While the need for retirement planning is obvious, few people do it. A
study by Merrill Lynch and gerontologist, Dr Ken Dychtwald finds 42% of baby
boomers do not know how much money they will need to be able to live
comfortably in retirement.
While the need seems ubiquitous, it is also fairly recent. Individual
retirement planning was unnecessary in a world where the replacement rate was
100%. Thirty years ago, retirement income was fully funded by employer pension
plans and Social Security.
Not only is it necessary, it is hard. The reason it is hard is it is
based on assumption - not just one assumption, either - a bunch of assumptions.
The problem, of course, is that none of us has a crystal ball, what happened in
the past is not predictive of what will happen in the future, and if we are
wrong in our assumptions the results can be catastrophic.
A March 27, 2006 article in the Wall Street Journal (subscription
required) outlines seven factors that will determine the validity of your
planning. They are: inflation, taxes, spending, health care, longevity, assets
and investment return.
INFLATION
The rate of increase in the cost of living is a vital factor
to consider when planning your retirement readiness. Deciding what rate to
assume, however, can be tough.
The most commonly used number for financial planning purposes
is 3%, but that's just an estimate based on historical norms. Actual rates of
inflation can vary widely. In recent years, a 3% rate of inflation has made
sense. In the '70s and '80s, however, inflation soared to double-digit levels,
hitting nearly 14% in 1980.
While you can't predict how the economy will affect costs
during your retirement, you can try to make your estimate more accurate by
tailoring it as closely as possible to your specific needs.
Inflation rates are really just a compilation of costs
derived from the consumer price index, or CPI, which is based on a basket of
goods and services bought by typical urban consumers. Some of the costs in that
basket will have a greater impact on you than others.
One way to get an idea of how inflation might affect you is
through a Web page of the Bureau of Labor Statistics. The site, at http://data.bls.gov/PDQ/outside.jsp?survey=cu,
lets you see how specific costs have risen over time. The site can be hard to
use, however. To get your inflation rate, first select the goods and services
that interest you. Then, under "more formatting options," you want to
click "12 month percentage change."
If you need help with the site, contact the Bureau of Labor
Statistics office of public affairs at 202-691-5902.
Where you live will also have an impact on your personal
inflation rate. The Bureau of Labor Statistics Web site allows you to adjust
for location, but it doesn't have comprehensive information for all the
locations listed.
To get a better sense for how location can affect your costs,
play with the cost of living calculator at www.inflationdata.com. It will show how
much you need to maintain your lifestyle in different cities across the
country.
Also consider whether some of your retirement income will
come with inflation protection. Social Security benefits, for example, have
built in cost-of-living increases. Some employer-sponsored pension plans come
with cost of living increases, but that's increasingly rare.
Fixed-income investments may appeal to conservative
individuals, but they run the risk of failing to keep up with inflation. In
recent years, most short-term fixed-income investments have lagged behind the
general increase in costs. One alternative is bonds that protect against rising
inflation, Treasury Inflation-Protected Securities, or TIPS.
Stocks are generally assumed to be the best investment for
fighting inflation because they do a better job than bonds of keeping up with
the rising cost of goods and services. Just be sure to factor inflation into
your return assumptions so you don't overestimate how much you will earn on
your stock investments.
"If you're expecting a 7% rate of return on an
investment today and inflation is 4%, your real return is just 3%," says
William Arnone, a retirement expert with the consulting and accounting firm of
Ernst & Young in New York.
TAXES
Taxes, too, automatically reduce income. Imagine you are
expecting $50,000 in pension income if you retire at age 65. If your combined
state and federal taxes lop 20% off your income, you'll have $10,000 a year
less to live on.
Yet some retirement-planning calculators don't even consider
the impact of taxes, or they don't allow you to adjust for the fact that taxes
will differ depending on what your investments are and where you plan to live
during your retirement. When using these calculators, you want to add the cost
of taxes to your spending or income needs.
As you make your calculation, assume for now that you should
be able to pay 15% long-term capital gains rates on your taxable stock
investments, but you will pay federal ordinary-income taxes on withdrawals from
pensions and traditional 401(k) and IRA accounts.
Roth 401(k)s and Roth IRAs are free of taxes on withdrawals.
Social Security, meanwhile, is taxed only at certain income levels. You may be
subject to a tax on between 50% and 85% of your Social Security benefit if your
income (as defined by the Social Security Administration) exceeds a certain
level.
For more information, you can go to the Social Security
Administration's Web site, www.ssa.gov.
Each state, on the other hand, takes a different approach to
taxing retirement income. Currently, nine states -- including Alaska, Florida,
Nevada, South Dakota and Texas -- have no personal income tax for anyone. As
such, they can be great for retirees who want to reduce their costs.
Other states offer reduced income taxes on retirement income.
