Tuesday, June 23, 2009

Retirement Economics

I recently received this question from a friend who is nearing retirement... How do you decide how much you are able to spend each year? A set percentage of your assets or a fixed amount? Retiement economics are very different than when you are working. Much more difficult.

After a few years in retirement in the recent environment, this question/comment rings more true than I realized at the time I left the work force, and is particularly timely with the bulk of baby boomers approaching retirement. So, I thought I might share my response.

You are right that retirement economics are considerably more complicated than when you are working.

When you are working you have a good handle on your income. You can just decide how much you want to save/invest and budget to spend the rest. When the market is up, your net worth seems to almost effortlessly skyrocket. If the market is down you still feel good, because you are buying at lower prices. And, worse come to worse, you always have your steady income coming in.

At the outset, retirement didn't seem so much different. I just budgeted 4% of my net worth. That is in line with most experts advice for long term maintenance of your portfolio and keeping up with inflation. Fortunately, my wants are modest and I generally came in well under my budget. Meanwhile, the markets were rising and my net worth was still growing significantly. I also determined to keep at least 3-5 years of spending money in liquid, low risk investments so I wouldn't have to sell assets in down markets. Things were good. So good, that I began to think of early 2008 as a down market. So, I didn't sell assets when I bought a new car, went on a luxury cruise and made gifts to the kids. Besides, returns on things like CDs were relatively low, so I didn't want to keep too many assets there. Meanwhile. I was able to live on less than capital distributions and dividends from my after tax account and stock options looked like money in the bank. I began to wonder if I'd ever even need to tap my retirement accounts.

Then things got a bit more complicated. The market was down more, I invested the surplus cash in my system (read about the system I use, call Dollar Cost Averaging on Steroids in previous posts) and my liquid assets had shrunk to less than 3 years spending. While I was still spending well under 4% of my assets per year, the capital gains distributions disappeared and the options became worthless. So, my disposable income went to near zero. I could always sell assets, but who wants to do that with the market at these levels. Besides, the return on liquid assets, which previously seemed marginal fell to 1-2%, and in some accounts where I'd prefer to keep the money, less than 1%.

I decided to invest a bit more in high dividend stocks, like BP, GE and Dow. Unfortunately, these stocks dropped by 50-75% before Dow and GE slashed their dividends. So far, BP is the best of the lot, and it is down 50% from a year ago. That makes the dividends look puny, and they don't feel much like the safe investments I envisioned. Fortunately, I held on and GE and Dow are up 100-200% from their lows, but they still are well below where I bought them.

And, even though my original assumptions still looked workable at current market levels, I began to worry that the markets might continue the freefall and I might have to replenish my cash by selling at asset levels I'd never dreamed of. Fortunately, I held on and ended up nearly 100% invested at the market lows, so the bounce has improved my outlook considerably and I've raised some cash. Still, the ridiculously low returns on liquid investments irks me, but the experience has driven me to conclude that I need to be just a bit more conservative. So, the problem now is where to put that cash. So far the answer has been oil and gas protected by covered options (see the link to my Energy Guru blog at right for details). I do worry that that is not as safe as it seems, despite the fact that it has worked great so far. I have considered selling options on the Dow and GE, and perhaps even the S&P 500 to make my investments more conservative, but so far I've not done it.

I did make some opportunistic investments in CDs of failing banks last fall which have a 5% return, but they expire in a few months and the best I can do to replace them with truly safe money is the 1.5% at Orange savings. Even my I savings bonds have a zero return now because of the negative inflation last year. And all this in the face of what I expect to be rising inflation in the next few years.

Bonds have been the traditional conservative investment, but I have little confidence it that route for now. For one thing, I think the current artificially low interest rates will really hurt bonds when it is unwound over the next few years. Bonds would also be badly hurt by high inflation that seems likely just over the horizon. Put all that on top of the fact that bond funds are the widely available and accepted substitute for bonds these days, and I see a disaster in the making for bond fund holders. This alternative is nothing like the old days of buying a bond and holding it to maturity in a stable market that made the reputation of bonds as a good route to conservative investment. I might add some inflation adjusted bonds when that becomes available in the 401-k in August, but otherwise I can't see adding to my 15% allocation to bond funds.

Some suggest gold as an alternative, but I'm not much of a fan of gold. To the extent I feel hard assets are justified I prefer something utilitarian rather that symbolic. So, oil, gas and land have filled that bill for me. That has worked pretty well, acting as a source of more reliable income and uncorrelated diversification. And you can always use them to match/generate your most basic needs like energy, shelter, food and water. Even so, these, like gold and other commodities, are subject to the same uncertainty as other market based products, meaning they are far from safe.

Of course, my system, Dollar Cost Averaging on Steriods, does provide quite a bit of protection. It reduces volatility and increases returns over even the tradional dollar cost averaging and diverse allocation methods. In addition to my 3-5 years basic reserve, it has me in an additional 10% cash now. The problem is that in the most severe down markets I tend to run out of cash to utilize too soon, losing its conservative effect in the most severe downturns. So, I've promised myself to be more conservative and disciplined in reinvesting that cash. I've lowered my target return to 3-4% over the past year, which keeps more cash in the account. I had planned to do that all along when I retired, but had not done it since I was not drawing cash from retirement accounts.

Yes, more difficult indeed. Partial solutions, perhaps, but, the hunt for conservative alternatives goes on. So, I'm open to suggestions for more conservative investments which offer at least a decent return that matches inflation and taxes. But, whatever you do, realize than some rethinking of your financial approach is worthwhile as you enter retirement.