Do not wait; the time will never be “just right.” Start where you stand, and work with whatever tools you may have at your command, and better tools will be found as you go along.
—George Herbert
Chapter 4
Returning to the Return You Need
How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.
—Robert G. Allen
This should grab your attention: Many Americans may not be able to retire successfully without taking advantage of the ideas in this chapter. I’m about to show you how you could potentially increase your rate of return by 50 percent and/or get the rate of return you need to retire comfortably with less risk. We will do some simple math to prove why.
Suppose you are a boomer heading toward retirement. You have been paying attention to retirement articles and books for quite some time, and you already know that at the end of the day, what matters is whether you have enough after-tax cash in your account to pay for the things you need. You’ve calculated that to maintain your lifestyle you will need a certain average rate of return on the money you already have invested. Let’s consider three cases:
1. You need an average return of less than 3 percent.
2. You need an average return of between 3 and 6 percent.
3. You need an average return of higher than 6 percent.
A few examples of the first situation, where you need a 3 percent return:
You have $500,000 and need less than $15,000 per year.
You have $1 million and need less than $30,000 per year.
You have $5 million and need less than $150,000 per year.
If this is you, congratulations! In all likelihood, you won’t need to incorporate a strategic debt philosophy into your financial life. You have a lot of resources relative to your needs.
The ideas in this chapter may still be beneficial and you may still want to take advantage of them, but you likely do not need this chapter.
If you’re in the second situation, needing an average return of between 3 and 6 percent, things become a little less clear. For example, you have $1 million and want $50,000 of annual income in retirement. You may need to take advantage of strategic debt, especially if the amount you need is closer to the 6 percent figure. As your required rate of return moves higher, you have to take risk. There is risk in having debt and there is risk in
reaching for return. But with the tools I will give you to compare and contrast these risks, you will be able to choose which path you believe is the least risky—and you may be
surprised by your conclusions!
If you’re in the third category—needing an average return of higher than 6 percent—then you may be in a problematic situation. I think it will be very difficult for investors to generate a rate of return higher than 6 percent these days. As I will discuss (and
mathematically prove) in Chapter 7, it’s highly probable that a portfolio of U.S. stocks and bonds will average less than 5 percent for the next several years. Worse, 5 percent is likely the upper end of the range. A portfolio of U.S. stocks and bonds could average close to zero—or even negative returns over the next few years! So, you may not want to take advantage of strategic debt, but if you don’t, the type of retirement you’ve always envisioned may rapidly turn into an unachievable dream rather than the promised
destination you’ve been aiming at for many years. I will show you how to increase the size of your portfolio, thereby potentially decreasing the necessary return that you must aim for in order to have the retirement you want.
Cash Flow and Incoming Money: The Ultimate Key to Resource Management
The greatest achievement of the human spirit is to live up to one’s opportunities and make the most of one’s resources.
—Luc de Clapiers
Ultimately, the key to managing your resources is to get a handle on cash flow, or
incoming money. The term “replacement ratio” is often used to describe the ratio between your current working income and the income you will need in retirement. Consider the words of bestselling author and life coach Ernie J. Zelinski:
No doubt the people with the best opportunity to fulfill their dreams in retirement will be the ones with the biggest nest eggs. . . . Individuals looking forward to retirement must determine what sort of lifestyle will make them happy and how much money they will need to support it. . . . Most financial planners today believe that retirees need to “replace” at least 80 percent of the income they made in their working years. Some financial planners even say that retirees need a higher income than they made in their careers. . . . They may need to replace 105 percent of their working income if they hope to maintain their living standards. It shouldn’t take a genius to figure out that a rigid retirement replacement ratio—whether it’s 80 percent or 105 percent—is irresponsible and misleading. . . . There is no formula that will fit everyone.1
While no formula fits everyone, a good deal of legwork and preparation can be done
ahead of time to assess both your needs and your resources. Consider making a projected yearly budget for retirement. Of course, you may leave things out when making your projections, and things will change through the years and decades. Nonetheless, you should come up with a reasonable figure that should encompass everything you need to live, from housing to transportation to food to entertainment to medical and insurance costs, and so on.
Once you have the amount you will need in mind, you should assess your resources. With all of your existing, known, likely, and additional potential resources listed, you can
calculate the level of outgoing cash flow that you will need as a percentage of your resources.
You Have to Get Your Numbers Right!
I have seen over and over that people make two fundamental mistakes when they are calculating how much money they will need in retirement. First, they start with the wrong number. Second, they forecast future expenses and inflation the wrong way.
Let’s start with the first point—getting to the correct number. I have run retirement plans and forecasts for almost 20 years. For years I asked people how much money they needed in retirement. At first I accepted peoples’ estimates at face value. After all, I figured, who could know how much money somebody needs more than the person I am asking? It took me years to realize that most people start with the wrong estimates. For example, many people assume that if they make $100,000 a year, they need $100,000 a year in
retirement. Occasionally they adjust it by old rules of thumb and come up with 80 percent or $80,000. Only after working in the industry for years did I learn that the question is better asked a different way: How much incoming money do you need, after taxes, on a monthly basis, to cover all of your expenses?
Most people take a “top-down” approach. I recommend a “bottom-up” approach. When we make money, we pay into payroll taxes (Social Security and Medicare), federal income taxes, state taxes (in most states), and savings that go into a tax-deferred program such as a 401(k). Most people typically have other savings that they are building up to stay on track for retirement. The essential point is that your taxes are likely to be vastly different in retirement than they were when you were working. Further, you are not trying to replace the saving component, just the spending component.
How much incoming money do you need, after taxes, on a monthly basis, to cover all of your expenses? Remember, you are not trying to replace the savings component, and your taxes may be vastly different than you anticipate.
The full impact of this will depend on your income and savings rate before retirement. If you are making less than $100,000, in all likelihood something around 80 percent (and potentially more than 100 percent) may be a reasonable number. The “traditional rules of thumb” may indeed be quite accurate. However as your income grows, these figures may change significantly. I know a successful attorney who was making $300,000 but realized that his family needed only $150,000 or $12,500 per month after taxes in retirement.
This was because so much of the family’s money was going to taxes, savings, and the kids’
college expenses. A need of $150,000 is 50 percent of $300,000, and I assure you this makes a big difference in running their plan!
This phenomenon gets even more extreme with very large incomes. I know specialty physicians (think neurosurgeons) who refer to “the rule of thirds,” in which about one third of income goes to taxes, one third to savings, and one third to lifestyle. A specialty physician making $750,000 may in fact need to replace only $250,000 of income or
approximately $20,000 per month after taxes in retirement. At very extreme levels where individuals have incomes of, say, $2 million, it may turn out that the monthly need is in fact closer to $40,000 per month (especially when you take out the expense of kids). In this case, they only need to replace 25 percent of their income.
The bottom line is that the percentage doesn’t matter; determining the right number for you does! Once you get to the right number, you need to subtract your other sources of income to determine how much you need to generate from your portfolio. For example, if you need $5,000 per month but have a pension of $1,500 and Social Security of $2,000, then you need $1,500 per month, or $18,000 per year, from your portfolio.
For reasons I discuss in the next chapter, I like to focus on your after-tax need. If you’re properly positioned, you may be able to run at levels that are much more tax-efficient than most people estimate.