The Bogleheads' Guide to Retirement Planning (6 page)

Scientific formulas are fine for physics, where there are rigid laws of nature. But they can give you false information in the subjective world of financial planning. The simple method for calculating your number has many assumptions built into the formula, some of which may not be realistic. For example, a 4 percent income level from investments assumes that you desire to have your heirs inherit every dime you ever saved after inflation. If leaving every penny to heirs is not part of your estate plan, or you do not care what anyone gets after you are gone, then you could take out more money without worry. Perhaps you could take out 5 percent per year rather than 4 percent. In that case, you would multiply your income shortfall by 20 rather than 25 to find the number.

Also, the idea that someone is going to spend the same amount of money at age 65 as they do at age 85 is simply not realistic. Department of Labor surveys show that spending goes down with age, particularly when people get into their 80s. At that point, people start to downsize by selling the second car and selling the second home; they do not travel as much or go out to eat as much. Adjustments can and should be made to the number to approximate these decreasing spending habits. Perhaps a realistic number is closer to 17 or 18 times annual income shortfall rather than the rule of thumb of 25 times.

To assure that your retirement assets provide for 30 to 40 years of retirement, you need to do a new calculation each year and adjust for inflation accordingly. These readjustments to your goal account for market fluctuations and other factors that affect your ability to save for retirement. Downsizing and/or relocating to a less costly area are additional means of reducing the difference between total annual income in retirement and the amount indicated as a safe withdrawal from your savings.

Even if you spend considerable time and effort calculating a savings number that will produce a safe, sustainable withdrawal rate in retirement, it is prudent to note an important caveat: Applying rigid scientific formulas to finance are helpful in that they are conceptual, but those formulas cannot account for the unknowns.

Compound interest calculators and savings calculators can project average returns over time, but they cannot project the impact of a major market downturn in the years just before retirement. Nor can they project the loss of a job or a severe decline in real estate values for someone hoping to relocate.

Many financial planners use complex Monte Carlo simulation analysis to predict the probability of successful withdrawal rates, taking into account past inflation and market performance. But those formulas are built around strict scientific laws that do not apply to future economic events. Monte Carlo simulation cannot forecast changes in the tax code, the bankruptcy of a pension plan, or an inheritance.

How do you budget for the seemingly staggering amounts needed for retirement? If you are a young investor just starting out, make early, regular contributions to your employer’s deferred compensation plan, and establish a savings pattern and lifestyle that never take into account that portion of your income. As an older investor, you have to consider retirement savings a necessary expenditure, not a discretionary one. You will also have the challenge of applying more strategies to meet your goal.

When starting a new job with an employer who offers a salary deferral or defined contribution plan, how much should you defer? Based on the Social Security tax of 12.4 percent of wages and the fact that Social Security retirement benefits pay out about 40 percent of earnings at age 67, your strategy should ultimately be to save 15 to 20 percent of gross income—more if you plan to retire early. You don’t have to start at that level if part of your strategy is to dedicate some or all of your future salary increases to savings until you reach that level. If you are barely making enough to get by, set up a budget and track your spending habits over a few months. Distinguish between wants and needs.

Controlling out-of-pocket expenses can help fund a retirement plan. A partial list of expense items to consider includes credit card debt, clothing purchases, personal care expenses (cosmetics, haircuts, hair dying, manicures, pedicures, spa treatments, etc.), cell phone plans, eating out (both lunch and dinner), expensive entertainment, daily lattes and happy hours, lottery tickets, grocery bills (prepared foods and deli items are expensive; many store brands are indistinguishable from national brands), DVDs, iPods, and music downloads.

Also consider some less frequent expenses, such as insurance deductibles and the big hitters—transportation and housing costs. No one expects you to be a hermit, but there are many small purchases made each week that do not significantly impact happiness, social interactivity, or well-being. Jean Chatzky characterizes some of this spending as “unconscious consumption”; if unchecked, such spending undermines your savings goals.

At this point in your life, your well-established spending habits have provided you with a good idea of how much annual income you will need in retirement. The Social Security and pension income numbers you provided when calculating the savings needed to support your future lifestyle are fairly solid. The gap remaining will need to be filled by future savings and the income from your investments. Returning to the example of a $1 million goal with $600,000 saved, if you are 5 years (60 months) from retirement and you expect your investments to return a conservative 5 percent, the calculation is as follows: the $600,000 current savings earn 5 percent per year over 5 years to grow to about $765,000, leaving a gap of $235,000 for which you have to budget. Using a compound interest calculator with length of savings equal to months to retirement, you would have an approximate savings goal of about $3,500 per month. (This assumes that half of the savings go into tax-deferred accounts.)

If you know how much you can afford to save and how much you need to save, you can also use the same formula to solve for the number of months you must continue to work until you can afford to retire. Choose from a number of online interest calculators at
www.analyzenow.com
,
www.choosetosave.org
,
www.AARP.org
, or
www.MSNMoney.com
.

If you are approaching retirement, you may need a strategy of savings and cost reductions that go beyond the daily expense controls employed by the younger investor. Think of the process as a lifetime spending plan where you can adjust either your lifestyle today or your time line for tomorrow to achieve your goal. In the example, the $3,500 per month needed for five years is reduced by $1,000 per month if you delay retirement by two years.

