Although they are far and few between, there are folks out there who still enjoy the benefits of a pension. They were able to enjoy the days of going to work for a company for 30+ years earning their regular income, then stopping work to retire and still enjoy their regular income. In those times it was uncommon for women to work outside of the home, but if their husband were to pass away before them it was of no monetary concern. Most pensions would continue to pay out throughout the beneficiary’s life as well. These golden years are long gone in today’s society. Pensions faded out in the 1970’s when companies realized how much cheaper and easier it was to offer defined contribution plans (like a 401k) by utilizing mutual funds.
According to the Bureau of Labor Statistics, the average tenure within companies today is 4-5 years. This means the average person will change jobs 10-15 times throughout their working career! We can always resort to the “What came first, the chicken or the egg” scenario to decide if pensions faded due to lack of employee loyalty or vice versa, but the point is a line in the sand was drawn. The responsibility for lifetime income in retirement was shifted from employer to employee without any affiliated guidelines or planning principles. An environment of competing financial firms offering proprietary products and paying their representatives based on their assets brought into the company (as opposed to true, beneficial planning for the client) wasn’t just created, it was stimulated. Now the Average Joe is tasked with deciding which cup of Kool-Aid he wants to drink form within a culture of “advisors” one-upping each other and shooting down any idea that does not result in money being funneled into their company.
You can walk down any street to pickup a Slurpee from 7 Eleven and an Edward Jones mutual fund because they’re both on every corner. Anyone who knows my back story knows these words sting my heart as well because I started my financial career on the same platform. I got hired by a large financial planning company and learned very quickly that when you work for company ABC, you are then pushed to sell product ABC. Basically, I was given 2-3 financial products, taught all the ins and outs of each and how to sell them to people. I was also trained how to “poo-poo” the other large companies 2-3 products that other advisors offered. No matter who I met, they were all getting 1 of the 3 options I had.
There were a multitude of reasons I did not stay in that position, but my biggest takeaway was when I began to realize how often the more experienced advisors’ clients were running out of money in retirement. It was not a one-off situation, but a regular occurrence that has stuck with me for years. In conversations with some of my own clients I was asked, “I’m saving this money now but how do I know how much I can live on in retirement?”. Being repeatedly stumped by such an obvious question made me realize I was not doing any real planning and lead me to where I am now. Passionate on educating responsible adults who love their family how to create lifetime income.
Notice I did not say, how to create the biggest account balance. Believe it or not there is a substantial difference in saving into a retirement account for a big, fat dollar amount and creating a pension-like system for yourself and your family that will generate lifetime income without the fear of running out. How to create the forever income stream is another conversation. First, our society needs to have a mind shift of focusing on cash flow as opposed to accumulating the largest account balance and why that dynamic is so impactful.
The 4% Rule
Let’s start off with the most gut-wrenching piece of information I eventually discovered in my “financial planning” career. In the 1990’s, financial advisor Bill Bengen introduced the “4% rule”. Bengen’s rule was derived from using stock market data from 1926-1976 within a Monte Carlo Simulation to determine 4% was a “safe withdrawal amount” for retirees. His selection was a very interesting time period in that we saw outlandish market and bond performance for almost half that stretch but we’ll ignore that for now. This rule became standard practice for the financial sector in creating retirement income plans for their clients. However, like I mentioned earlier, there is an over whelming number of retirees being forced to alter their lifestyle and running out of money. In May of 2015, Bill is quoted in the New York Times that “[He] always warned people the 4% rule is not a rule of nature” and “It is entirely possible that at some time in the future there could be a worse case”.
So, the same MIT graduate that developed the rule has established its fallacy in income planning. In today’s economic climate, withdrawal rates are being driven lower. Assuming you retire at a reasonable age and have a normal life expectancy (usually about a 30 year time horizon for retirement), you are statistically able to withdraw approximately 3.5% from your retirement account and have a 96% chance of not running out of money. See for yourself by searching “Vanguard Retirement Nest Egg Calculator” online. Those odds are not terrible but let’s look at this situation from another angle. If you accumulate $1 million into your retirement account, you can live on about $35,000 per year (which is before taxes if you’re withdrawing from a traditional pre-tax retirement account).
