Understanding Retirement Planning
08/15/2003 12:00 am EST
Mary Farrell, chief investment strategist for UBS Wealth Management USA, has over three decades of experience as an analyst. A frequent guest of Louis Rukeyser's and a noted author, she was named the 2000 "Woman of the Year" by the Financial Women's Association. Here, she turns her knowledge toward retirement planning.
"We’ve done a tremendous amount of research on people’s preparedness for retirement and in many cases we’ve been unpleasantly surprised at the lack of planning. One of the problems of the bull market of the 1990s was that it really shifted the focus of investing towards stocks as a way to reach your financial goals. Over that period, investing became like a national sport and not what it should be–which is achieving financial goals. Given the big gap between assets put away for retirement and assets needed for retirement, we decided to focus on the issue of retirement planning.
"One fact going forward is that we are living longer. Today if you make it to 65, your life expectancy is still another 20 to 25 years. So people find they have to support themselves for much longer than they had traditionally planned. Socially Security was enacted in 1935 and retirement was pegged at age 65. But at that time, life expectancy was 62 and it was expected that few people would actually live to collect many Social Security checks. Also, back then, many more people did physical labor and were unable to work much longer in their lives. As a result, 65 as an age for retirement is now very arbitrary.
"Another tradition that has to go by the wayside is the traditional investment strategy and asset allocation, which historically said that when you retired at age 65, you should have 65% of your assets in bonds, with this figure getting more conservative as one gets older. But in today’s environment with interest rates so low, it is difficult for one to use bonds to plan a retirement that will last so long. Again, that may have been appropriate in the 1950s, but today many investors will find they need to build some growth into their retirement planning.
"Remember in the early 1980s when you could get a 13%, 30-year bond? Those days are over. There are some strategies such as using junk bonds, which can get you that kind of yield, but when you are talking retirement money that is likely to be too risky. When you look at your asset allocation during retirement you have to take into consideration that short-term rates are very unappealing now and even 10-year to 30-year bonds are yielding only 2 ½%. And those are fully taxed, so on an after tax basis, that is not a particularly good place for your money. So you have to rethink this through to understanding your own risk tolerance and what your are comfortable with, as well as the total assets you have for retirement. If you have excess assets you can take on some extra risk. But if you can’t afford to lose your retirement funds you need to consider a more conservative approach. But this is really the time to sit down a rethink these factors because every retiree's nightmare is outliving their assets.
"When it comes to retirement planning, sooner is better than later. Later is better than never. It would be much easier today if we better understood the power of compounding back in our youths. We calculated that if you started at the age of 21 and just took the cost of a café latte and put it in the bank seven days a week, you would accumulate hundreds of thousands of dollars by the time you were 65. Clearly, the earlier you start to take advantage of that, the better.
"Our market view at UBS is essentially that we are returning to more normal markets–and more normal returns have been 7% to 10% a year. Yes, sometimes the market will go down, but on average we should see a gain of 7% to 10% a year. Very significant about that–and given the low interest rate environment we are in today–we think this estimate is a very good real return. Historically, we’ve averaged about 2% in inflation and it is important to understand how devastating inflation can be to a retirement portfolio.
"If you in had invested $1,000 in stocks in 1925, at the end of 1992, you would have almost $2.6 million. That sounds impressive, but on an after tax basis, that shrunk to $256,000. But that looks really good compared to bonds. The same $1,000 investment in bonds would have grown to $49,000–but adjusted for inflation would be worth only $5,000. Milton Friedman called inflation the one form of taxation that can be imposed without legislation. So 2% inflation does not sound that bad, but even at that level is does erode the value of your funds quite significantly.
"As for Social Security, back in 1945, there were 42 workers for every retiree. By 1960, there were just five workers. By 1995, four workers. And it is estimated that as of 2020 it will be only 2.4 workers. Some of the calculations are that they would have to turn over some 70% of their paychecks to support these aging baby boomers. Clearly, that is very problematic. The government is not going to take Social Security away, but I think people better envision that as a shrinking part of their retirement income.
"The next major change–which is a rather devastating one–is the shift from pensions to 401Ks, which is a very nasty way of shifting responsibility to the individual and removing a basic security in retirement. Only 22% of those in the workforce now have pensions and those people are very lucky–they will be guaranteed their check every month. For the rest, we are guaranteed nothing. Much of our retirements depends on the choices we make in our 401K–and in general people have been very poorly educated about these investments. I remember in school they had home economics for the girls and shop for the boys. I really wish they would have managing your finances for everyone so that people can develop the right mindset. Statistically, your 401K will be the most significant part your retirement portfolio for most people, with Social Security becoming a much less important component.
"The savings rate today is pretty dismal. Just 12 years ago, people saved about 6% to 8% of their disposable income. Now it’s about 1%. In addition, we also now have a much higher debt rate. So this certainly suggests that people are not socking away savings that they were going to have for retirement. In fact, some 20% of people who do have 401Ks at work do not take advantage of it, and that is like throwing money away.
"Develop a savings strategy. Savings must be a part of any strategy. The sooner you look at a retirement budget, the sooner you can figure out gaps will need to be filled. And educate your kids. The best thing you can do for children and grandchildren is to get them to understand the importance of saving and the power of compounding. Probably the question I have been asked the most in the past few years, is how can I get more income? I think retirees are safe in not worrying too much about inflation. But the downside of that is that it’s unlikely you will see higher income yields. Meanwhile, the average age of widows is 56, so it's important for women to take a very full and active role in any of their financial planning because statistically, there is the likelihood that you will be handling things on your own. It’s worth being prepared rather than being naïve.
"To summarize, planning to achieve the result that you want, really sitting down and making a plan to achieve those goals and doing it in the context of proper time frames, and risk tolerance. We will see bear markets and they can get painful. One of Louis Rukeyser’s quotes is that betting against the United States has not been a good bet since 1776 and I feel the same way about the stock market. We may be going through a slow environment right now, but what we are now seeing is a recovery, an improvement in corporate earnings, and the market’s current valuation levels look reasonable to us. Common stocks have historically been the major protection against inflation and have delivered the best returns of any financial asset. Believe they belong in most retirement portfolios. Even though they do up the level of risk, proper diversification and asset allocation bring these risks down to much more manageable levels."