Scott Peterson was a guest writer on the popular White Coat Investor blog—a blog esteemed amongst physicians and other high-income professionals. Scott’s blog outlines our proprietary process for investing, The Perennial Income Model™. The article also presents a retirement income plan creation example of a couple who have accumulated $1 million for their retirement.
Click here to read Scott’s blog in its entirety on WhiteCoatInvestor.com.
“You must pay taxes. But there is no law that says you gotta leave a tip.” -Morgan Stanley
How can any retiree make a good decision about reducing taxes in retirement, or any financial professional recommend a proper course of action, without first mapping out, and projecting a future income stream?
The answer is . . . they can’t. Retirees often end up making only short-term, immediate tax-saving decisions, while missing out on more advantageous, long-term tax reduction opportunities because neither they nor their advisor project income streams across a full retirement. Focusing only on the current tax year ends up costing retirees many thousands of dollars because they fail to recognize, and then to organize, their finances to take advantage of long-term opportunities to reduce taxes.
A comprehensive retirement income plan must consider a lifetime tax reduction strategy that focuses on how today’s decisions to withdraw money from the various types of accounts will impact their tax liability years into the future. The Perennial Income Model™ is the ideal tool to help retirees recognize and organize long-term tax-saving opportunities to keep more of their wealth.
Before looking at strategies to maximize your lifetime tax savings, you must first understand the categories of retirement accounts and the tax implications of each. How your investments are taxed depends on the type of account in which they are held. There are three categories of accounts to consider:
The money in IRAs/401(k)s and a variety of other company-sponsored retirement saving plans are 100% taxable upon withdrawal unless you use the Qualified Charitable Distributions exception (to be explained). Non-IRA annuities can likewise be lumped into this category with the exception that only the interest earned on the non-IRA annuity is taxed upon withdrawal, not the entire value of the annuity.
The funds in Roth IRAs and Roth 401(k)s can be withdrawn tax-free.
Investments that are individually owned, jointly owned, or trust owned have their dividends and interest taxed annually. They are also subject to capital gains taxation in years when investments are sold at a profit.
At Peterson Wealth Advisors we use our Perennial Income Model to provide the organizational structure to recognize and benefit from major opportunities to reduce your taxes. Let’s consider three of these tax-saving strategies that can benefit you in retirement:
Thankfully, your retirement income stream can come from a mix of tax-deferred, tax-free, and non-retirement accounts used in combination to lower your tax liability. Even though income stemming from tax-deferred accounts is 100% taxable, Roth IRA funds can be withdrawn tax-free and money coming from non-retirement accounts hold investment dollars that can oftentimes be withdrawn with limited tax consequences.
The key is to determine which of the above categories of accounts should be tapped for future income needs . . . and when. Tax-efficient income streams that are thoughtfully mapped out at the beginning of a retirement, as we do with the Perennial Income Model, can be extremely effective to help minimize your lifetime tax burden. With advanced planning, you can avoid the costly mistakes of conventional wisdom: paying almost zero tax from retirement date to age 72, then paying high taxes and higher Medicare premiums until death. The Perennial Income Model shows us that it is better to pay minimal taxes from retirement date to age 72, along with how to be able to pay minimal taxes and minimal Medicare premiums from age 72 to death. When you structure your retirement income streams from a variety of tax locations within your portfolios, thoughtfully planned out, you can experience a higher standard of living while still paying very low tax rates.
The most overlooked, least understood, and one of the most profitable tax benefits recognized by forecasting income streams through the Perennial Income Model comes from the use of Qualified Charitable Distributions. A Qualified Charitable Distribution, or a QCD, is a provision of the tax code that allows a withdrawal from an IRA to be tax-free if that withdrawal is paid directly to a qualified charity. Our clientele consists of retired people who regularly donate generous sums to charities. By simply altering the way contributions are made to charity, you can make the same charitable contribution amounts and reduce your taxes at the same time.
The ability to transfer money tax-free from an IRA to a charity has been around for a while, but the doubling of the standard deduction from the 2018 Tax Cuts and Jobs Act, was the catalyst that brought this valuable benefit to the forefront. With larger standard deductions, only 10% of taxpayers itemize deductions. Here is the catch: you only get a tax benefit from making charitable contributions if you itemize your deductions, and with the higher standard deduction, fewer of us will be itemizing. So, a 65-year-old single taxpayer, with no other itemized deductions, could end up contributing up to $13,000 and a 65-year-old couple could end up contributing up to $27,000 to charity and it would not make any difference on their tax returns, or their tax liability, because both generous charitable contribution amounts were lower than the standard deduction. So, they will just end up taking the standard deduction. Another way of saying this is that these charitable donors will not receive a penny’s worth of tax benefit for giving so generously to charity.
Doing a direct transfer of funds to a charity by doing a QCD versus the traditional writing a check to a charity, can restore tax benefits lost to charitable donors. QCDs are only available to people older than age 70 1/2, they are only available when distributions come from IRA accounts, and a maximum of $100,000 of IRA money per person is allowed to be transferred via QCD to charities each year.
Converting a tax-deferred IRA into a tax-free Roth IRA can be a valuable tool in the quest to reduce taxes during retirement. Unfortunately, few retirees get it right deciding when to do a Roth conversion, deciding how much of their traditional IRA they should convert, or even deciding if they should convert any of their traditional IRAs at all. Without a projection of future income that the Perennial Income Model provides and the subsequent projection of future tax liability, it is virtually impossible to determine whether a Roth IRA conversion is the right course of action. Perhaps the greatest unanticipated benefit that we have observed since creating the Perennial Income Model is its ability to clearly estimate future cash flows and subsequent future tax obligations for our retired clients. Given this information, the decision whether to do a Roth conversion becomes apparent.
