Timely Tale

Jonathan Clements  |  December 2, 2017

IMAGINE AN IDEALIZED CHART that summarizes our finances over the course of our lives. What would the chart look like? Picture these five lines:

  1. Our nest egg grows, slowly at first and then ever faster, hitting a peak of around 12 times our final salary when we retire.
  2. Our portfolio in our 20s stands at perhaps 90% or even 100% stocks. We dial down our allocation in the years that follow, especially during our final decade in the workforce, so upon retirement we have maybe 50% or 60% in stocks.
  3. Our debts spike in our 20s and early 30s, as we take on student loans, car loans and a mortgage. But the sum borrowed dwindles from there, allowing us to retire debt-free. At that point, we have clear title to a valuable asset: our home.
  4. Our insurance costs rise sharply through our 20s and 30s as we buy cars, purchase homes and have children. That necessitates auto, homeowner’s and life insurance, in addition to the disability and health coverage we should already have. But thereafter, the premiums we pay diminish, as our growing wealth allows us to raise the deductibles on our home, health and auto insurance, and possibly drop our life and disability coverage. By the time we retire, we might have just high-deductible auto and home coverage, plus perhaps umbrella-liability insurance, a Medigap policy and long-term-care coverage.
  5. Our human capital—a fancy term for our income-earning ability—is at its peak value when we enter the workforce and pull in the first of 40 years’ worth of paychecks. But its value fades over time and eventually goes to zero when we quit the workforce and stop earning money.

While I listed human capital last, it’s arguably the thread that connects everything else: It provides the income to service our debts and fund retirement accounts, while freeing us up to invest heavily in stocks. But as our stream of paychecks peters out, and we approach the day when we’ll live off savings, we can’t afford to invest so aggressively or carry so much debt.

Should everybody’s financial lives follow the five trajectories outlined above? Not necessarily. You might chart a somewhat different course, depending on your personal situation.

Save 12 times income. What’s the rationale behind this number? Suppose you make $100,000 a year. If your nest egg upon retirement is equal to 12 times that income, or $1.2 million, you could reasonably withdraw $48,000 in the first year of retirement, assuming a 4% portfolio withdrawal rate. That $48,000 would replicate almost half your final salary. Add Social Security benefits, assume all debt is paid off and you’d likely be set for a comfortable retirement.

This presumes Social Security replaces 20% or so of your final salary. But for those on lower incomes, the percentage is often significantly higher. The upshot: Instead of aiming for 12 times income, you might be able to retire comfortably with savings equal to, say, eight times income. At that level, a 4% withdrawal rate would replicate 32% of your final salary. If Social Security replaces another 30% or more, you would likely be in good shape.

This is not to suggest that eight times income is an easy goal. Most retirees don’t have anything close to that amount. The National Institute on Retirement Security calculates that 60% of all households headed by someone age 55 to 64 have a net worth equal to less than four times income—with almost 26% of all households at less than one times income. Moreover, the measure of net worth used includes home equity, which can only ever be a partial source of retirement income and only if we’re willing to trade down to a smaller home or take out a reverse mortgage.

Buy bonds as we age. While almost everybody should earmark more for bonds as they grow older, the precise allocation will vary depending not only on personal appetite for risk, but also on each investor’s individual circumstances. What circumstances? At issue are the bond lookalikes in the rest of our financial lives.

“Even if we retire from the workforce, we shouldn’t ever retire from the pursuit of a fulfilling life.”

For instance, our paychecks can be viewed as similar to collecting interest from a bond, which then frees us up to invest heavily in stocks. But some workers’ paychecks aren’t so bond-like—think of folks who work on commission or have poor job security—and they should probably compensate by investing their portfolios more conservatively.

Meanwhile, for others, their holdings of bond lookalikes might go way beyond their paycheck. Let’s say you expect to receive not just Social Security retirement benefits, but also a traditional employer pension. With that handsome stream of reliable income to fall back on, you might keep a high percentage in stocks, even after you retire. What are these income streams worth? You can find out by checking what it would cost to buy income annuities that pay comparable amounts of income.

Retire debt-free. As you’ll have gathered, there’s no firm rule on how much folks need for a comfortable retirement or how much they should allocate to stocks. Debt is different: It rarely makes sense to carry loans into retirement.

Why not? At that juncture, most folks will have substantial sums allocated to bonds and other conservative investments—and the after-tax interest earned on these investments will almost always be less than the after-tax interest charged by their debts. The smart move: Instead of buying bonds, get rid of all debt.

Moreover, by paying off debt before leaving the workforce, we reduce the amount of income we need to generate each year to cover our retirement living expenses. That lower taxable income can, in turn, result in lower Medicare premiums and lower taxes on our Social Security benefit.

And let’s not forget the biggest benefit of all: Paying off all debt, especially mortgage debt, can sharply reduce our cost of living, making retirement more affordable. One rule of thumb says that we can retire comfortably on 80% of our final salary because, at that point, we no longer have to pay Social Security and Medicare payroll taxes and, of course, we no longer have to save for retirement.

Shedding all debt can further slash our retirement income needs, to maybe 60% of final salary. Indeed, for many folks, sending off that final mortgage check is the signal that retirement is finally affordable.

Trim insurance over time. As our wealth grows, we can shoulder more financial risk—and hence there’s less need for insurance. Suppose you have $1 million or more socked away. You likely need little or no life, disability and long-term-care coverage, and you can also cut your premium costs by raising the deductibles on your health, auto and homeowner’s policies.

But not everybody can take so much risk. If you have less than $1 million saved, the financial perils of suffering a disability or needing long-term care will loom large and you’ll need to continue carrying substantial insurance, even into retirement. In fact, retirement could involve not only hefty premiums for long-term-care and Medigap insurance, but also significant out-of-pocket medical costs.

Call it quits. Even if we retire from the workforce, we shouldn’t ever retire from the pursuit of a fulfilling life. After four decades at the beck and call of others, retirement is our chance to take up activities that we’re passionate about and consider important. These activities may bring a newfound sense of purpose to our final decades.

But don’t rule out getting that sense of purpose from work itself. Once retired, if we can find enjoyable paid employment that takes up maybe a day or two each week, we won’t just make our retirement more fulfilling. We’ll also continue to wring some income out of our human capital—and that extra income could make our retirement far less financially stressful.

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