Retirement Planning

Good Day,

Ever since I started talking about retirement and the importance it has on one’s life in their golden years, I still get comments from people who clearly don’t see the need of having or planning for their retirement. Sometimes , I agree with their comments, although not entirely. But the bottom line is this, that no matter what sort of excuse you convince yourself that you can do without retirement planning, a time will come when you will not be able to handle all these pressures of life, physically and mentally, and the last thing you want to do is depend on other person to take care of you. So, today I thought that instead of sharing with you one of topical issues that touch on retirement, I’ll share with you an article by Jonas Elmerraji, that basically gives a total picture of what retirement planning is all about. Due to the length of the article, I have divided it into two parts, I’ll share the rest tomorrow.

Retirement is one of the most important life events many of us will ever experience. From both a personal and financial perspective, realizing a comfortable retirement is an incredibly extensive process that takes sensible planning and years of persistence. Even once it is reached, managing your retirement is an ongoing responsibility that carries well into one’s golden years.

While all of us would like to retire comfortably, the complexity and time required in building a successful retirement plan can make the whole process seem nothing short of daunting. However, it can often be done with fewer headaches (and financial pain) than you might think – all it takes is a little homework, an attainable savings and investment plan, and a long-term commitment.

In this tutorial, we’ll break down the process needed to plan, implement, execute and ultimately enjoy a comfortable retirement.

Why Plan For Retirement

Before we begin discussing how to plan a successful retirement, we need to understand why we need to take our retirement into our own hands in the first place. This may seem like a trivial question, but you might be surprised to learn that the key components of retirement planning run contrary to popular belief about the best way to save for the future. Further, proper implementation of those key components is essential in guaranteeing a financially secure retirement. This involves looking at each possible source of retirement income.

Uncertainty of Social Security and Pension Benefits

First off, we need to be up front about the prospects of government-sponsored retirement – they’re not very good. As we all know, the developed world’s populations are continuing to age, with fewer and fewer working-age people remaining to contribute to social security systems.

For instance, consider that according to a 2005 study by Stephen C. Goss, chief actuary of the Social Security Administration, the ratio of covered workers versus the number of beneficiaries under the U.S. Social Security program has been reduced significantly over the years. In 1940, there were 35.3 million workers paying into the system, with only 222,000 beneficiaries – a ratio of 159 to 1. In 2003, the number of workers increased to 154.3 million, with 46.8 million beneficiaries – a ratio of 3.3 to 1.

A similar pattern exists with other pension systems, including those in many European nations. At the same time, greater and greater burdens are being placed on the system, as more and more people retire and, due to advances in health care, are living longer than ever before.

This “double-whammy” effect holds the potential to put significant strains on the system and could leave governments with no other viable option but to reduce social security benefits or suspend them altogether for all but the poorest of the poor.

Private pension plans aren’t immune to shortcomings either. Corporate collapses, such as the high-profile bankruptcy of Enron at the turn of the century, can result in your employer-sponsored stock holdings being wiped out in the blink of an eye.

Defined-benefit pension plans, which are supposed to guarantee participants a specified monthly pension for the duration of their retirement years, actually do fail every now and again, sometimes requiring increased contributions from plan sponsors, benefit reductions, or both, in order to keep operating.

In addition, many employers who used to offer defined-benefit plans are now shifting to defined-contribution plans because of the increased liability and expenses that are associated with defined-benefit plans, thus increasing the uncertainty of a financially secure retirement for many.

These uncertainties have transferred the financing of retirement from employers and the government to individuals, leaving them with no choice but to take their retirement planning into their own hands.

Unforeseen Medical Expenses

While the failure of a social security system may not occur, planning your retirement on funds you don’t control is certainly not the best option. Even with that risk aside, it’s important to realize that social security benefits will never provide you with a financially adequate retirement. By definition, social security programs are intended to provide a basic safety net – a bare minimum standard of living for your old age.

