Chapter 11: Retirement issues.
Most workers have a dream--and that dream often involves not working anymore. Of course, they realize that not working comes at a cost. That check that magically appears in their bank account or mailbox every so often will suddenly stop.
Retirement planning, therefore, is essentially the process of making sure there will be enough assets accumulated that workers can afford to stop working at a given age and still live their desired lifestyle for the rest of their lives. The process should begin long before the anticipated retirement. Hopefully, you will never have a client come in and say, "I am retiring on Friday and I want to make sure that I have enough saved..."
At its core, retirement planning is nothing more than cash flow planning. Cash flow planning is making sure the money will be there when it is needed. Before retirement, decisions are made to spend or to save. Every dollar spent reduces the amount that will be available for retirement. After retirement, every dollar that is spent reduces the amount of time the nest egg will last. Of course, the goal of planning is not to stash the funds away, never to see the light of day again. It involves an understanding, or even an education, that decisions made now can have a dramatic impact on resources later.
Typically, retirement planning should begin at least 15 to 20 years before retirement. This will normally place the clients solidly in their most valuable years with the maximum potential for savings. Starting earlier is difficult beyond encouraging the contributions into the company retirement plan since you are dealing with workers who are seeing money for the first time, developing their personal lifestyle, and starting families.
Of course, by starting so far in advance of retirement, assumptions are going to be necessary. Anything planned will need to be reviewed and updated. Inflation, expected investment returns, salary, bonuses, job changes, college costs, etc. may all change during the years before retirement. Some of the factors that should be considered when making these assumptions are explained below, under "Sensitivity of Assumptions."
For more information on retirement planning, please consult Chapter 29 of this book, and our sister publication, The Tools and Techniques of Employee Benefit and Retirement Planning.
1. Retirees are living longer than ever. The average retiree can expect to live 20 to 25 years after retirement.
2. Fewer businesses are offering company-funded pensions. Therefore, most of the funds needed for retirement will need to come from the worker. This is putting a heavier emphasis on savings in advance of retirement--and most workers do not start the savings process until they are in their late-30's.
3. Despite the fact that Social Security benefits do not begin until age 62, at the earliest, most workers will have retired before they reach that age. However, with the recent economic uncertainties and fall in the stock markets, many retirees have headed back to the workforce.
4. The average savings rate in the U.S. is under 3% of disposable personal income.
HOW DOES THE RETIREMENT PLANNING PROCESS WORK?
Step 1: Evaluate the current situation--The planner needs to obtain accurate information about the client's current assets and liabilities, cash flow needs, and major expenditures or inflows expected in the future.
Be sure to understand everything about the client's employment benefits. What retirement plans exist? Are they permitted to contribute the maximum allowed under the law? Does the company match any contributions? Are there any benefits available for retirees? See Chapter 29 regarding how to obtain this information with respect to employer-funded plans.
Step 2: Determine retirement needs--It is impossible to predict what a client's spending level is going to be at retirement. The best approach for planning purposes is to ask the client, if they were to retire now, would their spending go up, down or stay the same. From there, you can apply an appropriate estimate of inflation to arrive at the projected retirement lifestyle. Figure 11.1 (found at the end of this chapter) can be used to accumulate client information and estimate the retirement need.
Example: A client needs $60,000 annually (in current dollars) in order to retire. If the client is 10 years from retirement, that need will grow to $88,814 assuming a 4% inflation rate. If inflation continues at 4%, and the client is able to earn an investment return of 7% (after-tax), the client will need $1,374,059 at his retirement date.
If the client has absolutely nothing saved when you are brought into the picture, he would need to save nearly $7,900 per month assuming he can achieve that same 7% return. Hopefully, that situation will not come up too often!
Step 3: Getting to retirement--The capital requirements needed for retirement will often seem daunting, if not downright unattainable. This is where the planner's strategy is developed and implemented.
It is hoped that the client will have hired you well in advance of retirement. This will allow for the periodic review of goals, needs, and resources to determine if the plan is still on track. Keep in mind that the overall plan should be reviewed whenever there is a life-changing event or major change in the tax law.
SENSITIVITY OF ASSUMPTIONS
As mentioned previously, financial planning is based in large part on assumptions that will be made about the future. Spending, inflation, and expected investment returns are only some of the factors that planners need to address when constructing a financial plan for a client.
How good are your assumptions? Time will tell, of course. Understanding how small changes in your assumptions affect long-range planning is an important aspect in explaining a plan to a client.
