I’ve had the great honor and privilege of working with many business owners throughout my career. These are some of the smartest, hardest-working people I’ve ever known. Although they typically have a great head on their shoulders, when it comes to business, many business owners are susceptible to believing myths about their retirement. This could be from hearing the same myths repeated time and again throughout their networks. It could be wishful thinking. Whatever the root of these myths, I want to take some time to sort fiction from fact.
Perhaps the biggest lie business owners believe, is that their business is worth more than it really is. As a business owner, proximity blindness can cripple your ability to leverage your greatest asset for retirement. I encounter business owners who believe their business is worth more than it is almost every day. Typically, this misunderstanding is based on the annual revenues of the business.
Although revenues are a part of the business’s valuation, there are several factors that can cause the value to be more or less than you might anticipate. For example, let’s say you own a business that produces $1MM in annual revenue. However, all of the business processes run directly through you. It doesn’t matter how much money passes through your business each year. If you’re seated firmly at the center of your company, nobody will buy it from you. I see this scenario all the time. Ultimately, your business is worth whatever someone is willing to pay for it. It’s up to you to do the things that will increase the multiplier.
This belief makes the next myth far worse. I regularly see business-owning clients with zero assets outside of their business. Diversity of investments is such a well-known strategy that even people who have never invested in the market have at least heard of it, even if they can’t explain what it means. Yet, rather than diversifying, many business owners believe they can just slap a “For Sale” sign on their door and ride off into the sunset, living on the proceeds from the sale, when they’re ready to retire. Unfortunately, the numbers don’t support that belief. According to the Exit Planning Institute (EPI), only around 20%-30% of businesses are able to be sold. Even fewer do so without concessions by the owner.
One of the biggest problems with believing myths like these, is the level of risk you open yourself up to. If you believe you’re going to just put your business up for sale and someone’s going to immediately walk up and hand you a check for what you believe the business is worth, then your exit plan needs a major overhaul.
Without doing the work today, you will never reach your retirement goals. Think about what you would do if you were suddenly forced to sell your business due to disability or illness? What about market disruption? How does it impact the salable value of your business? These are things that must be considered and built into your exit plan.
Even if you do receive a letter of intent, so much can change between that moment and closing. During the due diligence period, the price, terms, conditions, and ongoing income can all change. Through it all, your accounting team must also work to ensure that you’re paying the taxes you’ll owe from the sale without overpaying. So, when should you begin making preparations for a sale? I believe you should begin at least 12 to 18 months before putting your business on the market. If you’re thinking that sounds like it’s too soon, let me tell you, even that is an aggressive schedule. However, giving your CEPA® team at least that much time will help to mitigate some of the types of retirement risk you could face.
Yet, to combat retirement risk truly, you must diversify beyond your business. You must realize that your business may not sell for what you think it will… Or at all. So, how do you diversify outside of your business while still working to grow its value?
Using the Tax Triangle to Diversify
Although it’s not always possible, we try to double the business-owning client’s net worth every three to five years. The way we do this is by working to increase the intrinsic value of their business. But, when it’s time to retire, you will need to have a more diverse set of assets. You see, when you’ve retired, you will no longer have that business to provide you with income.
Therefore, you must begin spreading some of that wealth to other income-producing assets. This isn’t that simple though. It must be done in a tax-sensitive way because, believe it or not, taxes are a big retirement risk. That’s why I like putting money into long-term investments that make up what I like to call the tax triangle. The tax triangle utilizes tax-deferred (your business, 401Ks, etc.), tax-free (Roth IRAs and other pre-taxed items), and taxable (assets with no tax restrictions) assets to grow wealth. At the same time, it helps to mitigate your present and future tax liabilities.
Using this method can protect your wealth from being completely eaten up by the government. But how does it work? It does this by alleviating some of your present tax burdens through assets that enable you to grow wealth and pay the tax later. Similarly, it uses other assets that allow you to pay the taxes at the current rate so you can grow your money without worrying what the tax rate will be when you’re ready to withdraw. But what if you’re already retired? What can be done to mitigate retirement risks then?
When planning for retirement, it’s true that you must plan for the risks that come with it. But, you must also remember that retirement isn’t a hedge fund. When you retire your liabilities should decrease. This should create some flexibility. When inflation increases, as it currently has, you could invest a small amount to offset the impact it has on your retirement accounts. If the markets take a downturn, you might have to make a small adjustment to your spending habits to weather the storm until the market stabilizes.
It’s normal to have concerns, but the risk in retirement is different than the risk you face while planning for retirement. To illustrate this, let’s look at the five major stock market crashes of 30% or more since 1928. In this chart from ThinkAdvisor, you see what happens to a couple retiring six months before each crash and following the “4% Rule” (the author of the 4% rule has recently updated it to the 4.5% rule to adjust for inflation). The only outcome that hasn’t made its way back above the principle is the COVID Crash. This one is still in recovery.
Similarly, the above chart shows the portfolio (valued at $1MM in today’s dollars), of a couple retiring in 1966. The couple retired just before a prolonged period of high inflation and low real returns. They began earning $45,000 per year in portfolio withdrawals and planned to adjust their withdrawals for inflation over time. With just a single reduction in nominal income (in 1975) and two less-than-full inflation adjustments (in 1980 and 1981), they retained over $800,000 in portfolio balance after 30 years. As you can see, small adjustments like these can make a huge difference when you’re dealing with risk in retirement.
There are some myths that business owners must stop believing. Retirement risk is something that must be planned for. However, the risk in retirement, often, isn’t as great as you may fear it is. No matter where you find yourself on this spectrum, consult with your advisory team. Together, you can begin working through an exit plan, shoring up your retirement plans, or making a few minor adjustments to your investing and spending habits to mitigate the risks you’re facing.