Early retirement planning considerations.

Making early retirement a positive experience requires knowledge of a wide range of financial areas. The effects of early retirement on Social Security benefits, employee pension benefits, health insurance coverage, and current investments and savings should be carefully reviewed prior to making the decision to retire. While U.S. workers continue to follow their desires to retire early, the statistics available from the Social Security Administration (1) and private research studies on retirement planning (2) indicate that the majority of U.S. workers are not financially prepared for retirement. People are living longer and, at the same time, more and more workers opt for early retirement without the resources needed to generate sufficient retirement income. This article explores some basic financial planning considerations for early retirement.

Meeting Retirement Income Needs

Early retirement, or retirement at any age, may be less than an enjoyable experience without sufficient income. Generally, financial planners recommend that an individual should strive to maintain 70 percent to 80 percent of his or her final working year's income during retirement and have made provisions to increase income in retirement to keep up with inflation. A small but growing number of financial planners recommend that individuals should strive for 100 percent or more income replacement during retirement years. (3) The logic behind this recommendation is that individuals tend to spend more money when they have time to do what they would like to do. In planning for retirement at any age, the first task is to determine the income desired in retirement and examine how those income goals will be met. The exact amount of income that an individual needs in retirement is specific to each individual's financial circumstances and goals. For example, an individual or couple with a home that is paid for would li kely spend less on housing in retirement than an individual or couple who are still paying off their home or renting.

Financial planners generally suggest that an individual's retirement plan include at least three important sources of retirement income. These sources usually include Social Security benefits, personal savings/investments, and employer/employee retirement accounts, such as defined benefit plans, 401(k)s, 403(b)s, and IRAs. Of the aggregate income received by retired Americans, Social Security benefits consist of 42.5 percent; individual savings and investments generate 36 percent; and employer/employee retirement benefits make up 21.5 percent of retirement income. (4) The anticipated income from each of these sources should be carefully examined prior to making the decision to retire.

Social Security Retirement Income

According to the Social Security Administration, 60 percent of U.S. workers elect to begin Social Security retirement benefits at the youngest eligible age, 62. Up until the year 2000, opting for early retirement at age 62 meant a 20 percent reduction from the amount received for full Social Security retirement at age 65. The full retirement age began to gradually increase in the year 2000; it will reach age 67 in the year 2027. The earliest retirement age for Social Security remains at 62, but the reduction in benefits for early retirement will gradually increase to 30 percent by the year 2022. (5)

If U.S. workers continue to retire early, aggressive retirement planning is even more essential in light of the scheduled reduction in benefits from Social Security for early retirement. Table 1 lists the scheduled Social Security early retirement reduction. Once an individual elects to begin receiving Social Security early retirement benefits, the reduction in benefits is permanent.

Another aspect of Social Security to consider is the retirement benefits for the retiree's spouse. Spousal benefits are typically calculated as a percentage of the primary wage earner's benefits. The spousal benefit for a spouse age 62 would be 37.5 percent of the primary earner's full benefits. At full retirement age, the spousal benefit is 50 percent of the primary earner's benefits. A spouse may receive Social Security retirement benefits based upon the greater of his or her own employment record or the spousal benefit. Similar to the situation with a covered worker, a spouse's benefits are permanently reduced by a percentage based on the number of months before he or she reaches full retirement age. (6) For many married retirees, the combined reductions for early retirement may be significant.

Social Security provides a smaller percentage of income replacement in retirement for higher salaried workers. As can be seen in Table 2, Social Security retirement benefits, as a percentage of earnings, are less as a person's income rises. In order to maintain the desired income replacement percentage in retirement, other substantial sources of retirement income become more critical.

Employer/Employee Retirement Benefits

Another important consideration before opting for early retirement is the amount of money that will be provided by any employer/employee retirement plans. Most individuals are eligible to participate in several different tax sheltered retirement plans. The current trend in pension plans to give the employee more flexibility creates more uncertainty re a precise determination of future retirement benefits. With most pension plans today, retirement income is based on the performance of the investments selected by the employee. In recent years, the down stock markets have altered many early retirement dreams. However, even in down markets, it is important to keep in mind the advantages of investing in employee/employer retirement plans.

