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A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
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Hello there. David McKnight. Welcome to The Power of Zero show. As you know, I'm the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield. We are on episode 57. We have not missed an episode in over a year and you, our loyal listeners, have been with us every step of the way. Just by way of reminder, you can get any of our books at powerofzero.com/Books. You can get the DVD/Blu-ray Combo of our movie, The Power of Zero: The Tax Train Is Coming, by going to thetaxtrain.com and you can watch the movie, you can stream it pretty much wherever movies are streamed. We love it when you put reviews for any of our books on Amazon. They really do help and would love if you gave us a follow on Twitter at @mcknightandco.
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Today, we're going to be talking about something called a risk multiplier. Usually, in the context of retirement planning, when somebody talks about a risk multiplier, they are referring to what we call longevity risk. Why is longevity risk known as a risk multiplier? Basically, because the longer you live, the more likely you are to experience a subset of risks that could completely derail your retirement plan. What's the subset of risks that could send your retirement plan careening off the tracks? There are essentially three of them that I'm going to talk about today. There are lots of different retirement risk. I'm going to talk about three major risks that go into that subset of risks that get multiplied, enhanced, magnified, whatever way you want to put it if you live too long, if there's too much that could cause you to have too much life at the end of your money.
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What we're trying to avoid here, folks, is running out of money too soon. There are all sorts of risks that could cause you to run out of money too soon. The longer you live, the more likely you are to experience one of these risks. Let's identify some of these risks that get enhanced or magnified if you live too long in an effort to, hopefully, motivate you to put some safeguards in place that will prevent you from ever having to experience these risks to mitigate the impact of these risks.
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The first risk we're going to talk about is the long-term care risk. This is one that is something we've talked about for a long time. A long-term care risk is best described with a conversation I typically have with my clients. It goes a little bit like this—if you've been listening to the podcast long enough, you've heard me say this a couple of different times—I'll sit across from Mr. and Mrs. Jones and I'll say, “Mr. Jones, you know I love you, right?” He'll say, “Yes, Dave, I know you love me.” I'll say, “I do love you but you're better off dying than needing long-term care.” He’ll say, “Gosh, Dave, why is that?” I'll say, “At least, if you died, Mrs. Jones here would be beneficiary on your IRA, 401(k), stocks, bonds, savings accounts, and maybe your life insurance. While we will miss you terribly, life for Mrs. Jones here would go along relatively unchanged. However, if you didn't die, if you almost died, and you end up needing long-term care, now, all of the money that she was planning on spending in retirement gets earmarked towards the long-term care facility. What was shaping up to be a perfectly rosy retirement for Mrs. Jones had you died turns into bare-bones subsistence type living. She gets to keep one house, one car, a minimum monthly maintenance needs allowance of about $2,500 a month, depending on the state that you're in, and about $126,000 of cash.” Of course, the converse is true if Mrs. Jones ends up leading long-term care and Mr. Jones is the community spouse, then Mr. Jones ends up leading this bare-bones subsistence type living.
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How do we mitigate this risk? What if that long-term care event happens early in your retirement? Then, all of a sudden, all of your hopes and aspirations for a happy and prolonged retirement go out the window. How do we mitigate this risk? We know that historically, long-term care policies have been the way that people mitigate this risk. The issue that people have with traditional long-term care policies is, number one, they get more and more expensive, long-term care companies have had a really difficult time actuarially figuring out what the right premium is to offset the expense that they're going to have to pay down the road when you need long-term care. What they've done is they don't have any guarantees as to whether the price will go up or not and so prices have gone up. They've gotten up to prohibitive levels. This gives people heartburn.
0:05:43
The other part is it's really tough to qualify for long-term care. Like I tell my audiences across the nation, you may live forever, you may live to be 120 according to life insurance company but if you have a bad back, a bad knee, a bad hip, you may not even get accepted, you may not even qualify.
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Then the third thing that really gives people heartburn with relation to traditional long-term care policies is this idea that you could pay for something for 30 years, die peacefully in your sleep never having used it, and not get anything back at the end. That really irks people. This idea that you're paying for something that you hope you never have to use, it's a use-it-or-lose-it proposition.
