My Net Worth Says "Ouch"!

Here's a chart of my latest net worth estimate. Ouch!! My 401(k) (pink area at the top) took a hit from the recent stock market decline.

For now though, I'm remaining in the stock market, my 401(k) plan offers some good index funds.

I haven't made any adjustment to my property value (area in green) yet. I have been basing the value of my house on the tax appraisal that comes out one a year. Given the housing market slowdown due to the credit crunch, I'd expect that to happen. But the cynic in me suspects that they'll never reduce the tax appraisal.

The Retirement Reality Game Show

Welcome to the Retirement Reality Game Show. Here are the rules: you have 6 months to prepare by storing up all the supplies you need, and then you will be locked in your house for an average of 6 months, during which time additional contests will be played.

Contestant Bob buys up 6 months worth of food and other supplies, and is locked in his house. A jar with 364 black balls and one white ball is prepared. Every day, the game show host pulls out at random one ball. If a black ball is pulled, then Bob stays in his house another day. If the white ball is pulled, then Bob is released from the house.

On average, Bob will stay in the house for 183 days, which is about 6 months. But there's a 50% chance that Bob will stay in the house longer. If Bob plans his meals to last 183 days, there's a 50% chance that the viewers of the show will watch him starve.

Let's look at the graph of the probability that Bob will still be locked in the house on a certain day.
Now let's take another look at the probability of a 65-year-old surviving to a certain age.
The life expectancy graph was previously presented and explained in this post.

Aside from the fact that one graph is a simple straight line and the other is curved, these graphs are similar. If Bob prepares for an average stay in the house, he has a significant chance of starving. If you plan your retirement savings and withdrawals in retirement for an average life expectancy, there is a significant chance that you will run out of money and suffer whatever consequences follow.

While no analogy is perfect, it should put in basic terms the idea that if you prepare for the average, there's a significant chance that you will have under-prepared.

Putting the Personal in Finance

Grace over at GRACEful Retirement had this comment recently about my blog.
EMF at Engineering My Finances tends to be a bit more general and way more math-oriented. I read him, but I don't always understand him!
I have to say that I agree with her, and take it as a reminder that I need to improve my writing skills when communicating some of the complex topics I take on.

Unlike many in the Personal Finance Blog-o-sphere, I never had the situation with a financial meltdown to overcome. I've never had to answer the phone worried that a bill collector was on the other end. I've never had to decide which utility bill I might get by without paying that month.

Does that mean that I always had it easy? Or that I inherited money? No, quite the opposite. Growing up in a large family, I never went hungry. But there were few extras, and my parents struggled to pay bills. I did not live in a house with indoor plumbing or a TV until almost a teenager. When a teenager, I did not have an allowance handed to me. Instead I got small amounts for doing chores, and later on I got jobs. I will say that some of the low skilled jobs I had as a teenager were lower paying yet harder than jobs I had later as an adult.

Then as an adult, I was not provided a free education -- I had to earn it. After 4 years in the military, I had the Vietnam Era GI bill. But with a wife and child, the GI bill did not pay enough to get by, so I had to work full time and did not graduate until in my 30's. But with the GI bill I was able to pay my tuition and buy textbooks as I went along and had no student loan debt.

My experiences growing up taught me the value of money, and impressed upon me that I didn't want to be caught without it. So I've always tried to live reasonably but within my means. My wife didn't agree, wanting to spend freely, and ended up divorcing me. Within a year she had spent the entirety of the divorce settlement. Although I didn't think so at the time, in the long run she did me a favor by divorcing me.

As Grace pointed out, I am math oriented. A few years ago, some friends came into a lump sum and were arguing whether to pay off credit cards or pay ahead on their mortgage. When asked, I gave the logical financial answer that it was better to pay off the credit cards because the interest rate was higher and also not tax-deductible. Being a few years older and having reflected a bit, I would now give the personal answer. Which would be along the lines of "Unless you understand why you have this credit card debt, I would pay down the mortgage. Because if your credit limit or the payments is what's keeping you from charging more, that's the better course. Because in 20 years you won't have anything to show for what you've charged except for the debt -- you'll have none of the crap you charged, but at least your house will be paid for. On the other hand, if you have control of your credit card spending and can pay the credit card bill in full each month, then go ahead and pay them off. Then take the money each month you would have been paying on your credit card bills and apply it to your mortgage." Actually, because it is personal and I'd want to keep them as friends I wouldn't put it quite so bluntly.

