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Chapter 20: Education and Retirement: Ouch!

By: Investor Solutions

Education: A Closer Look

The vast majority of investors I work with have two primary concerns: retirement or college education for their children. They have every right to be concerned. Both will require startling amounts of resources. And neither is likely to receive increased government assistance in the foreseeable future. Individuals are on notice that they are going to be on their own to provide for both.

As an in-state student in 1962, my first semester’s tuition at the University of Virginia was $214. Out-of-state students paid about twice that. I was never able to conspire to spend more than $2,200 for an entire year’s expenses including books, car, insurance, gas, rent, food, clothes, and pocket money. Most of that could be earned at a good summer job.

Those days are gone forever. Education expenses have, for over a generation, inflated more than twice the rate of the economy as a whole. Working your way through school isn’t possible for most college kids. The available jobs just don’t pay anything close to enough. Only a few fortunate families can afford to fund college expenses from their current income. Many boomers and yuppies failed to provide an education fund for their children. So today, many graduates start life with debts in the $60,000 to $100,000 range.

While education may be expensive, ignorance is unthinkable; education isn’t optional. In the twenty-first century, the fault line between rich and poor will be determined by schooling. And all degrees are not created equal. Anyone who thinks a local community college degree is worth the same as Harvard’s is deluding themselves.

Software is available from many mutual-fund companies to assist parents to estimate the future cost of college. The packages I have seen have a database of current college costs listed by the type of institution, and information on past inflation factors. Plugging in the child’s current age will then generate a total estimated future expense. Once we know that, and current investments allocated to meet the college expense, it’s a small step to back off and determine the amount that must be invested each year to meet the education goal. For instance, the excellent Scudder Tuition Builder (TM) has cost data on just about every school in the country for tuition, room, and board. You can plug in your own assumptions for just about everything. Call 800-225-2470 ext. 7223.

These packages are great tools to estimate the range of possibilities. However, they are all very sensitive to assumptions on future inflation and investment rates of return. So, use a little discretion when plugging in those factors. Otherwise, the numbers can get a little strange.

Time Horizons and Taxes

The college funding problem is compounded by two factors: time horizon and taxes. Time horizon may be a very important factor in setting our investment policy for education. Assuming we begin to fund the day of birth, we only have 17 or 18 years until we need our first big checks. And then we need big checks very regularly for an additional four years at least. That’s the best case scenario. We have already discussed in Chapter 10, Fun with Numbers, the overwhelming advantage that starting early has when investing for any financial goal. Education is no exception.

Often young families feel they cannot afford to begin college funding at birth. Delay, of course, compounds the problem.

Given what we know about variability of market returns, as the time horizon shortens up, it’s not comfortable to maintain a fully invested equity portfolio. We are going to have to come up with big bucks on a very tight schedule. Sometime about five years out from our goal we will need to look hard at reducing the risk in the portfolio. After all, we don’t want little Suzy to miss Harvard because the market went into a funk when she was 16. So, any family with limited resources may wish to begin moving assets from equity to short-term bonds or CDs. (Of course, if you are really well off, you may not be so concerned with short-term market conditions. Rich people always have more options.)

For most parents, even those that are very comfortable with market risk, at best there may be only a thirteen-year window to invest in an all-equity portfolio.

Taxes add another wrinkle to the investment-policy decision. Many parents’ careers are just hitting their stride as the college years approach, so they often find themselves in a high tax bracket. It’s annoying to have to pay taxes on the investment earnings of your child’s college fund. This sets up a situation where many “bright” financial planners propose cures worse than the disease.

UGMA, Potentially Ugly!

The first knee-jerk proposal often advocated is that mom and dad transfer the college funds to a Uniform Gift To Minors Account (UGMA) for the child. Hardly a week goes by without seeing this written up as a miracle tax cure by some member of the popular press. The advantage of a UGMA account is that earnings on the investment account may be taxed at the child’s lower tax rate. However, most of the income will be added back into the parents tax bracket until the child turns 14. (In 1995, if the child is under 14, unearned income over $1,300 is taxed at the parents’ highest tax rate. The child may use the standard deduction of $650.)

