The Money Class
Page 24
• I also want you to have your antennae up for any advisor who tells you to take the higher single-life-only benefit and then use the extra amount of the payout to purchase life insurance that the survivor would receive. I don’t like that advice at all. It’s an opportunity for the advisor to sell you an expensive life insurance policy that no doubt earns him a large commission.
A note on pop-up provisions: Some pensions offer a provision that goes like this: If the spouse dies before the employee, the employee may be able to switch (pop up) to a higher pension payout. This is another issue to discuss with a fee-only financial advisor.
COMPARING THE LUMP SUM TO THE ANNUITY
To help you create an apples-to-apples comparison, let’s see how much monthly income you might be able to withdraw from your lump sum and compare that to the monthly annuity option:
1. Take the amount of your lump sum that you could roll over into an IRA and multiply it by 4%. This is what you could afford to initially withdraw annually from your rollover without having to worry about running out of money if you were to live a long life.
Enter that figure here: $____________________
2. Enter the annual amount of the annuity you could receive. Choose a 100% joint-and-survivor option if you are married, or the life-only if you are single.
$____________________
I think you will be surprised to see that you will be getting considerably more by taking the annuity. That said, one important consideration is that most annuity payouts do not include an inflation adjustment: The payout you receive in year 1 will be the same as year 5, year 10, and so on. If you took the lump sum and invested it wisely you would have the opportunity for gains that would effectively allow you to keep pace with inflation. That is another factor a financial advisor can help you weigh.
Your Estimated Monthly Pension Annuity
or Annual Income from Your Rollover IRA: $____________________
Is Your Pension Safe?
It is no secret that some pensions—both private and public—are facing financial challenges. But I want you to understand two important points: It is highly unlikely that any public or government pension will change the benefit formula for anyone near retirement. The rules, if they change, would affect new employees; there will likely be a grandfather clause for current employees, especially those near retirement age.
If you have a private-sector pension, you may wonder what happens if your company goes bankrupt or it can’t fulfill its pension obligations. Please understand that the money your firm has in its pension accounts is kept separate from its other operations. And the plan is required to report each year whether it has enough money to pay its future obligations. This is called its “funded status.” You have a right to receive an annual statement showing your plan’s funded status. Request a summary plan description (SPD) to find this information.
So let’s say your plan is in fact underfunded. Time to panic? No. Check the SPD to confirm if the pension plan is covered by the Pension Benefit Guaranty Corporation (PBGC). Most plans are. This is a federal agency that guarantees the payments for member firms. Its job is a lot like the FDIC for banks or the NCUA for credit unions: They step in and cover payments when member firms fall into trouble and can’t make their pension payment.
Just as with FDIC or NCUA insurance, there are limits to what you can receive from the PBGC. If you are already receiving a benefit from your pension, the PBGC limit is set by your age at the time it took over your plan. In 2011 the maximum monthly benefit for someone age 65 is $4,500; for a joint-and-survivor benefit the maximum payout is $4,050. If you are under age 65 the PBGC benefit will be lower than those amounts; if you are older the maximum will be higher. At the PBGC website (www.pbgc.gov) there is a table of maximums based on age. If your plan is taken over by the PBGC before you retire, your maximum benefit will be tied to the age at which you begin to receive your benefit.
The bottom line is that even if you are concerned about your employer’s future, as long as it is part of the PBGC and your expected payout is below the agency’s limits, you should rest easy.
Now let’s add up your various sources of retirement income.
Your Total Estimated Monthly Retirement Income:
Social Security $____________________
+
Your investments $____________________
+
Your pension $____________________
+
Other sources of income (rental properties, etc.) $____________________
=
Your total estimated monthly retirement income before tax $____________________
Please remember that any money you withdraw from a traditional IRA or 401(k), as well as pension payouts and Social Security (to a limited extent based on your overall income), is taxed as ordinary income in the year it is paid. Federal income tax rates vary from 10% to 35% depending on your total income, and some states tax retirement income as well. Just keep in mind that the figure above is going to be lower once you settle your tax bill.
ONCE AGAIN, IT IS TIME TO STAND IN YOUR TRUTH
Now compare this figure to your current expenses—the figure you arrived at in Class 2, when you used the expense tracker tool on my website. Of course we need to adjust your current expenses for inflation. You can use the compound interest calculator in The Classroom at my website to get a rough estimate. In the Initial Investment box input your current annual expenses. Leave the Monthly Addition box empty and then for the interest rate plug in 4%. That is actually slightly higher than the long-term inflation rate over the past few decades, but I think given what is going on in our economy and with our fiscal deficit we could in fact see above-average inflation in the coming years. Finally, input 10 years past the date you expect to retire. Why so long? Well, if we just plan to the date you retire we won’t know what your expenses might be down the road in retirement.