Can we agree that anyone who has saved $1 million dollars probably makes more than $35,000 a year? It’s an unrealistic idea that causes stress and panic. I clearly remember being taught the options for retirement planning: 1. Save more 2. Work Longer 3. Live on Less. That’s it! More and more accumulation is what I as an “advisor” was taught to implement into people’s lives. All of those options suck which is why nobody sticks to them and here we are in the midst of the retirement crisis. The problem in the financial industry is they’re so focused on working to bring money into their company, they’ve lost sight of making money work for their clients.
Real estate specifically targets cash flow, partnered with forced appreciation which eventually allows you to buy more real estate and gain more cash flow. The cash on cash returns are in direct relation to the asset and underwriting performance and typically outperform the market. There may be a year or two that the market has great returns. And yes, we must acknowledge that real estate is correlated to the economy and that there are circumstances that can impact the amount of cash flow coming through at times.
But how often the market has gone negative compared to the number of times a responsibly underwritten real estate deal has had negative cash flow? I have not done the exact math but it’s fair to say, a lot more often. Building a portfolio of income producing assets is crucial to life, but more specifically retirement planning. You can create your own income utilizing whatever methods you see fit but like I mentioned, the job is usually easier and more efficient when you use the tool designed for that job.
Lifestyle & Life Expectancy
- Northcote Parkinson said, “A luxury, once enjoyed, becomes a necessity”. This is the same man who developed Parkinson’s Law so it is easy to see his unique and insightful perception of the world. My first vehicle was a previously totaled out, F-150 extended cab pickup with no bed liner, cloth seats and stick shift transmission. I loved that truck and have so many fond memories of growing my independence in that driver’s seat. But over the years, my choice of personal transportation has evolved. I do not drive the most expensive vehicle on the road by any means, but I have definitely continued to upgrade periodically. Am I alone in the thought of having to revert back to my teenage years and drive an older model pickup with a sticky 3rdgear making me cringe a little? I doubt it.
There’s a recurring phrase we hear while discussing retirement planning when people realize their 401k isn’t the silver bullet they were told it would be: “Well, I won’t need that much in retirement”. There is some minor truth to that statement in that most people have their home paid off and they aren’t saving into their retirement account anymore, etc. There is another uglier truth that contradicts that statement though. You can never pay off the cost of life so consistent cash flow will always be crucial. Even if the mortgage is paid off, most people’s all-inclusive house payment is 40% or more taxes and insurance. Not to mention utilities, other bills and general living expenses. We attended a mortgage payoff party last year (I didn’t even know that was a thing) and while talking with the host we asked,
“So how does it feel to have your house paid off? Anything special you’re going to do with the extra money?”. His response was very candid. “Honestly, my mortgage payment isn’t very much compared to what my taxes and bills are nowadays.” I’m not saying paying off your house is a bad idea but putting your faith in being able to pay off all of life’s responsibilities so you don’t need an income anymore is fruitless. Also, if quarantine has taught me anything, it is that buying useless items online is way too easy. It’s not the big purchases that get us, it’s the sum of all the little ones along the way.
Even in our normal life setting, do we spend more money during the week or on the weekend? Guess what,……every day is Saturday in retirement. It’s a blessing and a curse. Of course, living below your means and operating on a budget is important but sometimes there are circumstances out of our control. Inflation is a silent killer that works slowly and stealthily. Living for 30 years in retirement is more than feasible and in that time the buying power of our dollars will dissolve. The average income in America 30 years ago is $30,000 in 1989. Now imagine living off that salary in today’s world. It might be doable, but certainly not enjoyable. In 2019 the average income was reported at approximately $58,400. Almost double the average from 1989.
Even of we manage to keep our expenses level (which is highly unlikely considering the exponential increase for medical needs after age 70), general cost of living will always gradually increase. Humans are living longer which is emotionally heartwarming but can cause financial turmoil. Longer lives mean our money must last longer and stretch farther due to inflation. Trying to rely on an accumulation account to perpetually generate a sustainable income may prove unsatisfactory. Utilizing a cash flow asset that increases alongside or in excess of inflation provides a more assured future.
