By Carrie Coghill, CFP
In the past, the word retirement had the same meaning for most of America. It was a time when you were considered to be “old,” a quiet time to relax and rest from all of the years of hard work you had endured. It was easy to relax because, typically, you were supported by the government (via Social Security), and the corporation that had employed you for 30+ years.
But times have changed. It is now becoming unusual to stay employed with the same company for such a long period of time, thereby eliminating the possibility of Corporate America taking care of your retirement income needs. In addition, as Alan Greenspan pointed out to us recently, Social Security has many problems that need to be addressed. Under its current structure, that source of income may not be available for many Americans. Not only has the financial structure of retirement changed, but the psychological structure has also evolved. Many individuals view retirement as a time to reap the rewards of their hard work. Instead of merely relaxing, the idea of enjoying new hobbies, traveling, and even pursuing other career paths has become popular.
Due to these financial and psychological changes, it is easy to see why retirement planning is essential. Simply stated, retirement has become a phase of life that will require more money than ever before, without the availability of traditional resources. So what does this really mean? It means that every individual is responsible for providing the resources to fund his or her own retirement. If they don’t, they will never be able to retire.
Unfortunately, the wake-up call for Americans hasn’t even begun. Many of today’s retirees have it all. They come from a generation that still has corporate benefits, Social Security benefits, and have been great “savers,” primarily due to memories of the Depression. This is not the case for the next generation of retirees, many of whom are classified as Baby Boomers. Baby Boomers have had it all up to this point. They have been well provided for by their parents. They are a white-collar generation that knows how to make money as well as how to spend it. But, in the future, many of these individuals will not be able to retire because they haven’t considered the consequences of their financial decisions. This will be the real wake-up call for retirement planning.
Retirement planning involves identifying your individual needs and resources. Because the scope of retirement can differ dramatically from person to person, it requires vision about the future. At what age would you like to retire? How do you envision your standard of living? Thinking about your standard of living today and comparing it to retirement will help you put your current spending habits into perspective. Most people want to maintain their standard of living in retirement, not reduce it. The problem is that if you have a high standard of living today that doesn’t incorporate sufficient retirement savings, you may never be able to retire. It is my belief that many individuals are putting themselves into the trap of living a life that will never enable them to enjoy a wonderful retirement.
When it comes to retirement planning, the most important number that needs to be identified is your projected income need at retirement. If you don’t know how much money you will need, then how can you possibly create a successful retirement plan? The easiest way to arrive at this number is to look at your expenses today and identify what changes that will most likely take place during retirement. For example, your transportation costs may go down, but your travel expenses may go up. Be sure to consider your debts. The most successful retirement plans involve eliminating debt before retirement. This includes your mortgage. Having a big mortgage that extends into retirement may prevent you from accumulating a large enough nest egg to support the standard of living that you are accustomed to.
Once you’ve identified what your potential retirement income needs are, in today’s dollars, you must then consider inflation. For example, if you’ve estimated your income need to be $75,000 today, and you have 20 years until retirement, at a three percent inflation rate, your actual retirement income need would be $135,458 during the first year of retirement. A word of caution: anytime you are projecting percentages over long periods of time, the numbers are extremely sensitive. Consider the same example of $75,000, 20 years until retirement, but a five percent inflation rate. This would take your actual retirement income need up to $198,997. That’s 47 percent more than our original calculation. A simple oversight of that nature can destroy a retirement plan. Be careful with your projections.
One more word about inflation: as you consider the impact of inflation while you work towards retirement, you must also continue to factor in inflation during retirement. Therefore, your income need will be increasing throughout retirement. For example, if you project your future retirement income need to be $60,000 during the first year of retirement, an inflation rate of three percent over 20 years would decrease your purchasing power to $33,200 by the 20th year. Not many individuals can take a pay cut of that magnitude. Again, the numbers are very sensitive. If the inflation rate was five percent, your purchasing power would decline to $22,613. Be sure to put yourself into a position that will enable you to increase your retirement income annually in order to maintain your standard of living throughout retirement.
Ultimately, you will need to accumulate a nest egg for retirement from which you will draw income. When making assumptions about investment rates of return, it is also very important to be conservative in your estimates and monitor the returns you have applied to your retirement projections versus the actual earnings you accumulate. For example, if you are saving $1,000/month or $12,000 per year, at a nine percent growth rate, over 20 years, you would accumulate approximately $670,000. However, what if your investment returns only provided an average of 6 percent per year? It doesn’t appear to be that big of a difference; however, when you apply the lower rate of return, you end up with approximately $468,000. That’s 30 percent less! Would you be able to cut your expenses by 30 percent?
Another critical issue to consider when reviewing and planning for investments returns is to be sure to apply “average” returns over reasonable periods. If your investments increase by 20 percent in one year, it would be a huge mistake to assume that your portfolio would sustain that type of performance consistently. On the other hand, if you experience a loss in one year, it is not appropriate to assume that the market will never go back up. Consider the types of investments you own and how they have performed over the long-term. As Jeremy Siegel point out in his book Stocks for the Long Run, stocks have outperformed other investment classes; but, these results provide for a long-term time frame for the investment. This translates into a positive investment discipline. In order to be a successful investor, you must stay invested through market declines and not get overzealous during times of market increases. If you average the good years with the bad years, within an investment sector, you’ll have a much better idea of the potential for that sector.
Finally, you’ll want to consider what will happen to the nest egg you’ve accumulated after retirement. This is important in determining how much you will need to save in order to accumulate your retirement savings. There are two basic options to consider. The first option involves saving enough money so that your retirement savings will generate enough income to meet your expenses throughout retirement. Therefore, at your death, your retirement savings will be available for your heirs. The second option involves living off of your earnings while also slowly depleting the principal throughout your retirement, in order to meet your expenses. For example, if an individual has accumulated a nest egg of $1,000,000, generating six percent, this would provide earning of $60,000. As long as the $60,000 never exceeded you income need, you should be able to maintain a portfolio value of $1,000,000.
However, if we look at the second option, a retiree may decide that leaving a large inheritance isn’t a primary objective. But, obviously, his life expectancy is unknown, and he doesn’t want to fully deplete his portfolio. In this scenario the retiree may plan for a 20 year retirement, with the desire to reduce the portfolio to $200,000. With the same $1,000,000, generating a six percent return, this would provide available income of $87,378. Whereas, if $87,378 was the average desired income, and the individual wanted to live off of the portfolio earnings (as in the first option), he would need to accumulate approximately $1,456,000. Quite honestly, in the future, more and more people will need to deplete the portfolio principal because they have not been able to accumulate enough money to live off of earnings alone.
Remember that retirement planning is a process. It is not a plan that you create and throw into a drawer for to 10 or 15 years. You should revisit it frequently, even annually. By regarding retirement planning as a process rather than a set-in-stone plan, you are more likely to review and monitor the assumptions you’ve made in order to stay current with changing market conditions. Remember, retirement planning is designed to enable you to meet your goals, not to restrict them. Regardless of your age, retirement planning is an essential part of everyone’s financial plan.
Carrie Coghill, CFP, is President of D.B. Root & Company Financial Planning based in Pittsburgh, PA.