The Principal Problem
There are no right answers to wrong questions. ~ Ursula K. LeGuin
Today we examine The Principal Problem: the main problem we are trying to solve with retirement financial planning. It’s not what you think.
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Most of us have been told that we need to save up a certain amount of money to retire—a capital sum of investments: our Retirement Principal.
We are then told that we need to protect our principal amount, to go from “growth and accumulation” to “preservation and distribution.” We are told the primary problem is the loss of our retirement principal. Therefore our prime directive is to protect and preserve that principal with “safe” investments.
I believe this is wrong.
People don’t live off principal. They live off of income. You rely on an income in your working years. You will live off retirement income in retirement.
The Principal Problem in retirement, thus, is not your retirement principal at all. It is retirement income.
Your prime directive is not the protection of principal but the creation of income. You need income that lasts the duration of your retirement, goes in the direction you require to cover rising costs, and has the deviation to flex with your variable expenses. You need an increasing flexible income over 30+ years.
That contrast, the creation of retirement income versus the protection of retirement principal, may be the decisive difference between your money outliving you or you outliving your money.
Let’s explore this deeper.
The Principal Problem
There are two doors that every one of us will face, only one we will walk through. The two doors present two options, and each of us will walk through one or the other.
These doors are the outcomes of our retirement. Each one of us will retire someday, whether by choice or by force. And at the end of our retirement, we will walk through one of two doors.
The First Door: The money outlives the people.
Both retirees live a life of independence and dignity through their retirement and leave a legacy of generosity and blessing to their children and loved ones.
The Second Door: The people outlive the money.
The money runs out. The couple is forced to be dependent on others. They leave a legacy of stress and financial hardship.
Anyone can retire comfortably, but not everyone will stay comfortably retired.
The only way to stay comfortably retired is to overcome the Principal Problem, the main problem that everyone in retirement will face.
So let’s cover what the problem is not, what the problem is, and how we can begin to solve it.
What the Problem is Not.
Point 1: The Principal Problem is Not Protection of Principal
Most Americans are taught to believe that for retirement, the main goal is to save up enough money to build their retirement principal. To build up the total value of all their retirement accounts to a certain point so that they can comfortably retire.
We’re taught to invest in “riskier” investments early on in life. Then, as we approach and enter retirement, we progressively change those over into “safe” investments. Typically stocks on the one hand and then transitioning into bonds and cash on the other.
We enjoy seeing our retirement principal grow as the stock market is good, and we are terrified when we see it fall. The thought of losing our life-saving drives many people to choose “safer” investments in retirement. They select “fixed income” investments: bonds, annuities, CDs, options that are “safe.”
When the market crashes, we hear people talking about losing their retirement principal. How much did the stock market go down, and how much money did people “lose.” Therefore we think that the principal problem that retirees face is losing their retirement principal.
But this is not the problem.
Think about it.
When you decide whether or not you can buy something, you don’t think to yourself, “Do I have a high enough net worth to afford this?”
When you are asking if you can afford something, what you’re asking is, “Do I have enough income to afford this? Do I have enough in my savings account to afford this? Will enough money be coming in to allow me to purchase this and the other things I will need to purchase in the near and far future without jeopardizing my financial security?”
No one in their working years calculates the total value of their retirement net worth to determine their current budget. Even in retirement, we don’t think, “Do I have enough retirement principal to buy this?”
Why? Because we cannot do the math in our heads to calculate how to spread out a principal investment. It is easy to think in terms of income while we are earning that income. If we were not taught otherwise, we would continue to think in terms of income in retirement.
It is an income problem, not a principal problem. Therefore the principal problem in retirement is not principal at all.
What the Problem Is
Point #2: The Principal Problem is Retirement Income
How does one create an income in retirement to replace the income you have become accustomed to over decades? That is the issue.
And this income needs to do three things. You must have what I call Three Dimensional Income in retirement.
The first dimension is
Duration: Income that lasts as long as you do.
