If you are retiring as a couple, it is very important that you agree on a common vision for the future and the strategies that are needed to reach your financial goal. Without consensus, there is the chance that you may be at cross-purposes, a potential recipe for conflict. Planning for the future involves trade-offs; you should agree on what you are willing to give up today in return for your shared vision of life tomorrow.
WHEN TO BEGIN THE RETIREMENT PLANNING PROCESS
Financial planning to support yourself in retirement should begin early in life, although planning
how
you will live your future life in retirement may not take place until well after you reach your mid-50s. Accumulating assets for retirement can and should begin as soon as you earn steady income, and even before. Parents who have children with earned income can set up a custodial Roth IRA and fund the account up to the extent of the child’s earnings, or the maximum allowable by law, whichever is less.
Early retirement planning should begin when you have your first full-time job. Planning at this stage involves having a savings plan so that 40 years later you will have
something
put away for retirement. You may not know how much to save or how long you will need to save, but saving is the beginning.
Many employers have a 401(k), 403(b), or other self-funding defined contribution retirement plan. Study the defined contribution plan options offered by your employer. Choose a broad-based low-expense mutual fund, and contribute at least enough to capture your employer’s match. Contribute more if you can—10 to 15 percent of gross income is a good target—but especially take advantage of any raises you earn to increase your contributions. If your employer does not offer a plan, or if the only investment choices are high-expense funds with no employer match, you may be better off establishing a Roth IRA at an investment firm that offers low-cost plans and a low minimum investment amount. All of these concepts are discussed in other chapters throughout this book.
Choosing the right mix of assets at the beginning of your career is not as important as getting started on retirement early and establishing good financial habits. At the beginning, it is the amount that you put into a plan that counts, rather than the return of the investment in the plan.
It is not difficult to budget for retirement savings at an early age because your spending habits have not been developed. One core strategy that works is living below your means; this strategy entails distinguishing between wants and needs and deferring gratification (minimal use of credit and avoiding revolving credit altogether). There are also psychological benefits to getting started early. Money deferred from your paycheck has an out of sight, out of mind quality, and the quarterly statements that report your fund’s growth typically offer positive reinforcement for the decisions you have made.
THE TIME VALUE OF MONEY AND OTHER IMPORTANT CONCEPTS
Letting your money work for you is a key component of saving for retirement. Compound interest, dollar cost averaging, tax-deferred savings, and diversification help lower your risk and boost your return on investment over time.
Compound Interest
Compound interest is the interest on your principal plus interest on the interest you earned previously. For example, a single investment of $10,000 at 5 percent compounded annually earns $10,789 in interest over 15 years for a net amount of $20,789. Straight interest would accrue at the rate of $500 per year, $7,500 in total interest, for a net amount of $17,500. When interest is reinvested and compounds at 5 percent, it adds another $3,298 to the value. That is the magic of compound interest. To calculate compound interest, use one of the many compound interest calculators available on the Internet.
Rule of 72
The rule of 72 offers another interesting perspective on compound interest. Divide the interest rate that an investment is earning into 72, and the quotient is the approximate number of years it will take for that investment to double. For example, an investment with a 7 percent total return will double in about 10 years and a 10 percent return will double in about 7 years.
Starting Early
To illustrate the connection between compound interest and the importance of starting early, here is an example using a scenario from the
Bogleheads’ Guide to Investing.
Eric Early starts investing at age 25 and invests $4,000 each year in a Roth IRA until age 35 and then invests nothing. At 8 percent interest his $40,000 grows to more than $629,000 by age 65. Larry Lately begins at age 35 and invests $4,000 for the next 30 years. Assuming the same 8 percent rate of return on his $120,000 investment, Larry’s Roth account balance at age 65 is $489,000. It’s the power of compound interest over long periods of time that gives Eric the advantage.
Dollar Cost Averaging
Dollar cost averaging is another math-based approach to investing that can boost returns over time. Dollar cost averaging is periodically investing a fixed dollar amount to purchase shares (usually a mutual fund). For example, if you set aside $100 each month and buy shares in the same mutual fund every month with that contribution, you are dollar cost averaging. It works to your benefit by buying more shares when the price is down and fewer shares when the price is up. Over a period of time, it lowers the average cost of the shares purchased. If you contribute to a retirement account each year, then by default you are dollar cost averaging.
Tax-Advantaged Savings
Taxes erode retirement savings more than any other expense. You can grow your retirement account faster by using a tax-deferred savings account such as a 401(k), 403(b), 457, SIMPLE or SEP account, traditional IRA, or tax-tree Roth IRA. Assume you save $500 per month for 30 years at 5 percent interest in a tax-deferred or tax-free account. The account grows to a total of $417,863. If you save the same amount for 30 years in a taxable account, the result is $364,201 at a 15 percent tax rate or $324,290 at a 28 percent rate. You will learn more about tax-advantaged strategies in other chapters throughout this book.
Risk Tolerance
All investors should assess their risk tolerance when getting started in investing. Your risk tolerance is an assessment of how you will react psychologically when the stock market and your investments go up and down.
Investors who buy riskier mutual funds could use one or more of the Internet-based risk tolerance assessment tools to help them determine what percentage of their investments they wish to have in stocks and what percentage they wish to have in less volatile investments like bonds and certificates of deposit (CDs). A high risk tolerance indicates an investor who is less likely to sell shares when the market is down, a key attribute needed if you hope to match or beat overall market performance. Do be aware that you probably can’t really appreciate your risk tolerance until you pass the sleep test during a major market downturn such as those experienced in the early 1970s, 1987, early 2000s, and in 2008. Down markets of 20 percent or more happen more frequently than people think.
