BY ANTHONY M. LEONARDI
Roughly 10,000 baby boomers will turn 65 today and about 10,000 more will cross that threshold every day for the next 19 years, according to Pew Research Center population projections (“Baby Boomers Retire,” Dec. 29, 2010). The financial services industry, as a whole, recognizes there is a retirement boom in the making and they are positioning themselves to scoop up billions in retirement investment dollars.
In many cases, their tools of choice are colorful and attractive, yet rudimentary, modeling programs for their sales force to mass market to potential new clients. However, there are several problems inherent within basic modeling programs. Primarily, they look at retirement income planning as a linear, straight line modeling function, assuming that average returns will be made every year from the first year of the model to the last year of the model.
For instance, if it is assumed that the average annual return in a retirement model is going to be 7 percent, the model will calculate a 7 percent return each and every year for the life of the model. The fallacy in this model, and in all linear models, is that the real world does not work in a straight line and neither do the investment markets. It would be highly unreasonable to believe that any investment portfolio could return a steady 7 percent year after year for decades.
Average returns over long periods of time may not paint a reliable picture in a retirement plan. The volatility that occurs naturally in the investment markets needs to be understood and considered when utilizing linear models.
Let”™s take a look at a hypothetical example:
John just turned 65 and is ready to retire. He has accumulated $1 million in his 401(k). He will need a $50,000 per year pre-tax income in order to maintain his lifestyle and he would like to preserve his $1 million principal for his children when he passes.
John and his financial adviser calculate he will have to produce a 7 percent per year average return on his investments in order to generate the 5 percent withdrawal rate needed ($50,000), adjusted for inflation. John”™s adviser shows him an asset allocation model that has averaged 7 percent return per year for more than 20 years. John begins his retirement with $1 million. He withdraws $50,000 per year, adjusted for inflation. After 30 years, he still has $1,131,014 to pass on to his heirs.
But, what happens to this portfolio if we have two negative years to start retirement? In years 1 and 2, the account loses 7 percent. In years 3 through 29, we make our steady 7 percent return, and in year 30 the account earns 35 percent, for an average annual return of 7 percent, as suggested by the adviser. Because of two slightly negative years in a portfolio that was otherwise consistent in its returns, John runs out of money in year 25. Projections calculate that John will have a negative balance in his account of $832,307 in year 30.
The two portfolios, which average a 7 percent return very consistently over a 30-year period, have projected ending values ranging from a high of $1,131,014 to a low of negative $832,307 in value. This is a range of $1,963,3212 ”” nearly twice the original starting portfolio value!
There will always be volatility in the investment world. As you are accumulating retirement assets, volatility can work to your advantage when properly understood and managed. But, when you decide it”™s time to retire and become responsible for creating your own paycheck from your savings, volatility can be one of your biggest challenges.
Investing for accumulation takes a certain skill set, as well as a great amount of patience and time. Investing for retirement income requires a different level of understanding and a completely different skill set. Be sure to consult with an adviser who is well trained and experienced to provide adequate advice for those approaching, entering or trying to survive retirement.
(The hypothetical examples used are for illustrative purposes only and are not indicative of any particular investment or investment performance. The examples assume no transaction costs, taxes, management fees or other expenses. Withdrawals from tax-deferred retirement accounts are taxed as ordinary income.
Diversification may help reduce, but cannot eliminate the risk of investment losses. There is no assurance that by assuming more risk, you are guaranteed to achieve better results.)
Anthony Leonardi is a private wealth adviser with Sagemark Consulting/Lincoln Financial Advisors in Rye Brook. He has been assisting investors for more than 20 years. Leonardi holds the certified financial planner designation and the chartered retirement planning counselor. He can be reached at 914-305-9017 or anthony.leonardi@LFG.com.
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