Pre-Retirees Must Prepare For Life's Unexpected Turns

John and Ann thought they finally had it made. After years of saving for their youngest daughter's education, she earned her college degree. They weathered the $120,000 storm even as they steadily saved for retirement. For a moment, it looked like clear sailing, when suddenly another major expense popped up: John and Ann's daughter met a guy. She's in love, and there's a wedding to plan, along with some very practical considerations. Though the young man's prospects are bright, his present circumstances are dim. Paying for the happy event is falling entirely on John and Ann. Both age 59, John and Ann, have a combined annual income of $180,000. They have $1 million in investments to fund their retirement:

• $310,000 in John's 401(k)
• $60,000 in Ann's IRA
• $415,000 in John's brokerage account
• $215,000 in Ann's brokerage account

This is a situation where having a detailed retirement plan can give you clarity and comfort about life's unexpected twists. Take a look at why.

Before the wedding came up, John and Ann had a realistic retirement plan:

• John was expected to live until 2035, age 91, based on actuarial projections, and was Ann expected to live until 2038.
• They would need retirement income of $70,800 annually to meet all their goals and expenses until 2035, and Ann would need a reduced income of $58,200 annually for 2035 to 2038.
• Inflation, they assumed, would run at 4% annually through 2038.
• Between 2004 and 2009, John would annually add $16,200 to his 401(k) and $5,000 a year to his brokerage account.
• Their balanced investment portfolio would consist of 60% stocks, 30% bonds, and 10% cash equivalents.

John and Ann's had felt comfortable about their retirement plan before the wedding came up. They had used an advanced financial planning technique to simulate what might happen with their portfolio through 2038. This statistical analysis, Monte Carlo simulation, applied the range of ups and downs that occurred in stocks, bonds and T-Bills between 1970 and 2003 to simulate what might happen to John and Ann's portfolio through 2038.*

Investment returns don't come in uniform predictable numbers. You might get a big gain in stocks or bonds one year and a loss the next year. Monte Carlo simulation randomly runs possible returns you might get each year from each asset over the length of your financial plan. Instead of running just one possible outcome for your portfolio, it simulates the future by running hundreds of outcomes for your portfolio to simulate the many possibilities that could befall your plan. The simulation tells you the probability of success for your financial plan. Monte Carlo simulation is not foolproof, but it is a useful statistical approach to model the future.

Before the wedding came up, John and Ann's portfolio gave them a 70%chance of being able to draw their desired yearly income during retirement, according to MoneyGuide Pro, makers of financial planning software for professionals.

To throw their daughter the wedding of her dreams, John and Ann would withdraw $60,000 from Ann's brokerage account. Suddenly, their ability to achieve their long-term goals suddenly is dubious.

Losing $60,000 hurts in two ways. They not only lose that money but also the future compounding on its returns. In addition, because they are selling stocks in Ann's brokerage account to raise the cash, they owe capital gains tax of 15% on Ann's profits.

As a result, John and Ann's plan now had only a 60% probability of allowing them to achieve all their retirement goals. To get back to a more comfortable 70% probability for success, they'd both have to work a year or two longer than they originally had planned. Alternatively, they could cut expenses. For instance, they had planned on buying a new $30,000 car every four years. They could stretch that to six-year intervals or settle for less expensive cars. They also wanted to spending $24,000 annually on vacations, but could cut it to $16,000 to raise their probability of success. John and Ann will have to make some tradeoffs to achieve their goals.

John and Ann's situation isn't unusual. Many pre-retirees fail to save for weddings and other expenses because life is so unpredictable. The best anyone can do is to plan for what's known. It won't be scientific, it won't be perfect and it will need to be updated every year or two. However, by simulating the future for your portfolio and accounting for the liabilities you must incur to live the retirement lifestyle you desire, you'll get a clearer, more realistic picture about your retirement years. And maybe you'll worry less about paying for those unpredictable twists life brings us all.

*From 1970 to 2003, stocks, represented by the Standard & Poor's 500 index gained an annualized 10.32%; bonds, represented by the Ibbotson Long-Term Corporate Bond Index, gained an annualized 9.4%; and cash-equivalents, represented by the Ibbotson 30-Day U.S. Treasury Bill index, gained an annualized 6.25%. Past performance is no guarantee of your future results.

8/5/2004
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