A business writer recently asked, “What should you do five years prior to retirement?” We often receive this sort of question from our readers and occasionally from our clients at McLean Asset Management. The essence of this question is what, out of the hundreds of strategies available, is the best? While initially unsatisfactory, our answer, as always, is “it depends.” It depends on your specific circumstances and goals. Rather than developing an exhaustive list of to do’s that may or may not be appropriate for everyone, our approach is to help the client develop a retirement framework for retirement or way of thinking about retirement. We call this the “CARE” retirement framework and it will help you build a foundation for a successful retirement.
First, a quick definition of what we mean by the CARE framework. “C” refers to Capacities. Think of these as your resources. “A” refers to your Aspirations or goals. These can be lifestyle goals or other goals like legacy goals. “R” stands for Returns and it gets to the point if your return assumptions are grounded. Finally, “E” refers to your Emotional comfort with your plan. Are you in emotionally in sync with your strategy and will you be able to stick with it during the ups and downs of retirement? For more on the CARE framework click here.
So, what is a CARE retirement framework for someone retiring in five years? Let’s address each element of this framework. We’ll start with the “A” – with the aspirational part of the equation – the “what” and “why” of a successful retirement. Then, we’ll move on to discuss the “C” and the “R” — the capacities and returns, or the “how” part of the retirement equation. Finally, we’ll touch on the “E” — the emotional comfort aspect of the framework, or how comfortable you are with the financial strategy you’ve selected. Full disclosure: while I am not precisely in the five-years before retirement category, I am certainly in the nearby category, so this topic hits pretty close to home for me.
Before we start, we should take a step back and recognize that if you are within five years from retirement, you are in a potentially precarious situation. To be specific, at five years before retirement, your human capital (your ability to earn a salary) is dwindling and you are not only a candidate for unforeseen shocks in the market, but also personally. If you work in a corporate setting you are at risk to be laid off and because of normal aging, you are at increased risk for an adverse health event. In fact, 60% of workers are forced into early retirement because of a combination of these reasons. They end up not having the luxury of five years to prepare for retirement. People who go cold turkey into a forced retirement are not as happy as those who “control” their destiny. We call the five years before retirement and the five years after retirement “the fragile decade” because over 80% of a retirement successful outcome is determined during this decade. What you do during this time matters a great deal!
As a general rule, advisors do not spend nearly enough time working with clients on the aspirational and emotional aspects of their framework for retirement. We are more comfortable talking about what is an appropriate amount to draw from a portfolio, or what is an appropriate asset allocation? Nevertheless, the first question for someone about five years from retirement is what do you want to do in retirement and why?
To be clear, this is not an envisioning exercise where you paint a picture of a beaches, mountains and oceans as your ideal retirement or put yellow stickies with your ideas on a wall at some retirement seminar. Nothing against beaches, mountains, oceans, or yellow stickies for that matter, but your answer should be more concrete.
You may already have a good idea of what you want to do in retirement, and if you do, great! Our question to you in this situation is “have you actually done it, yet?” In our experience, more than a few become bored with golf, travel or pottery or whatever it is you have imagined as the perfect retirement and you may eventually seek other challenges. Golf is great one day a week but can be like a job when you do it seven days a week. For me, golf is a job even at one day a week! Our recommendation is to take a test run on retirement either through sabbaticals or a phased retirement. More on phased retirements later.
For those who don’t exactly know what to do in retirement, our first recommendation is to start thinking in terms of “remaining life” versus “life expectancy.” This is a subtle shift. When you say you have life expectancy of 90, this is something you have thought about in the past and the risk is your answer or feelings are anchored in the past. However, when you think of “remaining life,” there is an immediacy to it and it forces you to think about what you want to do in the first 10 years, the second 10 years of retirement, and so on. Wade Pfau breaks this down into the Go-Go, Slow-Go and No-Go years.
Don’t forget to consider what your partner wants to do during retirement, as well. A follow up point to the “what you are going to do and why” question is, “What is your spouse going to do and why?” It is crucial that couples talk about their goals together. We have done several retirement seminars where the spouses’ answers to basic retirement questions are wildly different and each had assumed the other bought into their “retirement” plan without talking to them. We also see this in our initial consultations with prospective clients. As you can imagine, it can take some finessing to sort out, but it’s a lot better to have these conversations now, rather than 5 years after retirement – when one of you is unhappy with how retirement is going.
