Monday, May 30, 2011

Overestimating Your Retirement Needs

A million dollars sounds like a nice round number to shot for when you discuss retirement planning. But the goal might be self-defeating for most folks as they check their quarterly balances in their 401(k) plans. In all likelihood, you contribute (but not enough) and your 401(k) plan is adequate (even a smallish 401(k) will have at least fifteen mutual funds, some of which will be passive type investments such as index funds). And even if you are average - average 401(k) balance of $20,000 and an average household income - around $50,000 - you can achieve enough wealth in retirement to do just fine.

And you can do it on a quarter of that sum, a much do-able number. But there are caveats, as there are in all things and not something you should ignore. First of which, we have briefly addressed is your expectations. Retirement savings, including Social Security is not really designed to replace 100% of your income. In fact, even in the heyday of the pension, and amongst those that still exist, the average payout is normally about 70% of what you can expect.

So working in round numbers: $50,000 in income/35 years until traditional retirement/10% contribution/4% return invested passively in index funds we have come up with the following future profile.

In retirement, you will need $35,000 a year in income. (Because of inflation, in 2046, that will be equivalent to $98,485. Inflation has the net effect of making what seems like a small amount look far larger. The flip side of inflation is that money will buy the goods at an equally inflated cost.)

Part of that income will come from your Social Security and/or pensions. To produce the rest, you should build up your nest egg (including your 401k, IRA and other savings accounts) to $251,110 by the time you retire. (In 2046, that will be equivalent to $706,590).

To save $251,110, your investments need to gain an average of 4.28% from now until retirement. If we are calculating this right, it is a safe estimate (about 99.78% chance) of this happening. But not without some effort on your part.

Even beginning at 30 can be considered young or starting early. With all of the rhetoric surrounding our longevity, the normal target age of 65 can be expected to be pushed back making 30 the new 20.

By passively investing, you have assumed as much risk as is considered advisable and even under the most modest of circumstances projected at 4% or slightly higher, the low cost of this type of investing will give you bigger gains than if you had assumed more risk at a higher expense.

And although inflation will inflate your net total, taxes based on the $35,000 a year income should remain relatively stable. And by using index funds across several markets (an S&P 500, a mid-cap and a small-cap domestic equity, an international index and a bond index) you have chosen the most tax efficient method of investing ever invented.

The remainder of the plan relies on you contributing 10% of your pre-tax income and staying out of debt. This means you will have to adhere to some sort of budget from now until the end.

The bottom line: a million might be too lofty a target for most and may spur some folks on to achieve more. But for the vast majority of us, comfort and security is enough to give us hope. More than that - strongly encouraged by the way - will simply be icing on the retirement cake.

Paul Petillo is the managing editor for and a fellow Boomer

Thursday, May 26, 2011

Our Instincts are Never Wrong: Until They're wrong

It has been decades since behavioral economics took hold as a science of investor actions. Designed to study the irrational decisions that we all are apparently hard-wired to make, the field grew into a respectable and well-quoted discipline. Which is fine. We know we have incredibly limited potential to redesign ourselves, despite the pushing and prodding in one direction, the look-in-the-mirror study of our own foibles and the instructions on how to improve this very human lot in life. But we muster on. And this is why, even despite the improved access to our 401(k) plans does our retirement still suffer.
Studies done quite recently suggested that most folks will simply accept the status quo if given a confusing situation. Investing is just such a case-study in chaos, less so for the experienced investor, but even for that group, a churning pool of information keeps them struggling to keep up. But the behavioralists  insisted that auto-enrollment in a retirement plan would create great strides for the plan and even greater rewards for those who may have - and still do have the option of - opting out.

Auto-enrollment we have found out is a trip through the wardrobe. We may all have taken the first step. But what awaits us on the other side, in almost every instance, is our irrational mind. And in almost every instance as well, a less-than-wonderful 401(k) plan. But more on the plan later. Let's just focus on what we have done recently as we embrace our biases, follow our illusions and believe in the fallacies.

There have been several alarms ringing on Wall Street and those who invest in mutual funds have turned a deaf ear. Herd mentality, the primitive instinct to follow the herd because doubt in the face of danger can present death was considered a valuable possession. Somewhere along the line though, things changed.

In our wonderful modern brains, this instinct has evolved into a trait, or so say the behavioralists, the makes us run towards the danger because everyone else is. What once once a survival instinct is now a suicidal tendency, at least in the world of investing. (Look at it this way: It would be similar to seeing a crash on the highway and deciding that driving your car into the pile would be in everyone's best interest, including your own.) Evidence of this is beginning to crop up and our big "modern" brains are at fault.

