9 Retirement Planning Topics That Need Clarification - Part I

Especially at the beginning of a new year, there seems to be a never-ending supply of articles offering advice about retirement planning. Some offer well thought out points, some offer generic assumptions, some offer half-truths, and some don't seem to have much to offer at all. The following topics need some clarity before taking them too seriously:

Plan On Replacing 75% Of Your Salary In Retirement.
Really? Many articles suggest that you should plan on replacing 70% - 80% of your gross salary in retirement, so I split the difference. In general terms, with a salary of $75,000 per year, you may pay 18% in Federal and State taxes ($13,500), and another 15% ($11,250) may be deducted pre-tax for items such as employer sponsored health care, 401k savings, health care spending accounts, or other elective deductions. This leaves a take-home amount of $50,250 per year. For the sake of round numbers, let's assume that $2,250 of that is earmarked for general, college, emergency, or other savings. This means that you are living on $48,000 per year. If your expenses stayed perfectly constant throughout retirement (they won't), you budgeted perfectly and spent your last penny on the day that you died (you won't), and you knew that you would die exactly 25 years after retiring (not likely), you would need $1.2M in savings to get through retirement. Almost. Actually, it would be closer to $1.35M because ~$135,000 would be needed to pay for taxes on annual withdrawals from Traditional 401k/IRA savings.

However, you are likely to be eligible for Social Security benefits. The average benefit is approximately $1,300 per month, and a non-working spouse (who is not eligible for their own benefit) is eligible for 50% of their spouse's benefit. This would provide a one earner household with income of $23,400/year ($1,950/month), or $19,450/year after taxes (yes, a portion of social security income may be taxed over certain income thresholds, and Traditional 401k/IRA withdrawals count as income). This means that you would need $24,600/year from savings to pay your expenses of $48,000 ($48,000 - $19,450), or a total of $713,750 over 25 years ($795,000 including taxes on savings withdrawals). That's ~53% less than the $1.35M stated above, and only 42.4% of your $75,000 salary.

This is a very simplistic example, with a lot more details that could be considered, but believing that you will need savings that will replace 75% of your salary in retirement is most likely misleading. It's not your salary that should be a driving factor for retirement saving, it's how much you intend/need to spend in retirement. This is why it is crucial to run your own numbers, and not follow generic advice or benchmarks.

Paying Off Your Mortgage Before Retirement Eliminates That Expense.
This is only partly true. Most people have their home insurance and real estate taxes included in their mortgage payment. If you have a $2,000 mortgage payment each month, and you pay off the balance owed, you will still need to pay for home insurance and real estate taxes. These costs vary widely, but it may be 25%-30% of your current payment. That would be $6,000 - $7,000 per year that doesn't go away. Whether you rent or own, you will always have a housing expense in retirement.

Retirement Calculators - Great Toys For Those 12 And Under.
The vast majority of articles written about retirement planning end up recommending the use of a retirement calculator (usually found on financial sites) to figure out the total amount that may be needed to save for retirement. They do this because the article only presents generalities in the planning process, and never the mechanics involved in figuring out the entire equation. Fair enough, since it's an article, not an instruction course. The problem is that the calculators that they recommend have exactly the same shortfall - they're quick, and usually easy to use, but they only consider a small portion of your essential information and rely on generic assumptions that probably don't apply to you (see #1 above). Elements such as taxes, spouses retiring at different ages (or any spouse information?), the ability to vary income, expenses, and savings by year, and much more, are not included. What good is a retirement calculator if it only calculates 10% of the necessary information, and then uses erroneous assumptions for the rest (like an 8% inflation rate! Really? And on a reputable financial site!)? Supplying 4 or 5 numbers on your part, combined with erroneous assumptions and a complete lack of pertinent information on the calculator’s part, will never yield an accurate answer to anything. That may be why they’re free, but don't be penny wise, and pound foolish. They are misleading at best, have no redeeming qualities, and should be avoided at all costs.

Think of it this way - if you are planning a trip to Paris and will be satisfied with directions that only tell you to head East (or West!), then perhaps retirement calculators are for you. But if you'd like to know the details for available flights from your specific location, hotel choices that are to your liking, a list of activities that you might enjoy in Paris, and what all that might cost, then you will be better served by doing your own due diligence. It's not enough to choose a destination, you need to know if it's the right destination for you, and, specifically, how to get there.

• Why Is Anyone Still Talking About The "4% (3%?, 5%?) Rule" As A Retirement Withdrawal Strategy?
The severe limitations of this "rule" (which is not a rule at all, and was never intended to be a rule) have been written about many times, and yet, many financial advice articles persist in suggesting it. Besides the fact that it is based on outdated and prohibitively rigid assumptions (e.g., bonds earning 5% every year (remember that?), no variability at all in expenses or withdrawals for any year), there's no need to follow a set withdrawal percentage to have your money last through retirement in the first place. In addition, what good is this notion if 4% isn't enough to pay your bills? You don't need such a rigid rule to follow to not run out of money, and trying to find a magic withdrawal % is really an amateur move as it's only part of a much larger equation. No financial adviser worth their fee will ever advise you to use such a rule. Here's an example of why a varying, and even large, withdrawal rate can still meet your needs:

A couple retires at age 62 (both are the same age), with $1M in savings, earning 5% until age 70, and then 3% thereafter (a reasonable approach). They will both wait to receive Social Security until they are 67, when their combined benefit will be $25k/year. Their expenses are $50k/year and inflation is assumed to be 2.25%.

For the first 5 years they will rely only on retirement savings to pay expenses. Their withdrawal rate will be ~ 6% - 7% for those years (enough to account for taxes on the withdrawals). At 67, their withdrawal rate will fall to ~ 4.0%, since Social Security income will begin. From then on, the withdrawal rate will increase slowly, year by year, because their expenses will increase with inflation, but their savings will decrease, requiring them to withdraw a larger percentage of the total each year (Social Security isn't enough to pay their expenses, and they're withdrawing more than the 3% they're making). At age 80, they will withdraw ~8.7% of their savings, and at age 85, they will need to withdraw ~15.0% of savings. Will their money last until they reach age 90 (a reasonable life expectancy). Yes! Barely, but yes.

The moral: your exact withdrawal rate shouldn't be a focal point as long as you can afford to live your life. Use a reputable financial planning tool (or an adviser) to figure out what will be needed, and ignore all generic "rules of thumb", assumptions, and benchmarks meant for everyone else and no one in particular. You're smarter than that.

Part II of this post will be available at the beginning of February and will discuss deciding when to claim Social Security, the rate of return to use in a financial plan, sequence of risk, estimating health care costs, and planning for unexpected events/costs. Stay Tuned!

 


Older Post