When you stop working and start turning your retirement money into income, you need an income that will last the duration of a two-person retirement. Typically 30 years.
How do we make sure that the money you saved up over a forty-year career lasts thirty more years without you working? How do we make sure we don’t burn through it too fast?
The issue of longevity is where many people lean on annuities and pensions.
Pensions are income streams that are usually guaranteed to last the lifetime of the pension holder, and sometimes their spouse’s life if that ends up being longer. These guarantees are backed by the retiree’s employer: a governmental entity or company. Sometimes this is good. Sometimes this is bad.
The “guarantees” are only as good as the entity guaranteeing them.
The Tax Foundation ranks state pensions by how well they can pay their promises. That is, of the money they have pledged to retirees, what percentage of those pledges has money to back it up. They have a handy map from the 2017 fiscal year.
I live in Wisconsin, which has one of the best pensions in the nation: the Wisconsin Retirement System’s Employee Trust Fund. It was ranked number 1 in 2017, with 103% of its promises funded. Excellent pension, very well managed.
Minnesota’s PERA pension, the Public Employee’s Retirement Association’s pension, is ranked number 36, with only 63% of its promises funded.
To the south of us, Illinois is ranked #48, with only 38% of its promises funded. And before you begin to think this is a red state vs. blue state issue, Kentucky was worst, with its contracts only 34% funded. It turns out that when it comes to promising retirees more than they can deliver, Republicans and Democrats are equal opportunity offenders.
Some corporations still have pensions, but we have all heard of company pensions going bankrupt and the employees losing large portions of their retirements.
If you depend on a pension that is only one- to two-thirds funded to “guarantee” your income in retirement… You may want to rethink your retirement income.
For the vast majority of American retirees without pensions, many will look to annuities to provide income.
The use of annuities is a big topic and one to which we will devote an entire episode. In short, an annuity is offered by an insurance company where an individual can deposit a large sum of money, say $100,000, and get a guaranteed payout for life. Those payouts are usually around 5%, so about $5,000 per year on $100,000. The guarantees are backed by the company, meaning if the company goes bankrupt, there is no guarantee.
Let me say that again in case you missed it. There is no way to guarantee retirement income. Not truly. There are better and worse ways to promote it.
Annuities are often marketed as personal pensions and are used to help resolve the first dimension, duration. Pay $100,000 and get $5,000 for life, no matter how long you live. Live 20 years, and you get it back. Live 30 plus years, and the company has to keep paying you. Live long, and you win. Live shorter, and maybe the insurance company wins.
This “guaranteed” paycheck for life can help ease people’s minds about outliving their money.
But here is where annuities are oversold and underdeliver. They mostly fail at the second dimension of retirement income.
The Second Dimension
Direction: Income that rises faster than the cost of living.
You need a retirement income that will go in the direction you need it to go over 30 years: up.
Who would be satisfied if they were making the same income now that they made 20 years ago? No one. Your income has needed to increase to match the rising cost of living over your entire working life.
Between the day you retire and the day you die, the cost of everything will double.
You need a retirement income that will rise to the occasion.
If the cost of everything you need is doubling, your retirement income is that “guaranteed” for life, but at a set amount, will be less and less useful. Take this example: Suppose an employer offered you a guaranteed salary to work over the next thirty years. But over those thirty years, your employer would gradually cut that salary in half. Would you take that job? Even if it was guaranteed?
Probably not.
When annuities are sold, inflation is rarely discussed. Neither is the reality of an income that is effectively halving in value over a lifetime. It does not matter if your income lasts the duration of your retirement if, by the end, it is half of what it needs to be.
Anyone can retire comfortably, but not everyone will stay comfortably retired. Far too many retirees will underestimate their need for this second dimension.
The third dimension of retirement income:
Deviation: Income the flexes with your variable expenses.
Is your Retirement Income flexible? Can it deviate? Your expenses aren’t the same each year. And they also don’t perfectly inflate by 3% each year.