As advantageous as Roth IRA conversions can be, they are not free! The price you pay to convert a traditional IRA to a Roth IRA comes in the form of immediate taxation. 100% of the conversion amount is taxable in the year of the conversion. For this reason, investors must carefully weigh whether doing a Roth conversion will improve their bottom line.
Too much of a good thing usually turns a good thing into a bad thing. So, it is with Roth conversions. Excessively converting traditional IRAs into Roth IRAs without fully considering the tax consequences, can cause some investors to pay more tax than they otherwise would if they didn’t do a Roth conversion in the first place. So, it’s important to recognize when, and when not, to do a Roth conversion.
We first designed the Perennial Income Model to provide the structure to reinforce rational decision-making. It started with a focus on helping retirees match their current investments with their future income needs. Now, we see that the Perennial Income Model’s role is much bigger, including providing the benefit of reducing your taxes throughout the entirety of your retirement.
After my last blog, where I described the reasons we are experiencing high inflation this year, you might be asking “What can I do to combat inflation in my own life?” As I consulted with my team members, financial professionals that work with retirees all day every day, we came up with twenty-six inflation-fighting ideas that will help the retiree, or those nearing retirement. Some of these ideas will have a huge impact, other ideas are less significant but are things that you may not have thought of previously.
I found it interesting that as we compiled our list, it morphed from being merely an inflation-fighting list into a commonsense checklist of things that every retiree should consider going through as a matter of just being financially responsible. Obviously, not every one of the money-saving ideas on our list will apply to your specific situation, but some will. We are confident that every one of you will benefit from going through this list in your own situation and that you will end up saving money by implementing the applicable ideas. These savings will be helpful for you to maintain your lifestyle as you are squeezed by inflation.
Investment mistakes early in retirement can be devastating and there are no do-overs. So, I first wanted to remind you of the inflation-fighting capabilities of your investments before we talk about any other inflation-fighting/money-saving ideas.
1. Remember, the price we pay for inflation-beating investments is having to endure temporary periods of volatility. Volatility is not risk, the synonym for volatility is unpredictability and in the short-term, equities are certainly unpredictable. You wouldn’t be human if this year’s stock market hasn’t caused you concern. However, you need to stay the course and not let yourself be frightened out of owning a piece of some of the most profitable corporations the world has ever known. Compound interest has helped you accumulate the nest egg that you now have. Keep the miracle of compound interest alive during retirement by owning equities. Hold on to your equities if keeping up with inflation is your objective.
2. Have a plan. We follow our proprietary Perennial Income Model™ to create an income plan that protects our retirees’ short-term income from stock market downturns while protecting their long-term income from the ravages of inflation. The Perennial Income Model helps to strike the right balance between owning less-volatile types of investments and owning the more-volatile inflation-fighting equities in a portfolio. It matches your current investment allocation with your future income needs. Do yourself a favor and learn how the Perennial Income Model can help you create your retirement income plan. To learn more about the Perennial Income Model, order a free copy of my book, Plan on Living, here.
3. Have faith in the future and follow your plan. We are not facing an investment apocalypse. Market conditions are cyclical, and we will continue to experience good as well as bad economic cycles. A well-thought-out investment and retirement income plan should have built within itself a contingency plan to deal with economic downturns and periods of market turbulence. In fact, your plan should not just help you to navigate volatile markets it should assist you in taking advantage of them. Don’t allow yourself to get derailed from your plan.
4. If you haven’t started Social Security yet, consider delaying applying for your own benefit until age 70. Beyond the built-in annual cost of living adjustments of Social Security, your benefit will increase by 8% each year that you delay from your full retirement age until age 70 by simply waiting. Your full retirement age is somewhere between age 66 to 67 depending on your year of birth. Receiving 24%-32% more each month in Social Security benefits for the rest of your life can be a handsome inflation-fighting boost.
5. Go back to work. Statistics show that almost half of all retirees go back to work after two or three years of retirement and they go back to work for reasons beyond satisfying income needs. In other words, they get bored. Work satisfies their need for social interaction and the need to be part of something bigger than themselves. Find a part-time job that is interesting to you for a day or two a week. With a nationwide worker shortage, there are endless opportunities for retirees to find the kind of job they would enjoy with the flexible schedule that they desire. Being engaged in something that interests you, while picking up a couple of bucks to help with inflation can be realized…have fun!
6. Replace light bulbs and fixtures with LED. LED bulbs last longer and use 25% less electricity than outdated light bulbs that you still might be using in your home.
7. If you are regularly away from your house during the day, program your thermostat. Don’t heat or cool an empty house. You can drop your electric and gas bills by as much as 10% by adjusting your home temperature by a few degrees. Open a window in the summer or wear a sweater in the winter to offset the mild changes in temperature.
8. Take advantage of the energy-saving programs offered by your power and gas companies. Utility companies provide valuable energy-saving tips and even will send representatives to your home to help you recognize where you could substantially save on your energy bill. They will also keep you up to date with rebates and tax credits that are available to you as you update your home. This service is free or available at minimal costs.
9. Save gas by better organizing your errands. Knock out all your errands in one trip versus three or four separate trips.
10. Don’t run your appliances until they are full, specifically your washer, dryer, and dishwasher.
11. Don’t be shy about asking for senior discounts. We found a website, www. seniorliving.org, that keeps a list of discounts available to seniors or those approaching retirement. It provides dozens of discounts and covers everything from grocery shopping to cruises. We found that many of these discounts are not well known, nor are they advertised by the companies offering the discounts. You will have to know about these discounts in advance and you will have to specifically ask for many of these discounts.
12. Life has become so much easier since we have evolved into online shoppers. Online shopping has also made it easy to comparison shop and find the best deals. Take a couple of extra minutes to compare items as you make your online purchases. We found two websites, Honey and RetailMeNot, that assist you in online shopping. Both websites show you some of the best available coupons on the internet to help you get the best deal possible.
