By Chad Burton, CFP®
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.
First, Start with Your Expenses
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 traveling, your philanthropy. Whatever those plans are, they are discretionary expenses, and you need to know those numbers.
You also need to have a basic understanding of what you will pay in taxes in retirement. When you pull money from your IRAs, 403(b)s, and 401(k)s, those funds will be taxed as ordinary income. In addition, up to 85% of your Social Security could be taxable.
When you sell stocks, mutual funds, or exchange-traded funds (ETFs) in your non-retirement accounts, the gain will be taxed at the capital gains tax brackets. Dividends from qualified stocks will also be taxed at the capital gains brackets.
Thus, you should do some modeling in order to add an annual tax bill to your list of expenses before moving on to the retirement readiness tests that follow.
Test #1: Linear Cash Flow Model
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 a 10-year return from January 1, 2007, to December 31, 2017 (which included a significant market decline during the Great Recession), many balanced funds based on U.S. stocks and bonds averaged 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 had been rebalanced annually over those 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 2007 through 2010? How would that look?” (Make sure to check out the “Home Bias and Global Diversification” download under the Insights/Resources tab.)
You may be thinking that a 3% inflation rate is too high based on the last decade. However, the rate factors in more than normal living 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.
Test #2: Risk Number Based on 6-Month Tolerance
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 difficult market cycles or a sudden jump in interest rates. To get a very basic idea on how to do this using risk measurement tools, go to newfocusfinancial.com or chadburton.com and look for the question “What is your risk number?”
With the process, you can eventually do a portfolio review that will show you with high probability what will happen to your portfolio over multiple market scenarios such as a -10% or -20% correction in the S&P 500.
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. For example, 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.
Going to 100% cash is also a mistake because you miss out on dividends and interest income you can receive regardless if the stock market is up or down. As an example, a balanced portfolio may yield around 3% from dividends and interest. If a retiree with $1 million invested decided to panic and go to cash, the income of $30,000 per year stops immediately. They then have to guess when the right time to get back in will be, which is nearly impossible.
Test #3: 3 Years of Portfolio Draws in Safe Money
Retirees should have three years’ worth of portfolio draws in safe money, in cash-type investments: CDs, Treasuries, high-yield FDIC-insured money markets, or credit unions. Short-term bond funds do not qualify as safe money. 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: Monte Carlo Simulation
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 such as longevity, and then run your situation through thousands of simulations.
In general, you want to make sure you have at least an 85% probability of success with Monte Carlo simulations. However, if you won’t have three years of portfolio draws in safe money, 85% won’t be enough, in my opinion. Also, keep in mind that the Monte Carlo simulations do not factor in our NewFocus withdrawal strategy.
Bottom line: 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.
Test #5: Taxes
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.
This test will show you what happens to your tax bracket at age 70 1/2 when you’re forced to pull money out of your retirement accounts to complete required minimum distributions (RMDs).
We often have a withdrawal strategy for up markets and a withdrawal and tax strategy for down markets where IRA-to-Roth conversion become even more attractive.
Test #6: Long-Term-Care Simulation
If you live to age 70, you have a 60% chance of spending time in a nursing home or assisted living facility at some point in your life. What happens to your portfolio if you’re single? What happens to your spouse if you’re married?
Proper projections can help you create a Plan B, which could include self-insuring, long-term-care insurance, selling your home, or doing a reverse mortgage.
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 all your assets down to poverty level.
So, really, you need to consider insurance unless you have more investments or income than you need. If you have an old cash value life insurance policy, you may be able to exchange the policy for a new hybrid policy that allows you to use the death benefit while you are alive to pay for in-home care, assisted living, or nursing home care.
Completing these six tests, along with detailed cash flow projections, could help you feel comfortable with your answer to the question of “When can I retire?” But don’t do these tests and forget about them. They should be done at least 10 years from the date you want to retire and then reviewed annually.
Schedule a complimentary meeting with a wealth advisor to discuss your personal situation.
