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Seeking Financial Security When Life Changes Strike

As seen on Forbes.com

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When a major life change occurs, we often find ourselves more responsible for our own financial future. Sometimes we have planned and saved for it, as for retirement. Other times it may be thrust upon us, as with the death of a spouse or a divorce. Most people do not have the background or inclination to manage their own investments, but knowing some of the basics can help make you a more intelligent consumer.

Man and woman sitting on the couch working on financial papers

Playing It Safe Does Not Usually Work

We would all love to meet our needs by investing in assets that have no risk of losses. Thus, many investors want to rely exclusively on income their investments generate - until they find out how much that provides. The 10-year Treasury is considered one of the safest investments available, but it currently pays only 2.25% on the amount invested. To generate the average household income of $56,500 with those bonds, you would need to have $2.26 million invested.

Inflation pushes the amount required even higher. With 2% inflation, a $56,500 income would rise to $82,310 by year 20 and to $100,335 by year 30. Assuming the same 2.25% Treasury yield, you would need to have $3.2 million invested in year 20 and $4 million in year 30 to provide that level of income solely from Treasury interest.

Consequently, most people meet their spending needs by consuming some of their invested capital as well as the income their investments generate, which makes it particularly critical to plan carefully. To avoid running out of money, you need a reasonably good projection of present and future spending needs while also allowing for a margin of error.

Assume again that you want to generate $56,500 for 30 years from funds earning the Treasury's 2.25%. If you do not increase that amount as inflation erodes the purchasing value, you will need to invest roughly $1.2 million instead of the estimated $2.26 million needed using only income from the bonds.

As expected, allowing for inflation raises that amount significantly. Assuming a modest 2% inflation rate, you would need a total investment of $1.9 million to cover the 30-year horizon - less than what you would need consuming only the interest income, but still a challenging amount to accumulate.

Be a Risk-Taker

Fortunately, you can significantly reduce the required amount if you take more risk. Equities, or common stock, offer the potential for much higher returns than bonds. Equity prices decline severely at times and are therefore riskier than bonds. At the same time, they should provide more to fund your future spending needs than "safer" assets will.

How much more can you get from equities? Remember that 10-year Treasuries recently yielded about 2.25%. Theoretically, equities should provide a total return (capital gains plus dividend income) of something more like 5% to 6%. We saw that it would take $1.9 million of Treasury bonds to provide $56,500 of inflation-adjusted returns for 30 years. Assuming your invested assets provide a return of 5.5% over 30 years, you would need to invest just over $1 million to generate $56,500. Moreover, equities tend to offset inflation over the long term, so equities can also help protect you from the effect of rising living costs.

Invest Differently for the Long and Short Term

While equities provide more upside potential, you typically should not invest all your money in them. They can lose 30% to more than 50% of their value over a very short time - you do not want to be forced to sell them after their price has plunged. Bonds and some other asset prices remain more stable, so they can help sustain your spending needs until equity prices recover. For that reason, bonds are often a strong part of the investment strategy for money needed over the next few years.

The risk of major equity declines, however, is all but eliminated over long periods of time (see: When Investment Diversification Fails). Money that will not be needed for 20 years or longer can be devoted to equities with comparatively little risk. Bottom line: the investment horizon of your spending needs plays a critical role in determining where your assets can be safely invested.

Allow for Taxes

Bear in mind, too, that federal, state and sometimes local governments require you to "share" what you earn. You currently pay a lower tax rate on the appreciation of assets you sell than on dividends or the interest from taxable bonds. Yet with even a minimal tax of 15%, the assumed $56,500 would net only $48,025 after taxes, and tax rates often run much higher than 15%. Be sure to allow for government "sharing" as you plan for your financial needs.

Passing the Test

Major life events can leave us extremely anxious about our financial future. By understanding the realities of financial planning and investment, however, you can at least understand more about your circumstances and make intelligent choices. Particularly when you have long periods of time to prepare, you have options that can ease the burden of providing the money you will need for future living costs. Most of us need to take more risk than we would like, but financial professionals can help you use investment risk in ways that can help secure your financial future.

About Bruce McCain

Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor's Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com. Bruce joined a predecessor of Key in 1987, after spending six years on the business faculty of the University of Iowa's Henry B. Tippie College of Business. Bruce earned a PhD in Business Administration from the University of California at Berkeley, and undergraduate degrees in Psychology and Accounting from Boise State University.

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