13. Shop your pantry or freezer first. How many times have you run to the grocery store to buy an item, only to later find that same item sitting on a shelf or in your freezer at home. All of us are guilty of wasting food and money as we throw out food that has exceeded its expiration date. According to Feeding America, “Each year, 108 billion tons of food is wasted in the United States. That equates to 130 billion meals and more than $408 billion in food thrown away annually. Shockingly, nearly 40% of all food in America is wasted.” The key to avoiding waste is to take the time to better organize your pantry and food storage.
14. Try using store brands over name brands.
15. Barter – I’m not suggesting that you haggle over everything but, look for opportunities to get a better deal. You will be shocked at the discounts you will receive as you ask one simple question as you book hotel rooms, rent cars, and hire services. Try asking, “is that the best you can do?” That question has saved me thousands of dollars over my lifetime.
16. Audit your own credit card statement. Are there subscriptions that you can eliminate that you no longer use? Gym memberships, multiple streaming services that you don’t use, and magazines that are never read are the most likely culprits.
17. Make an extra effort to pay off debt, especially adjustable-rate loans. Specifically, be mindful to not carry a balance on your credit cards month to month.
18. Consider a lower-cost cellphone plan. With WIFI being so prevalent, maybe that unlimited data plan might not be necessary.
19. Load up on nonperishable items when they go on sale.
20. Work off a budget. It may have been years since you followed a budget but following a budget can be useful to help limit impulse purchases.
21. Do your kids a favor and sell the stuff you don’t use anymore. All who have had to clean out a deceased parents’ home know what I’m talking about. Learn how to sell your unwanted items on eBay, Craigslist, Facebook Marketplace, and more. You will be shocked what people will buy, and who knows, that collectors’ edition Barbie doll that has been hiding in your basement for decades might be worth thousands.
22. Be strategic as you consider making major purchases such as houses. Interest rates will have to rise to cool down the economy. As rates rise, people will be forced out of the housing market and house prices will drop. Be patient and thoughtful as you consider your next big purchase.
23. Investigate cash back rewards and frequent flier discounts offered by your credit cards and learn to use them.
24. Consider vacationing closer to home during inflationary times. People come from all over the world to visit the national parks and vacation destinations that are often within driving distance of our homes. Make a bucket list of regional getaways that you would like to see. Your next “thrifty” vacation may end up being one of your most enjoyable.
25. Shop for lower auto and car insurance rates. It’s amazing the money that you will save as you shop around. You may also consider raising your deductibles for additional savings. As long as you are talking to your insurance agent, check out how much your house is insured for. The recent inflation has raised the value of your home. Is your home adequately insured?
26. Don’t lapse or cancel that old life insurance policy that you no longer need…sell it. There are viatical companies that will sometimes pay top dollar for life insurance policies that no longer fit your needs. You get paid for your policy and you free yourself from having to pay future insurance premiums.
Before I end, I want to mention some developments regarding inflation that have occurred since our last blog was published. Last week our elected officials announced a student loan forgiveness program that promised to forgive the loan obligation for billions of dollars’ worth of loans. Essentially, the government will be going further in debt to pump billions of dollars into an already overheated economy. During the same week, Jerome Powell, the Federal Reserve Chairman announced a plan to aggressively raise interest rates to quell inflation.
So, our politicians are stepping on the gas pedal while the Federal Reserve is stomping on the brakes. I wish to point this out to you to help you understand that until policies in Washington D.C. are changed, higher inflation rates will be with us. So, in the short term, we are going to have to learn how to live with higher inflation rates than what we have been accustomed to. I hope the ideas I shared with you will offer a little relief.
Hang in there, this too shall pass!
If you have questions, or concerns, or would like to review your personal retirement situation, please click here to schedule a complimentary consultation. You can also click here to learn more about the Perennial Income Model mentioned above in the second fighting inflation idea.
The Bureau of Labor Statistics just reported a whopping 9.1% year-over-year increase in the inflation rate. This is the highest in forty years and many economists suggest that inflation will get worse before it starts to get better. To put a 9.1% inflation rate in perspective, one million dollars today has only $909,000 worth of purchasing power compared to just one year ago.
Americans are facing higher prices for food, fuel, and housing and are grasping for answers about what is causing inflation. How long it will last, and what they should personally be doing to combat its effects.
There are no easy answers or painless solutions when it comes to the inflation problem. Before we jump into how long it will last and what can be done to resolve it, we need to define how inflation is caused.
Stated in its simplest terms, “inflation happens when too many dollars are chasing after too few goods and services”. So, inflation is really a supply and demand problem. When there is an equilibrium between the supply of goods and services and demand (money available to spend), inflation is in check. When the demand outpaces the supply of goods and services, inflation accelerates. Once this concept is understood, we can dissect what is limiting the supply of goods and services and what is driving demand.
A couple of events have contributed to the limited supply of goods and services:
First, the COVID pandemic in early 2020 led to lockdowns and numerous restrictive measures by governments around the globe to stop the spread of the virus. These government-imposed lockdowns disrupted the global supply chain as factories were shut down and maritime ports were closed. Currently, COVID continues to affect worldwide supplies as China, the world’s largest manufacturer, is still troubled by shutdowns as they try to get on top of the COVID pandemic still plaguing their nation.
Second, the United States went from being energy independent just a couple of years ago to once again being forced to purchase oil in the world markets. U.S. production has decreased while our consumption has increased. The inevitable result of this supply/demand imbalance is inflated oil prices. Higher oil prices serve as a catalyst to higher prices in all other parts of the economy as higher energy prices increase the cost to produce and ship goods.
Consumers are spending big. When the pandemic started, the personal saving rate in the United States was sitting at an all-time high. With large amounts of savings on hand, the federal government sending out relief checks to individuals and businesses, and employees sitting at home with shopping at their fingertips, the U.S. consumer spent a lot of money. And the spending spree isn’t over, with unemployment numbers sitting at all-time lows, employees are either finding better paying jobs or are requiring higher wages from existing employers. These higher wages continue to encourage high demand for the limited goods and services available.