There are three types of mutual funds or mutual fund investment strategies that have shown a tendency to attract these kinds of investors: emerging markets, commodities and a category I'd be willing to wager you didn't realized existed, floating rate funds. (Amy Or of describes them as "Unlike fixed-rate loans, floating-rate loans can capture rising interest rates and are deemed a good inflation hedge" and with some uncertainty about when if sooner-not-later, interest rates begin to rise, these funds will be able to capture the change in market conditions.

Recent herd-like inflows of over $14B suggest that the usually high load fees and the underperformance of late matter little. It is where, these investors believe they should be. But because, as so often is the case with herds like this, so many have heard the siren's call, the opportunity to make any more moves to the upside have been hampered. That means a lot of people will eventually follow the herd off the cliff, ost of whom bought at the top.

When they aren't betting on debt, they are looking at commodities. These funds, focused on such tangibles as oil, silver and gold will to most of us, seem to be destined to go higher. And if you bought into this sector recently, you have  high hopes that it wasn't at the top. But silver suggested it was, as did oil, and the drop in prices found those same people scrambling to get out. Most bought in with expanded exposure in their supposedly well-balanced portfolios and are now paying the price for having believed that diversity was just another word for profit.

And emerging market investors are beginning to realize that perhaps they too have been failing to listen to the global heartbeat. Europe is not finished with its economic woes. Commodity prices may have fallen but they still remain uncomfortably high for countries looking to emerge and now, predictions of slowing growth at expanding powerhouses like China have begun to worry the savvy investor. You newbies are deeply embedded in the herd still.

You may have been auto-enrolled, but the walk through the wardrobe left you in the middle of the Serengeti. And you probably won't get the memo that you are in danger until it is too late. This thinking about getting you in, attempting to educate you, guide you, slip you into an ill-suited target date fund came by way of Thaler and Sunstein's book called Nudge: Improving Decisions About Health, Wealth and Happiness. In is not the same as knowing what to do or how to act when you arrive. The information tsunami hasn't lessened and may have even gained strength over the last several years and investors, particularly the neophytes, will still drown before they learn to swim.

How running with the herd once saved you only to become the complete opposite will remain a mystery. And getting people into these plans by using science to study our unpredictable-ness is still a good idea, even if it seems suspect. But once there, the status quo is good. But who says what the status quo is? You may never get a clear bead on the answer,  Until you realize the herd is leaving the room.

Paul Petillo is the managing editor of and a fellow Boomer

Friday, May 20, 2011

Remember how You once thought of Old?

Boomers have no problem with admitting they are getting old. They may not want to face the realities of age but the facts are there - if only in the reflection staring back from the mirror.

Remember when old was anything just a generation ahead of you. If you were ten, anyone in their thirties, more often than not, your parents and their friends, your teachers and coaches, were all old to you. It seems that as you got older, the definition of what old was was pushed back further. By the time you were 30, old was fifty. Why do we place such importance on this bookmarkers of passing time? Because each "old" has its own problems, not just health-wise as our bodies age, but financially as well.

Everyone has an answer to the conundrum of age. When it comes to money, the issues seems to double in size and complication and as a result, weigh much more on what our next stage of old will be like. You are told to invest in your retirement early and often even as the only word financial word you have any real acquaintance with is debt. In your early to late twenties, it manifests as college debt and the high cost of flying on your own for the first time. You invest little for retirement and pass up the financial golden ring to pay-as-you-go because you will never be old.

And then, a decade or so later, you are older faced with mortgages and kids and schools, saving for college, insurances and taxes and simply keeping pace with your family. You have begun to invest but in a piecemeal way. You may be auto-enrolled in your company's 401(k) if your workplace has one. If not, you probably haven't done much, at least regularly with investing for old when left to your own devices. You may have lumped summed it, which is bette than having done nothing, by dropping tax returns or bonuses in some IRA. But old costs more than you might have and debt, that first word you learned upon getting your diploma, is probably still a very real participant in your day-to-day decisions.

Forty is better and older but you now feel the bruden, mostly in the form of guilt at having underinvested. Now you struggle with older kids, college realities and aging parents. You probably have refinanced you home and if you are like many Americans, still paying for a vacation you took a couple years back all the while planning on the next. If you are like most, you haven't increased your payroll deduction in your 401(k) since you enrolled and probably haven't done much in the way of rebalancing or choosing the best age-appropriate investments.

