[music]
In this video I’m going to tell you the four steps to goal-based investment planning
and then illustrate with an example.
Our example will focus on retirement planning because it is one thing that you are guaranteed
to all have in common. And it helps to start early.
This is important for everyone. Perhaps, particularly for women -- because many women live longer
than men, earn less than men, spend years out of the workforce caring for children,
and accumulate less retirement savings.
I’m Rick Van Ness. You’re watching The Ten Rules of Common Sense Investing, a video
series about saving and investing to maximize lifelong happiness. These rules help you answer
two questions:
How much to save? and How much risk to take?
Some of our dreams need a little money. This list is where we begin.
We need to have some idea of how much we need to save and how we will save that.
There may be part of you rebelling already. Relax! Of course you don’t know the future!
But it will serve you to imagine one scenario. The enemy of a good plan is the search for
a perfect plan.
Make assumptions, and then change them when you get better ideas, or better information.
Our goal is to enable these possibilities.
Step 1 is to start simple with goals, dates, and costs.
Expect to change your plan every year. That’s OK! Keep it simple or you won’t remember
it! Write it down now. Improve it later.
Your goals are dreams with deadlines. Think in terms of how old you will be. That’s
the same as a date, but you are imagining it. It’s more personal.
Make a quick wild guess at how much money each goal will need. I promise you: that turns
on your radar, and subconsciously you’ll begin gathering information that will improve
your initial guess. So don’t worry about being way off!
You know, just doing this simple exercise is the hardest part. It’s not a workable
plan yet, but it is a direction. And you may eventually get where you want — just by
going in that direction.
Step 2 is to improve the cost estimates.
Whether your goal is to buy a house, remodel your kitchen, or to plan a comfortable retirement,
the place where these planning steps differ the most is in how to improve the dollar estimates.
You probably don’t need as much help with your other goals, which is another reason
I’ve chosen our example to focus on retirement planning.
Considerations for retiring include figuring out the savings you’ll require, when to
start Social Security, and whether to use CDs, a lifetime annuity, stock index mutual
funds, or a combination of these kind of things.
Step 3 is to prioritize by needs, wants, and wishes.
The idea here is to match safe investments for your essential needs and consider investment
risk only for the wants and wishes that you could live without — if risk rears its ugly
head.
Step 4 is to match each goal with investment risk.
This will be the grand finale and easiest for me show by our example. The challenge
here is to turn retirement savings into monthly income — for however long you might live,
and avoid some of the other big financial risks ahead.
Big risks are: not saving enough, inflation, stock market volatility, outliving your money,
and common investing mistakes -- because we’re human.
Let’s dive in.
We’ll use an easy to follow example. His name is Ed. He was single his whole life and
is now retiring at age 66.
Every year since he was age 25 he wrote this same goal, and kept adjusting it every year
for inflation. Back in 1980 it looked like this.
It now takes three times as much money to retire with the same standard of living. Always
keep your plan updated in today’s dollars.
The total savings dollar goal is important to choose. It’s often called your “nest
egg”.
Goal based investment planning for retirement starts with an estimate of annual living expenses.
Most people want to keep their lifestyle in retirement to be the same as they had just
before retirement, and they can do that by replacing only a portion of their pre-retirement
income. This replacement income is lower because:
you no longer need to save for retirement, your tax rate might be lower,
you may have paid off your mortgage, the kids may have moved out,
you spend less related to your career, you have more time to shop around for a good
deal and more time to cook at home.
I’ll show you two methods to estimate to estimate the total savings that will be required.
The primary sources for retirement income are Social Security, pension benefits, and
accumulated savings. We need to estimate the amount of retirement living expenses that
will need to come out of your savings.
In the United States, your Social Security benefit is often most significant for low
earners. For high earners, a larger portion will need to come from savings.
A simple method for those with modest lifestyles is to multiply replacement income by 12.
The idea here is to assume your Social Security benefit will cover about half of your retirement
income needs.
In our example, Ed used this approach because it was simple. Later in this video you’ll
see how well it works out for him.
He recently decides his replacement income should be $65,000 a year, and then grow with
inflation. So, his total savings in his nest egg needs to be twelve times that, or $780
thousand.
Remember that number for our example, because he'll have to draw from that to supplement
his Social Security income -- and there are some important decisions ahead in Steps 3
and 4.
Now, some of you are going to need to save more. Well, who might that be?
If you choose a higher standard of living, or if your Social Security benefit might be
lower, or if you need to buffer stock market volatility.
Moreover, some you have other sources of income -- like a pension.
So, another very popular method to figure out what nest egg you'll need is the 4% Rule.
You start with your replacement income, subtract income you'll get from Social Security and
pensions, and come up with your annual draw from your savings.
Your total savings nest egg should be 25 times your annual draw to finance 30 years of retirement.
You get those extra years because it assumes you are invested 50% stocks and 50% bonds.
This method might suggest you'll need a bigger nest egg. It would for Ed.
Is one method better than the other? It depends. You'll get some insights as we keep working
on our example.
