Get With The Plan: August 5, 2012

Michael, 53, and Hope, 44, want to make some big changes in three years. They hope to pay off their primary home by then, purchase a vacation home and then Michael would like to leave his job and sort of retire.

“I’ll work part-time in a less stressful environment,” he said. “We also have four years of college expenses at $52,000 per year starting in September 2012, one more year of Rutgers tuition at $25,000 and then college for our 8-year-old.”

None of the couple’s assets is specifically earmarked for college.

Michael and Hope, whose names have been changed, have saved $90,800 in 401(k) plans, $365,400 in IRAs, $869,800 in mutual funds, $288,900 in Certificates of Deposit, $105,300 in savings and $21,500 in checking.

The Star-Ledger asked Jeffrey Boyer, a certified financial planner with RegentAtlantic Capital in Morristown, to help the couple scope out the best way to reach their goals.

Boyer made some assumptions in order to look at the couple’s future finances. He assumed that the current mortgage would be paid off in three years, and that the couple’s post-retirement income from part-time work would be $75,000 a year. He also assumed they’d cover the cost of college for their three children, and when they buy a second home, they’d put down $200,000 and take a 15-year mortgage of $300,000. And in 2032, he assumed the couple would sell their current home for $650,000 in today’s dollars.

He also assumed their base living expenses would be $80,000 a year and rise 3 percent a year for inflation. They don’t include expenses such as college costs, mortgages and income taxes.

“The results of this scenario are highly contingent on the risk and return profile the couple is willing to accept with their portfolio,” Boyer says. “Assuming a current portfolio that is allocated to 40 percent equity and 60 percent fixed income, we project an 81 percent probability that they will not deplete their assets by the time Hope reaches age 92.

Boyer says reducing the portfolio’s exposure to equities by 10 percent would result in the probability of success dropping to 63 percent.

“In order to achieve a successful analysis with this reduced risk tolerance, we would need to assume that they would retire two years later in 2014,” he says. “Alternatively, a portfolio with a greater exposure to equities will yield higher probability results.”

That means the couple’s investment choices will have a great impact on their success level over the long term.

Boyer says today, their portfolio isn’t a diversified one. The majority of their investment assets are allocated in two asset classes: American large cap stocks and government bonds. Plus, a significant portion of the portfolio is in cash.

“Cash, in large sums, should not be viewed as a long-term investment,” he says. “As part of a long-term portfolio, cash is a sure way to lock in a very low rate of return and to lose purchasing power to inflation.”

Boyer says the same could be said for investing in short-term government bonds, where rates are near all-time low yields. There is a risk that these investments return negative real yields while failing to keep up with inflation as well.

Accumulating cash savings would be appropriate to set aside an emergency fund or to establish a reserve for a known near-term expenditure.

They also have a substantial stake in Ginnie Mae’s, also called GNMAs, which are mortgage-backed securities. Boyer says these have historically been good for conservative bond investors.

“They typically provide higher returns than Treasuries due to lower liquidity on the underlying assets, but are explicitly government-backed, thus not posing a large credit risk,” he says. “The problem, however, is extension risk. When interest rates rise, the underlying mortgages are paid back more slowly — people are less likely to refinance — so duration increases precisely when you do not want it to.”

He says investors do not benefit much from falling rates because pre-payments spike because of refinancings and the bond is paid back more quickly, again, precisely when you do not want it to.

“GNMAs are great in a stable rate environment,” he says. “We are not likely to get that.”

Their portfolio may need a greater allocation to equities, or growth assets, in order for the assets to sustain their current lifestyle, Boyer says.

When Michael leaves his job, he needs to re-evaluate his life insurance coverage. Today he has $2 million of term insurance, which is enough, but half of that is provided through his employer. An updated life insurance needs analysis and would be prudent at that time, Boyer says.

The couple recently updated their estate planning documents, which Boyer applauds, and he recommends they remember to periodically review their plan as their life circumstances change and as we gain more clarity on the future of estate tax law.

“The key takeaway from this analysis is that Michael and Hope need to maintain a reasonable exposure to growth investments in their portfolio to achieve the goals they have planned,” Boyer says.