To find out, he [financial planner Jim Shambo] looked at inflation calculations by the Bureau of Labor Statistics and found something interesting: Inflation tends to strike retirees harder than preretirees. Most notably, health care costs are rising faster than the inflation rate.

Beyond that, the CPI calculation factors out cost increases that are attributable to improvements in the goods and services you purchase. A car may cost 4% more this year than last, but if there are new fancy electronics in the standard model, the government may decide that inflation only counts for a half-percent of the increase. Of course, if you buy the car, you still have to pay the full higher cost. Add it all up, and people aged 65 to 74 appear to be experiencing an inflation rate that is a remarkable 1.11 percentage points a year higher than CPI, and this grows to 2.09 percentage points (a year!) when retirees get past age 75.

That’s rather remarkable.  The rule of thumb that you should be able to retire on 70% of your working income appears to have a big hole in it.  Inflation is even worse for retirees than we thought.

To the outside world, Curt Degerman was a poor can collector.

The aged Swede, known as “Tin Can Curt,” spent 30 years roaming the streets of Skelleftea in northern Sweden in his blue jacket and ragged pants, collecting tin cans and bottle for cash. He was, in the eyes of most people, an ordinary street bum.

Yet when he died he left more than $1.4 million to his cousin.

How did he do it? Thrift and smart investing.

It turns out that in between collecting cans, Mr. Degerman spent a lot of time in the local library reading business papers and studying the stock market.

“He knew stocks inside and out,” said his cousin.

He used his tin-can earnings to buy mutual funds. He also bought 124 gold bars and also grew his cash with a savings account.

Amazing.  Mr. Degerman passed away at only age 60, yet managed to amass $1.4 million.  Imagine if he had lived another ten or twenty years (like Warren Buffett), or had another bull market to help his compounding rate!

Advisors have to deal with investors that have undersaved all the time—and yet still hope to retire with their working income.  I’m sure Mr. Degerman followed classic principles: 1) keep your expenses down, 2) live beneath your means, 3) save like crazy, and 4) invest for growth and let compounding work its magic.  If Tin Can Curt can do it, so can you.

HT: iShares, Brian Page

For retirement savings data, we turn to Employee Benefits Research Institute (EBRI) reports. For 2010, EBRI data shows that people over 60 employed for 30 or more years had about $200,000 in their 401(k) accounts, while people in their 50s are poised to retire with similar account balances. Even if we didn’t take living costs into account, it is obvious that these amounts are inadequate, even for two-income families. Moreover, the time required to undo such gross errors is running out.

When I look at quotes for even a joint life annuity, $200,000 generates only about $950-1000 per month—clearly not enough to live on.  Must reading for advisors.  Save until it hurts.

At the core of any reform, Munnell said, there has to be massive education of employees on how to plan for retirement. Many people think that saving 6 percent with a 3 percent match, for example, is enough. Not so, according to the Center for Retirement Research.

As a baseline, the group estimates that a household earning at least $50,000 needs roughly 80 percent of its earnings to maintain its pre-retirement lifestyle.

To pull that off, a person who is 25 and earns $43,000 needs to be saving 15 percent a year in order to retire at 65, assuming a 4 percent rate of return on his investments. Wait until 35 to start saving, and the necessary savings rate creeps up to 24 percent.

The solution for many people, Munnell said, will be to work longer. If that 25-year-old doesn’t retire until 70, he would only have to save 7 percent a year.

When you do the math, that 15% savings rate comes up a lot.  If your investments do really well, it might turn out that you saved too much.  But under a lot of scenarios, especially adverse ones, a 15% savings rate will often bail you out.  Advisors can have a huge impact in getting their clients to save.

The alternative of having to go back to work at an advanced age because your savings were inadequate is not very appetizing.  (And let’s face it: if you’ve been in the business for 25 years or more like I have, you’ve seen this happen to clients who were unwilling to save.)  If it’s a question of living too well in retirement—well, that’s something most clients will not lose sleep over.

Question #1:  What investments make up your investment universe?  Does your investment strategy allow you to invest in a broad range of asset classes, including U.S. equities, international equities, currencies, commodities, real estate, and fixed income?

Question #2:  What role do current market conditions play in the asset allocation decision-making process?  Does your investment strategy have a means of increasing exposure to asset classes in secular bull markets and decreasing exposure to asset classes in secular bear markets?

Question #3:  Does your portfolio include investments in complementary strategies?  Relative strength and value are both long-term winning investment factors.  They also tend to have low, or even negative correlations to each other, thereby providing useful diversification.

Question #4:  Is your asset allocation divided into segments?  Breaking a portfolio into an income segment, balanced segment, and growth segment can provide tremendous psychological benefits and therefore may increase the odds that you will stick with your investment plan over time.

Question #5:   Do you have a plan for systematic contributions?  There are many ways to accomplish this goal, including setting up a monthly automatic withdrawals from your bank to your brokerage account or regularly sending 15% of every dollar earned to your brokerage account, but the key is to have some systematic means of continuing to save money for your financial goals.

Question #6:  Do you have a plan for how you will approach distributions from your portfolio during retirement?

Question #7:  Do you have a financial advisor that will give you the TLC you will need to be educated and guided along all the inevitable bumps in the road?

Some relevant resources:

Savings or Growth? 

Expected Returns

Safe Withdrawal Rates

What’s Your Retirement Number?

