Sunday, November 11, 2007

ASK S&B: The 90/70/30 rule

DEAR S&B: Do you have a rule of thumb to determine when a person can financially retire and stay that way for the remainder of their life? I figure that I spend approximately $10,000 per month to maintain my status of living. Thanks.

Dan Santa Barbara
DEAR DAN: You hit upon the most frequent question we receive. Over the years we have developed a handy little formula we call “90/70/30” which gives us the “back of the envelope” answer to this question.

This is how it works….the 90 is correlated to your known lifestyle expenses, the 70 relates to the maximum amount of your “investment” assets that should be allocated to “income”, and the 30 represents your “growth” investments. Let’s run through a quick example using your needs of $10,000 per month to maintain your lifestyle.

Step #1: Take the first number in our formula (“90”) and calculate that 90% of your monthly lifestyle expenses ($10,000) results in $9,000. We then tally up all your “known” income sources outside of your investments which will typically be Social Security, pensions and deferred compensation payments. For illustration purposes, let’s assume that number is $1,500 per month (don’t worry about inflation at this moment). We then subtract that number from the $9,000 figure above to understand that you need to generate around $7,500 per month from your savings and investments to cover 90% of your lifestyle expenses. The source of this “known” income should be generated from investments that are intended to generate cash flow, regardless of day to day changes in the stock markets. The leftover 10% of the formula can be made up from “other” sources such as dividends and capital appreciation.
Step #2: We then need to figure out how much money it will take from “income” investments to yield $7,500 per month or $90,000 per year. At the current time, interest rates and yields are relatively low, so let’s figure a conservative number is approximately 5.5%. Divide that number into $90,000 per year and we come up with $1,636,363. So as long as we hypothetically invest this lump sum of money into an income portfolio that yields 5.5%, that will give us $90,000 per year of “known” income. However, we need to account for future inflation which is addressed in Step #3.
Step #3: Depending on your age, the following number could be higher or lower. The younger you are (say under 60) the formula should be higher and the older you are (over 70) you may want to decrease it. But for a rule of thumb we say that 30% of the money you currently allocate to “income” (Step #2) should be targeted to “growth” investments. That’s a minimum figure; you can always allocate more.
This is intended to combat inflation and to help you pay for future “big” ticket items such as cars, home repairs and luxury items not in the budget. In this example, we take $1,636,363 x 30% to get $490,909. So when you take this number coupled with the result of Stage #2, we come up with a hypothetical lump sum of $2,127,272 needed to fund your retirement income needs.

Investment Management: When it comes to investing, the two forces that significantly tug on us are greed and fear. Though the mindset of the formulas above is to create a high level of financial security, they will “under perform” the general markets during the “good” times.
However, this philosophy will also help keep people retired during the “bad” times such as those we saw after 9/11. Retirement means you are in the “distribution” phase of your financial life where you need to live off your investments. Generally speaking, that means you are consuming a good deal of what you earn. Thus, this means that appreciation tends to slow down and you need to mentally prepare for that.

Wealth Management: There are generally three main stages of a persons’ financial life which are establishment, accumulation and distribution.
During this last phase, you need to understand your personal life goals and establish an implementation plan to match. Everyone has different goals and for many across the country, financial independence is trumped by “survival.” So if you have the means and choices of what life has to offer, it is vitally important to prioritize your true inner objectives. These goals will ultimately drive what you should do financially.

Risk Management: When putting together your planned budget, you also need to consider health care expenses as you age. You also need to account for the possibility of a long term care illness to see how that impacts your retirement. One of the most cost effective ways to provide protection is the purchase of long term care insurance.
Though people generally do not want to think about themselves becoming ill, we all know it happens everyday to those around us. It is really easy to say, “it will never happen to me,” but don’t fool yourself on this one, the costs of care can wipe out a lifetime of savings so a contingency plan should be considered.

Tax Management: The three largest expenses we see for people are home mortgage, taxes and college funding. As you head into retirement, the mortgage is generally low or completely paid off and the children are grown. This leaves taxes as the highest single expense we would anticipate in retirement for the masses.
It is important to estimate this cost into the formulas above and to also have a “tax plan” which is most effective for your asset mix. If you have a lot of money concentrated in IRA or 401k accounts, those are taxed at marginal rates when distributions are taken and that needs to be factored into the equations. Additionally, we are big believers that taxes in general will have to go up in the future, regardless of who is the President, so it is safer to pad the budget in this area to protect yourself against unexpected costs in the future.

If you would like to have your specific question answered, please submit your inquiries to: Brad Stark, MS, CFP, AAMS, CMFC and Seth Streeter, MS, CFP, CEA, Co-Founders of Mission Wealth Management, LLC, a Registered Investment Adviser and a nationally “top ranked” Wealth Management Firm located in Santa Barbara, CA at 1123 Chapala Street, 2nd Floor, Santa Barbara, CA 93101, (805) 882-2360

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