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 Published
Monday, April 9, 2007
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Keep the right stock/bond mix
by Stephen Butler
What exactly will happen when we start living on our savings
to support that eccentric personal lifestyle to which we all look
forward?
When that day comes, we will typically have two types of money.
First will be retirement plan money in IRA or 401(k) accounts.
The rest will be so-called "after-tax" money that could
have come from home equity available after downsizing. We might
have inherited some money or sold a business.
A few of us may even have a conventional savings and investment
account resulting from the practice of self-discipline and living
like a monk.
Whatever. In deciding how to live on income from our assets,
we start by identifying what we have and where it is located.
Retirement accounts (such as IRAs) allow earnings on investments
to continue to accumulate without having to pay taxes on them,
so this should be the last place we turn to for income. We should
let this money compound in its tax-deferred nirvana as long as
possible. The only exception is the so-called "minimum required
distribution," which requires that we take at least some
money out of our retirement plans each year after reaching age
701/2.
At the onset of retirement, assuming we're not on our death beds,
we should have a 50/50 mix of stocks and bonds, because inflation
could eat away at the value of our money if we don't have at least
some of it in investments that rise with inflation.
We could be looking at a retirement period that will last for
30 years or more. The stocks, or mutual funds investing in stocks,
should be in the taxable accounts and bond funds should be in
retirement accounts.
This is because stocks gain in value and expose those gains to
taxation only at the point at which they are sold. Bonds generate
taxable interest each year, which is tax-sheltered by a retirement
plan.
Capital gains taxes today are only 15 percent federal, plus California
state income tax, so even as we start nibbling away at our after-tax
money, we are receiving a tax break compared with the full marginal
regular income tax we would pay (combined state and federal).
Considering that the base income will be coming from taxable
Social Security, this investment income will be additional income
taxed at our highest marginal bracket. That will be at least 35
percent for most of us if we're single making more than about
$35,000 and married making more than about $60,000.
In the early years of retirement, we should access the nonretirement
plan money first. However, we can't lose sight of the big picture.
We preserve our 50/50 mix of stocks and bonds by annual rebalancing.
As we sell stock mutual funds in our after-tax account, we may
have to move some bond money in the retirement account over to
stocks to compensate.
Financial models illustrate that someone with $1 million in total
assets during a period of poor stock market would be able to take
out $35,000 per year for 30 years before exhausting everything
and being flat broke.
Assuming normal stock market returns, the income level could
be as high as about $50,000 per year before exhausting the principal
in 30 years.
These represent 3.5 percent and 5 percent returns on the $1 million.
We can earn that easily, so why does the principal disappear?
The answer is inflation. If we have 3 percent annual inflation
chewing into our asset value, the equivalent of today's $35,000
will be $85,000 in 30 years.
To put it another way, $1 million in today's dollars will be
equivalent only to $410,000 in 30 years. This inflation factor
illustrates why the 50 percent in stocks is so important.
Even then, we can have some bad periods such as the late 1970s
and early '80s, when stagflation kept the stock market down and
annual inflation ran at 18 percent -- a "tsunami" at
the time for retirees, unless they moved everything into a new
invention at the time known as "money market funds."
Banks back then lobbied furiously to outlaw this new investment
opportunity so that they could continue paying 5 percent on savings
accounts and investing the money in 18 percent risk-free investments
themselves.
In a similar vein, the so-called lifestyle and target funds that
offer an automatic shifting allocation of stocks and bonds to
solve this problem are not the answer.
They are too simplistic and unsophisticated and will lead most
investors toward a false sense of security. They ignore all of
the careful analysis we considered above and offer a further demonstration
of how the financial services industry thinks of itself first
and us second.
When we're on our own, there is no substitute for sharpening
a pencil and doing what are called "projected cash flows."
Nobody can predict investment returns beyond just a historical
average rate of return for stocks and bonds in general. However,
the extent to which you work around the tax code successfully
can add hard-dollar guaranteed increases to your asset base.
It is time better spent than chasing mutual fund performance.
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