Additionally, with the pandemic mostly behind us, there is a pent-up demand from people looking to travel and vacation once again. If you have traveled recently, you would have noticed the inflated prices of airline tickets, rental cars, hotel rooms, restaurants, and more.
There are thousands of economists attempting to answer this question, all with different opinions. So, how long this recent inflation acceleration might last is anybody’s guess. However, there is a consensus on how the inflation supply/demand equilibrium will be brought into balance. The inflation rate will decrease as consumer spending slows down, or in other words, when the demand for goods and services is reduced. Two of the main ways demand is reduced is either by raising interest rates, by the economy suffering a recession, or both.
The Federal Reserve has the responsibility to monitor the economy and implement policy to maintain the equilibrium between supply and demand, in other words, keep inflation in check. The Federal Reserve is raising interest rates to slow consumer demand and subsequent price growth. This policy response means that the economy will surely head for a slowdown. We have already seen how higher interest rates and higher borrowing costs have begun to cool off the housing market. The question — and big uncertainty — is just how much federal action will be needed to bring inflation under control.
A recession is when the economy shrinks. This is a more painful and less desirable way to slow consumer demand, but it can work towards taming inflation. During a recession, the overall economy struggles, corporations make fewer sales and become less profitable. Workers are laid off and unemployment surges.
The hope is that the Federal Reserve can raise interest rates just enough to slow consumer demand without throwing the country into a recession. This optimistic scenario, often called a soft landing, is difficult to orchestrate and despite the best efforts by the Federal Reserve board, can still end up throwing the economy into a recession.
In our current environment, the so-called soft landing is especially challenging. As the Federal Reserve tries to reign in demand with higher interest rates, they have zero control on the supply side of the equilibrium. If supply chain shortages persist, the Federal Reserve will be required to raise interest rates more drastically. This will slow the demand enough to bring higher prices under control. It’s an economic tightrope, we will see if the Federal Reserve can walk it.
Currently, there is talk on Capitol Hill of sending out additional stimulus checks to help the U.S. consumers pay for high gas prices and other goods. This is indeed a noble thought, but terribly misguided. The demand side of the equilibrium is already out of balance. In other words, there is already too much money chasing too few goods and services. Going into more debt, to throw more money at a problem caused by too much money pursuing too few goods and services is not the answer. We cannot spend our way out of inflation and any attempt to do so, will only result in higher inflation.
We have addressed the causes of inflation and talked about how inflation rates will be reduced. In our next blog we want to get personal. We will be going over the personal dos and don’ts of managing higher interest rates and making good decisions concerning your investments during recessionary times.
If you have questions, concerns, or would like to review your personal retirement situation, please click here to schedule a complimentary consultation.
At Peterson Wealth Advisors, we manage the retirements of several retired commercial pilots. As I have discussed these pilots’ careers with them, one of the retired pilots explained that being a pilot can be described as, “hours and hours of boredom punctuated by moments of sheer terror.” Although these moments of sheer terror are rare, pilots will spend countless hours of training throughout their careers. They are preparing for that moment when their flight plan might not go according to plan.
Just as pilots have a plan, investors also need to have a plan to follow when their investments are not going according to plan. The last couple of years have provided investors ample unplanned and unforeseen market turbulence. A pandemic, a supply chain crisis, the highest inflation rate in our lifetimes, and the prospects of another world war in Europe have certainly rocked the investment world. It’s even caused the best-made investment plans to not go according to plan.
Investors should always be asking, “what is my plan when things temporarily aren’t going according to plan?” Let me share with you the Peterson Wealth Advisors’ perspective and what we are doing for our clients. Especially when it appears that things aren’t going according to plan due to ‘investment turbulence’.
First, temporary downturns are not a deviation from the plan. Rather, they are an expected part of the plan. Stock and bond market downturns are always temporary. Historically the duration of almost every major decline is measured in months, not years. The media would have you think that market corrections, “are unexpected events that are shocking in both their occurrence as well as their impact.” As investors with longer-term perspectives, we understand that the price you pay for inflation-beating investment returns consist of enduring occasional periods of market volatility. Few of us would pass up a Hawaiian vacation because there will surely be some turbulence in our flight to and from Hawaii. We likewise need to keep temporary market downturns in perspective and remember that turbulence is a planned for event.
Even though the exact timing of a correction is difficult, we should expect and even embrace market volatility. Investors should seize the opportunity to make wise tax moves during declining markets by doing Roth conversions, rebalancing portfolios, and tax-loss harvesting. They should also be opportunistic by purchasing depreciated equities while they are being sold on discount.
We believe that investors should never be in a position where they need to liquidate depleted investments due to a temporary market downturn. This is difficult to do if an investor is not preparing for the downturns before they happen. With the Perennial Income Model™, we proactively attempt to protect our clients from selling investments at a loss. This is done by following a rigid, goal-centric, approach to harvesting investment gains once the goal of an investment has been reached. Harvesting is the process of transferring aggressive investments to more conservative investments as goals are achieved.
Navigating retirement with a plan that establishes investment goals and appropriately harvests gains can bring order, discipline, peace of mind, and added security to the retiree.
If you have the flexibility, you can wait out market downturns and wait for good investment opportunities. The best way to add flexibility, and tip the investment odds in your favor, is by increasing your time horizon. The longer you are invested, the better opportunity you have to endure a range of market turbulence. This endurance flexibility lets you stick around long enough to let the odds of benefiting from a positive outcome fall in your favor.
Additionally, flexibility within an investment portfolio allows Peterson Wealth Advisors to select only positive-performing investments within a portfolio to be drawn upon for income. This allows investments within that same portfolio, that may have temporarily dropped in value, to rebound.
