Retirement Focus - How Much Is Enough?
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. The Holy Grail Of Retirement Planning
2. How Much? It Depends
3. Retirement Calculation Guidelines
4. The Bottom-Up Saving Strategy
Editor’s Note: This week, Mike Posey (Senior Vice President at my company) will bring us his latest edition of Retirement Focus. With his many years as the head of a large trust company, not to mention the last 10 years working with me, Mike brings a wealth of retirement knowledge and experience. We trust that these periodic Retirement Focus articles will be very helpful to you. So, take it away Mike.
As I have been preparing to write these periodic Retirement Focus issues of the Forecasts & Trends E-Letter, perhaps the biggest challenge has been to decide on one topic among the many retirement issues that are important today. This is where your input can help. I welcome your comments regarding retirement topics that you would like to see addressed in future Retirement Focus issues.
While I’m sure I’ll eventually get around to most of the key topics in the ever-growing mountain of retirement issues, I would love to have feedback from you, our clients and readers, so that I can prioritize the subject material to the issues that are of most importance to you. Please e-mail me at firstname.lastname@example.org and let me know what retirement topics are of most interest to you.
This week, I’m going to address one of the most frequent questions we get from our clients who are in the process of planning for a comfortable retirement. I call it the “Holy Grail” of retirement planning because so many other pre-retirement and post-retirement decisions hinge upon how the following question is answered:
“How much do I need to save for retirement?”
While the independently wealthy may be spared from having to think about this question, most of the rest of us will have to deal with it, and the sooner we do, the more secure our retirement will be. As I noted in my very first article, the financial media have already anticipated the heightened interest in retirement planning, but there seems to be no consensus of opinion on exactly how much is enough to save for retirement.
I’ll attempt to guide you through this complex maze of conflicting advice, and give you some general guidelines that I believe will serve you well as you approach retirement. If you have already retired and are no longer in your “accumulation phase,” you may want to pass this along to a younger relative or friend who may benefit from it.
The Holy Grail Of Retirement Planning
A lot of us Baby Boomers are now thinking about our post-retirement existence. As we do so, however, we often encounter a lot of negative reports and conflicting information. We are often told that we, as a group, have not saved nearly enough money for us to have a secure retirement. In addition, we are warned about the rising cost of health care, the precarious Social Security situation, and extended life spans that could cause us to outlive our money.
For instance, how can you not be troubled when a recent study reported that 63% of Americans aged 50 to 59 said they were concerned about not having enough money in retirement? Or when another study found that one-third of workers aged 55 and over have less than $25,000 set aside for retirement, and one-third of workers aged 45 and over are not saving anything for retirement?
Post-retirement health care and long-term care costs are also factors of concern. One recent study by the Employee Benefit Research Institute (EBRI) estimated that a couple retiring in 2006 and living to an average life expectancy would need $295,000 to cover post-retirement premiums and other health care costs. And EBRI’s numbers do not include any long-term care costs.
Statistics show that the average cost of an assisted-living center is $35,000 per year, but can be sharply higher in your local area. Nursing home care can cost over $75,000 per year on the average. Thus, any discussion about retirement expenses must also include provisions for long-term care, but this is a subject for a future Retirement Focus E-Letter.
Worst of all, studies show that only about half of us have even attempted to calculate how much we’ll need to retire comfortably. The insurance industry has a saying about how people “don’t plan to fail, they just fail to plan.” The same appears to be true in regard to retirement.
Which brings us around to the original question of how much you should be saving for retirement. While there are many Internet websites and investment industry publications that claim to “help” you determine what you need to save for retirement, many are based on simplistic rules of thumb and questionable assumptions (more about this later on).
In my first Retirement Focus issue, I stated that the answer to many client retirement questions is often “It depends.” How much you need to save for retirement is one such question. I wish I could point you to a software program or Internet website that would give you all of the answers you seek, but each person’s retirement needs can be different. Thus, you need to tailor your calculation based on a variety of factors that I will discuss in more detail below.
How Much Is Enough? It Depends.
The financial services industry has a number of suggestions for saving enough money for retirement. Almost all take what I call a “top-down” approach, in that they seek to identify an amount of retirement income you’ll likely need, and then back into a lump sum goal to target at retirement. For example, some sources suggest that you target anywhere from 70% to 100% of your pre-retirement compensation. That makes the calculation easy, but it doesn’t necessarily get you to a decision point. After all, which is correct, 70% or 100%? There’s a big difference between funding the two.