Fifty, the real old, hits you like a ton of bricks. You may have some or all of the same problems you did at 30 (I hope not) and at 40 (kids are failing to launch, parents are a real concern) but now you grasp them to their fullest. And with a gasp and a moan, you realize that you will have to work until you are 70. the oldest person alive when you were 10.
Here are five basic things to do if you realized you are old. Or 50.
  1. Get your head around any and all debt. Nothing will bring a future to its knees faster than paying interest on borrowed money.
  2. Get out a calculator. Not just the physical kind but the online kind as well. As much as I dislike these tools, because one allows this input while another doesn't, just take the raw data: how much is currently in your retirement accounts, estimating that they will grow until you decide to retire at a modest 4% (this accounts for mistakes you can't know about like inflation and taxes) with a modest 4% withdrawal if asked to enter this as well and hit enter. Now take that number, usually expressed as a annual income, divide it by twelve and ask yourself, can you live on this?
  3. Ask yourself is this enough? If it is 75% of what you currently need to live on, you aren't just old you're wise too. It its less than that, you will need to rethink your cost of shelter, the amount of money you spend each month and in doing so, channel every available cent to the plan you have in place. It might seem like a huge hurdle and it is. But you are running out of time. It means budget, budget, budget.
Of course, it goes without saying that starting early is best. And it also goes without saying the every age has its own setbacks financially. But every age has its potential for success and as you age, the potential doesn't go away, it simply becomes a little more challenging. Worrying about money as many surveys suggest we do, will not fix the problem. Why? Because worrying is the purview of someone who has no control over a situation happening. This one is all yours and well within your ability to control.

Paul Petillo is the managing editor of and a fellow Boomer

Tuesday, May 10, 2011

Putting Your Money on a Treadmill

Baby Boomers may be acquainted with stress test and treadmills. But the importance of testing your retirement plan under certain types of stress is just as important as trying to figure out how well your heart is pumping.

The term stress test brings the fear of the unknown to otherwise stable events in our lives. The term became part of the vernacular of the financial system when the Secretary Treasurer  Andrew Geithner began asking how well the banking system would hold up under certain conditions. He knew that there were problems in how well a bank would withstand a crisis but until they tested for it, few people knew it as much more than a gimmick. Turns out, the nineteen banks that were tested, eleven failed.

Now stress testing adds its own stress. In part because we are all optimists at heart, seeing the future as brighter than it is and always believing that somehow we will survive whatever life throws our way. Even the off-handed question: "what's the worse that could happen?" never really attempts to answer the query, simply make you consider that something wrong might occur. And when it does occur, we simply suggest that we didn't see it coming.

In the world of personal finance, asking what's the worst that could happen is not the same as asking: "will I be able to afford this?" or "have I saved enough for retirement?" The worse-that-can-happen actually imagines the worst. It doesn't make plans for the worst based on optimistic scenarios. It plans for the downside and readjusts the outlook from just-in-case to what-now?

We're not conditioned to think like that. So I thought I'd give you some scenarios you think so brightly about and throw a little water on them. First: your budget. You lie about this too often. You project into the future (I'll be receiving a bonus or a raise next month) and spend money as if you had it. Otherwise you would even pull your credit card from your wallet. it is borrowed money that projects your optimistic ability to pay the money back at the end of the month. There are few of us out there who prudently deduct this cash from your available cash balances; but their number is small.

To stress test your budget you will need to know exactly how much meeting the so-called ends actually is. Not adding in the incidental items that can be canceled in the event of an extreme financial emergency (cable, internet, cell phones all of which are still luxuries even though we identify them as necessities), how much is your survival costs: housing, food, fuel, utilities?

A stress test would ask if you have accumulated enough in reserve to pay those basic necessities in the event of an emergency. How long could you pay for these necessary items based on what you have in your emergency accounts? My guess is not long. But once you identify this problem, you have to solve it - which is why many of us fail to do this sort of test. It adds stress. To realign this budget problem you can do three basic things: put $25 a way each week for emergencies (a cookie jar is just fine and you'd probably be surprised at how much loose change you can accumulate over time), stop spending someone else's money (try to get through a month, perhaps two without using a credit card - yes you will have to think more about each purchase) and debate the worth of every purchase (remember, just because something is on sale or looks inexpensive doesn't make it something you need.)

Another optimistic project that needs to be stress tested is your retirement. I suggest based on what I know and what I research, that most of us are not in a good position to retire anytime soon. But even these folks who acknowledge their financial shortfall are still looking at the big picture through rose colored glasses. We project investment earnings (without any real basis for these conclusions). We often think our portfolios will return 5-7% even as we switch from aggressive investments in our youth to conservative investments as we near retirement, which even a math challenged person will see as a falsehood. You can't protect money and still earn better than historic returns.

