Many authors (Michael Kitces and Wade Pfau among others) consider retirement planning to be among the most difficult problems to solve. Their reasons are many but mainly it has to do with the myriad of unknown (and some essentially unknowable) quantities. Among these are lifestyle and the associated costs, health and associated health care costs, life expectancy, inflation, safe withdrawal rates, and future rates of return. These variables are all just related to the costs of retirement and have not addressed the “plan” that was followed in order to get to retirement — that is, how and when was the funding of that retirement gathered: after tax vs. pre-tax, risk analysis, and return on investments.
What I intend to do here is to assemble some of my observations that will, hopefully, help the reader to understand some of the problems, and show some assumptions that will ameliorate some of the difficulties. The ultimate goal is to allow you, the reader, to set your own goals and enjoy a nice retirement without having to depend on a community of financial planners (FPs) for whom I have more than a bit of disdain.
We will start by establishing the primary retirement goals and establish some planning guidelines/assumptions (lifetimes, returns on investments, inflation, the 4% rule). Then, look at how much income will be needed in retirement. The amount of income needed in retirement is intimately related to how much you make today and how much you save today. Once you know how much you plan to spend in retirement, then we can establish how that income will come to be from various sources: social security, pensions, savings, work etc. And, of course that income in retirement must exist after taxes – and so we will discuss taxes while working and in retirement.
One of the major problems associated with retirement – especially early retirement is how to fund health care. This almost intractable problem has almost innumerable variables: costs, personal considerations, government programs, and employer options. I have really given short shrift to health care. The reason is I don’t understand it – haven’t had to deal with it, and it is changing so rapidly that I cannot (nee will not) attempt to keep up.
It is my belief that retirement planning, and actually retiring is significantly easier than FPs would have us believe. I base this belief on the fact that 10,000 baby boomers a day are currently retiring. According to essentially all of the literature, these people are unprepared for retirement. The fact that they do it doesn’t seem to bother the FP community at large. They continue to produce articles, books, videos, and interviews that espouse their view that these people are unprepared – and yet boomers continue to retire.
My feeling, one that I hope to present here, is that the outrageous savings demands that are put forth by the FP community are arbitrary and well beyond the means or the needs of most average people.
I mentioned that I have disdain for the whole community of FPs. Why? Mostly because they have sold the American public a lie: specifically, that they need to save huge amounts of money to fund their retirement. The basis for these claims lies in the assumption that you will need 80-100% of your pre-retirement income in order to retire comfortably.
The 80-100% rule is absurd.
If you think carefully about what this means you discover the source of this rule and its fallacy.
First lets assume that we will work with a dual income couple, filing “Married Filing Jointly (MFJ), paying FICA (7.65%), State (5%) and local (2.5%) taxes and using 2017 tax rates.
A couple making 75K each might face a total tax bill as high as 47K (MFJ – non itemizing): 11.5K FICA, 4K local, 7.5K state, and 24.5K to the feds. This leaves them with 70% of their salary after taxes. The assumption from here is that you need the same income, after taxes, in retirement that you had before retiring. Therefore you need 80-100% of your pre-retirement gross income (GI) in retirement. It is simple, easy to understand — and wrong.
Here is the basic problem – If while you are working you spend everything you earn after taxes, you sure don’t need a financial manager. Any kind of retirement plan, or even a simple savings account is beyond your means. If you spend it you don’t save it.
If you do save it – say 15% for this couple (this is just an initial guess) in a 401k, then they might be spending only 55% of their 150K income. In addition, a couple making that kind of income may well be saving in after tax accounts an additional 10-15% of their income.
There are other factors that can decrease this percentage even further: mortgages and college loans are a couple of the biggest corrections — assuming that the prudent couple has planned so that these things disappear at or near the time of retirement. We’ll discuss some of these matters further into this document but it is easy to see that retirement planning for this couple may revolve around replacing as little as 40% of their income; a far cry from 80-100%.
Taxes will have an impact on your retirement income also, but… Retirement income is generally treated significantly differently – read much better — than working income. We’ll discuss the differences below.
The bottom line is that retirement may not cost near what the FP community has led us to believe. Why? I believe Darrow Kirkpatrick put it best. “Financial advisers can have serious conflicts of interest when it comes to computing your retirement “number.” Unfortunately, the profession has strong incentives for being overly conservative, and lots of cover for doing so. For starters, the most prevalent compensation model for advisers is still a percent of assets under management. And guess what happens when you retire? Yes, you start spending those assets that your adviser is collecting fees from, and their income goes down. Secondly, liability for the adviser is more clearly connected to you running out of money than you having too much money in retirement. There is little risk to an adviser in you working five or 10 years longer and dying with a few extra million on hand. (And your kids will love them for it.) However, if you run low during retirement due to professional advice you received, there will be hell, and possibly lawyers, to pay.”
Primary Retirement Goal
The primary goal of any retirement plan should contain the following two ideas.
- (PRGA) It should have a probability of success greater than 95%; preferably ~99%.
- (PRGB) It should have sufficient income in retirement to maintain the lifestyle that you enjoyed prior to retirement.
These two seemingly simple statements (PRGA and PRGB) have many implications that we will discuss further below. As to PRGB, there is nothing that prevents a retiree from wanting to improve his lifestyle while in retirement vs. working; having more free time can allow for a lot of new or expanded (expensive) activities. It is just meant to set a floor to your retirement – if you do not have sufficient income to maintain the lifestyle you are used to, you are likely to be very unhappy in retirement.
One thing that everyone should understand is that there is a distinct possibility that you will live to 90 plus years old. That’s right, male or female there is a 5-15% probability that you will be alive at 95. While those probabilities may seem high, the lifetime of a couple (when the second death will occur) is astonishing. There is a 25% chance that one of a couple of 65 year-olds will live to be 95.
