Protecting Your Wealth in Good Times and Bad Chapter 14 pptx

This program estimates the amount of wealth you will need at retirement to sustain your standard of living and establish-es guidelinestablish-es for creating an appropriate investablish-

PEOPLE MATUREin several ways, including physically, emotion-ally, professionemotion-ally, and financially Accumulating and maintain-ing wealth durmaintain-ing our 40s and 50s requires a different attitude and

a different set of financial tools than it did during our 20s and 30s Sometime in midlife we realize that we are mortal and that there are limits to our abilities We become more conservative and set

in our ways We also change the way we manage our wealth as retirement draws closer

As we learned in Chapter 13, Early Savers are busy establishing careers and forming families Reaching permanent financial

securi-ty is only a vague image in the distant future As a result, the plan-ning aids that guide wealth accumulation center around learplan-ning

to save on a regular basis and investing that money at an accept-able level of risk

By midlife, managing wealth takes a new direction By this time, retirement accounts should have adequate assets in them

Chapter 14

One of the many things that nobody ever tells you about middle age is that it’s such a nice change from being young

—Dorothy Canfield Fisher

Midlife Accumulators

and savings habits should be well refined Careers and family life are generally well established at this point and we have formed a lifestyle that is comfortable and affordable It is now time to refine our ideas of a secure retirement Armed with genuine content about our lifestyle, we begin to envision what retirement will be like and where the money must come from to fund that vision

By midlife, saving for retirement is no longer an option; it is a necessity If you have not started a regular saving program, procras-tination is no longer a luxury that you can afford The realization that you must save in midlife is coupled with the realization that investment returns are also becoming increasingly important As the assets in retirement accounts grow, the investment returns on those savings will have a much greater impact on your lifestyle in retire-ment than the investretire-ment return during your Early Saver years Midlife Accumulators must understand and apply sound investment principles These principles include a proper asset allocation and the use of low-cost investment products, such as index mutual funds

In addition to saving regularly and understanding personal risk tol-erance, Midlife Accumulators should form a detailed investment plan This chapter introduces a method for creating a detailed plan that uses

a six-step approach This program estimates the amount of wealth you will need at retirement to sustain your standard of living and

establish-es guidelinestablish-es for creating an appropriate investablish-estment portfolio that has the best chance of reaching your wealth accumulation goal

Where Does All the Money Go?

Over 80% of midlife adults have children As families mature, they tend to accumulate a lot of stuff, like automobiles, appliances, elec-tronic gadgets, closets and boxes full of clothes, tools, and possibly a vacation home, a boat, a recreational vehicle, or all three Of course, raising children is extremely expensive, including increased insurance costs, medical costs, and dental costs The older they get, the more they cost Demand for space usually leads to a larger house, which means larger bills, including higher mortgage payments, utilities, and taxes Having children also creates a need to save for their education

so that some day they will leave the nest and be self-sufficient

At least that is the plan There are other reasons midlife can be very costly By that time, many people are on their second or third marriage and are supporting two families and two homes

The Art of Budgeting

Managing household budgets becomes a fine art form in midlife We earn more, we spend more, and, at the same time, we need to save more Regardless of how difficult it sounds, saving for retirement and saving for the children’s education has to take priority over all the other bills

The most successful savers in history have a mantra—“Pay your-self first.” How do you do that? The way to do it is through payroll deduction As we covered in Chapter 13, have the money for retire-ment and education automatically deducted from your paycheck so

it does not get spent someplace else Don’t let the house bills over-power your need to save Granted, this is not easy A successful sav-ing plan requires you to take a good look at exactly how much you earn and how much you spend and then form a workable budget around those numbers

There are plenty of good financial planning books at your local bookstore and library to help with budgeting I highly encourage you to pick up one or two of these books and read them In addi-tion, the Internet is full of family budgeting tips that are absolutely free Simply type the phrase “family budgeting” in a search engine like Google.com and you will get a list of dozens of sites offering free software and planning

