Retirement and Keeping Up with the Joneses.


Yesterday, I wrote about the 401(k) myth, which is the idea that the mere virtue of having a 401(k) with some money in it will protect you through retirement. People who believe this have lost touch with reality. The fact of the matter is that anything much less than $1 million saved, 401(k) or otherwise, is not going to last you long in retirement on a middle-class living. Having the 401(k) is not the key; lifelong productive activity coupled with frugal behavior is the key.

I want to discuss retirement a bit more. Let us begin by examining the following article, appearing on Marketwatch. The author is Robert Merton, a somewhat notorious investor who designed Long-Term Capital Management, a wealthy hedge fund that lost $4.6 billion in a 1998 bankruptcy which nearly brought down every major bank in America. Keep that tidbit at the forefront of your noodle while reading the piece below.

It tries to put a happy face on the mainstream situation facing future retirees:

A lot of time is spent on telling retirees and those who are rapidly approaching retirement that they haven’t saved enough. It’s a gloomy future for those who don’t get their fiscal house in order.

These statements are based on very sound, but conservative, estimates of growth. They’re also looking at the entire retirement picture the wrong way.

The Harvard Business Review recently published an article on the subject, and it really got me thinking. Dr. Robert Merton, the author of the piece, is a Nobel Laureate and Professor of Finance at MIT, so he knows a thing or two about finance. Here’s the gist of the argument — retirees should focus on the cash-flow their portfolio will generate, not the size of their retirement savings.

Of course, there’s a correlation between how much you can get in cash-flow from your portfolio and its size. However, by focusing on cash-flow and not being fixated on market gyrations and their impact on your portfolio, you gain peace of mind and reduce the probability of making investment mistakes driven by emotional overreactions — which have ruined more than one portfolio.

We had the opportunity to interview Dr. Merton on our weekly radio program recently about the crisis in retirement planning.

Sadly, there is a large portion of Americans — 19% of those age 55 to 64 — who haven’t saved any money for retirement. Unfortunately there isn’t much help for them. But let’s take a look at a much more common scenario. Let’s take a husband and wife who have saved $500,000 in various 401(k), IRA and other accounts for retirement — we’ll call them Mr. and Mrs. Jones.

He says 20% of late middle-aged folks are a lost cause. The number is far larger than that. Very few families have $500,000 saved, not counting the value of their home. At the National Institute for Retirement Security, we read:

Two-thirds of working households age 55-64 with at least one earner have retirement savings less than one times their annual income, which is far below what they will need to maintain their standard of living in retirement.

Moving on:

Mr. and Mrs. Jones diversified their portfolio into a variety of exchange-traded funds, no-load mutual funds, and a hand-full of “blue chip” stocks. If “the Jones” behave like most investors, they’ll check their statements and account values frequently and might determine that they can withdraw between $20,000 and $25,000 a year from their portfolio without depleting it. Additionally, they will receive Social Security payments, which adds another $20,000 in annual income. The problem is that this income stream is subject to market risk. If the market corrects by 20% — a risk that cannot be ignored. The amount of income these types of investments can produce will be cut and so their withdrawals will likely have to be reduced to avoid further depletion of the nest egg.

This means the Joneses will have approximately $45,000, at best, to live on yearly. This is probably far less income than they earned pre-retirement.

Many analysts say that retirees should plan for living expenses of at least 75% of their pre-retirement income. Unfortunately, even that won’t suffice for many retirees. According to research conducted by Prof. Dan Ariely, most soon-to-be retirees were planning living expenses of 135% of their pre-retirement income. Most soon-to-be retirees can barely afford their current lifestyle, much less upping their lifestyle by 35%. Most of these people are in for a rude awakening.

Merton throws out a plug for his own expertise:

If the Jones’ were my clients, here is what I would tell them: Put $250,000 ($125,000 each) into a managed variable annuity with a guaranteed minimum withdrawal benefit (Income for life).Many of these policies have ratchets that allow for appreciation of the income benefit event if the market declines. (A word of caution — these can be complex so always read the prospectus before investing).

Put the other $250,000 in high-quality dividend paying stocks that have a history of raising their dividends annually — so called Dividend Aristocrats. Our portfolio of such stocks has consistently generated an income stream between 4.5% and 5% after dividend hikes. Investors who held the portfolio for the past four years (since we launched the strategy) are now earning over 8% on their initial principal. While the income stream from this portfolio is very similar to the income stream from the Jones’ original portfolio, it is more reliable and less susceptible to volatility. This income stream is consistent, predictable and has upside. (For example, the dividend aristocrats found in the State Street High Dividend ETF SDY, +0.14% have raised their dividends by an average of over 11% annually over the past two decades; that’s an 11% raise each year).

Ah. Invest in high-quality stocks. I see. Why didn’t I think of that?

The obvious question is this: What happens to the Joneses’ investments when the market busts? We are in the midst of the largest asset market bubble in history. I would not want to be Mr. and Mrs. Jones when the market busts, should they take Merton’s advice. The last time Merton was wrong, it was to the tune of $4.6 billion flushing down the drain.

There is no way to put it nicely: The Joneses screwed up. They are not going to be able to maintain a middle-class living on a $500,000 nest egg for very long. This doesn’t even consider non-Medicare healthcare costs. This doesn’t consider assisted living costs. This doesn’t consider life’s little surprise expenses.

The Joneses are not going to be able to retire. They are going to work until no longer physically able to do so. They’d better have raised some charitable children who are willing, and can afford, to take them in. Paying a stranger to change your diaper isn’t cheap.

Do not do anything the Joneses do. The Joneses blew their money on expensive depreciating assets like brand new cars. They moved into larger houses 3 or 4 times throughout their lives and took on bigger debt each time. They spent decades stuffing a small amount of money into passive investment funds and expected it to float them through their golden years. For years, it may have looked like the Joneses were climbing into the upper class. It seemed nice while it lasted. But they never realized they were tying their own retirement noose.

“Keeping up with the Joneses” is a popular phrase in America. It involves measuring yourself culturally and economically against your peers.

Don’t keep up with the Joneses. Keep away from the Joneses. The Joneses make poor decisions.

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