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Financial Planning for a Long Retirement

How should an individual investor ensure they have enough money for retirement?

Such a person is often a professional or entrepreneur who has worked to accumulate wealth. Legions of "advisors" are lined up to take this money and manage it or else to sell "products" that promise to solve some problem or other.

A person who has created their career and their wealth from scratch by intelligence and hard work can also manage their investments themselves, or at least supervise the process from a position of strength created by knowing what needs to be done.

This collection of articles explains to the individual investor how to take control of their wealth. They may eventually decide to look for help from an advisor but they will retain control of their assets and they will know what to do.

Financial Planning videos on YouTube

Retirement Planning

Retirement is a modern concept. As recently as 1900 there was no such thing as retirement. Average life expectancy was around 47 and people essentially worked until they died.

{Life expectancy at birth}
Life expectancy at birth

Life expectancy today is nearly double that and spending 20 or 30 years out of the workforce in retirement is quite common.

{Life expectancy at age 65}
Life expectancy at age 65

As recently as 1934 when Social Security was established and the retirement age was set at 65, the expectation was that very few people would live to collect and that those who did would collect only for a few years. Two generations later, American politics is facing the crisis that nearly everyone is expecting to retire and to collect retirement benefits for almost 20 years on average with an outstanding health care system pushing up life expectancy by 2 years per decade; the system is projected to run out of money in our lifetime if no changes are made.

So it's not surprising that society as a whole doesn't know how to handle retirement: it's never really been done before.

At the same time, corporate pensions are rapidly becoming a thing of the past. Even the largest and most stable companies like IBM are doing away with their pension plans, and plenty of other companies never had a pension plan to start with. The corporate pension system is being replaced by a system in which individuals must take of themselves.

{personal savings rate}
personal savings rate

Taking care of yourself isn't a bad thing; it's what America is supposed to be all about. But most people are not prepared to do it because it sort of snuck up on us.

America as a whole is saving less than nothing. This is a pretty amazing statistic given the country's obvious affluence and the truth is that the statistic isn't well understood even by the Bureau of Economic Analysis who publishes it; but the debt-to-income ratio has been growing for a long time and many people have simply not been saving for the future.

By now, pretty much everyone knows that they should not count on either government help or corporate programs to support them in retirement and the question is what to do about it. The answer, in a word, is PLAN. In a few more words, SAVE and INVEST. We're not concerned with society as a whole here, this is not politics; we're concerned about helping specific individuals. Namely, you.

Everyone's situation is different and needs careful, detailed analysis. This is particularly true because of the complexity of all the rules governing Qualified Plans and tax-deferred accounts, to say nothing of trusts and closely held businesses and so on. However, it is quite possible to get a very good idea of how much money you need to support yourself in retirement. There is an online spreadsheet you can fill in to do this. It won't be exact, but it will be close; and for many people, it will also be a shock.

If you click the link the online retirement savings spreadsheet will open in another tab or window:

Online Retirement Savings Calculator

{retirement planning parameters}

The first things to enter are

  • The number of years from today until you expect to retire, the Years TO Retirement, during which time you can save money
  • Then, the number of years of retirement itself,
    the Years IN Retirement, which is the amount of time you will live off of your investments, at least partially
  • How much you currently have invested, your Current Portfolio Amount
  • The rate of inflation, 3% is a good estimate
  • And then the amount you expect your investments to return every year; on average, pre tax

{expected income requirement}

Then enter what you expect to need from your investments every year once you retire. Use today's dollars, the spreadsheet will adjust for inflation.

  • First enter the amount of money that you expect you will spend. Taxes are an expense to be included in this amount. The best place to start is with your current expenses.
    • If you stop earning wages, you won't pay FICA taxes, you may have paid off loans and mortgages and your kids will probably be independent, which will reduce your expenses.
    • On the other hand, you may be planning to go around the world on a private jet, which will increase your expenses.
    Whatever. Make your best estimate. There are lots of rules of thumb that say you can live off 60 or 80% of your pre-retirement income, but you know your own wants and needs best. And don't forget that later in life you may have very high medical expenses.
  • Subtracted from that amount will be any outside sources of income. Social Security is inflation adjusted; most corporate pensions are not. Enter whatever outside sources of income you can reasonably expect during retirement.


{minimum investment portfolio size}

Given that input, the minimum portfolio size can be calculated. This is the amount of money you need in the bank on the day you retire.

There are four ways of looking at the amount of money you need.

  1. First, you can plan to spend all of your money and have none left over when you die. Philosophically, there's nothing wrong with approach but if any of your assumptions are just a little bit optimistic, you'll find yourself with no money before you die, which is not a good plan.
  2. Option number 2 is to plan to have the same dollar amount in your portfolio at the end of your retirement as when you start. This is a safer bet than Option 1, but inflation will take a toll.
  3. So, Option 3 is the amount that you need in order to end up with the same amount adjusted for inflation.

    The problem with the first three options is that they just rely on the math of Future Value calculations, and they rely on your assumptions working out perfectly. Which isn't the way life is, particularly over 30 or 50 years.
  4. Option 4 says, "How big must my portfolio be to allow me to withdraw 4% every year, adjusted for inflation, and not eat into it?"

    This is the highest hurdle but it is the one you should be shooting for. This is the punch line... (See Withdrawal Limits From A Fixed Portfolio )

    The link cites a study which looks at what happens to an investment portfolio when nothing is going in and an annual withdrawal is being made.
    If we assume that a good part of the investments are in the stock market, since that's the only way to beat inflation, then there will be times when the portfolio actually shrinks.

