Financial Makeover: Living Off Investments

Nov. 10, 2003 -- — Q U E S T I O N: I am considering retiring next August at age 59½. I'd like to live on the interest earned on my IRA and 401(k). I have $516,000 in retirement accounts and will add $16,000 by next August. If I could get an 8 percent return, I could make it. I'm thinking about moving the money into bond accounts or preferred stock. What would you advise?

— Ron

A N S W E R:

Many people are fascinated with the idea of living "off" a portfolio: "I'll build a portfolio during my working years and invest it in bonds when I retire so that I can use the interest income to cover my expenses and preserve the principal." Unless the portfolio size is already significantly larger than what the person needs to cover their financial desires, this strategy is a difficult one to pull off successfully. Here are some factors that Ron should keep in mind:

Spending Levels

Ron estimates that if his retirement accounts generate income equal to 8 percent of the total retirement account balances each year, they'll throw off enough interest and dividends to cover Ron's living expenses for the remainder his life. Theoretically, Ron wouldn't touch any of the principal, and it would, therefore, be available for some unidentified reason at Ron's death. My concern is whether the 8 percent income return is an accurate calculation of Ron's annual needs.

Ron's current salary is $112,000 per year. After 401(k) contributions, $97,000 of his 2003 pay is subject to tax. Assuming a 30 percent average federal and state income tax rate and no other sources of income, Ron generated about $69,000 of after-tax earnings this year.

On the other hand, Ron's combined 401(k) and IRA balance, after considering 401(k) contributions he makes before retiring, is $532,000. An 8 percent annual income return means Ron would take annual pre-tax distributions of about $43,000 from the accounts.

Assuming a 10 percent average combined income tax rate (this rate is lower that the average tax rate I used above because Ron's taxable income is much lower and is, therefore, not exposed to the higher marginal tax brackets), Ron would have about $39,000 after taxes to spend each year. This is 43 percent less than Ron's current after-tax salary!

Based on observing clients who've retired in past years, spending during retirement tends not to decrease from pre-retirement levels. During working years, people spend money on clothing for work, commuting costs, and other expense that go away when they retire. However, retirement provides the luxury of free time.

And, from what I've seen, people often fill this time up with activities (golf, travel, charitable involvement, etc.) that cost just as much money, if not more, than the expenses that went away when they stopped working.

Inflation and Time

Inflation is another factor for Ron to consider. If he's spending all of the retirement portfolio's return, the portfolio is not growing. So, if the portfolio successfully generates $39,000 of annual after-tax distributions, the static income level would be problematic because Ron's spending will increase by inflation each year.

If we assume a 3 percent average annual inflation rate for the remainder of Ron's life, the $39,000 of current dollar expenses becomes $63,000 in future dollars at Ron's age 75. The impact on inflation becomes even more extreme the longer Ron lives.

How do you achieve a consistent 8 percent annual income return? Historically, large domestic stocks have achieved average annual total (dividends plus stock price appreciation) returns of about 10 percent over long (20+ year) periods of time. Said differently, based on history, a portfolio invested in only U.S. equities has a 50 percent likelihood of achieving a 10 percent average annual return over long time horizons … which means the portfolio also has a 50 percent likelihood of achieving less than 10 percent.

Since planning around a 50 percent likelihood isn't comforting in a retirement situation, where the objective is to avoid returning to work, I'll point out that that same equity portfolio, historically, has an 80 percent likelihood of achieving an 8 percent pre-tax return.

Though fixed-income returns during short time periods are generally attractive and more stable, fixed-income returns over long time periods have, historically, been significantly lower than equities.

Over the past couple of decades, the domestic equity markets have expanded and more individual investors have been buying and selling stocks. As a result, many financial commentators agree that because of pricing efficiencies triggered by this trend, future equity returns won't likely be as strong as they were in the past.

In recognition of this lower future return expectation, I think it's appropriate to conservatively assume that, going forward, an all-equity portfolio has an 80 percent likelihood of achieving a 7 percent average annual total return. The likelihood of achieving this return should strengthen if the portfolio is expanded to include diversified equities (both large and small stocks in the U.S. and abroad).

Based on what we know from history and what we expect from the future, if Ron really wants to target an 8 percent annual income (as opposed to a combined income plus appreciation) return, he'd have to invest his retirement plans very aggressively in high-dividend-paying stocks.

This would expose the retirement accounts to much more risk than Ron would likely be willing to accept, knowing that he needs this money to get him through the rest of his life. If Ron instead heavily weights the portfolio with bonds and preferred stock, it would be very unlikely that Ron could achieve the 8 percent income return, on a sustainable basis, he estimates he needs to cover living expenses.

Another Approach

The challenge of investing in equities is that over short periods of time, as evidenced by the bear and bull markets we've experienced during the last five years, they can be extremely volatile. The same equity portfolio that we expect to achieve at least a 7 percent return over a 20-year period, might return more than 25 percent … or lose more than 3 percent … over any given five-year period. This ride could be unnerving for a retired person.

To make the portfolio volatility work for him over the long run, Ron could arrange his entire portfolio … the retirement accounts plus his savings and investments outside of the retirement plans … in a layered fashion that utilizes fixed income and stocks. For example:

Layer 1: Ron keeps the current $37,000 savings account balance reserved for living expenses during year one of retirement.

Layer 2: Ron sells the $85,000 of non-retirement investments and buys two bonds. The first bond matures at the beginning of retirement year two and the second bond matures at beginning of retirement year 3. Ron uses the maturity proceeds from each bond to cover the next year's living expenses.

Layer 3: Ron invests the $500,000+ retirement account balances in diversified equities. This allows him to take advantage of the growth that equities are expected to provide over long time periods. Assuming Ron expects to live for at least another 20 years, he'll need this growth to cover future expenses.

Allocating 1/3 of the portfolio to U.S. large cap equities, 1/3 to U.S. small cap equities, and 1/3 to international equities (some combination of large, small, and emerging markets) might be a good starting place. Mutual funds are probably the cheapest and most efficient investment vehicles for Ron to use to achieve these exposures.

As Ron spends Layer 1 funds, there is money available from Layer 2 to replace them. Similarly, Ron should sell enough equities in the Layer 3 retirement plans each year to replenish Layer 2. (Ron should avoid buying tax-exempt bonds in the retirement plans because that money is not subject to income tax until the funds are distributed). If Ron continues this process each year he should have a greater likelihood of continuing his planned lifestyle during retirement.

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Guest columnist Sandra Bragar, CFP, serves on the board of directors of the Financial Planning Association of San Francisco (www.fpasf.org) and is a financial planner with Kochis Fitz, a wealth-management firm in San Francisco (www.kochisfitz.com). Bragar is also an instructor in the Personal Financial Planning program at the University of California-Berkeley Extension.