Most retirees have to shift gears in the way they think and invest. When you retire, the habits and attitudes that may have helped you accumulate what you believe is enough money for the rest of your life can suddenly threaten your financial future.

Here’s an example: From 1970 through 2001, equity funds and bond funds each had their ups and downs. But the effect on somebody accumulating money was quite different from the effect on somebody withdrawing money, as in retirement.

First, think about a worker accumulating money. If somebody began saving for retirement in 1970, investing $10,000 every year through 2001, a portfolio invested 100 percent in the Standard & Poor's 500 Index (S&P 500) would have grown to $4.37 million by the end of 2001. If instead this worker had invested $6,000 a year into the S&P 500 and the other $4,000 into five-year Treasury notes, by the end of 2001, the portfolio would have been worth only $3.06 million. The clear lesson: all-equity is better.

Now think about somebody retiring with a $1 million portfolio in 1970 and taking out $60,000 the first year, then increasing the withdrawal by 3.5 percent every year after that. In an all-equity portfolio, represented by the S&P 500, the ending value in December 2001 would be $774,714. The annual distribution would have grown to $174,302, enough to doom this portfolio to only a few more years of life, perhaps half a dozen, before it ran out of money.

But if the same retiree had invested 40 percent of the portfolio in 5-year Treasury notes and 60 percent in the S&P 500, the year-end balance in 2001 would have been $1.66 million, enough to sustain increasing withdrawals for another decade or more. The clear lesson: 60 percent equity and 40 percent fixed-income is better.

In other words, what’s better for an investor in the accumulation stage can be worse for a retiree. When you retire, you have to “unlearn” some major lessons you learned while you were accumulating your savings.

Most retired investors need to squeeze as much value as they can out of every dollar they have. In investments, the difference between having enough money and going broke can be as little as 0.50 percent per year in return. A difference of 1 percent in annual return can make a whopping difference in the chances of going broke.

Going broke is the biggest risk of retirement, and I want to demonstrate how important it is that retirees avoid some common and seemingly minor mistakes that can rob them of 0.5 percent to 1 percent of the returns they could get.

I asked Ed Ward, a former financial advisor for Merriman, to use a piece of software that simulates hundreds of possible outcomes to do a “Monte Carlo” study of the results of taking retirement withdrawals. We entered the annual investment returns for the past 50 years, which we believe is a typical period, and asked the computer to randomly pick hundreds of possible sequences of them in a retirement portfolio.

Sequence is very important to retirees, for the following reason. If you start retirement with a bear market, your portfolio can quickly become depleted, weakening all your future results. But if you start retirement with some very positive years, the earnings give you a cushion to fall back on later during hard times.

We asked the computer a seemingly simple question: If the past 50 years of returns could occur in any random order, what are the statistical chances that a retiree could start with $1 million and take out $60,000 a year, with the distribution adjusted upward every year by 3.5 percent, for various time periods, including 25 years, 30 years and 35 years, without running out of money? The computations assume a buy-and-hold portfolio invested 60 percent in the S&P 500 and 40 percent in five-year Treasury notes.

The results: This portfolio had a 100 percent chance of success through 15 years of withdrawals. The ratio dropped to 96 percent for 20 years, 89 percent for 25 years, 82 percent for 30 years and 74 percent for 35 years.

In other words, somebody who retired at age 55 with this portfolio and this plan of escalating withdrawals had a 4 percent chance of running out of money before age 75 and a 26 percent chance of running out of money before age 90.

What are the implications of this? I think this means retirees had better think mighty carefully about when they retire, how much they withdraw and especially about how they allocate their investments.

A 6 percent withdrawal rate is fairly conservative, and it requires a substantial amount of money when retirement begins. Nobody knows what inflation will do to the future purchasing power of those withdrawals, but an assumption of 3.5 percent is also relatively conservative. Many people wish to retire at age 55, at the same time that retirees are living longer than did their parents and grandparents. It’s not at all unreasonable to assume you’ll live to age 90. That means people who retire at 55 had better have a portfolio that will last for 35 years.

In addition, this portfolio allocation, while very simple and undiversified, is better in some ways than what many retirees have. The portfolio assumes an investor got the full return of the U.S. stock market (measured by the S&P 500 Index) and of five-year T-notes each year without any expenses or transaction costs. As a practical matter, that’s unrealistic.

