It occurred to me recently that 2018 marks a milestone anniversary for me. I've now worked professionally in the financial services/insurance industry for 10 years. That's 10 years of being paid to assist people to navigate various financial mazes. Most usually the primary topic at hand is life insurance, but there are plenty of circumstances that warrant discussions outside of the insurance topic.
Like a lot of people who reach round number milestones such as this one, I've spent some time recently reflecting on the things I've learned, the things I've experienced/witnessed, the things I look at as victories and the things I look at as defeats.
Today I want to spend some time with a subject I place in the “defeat” category. Not necessarily a defeat for me personally. But a defeat for most of the industry.
Retirement Income Planning: The Subject that Dominates them All
When I started my career, I fancied myself an investment guy. I wanted to talk about financial markets and “talk shop” about my well crafted and thoroughly researched investment ideas. Few people took me up on the opportunity.
While there were those interested in hearing my perspective, the majority of those I cornered into an unsuspecting meeting with me about their finances figured they could use the time to answer some outstanding questions that HR had yet to address satisfactorily. You'd be surprised by the number of people who worry about whether or not they will lose their vacation days when they retire.
It took me years to realize that no one cared about my wiz-bang investment theories because ultimately the only true issue anyone cared about was how on earth they were going to afford retirement.
Most of these people couldn't do what their parents did–retire at 55 with a pension paying 60-80% of their re-retiremenpt salary.
No, these people needed to save their own money and finance their own retirements. They had learned, over the years, that apparently people were doing this with the Stock Market somehow, but CNBC was a really boring news station, and the Wall Street Journal was a publication for accountants and other stuffy people who fretted over matters like t-bills and the price of lean-hogs.
They owned investments–unwittingly–within their five-figure 401(k) account balances, but they always appeared more worried about what I thought of their CD's and Savings Bonds (it's a funny world out there).
The 401(k) was (still is) esoteric so people tended to focus most attention upon the items with which they had more comfort. Despite this, the ultimate focus was the same. How do I manage to keep the ship afloat if I'm not earning an income?
A Problem that Transcends Professions, Successes, and Everything Else
I've worked with a lot of different people over the years. From those, we'd generally consider working class poor to multi-millionaires. And for the most part, retirement income is a subject that strikes fear into everyone's heart.
Sure a tiny few achieved wealth placing them in a category outside of this problem. Provided a massive financial deterioration doesn't hit them, it would be hard to spend all their money over the remainder of their life expectancy.
They are the lucky few (very few). The majority, even those who hold account balances many would envy, worry a lot about how assets will translate to income at some eventual point.
The “Real” Problem Though…
The real problem is people don't know how to convert assets into income.
There are myriad reasons why this is the reality. The death of the pension happened more abruptly than many people realized and the need to finance one's own retirement is an exercise yet to have much in the way of a test subject.
CD's once a bastion of safe passive income were slaughtered by low-interest rates and no longer provide adequate yields for most savers.
Lost Hope and False Promises: The Bengen Rule
You've probably heard someone somewhere mention that you should plan to withdraw no more than 4% of your assets in retirement to ensure against running out of money. This number is a rule-of-thumb first solidified by William Bengen and further analyzed by academics most notably three professors from Trinity University.
In the interest of time, I'll uncharacteristically skip the mathematical details and simply point out that much number crunching discovered that data available at the time showed a very low probability of running out of money when using a withdrawal rate no higher than 4(ish) percent.
This has led many financial advice practitioners to recommend a plan where individuals liquidate no more than 4% of total assets in any given year to cover retirement expenses.
On its face, there is nothing wrong with this approach. It's been analyzed six ways to Sunday and holds validity. But just because something is mathematically accurate doesn't guarantee it's success when applied to “real life.”
Financial Planning Rarely Entails Income Planning
This might come as a shock to you–perhaps you've been around the block a time or two and have already come to this conclusion–but financial planning has almost nothing to do with income planning. In fact, financial planning usually has almost nothing to do with anything outside of investment planning/strategy.
