Get With The Plan: October 30, 2011

At age 55, Ethan is taking a new look at his retirement prospects. His wife of 20 years passed away seven months ago after losing a fight with pancreatic cancer, so Ethan is on his own.

“Although I like living in New Jersey, this is not my home and I wouldn’t see myself living here after retirement,” Ethan says. “I am from a large family and have eight brothers and sisters living in the Midwest, where I would live in retirement.”

He wants to know how long he has to wait before starting his retirement adventure.

Ethan, whose name has been changed, has saved $1.56 million in a 401(k) plan, $30,200 in IRAs, $71,000 in annuities, $157,800 in mutual funds, $10,600 in money markets, $157,100 in savings and $171,300 in checking.

The Star-Ledger asked Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton, to help Ethan plan his golden years.

Hook says he prepared retirement projections, based on Ethan’s cash flow information, assuming a 6 percent return and a 4 percent inflation rate on expenses.

“Those projections show that he would be able to retire at his current age, 55, and not worry about running out of money well beyond age 90,” Hook says. “As a matter of fact, the projections show that his net worth will continue to increase during retirement.”

Hook says most people see their net worth decline during retirement as more money is withdrawn from their investments to meet cash needs.

Ethan’s initial cash needs as a percentage of his liquid investments is approximately 2.5 percent, which is well below what is considered a comfortable withdrawal rate.

Hook says the retirement projections assume tax efficient distributions from Ethan’s investments once he is retired. This assumption cannot be understated, he says, using this example to explain why:

Imagine Ethan retires now, at the end of 2011, sells his New Jersey home and moves to the Midwest. His cash flow shows he needs approximately $5,000 a month to cover living expenses before income taxes.

Based on his investments, Ethan has three places to take the $5,000 a month.

First, his 401(k) plan: If he takes money from his 401(k), he’d owe taxes plus a 10 percent penalty because he’s under age 59½. If you need $5,000 a month before income taxes, he’d need to withdraw closer to $7,000 a month to cover the taxes and penalties.

Then there’s his after-tax mutual funds account. If he takes money from this, depending on his cost basis, he may owe taxes on the distributions, but probably not as much as if he withdrew the money from the 401(k) plan.

Finally, Ethan has significant assets in liquid accounts. Taking money from here would mean no taxes owed on the withdrawals.

That makes the savings account withdrawals a slam dunk.

“Ethan can save $2,000 a month — $7,000 needed from 401(k) versus $5,000 from savings accounts,” Hook says. “That $2,000 can remain in the 401(k) plan and continue to grow tax-deferred, which is another benefit to taking tax-efficient withdrawals,” Hook says.

Another option is taking some of the distributions from the after-tax mutual funds if there are losses in the account. By selling those mutual funds, Ethan can reduce his income taxes at the same time he is meeting his cash needs.

“The results of the retirement projection are so good that the focus of Ethan’s planning should shift from trying to maximize investment performance to ensuring against unforeseen risks that could cause reality to be different than the projections,” Hook says.

Considering long-term care insurance is a start. Hook says long-term care can be quite expensive, and depending on the condition that caused the need for care, could last quite a long time.

“His exposure to a long-term care need is greater while he is younger since his assets are less now than what we project them to be 25 years from now,” Hook says. “If he was to need care over the next several years, this could have a material effect on his asset base.”

Hook says a long-term care policy could protect Ethan’s assets, and he can always consider dropping or reducing the policy once his asset base is sufficiently built up.

Hook says there are two other unforeseen risk areas.

First, 13 percent of Ethan’s portfolio is invested in his company’s stock. Hook says he doesn’t like to see concentrations of individual stock holdings greater than 10 percent.

“Given what has happened to shareholders of such blue-chip companies such as Lehman Brothers, AIG and GE, it would be wise to pare holdings.”

The second risk is that 73 percent of the equity portion of Ethan’s portfolio is in large-cap stocks. This includes the employer stock, but it goes beyond that holding. Hook recommends Ethan reduce exposure to large-cap stocks and increase exposure to small-caps.

“Diversifying within equities can help reduce volatility,” Hook says. “A great example of this is that investors in large-cap stocks have made no money the last 10 years. However, investors in small- and mid-cap stocks have made some very good returns over the same time period.”

Ethan says he has no children and there’s no one in particular he wants to leave his money to when he’s gone.

Now is a good time for Ethan to review his estate planning documents, in particular, his power of attorney and health care proxy or living will.

He should make sure they’re viable in the state where he plans to retire, Hook says.