It is statistics like this with which you must deal in order to satisfy PRGA. If you only consider an average lifespan you are basically planning to fail half the time. In order to guarantee PRGA (>95% chance of success) you must plan for a lifetime that can occur with a frequency of as low as 5%. To wit, plan on a 30-35-year retirement. Anything less and there is a significant chance that one of you (for a couple) will be living in poverty for the last few years of life.
If you have a 5% chance of financial ruin in year 30 of retirement, and a 5% chance of living 30 years in retirement, then you will only fail when both remote possibilities come true. If you have planned for each of these your plan will be successful 99+ % of the time.
To get an accurate estimate of your own personal planning horizon I suggest http://www.longevityillustrator.org/Profile?m=1 . This tool will personalize the lifetime probabilities for your situation. It will (likely) clearly show that to guarantee PRGA you should be planning on a long lifetime.
Inflation and Rates of Return
Two of the variables that many planners throw around unnecessarily are inflation and rates of return. At first glance they each seem to be important, unrelated, and highly variable. However, I have done the spreadsheet analysis of various scenarios using fixed and variable inflation rates and discovered an interesting fact. The inflation rate is not an important variable if you use real rates of return. A real rate of return (RR) is a rate of return above inflation. Basically ignoring inflation and working in present day constant dollars. It is simple to understand and produces accurate savings growth predictions. Predicted future dollars have essentially the same purchasing power as today.
If you are invested in stocks or fixed return bonds the RR can vary as inflation increases or decreases or as the market goes up or down. However, Treasury Inflation Protected Securities (TIPS) yield a RR. Currently that return is about 1% for 30-year bonds.
For planning purposes I use a 2% RR for savings before retirement. This should be an easily achievable real ROI while working. There is no serious need to be overly conservative while saving for retirement as you not only have a long time horizon for savings, but you still possess a wonderful resource: YOU. If you are saving for retirement, then you are working. Earning a salary etc. You have your job and skill set as a resource to help get over market downturns.
However, PRGA dictates retirement income should be guaranteed for a long time and you have given up yourself as a major resource to fund your lifestyle. To this end, I always use RR of guaranteed instruments and currently that rate for 30 year TIPS is 1%. At a minimum, this 1% RR can be used as a goalpost – something that you may beat, but do not want to miss. A gauge if you will that can be used to measure your returns against.
Clearly investing in equity markets have (in the past), can (in the present), and probably will (in the future) produce better returns. There is nothing wrong with making a better RR in your retirement account than 1%, I just don’t feel that a prudent plan should include these outsized gains. I personally knew several people that retired in 2000-2001 after the market surges of the late 90s on the assumption that they would continue to beat the then current TIPS returns of 2-3%. They didn’t and their retirement dreams went up in smoke.
Sequence of Return Risk
One of the biggest risks, IMO, in retirement is Sequence of Returns (SOR) risk. SOR problems come from average up markets that might experience a few down years. The earlier in your retirement these down years occur – the more devastating the effect on your retirement plan.
As mentioned above, many people retired in 2000 – and watched the market tank for a few years. It has since come back. We will use these people as an example for our study of SOR risk.
The SP500 in Jan 2000 stood at 1450. In January 2017 it stood at 2700. That is an average gain (not including dividends) of 3.7%/yr. CPI-U over that period has risen from 169 to 243 – an average increase of 2.1%/yr. Clearly, the average return of the markets has beaten inflation by more than 1%. And yet, people that were in the markets and retired in 2000 were most disappointed.
What happened? The markets dropped from 1450 to 850 in January of 2003. Assuming you started with 100K and withdrew 5K/yr. (inflation adjusted) to fund your retirement, you watched your savings balance drop from 100K to 47K. Your 5K withdrawals represent a much larger percentage of capital withdrawal as the markets dropped.
The markets began to recover – reaching 1420 in January of 2007 (nearly back to the original 1450) but your balance recovered to only 52K. The next sell off nearly annihilated your savings. In January 2009 its balance was so low. 22K, that it would not recover. By 2017 your plan would fail. These trends are listed in Table 2.
Table 2. Savings balance invested in the SP500 using a $5000/yr. (inflation adjusted) withdrawal (dividends not considered)
As a point of comparison, TIPS could be purchased in 2000 that guaranteed a RR of 1.6% (this was easily doable in 2000). After 17 years withdrawing identical amounts and earning inflation plus 1.6%, an initial 100K investment would have a balance of 66K.
This, in a nutshell, is SOR risk. Sure, the markets have beaten 1%RR, but the volatility, and specifically the early years of low RR, reduced your savings significantly. You could never recover sufficiently to fund the remainder of your retirement. Avoiding SOR risk – or at least investing so that it will not ruin your plan is critical.
Top Down Planning – How much do you Spend
When it comes to the question of “How much do I need in retirement?” it is tempting to fall back on easy answers or “expert” opinions.” See above for my feelings about FPs – the “experts” and their quality estimates. And yet, this is probably the most critical factor to determine in retirement planning. How much you need in retirement impacts how much you need to save while working, what kind of return you need to achieve and how you will invest in retirement.
It makes perfect sense to me that the day after I quit working essentially the same bills will show up in the mailbox, I will still want to go on my summer vacation, take the wife out to eat on occasion, go to the theatre, and pay the plumber when necessary. Life won’t change all that fast so what I was spending last year while working is what I will want to spend next year while retired. So, to meet PRGB you should want to ensure that your after tax retirement income (ATRI) meets or exceeds your current SPENDING (Capitalized because this is a critical number in retirement calculations. It will occur frequently in this discussion).
