Planning for a realistic retirement.

CPAs who do financial planning are frequently asked to help with retirement planning. The technical aspects of retirement planning are fairly straightforward. However, the human side of the problem must also be considered. Sid Mittra, PhD, CFP, professor of finance at Oakland University in Rochester, Michigan, explores some of the key questions planners must ask in helping clients develop an effective retirement plan that realistically meets their future needs.

Planning for any financial goal generally means finding answers to key questions. These answers form the basis for assembling the resources necessary to meet that goal. In planning for retirement, here are some questions that must be answered to ensure the plan being developed will adequately meet all of the retiree's needs:

* How much income will be needed at retirement?

* What rate of inflation should be used in projecting income and expenses?

* How much retirement income is expected?

* How long should retirement income continue?

* Will the family be able to meet any retirement income shortfall?

While these are difficult questions, they must be answered responsibly if the client is to enjoy a comfortable retirement.

Here's a retirement budget for a hypothetical family. John and Betty Burr have been married for 22 years and have two grown children. Betty is a corporate executive and John is a dental technician. Both participate in corporate retirement plans. Betty is 45 and John is 43. They plan to retire in 20 years. RETIREMENT EXPENITURE ANALYSIS

The Burrs'current expenditures are shown in exhibit 1, page 1?A.

The planner's task is to estimate expected expenses during retirement. There are no hard and fast rules for estimating retirement expenses. The accepted rule of thumb is that retirees will spend 70 to 80% of their preretirement expenditure level. This rule may be too rigid and often is misleading because it does not recognize the differences between various categories of expenditures and differences between anticipated postretirement lifestyles.

A better approach to estimating retirement expenditures is to divide fixed and flexible expenditures into several key categories and ask clients to estimate expenses in each category. This approach provides them with an opportunity to fine-tune their retirement income estimates.

Exhibit 1 reveals the Burrs' plan to continue making mortgage payments after retirement; consequently, their housing expenditures remain virtually unchanged.

Another area of interest is entertainment expenditures. Some families may wish to drastically reduce entertainment expenses after retirement, while others may plan to spend a great deal more traveling or developing other expensive hobbies.

After retirement, the Burrs expect to spend a total of $85,100 per year, which is approximately 50% of their current expenditures. RETIREMENT INCOME The Burrs expect to receive annual income of $60, 000 from corporate and noncorporate retirement plans and Social Security.

  Social Security          $10,200
   Pension                   32,400
   401(k) Plan                9,200
   IRA                        8,200
   TOTAL                         $60,000

Social Security benefits can be calculated with the help of a Social Security pamphlet called Estimating Your Social Security Retirement Check. Or, for people age 61 or older, the Social Security Administration will provide an estimate. Employee benefits departments can estimate income from pension, profit sharing and 401(k) plans. Income from IRA and Keogh plans can be calculated by projecting the value of each plan at retirement and using annuity tables to estimate the amount of lifetime income such a sum will provide.

At retirement, the Burrs expect to have annual living expenses of $85,100, but income from retirement plans and Social Security is expected to be only $60,000. The balance of $25,100 must come from personal investments. POTENTIAL SHORTFALL The Burrs must generate $25,100 annually from personal investments to meet their retirement goals. At this point, the planner can determine whether they can reasonably expect to meet this goal.

The formula for calculating the savings required for retirement is presented in exhibit 2, page 125. In constructing this table, the following assumptions have been made:

* The Burrs' current personal, nonretirement savings amount to 90,000.

* The Burrs will retire in 20 years, when Mrs. Burr reaches age 65.

* Both qualified and personal savings will grow at 8% annually, a reasonable return for low risk investments.

* The annual rate of inflation will be 5%.

All calculations presented here were performed on a standard financial function calculator (such as a Hewlett Packard 12C) that has the following five functions:

* PV = Present value

* i = Interest rate

* n = Number of years

* FV= Future (compound) value

* PMT = Payment (annuity)

The Burrs'annual income shortfall is $25,100 in today's dollars. Assuming inflation of 5%, the Burrs will need an inflation-adjusted income of $66,598, computed as follows PV = 25, 100 i=5 n = 20 FV = 66,598

Assuming Betty Burr is 45, wishes to retire in 20 years and has a life expectancy of age 85, the next step is to determine how much capital is needed at retirement to fund a retirement income gap of $66,598 a year at the end of each year for 20 years. This is a two-step process: Step 1: Calculate the inflation-adjusted rate of return factor:

(1 + 0800 (investment rate)/

1 + .0500 (inflation rate) Step 2: Calculate the lump sum requirement: PMT = 66,598 i = 2.857143 n=20 PV = 1,004,024 This means the Burrs will need $1,004,024 in capital at retirement to meet their ongoing income needs.

The next step is to estimate the amount of personal savings the Burrs would have to have today to accumulate $1,004,024 at retirement. Assume these savings grow at an annual aftertax rate of 8%. The value of the savings needed in today's dollars would be $215,412. FV = 1,004,024 i=8 n=20 PV = 215,412

At retirement, the Burrs need total personal savings of $1,004,024. To 1 x 100 = 2.857143 accumulate this amount, they would need to have $215,412 today. This means they have a savings shortfall of $125,412 ($215,412 - $90,000). This shortfall can be met if the Burrs save at an annual rate of $12,773 for 20 years and realize an 8% rate of return on investments. PV = 125,412 i=8 n=20 PMT = 12,773

It's important for the Burrs to understand that the additional annual savings of $12,773 required to meet their retirement goal can quickly change as key variables (for example, interest rates or inflation) change. Despite this problem, this analysis does provide them with a basis for developing an effective retirement plan. PLANNING OPTIONS Given the basic assumptions made in this example, the Burrs have four options:

* They can retire on time if they manage to save an additional $12,773 per year. In addition, the rate of return on their investments must be 8% annually.

* Even if the Burrs cannot save the additional funds required, they still can meet their retirement goal if they succeed in having their savings grow at a faster rate. However, this often means taking more risks to achieve this higher return.

* The Burrs can lower their retirement income goal.

* Betty Burr can extend her desired retirement age by continuing to work beyond 65.

A potential shortfall in clients' retirement budgets requires the development of specific strategies to solve the problem. These strategies can be divided into four categories.

Tax-advantaged investment planning. This strategy requires that the clients consider the possibility of making the maximum contribution to qualified retirement plans, an IRA and/or Keogh if that is not currently being done.

Savings planning. Increasing the amount of annual savings may entail a thorough examination, and eventual reduction, of current monthly expenses. A more austere budget may force the family to choose between nonessential current expenditures and a better standard of living at retirement.

Asset repositioning. A review of existing investments may convince clients to shift their current portfolio into more aggressive investment vehicles if there are strong feelings about reaching the desired level of retirement income.

Of course, if these planning strategies do not produce the desired results, clients would be forced to lower desired retirement income or postpone retirement age, neither of which might be attractive. POTENTIAL SURPLUS Not every retirement plan has an income shortfall. Assume the Burrs anticipate annual retirement expenses of $85,100 but at retirement expect to receive an annual income of $90,000 instead of $60,000. In that case they would have a surplus in their retirement budget, and no further action will be necessary on their part, except periodically monitoring their plan over the next 20 years to make sure that surplus is not eroded by inflation, poor investment performance or similar circumstances. SOPHISTICATED PLANNING Working closely with clients to develop retirement goals that meet their personal circumstances results in a plan that is both sophisticated and comprehensive. And, because of the plan's logical format, the planner can make it more or less complicated, depending upon the degree of sophistication of the clients. n