GUEST BLOG POST BY JOSEPH REINKE, CFA, CEO of FitBUX
Today I have a guest blog post for you guys from a finance professional and not someone that just plays one on the internet, like myself. Joe is a very intelligent guy who spoke way over my head in the conversation that we had so I was very excited when he offered to write a post for the blog. Anyone that has student loans should check out his site FitBUX because he has created a wonderful FREE resource for determining the best payment plan to choose for your situation. In this post he offers a conservative and foolproof approach to determining net worth needs for retirement. I hope you guys enjoy.
Recently, Jared Casazza published the article “Retiring Early on a Physical Therapist’s Salary” on his blog. The article was a guest blog by Chris from Eat The Financial Elephant. Chris discusses retiring early as a physical therapist and references his article “Our Ultra-Safe Early Retirement Plan”. In the last section of the referenced article, Chris mentions a few of his fears in regards to his plan.
This article discusses the problem with using “traditional” ways to determine how much money you need to retire, how to reduce how much you need, and how to limit the risks you face. Most importantly, this article highlights a phrase I often say, “Every financial product has their purpose. If used correctly, you can maximize the benefit.”
“Traditional” ways to calculate how much you need for retirement have three large problems (note: there are many mathematical problems with the traditional approach but I will spare you the boring details and state the high level problems):
- They make a lot of assumptions. When it comes to money, the more assumptions you make the more risk your plan has.
- The calculations dramatically underestimate how much you actually need to retire.
- A “safe withdrawal rate” is often stated by financial professionals when planning retirement. However, most of this research drastically underestimates how much money you will actually withdrawal in retirement thus underestimating how much you need. The main flaw in this research is again, a lot of assumptions.
Financial professionals continue to use the “traditional” way because the actual number would demoralize many individuals. Non-financial professionals continue to use this approach because the materials they read reference it….but where did this type of analysis come from? Many pensions used to use the same models so that is where we will look for answers.
A Conservative Approach
For years pension funds used similar calculations to predict future liabilities, withdrawal rates, and asset allocations. Overtime, pension funds became seriously underfunded and ultimately have gone bankrupt. The solution they have begun implementing is a portfolio management approach called Asset Liability Matching (ALM). Pensions, banks, and insurance companies use this approach in managing their portfolio of assets.
The most basic form of this approach for personal finance looks at a liability in the future and then invests in a risk-free asset that will grow in value to match the liability in the future. In the case of retirement, the liability his our annual expenses we will have to pay for while we are in retirement.
For example, say you have a $40,000 expense in a year from now and you can earn 1% on a risk-free investment today. You would invest $39,604 today and it would be worth $40,000 next year when you need it to meet your expense.
This approach removes stock market risk because there is no market risk. It also removes the risk around a “safe withdrawal rate” because you have an asset to directly match the liability (the liability in this case is your annual expenses.) Although there is risk in this modeling approach, such as predicting expenses and reinvestment risk, it removes many assumptions. In short, it is the most conservative way of predicting how much you need in retirement. So why doesn’t everyone use it…the results…
Using Chris’ scenario, assume he has retired at age 40 and estimates his expenses each year are going to be $40,000 with inflation at 2%. At todays risk-free rates, if he were to use the ALM approach and he wants enough money to last him until he is 100 years old, he would need $2.2 million to retire (for those that are wondering, if he wanted enough money to last till 87 years old he would need $1.7 million). Having this amount and using the ALM approach would greatly reduce Chris’ risk of running out of money. However, there are ways to reduce the amount needed to retire.
For example, most financial professionals agree that you should have between 10% and 30% (depending on your age) of your investable assets in an annuity. This greatly reduces what is referred to as longevity risk, i.e. you will outlive your retirement income. Let’s make the assumption that Chris puts $200,000 into a variable annuity. This annuity has a guaranteed withdrawal benefit of 5% per year with a rider that increases the withdrawal base by 10% per year regardless of stock market performance.
At age 60, Chris begins to withdrawal the income each year from the annuity to meet a percentage of his required expenses. Based on these assumptions, Chris would need an additional total of $874,000 invested using the ALM approach to meet his retirement needs until he reaches 100 years old. Therefore, the total amount he would need today to retire is $1.074 million.
One of Chris’ fears was related to health expenses. Most people will spend more on long-term care than actual medical expenses in retirement. Therefore, Chris could hedge this risk with a long-term care insurance policy and since he is relatively young he could do so cheaply. For our example, we’ll assume he spends an extra $5,000 per year for he and his wife to be covered, thus, upping his annual expenses to $45,000.
Adding long-term care insurance would increase the total amount Chris needs to retire today to $1.32 million.
For his investment portfolio, instead of using all risk-free assets such as treasuries, he could put some of the longer term investments into other secured products such as structured CDs. These investments are FDIC insured, have a minimum annual return (most of the time between 0% – 2%) and the actual returns are based on the performance of the stock market.
I would again like to thank Joseph for taking the time to write this post for the blog. Leave any questions or comments for him below and check out his site, FitBUX as he is helping a lot of people with their student debt burden.