Individuals who participate in employer-sponsored tax-deferred retirement plans have the opportunity to deduct their annual contributions from gross income before taxes. The earnings accumulate tax deferred and the income received from the account in retirement is taxable in the year received. The federal legal annual contribution ceiling on 401(k) and 403(b) plans is $11,000 for the year 2002. Recent tax law changes increase the annual employee contribution limit for 401(k) and 403(b) plans by $1,000 in each subsequent year until it reaches $15,000 in 2006. After 2006, the annual contribution limit will be indexed for inflation.

Under the new tax laws, individuals who are at least 50 years old are eligible to make additional contributions above the annual limits. In 2002, the additional amount is $1,000 and will increase by $1,000 per year in each subsequent year until it reaches $5,000 in 2006. As a result, beginning in 2006, individual employees over age 50 will be able to contribute up to $20,000 per year into their 401(k) or 403(b) plans. Also, effective in 2002, the new tax law allows an employee to contribute up to 100 percent of his or her compensation into a 401(k) or 403(b) plan up to these new limits. The scheduled increases in the legal annual contribution ceiling enhance the opportunity for individuals to invest for retirement.

Many employer-sponsored plans contain provisions for the employer to provide matching funds. An employer's matching contributions increase the amount that an individual has invested annually into his or her retirement account and will magnify the sum available in retirement. Eighty-two percent of 40 1(k) plans offer a company match. The most common match is 50cents for each $1 of worker contribution up to 6 percent of the employee's wages. (7)

Where matching funds are involved, individuals generally should maximize employer-sponsored plan contributions before considering other tax-sheltered options. When an individual is considering retirement, the company's human resources office or pension fund administrator should be able to give an accurate estimate of the monthly income available in retirement under different options.

Personal Savings/Investments

There is no simple equation or rule of thumb that financial planners use to calculate the amount of money needed to produce a comfortable income in retirement. A recent Wall Street Journal survey of website retirement planning calculators reported that the amount of money that the various calculators say an individual needs for retirement varies widely. (8)

A number of factors can influence the amount of income that personal savings and investments generate in retirement. The most important factor is the amount of personal savings and investments that an individual is able to accumulate during working years to supplement other sources of retirement income. Financial planners generally recommend systematic savings programs, such as payroll deductions. These are automatic, allow for investment dollar cost averaging and, once established, can help to maintain the savings habit.

While investment options are numerous, quality mutual funds from established investment firms are often recommended for long-term growth. Table 3 illustrates the importance of starting an investment/savings plan as early as possible. The accumulations in Table 3 assume long-term annual rates of return, which historically have been obtainable in quality growth mutual funds.

As can be seen in Table 3, starting a savings plan at an early age allows the time value of money (compound interest) to work for the investor. It is also important to note that a slightly higher rate of return can produce significantly greater results over time, as seen when comparing the annual rates of return.

While it is important to be aggressive in accumulating money for long-term growth, it is prudent to be conservative in estimating the income produced by a given principal. The logic here is that it is better to have too much retirement income than not enough.

If an individual wishes to pass all or part of his or her savings and investments to heirs, then living on the interest earnings is appropriate. For example, assuming an interest rate of 5 percent, when asset preservation is desired, it takes $20,000 of principal to generate $1,000 of annual income. If an additional $40,000 of annual retirement income is desired, then it takes $800,000 of personal savings and investments to generate the income. ($800,000 X .05 = $40,000).

If an individual desires to maximize retirement income with low risk and is not concerned with leaving his or her savings and investments to heirs, then a life annuity may be appropriate. Following a basic annuity rule of thumb, using a single life annuity for a male at age 65 and assuming an interest rate of 5 percent for each $1,000 of annual income in retirement, a sum of $12,500 is needed. As a result, if your goal is to have an additional $40,000 per year in retirement income from savings and investments, then an estimated $500,000 is needed in investments at age 65 ($40,000 X $ 12,500/1,000 = $500,000). Keep in mind that many factors may have an impact on the income generated and early retirement will reduce the annual annuity that a sum of money will produce.

Employment After Retirement

Many individuals continue with some type of employment after beginning retirement, and this income may be an important part of their total income. Careful attention needs to be given to early retirement considerations when continued employment is anticipated. Social Security retirement recipients between the ages of 62 and full retirement age are subject to the annual earnings limitation test that reduces Social Security benefits by $1 for every $2 earned over $11,280 in the year 2002. Retirees past full retirement age can continue employment without suffering a reduction in their Social Security retirement benefits. The income limitation is scheduled to be adjusted annually for inflation. This limitation on employment after retirement may present some serious problems for individuals who plan to retire early and supplement their retirement income with part-time employment.