Any gift to the child of over $10,000 in property in any year ($20,000 if both parents agree to split gifts) must be declared and a gift-tax return filed. Gifts over this limit may consume some of the parents’ uniform credit for gift and estate tax. You may not like this result.

The real problem with this solution, and the part seldom understood by parents is that when a UGMA is set up, an irrevocable gift is made to the minor child. The parent becomes the custodian of the child’s funds. The parents cannot take the money back, for family emergencies without incurring ordinary taxable income on the entire amount reclaimed! To say the least, a UGMA lacks the flexibility that might prove useful in an uncertain world.

Worse yet, the child must obtain control over the entire amount without restrictions of any kind on the day he/she reaches majority. (This age varies from state to state.) To put it as nicely as I can, some children may not be ready for that type of responsibility at that early age. Wisdom doesn’t always arrive exactly at the age of majority. Not every child is college material, or will decide to use the funds for the intended purpose. Young people can occasionally be a little unpredictable. More than one college fund has turned into a sports car or drug supply while the parents watched helplessly! This unintended result wiped out years of effort and sacrifice by parents. This seems like a perfect case of the tax tail wagging the dog.

Compliance with this section of the tax code is not perfect. For a long time, banks and brokerages routinely allowed parents to cash out UGMA accounts. Now, most are reluctant to participate in a tax fraud by turning over UGMA assets to parents. They will usually insist that checks are drawn in favor of the child. This has created more than one sticky situation where opinions between generations differed.

Finally, the presence of a UGMA account asset may actually prevent the child from obtaining financial assistance or loans where he/she may otherwise qualify. While a UGMA might work for your family, consider it carefully before taking the plunge. A little tax saving may not be worth it.

Annuities for College Funding? Not!

Another inappropriate solution to the tax problem is the use of an annuity. Under today’s law, withdrawals suffer ordinary income tax, and a 10 percent penalty if the owner is under age 59 and a half. Most parents will be younger than this during the child’s college years. I find it hard to imagine that the tax-deferral value of an annuity could overcome the additional cost of the annuity shell, ordinary income tax treatment, and a 10 percent penalty in any reasonable time frame associated with college funding. In my humble opinion (readers may by now have guessed that I have very few humble opinions), only ignorance or greed could account for the prevalence of annuity recommendations as a college-funding vehicle.

As this is written, the Congress is considering several amendments to the tax code. Some of these include expanded IRA-type investment vehicles that would allow withdrawal without penalty for college expenses. Until and unless this type of legislation is passed, perfect solutions may not be available.

In the Meantime

Most families find college expense to be a high and moving target. The best you may be able to do is start early, and invest for high rates of return especially during the early years. As college approaches, you may wish to consider reducing the risk in the portfolio.

Consider this tactic to control taxes: invest in index growth funds to avoid high dividends and capital-gains problems caused by portfolio turnover. When the children enter college, make gifts to them of the shares of the funds. The children can redeem the shares and pay the capital-gains tax at their lower rate. They will assume your basis for computing the capital gain, but whatever dividends and capital gains you have collected along the way will reduce their cost basis.

I’ll be the first to admit that this isn’t an ideal solution. But, it does control taxes to a tolerable level, and keeps the funds under your control. The funds are available for emergencies. And, if your child decides not to utilize the funds for their intended purpose, you can just use the accumulation to enhance your retirement. (I have very few clients who feel that they have too much money at retirement time.)

 

Retirement Planning: Endgame Strategy

Few subjects provoke as much emotional stress as the later stages of retirement planning. Our jobs and money both become part of our self-image. Suddenly both seem at risk.

Up until retirement, new checks usually arrive with great regularity. Most will be consumed, a little saved for that far-off day. There is always time to make up for an occasional bad investment decision.

One day the nature of the entire game changes irrevocably. Retirees know that they won’t have any chance to make up for poor investment decisions. Whatever they have accumulated is going to have to last forever! In one sense, time has run out. In another sense, time seems to stretch out without limit. The natural inclination is to stop taking any risk at all.

But, there is a strange paradox at work. The avenue that offers the highest probability of achieving long-term financial goals is not the one with the lowest risk! Cavalier self-confidence can quickly deteriorate into morbid concern as potential retirees ponder, “When can I retire, how much is enough, how do I make it last?”

