Probability of Plan Success

Two of the most unpredictable variables affecting the success of a retirement plan are life expectancy and investment experience. In retirement plans, we usually simulate these variables based on probabilities of historical results. We first assume a life expectancy by evaluating what percentage of people have lived to certain ages. We then develop a plan that would have been successful in a certain percentage of past investment time periods. When we combine these probabilities of life expectancy and investment return, we may amplify the probability of success for a retirement plan.

Let's consider a plan that assumes a 50% life expectancy, meaning half of people live beyond that age, and a 80% historical success ratio, meaning one-fifth of past time periods had a lower investment return. The plan would fail only if the person lives longer than 50% of people AND if the investment return is worse than 80% of past time periods. Because plan failure depends on both events occurring, the probability of success is amplified. To calculate this, we multiply the probabilities of both events to find their combined probability. [(1-0.50) x (1-0.80) = 0.10] There is a 10% chance both events occur; therefore, the combined probability of success for that scenario is 90%.

We should be cautious regarding how the combination of conservative assumptions for life expectancy and investment experience can magnify the probability of success. Let's consider a plan that assumes a 25% life expectancy and a 88% historical success ratio. The plan would fail only if the person lives longer than 25% of people AND if the investment return is worse than 12% of past time periods. [(1-0.25) x (1-0.12) = 0.03] There is a 3% chance both events occur; therefore, the combined probability of success for that scenario is 97%. These assumptions may cause the plan to be more conservative than was originally intended.

Although we may like retirement plans that have little chance of failure, no person wants to feel constrained due to overly conservative plan assumptions. Most people want to spend what they can before death rather than leave behind a large estate. We must strike a comfortable balance between the amount of spending and the probability of plan success. If the life expectancy and investment returns do not follow the plan projections, spending can usually be modified later in life to compensate. Retirement plans must always adapt to changing variables in order to maintain an acceptable probability of success.

Your Retirement Number

As you may have noticed by the advertisements, a currently popular trend in retirement planning is to calculate "your number." This refers to the amount of savings you need to have at retirement. From a marketing perspective, "your number" attracts consumers who prefer simplicity and an easily defined goal, but from a financial perspective, "your number" does not address all the dynamic variables of retirement planning. Retirement planning is more complex than just a number.

Retirement planning is a process that continues over your lifetime, not a one-time occurrence. You cannot calculate "your retirement number" now and carry that same number around for years expecting it to remain static until you retire. During your lifetime, "your number" will be affected by many variables that can unexpectedly change, such as incomes, expenses, savings rates, tax rates, inflation rates, asset allocations, and investment performance. Your retirement plan should be updated and modified as these changes occur so that you can adjust the other variables to maintain an acceptable probability of reaching your goals.

Retirement planning allows you to map a course of actions from now until your death. Just knowing "your retirement number" is like having a destination without having directions. You need directions such as how much to save and where to invest in order to reach your goals. You should also recognize that death, not "your number," is the ending destination point in your retirement plan. Even though you might reach "your number" by retirement, you could still run out of money before death if variables such as inflation rates, investment returns, and portfolio withdrawals are different than planned.

The advertising of "your number" has been beneficial for retirement planning awareness, but consumers should recognize that just calculating "your number" is not an adequate substitution for a comprehensive retirement plan. A retirement plan should be developed, implemented, monitored, and modified as needed over your lifetime to help you achieve your goals. If you would like help with this process, please consult with a CFP® professional who provides financial planning services.

Death File

Imagine you die today and your loved ones are left without instructions for what to do. Thinking about death may be unpleasant, but planning now for that inevitable event will be very helpful to your survivors once you are gone. Many people think their estates will be taken care of after they die as long as they have a last will and testament. While the will is useful for distributing your estate after death, it does not provide adequate directions for your survivors. You can better prepare for your survivors by building a "death file" that includes all the important documents and instructions they may need to manage your estate after you die. You may want to call it something less morbid than "death file," but make sure your trusted loved ones know about the file and how to access it after your death. Let's review some items you should include in the file.

