Discuss the pros and cons of retirement funding by conserving principal and living off the interest. |
You work your entire life to grow you nest egg to a point where you can afford to retire. When you enter retirement, you are going to ask your nest egg to perform three very important, very different functions: •First, you are going to need it to provide you with an income. So, you take your nest egg and you invest it in something that gives off a “reasonable” interest rate, and you try to live off the interest that the nest egg spins off. •Second, you need to make sure that you never run out of money, since this is all the money you will ever have and it needs to last you until your (or your spouse’s) life expectancy. •Finally, you will pass the nest egg on to your heirs in the form of your legacy. We refer to this Retirement Alternative as “Conserving Principle and Living Off the Interest”. When you utilize this alternative, you face five major risks to your plan: 1)Inflation is the first risk. Since you are living only off the interest that the nest egg provides, you have a fixed amount of income. However, because inflation is eroding your purchasing power, you will likely experience a decrease in lifestyle. 2)The second risk is “Tax Rate” risk. Since the government taxes the interest that you earn, you don’t get to keep the entire amount of interest that is generated by the nest egg. What is the effect of the government raising the tax rates? You are still getting the same amount of income, but the government takes a larger share so your spendable income is decreased. 3)The third risk is “Interest Rate” risk. What happens to your income if the amount of interest you are earning decreases due to changes in the economy or the interest rate environment? Again, you experience a decrease in spendable income. 4)The fourth risk is “Loss of Capital” risk. What happens if either by choice or out of necessity, you have to invade your principle? Perhaps you have an unexpected medical expense or maybe you choose to help a child or grandchild with some money. Any amount of capital that you remove from your nest egg will affect the amount of interest that you will earn in the future, which will result in a decrease in spendable income. 5)Finally, in order to compensate for the first four risks, many people choose to put a portion of their nest egg into the stock market, which introduces “Market Risk” into the equation. |
Presentation Math: First Year Gross Income = Total Assets * Interest Rate First Year Taxes = Annual Return * Tax Rate First Year Net Income = First Year Gross Income - Taxes
Documentation Worksheet: Gross Withdrawal = Total Assets * Interest Rate (Total Assets remains constant since all growth is withdrawn at the end of each year.) Tax Rate = Annual Taxes Paid / Annual Gross Withdrawal (Tax Rate remains constant since the withdrawal is all taxable growth.) Taxes Paid = Annual Taxable Growth * Tax Rate Purchasing Power = Present Value Calculation with the following inputs: Rate = Inflation Rate, Periods = Year - 1, Pmt = 0, FV = Gross Withdrawal - Taxes Paid. Documentation Summary Line: Gross Withdrawal = Sum of all Gross Withdrawals in projection. Tax Rate = Sum of Tax Rates / number of years in projection. Taxes Paid = Sum of all Taxes Paid in projection. Purchasing Power = Sum of all Purchasing Power results in projection.
|