The Millionaire These Days
Today I am pleased to bring you another great post by fellow NAPFA member Phillip Christenson, CFA. Enjoy!
Having a $1,000,000 used to be quite a milestone. Most people who had this type of money saved up generally had a sense of being “rich”, and along with it reduced stress and worry about the future. But now, it seems whenever I work with clients who are at or near the $1,000,000 mark quite a bit of financial stress remains. What it all comes down to is a fear of running out of money. This fear can be blamed on inflation (increased costs), low interest rates (decreased income), or even the general turmoil that is headlined every time you turn on the TV (fear of recession, terrorism, etc.).
Regardless of the reason, this is not an ideal place to be right before you decide to quit working and start your long-sought retirement. To regain that sense well-being, you need to understand how much income your portfolio can produce and how your spending will evolve through retirement.
The Safe Withdrawal Rate and Other Income
In the financial planning industry, there is something called the “safe-withdrawal” rate. Basically, this is the percentage of your portfolio that you can withdraw each year throughout retirement and not run out of money. Based on the research by William Bengen this rate is generally thought to be about 4%. This means that for a $1,000,000 portfolio you can withdraw $40,000 each year in retirement. When we prepare this type of analysis for a client we find that if you take a dynamic approach and account for a client’s time horizon and portfolio diversification, among other factors, this rate can sometimes get to 5%. But for the sake of this post let’s just stick with 4% as the rule of thumb.
While this is a large piece of your retirement income puzzle, most retirees will also have Social Security. Some fortunate retirees will also have a pension, rental income, small business income, or other means to draw from during retirement, but this is sadly now the minority of soon-to-be retirees.
So, by calculating your safe withdrawal rate (about 4% of your portfolio annually) and your Social Security you can get pretty close to the monthly cash flow you can expect during your post-career phase, the next step is to determine your spending needs.
How much are you Really Going to Spend?
For this I’ll give you another rule of thumb. Historically, people planned to replace approximately 70% to 80% of their pre-retirement income. If this seems very simplistic that’s because it is, and many in the financial planning community (this author included) do not consider it a very accurate estimate for most people. However, it is a good starting point if you are trying to do some quick “back of the napkin” calculations.
The better way of analyzing your retirement cash flow needs is to use a more dynamic approach. You should map out your anticipated spending needs over the 30+ years of retirement. To start this process, you need to understand something about the phases of retirement, which I’ll discuss next. Before moving on we should briefly cover life expectancy. While many readers might have a life expectancy in the low to mid 80s as planner we prefer to take a more conservative approach. We typically advise our clients to plan on living into their 90s unless we have a good reason to reduce it.
The Phases of Retirement
Most retirements go through three phases. While retirement is different for everyone, in practice I have seen they generally follow this pattern.
First you retire. You’ve worked hard, saved, and planned, and now the big day has finally arrived. You start new hobbies, you travel, and check off a lot of boxes on your bucket list. This generally leads to overspending. While not necessarily a bad thing, it’s something to prepare for. If you’ve wanted to take a trip around the world, go for it, just make sure you account for it when determining your income needs for the rest of your retirement. The early phase of retirement typically runs into your early-mid 70s depending on your health.
Second, you settle into a routine. You have a few hobbies, you hang out with the grandkids, and you are involved in the community. Whatever it is, you become accustomed to the retirement lifestyle and your spending tends to level out. This period will take you into your 80’s.
The third and final phase generally deals with managing your health. While your medical expenses go up, your other costs tend to go down. You don’t travel as much and your hobbies become less active and many times less expensive, although this is not always the case.
Knowing these phases ahead of time will help you better plan for your spending needs, and therefore help you make better decisions heading into retirement.
Not So Fast – Don’t Quit Until You Are Ready
Ok, you’ve done the work and you realize you have plenty of money and spend very little. You are confident in your calculations and have sufficient protection in place. Congratulations, you are ready to retire!
But what if there is a gap between your expected income and your estimated spending needs?
Well, now it’s time to make the tough decisions. There are several ways to correct this, some easier than others. The easiest one is to work longer. Not the most appealing, but it might be an option. Maybe you could adjust your goals and other spending. Maybe you can better align your investment portfolio with the goals of the plan. There are a number of things you can do to improve your plan, but the first step is doing the math to determine if changes need to be made.
With hope, thinking through your retirement income and spending will put you on the path to feeling like the millionaires of old and provide some confidence before your actually quit your job. If not, then maybe it’s time to get some help. A good fee-only financial advisor can help you articulate and achieve your goals. Some retirements need more planning than others, but the key to removing any remaining lingering doubts is knowledge. A planner will also be able to answer all the “other” questions you might have such as, how do I withdraw money from my portfolio? How do RMD’s play into this? How to plan for taxes when my income will be changing? Should I convert my 401(k) to a Roth IRA? Let’s get started.