Consider, too, whether you will do something substantially different in retirement than what you are doing now, or whether you will you continue to do the same things, but have more time to do them. There is no right or wrong answer here, this is simply an exercise to identify what you want out of your retirement. We have seen clients take up successful painting careers in retirement, become expert photographers, and others garden or pursue their hobbies in a more general, but still satisfying, sort of way.
If you are still unsure of your answers to the above, you may consider a phased approach to retirement where you dial back over a period of years. This strategy will allow you to test the waters, keep your social network intact and skills up to date. Of course, this depends on your current job flexibility.
Speaking of your social network, it is extremely important to have an active social network in retirement, and like diversifying your investment portfolio, one should think about diversifying their current social network before retirement. Most often, work connections aren’t as strong after retirement, for obvious reasons. For example, one recent study from the Rush Alzheimer’s Disease Center found that highly social seniors had a 70% lower rate of cognitive decline compared to those who were less social.
So, assuming you have an idea of how you want your retirement to look and feel, where you’ll be, and what you’ll be doing, the next step is to establish an effective retirement framework that aligns your capacities with your goals. This is your reality check. The following are two critical questions:
- Will I have enough to meet my goals?
- What mix of stocks, bonds and reliable income sources is right for me?
To answer the first question, you need to know your budget, both your essential and non-essential expenses. Unfortunately, many have not taken the time to figure out what they think they will spend in retirement. This is an absolute must if you are serious about your retirement plan. It is also important to know your remaining life expectancy. Once you know these two data points, then you can establish a funded ratio. The funded ratio is a snapshot of your current financial health relative to your resources and goals. It is analyzed by dividing your assets by your future liabilities. If your ratio is one or higher, then it is likely you can meet your goals and you will have some flexibility and if it is under one, some adjustments may be necessary. We use the funded ratio to determine if our clients are on track to meeting their goals.
Now that you know generally if you are on track to meet your retirement goals, the next questions to answer are what retirement approach you should take to maximize your chances of a successful outcome and how comfortable you are with that approach.
There are two basic retirement income approaches that have been used in the past. Insurance agents solve the income puzzle with some sort of annuity with a guarantee – a safety-first approach. The benefit of this is that you have a reliable income source, and you know exactly (or reasonably close to exactly) what your income will look like through retirement. The downside is it can be expensive to implement and other goals, such as your legacy goals, may suffer. Brokers and financial advisors, on the other hand, generally use a mix of stocks and bonds – the total return approach – to solve the retirement problem. The total return approach works well for many, but not for all. The chief objection is that stocks in the long run will be just fine, but you also need to consider your “own run” so to speak. It’s important to think about what the next 10 years will bring and whether your portfolio (and you) could withstand a 2008 type of market. Again, there is no right or wrong answer on which strategy, or mix of strategies, is “optimal”. You just need to find the strategy that you are comfortable with and you can stick with.
Some of our clients can determine the retirement income approach — safety first, total return, or mix — rather easily. But some do not. For those that have not made up their mind, financial advisors can help. Be careful of the advisor that only recommends one approach though. Both approaches can work, it just depends on the situation. Based on their academic research, Alex Murguia and Wade Pfau have developed a Retirement Income Optimization Map (RIO Map) that we use with our clients to help determine what approach makes the most sense for them. To learn more about the RIO map click here.
Building an optimal CARE framework is a process. It does take some time and effort. But once you have done the legwork, then you will be more confident in your retirement strategy and you’ll be better able to weather unforeseen circumstances. Another key benefit of the framework is it will allow you to analyze future decision points within an overall strategic framework versus a series of haphazard one-off decisions. You will be able to tie a tactical decision back to an overall strategy. For example, once you have a framework in place, your social security claiming strategies decisions will likely be easier. You will also know if a bond ladder makes more sense than an immediate annuity and if it makes sense to tap into home equity through a reverse mortgage. These are just a few of the tactical decisions that will be made easier by having a framework. We plan to discuss these tactical decisions in the future, but for now, if you have the CARE framework in place, Congratulations!