Diversification (Asset Allocation)
Overall portfolio risk is controlled through diversification. In financial planning, diversification of a portfolio is usually referred to as asset allocation. In its simplest form, asset allocation is a recommended percentage of assets that should be in equities (stocks or stock mutual funds) or in fixed income (bonds, money markets, or certificates of deposit).
Rebalancing is the process whereby you periodically adjust the current allocation of your portfolio to stay close to your desired asset allocation, thus controlling your portfolio risk. For example, when the equity percentage is too high because your stocks went up in value, sell some equities and buy more bonds. This sell high and buy low transaction can be an effective strategy to keep you on track to meet your goals. No matter what your risk tolerance is, your asset allocation should become more conservative as you approach retirement age or as you realize your planning goal—regardless of age. Later chapters cover rebalancing in more detail.
CALCULATING YOUR NUMBER
Most couples planning for retirement want a savings number that will tell them when they can retire. In his book
The Number
, Lee Eisenberg refers to it as “how much [you] need to walk away on [your] own terms, never to look back.” Coming up with an accurate savings or net worth number is difficult because you have to weigh numerous factors that affect your decision about when to voluntarily retire: health, age, savings, and lifestyle.
The rule of thumb many financial planners use to determine how much income you will need to maintain your current lifestyle in retirement is 70 to 80 percent of your income while working. Unfortunately, the 70 to 80 percent guide can be an erroneous amount because it is based on earnings, not spending. Many people live on much less than they earn, and others with the same income struggle from paycheck to paycheck. The 70 to 80 percent guide also oversimplifies the issue since it fails to take into account your age at retirement, pension from an employer, eligibility for Social Security benefits and Medicare, postretirement health insurance costs covered by your employer, your health, and even your lifestyle. A better approach is to do a financial plan that includes a detailed retirement budget, as Eisenberg suggests.
LIFESTYLE IMPACT ON SETTING A RETIREMENT DATE
Although many of the elements that comprise our lifestyle do not necessarily bring us more happiness or meaning, we should also consider the trade-offs that lifestyle choices represent. The basic needs of families in the twenty-first century are food, clothing, shelter, and health care. Beyond these needs, most items fall into the wants category, wants being an indicator of your lifestyle and a variable that you can control. A frugal lifestyle would allow you to retire much earlier than a lifestyle designed to keep up with the Joneses. How big a house do you need? How often do you buy a new car? How important is dining out and entertaining? How important are designer labels and fashion? Think about your value system and what provides meaning and happiness in your life.
Adam Smith, the father of modern economics, made this comment about lifestyles in
The Wealth of Nations
in 1776: “The desire for food is limited in every man by the narrow capacity of the human stomach; but the desire of the conveniences and ornaments of buildings, dress, equipage, and household furniture, seems to have no limit or certain boundary.”
LIFESTYLE CONSIDERATION: THE COST OF TRANSPORTATION
The cost of owning an automobile is a significant expense over a lifetime. When buying an automobile, consider not only the purchase price of the vehicle itself but also the opportunity cost (investment return on money not spent). For example, compare two similar highly rated cars, one with the standard nameplate and the other in the luxury line. Buying the standard version for $10,000 less every five years results in an out-of-pocket saving of $80,000 over 40 years. The opportunity rate on those savings in a Roth IRA at 5 percent simple interest for 40 years is $279,038.
HOW TO CALCULATE YOUR NUMBER
You are now ready to calculate your number, the principal indicator of your ability to support your life plan in retirement. There are many ways to do this calculation; some are simple, and others are very complex. Here is a three-step simple method to
estimate
your number without getting too detailed:
1. Examine your current spending after taxes as a basis for your desired annual income in retirement. Don’t include items such as a child’s college cost because that will be over by the time you retire.
2. Estimate your future sources of retirement income before investment income. If you are in your mid-50s or older, you can get a fairly accurate picture of your future Social Security benefits from the annual statements provided by the Social Security Administration.
3. Subtract your annual spending before taxes from your future Social Security income and any pension income to find the amount of investment income needed in retirement. The only thing missing is income taxes, which are typically low for a retiree because you are no longer earning high income and you are not paying into Social Security or Medicare. A small adjustment for income taxes may be needed, but don’t overestimate that expense.
This calculation may result in a projected annual income shortfall. That difference will have to be made up by taking a distribution from your savings. The question is how to calculate the lump sum you will need based on the annual shortfall.
There are two ways to determine the amount you need at retirement. Financial planners consider a safe withdrawal amount from a retirement portfolio to be about 4 percent of the value per year. That is the industry standard amount that planners believe you can withdraw for the rest of your life and not worry about running out of money. Based on this standard, to find the lump sum amount you need, divide your shortfall by 4 percent (0.04) to calculate your savings goal. For example, if your annual spending, minus projected Social Security and pension benefits, is a $40,000 shortfall, then you would need investment assets of $1 million: ($40,000/0.04 = $1,000,000). Another method to find your lump sum number is to multiply the shortfall by 25 years: ($40,000 X 25 = $1,000,000). The 25-year number is derived by dividing 100 percent by 4 percent.
From the $1 million, subtract your current savings to determine how much you need to accumulate. You can estimate that part of your accumulation will come from growth of your current investments. If you subtract that potential growth, you will arrive at the additional savings you need. For example, if you have already saved $600,000 and you expect those savings to grow to $765,000 prior to retirement, the savings target becomes $235,000: your savings goal during your remaining working years. Note: If you are planning to retire before you receive Social Security or a pension, you will have to plan for additional outlays from savings in your initial retirement years and adjust the numbers accordingly.