Without your own savings to add to the mix, you’ll find it difficult, if not impossible, to enjoy much beyond the minimum standard of living social security provides. This situation can quickly become alarming if your health takes a turn for the worse.

Old age typically brings medical problems and increased healthcare expenses. Without your own nest egg, living out your golden years in comfort while also covering your medical expenses may turn out to be a burden too large to bear – especially if your health (or that of your loved ones) starts to deteriorate. As such, to prevent any unforeseen illness from wiping out your retirement savings, you may want to consider obtaining insurance, such as medical and long-term care insurance (LTC), to finance any health care needs that may arise.

Estate Planning

Switching to a more positive angle, let’s consider your family and loved ones for a moment. Part of your retirement savings may help contribute to your children or grandchildren’s lives, be it through financing their education, passing on a portion of your nest egg or simply keeping sentimental assets, such as land or real estate, within the family.

Without a well-planned retirement nest egg, you may be forced to liquidate your assets in order to cover your expenses during your retirement years. This could prevent you from leaving a financial legacy for your loved ones, or worse, cause you to become a financial burden on your family in your old age.

The Flexibility to Deal With Changes

As we know, life tends to throw us a curve ball every now and then. Unforeseen illnesses, the financial needs of your dependents and the uncertainty of social security and pension systems are but a few of the factors at play.

Regardless of the challenges faced throughout your life, a secure nest egg will do wonders for helping you cope. Financial hiccups can be smoothed out over the long-term, provided that they don’t derail your financial plan in the short-term, and there is much to be said for the peace of mind that a sizable nest egg can provide.

How Much Will I Need

So now that we’ve been through the important parts of the why, let’s start tackling the how of retirement planning by asking the No.1 retirement question: “How much money do I need to retire?”

The answer to this question contains some good news and some bad news.

First, the bad news: There really is no single number that would guarantee everyone an adequate retirement. It depends on many factors, including your desired standard of living, your expenses (including any medical costs) and your target retirement age.

Now for the good news: It’s entirely possible to determine a reasonable number for your own retirement needs. All it involves is answering a few questions and doing some number crunching. Providing you plan ahead and estimate on the conservative side, it’s entirely possible for you to accumulate a nest egg sufficient to last you through your golden years.

There are several key tasks you need to complete before you can determine what size of nest egg you’ll need in order to fund your retirement. These include the following:

1. Decide the age at which you want to retire.
2. Decide the annual income you’ll need for your retirement years. It may be wise to estimate on the high-end for this number. Generally speaking, it’s reasonable to assume you’ll need about 80% of your current annual salary in order to maintain your standard of living.
3. Add up the current market value of all your savings and investments.
4. Determine a realistic annualized real rate of return (net of inflation) on your investments. Conservatively assume inflation will be 4% annually. A realistic rate of return would be 6-10%. Again, estimate on the low-end to be on the safe side.
5. If you have a company pension plan, obtain an estimate of its value from your plan provider.
6. Estimate the value of your social security benefits. U.S. residents can obtain their estimated benefits at the Social Security Administration (SSA) website.

Keep Inflation in Check

Now, keep in mind all these numbers are expressed in today’s dollars. Since we’re talking about a time period spanning several decades, we’ll need to consider the effects of inflation. In the United States, the federal government has kept inflation within a range of 2-4% for many years, and analysts project that it will remain within that range for a while. Therefore, assuming 4% annual inflation should keep your projections from falling short of your actual financial needs.

The key is that we assume that savings will grow at a real rate of return of 6% annually. The numbers would actually be growing at 10% annually, but inflation would be running at 4%, so the growth in purchasing power would actually be 6% per year.

You don’t need to worry about this too much for your retirement plan, but just keep inflation in mind when you determine how much you want to save for your nest egg every month. A $200 monthly contribution is nothing to sneeze at right now, but after 20 or 30 years, $200 won’t buy you very much. As you continue with your retirement plan year after year, simply check the inflation number each year and revise your contributions accordingly. Provided you do this, you should be able to grow your capital at your estimated real rate of return and reach your target nest egg.

