9 Retirement Planning Topics That Need Clarification - Part II

The following is Part II of our 1.1.22 blog post:

At What Age Should You Claim Social Security?
Everyone's circumstances and needs are unique, so only you know the answer to this. The best course of action is to make sure that you understand all of your options so that you will be comfortable with your decision in the long run.

In general, the earliest that you can start claiming Social Security is at age 62. However, your benefit is reduced by ~8% for every year that you claim before your Full Retirement Age (age 66 if born before 1960, otherwise age 67). If you delay claiming until after your Full Retirement Age, your benefit will increase by ~8% for every year that you wait, up until age 70 when you would reach your maximum benefit amount. This increase in benefits is why you see so many recommendations to wait until age 70 to claim Social Security. While this information is accurate, it is too simplistic to act on by itself. Roughly speaking, the break-even point between claiming at age 62 and receiving smaller checks, or claiming at age 70 and receiving your maximum benefit amount, is around age 80-81. Rather than basing your decision on a benefit amount alone, you should also consider if/when you will need Social Security to help pay monthly expenses, and your life expectancy. If you are in good health, will not need to rely on Social Security for income before age 70, and your family has commonly lived into their 80's, waiting to receive the largest benefit possible may be a good idea. If all of those considerations are not true, it is best to adjust your claiming strategy based on your needs, health, and life expectancy. If you are married, there are several additional strategies to consider (e.g., Spousal benefits and Survivor benefits), depending on your respective ages and individual benefit amounts, that may help you to maximize your income potential. The Social Security website (www.ssa.gov) can help to explain your options in detail. Make sure to take your time making this decision as it will affect the income for both spouses for the rest of your lives.

Make Sure To Use Varying Rates Of Return For Savings In A Financial Plan
When creating a financial plan, most people (and planning tools) default to using a single return rate for all years because they believe (correctly) that there is no way to accurately predict decades of future investment returns, and because using an average rate seems like it should accurately account for the highs and lows of annual returns that are likely to happen. Unfortunately, that just isn't the case. Using a variety of higher and lower annual return rates is far more likely to produce realistic results than smoothing the results out to mimic an average historical return for every year. For example, $1M earning 9.06% for 20 years (the S&P historical average for the past 20 years) results in $5.6M. Using the actual S&P results for each year results in $4.2M. That's not a difference that should be ignored.

While you can't foresee how financial markets will behave year by year, you can model your return rate to reflect your actual results over time. This will reflect your investing style. Start with your personal average return rate (not a market average) for the past 10-20 years. Then include random lower, higher, and even a few negative return years to reflect a more challenging environment. You won't get it right by year, but that's okay. Including a variety of possibilities, even within a tight range, will be more realistic than using a static rate. When I tried this, using the S&P average of 9.06% as a median starting point and then varying the annual return rates, I ended up with $3.99M, or within 6% of the S&P actual results for the same time period. Using the same 9.06% return rate for all years resulted in a 30% higher result.
When creating a financial plan, use the same rate of return for all years at your own risk.

Modeling "Sequence Of Returns" Matters
Equally important to using varying return rates in a financial plan, is modeling the timing of those returns. The term, "sequence of returns", refers to the importance of the order in which you receive your returns, especially at the beginning of retirement. Before retirement, your balance is only affected by annual return rates, so the order in which the returns occur doesn't matter. Your balance at the end of ten years, for example, is the cumulative effect of the ten years of returns. However, once you start taking distributions, the order of returns can matter a great deal.

Assume that you start with $1M, take a $50,000 distribution each year, and earn the following returns over 4 years:
25%, 8%, 10%, -15%. Your ending balance would be $1,072,510. 

Using the same assumptions, but reversing the sequence of the returns, your ending balance would be $1,008,000.

In both cases the total average return is 7.0%, but the second case results in $64,000 less after only four years!
The Sequence Of Returns matters! This is especially important in the beginning years of taking distributions and should be factored into any financial plan to help protect yourself from possibly overstating your forecasted results. You can't predict the future, so you should always be prepared for a variety of outcomes.

Your Budget Needs To Include One (Or Two, Three, Four?) Large One-Time Expenses.
Creating an itemized budget of expected expenses and adjusting them for how they may change over time is an essential part of learning how much savings you may need in retirement. Food, utilities, clothing, and other everyday items are easy to account for, but what is rarely mentioned is the inclusion of substantial expenditures that will
(not may, but will) occur over a 25-year time frame. Factor in items such as the cost of a new car (or two) (at least new to you), a new roof for your house, painting your house, replacing a furnace or worn-out major kitchen appliances (refrigerator, oven, dishwasher), a major family trip, or helping a child with a down payment for a house. These are expenses that can cost anywhere from $5,000 - $25,000 each, and they are more than likely to happen. These additions to your "regular" budget could easily require an additional $100,000 of savings. Don't forget that you will be taxed on these withdrawals, and those big chunks of savings will then no longer be generating income. These types of expenses, and the impact of withdrawing large amounts all at once, are often overlooked, or dismissed as "one-time" anomalies. Either you will incur these expenses, or you won't, but my bet is that you will, and it would be best to plan for it.

Health Care Costs - The Biggest Single Wild Card In Retirement Planning.
Ugh! Current guidelines suggest that a couple may need ~ $300,000 for health care costs during a 25-year retirement. This is a median amount and could vary considerably depending on the specifics of your general health before retirement, how you take care of yourself during retirement, genetics, the ability to avoid any health catastrophes (accidents), and pure luck or good fortune. There are no guarantees, and no way to accurately prepare for what will likely be the largest single expense in retirement but prepare you must. When you are working, your employer is likely paying a portion of these expenses, and the remainder is being deducted from your paycheck pre-tax. You never see it. For this reason, it may not be included in your regular monthly household budget. When planning retirement expenses, don't forget to add in Medicare (Parts A, B, C, and D) and all the costs that Medicare doesn't cover. When you stop working, you will be solely responsible for all of your health care costs. Medicare provides some very basic coverage, but it's not free, and even adding basic vision, dental, and prescription coverage is an optional additional cost. Most people augment Medicare with additional private health insurance plans. Make sure that you are aware of what is covered, what is not covered, how much coverage you may want/need, and the costs of all available options to be as well prepared as possible. Also, make sure that you sign up for Medicare 3 months before turning 65, even if you aren't ready to start collecting your Social Security benefit. There are penalties for not signing up on time.

Important - as you create your financial retirement plan (as you know you should), health care costs should be calculated using a separate inflation rate of ~6%. This is well above the regular historical inflation rate of 2%-2.5% (and even above a 3% rate suggested for planning purposes by financial advisers), but this is what is projected by the U.S. Department of the Actuary for at least the next decade, and it will have a significant impact on your long-term outcome.

There are a lot of components that go into creating a reliable financial plan, but the 9 topics discussed above (Part I & Part II) are some of the most widely discussed. The most important take-away is that your financial needs and goals are unique, so generic advice and benchmarks do not apply to you. Listening to what others do or suggest that you do, or trying to reach benchmarks that were created as generalizations for everyone and no one in particular, is a waste of your time. Create a financial plan that is based only on what you have, what you want/need, and what you are able to actually do. You can always review it, and adjust it, letting it help you to make informed decisions based only on your actual circumstances. You are trying to prepare as best you can for your future, not anyone else's.

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