Tag Archives: Retirement

The Best Time to Start Investing For Retirement Is Now

While it may be a long ways away for the students in the monetary and financial policy class, financial wisdom states that now is the time for us to start saving for retirement. As many of us approach graduation and graduate school or our first full-time jobs, we’ll be soon required to answer questions like: “Roth or traditional?” or “mutual funds or ETFs” when setting up our mandatory retirement accounts. Common sense financial knowledge suggests that one should redistribute one’s investment account from stocks to bonds as one ages. This is often formalized in the investing heuristic where one should subtract their age from 100 to determine the proper allocation of stock in their portfolio. However, many financial researchers have had a change of heart and have begun to take a much greater liking to investing in stocks leading up to and during retirement.

Kelly Greene from the Wall Street Journal explains in her article, titled “How Much Stock Should You Own in Retirement?,” that investment researchers have concluded that individuals should invest in stocks in a “U-shaped” pattern in which they invest more heavily in stocks until they near retirement, upon which they dial back their stock holdings to between 20% and 50% of their portfolio at the start of retirement, and then begin to increase their stock holdings by around one percentage point per year throughout retirement. After examining 10,000 simulations with assumed average annual returns of 6.5% for stocks and 2.4% for bonds, the authors explain that those that instead keep 60% of their portfolio in stocks throughout retirement are likely to run out of money after 28 years in the worst case scenario. According to Professor Wade Pfau, a retirement-income professor at American College who was one of the researchers involved,

“You want to have the lowest stock allocation when your portfolio is largest, and that’s going to be right before and after retirement. That’s when you’re most vulnerable to losing wealth. Once you transition into retirement, you no longer have as much ability to change your plans and make it back up.”

This makes sense given the fact that many baby boomers are expected to live into their 80s, meaning that if they retire at the traditional age of 65 they may require a retirement account that could last them upwards of 15-20 years. In this case, retirees can reduce their risk at the beginning of retirement when they are most risk averse, and slowly dial up their risk as they age, thus increasing the odds that they’ll have enough money throughout their life.

It seems that stocks should remain a critical part of ones portfolio even after retirement, so what portion of one’s portfolio should one keep in stocks when one is far from retirement? In his article “Why My Retirement Savings Accounts are Currently 100% in the Stock Market,” Professor Kimball explained that 100% of his paper assets are currently diversified stock market index funds. If we look at this decision using knowledge gained from Burton Malkiel’s “A Random Walk Down Wall Street,” this appears to be a strategy that returns relatively high rewards for low risk. Why? First, there is the decrease in risk that comes with investing in a diverse index fund. By splitting up the investment among dozens of different companies, one can reduce the probability of losing a substantial amount of money in the presence of a random occurrence such as a hurricane or a not-so-random occurrence such as bankruptcy. According to Malkiel, a portfolio of around 60 well-diversified securities (meaning their returns are largely independent) will eliminate nearly all of the unsystematic risk (risk that your portfolio will be in jeopardy after a calamity hits one stock). The systematic risk, or risk that may occur as a result of stock market shocks, can be further diversified away by investing in many different markets, such as by investing in U.S. and European stocks. Kimball’s investment in the Fidelity Spartan International Fund allows him to reduce the risk that a collapse in one stock market or one economy will negatively impact his annual returns. Beyond risk, it’s also important to consider the rate of return of the fund when choosing where to place one’s savings. In his book, Malkiel cites the research of Jeremy Segal, the author of the investment book “Stocks for the Long Run.” Segal calculated the returns of a variety of assets from 1800 to 2010. He concluded that if one invested $1 in the stock market in 1800, after compound interest that $1 would have grown to over $10,800,000 in 2010. If one had invested that same dollar in bonds, which was the next largest gainer, it would have only grown to $27,604. This demonstrates that out of all basic investment instruments at the disposal of the average investor stocks bring the highest returns. So by investing in a well-diversified international stock fund, such as the Fidelity Spartan International Fund, an investor may expect much higher returns with a relatively low level of risk.

