Lesson
4d: Retirement Planning (continued)
Objective: Create
a retirement plan and understand risks involved.
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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).
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