In real life, many people invest much less efficiently than even this simple portfolio. Mutual fund expenses, improper diversification and poor investment choices, including insurance products, can very easily – and often do – rob investors of at least 0.5 percent per year of return. Quite often the penalty is one full percentage point.

So we asked the computer to make the same calculations, only with the assumption that every year’s return over the past 50 years was reduced by 0.5 percent.

The results: With this reduction, the portfolio still had a 99 percent chance of success through 15 years of withdrawals. But the ratio dropped to 94 percent for 20 years, 85 percent for 25 years, 75 percent for 30 years and 64 percent for 35 years.

That means somebody who retired at age 55 had a 15 percent chance of running out of money before age 80 and a 36 percent chance of running out of money before age 90.

When we ran the calculations assuming that every return was reduced by one percentage point, the odds worsened considerably. The portfolio still had a 99 percent chance of surviving for 15 years. But the chances of success dropped to 91 percent for 20 years, 80 percent for 25 years, 65 percent for 30 years and to 57 percent for 35 years.

In blunt terms, this means that a combination of costs and mistakes adding up to only one percentage point a year of return dramatically decrease the odds that a retirement portfolio can keep up with inflation-adjusted withdrawals for 30 or 35 years.

That’s the bad news, and it’s summarized in Table 1:

But there is good news, too. It’s not difficult to improve on the base portfolio in these calculations. The main opportunity for improvement is to properly diversify the equity allocations beyond the S&P 500, which over the past 32 years has underperformed most equity asset classes. Proper diversification should easily add 1 percentage point to the returns of a portfolio, and retirees who can get by on slightly less than 6 percent withdrawals have another opportunity to effectively improve their return.

I don’t think it’s unrealistic to believe retirees can add 0.5 or 1.0 percent to the annual returns of the base portfolio we described. And doing so will decrease the chances that those retirees might run out of money.

Once again we asked the computer for the probabilities. The results are summarized in Table 2, which shows that in the toughest case, a portfolio that must last for 35 years, adding even 0.5 percent return increases the chances of success from 74 percent to 83 percent. Adding a full percentage point of return brings the chance of success up to 87 percent.

The lesson: Differences in return that seem small can make a huge difference in retirement.

Even before I saw these results I had been thinking about what retirees can do to make their money do more for them. I’ve come up with a list of 14 things that can help you maximize your return without taking on more risk.

Credit cards are like awful junk foods: Once in a while, if you use them sparingly and carefully, they can come in handy. But as a habit, they are poison. This step seems too obvious to even have to mention. But I’ve been surprised at how many people are sitting on both low-yielding CDs and high-interest debt. A mortgage is often a necessity. But why would any retiree borrow money at 8 or 9 percent to buy a car and at the same time collect 3 or 4 percent interest, or even less, on a certificate of deposit or in a money-market fund?

A friend recently realized that he could do better with the $30,000 he had in a money-market fund earning less than 2 percent. He raided the money-market fund, signed up for a “platinum” checking account at Washington Mutual and immediately started earning 3.5 percent on his checking balance. The platinum account requires a balance of $25,000, so it’s not for everybody.

But if you have a substantial stash of cash in a bank earning very low interest, this can make a meaningful difference. How tough is it to make the switch? A customer service person at Washington Mutual pushed a few buttons on her computer and announced: “Done!”

Most retirees have cash (or equivalents) with totals at least in four figures. Half an hour of telephoning or looking on the Internet at sites like www.bankrate.com can show you ways to make that cash work harder. Late last month, we did a quick search on that site and found money-market deposit account rates ranging from an insultingly low 0.2 percent to a surprisingly generous 3.3 percent.

Yes, short-term bond funds have more risk than money-market funds, which are essentially risk-free investments. For an emergency fund that you aren’t likely to tap into very often, the mild volatility of short-term bond funds should be quite acceptable, especially considering the higher return.

From 1984 through 2001, three-month Treasury bills had an annualized return of 6.0 percent, while Vanguard’s Short-Term Corporate Fund had a 9.3 percent return. The short-term bond fund’s worst 12-month loss in that time was only 0.1 percent, hardly enough to notice.