Let's recap. Initially we made our best guess at the dollar cost. Step 2 looked at two easy
guidelines to improve it. We're not after precision here; just to get
in the ballpark. The next two steps will look at how he should
invest this money.
Step 3 is to separate essential needs, wants and wishes
Ed has met his retirement saving goal and would like to retire this year at age 66.
To achieve a worry-free retirement he now expands his one goal into three: his essential
needs, his wants, and his wishes. Here’s a closer look at how his annual living expenses
break down. His essential NEEDS are not optional. They
add up to $40K/yr. His WANTS are discretionary. He could live
without these, but they are important to his quality of life. They are another $25,000/yr.
If he had enough money, he has additional WISHES as well.
For Step 4 we’ll compare three strategies to match investment assets with each goal.
Most important is to establish safe, guaranteed income sources for your essential needs that
will last your lifetime. That’s the needs below this red line.
Since there is uncertainty about how long you will live, Social Security, pensions and
some commercial annuities are well-suited for matching with this goal. This is the role
of annuities. People that live short lives subsidize people that live long lives. Society
comes out ahead, because everyone is not over-saving for a long-life contingency. This frees up
money for people to take trips or other spending that increases happiness. My example will
illustrate this.
Next, Ed considers three different ways to match investments with his goals.
First, hedging inflation with Social Security and TIPS bonds.
Second, delaying Social Security and buying a lifetime annuity.
Last, using low-cost index funds instead of an annuity.
Just for fun… Do you want to guess which of these three strategies will be best for
our example?
To evaluate these strategies, Ed must consider them as generating steams of income for each
year of his retirement, with income for his essential needs coming from one source, and
income matched with his wants coming from perhaps another source.
Detaching this income from the stock market enables a worry-free retirement. Ed’s goal
is to create inflation-protected replacement income of $65,000 a year using Social Security
and his savings.
Ed’s first potential strategy is to hedge inflation using both his Social Security benefit,
plus use inflation-indexed bonds called TIPS bonds.
He starts by looking up his Social Security benefit at mySocialSecurity.gov.
It shows you your monthly benefit for different start ages. Starting at age 66, Ed’s benefit
will be 12 times this monthly amount, or about $30,000 this year, with an annual inflation
adjustment.
He receives the social security benefit for as long as he is alive. But so far, he’s
$10,000 shy of the red line—his annual bare essential needs, which are $40k /yr.
His savings could give him an additional 22K until he is 100.
But that doesn’t even cover half of his WANTS, so he sees that as an unhappy retirement.
Alternatively, he could fully fund his budget for WANTS, but he would run out at age 87
and he would have to hope to get into a desirable Medicaid facility -- which he's not at all
excited about.
Hmmm, Ed thinks. That Social Security benefit is looking better than ever!
There is a huge benefit from delaying Social Security until age 70. In this example it
is an additional $10,000 per year.
He’d get $40K /yr for the rest of his life. And it includes a cost-of-living adjustment.
For most people, this is an exceptionally good deal.
In this second strategy, Ed still retires while age 66 and uses maturing bonds to fund
the four years before his Social Security benefit starts at age 70, which will now be
$40,000 and fully cover his essential needs.
With the balance of his money he plans to purchase an immediate income annuity, also
at age 70.
He looks up a free quote for an immediate income annuity to fully fund his WANTS for
as long as he lives, keeping up with inflation with 2% cost-of-living-adjustments.
Looks good. Again, he retires at age 66, uses his savings for 4 years to get the higher
SS benefit, and will buy an annuity with a cost-of-living-adjustment when he reaches
70 to cover all his WANTS.
In fact, he’ll have 58K left over to use for his WISHES.
He has eliminated longevity risk, inflation risk, and market risk!
Looks pretty good. All his needs and wants are covered, and he’ll sleep well — never
to worry about the stock or bond markets again. But, he WISHES he could be more generous — which
he maybe could be if he didn’t purchase the annuity. So, for completeness, he considers
whether he might rather be in stock mutual funds.
He could allocate money to get his essential needs. Then, using the 4% Rule for the rest
of his nest egg would suggest that he could safely meet his WANTS for 30 years with a
portfolio of stock and bond index funds. This would give him the best chance of additional
funds if the market is strong, but also the greatest risk of shortfall if the market does
badly. He’d especially be in a jam if his retirement years start with a sequence of
bad returns.
This isn’t a good strategy for Ed. But everyone is different! Somebody very frugal, with very
few WANTS, might prefer this. Or, somebody wealthy enough that they could bear the market
risk.
In this video I’ve shown that it is easy to make a plan and improve it each year. It
starts by putting your goals in writing.
For our retirement planning example, we used guidelines to estimate our annual living expenses
and then calculate the total savings “nest egg” required for that retirement income.
We prioritize to separate essential needs from those we could live without.
And finally, match investment risk with each goal.
Don't worry if you don't feel like you can do all this yet. There’s more to learn.
And you'll become comfortable. I'm showing you the kind of thinking you'll
be able to do.
Keep watching this video series. Learn how to take control of your finances and live
the life that you want to live.
The next video will look at saving. How do people save that much money? What important
tricks make it easier?
After that, learn about your most important decision: investment risk.
See you in the next video!