Other “experts” say that you should plan on having 20 times your pre-retirement annual income set aside as a nest egg for retirement. Thus, if you expect to be making $100,000 just before retirement, you’ll need $2 million overall, based on some models. Still others suggest that you budget based on anticipated post-retirement expenses to get to the correct amount you will need.
While all of the above are workable rules of thumb, the amount you will need to accumulate for retirement will depend upon your personal financial situation, which will not always fit within the confines of an Internet or software program solution. Factors that may affect the amount of income you’ll need at retirement include the following:
1. Other Sources of Income: You may overstate the amount needed to fund for retirement if you don’t factor in other sources of income that may be available to you. If you are covered by a defined benefit retirement plan that will pay you a guaranteed monthly benefit, this should be factored in. The same goes for rental income from properties that you may own and expect to keep during retirement. Also, don’t overlook other possible sources of income, such as the use of a reverse mortgage or continuing to work either full-time or part-time after retirement.
Social Security benefits are another story. Because of the uncertainty surrounding Social Security benefits, I have always recommended omitting them entirely when doing retirement funding calculations. Maybe this is an extreme position; maybe it is unlikely that future Social Security benefits will be reduced or eliminated; but this does make the estimate of the amount of money needed at retirement more conservative. You might try estimating your retirement needs both with and without Social Security monthly income, and then decide which is most feasible for your financial situation.
2. Method of Taking Income: Just as important as what level of income you will need is the matter of how you plan to take your income, since this will have an effect on how much you need to save for retirement. There are a number of ways people take retirement income. If you are covered by a defined benefit pension plan, you will be able to select among alternative monthly income options.
However, with defined benefits on the decline, it’s more likely that you will have a lump sum in a 401(k) or IRA that you must manage for retirement income. There are many options available to you, including withdrawing only income earned or a set percentage of your balance each year (and hopefully not touching the principal), taking periodic withdrawals only when needed to supplement other sources of income, or taking distributions of both income and principal. You can also purchase an immediate annuity to provide a payment for life, or you can use a combination of these methods.
There are a number of pros and cons to each of these methods of taking retirement income, but a discussion about how to take income is enough for several future E-Letters. For our purposes today, I’ll just boil it down to two options to illustrate how the distribution method can affect the amount you need to save.
First, let’s consider retirement income that is either a set percentage of your total nest egg, or equal to the earnings on your accumulated value each year. Obviously, each of these methods is designed to maintain your principal, or even allow it to continue to grow over time. As a general rule, you will usually need to fund for a larger amount using these methods, since the amount of income is determined by the size of the nest egg and the withdrawal rate you select. Most retirement planning resources I read suggest using a conservative withdrawal rate.
Using a conservative withdrawal rate of 4%, a $1 million nest egg would produce annual income of $40,000. Any earnings in excess of the 4% withdrawal rate would increase the size of the nest egg, effectively providing for inflation and growth. Any earnings less than the withdrawal rate could lead to giving up part of the principal. If you can successfully live off of the income on your investments, you may be able to leave an estate in the amount of your original nest egg plus any growth over and above the income you’ve taken.
The second option to consider is to take distributions of principal and earnings over your life expectancy. This method may allow you to receive a similar level of income as discussed above, but with a smaller nest egg. That’s because you are systematically withdrawing part of the principal over an expected lifetime.
While this can result in a smaller total amount of money required at retirement, it’s also risky, since you can conceivably outlive your money. It also requires that you select an assumed rate of post-retirement returns as well as a life expectancy for you, and possibly your spouse. While charts are available with estimates of life expectancy, no one can predict exactly how long you will live.
Insurance companies have attempted to solve this problem by offering what’s known as “immediate annuities,” or contracts that guarantee a payout for life, no matter how long you live. However, in return for the guaranteed monthly income, you give up the ability to access any of the money paid to the insurer. Plus, in some annuity payout options, if you die prematurely you forfeit the entire premium – even if you didn’t live long enough to get all of your money back.
3. Tax Advantages: Another factor to consider when accumulating money for retirement is the tax status of your savings. Employer 401(k) plans and traditional IRAs have the most tax advantages because not only do earnings grow tax-deferred until actually withdrawn, but contributions can be deducted from taxable income within limits. Roth IRA contributions are not tax deductible, but the earnings escape taxation if accumulated for at least 5 years.
