Retirement planning has become more complicated.
The shift from the old-fashioned pension plans that pay retirees a monthly check for life to the newer 401(k) type plans has accelerated. This trend has placed the responsibility squarely on the individual to save aggressively, invest prudently, then expertly convert those savings into a “paycheck” that needs to last throughout retirement.
Furthermore advances in science and medicine are enabling retirees to live longer and more active lives. This means that nest eggs must fund more expensive retirement lifestyles that may last for 30 years or longer.
In our series of articles on retirement planning, we identified the key issues facing investors before and after retirement and discussed sensible options for addressing them effectively. In broad terms, the fundamental building blocks for a well thought out retirement plan are:
— Estimating how much retirement will cost. The first step in the planning process is to establish a realistic annual budget that reflects the lifestyle you envision. Assuming that your living expenses will drop significantly once you stop working may be wishful thinking. With higher medical expenses and more time to spend on travel and entertainment and with family and friends, many retirees especially in the early years will spend as much as they did while working if they have the money to do so.
— Identifying your sources of retirement income. How much are you expecting to receive from non-portfolio sources such as Social Security, an employer pension or rental property? It is almost certain that inflation will substantially erode the purchasing power of these benefits (even Social Security), so any sensible estimates need to incorporate this reality.
— Determining the size of the nest egg you’ll need when you retire. The amount you’ll need will depend upon the difference between expected income and expenses, and other factors that you have little control over including how long you will live, your health related expenses, future investment returns and inflation. Since you can’t predict these variables with any degree of accuracy, it’s wise to take off the rose colored glasses. Worst case is you’ll find yourself in better financial shape than you expected in your later years because you were more conservative.
— Calculating how much you’ll need to save each year to reach your nest egg goal. Once you approximate the lump sum needed at retirement, the next step is to determine how much you should be saving each year to achieve that goal. The amount will largely depend upon when you want to retire and how much you have already saved. All things being equal, the longer you have to save before you retire the less you’ll have to save each year.
— Investing sensibly during your working years. Sound investment principles don’t change from year to year. Build a portfolio that is broadly diversified, low-cost, tax-efficient and consistent with your goals and investing temperament. This will give you the best chance of keeping more of what you earn and sticking with the plan through good times and bad.
— Establising a tax-efficient investment and spending program during retirement. After a lifetime of working hard, saving diligently, and investing sensibly, the goal in retirement is to preserve, grow, and spend from the portfolio in ways that will generate sufficient income that will last throughout retirement.
There are three key steps to creating and managing such a program.
First, it requires building and maintaining a diversified mix of investments that generates income to pay for living expenses today and growth to meet future spending needs.
Second, the retiree must be realistic about the level of withdrawals the portfolio can safely withstand and vigilant in monitoring and adjusting spending as warranted by market conditions and investment balances.
Third, because taxes can have a big impact on a retirement plan, understanding how different investments and different accounts are taxed, keeping abreast of your tax status each year, and then managing the tax-efficiency of your withdrawals based on those factors, can minimize unnecessary taxes and help your retirement savings last longer.
For most Americans, their most important financial priority and biggest financial liability is achieving a secure and comfortable retirement. Because of changes in pension policies, longer lifespan and greater expectations for more active and expensive lifestyles, reaching this goal requires more and better planning than ever before. Having a sound plan in place can go a long way to reaching that goal.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.