General Wealth & Taxation
I’ve always loved the selling point used by 401k or traditional retirement account representatives of “you’ll make less money in retirement, so you’ll pay less in taxes then to pull the money out”. Now I know we’ve already discussed inflation, but leaving that fact aside, who in the world expects to work another 10+ years and not earn more money? Sure, if you have 1-2 years left to go you may see your income drop slightly but we’ve already discussed that most people expect to maintain their current lifestyle. Even if income levels did stay the same, do we really expect tax brackets to go down? The government has issued over $2.3 trillion dollars in stimulus funds. For those that haven’t put this together yet, the government has no money.
The only way they get more is to increase taxes or print. What is being done in our economy today has to be made up for eventually. There is no such thing as “free”. Below is a chart that outlines the history of tax brackets since the early 1900’s You’ll notice there has always been fluctuations but also understand we are in one of the lowest tax environments for an extended period of time. So no, I do not expect tax rates to go down in the future and I definitely do not anticipate being in a lower tax bracket when I retire in a few decades.
Even if tax rates did stay the same, why kick the can down the road? Here’s another analogy for you: If you were a farmer would you rather pay taxes on your seed, or your harvest? I understand the tax deferral received today (notice I said “deferral” because contributions are not deductions) but what is that benefit costing long term? $10,000 saved today in an effective 20% tax bracket saves you $2,000 in tax liability. Over 20 years, if that $10,000 grows at an average of 5% per year you will have $26,533 on which you’ll pay regular income tax. Assuming tax rates have remained level at an effective 20%, that $26,533 will cost you $5,307 in retirement. That is almost 38% more than the amount you “saved”. Real estate creates true tax benefits that impact tax liabilities today and in the future! Single family investors are able to write off expenses from their properties. Many investors will create an LLC to impose a degree of separation from liability.
These LLC’s are a wise decision for protection, but they also open up the opportunity for more tax savings. The new tax law only allows business owners to itemize expenses for work so having an LLC institutes business ownership and tax deductions. For example, I have an investor who is a high school principal whose children are now out of her home so she’s lost those deductions and her annual tax liability continues to rise due to not being able to write off anything else. She opened an LLC to invest in real estate through single family new developments. Now she can write off all expenses pertaining to her new development investments, including the mileage to drive out to her property for inspections and updates. Depreciation is another incredible tax relief. Many investors in the multi-family space take advantage of accelerated depreciation through cost segregation.
This deprecation can actually offset income received from real estate. So, you can reduce taxes on real estate income through the deprecation of the asset as its received. Tax benefits later on are utilized in a few different ways. When properties are sold, gains are realized. These gains can be “rolled over” into a new property through a 1031 exchange without paying taxes on them. Later on, when properties are sold and gains are realized and not rolled over taxes will then be paid. The benefit to paying taxes later on in this scenario is replacing regular income tax with long term capital gains tax. There are 7 income tax brackets with 37% being the highest rate. Long term capital gains only has 3 brackets with 20% being the highest. The point is long term capital gains tax is typically a lower liability.
The other long-term option is to “die with real estate”. I know that sounds morbid but there is a tax benefit when a real estate owner dies. Heirs of the real estate are given a step up in basis. Generally, you only pay taxes on the amount received over the amount you initially paid (your basis). When heirs receive property, their basis is considered to be the value on the day of the owner’s death. Here’s an example: Suzie is a real estate investor who purchases a rental property for $200,000 and keeps the property until she passes away 25 years later.
At that time the property is valued at $400,000 and Suzie’s daughter Beth inherits the house. Beth is given a step up in basis of $400,000. If she were to sell the house in 20 years for $600,000, she would only pay long term capital gains on $200,000 because that is the amount over her basis. Across the board, real estate creates opportunities for tax savings in the short and long term.
There’s a saying that is very applicable to financial planning: “If you want what everyone else has, do what everyone else is doing”. Our society is in the midst of a retirement crisis and it isn’t being addressed. More people are working longer, coming out of retirement to go back to work, running out of money and continually lowering their lifestyle to nothing.
I do not want to fall into that same situation so I will not do what most people do. Most people go to work, save money into their 401k, and hope for the best. They are never taught how to get their money from their retirement account and make it last forever. There has to be a mindset shift from trying to accumulate the biggest account balance to creating reliable, sustainable, lifetime cash flow. We all want to be able to pay our bills and have money left over to enjoy. Cash flow through real estate investing promotes that financial independence.