“There’s no harm in hoping for the best as long as you’re prepared for the worst.”
I love this quote in general, and especially as it relates to financial planning. If you look at the last 13 years since the “Great Recession,” we have had one recession which of course was caused by Covid-19. I think most would agree that 2008-2009 was a much deeper recession caused by problems in the financial markets. This recession, obviously spearheaded by a global pandemic, was unprecedented and hopefully something we don’t see for a very long time. GDP, or Gross Domestic Product, is often a measuring stick for how bad a recession really was. We know in 2008-2009, GDP declined 5.1%. During the Great Depression GDP declined 26.7%! The two recessions following the Great Depression (one in 1937 and one during WW2), GDP declined 18.2% and 12.7% respectively.
For the COVID-19 Recession, GDP from peak to trough has estimated to have dropped about 3.4%.
The takeaway here is that we have seen some very bad recessions in our lifetime, and nobody can predict what the next catalyst will be. However, as a Financial Planner, it pains me to see people preparing for retirement as if things will be “normal” or static throughout their life expectancy. As modern medicine has progressed significantly, evidenced by how lightning fast a vaccine was produced for COVID-19, combined with people being more conscious of what they eat and the lifestyle they live, people are living longer. Of course, genetics play a role in this. My wife’s late-grandmother, Nell, lived to be 98 years old. When I asked her what her secret was, she told me it was Jack Daniels. Nonetheless, if you think about retiring at let’s say, Age 65, and living until 98, that is a 33 year retirement! That is roughly 8 election cycles, which means the economic landscape is guaranteed to change many times during retirement.
The big question people ask me is, “How do I sustain my lifestyle without running the risk of outliving my money?”
Well, the answer is easy if you know exactly how long you will live, and exactly what returns you will expect on your investment portfolio. The reality is, nobody knows the answer to those questions. Out of all of the talking heads on TV or other media outlets, the majority of these stock market predictions are dead wrong! They aren’t paid to be right, so no fault to them. They are paid to entertain (remember this the next time you here something on TV that seems overly exaggerated).
With that being said, I like to draw a parallel with financial planning and medicine. Doctors don’t know how healthy your heart truly is unless they put it under some stress. Hence the term, Stress Test.
With Financial Planning, we won’t know how healthy your Retirement Plan looks without running it through it’s own Stress Tests!
Here are the four stress tests I like to run to see how healthy a client’s portfolio and Retirement plan truly are:
- “Great Recession Loss”
- Long-term Care Costs
- Prolonged Low Returns
- Living Longer Than Expected
Others I may consider, depending on the situation my client is in, are; high inflation, Social Security cuts, or cuts to their pension.
Before I go into detail on each of the four stress tests, I want to emphasize how important it is to work with an objective party to set goals. It may seem elementary, but I am a big believer in goal-setting. There are countless books and research papers out there on the importance of not only setting goals, but also writing them down and tracking them. I am lucky enough to have a job where I can take people off the figurative treadmill of life, and get them to think about what is important for them and their families. This is significant for two reasons.
- It allows us to prioritize what goals are most important. Therefore, when we go through uncertain times and a sacrifice has to be made, we know which goals are “needs,” and which goals are “wants” or “wishes.”
- Secondly, we have a much greater likelihood of weathering a storm if we know how that hypothetical storm might impact the actual goals. Another way to put it, we can remove the emotion from the decision making and focus on the data.
GREAT RECESSION LOSS
Let’s hope we do not experience a “Great Recession Loss,” but it’s highly probable that one will live through several bear markets during their investing lifetime. In fact, since 1945, the US has averaged one bear market (quantified as a 20% drop in the stock market from a previous high) roughly every 5 years. If you have a 30 year retirement window, that means you will be lucky enough to live through 6 of them! The issue of timing and how severe each bear market is will be the unknown factors. Nonetheless, running a simulation of a “GREAT RECESSION-like” bear market is prudent to see how it will impact a client’s retirement goals.
This is also where prioritizing those goals into “needs,” “wants,” and “wishes,” comes into play. For a fair number of people, if we stress their portfolio and retirement plan with a Great Recession-like scenario, they will likely have to make some sacrifices. Therefore, the up front planning is a hugely important for me as a practitioner in delivering the results of this stress test.
