Book Notes: Spend Til The End, Part 3 (B)

Moving right along on our series on the contrarian financial planning book Spend Til The End. This is the second part of the third section, beginning with the 17th chapter. From the 25th latitude. In my flip flops.

Chapter 17: Cashing Out

The conventional wisdom says to delay withdrawing from your 401(k) to defer taxes as long as possible and to take your Social Security benefits as soon as possible, so you don’t die before fully using them. But can you ever realistically predict your life expectancy? In addition to planning for an earlier than expected demise, it may be smart to plan for living too long as well.

So when should you withdraw from your 401(k) and take Social Security? Consider a 62 year-old childless retired couple with $500K in regular assets and $250K each in 401(k) accounts. Contrary to conventional wisdom, their best option is actually waiting until they’re 67 to withdraw from the 401(k) plan and to wait until age 70 to take Social Security. This option allows the couple to increase their living standard by almost 13%. Why the huge difference? Because each year you delay collecting Social Security, it’s increased by approximately 7%, adjusted for inflation. If our couple started their retirement account withdrawals before the age of 67, they would pay a lot more in taxes and simply be worse off.

How long you can wait to collect those assets largely depends on the assets you can use prior to retirement. If you are asset-light, then taking 401(k) withdrawals between the ages of 62 and 69 is probably your best bet. If you want to leave money to your kids, it’s best to give it to them now or buy life insurance to give them the inheritance you want – instead of taking Social Security early just to leave them money in the event you die early.

Chapter 18: Double Dip on Social Security

Little known fact: you can receive more than one type of Social Security benefit, or be paid the same benefits more than once.

Let’s focus on the first option. Consider Bill and Hillary, a 62 year old couple where Hillary is the bread winner and a lucrative lawyer while Bill plays sudoku all day. Bill is entitled to both spousal and survivor benefits based on Hillary’s earnings. These benefits will not impact the choices around collecting his own retirement benefits because he is not trying to collect both spousal and survivor benefits at the same time. If he does try to collect both at the same time, he will only get the larger of the two.

Bill’s best option is to collect his own retirement benefits of around $7,000 for each of the next four years until the age of 66 after which he can collect spousal benefits of $13,305 – even if Hillary hasn’t begun collecting hers. By taking his retirement benefits first and spousal and survivor benefits later, Bill receives $28K between the ages of 62 and 66.

Now let’s consider the second option. Did you know you can apply for Social Security early, then repay the amount taken without interest or adjustment for inflation, and then reapply again later? Say hello to Form 521, Request for Withdrawal of Application.

If you have begun taking your Social Security early, but then read Chapter 17 above and realized the benefits of deferring your Social Security, you can still correct the situation with a Form 521 and improve your living standard. And reapplying for Social Security is still a good option even after having paid federal taxes because the IRS allows you to recover these taxes by taking a deduction or credit.

Chapter 19: Russian Roulette for Keeps

Note: I expected more railing against annuities in this chapter but got very little. It concerned me that the only warning given to readers about the downsides of annuities was two tepid sentences. The authors do come to a reasonable conclusion, though only after four pages of explaining how, in the economic sense, annuities in theory fill a valuable void.

The name for this chapter also probably merits explanation. It comes from the author’s assertion that when an individual buys an annuity, she is joining lots of others who have made the same decision. Then, “when your fellow players shoot themselves, you and the other survivors get to confiscate the decedents’ money.” I suppose it’s true, but it sounded like a script for the next shoot-em-up video game:

‘Locked and Loaded: Septuagenarian Rampage.’

In the end, the authors encourage the reader to think of annuities as “confiscatory Russian roulette” in which the firms who sell them take a hefty cut of the pot before handing out what’s left to the survivors. In the detachment only an economist can muster, it is cautioned, “the insurance industry isn’t offering actuarially fair deals, at least not at the moment.” Don’t hold your breath.

We are all at risk of outliving our savings, and the authors believe annuities can be quite important in raising a person’s living standard.

Let’s take an example of 65 year-old, single Sue Sanguine. Sue has $300K in each of three buckets – regular assets, regular IRA and home equity. She has invested all of her regular and retirement account assets in TIPs yielding 3% over and above inflation. Her only annuity is the $1,000 she receives every month from Social Security. Her annual expenses are $6K for housing and $1,122 for the Medicare Part B premium. Sue has correctly decided she can spend $28,643 annually based on the income she will get from the TIPs.

Sue leaves a lot of money up for grabs because she fails to annuitize her assets. Even if she lives until her maximum life expectancy of 100, Sue will leave behind $300K in home equity – assuming she doesn’t sell her house at all.

Sue’s retirement account assets currently give her only $13,969 annually. If she purchases an actuarially fair inflation protected annuity, she can spend $19,156 annually, which is 37.1% higher than the previous $13,969. If Sue were to annuitize her assets by taking a reverse mortgage on her house, she could raise her living standard by a whopping 50%. This would allow her to spend $42,947 annually instead of $28,643. Sue could further improve her living standard by waiting until the age of 70 to take Social Security, which would allow her to spend $44,625 annually.