I am a fan of simplicity. I think the easiest way to answer the question “What is SPENDING?” is to take a top down approach. That is, start with your income (a figure with which most people are familiar), and then subtract known amounts that do not contribute to your daily living activities. The idea is to determine how much you spend for the lifestyle you are living today. You start by subtracting large known amounts (taxes and savings) and fine-tune this estimate by subtracting other costs that will not continue into retirement (e.g. a home mortgage). I would not recommend trying to put too fine a point on the calculation.
The advantages to this top down approach are: A. The numbers are known and B. the estimate is actually a maximum. This means that the calculation can be done accurately (and simply), and the answer will overestimate how much you need (underestimating SPENDING can be disastrous).
Taxes and Retirement Savings
Taxes (FICA, Federal, local and state) and savings (401k, IRA, after tax) are probably the largest expenditures that do not contribute to your lifestyle. Subtracting these generally well known amounts from GI gives a zeroth order approximation to answer the question “How much do I spend now?”. The reality of the situation is you only spend what is left from your paycheck. You don’t spend the money you send to the governor or the IRS. You don’t spend the money you put into your retirement accounts or even into your after tax investment accounts. Therefore, what is left, after subtracting these reasonably easily knowable amounts, is what you spend while working – aka SPENDING.
Generally speaking (for anyone actually saving for retirement) this estimate will be 60% of GI or less. I have run this analysis for several people and have found SPENDING to be in the range of 45 -55% of GI.
Mortgages and other costs
Something I refer to as imputed income (or imputed savings) is not really income, but reflective of something that you no longer need to purchase. The idea is that if you did purchase it you would need ATRI to do so. The most significant item that qualifies – and is surely in nearly everyone’s retirement plan is housing. Yes, in retirement you need housing. Many folks have paid off their mortgage and own their primary residence outright and some even own a vacation home.
Clearly you can get by on less income if you don’t have to pay for housing. With a national average home price of nearly 200K and interest rates at 5% this is 10 – 12 thousand dollars that was needed in yearly income while working and buying a home that is not needed in retirement. Yes there are any variables here: tax rates, interest rate, balance, location, housing choice, opportunity cost – what you would get in an investment account rather than investing in housing etc. The bottom line is that buying a home while working is either an investment that pays off (as imputed income) in retirement or it is a cost of living while working that does not carry over into retirement (imputed savings).
It is, I believe, easier to consider the mortgage you pay while working (if it is planned to disappear in retirement) as a deduction to SPENDING. That is, it is a cost while working that will not continue into retirement. Then, in keeping with PRGB, this amount is not needed in ATRI. Accounting for mortgage payments can easily reduce the fraction of GI that is actual SPENDING by an additional 10-20%.
There may be other costs that do not continue into retirement that can also reduce SPENDING: Union Dues, Commuting Costs, Student Loans, and College Tuition. I do not suggest that the calculation of SPENDING be finessed too much. However, some of these other costs can be significant. Many people are considering retirement even while they are paying tuition for their children; some are even still paying off student loans that are significant drains on cash flow. Commuting costs can be real, but if you are not willing to decrease the number of automobiles that you own, insure, maintain and operate there is probably little to be gained there.
The bottom line on SPENDING is that a simple top down calculation can easily show that you may be happy in retirement with as little as a third of your pre-retirement GI. Peter Hodes (a friend) did this calculation and, in fact, determined that he only needed 35% of his GI. Doubting this, he did a bottom up calculation (a much more difficult calculation to perform accurately). Having kept reasonably meticulous records for several years he was able to determine that the top down calculation was very close to his bottom up calculation.
As mentioned earlier, healthcare is clearly the most complicated and indecipherable part of an early retirement plan. Once you have reached age 66, the costs can be determined (Medicare parts B and D or Part C and possibly a medigap policy). But before age 65 – who knows. Who paid how much before retirement and who will pay how much after retirement?
I have basically punted on healthcare in early retirement. Courtesy of the US Governments involvement in vietNam in the late 60s and early 70s, and a conscription that was the law of the land, I am eligible for VA care. This provided health care for my early retirement.
You will have to determine how much insurance you want, what the cost will be, how much you are paying now, and then fit the difference into your plan. The bottom line is that healthcare can increase SPENDING by 10-12K/year until you are eligible for medicare.
After eligibility, costs do not disappear. Part B is currently 134/month. Part C supplement is 45/month. For a couple, that works out to about 4000 a year. There may also be copays and deductibles. Of course there might have been some costs before retirement including insurance payments, copays and deductibles. There may be little change in cost or costs could go up several thousand.
As a first order cut add to SPENDING $4,000 less what you spend for insurance and copays today.
Well, hopefully, now you understand why I gave up.
Now comes the really interesting observation. The more you save (whether in retirement accounts, imputed savings, or after tax accounts) the less you spend. The less you spend, the less you need to fund in retirement. So as you step up your savings rate you hone in on your retirement goal in two ways. 1. You are increasing your savings faster and 2. You are decreasing the amount needed in order to fund your retirement because you are decreasing SPENDING.
Therefore if you are setting up a plan, be sure to have a feed back mechanism that allows your goal to change based on how much you save. This is one of the major mistakes many people make. They assume that they spend 70% of their income today and need to replace that with ATRI. To save a sufficient amount to replace that 70% after taxes, FPs assume they need to have income from retirement accounts that replaces about 85% of GI.
Without going into details the savings plan to achieve that 85% goal may require that the couple save 15-20% of their salary. But, if they are saving 20% of their salary, they need replace only 50% of their salary. This would result in a lower savings goal and obviously a lower savings rate. Feedback is important.
Conclusion: Establishing Your Retirement Goal
The first step in retirement planning is to determine what you are spending to maintain the lifestyle you are living today. Using a top down approach can calculate this number reasonably accurately, giving an upper estimate. Knowing what I have called SPENDING is crucial to establishing a savings plan and making retirement decisions (see PRGB). Feedback is important as SPENDING decreases as savings increases.
