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Retirement: The Accumulation Phase

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Retirement is one of investors’ biggest concerns. Yet surprisingly few investors have a comprehensive road map to get them where they want to go. The right strategy and asset allocation plan can certainly help. But the best possible strategy is only talk without the discipline to make it happen. Investors must actually make the deposits their plans require and stay the course during inevitable market downturns.

Retirement plans have two equally-important components: 1) building an adequate nest egg, and 2) making it last forever. In this article, we’ll focus first on the former.

Too Much is Never Enough

A secure retirement takes lots of capital. With younger retirement and longer life expectancy, the average retiree will spend more years retired than he spent working. Most couples should plan for the survivor to reach at least the age of 95. You might say that retirement is really one third of your life without a paycheck!

How big does that nest egg need to be? Most people find that they need at least 70% to 100% of their pre-retirement income to live comfortably. Few of today’s retirees expect to stay home and watch TV all day. They are younger, healthier, and anticipate a longer life than any generation before. Most expect that, after parachuting out of the working world, they’ll hit the ground running with the newfound freedom to travel, pursue hobbies, and participate in community activities. Many financial planners working with active retirees find that their clients actually spend more money during their 60s and 70s than they did during their working years. The pace of spending slows down a bit once they reach their 80s, but increasing health expenses soon raise their total income needs again.

To figure out how much capital is needed at retirement, I use a rule of thumb that investors should plan on withdrawal rates of not more than 5% to 6% of their accumulated capital each year. This range allows for sustainable income as well as growth of income to hedge inflation, and growth of capital. For each dollar of income needed above Social Security and pension income, count on needing a nest egg of at least $16 to $20. For instance, if you will need $10,000 a year of income from your investments, you should start out with $160,000 to $200,000.

Success in the accumulation phase is directly related to three variables: starting early, investing enough, and attaining reasonable rates of return. The math is pretty elementary. The relationship between time, amount invested, rate of return, and ultimate results are pretty well known. The dreary reality is that success requires discipline, and that retirement planning must be given a high priority early in one’s career. After all, hope is not an action plan!

The magic of compounding rewards those who start early. Delay may make it impossible to ever attain a reasonable goal.

Million Dollar Countdown

How much would you need to invest per year to get to $1,000,000?

30 years 20 years 15 years 10 years 5 years
at 10% annual return $5,526 $15,872 $28,612 $57,041 $148,906
at 8% annual return $8,173 $20,233 $34,101 $63,916 $157,830

Failure to obtain a market rate of return also raises the stakes dramatically. Reaching the same goal requires dramatically more savings if your portfolio returns just 8% rather than 10%.

The longer your time horizon until retirement, the more aggressive you can afford to be with your money (excluding, of course, what you set aside as an emergency fund and any other short-term needs). If you aren’t spending the money in the next few years, you shouldn’t be too concerned about short-term fluctuations.

Early, Often, and With a Dose of Risk

Paradoxically, not taking enough investment risk may guarantee failure. Risk actually decreases over time. Strange as it may seem, over longer periods the risky asset is the high-probability shot. The S&P 500’s long-term—we’re talking about 40 years, here—average historical return is 12.97%, and it has demonstrated an annual standard deviation of 16.28%. This makes us 90% confident that we will net 8.13% or better over the long run by investing in it. By comparison, the one-year Treasury bond has a 7.98% return with a standard deviation of 3.36%. We are 90% confident that we will receive a return of no more than 8.72%. So, the worst case estimate for stocks is almost better than the best case estimate for bonds.

Bonds and other savings alternatives do not offer enough real total return to meet reasonable economic needs later. A 100% equity portfolio loaded up with high-risk asset classes like small-cap, foreign small-cap, emerging-market, and growth funds has the highest chance of a successful outcome over long time periods. As a starting point, consider the all-equity portfolio from our previous article. Tweak as required to bring it in line with your personal investment philosophy.

The moral is pretty clear: Invest early, invest lots, and invest in a diversified portfolio of equities to get reasonable long-term performance.

Experience has shown that an investor saving between 20% to 25% of income over a working career can achieve economic security. Maxing out contributions on IRAs, 401(k)s, profit sharing, or pension plans should go a long way toward meeting the goal. Current tax deductions and tax-deferred compounding make the whole process both more efficient and somewhat less painful.

If the concept of spending somewhat less than your total income plus credit-card limits is foreign to you, you may wish to consider the alternatives. Failure to attain your retirement goal will result in delayed retirement or drastic cuts in your lifestyle. Those second-career elderly that McDonald’s is so proud of probably aren’t flipping hamburgers because they burned out on golf and sailing!

The sad truth is that Americans are saving less than at any time since the Great Depression. Figures released in September by the Department of Commerce show that (excluding pension, IRAs, and 401(k)s, etc.) the savings rate of U.S. consumers fell to 0.6% in the second quarter of 1998, down from 1.2% in the first quarter. Not a good sign during the longest economic expansion in memory. Baby boomers might want to rethink their consumption habits.

No Hard Answers From Your Software

A word of caution if you’re using retirement planning software, such as that provided by some leading mutual fund companies: These calculators don’t distinguish between average return rates and the range of possible outcomes. For example, if you plug an average 10% rate of return into one of these tools, the software doesn’t point out that the range of possible returns for that portfolio may fall between 6% and 14% three quarters of the time over a long period. You now have a 50% chance of falling short of your goal, because in context, “average” means that 50% of the time you will do better, and 50% of the time you will do worse than projected.

A more conservative rate-of-return assumption may make better sense. By saving somewhat more based on the lower range of possible outcomes, you can improve your chances of meeting your objective from 50% to 90%. Now you have minimized any chance that you won’t reach your objective, and even set yourself up for a possible positive surprise.

Many other assumptions your software is making may be overly optimistic. If expected returns are based on past index performance, they don’t account for expenses and they assume that every penny is invested every second. That’s worth maybe 1% to 2% per year. If your software calculates arithmetic averages rather than compound returns, that’s worth another 1.5%. Finally, these programs usually assume that the next 30 years will look just like the past thirty years. Who knows how much to discount that? Perhaps 2% is appropriate. So, you might want to give the final “expected” return a 4% to 5% haircut. We are still making a guess, but now it’s one that is educated and conservative.

Keep It Real

Investors need to recognize that all models are very crude approximations of reality, so it pays to err comfortably on the side of conservatism. Few investors lament having too much money when retirement rolls around. On the other hand, for those who are a little too optimistic in their planning, there’s always McDonald’s.