So I recognize the need to remember the personal as well as the finance. Even though some of my posts have been and will continue to be more on the side of finance.

Tax Considerations for Investments in Retirement Accounts

Humberto Cruz has an article entitled “After-tax allocation tricky to calculate”. It reminds us of two factors for considering our retirement savings.

First, funds in a before-tax account such as a traditional IRA should be discounted based on your expected taxes when withdrawing them. $100,000 in a traditional 401(k) is not the same as $100,000 in a Roth IRA or even $100,000 in a normal after-tax account. While I expect at least some of my 401(k) savings to be withdrawn at a lower tax rate, I also expect to pay some taxes on it. For current tracking purposes, I discount the value of my 401(k) and traditional IRA accounts by my current marginal tax rate when calculating my net worth.

The second factor to keep in mind is that withdrawals from before-tax accounts are taxed at your ordinary tax rates at the time. Long term gains from stocks do not enjoy the capital gains income tax rate of 5% or 15%.

Read Humberto’s article to see how he handles these two factors.

The Zeroeth Law of Financial Security.

CNN reports that Tony Snow may be stepping down. No this is not turning in to a political blog. From the CNN article:

"I'm not going to be able to go the distance, but that's primarily for financial reasons." Snow said. "I've told people when my money runs out, then I've got to go."

According to The Washington Post, Snow makes $168,000 as the White House spokesman.

$168,000 is more than the income of the vast majority of Americans. Tony Snow-job took a cut in pay from his job at Faux News. And it would appear has not changed his spending habits, so has depleted whatever savings he had which appear from the article to include college money for his kids.

Financial security isn't what you make. At any income level, it's also what you spend. So let me restate it:
The Zeroeth Law of Financial Security "Spend less than you earn."

Why not call it the first law? Even Dave Ramsey doesn't include it in his list of "Baby Steps". It's so elementary that it shouldn't need to be stated. Unfortunately, too many people forget it and end up in trouble. At least Tony Snow has his eye on his situation.

When Will You Die?

Average life expectancy seems to enter into on line discussions on deciding when to collect Social Security benefits, with the goal of maximizing benefits collected during your lifetime. Some comments imply that if you're age X you'll live Y years and die, for instance one commenter stated that a 65-year-old has a 20-year life expectancy implying a certain death age of 85. But I'm sure that if put to them that way, they would tell you that's not what they meant.

I decided to look into it a bit further. On the Social Security Administration's web site, I found a table with life expectancy data calculated by their actuaries. Excel has the capability to import HTML data formatted like the chart. I did so, and with some added calculations, I was able to produce the graph shown below. In case you have difficulty reading the legends, the blue curve shows the probability of an average male aged 65 surviving to a particular future age, and the vertical blue dashed line shows the average life expectancy for that male. The pink curve and dashed line is the equivalent data for a female aged 65. As you might expect, the average life expectancy for a 65-year-old female of 84.2 years is longer than the 81.33 years for a 65-year-old male, almost 3 years longer.

If we look at the curves, a straight line approximation starting from 1 at age 65 and dropping to zero at age 100 would be a reasonable approximation. Certainly not perfect, but a lot closer to the curves than an approximation which has a value of 1 from age 65 and then falls to zero at the average life expectancy. So no, the average person doesn't live to their life expectancy and then fall dead.

This is significant to retirement planning. If you are among the more than 50% who live longer than your average life expectancy and that's the age to which you planned your savings prior to retirement and spending after, then you'll suffer the consequences.

Yes, I said that you have a greater than 50% chance of exceeding your average life expectancy. If you'll look closely at the graph, you'll see the life expectancy lines intersect their curves above the 50% line. For females, the median life expectancy is almost a year longer than the average life expectancy.

With a bit more computation on the data I downloaded to analyze the data for an average 65-year-old, I produced the following graph: Using the same blue-for-boys/pink-for-girls coding scheme, this graph shows the probability that an average 65-year-old will die at a particular one-year span of age. Note that the probability is less than 4.5% at any age, and the highest probability for a one-year span is at greater than average life expectancy.

