In 1953, when “How to Marry a Millionaire” was in movie theaters, $1 million bought the equivalent of $8.7 million today. Now $1 million won’t even buy an average Manhattan apartment or come remotely close to paying the average salary of an N.B.A. basketball player.
Still,
$1 million is more money than 9 in 10 American families possess. It may
no longer be a symbol of boundless wealth, but as a retirement nest egg, $1 million is relatively big. It may seem like a lot to live on.
But in many ways, it’s not.
Inflation
isn’t the only thing that’s whittled down the $1 million. The
topsy-turvy world of today’s financial markets — particularly, the
still-ultralow interest rates in the bond market — is upending what many people thought they understood about how to pay for life after work.
For
people close to retirement, the problem is acute. The conventional
financial advice is that the older you get, the more you should put into
bonds, which are widely considered safer than stocks. But consider this bleak picture: A typical 65-year-old couple with $1 million in tax-free municipal bonds
want to retire. They plan to withdraw 4 percent of their savings a year
— a common, rule-of-thumb drawdown. But under current conditions, if
they spend that $40,000 a year, adjusted for inflation, there is a 72
percent probability that they will run through their bond portfolio
before they die.
Suddenly,
that risk-free bond portfolio is looking risky. “The probabilities are
remarkably grim for retirees who insist on holding only bonds in the
belief that they are safe,” says Seth J. Masters, the chief investment officer of Bernstein Global Wealth Management,
a Manhattan-based firm, which ran these projections for Sunday
Business. “Because we live in this world we tend to think of it as
‘normal,’ but from the standpoint of financial market history, it’s not normal at all,” Mr. Masters said. “And that’s very clear when you look at fixed-income returns.”
But for savers, low rates have been a trial. The fundamental problem is that benchmark Treasury yields
have been well below 4 percent since early in the financial crisis.
That creates brutal math: if your portfolio’s income is below 4 percent,
you can’t withdraw 4 percent annually, and add inflation adjustments,
without depleting that portfolio over time.
And with rising life expectancies, many people will have a lot of time:
the average 65-year-old woman today can be expected to live to 86, a
man to 84. One out of 10 people who are 65 today will live past 95,
according to projections from the Social Security Administration.
“If you’re invested only in bonds and you’re withdrawing 4 percent, plus inflation, your portfolio will decline,” said Maria A. Bruno, senior investment analyst
at Vanguard. “That’s why we recommend that most people hold some
equities. And why it’s important to be flexible.” In some years,
investors may need to withdraw less than 4 percent, she said, and in
some years they can take more.
And
if you’re not close to being a millionaire — if you’re starting, say,
with $10,000 in financial assets — you’ve got very little flexibility
indeed. Yet $10,890 is the median financial net worth of an American
household today, according to calculations by Edward N. Wolff, an economics professor at New York University.
(He bases this estimate on 2010 Federal Reserve data, which he has
updated for Sunday Business according to changes in relevant market
indexes.)
A millionaire
household lives in elite territory, even if it no longer seems truly
rich. Including a home in the calculations, such a family ranks in the
top 10.1 percent of all households in the United States, according to Professor Wolff’s
estimates. Excluding the value of a home, a net worth of $1 million
puts a household in the top 8.1 percent. Yet even such families may have
difficulty maintaining their standard of living in retirement.
“The bottom line is that people at nearly all levels of the income distribution have undersaved,” Professor Wolff said. “Social Security is going to be a major, and maybe primary, source of income for people, even for some of those close to the top.”
Professor Munnell
said that in addition to relying on Social Security, which she called
“absolutely crucial, even for people with $1 million,” other options
include saving more, spending less, working longer and tapping home
equity for living expenses. “There aren’t that many levers we can use,”
she said. “We have to consider them all.”
THE bond market has always been a forbidding place for outsiders, but making some sense of it is important for people who rely on bond income.
Low bond yields have been a nightmare for many investors, but that’s not the only issue. Today’s market rates aren’t stable. Steve Huber, portfolio manager at T. Rowe Price, said, “Current yields are an anomaly when you consider where rates have been over the last decade or more.”
And bond investing is likely to remain challenging for years to come. Investors may face a double-whammy — low yields now and the prospect of significant losses as yields rise. On Friday, after the Labor Department reported that the unemployment rate edged up to 7.6 percent from 7.5 percent, yields rose further, amid uncertainty about the Fed’s intentions.
Despite this market instability, bonds tend to be the investment of choice as people retire, because they throw off steady income. But as the projections from Bernstein Global Wealth Management suggest, over-reliance on bonds leads to financial quandaries.
These
projections, based on proprietary market and economic forecasts and
portfolio analyses, as well as on standard actuarial and tax data,
estimate future probabilities for investors. That’s a quixotic task at
best, intended to illustrate possible outcomes rather than to provide
precise forecasts, said Mr. Masters at Bernstein.
Still,
they are worrisome. Consider again the 65-year-old couple who are
starting to draw down $1 million in savings this year: if they withdrew 3
percent, or $30,000, a year, rather than that standard rate of 4
percent, inflation-adjusted, there is still a one-in-three chance that
they will outlive their money, under current market conditions.