It is highly likely that you spend significantly less than your GI. Fractional spending might be on the order of a third to a half of your GI. This makes saving for retirement significantly easier than the FP community declares. Anecdotally, I and my wife Kathleen are living very happily with a better lifestyle, and have been for 18 years, on 40% of what we earned while working.
Finally, once you have a good understanding of SPENDING then you have established your goal. Specifically, you will want to ensure that ATRI is equal to or greater than SPENDING. That is what guarantees PRGB.
Now that you have established a goal (or at least the mechanism for determining the goal) for retirement income it is possible to begin understanding how to achieve the necessary savings that will fund that goal. There are several major sources of “income” that can be used to fund a retirement: Social Security (SS), retirement savings, after tax savings, pensions (not considered here) and lifestyle changes (imputed income).
One of the most important for many people will be Social Security. SS income is tax advantaged, guaranteed, and inflation indexed. It is hard to beat that combination. So, it is important to understand how much to expect from SS.
The second source of income comes from savings – whether from retirement accounts or after tax, Roth or traditional IRA, 401k etc. Many people consider that their savings must make up for the total shortfall between SPENDING and SS retirement benefits (SSRB).
I personally like to consider a third source: Imputed income from lifestyle savings.
Social Security is in reality an annuity program that provides inflation-indexed payments to the beneficiary – and often it is a two-life policy, supplying benefits to the surviving spouse as well as possible benefits to current spouses, ex spouses and children. At a minimum SS payments are at least half what your spouse gets while he (or she) is alive and increases to the full amount for the surviving spouse.
Estimating your SS benefit
Simply, your SS benefit depends on two factors: Your Average Indexed Monthly Earnings (AIME) and your age when you claim your SS benefit relative to your full retirement age FRA).
For those that are interested, I give reference to and explanation of how to calculate AIME and your primary insurance amount (PIA). For many it may be best to use the calculator at https://secure.ssa.gov/acu/ACU_KBA/main.jsp?URL=/apps8z/ARPI/main.jsp?locale=en&LVL=4 . However, I have been told that this is not always straightforward when estimating SSRB in the future for an early retirement today. Regardless, obtaining an accurate estimate is critical as SSRB is likely to be half or more of your retirement income.
I think it is important to understand the mechanics of the SSRB calculation as working even just one additional quarter may have an out-sized effect on your PIA, See, https://www.kitces.com/blog/social-security-fica-self-employment-taxes-return-on-investment-roi-irr/. Knowing whether one more year of work will replace a “zero” in your highest 35 years, or whether the increase in PIA will be 15% of the increased AIME or 32% of the increased AIME may play a part in your decision to work/retire.
Your AIME is a complicated formula that indexes your yearly incomes using the national average wage index (NAWI) to determine your indexed yearly income. The NAWI is the ratio of the national average wage to the average wage for the year the income was earned. SS can easily supply a list of the NAWI used for a given retirement year at https://www.ssa.gov/oact/cola/awifactors.html .
Once the NAWI has been determined, then your yearly income is multiplied by the NAWI and the 35 highest years are used to calculate your AIME (sum of the highest 35 years divided by 420). Then from AIME, SS determines your primary insurance amount (PIA).
For an individual who first becomes eligible for old-age insurance benefits or disability insurance benefits in 2018, his PIA will be the sum of:
(a) 90 percent of the first $895 (firsts bend point) of his average indexed monthly earnings, plus
(b) 32 percent of his average indexed monthly earnings over $895 and through $5,397 (second bend point), plus
(c) 15 percent of his/her average indexed monthly earnings over $5,397 (up to the maximum AIME subject to SS benefit withholding.
The bend points change yearly.
Then, finally, The PIA is adjusted lower for retiring before FRA and increased for delaying beyond FRA. If you claim SSRB at age 62, you receive something less than 75% of your Full Retirement Age (FRA) benefit. Waiting until age 70 supplies you with nearly 32% more than FRA benefits. The exact numbers are currently in flux as the FRA is changing from age 66 to age 67.
The current values for bend points and FRA and total description is available at https://www.ssa.gov/oact/cola/piaformula.html .
When to claim SSRB
First, note that there is a distinct possibility that SSRB will be curtailed around year 2033. This can have a significant impact on the calculations, especially for people younger than 62. I am not going to consider the myriad possibilities of varying FRA and possible declines in SS payments in 2033 or 2034 etc. However, for those that have an FRA of 66, Wade Pfau has a nice description of the “return” expected by delaying SS claiming decision in Forbes – https://www.forbes.com/sites/wadepfau/2014/04/01/delaying-social-security-what-an-investment/?ss=personalfinance#27b0044c761a
In the referenced article Mr. Pfau clearly shows that the return on waiting starts off negative (if you die between age 62 and 70 it is negative 100%) but by age 80 begins to show a positive real return that increases with longevity. In keeping with PRGA, you should consider that you will live to age 90-95 and get a real return from SS for delaying your claiming decision until age 70 of nearly 6%.
It should be easy enough to replicate Mr. Pfau’s work with your FRA, and different SS curtailment scenarios as the situation becomes more clear.
Delaying receipt of SSRB can easily be shown to be a good “investment”. It is a very cheap form of longevity insurance. Where would you be able to get a guaranteed RR of 5-6% today? Note well, this discussion has so far only discussed the dollar value of delaying claiming. There are other considerations than just dollars. And, You do need to have funds available to spend to delay 5-8 years.
I delayed claiming for a couple of reasons: A. I was eligible to claim a spousal benefit at age 66. B. Delaying my SS retirement benefit until age 70 will garner my spouse a significant increase in her SS benefit if, as is likely, she outlives me. I wish to make it as easy for her as possible.
