Get With The Plan: December 8, 2013

12813Gerard, 60, has been semi-retired for four years. Divorced for more than 30 years with three grown children, he’s turning his attention to his needs for now and the future.

“As a relatively early retiree, I need to determine how to use my assets over the remaining years of my life,” he says, noting that he doesn’t know when to start 401(k) distributions, and what the tax ramifications would be. “I am living the retirement I envisioned with a small part-time job, some recreational travel and spending time doing things around the house.”

Gerard, whose name has been changed, has accumulated $576,300 in 401(k) plans, $65,300 in IRAs, $58,900 in mutual funds, $100,500 in a money market, $20,900 in savings and $1,000 in checking. He owns his home outright and has no other debt, and he receives a pension of $50,500 a year.

The Star-Ledger asked Reed Fraasa, a certified financial planner with Highland Financial in Riverdale, to help Gerard create a strategy to make his assets last for his long retirement.

Fraasa says Gerard is a good saver and is living well within his means.

“He doesn’t plan to increase his lifestyle significantly when he transitions to retirement,” Fraasa says. “His financial plan, based on his goals and objectives, shows a very high probability of success.”

He has some important items working in his favor, including the pension he’s currently receiving, and that job gave him lifetime retiree health insurance.

Gerard’s part-time job offers a 401(k) plan, in which he participates, and he’s also accruing pension benefits there.

As part of his plan, Gerard plans to take Medicare at age 65, and receive his full Social Security Benefit at age 66. When he receives Social Security, his current pension will be reduced dollar for dollar, so his retirement income won’t change.

Gerard has done a good job with his investments, choosing low-cost diversified mutual funds in his portfolio.

“The only concern I would have is the long-term prospect of how he intends to maintain the income stream once he stops working part time, and managing the risk in the portfolio for the duration of retirement,” Fraasa says.

Gerard’s portfolio is invested with 40 percent of the assets in U.S. large-caps, 45 percent in U.S. small-caps and 16 percent in a money market.

“While this has been the place to be for the last two years, markets are very unpredictable and he should not fall into the trap of thinking that recent history will continue to repeat itself over the long term,” Fraasa says. “This is known as ‘recency bias,’ when we tend to make long-term decisions based on our most recent experiences.”

Fraasa says this can either cause someone to be overly conservative, as many investors were post 2008-2009, or overly aggressive and concentrated, as many are doing today.

“For the next few years, Gerard can afford to take extra risk, but once he prepares to transition to depending fully on his investment capital and pension income, he will do well to mitigate as much risk as he can,” Fraasa says.

Fraasa says his analysis shows Gerard should feel very confident with his current situation. His cash flow analysis shows that he is spending within his limits, and all his financial ratios look good, with two exceptions. Fraasa says he has a lower savings rate, but that’s explained by his retirement status. Also, Gerard’s liquid assets to net worth ratio is off, but explained by his over-weighting in qualified retirement assets relative to after-tax assets. Neither of these are significant or something that would be prudent to change at this point, Fraasa says.

Preparing for the transition to full retirement will require Gerard to replace his working capital paycheck with an investment capital paycheck. Fraasa says the characteristics of a paycheck are that they’re predictable, consistent, independent from financial markets and inflation adjusted.

First, Fraasa says Gerard should determine the amount of monthly income he will need to replace in retirement. This is estimated to be about $1,000 per month, or $12,000 per year. Then, he should establish a separate reserve account to hold two to three years’ worth of income, or about $32,000.

“This should be invested in money market and short-term CDs to avoid loss of principal over the short term,” Fraasa says.

Next, Gerard should reallocate the balance of his assets to be a broad mix of assets classes. This should be done with the goal of maintaining an inflation hedge over the next 25 to 30 years, and to capture market returns.

“By being broadly diversified, he will not have as many home runs, but he will not have as many strike-outs,” Fraasa says. “The objective is to be consistent with our investment plan, and the reserve account … provides him with the cushion to weather any recessions or corrections in the market without having to sell in a down market to support his lifestyle.”

Over time, Gerard should periodically rebalance his portfolio to maintain his broad allocation, and when he does, he will occasionally refill his reserve account to maintain the two- to three-year cushion.

Fraasa says because Gerard has a significant proportion of his assets in retirement accounts, he will incur ordinary income taxes when he withdraws funds to support his lifestyle.

“This can be done annually on an as-needed basis so he will not withdraw more funds than needed to maintain his reserve,” Fraasa says.

He says another result of this approach is that the financial planning analysis shows that if he takes these recommendations, he can increase spending by 20 percent and still have the same probability of success.

Fraasa says the difference is the benefit of reducing risk over the long term.