The file should include your original last will and your trust documents, or at least copies and the noted location of the originals. Your healthcare power of attorney and financial power of attorney should be accessible by a trusted person before your death, but you may also want to store these documents in the file since they are often prepared with your other legal documents. You should include a letter of final instruction that covers any other requests not specifically addressed in your will, including funeral arrangements. Note any advance payments you made regarding your funeral and burial. The letter of final instruction also allows you to request how your beneficiaries manage your estate after you die; although, they are not legally bound to abide.

Your beneficiaries may not know about all of your assets that are not specifically listed in your will, and if so, those unknown assets could go unclaimed. Therefore, your death file should document all of your assets and their details. These include bank accounts, investment accounts, retirement accounts, business interests, life insurance contracts, real estate deeds, vehicle titles, and anything else where you are the registered owner. For each asset, note the account title, account number, location or custodian, and contact information. Also include this information for any mortgages, loans, credit cards, or other liabilities you have. Some debts may be forgiven at your death while others may need to be paid back using assets from your estate.

Do not expect life insurance companies or any other institutions to initiate contact with your beneficiaries after you die. For this reason, include records of all your life insurance policies so you beneficiaries know about the available death benefits they should claim. Also include records of your other insurance policies such as homeowner's insurance, automobile insurance, health insurance, disability insurance, and long-term care insurance. Your survivors may need to contact the insurance providers to cancel your policies or transfer ownership of the policies.

Income you are receiving should terminate at your death, so your survivors may need to contact certain benefit providers to stop those income payments. Include records of any income sources you have such as Social Security benefits, retirement pension benefits, and annuity contract payments. For each, note whether your survivors are entitled to continue receiving your benefits or reduced benefits. If your survivors are not entitled to the benefits, they may be required to return any payments sent after your death.

Expenses you have could extend beyond your death, so you should include records of all bills that you pay. These could include monthly payments such as rents, utilities, and credit cards, as well as annual payments such as real estate taxes, insurance premiums, and membership dues. Your survivors may need contact the service providers to cancel your accounts and settle any outstanding balances. You may want to leave instructions regarding how you manage and pay the bills. Also note deposits that may be refunded at cancellation.

Your file should include your marriage license so your spouse can prove your relationship and exercise any rights he/she has as your survivor. For similar reason, you should include your divorce records in case your ex-spouse attempts to claim property he/she is not entitled to receive. You may want to include birth certificates, and adoption records if applicable, for your children or other decedents who are named in your will. The file is also a good place to store Social Security cards, passports, and other forms of identification.

The list of items reviewed above should not be considered comprehensive. If you have additional documents or instructions you feel will be important to your survivors, include all of those in your death file. No matter how much information you include in the file, your loved ones may still have questions after you are gone. Include a list of professionals you have worked with that could help answer your survivors' questions. These might include your attorney, accountant, and financial advisor.

Once your gather the documents for your death file, store them in a secure place and share the file's location with your trusted loved ones. Be sure more than one trusted person can access the location and retrieve the file because it will serve little purpose if the only access person has also died. Discuss the file with your loved ones now so they can ask questions and learn what to do following your death. Although it will be a difficult time for your survivors, they will greatly appreciate this invaluable resource when that day eventually comes.

Life Expectancy of Couples

One of the biggest concerns people have in retirement planning is the possibility they will run out of money before they die. People do not know when they will die, so they have to make assumptions about life expectancy in their retirement plans. They often consider life expectancy probabilities of the general population in determing what age to assume they die.

The process is simple for a single person. A woman may want to assume she lives longer than 50% of women her age, so she would observe historical data that shows at what age 50% of women her age have died. If historically, 50% of women her age have died before age 85, she would want to assume a life expectancy to at least age 85 in her retirement plan.

A complication arises when determining the joint life expectancy for a married couple. The couple may want to assume they each live longer than 50% of people their ages, but they should not consider their life expectancies independently. The married couple does not want to run out of money until both have died, so they should calculate the probability of at least one of them living longer than 50% of people their age. The probability that both die before 50% of people thier ages is much lower than 50%.