Flexibility gives you room for error. Giving yourself a margin of error is the only way to safely navigate the world of investing. The world of investing is governed by probabilities, not certainties.
In other words, plan for the worst and hope for the best. As the creators of the Perennial Income Model™ we project retirement income streams over decades. This process is unique to our firm. We have concluded that it is in everybody’s best interest to project low. We assume future investment returns 30% less than historical averages in all of our planning and projections. If an acceptable retirement income stream can be created from the conservative assumptions that we use, an actual income stream that spins off more income than originally projected will certainly be welcomed.
Market turbulence has and will continue to afflict investors with regularity. This is why we choose to create retirement income streams. We follow the goal-based, time-segmented processes of the Perennial Income Model.
A retirement income plan is only successful if it can survive reality. A future filled with unknowns is everybody’s reality. That is why we feel it is important that retirees understand and embrace volatility, follow a goal-based plan to protect investment gains, maintain investment flexibility, and use conservative estimates as retirement income streams are projected. If retirees understand and embrace these points, they will be prepared to answer the question, “what is my plan when things temporarily aren’t going according to plan?”
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The Perennial Income Model™ was created and launched in 2007. Through all the ups and downs of the stock market, it has withstood the test of time. The initial goal of the model was to provide a logical format for investing and for generating inflation-adjusted income from investments during retirement. In the beginning, we did not fully anticipate all the accompanying benefits that would result from projecting a retiree’s income over such a long timeframe. However, our eyes have been opened to a number of benefits, one of them being how the Perennial Income Model acts as a ‘bad luck insurance policy’.
The Perennial Income Model can protect you if you are unlucky and happen to retire about the same time as a stock market crash. Every stock market correction is temporary, but that knowledge isn’t helpful if you are ill-prepared and are having to liquidate equities in down markets to support yourself.
Let me share with you an example, Mike had been carefully planning for his retirement for years and it was finally his turn. He wanted to be conservative as he selected investments for his retirement years, but he knew enough about investing to realize that a good part of his investment portfolio had to be invested into equities if he was going to keep ahead of inflation.
So, he reluctantly invested more than half of his portfolio in stock-related investments. Mike retired, and almost immediately his worst fears were realized, as the stock market dropped by 50%. His money was invested in a balanced mutual fund that was composed of 60% stock and 40% bonds. Unlike the working years, Mike couldn’t just wait for the stock market to recover, he had to withdraw a portion of his money every month from his mutual fund just to pay the bills. As Mike withdrew his monthly stipend, he realized that he was liquidating a proportional amount of stocks and bonds each month from his balanced mutual fund. This meant, he was systematically selling stocks at a loss every month that the stock market was down, and it could take months, or even a couple of years before the stock market recovered.
Mike was frustrated, and even a little angry. He thought to himself, “why did this happen to me? I anticipated, and planned for, every contingency of my retirement in detail, then the one thing that I have no control over trips me up. I must be the unluckiest person on the planet!”
Mike is not alone; this exact scenario happens and will continue to happen to millions of new retirees every time there is a market correction. It’s true when we are no longer contributing and we begin taking withdrawals from our accounts, the temporary ups and downs of the market can have a much bigger impact on our investments than when we were working and had time to wait out market corrections.
To be clear, Mike’s mistake wasn’t in being too aggressively invested because a 60% stock, 40% bond portfolio is a very reasonable allocation for a new retiree. His mistake was failing to have a plan that allowed him to only liquidate the least impacted, non-stock portion of his portfolio to provide immediate income during a market downturn.
To illustrate this point, let’s take the example of two investors, Mr. Green and Mr. Red. Both have decided to retire at age 65 and both have saved up a $1,000,000 nest egg. Each of them plan to withdraw 5% of their initial balance each year to have an annual income of $50,000. As you can see from the table, both average the same 6% return during their 25-year retirements, but Mr. Green ends up with more than $2,500,000 to pass on to his heirs at death, while Mr. Red runs out of money halfway through his retirement. How can this be?
Every aspect of their retirement experience is identical except for one thing: the sequence of their investment returns.
As you can see from the chart, Mr. Green experiences overall positive returns at the beginning of his retirement and a string of negative returns towards the end. Mr. Red experiences the same returns only in reverse. He goes through a series of negative returns at the beginning of retirement and the more positive returns come at the end. Again, both investors average the same 6% return over their 25 years of retirement. The sequence of those returns is the only difference. We can see from the table just how much of a difference the order of returns makes.
The good news is that it’s possible to set ourselves up to be successful no matter what the markets happen to do year by year. The Perennial Income Model is the bad luck insurance policy that can protect you from the pitfalls that Mr. Red experienced.
I’m not suggesting that following the Perennial Income Model will guarantee that your account balance will never go down, or suffer temporarily because it will. What I am saying is, that by following the Perennial Income Model, you shouldn’t find yourself having to sell stocks at a loss during a stock market correction.
Mr. Red’s losses are realized as he liquidates equities in down years at a loss to cover his expenses. If Mr. Red were to have his portfolio organized according to the investment regimen provided by the Perennial Income Model, he would not be in a position where he would have to liquidate stocks in down years to provide income. He would have a buffer of conservative investments to draw income from while giving the more aggressive part of his portfolio a chance to rebound when the stock market temporarily experiences periods of turbulence.
The Perennial Income Model’s design is intended to give immediate income from safe, low-volatility types of investments. At the same time, it furnishes you with long-term, inflation-fighting equities in your portfolio, equities that won’t be called upon to provide income for years down the road. Market corrections typically last for months, not years. So, even if you are the unluckiest person on the planet and your retirement coincides with a market crash, your long-term retirement plans won’t be derailed as long as you are following the investment guidelines found within the Perennial Income Model.