In Illinois, for example, income from qualified retirement plans and IRAs isn't
taxed, according to John Logan, senior state-tax analyst with tax-information
provider CCH Inc., Riverwoods, Ill. In Hawaii, income from employer
contributions to pensions and profit-sharing plans is tax-free. In New York,
taxpayers over age 59½ can exempt $20,000 of their pension income from taxes
annually. And some states, like California and Maryland, exclude all Social
Security benefits from state income taxes, says Mr. Logan.
Once you get a good sense of your tax picture in retirement,
try toying with how it might change if you move to another state. You might
find that a move to Florida, for example, could allow you to retire sooner than
you anticipated.
Just be careful about retaining two residences in retirement.
If both states can claim you as a resident, your retirement income might still
be subject to state income taxes.
SPENDING
To estimate your spending in retirement, it's best to get a
handle on what you're spending now. This means creating a budget. It can be
easily done with expense-tracking software like Intuit Inc.'s Quicken or
Microsoft Corp.'s Money.
A free tool for tabulating retirement expenses, taking taxes
into account, can be found at www.financialcalculators.com,
owned by Financial Calculators Inc. in Riverton, Utah.
Your spending will change once you reach retirement, so you
need to adjust accordingly. Work-related expenses, such as dry cleaning,
transportation, lunches and work clothes, will decline or disappear. Certain
fixed expenses, like the mortgage, life-insurance premiums and contributions to
retirement savings accounts, might also disappear. Other expenses could
increase, such as travel costs and medical care.
Consider costs that are unique to you. Might you need to care
for an elderly parent during your retirement, or contribute to a child's
college tuition? Some people may want a bigger home in their retirement, or a
new car. Tailoring the computation to your specific spending needs is an
important part of the planning process.
According to a new study using data from the Bureau of Labor
Statistics, many people may overestimate the amount of money they will spend in
retirement. The study found that retirees' total spending, after an initial
drop from pre-retirement levels, doesn't rise with inflation -- it generally
remains steady. That's because even though inflation pushes prices higher, the
elderly tend to consume less as they age.
The study's author, Ty Bernicke, of Bernicke & Associates
in Eau Claire, Wis., found that health-care spending increased, but this rise
was offset by a decline in other spending. It's a trend that spans all income
brackets, not just retirees who need to count their pennies, says Mr. Bernicke.
The prospect of a spending level that remains constant is at
odds with the scenarios depicted by many financial planners, who tend to assume
that spending increases with inflation from the first year of retirement on.
HEALTH CARE
In Mr. Bernicke's research, the cost of health care was the
wild card. Two individuals' experiences and health can be wildly different, and
with health-care costs rising faster than the rate of inflation, it's important
to consider how potentially high medical costs might affect your retirement
plan.
First, there's the cost of insurance. If you retire before
age 65, you'll need health insurance until you're eligible for Medicare. Once
you're eligible for Medicare, at 65, you'll also need insurance to cover the
gaps in coverage, known as Medigap insurance. It can be expensive, even for
people who have employer-sponsored retiree health care, because of the fast
deterioration of these plans.
When Ed Beltram of Woodland Park, Colo., took early
retirement from Lucent Technologies Inc. in 2001 at the age of 56, he was
paying premiums of $42 a month for dental and medical care for both himself and
his wife.
Just five years later, those monthly premiums have jumped to
$690, not including dental coverage. The reason: Mr. Beltram's employer --
which promised a cap on employee contributions when he retired -- stopped
covering dependents in 2004.
"We really had a curveball thrown to us," says Mr.
Beltram, who is the spokesman for the Lucent Retirees Organization, an
organization created in 2003 by the company's retirees.
Lucent's director of corporate media relations, Mary Ward,
responds that the soaring cost of health care "is something everyone in
this country has had to deal with. The fact is, Lucent simply could not afford
to continue covering virtually the entire cost of health care for 114,000
retirees and their dependents and remain competitive."
Despite the cuts, Ms. Ward says, Lucent still provides better
benefits to its retirees than most U.S. companies.
Indeed, few retirees in the U.S. even have access to an
employer-sponsored health plan. In 2002, 13% of private-sector employers
offered health benefits to retirees who were eligible for Medicare -- down from
20% in 1997, according to the Employee Benefit Research Institute, a
Washington, D.C., nonprofit. For early retirees, 13% offered benefits in 2002,
down from 22% five years earlier.
Long-term nursing care can be another wild card. The national
average cost of a private room in a nursing home was $70,080 a year in 2004, or
$192 a day, according to data from New York insurer MetLife Inc. The most
expensive state was Alaska, where nursing care averaged $204,765 a year.
Meanwhile, the national average stay in a nursing home for current residents
was 2.4 years, making the average cost $168,192.
It's an easy cost to overlook, since not all retirees will
need nursing care in old age. But the financial implications of disregarding
this risk can be devastating.
One solution is long-term care insurance, which is especially
appealing to middle-income retirees. Those wealthy enough to pay for their own
health care can generally bypass this insurance, as can low-income retirees,
who qualify for Medicaid coverage of long-term care costs.
