Estimating the True Cost of Retirement

Transcription

1 Estimating the True Cost of Retirement David Blanchett, CFA, CFP Head of Retirement Research Morningstar Investment Management 2013 Morningstar. All Rights Reserved. These materials are for information and/or illustrative purposes only. The Morningstar Investment Management division is a division of Morningstar and includes Morningstar Associates, Ibbotson Associates, and Morningstar Investment Services, which are registered investment advisors and wholly owned subsidiaries of Morningstar, Inc. All investment advisory services described herein are provided by one or more of the U.S. registered investment advisor subsidiaries. The Morningstar name and logo are registered marks of Morningstar. This presentation includes proprietary materials of Morningstar. Reproduction, transcription or other use, by any means, in whole or in part, without the prior, written consent of Morningstar is prohibited. <#>

2 Agenda Retirement For illustration only. 2 For financial professional use only.

3 Two Sides to the Equation = Assets Liability Income For illustration only. 3 For financial professional use only.

4 Assets 4 For financial professional use only.

5 The Good Old Days For illustration only. 5 For financial professional use only.

6 Investing for the Long Run For illustration only. Past performance is no guarantee of future results. Hypothetical value of $1 invested in Assumes reinvestment of income and no transaction costs or taxes. An investment cannot be made directly in an index. 6 For financial professional use only.

7 An International Perspective on Historical Returns 1.28% 1.84% 2.34% 2.72% 4.06% 5.01% Average Compounded Real Return for a 60% stock, 40% bond portfolio: , Source: Dimson, Marsh, and Stauton 7 For financial professional use only.

8 Some Perspective, Past versus Future Arithmetic Average Historical Projected Difference Cash 3.58% 1.26% -2.32% Govt Bond 5.50% 2.40% -3.10% Large Stock 11.82% 9.31% -2.51% Small Stocks 16.53% 11.23% -5.30% Geometric Average Historical Projected Difference Cash 3.54% 1.24% -2.29% Govt Bond 5.36% 2.27% -3.09% Large Stock 9.84% 7.75% -2.10% Small Stocks 11.95% 8.65% -3.30% Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 8 For financial professional use only.

9 Probability of Failure Return Assumptions (Really) Matter 100% 75% 75% 50% 25% 0% 37% 9% 1% 0% 2% 4% 6% Geometric Return For illustration only. 9 For financial professional use only.

10 Bond Yield CAPE Ratio Historical Perspective: % 10.00% 5.00% 0.00% Year Source: Robert J. Shiller Change over time Historical Average Year Source: Robert J. Shiller For illustration only. 10 For financial professional use only.

11 Average Annual 10 Year Future Compounded Bond Return Bond Yields and Future 10 Year Bond Returns Source: Ibbotson 16% 14% 12% 10% 8% 6% 4% 2% 0% y = x R² = % 5% 10% 15% Current Bond Yield 11 For financial professional use only.

12 Future 1 Year Return Future 10 Year Annualized Return CAPE and Future 1 Year and 10 Year Stock Returns 60% 40% 20% 0% -20% -40% -60% Source: Robert J. Shiller y = x R² = CAPE Ratio 20% 16% 12% 8% 4% 0% Source: Robert J. Shiller y = x R² = CAPE Ratio 12 For financial professional use only.

13 Where You Start Matters Probability of success for a 4% initial withdrawal rate over 30 years for a 40% stock portfolio Initial Bond Yield Initial CAPE Ratio % 67.1% 58.1% 46.8% 35.4% 26.1% 17.7% 2.0% 71.6% 62.3% 51.0% 41.6% 29.7% 21.9% 3.0% 75.4% 66.5% 55.9% 45.6% 34.8% 25.7% 4.0% 78.3% 70.8% 62.1% 50.2% 38.3% 29.5% 5.0% 82.1% 74.0% 65.2% 54.7% 43.7% 32.6% 6.0% 85.0% 78.4% 69.1% 60.3% 49.0% 37.1% For illustration only. Source: Market Valuations, Bond Yields, and Retirement Success. White Paper. 13 For financial professional use only.

14 Liability 14 For financial professional use only.

15 Retiree Risks Retiree Risks Inflation Risk Longevity Risk Liability risk Sequence Risk Asset risk Early Retirement Mid Retirement Late Retirement For illustration only. 15 For financial professional use only.

16 Income How Much Do I Have to Save for Retirement: the 4% Rule $100,000 $90,000 $80,000 $70,000 $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $ Retirement Year For illustration only. Source: author s calculations. 16 For financial professional use only.

17 Common Liability Assumptions ~80% replacement rate Need increases annually by inflation 30 year retirement period 17 For financial professional use only.

18 Estimating a Replacement Rate Replacement rate concept is based on consumption smoothing (life-cycle hypothesis) Certain expenses decrease/disappear during retirement: Pre-tax: Traditional deferral, pre-tax insurance Post-tax: Roth deferral, work expenses, post-tax insurance Replacement rates are typically higher for lower income households because they tend to pay lower (or no) taxes Source: Estimating the True Cost of Retirement by David Blanchett, White Paper 18 For financial professional use only.

