Sunday, October 16

Week 15 - Retirement on a Shoestring: The Rainy Day Fund

Situation: A middle-income worker reaches age 50 without a pension, 401(k), or 403(b) plan. She’ll need to put aside the maximum amount allowed ($6,000/yr) into a Roth IRA. In addition, it would be smart to start a “Rainy Day Fund” (~$1,200/yr) to protect the Roth IRA from being depleted in the event of illness or unemployment. 

Goal: Determine how much money would be in the proposed Roth IRA and Rainy Day Funds (started at age 50) upon approaching a retirement age of 65, using the lowest expenses and least risky investments. 

Everyone needs to have a Rainy Day Fund as the first line of defense for economic well being. It needs to be readily available without paying significant penalty fees for early withdrawal (aside from taxes due). Such a fund should contain enough to pay 6 months of basic expenses. Most people use a savings account but here at ITR we advocate for something a little more remunerative. Consider a fund that balances stocks and bonds 50:50.

On the bond side, the Inflation-protected Savings Bond (ISB) is hard to beat. It is the benchmark for “net net net investing” (i.e., total return after expenses, inflation, and taxes). An ISB has no up-front expenses (and you know from our prior blogs that is a big point). To purchase yours, go to Treasurydirect and set up electronic withdrawals from your bank account. ISBs pay a fixed rate of interest but also add principal in direct proportion to inflation. There are no taxes on an ISB until you cash it in, typically at a time of minimal tax liability, ideally, after retirement. Invest at least $50/mo until you have enough ISBs to cover 3 months of living expenses. A small fee is assessed if you withdrawal your money prior to 5 years after purchase (you pay 3 months worth of interest income).

To cover the remaining 3 months of expenses, invest at least $50/mo in a Lifeboat Stock with a low beta and high dividend. Abbott Laboratories (ABT) meets those requirements and setting up your DRIP using Computershare is user-friendly. There are no fees for an automatic investment plan of as little as $10/mo. [There is one significant inconvenience: the initial shares need to be purchased through a stock broker and transferred electronically to Abbott Laboratories for registration in your name.] Other DRIPs to consider include Johnson & Johnson (JNJ), Procter & Gamble (PG), and Wal*Mart (WMT). Most of those DRIPs charge ~$1/mo but do not require you to register shares through a stock broker.

Once you have your Rainy Day Fund and Roth IRA (review Week 14) on autopilot, you will breathe a little easier. Now you can take an active interest in the rest of your retirement preparations, namely, paying off your obligations which for most people is a mortgage. This will leave you well positioned for starting a reverse mortgage at age 65. We also recommend taking an active approach to keeping your job skills tuned up by taking one evening class per semester at a local community college. This allows the maximum level of flexibility for remaining competitive in your current job, or finding a new job if that (unhappy) situation should arise.

We have attached a Spreadsheet summarizing the investment options mentioned for establishing a Roth IRA (Week 14) and a Rainy Day Fund. ISBs did not become available until 1999, so the history of transactions is shorter than what we’ve used in other examples. But if the total return for that shortened period (3.33%/yr) were to be applied for the same 14.7 yr period as our other examples, the total amount invested would be $8,850 (same as for ABT) and the ending value would be $11,587 instead of the $9,241 listed in the spreadsheet. That would bring the total ending value for the Rainy Day Fund to $24,966 after 14.7 yrs (total return = 4.16%/yr). Since the ending value for the proposed Roth IRA is $155,955, the total savings for retirement equals $180,921. That money could be used, for example, to purchase a fixed annuity paying over $1,000/mo beginning at age 65 in today’s dollars. Alternatively, you could just cease paying the $7,200/yr and draw the annual dividend and interest income from that $180,921 (i.e., $6,107/yr, or $509/mo). That payout would continue to grow ~4%/yr faster than inflation while leaving the principal untouched. Taxes would only be due on expenditures from the Rainy Day Fund. Social Security would likely add >$2,000/mo to your retirement income, which amount is partly taxable but also keeps up with inflation. 

Let’s face it, $2,600+ a month doesn’t go very far even if it is protected from inflation and taxes. This is why setting up a reverse mortgage and continuing to work will become important options to have available for fine-tuning your retirement income.

Bottom Line: Retirement is perilous. Plan ahead. It’s later than you think.

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