There’s No Magic Number

Of course, there are a lot of changes to these financial estimates that could end up making John’s $500,000 target nest egg too small. Poor return on investments, increased taxes, unexpected medical expenses, or a reduction of social security benefits could occur, resulting in John’s actual nest egg falling short of projections.

Other Factors Come into Play

Even if your financial estimates are not fully realized – for instance, your investments earn lower-than-projected returns, social security benefits don’t come through, tax rates are higher than projected, etc. – there are other factors that can change the retirement picture dramatically.

For example, if you are considering retiring early, you won’t have access to such benefits as social security or pension funds until the specified age (at least, without penalty). Therefore, if you are planning to retire at 55, be sure to determine whether you will have access to the entire balance of your retirement savings at that time.

In our above example, John’s retirement plan included a significant amount of capital to be passed on to his heirs. You may wish to “die broke”, or you may wish to leave a large inheritance for your children. Either way, these decisions can impact your financial plan considerably.

On the flip side, it is becoming increasingly common for retirees to choose to work part-time during their retirement years. Some who choose to work during their retirement do so for personal-fulfillment reasons, others may do it for the extra income it provides.

Whatever the reason, the reality is that a part-time job during your golden years can do wonders for financing your retirement. For instance, if you’ve neglected saving for retirement until late in the game, a part-time job during retirement may be a critical part of your plan. If you decide that you will be working during your retirement, you will likely be working on a part-time basis. Be sure to consider this in your calculations and estimate conservatively, as your salary will likely be reduced from what you were used to earning before your retirement years.

If you have any substantial retirement plans such as buying a summer home or traveling frequently, be sure to include these numbers in your financial projections, as it is likely that you are not incurring costs such as these during your pre-retirement years.

Also, consider your time span until retirement. If you are drawing up your financial plan only a few years before you intend to stop working, you will not be able to risk very much of your investment capital, and consequently your return estimates should be on the low side. Conversely, if you have 30 or 40 years to go until your desired retirement date, you can realistically aim for 10% or more in annualized returns.

Finally, while the idea may seem a bit grim, honestly consider your expected life span and make sure your financial plan can sustain your retirement if you live well into your golden years. Remember that along with advances in health care, average life spans are increasing. According to the National Center for Health Statistics, the average lifespan in the U.S. in 2004 (the most recent year for which data is available) is 77.9 years, so don’t sell yourself short!

Where Will My Money Come From

Now that we’ve outlined how to calculate the money you’ll need for retirement, we need to figure our where that money will come from.

While employment income seems like the obvious answer, there are actually many sources of funds you can potentially access to build your retirement nest egg. Once you lay them all out clearly, you can then determine how much money you’ll need to save every month in order to reach your retirement goals.

There are typically several sources of retirement savings for the average individual. These include the following:

1. Employment Income

As you progress through your working life, your annual employment income will probably be the largest source of incoming funds you receive – and the largest component of your contributions to your retirement fund.

For your retirement plan, simply write down what your after-tax annual income is. Then subtract your annual living expenses. The amount left over represents the discretionary savings you have at your disposal. Depending upon how the numbers work out, you may be able to save a large portion of your employment income toward your retirement, or you may only be able to save a little. Be sure to use a budget and include all your recurring expenses. One way to ensure you save the projected amount for retirement is to treat the amount you plan to save as a recurring expense.

Regardless, figure out the maximum amount of your employment income you can contribute to your retirement fund each year. Also, if you are able to work part-time during your retirement years, include this information in your retirement income calculations. For example, let’s assume that Alison’s after-tax earnings are $34,000, and her living expenses are $2,000 per month, or $24,000 per year, and that she will not be working during her retirement.

Thus, Alison has $10,000 per year of discretionary savings. She can choose to contribute all of this money to her retirement plan, or she can contribute a portion of it to her retirement fund and spend the rest on a vacation or something else she desires, but we know that her available retirement funds from her employment income add up to $10,000.