19 Replacement Rates: One Size Does Not Fit All Post-Tax % $25,000 Primary / $12,500 Spouse $100,000 Primary / $50,000 Spouse Pre-Tax Expenses as a % of Income 0% 3% 6% 9% 12% 15% 0% 3% 6% 9% 12% 15% 0% 87% 84% 82% 79% 76% 74% 0% 84% 81% 78% 75% 72% 70% Post-Tax % Pre-Tax Expenses as a % of Income 3% 84% 81% 79% 76% 73% 71% 3% 80% 77% 74% 71% 69% 66% 6% 81% 78% 76% 73% 70% 68% 6% 76% 73% 70% 68% 65% 62% 9% 78% 75% 73% 70% 67% 65% 9% 72% 70% 67% 64% 61% 59% 12% 75% 72% 70% 67% 64% 62% 12% 69% 66% 63% 61% 58% 55% Post-Tax % $50,000 Primary / $25,000 Spouse $150,000 Primary / $75,000 Spouse Pre-Tax Expenses as a % of Income Pre-Tax Expenses as a % of Income 0% 3% 6% 9% 12% 15% 0% 3% 6% 9% 12% 15% 0% 87% 84% 81% 78% 72% 69% 0% 84% 81% 79% 76% 73% 70% Post-Tax % 3% 84% 81% 78% 72% 69% 66% 3% 80% 77% 75% 72% 69% 66% 6% 80% 77% 71% 68% 65% 62% 6% 76% 73% 71% 68% 65% 62% 9% 77% 71% 68% 65% 62% 58% 9% 72% 69% 67% 64% 61% 58% 12% 70% 67% 64% 61% 58% 55% 12% 68% 65% 63% 60% 57% 54% Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 19 For financial professional use only.

20 % of Total Expenditures Expenditures as a Percentage of Total Consumption Over Time 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Household Average Age Other Transportation Insurance & Pensions Housing Healthcare Entertainment Food Charity Clothes Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 20 For financial professional use only.

21 % of Total Expenditures % of Total Expenditures Medical Spending for Different Income Levels 50% 40% 30% 20% 10% 0% Age Low Income Mid Income High Income Median Spending 50% 40% 30% 20% 10% 0% Age Low Income Mid Income High Income Highest 1 in 20 Households Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 21 For financial professional use only.

22 Inflation Risk: The Three Stages of Retirement Go-Go: Retirees maintain lifestyle, travel, the group that does not consider themselves "old". Slow-Go: Between the ages of 70 and 84, brought on by the body saying Slow Down, 20%-30% budget decline. No-Go: 85+, significant changes in retirement lifestyle is generally brought on by health issues. Source: "The Prosperous Retirement, Guide to the New Reality", Michael Stein. 22 For financial professional use only.

23 Inflation Different Types of Inflation 14% 12% 10% 8% 6% 4% 2% CPI Inflation U.S. Medical Cost Inflation 2.2% higher, on average 0% Year Source: Bureau of Labor Statistics. For illustration only 23 For financial professional use only.

24 Medical Inflation CPI-U versus Medical Inflation Medical inflation has averaged +5.42% per year from 1948 to 2012, versus +3.63% for the CPI-U, therefore, has been growing about 50% faster than general inflation 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% y = x R² = % 0.0% 5.0% 10.0% 15.0% General Inflation ( in CPI-U) Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 24 For financial professional use only.

25 Different Price Indexes From December 1982 to December 2012 the average annual change in the CPI-E has been 3.07% versus 2.92% for CPI-U Expenditure Weights from CPI-U Expenditure group CPI-U CPI-W CPI-E CPI-W CPI-E Apparel 3.5% 3.6% 2.4% 0.1% -1.1% Education and communication 6.7% 6.7% 3.8% 0.0% -2.9% Food and beverages 15.0% 15.7% 12.8% 0.7% -2.2% Housing 40.2% 39.2% 44.5% -1.0% 4.3% Medical care 6.9% 5.6% 11.3% -1.3% 4.4% Other goods and services 5.3% 5.1% 5.4% -0.2% 0.1% Recreation 5.9% 5.5% 5.3% -0.4% -0.6% Transportation 16.5% 18.7% 14.5% 2.2% -2.0% Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 25 For financial professional use only.

26 Analysis/Methodology Summary Uses the RAND HRS (Health and Retirement Study) dataset HRS is a panel household survey specifically focused on the study of retirement and health among individuals over the age of 50 in the United States Match each household to the RAND CAMS (Consumption and Activities Mail Survey) survey, which is a supplement to the HRS Five available waves: 2001, 2003, 2005, 2007, and 2009 A variety of filters to clean the dataset: minimum consumption is $10,000, no change in spending over 50% between two surveys, must participate in all surveys, must be retired Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 26 For financial professional use only.