The situation would change significantly if Sue had three children and wanted to leave them an inheritance. She could make an arrangement with her kids whereby they inherit her assets and they help her financially during her retirement, but the risk with this arrangement is that Sue’s kids could loose their jobs or run into a financial crisis, leaving them unable to help Sue.

After taking all of these risks into consideration, Sue could decide to pick from any of the following options:

1 – Give the kids whatever she wishes to leave them right now;
2 – Hold some cash in the event she chooses to live in a nursing home;
3 – Take out a reverse mortgage; and/or
4 – Use her retirement and regular asset accounts to buy annuities.

Bottom line: annuities can be useful, like reverse mortgages, but they should be considered carefully.

Chapter 20: Learning your B’s and D’s

Another way to control your benefits from the government is to decide whether and when to take Medicare Parts B and D. There are significant lifetime penalties for signing up late, and waiting to enroll makes sense only if you have extremely secure alternative coverage.

The premium amount rises with each passing year. The Part B (outpatient) premium rises by 10% each year you delay enrolling, while Part D (prescription drug) rises by 1% each month you wait to enroll.

If you have very reliable basic coverage which excludes prescription drugs from a previous employer, it makes sense to enroll in Medicare Parts A and D at the age of 65.

If you are extremely certain you’ll have complete coverage from a past employer, the best move is to completely avoid Medicare.

The last scenario is trickier. If you are 65 years old and intend to work two more years for an employer that covers everything, it still may make sense to enroll in both Medicare Parts B and D at age 65. You’ll have to pay quite large premiums for two years with no return, but after those years your annual premium payments will be more than one-fifth smaller for the rest of your life than they would otherwise be.

Chapter 21: Holding Your Nuts

Squirrels hoard nuts, we should hoard assets. Enough said about that title.

Investing in a tax-efficient manner is more important the higher your tax rate.

Equities held long-term are currently taxed at 15% or less, depending upon your income level, while interest earned on bonds is taxed as high as 35%. If you have both regular and retirement accounts and invest in stocks as well as bonds, your smartest move would be to shift all your stocks and other tax-favored assets (like tax free municipal bonds) into the regular asset accounts and move other taxable assets into the retirement accounts. This will help you increase your living standard due to tax breaks.

Chapter 22: Fire Your Broker

How to define most mutual fund managers: they systematically fail to do their job (i.e. they almost always fail to meet the market/index, let alone beat it) but still make a fortune and spend an extravagant amount of time playing golf with your corporate benefits people. For these services typical brokers and investment companies charge commissions or an annual flat fee of 2% a year. And 2% is significant. Assume your portfolio yields 5% after inflation, paying the manager 2% will shrink your annual returns by an astonishing 40%.

An easy way to maximize returns is to fire your broker and manage your own investments in the simplest and cheapest way possible: buying index funds. Using the same logic, your employer should fire your 401(k) plan manager. A Federal Thrift Savings plan with an annual cost of just 0.03 percent goes a long way towards enhancing your returns and standard of living. So if you don’t have them, badger your employer to offer hyper-low-cost index funds.

Chapter 23: Downsize

Reducing your off-the-top expenses like college tuition and housing – or cutting down on vacations and weddings and other non-routine expenses – can dramatically raise your living standard. Living in a lavish $3.5 million mansion that means spending $60K annually in property taxes could leave you with very little disposable income to spend during retirement. In such a situation, taking a reverse mortgage or moving to a less expensive home can dramatically increase your living standard.

In short, make sure you understand what cutting down on a few luxuries really means for your disposable income by calculating your living standard with and without them.

Chapter 24: Equitable Alimony

Divorce comes with heartache, but it could also come with a lower living standard if you don’t get a fair deal. Take Frank (45 years old) and Stacy (30 years old). They have two kids. Frank is a dentist making $150K annually from his practice which would sell for $300K, while Stacy is a dietitian making $30K per year. They own a $500K house with a $200K mortgage and have $500K in regular assets. In addition, Frank has $200K in his retirement plan.

The current settlement deal lets Stacy keep the house (along with the mortgage) and the regular assets along with $15K per year, per child, in child support from Frank. He keeps his practice and his retirement plan money. With this deal, Frank’s living standard will be $45,075 a year while Stacy’s will be half of Frank’s at $23,659 a year. If Stacy gets $10K alimony each year, Frank’s living standard would drop to $32,689 a year while Stacy’s rises slightly to $25,553 annually. They can both improve the situation by contributing to retirement accounts and delaying drawing down their social security benefits as well.

In a divorce you could spend years playing the blame game, but your time is much better spent by definitively determining how each party is treated in terms of what really matters: future living standards.

Next up – Part 4: Pricing Your Passions. I’ll be on the road again next week this time, so Book Notes will pick up again on July 9th.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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