About the Author
Phillip Christenson, CFA, is the co-owner of Phillip James Financial, an independent Fee-Only Financial Planning company located in Plymouth, MN. He helps individuals and families with wealth management, investments, tax planning, and tax preparation.
Investing in Value
I'm very excited to bring you another great post by fellow NAPFA member Greg Phelps! Greg writes about maximizing your wealth in retirement at Retirewire.com and is the President of Redrock Wealth Management. If you aren't familiar with the differences between value stocks and growth stocks I'm sure you will find this post to be very enlightening!
Understanding the difference between “growth” and “value” stocks is important to your investment plan. Unfortunately, most investors just don’t get it!
I’ll be honest. Early on in my career (1995) with Morgan Stanley, I didn’t get it either! I thought, “Who would ever want to buy a value stock? I want my stocks to grow!”
Then again, I was 20 years old, fresh out of college, and working for a major Wall Street brokerage. I didn’t know squat! And they didn’t care to teach me.
The training at those big brokerage firms is dominated in sales tactics, not how to create a financial plan or invest properly.
Fortunately, I was able to learn a lot over the years. If you invest in stocks at all, you really need to understand the difference between growth and value.
What is a value stock relative to a growth stock?
Relative to growth stocks, value stocks are “cheap” or “beaten down” by most fundamental standards. It’s like buying clothes on sale. They are less expensive than if you went to Nordstroms, but they’re still clothes. Value stocks often pay a dividend, which can be an important component of their return. Not all value stocks pay dividends.
In contrast, growth stocks are more “expensive.” This is because they have higher expectations for company profitability and stock performance. In general, growth stocks do not pay significant (if any) dividends so investors are relying on future price increases to create an investment return for owning the stock.
The most common measures of this price differential are:
- PE Ratio - The company’s current share price divided by its earnings per share
- PB Ratio - The company’s current share price compared to its book value
- Dividend Payout - The percentage of earnings paid to shareholders
That being said, the value versus growth metric can use nearly any financial indicator. Sales, profits, just about any way you’d measure a company’s financials can be a tool to compare a value stock to a growth stock. It’s all in the eye of the beholder.
Value and growth stocks in real life
Take for example the following four industries: technology, telecommunications, financial and retail. From Vanguard’s value and growth funds largest holdings, I selected four companies from each market sector. The following was data as of 5/4/2017:
Price to Earnings
Price to Book
Wal-Mart Stores Inc.
Price to Earnings
Price to Book
A few things jump out at me. Value stocks pay more back to shareholders in the form of dividends. They also cost less per dollar of earnings and less per dollar of book value than their growth counterparts. Using the Price-to-Earnings (PE) ratio value stocks tend to be cheaper than growth stocks.
Because of their differences, value stocks (like Microsoft) perform differently than growth stocks (like Google).
Value and growth stocks perform differently (1926 through 2013)
The value versus growth story is true across markets
Since 1928, value stocks have outperformed growth stocks across the board. This holds true over domestic, international, and even emerging markets.
We aren’t talking just a couple basis points here and there (a basis point is 1/100th of a percent). We’re talking upwards of 3, 4, or 5% depending on the marketplace.
Now, I don’t want to give the impression that year in and year out this “value premium” is going to hold true. It won’t.
There will be years, like several over the last decade, where growth stocks outperform value stocks. Take a look at the investment performance by asset class chart here. Not only will you see how growth and value perform relative to each other over the last 15 or so years, but relative to international stocks, bonds, real estate and commodities.
While the premium doesn’t hold true each and every year, it does so in a visible majority of years. See for yourself:
I realize this looks like a lot of noise and random patterns. What you’re looking at above is the value versus growth premium. For every year value smashes growth you’ll see a positive blue bar. For every year growth beats value you’ll see a red negative bar.
I see a lot of blue bars, with a few red bars. It still looks very noisy. But there’s one critical thing to remember:
You’re not a short term investor
If you are, stop reading now. Fly to Vegas and put it all on red!
Short term investing is anything less than a 5-year timeframe. Even my 98-year-old grandmother wisely planned for 5 more years before she passed!
Thinking longer term, let’s extend the one-year time frame to 5 year rolling periods. How does it look?
That graphical “noise” morphs into a subtle “purr”. Rather than having sporadic years scattered throughout, there’s a clear pattern, with only a handful of periods in time you would’ve been worse off.