The probability of multiple independent events, such as the ages of death for two people, can be calculated by multiplying the probabilities of each event. For example, the combined probability that a man dies before 50% of men his age and a woman dies before 50% of women her age equals 25% (0.50 x 0.50 = 0.25). If the a couple wants to plan for at lease one partner living longer than 50% of people their age, they should assume each partner lives longer than 70.7% of people thier age (0.707 x 0.707 = 0.500).

Life expectancy is just one of many assumptions that must be made in retirement planning. Assuming a long life expectancy will not ensure retirement plan success, but assuming too short of a life expectancy will increase the chance of running out of money before death. People can better prepare for making their money last a lifetime if they give adequate thought to their life expectancy assumptions.

Mutual Fund Cost Basis

The IRS rules for mutual fund cost basis reporting have changed effective January 1, 2012. Before 2012, investment companies were not required to report cost basis information to investors or the IRS when investors sold mutual fund shares. Investors were solely responsible for reporting their cost basis and capital gains to the IRS when they sold mutual fund shares. Investment companies that historically provided cost basis information did so at their own discretion. Now for the 2012 tax year and beyond, the IRS requires investment companies to report cost basis information to investors and the IRS when investors sell mutual fund shares. The cost basis reporting requirement only applies to mutual fund shares acquired on or after January 1, 2012. Investment companies are still not required to report cost basis information for mutual fund shares that investors acquired before 2012. The cost basis reporting also only applies to shares sold in taxable, non-retirement accounts because realized capital gains in retirement accounts are typically tax-deferred or tax-exempt.

Investors have three options for how their mutual fund cost basis will be reported. The average cost method assumes the cost of shares sold equals the average cost of all shares acquired by the investor. The first-in first-out method stipulates for the shares to be sold in the same order they were acquired by the investor. The specific identification method allows the investor to select which shares are sold regardless of when they were acquired. Investors are free to choose which cost basis method best suits their individual tax situation and even switch between the different methods with one exception. Investors who use or have used the average cost method to report capital gains or losses on mutual fund shares acquired before 2012 must continue to use the average cost method for all shares of that mutual fund acquired before 2012.

When investors sell mutual fund shares acquired before 2012, they are not required to decide on a cost basis method for those shares until they file their income tax returns because investment companies are not reporting the cost basis to the IRS. With that flexibility, investors can choose which cost basis method provides them the lowest tax burden after they have evaluated their entire tax situation for the year. That flexibility does not exist for mutual fund shares acquired in 2012 and beyond. When investors sell mutual fund shares acquired on or after January 1, 2012, they need to select their cost basis method before or at the time of sale so investment companies know which method to report to the IRS. Investors should be motivated to select their own cost basis method because an investment company's default reporting method may not provide the best tax advantage. Ultimately, the new cost basis reporting requirements should benefit investors as well as the IRS. Although more tax planning may now be required, fewer tax reporting errors should occur. Investment companies and investors are now cooperating parties in the calculation of mutual fund capital gains.

Index Fund Advantages

Mutual funds can be classified as either index funds or active funds. Index funds attempt to replicate the performance of a benchmark index by owning the same securities as the index in the same proportions as the index. Active funds attempt to perform better than a benchmark index by owning specific securities that may or may not be included in the index but are expected to perform better than the index as a whole. Both types of mutual funds have proponents who will argue their advantages. Three advantages of index funds are convenience, consistency, and cost-efficiency.

Index funds are very convenient for investors who prefer not to spend a lot of time and resources trying to determine which mutual funds to buy and sell. Investors decide which segments of the market they want own and then buy and hold index funds that track those segments. This eliminates the need to evaluate all the active fund offerings of multiple companies to select which fund might perform best in a category. Instead of analyzing mutual funds, index fund investors rely on the benefits of diversification and allocation. Diversification within a category is easy to achieve with index funds because they typically own most if not all of the securities that comprise a category. Rather than determining which categories to overweight or underweight, index fund investors can get market performance by simply allocating their portfolios to match the percentages each category represents of the overall market. Risk levels can be easily controlled by adjusting the allocations between stock index funds and bond index funds, and occasionally rebalancing among those index funds will allow investors to maintain their desired allocations.