There are ways to improve these outcomes, but they have their own hazards. Adding stocks
to a portfolio is an obvious counterbalance. And there is now a broad
consensus among asset managers and academics that stocks have an
unusually high likelihood of outperforming bonds over the next decade.
That was the finding of a recent study by two economists at the Federal Reserve Bank of New York.
The Bernstein projections
concur that adding stocks to a portfolio reduces the risk of outliving
your savings. But it also increases the risk of big losses.
Assume,
for example, a diversified portfolio that is 80 percent invested in
stocks and 20 percent in bonds — a much higher stock-to-bond ratio than
advisers typically suggest for someone near retirement. In that situation, under current market conditions and at a 4 percent withdrawal rate, the probability
of running out of money drops to 14 percent. That’s mainly because of
higher expected returns for stocks. At a 3 percent withdrawal rate, the
probability of outliving the portfolio is only 4 percent.
But then stock market
risk comes into play. Over the long term, stocks tend to outperform
bonds, but typically fluctuate much more wildly. There’s a good chance
that at some point, stock investments will produce major losses that
many people simply can’t tolerate.
“We
find that people tend to think of losses in their portfolios based on
the peak value they’ve ever had,” Mr. Masters said. So Bernstein calculates the probability of what it calls a “peak-to-trough loss” of at least 20 percent in its sample portfolios.
“Large losses may not be something that people are willing to live with, even if they are associated with higher returns over the long term,” Mr. Masters said. “Which is why we’d recommend holding some stocks, but not as much as 80 percent, for most people.”
Bonds would fare better in an economic environment more typical of the past, with higher interest rates, among other factors, Bernstein projections show. Should those conditions return one day, investment
choices would be less stark. Under “normal” conditions, Bernstein
projects, at a 4 percent withdrawal rate, inflation-adjusted, a
portfolio 100 percent invested in bonds would have a 38 percent chance
of running out in an investor’s lifetime; at a 3 percent withdrawal
rate, the chances drop to 14 percent.
T. Rowe Price
projections — which don’t differentiate between current conditions and a
historically normal environment — include different stock and bond
indexes, and don’t include the effect of taxes. That outlook finds that a
65-year-old couple who invested entirely in bonds have a 21 percent
chance of outliving their portfolio. That’s much more favorable than the
Bernstein projections.
Still,
Jim Tzitzouris, quantitative analyst at the asset allocation group of
T. Rowe Price, said, “In the current environment, it’s worth being quite
concerned about the effects of low interest rates on a retirement portfolio.”
Still, the expectation of working longer seems to be the trend. An annual survey for the Employee Benefit Research Institute found that in 1991, only 11 percent of workers expected to retire after age 65, while this year, 36 percent said they would retire after 65 — and 7 percent said they didn’t plan to retire at all.
Working longer improves your financial prospects, and one reason is morbid: you won’t have as long to live on your savings.
Working longer helps in a happier way, too. Professor Munnell notes that by delaying retirement, monthly Social Security
benefits rise substantially. For example, if you delay claiming
benefits past what the government calls your “full” retirement age — 66,
for people retiring this year — your monthly benefits increase by 8 percent a year until you reach 70.
It’s also a much
better return than a commercially available annuity will provide.
Vanguard estimates that a basic fixed annuity that ends at death will
produce an annual inflation-adjusted payout of only 3.7 percent if
bought today for a healthy 65-year-old couple. (But the money is
definitely gone when they die; there would be no surplus to pass on, as
there could be in an investment portfolio.)
Paying close attention to Social Security benefits is likely to be meaningful for retirees at nearly all income levels, Professor Wolff said. “Even at the millionaire level, for most people, Social Security is going to be very important.”
Still, even $61,000 or $71,000 a year — the combined Social Security and cash flow from the $1 million portfolio — isn’t likely to be enough for most people who have grown accustomed to living on $150,000 or more a year. And $150,000 is the median income of a typical household in the top 10 percent, roughly the ranking of a family with $1 million in net assets, Professor Wolff says.
Without another source of income, perhaps from traditional pensions from either or both spouses, he adds, a household like this won’t come close to replacing 80 percent of its pre-retirement income — often considered an acceptable target level.
And, he says, if Social Security is important for the relatively affluent, it’s all the more so for those with less income and wealth, especially with the decline of traditional pensions. “Social Security needs to be strengthened, not cut,” he says.
Professor Munnell
says this might be accomplished simply by raising the maximum taxable
income level for Social Security payroll taxes. Currently, that level is
$113,700. “Social Security has done its job and it can easily be made
solvent in the future,” she said.
There
are a few steps that people can take on their own, she said. “When
you’re younger, and have a lot of human capital, you can save more and
put a lot of the savings into stocks,”
she said. And then you can gradually shift into bonds as you age, fully
understanding that the bond income may be quite limited. “When you’re
in your 50s,” she continued, “you can try to save as much as you can,
and try not to get accustomed to a lifestyle that you won’t be able to
afford later on.”
That
might not be the way you imagined your life. But the numbers suggest
that even if you’re a millionaire, you might have to start.
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