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Warren Buffet once called the babies born today “the luckiest crop in history” because they are expected to live longer and enjoy greater prosperity than any previous generation. I believe it would be a fair assumption to add that the baby-boomer generation is the “luckiest crop” of retirees to have ever lived. Today’s retirees are healthier, wealthier, happier, safer, freer, more educated, more equal, more charitable, and more technologically advanced than any previous generation.
Ironically, the wonderful advancements that current retirees are blessed with are also the root of the problems that retirees will face. Longevity, inflation, and the retiree’s individual responsibility to manage their own investments will be the challenges that this generation of retirees will have to grapple with.
Not only are we living better, we are also living longer. Therein lies the challenge: We are living too long. Life expectancies are steadily climbing. According to the Social Security Administration, a couple who is currently 65 years old have a 48% chance that one of them will live to be the age of 90.
Because of long life expectancies, many retirees face the very real risk that they will outlive their money if they don’t plan for a lengthy retirement. Planning on living to the average life expectancy is not enough. It is best to plan on living longer than your life expectancy, because life expectancy estimates the average time a person will live. To be certain, some people will die before their life expectancy, but some will live beyond, sometimes many years beyond, their projected life expectancy.
Longevity is the catalyst for today’s retirees’ second challenge: their dollars are shrinking.
Every day, the purchasing power of the retiree is eroding as goods and services are getting more expensive. Although inflation has always existed, no previous generation has had to deal with it to the extent that today’s retiree does. Our parents and grandparents lived ten or fifteen years past retirement, inflation never had time to develop into a problem for them.
A retirement lasting thirty years or more is a game-changer. Inflation isn’t something that may happen, it will happen. In our opinion, inflation has confiscated more wealth, destroyed more retirements, and crushed more dreams than the combined effects of all stock market crashes. Historically the average inflation rate has been more than 3% annually. To put that into perspective, at a 3% inflation rate, a dollar’s worth of purchasing power today will only purchase forty-one cents worth of goods and services in thirty years from now.
Inflation poses a “stealth” threat to investors as it chips away at real savings and investment returns. The goal of every investor is to increase their long-term purchasing power. Inflation puts this goal at risk, because investment returns must match the rate of inflation just to break even. An investment that returns 2% before inflation in an environment of 3% inflation will actually lose 1% of its purchasing power. This erosion of purchasing power might seem incidental, but this type of loss, compounded over the duration of a retirement, is life-changing.
Dollars invested into money market accounts, certificates of deposits, fixed annuities, and bonds, never have, and never will, keep up with inflation. Uninformed, anxious, stock market-leery investors that depend on these types of investments for long-term growth may be insulating themselves from stock market volatility, but they are committing financial suicide, slowly but surely. To make matters worse, the paltry gains associated with these products must be taxed, which makes it that much more unlikely that they will be able to preserve purchasing power.
In the current environment of huge government budget deficits and spending, it is likely that inflation will continue to rise at least at the same pace as its historical average. Given the one-two punch of longevity and inflation, it is imperative that retirees are mindful of inflation as they invest and plan for the future.
A third challenge for retirees to be aware of is the personal responsibility they now have to manage their own investments.
During the last couple of decades, a subtle transfer happened. The responsibility to provide retirement income shifted from the employers to the employees. The popular pension plans of the past, which guaranteed a lifetime of monthly income to retired employees and their spouses, are disappearing. Pensions have been replaced by 401(k)s and other similar plans that all place the burden of funding, managing, and properly distributing investments to last a lifetime, squarely on the backs of the unprepared employee. Like it or not… you, not your employer, hold the keys to your financial future.
An annual study done by DALBAR, Inc. shows that the average stock fund investor managed to capture only 60% of the return of the stock market over twenty years. Ouch! The largest contributing factor that explains this blatant underperformance was the investor’s own behavior. It appears that the typical investor followed the herd mentality, buying when stocks were high and selling in a panic when stocks were low. Seldom was the investor guided by a comprehensive investment plan. Consequently, little or no discipline was demonstrated. What is most concerning, is that for the most part, the investor failed at the easy part of investment management: the accumulation phase.
When people enter retirement, they also enter the distribution phase of investment management. In other words, they start withdrawing their investments. The distribution phase is much more difficult to manage than the accumulation phase. In the distribution phase, it is still crucial to know how to properly allocate and invest a portfolio, but additional complexity is added to the mix. Therefore, income-hungry retirees need to know how to create a distribution plan that will provide a stream of income that will last until the end of their lives. They need to create and then follow a Retirement Income Plan.
Retirees need to be kept informed in order to make the best financial decisions. It is also important to work with a financial professional that specializes in retirement issues and that is a fiduciary who puts the retiree’s best interest ahead of their own.
Are you ready to start planning your 30-year retirement? Click here to schedule a complimentary planning session to start creating your own ‘Retirement Income Plan’.
As 2019 came to a close, the president signed into law a sweeping series of changes that will affect how we save for retirement as well as the distribution of IRA proceeds. The new law is officially entitled the Setting Every Community Up for Retirement Enhancement Act, but it is more commonly known as the SECURE Act. This new law includes both welcome changes as well as some controversial elements. As I said, the changes brought about by the SECURE Act were sweeping, but I am only going to highlight those changes that impact the retiree.
First, let’s address the more controversial parts of the law. There is a change to the rules that govern inherited IRAs, or so-called stretch IRAs.
Previously, if you inherited an IRA, you were allowed to take distributions from the retirement account over your life expectancy. That is to say, a healthy 40-year-old person who inherited an IRA from their parents or grandparents could withdraw the funds over several decades.
While there are exceptions for spouses, minor children (until they reach the age of majority), disabled individuals, the chronically ill, and those within 10 years of age of the decedent, the new law requires that you withdraw the assets from an inherited IRA account within 10 years if the decedent passed away after December 31, 2019. There are no changes to inherited IRA accounts for those who died prior to 2020.