The “value stock” story is becoming more apparent…
But why stop with 5-year periods? Let’s take a look over a 10 year period.
In only 3 noticeable 10 year rolling periods the value-overweight strategy faltered. If you’re investing for 10 years or more (and you probably are) there’s a lot to learn here!
Over long periods of time, value stocks have a clear edge on growth stocks. They have simply performed better!
Higher risk, higher returns
Why do “value” stocks tend to outperform “growth” stocks?
Investors require a higher return for riskier investments right? I mean, if you had 10K to invest and the risk was low (like a CD or a bond) you might expect a sub 3% return over the next 10 years in the current interest rate environment.
Yet, if you invest that same 10K into a stock portfolio, you’d surely expect a return much higher! You’re taking more risk after all, right?
So investors leaning their portfolio towards value stocks should expect higher rates of return over long periods of time.
They’re buying stocks that by definition are “cheap” or “inexpensive” relative to their growth counterparts after all. Perhaps their profits are not growing as quickly as other companies. Or they have experienced some headwinds in the news. These are “unattractive” stocks (to most investors) that have been beaten down because they’re out of favor. However, we can’t forget that a company that can regularly pay a dividend is also giving a tangible return on an investor’s investment. These dividends have contributed significantly to a value investor’s return over time.
The moral of the value versus growth story
Value stocks and growth stocks are two distinct types of investments. It depends on how you want to measure them, but one is out of favor or “cheap” and the other is clicking on all cylinders like a finely tuned Ferrari!
Angling your portfolio a bit towards value stocks makes a lot of sense. I’d never say, “Throw caution to the wind and get out of growth stocks” but I absolutely believe in the risk/reward story of value versus growth stocks.
Remember, the news is a bad indicator of YOUR investment results. Indexes like the S&P 500 are notoriously large cap weighted and growth stock weighted. If you’re a value believer, your returns may have some serious deviations from the “norm” you see on tv.
About the Author
Greg Phelps, CFP®, CLU®, AIF®, AAMS® is the President of Redrock Wealth Management, a fee only fiduciary financial advisor firm in Las Vegas, Nevada. The firm specializes in retirement transition and decumulation planning for baby boomers.
The World According to Bok
Today I am excited to bring you a post written by Fee-Only Financial Planner Warren Ward of Indiana! Warren has been in the business for over 20 years. He is the editor of Warren’s Wisdoms and is often quoted in national media. You can find more of Warren’s writing here: http://www.wwafp.com/
Making the Right Investment in Education
Although inflation has been quite benign for the past several years, costs are ever on people’s minds. The cost of higher education always seems to be rising more quickly than other costs and this has been true for a very long time. Way back during my college years, I remember a comment made by Harvard President Derek Bok. In answering a parent’s question about the cost of a higher education, he said: If you think education is expensive, try ignorance. Bok, who had previously been Dean of Harvard’s law school, earned three degrees: bachelor’s, master’s and a doctorate in law. He continues to lead a very productive and successful life and his career simply would not have been possible without those educational credentials.
College or Bust?
Yet, a traditional education may not be the only path to a successful career. Indiana’s department of workforce development provides a list of the most in-demand jobs and we turn to it when we’re asked to suggest a course of study. No doubt your state offers something similar. Even in manufacturing-centric Indiana, the number one job is nursing, a field which can be entered with an Associate’s degree. Number two is elementary education which requires at least one college degree but careers number three and four are truck driver (certification) and sales representative (high school diploma). In fact, six of the top ten careers can be entered with something less than a four-year degree.
Indiana’s list has been developed with the intention of steering people to careers for which there will be a demand and the current number 47 is computer programming. According to the website, this field requires a college degree but there may be a quicker and less expensive route to a programming job. An industry has sprung-up in the past few years to teach basic software code-writing skills to those with no computer education at all. Becoming a manager in this field will almost certainly require a college education but coding is being taught in non- and for-profit classes all over the country and graduates are going straight to work. The typical model is an intensive ten to fourteen week course after which grads are prepared for entry level coding positions. The schools generally shy away from the current ‘hot’ programming languages, instead focusing on the older languages in regular use by manufacturers and financial institutions.
Of course, there’s now a website which attempts to match potential coders with appropriate schools. It’s called Course Report and it offers information on 91 such programs around the country. The website doesn’t mention the level of educational attainment of co-founders Liz Eggleston and Adam Lovallo.
Incidentally, Indiana’s job number fifty is personal financial advisor. For those of you who are wondering about taking my place when I eventually retire, this field now requires an undergraduate degree. Going further and acquiring the Certified Financial Planner® designation requires the completion of six Master’s level courses and passing a two day examination. Most business-related Master’s degrees now include those courses in their curriculum.