You have a few years of low expenses; then you need to buy a car or pay your max out of pocket for healthcare. Or you are going on that once-in-five-years trip. Your expenses flex, and your income needs to flex with it.
If all your income is from pensions, social security, and annuities, it may have duration. It may even have direction. But it will lack any ability to change year to year. Deviation, both for planned and unplanned expenses, needs to be a feature of your retirement income.
Three Dimensional Retirement Income.
Duration: Income that lasts as long as you do.
Direction: Income that rises faster than the cost of living.
Deviation: Income the flexes with your variable expenses.
The principal problem in retirement is not the stock market going up and down—the temporary dips of your retirement principal. The principal problem in retirement is inflation—the rising costs of everything you want and need to buy over a two-person 30-year retirement.
Therefore, the focus should not be on protecting your retirement assets in the short run with “safe“ fixed-income investments.
The focus must be on how you grow that income to match your needs 10, 20, and 30 years from now.
I don’t know about you, but I don’t want to carry a fixed income into 30 years of rising costs.
The problem is not principal. It is income.
So how do we solve this problem?
You Need a Plan & a Partner
You need a plan.
People don’t plan to fail, but they fail to plan, which has the same result.
You need a retirement income plan, not a retirement income product (though that may be part of the plan). You need a plan to turn that Retirement Principal into Three Dimensional Retirement Income. Income that will last you the duration of retirement, heads in the right direction in retirement, and has the useful ability for deviation in retirement.
You need a plan that will be able to roll with the punches.
What is your plan for when you experience a market correction or global recession in retirement? What is your plan for when inflation takes off? What is your plan for unforeseen health costs? A good retirement income plan will have the flexibility and structure to deal with the various problems you will face.
You need a Partner.
Someone to show you the way, teach you how to create three-dimensional income. Someone who will coach you through the difficult times that you will face. Someone to provide accountability and guide you every step of the way, keeping you on the straight and narrow path.
You need an excellent Financial Planner that you trust and who knows how to do this.
Before you can solve the Principal Problem, you need to know what it is. If you go to a Financial Advisor or Planner and ask, “I saved up all this money for retirement, how do I keep it safe?” you are asking the wrong question.
There are no right answers to wrong questions. Suppose that advisor does not focus on long-term retirement success. In that case, she might give you an answer to that question. She’ll have you take a risk tolerance questionnaire, and stick all your money in low-volatility, low-growth instruments or guarantee a fixed income for you.
But it was the wrong question, and you will not like the results of that right answer to the wrong question.
Instead, ask, “I saved up all this money for retirement; how do I turn it into increasing income that I cannot outlive?” Then, if you are with a retirement Financial Planner, you will get an answer in the form of a plan that gives you the best chance for your preferred outcome. Outcome number 1: The Money Outlives the People.
Then you will have the best chance at solving the Principal Problem.
This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are the opinions of the people expressing them. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. RetireMentorship is not affiliated with any Registered Investment Advisor, Broker-Dealer, or other Financial Services Company.
- Equity benchmark performance and systematic equity investing examples are represented by the Standard & Poor’s 500 Composite Index, an unmanaged index of 500 common stocks generally considered representative of the U.S. stock market. Indexes do not take into account the fees and expenses associated with investing, and individuals cannot invest directly in any index. Past performance cannot guarantee future results. Bond benchmark performance are represented by the BloombergBarclays Aggregate Bond Index, an unmanaged index of bonds generally considered representative of the bond market. Indexes do not take into account the fees and expenses associated with investing, and individuals cannot invest directly in any index. Past performance cannot guarantee future results. Average stock investor, average bond investor and average asset allocation investor performance results are based on a DALBAR study, “Quantitative Analysis of Investor Behavior (QAIB), 2020.” DALBAR is an independent financial research firm. Using monthly fund data supplied by the Investment Company Institute, QAIB calculates investor returns as the change in assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions, and exchanges for the period.