There are other types of after-tax investments that also carry some degree of tax deferral benefits. Capital gains on stocks, bonds and other types of securities are generally not taxable until realized upon sale of the asset. However, stock dividends and bond interest payments are taxed as received while the asset is held. Deferred annuity contracts also allow earnings to grow tax-deferred until withdrawn, though contributions are not tax deductible.
Last on the list are fully taxable investments such as savings accounts, certificates of deposit and other similar depository type investments. Earnings on these instruments are taxed each year as earned, and are usually modest due to principal guarantees.
Faced with the array of tax treatments for various types of investments, you will likely want to fund your nest egg in such a way as to maximize the federal income tax benefits available to you, as this allows you to get the most bang for your investment buck. As a general rule, this means you should max-out contributions to 401(k) and IRA programs first, and then go on down the tax efficiency line from there. Note, however, that tax deferral of capital gains usually applies to investments that carry a risk of loss. Thus, you will want to make sure any such investments are in line with your individual risk tolerance.
4. Other Post-Retirement Goals: Much of the advertising by financial services companies today promotes a retirement filled with chasing your dreams. While most of us will just wind up chasing our grandkids, it’s nice to think that we might be able to have the option of starting a new business, traveling the world or making a commitment to a church or other worthy cause. This is great and I’m all for it, but it’s important to consider this to be a separate goal from your retirement income needs, and should be funded in addition to what you calculate you’ll need for retirement.
Plus, you should avoid raiding your retirement nest egg if things don’t go well while chasing your dreams, especially a business venture. While the oft-quoted statistic of 80% of new businesses failing within the first five years has been shown to be exaggerated, there is still a high degree of risk involved in any new business. While it’s tough to face up to the fact that your dream business may not work out, it’s better to do this than deplete your retirement savings.
5. Just Say No: I’m probably going to ruffle a few feathers here, but it needs to be said: Both during the accumulation phase and after retirement, you need to protect your nest egg from raids by the kids, grandkids, etc. If there are expenses related to college, upkeep or assistance for family members, it should be funded separately from your retirement money. I’ll admit, however, that this is easy to say, but often hard to do.
One reason to be stingy with your retirement money is the tax efficiency discussed above. If you maximize pre-tax contributions to 401(k) and traditional IRA programs, then certain distributions are going to be fully taxable. Plus, 401(k) “hardship withdrawals” and traditional IRA withdrawals prior to age 59½ will usually be subject to an extra 10% penalty tax applicable to “premature distributions.” These taxation rules were specifically designed to be a deterrent to taking money out of tax-qualified plans.
Some 401(k) participants feel it’s OK to fund family needs with a 401(k) loan, since this is a tax-free way to access the money in your plan. Well, yes and no. A 401(k) loan isn’t currently taxed, but it does remove part of your account balance from the plan’s investments. The money borrowed will earn only a set interest rate for the term of the loan. Plus, if you terminate employment without paying back the loan in full, any outstanding balance will be considered a taxable distribution, complete with a 10% penalty tax if you’re under 59½. Even so, a 401(k) loan is a far better option than a hardship withdrawal in most cases.
Of course, kids are not the only family members that may need assistance. Baby Boomers often find themselves sandwiched between needs of elderly parents and expenses related to children. One answer to the elder care dilemma is to plan for that contingency now, rather than waiting for it to happen. Gary has noted in the past how it is sometimes difficult for parents and grown children to discuss financial matters, but it’s important that you do so.
While I certainly understand that there may be times when it’s necessary to dip into retirement money to meet the urgent needs of parents and children, you should try to keep these to a minimum.
6. Don’t Take On Undue Risk: Sometimes, we see investors who have reached their 40s or 50s and do not have enough money saved to be on-track for a secure retirement. If this happens to describe your situation, be careful not to select investments that subject your portfolio to unreasonable risks in order to get potentially higher returns to “catch up” to where you should be.
The old rule of thumb is that you have to take more risk to get a higher return, and this is generally true. However, taking on more risk doesn’t guarantee a higher return (or any return at all, for that matter) for any given period of time. Plus, higher risk could mean that you suffer significant losses just when you need your money for retirement.
After the bloodbath during the bear market of 2000 – 2002, we had a number of people tell us they needed to invest aggressively to “make back” what they had lost. Sadly, many of these individuals had been close to being able to retire early, but were suddenly put in a position of possibly not even being able to retire at normal retirement age because of investment losses.