The Spendthrifts

The conflicts and stress inherent in the retirement problem can lead to several dysfunctional responses. One group goes into severe denial. They refuse to admit to themselves that anything has changed, or that there is any requirement for them to change anything. Many members of this group have built-in lifestyles that their resources can no longer support. Rather than face up squarely to the new reality, they continue spending until their assets are all, or substantially all, gone.

Individuals that have not accumulated sufficient assets prior to retirement or individuals that have had their careers involuntarily shortened by health problems, corporate downsizing, or other misfortune, occasionally fall prey to this syndrome. The results can be tragic.

Another group who finds their assets insufficient to meet their perceived needs will take on excessive risk in an attempt to maintain their lifestyles. This group can fall victim to fraud as they chase results just a little too good to be true. At best they leave themselves too little room for market disappointment, and their financial existence is always in mortal peril. A small downturn can wipe them out.

Some of this group will shop financial advisors until they find one that promises them a rate of return that meets their needs. I had one tell me that he had it all figured out. He could get by if he could just make 14 percent. The strong implication was that the first advisor to assure him of this result would get his business. The whole approach screams: “Lie to me, baby!” I don’t know what became of him after he left my office. I do know that the word budget wasn’t in his vocabulary, and wasn’t a concept he would consider.

The Hoarders

At the other end of the spectrum are retirees who refuse to spend anything. They are so concerned about a rainy day that they would live like paupers rather than withdraw reasonable amounts from their nest eggs.

A few years ago, all retirement plans were paid out as one form of annuity or another. Retirees knew that each month they were going to get another check as long as they lived. So they cheerfully spent each check and enjoyed it. They had no responsibility for the investment results, and little concern for the management of the funds.

An unfortunate side effect of the lump-sum payout and IRA-rollover concept is that it shoves responsibility for investment management upon the retiree. Many retirees have no concept of what to expect from the markets or how much might be reasonable for them to withdraw without imperiling their long-term plan. So, some retirees respond by refusing to spend any of their gains. What should be a reasonably carefree golden age turns into a constant worry. At least psychologically, these people would have been far better off had they opted for a variable annuity payout.

Building Your Own Variable Annuity

Retirees can rather easily construct a “mock” variable annuity for themselves. We have already examined one possible program using a 70/30 mix of equities and short-term bonds and a 6-percent annual withdrawal of available capital. In practice this will very closely resemble a commercial variable annuity used to fund retiree benefits.

There is nothing magic about the 70/30 mix. I just said to myself that I know that for the next five years I want to withdraw 6 percent a year or a total of 30 percent. Five years is a very short-term time horizon. I know that the market can get a little flaky in the short term. I don’t want to have to sell any of my equities at a time when they might be depressed to finance a known income need.

If I could set aside enough to finance at least five years of income need, then I wouldn’t be as concerned about short-term market fluctuations with the balance of my funds. I have time for the market to get back on track. On the other hand, if I don’t have enough set aside, and I have a large income need, then I run the risk that I may invade my principal to the point where it will never recover.

An investor with a larger income need, or who has a smaller risk tolerance, may want to set aside more — perhaps the 60/40 percent portfolio we developed earlier, or even more in short-term bonds. However, if the investor sets aside too much, she runs a risk that her portfolio will not keep up with inflation. Most retirees will need growth of income and capital and will need to balance the risks.

I assumed that the investor would re-balance the portfolio so that in good years he would replenish his hoard of short-term bonds, and in bad years he would draw it down. This idea isn’t entirely new. A similar technique was used by Pharaoh about 3,000 years ago with some notable success.

One great thing about this strategy is that while income and capital will vary from year to year, the investor runs no risk of zeroing out the account. The draw down decreases as the capital decreases during bad years, so in effect it self-corrects.

How the Rich Do It

This is not the only possible exit strategy. If you are fortunate enough to be very well off, you might consider withdrawing only your stock dividends. Dividends tend to be very resistant to decreases in bad times. Most companies are very reluctant to declare a dividend unless they can continue it through thick and thin. Cutting a dividend sends a very negative and embarrassing message to the world at large. Companies hate to do it.

So, a diversified portfolio of dividend-paying equity stocks has a remarkably stable income potential. This income is far more stable than income from either CDs or bonds and usually shows good increases over time. Of course, dividends are usually less than bond yields, at least to start. And, capital value will fluctuate more than either CDs or bonds.