QE May Be America’s Friend, but It’s Not Mine

After the Great Recession, the Fed began the use of Quantitative Easing (QE) in an attempt to put the economy back on track.  With short-term interest rates already near zero, the Fed began purchasing unconventional, longer-term assets in order to bring down long-term interest rates.  And much of the world followed suit.  Since the Great Recession, the Federal Reserve, ECB, Bank of England, and Bank of Japan have injected more than $4 trillion of additional liquidity into the world economy.  Looking at the results of this “easy money” policy, QE seems to have been beneficial.  Indeed, more QE, coupled with the elimination of the Zero-Lower-Bound, would likely have made America’s long economic recovery much faster and much less painful.

According to a study by McKinsey, low interest rates brought about by QE have saved the federal governments of the USA and European countries over $1.6 trillion since 2007.  This savings on debt-interest payments has allowed governments to achieve higher levels of spending and reduced levels of economic austerity (at least in some places).  The private sector has also benefited, with non-financial corporations saving over $700 billion in interest payments in the last five years.  This savings has helped boost profits for US corporations over 5% in a time when the economy was struggling, helping to contribute to a reduced unemployment rate (even though this recovery has been very slow and painful).

Nevertheless, as is commonplace in economics, what benefits the greater economy does not usually benefit individuals.  Take a recession, for example.  During an economic downturn, individuals benefit from increased savings.  Increased savings allows individuals to tolerate a slump better, ensuring adequate income at a time of economic uncertainty.  Increased savings, however, is bad for the economy.  The aggregate economy requires increased levels of spending to boost aggregate demand and help pull the economy out of its slump.  In this way, we can see that the micro-level and macro-level goals do not necessarily align in economics.

Unfortunately, this goal divergence applies to QE as well.  I have already pointed out that QE greatly benefited the aggregate economy by lowering interest rates and making it easier for governments and corporations to spend.  For individuals, however, these low interest rates have had a devastating effect.  Most notably, low interest rates have wreaked havoc on the cash flows of retired, fixed-income investors.  Indeed, household in the USA and EU have lost over $600 billion in net interest income since the introduction of QE.  For those in retirement relying on cash payments from interest-bearing assets, this typically means a reduction in income and a reduced quality of retirement.

In this way, it seems that QE has benefited the aggregate economy at the expense of individuals.  It is true that those relying on increased wages have benefited from QE as unemployment falls.  But more senior individuals, who rely on fixed-income assets as their main source of cash, have greatly suffered from lower interest rates.  I do not mean to say that QE is a bad policy.  Indeed, I believe QE, like negative interest rates, is a necessary policy to help control our bleeding economy’s pain.  But the effect of QE on individuals points out that in economics, there is rarely a win-win situation.  Whether it is QE, taxation, subsidies, trade barriers, or any other type of economic policy, there is almost always a loser.

Get Ready to Your 90s?

According to the interviews from WSJ, “People grossly underestimate their longevity,” says Steve Sperka, vice president of long-term care at Northwestern Mutual Life Insurance. At least one member of a couple retiring at age 65 today can expect to reach 94. His research shows a mere 35% are financially prepared to live into their 90s. (Are You Ready for a Long Retirement?)

Although life expectancy in the United States ranks 26th out of the 36 member countries of the Organization for Economic Cooperation and Development (OECD), according to a new report from the organization. U.S. expectancy in 2011 was 78.7 years, which is slightly below the OECD average of 80.1. For U.S. men, the average life expectancy is 76, while it’s 81 for U.S. women. (At five years, this gap in life expectancy between men and women is smaller than the OECD average of six years). (U.S. Life Expectancy Ranks 26th In The World, OECD Report Shows)

From the statistics above, we can easily draw a conclusion that Americans are more likely to get to their 90s in the near future. However it seems that they haven’t prepared well to live to their 90s as a long retirement because they don’t have enough money to survive to their 90s – according to the insurance company records.

Experts suggest people remember that their retirement spending isn’t something they can put on autopilot, starting with an initial withdrawal rate and blithely increasing it by inflation without regard to how your nest egg is faring. To avoid running out of money too soon — or ending up with a big stash late in retirement, along with regrets they hadn’t spent more freely early on — they’ve got to remain flexible, cutting back when returns are lean and perhaps spending more if their portfolio’s done especially well.

