Wednesday, September 21, 2011

Conventional wisdom has been to increase exposure to fixed income instruments such as bonds and certificates of deposit. The rationale for this has been the need to generate a reliable source of retirement income. In retirement, reliability of income is more important than potential capital appreciation. Furthermore, at this stage of one's life, one has fewer years available to recover from any portfolio losses. To put it another way, the closer one is to needing money, the safer one's investments must be. Current income becomes more important than future gains. However, in order to guard against inflation, a portion of the assets of even those in retirement should be placed in assets classes that have the potential to at least offset the diminished purchasing power of the dollar.

The question that each of us has is how much income do I need in retirement? Recognizing that everybody's circumstances are different, a good place to start is to assume that your retirement income needs will be the same as in your preretirement. While some expenses such as commuting to work will no longer be incurred, others such as healthcare will increase as we age. For purposes of illustration a convenient number to use is $50,000 per year which is the statistical middle of household income in 2010 according to the Census Bureau.

When five year Treasury Notes yielded over five percent, which they did from 1928 to 2005, the notion of increased exposure to fixed income made sense. A retiree needing his/her preretirement income of $50,000 per year would have needed retirement assets of $1,000,000 in order to rely solely on the income produce by his/her portfolio. Currently, these five year instruments are yielding less than one percent. This means that in order to generate that same amount of annual income, one would need retirement assets of $5,000,000. Considering that households headed by someone between fifty five and sixty four years had a net worth of $110,999, for all but the most fortunate among us this is not an assumption upon which to plan for one's retirement. If this article does nothing else it should serve as a wakeup call to get realistic about one's retirement needs and to act now in preparing for retirement. The younger one is, having more time to reach one's retirement goals the less one will have to set aside each year.

Using the target of twenty five times one's last year of preretirement income as detailed in "A Common Sense Road Map to Uncommon Wealth", one would need $1,250,000 in financial assets which would produce a risk free return of 1 percent, would or $12,500. In order to compensate for this shortfall, one would have to withdraw $37,500 ($50,000 required income less interest income of $12,500). The next year, the financial assets of $1,125,000 (original balance of $1,250,000 less withdrawal of $37,500) would produce interest income of $11,250 which would require withdrawing $37,500 to achieve the required annual income of $50,000. Under this scenario of earning one percent a year and compensating for the income shortfall by withdrawing the balance from one's financial assets, the assets could last as long as thirty years. However, one must take into consideration the impact of inflation which is a reduction in the purchasing power of the dollar. According to the U.S. Bureau of Labor Statistics, the Consumer Price Index for All Urban Consumers (CPI-U) for the twelve months ending in August 2011 was 3.8 percent, a number that is consistent with the average inflation rate from 1928 to 2005 which was 3.8 percent. This means that each year one would need 3.8 percent more money to compensate for the loss of purchasing power. Instead of an annual rate of return of 1.0 percent one would have a negative annual return of 2.8 percent (annual interest of 1.0 percent less annual inflation of 3.8 percent).

With risk free rates of return of 1.0 percent, one should consider other investments that can produce higher returns. For most of us this means having a more significant portion of our financial assets in equities. However, this search for income must take should take into consideration the risks involved. The higher the rate of return, the greater the potential risks. One must factor in the return of investment as well as the returns on investment. Receiving annual returns of say 5 percent for five years and losing one's principal is something investors, especially those in or approaching retirement age, cannot absorb. Each of us has to balance potential risks against potential rewards in making any investment decision. It is the investor, not the investment advisor, that ultimately must live with the outcome.

About the Author

Experienced as a registered representative, an individual investor and a management consultant to Fortune 500 companies, Marvin Doniger has developed his perspectives on the economy from a lifetime of smart investments. He has taught undergraduate and graduate level courses in finance, information technology, and production management. His books include A Common Sense Road Map to Uncommon Wealth, a Common Sense Approach to Successful Investing and Common Sense Prescriptions for Financial Health. He is also a regular guest on the Business Talk Radio Network and other radio shows. His articles have been published in media outlets such as Investor's Digest of Canada and Morningstar.

Marvin H. Doniger

Doniger Associates

Laguna Niguel, CA

949-661-5456