At times a few nuggets of wisdom get thrown in. Maybe the rule of 72 (also wrong), thoughts on the appropriate mortgage length, or an opinion about your car loan interest rate. But deeply profound conversations about income or income planning are few and far between.
In fact, the industry has long faced criticism for this. Financial advisors spend countless hours talking to clients and prospective clients about how nifty their company's investment resources are.
They also come prepared with lots of glossy slicks extolling the virtues of this that or the other investment fund track record. Periodically, they prepare impressive looking graphs that illustrate someone's financial life and what they are doing right or wrong.
But when it comes time to use the money everyone spent so much time worrying about accumulating, the advice leaves most feeling very underwhelmed. The annuity industry took huge advantage of this and managed to rip a lot of assets away from investment funds in the process.
The advice came back to Bengen and some terse statement about 4% of assets.
Left Outside in the Cold
If I told you simply withdraw 4% of your assets in retirement and you'd be fine, you'd most likely feel a little alone and unclear about the future. Will the 4% deplete your assets to a point where you run out of money? No one really knows.
Is 4% too much? Too little? What are your retirement expenses anyway?
At it's best a rule-of-thumb figure like “withdraw 4% of assets” can act as a guideline. In other words “don't go beyond this point” or “if you keep it within this range you'll be fine” are reasonable applications of this sort of rule-of-thumb.
But my experience tells me people have a funny way of varying from the plan and lose sight especially when they have less solid an understanding of the overall strategy.
Then, of course, we have the sequence of returns risk and the possibility that your 4% might not be as good as my 4% because the timing didn't work out the same.
Asset-Liability Matching: A Better Way
Asset-liability matching is a common practice in financial circles. It's the quintessential practice of those who espouse passive income planning, especially among those who target early retirement.
It might sound like a complicated practice reserved only for the truly special, but I assure you it's not. It's simply a practice of ensuring you have income producing assets that meet or exceed the income needs (i.e. expenses or “liabilities”) that you face each month (or whatever period of time you want to think about it).
Consider this example:
Lilian has $4,000 in monthly expenses and income producing assets that produce $2,500 of monthly income to her. This means she only needs $1,500 in earned income to meet her monthly expenses.
Now imagine if Lilian had income-producing assets that generated $4,100 in monthly income. She has zero need to earn income at this point because the income produced by her assets exceeds her monthly liabilities.
Practical Application of Asset Liability Matching for Retirement Income Planning
If financial planning tied into retirement income planning focused on projected retirement liabilities and the capital required to generate the income needed to meet those liabilities everyone would be better off.
It's a bit of a task to sit down and speculate what your expenses will be in retirement–I'm not trying to oversimplify or understate the effort required here. However, once completed the need to redo the entire figure is unlikely so long as your regularly monitor your lifestyle and expenses and update as appropriate.
Once you know what your retirement liabilities are likely to be, you can both map out a plan to save money to accumulate capital needed to acquire the assets needed to generate the income to meet these liabilities.
The specific income producing assets depend on individual circumstances, but will usually look something like bonds (not bond funds), annuities, real-estate, CD's, and (maybe) life insurance (using life insurance in this instance would require a much longer-term execution than all of the other options).
This approach builds a much more solid foundation for retirement income than simply withdrawing 4% of your assets. It also lends to much greater peace of mind because income producing assets aren't generally subject to loads of fluctuation when markets behave badly–unless you prescribe to a level of thinking that suggests stock dividends or bond funds are income producing assets…bad idea.
Caution: Be Detailed and don't be Discouraged
It's important not to spit-ball the income figures too much. Don't make wild generalizations about your expenses, look them up and have built in a contingency for increases. Don't assume much in the way of decreased expenses in retirement without thinking long and hard about how realistic those decreases are (are you really going to drive the car less or eat out fewer times a week in retirement?).
You might find that you have little hope of completely matching income assets to your retirement liabilities and serious changes might be necessary. Don't give up just because this happens. Implementing a plan that will likely only cover a portion of retirement liabilities puts you in a much better place than you think.
More often then not, if you actively engage a problem instead of running away from it, you'll find a way to deal with it.