The Vanguard fund has an annualized return of 6.5 percent over the past five years. In that time, it didn’t experience a single losing calendar quarter.

This is not new advice to savvy fund investors. But it’s always amazing to me how many people pay so little attention to fund expenses. Some of these same people take pride in turning off lights and turning down the heat in their homes at every opportunity. Yet they essentially throw away much larger sums of money by investing in expensive mutual funds.

The lowest-cost way to invest in mutual funds is through index funds. Vanguard’s 500 Index Fund (VFINX) has annual expenses of 0.18 percent. For investors with less than Vanguard’s $3,000 minimum to open a non-IRA account, the TIAA-CREF Equity Index Fund (TCEIX) has expenses of only 0.26 percent (and a minimum of $1,500 to open an account).

Actively managed funds vary widely in their expense ratios, too. If you’re looking for a lower-cost alternative to a fund you own or are considering for investment, you can find online help at www.Morningstar.com. You’ll need to know the fund’s asset class, such as large value, small growth or international stocks.

From the Funds page at Morningstar, click on “Funds” at the left of the page, then choose “Fund Selector.” This takes you to a page where you can set your criteria, for instance domestic no-load, large-cap value funds with expense ratios lower than the category average. Enter your preferences, then click on the “Show Results” tab.

You’ll get a list of funds that meet your criteria. If you want to see the lowest-expense funds, click on the column heading that says “Expense ratio” and you’ll see the funds sorted with the lowest ratios first.

For example, Selected American Shares (SLASX), an excellent large-cap value fund, has expenses of 0.94 percent. That’s below average for its category, but first-rate competitors are available for less. Vanguard Windsor (VWNDX), for example, has expenses of 0.31 percent, giving the management of that fund an advantage of 0.63 percent over Selected American.

Every dollar you don’t pay in expenses is a dollar that belongs to you, not somebody else.

Too many people in high tax brackets fail to use municipal bond funds and tax-free money-market funds. They wind up needlessly paying more taxes than they would otherwise.

On the other hand, some investors are so tax-averse that they invest in municipal bond funds even when taxable funds would give them a higher after-tax return.

Muni-bond funds make sense only for investors in relatively high tax brackets. If you aren’t sure whether or not that applies to you, the easiest way to figure it out is to make a comparison between two alternatives available to you.

Here’s how: Start by converting muni-bond yields to equivalent taxable yields. To do that, you’ll need to know three numbers: your marginal tax bracket, the yield you could get on a taxable fund and the yield you could get on a tax-free fund.

Divide the tax-free yield by the difference between your marginal tax bracket and 1.0. (Remember to include your state income tax bracket in this calculation if the fund would be tax-free for state purposes.) The result is an equivalent yield that is directly comparable to taxable yields.

Here’s an example using simple numbers that aren’t necessarily current or accurate: Suppose you are considering a municipal bond fund that yields 4 percent and you are in the 30 percent marginal tax bracket. Divide 4 percent by .7 (the difference between l.0 and .30) and you get 5.71 percent.

That means that a taxable fund yielding 5.71 percent will give you the same return after taxes as the tax-free fund yielding 4 percent. Any taxable fund that yields more than 5.71 percent will be a better deal for you than the tax-free fund, assuming everything else is equal such as the quality of the funds’ portfolios.

Among tax-free funds, two of my favorites are Vanguard High-Yield Tax-Exempt (VWAHX) and Vanguard Long-Term Tax-Exempt (VWLTX). To get their current yields, call Vanguard’s toll-free number at 1-800-662-7447. When we called late in March, we were quoted 30-day yields of 4.95 percent for the high-yield fund and 4.54 percent for the long-term fund. Using the formula above, for somebody in a 30 percent tax bracket, those are equivalent to muni rates of 7.07 percent and 6.49 percent, respectively. For somebody in the top federal tax bracket (38.6 percent for 2002), the equivalent yields are 8.06 percent and 7.39 percent.

Take the time to do the math. It’s the only way you’ll know what type of fund is a better deal for you.

This step won’t matter if all your money is in IRAs or other tax-sheltered accounts. But if you have any taxable accounts, you should never forget a simple truth: A tax is a loss.

