Get With The Plan: May 20, 2012

Frank and Sue are halfway there. Frank, 64, is already retired and collecting a pension, and Sue, 59, wants to retire at age 62.

“We want to know if we can enjoy our retirement without concerns of outliving our savings,” Sue says. “We would also like to help our two children by giving them a sizable down payment for a home when they are ready to move.”

The couple, whose names have been changed, have saved $850,400 in 401(k) plans, $130,700 in IRAs, $325,000 in savings bonds, $125,000 in a money market and $80,000 in checking. Frank receives a pension, and the couple earns money from a rental property they co-own with Sue’s sibling.

The Star-Ledger asked Brian Power, a certified financial planner with Gateway Advisory in Westfield, to help Frank and Sue see if they’re ready for full retirement.

“For my analysis, I used a very modest after-tax retirement lifestyle of $50,000 per year increasing every year for inflation, based on the budget Sue worked up,” Power says, noting the couple has a very strong cash flow in retirement.

Frank’s pension is $45,600 per year, and it provides a 100 percent survivor payout. They expect Frank will receive $1,300 a month from Social Security, and Sue, $1,200 a month. They also have rental income from their co-owned property.

Their before-tax retirement income of $83,600 should more than meet their after-tax lifestyle of $50,000, Power says.

Instead of assuming a constant rate of return on their assets, Power used a Monte Carlo simulation to evaluate the outcome of their portfolio over time with different stock market scenarios.

“By varying the rates of return and inflation to simulate the fluctuations that can be experienced in the marketplace, a more accurate reflection of the real-life ups and downs of the investment environment is presented,” Power says.

In order to create a Monte Carlo simulation model, historical performance of the securities market must be analyzed, he says. The analysis does not use historical data for any specific securities, but instead uses historical data for broad asset classes such as “small-cap equities,” “long-term bonds” and the like.

“As expected, based on their very modest lifestyle and strong retirement cash flow, the couple had a 100 percent probability of success,” Power says. “In fact, even after gifting $200,000 to their children, their portfolio assets ended up increasing in value over their lifetime, even in the worse case market scenario using my recommended asset allocation.”

The couple could even double their anticipated expenses in retirement and still have a positive outcome.

Power says Sue and Frank’s risk tolerance is “moderate conservative.” With 34 percent equities and 66 percent fixed income, Power says the couple is in line with his recommendations for conservative clients (35 percent equities and 65 percent fixed income).

“If you dig a bit deeper to see what kinds of equities they own and what kinds of bonds they own, they only have four asset classes being represented in their portfolio,” he says.

They currently hold large-cap U.S. stocks, intermediate-term U.S. bonds, long-term U.S. bonds and money markets.

Power recommends additional asset classes because they currently don’t have exposure to classes such as mid-cap U.S. equities, small-cap U.S. equities, international equities, high-yield bonds, international bonds, REITs and commodities.

“When back testing portfolios, by combining certain asset classes together using the proper percentages in each, over time, you can lower the volatility of a portfolio and at the same time enhance returns, essentially making the portfolio more efficient,” Power says.

He had some additional suggestions.

Frank and Sue should review their wills and estate documents to make sure they can both take advantage of the New Jersey estate tax exemption, which is currently $675,000. Along with that, Power says they must each own $675,000 of assets in their individual names to be able to take advantage of the exemption — but currently, that’s not the case. Most of their assets are owned joint with rights of survivorship, which will not allow those assets to pass through each others’ wills to take advantage of the exemption.

While Power assumed they’d both wait to take Social Security benefits until age 66, they should look carefully at this decision.

“There are many strategies that most people are not aware of that can generate tens of thousands of dollars of additional Social Security benefits over one’s lifetime,” he says. “A simple ‘break even’ analysis doesn’t tell you the whole story.”
Frank and Sue may also benefit from converting a portion of their traditional IRAs to Roth IRAs, Power says.

“With our country being in such a financial mess, there is a good chance that income tax rates could go higher after 2012 to help balance our country’s budget,” he says. “This could mean that a person’s income tax bracket may not be lower at the time of required IRA distributions and in fact could be higher.”

That said, Power says having a diversified income of both taxable and tax-free options in an uncertain income tax environment is a very prudent approach to retirement planning.

Additionally, Power says because the government does not require minimum distributions from a Roth 401(k) or Roth IRA, these are great assets to leave to heirs as legacy assets.

This couple may never need to touch their 401(k)s and IRAs to live on in retirement. Power says people who fall into this category should definitely consider having some of their retirement savings put into the Roth option so they are not forced to take out money from their accounts at age 70½ and beyond.