As a general rule, it’s not advisable to dial up the risk of a portfolio in an effort to make back past losses. Investors who do this often come under the old saying of “throwing good money after bad.”
7. Retiring On Less: In light of news articles about the number of Baby Boomers who have not adequately prepared for retirement, I have seen several stories about how retirees could get by on less money than they think. Unfortunately, some of these articles are misleading, in my opinion. For example, one article I read recommended you consider living on a sailboat to save on property taxes. That’s nice duty if you can get it, but it’s impractical for most people.
However, another publication discussed a study originally presented in the Journal of Financial Planning that concluded Americans may be able to get by on less money during retirement. This conclusion was based on the government statistics showing that older retirees spend less money than younger retirees.
Citing information from the Bureau of Labor Statistics’ 2005 Consumer Expenditure Survey, the study found that the average amount paid for housing, transportation, food, entertainment and apparel all dropped as people got older. The only expenses that increased were those related to health care.
Most retirement planning software assumes an ever-higher level of spending during retirement. However, this may not be an accurate portrayal of how your actual retirement expenses may trend as you age. Thus, the authors of the study contend that retirees can take a larger percentage distribution in the early years, and then scale them back as age increases. Doing so, they say, could mean the difference between running out of money in retirement, or leaving a significant estate.
So, does this mean you can put off saving for retirement? No way! My take on this study is that while some retirement calculators may be overzealous in projecting expense increases, it’s still better to be on the safe side and use conservative projections. However, if you are behind in your retirement savings, don’t panic. You may be able to adjust your expenses during retirement to get by.
Retirement Calculation Guidelines
I always suggest using a trusted Advisor when trying to calculate how much to save for retirement. While we offer help with your retirement planning at Halbert Wealth Management, I realize that some would prefer to deal with a local Advisor who can meet face-to-face and discuss retirement planning. A good place to look for a local financial planner is on the website of the Financial Planning Association:
However, I also realize that there are a lot of do-it-yourselfers out there. For those of you who would like to take on this project, there are many retirement calculator software packages and Internet resources. AARP’s retirement calculator is a good one. This program allows for options and features that some of the more simplistic Internet calculators omit, including the ability to add an expected inheritance and even post-retirement wages should you plan to work after retirement.
Whether you use a financial planner or retirement planning software, it’s important that you avoid using unrealistic assumptions. Unrealistic expectations in regard to the growth of your investments before or after retirement can lead to not putting enough away for retirement. Likewise, a too-aggressive withdrawal rate could cause you to outlive your money.
As humans, we tend to project our current situation into the future, which may be totally unrealistic. Remember in the 1980s, when CD and fixed annuity rates were high? Or the late 1990s when stock market gains averaged 20% to 25%? Many savers and investors thought these rates would continue into the future, and planned their investments accordingly, only to be disappointed later on.
It’s also a mistake to assume that all brokers and other investment professionals will always use conservative assumptions. Back in the 1980s and 1990s, I was aware of some investment professionals that prepared proposals for their clients using these sky-high assumptions. And it didn’t stop with the recent bear market. I just recently reviewed a nationally known household finance program that advised its clients to assume a 10% return for their investments, and then assume they could take 10% of their retirement nest egg per year after retirement and never touch the principal. Sorry folks, that’s about as unrealistic as you can get!
Though historical stock market returns average 10% to 11%, it’s unwise to use that as an assumption of growth. There have been extended periods of time when the stock markets did not gain this much. Plus, you will likely have your portfolio diversified such that other types of assets such as bonds and real estate are included. Thus, an 8% growth rate is the highest I would go, with 6% being better, in my opinion.
You should also factor in a level of inflation, especially in regard to pre-retirement calculations. This is especially true if you are many years from retirement, as your compensation and expenses will not likely be the same far into the future. I suggest using a 3% inflation rate, which roughly corresponds to long-term U.S. inflation rates. As I discussed above, post-retirement expense increases may be overstated if you project a 3% inflation rate, but I still think it’s better to be safe than sorry.
Other guidelines to consider when using a calculator program include being wary of any Internet calculator that requires you to enter personal information (name, address, Social Security No., etc.) before it will provide an answer. There are plenty of calculators out there that do not require this information. Also, some investment product calculators will only let you go so far before requiring you to go to a salesperson for the answer. While I do support the use of an Advisor, be aware that not all Internet salespersons have a fiduciary duty to keep your best interests in mind.
