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Chapter 2: planning for retirement needs.

Retirement planning is a critical part of the financial services industry. With the baby boomers ranging from middle age to early retirement age, the number of individuals with significant savings and retirement planning needs is increasing dramatically. At the same time, the economic and tax complexity of all types of retirement-related financial planning has also increased.

Retirement planning is "interdisciplinary." It combines the skills of the traditional estate planner, the financial planner, and the benefit/compensation planner. The broad range of issues that must be addressed makes this one of the most challenging of the financial services disciplines.

Retirement planning is also multifaceted because of the broad range of clients that must be served. For example it encompasses advice to clients many years in advance of retirement, as well as to clients just at retirement and thereafter. Clients may also range from business owners who are able to use their businesses to help provide retirement benefits, to key executives who can bargain effectively with their employers regarding retirement benefits, to employees who have no significant say in their employee benefit package. All these different types of clients may have needs for retirement planning as well as sufficient assets to require the services of a planner.

Perhaps no single advisor should attempt to handle all aspects of retirement planning alone. Any person giving advice in these situations should know when it is appropriate to call in an employee benefits expert, a lawyer specializing in estate planning, an expert portfolio manager, or whatever other specialist is required. However, all financial planners should understand the basics of retirement planning-the broad general approaches, the tools and techniques-and where they fit in.

Retirement planning is fundamentally composed of three basic steps: (1) assessing the financial needs the client will have at retirement, (2) determining how much of this need will likely be met, based on current assets and income, and (3) establishing a plan for any projected shortfall in cash flow. But before any of these steps can be undertaken, the planner must determine what the client's current assets and income sources are, and evaluate the impact that major financial goals may have on these assets.


A worthwhile retirement plan cannot be provided unless the planner has detailed and precise financial information about the client's existing assets and income sources. In fact, "due diligence" in retirement planning requires the planner to make every effort to obtain accurate and complete financial information. The planner should be wary of clients who are reluctant to provide such information. (See Appendix I, Malpractice.)

Retirement planning practitioners should develop a "fact finder" for clients that will systematize this process. A sample fact finder, titled Retirement Planning Asset Worksheet (see Figure 2.1) is included at the end of this chapter. Some key elements:

A. Benefit plan information. Retirement planning requires complete information about all employee benefit plans in which the client and the client's spouse are currently participating or have ever participated. Not only retirement plans (qualified or nonqualified) but other benefit plans such as health insurance, life insurance, or even such fringe benefits as membership in company athletic or health clubs after retirement may be significant in the retirement planning process.

In addition to private employer benefit plans, government benefits also should be estimated-Social Security, veterans' benefits, and the like.

In order to accurately forecast the level of employee benefits available, the planner needs to see actual benefit plan documents; it is not enough to rely simply on the client's informal impression of what his benefit programs provide. Generally, if a plan provides a Summary Plan Description (SPD), as do most ERISA-affected plans (see Chapter 12), the SPD should be sufficient. For qualified plans, employers are required to provide an individual benefit statement at least once annually. In some cases, the planner might wish to look at the actual underlying plan documents, which the client has the right to request under ERISA. (Companies can charge a reasonable copying fee for providing copies.)

For non-ERISA plans, there often are no formal documentation requirements, so it may be difficult to obtain adequate written information about such benefits. However, most companies provide a "benefits manual" or other literature covering these benefits.

In general, when examining benefit plans, focus on:

* What vested benefits at retirement does the plan now provide-that is, even if the employee terminated employment today?

* What will the plan provide at retirement, if the employee continues working? If the benefits are based on salary, what is a reasonable salary forecast?

* How solid are predictions of future benefits? For example, health benefit plans are currently in constant flux. Can a planner have any confidence that if health benefit plans are even available at retirement 15 years from now, they will have any resemblance to current benefits? The employer's financial stability also has a bearing on this issue.

* To what extent can the employee control the employee benefits available at retirement? Do employer plans have options available to the employee to change or increase benefits, possibly on a contributory basis? (See the chapters on FSAs (Chapter 40) and Cafeteria Plans (Chapter 39), for example.) Can the employee individually negotiate better or different benefits? At the extreme, an owner or majority shareholder can-and generally should-arrange the company's benefit plans to be consistent with his own individual retirement planning.

