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Lesson 4d: Retirement Planning (continued)

Objective: Create a retirement plan and understand risks involved.

To calculate the amount that you will need in retirement, there are many different retirement calculators on the internet and financial advisors who can help you.  However, each website and financial advisor will probably give you a different answer.   The differences are due to using different assumptions in creating your retirement plans.   These different assumptions are a part of the financial risks you will experience in retirement.

The more significant risk factors that will affect how much you need to save for retirement are:

  • Expected return on assets

    The actual asset return that you receive over the years will depend on which assets you invest in and how well your assets do.  Even a small difference in the return can have a large difference in actual results after many years.  For example, the difference in a portfolio that returns 8% versus one that returns 10% is approximately 20% after 10 years and 40% after 20 years.

    Some financial planners are using a 10% to 12% return on investments because historically the stock market has returned 11%.  However, if you factor in investment fees and the fact that most portfolios are not invested 100% in stock, especially as you get closer to retirement, your actual return will be lower. Thus, a lower interest rate (e.g., 8% return) may be more appropriate to use.  For more information, see Myth - 12% Return in Stock Market.

  • Life expectancy

    Many of the websites will initially expect someone to live to age 85 when planning for retirement.  However, if you estimate living to 95, the retirement savings needed at age 65 will be approximately 33% higher than if you estimated living to age 85.  So, you may want to assume that you will live to age 95 or 100 to be conservative, to lower the risk of running out of money if you do live longer than age 85.

    Age 85 is typically used because it is the current average life expectancy for a 65 year old:

    Person currently age 65
    Male
    Female
    Life expectancy
    18 years (age 83)
    20 years (age 85)
    with 10% chance living
    28 years (age 93)
    31 years (age 96)

    So, yes, age 85 is a reasonable estimate for the life expectancy of a 65 year old.  Yet, there is still a significant probability of living to age 95 (approximately 10% chance) and even to age 100 (approximately 5% chance currently - and expected to rise in the future).  For a married couple who are both age 65, there is a 18% change that one of them will live 30 years (to age 95).  So, do you want to be caught short because you planned to live 20 years in retirement, but lived for 30+ years?  For more information see,  life expectancy.

  • Retirement income needed

Most financial advisors will tell you that you will need approximately 70% to 80% of pre-retirement income during retirement.  This estimate can be tied to a Georgia State and Aon study. The study is based on the average expenditure while in retirement based on US census data of what retirees actually spend.  This is a reasonable estimate to start from when you are less than age 50 and doing a quick estimate.  For those over age 50, I would suggest budgeting a more exact calculation of your estimated expenses which can be drastically different depending on if your mortgage is paid off or not and depending on your vacation plans.  For more information see, retirement income replacement ratios.

  • Inflation

    Will your income sources (e.g., pension benefits) increase with inflation, or are they a fixed amount that will lose value over time?   Did you know that most retirement plans (with few exceptions) are a fixed amount that are not adjusted for inflation.  Thus, if you are targeting to live on 80% of your pre-tax income as mentioned above and a large part of your retirement income is from a company pension plan which is not indexed for inflation, you will want to target 90-100% instead of the 80%.  This is because over time your fixed pension benefit will lose value.  Thus, to keep your buying power at 80% of your pre-retirement income, you will need to target 90%-100% and save the excess portion over 80%.   Thus, later in life as your pension loses its buying power and falls below 80%, the earlier savings can be used to cover the extra expenses caused by inflation.

  • Retirement age
  • The age at which you retire will have a large impact on the amount needed to be saved for retirement.  Plans to retire at a particular age are subject to several factors, such as company downsizing, your health later in life, and your desire to continue working.  Based on a survey from Employee Benefit Research Institute, 48% of the current workforce intends to work past age 65.  However, history tells us, only 28% of current retirees have worked past age 65, and 40% of retirees said that they left earlier than expected.  So, you may want to budget to retire a little earlier than your actual plan in case you can not work as long as you plan to (e.g., assume 65 even if your Social Security retirement age is 67). 

  • Social Security
  • Will Social Security be around by the time younger workers retire?  It will probably still be around, but there may be a higher retirement age and/or lower benefit amounts.   

So what do you do when there are so many risk factors? 

"Only 1/3 of workers feel very confident that they will have enough for their basic expenses in retirement."
- Retirement Confidence Survey

If you are a gambler, you may plan to have an average retirement (for example, retire at 65, earn 10% return and live to 85) and may lose if you live longer than expected or earn less on your retirement savings than you expected.  If you are less of a gambler, you may want to assume more conservative estimates to make certain you have enough money in retirement (e.g., 8% asset return versus 10%, and/or plan to live to age 95 or 100 instead of age 85).   