The Bottom-Up Approach To Retirement Saving
As I noted earlier, all of the above discussion relates to a top-down way to plan for retirement. In other words, you arrive at a monthly income figure, and then work backwards to calculate the amount of savings per month that will get you there. Unfortunately, the retirement calculators sometimes come up with a monthly savings requirement that is virtually impossible to meet. This is especially true for individuals who may have come late to the party, and are now in their late 40’s or early 50’s with little money set aside for retirement.
Unfortunately, some of these retirement calculators present such a hopeless case that investors may not take retirement planning seriously. If the retirement calculators don’t work out for you, then I would suggest you take the “bottom-up” approach to saving for retirement. This simply suggests that you save as much money toward retirement as you possibly can.
You should start with tax advantaged plans like 401(k)s or IRAs, and then move on to investments and liquid savings. Sure, it will likely mean you have to forego some current discretionary expenditures, but this reminds me of an old saying I just made up:
There’s No Such Thing As “Saver’s Remorse”
We’ve all heard of “buyer’s remorse,” an emotional condition where you regret having made a purchase once it’s complete. In my years as a financial services professional, I’ve heard a lot of buyer’s remorse, whether it concerns a house, car, boat or whatever. The sinking feeling you get in your stomach when you wish you could just get your money back after having made a major financial commitment is just a part of being human.
However, I have never heard a successful retiree complain of having “saver’s remorse.” In a retirement context, I define saver’s remorse as the regret of having saved money for retirement instead of spending it through the years. I can’t imagine anyone saying something like, “I have too much money accumulated to fund my retirement. I wish I had used some of it along the way to buy a nicer boat/home/car/RV.”
That’s why I recommend that clients save as much as they can as soon as they can. The younger you are when you get started, the more time you have for the magic of compound interest to work on your behalf. Believe me, a depreciable asset will not be nearly as much comfort in your retirement as having saved the money and allowing it to accumulate earnings.
Today, we have just nicked the surface of the subject of retirement income planning. In future Retirement Focus issues, I’ll discuss the pros and cons of various ways to convert your nest egg into periodic retirement income. I’ll also discuss methods of taking distributions that will reduce the tax bite, and provide other guidance designed to help put more “gold” in your golden years.
Before leaving the subject of how much you should accumulate for your retirement, I need to revisit something I mentioned earlier that can be important to your success. While it may sound a bit self-serving, a recent study has shown that retirees who had the help of a financial advisor were more successful in meeting their retirement needs than those who did not.
A research study by Fidelity Investments showed that U.S. households who used financial advisors were on target to replace 67% of their pre-retirement income, compared with 57% for those going it alone. While this is short of Fidelity’s recommended 85% replacement recommendation (remember, they need to try to sell you something), it still represents an important step toward a secure retirement. The 2007 Retirement Index report also found that investors with financial advisors were saving at almost twice the rate of those without one.
I can think of several reasons this might be true. First, working with an advisor requires that you vocalize your retirement goals. While this may sound odd, actually stating your goals often leads to a more realistic assessment of them. It also allows your spouse to get in on what you’ve been kicking around in your head, as well as you getting to hear what’s been on their mind.
Another thing an advisor can bring to the table is the ability for realistic thinking. This not only applies to using realistic assumptions as I noted above, but also in regard to an objective, third-party reviewing your vision for the future. Quite frankly, we sometimes have to tell clients that they “can’t get there from here” because their goals are bigger than their bankroll. In other cases, however, we are able to develop an investment plan with the potential to meet all of their various financial and personal retirement goals.
Advisors can also help you to start a regular program of saving and investing, and follow up with you periodically to make sure you’re still on track. Advisors are also able to cull through the myriad of investment alternatives. It takes time and sophisticated software to analyze different investment alternatives, and many investors either cannot or do not want to commit the amount of time and research it takes to do the job. That’s why so many will use magazine or Internet articles about the latest “hot” funds as the basis for their selection, only to be disappointed in the end.
We’d be happy to help. Just give one of our Investment Consultants a call at 800-348-3601, or visit our website at www.halbertwealth.com. If you prefer a local Advisor, look at the FPA website “Find a Planner” resource discussed above. Be sure to ask if the person is a Registered Investment Advisor, as he or she will have a fiduciary responsibility to put your needs first.
10 Things You Should Ask Yourself About Retirement
Tenet vs. Tenet
U.S. Economy Expanded at a 1.3% Annual Rate in First Quarter
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.