Planning for retirement today, now that many employers have eliminated defined benefit pension plans in favor of participant-directed profit sharing and 401k plans, can seem intimidating – but it doesn’t have to be.
Taking a step by step approach to the process can enable you to develop a plan to handle the complexities of deciding how much to set aside for retirement and how to invest those funds.
This guide is designed to provide you with a comprehensive outline of the retirement planning process to help you gain a better understanding of what you need to do to prepare for your golden years.
Questions that should be answered in the retirement planning process include:
- How much do you need to save today to be able to live the retirement lifestyle of your choice?
- How long will you have to work before you can retire?
- How should you invest your retirement savings to give yourself the best chance of achieving your retirement objectives?
- Will you have sufficient assets so that you won’t run out of money before you die?
- Where do you plan to live when you retire?
Each of the steps outlined in this guide is designed to help you, either on your own or in conjunction with a financial advisor, gather the data and make the choices necessary to effectively plan for retirement. The first step in the process is to determine whether to work with a financial advisor in creating and implementing your plan.
Decide If You Will Work with a Financial Advisor
Given how complicated retirement planning can be, it is no surprise that many people choose to work with a financial professional at some point in the process. If you have significant expertise in and experience with financial planning and investing, it may make sense to do your own retirement planning. For most people, however, the time and knowledge required to successfully create and implement a retirement plan is a barrier to taking a do it yourself approach. In most cases, they would be better off working with a financial specialist who has the necessary training, experience and tools to help them reach their retirement goals.
Learn more in our blog article: Don’t Let These Investing Mistakes Derail Your Retirement Plan
The Benefits of Choosing a Retainer-based CFP®
When selecting a financial advisor, the CFP® (CERTIFIED FINANCIAL PLANNER™) designation is often thought of as the gold standard for advisors. To gain this certification, an advisor must study for and pass tests covering the full spectrum of financial planning concepts, from budgeting to saving to investing and more. In addition to the high ethical standards required of CFP®s by the CFP® board, CFP®s typically operate as fiduciary advisors, meaning they must put the best interests of their clients first when offering financial advice.
Non-fiduciary advisors such as stockbrokers are oftentimes compensated via commissions, which may present a conflict of interest as they can make more money by placing more trades in a client’s account. This can lead to what is known as “churning,” where an advisor makes trades solely for the purpose of increasing their compensation.
CFP®s who charge retainer fees are not subject to this conflict of interest. Their compensation does not rise based on the number of trades placed in a client’s account. Instead, their business success relies on providing good advice to their clients – if their advice is not seen as helpful, their clients are unlikely to want to continue to pay for their services by extending their retainer.
All of the advisors at Financial Freedom Fee Only Wealth Management are CERTIFIED FINANCIAL PLANNER™ professionals and act as fiduciary advisors. Our client focused team puts your interests first.
Read our blog article: Do I Need Personalized Wealth Management?
Establish your financial goals
Because retirement planning is most often a decades-long process, it is best pursued as part of an overall planning approach. It’s hard to know how much you can set aside for retirement purposes if you haven’t considered how other financial goals such as purchasing a home or financing a child’s college education figure into the equation. This is why the first step in retirement planning is to identify your other major financial goals and estimate how much it will cost to achieve them. Doing so is crucial to making realistic retirement plans.
Certainly, we would all like to retire with as much money set aside as possible to fund our retirement spending. However, some of your savings are likely to be dedicated to funding other important objectives. Thus, your retirement planning must take into account how much is feasible to set aside without impeding your ability to achieve your other financial goals.
Whatever your financial objectives, the sooner you start saving for them the better. While it’s never too late to save for retirement, the more time you give your retirement savings to grow, the more likely you are to reach your objectives. The idea here is to use the power of compounding to your advantage to grow your savings over time.
Whenever you start to save, a key facet of retirement planning is figuring out the amount of savings you will need to fund your retirement dreams.
Determine How Much You Need to Save for Retirement
A key number to help you successfully plan for retirement is the total amount of savings needed to fund your retirement spending.
Once you’ve determined this number, you can plug it into a retirement calculator to see how much you need to set aside at specified rates of return to reach that amount. While a common rule of thumb holds that an individual is likely to need around 75% or 80% of what they spent while they were working to fund their retirement expenditures, this number will ultimately depend on your particular financial situation. It’s worth mentioning that with the rising cost of health care these days, some experts believe that aiming for close to 100% of what you spend pre-retirement is more realistic. Additionally, many people feel that they have worked hard all of their lives to save for a successful retirement and want to enjoy retirement by spending at least what they had been spending while working. So, keep in mind, common rules of thumbs may or may not apply to your specific situation.