America’s old line blue bloods have done very well by living off dividends, and letting the capital ride. Dividend stocks usually have a high book-to-market ratio (value), and as a class perform quite nicely compared to growth stocks. That is to say that dividend stocks have high total return for the level of volatility you must endure. Because you are going to spend the income anyway, income taxes should not be a particular concern. You can let the capital gains run free if you don’t sell your portfolio and you will never have to pay a capital-gains tax. Your heirs will receive a step up in basis at your death, so they won’t have to pay a capital-gains tax either.

The Nightmare

It is not appropriate to withdraw a high fixed amount from a variable portfolio. Doing so will prevent the self-correcting mechanism from compensating for down markets. This can lead to a self-liquidating portfolio. Let’s look at how both strategies might perform during a very bad market.

My personal nightmare, the thing that keeps me up nights worrying, is the experience of 1973-1974. During this time, most growth and balanced mutual funds declined around 50 percent. This is an extraordinarily rare market event, hopefully a once in a lifetime event. No one enjoyed it, but some strategies performed much better than others.

Investors who were withdrawing a percentage of available capital saw a drop in income and capital of over 50 percent. You can be sure that this caused some hardship and anguish. However, in the following bull market both recovered. The decreased withdrawals allowed the capital to bounce back. The self-correcting mechanism worked. Today those investors would be rich.

An investor withdrawing a level 8 percent of her starting capital would have seen her capital cut in half by the market, and seen a further hit of 16 percent caused by her two annual withdrawals. Her dollar at the end of 1972 is now 34 cents. There is no possible way that 34 cents can support an 8 cent withdrawal in the following years. Every growth or balanced mutual fund in the then available universe would have self-liquidated.

At its most fundamental level, the biggest threat to the retiree’s nest egg is not capital fluctuation in the stock market, but unrealistic assumptions and withdrawals too high to be supported. The worst long-term mistake is to invest too conservatively and withdraw too aggressively.

Toward a Comfortable Withdrawal Plan

So, how much is safe in the long run? If we are going to err, let’s do it on the conservative side. For the 60/40 equity/short-term bond portfolio we devised earlier, I feel pretty comfortable with a 10 percent total return assumption over the long haul. With a 6 percent withdrawal program, we have an average of 4 percent to reinvest to hedge inflation and grow capital. If we do better, and we certainly hope we will, we will just have to deal with the problem of having too much income in our old age.

If we use a 6 percent withdrawal program, as a rule of thumb, for every $6,000 of necessary annual income, you must have $100,000 of capital to support you. Of course, you must adjust your income needs for other fixed income sources like pensions and social security.

Vanguard has an excellent and very inexpensive retirement planning program that will help you estimate your future needs. I was amazed at how much power I could buy in a computer program for just $17. I highly recommend it.

The Health-Care Menace

ONE ADDITIONAL RISK the middle class should take very seriously is the threat of long-term health-care expenses. The very rich can afford to self-insure, and the poor will have Medicaid, but those in-between can have their entire life’s work wiped out by nursing-home expenses. The odds are uncomfortably high that one member of a couple will need long-term care, and few Americans can easily support an unexpected $30,000 to $40,000 a year expense for very long. Long-term, health-care insurance may be a very viable solution to the problem. At very least it merits a close look.

There are also non-financial concerns that may be just as important as investment decisions. Maintaining a positive self-image distinct from the career is crucial. Finding meaning and value may take on an entire new dimension as retirees wonder, “What am I going to do now?” Endless golf may not turn out to be all it was cracked up to be. Retirees need to develop positive outside interests, nurture their support groups, and take care of their health. These problems are vital, but beyond the scope of this book.

 

Coming Up

How can investors conspire to so consistently lose a game that is strongly rigged in their favor? On average, individual investors get such miserable returns that it threatens our belief in the efficient market theory. If markets are efficient, how do we do so poorly? It really shouldn’t be possible. What else is at work here? Next chapter we will look deep in the heart of average investors to see why they fail so often to meet their goals. It turns out that few of us are as rational as we like to think. For investors, self-defeating behavior may be the biggest risk of all.