Note: if you plan to pay off your mortgage before you retire, remember to deduct that current expense from your calculation.
Okay, now you have a rough idea what your expenses might be in retirement. I hope you’re smiling because your expected retirement income is plenty to cover your anticipated expenses. But if that’s not the case, and you see a shortfall, please do not panic. You have time to figure this out. That’s why we are doing this exercise now, in your 40s and 50s. You have 15 or more years to make up ground. It can also help you focus on some priorities, such as working longer and delaying when you begin to draw Social Security. And perhaps you might recognize that my advice to focus on your retirement rather than saving for your child’s college costs makes a ton of sense.
Or let’s take a different approach: Maybe your next few vacations are to different parts of the country—or the globe—where the cost of living is lower than where you live today. Start scoping out possible places you might consider retiring to. There’s no pressure; just make this an enjoyable adventure where you explore your options. Now is the time to do that exploring and planning. I am confident you can indeed reach your new retirement dream, but we are committed to standing in the truth that there may be some adjustments necessary between then and now to get you there.
Next I want to discuss one more important way you can increase your retirement security: Save more, and save smart.
LESSON 5. SAVING MORE, AND INVESTING STRATEGIES IN YOUR 50S
Obviously, one of the surest ways to improve your retirement picture is to save more over the next 10 to 15 years. In fact, the annual contribution limits for your 401(k) and IRA savings are higher once you turn 50. In 2011:
401(k)s: If you are at least 50 years old, you can contribute $22,000. The maximum for younger employees is $16,500.
IRAs: If you are at least 50 years old, you can contribute $6,000. The maximum is $5,000 for younger savers.
I think it is a smart time to consider saving more in those accounts. Don’t expect HR or your 401(k) plan sponsor to send you a note on your 50th birthday informin
g you of this great opportunity. It’s up to you to take the initiative here. My one caveat, as you have already learned, is that if you currently live in a home that you intend to retire in, and you can honestly afford to stay in that home, then it can make sense to divert some of your retirement savings to accelerate paying off your mortgage.
HOW TO INVEST SMART
It is so interesting to me that people in their 50s tend to take extreme positions when it comes to investing their retirement money. At one end of the investing spectrum are the people who realize they are way behind in their savings. Therefore they decide they should put all their money in stocks; they think that is the only way to have a shot at the big gains they need to make in order to amass what they want by their targeted retirement date.
At the other extreme is the conservative bunch. They think that because they are retiring in 10 or so years they can’t afford to own any stocks. After watching what happened in the bear market that began in 2008, they feel it would be a huge mistake to risk having any of their retirement savings lose value.
The truth is that neither camp is correct.
It was very frustrating to me in the wake of the 2008 financial crisis to see people in their 50s shell-shocked that their portfolio was down 40% to 50% or more. The only way that could have happened was if their portfolios had been 100% invested in stocks. If they had owned a more appropriate mix of stocks and bonds, the losses, while still steep, would have been far less devastating. While the S&P 500 stock index lost 37% in 2008, the leading index tracking the bond market gained 5% for the year. Someone who simply had an even split between stocks and bonds might have come out of 2008 with a cumulative loss of 16%, or less than half of what so many of you told me you experienced.
Now I realize that the 16% loss may not sound so good either. Because you are in your 50s you feel as if you don’t have time on your side, so you can’t afford to have any losses in your portfolio. I agree—as you near retirement you should definitely become more cautious with your investments, favoring bonds over stocks. But that does not mean you can afford to completely shun stocks. Remember, a 65-year-old today will on average still be alive into his or her 80s. That means anyone in their 50s today must consider that some of their retirement savings will not be used for another 25 to 30 years, and possibly longer. It is a mistake to look at your retirement date as your investing stop point. You must consider how long you will need your money to support you. In your 50s you should invest with the awareness that some of that money will not be touched for another 25 years at least. And that raises a potential problem if you were to prematurely move all your money into bonds or cash. The long-term trend tells us that those investments, while earning a steady return, won’t typically earn enough to keep pace with inflation.
What’s inflation got to do with this? Well, if you do live into your 70s and 80s the price of things you need and want to buy—from groceries to medications—will be higher. If your investments haven’t grown at a pace that keeps up with inflation you will have to use more of your savings just to maintain your standard of living, and that raises the risk of running out of money too fast. The solution is to keep a portion of your money invested in stocks, which over the long term have the best potential for producing gains that beat the rate of inflation.