Meaning that when 65 years old, your chances of dying in a year other than your average life expectancy is greater than 95%. A very high degree of uncertainty when planning your retirement. I plan to discuss this further in a future post.

Means Testing of Social Security Benefits Already in Effect

Jed Pittman on HelpYourMoney has a post entitled "Thoughts on Social Security" which discusses the possibility of means testing for Social Security benefits, and ends that part of the discussion by quoting Ben Stein who said "Those who have saved will be made to pay for those who haven’t ..... "

It just so happens that a mechanism for means testing Social Security benefits is already in place for taxing those who have saved for retirement while not taxing those who haven't.

The way it works is that a test amount is computed based on adding your taxable income (which includes withdrawals from tax-deferred retirement savings) to 1/2 of your Social Security benefit. If the test amount reaches $25,000 for a single person or $32,000 for a married couple, then each additional dollar of income results in taxation of $0.50 of Social Security benefits. At higher test amounts, an additional dollar of income results in $0.85 of Social Security being taxed for each $1 of other income. Specifically when I say that Social Security is taxed, up to 85% of your benefit can be added to your Adjusted Gross Income (AGI). But if your AGI is less than your exemptions and deductions, then it still won't be taxed. Refer to the worksheet for line 20 of the 1040 tax form for details, although the computations are rather mind numbing -- I set up a spreadsheet to do them so I could see how it worked.

The problem is that the $25,000 and $32,000 exclusion amounts in the test computation are not adjusted for inflation.

Let's consider a single person who has not saved for retirement at all and only has income from Social Security. This person has no pension, no portfolio of stocks -- just Social Security. That person would need to have more than $50,000 in Social Security benefits before 1/2 of it exceeds $25,000 and any of his benefit is added to his AGI. Exemption and standard deduction for a single person adds up to almost $10,000 in 2007 for a single person 65 or older. So this year over $80,000 of Social Security benefits would be needed before he would pay any taxes at all. Since the exemption and standard deduction amounts are indexed for inflation, this will increase beyond $80,000 in future years.

An average earner retiring at age 66 would draw somewhere around $16,000 in Social Security benefits. Social Security benefits are adjusted for inflation. Even so, at a modest 3% annual inflation rate it will be decades before he would have to pay taxes.

Let's compare our spendthrift to another average earner retiring at the same time who has saved enough for an initial withdrawal of $24000 from tax deferred savings with annual adjustments for inflation. The test amount for that person would be $32,000 and he would add $3500 of Social Security to his AGI and unless he had lots of deductions would pay taxes on it.

And as our conscientious saver increased his tax-deferred withdrawals for inflation, more and more of his Social Security benefits will be taxed. He's at the level where every $1 of additional taxable income results in taxation of $.50 of Social Security benefits. So instead of being in the 15% tax bracket, he's really in the 1.5 x 15% bracket or 22.5%. And if in the future the 15% bracket becomes 20%, his marginal tax rate is 30%. With more income such that $.85 of Social Security is taxed for each dollar of other taxable income, then his tax rate gets multiplied by 1.85. (Kind of hurts if the taxes were 15% or even 25% when deferred.) At a 3% inflation rate, the rule of 72 says that his tax-deferred withdrawals 24 years from now will be $48,000 and his Social Security benefit $32,000, of which $27,200 or the limit of 85% would be taxed.

And if he thought he could reduce his tax bill in retirement by investing in municipal bonds, guess what! The interest from the bonds is not taxed at the federal level, but the interest is added to the test amount used above to compute how much Social Security is added to his AGI. So he could effectively pay some federal taxes on it anyway. Don't be surprised if in the future Roth distributions are treated similarly.

At the same time, the spendthrift would be a long way from having any Social Security added to his AGI, and because of exemptions and standard deductions which would be inflation adjusted by then to $20,000 it would take even longer before inflation would result in his paying any taxes at all.

When this means-test equivalent was originally put in place, only the very wealthy were effected. With the inexorable march of inflation, more and more Boomers who have saved responsibly will pay more and more taxes. Taxes that will help pay the benefits for the irresponsible who haven't saved.

An Anecdote of the Credit Crunch

A coworker recently bought a new (used) house as part of his plan to downsize now that he's expecting to be an empty nester. But he made the purchase before placing his old house on the market.

Talk about bad timing!!! In the last three weeks he's had no one even come to look at his house. And the local economy is not depressed. Nor is his house in a depressed area.