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What insurance companies did a while back, and I think this is probably 10 to 15 years ago, they said, “Hey, what if we could give people their death benefit in advance of their death for the purpose of paying for long-term care? We're not going to charge them anything along the way for this benefit. If they should need the long-term care benefit on the back end when we give them the payment, we’ll discount it slightly based on the fact that we are giving them their death benefit earlier than we anticipated giving it to them from an actuarial standpoint.” They may discount it slightly on the back end, but the point is this, you are now in a scenario where you're simply spending down your death benefit and should you die peacefully in your sleep never having a needed long-term care, you now have this tax-free death benefit that goes to the next generation in a completely tax-free way at a period in their lives when they can probably really use some tax-free infusion of cash. They'll probably be at the apex of their earning years, paying historically high tax rates. Getting an infusion of tax-free cash at that point will probably be a real shot in the arm for your beneficiaries. The LIRP is how we traditionally like to deal with the risk of long-term care. Again, the longer you live, the more likely you are to experience a long-term care event.
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The second risk that we're going to talk about is what we call withdrawal-rate risk. Withdrawal-rate risk simply says that there is an appropriate amount of money to take out of your stock portfolio in retirement without running the risk that you're going to run out of money before life expectancy. Now this was an idea that was first really hit upon, I think it was back in 1992, by a guy named William Bengen, who basically said, “Hey, look, historically, we've always eyeballed this and say if you take out about 5% per year, we're going to be in good shape, you'll never run out of money.”
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He started to run some Monte Carlo scenarios where he backtested this notion of taking out 5% and ran 100,000 different scenarios based on all sorts of different market conditions over a 70-year period. What he found was that quite a few of those 5% scenarios actually failed. People actually ran out of money before their average life expectancy. He started to fiddle with the withdrawal rate and what he found was that if you only withdraw 4%, then the likelihood that you would never run out of money went up closer to 90%. I think most people can live with this success rate of 90%. What does that mean? That means that if you want to live on $100,000 per year, divide $100,000 by 4% and you'll figure out how much money you need at a 4% withdrawal rate to crank out a $100,000 income per year. Of course, if you do that, you get $2.5 million.
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Withdrawal rate risk basically says that if you take out too much money through a series of dips in the stock market, you could run out of money much faster than you ever thought. Now closely related to withdrawal rate risk, let’s say they're kissing cousins, is this idea of sequence of return risk. Now sequence of return risk says that in the first 10 years of retirement, if you are withdrawing money from a stock portfolio and you do it in a down market, maybe you experienced two or three years in a row of down returns and you're taking out a consistent stream of income, you could send your stock portfolio into a death spiral from which it never recovers.
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For those of you who have read The Volatility Shield, my third book, you know exactly what I'm talking about. We tell the story of Ted Hardy who spent down his money much too aggressively, ran out of money literally 20 years earlier than he thought he ever would, and that was simply because his withdrawal rate was too aggressive. He experienced a series of down years in the market and that corpus of money that was in the market couldn't sustain, after those series of down years and the withdrawals, those continued withdrawals. He ended up running out of money much, much sooner than he ever thought.
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Sequence of return risk is something that can really upset your applecart in retirement if your withdrawal rate risk is too high. The point of the withdrawal rate rule, the 4% rule—by the way, The Wall Street Journal is telling us that 3% is the new 4% rule and others are telling us that if you really want to be bulletproof in retirement, then 2% is really your best bet. It depends on what research you're looking at but a lot of people are saying, “Hey, look, the 4% rule is now the 3% rule.” How do you shield yourself from sequence of return risk? You have to figure out what your ideal withdrawal rate. What is an acceptable withdrawal rate? It's probably not higher than 4%, it could be as low as 3%.
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Part of the issue with withdrawal rate risk and sequence of return risk is in order to fully mitigate them according to conventional wisdom, you have to have a massive amount of money saved by the time you reach retirement. Like I said earlier, if you want $100,000 to live in retirement above and beyond maybe a pension or Social Security, then you need to, based on the 4% rule, you're going to have to save $2.5 million. Based on the 3% rule, it's a much higher number. Depending on whether you think it's a 4% or 3% rule will determine how much you really, really need.
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To have a reasonable lifestyle in retirement, all of a sudden, you have to have accumulated this massive, massive amount of money. This, I think, does get people heartburn. They're saying, okay, to enjoy a retirement that's insulated and protected from sequence of return risk with withdrawal rate risk, I have to accumulate this huge amount of money, which means that I might have to save more during my accumulation years, maybe even more than I was otherwise planning on saving. I'm going to have to cut back on vacation. I'm going to have to maybe have a staycation instead of taking that two-week holiday. Maybe I'm going to have to downgrade the car I'm driving, take my kids out of private school just so that I can have enough money saved by the time I retire in order to live on that 4% rule. There is a way to mitigate this risk without all that heartburn and that is through guaranteed lifetime income in the form of an annuity.