This is also where having non-correlated assets to stocks is paramount. I saw an article the other day from a major publication that said “Bonds are Terrible Investments.” Maybe I’m nerdy, but my blood boiled. But then again, I realized they are paid to entertain (aka scare people) and have people click on their article (which I did). It stated that the prolonged low interest rate environment has made bonds irrelevant and that stocks should be the only investment to use for income.
The last time I checked, bonds returned 5.24% in 2008 and 7.51% in 2020 (the last two recessions). Yes, the coupons on bonds are way down, but the beauty of bonds are that they are negatively correlated to stocks. Therefore, my clients that are drawing income from their portfolio in retirement can leave their stocks alone during bear markets if they have bonds! The key here is to make sure you have enough in fixed income/cash alternatives to weather a significant storm. If we want to use 2007-2009 as the benchmark, it took 49 months to fully recover stock prices from the 2007 highs. Therefore, we would want four years of income needs in fixed income or cash to prevent from the dreaded “selling stocks low” move that we all try to avoid.
- Stress test retirement plan with a major bear market scenario.
- Make sure you can at least cover your necessities in retirement during those down turns.
- Protect your long term growth investments (stocks) with four years of your retirement income needs in fixed income investments or other alternatives to stocks.
Long-term Care Costs
Every year since I’ve been in the business, I would say the % of individuals that might need some sort of long-term care in retirement has gone up. Currently, someone turning 65 today has almost a 70% chance of needing some type of long term care services in their lifetime. Furthermore, 20% of those age 65 or older will need care longer than 5 years. That is staggering! For those who need care, women average 3.7 years of care and men average 2.2 years of care.
As a financial planning practitioner, this puts me in a situation where I have to plan assuming everyone I talk to will need some sort of care. However, the unknowns of the extensiveness of said care makes planning complicated. Of course, I can dive deep into some family history or current medical conditions. Cognitive declines leading to dementia could be linked to family history, but who am I to say? Again, I hope for the best, but plan for the worst. And if my client(s) needs long term care help, we need to find a way to pay for it.
Just a quick aside, Medicare does NOT pay for long-term care. Medicaid does, but 100% of the people I talk to will not qualify for Medicaid. And likely, if you are reading, the chances are you won’t either unless you plan to give all of your money away before needing the actual care.
So, how do we plan given all of the unknowns? Well, I see the best route to take is to use averages. I take an average of 3.7 years for women and 2.2 years for men. I then multiply those years by the average cost of long-term care, which varies significantly depending on how you would receive that care. The most expensive route is a private room nursing home facility. These average $105,850/year. It makes sense because likely you are needing close to around the clock care by professionals. For those receiving in-home care, they may have other family members helping them, and therefore this averages out to $54,912/year. Assisted living averages $51,600/year.
So, I will use the high end of $105,850/year over the number of years we just mentioned. This comes out to $232,870 for men, and $391,645 for women. I will typically stress test in the future around the age of 80 to 85 depending on certain factors. We will have a pretty good idea of how the plan shakes out, not just for them but their loved ones. I just said love ones on purpose. If my client has family, the number one quote I always hear is, “I don’t want to be a burden on them.” Well, one way to guarantee being a burden is by failing to make a plan for this fairly probable event.
Okay, let’s move away from the depressing facts and figures and talk about the solutions.
If the plan goes through that stress test successfully, than great! If not, we need to find a solution.
For those unsuccessful stress tests, one solution to pretty much guarantee a higher probability of success is purchasing Long-term Care insurance. One quick aside, I do not sell Insurance Products and I am 100% agnostic on if my client decides to buy one. However, given my background I do consider myself to have a high level of expertise on this specific topic and will absolutely advise them on certain policies they are reviewing (or have purchased already). One nice thing about purchasing insurance is that you don’t have to “go all in.” In other words, you can hedge your bets with some insurance, and self insure (use your own assets) with the rest. Another solution is to change your goals! Spending less, working a little bit longer, downsizing your home, or even spending some of the kids inheritance (oh well). These are issues a good financial planner can help you make decisions on based on how well funded your plan is.