Let's consider inflation for a minute. A popular theme is that advances in technology are making things more affordable. But this isn't always the case. While it is true that a DVD player that was over $300 only a couple of years ago can be purchased for under $100 now, there is always a newer breed of technology that is commanding consumers' dollars. Look at the cost of televisions. You can spend as much or as little as you like. Technology has advanced to such a point that the older versions are being replaced by more expensive, powerful, and fancy models. Does that mean that your client needs to spend more? Not necessarily--but the lure of buying the bigger, better TV, for example is difficult to overcome. So, while advances in technology may bring down current prices of current models, those current models may become more difficult to find, own, and service as newer, more expensive models are continually being introduced to the public.
For retirees, inflation often doesn't have the same impact as it did when they were working. Most of their costs are more fixed, with the obvious exception of health insurance. The items that retirees tend to buy are not as impacted by inflation. Also, retirees tend to live further away from the big cities with the more inflated prices.
For example, Jack, a 65-year-old new retiree walks into your office with $2,000,000 of assets to support his retirement. He wants to know whether his assets will last for 20 years if he earns 6% after taxes. You look at him squarely in his eyes and say--"It depends..."
If you assume that inflation over the next 20 years will rise at 3% annually, Jack could spend $129,300 and have his money last. Jack breathes a sigh of relief and says--"That's good, I only spend $125,000 per year." However, if inflation rises to 5% per year, his annual lifestyle can be only $106,900 or else he will run out of money well in advance of his 20-year goal.
When dealing with expected returns on investments, most planners use a flat average annual rate of return. While this can work for simplicity's sake, do not overestimate this number--volatility, which is not considered in an assumed investment return, has a dramatic impact on the actual average rate of return.
Although the public has been educated by the media that volatility kills investment returns, it is rarely shown numerically. Consider the following. A planner uses a 10% average return in a client's financial plan. In five years, $100 grows to $161.05. Instead of assuming a flat 10% year-over-year return, what if the portfolio earned 20% in each of the first three years, then 5% in the fourth, but loses 15% in the fifth year. The "average" of those returns is still 10%, but the $100 only grows to $154.22. Figure 11.2 shows other 10% average returns and the impact on the portfolio after 5 years. Obviously, if you extend the time period further, the impact is that much more dramatic.
The sensitivity of assumptions is clearly something that should be discussed with clients in order to allow for as complete an understanding of their financial plan as possible. Be conservative with your assumptions--that way, if things turn out better, you have other opportunities to plan in the future with more resources at your client's disposal. If you are too aggressive, the client may end up without the resources he expected and you will be unlikely to get a second chance to plan for your client's future.
THE NEAR-TERM OR TROUBLED RETIREMENT
As retirement approaches, many clients will have a sense or know that they do not have the funds to achieve their goals. This is where the tough decisions often need to be recommended to the clients.
Housing--Should the client consider downsizing his or her home in order to lower housing costs (real estate taxes, mortgage, utilities, etc.)?
Health care--What provisions have been made or can be made for health care during retirement? Does the client understand exactly what and how much is not covered by Medicare? How much does supplemental health insurance (Medigap) coverage cost? Have the clients made provisions for long-term care?
Pensions and Social Security--What options are available for pension payouts? Should Social Security benefits be started before "normal" retirement age?
Many workers under age 40 are not even counting on Social Security existing in its current form when they become eligible to collect. For many, the benefits received do not even begin to put a dent in their overall retirement need. However, for too large a percentage of the population, Social Security is the only method of forced savings they have--and, ultimately count on that check arriving each and every month.
Keep in mind that the younger you are, the older you need to be to collect your full Social Security benefit. For those who were born after 1938, normal retirement age is greater than age 65. If you were born after 1959, normal retirement age is age 67 (see Chapter 29 for details).