Index funds are among the most tax-efficient ones. They do only minimal selling, and they rarely have to distribute much in the way of capital gains. Tax-managed index funds like those at Vanguard are superb vehicles for investors who can meet the $10,000 minimum opening balance requirement. Vanguard Tax-Managed Growth & Income (VTGIX), for instance, has never paid a capital gains distribution since it was started in 1994. This fund deviates only slightly from the S&P 500, in order to minimize taxes. And it has delivered slightly higher returns than the index over the past three and five years, according to Morningstar.

Over the five years ended February 28, 2002, Vanguard Tax-Managed Growth & Income had a tax efficiency ratio of 94.0 percent, according to Morningstar. That is about as good as it gets for large-cap blend funds that own lots of dividend-paying stocks. The comparable figure for Vanguard 500 Index Fund (VFINX) is 92.5 percent. That looks mighty attractive when compared with the tax efficiency of Fidelity Magellan Fund, 86.5 percent for the same five-year period.

Investors in actively managed funds can also find some that are very tax efficient. Two examples among large-cap funds are Dreyfus Appreciation (DGAGX) and Jensen Fund (JENSX). Their tax efficiency over the past five years, respectively, is 92.4 percent and 93.6 percent, according to Morningstar.

Most retirees have both taxable and tax-deferred (or in the case of Roth IRAs, tax-free) accounts. Some withdraw part of their living expenses from taxable accounts and the rest from tax-advantaged accounts. This can be counter-productive; future growth will be worth more if it comes inside a tax-sheltered account than inside a taxable account.

There may be estate planning considerations or other reasons for withdrawing money from particular assets. This is a case where it can be quite worthwhile to sit down with your tax advisor to discuss your individual situation.

In our workshops, we show a table of year-by-year figures assuming an investor retired in 1970 with $1 million and took out $60,000 the first year. We assume each year’s withdrawal was increased by 3.5 percent to simulate inflation.

A portfolio invested completely in stocks, represented in our table by the S&P 500, just barely kept its head above water for that period. By the end of 2001, the portfolio, which started with $1 million, had fallen to $774,414. That may seem like a loss from which it could recover, and that might be the case if annual withdrawals remained at $60,000. But after all the annual 3.5 percent adjustments, the withdrawal in 2001 was up to $174,302. There is no way such withdrawals can be sustained by a $774,714 portfolio, and this investor would very soon run out of money.

However, a portfolio split equally between the S&P 500 and five-year Treasury notes ended 2001 with a value of $1.57 million. Even that amount is probably too little to withstand many more years of escalating withdrawals, which in another four years would rise to $200,000 a year, or more than 12 percent of the portfolio at the end of 2001.

It’s important that retirees figure out their risk tolerance and what percentage of their portfolio should be in bonds. We’ve written extensively about that in the past, and I won’t repeat the whole discussion here.

If you don’t have a clue what the right percentage is for you and you need a quick and dirty answer, consider that you won’t go too terribly wrong by adopting the classic formula of large pension funds: 60 percent stocks, 40 percent bonds. Pension funds need growth but cannot afford to take any risk of running out of money. You’re probably in the same position.

Our most popular private management strategies for retirees are split 50/50 between bond funds and equity funds. Over the long haul, this seems to work very well for our clients, and it could work well for you too.

The heart of the matter is this: Bonds reduce risk when they are added to a portfolio of equities. The most effective way to obtain this effect is with short-term bond funds. Some investors prefer intermediate-term bond funds or long-term bond funds because of their higher yields. But longer-term bonds are more volatile, and they don’t provide quite the same amount of stability as short-term bonds.

I tell people that if you’re willing to take the additional risk of owning long-term bonds, you are better off to stick with short-term bonds and put a little more of your portfolio into equity funds. In other words, get your return from equity funds; get your stability from short-term bonds. That’s the most efficient way to construct a balanced retirement portfolio.

Value funds are an “easy sell” these days, as they have outperformed growth funds for the past few years. While the Standard & Poor's 500 Index was losing money, U.S. large-cap value stocks rose 10.2 percent in 2000 and another 3.9 percent in 2001. U.S. small-cap value stocks rose 10.8 percent in 2000 and another 22 percent in 2001. This data is from Dimensional Fund Advisors.