It is possible that neither of my reasons is applicable to your situation. Also, you must decide if longevity insurance is something you need. If you will have sufficient annuity and SSRB available at age 90 given you claim at 62 then consider claiming early.
That leaves only the question of whether you want to claim early and have a lot of flexibility (vacationing/investing) or get a nice guaranteed return and claim later.
There is no question that delaying benefits is a monetary winner given the recipient lives until age 85 or so (and of course maintaining PRGA requires you at least plan to live beyond 85). But, there are other considerations than just maximizing the bucks.
Among those other considerations are: Your health and the likelihood of a long life. Will your spouse outlive you and need extra income. Are you interested in maintaining a significant legacy? Or maybe you just want to buy a boat.
How much income does SS replace
The percentage of GI that SS replaces varies from more than 100% for very low single income married couples to about 30% for a single individual that earns near the SS salary cap ($120,000 per year). The replacement percentage continues to drop for higher income workers as income above the salary cap is neither taxed by SS nor used in the AIME calculation.
For average married two income families with a total household income of $55,000/yr. that are kind of the rule in America these days, the replacement percentage is around 55% of GI. Table 1 shows the expected SS income at FRA for various households’ incomes and the income replacement percentage versus GI or GI after taxes.
Table 1. Income, SSRB, and SS replacement percentages for various incomes
||SS replacement of GI
||after tax total
After tax total income is calculated assuming 7.65% FICA and standard federal tax deductions MFJ return. No state or local income taxes are considered.
Summary of Social Security Benefits
SSRB are generally a really good deal for most Americans. With an average household income in the US making just under $50,000, you can easily see from Table 1 that a married couple can expect that SS will replace 2/3rds or more of your after tax working income (and, obviously even more of ATRI). It is probably for this reason that so many people are actually retiring successfully today. Even for upper middle class folks (those making upwards of 100K/yr.) SS will likely replace half of your after tax income – and surely more than half of SPENDING.
Since SSRB are likely to be a major fraction of funding towards achieving your ATRI goal, it is critical that you: understand how SS works, when is best to claim your benefit, how much you (and your survivors) will get, and how important it is to you and the entire retirement community.
Saving for Retirement Roth vs Traditional IRA (or 401k)
So, now we get around to saving for retirement. Once you know how much ATRI is needed, and you know how much will be replaced by SSRB, you will need to replace the shortfall from retirement accounts or after tax savings.
There seems to always be questions raised concerning whether it is better to pay taxes now and invest in a Roth IRA or invest in a traditional IRA (or 401k type) and pay the taxes later. It can be easily shown that if tax rates didn’t change – it wouldn’t matter. Michael Kitces clearly points this out in https://www.kitces.com/wp-content/uploads/2017/05/To-Roth-Or-Not-To-Roth-BAM-Alliance-Jun-28-2017-Handouts.pdf on slide 7 page 4. To quote what he refers to as the tax equivalency principle “A certain amount of pre-tax income results in the same amount of after-tax wealth in the end, regardless of which account type it goes to, whenever tax rates remain the same”.
Taxes are not likely to remain the same in retirement as when working. There are several reasons for this:
- Taxable income will likely be considerably less than total income resulting in lower taxes.
- Unearned income is generally taxed more favorably than earned income.
- Elderly get larger personal deductions.
- Savings are generally taken at the highest marginal tax rates.
- SS income is tax advantaged.
- Tax rates continue to fall despite the overwhelming agreement among economists that rates need to rise.
In addition to the clear possible savings by funding retirement plans pre-tax, there is the flexibility of withdrawals that allows the taxes to be paid at a time of your convenience. For instance if you decide to retire early and fund part of your retirement with after tax savings and part from your traditional IRA, you may avoid taxes on the withdrawal completely. Another example is rolling over much of your savings in the year that you have a disaster claim – or huge medical bills. It happens.
Bottom line, pay the taxes later – always better. Michael Kitces, Dirk Cotton, Wade Pfau and other financial writers agree – as do most FPs.
Safe Withdrawal Rates and Annuities
In keeping with the safe and guaranteed return that ensures PRGA I suggest following the 4% rule. This basically says that you can draw down your savings by 4% every year in constant dollars and expect your retirement accounts to last throughout your lifetime. To guarantee a monthly income of $100 requires 300 ($100*12/0.04) times that amount in savings; about $30,000. Funding a retirement for thirty years or so can be expensive.
It is a fairly easy exercise to set up a spreadsheet that starts with 100 dollars that increases by inflation plus 1% every year and decreases by 4 dollars (increased by inflation every year). Starting with inflation set at 0% it shows that this simple “portfolio” would last for 30 years. Interestingly, (as stated above in Inflation and Rates of Returns) maintaining the real rate of return at 1% and increasing inflation to 4% shows that the portfolio has a 32-year lifetime. That is: A. It essentially satisfies PRGA and B. As contended above the inflation rate has little effect on the outcome so long as one works with real returns.
Many people find it simpler and easier to fund an annuity. Annuities can currently be purchased for 65-year-old males that “return” about 6% per annum. First note that this “return” is not a return on investment (ROI) but the yearly income you get as a fraction of the annuity purchase price. That is, if you give the annuity company $100,000 they will give you $6,000/yr, essentially guaranteed for your lifetime.
That $6,000 is not inflation indexed. It is more realistic for planning purposes to assume that the “real” value of that $6,000 is actually $4,000. That coincides with the 4% rule above. The remaining $2,000 should be reinvested to help ameliorate the effects of inflation in later years.