Index funds consistently provide the average performance of a category because they always own a representative sample of all the securities in a category. The investment return of an index fund will resemble the aggregate return of all the securities that comprise that index. The securities owned by active funds may not fully represent the category, so their returns can be very different and inconsistent from the average returns of the category. When active funds in pursuit of better performance buy securities outside of their benchmark category, this changes the style and composition of the funds. Index funds are consistent in their style and composition because they will only own the securities that are included in the benchmark index. As a result, index funds have little risk of performing worse than their category benchmarks. Index funds appeal to investors who seek investment returns that are consistent with the returns of their targeted categories.

Index funds are cost-efficient because they do not require a lot of management labor. Index fund managers simply buy and hold shares of the securities that are included in the benchmark index. Active fund managers must research and monitor securities inside and outside of the index to determine which to buy and sell for their funds. The active fund managers ensure they are compensated for this additional work by charging higher expenses, thereby passing along extra costs to investors. In addition to higher fund expenses, investors may incur more tax costs with active funds. As active managers buy and sell multiple securities attempting to perform better than an index, they increase their funds' turnover ratios, which increases the frequency of realized capital gains. Index funds buy and hold the same securities as long as they are included in the index, so index funds typically have lower turnover ratios and fewer capital gains tax liabilities.

Index fund advocates follow a certain philosophy about investing. They believe active funds are inconvenient to analyze and monitor, inconsistent in composition and performance, and inefficient regarding costs. They believe the probability of an active fund performing better than a benchmark index does not warrant the acceptance of those disadvantages. They believe index funds are superior because they are convenient, consistent, low-cost investments, and maybe the biggest advantage of index funds is performance. Data from Standard & Poor's Index Versus Active scorecard shows index funds have historically performed better than a majority of their active fund peers.

When To Start Social Security Benefits

People who are eligible for Social Security retirement benefits may start receiving benefits anytime between ages 62 and 70. However, people who start receiving benefits before their full retirement age, which is 65 to 67 depending on year of birth, will see their monthly benefits permanently reduced, and people who delay receiving benefits past their full retirement age will see their monthly benefits permanently increased. This trade-off causes many people to question when is the optimal age to start receiving benefits. The following are a few aspects to consider before deciding when to start receiving Social Security retirement benefits.

Life Expectancy
Assuming everyone lives to the same age, people who begin receiving Social Security benefits at younger ages will collect a lower monthly benefit for more years, and people who begin receiving Social Security benefits at older ages will collect a higher monthly benefit for fewer years. While we know not everyone has the same life expectancy, the Social Security Administration (SSA) attempts to predict what the average age of death will be for people depending on their gender and current age. You can find the average life expectancy for a person of any age on the SSA website. The SSA considers the average life expectancy age to be the break-even point for the total lifetime benefits a person will receive. So theoretically, a person will have received the same total lifetime benefits at his or her life expectancy age, regardless of which age he or she began receiving benefits. People who feel they will live more or less years than the average life expectancy should let that influence their decision of when to start receiving benefits. People who will die before the average person their age may want to start receiving benefits at an earlier age, and people who will live longer than the average person their age may want to delay receiving benefits until a later age.

Investment Return
Once a person starts collecting a Social Security retirement benefit, that monthly benefit amount is locked in for life with an increase only for cost-of-living adjustments when determined by the SSA. For every month a person starts receiving Social Security benefits before his or her full retirement age, the benefit amount is reduced by a certain percentage, and for every month a person delays receiving Social Security benefits after his or her full retirement age, the benefit amount is increased by a certain percentage. You can find the percentage adjustment for a person of any age on the SSA website. The percentage increase or decrease may be considered favorable or unfavorable compared to a person's expected investment return. If the percentage increase or decrease of the monthly benefit is less than a person's investment return, he or she may may want to start receiving benefits at an earlier age and invest the benefits for a return greater than the SSA adjustment. If the percentage increase or decrease is more than a person's investment return, he or she may want to delay receiving benefits until a later age because the SSA adjustment will provide a greater return than investing the benefits.

