If you’re like most of us, you may be looking at retirement with a mix of anticipation and trepidation. It may be decades away, or it may be right around the proverbial corner. During your working career, you’ve probably been diligent about saving to buy a home, have a family, pay for your kids’ college, and for retirement. For many, these can be competing goals. How much should you save for each? And for retirement, how much will you need to have saved to be comfortable and secure? After all, running out of money is one of the top retirement concerns for most Americans.
Get a Picture of Your Spending – Have a Plan
It may seem obvious, but if you don’t know how much you’ll want to spend in retirement, it’s hard to say how much you’ll need to save during your working years. So, the first step in making sure you won’t outlive your retirement savings is to get a financial plan.
- Define and Prioritize Your Goals
A robust financial plan will include all of your financial goals – think of them as “needs”, “wants”, and “wishes” – ranked by priority. Your “needs” would include your core, or essential, living expenses – things like housing, utilities, food, and other expenditures that don’t change much from year to year – while your “wants” and “wishes” might include variable expenses like vacations, periodic upgrades to your home, replacement cars, and charitable giving, for which you have some flexibility around when you incur them. Your financial advisor should be able to help you look at your current spending, categorize it, and project it into the future.
- What Are Your Assumptions?
Once you have a good sense for your current and projected spending, you and your advisor can make some assumptions about future inflation (which will reduce the value of your savings), investment returns (which will grow your current and future savings), tax rates and, perhaps most importantly, your planning horizon (or life expectancy).
- How Much Can You Spend?
With a set of realistic assumptions and a clear picture of your desired spending, you’ll be able to determine a “safe” withdrawal rate for your retirement savings. A “safe” withdrawal rate is one that will allow you to take a certain amount out of your portfolio in the first year of retirement, increase that amount each year to keep up with inflation, and be very confident that your portfolio won’t be depleted over your lifetime. By calculating and sticking to a safe withdrawal rate, you can minimize the likelihood that you’ll run out of money – a key retirement concern for many.
Have retirement concerns? Contact us today to see how our team at Springwater Wealth can help you develop a plan for your financial peace of mind.
Save and Invest
For an American with average earnings, Social Security will replace only about 40% of their pre-retirement income. For higher income earners, this percentage is lower, while for those with lower than average incomes it’s higher. So, since most of us no longer receive defined benefit pensions from our employers, it’s important that we save and invest to build a nest egg that can provide additional income in retirement to supplement Social Security.
- The Magic of Compounding
“Save early, save often”, so the saying goes. The implication is that you start saving as early as you can, and that you should save as much as possible. Why? Because of the “magic” of compounding. Compounding is what allows even small amounts of money that you save to grow into a large sum, given enough time. The money you save – in a savings account, a retirement account, or an after-tax investment account – earns a return. Over time, your account will generate earnings on your old and new contributions, as well as on past earnings you’ve accumulated (“earnings on earnings”). As your savings grow, you generate earnings on a bigger and bigger pool of money.
By way of example, let’s say you want to save $1 million for retirement at 65, and assume you’ll earn 7% per year on your investments. If you start saving at age 20, you’ll only need to save about $264 a month. But if you wait until age 45 to start saving, you’ll need to set aside over $1,900 a month to reach that $1 million nest egg by age 65.
- Tax-Advantaged Saving
While few Americans today enjoy defined benefit pensions for their retirement, there are still some tax advantages available to you. Most companies sponsor defined contribution retirement plans (like 401(k) and 403(b) plans). Defined contribution plans allow you to defer a portion of your salary into a retirement account, and to defer taxes on the growth in your account until you decide to begin taking distributions in retirement. Many of these plans include matching and/or profit-sharing contributions from the employer.
If your employer doesn’t sponsor a retirement plan, you should still save in a Traditional and/or Roth Individual Retirement Account. And if you’re self-employed, you can set up your own “solo” 401(k) plan at almost any bank or financial services company.
- How to Invest
As important as how much you save, is how you invest your savings. You should make sure that your portfolio takes enough investment risk to enable you to meet your goals, but not so much that the periodic fluctuations in the value of your investments cause you to lose faith, panic and abandon your investment strategy at the worst possible time. Your asset allocation – the broad mix of investments – should be appropriate for your investment horizon, risk tolerance, and other unique goals and constraints. Your portfolio should be well-diversified across a range of “asset classes”, and well-diversified within those asset classes. Proper diversification will improve the risk/return relationship for your portfolio. You should use investments that are low-cost and tax-efficient. For most investors, that means mutual funds and exchange-traded funds, rather than individual stocks and bonds. And you should pay attention to asset location in your portfolio – ideally, holding investments that pay regular taxable distributions (i.e. bonds and real estate investments) in a tax-deferred retirement account, and investments that generate most of their return from capital appreciation (i.e. stocks) in a taxable account.