I suggested that he look at finding a renter. Insurance companies don't like to underwrite empty houses, and he is losing much of his coverage because the house is unoccupied.

A Graphical Look at Delaying Social Security Benefits

In earlier posts here and here, I provided some figures comparing the effect delaying Social Security on future benefits against the monthly return of other options using the amount of delayed benefits. If a picture is worth 1000 words, then here they are. Should the legends in the chart be too difficult to read, here's a recap:
-- The top jagged line is the increase in monthly SS benefits for the amount of benefits delayed. The discontinuities are due to the benefit formulas set up by current Social Security law.
-- The bottom horizontal line is the monthly 4% rule-of-thumb withdrawal on a retirement fund equal to the delayed SS benefits.
-- The three upward sloping lines are inflation adjusted annuities purchased with an amount equal to the delayed SS benefits
----- Top sloping line is the annuity for a male
----- Middle line is the annuity for a female
----- Bottom sloping line is a joint-and-survivor's annuity

The vertical axis is the rate of return. For instance a value of 0.006 is an initial monthly income of $6 for each $1000 of initial payment. All the payment options shown on this chart are adjusted annually for inflation.

Please read the original posts here and here for further explanation.

In my opinion, the 4% rule-of-thumb withdrawal rate should be adjusted for age. But that would be a topic for another post.

Thanks to "J" at Home Finance Freedom for suggesting the graph.

Another Look at Delaying Starting Social Security Benefits One Year

In an earlier post, I compared the added monthly Social Security benefit received for delaying starting your benefits against the monthly annuity payment that could be purchased with the amount of benefits "lost" by waiting. The comparison used inflation-adjusted annuities, since Social Security is also indexed for inflation.

In this post I'll compare delaying Social Security benefits against a withdrawal rate from your own retirement savings based on the 4% rule-of-thumb.

Under the 4% rule-of-thumb for retirement withdrawals, you take out 4% of your savings in the first year you retire. The second year you take out an increased amount based on inflation, and continue to adjust your withdrawals each year after that for inflation. For example, with retirement savings of $250,000, you take out $10,000 the first year and if inflation is 3% you take out $10,300 the second year, $10,609 the third year, and so on.

Let's consider an example of a Boomer born before 1955 with a monthly Social Security benefit of $1000 at his Normal Retirement Age of 66. If he waits one year before starting his Social Security, then his benefit would be 8% higher or $1080/month. During that year's delay, he "gave up" $12,000 of Social Security benefits, but gets an additional $960/year thereafter. During the year of delay, he had to make up the $12,000 by extra withdrawals from his retirement savings. At age 67 when starting Social Security, he recalculates his withdrawals from his retirement savings using the 4% rule-of-thumb and finds that he needs to reduce withdrawals by 4% of the $12,000 or $480/year.

So what's the net change in annual income for our example Boomer from delaying Social Security?
+ $960 from Social Security
- $480 from retirement savings
------
+ $480 net annual increase.

In addition, depending on his taxable income (which include withdrawals from tax-deferred retirement savings), he could find his taxable income reduced by up to $480.

Who loses by his doing this? His heirs, should he die early -- if he died at age 67 then his heirs would inherit $12,000 less. IMO, this should not be a consideration unless your heir is your dependent, such as a special needs child. Otherwise, it's better that you have a secure retirement and not depend on your heirs for support.

In a future post, I'll discuss the 4% rule-of-thumb and my take on it.

How to Use a Windfall?

I received my AARP: The Magazine today. In it was a column of the same title as this post.

The question put to columnist Eric Tyson was: "I'm 54 and just inherited $50,000, which is about what I owe on my mortgage -- the only debt I carry. Like many people, I have some retirement savings but should be saving more. What's the best use of this money?"

Eric replies by asking if he has 3-6 months savings in an emergency fund, and whether he has disability and long term care insurance. As to whether to pay the mortgage Vs investing, Eric took somewhat of a pass and said that it depended on his tolerance for risk.

My personal recommendation would be that the windfall first be used to increase his tax deferred retirement savings (I guessing that "some retirement savings" might be $50,000 or less). IRS limits for 401k contributions in his case are $20,500 this year, including the catch-up amount of $5000 for someone over age 50. And there will be a similar contribution amount next year. Would also recommend he take advantage of Roth IRA savings, if eligible. If not eligible, your income is pretty high, so same on you for such poor savings.