Employment Status
People who are still working and earning income do not usually benefit from starting to receive Social Security benefits before their full retirement age. Not only do they receive a reduced benefit by starting at the earlier age, but the SSA imposes an additional penalty by reducing their monthly benefit by $1 for every $2 of income they earn above $14,160 per year (limit adjusts for inflation). People who are working often have higher incomes and higher marginal tax rates before retirement than they will have after retirement. Social Security benefits are counted as part of taxable income, so some people may not want to receive benefits during their working years when they are paying income taxes at higher marginal rates. In some cases, starting to receive benefits while continuing to work may push them into higher marginal tax brackets. The effect of income taxes on Social Security benefits should be evaluated in conjunction with a person's after-tax investment return. If income taxes suppress a person's net investment return to less than the percentage adjustment for delaying Social Security benefits, receiving later may be preferable to receiving early.

We cannot definitively determine the optimal age to start receiving Social Security retirement benefits because the decision is often based on multiple unknowns. We must make assumptions about life expectancies, investment returns, and income taxes. However, we do know the aspects to consider in the evaluation, and we use this information to guide us to the best decision we can make at the time.

Saving For Children

Personal finance experts emphasize the importance of starting to save at an early age. The power of compound interest can provide a huge financial advantage for people who begin saving for retirement several years sooner than their peers. Some of us have seen the calculations that show the difference between starting to save in your 20s versus your 30s and how the person who starts saving sooner has a larger account balance at retirement. Most people have reached their older years before they realize this benefit and then can only wish they had started saving sooner. While the benefit of starting to save early may have been missed by older people, they can still help their children benefit from a long time horizon. If starting to save just ten years sooner than your peers provides a large advantage, imagine the benefit of starting to save twenty or thirty years sooner. With some assistance from their families, children can benefit from the power of compound interest while also learning the valuable lesson of saving.

Assume you save $100 per month for your child from her birth to her age 18. If you invested the savings in a diversified stock market mutual fund, and it grows by 8% per year, the account balance would be $48,009 by her age 18. That would be a nice gift for college, but what if she leaves the money alone? If she does not touch the account for the next 47 years, no additions or withdrawals, and it continues to grow by 8% per year, the account balance would grow to $2,036,326 by her age 65. That nice gift for college turns into a nice nest egg for retirement.

In the above scenario, your child does not save any additional money to the account after her age 18. Now assume she continues saving $100 per month to the account after age 18, and it grows by 8% per year. In that case, the account balance would be $2,657,564 by her age 65. Although she continues to save for 47 additional years, the ending balance is only about 30% higher. That shows the true power of starting to save early. The first 18 years of saving produce a balance of $2,036,326, while the last 47 years of saving produce a balance of only $621,238. The reason is the earlier savings experience more years of compound interest growth.

Saving for your children's retirement may not be a priority, and you should not place that goal ahead of saving for your own retirement, but if you have the ability to invest for your children, they will thank you one day. Imagine if your parents had invested for you in the stock market back when you were a child and how much that investment might be worth today. You would be pleased, and your children would probably feel the same. Teach your children the concept of saving by getting them involved in the process. For example, if you want them to have an allowance of $10 per week, give them an allowance of $15 per week with the requirement they save $5 in an account so their net is still $10. This will teach them that they must always save a portion of the money they earn or receive. Children have the ability to learn the concept of saving at an early age, and parents who teach this to their children pass on a valuable life lesson.

Time And Risk

Investors want to receive the highest possible return with the lowest possible risk. However, the risk/reward trade-off principle says we cannot increase our potential return without increasing our exposure to risk. Is that always true? The risk/reward principle is usually applicable for short-term investments, but when we consider long-term investments, we can maximize potential return with minimal exposure to risk.

Consider the risk/reward principle in comparing a stock portfolio and a bond portfolio. In any one year, an all-stock portfolio has a higher potential return and a higher probability of loss than does an all-bond portfolio. Therefore, stocks are considered the higher risk/reward investment over a short time period. The applicability of the risk/reward principle depends the time horizon considered. When we evaluate the stock portfolio over a longer time horizon, the potential return increases and the probability of loss decreases.