B. Current asset information. The planner must have detailed information about the client's current assets and sources of income. Completeness is a must--it is not optional. The fact-finder worksheet at Figure 2.1 includes categories for cash and cash equivalents, investments (detailed by type), and personal assets, including real estate.

Assets must be valued-book value is of little use in developing a financial or retirement plan. Some assets are easy to value; others may be impossible to value with certainty. Asset valuation is discussed in The Tools and Techniques of Estate Planning.

Owners of closely held businesses are in a special category. It is difficult to value an interest in a small business, of course. But retirement planning requires more than this. The important factor about a small business interest is not what it is worth now, but what will happen to it in the future-including the extent to which it will continue as a source of income in retirement. In other words, retirement planning for closely held business owners is inextricable from planning for business succession through buy-sell agreements, gifts or sales to successors, or whatever mechanism is set up for continuation of the business or retrieving its value for the owner's benefit. For additional information on business succession planning, see Appendix B.

In obtaining asset information, do not overlook liability information. This includes not only traditional debts outstanding, but also legal obligations such as future alimony or child support that involves a recurring obligation, property settlement payments that are outstanding, state or federal tax liabilities outstanding, or fines or judgments not yet fully paid. Many of these are things that clients understandably would rather not think about and they may not be volunteered.

C. Nonretirement goals and objectives. As with estate and financial planning, retirement planning requires the development of a complete profile of the client's financial status, including goals, plans and other anticipated events that may have a significant impact on his retirement assets, such as:

* College or graduate school expenses

* Long term care for a parent or disabled dependent

* A future windfall, such as an inheritance

* A desire to fund a charitable trust or foundation

These contingencies can be very difficult to value and, unfortunately, they can render a financial or retirement plan nearly worthless if they are ignored. The planner must deal with these issues as well as possible, but must also be willing to "caveat" the ultimate retirement plan-that is, state clearly that the plan does not take into account certain contingencies that potentially exist but are impossible to predict.


Serious retirement planning must begin well in advance of actual retirement. Although a client far from retirement cannot foresee what his or her life will actually be like after retirement, one way of developing an approximation of retirement needs-at least a good starting point-is to make an estimate of what it costs now for a standard of living that the client considers acceptable. By adjusting these amounts for inflation, a reasonable estimate of the total capital needs-the lump sum amount needed at retirement-can be made.

Steps in Calculating Retirement Funding While detailed planning is appropriate, planners and clients should not expect exactness in all financial planning targets. There are numerous imponderables-future investment return rates, future tax rates, the client's life expectancy, all of which demand reasonable assumptions.

There is no perfect method for calculating retirement needs, shortfalls, and savings requirements. It is unlikely that a process requiring twice as much data, or involving twice as many steps, will be twice as accurate. Even if it is conceded that securing more data will result in greater accuracy, this must be balanced against the likelihood that fewer clients will "sit still" for the process. Current savings requirements should be based upon realistic retirement objectives using a process understood by the client that produces results accepted by the client.

The 7-step planner that follows is adapted from Field Guide to Financial Planning, by Donald F. Cady, J.D., LL.M., CLU (National Underwriter, 2007), which includes worksheets and additional information. The 7-step process attempts to achieve both accuracy and usability while striking a balance between detail and simplicity. Income requirements, sources of income, and required savings are all reduced to monthly amounts (most individuals more easily relate to monthly cash flow). Where simplicity produces less than total mathematical accuracy, the process defaults to the more conservative result. Two approaches to determining income requirements are offered, the replacement ratio method and the expense method.

It is important to remember that these retirement needs calculations are not an end in themselves, but rather a means of moving a client to action, whether that action is allocating more income to savings, becoming more or less aggressive with respect to investment decisions, or planning for a delayed retirement and scaled down lifestyle.

Seven Step Planner

The following steps are designed to determine the required current monthly savings that will meet a future retirement income objective. The tables used for this analysis do not provide for preservation of capital, therefore they contain built-in conservative assumptions. Likewise, in establishing retirement objectives it is usually better to err on the conservative side, by assuming greater longevity, higher income needs, and lower rates of return, than to err on the liberal side. The calculations allow for considering the impact of both inflation and taxes.

