In January 2012 the Brandes Institute once again published a very interesting 32 page research paper called “Boomers Behaving Badly: A Better Solution to the “Money Death” Problem” that you will most definitely be interested in because it affects your retirement.
The paper tells you what you have to do to avoid “money death” – the risk that you run out of money during your retirement.
As you know because of changing demographics (the world getting older) you can no longer rely on government funded pension plans. Too many people entering retirement at the same time will impact you most likely wherever you live in the form of tax increases or lower pensions or both.
In spite of the current worldwide impression that Europe has the most serious demographic problem the paper shows that the US has got by far the largest percentage of its population entering the 10 years above or below the normal retirement age over the next nine years.
Most have not saved enough
And in spite of the substantial assets the 55 year plus age group has accumulated if you break this amount down to real numbers per person (just over $100 000 in the USA for example) you will quickly see that it is far too low to give them a comfortable retirement without help from the public or private pension system.
But how much money do you need to comfortably retire you may be asking?
And even if you have enough money to retire the current low interest rate environment substantially decreases the income your savings will produce. So even if you have saved enough money to normally allow you to comfortably retire the current low returns will make it difficult for you to live comfortably on what you previously thought was more than enough.
Two good questions to ask yourself
The paper comes up with two very good questions to ask yourself if you are desperate to generate more income with your assets.
The wrong question is: “what investment can generate the X% return that will pay me the income I need?”
The right question is: “how can I take the needed amount out of my portfolio every month without ultimately depleting my assets?”
The important trap you should not fall into is to think that you should never touch your capital and only live on your income when in retirement. This is especially important at times when interest rates are very low, when you will be very tempted to invest in high risk investments that may give you the income you need to cover your expenses.
The paper mentions that according to the book The Retirement Plan Solution: The Reinvention of Defined Contribution (Don Ezra, Bob Collie and Matthew Smith) for a portfolio 20% to 100% invested in equities you can safely spend 3.5% to 4.5% of your capital each year with a high probability that you will not run out of money.
What is also very important is to not invest in higher risk investments when your portfolio has gone through a tough time recording losses in one or two years. It is definitely not worth taking on the added risk just to make up for past losses.
Stick to your original investment strategy.
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Another thing you must also be careful of is thinking that as you move closer to retirement you should move more of your investments to safer investments such as bonds and cash.
The problem with this thinking is that it moves you into safer low return investments just as investment returns become more important than ever.
In the book (The Retirement Plan Solution) mentioned above the authors calculated that 60% of the total money you spend in retirement will come from investment earnings earned after you have retired.
Think about this for a moment.
More than half of the money you will have two spend after you have retired will come from growth your investments based on investment decisions you have made after you have retired.
The biggest problem you have when planning your retirement finances is that you just don’t know how long you will live. Improving medical technology and because people are leading more active lives once they have retired has led to increased longevity.
For example if you live in Italy and retire at the age of 61 you will typically live to about 82.5 years the same age as an American will reach when he retires at the 65.5 years.
Thus if you are a man retiring you have about another 20 years to look forward to and for a woman up to 25 years.
Remember that these are median life expectancy numbers. If you are healthy at the time you retire and look after yourself it is highly likely that you will live substantially longer than the above numbers.
What if you live a really long time?
If you have so far planned your finances conservatively is there a way you can protect yourself financially from the consequences if you live a really long life you may be thinking?
The authors of the paper took a look at the insurance market to see if there weren’t any insurance products you can use to hedge the risk of you living a really long life. They found an insurance product (called longevity insurance) but mentioned that it is not widely offered or used.
Longevity insurance is simple insurance product where you pay a large one-time insurance premium to an insurance company before or after retirement.
The insurance company then promises to pay you a monthly amount for life if you reach a certain advanced age (for example 85 years).
To get the highest amount should you reach the advanced age you have to accept the risk that if you die before the age of 85 the insurance company will keep the whole amount with no money returned to you or your estate after your death.
The paper gives an example of a 2011 longevity insurance quote. An investment of $100,000 at the age of 60 would give you an income of over $75,000 a year until death once you have reached the age of 85.
In the above example if you are 60 years old you have a 59% probability of dying before the age of 85.
This means that longevity insurance will only be a good investment for you if:
- You believe you are healthier than other people your age and
- You don’t have a need for income until you reach the age of 85 and
- Your investment portfolio is large enough that you can afford the insurance premium.
In order to calculate if such an insurance policy is worth your while what you want to do is calculate your “real age” (Google “real age calculator”) with real age referring to how healthy you are compared to the number of years you have lived.
Should your real age be substantially lower than the number of years you have lived longevity insurance may be something you want to consider.
At the end of the paper the authors give you the following guidelines for your retirement investment portfolio:
1. Maximise the long-term return potential of your portfolio. Because you may live so long after you have retired you have to relook the common idea that you should have all your money in safe cash and bonds once you have reached retirement age.
2. Minimise the probability that your portfolio falls to a level that it can’t generate the cash to meet your spending needs. This means you have to the diversified both in terms of asset class as well as geographically. It also means that you should rebalance at least yearly, moving investments from part that have gotten too large to other parts that have gotten smaller.
3. Include some method of increasing your income even at advanced age. If you have the ability to generate income once you’ve retired this takes a lot of pressure off your investments and gives you the opportunity of staying active, both mentally and physically, well after you have retired.
4. Invest in longevity insurance early enough so that the premium payment does not represent more than a small part of your total wealth (under 10%).
Having a sound investment strategy based on investing in undervalued companies as you have been learning about in my emails will take care of the equity part of your investments. It is however up to you to make sure you have saved enough for retirement.
Your retirement planning analyst