If you have a hard retirement date, here are some expense reduction and savings strategies: If you have credit card debt, pay it off by using funds you may have in taxable low-yield savings, suspending Roth IRA contributions, taking out a home equity loan if you have a lot of equity (over 50 percent) in your home, or refinancing your mortgage if interest rates are favorable for doing so
and
if refinancing does not greatly extend the length of term of your mortgage. If you own more house than you need, consider downsizing. If you are making car payments or are leasing a car, try to reduce your transportation outlay by selling it and buying a dependable used car for cash. You could also reduce your support of children in college if they are eligible for educational loans since they can borrow for college, particularly if they are old enough to be in a graduate program.

Another cost-saving strategy is adjusting your insurance. Consider raising the insurance deductibles on your home and the collision deductible on your car—or drop the collision deductible altogether if the value of the car is less than $5,000. If you are paying for a portion of your health care and are in good health, look for a cheaper plan and/or raise your annual deductible. If you are taking prescription medicines, ask for a generic equivalent. Live a healthy lifestyle by not smoking, not drinking in excess, and getting regular exercise. Last, if no one is dependent on your income, drop your life insurance, and if you have a dependent, buy term life insurance.

You may be able to reduce some, if not all, of any projected annual income shortfall by selling your home and moving to a less expensive location. If you are a retired couple, ask yourself if you regularly use all the space you have and if you want the furnishings, maintenance, and taxes that go with it. Downsizing from a four-bedroom to a smaller three-bedroom home (net 500 square feet reduction) has the potential of freeing up $100,000 in cash and reducing ongoing costs for taxes, insurance, and utilities by 5 percent or more per year. Moving to another town may also reduce costs. For example, moving from Chicago to Champagne-Urbana, Illinois, will reduce your living costs by more than 10 percent. Retiring to Mexico or another location south of the border can reduce your living costs by a considerable amount. If you do move out of the country, rent for the first year or so to ensure that the lifestyle suits you.

A key strategy to keep your plan on track is an annual portfolio checkup as suggested later. Rebalance your asset allocation if the situation warrants. A semiannual review is recommended for individuals in their 50s. The closer you are to your retirement age, the less time you have to recover from adverse events.

Check your spending and saving habits at least annually, and make adjustments to your retirement savings when necessary. Has the contribution limit for tax-deferred savings increased? Can you save more or redirect savings from a taxable account to a tax-deferred account? Did you get a raise? Did you reduce ongoing expenses, and how did you redirect the money? Have health-care expenses changed? These adjustments do not require a detailed tracking of expenditures, only a big picture approach. Situations change over time, and we all need to be flexible enough to adjust.

In the decade before retirement, an annual review should include looking at all the major items that affect your ability to draw down assets at your desired rate in retirement. This includes reviewing your annual Social Security statement and its income projections, employer pensions, employer-sponsored plans (such as 401(k), 403(b), 457, SIMPLE, and SEP), traditional and Roth IRAs, savings in taxable accounts, other sources of income, and any amount that might be freed up from downsizing. On the expense side of the ledger, subtract your savings for the year and your Social Security taxes from your gross income to get a rough estimate of your cost of living. Make adjustments for changes in housing costs, transportation costs, health-insurance premiums, and changes in tax laws that affect both wage earners and retirees. Use an online retirement savings calculator to see if your current level of savings will allow you to reach your retirement goal.

As you get close to retirement, you can examine the percent withdrawal rate that might be right for you. Based on your current savings and projected postretirement income, how much do you really need to withdraw annually to live comfortably? If you have been a consistent saver and live well below your means, you may find that a 3 percent withdrawal rate allows you ample resources and additional peace of mind.

According to a 2008 AARP survey, 51 percent of workers reported retiring earlier than anticipated. Of those who cited one or more negative reasons:

While we can plan for our future and work to create a future of our choosing, we cannot guarantee results. Life happens. We can only anticipate some of the potential threats and prepare contingency plans. The death of a family member, serious illness, and natural disasters are phenomena most dreaded by all of us. Events such as these may alter our lives, our goals, and our futures. Conservative planning, insurance, and emergency savings can cushion some of these blows, but they will still be felt.

Divorce is often a monumental financial setback for both parties. It can be very costly, financially and emotionally, and leave both parties to fend for themselves, rather than pooling their assets and talents. Many divorces result in individuals starting over again with their financial savings. Even living a frugal lifestyle and saving aggressively may not provide enough savings to allow retirement at the desired age.

Loss of employment, family-owned business bankruptcies, and frozen or bankrupt pension plans may also be devastating events. If these setbacks happen to couples as they approach retirement, there is little time to recover, and the only solutions are to continue working past the planned retirement age, or accept a retirement that potentially provides less opportunity to pursue postretirement goals.

The condition of the financial markets has a huge impact on individuals approaching retirement, as well as those who have just entered retirement. These investors are the most vulnerable to market downswings because they are at a point in their lives when their net worth is at its highest. Higher returns come only with higher risk. If you have reached your financial goal in advance of your desired retirement age, there is good reason to take a more conservative approach to investing.

Source:
Employee Benefit Research Institute and Mathew Greenwald & Associates, Inc., 1996-2008 Retirement Confidence Surveys
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