There is 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 should be carefully considered when creating your financial retirement plan:
• 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. Factors 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, for every year! 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.
• Make Sure To Use Varying Rates Of Return For Retirement 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 9.75% for 20 years (the S&P historical average for the past 20 years) results
in $6.4M. Using the actual S&P results for each year results in $4.8M. 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. The market has a negative year ~every 4-7 years. 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 9.75% as a median starting point and then randomly varied the annual return rates withing a tight range from there. I did use 2 years of 2% returns, but no negative years. I ended up with $5.04M, or within 5% of the S&P actual results for the same time period. Using the same 9.75% return rate for all years resulted in a 33% higher result.
When creating a financial plan, use the same rate of return for all years at your own risk. It is not a realistic plan.
• 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 (and contributions),
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 in the second case you end up with $64,000 less - after only 4 years! The Sequence Of Returns matters! This is especially important in the beginning years of taking distributions, and it should be factored in to any financial plan to help protect yourself from possibly overstating your forecasted results. You can't accurately predict the future, so you should always be prepared for a variety of outcomes.
• Your Budget Needs To Include One (Or Two) 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 every day 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 (if taken from a tax-deferred account), 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 topics discussed above are some of the most over-looked. 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 do. You can always review it, adjust it, and let 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.