Figure 11.1 RETIREMENT PLANNING ASSET WORKSHEET Date________________________________________ Client's Name:______________________________ Address: ___________________________________ Telephone: (home)____________(office)_______ Business Address____________________________ Spouse's name:______________________________ Business Address:____________Telephone______ RETIREMENT PLANNING ASSET WORKSHEET ASSETS Valuation as of date prepared unless otherwise indicated. 1. Cash and cash equivalents Current Return Value (pretax) a. checking accounts _____ _____ b. savings accounts _____ _____ c. money market accounts _____ _____ d. life insurance cash values Total Cash/Cash Equivalents _____ _____ 2. Retirement Plans (Do not include defined benefit plans) Current Current Balance Return (pretax) a. IRA _____ _____ b. Keogh _____ _____ c. Section 401(k) _____ _____ d. Section 403(b) _____ _____ e. Other defined _____ _____ contribution Total Retirement Plans _____ _____ 3. Investments (Do not include amounts included in 2 above) Fair Market Adjusted Current Return Value Basis (pretax) a. Portfolio Investments (1) money market instruments certificate of deposit _____ _____ _____ T bills _____ _____ _____ commercial paper _____ _____ _____ (2) fixed-income securities U.S. government _____ _____ _____ U.S. agencies _____ _____ _____ municipal bonds _____ _____ _____ preferred stock _____ _____ _____ corporate _____ _____ _____ notes receivable _____ _____ _____ (3) common stocks listed _____ _____ _____ OTC _____ _____ _____ restricted stock _____ _____ _____ (4) other portfolio investments options _____ _____ _____ mutual funds _____ _____ _____ physical assets _____ _____ _____ (collectibles) b. Passive Investments (1) direct participation _____ _____ _____ investments (2) real estate (passive) _____ _____ _____ c. Active Businesses (1) value of business _____ _____ _____ owned and operated (2) real estate _____ _____ _____ (active participation) Total Investments 4. Personal Assets Fair Adjusted Market Value Basis a. primary residence _____ _____ b. other real estate _____ _____ c. household contents _____ _____ d. automobiles _____ _____ e. other _____ _____ Total Personal Assets LIABILITIES 1. Short-Term Liabilitie (12 months or less) Balance Interest Monthly Matu- Outs- Rate Payment rity tanding Date Consumer credit (credit _____ _____ _____ _____ card & open charge accounts Personal notes payable _____ Loans from life insurance _____ _____ _____ _____ policies Notes guaranteed _____ _____ _____ _____ Other _____ _____ _____ _____ Total _____ _____ _____ _____ 2. Long-Term Liabilities Mortgages on personal _____ _____ _____ _____ residences Loans against investment _____ _____ _____ _____ assets Loans against personal _____ _____ _____ _____ residences Total _____ _____ _____ _____ 3. Other Deferred taxes _____ _____ _____ _____ Alimony, child support, etc. _____ _____ _____ _____ Judgements, etc. _____ _____ _____ _____ _____ Total SUMMARY Assets (fair market value) Total cash and cash ___________ equivalents Total retirement plans ___________ Total investments ___________ Total personal assets ___________ Total Assets ___________ Assets (outstanding balances) Short-term Long-term Other Total Liabilities RETIREMENT NEEDS WORKSHEET Estimated Retirement Living Expenses and Required Capital (in current dollars) Per Month Per Year x 12 = 1. Food _________ _________ 2. Housing: a. Rent/mortgage payment _________ _________ b. Insurance _________ _________ c. Property taxes _________ _________ (if not included in a.) d. Utilities _________ _________ e. Maintenance (if you own) _________ _________ f. Management fee _________ _________ (if a condominium) 3. Clothing and Personal Care: a. Wife b. Husband c. Dependents 4. Medical Expenses: a. Doctor _________ _________ b. Dentist _________ _________ c. Medicines _________ _________ d. Medical insurance to _________ _________ supplement Medicare 5. Transportation: a. Car payments _________ _________ b. Gas _________ _________ c. Insurance _________ _________ d. License _________ _________ e. Car maintenance _________ _________ (tires and repairs) f. Other transportation _________ _________ 6. Recurring Expenses: a. Entertainment _________ _________ b. Travel _________ _________ c. Hobbies _________ _________ d. Club fees and dues _________ _________ e. Other _________ _________ 7. Insurance _________ _________ 8. Gifts and Contributions _________ _________ 9. Income Taxes (if any) _________ _________ 10. Total Annual Expenses _________ $________ (current dollars) retirement needs worksheet 11. Inflation Rate until _________ Retirement (I) 12. Total Years until _________ Retirement (N) 13. Inflation Adjustment Factor X________ [(1 + I).sup.N] 14. Total Annual Expenses =_________ (future dollars) 15. Inflation Rate _________ Postretirement (i) 16. Aftertax Rate of Return _________ (r) 17. Anticipated Duration of _________ Retirement (n) 18. Inflation-Adjusted _________ Discount Factor A = 1+ i/1+ a 19. Capital Required at _________ Retirement to Fund Retirement Living Expenses Amt line 14 x 1- [a.sup.n]/ 1+ a 20. One-Time Expenses +$_______ 21. Total Capital Need at Retirement ________=$ Source: Robert J. Doyle, Jr., Retirement Planning Handbook, The American College, Bryn Mawr, PA. Figure 11.2 Rate Index Rate Index Rate Index Rate Index 100.00 100.00 100.00 100.00 10% 110.00 20% 120.00 20% 120.00 -30% 70.00 10% 121.00 -20% 96.00 20% 144.00 -30% 49.00 10% 133.10 10% 105.60 20% 172.80 50% 73.50 10% 146.41 -5% 100.32 5% 181.44 50% 110.25 10% 161.05 45% 145.46 -15% 154.22 10% 121.28
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|Title Annotation:||FINANCIAL PLANNING|
|Publication:||Tools & Techniques of Financial Planning, 9th ed.|
|Date:||Jan 1, 2009|
|Previous Article:||Chapter 10: Education funding.|
|Next Article:||Chapter 12: Special circumstances.|