire?

  • At what age do you expect to retire?
  • How much of your portfolio are you willing to annuitize?
  • Is it important to you to leave money to your heirs?

The longer your expected retirement, the more money you need saved, and the fewer working years you have to reach that level of savings–meaning you need to save significantly more per year.

Working in the other direction, the less you care about leaving money to heirs, and the more of your portfolio you’re willing to annuitize, the less money you’ll need saved before you can retire (and, therefore, the less you have to save each year).

How Many Years Do You Have to Save?

  • When did you start investing?
  • Did you (or do you expect to) take any years off to have/care for children?

For example: Investor A gets a full-time job at age 22 and works straight through to age 65. Investor B gets a full-time job at age 25, doesn’t start saving until age 28, takes 6 years off from 30 to 35 to have/care for children, then works from 37-60, at which point he/she retires.

Investor A has 43 years of saving. Investor B has 26 years of saving. In order to finance the same level of retirement spending, Investor B will have to save significantly more per year than Investor A.

A Better Approach

Rules of thumb that ignore all of the above person-specific circumstances will, by definition, lead some investors to dramatically under-save and others to dramatically over-save.

Instead, I’d suggest working your way one-by-one through the following questions:

  1. How much do I expect to spend each year in retirement?
  2. How much of that spending will have to be financed by savings (rather than Social Security, pension, part-time job, etc.)?
  3. How much (total) savings will I need in order to finance that level of spending?
  4. Given how many years I expect to be saving, how much must I save per year to reach that level of savings?
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