One of the toughest conversations our planners at NewFocus Financial have comes when people want to pull the trigger on retirement because they have reached a certain number—say, $1 million or $2 million in their portfolio. But they didn’t do planning beyond saving for the magic number, and because of their expenses, taxes, or unexpected health care costs, they find out they are not done. They are not ready to retire.
So how do you know that you’re ready to retire besides reaching a certain portfolio number? The question prompted me to break down the planning process that we use at NewFocus Financial, and I pulled out the six most important tests for retirement readiness.
These tests assume that you know what your expenses are—both discretionary and non-discretionary. In other words, you have expenses that put food on your table and keep the lights on in your home. Those are non-discretionary. But you also need activities and plans that are going to motivate you to get out of bed in retirement: your entertainment, your golfing, your travel, your philanthropy. Whatever those plans are, they are discretionary expenses, and you need to know those numbers.
Can your portfolio survive on a 5 1/2% rate of return with 3% inflation and get you to age 100? Your answer to that question is your first test for retirement readiness.
Why do I use these numbers? If you look at the last 10 years, including the top of the market in 2007, you see that with any balanced fund based on U.S. stocks and bonds, the return has been around 5 1/2%. Yet most investors still have international exposure. So, if you look at any 50-50 or 60-40 type of global allocation fund that has been rebalanced annually over the last 10 years, the return has been about 5%. You have to ask yourself, “What if I go through a period in retirement where the first decade or two is slow or low growth like we just went through? How would that look?”
You may be thinking that 3% inflation is high based on the last decade. However, it factors in normal expenses. Health care costs run at about 6 percent inflation in retirement. That’s why I recommend using a 5 1/2% percent rate of return with 3% inflation for your linear cash flow modeling.
With test #2, you determine your risk number and your six-month tolerance for pain when it comes to stress-testing stocks and bonds for interest rates. You can do this on our website. If you go to newfocusfinancial.com or chadburton.com, look for the question “What is your risk number?”
With the process, you can eventually do a portfolio review that will show you, with up to a 95 percent probability, what your returns may be over the next six months. The range is quite wide because it includes factors such as underlying assets and standard deviations to illustrate upside and downside potential over the next six months.
The reason why you should do the “What is your risk number?” test is because most financial planning mistakes and investing mistakes are made when people panic. They cash out when their fear level is the highest. If you do that, you turn paper losses into real losses. If you cashed out in 2008–9, your financial plan has probably been decimated because you missed this last run-up that we went through and over seven years of dividend and interest income.
Retirees should have three years’ worth of portfolio draws in safe money, in cash-type investments: CDs, high-yield, FDIC-insured money markets, or credit unions. Three years in safe money can help get you through a tough market cycle.
To do this, you figure out the amount that three years of portfolio draws would be. Remember, not three years of expenses, but three years of portfolio draws, or your gross expenses minus Social Security, pensions, and dependable income. When you calculate your expenses, don’t forget health care costs and taxes that occur when you draw from your retirement accounts.
Test #4 is a Monte Carlo simulation, which takes your scenario, as well as your current investments, and runs it through thousands of variations of returns.
The order of returns is important when it comes to your retirement. For example, you could retire during a bull market and then, in your later years, experience slow growth or a bear market while you’re drawing the most out because of inflation.
Simply put, a Monte Carlo simulation will take highs and lows, underlying risks, and other factors, and run your situation through thousands of simulations.
You want to make sure you have at least an 85% probability of success. If you didn’t have three years of portfolio draws in safe money, 85% wouldn’t be enough, in my opinion. Keep in mind that the Monte Carlo simulation doesn’t factor in our NewFocus withdrawal strategy. With an 85% Monte Carlo success probability plus three years of portfolio draws and our withdrawal strategy, you have a better chance of not outliving your money.
In test #5, we determine the best accounts to draw from today. You also do things like modeling Roth conversions to max out your lower brackets.
What that means is, from the date of retirement—let’s say age 65 through 69—you might be doing partial Roth conversions, where you take some of your money from your IRA, convert it to your Roth, and pay the taxes so that you have tax-free growth in the future.
And also, this test will show you at age 70 1/2 what happens to your tax bracket when you’re forced to pull money out of your retirement accounts.
With #6, you run a long-term-care simulation. Ask yourself: If you stay in a nursing home or assisted living facility for five years, what happens to your portfolio if you’re single? What happens to your spouse if you’re married? Your answers can help you create a Plan B, which will be either long-term-care insurance or reverse mortgages, so that you can get through that period of time.
If your family has a history of issues such as dementia or Alzheimer’s, then this test becomes crucial to your financial well-being. Medicare won’t cover your long-term care. Medicaid (or Medi-Cal in California) will cover it—if you first spend off all your assets and go broke. So, really, you’ve got to have insurance. That’s all that’s going to cover your long-term care—the insurance or you.