But the advantage goes back much farther than that. From 1970 through 2001, U.S. large-cap growth stocks rose 10.7 percent, annualized, and U.S. small-cap growth stocks rose 10.6 percent. In the same time frame, large value stocks rose 15.0 percent annually, and small value stocks gained at the rate of 16.8 percent.

I’m not saying you should put all your money into value stocks. But they should have a weight in your portfolio equal to growth stocks.

The story is the same as with value stocks. Size does matter, and small-cap stocks have outperformed large-cap ones over the past two years. It hasn’t always been that way and it won’t always be that way in the future. But for the times (like 2001, for example) when small-cap stocks shine, your portfolio should have them.

In 2001, according to Dimensional Fund Advisors, small-cap growth stocks were up 6.0 percent, compared with a loss of 15.2 percent for large-cap growth stocks. And while small-cap value stocks rose 22.0 percent, large-cap value stocks gained 3.9 percent.

In the longer term, the story is similar. From 1975 through 2001, small-cap value and small-cap growth had annualized appreciation of 21.6 percent and 16.4 percent, respectively. The comparable figures for large-cap stocks were 17.5 percent (value) and 13.7 percent (growth).

My recommendation: Don’t put the majority of your retirement portfolio, even of the equity portion, in small-cap funds. But give those funds equal weight with large-cap funds.

Future returns are uncertain. But if you put these four asset classes together with equal weight in your portfolio, you’ll most likely achieve higher returns than the S&P 500, with no more exposure to risk. In fact, the diversification may even reduce your risk.

Withdrawing less money in the earlier years of your retirement will let you take out more later, keeping up with inflation – or even ahead of it. The reason is obvious: Every dollar you don’t spend this year gets a chance to grow to be worth more next year.

I’m not advocating a retired life of penny-pinching and sacrifice unless that is really necessary.

But smart retirees are very clear about which expenses are essential and which are discretionary. If you have a properly diversified portfolio and it’s producing disappointing returns, it makes very good sense to pull back a bit on non-essential expenses.

Remember, your biggest risk in retirement is running out of money before you run out of life. You can spend a dollar only once. If you spend it on non-essentials one year, you won’t have it available for the essentials in some future year.

Finding the right balance is tricky, requiring thought and care. People who get this one right usually have much less financial trouble in retirement than those who are too casual about their spending until their money is seriously depleted, leaving them with limited options.

In a nutshell, cut your lifestyle a little over a lot of years so you won’t ever have to cut it sharply.

Rebalancing is one of those chores that many people find easy to postpone, sometimes indefinitely. If you have determined your proper asset allocation for retirement, especially how much of your portfolio you need in bonds and how much in equities, you should restore that balance once a year.

Over the years, you’ll make more money if you rebalance. If you don’t rebalance, the asset classes that have performed well may gradually come to dominate your portfolio, raising your risk exposure higher than you ever intended.

We pointed out at length in our March 2002 issue how timing reduces risk over long periods of time while often (but not always) improving returns at the same time. It is a winning combination for retirees, though it is fairly demanding for do-it-yourselfers.

To get the real benefit of timing, you have to watch the markets every day and be ready at any moment to buy or sell, often when doing so doesn’t quite feel like the right thing to do.

We have shown investors how to do this using data that’s readily available over the Internet. But I don’t really want to encourage retirees to spend much of their time hovering over the market and thinking about their investments.

And that leads to my final suggestion:

Getting professional help will give you a discipline for your investments. You’ll have a written plan so that you always know where you are supposed to be heading and where you should be at any given time. It will also avoid procrastination in taking the steps that need to be taken.

Finally, hiring a professional will give you time to focus on what retirement is supposed to be all about. This is a time in life to do whatever you’ve been wanting to do forever. It’s about taking on new challenges, spending time with your grandchildren, giving back to the world some of what you have learned. It’s a time to travel, relax, and discover new ways to enjoy life.

Money is an essential tool to doing all this. But it is only a tool. It is not the end, it is the means. Focusing a lot of continuing attention on your money is likely to divert you from doing what you ought to be doing in retirement: finding new ways, and rediscovering old ways, to enjoy life.

Therefore, my most important recommendation for retirees is to set up their financial lives early in retirement so that the money they need is there when they need it, without requiring much attention.

 

 

 

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