Using such formulas can be a good place to start, but to get a more accurate number it is necessary to estimate to the best of your ability what your specific retirement expenses are likely to be. Some questions to ask to help you calculate this number include:
- Will you live in the same house you are in currently or sell it and move to a less expensive locale?
- Do you plan to pay down most of your debt prior to retirement?
- Do you have expensive travel plans for your retirement?
- Do you plan to help other family members buy a home or pay other expenses for them?
- Do you plan to pursue hobbies that will be expensive to fund?
- How much of your anticipated health care costs are covered by insurance?
Answering questions like these is crucial to coming up with an accurate estimate of your retirement spending plans. With healthier lifestyles increasing life expectancies, one risk to keep in mind is what is known as longevity risk – the risk that you outlive your income. If your retirement expense estimate is inaccurate, this risk increases.
Once you’ve come up with an estimate of your expected retirement expenses, you can plug that number into a retirement calculator to see how much you need to have set aside in savings, in addition to any income from sources such as Social Security payments, pensions, annuities, etc., to fund your spending.
Then, you can calculate how much you will need to contribute in additional savings at an expected rate of return to generate that amount of savings. If the indicated savings amount conflicts with funding your other goals, you will have to make some hard decisions. How important are the conflicting goals? Is your desired retirement savings number on the conservative side or is it primarily aspirational? It’s also incredibly important to be comfortable with your expected rate of return. Small changes in rates of return can make a big difference in projected outcomes 20-40 years from now.
To determine your average life expectancy, actuarial life tables can be consulted. Your retirement plan should be updated at least yearly to ensure that you are keeping up with your progress towards your goal. Remember that unexpected expenses can occur at any time in life – making it wise to budget for a reserve in your plan to be able to deal with such expenses when they arise.
When Can You Retire?
Once you establish a desired retirement savings amount, determining when you will reach that amount depends on two main factors: how much you can set aside each year and how well your retirement savings perform. There are a number of financial and retirement planning software solutions that can crunch the numbers and let you know how likely it is that your retirement savings will grow at a rate sufficient to allow you to retire when you want to.
Determining exactly when you should retire is as much of an art as a science. First of all, the returns experienced by your investments play a big part in determining how much you will have available in retirement income by the time you retire. If you haven’t added a sizable cushion to your baseline savings target in your planning, poor returns might cause you to consider delaying retirement. This occurred as a result of the Great Recession of 2008 and 2009. When the stock market plunged due to the crisis, some people who had expected to retire around that time found themselves forced to push back their retirement date to give their investment portfolios time to recover.
The potential for market volatility can make it challenging to align retirement standard of living expectations with realistic appraisals of the rate of return necessary to enable them. The use of financial planning software tools, with the help of an advisor, can be helpful in this regard by allowing you to model a variety of retirement savings scenarios.
Such solutions typically use past performance data to estimate the chances that your planned savings and investment strategy will enable you to retire at your preferred time. These software tools can be helpful in the planning process by giving you feedback as to how realistic your retirement planning is. If the simulations show that your plans are not likely to be achieved, it gives you the opportunity to adjust them. There are generally three ways to accomplish this:
- Increase the amount you set aside for retirement
- Change your investment approach
- Push back your planned retirement date
Analyze Which Retirement Accounts Are Best for You
There are a variety of vehicles you can use to set aside money for retirement. Choosing the right plan or plans can help maximize the amount of retirement savings you amass. Generally, retirement accounts such as 401ks and IRAs offer tax-deductible contributions and tax-deferred growth. Contributions to Roth IRA accounts are not tax-deductible, however, funds in these accounts grow tax-deferred and withdrawals can be taken without any tax consequences. Insurance products such as annuities and whole and universal life can also provide tax-favored growth. Achieving tax-deferred growth, especially over the long run, helps maximize the retirement savings available to you.
Selecting which type of retirement accounts to use to save money depends on what type of employer-sponsored plans you have access to and your expected future tax rate. Generally, your tax rate will drop in retirement as your income from employment falls, but this is not always the case. If you expect your tax rate to rise or remain high even after you retire, contributing some funds to a Roth IRA or 401k can help minimize the taxes you pay in retirement.
Tax-favored accounts, whether IRAs, 401ks, or annuities, generally feature penalties for early withdrawal – typically those taken prior to age 59 1/2 – so be sure to consider your liquidity needs before placing funds in such accounts. Generally speaking, your emergency reserve and short-term savings funds should not be placed in retirement accounts.
Read our blog article: Should I Convert My Retirement Account to a Roth IRA?