Variable rate Annuities can also help create inflation indexed annuity income. However, I think in keeping with PRGA that basic levels of income should be covered by fixed returns. If a third of the total annuity is invested in variable units that can earn ROI that increases its payout by 3 times inflation then the total annuity will produce inflation-protected income – at minimal risk. With inflation currently running in the neighborhood of 1-2% it is not too difficult to select a variable annuity investment that will beat inflation by a factor of three.
This introduction to annuities is far too brief to adequately address the cost, benefits, and options available. Interestingly just as I was writing this (7 Nov 2017) Dirk Cotton gave a nice description of some of the annuity world – he does it better than I do so … http://www.theretirementcafe.com/2017/11/income-annuities-immediate-and-deferred.html .
Taxes in Retirement
As mentioned previously, taxes in retirement are significantly different from taxes while working. There is no FICA to pay. Many localities do not tax unearned income; Social Security (SS) benefits are tax advantaged not only at the federal level but for many states as well. Finally, there is no need to maintain your residence in a high tax area – follow the lead of George W. Bush and Dick Cheney and declare residence in Texas (or Wyoming or Nevada) and avoid state and local income taxes altogether.
I will present here a couple of simple examples to demonstrate the dramatic tax differences between working couples and retired couples. In each example, I assume that 10% of salary is saved in tax advantaged 401k type retirement plans, and there are state (3%) and local taxes (2.5%) much like I experienced while working in Ohio. These are just examples based on 2017 tax rates and standard deductions.
Example 1. A couple making about 75K (50K for him and 25K for her)
While working this couple would pay: FICA of $5700; Local and state taxes of about $4000; and Federal taxes of $6000 – assuming that they used the standard deductions. The total tax bill for this working couple is nearly $16,000 — nearly 20% goes to taxes.
In retirement after saving diligently and producing 14K of taxable retirement income to go with their 36K of SSRB they would discover that they have essentially no tax liability. That’s it. No federal tax on 14K of taxable income. No local tax on unearned income, and no FICA because they have no salary income. Without having looked carefully, the state of Ohio would certainly not get very much if anything as Ohio exempts SSRB from taxation.
Example 2 A couple making 150K (75K each)
They might have a tax liability of nearly 40K (27%) while working – and yet after retiring and earning 43K of taxable retirement benefits (to go along with their 57K of SSRB) would have a federal tax liability of less than $7000 (7%). Their ATRI and SPENDING would be nearly identical at 94K. Again their state and local tax liabilities should be negligible.
The Tax Torpedo
One of the favorite topics for FPs to talk about is the SS tax torpedo. Why? Because it can in some cases put ordinary folks into a marginal 46% tax bracket, and can be at least somewhat avoided with careful planning.
There are people in the 25% income tax bracket that will have an additional 85 cents added to their taxable income (as more of their SSRB becomes taxable). The combination works out to a 46% marginal tax. There is a baby torpedo at lower incomes that raises the nominal 15% tax bracket to 22.5%. Many people will find themselves in this bracket.
Understanding the tax torpedo
The tax torpedo exists because the government has given tax breaks on SS income to lower income folks and removes this break as income increase. At low incomes, Social Security Income is completely tax-free. But as income increases from other sources (Dividends, Interest, and taxable retirement account withdrawals), the tax-free status is phased out. Until the tax break is fully “recovered”, the marginal rate can be excessive.
To determine the amount of SSRB subject to income tax you need to calculate a provisional or Modified Adjusted Gross Income (MAGI) that comprises your taxable income, your tax-free income from municipal bonds and half of your SS benefit. Then there are two thresholds for determining how much of your SS benefit becomes taxable as you income increases.
For couples with MAGI below 32K (25K for singles), no SS benefit is taxable. For each dollar above MAGI of 32K and below 44K a half a dollar of SS benefit is taxable up to half of your total SS benefit.
Once MAGI exceeds 44K (34K for singles) each additional dollar of MAGI adds $0.85 of SSRB to taxable income – up to 85% of total SS benefit.
Avoiding the tax torpedo
If you read through the above you probably have figured out that the tax torpedo is complicated – the reason why FPs love it. There are reasonable ways to avoid/ameliorate the tax torpedo effects. Professional FPs may have an advantage in this type of planning. The key to avoiding the torpedo is understanding that Roth IRA distributions are exempt from MAGI calculations and only 50% of the SSRB contribute to the calculation. So, clearly moving savings into Roth IRAs and increasing SSRB relative to taxable retirement incomes helps to minimize the effect.
Delaying claiming SSRB: If you delay SSRB you increase the amount you get from SS. But, of course, along the way you must live on something and that generally means drawing down retirement savings. This allows future earnings to be more heavily weighted by SSRB – which, as mentioned above, are advantaged. Those years before claiming SS allow time for Roth conversions.
Lumping taxable income in alternate years: In one year you hit the max for SSRB to be taxed and then roll over additional funds from a traditional to a Roth IRA. The additional funds are taxed at the marginal rate and do not trigger additional torpedo taxes as there is no more SS benefit to tax. Then in the following year take withdrawals just sufficient to hit the lower threshold.
Lifestyle changes: Imputed income in retirement.
Imputed income is savings that you achieve in retirement that were not available while working. These lifestyle changes decrease the amount of income needed in retirement without necessarily adversely impacting your retirement. For those that have not planned well, lifestyle changes that do impact your retirement will be forced upon them. In retirement, there can be many significant lifestyle changes.
Many retirees find that in retirement things that they did while working suddenly cost less or are non-existent. Why? Well partly because places like to give us old folks a price break. But also because we get to chose our times more carefully. For example:
- Without the constraints of working I no longer have to take a vacation during spring break. Skiing is just as much fun (and maybe better) the next week and the prices have dropped considerably.
- Camping in national Parks, National Forests, and BLM rec lands is half priced and you can go on weekdays when it is less crowded.