    When the markets go down, the amount of money gets smaller. And at the same time, you have to withdraw money to live.
    Put all of that into a simulator and the answer is that if you have a life expectancy of 30 years, then you really should not plan to withdraw more than 4% a year.


Math Favors The Early Saver

The earlier you start saving, and the more consistently you save, the easier it will be to retire comfortably.

Consider these scenarios in which three people save $15,500 a year tax free (the current limit to employee contributions to a 401(k)). All three people earn 10% per year on their investments.

  • Person 1 saves every year from ages 25 - 65
    • Total investment: $635,500
    • Amount at age 65: $7,561,703
  • Person 2 saves every year from ages 25 - 35 and then stops saving but lets the investment grow
    • Total investment: $170,500
    • Amount at age 65: $5,012,046
  • Person 3 waits until age 35 to start saving but saves every year afterward until age 65
    • Total investment: $480,500
    • Amount at age 65: $2,820,123
{the power of consistent, eraly saving}

How does Person 2, the one who stopped saving at age 35 to raise a family or something, do better than Person 3 who started 10 years later but saved for 3 times as long? It's the power of compound interest ... by age 35, Person 2 had built up $287,233 and that amount, compounded, was too much of a lead for Person 3 to catch.

The lesson is obvious: start saving as early as possible, save every year and put away as much as possible. For Person 3 to retire with as much as Person 1, they will have to work another 10 years or else increase the amount they're saving.

The trend in America has been to start work later and to retire earlier than our parents. To do this and to retire comfortably requires greater savings. If a person wants to become a doctor, say, which will require them to stay in school, etc. until age 30 and they want to retire at age 60 with as much money as Person 1, they will have to save $41,561 every year, at 10% tax free.

The maximum employer_plus_employee contribution to a 401(k) plan in 2008 is $46,000 so it is theoretically possible to achieve this, but not easy. For one thing, you have to forego spending this much money every year for your whole working life and for another, you have to invest at 10%; if you invest the maximum, the lowest interest rate that will allow you to achieve your objective is 9.49%.

If you're tempted to withdraw more than 4% a year from your portfolio in retirement, please read: Withdrawal Limits From A Fixed Portfolio

These sorts of considerations lead all too many people to "reach for yield" or otherwise invest foolishly; risky investments are just that, however, and one bad year can wipe out a lot of exceptional ones. Achieving returns that are better than the return on the 10-year Treasury bond require being willing to take some risk, to diversify and to invest for the long term; a suggestion on how to set up an investment portfolio to support yourself in retirement can be found here: Asset Allocation and Portfolio Rebalancing


{retirement involves entirely redefining yourself}

That's the math. Math is important and we can't ignore it; but life is a whole lot more than math.

And retirement is a huge transition for everyone.

Very often people put aside financial planning because of the emotional stress caused by the difficult life transition that is retirement. Just thinking about the subject gives a lot of people agita, no matter how old they are. This is natural.; the fact is that everyone responds this way because being young and in the workforce with plans for the future is what everyone plans for and expects. It is why we go to school for 20 or more years of our childhood, to prepare to be a member of the workforce. Work and family are what define most people at a very deep emotional level. Retirement disrupts everything; and many people compound the stress by moving away from their home on top of it.

What happens to us when our role in the workforce is diminished or eliminated? This is a tremendously hard question that goes to the heart of ...

  • our self worth,
  • our self-definition
  • our place in society.

Preparing for retirement is an act of complete self redefinition during a period in our lives when our physical capabilities are beginning to decline, no matter how hard we work to prevent this. Everything is new and everything is hard. And there's really no one to show the way because ours is the first generation to do this on a large scale. It's no wonder that financial planning takes a back seat. However, having one's finances in good order and well understood reduces fear and stress by replacing an amorphous unknown with a concrete known.

Aristotle said that Well Started Is Half Done and Woody Allen observed that 80% of life is showing up. If you get your financial house in order, you will have a much easier time of dealing with everything else that may be going on in your life; and the earlier the better.

For any individual, there is a lot more analysis required to make sure we get everything right. Furthermore, there's a lot more to Financial Planning than just Retirement Planning. But this should have given you an appreciation of the magnitude of the issues that you face and have given you an idea of what needs to be done to ensure that you are on the road to financial independence. Because ultimately, that's what we're trying to do here.

A detailed look at the investment process can be found here:

Asset Allocation and Portfolio Rebalancing

This is the text version of a narrated presentation that can be found here: Retirement Planning Overview

The link for this page is

Financial utility functions: http://www.georgefisheradvisors.com/utilities.htm

email: george@georgefisheradvisors.com

Please see the Disclaimers

(1373)

Post brought me to think, went to mull over!!....
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Thanks for noticing. We are shrinking the file size of the images, which is the main slow-down. However, we have several thousand images, so please be patient.
Posted by: George Fisher   |   Jun 3, 2008 4:30 PM
I'm enjoying your financial articles; but I find that the website takes a long time to finish loading even though I'm on a DSL connection.
Posted by: Marathonwmn   |   Jun 3, 2008 1:34 PM
very nice set of articles. I got here via your post introducing yourself in the ER Forum
Posted by: Alan   |   Feb 15, 2008 7:26 PM
Let's revise the earlier comment. When retirement need exceed resources, you can tighten the belt and not spend so lavishly. However, the younger person contemplating a bleak retirement has one other option: don't retire so young. His best plan is to find a sweet spot between retiring x years later, and spending y dollars less when he does.
Posted by: George Fisher   |   Feb 8, 2008 11:35 AM
The answer to

"How much can I withdraw from a fixed portfolio?"

is 4% a year.
Posted by: g4   |   Feb 1, 2008 9:01 AM

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