Decide How to Invest Your Retirement Funds
Investing for retirement involves weighing a number of factors related to your financial situation. Once you’ve determined how much you should be investing and what type(s) of retirement accounts to invest in, the next step is allocating your investment portfolio. When doing so, it is important to consider the following three factors:
- Risk tolerance: This measure focuses on how comfortable you are with different levels of volatility (movement up or down) in the value of your investments
- Time horizon: How long do you have before you plan to start withdrawing at least some portion of your retirement savings
- Investment objectives: How much in retirement savings do you need to meet your retirement income goals and what rate of return do your investments need to attain to generate that amount?
If you need to achieve high returns to reach your goals, you would typically invest more of your portfolio in equity investments such as stocks, mutual funds, and ETFs (electronically traded funds), which have tended to do well over long periods of time. However, if your risk tolerance is low, the volatility associated with such investments would have to be taken into account in the analysis process.
Generally, the longer you have until retirement, the more growth-oriented your approach should be. This is because you have more time to ride out the swings of the stock market. If you have a short time until retirement, fixed-income funds that invest in bonds or other such investments and are typically less volatile than stocks are likely to make up a larger portion of your portfolio. The reason for this is that people close to or in retirement are likely to be more focused on capital preservation than younger investors because they have less time to wait for their investments to recover from a market downturn.
If you work with a financial advisor, in many cases they will use Modern Portfolio Theory (MPT) or a similar approach to help you determine your asset allocation. MPT uses the past performance of a wide variety of asset classes to determine what is likely to be the optimal portfolio allocation for a given level of risk. The idea behind such strategies is to use diversification between asset classes to reduce volatility while still achieving an acceptable rate of return.
The reason such strategies typically advocate allocating a higher percentage to equity investments is that while these assets are more volatile in the short run, they stand a better chance of significantly outperforming inflation in the long run. Because retirees generally don’t have the ability to keep up with inflation via increasing compensation from employment, it is important that they do their best to earn more than the rate of inflation on their investments prior to retirement. Thus, while it’s important to be conscious of market risk, or the risk that the market as a whole falls, inflation risk (also known as purchasing power risk) should also be kept in mind as you make portfolio allocation decisions.
Whatever initial retirement investment strategy you use, it is important to rebalance your assets over time to reflect changes to your plan due to changes to your investment objectives and financial condition. For example, as you get closer to retirement and become more focused on capital preservation, moving to a more conservative allocation is appropriate.
Be wary of relying on an unrealistic rate of return to meet your retirement living expenses. This is especially true after you retire when most experts advise that retirees add more conservative fixed-income investments to reduce portfolio risk.
As you analyze your investment goals, it is important to understand how your risk tolerance plays into achieving them. Retirement simulation software can run Monte Carlo simulations on your planned retirement investment scenarios to provide you with a percentage chance of success based on historical returns. Generally speaking, if your strategy provides an 80% chance of success or higher, you are likely putting yourself in a good position to be at least close to reaching your goals.
Estate planning is part of a comprehensive retirement planning process. It is aimed at making sure any assets you leave behind go to the intended recipients as efficiently as possible. Using a will or trust is a crucial component of this process as doing so can help minimize the time and expense associated with the probate process.
Assessing tax considerations involved with passing on assets to your loved ones is an important part of the estate planning process. In some cases, gifting some assets to your beneficiaries during your lifetime may be optimal to reduce the tax consequences of transferring the assets. Life insurance, which avoids probate and passes directly to your heirs, can also be an important component of a well-designed estate plan.
One strategy focused on passing on wealth to a person’s beneficiaries targets building a portfolio that can provide enough income to pay for all of a person’s retirement expenses without dipping into the principal. Under this strategy, when the individual passes away, the remaining assets are then distributed to their heirs according to their wishes.
Putting it All Together
Retirement planning is one of the most important financial tasks an individual can perform. However, because it can be a challenging and complicated process, some people delay starting to plan much longer than they should. This type of procrastination makes it harder to successfully achieve the retirement lifestyle of your choice because you lose out on the ability to make the most of compounding your retirement savings.
Of course, it is never too late to take action to prepare for retirement. Even in retirement, it’s important to continue to analyze your portfolio allocation and expenses to make sure that you are doing everything you can to adequately fund your retirement expenditures.
Wherever you are in the retirement planning process, this guide can be helpful by providing a blueprint of steps you can utilize in devising a plan to provide the income to enable you to make the most of your golden years. Taken together, they represent a comprehensive approach to the process of planning for retirement.
Contact us today for a complimentary consultation. We believe that planning for a successful retirement is too important to leave to rules of thumb and on-line calculators and that professional financial advisors can add substantial value to help you and your family achieve your retirement and life goals.