If you are having trouble saving because you have lost track of your expenses, get back on track Keep a list of your expenses for at least three months There are some fabulous software packages that can help you track household inflows and outflows Try Microsoft Money® or Quicken®

Redefining Retirement Savings

Sometime during our 40s, we wonder if and when we will ever have enough money to retire with security Financial independence seems

so far away Being financially independent means having enough

accumulated wealth so that you can quit working for pay any time you want and not change your lifestyle Thoughts about financial independence naturally lead people to inquire about the amount of savings needed to sustain a certain standard of living and how to get

to that point from where they are currently

This chapter helps you develop a plan for achieving financial independence over a period of time, although the methodology assumes that you have not set a firm date for retirement A firm retire-ment date will be introduced in Chapter 15, Pre-Retirees and Retirees

Accumulating Wealth for Retirement

As we cruise through midlife, with the joys, trials, and tribulations of managing a career, and raising a family, we begin to think more about other goals we want to pursue while we are on this great Earth Many people envision retirement as a time of pursuing hob-bies, learning new and interesting things, traveling, making new friends, and possibly starting a small business or doing volunteer work while maintaining a comfortable standard of living

Whether or not our vision of retirement actually becomes a

reali-ty depends on several factors The most important factor is our health Without good health, retirement will not be the joy we envision it to

be The second factor is the wealth that we accumulate prior to retire-ment Over-funding a retirement plan is better than under-funding one The third factor is how much we will spend in retirement Overspending and outliving our money is not much fun either We will start an analysis of retirement needs with the third factor

If you are like most people, your expenses will go down after retirement There are three reasons for this decrease: taxes are lower,

a high savings rate is no longer required, and usually there are fewer mouths to feed at home On the other hand, a few expenses may be higher, such as travel expenses and health care costs A good rule of

thumb is that 80% of your current pre-tax income should sustain the

moderate lifestyle you envision in retirement

One piece of good news for retirees is that taxes will be lower Once you stop drawing a paycheck, federal and state income taxes are significantly reduced In addition, there are no Social Security or

Medicare taxes unless you work part-time The government also gives retirees several tax breaks Everyone over the age of 65 gets an extra exemption on Form 1040 Several states give retirees an assort-ment of tax breaks Many states allow retirees to draw tax-free retire-ment income from their pensions and IRA accounts Since state gov-ernments get federal money based on the number of residents, the state governments give retirees tax breaks so they will not change their residency to non-taxing states like Florida, Texas, or Nevada Retirees can also control the remaining income taxes by juggling the way distributions are made from various retirement accounts For more information on controlling taxes on investments and pen-sions, see Chapter 15, Pre-Retirees and Retirees

The second reason people do not need as much income in retire-ment as they did while working is that they no longer need to save for retirement, although many people continue to put some savings away each year as a hedge against inflation In addition, retirees seem to find many unique ways to cut costs and save money For example, retirees may take on the smaller home repair jobs them-selves rather than calling on a professional In addition, if an adult child is still hanging around the house, that resident should be encouraged start paying his or her full share of expenses As a result

of lower taxes, less savings, and some cost reductions, 80% of your current income is a good goal when planning for retirement After establishing the amount of after-tax income needed in retirement to sustain your lifestyle, start piecing together a retire-ment plan, which concludes with an investretire-ment strategy One way

to do this is to look at your savings in the same way as a corporation would look at a defined benefit pension plan

When a large corporation manages a defined benefit pension plan, the trustees estimate that future retirement checks will be based on some percentage of employees’ current compensation The company then manages the retirement account to best match those future liabilities The idea is to match the expected annual cash inflows of plan assets with the expected annual cash outflows to retirees If the inflows equal outflows, then the plan is fully funded Individuals can manage their retirement savings the same way