Step 1--Assumptions & Factors To Be Used. In the first step, current age, retirement age, and assumed age of death are used to develop factors for years to retirement and years in retirement. The selection of an anticipated rate of inflation is critical, because it will determine the inflation factor, a fixed-income factor, and an assets-to-income factor. Assumed rates of return before and after retirement must be chosen to allow for selection of appropriate accumulation factors.

For additional information on choosing inflation and rate of return assumptions, see Tools & Techniques of Investment Planning.

When estimating income required at retirement one of two approaches can be taken:

a. Expense method. This is the "long-form" approach and is probably more accurate than the replacement ratio method (see below). It is best used when a person is close to retirement age. However, there is no guarantee the results will be any more or less accurate than the replacement ratio method, particularly when projecting retirement costs years into the future. An estimate must be made with regard to those expenses that will either increase or decrease in retirement. Increased expenses include medical expenses, health care insurance premiums, care of aging parents, and travel and entertainment expenses. Decreased expenses might include education costs, life insurance premiums, and clothing.

b. Replacement ratio method. This is the "short-form" approach. It is generally considered less accurate but is much easier to use with individuals not yet on the verge of retirement. Generally the target should be a 70% to 90% replacement ratio of the client's final average salary.

Step 2--Inflation Adjusted Income. In this step, income sources are listed (such as Social Security and post-retirement benefits that include an inflation adjustment) whose value today can be estimated and whose future increases are either keyed to or will likely keep up with inflation (both from today to retirement and after retirement). In step 6, these income sources will be subtracted from income needs that do not have inflation adjustments.

Step 3--Income From Current Assets. In this step, the value of current assets (and plans) are listed whose value today is either known or can be reasonably estimated, and whose future growth will equal the assumed rate of return before retirement. These include both tax deferred and currently taxed assets.

Step 4--Income From Future Savings. In contrast to the current assets reflected in step 3, the assets listed in this step are future amounts intended to be saved on a periodic basis. For example, the current value of a 401(k) plan account might be entered in step 3, but intended future salary deferral contributions would be entered in step 4. Note that the 7-step planner assumes the investor's current savings will be continued at the same amount until retirement; however, many investors save more as they approach retirement.

Step 5--Fixed Income & Amounts Payable At Retirement. In this step, assets or resources are listed that are not expected to be available until retirement but whose value, either income stream or lump sum amount, is known or can be estimated today.

Step 6--Retirement Cash Flow. This step brings the previous steps together to determine whether there is a retirement income shortfall. First, subtract the inflation-adjusted income (in step 2) from the income requirement at retirement (in today's dollars). If there is an income requirement, the results are multiplied by an inflation factor in order to determine the income need in retirement age dollars. From this amount subtract the income streams available from current assets (step 3), future savings (step 4), and fixed amounts payable at retirement (step 5). Any other potential sources of income should also be subtracted. The balance equals the retirement income shortfall, if any.

Step 7--Required Savings. If there is a retirement income shortfall, the additional capital required at retirement to meet this shortfall must be determined, based on annual and monthly savings. Since it may be unrealistic to expect many individuals to commit to a high-level savings program to meet retirement needs many years in the future, this amount should also be redetermined based on an assumption that savings are increased each year (otherwise, savings is assumed to be constant until retirement).

Although necessary for purposes of illustration, it is important to again recognize that rarely, if ever, do investors save at a constant rate over the years, nor do rates of return remain constant. Despite their best intentions, most investors tend to do the bulk of their retirement savings later in life, generally due to rising income and decreasing expenses.

Financial Needs at Retirement

As retirement approaches, the focus will gradually change from accumulation planning toward the need to preserve and make the right decisions about assets the client already has. Decisions that must be addressed at retirement include:

* Housing-What should be done with the client's primary residence? What are the client's long range plans for housing? If the client's residence has a considerable market value, it may be tying up a significant portion of his or her net worth. Yet it is important to note that while costs are a critical factor, housing is not entirely a financial decision. The psychological value of circumstances such as outright ownership, low-maintenance housing and geographical location may trump any financial advantages of one form of housing over another.