Looking at the past 85 years of historical investment returns, from 1926 through 2010, we can see which time periods an all-stock portfolio performed better and which time periods an all-bond portfolio performed better. Considering all 5-year time periods from 1926 through 2010, stocks performed better than bonds in 70% of the 5-year periods. Considering all 15-year time periods, stocks performed better than bonds in 95% of the 15-year periods. Considering all 25-year time periods, stocks performed better than bonds in 100% of the 25-year periods.

The historical investment return data shows that as we extend the time horizon, the risk of a stock portfolio decreases because the probability of a higher return increases. That should be the focus for long-term investors. Do not worry about the daily volatility of a long-term investment. The ultimate goal of a long-term investment is to maximize return. In time periods of 25 years or longer, an all-stock portfolio has always produced a higher investment return than an all-bond portfolio. So if you are an investor with a long time horizon, investing in a stock portfolio should minimize your risk of inferior performance.

Overfunding Education with 529 Plans

The idea of saving too much for college may not seem like a big concern considering college costs are increasing at about double the rate of inflation. However, for families that use only 529 plans to save for future college costs, saving too much could cost them more than saving just enough. A 529 plan is a type of tax-advantaged account designed specially for college education savings. 529 plan contributions are not deductible for federal income taxes, but money contributed to the plan can grow tax-free, and withdrawals are tax-free if the money is used for education expenses. If the money from a withdrawal is not used for education expenses, the earnings portion of the withdrawal is taxed at ordinary income tax rates plus an additional ten percent penalty tax. That potential tax is an important reason why families should not save too much in 529 plans. Families should instead consider splitting their college education savings between 529 plans and regular, taxable accounts. Let's compare these strategies with a couple of examples.

The Martinez family wants to save enough for their infant daughter to attend an expensive private school at a future estimated cost of $200,000 for four years. The Martinez family saves $100,000 in a 529 plan for their infant daughter which grows to $200,000 by the time she graduates from high school. Once their daughter reaches college age, she decides to attend a more affordable public school that will cost $100,000 over four years. The Martinez family has $200,000 in their daughter's 529 plan but will use only half of that amount for her public college education. Therefore, half of the earnings in her 529 plan ($50,000) will be subject to ordinary income taxes and a ten percent penalty tax. So if the Martinez family is in the 25% federal income tax bracket, they will owe $17,500 in taxes on the half of earnings ($50,000 x 25%) + ($50,000 x 10%).

The Rodriguez family also wants to save enough for their infant son to attend an expensive private school at a future estimated cost of $200,000 for four years. The Rodriguez family saves $50,000 in a 529 plan and $50,000 in a regular, taxable account. The $50,000 in the 529 plan grows to $100,000, and the $50,000 in the taxable account grows to $100,000 by the time he graduates from high school. Once their son reaches college age, he also decides to attend a more affordable public school that will cost $100,000 over four years. The Rodriguez family withdraws the entire $100,000 from the 529 plan to pay their son's education expenses, and therefore, pay no income taxes on the earnings portion of the 529 withdrawal. They do not use the other $100,000 in the taxable account for education, but the earnings in the taxable account ($50,000) will be subject only to capital gains taxes. So if the Rodriguez family is in the 15% long-term capital gains tax bracket, they will owe $7,500 in taxes on the earnings ($50,000 x 15%).

In comparison of the two above scenarios, both families saved the same amounts and paid the same amounts for education, but they did not pay the same amounts of income taxes. The Martinez family paid $10,000 more in taxes than the Rodriguez family because they used only a 529 plan for education savings rather than splitting education savings between a 529 plan and a taxable account. The ideal way to save for college education is to use a 529 plan to save for the minimum education costs and use a taxable account to save for potential costs above the minimum. This strategy will help prevent the overfunding of a 529 plan while still saving an adequate total amount for education expenses. The 529 plan is a great tool in saving for college education costs, but the 529 plan must be used in moderation. Otherwise, income tax penalties may defeat the potential tax benefits.