They simply match expected annual cash inflows from pensions, Social Security, and investment income during retirement with expected annual living expenses Granted, there will be many uncer-tainties to this approach, such as the rate of inflation, so you will need to adjust your plan as time goes by Nonetheless, if expected cash inflows from all sources of income equal or exceed the

expect-ed cash outflows, then your personal liabilities are matchexpect-ed and you have attained financial independence

The Six-Step Retirement Saving and Investing Program

The six-step retirement saving and investing program should help set the course for your savings plan over the midlife accumulation phase and into the pre-retirement period, which starts about five years prior to retirement First, I will outline the six steps; then I will explain each step in more detail

One important note before we begin: all the lessons we learned

in Chapter 13, Early Savers, still apply When the plan is complete, make sure you save automatically and the asset mix is within your tolerance for risk Here are the steps:

1 Calculate your current living expenses using the direct or indirect

method (explained below) Make adjustments as necessary to estimate expenses in retirement

2 Estimate your known sources of income at retirement, not including savings

a The difference between the figure from Step 1 and the figure from Step 2 is your income gap

b Multiply your income gap by 22.5 to determine your required nest egg if you were to retire today (Why 22.5? That is the inverse of a 4.5% withdrawal rate, a figure that will be dis-cussed in detail in Chapter 15.)

c Figure the number of years you have until retirement and adjust this amount upward by 3% per year to cover inflation

3 List your current and future savings

a Inventory the assets you own that may be converted to income-producing investments at retirement

b Estimate the amount you will save each year, starting this year and for every year until you retire at age 65 (or age 62 if you want to retire earlier)

4 Compute—using a spreadsheet or a financial calculator—the required rate of return on your current retirement assets and future savings that you need to reach your required nest egg goal (Step 2b)

a Do not adjust any numbers for inflation before the calcula-tion

b Any required return over 8% is too aggressive at this stage If the required return is over 8%, you will have to recalculate the numbers so that you work longer, save more, or spend less in retirement

5 Using the market forecasting tools in Chapter 11 and asset allo-cation tools in Chapter 12, design a diversified portfolio that has the least amount of risk needed to achieve your required rate of return on investments Shares of restricted company stock are considered part of the equity allocation

6 Ensure that your asset allocation is at or below your tolerance for risk by stress-testing the stock-and-bond mix as outlined in Chapter 13 Write down the asset allocation and then rebalance your portfolio to the allocation periodically

If you design an investment strategy to achieve your objectives while not exceeding your tolerance for risk, it is very likely that you will be able to meet income liabilities when they come due The trick is to set a course and follow it, without being swayed by the irrational investment behavior that surrounds us The remainder of this chapter explains each of the six steps in detail, complete with examples of portfolios that may be used as a guide

1 Estimate Your Annual Expenses in Retirement

By midlife, we have a good idea of the standard of living that makes

us comfortable and how much that lifestyle costs Most people desire to maintain their standard of living after retirement, which is what this program assumes It is fairly easy to anticipate your

income needs in retirement: simply figure out how much you are spending now and make a few adjustments

There are two methods for determining your annual expenses— direct and indirect The direct method means tracking every dollar of household income and recording where it is spent or saved The indirect method takes the gross pre-tax earnings and subtracts taxes and savings to arrive at annual spending

The direct method is the most accurate, because it itemizes each

expense, but it is also the most time-consuming It is a tedious task

to keep track of all your cash outflows, including taxes and savings For a helpful list, see the income and expense guide at the end of Chapter 15 Once you have created a list of expenses and categorized them, it is easy to derive an annual budget from the data and to adjust specific line items in the budget that will likely be different when you retire

For example, many people have paid off their mortgage by the time they retire, which is a big cash savings each month In addition, life insurance is generally not needed after you have accumulated enough to retire, so that expense should go away Automobile costs will be lower, since you will not commuting to work each day and your children will be off your auto insurance policy Speaking of the children, you should be done paying for their educational costs by the time you retire or you should hand over the remaining bills to the newly well-educated and hopefully employed adult children Some costs may increase in retirement Health insurance may rise, especially if you retire before Medicare begins at age 65 Also, prescription drug costs are not currently covered under Medicare In addition, it is a good idea for most people over age 60 to purchase

a long-term care insurance policy that covers home care, assisted liv-ing, and nursing home costs not covered by Medicare

