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First Rule of Retirement – Be Comfortable with Uncertainty

Ode to the day that we can all sit back and have a drink in one hand overlooking the ocean on our first day of retirement. Just as we start thinking that we could get comfortable with this lifestyle, we think “what happens if I outlive our retirement money?” Luckily for us, we had the foresight to plan ahead. With all the retirement calculators out there, we think that this is an easy process. But, then a fear embraces us, as we think did we use the right one?

I was going to do an article on the different results that I got from all the retirement calculators and advice out there. However, as I was looking up the results on each site, things got confusing. Each one told me a different amount to save (some answers close to each other and others not). Then Kiplinger just came out with their analysis of 5 different online retirement calculators (it was sitting in my inbox until today). So why beat a dead horse?

Over the years, I have heard a lot of different advice on what to save for retirement that it became confusing even for me (an actuary who deals with retirement plans all the time). We have heard different strategies on how much to save, including:

• The standard answer, save 10% (very popular until about 2-3 years ago)

• The updated answer to the standard 10% advice, per Liz Weston at MSN, the article says if you save starting in your early 30’s, you need 10% for basics, 15% for comfort and 20% for a shot at early retirement

• The pessimistic answer, save as much as you can

• World is going to be over answer, live for today because tomorrow may never come

• More precise actuarial answer, per AON/Georgia State study in 2004, says that if an employee starts saving at age 35, we need to save 6.4% if we are earning $50,000, 9.9% if we earn $90,000 and 11.4% if we earn $90,000 and are female

So why is it that we can not get a clear answer? As the saying goes, there is no certainty in life except death and taxes. With retirement there are many things that are uncertain:

• Retirement age
• Life expectancy
• Social security benefits
• Return on investments
• Inflation (both general and medical inflation)
• Expenses (do we need 70%, 80% or 90% of their pre-retirement income)
• Marital status

With many different factors it is easy to see why everyone wants a standard answer like 10% or 15%.

I never like these simple rule of thumb approaches because it may work in some cases, but not for everyone (actually probably not for many). For example, United State’s Social Security benefits are projected to replace 30% or so of an average retiree’s final salary. However, if a retired couple is married where the one spouse worked and the other did not, the 30% replacement ratio may be close to 45%.

Thus, if someone was targeting to replace 70% of their pre-retirement income, they may need to save 40% if single (or dual wage earner family). Or, if one spouse stayed at home, they may need to save significantly less than the other couple due to only needing to replace 25% of their income (instead of 40%). Now, which scenario is the 10% to 15% of savings based on?

In addition, all rule of thumb examples need to make an assumption on income. A retiree’s income has another significant effect on their Social Security benefit. Someone who is earning a 6 figure income may only see 10% to 20% (or less) of his pre-retirement income replaced by his Social Security benefit. Thus, instead of the retiree’s 401(k) needing to replace 40% or so of his income based on rule of thumb estimate (which assumes a significant Social Security benefit), a higher paid retiree may need to replace 50% to 70% of his income (an additional 10% to 30% of his pre-retirement income).

Then, what if Social Security goes bankrupt? This is enough to make your head spin.

Note, Social Security will not go bankrupt in the sense it will stop paying all benefits. Social Security will still collect FICA taxes to pay most benefits. However, the amount of total benefits paid may only be 75% of what was originally projected to be paid (if nothing is done before then). The question is will some retirees see their benefits drop by more than 25% in order to help those who need Social Security the most (e.g., a poverty or income test).

The key goal for retirement planning is to become comfortable with the uncertainty. The easiest way to do this is a two prong approach:

• Know that you can handle what ever comes your way even if it means working in retirement or delaying retirement, the key is flexibility (such as not locking yourself into too many fixed expenses before retirement)

• Understand what the uncertainty is; in other words, run different calculation using different assumption

The best way to understand the possibilities is to run different assumptions using different online retirement calculators. I suggest using more than one calculator because they will each give you a different answer. Note, even when Kiplinger ran their sample person (a 37 year old) through 5 different calculators, the first year retirement income differed anywhere from receiving $75,000 to $250,000.

You may wonder, why even do retirement planning if there is going to be such a big range of results? Do not fear, the difference is due to all the different assumptions (investment return, inflation, etc.). For someone saving $1,000 a year for 30 years, the difference in the accumulated savings in 30 years is $113,000 at 8% assumption versus 164,000 at 10% assumption (45% increase). As you get closer to retirement, some of the uncertainty becomes more certain, as you have fewer years to project. However, there will always be some level of uncertainty because it is life (unpredictable).

By running some scenarios, you will see a reasonable range to target where you are aware how different things can affect your plans (like investment returns being less than expected). This way you know how your plans need to be adjusted based on how actual events unfold.

I know many would prefer just to be advised to contribute a specific % to their 401(k) and forget about it. However, I believe that simplifying retirement planning by using 10% or 15% is actually making matters worse for us in the long term. Recently, my local newspaper had an article on how debt is currently drowning retirees. It got me to thinking if these retirees are getting into trouble by using a rule of thumb estimates instead of really understanding the risks that they will encounter in retirement.

For example, a 50 year old couple may be able to afford a new home with a 30-year mortgage when they buy the home (and get approved by a bank). Yet, will they be able to afford the payments if they need to cut their expenses by 10% when they retiree because they were forced to retire early? Did they really understand how a small deviation in their plans could result in a significant financial issue?

So there is nothing certain in retirement. Best thing to do is to educate yourself on the risks and be better prepared to handle anything that comes your way. To help with this, I will have a series of articles on how some of these calculators make their estimates and compare the results to other estimates (one of which may be closer to your situation).

P.S. – Here is a quick summary of some of the results I got from internet retirement calculators. For it, I used a 35 year old with no retirement savings who wonders how much he needs to save (note, I do not endorse anyone of these calculators and do not guarantee the results):

Vanguard – 15%

Yahoo – 12.9% (It assumes 8% post-retirement investment return which seems high yet the default assumptions do not reflect any Social Security benefits and assumes the retiree lives 20 years)

CNN Money – if he saves 15%, he has 100% chance of reaching goal (yet the calculator default assumes retiree only lives to 85) if he saves 6%, he has 84% chance of reaching goal

MSN Money – if he saves 10%, money runs out at 102 (if no Social Security, money runs out at 81), if he saves 6%, money runs out at 83

AOL – if he saves 15%, money will run out just before age 87 (assuming their baseline expenses in retirement)

CCH Toolkit— If he saves 15%, money will run out at 88 without Social Security benefits and age 92 if he saves 10% with Social Security benefits (yet calculator estimates a 10% pre-retirement investment return and 8% post-retirement which seems a high yet a 90% pre-retirement income replacement ratio)