* Health care-What options are available under the client's employee health plans? (See Chapter 45.) What private insurance is necessary to supplement employee benefits and government benefits? What role will Medicare play in the client's plans? In many cases, the availability of health insurance (or lack thereof) may have a greater effect on the timing of an individual's retirement than the actual retirement income. For an explanation of Medicare and its role in the retirement planning process, see Chapter 4.

* Pensions and Social Security-Here there are often many possible choices and options; issues include:

1. How much current income does the client need?

2. Does the client want to maximize current income or provide for beneficiaries after his (or his and his spouse's) death?

3. What options are available under the client's benefit plans?

4. What are the tax consequences of different distribution options-federal income tax, and federal estate and gift taxes, as well as state taxes?

5. Does the client want to explore possibilities of moving money out of current qualified plans (through a rollover or other option) and investing it in another way-annuities, life insurance, or other investments?

Issues concerning distributions from qualified plans, tax deferred annuities, and IRAs are discussed in Chapter 8 in greater detail. See also Chapter 9 for retirement and estate planning issues. For a discussion of work after retirement and the extent to which it may result in a reduction of Social Security, see Chapter 3.

Figure 2.2 shows a Retirement Needs Worksheet that can be used in evaluating these issues. As an illustration of this worksheet, suppose that your client provides information for lines 1 through 9 that indicates he will need $60,000 annually (in current dollars). If the client is 10 years from retirement, assuming a 4 percent rate of inflation, this translates to a need for $88,814 (line 14) at retirement 10 years from now. Assuming continued 4% inflation, a 20-year payout after retirement, and after-tax investment return of 7%, this requires a total capital at retirement (line 21) of $1,374,059.

This worksheet converts everything to a capital equivalent. For example, if the client in the preceding paragraph expects to receive a monthly pension benefit at retirement, it should be converted to its then lump-sum equivalent. If the benefit is worth $300,000, for example, then the client's capital need is reduced to $1,074,059 ($1,374,059 less $300,000).

Capital needs at death. A final aspect of long-range planning that cannot be ignored is preparation for meeting the capital needs the client will have at death. This is a retirement planning issue for two reasons: (1) funding these needs is much more economical when the client begins at a younger age, and (2) in the event of premature death, all the foregoing issues (benefits for a spouse and children, college funding plans, care of a disabled child or spouse, etc.) become a "capital needs at death" issue.

Depending on the type of retirement plan the client participates in, a purchase of life insurance with plan dollars may be an option; see Chapter 13 for details. If the client is the owner of his or her own business, succession planning is a critical part of retirement planning, since the business may become a source of retirement dollars. See Appendix B for more information on succession planning issues. For estate planning issues involving retirement assets, which may necessitate the purchase of life insurance, see Chapter 9.

Retirement Funding Shortfalls

After the retirement planner has identified the client's current assets and expected future needs, the next critical contribution is the development of a plan for reaching the client's targeted capital needs. All the tools and techniques of financial planning for capital accumulation should be brought to bear on this problem.

Planning requires not only reaching the capital needs targets, but also making sure that the capital is translated appropriately into living expense needs. As noted above, a client's business or personal residence may have a considerable market value on paper, but how will that value contribute to living standards in retirement? Questions like this emphasize the need for planning for liquidity and diversification-here as in all investment planning, but particularly with a focus on retirement needs.

Alternatives for overcoming a retirement funding shortfall may range from a higher savings rate pre-retirement to a scaled back cost of living either pre-retirement, postretirement, or both. Some clients may choose to retire later or work part time after retirement. Business owners may choose to adopt a retirement plan that provides a more adequate or more secure retirement benefit.

In attempting to overcome the retirement income gap, some investors may be tempted to make high-risk investments in hopes of gaining higher returns. Another key role of the planner is to steer the investor clear of unnecessary or inappropriate risk. A complete discussion of risk appears in The Tools & Techniques of Investment Planning.


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Title Annotation:Overview
Publication:Tools & Techniques of Employee Benefit and Retirement Planning, 11th ed.
Date:Jan 1, 2009
Previous Article:Chapter 1: designing the right retirement plan.
Next Article:Chapter 3: Social Security.

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