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As my friend Tom Hegna says, “Annuity is a four-letter word for a lot of people.” Hey, Tom, we don't want to hear about no annuities around here. If you have a pension from your work, if you are a fan of Social Security, you're also a fan of annuities because they operate on the very same premise. It's basically a way of guaranteeing a stream of income regardless of what's happening in your stock market portfolio all the way until life expectancy, really, it's until the day that you die which, in many cases, goes beyond life expectancy. When we go back to this idea of the risk multiplier of longevity risk, why is that such a big deal? Why is it so intimately connected to the sequence of return risk and withdrawal rate risk?
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Here's the thing, if you're going to live a 40-year retirement as opposed to a 5 or 10-year retirement, then you run a much higher likelihood of enduring sequence of return risk or withdrawal rate risk. The longer you're planning your retirement, the more money you have to have in your retirement balances to be able to safely navigate the road to the end of your life without succumbing to sequence of return risk or withdrawal rate risk. One of the traditional ways of mitigating both of these risks is to simply take a portion of your stock market portfolio, give it to an insurance company that pools your longevity risk with a bunch of other people's longevity risks, and gives you a guaranteed stream of income all the way until when you die.
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Now here's the great part, when you get that stream of income, it's not going to be the equivalent of say 4% of the money that you gave to the insurance company, to begin with. It's going to be higher than 4%. It might be 6%, it might be 7%. Now, all of a sudden, you've gone from a point where you can only ever take out 4% out of this portfolio in order to truly insulate yourself from sequence of return risk, now you're able to take out 6%, in some cases, 7% which is much better than 4%. You no longer have withdrawal rate risk because that guaranteed stream of income goes all the way till when you die and you're also not exposed to sequence of return risk because you're not forced to withdraw money from your stock market portfolio in a down year.
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Remember, sequence of return risk happens when you take money out of your portfolio during the down year, if you have a guaranteed stream of annuity income, you're not forced to take money out of your portfolio during those down years, you can live off of your Social Security, that guaranteed stream of income in the form of an annuity, maybe you have a pension, allow that stock market portfolio to recover, and then you can be in a position where you can draw on that stock market portfolio for an even longer period of time to pay for those extras in retirement. Maybe it's a vacation, maybe it's a new car, maybe it's a sailboat, what have you. Remember, your Social Security, your annuity, your guaranteed stream of income for life, those are designated for the basic lifestyle needs in retirement. Anything left in your stock market portfolio goes to pay for all those other things, that stock market portfolio is going to last longer if you don't have to tap into it during those down years in retirement. This turns convention on its year.
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Basically, what we're saying is that the answer to the three basic retirement risks that are magnified by longevity risk are, number one, an LIRP, a life insurance retirement plan, and number two, a guaranteed lifetime income in the form of an annuity. That does defy conventional wisdom but there's a lot of PhDs in the world from Michael Finke to Wade Pfau from Princeton, Tom Hegna, a lot of these experts that have studied the math and science behind this stuff for years and years and years. They all basically say that mathematically speaking, your money lasts longer, you're able to spend more money in retirement, you're able to more successfully navigate all of these retirement pitfalls, you're able to more effectively mitigate longevity risk if you have some guarantees in your portfolio.
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Do you put all of your money in an annuity, all of your money in an LIRP? Certainly, not. You gotta have some money, I believe, in the stock market, but maybe make that annuity the bond portion of your portfolio. You can even make the LIRP the bond portion of your portfolio. Then what happens? Then you can take more risk in your stock market portfolio now that the annuity, and perhaps, the LIRP are functioning as the bond portion of your portfolio.
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Take more risk in the rest of your portfolio in the market. Why? Because you now have the luxury of allowing that money to recover after a down year without having to use it to meet your lifestyle needs. Longevity risk is the risk multiplier, it is the risk that will make all these other subsets of risks even more likely to derail your retirement plan. If you want to eliminate stress from your retirement, if you want to have more peace of mind, if you want to safely navigate all these pitfalls, then pooling risk and offloading risk to insurance companies is a way to do it from a mathematical perspective.
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All right, folks, that is the show for today. Thank you for joining me. Again, if you want books in bulk, go to powerofzero.com/Books. I would encourage you, certainly, to follow me on Twitter at @mcknightandco and also to subscribe, I would love it if you simply subscribe to our program. Every time we put out a new program, you'll know exactly what it's about and it'll give you a link to listen right in your email inbox. Other than that, I appreciate you sharing some time with me today and we'll talk to you next week.