If keeping detailed records of all household expenses sounds too

tedious, there is an indirect method to approximate your annual

expenses The indirect method is quick, but not as accurate or detailed and not very useful for budgeting To find your annual liv-ing expenses, your will need last year’s tax returns and W-2 form and the annual statements on all savings accounts

Go to the bottom of your IRS Form 1040 and find your adjusted gross income (AGI) According to the government, this is how much you made last year First, if you moved to a new location, add back the cost of moving that was deducted to get the AGI Second, sub-tract from the AGI any taxable interest, dividends, and capital gains (losses) from your taxable savings account In addition, net out new

after-tax savings and withdrawals for the year for all taxable

invest-ment and savings accounts This will tell you your savings-adjusted AGI Third, subtract all federal and state income tax from the sav-ings-adjusted AGI What you are left with is a close approximation

of the amount of money you spent last year

Here is an example of the indirect method for the past year Assume you had an AGI of $75,000 last year and did not move to a new location Of that amount, $5,000 was earned in capital gains, interest, and dividend income from taxable investments In addition, you added $6,000 to personal savings in taxable accounts, including college funds That equals a savings adjusted AGI of $64,000 Next, subtract $20,000 in income taxes paid to the federal and state govern-ments What you are left with is a close approximation of the amount that you spent—$44,000 Once you know this amount, it helps to go

a bit further and take out major items like the mortgage, health and auto insurance, other auto costs, utilities, and other items you can identify The remaining money was spent on food, clothing, travel, gifts, etc Finally, make any adjustments that you think will be more

or less in retirement, e.g., mortgage, college costs, insurance The entire process is listed in Table 14-1 The indirect method of estimat-ing expenses is not perfect, but it gets you in the ballpark

2 List Known Sources of Pension Income, Including Social Security

In Step 2, add your known pension income, including Social

Security This does not include employee savings plan assets such as

a 401(k) Most workers in America pay into the Social Security sys-tem and, depending on your age and the amount you paid in, you should get something out of it starting at age 62 In addition, many large employers still offer a defined benefit pension plan (See

Chapter 10, Other Sources of Retirement Income.)

The Social Security Administration sends you a statement each year that you can use in the exercise; however, I would use a lower amount than given in the statement because the amount is destined

to change as the trust fund runs out of money A reduction of per-haps 15% is appropriate for someone in their early 50s and maybe 25% for some in their early 40s So, for example, if you are 45 years old and the Social Security statement says you are entitled to

$20,000 per year starting at age 65, I recommend using $15,000 Employer defined benefit plans fall into two groups: those whose benefits adjust for inflation each year and those that pay a flat amount Each year your employer will provide a statement of

project-ed pension benefits if you continue to work for the company until retirement While the future benefits statement may be interesting, you need to calculate what your pension benefit would be worth today if you stopped working for that employer The value of the pen-sion today is the important number In addition, is that benefit adjusted for inflation each year or does it stay a flat amount? A flat monthly payout is not worth as much as inflation-adjusted benefits For our example, we will assume you have a vested pension from

a former employer that is worth $500 per month at age 65 Add this known employer pension benefit of $6,000 per year to an adjusted Social Security income of $15,000 per year to equal an expected total income of $21,000 per year Assume that you will be paying some taxes on the income; since income tax on Social Security is

Earned income $70,000 $70,000 Taxable interest and dividends

All savings and reinvestment Federal/state income taxes Adjustment for retirement*

$5,000 ($11,000) ($20,000) ($2,000)

$75,000

$64,000

$44,000

$42,000

*Known additions or reductions in retirement living expenses.

Table 14-1 Indirect method to calculate living expenses