In the past, we have commonly recommended that an IRA participant’s spouse be listed as the primary beneficiary and the children be listed as secondary beneficiaries (not the family trust). This, most likely, may still be your best option, but the new law makes listing the children individually as beneficiaries less tax advantageous than before the new tax law went into effect. We look forward to discussing alternatives with you to make sure your family has the right beneficiary designation going forward.
While the law governing stretch IRAs is creating challenges, there are also big, positive changes that we believe are long overdue.
Hopefully, this sheds some light on the parts of the SECURE Act that most likely apply to your situation. We appreciate the trust you have placed in us and we look forward to answering any additional questions that you might have.
Peterson Wealth Advisors has taken the academically brilliant idea of time segmentation and transformed it into a practical model of investment management that we call “The Perennial Income Model™”. To get a better understanding of the Perennial Income Model™ you can request our book “Plan on Living, a Retirees Guide to Lasting Income and Enduring Wealth”. For specifics on how the Perennial income Model™ could be applied to your retirement income plan, schedule a complimentary consultation with one of our Certified Financial Planner™ professionals.
Since 2009, investors have been well rewarded for owning equities. One surprising characteristic of this bull market had been the low volatility many investors have experienced. With this return of volatility to the market, a discussion of what volatility means to you as an investor seems warranted.
The price investors pay to achieve inflation-beating returns is volatility. The history of the stock market has demonstrated a lot of volatility and we don’t see that changing anytime soon. Most investors think that volatility and risk are the same thing which is not the case. Properly understood, ‘volatility’ is merely a synonym for unpredictability. The word volatility has neither negative nor positive connotations. Let me share with you an example that might help you to distinguish between volatility and risk:
My family’s favorite vacation destination is Lake Powell. We own a houseboat that we share with several other families. I have learned through experience that the most important safety precaution I must attend to at Lake Powell is the proper anchoring of our boat. I will sometimes have our boat tethered to four or five anchors at a time. Why? The Lake Powell area regularly experiences sudden and powerful thunderstorms. These storms come complete with white caps, driving rain, and microburst winds that are capable of sinking both large and small boats. Many inexperienced boaters have sunk boats because they were not prepared, they were not properly anchored, or they panicked in a temporarily volatile situation and let their emotions rather than sound judgment rule the day.
While the storms are volatile and scary, they last but a short time. If a boater is properly anchored, they will be safe. If a boater is prepared for the volatile storms, there is no damage to life or property.
Financial storms, such as stock market downturns, are likewise frightening but they too last but a short time. The experienced, anchored investor is prepared for the frequent, volatile gyrations equities give us. The unprepared and emotionally driven investor turns a temporary volatile financial storm into a permanent loss by panicking and selling equities at a loss. Remember, volatility itself does not lead to losses in the equities market. Rather, it’s the emotional reaction to volatility that ultimately leads investors to lose money in the stock market. In the world of investing, the anchor is having a plan. Having a plan to follow in times of market turmoil reinforces discipline and self-control to the prepared investor.
So now that we know what risk isn’t, let’s answer the question, ‘what is risk’?
Financially speaking, risk is the loss of purchasing power. Sometimes purchasing power is lost in dramatic fashion like when a business fails. Other times, the erosion of purchasing power is so gradual that the loss of purchasing power is imperceptible, such as in the case of inflation.
Every asset class is susceptible to its unique set of risks. Bonds are victims to interest rates, default, and inflation risks. Real estate has liquidity and market risks. Equities and commodities likewise have market risks to deal with. Fixed annuities and bank deposits are subject to inflation risks. All of these risks can erode purchasing power.
Many investors tend to either ignore the risks of their situation, or they don’t understand the risks that have the greatest potential to inflict damage. When I think of risks, I think of my personal phobia of sharks. I can’t think of anything more frightening than being attacked by a shark. My fear is shared by millions. In fact, there are many people who are so afraid of sharks they refuse to even get into the ocean.
I have done research on the frequency of shark attacks, and surprisingly discovered that of the more than seven billion people that populate the planet, on average, only ten people per year die from shark attacks. Ten. That means I have only a one in 728 million chance of dying from a shark attack. I would say my chances are pretty good that I won’t be dying of a shark attack any time soon. On the other hand, 66,000 people die from skin cancer each year. That means I have a one in 110,000 chance of dying from skin cancer. I am 6,600 times more likely to die from skin cancer than a shark attack!
It appears that, when I go to the beach, my fellow shark phobics and I are worrying about the wrong kind of risk. It’s not the dramatic, sudden shark attack that will kill us; it’s being exposed to the sun that is more likely to do us in. So, it is with investments.
The dramatic but temporary declines in the stock market, though scary, don’t do near as much damage as does the day-to-day loss of purchasing power caused by inflation. That is why it’s important to understand all the risks in your own situation and do what you can to minimize them.
The understanding that volatility is not risk and that risk is the loss of purchasing power is fundamental to becoming a good investor.
We chose to manage money for retirees because a lifetime of investment experience has usually taught these seasoned investors the difference between risk and volatility and the importance of preserving purchasing power. When you really drill down, you will find that investment decisions driven by emotion are at the core of almost all investment losses. Having a core knowledge, of what risk is and what it is not, goes a long way towards helping the investor through the inevitable ups and downs of the stock market that will be imposed on us with regularity.
If you are getting close to retirement and will have at least $1,000,000 saved at retirement, click here to request a complimentary copy of Scott’s new book!
It happens all too often. The office receives a phone call or an email from a nervous investor who has been surfing the internet or watching their favorite news network. They’ve come across an article, a headline, or an advertisement proclaiming that the stock market is poised to drop by some cataclysmic amount. Further, the advertisement promotes the idea that the stock market is a high-stakes gamble, a roll of the dice, and is certainly rigged against the “Little Guy.” We are told by these frightened investors that these warnings must be credible. “After all, they are advertised on Fox News,” and these warnings “are all over the internet!” It’s an amazing phenomenon to watch the power of the media as it turns otherwise rational people into devout believers that the apocalypse is on our very doorstep.
