Hardly a month goes by without financial advice publications (MONEY, Kiplingers, AARP, etc.) running articles about how to prepare for retirement. And, so much of this advice is needlessly complex.
For example, I just read the recommendation for a couple about to retire who had $1,200,000 and who had determined that they needed $5,000 per month, or $60,000 per year, in income to supplement their Social Security. The combined income would enable them to pay what they estimated their expenses to be.
Earning 5 percent on $1,200,000 was simple enough and certainly doable, assuming they weren’t paying 1-2 percent in adviser and/or brokerage fees. A balanced index fund with a 50-50 mix of stocks and bonds averaged 6.5 percent starting in 1999 — an 18-year period that included two major crashes and a famous “lost decade” where 500 index returns totaled zero.
The writer, however, couldn’t leave well enough alone. Part two of the recommendation was to buy a deferred annuity that would start paying $5,000 per month beginning after 20 years and continuing until both spouses had died. The annuity was going to cost $200,000 — an amount totally disappearing if both spouses died within the first 20 years — plus it reduced the income-producing nest egg by this amount in the meantime.
The supposition that they would run out of money plowing through their nest egg over the first 20 years assumes that the $1,000,000 left after the annuity purchase is earning nothing. Plus, having reduced their account by the annuity purchase means they are eating into principal to a greater extent in an effort to generate the $60,000 per year. Furthermore, it does not factor in the effect of inflation on the value of $5,000 per month starting in 20 years. At 3 percent annual inflation over 20 years, today’s $5,000 will be worth less than $3,000. In short, the whole “plan” paints an unrealistic picture designed to sell an annuity.
A more enlightened approach is to just invest the entire $1,200,000 in a 50-50 mix of stocks and bonds (a balanced index fund) charging about 0.2 percent (two-tenths of one percent) — and spend just 5 percent per year (currently $5,000 per month). This dollar amount may shift up or down from year to year based upon the account size at the beginning of each year. Any excess over 5 percent — and there should be some — can compound and increase the size of the “nut” to protect against inflation. The source of most of the monthly income will be interest and dividends. Any dipping into principal should be more than offset by gains on the 50 percent of the assets allocated to stocks.
Bear in mind that balanced index funds typically earned an average of 6.5 percent over a turbulent 18 years since 1999. It’s hard to imagine a period that could have been much worse from an investor anxiety standpoint, but it may be comforting to know that a 50-50 mix of stocks and bonds lost about 20 percent during the crash of 2008 and gained back 36 percent over the following two years.
A prudent retiree would have reduced the dollar value of the monthly income in 2008 (5 percent of a smaller asset base), even though previous years had generated a surplus.
In summary, elaborate schemes promising to squeeze blood out of rock usually fall short of what they promise. Simple steps like working longer, delaying social security as late as possible and belt-tightening during rare downdrafts in asset value are time-tested alternatives.