- You no longer need to attend theatre on weekends or evenings. Matinees are often cheaper.
- Golfing is cheaper on weekdays
- Senior dining specials
- Taking advantaged of last minute airfare/travel specials that working would have precluded.
- Traveling mid week when hotel rates are lower.
- Eliminating one or more automobiles
- Downsizing your home
- Finally paying off the mortgage or student loans
In retirement hobbies may have a significant impact on your quality of life – even while not actually producing income. Many of these hobbies/activities are just a bit too time consuming to really pursue while working, but in retirement time is aplenty. Many of these save significant sums of money and actually improve your life, for example:
- I personally found that cooking as a hobby more than adequately replaces dining out.
- Gardening is one of retirees favorite past times and gives better, fresher and cheaper food than the supermarket.
- Home/auto repair saves lots of money.
- Walking instead of working out at the gym.
- Reading instead of going out to shows.
Finally setting a savings goal
Finally, remember, as you adjust your savings rate to achieve a certain income goal that the income goal will decrease/increase as savings increase/decrease. That is the feedback discussed above. Adjust SPENDING to account for any significant lifestyle changes – difficult to assess but there may be significant knowable adjustments. Subtract pensions and social security and what remains is the ATRI you need to generate from your retirement savings.
You will probably need more than 25 times this annual amount in savings to guarantee PRGA and PRGB. That is using the 4% rule and you will need to generate more to account for taxes – low though they may be they are unlikely to be zero. Again, feedback in your planning will be necessary, as taxes in retirement will change with the savings plan. But with careful analysis, a final necessary savings figure can be determined.
For many folks with SPENDING at 70% of GI (saving very little for retirement) and SS replacing 55% of GI, ATRI will need to be about 15% of GI. Using the 4% rule would indicate that savings should be in the neighborhood of 4 times your annual salary — a not particularly onerous savings goal and a far cry from the 20 times annual income recommended by FPs. And of course, when savings are increased the ATRI needed will decrease and the subsequent result for savings necessary will decrease.
It is clear that getting a real 1% return will secure your retirement for about 30 years if you follow the 4% rule. However, following that rule can make for an expensive retirement and it is not easy to fund guaranteed investments that will yield a real 1%. Diversifying into equities or corporate bonds can easily beat the 1% real return but come with risks.
Losses in retirement can be devastating to a retirement plan. While working, you have a huge asset that does not show on the balance sheet – your ability to work. Retire early and if things head south you can always go back to work – may not be optimal but it is always doable. The largest risk (my opinion) that retirees (especially early retirees) face SOR risk.
It is precisely for these reasons that I think retirees should fund their basic needs with guaranteed returns: annuities, government bond ladders, certificates of deposit (CD) etc. Once an adequate income is guaranteed then, and only then, should a retiree begin to acquire equity exposure.
Certificates of Deposit
CDs can be an important part of building a bond ladder — particularly for years 1-5. A quick google search (March 2018) can easily show that returns from 1% to nearly 3% can be achieved using 1-5 year CDs.These yields are comparable to or slightly better than similar duration treasuries.
CDs are easy to purchase – whether from the bank directly or in a brokerage account. They are generally guaranteed by the Federal deposit Insurance Corporation. CDs don’t fluctuate in value – you can always cash them in for face value plus interest earned (less penalty).
CDs are also quite flexible. Yes, you will have to take a small hit to exercise the flexibility, but cashing a CD early generally costs 3-6 months of interest only. So, buying a 5-year, 2.8% CD (one of the highest available as of March 2018) and redeeming it after three years (with a 6 month penalty) would be essentially the same as purchasing a 3-year, 2.35% CD, which is only slightly worse than the best available 3-year CD (2.55%). So, the fact is there is really not much of a penalty.
CD advantages over treasuries: A. Ease of purchase, B. protection of capital, C. possibly higher yields.
Bonds can be purchased individually. Government bonds can be bought at TreasuryDirect.com for no fee. The nice part of owning individual bonds is known and guaranteed return. However, without significant effort (buying and selling and paying the appropriate fees) Bond Ladders are probably the most expensive way to fund a retirement. However, they also offer the least risk and the greatest flexibility.
If you want to fund retirement savings or a retirement with guaranteed bonds (good for guaranteeing PRGA and PRGB) then the question of course is which ones and how.
There are basically four types of US Government Issue bonds: Savings bonds in I and EE varieties, Treasury Bonds, and TIPS. They each have specific disadvantages and/or advantages. There are also municipal bonds and of course bond funds. I own three different types TIPS, EEs and I-Bonds.
EE savings bonds
You can purchase up to $10,000 of these bonds each year for you and your wife. The basic interest rate that they pay is minimal; currently 0.1%. However, if you hold these bonds for 20 years they are guaranteed to double in value, which is equivalent to 3.5% per year. There is a minimal holding period (1 year) and 3-month interest penalty if cashed in prior to 5 years.
EE advantages over treasuries: A. they pay better if held for 20 years. B. There are no tax implications until these are redeemed. And C. They never lose value – if interest rates rise you can redeem them at purchase price plus accrued interest. There is no decrease due to rising interest rates that might be experienced with Treasuries.
These bonds pay a fixed rate (usually small and currently 0.1%) plus a variable rate that is based on the latest inflation figures. The interest rate adjusts every six months. Again there is a minimal holding period (1 year) and 3-month interest penalty if cashed in prior to 5 years. There are no tax implications until these are redeemed.
I-bond advantages/disadvantages vs. TIPS: A. They never lose value due to deflation or rising interest rates. B. Taxes are not paid until the bonds are redeemed. But C. they pay significantly less nominal/fixed interest rates than TIPS
Treasuries are available with maturity dates from one month to thirty years and yields that currently vary from 1% to 3%. These bonds sell on the open markets and are not redeemable until maturity. So, if interest rates have risen and you need the money you will sell at a loss. Conversely you could sell at a gain but interest rates cannot drop much from present levels.