Someone to keep the lights on...
According to a 2012 report from the Social Security Administration, 10,000 Baby Boomers are leaving the workforce every day. For those of us who are slowing down, this can be a blessing – for companies in need of trained workers, perhaps not so much. Indiana’s list doesn’t include many manual trades, so called middle skill positions, such as welder, electrician, diesel mechanic and HVAC technician. Yet as Boomers retire, the country is going to need to find a way to replace those critical workers who keep our lives (and our factories) running smoothly. In large measure, such education is being provided best by our Community Colleges. In Indiana, Ivy Tech offers 12-month programs that culminate in a certification in one of these much in demand skill sets.
The highest paying job on Indiana’s list is number 17, Family Physician. This job obviously requires multiple degrees and shows there will always be a need for traditional higher education. A 2014 report from the non-profit Economic Policy Institute helps explain why. It reinforces both the lifetime learning differential between high school and college educated workers (approximately double) and the greater resilience better educated workers enjoy when they lose their jobs. Still, no one wants to become the subject of an article like some I’ve begun seeing recently describing Baby Boomers who are retiring with college debt. Giving careful thought to an appropriate career, including considering both the time and cost spent achieving it, is certain to be time well invested.
Derek Bok is an intelligent and very well educated man and I imagine he’d agree that there are paths to knowledge other than a traditional four-year degree. Regardless of whether you’re a graduate of Sioux City’s Morningside College, Stanford, Harvard and George Washington University, or a non-degree certification program; education is important. It’s the job of all planners to help clients and their offspring invest in education as thoughtfully as they do in their financial instruments.
Want to know more about funding a college education? Find out how to talk to your teen about what it really means to have student loan debt.
The Pension Choice May Still Be Yours
I am pleased to share with you this post from fellow NAPFA member Kent Addis of Addis & Hill, Inc. a Fee Only Financial Planning firm in Pennsylvania. Enjoy! -LZH
There is no shortage of headlines about the crisis facing pension systems all across the country. Many public pension plans are faced with similar issues. As a result, the number of employers offering defined benefit retirement plans dropped from 25% in 1979 to just 2% in 2013 according to the Employee Benefit Research Institute. This has created a steady move by employers from defined benefit plans to defined contribution plans such as 401(k) plans which shifts the responsibility of funding retirement to the employee. Longer life expectancy, lower investment returns, and lower interest rate assumptions imposed by federal regulations have all contributed to the move.
Despite the shift to defined contribution plans, there are still many who are participants in the old defined benefit programs. In Virginia many state employees still participate in a defined benefit plan. Many large companies, such as Merck, Johnson & Johnson, and JP Morgan, still offer defined benefit plans according to Pensions and Investments magazine. These public institutions and private companies carry the financial risk of paying a guaranteed monthly pension.
Defined benefit plans use a formula to determine what benefits are available to the retiree. The employee must decide at retirement how they want to receive their pension benefit and this is where it can get confusing for the new retiree. Does the new retiree choose a benefit based on his/her life only? Should they take a reduced benefit to provide a spousal benefit if they should die first?
The reduction in benefits that they accept is usually based on the sex of the retiree and spouse and their corresponding ages. A longer expected life expectancy for the survivor tends to result in a larger reduction in benefits for both, depending on the terms of the plan. Clearly, there are some important questions that must be answered at this point and before you make your pension benefit selection.
Here’s a few of the common ones to get you started:
- Does your spouse have a pension of their own? If so, do they need to have more funds available?
- Are there additional investment assets in other accounts that could be converted to income?
- Does the plan provide cost-of-living benefits for the spouse? Inflation can have a major impact on your standard of living as you get deeper into your retirement years.
- What will Social Security provide to the spouse?
- Do you have enough life insurance in an amount necessary to provide spousal benefits in place of taking a reduced benefit for life?
- Or, can you purchase new life insurance for an amount equal to or less than what your employer’s plan might charge?
- Is there an inheritance in your future that your spouse can count on?
Despite the employer’s willingness to accepting financial responsibility for you under the defined benefit plan itself, they are not going to provide much guidance for you and your spouse around these types of questions as they are not interested in accepting that type of liability. But, if you are not confident in your own planning abilities, fee-only advisors are usually well equipped to help since they are not paid commissions based on what you buy from them. The cost of hiring an advisor can be far less than the cost of making irrevocable pension option mistake.
Kent R. Addis, Jr.
Have a Roth 401(k) at work but don't know if it's the right choice for you? 8 Things to Know About Roth 401(k)s (written in plain English) Start here.