With a mortgage balance of $50K, I'd estimate that it's within about 10 years of being paid off. If not, then a contribution of $5-10K to the mortgage principal could put it within reach. While he may do a bit better in the stock market, he might not. A reduction in expenses when entering retirement is a more secure proposition.

But aside from what to do with the windfall, his retirement savings need to be structured to provide your retirement without depending on windfalls.

If I got a $50K windfall, I wouldn't have the same choices. I've already paid off my mortgage and am more than maximizing tax-advantaged savings. I'd probably put the money into an after-tax index fund at Vanguard.

What would you do with such a windfall?

I'm a Winner!!!!!

I received a sweepstakes mailing. It has a scratch-off panel, from which I uncovered a Royal Flush. This entitled me to the grand prize of a $5000 gift certificate. Being rather skeptical, I noted the tiny asterisk next to the prize description and looked at the fine print.

The prizes and odds are:
--$250 Racing Gift Certificate, Odds 1:121,398
--$500 Gift Certificate, Odds 1:121,398
--$5000 Gift Certificate, Odds 121,396:121,398
Look at that again. The odds of winning either $250 or $500 are almost nil. But the odds of winning $5000 are almost 100%. But it's not in cash, but rather a "gift certificate". And the "gift certificate" is really a coupon good only for a car at the car dealer sending this out, probably with the price jacked up to cover the $5000.

Further, they offer $3781.42 of "Down Payment Assistance". The cynic in me expects that "Down Payment Assistance" means that you are allowed to reduce the size of your down payment and borrow it instead.

I believe that if it's too good to be true, then it's probably not true. I'm not wasting any time going after my "prize", as it would be a booby prize instead. And I will keep this in mind the next time I'm in the market for a car.

Are We Saving Optimally for Retirement?

Scott Burns has written an article entitled "We're Better Off Than We Think" on the subject of how well we're saving for retirement. He points to “Are Americans Saving ‘Optimally’ for Retirement?” which is the results of a study at the University of Wisconsin concluding that we're not so bad off.

However, as pointed out in the article
"Is There Really a Retirement Savings Crisis?" published by the Center for Retirement Research of Boston College, that for Boomers the answer may be "No, we're not saving optimally."

The Wisconsin study sampled people who were in the age range of 51 to 61 in 1992. The youngest of this group was born in 1941, 5 years before the earliest Boomer. There are a number of factors involved which will make it more difficult for Boomers than for the older generation.

Boomers will be increasingly subject to having their Social Security benefits reduced by increasing Medicare premiums. Additionally, Boomers are more likely to have their Social Security benefits taxed since the exclusion thresholds of $25,000 for a single person and $32,000 for a married couple are not indexed for inflation. If other income (including some that is not ordinarily taxable) plus 50% of your Social Security benefits exceed your exclusion level, then some or up to 85% of you Social Security benefits are added to you Adjusted Gross Income and may cause you to pay tax. The seemingly inexorable march of inflation will make it so -- even at a modest 3%/year inflation rate prices will double in 24 years (per the rule-of-72).

The defined benefit pension is going the way of the dodo bird, with more and more companies freezing pensions and/or restricting participation by new hires. A larger percentage of the people sampled by the Wisconsin study have a a pension to help with retirement than will the percentage of Boomers when we retire.

The Federal Reserve's 2004 Survey of Consumer Finances shows that the median net worth of a household in the age range of 55-64 (with retirement imminent) is $248,000. However the median net worth of the vehicles and home of this age range was over $150,000. What will happen to the price of McMansions if a large number of Boomers try to downsize by selling to the smaller Generation X following? (The basic supply Vs demand curve.) But then you have to ask whether the average boomer will want to downsize, or prefer to continue living in the same house. Would you want to sell your house in which your kids grew up and in which you've grown comfortable and move to an efficiency apartment? If you want to stay in your house, its effective net worth is reduced. Even with a reverse mortgage, you will extract only a portion of the equity during your lifetime.

Personally, I think the average Boomer is in trouble when it comes to retirement. I'm doing my best to ensure that I'm not one of them. I suspect that most people really haven't given it much thought, just assuming that a comfortable retirement automatically awaits those reaching the age of 65.