Mon, 10 Sep 2012
Morningstar's Christine Benz outlines the advantages and drawbacks of working longer, tapping Social Security early, upping your savings rate, and tilting toward riskier assets to offset retirement-saving shortfalls.
Jason Stipp: I'm Jason Stipp for Morningstar.
It's Retirement Readiness Week on Morningstar.com, and today we're helping pre-retirees play catch-up if they're worried they haven't saved enough for retirement.
Here to talk about some of the pros and cons on the levers that pre-retirees can pull to play catch-up is Morningstar's Christine Benz, our director of personal finance.
Thanks for joining me, Christine.
Christine Benz: Jason, great to be here.
Stipp: Christine, one of the first things that folks who are concerned they haven't saved enough perhaps will resort to is the idea that, maybe I don't want to, but I'm just going to work longer into retirement, work past that regular retirement age. What are some of the pros and cons on working longer?
Benz: Well, there are really a lot of benefits to this strategy, so you can see why people have gravitated toward it. One is pretty obvious that, if you continue to work, you'll probably be able to continue to save, so that's an advantage.
Another one is that you will reduce the number of years during which you'll be drawing upon your portfolio, so you'll reduce the stresses that you'll put on your portfolio when you actually do retire. So, your portfolio won't necessarily need to be as large as it would for someone who retired younger.
Finally, you'll probably be able to defer Social Security for the number of years that you continue working. People who defer Social Security really do see a powerful compounding benefit; they get roughly a 7% to 8% increase in benefit for every year they wait past 62 until age 70, along with an inflation adjustment. So, that's a guaranteed benefit; it's very, very valuable.
So, those are three things that line up in favor of working longer.
The key disadvantage is that it's difficult to know for sure that you'll be able to continue to do so. So, while working longer is the backup plan for a lot of pre-retirees these days, they may have health issues or spouses' health issues that interfere with their ability to continue work. They may not be able to continue work. They may lose a job and not be able to replace it.
So, it's not necessarily a backup plan. In fact, our colleague Adam Zoll, wrote an article where he examined people's ability to work past age 65, and what he found was that, 70% of people who are not yet retired say that they plan to work past 65, but only 27% of people who are currently retired said they actually did work past 65. So, there is a little bit of a disconnect there, perhaps some people are being unrealistic about their ability to continue to work even though they have every intention of doing so.
Stipp: Certainly, we know that the job market is still very weak for folks of all ages, so there is that macroeconomic headwind. If you don't have a job currently or you lost your job, it's going to be probably much harder to find a replacement job across a lot of ages.
Christine, you mentioned there Social Security, and I think it's an interesting trade-off. So, if you're worried that you haven't saved enough and you're thinking, I might need to take that Social Security at age 62, and you don't want to invade what you think might be a smaller nest egg, how do you balance that trade-off against what you mentioned are some pretty compelling guaranteed returns essentially by deferring and taking Social Security later?
Benz: Well, in general, if you can wait past age 62, you absolutely should because you will be docked if you take Social Security prior to what's called your full retirement age. For most baby boomers, that's 66, 67. If you can wait at least until then, you'll receive your full benefit, and then you can increase your benefit for every year thereafter, until age 70. You see a compounded effect, a compounded benefit, by waiting longer. So, there is a lot lining up in favor of deferring.
The big disadvantage to not taking it right away is that if you are going to have to tap your portfolio prematurely and maybe you've encountered a down market, so you are going to have to draw upon it significantly, that would be sort of a dis-incentive to keep in mind. If that's what you're going to have to do in lieu of taking Social Security early, that's a trade-off that you really do need to consider.
Stipp: We've heard some folks say, well, I'll take it early and then I’ll … invest it, hoping to outpace that guaranteed 7% return or so, but that could be pretty difficult in today's current environment.
Benz: That's the thing: Unless you have a very aggressive portfolio mix, you'll be very hard-pressed to out earn that 7% or 8% plus inflation adjustment that you get by deferring Social Security.
Stipp: Christine, something that investors can control is how much they save. We know there are some incentives for folks who are approaching retirement to save more perhaps than they had been able to save before. What are the pros and cons of just socking more money away?
