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If you were to pull into a parking garage today, you wouldn’t worry that the garage would collapse from the added weight of your car. You assume the garage was engineered to hold the weight of your vehicle and that of many others across several floors.
Your retirement plan should give you the same comfort at each level, if it is weighted properly. Yet many people don’t have a well-engineered retirement plan in place. Instead, their plan was structured in a way that creates top-heaviness in stocks, uncertainty, worry and the threat of collapse.
Income plan first, growth second
There are two stages to take into account when building a solid, comprehensive retirement plan: Growth and income.
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The first mistake people make is focusing too much on growth. They worry about the rate of return on their stocks and wonder whether they should own Apple shares instead of Microsoft or Nvidia. Should they buy gold? Or should they own more rental properties?
But it’s difficult to make growth-based decisions on your investments without an income plan. Most people who are making decisions about growing their money do so without knowing how they will use that money in the future. Instead of planning, they’re betting.
People with a plan in place will always want their investments as closely aligned to that plan as possible because they don’t want to expose themselves to unnecessary risk.
But people consumed with the growth side worry more about growing their assets over time rather than planning for the actual income stage, which is far more important.
How much income will you have in retirement?
The income stage basically consists of three major components throughout retirement:
Guaranteed income sources. These are pensions, Social Security, some annuity plans, government bonds and rental properties. Basically, you’re getting the same check every month, or a check that increases over time and is guaranteed as long as you’re alive.
For most people today, the only guaranteed income is Social Security because defined benefit plans (pensions) have been dissolving in the corporate space for years.
The potential gap. Expenses increase over time mainly because the cost of living keeps rising. At the same time, your defined benefit and other guaranteed income does not go up appreciably.
That difference between increasing expenses and stagnant income creates a gap. And that’s where financial planning for retirement comes in.
Defined contributions. This is a variable pool of money (like a 401(k) or other employer retirement plan) that moves up and down with the stock or the bond market most of the time.
Taxes and inflation can negatively impact defined contributions when you withdraw money from those accounts. The difficulty is in projecting income in retirement and whether the defined contributions can fill the gap between expenses and the guaranteed income sources.
Stress-testing your portfolio
Once you’ve defined expenses and what’s guaranteed to come in, you have to look at the variable pool of money you have invested and determine whether it can fill the gap when it’s stress-tested.
Think of this as a parking garage that you’ve got to load up with a bunch of vehicles. You have to make sure the structure can stand by designing it and balancing it properly.
In retirement, it needs to withstand five points of stress:
Longevity. People are spending more and having a high quality of life for longer. That adds up to financial risk because you have to produce more money for a longer period, especially if you want to maintain your lifestyle. Increased longevity is partially why many companies did away with pensions.
Inflation. Inflation is a primary stress on retirement plans because it systematically erodes the purchasing power of savings, making it harder to afford essential goods and services over a 20- to 30-year retirement.
Rising costs, particularly in healthcare and housing, can outpace fixed income sources, creating significant risks of outliving savings. If retirement portfolios are not adjusted to keep up with rising prices, the real value of the investment returns is diminished.
Taxes. Taxes are a risk because investment money accumulating for retirement, such as in traditional 401(k)s and IRAs, is mostly income taxable at a future year and at a future rate that’s unknown.
Retirees can go into higher tax brackets through forced withdrawals (known as required minimum distributions or RMDs) while also triggering higher Medicare premiums and taxes on Social Security.
Health care. There are two parts to health care in retirement. The first is the cost to maintain your health care, usually through Medicare, a prescription drug plan, dental and vision plans or Medigap. Then there are out-of-pocket medical expenses. These are two completely different risks.
The first you budget for every month. With the second one, you assume that at some unpredictable point you will have an expensive medical event that Medicare and your premiums won’t fully cover.
The stock market. We have no control over the market. So it’s ironic that of all the stresses we can put on a retirement plan, this is the one we put on it the most. Many of us hope to have a 6% to 7% annual guaranteed rate of return to fill the expenses gap with full liquidity.
But there is not an investment that’s going to consistently provide that rate. You can’t buy a bond fund and average 7% a year. You can’t buy treasuries or CDs and average 7% a year. You might get 7% once in a while, but you’re not going to get that every year.
The most dangerous thing you can do is back-test your portfolio using the stock market we’ve experienced for the past decade. This has been an aggressive bull market that may not be replicated over multiple decades.
If that is the case, those expecting history to repeat may be way over-projecting their returns.
Yet the stock market is one of the few ways to invest that can generate the necessary returns to help fill the gap. You just need to see how it fits in with the rest of your income plan.
The bottom line
Your retirement plan needs to be stress tested. When those five stresses have been addressed and properly weighted, you’ll know that your parking garage is going to stand the test of time — and that retirement will be a relaxing ride.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