Treasury advantages over EE-bonds: You can invest in shorter maturity instruments – that may have significantly better yield (over the shorter lifetime) than EEs sold short of original maturity..
These inflation-protected securities are sold with maturities from 5 to 30 years and pay a nominal interest rate (currently ranging from 0.1% to 0.9%). The inflation protection increases the value of the bond as inflation is positive. The amount of interest you receive depends on the current value of the bond. You will owe taxes on the payments in the year in which you receive the payments. You will also owe taxes on the increased value of the bond in the year that it increases – but you will not receive that increased value until maturity. As with other treasuries you can sell them on the open markets at a loss or gain.
TIPS advantages/disadvantages vs I-bonds: A. TIPS pay better nominal interest rates. But B. TIPS can lose value with deflation and C. You may owe taxes on money not received.
Munies generally pay tax-free interest and thus are of interest to many high income individuals. For most people they have little benefit, are subject to default, and are added into MAGI and can result in additional SSRB being taxable – thereby removing some of the tax free benefit of owning them.
I know little of their total characteristics and will make no judgment of their suitability for anyone’s portfolio. There are none in mine.
Rather than buying individual bonds and “laddering” them yourself, you can invest in a bond fund. Bond funds come in a variety of forms: government, municipal, corporate, high risk or low risk, long duration or short duration, leveraged or not etc.
Many funds buy long term bonds and then sell them as they reach short maturity. This can (and generally does) increase the return of the bond fund vs. individual ownership. On the other hand, bond funds can (and do) lose value – particularly leveraged bond funds.
Bond Funds can make it easier, and give a better return at minimal additional risk.
Annuities probably give you the highest guaranteed return. Note however, that there is a small (very small) chance of default. The higher return does not come from higher risk but rather from “Mortality Credits”. Basically, some individuals will experience a short lifetime after purchasing an annuity while others will live forever (OK not really forever). The long-lived ones will take home higher monthly payments at the expense of the short-lived ones.
Finally, one other good thing about annuities, they will protect you from yourself late in life. For many of us, the time will come when we are not really able to fully comprehend and control our finances. If at a younger age you purchased a lifetime annuity, you will be hard pressed to give away your nest egg. In essence you have already given it to the insurance company. Sure, someone can come along and take the rent money today – but next month another tranch of money shows up. It makes you a much less valuable target and guarantees monthly income regardless of your faculties.
Michael Kitces gives a good description of Mortality Credits and why they can beat bond ladders at https://www.kitces.com/blog/understanding-the-role-of-mortality-credits-why-immediate-annuities-beat-bond-ladders-for-retirement-income/ .
The downside to annuities – you give you give up complete control of your capital to the insurance company. If you change your plans or experience a significant loss (market, health, or natural disaster) you will not have capital to bail you out. That is not always the worst thing (giving up control), but it is real.
Retirement is neither simple nor easy. Early retirement has an especially difficult set of circumstances and probabilities with which to contend. However, retirement is not the unwieldy, complex and overwhelming problem that the FP community would have us believe. Boomers are retiring in record numbers – many of them happily without near the savings “needed” according to the “experts”.
The income needed in retirement is significantly less than your needs while working. It is critical to understand where your money goes while working in order to determine how much you will need in retirement. Doing a careful calculation to determine how much you spend today (SPENDING) to maintain your lifestyle is critical to determining A. how much you will want tomorrow in retirement and B. how much you will have to save to generate that income in retirement.
Estimating your SSRB accurately is also critical as this is likely to be half or more of your ATRI.
Taxes in retirement will, for many people and most average income folks, be negligible, as compared to those paid while working.
Use the 4% rule to determine how much savings you need and expect to invest in retirement. The 4% rule basically assumes that investments will make a mere 1% real rate of return. Additional savings can be used to “improve” the RR. Even with these conservative assumptions, the amount needed to fund retirement is nowhere near as high as many FPs contend.
Don’t forget to always use feedback when determining how much you need to save in order to reach your goal. Any additional savings made while working will decrease your SPENDING and savings goal. This decrease can be significant.
I am not a FP professional of any type. The opinions expressed here concerning the FPs in general are mine. I successfully retired at 48 on well under 20x my salary in savings – that hardly means that you can.
While my advice is free, and I would like to think well justified, it most certainly could be wrong. Again, just because it worked for me does not mean it will work for you. Only you can decide if/when/how to plan and finally retire. The cost of any mistakes made in planning or retiring will be borne by you, not me. So – be careful. Read, learn, study, ask questions.
Finally, LEARN. Remember, your fidelity guy, me, and even uncle Eddy are not the guys that are going to suffer from the (possibly) bad advice that you might act on. You, alone, are responsible. I am always happy to share my thoughts, and even the mechanics of how I did it. Times are different now and the appropriate solutions may not be the same.
Good luck, and let me know if I can assist (or share an opinion) on anything.
FP Financial Planner
MFJ Married Filing Jointly
FICA Federal Income Contribution Act (Social Security and Medicare taxes)
PRGA Primary Retirement Goal A — ensure a 95% probability of success
PRGB Primary Retirement Goal B — maintain you pre-retirement lifestyle
TIPS Treasury Inflation Protected Securities
ATRI After Tax Retirement Income
SPENDING What you are spending today, before retirement, to live
IRA Individual Retirement Account
SS Social Security
ROI Return on Investment
MAGI Modified Adjusted Gross Income
FRA Full Retirement Age
AIME Average Indexed Monthly Income
GI Gross Income
SOR Sequence of Return
SSRB Social Security Retirement Benefits