This is part one of a five-part series on Retirement Planning.
Part 1: Years to Retirement
Part 2: Savings Rate
Part 3: Inflation
Part 4: Social Security
Part 5: Large Asset Ownership
I was blessed to be born into a home where my parents actively taught my 5 brothers and myself the importance of managing our personal finances at a young age. They impressed on me the need to think ahead very early in life. By the fourth grade, I understood the importance of budgeting, by the 6th grade the power of compound interest, and by the 8th grade, I had completed my basic retirement plan.
Retirement planning, I remember, struck me particularly hard because by 8th grade I felt I had a good handle on my financial future. But then they started introducing me to all sorts of very important considerations about retirement planning that my 8th-grade mind completely forgot to take into account.
These considerations impacted my original calculations more profoundly than I thought they would. This made the process more challenging than I originally thought it would be. Although I did eventually create a retirement plan in the 8th grade, thanks to my mom and dad, it was much harder than I thought it would be!
Years to Retirement
This is quite possibly the most important factor in retirement planning. It can have a greater impact than any of the other factors.
What about savings rates? Yes, that is also a very important factor, but saving less earlier could still have a greater impact than saving more and starting later.
That is exactly why I believe that the number of years to retirement, thanks to compound interest, is the most important factor in determining your retirement income and overall plan.
Without having a good understanding of how compound interest works, the rest of this exercise might seem a little confusing, and truthfully even pointless.
Retirement Year and Asset Types
Aside from compound interest, asset type (and therefore your investment return) is also another significant factor. The risk profile of your retirement (investment) portfolio will change over time, and this change is primarily indicated by the number of years to retirement.
Here is the basic concept: Higher risk investments are more volatile and are likely to have large losses in some years, but are also more likely to have larger returns on average. The keyword here is the “average”. In the long term, the S&P 500 has averaged nearly a 10% return since 1926, and this has been used as the standard return to compare other investments. However, the truth is much more nuanced than that.
For instance, in 2019 the S&P 500 yielded nearly a 30% return on investments, which is outstanding to say the least. However, in 2018 the market actually saw a 6.24% loss! In fact, there were times when the S&P showed a double-digit loss for more than 5 years or individual years where it showed gains over 30%.
So, which year you end up retiring in will have a profound effect on the total you have tucked away for retirement. If you end up getting stuck retiring in a bad five or ten-year recession, your life savings may be profoundly less than in a good year. Essentially it will have the same effect as if you were saving for many years less than you have saved.
The way that we get around this is by migrating assets from higher-risk investments to lower-risk investments as retirement approaches.
Migrating Your Assets
I know just what you’re thinking, “Doesn’t lower risk mean a lower return on my investments?”.
Yes, in general, it does. But it also means more consistent and predictable returns on your investment.
In the bond market, high rated portfolios can yield a 2%-6% return nearly every year. With this type of portfolio, you wouldn’t have to worry about retiring in a year that has a huge loss, but instead in a lower return year.
There are a lot of strategies that exist on how to convert assets from high growth to preservation funds, which are based mostly on your risk aversion, or tolerance, and amount of asset accumulation.
Migrating assets from higher-risk to lower-risk investment vehicles won’t guarantee that you retire in the highest return year, or that you will avoid large losses in any given year. But it can certainly provide some peace of mind that you aren’t retiring in a year that experiences a significant amount of loss on your investments.
In up years, or high return years, move more assets over. In down years move fewer assets over, or even none. The longer you give yourself to make this transition, the more careful you can be to move your assets to wealth preservation funds (also known as income funds).
Start Planning Your Retirement
The further out retirement is, the more you need to be concerned with the growth of your retirement funds and net worth. The closer you are to retirement, the more you need to be concerned with asset preservation.
If you still have plenty of working years ahead of you before even considering retirement, you will have lots of instances to average high returns on your investments. That means you can afford to bear the risk of a few down years and take advantage of higher-risk investments.
However, if retirement is near, then take a lower return and preserve your assets. Make hay while the sun shines, but give yourself enough time to absorb a few rainy years.
Additional Considerations
I recommend assuming an annual return of 8-10% for your initial employment years, and then somewhere 5 to 10 years before retirement drop the return to 5% to 7% (to represent a transition from a high return to asset preservation process). After retirement drop the return to 3% to 5%.
It’s important to keep in mind that actual results will be based on real market performance, along with how good your timing is in transitioning assets over to protect principal payments. Too few transition years may destroy a lifetime of great savings. If you are planning on going full speed ahead with your retirement planning, make sure you give yourself time to break, otherwise, your portfolio might just crash.
Starting your financial future today
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