For those successful stress tests, you have a couple of decisions. First, you can decide to use your own assets to pay for care (self-insure). Alternatively, you can buy insurance to protect your assets! Another beautiful thing about Long-term Care Insurance is the benefits are tax free. The 401ks or IRAs on your balance sheet will be fully taxable when you make withdrawals (unless they are ROTH accounts). Other investments you may have will also be taxable at the applicable rates upon liquidating those investments. This is a big reason many wealthy individuals (think Warren Buffet) have Long-term Care insurance. They understand that by leveraging a small fraction of their net worth to pay insurance is worth keeping their assets and letting those assets work for them and future generations. This is a big part of the decision for those clients that do want to leave a financial legacy for their family. If you think about the expense we mentioned above ($232k-$391k), these are in today’s dollars. The rate of inflation for long term care costs have far out paced normal inflation indices, so that can easily amount to $500k-$700k by the the time you reach 80/85 years of age. Paying $500k out of a Traditional IRA plan would really “cost” you $700k-$800k after you pay the taxes. This is why that leverage is so important to consider.
The decision on buying insurance or not to buy insurance has to be a decision for every individual approaching retirement or already retired. We have to live with the reality that expenses for healthcare will go up towards the end of life and failing to make the decision, from my experience, makes all of the difference in how that individual is remembered. I completely understand not everyone wants to talk about this, which is why it’s my job to bring it up and make sure there is a plan for each client I work with! I will touch on two additional thoughts around Long Term Care planning in the final section of this post regarding the risk of Living Longer than expected.
- See if your Retirement Needs, Wants and Wishes hold up if you, your spouse, or both of you need some sort of Long-term Care.
- Make a decision on how you will pay for this care:
- Self Insure
- Buy Insurance
- Or a hybrid model
- Once the decision is made, make sure your Powers of Attorney(s) know the plan (both Medical and Financial Powers of Attorney)!
Prolonged Low Returns
Prolonged low returns, of course, are a significant risk in Retirement. There had never been a period of 10 consecutive years where the stock market was NOT positive from beginning to end, up until the Great Recession in 2008. If you think about the timing of someone who retired in 1998, they went through 2 significant bear markets and recessions in a period of 10 years. If you think about the landscape we are in where quantitative easing and bailouts have buoyed stocks through the last two recessions, and how perfectly priced stocks are in the US, this leads to some questions on how stocks might perform over the next 10+ years. I am not here to make stock market predictions, that’s what the entertainers are for on TV, but I am here to say that a prolonged period of slightly lower returns than we might normally expect is entirely possible. I once saw a projection of a Retirement Plan done by another professional that stated the assumed rate of return in the plan was 8%/year. I was blown away, especially because that client was not particularly prone to taking on significant risk. The results of this analysis, no surprise to me, painted a picture of utopia. The reality is, we don’t know what returns will be throughout an expected retirement period. Therefore, you guessed it, we shall stress test several scenarios. I am all for using Monte Carlo simulations, and on top of this stress testing even lower than those hypothetical returns. This all goes back to giving my clients peace of mind that they can still enjoy life even if the stock market isn’t hitting home runs every year! The best part about doing what I do is hearing clients tell me they are sleeping better at night knowing they are on the right track.
Living Longer Than Expected
Living longer than expected is a tricky one. Nobody has a crystal ball. I’ve seen clients plan to live a long time and get an unexpected diagnosis. I have also seen the opposite where one lives way longer than anticipated. Of course, genetics plays a key role, but as a financial planner, I have to assume this is a risk for anyone. One statistic that jumped out to me when researching life expectancy, was that a 60 year old Female (non smoker) has a 30% chance to live until 94, a 20% chance until 96 and a 10% chance to live until 100! A 60 year old male (non smoker) has a 30% chance to live until 92, 20% chance until 94 and a 10% chance until 100. Women living longer than men is statistically evident, so that also plays into how I go about financial planning, specifically with buying Long-term Care or Life Insurance. If the female is going to outlive the male, and cost of Long-term Care Insurance premiums are a concern, I will often advocate the female spouse buy the Long-term Care Insurance. This way, if the wife outlives the husband, she is able to get professional care paid for (or at least partially) without having to depend on children or grandchildren. Another way to attack this is to have the husband own a Life Insurance policy (ideally a permanent policy), to add an additional cash reserve upon their passing. IF he dies first, he will provide an infusion of cash into the portfolio from the Death Benefit, which can then be used by the spouse for Long-term Care expenses.