27 Annual Real Change in Total Expenditures Annual Real Change in Expenditures for Retirees 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% -5.0% -6.0% R² = R² = Age Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 27 For financial professional use only.

28 Average Real Annual Average Real Annual Change in Expenditures by Total Spending and Household Wealth Matched Spending and Wealth Mismatched Spending and Wealth 8.0% 4.0% 8.0% 4.0% R² = % R² = % -4.0% -8.0% R² = Age Low Spend, Low Net Worth High Spend, High Net Worth -4.0% Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper R² = % Age High Spend, Low Net Worth Low Spend, High Net Worth 28 For financial professional use only.

29 Building a Better Model Incorporate the spending smile Incorporate different spending by wealth rates 29 For financial professional use only.

30 Annual Real % Change in Consumption Annual Real $ Change in Consumption Retirement Income Targets Annual Real Change in Consumption 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% Age 25k Spend 50k Spend 100k Spend Lifetime Real Income Target, Age 65 Retiree $1.2 $1.1 $1.0 $0.9 $0.8 $0.7 $0.6 $ Age 25k Spend 50k Spend 100k Spend Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 30 For financial professional use only.

31 Probability of Success over 30 Years Impact on Success Rates 100% 80% 60%.8% difference 40% 20% 0% 2.0% 3.0% 4.0% 5.0% 6.0% Initial Withdrawal Rate 7.0% 8.0% Constant Real 25k Curve 50k Curve 100k Curve Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 31 For financial professional use only.

32 What is Failure? Client Living Status Alive Dead Portfolio Balance â $0 < $0 Not Failure Failure Not Failure Not Failure For illustration only. 32 For financial professional use only.

33 Probabilities of Success for Different Scenarios Initial Withdrawal Rate Withdrawal Increases Annually by Inflation Period Certain (Years) During Lifetime (Age 65) Male Female Joint 3.0% 100.0% 98.9% 95.4% 89.6% 81.9% 98.3% 97.5% 96.3% 4.0% 97.8% 88.4% 73.3% 58.5% 46.9% 90.7% 87.0% 81.5% 5.0% 85.6% 61.0% 39.7% 26.3% 17.5% 76.4% 68.6% 57.4% 6.0% 59.0% 29.9% 14.8% 8.1% 4.8% 60.0% 49.3% 34.5% Initial Withdrawal Rate $50k Initial Goal Curve Period Certain (Years) During Lifetime (Age 65) Male Female Joint 3.0% 100.0% 99.7% 98.5% 95.6% 91.6% 99.3% 99.0% 98.5% 4.0% 99.2% 94.8% 86.0% 75.4% 64.2% 95.1% 93.0% 89.9% 5.0% 92.5% 75.9% 57.8% 42.8% 31.7% 84.2% 78.5% 70.3% 6.0% 72.7% 45.3% 28.1% 17.2% 11.0% 68.4% 59.2% 46.3% Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 33 For financial professional use only.

34 Conclusions While a replacement rate between 70% and 80% may be a reasonable starting place for most households, the ideal rate can vary considerably, from under 54% to over 87% Real retiree expenditures aren t constant and they don t rise (or fall) in nominal terms simply as a function of broad-based inflation or expected health care inflation. Households with lower levels of consumption and higher funding ratios tend to have real increases in spending that are greater than households with higher levels of consumption and lower funding ratios. The implication is that households that are not consuming retirement funds optimally will tend to adjust them during the retirement periods. The goal of many retirees is to create income for life, not income over a specific time period. When combined and correctly modeled, the true cost of retirement is highly personalized based on each household s unique facts and circumstances. Source: Estimating the True Cost of Retirement by David Blanchett, Morningstar White Paper 34 For financial professional use only.

35 Questions 35 For financial professional use only.

36 Disclosures Important Disclosures The above commentary is for informational purposes only and should not be viewed as an offer to buy or sell a particular security. The data and/or information noted are from what we believe to be reliable sources, however Morningstar Associates has no control over the means or methods used to collect the data/information and therefore cannot guarantee their accuracy or completeness. The opinions and estimates noted herein are accurate as of a certain date and are subject to change. The indexes referenced are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results. The charts and graphs within are for illustrative purposes only. Monte Carlo is an analytical method used to simulate random returns of uncertain variables to obtain a range of possible outcomes. Such probabilistic simulation does not analyze specific security holdings, but instead analyzes the identified asset classes. The simulation generated is not a guarantee or projection of future results, but rather, a tool to identify a range of potential outcomes that could potentially be realized. The Monte Carlo simulation is hypothetical in nature and for illustrative purposes only. Results noted may vary with each use and over time. The results from the simulations described within are hypothetical in nature and not actual investment results or guarantees of future results. This should not be considered tax or financial planning advice. Please consult a tax and/or financial professional for advice specific to your individual circumstances. 36 For financial professional use only.

37 37 For financial professional use only. 37