Building a strong portfolio and tracking your rate of return is a great way to measure investment success, but is a quarterly percentage the best measure of how you’re tracking towards your long-term goals? While that rate of return is an important barometer; there are other facets that can impact how you access your overall wealth picture.
“We deal with it every day as we work with our clients, whether they're very high net worth or more modest – the mass affluent level – they all have pretty much the same concern,” says J. Barry Zischang, vice president and wealth strategist at RBC Wealth Management in Stamford, Connecticut. “They want to sustain their lifestyle in retirement and they don’t want to run out of money.”
“Having enough” means keeping tabs on more than just that rate of return because the road to retirement is a long one that’s paved with taxes, inflation and volatility in the market. Here’s how to check the pulse of your retirement goals, ensure you get the returns you need and are prepared for whatever the financial tides may bring.
When three is better than four
One key concept, says Zischang is figuring out your “real” rate of return. In other words, how much do you actually keep after taxes?
“Let’s say, for example, you could buy a taxable corporate bond from a, major U.S. company that’s paying four percent or you could get a similar maturity, municipal bond paying three percent – which is better four or three?” he asks. “It really depends on your tax bracket.”
If you pay higher than 25 percent on the four percent bond then your after-tax return on the three percent is actually better, explains Zischang.
“It’s a very simple concept where sometimes three is better than four – it depends on what you’re going to keep after tax,” he says.
While tax-aware investing is an important part of any investor’s portfolio strategy, it has become increasingly critical for high net worth individuals in recent years. The American Taxpayer Relief Act of 2012 (ATRA) raised the top tax rate on dividends and long-term capital gains from 15 percent to 20 percent and the ceiling on ordinary income and short-term capital gains from 35 percent to 39.6 percent.
In addition, many high-income tax payers will owe an additional 3.8 percent net investment income tax, which is earmarked to help pay for the Affordable Care Act, also known as “Obama Care”. That brings the top rate for dividends and long term capital gains to 23.8 percent and the top rate on short term capital gains and ordinary income to 43.4 percent. Many states also impose an income tax, bringing the top rates near 50 percent in some cases.
Knowing how those tax rates will affect your rate of return is just as important as keeping tabs on how your investments are performing.
Inflation: The third dimension
Inflation is another aspect that’s often under appreciated when it comes to tracking long-term goals. While investors expect inflation to remain below three percent for the next five years, according to a study by the Financial Planning Association, investors more than five years off from retirement should be weary of the erosive effects inflation can have on their wealth.
“Let’s say we took a hypothetical client who had 50 percent in stocks as represented by the S&P 500 Index and 50 percent in bonds based on the Barclays Aggregate Bond Index – that generic portfolio for the year 2010 provided a combined pre-tax return of 10.8 percent,” says Zischang.
In 1979, according to historical data, the same portfolio would have returned a comparable 10.3 percent.
“But the difference was the inflation rate in 2010 was 1.4 percent so you had a very substantial return, even after tax,” he says. “On the other hand, that similar 10.3 percentreturn in 1979 came in a year when the inflation rate was 13.3 percent –so you actually fell behind in your goal of having a long, sustainable and comfortable retirement.”
He calls the inflation rate a “third dimension” which should be top-of-mind for any investment management plan.
“Over the last decade or so we've had very low inflation, so it has not been a problem,” he says. “Going forward we can’t always assume that’s going to be the case.”
The drama of volatility
Markets are volatile and so are people; both can impact your financial goals.
In the past year alone, the S&P 500 has ping-ponged from being down 10.5 per cent to up 1.1 percent. The Nasdaq is down 2.3 percent on the year and the Dow Jones Industrial Average is up 1.8 percent for the year.
In the longer term, suppose your wealth management plan is predicated on you earning an average rate of return of around five percent. Yet, your portfolio’s rate of return has shown volatility over the past few years, dipping below five percent some years and others up to 10 percent.
“And let’s say your plan calls for you spending roughly four percent of your portfolio each year in your retirement,” says Zischang.
In a year when that portfolio is down by 10 percent, including the four percent you spend, that portfolio will finish down 14 percent from where you were at the beginning.
“Which means the portfolio has to earn back over 20 percent the next year to bring you back [to breaking] even plus what you have to spend for the following year,” says Zischang. “So volatility in the portfolio is one of the key things that has to be measured [to] make sure you’re still on track to meet your goals.”
And it isn’t just market volatility that will impact your portfolio.
“Clients are volatile too … maybe they’re spending more than they told us they would – they underestimated what their lifestyle would cost or what obligations there would be to help others, or they’ve incurred a health change. All of these are things that go into the dialogue surrounding the planning process.”
Healthcare and long term care costs can be a substantial drain on any nest egg. According to HealthView Services, the average lifetime retirement health-care premium costs for a couple living into their late-80s is $266,589. A private room in an assisted living facility can cost upwards of $43,200 per year, according to Genworth, while the cost of a nursing home can run from $80,000 to more than $90,000 per year depending on a semi-private or private room placement.
An unexpected change in marital status can also derail your wealth planning. Divorce settlements can be very costly for high net worth individuals. Invenergy CEO Michael Polsky’s 2003 divorce from his wife cost $184 million and BET founder Robert Johnson handed over $400 million in his divorce settlement from his wife Sheila in 2000.
When Zischang sits down to set up a financial roadmap, he likens the process to setting sail in a lake versus planning a transatlantic voyage. With a short lake crossing, he says, pointing yourself at your destination a degree of course and failing to adjust your bearings along the way will likely result in a minor inconvenience when you get to the other side.
“But if you’re a degree off course in the ocean, by the time you get to the other side you could be in Africa instead of London,” he says. “The longer the journey – and for most of our clients retirement is a long journey as people are living longer than ever – the more important it is to make for good course corrections based on changes in the financial currents.”
Tracking your investment returns is only one part of managing your overall wealth management picture, which can also include estate planning considerations, philanthropic desires and managing life-altering events.
“It’s very necessary that a plan be reviewed and updated on a periodic basis and adjustments are made where necessary,” says Zischang. “If there is a major event – be it a market event or major event in your life – as those (events) occur and dramatically change the assumptions we've been using, we must sit down as soon as possible and reevaluate everything to ensure you’re going to remain on track for your goals.”