July 24, 2011

USA: The sublime benefits of death

BYRAN / COLLEGE STATION, Texas / The Eagle / Business / July 24, 2011

When it comes to retirement and living without a paycheck, older people have a sublime advantage. It's called death.

Once you reach a certain age, it is no longer necessary to plan as though you will live forever. You won't, so you can plan, invest and spend accordingly. It's a big advantage because your life expectancy at 60 or 65 really is a lot shorter than it is at 25. That, in part, is why a young person would need about $4 million to live the Life of Riley - An easy and pleasant life

But it's a whole other deal if you are a retired person. These folks can live the Life of Riley on a fraction of that amount -- about $700,000.

Here's why the difference is so large. As I reported last week, the Life of Riley Index now shows that you would need an investment fund of about $4 million to sustain a standard of living better than 75 percent of all households. The large amount is needed because current investment yields are so low -- about 1.77 percent for a 50/50 portfolio of stocks and Treasury obligations. If you are young, you can't take the chance of making principal withdrawals because you would have to do it for many decades. All of your spending money has to come from dividends or interest income.


Older retirees don't need such a large nest egg for two reasons:

* Social Security retiree benefits are a major substitute for dividend and interest income. Better still, some of those benefits won't be taxed, so you have more of them to spend. According to studies of retirement income, a couple hoping to sustain a $70,000-a-year standard of living (consumption plus income taxes) can expect to have Social Security benefits and lower income taxes cut their need for investment income to less than $35,000. That's a gigantic reduction.

* While a young person has to live on investment income to have his money last as long as 50 or 60 years, a retiree couple need only consider individual life expectancies of 20 years, or a joint expectancy of about 25 years. As a consequence, they normally can make withdrawals at a 4 percent or 5 percent annual rate and have no fear of running out of money. This implies a nest egg of "only" $875,000 (4 percent) or $700,000 (5 percent) to provide $35,000 to supplement Social Security income.

That's all good news for retirees, right? Well, maybe.

The portfolio survival studies that tell us we can safely withdraw 4 percent to 5 percent from our nest egg each year are based on historical time periods when fixed income and stock yields were higher than today. In his book Unexpected Returns (Cypress House, $40), however, investment manager Ed Easterling shows that future stock returns depend on how stocks are priced relative to earnings at the beginning of the time period. If stocks are selling at high price-to-earnings (P/E) ratios, future returns tend to be lower.

Easterling isn't alone in making this observation. Researchers such as Steve Leuthold, Rob Arnott and Jeremy Grantham have done similar research.

The P/E effect is why people who retired in high P/E periods like 1972 and 1999 have faced difficult retirements, while people who retired in depressed stock market periods like the late 1970s have had plenty of money to spend -- even as their estates increased. A lot depends on valuation levels in the year you retire.

So how are stocks priced now? According to several measures, they are at the high end of the historical range. Add fixed-income yields near record lows, and retirees who count on a 4 percent or 5 percent withdrawal rate may be pushing their luck. The "probability of ruin" -- as financial economist Moshe Milevsky cheerfully labels going broke in retirement -- is high.

So what can you do to reduce that risk? Not much. There are only two big levers.

First, you can spend less. That's easier said than done, but it's a lot easier from an affluent starting point than a poor starting point.

Second, if possible, you can work longer. Paychecks are good -- one small paycheck is the equivalent of a whole lot of common stock.

Working longer is exactly what savvy (and fortunate) older people are doing. As I pointed out in a recent column, the labor force participation rate for men 65 and over has risen over the last 10 years. Ditto, the participation rate for women 55 to 64.

When the going gets tough, the tough go to work.

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