A guide for planning that ultimate “vacation.”
Planning vacations can be a lot of work. Sometimes it seems that researching destinations, booking transportation and lodging, and, of course, packing can take up as much time as the vacation itself. But how much time do you spend planning for what could be the greatest vacation of your life?
Six Retirement Realities
Before you start planning, it is important to understand some basic retirement truths:
1. You’ve got a long way to go.
People are living longer. For a married couple ages 65, one partner will, on average, live to be 91. And based on the rapid rate of scientific advancement, some futurists predict we may soon be living to 120 and beyond. Whether you retire in five years or 50, you need to plan to be retired for a long time.
2. The money you begin retirement with may be the most you will ever have.
Once you stop working, the paychecks stop coming in. You will need to supplement any pensions or Social Security benefits with the money you’ve saved for retirement.
3. You have a finite amount of money in your retirement accounts — and it’s less than you think.
Even if you have money socked away in IRAs and 401(k)s, withdrawals are typically taxable and state and federal taxes may be as high as 40 percent.
4. Your expenses won’t go down in retirement; they will change and will probably go up.
They call it free time, but few things are really free. Hobbies, movies, meals out, travel, health care and possibly assisted living all cost money.
5. You need to factor in inflation.
It is a safe bet that things will cost more in the future.
6. Financial market returns come with risk.
Although investing is important to meeting your financial goals, you don’t want to be playing catch-up. The higher the potential returns, the greater the risk.
Planning Your Trip
Just like a great vacation, meeting your retirement goals requires careful planning. The process begins by understanding the realities you face and continues by asking questions about your goals and the resources you might rely on. Here are a few questions to get you started:
- Do you have other savings? How much have you saved in retirement accounts and elsewhere?
- Will you receive a pension or Social Security benefits? How much?
- Do you plan to work in retirement? How much? How long?
- Will you receive an inheritance?
- Are you willing to spend principal in retirement?
- What is your medical history? Your family’s?
- Do you want to leave a legacy?
So How Much Do I Need?
When it comes to determining need, no two people are exactly alike, and a one-size-fits-all approach won’t work. Most of us will need to rely on the money that we save, and invest in various retirement accounts such as IRAs, 401(k)s or other retirement plans. One approach to planning your future is to reverse engineer your retirement.
Begin with the best estimate of the projected annual income you’ll need. Then you can subtract the following:
- Income from part-time work or a second career
- Pensions/Social Security benefits
- Nonretirement savings (consider rate of return, accessibility and need for a cash reserve)
- Any inheritance you might receive
What’s left over is your remaining need. Next, look at your sources of income and how they might change in the future. Consider:
- When will you stop working completely?
- How long might any inheritances or nonretirement savings last?
Now you can anticipate how much income you might need from your retirement plans and project that need over your life expectancy. And don’t forget inflation. When you determine your remaining annual income needs, you can convert that amount into a percentage of your projected retirement account assets. Finally, you can determine the rate of return you’ll need and build a diversified portfolio accordingly.
Say you retire with $1 million in your retirement account. You need $40,000 per year in additional income, (4 percent of your account’s value). Congratulations! With a properly diversified portfolio, you should be able to meet your goals. And by the way, 4 percent is near the top of what we’d advise you to withdraw on an annual basis. Remember, this vacation has a long way to go, and you need to compensate for increasing expenses over time.
Wait a Minute, I’m Nowhere Near Retirement and I Don’t Have $1 Million in My 401(k) Plan
No matter when you think you’ll retire, the time to start planning is now. The first step is to pay off credit cards and other high-interest, nondeductible debt you might have. Then you should build up a cash reserve of at least three to 12 months of salary should you face any reduction in your current income. Now you are ready to start working on your retirement goals.
The basic goal is to save, invest and grow assets to provide a required income for as long as you live, and one of the best tools you have is your workplace retirement plan. For many, that’s a 401(k), although there are similar plans depending upon where you work. Some of the benefits of using your employer’s plan include:
- It’s convenient — You can do it all at work, and recordkeeping, document planning and other paperwork is done for you.
- It’s automatic — Money is deducted from every paycheck and invested in funds of your choice.
- Tax advantages — If you are in a 25 percent tax bracket, every $1 you invest only reduces your take-home amount by 75 cents. And the money you earn isn’t taxed until withdrawn.
- It forces you to save — You can’t spend your contributions and you probably won’t even miss the money.
But What If I Can’t Afford to Contribute to My Retirement Plan?
Most employers will match employee contributions up to a certain amount, typically 3 percent of your salary or more. That’s free money! Start there and slowly increase the amount you contribute. Additional strategies include:
- Add 1 percent every six months.
- Increase contributions by 50 percent of any future raises or bonuses.
You may be surprised to see you really won’t miss the money you contribute. After all, 1 percent of $50,000 is less than $10 per week, and that’s less than $7 after taxes. If you want to save even more, you might look at reducing your expenses, such as:
- Drive an older car.
- Own a modest home.
- Limit travel.
- Eat out less and bring lunch to work.
- Re-assess costs of cable, phones, etc.
OK, But I’m Not Sure How I Should Be Investing the Money I’m Saving
If professional money managers can’t consistently outperform the market, how can you? The answer is that you can’t. But, more importantly, you don’t need to. First, let’s look at some of the ways you should not invest.
- DON’T: Buy the fund that had the best return last year.
Past performance is no indication of future results. The fact that a fund did well last year, the last five years, or the last 10 years is no indication of how it will perform tomorrow.
- DON’T: Buy when the market is soaring and sell after the market drops.
This is what so many people do, and it is the exact opposite of what you should be doing.
- DON’T: Invest in a fixed account to “play it safe.”
Although fixed accounts offer low risk, they also offer low returns — and those returns probably won’t get you where you want to go.
The bottom line is that nobody can predict the future, and neither should you. So, what should you do?
- DO: Maintain a long-term focus.
- DO: Diversify across all asset classes (asset allocation).
- DO: Save consistently to take advantage of dollar-cost averaging and compound growth.
- DO: Use strategic rebalancing to maintain your proper allocation.
This is going to be the vacation of your life and you deserve it! You just need to take an honest look at where you are, where you want to be and how you are going to get there. That is what we at Edelman Financial Engines are here to help you do.
Sound Easy? Maybe Not
Planning a vacation is one thing, but proper financial planning involves a great deal more time and expertise. Although some people may feel comfortable doing things on their own, many people need help. For those people, it’s important to work with competent experienced financial planners who can coordinate with your own tax and legal advisors.