But why do Americans live so short? And why the life expectancy is increasing?

In the WSJ, for instance, a chief wellness officer in Ohio opined that if Americans exercised more and ate and smoked less, the United States would surely start moving up in the global health rankings. But many epidemiologists — scientists who study health outcomes — have their doubts. They point out that the United States ranked as one of the world’s healthiest nations in the 1950s, a time when Americans smoked heavily, ate a diet that would horrify any 21st-century nutritionist, and hardly ever exercised.

Luckily, life expectancy has been increasing for several reasons especially that improvements in heart disease and stroke mortality have had a big impact. That’s a large proportion of total deaths and that’s where the action really is in terms of improved life expectancy. A recent analysis by the Institute of Medicine suggests that increases in life span in the United States are not matched by increases in “health span” — time spent living in good health. A long life with a high burden of chronic disease — such as diabetes, heart disease and chronic obstructive pulmonary disease (COPD) — means more time living with illness and disability.

Also, life expectancy is greatly influenced by advances in medicine and the public health system, while the health span is most affected by lifestyle practices, in particular the quality of diet, physical activity and avoiding tobacco.

But do prepare enough to live to your 90s before retirement. People are living longer and longer.

 

(Revision) Social Security- Situation as bad as it seems?

In my last post, I wrote about the retirement situation in America and its recent implications on Social Security. In the post, I commented on an article that summarized the perception that most retirees will be “poor” upon retirement is an exaggeration. This assumption was drawn on the fact that retirement income ignores at least 60% of the money that retirees receive- as shown from the Current Population Survey. In this post, I will shed light to recent implications of the recent shift from defined-benefit to defined-contribution retirement plans and also will comment on an article that offers a new perspective on the Social Security situation.

First, to re-cap, defined-contribution plans are the ones where the participant adds a fixed portion per year. Of this sort, the 401(k) is the most common and this option is the one which employers have shifted toward recently because it is cheaper for them. However, in a defined-benefit plan (pension), the employer covers the cost and the individual receives the average compensation from his or her three consecutive highest paying years.

We can see implications of the winners and losers of this shift in the news today. Locally, we see situations where this has happened to those who were employed in Detroit. After the bankruptcy decision, many Detroit retirees faced the burden of the risk that was associated with their pensions. While it was once thought that the defined-benefit pension was safer than the 401(k), the playing field has now changed. While opponents to this view propose that defined-contribution plans face more market risk as opposed to the minimum lifetime guarantee offered through a pension, we can judge this to be false based on the real-world implications we currently see here in the job market in Detroit. However under a 401(k), that worker can keep the account if he or she changes jobs. In Detroit, pension plans are the ones that carry more economic and political risk, especially since politicians cannot guarantee pension benefits in the future if their views do not align with those of unions.

In my last post, the article featured commented on how Social Security is not accurately measured.  Although I searched for more information as to why certain measures were not included in the Current Population Survey, I was not able to find very much evidence. However, I did find a new perspective on the Social Security situation. This article offers a new perspective despite the fact that Social Security is operating in deficit. Ms. Warren, Massachusetts senator, offers an intriguing view on the subject. She argues that it is “not the time to trim Social Security benefits slightly to prevent the program from slipping into insolvency, but rather to do the opposite. She says it is time to increase the benefits the program pays out.” The argument that she makes is based on the fact that a lot of baby boomers saw their money for retirement deflate during the financial crisis of 2007 and 2008. Later, she proposes that this issue also draws concern on income inequality in America and pushes for a boost in upper-income payroll taxes to finance these higher Social Security benefits. In my opinion, this opens a whole new debate. Although I anticipate this senator’s view not to receive much praise under recent economic conditions, it is still interesting to take into consideration information from both sides of the debate.

Social Security- Situation as bad as it seems?

According to Schieber and Biggs, the retirement situation in America is not as bad as it seems. Over the past 30 years, we have seen many employers switch from defined-benefit pensions to defined contribution savings plans (such as 401(k)s). This switch has lessened the income that is combined with the Social Security benefits that retired individuals receive.