If you construct your portfolio of retirement and investment accounts properly, you can give yourself the best possible chance of accumulating a solid retirement nest egg, which is a top retirement concern for many investors.
If You Can, Consider Delaying Taking Social Security
Unfortunately, many Americans will have to rely on Social Security for the bulk of their retirement income. And, as we noted before, for someone with average earnings, Social Security will only replace about 40% of their pre-retirement income.
The Social Security program was established in 1935. Social insurance, as conceived by President Roosevelt, would address the permanent problem of economic security for the elderly by creating a work-related, contributory system in which workers would provide for their own future economic security through taxes paid while employed.
- Full Retirement Age
The age at which you can claim your full Social Security benefit – known as your Full Retirement Age, or FRA – is increasing gradually because of legislation passed by Congress in 1983. Traditionally, the full benefit age was 65, and early retirement benefits were first available at age 62, with a permanent reduction to 80% of the FRA amount. Currently, the full benefit age is 66 years and 2 months for people born in 1955, and it will gradually rise to 67 for those born in 1960 or later.
- Should You Delay?
Importantly, it’s also possible to delay taking your Social Security benefit beyond your FRA, to as late as age 70. For each year that you delay taking your benefit, your payment will increase by 8%. So, for someone born in, say, 1964 and whose FRA is therefore age 67, if they wait until age 70 to begin claiming, their benefit will be 24% higher.
Of course, if you delay taking your FRA benefit at 67 until age 70, you’ll miss out on receiving benefit payments for three years. This means that you want to be reasonably sure that you’ll live long enough for the value of your delayed, higher benefits to be greater than that of the missed (lower) benefits. In most cases, that “break-even” age is about 84.
And, if you retire before you begin taking your delayed Social Security benefits, you’ll need other savings to provide you with income until your higher benefits kick in. But, all things considered, if you think you’ll live well into your 80s, waiting to claim Social Security until age 70 can provide you with a significantly higher benefit, and more guaranteed income – which is a key retirement concern for many.
Insure Against These Two Risks
Many Americans, including many of our clients at Springwater, are living long, healthy lives. It’s quite possible that you’ll live longer than the average American, longer than your parents did, and perhaps longer than even you might have thought possible.
But living longer brings with it two financial challenges – the possibility of needing care later in life, at home or in a facility, and the possibility of outliving your resources. Fortunately, both of these retirement concerns can be addressed in the context of a robust financial plan.
- The Cost of Long-Term Care
Paying for long-term care costs can be a significant drain on your financial resources. So, this may be a risk that you want to insure against, particularly if there’s a history of needing care in your immediate family. It’s possible to buy long-term care insurance, which will pay you a benefit to help defray these costs, as soon as your doctor indicates you need help with activities of daily living.
If the cost of long-term care insurance seems unattractive, and you have other resources to pay for the cost of care, you may elect to “self-insure”. In this case, you’ll want to make sure that you mentally set aside the financial resources you may need, or consider an alternative like accessing some of the equity in your home through a home equity conversion mortgage (or “reverse mortgage”). And you’ll want to incorporate the cost of care, and the resources needed to pay for it, into your financial plan.
- The Challenge of Longevity
Even if you’re fortunate enough to never need care, it’s possible that you could simply live much longer than you, or anyone else, anticipated. The number of Americans age 100 or older is about 50% higher today than it was just 20 years ago.
So, even the best financial plan and investment strategy will wobble if you planned to retire at 65, and live to 95, but you’re still going strong at 100. Is it possible to insure against living “too long”? In short, yes. You can take a portion of your savings, and buy an immediate annuity from an insurance company. You’ll receive a monthly payment from the insurance company for whatever length of time you agreed with them. How long do you need to live for this to “make sense”? Well, the payment you receive from the insurance company is closely tied to interest rates, and rates have been at or near historic lows since the 2008-09 financial crisis. This means that you need to live a relatively long time for the return on your money given to the insurance company to be attractive. But, your primary concern is probably not the return on your dollars, but rather allaying your retirement concerns by buying an income stream that you can’t outlive.