Retirement Planning

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.

Here we 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. (For related reading, see Introduction to Social Security and The Generation Gap.)

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 now and again, sometimes requiring increased contributions from plan sponsors, benefit reductions, or both, 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 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 retirement fund, 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 retirement fund or simply keeping sentimental assets, such as land or real estate, within the family.

Without a well-planned retirement fund, you may be forced to liquidate your assets 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 curveball 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 retirement fund 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 retirement fund can provide.

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 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 and estimate on the conservative side, it’s entirely possible for you to accumulate a retirement fund sufficient to last you through your golden years.

There are several key tasks you need to complete before you can determine what size of retirement fund you’ll need 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 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.

Estimate the value of your social security benefits. U.S. residents can obtain their estimated benefits at the Social Security Administration (SSA) website.

A Sample Calculation

Before we begin with our sample calculation, a word on inflation. When drawing up your retirement plan, it’s simplest to express all your numbers in today’s dollars. Then, after you’ve determined your retirement needs (in today’s dollars), you can worry about converting the numbers into “tomorrow’s dollars,” i.e. factoring in inflation.

Compute all of your numbers in today’s dollars. When you are finished, you can apply an inflation assumption to get a realistic estimate of the dollar amounts you will be dealing with as you make your contributions over the decades.

Now on to the sample calculation. Consider the hypothetical case of your 40-year-old currently earning $45,000 after taxes. Let’s go through the key factors for you:

1. You want to retire at age 65.

2. You will need $40,000 of annual retirement income – in today’s dollars (i.e., not adjusted for inflation).

3. You currently have $100,000 in savings and investments.

4. Over 25 years of investment (age 40 to 65), you should realistically earn a 6% annualized real rate of return on his investments, net of inflation.

5. You do not have a company pension plan.

6. Visiting the SSA website, we can quickly calculate your estimated social security benefits in today’s dollars. Assuming you are born on today’s date 40 years ago and will retire 25 years from now, we can retrieve your estimated social security benefits in today’s dollars. The SSA website gives us a value of around $1,300 per month.

Now, we have already determined you will need $40,000 (in today’s dollars) annually to live during your retirement years. To the nearest $100, this works out to about $3,300 per month. Assuming your social security funds come through as estimated, we can subtract your estimated monthly benefits from your required monthly income amount.

This leaves you with $2,000 per month that you must fund on his own ($3,300 – $1,300 = $2,000), or $24,000 per year or $600,000 over 25 years.

Keep Inflation in Check

Now, keep in mind all these numbers are expressed in today’s dollars. Since we’re talking about a 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.

In your case, you needed a $600,000 (in today’s dollars) 25 years from now. To express this in dollars of 25 years from now, we simply multiply $500,000 by 1.04, 25 times.

This is equal to 1.04 to the twenty-fifth multiplied by $500,000. So, we have power:

  • - Retirement Fund = $600,000 x 1.0425

  • - Retirement Fund = $600,000 x 2.67

  • - Retirement Fund = $1,602,000

As you can see, the $1.6 million retirement fund is a much larger number than the $600,000. This is because of the effects of inflation, which causes purchasing power to erode over time and wage rates to increase each year. Twenty-five years from now, you won’t be spending $40,000 per year – you’ll be spending $106,600 ($40,000 x 2.67).

Either way, for our retirement calculation, the inflation assumption doesn’t really matter. A $600,000 retirement fund and a $40,000 budget expressed in today’s dollars is the same thing as a $1.6 million retirement fund and a $106,600 budget 25 years from now, assuming inflation has run its course at 4% per year.

Keep inflation in mind when you determine how much you want to save for your retirement fund every month. 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 and reach your target retirement fund.

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. – other factors 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.

If you have any substantial retirement plans such as buying a summer home or travelling 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.

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 out where that money will come from.

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

2. Social Security (State Pension)

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 retirement fund, but it will help to fund your living expenses when you’re retired and reduce the size of the retirement fund you will need.

3. Employer-Sponsored Retirement Plan (Work Based Pension)

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 our previous example, your retirement plan 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, you will have about $429,200 in today’s dollars by the time he is 65.

If you do have current savings and investments, be sure to include only the portion you expect to have leftover by the time you have retired. 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.

There is a myriad of investment accounts, savings plans and financial products you can use to build your retirement fund. Many countries have government-sanctioned retirement accounts that provide for tax-deferral while your savings are growing in the account, thus postponing taxation of your investment earnings until you withdraw your funds for retirement.

Due to the wide array of savings methods available (each with their pros and cons) and the fact that each individual will have a different solution based on his or her circumstances and personal preferences, it would be impractical to discuss each in detail.

That said, there are financial goals and strategies common to pretty much everyone, and a core group of investment vehicles available to most as well. A quick overview of the tools at your disposal and the characteristics of each will help you determine what route is best for you. If you feel you need assistance choosing the financial vehicles with which to build your retirement fund, consider consulting with a professional financial planner.

The Early Bird Catches The Worm

While it’s not difficult to understand that building a sufficient retirement fund takes more than a few years’ worth of contributions, there are some substantial benefits to starting your retirement savings plan early.

One of the most important determinants impacting how large your retirement fund can get is the length of time you let your savings grow. The reason for this is that the effects of compounding can become very powerful over long periods of time, potentially making the duration of your retirement savings plan a much more critical factor than even the size of your monthly contributions.

The bottom line is if you don’t start saving for retirement early on in your working life, it will be more costly trying to play catch-up later on. It’s much easier to put aside a small amount of money each month starting from a young age than it is to put aside a large amount of money each month when you are older. Unless you have other serious financial pressure to take care of, such as a lot of credit card debt, you should seriously consider starting to save for your retirement as early as possible.

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