Benz: Well, it's a good strategy in that you can save more in tax-sheltered vehicles if you're over age 50 than you could if you were younger than age 50, so that's something to keep in mind. You get to put $6,000 in an IRA, $22,000 in a 401(k), if you're over age 50. So, that's an important advantage.
The downside is that you do not have much time to benefit from the compounding that you get from those investments. So, even if you are getting that tax-sheltering benefit, you may not have many years for your new investments to compound upon themselves. So, I think it's certainly a reasonable portion of a strategy, but it can't be an entire strategy because you just don't have enough time to sock it away and see a significant appreciation on those assets.
Stipp: So, if you're in your 40s, and you're thinking, well, I’ll just wait until I can sock away more money, you might want to think twice about that just given that the power of compounding is so compelling the more years you can add on to that.
Stipp: What about, Christine, folks who say I haven't saved as much as I want to, I know that I probably should be mixing my assets with more bonds as I get older, but I'm going to make up for last time, and I'm going to take what money I do have and be as aggressive as possible in order to try to compound those returns at a higher rate--pros and cons?
Benz: Well, the key pro is that, indeed, you could outpace what you might earn from a bond- and cash-heavy portfolio by having more in equities. So, I don't think it's an unreasonable strategy to tip maybe slightly more in stocks than standard at asset location advice would call for.
The big downside is that you don't have time to make up for big losses, if you have a very equity heavy portfolio. Say you go through a 2008, early 2009 style, bear market again, you would not have necessarily the time to recoup those losses in your equity portfolio.
So, I think it's reasonable to shade a catch-up portfolio maybe slightly toward equities; you probably wouldn't want to have a 100% equity portfolio if you were, say, over age 50.
Stipp: And it's still important, as we’ve talked about many, many times, to carve out that section of the portfolio, no matter how tilted or aggressive the other side might be, for more conservative investments. So, if you do see a market dip, you won't have to sell those assets when they are at very depressed prices potentially?
Benz: Exactly. To make sure that you have that that safe component of a portfolio is key, and I think right now a lot of people say, well, I am not that convinced that bonds are too safe right now--we have very low yields [and] the prospect of rising interest rates down the line--but I think that people need to bear in mind that the volatility you would have with a high-quality bond portfolio would still be much, much lower than what you'd observe with even a high-quality equity portfolio.
Stipp: Lastly, Christine, a lever that pre-retirees or folks nearing retirement may need to pull is, how they envision their retirement lifestyle and the expenses that they'll have in retirement.
What are some of the realities about retirement spending? How much freedom or leeway do you have to ratchet that back if you need to?
Benz: I think it's a really interesting idea, and I know in interacting with a lot of our Morningstar.com users, many of them have really relished simplifying their lifestyles in retirement; they've relished downsizing, they've relished getting rid of stuff--we all have too much stuff.
So, I think that this is a place to look, rather than just … setting back your retirement date or [taking early] Social Security. Think about well, how could my retirement lifestyle potentially look different than my lifestyle did while I was working? So, I think it's worthwhile to explore that issue.
One thing that the data show us, though, is that people with lower incomes while they are working are going to need to replace much of that income when they're retired. The reason is that they were living probably pretty close to the bone, spending a lot of what they made, while they were working. So, they don't have a lot of wiggle room to cut their expenses. I think higher-income people, who had a lot more discretionary expenses in the pre-retirement years, will have more room; they can move the needle a little more by cutting back some of that stuff. If you had a pretty tight budget prior to retirement, chances are you will need to replace a lot of income during retirement as well.
Another wild card in the mix is health-care costs. It's really an unknowable, for all of us, how healthy will be in retirement. So, even though you might have grand plans for really scaling back your in-retirement expenses, you want to be careful because you may need to defray some health-care costs that you didn't bargain for.
Stipp: Not only that, but if you're thinking maybe you won't feel as much like traveling [in your retirement], but then you end up having a very robust 70s and 80s, you may wish that you had perhaps socked a little bit more away to enjoy what could be an extended healthy golden years?
Stipp: Christine, some very important tips for the levers that folks can pull if they feel like they need to catch up. Thanks for joining me today.
Benz: Thank you, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.