Fringe Benefits: Health Insurance and Extended Care

A person contemplating early retirement needs to consider the additional costs associated with any lost fringe benefits, such as life insurance, health insurance, and provisions for extended care. Everyone has a some-what unique set of circumstances and, therefore, no "one size fits all" plan exists for this important part of the early retirement decision. Employee benefits are usually a very good deal from the perspective of the employee. More often than not, the rates for such insurance are group rates, which are lower than those for individuals. When considering early retirement, it is important to recognize that Medicare coverage is not available until age 65; the result is a potential insurance "black out" period between the date of early retirement and age 65. When an employee elects early retirement, he or she may not be able to keep group insurance coverage or may have to pay significantly higher premiums. This insurance can take a significant portion of the early retirement income.

Summary/Conclusion

Financial planners generally suggest 70 percent to 80 percent income replacement in retirement, with provisions for annual adjustments for inflation. The effects of early retirement on Social Security benefits, pension benefits, health insurance coverage and personal savings should be carefully reviewed prior to making the decision to retire. Once made, many of the decisions affecting retirement are irrevocable.

TABLE 1

Social Security Early Retirement Reduction

                    EARLY         REDUCTION PERCENTAGE     AGE NEEDED
YEAR OF           RETIREMENT        OF FULL BENEFITS        FOR FULL
BIRTH                YEAR       (IF RETIREMENT IS AGE 62)   BENEFITS

1938                 2000                20.833% *         65 and 2 mo.
1939                 2001                21.666%           65 and 4 mo.
1940                 2002                22.50%            65 and 6 mo.
1941                 2003                23.333%           65 and 8 mo.
1942                 2004                24.166%           65 and 10 mo.
1943-54           2005-2016              25.00%            66
1955                 2017                25.883%           66 and 2 mo.
1956                 2018                26.666%           66 and 4 mo.
1957                 2019                27.50%            66 and 6 mo.
1958                 2020                28.333%           66 and 8 mo.
1959                 2021                29.166%           66 and 10 mo.
1960 and later  2022 and after           30.00%            67

* Source: The Social Security Administration.
TABLE 2

Approximate Percentage of Social Security Retirement Income Replacement
in 2002 at Full Retirement


Employees' Average Annual     $24,000  $48,000  $84,900  $125,000
  Income
Estimated Social Security     $12,269  $17,360  $19,920   $19,920
  Annual Retirement Benefits
Social Security as a            51.1%    36.2%    23.5%     15.9%
  Percentage of Earnings

Source: The Social Security Administration.
TABLE 3

Accumulating Personal Savings and Investments; Accumulated Amount at Age
65, Investing $200 per month or $2400 per year

AGE SAVINGS
BEGIN        AT 8% RETURN  AT 10% RETURN  AT 12% RETURN

25             $621,736     $1,062,222     $1,841,618
30              413,559        650,457      1,035,991
35              271,879        394,785        579,198
40              175,454        236,033        320,001
45              109,829        137,460        172,926
50               65,165         76,254         89,471
55               34,768         38,250         42,117

This article was republished with permission from Personal Financial Planning Monthly, Volume 2, Number 5, May 2002, Copyright 2002, Aspen Publishers Inc.

Endnotes

(1.) Social Security Retirement Benefits Publication No. 05 - 10036, February 1999 ICN 457500, published by the Social Security Administration.

(2.) "Financial Strategies for Approaching Retirement," American Express Financial Advisors, Summer 1999.

(3.) "Steps to a Great Retirement," Lisa Reilly Cullen, Beverly Goodman and Henry Weil, Money, November 1999, pp. 85-102.

(4.) See endnote 1.

(5.) See endnote 1.

(6.) See endnote 1.

(7.) "Comparing the Roth IRA to Other Tax Sheltered Programs," Clarence C. Rose, Personal Finance, May/June 1999, pp. 27-32.

(8.) "Calculating Retirement? It's No Simple Equation," Bridget O'Brian, Wall Street Journal, February 7, 2000, p. R1.

Clarence C. Rose, PhD, is a Professor of Finance in the College of Business and Economics at Radford University in Radford, Virginia.

L. Keith Larimore, PhD, is a Professor of Marketing in the College of Business and Economics at Radford University in Radford, Virginia.