We base inflation numbers on what we know. We think of taxes based on what we currently pay. And we calculate our withdrawal based on what we think we'd like to live on. These aren't stress tests; they're optimistic projections. Stress tests give us a worse case scenario. You can also do three things here as well: contribute more, use both a before tax and after tax retirement plan (such as a 401(k) and a Roth IRA) and lastly, imagine life on half the income you currently earn.

Paul Petillo is the managing editor of and and a fellow boomer.

Wednesday, May 4, 2011

Baseline Decisions about Retirement: Calling it Quits

There is no accurate predictive tool to tell you what the next year, five, or ten will be like. You can’t even make an educated guess. You can make a few assumptions. But the real truth is you will be making those based on biases, illusions, and dreams that may or may not come true. So who do you cross the threshold of retirement with any degree of confidence? Perhaps a little real time preparation would be nice.
Most of the people (Boomers) thinking about retirement know one or two things: first and not the least, they no longer want to work. This sort of commitment will come from a sector of the working population who has felt the largets physical toll on their bodies. That doesn’t mean that they have labored so hard – although many do – it suggests physical exhaustion with getting up, going to workplace that no longer holds any interest other than a paycheck, and may be causing you more mental grief, which often translates into physical problems, than would otherwise be worth it.
The second is that you think you can afford it. In either of these two instances, the desire may outweigh the resources. But you are willing to give it a try. Here are a couple of things you should consider before you make the leap.
Refinance. If you are still paying on your mortgage, while you are working is the best time to get a new deal. If the statistics hold true, you probably do not own your house. Unlike your parents, who entered retirement in full ownership of the home they lived in, you will be entering into this time-of-no-work with a mortgage hanging over your head. Get the lowest possible interest rate possible and if you can draw some of the equity, make some improvements that will make the home more liveable and in need of less maintenance.
Now you have a baseline for your shelter needs. Your car may or may not be something you will need but I’m willing to bet, you’ll want one. While the lure of a sports car or something similarly racy is appealing as you approach second youth, keep in mind that you will need to get in and out of it and so will your friends.
You still have to eat, do stuff and be entertained. If you haven’t begun tracking your budgetary needs by now, start. Now cut them by about a third. Even if you believe that you have saved enough and have enough to live on, you won’t spend as much in the fifth year of retirement as you will in the first. And ten years into it, the number will go down further. So calculating a third of what you use now will not only take into consideration your diminishing activities, but the cost of inflation, taxes and insurance (which includes health).
Understand this: You need a will to keep things out of probate. But you do not want to think of your assets as inheritable. What some planners call capital preservation is fine while you are closing in on retirement – in other words, while you are still working – but preserving capital once retired can be a foolish and costly mistake. Preserving capital for your heirs is not and should not be part of your plan. There a two things you should know. As you age, you will spend less money on leisure and more on your health. The second thing you should know: keep your risk low but if your income needs a boost, tap your capital in reserves. Each $50,000 saved will net about $500 a month (at a reasonable 5% return) for eight to nine years. That can be a real boost to your lifestyle and help with any health insurance gaps.
Understand this, part two: If you are married, one of you will die first, Regrettable but true, one spouse will survive the other and in many instances, it will be the woman. Good financial prudence and smart decisions at retirement will make this transition much easier. When calculating pension benefits or annuity decisions, do so based on the fact that your spouse will need money after you die. You may have to live on less. BUt the peace of mind will be the legacy you leave to your partner. Don’t worry about the kids. Just your spouse and his/her welfare after-the-fact.
So the bottom line is: get your home finances in order (refinance, repair, and re-evaluate), understand the constraints of fixed incomes (cars, entertainment, health concerns), be sure you have a will and make sure your kids know your finances, have met your lawyer or financial planner and are authorized to speak with them, and lastly, do what you can to stay healthy – both before you retire and after the fact. Nothing will get cheaper. But then, it never has in your lifetime. If you have to work longer, keep in mind that $50,000/5%/$500 rule, understanding that five years more work at $6,000 a year in contributions to an IRA (more to a 401(k)) will get you very close to having that amount eight years into your retirement.
All of this of course is based on the assumption that you have done your best, used your plans at work and have lived life smartly. If not, there is little time to waste.
Paul Petillo is the managing editor of and and is a fellow Boomer