LONGEVITY
How long you expect to live is another important factor.
Payments from Social Security and defined-benefit pension plans should last as
long as you do, but your 401(k) and other personal savings will need to be
doled out carefully.
Say you're a 65-year-old woman who's about to retire. At that
age, you can expect to live roughly 20 more years on average. But if you start
tapping your nest egg at a rate that will deplete it in 20 years, you may be
underestimating how long you'll need income. You could easily live years beyond
the average, without any assets of your own to provide income in the later
years.
So, what life expectancy should you use as you begin to draw
on your savings? Stuart Ritter, a certified financial planner with T. Rowe
Price Group Inc., Baltimore, recommends that people always plan to live until
at least age 95. The reason: Of four 65-year-old couples, one person will live
to age 95, he says.
Indeed, 41% of women age 65 will live to 90, 19% will make it
to age 95, and 5% will celebrate their centennial, according to Ron
Gebhardtsbauer, a senior pension fellow with the American Academy of Actuaries,
a professional organization in Washington, D.C. Twenty-eight percent of
65-year-old men will make it to age 90, 11% to age 95 and 2% to 100, says Mr.
Gebhardtsbauer, who based the data on a pool of pensioners.
You can also assess your personal life expectancy with online
calculators based on factors such as diet, exercise, family health history and
personal support network. Some good calculators that can be found on the Web
include the BBC's http://bbc.co.uk/health/interactive_area/calculators_lifeexpectancy1.shtml,
and MSN Money's http://moneycentral.msn.com/investor/calcs/n_expect/main.asp.
Another neat one is provided by some professors from the
Wharton School of the University of Pennsylvania, at http://gosset.wharton.upenn.edu/mortality/perl/CalcForm.html.
One simple way to protect against spending your money too
fast is to assume a 4% annual withdrawal rate, according to research by T. Rowe
Price.
ASSETS and INVESTING
Know what assets will be available to you.
While Social Security, for example, is expected to remain
largely unchanged for people currently nearing retirement age, concerns about
the program's long-term solvency may make it a good idea for younger people to
consider what their retirement would look like without this benefit, or with a
scaled-back payment.
Also, if you have an employer-sponsored pension, plan on
receiving only what you have earned thus far -- not what you might expect based
on your age and wages when you retire, says Alicia Munnell, director of Boston
College's Center for Retirement Research. Employers are increasingly freezing
pension plans, essentially stopping workers from receiving additional benefits.
You also shouldn't count on your primary residence as a
retirement asset, says Ms. Munnell. If you sell your home to raise money for
retirement, you still have to buy a new home or pay rent, she says.
Other experts warn that you should be very careful about
rate-of-return projections when assessing returns on your personal savings.
While average stock market returns can be 10% or more a year, those averages
are based on a much longer time frame than you will have in retirement.
For a shorter time frame, you should be more conservative,
says Ron DeStefano, a consulting actuary with Aon Consulting, an arm of Aon
Corp., which is based in Baltimore. Mr. DeStefano often suggests that retirees
assume an annual pretax rate of 6% on their investments.
"With equity these days, you're not sure what's going to
happen," Mr. DeStefano says
There are several statements in this article that I strongly disagree
with (surprise, surprise). For instance, there are many studies that suggest
spending initially goes up in retirement and doesn't begin to decline below
pre-retirement levels until the retiree gets much older. Even then, as noted in
the article, healthcare spending is still the wildcard.
Here are some other things I disagree with: the idea that stocks are a
good hedge against inflation is a myth. I'll have to write more on that some
time. Also, given traditional asset allocation models, a 4% maximum sustainable
rate of withdrawal may be over-optimistic. I've written a lot about that on
this blog. You can find the old posts if you are interested.
On balance, however, I think this article is a good starting point for
understanding the implications for all the different assumptions you must take
into consideration when doing retirement planning and a good resource for
various calculators on the web.
What do you think? Are your retirement assumptions this detailed? Do
they take all these factors into account? Did you read anything that makes you
rethink your planning? Do you agree with everything in the article? As always,
leave your thoughts and comments below.
PROPS:
Thanks to Snider Investment Method Workshop alumni Christa and Michael
Gamble for the heads up on the WSJ article.
SOURCE:
1. Kaja Whitehouse; "What if … ?" Wall Street Journal 27 March 2006; R6
http://online.wsj.com/article/SB114312865030906362.html
(subscription required)
Kim Snider, Kim Snider Financial Communications, Chronim Investments
and/or Snider Advisors make no representation that the information and opinions
expressed are accurate, complete or current. The opinions expressed should not
be construed as financial, legal, tax, or other advice and are provided for
informational purposes only. Call 866-952-0100 to request the Snider
Investment Method™ Owner's Manual, which includes a description of the
Snider Investment Met