The promoters of this brand of financial pornography are especially troubling. They prey on the uninformed and the most anxious investors of our society. They dupe the very investors that probably have the greatest need to own inflation-beating investments. Scaring the already apprehensive investor into purchasing high-commission products that will “keep their money safe” from stock market corrections is their modus operandi. Certainly, their articles, advertisements, and headlines are provocative. They are masters in the art of deception as their message distorts reality and is damaging to those who fall under its influence.
Anybody who understands investing knows that, in the long run, the only way you will be able to maintain the purchasing power of your money is to become a partial owner in a collection of the most profitable companies the world has ever known. In other words, you must own equities if beating inflation is your objective. The price the investor pays for superior, inflation-beating returns is short-term volatility. The stock market has been and always will be volatile. Those who are deceived by the grand illusion that equities are too risky and must be avoided fail to discern the difference between volatility and risk. Few people can make this distinction, but that is precisely the reason why few investors prosper.
Volatility is the advent of a temporary decline, while risk refers to the chance of a permanent loss. Properly understood, “volatility” is merely a synonym for unpredictability: it has neither negative nor positive connotations. It is worthwhile to take a minute and review the volatile history of the stock market as measured by the S&P 500 or large company stocks.
Remember, a bear market is a drop of about 20% in value from the market’s previous high. This phenomenon is not something that is unusual or unique, bear markets are as common as dirt. As you can see from the chart below, in the seventy-three years since World War II, there have been 13 bear markets. They come around about every five years on average. These declines vary in their severity, frequency, and duration, but on average, the stock market retreats a little over 30% in a bear market. They last on average about 15 months, then the stock market rebounds and moves on to new highs. Given the very real possibility that your retirement could last two or three decades, you’ll be a participant in five or six bear markets during your retirement, so you might as well get used to them.
The biggest issue with bear markets is fear. Not fear of what the stock market is doing, but fear of what the investor is doing. Peter Lynch, the fund manager for the highly successful Fidelity Magellan Fund throughout the nineties, said, “The key to investing in stocks is not to get scared out of them.” You must not abandon equities when they are down because as sure as bear markets are to come, bull markets will surely follow.
Included below is a chart that shows all the bull markets since World War II. As you can see, most investors are missing the point. Instead of worrying about avoiding the next -30% bear market, we should focus our attention on making sure we participate in the next 300% bull market!
As mentioned in our blog on market timing, it is an exercise in futility to try to guess when to be in or out of the markets. The key is to be disciplined and to stay invested. Since 1945, or the end of World War II, the S&P 500 has averaged an annualized rate of 11% including dividends. Another way of looking at this, if you could have invested $1,000 in the S&P 500 in 1945, that $1,000 would have grown to more than $1,800,000 today. A handsome reward for staying invested.
Instead of teaching the public the virtues of investment discipline and sharing a historical perspective of investing in equities, the purveyors of this grand illusion that the equity markets are dangerous and should be avoided design advertising campaigns to reinforce the irrational fears of the financially ignorant. They fail to provide a historical perspective that a diversified portfolio of U.S. stocks has never gone down without fully recovering within a relatively short period of time. Never. Nor do they reveal that in a diversified portfolio of stocks, such as the S&P 500, the only way to lose money is to sell when the stock market is down. Not so coincidentally, this is exactly what they suggest you do to free up the cash to buy their “safe” products. The promoters of these sleazy enterprises profit only when you panic. They win only when you choose to lose.
So, who are the promoters that benefit from this grand illusion? The answer is simple. Any entity that benefits from frightening people out of equities is a co-conspirator. The companies that profit when you panic are predominantly the sellers of precious metals and annuities with the financial media assisting as a loyal partner in crime. For as they say in the news business, “If it bleeds, it leads.” Frightening, sensational, and exaggerated headlines and stories touting the demise of the stock market are the tools they employ to promote their ratings and sell their products.
In an accompanying blog, we look at the world’s worst investments. It may come as no surprise that in our estimation, the world’s worst investments are precious metals and index annuities. These historical underachievers are bought only by the fearful and ignorant. These products have horrible performance histories and are purchased only because, as Jeremy Siegel was quoted to have said, “fear has a greater impact on human action than does the impressive weight of historical evidence”. Unfortunately, experience has taught us that Mr. Siegel’s quote is entirely accurate.
Peter Lynch said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Think about this. Some investors are more than willing to systematically watch their purchasing power erode, because they are afraid of the pain associated with a temporary stock market correction. They are willing to pay unbelievably high fees to insurance companies that sell annuities with the promise to protect their money should the stock market crash. Some investors willingly throw money at the poorest of investments and subject their money to the promises of the shadiest of characters before they allow their money to be exposed to the temporary fluctuation in price of a share of the most profitable companies the world has ever known. The fearful investors are so focused on missing the next bear market that they willingly skip out on one of the most profitable investment opportunities ever made available to mankind: investing in equities.
Certainly, there will be temporary periods of pain and discomfort from investing into equities, but the pain of owning a well-diversified portfolio of equities has always proven to be temporary, and the long-term results have always been able to protect purchasing power.
Investing is more of an emotional exercise than it is intellectual. Those who can harness their emotions during volatile times, and not fall prey to the peddlers of doom, will be successful. Those who lack the emotional maturity to be a disciplined investor will forever struggle. The antidote to fear and panic is having a plan. Every investor needs to have an investment goal in mind when investing and then they need to create an investment portfolio that matches their future income needs. Without a goal-driven plan, emotions drive our investment decisions and emotionally charged investing will never produce a good investment outcome.
If you are getting close to retirement and will have at least $1,000,000 saved at retirement, click here to request a complimentary copy of Scott’s new book!
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Grand Illusion #1: Market Timing
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