What about income for life?
The most common source of guaranteed income is Social Security. It comprises of roughly 40% of all income received by individuals aged 65 and older! In a recent report, it showed that Social Security represents approximately 20% of the entire federal budget! These numbers will continue to grow as people live longer than Social Security planned on. It’s estimated by 2041, there will be a deficit in funding Social Security (unless of courses additional taxes are levied, which is likely). While many people aged 62+ that are close to, or already, receiving Social Security benefits are not as concerned with this, I talk to plenty of people that are. With Pensions going by the wayside, many people are relying on their Investment Portfolios to provide the majority of their Retirement Income. Additionally, those who expect to live 20, 30 or even 40 years during retirement have concerns with relying on an asset that is NOT guaranteed. The result often times has people rushing to buy Annuities for income in retirement. These are brilliantly packaged by the Insurance companies and sold with a nice pretty bow around the box. The issue is these products are extremely complex and not understood by the individuals buying them (and sometimes not even the agents selling them!). This is one of many reasons I always recommend folks talk to a Fee Only Financial Planner, like our firm, when making big decisions such as buying an Annuity. Additionally, interest rates have been historically low for over a decade. This has put substantial pressure on these insurance companies to redesign their annuity contracts to stay competitive. It’s also hurt their ability to maintain a healthy reserve given they are earning a much lower return on their own general portfolios than expected.
Let me take a step back. Annuities have many benefits. These include providing a guaranteed income that you can never outlive, protection from market dips while even providing some upside, and can also be a very tax efficient asset to accumulate wealth outside of retirement plans. However, just like with any financial product, there are downsides and limitations.
I look at the primary benefit of an Annuity, which is providing a guaranteed income stream in retirement, as the primary driver on whether I recommend this to a client or not. If they have the majority of their expenses in retirement covered by guaranteed income such as Social Security and a Pension, I may not lean towards an Annuity. However, let’s say they have only Social Security and Investments (which is becoming more common). Let’s say they also have longevity in the family and/or will potentially lose sleep over big stock market swings. In this case, an Annuity can provide some peace of mind to those individuals that this paycheck won’t fluctuate with the market swings and it will never turn off as long as they are living. As I craft the financial plan for a client, and we stress test longevity, we will find out what the rate of withdrawal will be on the portfolio. If it not a “safe withdrawal rate,” an Annuity can also help alleviate some of this risk.
Let me also say that NOT using an annuity, and using a disciplined withdrawal strategy on your Investment Portfolio, is completely acceptable. The key word here is “disciplined.” Out of all of the mistakes individuals make that manage their own portfolio, I would say drawing down income in Retirement is probably #1 or #2 on the list. Our firm takes the Endowment Model approach, which will naturally create a systematic way to withdrawal the right funds during the right times. If this is done properly over the duration of a retirement period, we can reasonably expect to achieve the withdrawal rate necessary to make the plan work.
- Married couples should consider the risk of the female outliving the male, and think about how to construct their insurance policies to alleviate this risk.
- Social Security could run into issues if changes aren’t made, and thinking about other sources of guaranteed income is prudent.
- Annuities are a great source of guaranteed income, but there are drawbacks and costs associated with them. Consult with a Fee Only Financial Planner, such as our firm, to see if it makes sense.
- Annuities are not necessary for everyone, and a lifetime income can be achieved with a disciplined withdrawal strategy on a well diversified investment portfolio.
I hope everyone enjoyed reading and found some valuable information. If you have questions or would like help stress testing your retirement plan, you can access my calendar directly here to book an initial consultation.
You can also email me directly at firstname.lastname@example.org
Until next time, thanks for reading.