Strategic Allocation Bites

The Upside of Mental Accounting

The Bucket List

Combining Global Macro & MDLOX

Why Tactical Asset Allocation

What is a Balanced Fund, and Why Should You Care?

You Need to Save to Grow!

Source: AdvisorOne    (click to image to enlarge)

In true miracle-of-compounding fashion, investment performance only starts to overwhelm savings in the out years!  All of the years where investment performance are more than 50% of the return are in red, and even when the assets are compounding at 10% annually, it takes more than a decade before investment performance outstrips savings.

Clearly, in the early phases of capital accumulation, savings is much more important than investment performance.  Instead of worrying about investment recommendations, you can best help the client by keeping them focused on making regular account contributions.  When the regular contributions become small relative to the overall account size, investment performance will tend to be the main driver of growth.

Investment management is most important for clients who have already acquired critical mass; saving is most important for clients trying to get there.

Pensions everywhere, corporate and government, are potentially underfunded by trillions of dollars.  Again, it all depends on the return expectations.  In the most recent issue of Investments & Wealth Monitor (sorry, behind a pay wall), author Christopher Brightman cites an expected return study by Research Affilates.  The study uses beginning dividend yield, long-term real earnings growth, and implied inflation to forecast the expected equity return for the market.  It uses the beginning bond yield to forecast the expected return for bonds.  The expected return that is derived is a 10-year estimate.  Based on their forecasting method, their average gross error was about 2.1% (+ or -) between the expected return for the decade and the actual realized return.

There is no real precision in forecasting, obviously, but there may be some merit in altering expectations depending on your starting place.  Reported performance, even for an individual account, is extremely dependent on the starting and ending points.  Consider, for example, this table from an article on performance at AdvisorOne:

Source: AdvisorOne      (click on image to enlarge)

A spending policy that seemed prudent during the 1980s and 1990s is going to freak out a client in the current environment.

The concept of fecundity, as espoused by James Garland, may provide both a simple spending rule and serve as a proxy for estimating returns.  Garland points out that you can’t sustainably spend all of your earnings (dividends + capital gains), but you can probably spend more than just the income because there is often some capital growth over time.  His rule of thumb is that sustainable spending is about 130% of the yield on the major indexes.  By combining this data with some of the inputs in the Research Affiliates estimation process, I discovered that return estimates with a similar average gross error (2.0% + or -) could be calculated.  All of the inputs are readily available.  Just for fun, here’s where we are now.

Current S&P 500 yield: 2.0%

Current breakeven 10-year yield: 2.3%

Current US 10-year note yield: 2.0%

60/40 balanced account return expectation over next 10 years:[( ( 1.3 x 2.0% ) + 2.3% ) x .6] + [2.0% x .4] = 3.74%

The equity return expectation is 4.9% (130% of yield + expected inflation) and the bond return expectation is 2.0% (the current yield).

If that number seems low to you, I would suggest that pushing a client to save diligently and invest intelligently is going to be very important to your Baby Boomer retirees.  There’s still time for a lot of the Baby Boom generation, although some of them might need a kick in the pants.

I also feel pretty certain that even if the equity market return is 4.9% for the next decade that there will be other markets where returns are much higher, or years when the equity market does much better than 4.9%.  It’s important to be aware of global trends and asset class returns.  To make money over time, you at least need to have a sense for where the action is.  In other words, what is showing the best relative strength?

The bucket approach offers the client a greater feeling of self-control. “For retirees feeling overwhelmed by the many decisions they face as they enter retirement, a bucket strategy may help them divide what they see as one large, stress-inducing problem into smaller, more manageable pieces,” the analysis states.

The article references a paper done by Principal Financial, which goes into more depth.

According to an AARP study, the majority of people fear running out of money in retirement more than they fear death. It’s no wonder many people look to financial professionals for help as they enter retirement. While working with a financial professional on any type of retirement income strategy can help a retiree feel more confident in his or her plan, research has shown that the bucket strategy may provide some additional psychological benefits. A bucket strategy can address a human preference for smaller, simplified issues. For retirees feeling overwhelmed by the many decisions they face as they enter retirement, a bucket strategy may help them divide what they see as one large, stress-inducing problem into smaller, more manageable pieces. A bucket strategy that links portions of money directly to goals may also promote self-control.

The paper is well worth reading, although I have some reservations about it.  It makes a number of assumptions about how the bucket strategy is to be carried out and then tries to make a comparison with systematic withdrawals from a target date fund.  Suffice it to say that a glide path that holds more and more bonds as you age (and are more exposed to inflation) may not be an ideal solution.  In addition, I’ve written before that there is no necessary functional difference between a balanced account and a portfolio using buckets.  You can have the same allocation in both—it’s just a matter of controlling investor psychology.

In reality, most investment performance problems are investor behavior problems.  To the extent that a bucket approach can mitigate that for a client, I say to go for it.

Workers under the age of 35, the generation most likely to depend almost solely on defined-contribution plans rather than the typical Social Security-savings-pension three-legged model, need to be diligent if they expect to save enough for retirement, a report released in October by Northern Trust found.

“Sponsors have to engage younger workers to save, save a lot, and to continue saving,” Lee Freitag, product manager of defined contribution solutions for Northern Trust, told AdvisorOne on Monday.

Yep.  Save ’til it hurts.  No investment advisor can help you grow your money if you haven’t saved any.