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Your Ideal Retirement Number Is Zero

The neglected subject of liability management.

John Rekenthaler, 06/27/2014

Pay Offs
You've surely seen ING's advertising campaign, “What's your number?” It features actors toting giant orange signs that represent the amount of money they will need at the time of their retirement. The commercials are goofily memorable and effectively deliver the company's message: Plan for retirement.  

They do, however, ask the question from the wrong perspective--at least according to Michael Falk, keynote speaker of one of last week's Morningstar Investment Conference sessions. ING inquires about assets. Falk argues that the better approach is to begin with debt. The ideal retirement number for liabilities is zero--no mortgage, no credit card rollover, no unpaid loans.

Doing so means that the retiree may be able to fund basic needs (food, utilities, taxes, automobile, insurance, clothing, etc.) solely from Social Security payments (and/or other guaranteed pensions). In such cases, ING's numbers would therefore apply only to the retiree's discretionary spending.

They therefore can be substantially cut. ING's signs range from $600,000 to $3 million, with the median figure being roughly $1.5 million. At a 4% withdrawal rate*, those lump-sum amounts translate to from $2,000 to $10,000 monthly, with a median of $5,000. For comparison's sake, per this report, the median American household has $1,100 month for discretionary spending.

(*Whether a 4% withdrawal rate is realistic given current market valuations is open for discussion. For the purposes of this column, we'll assume the answer to be yes.)

To state the matter in reverse, the lump-sum at retirement that is required to fund $1,100 of monthly spending, assuming a 4% withdrawal rate, is $320,000. For the millions of households that currently have almost no savings at all, retirement or otherwise, that number will look daunting. But a lot less daunting than what is currently being shown to them.

Moreover, argues Falk, retirees can shrink even these lowered lump-sum amounts. Consider, for example, a worker who retires at age 70 and buys a deferred annuity that begins 15 years later. This annuity, which would cost pennies on the dollar, will be used to pay discretionary expenses from age 85 onward, thereby slashing the investment time horizon to 15 years. The investor can therefore safely increase the withdrawal rate (although carefully and cautiously in the first few years, to defend against the possibility of an early bear market).

The effects of eliminating liabilities spill over into asset allocation. If required spending is fully covered by guaranteed payments, then the "number" can be more aggressively invested. After all, even a steep market decline would only moderate alter the retiree's lifestyle. Also, the investor without liabilities can adopt flexible withdrawal policies, to avoid selling assets into weakness during down markets. Such an approach effectively increases the acceptable withdrawal rate. The combination of more stocks leading to higher returns, and a flexible policy leading to a higher withdrawal rate, is powerful.

is vice president of research for Morningstar.

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