For U.S. residents, disposable income that is earmarked for retirement savings can be deposited to an after-tax account, where earnings are added to your income and taxed each year; or to a retirement account, such as a Traditional IRA, where earnings are tax-deferred, or a Roth IRA, where earnings could be tax-free. The amount in an after-tax account will not be taxed again during retirement. The amount in a Traditional IRA may be taxed at your ordinary income tax rate for the year you withdraw the amount.

2. Social Security

As we mentioned earlier, social security benefits can provide a small portion of your retirement income. By visiting the SSA website, you can estimate your retirement benefits (in today’s dollars) by using the site’s online calculator.

You may not want to include social security benefits in your retirement calculations because, as we already mentioned, the entire projected amount may not be available at retirement time. Alternatively, you may wish to include them at a portion of their value, say 50%, to be on the conservative side.

Either way, figure out what your estimated social security benefits are expected to be in today’s dollars and add them to your list of retirement income sources. You won’t be able to use this money to build your nest egg, but it will help to fund your living expenses when you’re retired and reduce the size of nest egg you will need.

In John’s example, his social security benefits were estimated to be about $1,300 per month, in today’s dollars.

3. Employer-Sponsored Retirement Plan

You may or may not participate in a retirement plan through your employer. If you don’t, you will need to focus on your other income sources to fund your retirement. If you do participate in an employer plan, contact your plan provider and obtain an estimate of the fund’s value upon your retirement.

Your plan provider should be able to give you an estimated value (in today’s dollars) of your retirement funds in terms of a monthly allowance. Obtain this number and add it to your list of retirement income sources.

Similar to your social security benefits, the funds from your employer plan can help cover your living expenses during your retirement. However, most employer plans have rules regarding the age at which you can start receiving payments. Even if you quit working for your company at age 50, for example, your employer plan may not allow you to begin receiving payments until age 65. Or they may allow you to begin receiving payments early, but with a penalty that reduces the monthly payment you receive. Talk to your plan provider to determine what rules apply to your employer plan and consider them when you are making your retirement plan.

4. Current Savings and Investments

Also consider what current savings and investments you have. If you already have a sizable investment portfolio, it may be sufficient to cover your retirement needs all by itself. If you have yet to begin saving for your retirement or are coming into the retirement planning game late, you will need to compensate for your lack of current savings with greater ongoing contributions.

For example, with John’s retirement plan he already had a $100,000 retirement fund at age 40. Reasonably assuming this fund grows at a real rate of return of 6% per year until he is 65, John will have about $429,200 in today’s dollars by the time he is 65. Depending on other sources of income he may have, this could be enough to fund his retirement so that John does not have to contribute large amounts of his ongoing employment income.

If you do have current savings and investments, be sure to include only the portion you expect to have left over by the time you have reached retirement. Don’t include any portions you’re planning to leave for your children or spend on other assets, such as a summer home, which will make the funds unavailable for covering your living expenses.

5. Other Sources of Funds

You may have other sources that will be available to fund your retirement needs. Perhaps you will receive an inheritance from your parents before you reach retirement age or have assets, such as real estate, that you plan to sell before retiring.

Whatever additional sources of funds you do happen to have, be sure to include them in your retirement projections only if they are certain to occur. You may be expecting to realize a large inheritance from your parents, but they may have other plans for their surplus savings, such as donating them to charity.

Other unexpected cash inflows may also come along as you build toward your retirement, such as lottery winnings, gifts, raises or bonuses, etc. When you do happen to receive these additional cash inflows, consider adding them to your retirement fund. It’s also fine to include the planned sale of real estate to when you estimate your retirement funds (at a conservative price).

Adding Up Your Income Sources

After you have clearly defined all the available income sources with which to fund your retirement, make a list and add them up.

The key is to remain conservative in your financial estimates (i.e., don’t assume 20% annual investment returns or large inheritances from your parents) and settle on a plan that is feasible and sufficient for your needs.