This may all sound confusing and you may be wondering how you can afford retirement based on living to 100 when even under the average scenario (living to 85) you may not have enough to retire on.  However, the larger savings needed to account for these risks should not stop you from saving for retirement.  Every bit of savings will help.  So do not give up even if it looks like you can not reach your goal of a secure retirement.  Because even if it does not look like you will have enough for retirement, there are three mechanisms that will work together to help balance your savings (what you can save) with your expenses:

  • If you plan and monitor your plan in retirement, you will tend to live within your means - you may plan 3 to 5 vacations a year in retirement but if you find that the markets did not perform up to your expectations, you will find a way to cut back to what you can afford (e.g., 1 vacation a year).
  • Those who are healthy and have a longer retirement will be able to work part-time to supplement retirement income- The retirement age of 65 was created when life expectancy was a lot shorter.  Setting the retirement age at age 65 was never intended to have people live 30 years in retirement.  Healthier retirees who tend to have a longer retirement (e.g., 30 years) will be able to work part-time in retirement for additional income if their savings are not adequate.  Being active and able to help others (e.g., through work) will also increase longevity in retirement.  Those who are not active and unable to work for health reasons, tend to have shorter retirement/life expectancy and thus will need less savings due to a shorter retirement.
  • There are programs to help seniors stay out of poverty in retirement - As a country we take more care of our elderly living in poverty than we do children living in poverty.  Drug companies and Medicare provide assistance to purchase prescription drugs for elderly with limited income.  Medicaid also provides long-term care to elderly with limited assets.  Similarly, Social Security was created to help boost seniors out of poverty. 

So even if you do not save enough for retirement, there are alternative ways to live on what you have.  And, by planning your retirement early and saving for retirement, the less likely you will be in need of additional help.

Should I use generic advice that says I need to save $1 million, save 12 to 16 times my final pay or 10% of my pay annually for retirement?

No!  I do not know how financial advice is ever given without knowing anything about the person.  The amount someone needs for retirement is based on numerous factors including:

  • Age at retirement
  • Income before retirement
  • Company pension plan benefits
  • Social security benefits
  • If they have a spouse (e.g., due to extra social security benefits)

You should do a specific calculation based on your specific situation.   When I hear these quick estimates, I wonder how they were calculated.   For example, is the $1 million estimate calculated for a 60-year-old retiring in 5 years or for a 30-year-old retiring in 35 years because each situation is different.  If the amount is for the 60-year-old, then the 30-year-old would need $2 million at retirement to account for inflation.  If the amount is for the 30-year-old, the 60-year-old would need only $500,000. 

Where can I go to calculate what I need for a retirement?

Below are some websites that will provide you a free analysis.  For a more detailed analysis, you may want to see a financial advisor that specializes in retirement planning.  Beware of advisors whose fees are based on commissions from mutual funds or retirement annuities because their advice may be biased towards these products.

Website Calculator
Pros
Cons
American Savings Education Counsel

Quick estimate

Printable Worksheet

Worksheet is not a precise calculation (uses 5 year age bands)
CCH Retirement Planner

Easy calculator to use

 

Uses high estimates for pre- and post-retirement investment rates (10% and 8% respectively) - I have used 8% and 6% personally to be more conservative

Does not factor in a company pension plan

MSN Money Central Another easy to use calculator Factors can be changed easily and you can see the instantaneous impact (e.g., retirement age, rate of return, etc.)
CNN/Money Retirement Planner

Splits pre-tax and post-tax assets (takes into account some tax consequence)

Shows likelihood of meeting goals based on various market conditions (stochastic forecast)

Does not factor in a change in asset allocation as one gets closer to retirement (e.g., to be more conservative by investing more in cash and bonds)

Starts with age 85 life expectancy (should be higher to be conservative)

Starts retirement income at 70% of pre-retirement income (should be increased to 80% or more based on recent studies)

Financial Engines

Sophisticated forecasting for various asset classes

 

Membership fee applies (some companies may offer it for free to their 401(k) participants)

Assumes participants buy a single life annuity at retirement (does not factor in spouse life expectancy if married)

In addition, many financial institutions (like Fidelity and Vanguard) will also provide free online advice to its clients.

Exercise:

  • Do a quick calculation on how much you need to save to meet your retirement goals.
  • Run different scenarios of your retirement plan to understand the financial risks in your retirement. For example, if your actual investment return is lower than expected (8% instead of 10%), or if you live longer than expected (to age 95 or 100 instead of age 85).
  • If you are older than age 50, learn more about the psychological effect of retirement (e.g., how will my spouse react to me being around the house more, how will I replace the lost social contacts of my co-workers, etc.). 
  • If you are younger than age 55, understand the effect if Social Security benefits are cut by 25%, 50%, or entirely eliminated (especially if you have a higher than average income and are younger).

 

Financial Topic : Planning - College
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