Firstly, it is necessary to distinguish between a defined-benefit plan and a defined contribution savings plan. “A defined contribution plan is a retirement plan that requires that an individual “account” be set up for each participant in the plan — even if the only participant in the plan is you.” It is a “defined contribution” plan because you can only add a fixed maximum amount per year. The contributions are based on a percentage given in the plan. The most common type of defined contribution plan that we have all heard of is called the 401(k). Basically, in a defined contribution plan, a fixed percentage of your income is invested each year.

In contrast, “A defined benefit plan is a retirement plan set up to pay a fixed annual amount to eligible employees during their retirement years.” It is called a “defined benefit” because your quarterly or annual contribution is based on an actuarial calculation of what your benefits should be. At retirement, you receive your benefit. The actuarial calculation will be the smaller of the two options: 1) $180,000 or 2) Your average compensation from the three highest, consecutive years where you made the most money. A defined benefit pension plan is the most appealing option because with this option, a portion of your paycheck is not sacrificed. Your employer covers this cost. Whereas in a defined contribution plan, your own money is going into the 401(k).

Accordingly, this is precisely the reason why many companies have been switching from defined benefit to defined contribution; these plans are less costly to the employer. Some employers offer hybrid plans, which are harder to come across. But if the hybrid is offered, it is a good idea to participate in the defined contribution as well because it is likely that the newly refined pension plans will only allow you to ‘just get by’ in retirement.

The writer of the Wall Street Journal article (cited at the beginning) is a former chairman of the Social Security Advisory Board. A brief summary of his claim is that the perception that most retirees will be “poor” is an over exaggeration because retirement income ignores at least 60% of the money that retirees receive. The story that most Americans believe is based upon data from the Current Population Survey (CPS), ran by the U.S. Census Bureau. However, this survey fails to take into account the income that Americans derive from 401(k)s and IRAs (which is defined contribution, the direction in which most employers are pushing toward). This understatement of accounting for retirement funds will only increase as more employers switch to defined contribution plans.

In the article, you will find that there are other measures which the CPS fails to take into account- such as certain tax figures and DC plans, but even though the social security situation is not good (it’s currently operating in deficit), it is clear that the social security predictions are not as grim as they may seem on the surface. In order to make accurate predictions of how to advise successful future policy for social security, it will be necessary to include all measures of retirement incomes that Americans are currently receiving.

How to Budget Holiday Spending and Should You Consumption Smooth?

It’s no secret that most of us tend to overspend during the holiday seasons. But why does this seem to ALWAYS happen? We know the holidays are coming around and yet many of us still make poor planning decisions year after year. Wouldn’t it be nice to stay under budget just once? As noted in the Wall Street Journal, there is a simple solution in which you can effectively manage your spending during the busy holidays and avoid making what is called the worst financial mistake people tend to make around these times of the year. That is, create a “spending strategy”, or in other words, create a holiday budget. While this may be a simple solution that takes little time and effort, the majority of people fail to do so and it can result in a huge financial mistake. Michelle Higgins recommends preparing a list of all your holiday expenses along with an estimated budget. By keeping track of your purchases, it allows you to see where you are overspending and what areas you need to cut back on.

Throughout the year, people receive raises and bonuses. While this is great news for anyone, some people do not make the wisest decisions on what to do with this extra income. Michael Kitces suggests one possible way to avoid overspending- simply do not spend more than half of your raise. That is, commit at least half of it toward saving for your future retirement. In this way, you increase your consumption today as well as your consumption tomorrow. That is, you are better off both now and in the future because you will have more money to spend after you retire. Some people like to call this strategy “consumption smoothing”. Consumption smoothing is simply balancing your spending with your savings in a way that allows you to have a relatively consistent standard of living throughout your working years and retirement years. It allows you to better prepare for the later years when you might incur unexpected expenses, such as those dealing with your health. In this way, people who consumption smooth are often better off because if they happen to be hit with a health emergency, their savings does not take as hard of a hit.

However, according to one recent article, over 3 million people believe that there is “no point in saving for old age because it will just be taken away later when they need it”. Many people like myself however, will disagree. The earlier you start saving for retirement, the more savings you will accumulate. The sooner you put aside a set amount of money, the more interest you will accrue and the more your savings will expand.