Have the Right Mix of Stocks and Bonds
So what’s the right mix in your 50s? Well, I will be the last person to tell you there is any single right formula. You must decide for yourself. If you have so much money saved up that you are confident that you could keep 100% of your money in CDs and bonds and still be able to pay for everything in your 80s and beyond, then that is a wonderful truth! But the reality is that for most of you, you must think about the rising cost of things 20, 30, or 40 years from now. And that makes it wise to keep some of your money in stocks. A rule of thumb that is actually very sound is to subtract your age from 100. So at age 55 you might have 45% invested in stocks. At age 65 you might have 35% invested in stocks. (Every few years you should be rebalancing your retirement portfolios so you have less in stocks and more in bonds.) This rule of thumb is a guideline you can tweak to fit your emotional truth. If you want a little more or a little less in stocks, that is for you to decide. I just ask you to avoid any extreme allocation: 100% in stocks is way too risky. And unless you know for sure that you have ample savings so you don’t have to worry about inflation, 100% in bonds and cash is too risky as well.
MAKING THE MOST OF WHAT YOU HAVE
A critical step in building your new retirement dream is to focus on how to maximize the money you have in all your retirement accounts. And if you have changed jobs through the years and have left behind old 401(k)s at former jobs, you are likely dropping the ball here. What you need to focus on is that once you leave a job, whether voluntarily or not, you no longer have to keep the money invested in your former employer’s 401(k). You have the option to move your money out of the 401(k) and into what is called a rollover IRA, where your money will continue to grow tax-deferred. I believe that is often the smartest move you can make. I discussed IRA rollovers in the previous chapter about planning for retirement, so if the concept is new to you, I would encourage you to go back and reread that section. There you will learn where to open an IRA rollover account and whether to choose a traditional IRA or a Roth IRA.
One of the reasons I recommend rolling over old 401(k)s into one account at a single brokerage, and consolidating your IRAs as well, is so you have an easier time looking at the entire retirement pie you have. It will be infinitely easier for you to make sure your overall allocation of stocks and bonds/cash makes sense if you have everything under one roof; most discount brokerages and no-load mutual funds have free online tools that will produce easy-to-grasp pie charts that can show you what you’ve got. And if you are indeed rolling over old 401(k)s you will also benefit from the wider array of investment choices you have with an IRA at a discount brokerage, including investments in individual bonds and all sorts of specialty ETFs, such as precious metal and other commodity-based sectors.
And the reality is that by the time you are in your late 40s or have segued into your 50s, you—and your spouse or partner—no doubt have a mix of different accounts. I bet there are a few traditional IRA accounts, maybe a Roth IRA or two, a handful of “old” 401(k)s from past jobs, along with the retirement plan from your current employer.
Note: If you have old 401(k)s that include company stock, I recommend you work with a fee-only financial advisor before you roll over any of your 401(k)s into an IRA. There is a special way to handle your company stock that is in a retirement account—referred to as net unrealized appreciation (NUA)—that can help you boost your after-tax return on that stock. At my website I have more information about the NUA rules for handling company stock in an old 401(k).
A trusted financial advisor can also help you sort through whether it makes sense for you to convert some of your retirement savings into a Roth IRA rollover. Beginning in 2010, anyone, regardless of income, can do a Roth conversion on all or part of their IRA accounts, including money being rolled over from old 401(k) accounts. You will owe income tax at the time you convert the money, and the tax bill is based on a convoluted formula that includes more than simply the amount of money that is being converted.
That’s why you want to work with a financial advisor or tax advisor who has experience with all of this. An added complication is that the amount you convert in any given year is added to your taxable income for that year, and that could bump you into a higher tax bracket. So one consideration is spreading out your conversion over a few years to make sure that no single-year conversion pushes you into a higher tax bracket. Again, that’s why you want to have a pro run the numbers and walk through your options with you.
The advantage of doing the conversion today is that once your money is in a Roth you will be able to use it in retirement without owing any tax whatsoever. Moreover, you will not have to take a required minimum dist
ribution from a Roth account (explained in greater depth in the next chapter); so if you don’t need to tap that money for living expenses it can stay growing for your heirs.
After you consolidate your accounts (other than your current 401(k)s) under one roof, you can more easily consider a few strategic moves:
Focus on the Entire Pie
Your goal is to make sure that the sum of all your retirement assets is invested in a way that matches your long-term allocation strategy. So, for example, if your goal is to have 60% in stocks and 40% in bonds/cash, then your focus should be for all the various accounts in the aggregate to give you that 60/40 split. But that does not mean every single account must have the same split between stocks and bonds. You don’t need your Roth IRA to be 60/40 and your 401(k) that you have at your current job to be 60/40. All that matters is that the total sum of all your money divided between stocks and bonds/cash lands at 60/40 (or whatever you have decided is the right truthful mix for you).
And one smart move to consider is how you are investing the money in your current employer 401(k). Of course you are limited to the investment choices offered in the plan, but because you are taking a holistic approach to your overall retirement pie, a smart move can be to pile your 401(k) savings into the least expensive option. I explain this in the next step.