Last month’s column discussed how to prepare psychologically for retirement. Today, we will focus on how to prepare financially.
Retirement strategies fill an entire chapter in my book, so this article will just skim the surface.
Focus on saving
The best way to prepare for retirement is to start saving at a young age. Beginning with a first job, saving 15 percent of your income is recommended, and 20 percent to 25 percent is even better. Many people do not start saving until they are in their 40s or 50s, and saving enough is difficult. Adding to the problem is that many future retirees will not be able to rely on a pension in retirement and Social Security benefits could be reduced.
Many people wonder “am I on track for retirement?” and “how much money will I need?” There is not a magic number, and the figure that is accurate for you will depend on several variables – including how much you expect to need each year for living expenses, and whether you will have other sources of income (such as a pension, Social Security benefits, or a salary from a part-time job). How much you will need also depends on your estimated tax rate, the age when you retire, and the estimated annual return from your investments.
All of the above variables (and more) are considered in a thorough, customized retirement plan. Unfortunately, I cannot recommend any websites or software packages for you to “run the numbers.” Several years ago there were many, but now they all include a strong sales pitch. You may find the Social Security website helpful at www.ssa.gov/retire/ or you can search online (many brokerage firm websites have retirement calculators).
There is a simple concept that avoids all of the complex analysis. It involves setting a maximum withdrawal rate from your investment accounts, and then using that concept to determine how much you need to be able to afford to retire.
The 4 percent rule
The concept of a sustainable withdrawal rate has been studied extensively. It began with financial planner William Bengen’s research in 1994, which determined a 4 percent annual withdrawal rate would prevent retirees from running out of money during retirement. This rule has a couple of important disclaimers.
First, it was designed for a 30-year retirement period – specifically, a person retiring at age 65 and living to be 95. It does not work for someone retiring in their late 50s or early 60s because their retirement may last over 30 years. In that case, a figure lower than 4 percent is recommended.
Second, it assumes you have a balanced, diversified investment portfolio with at least 50 percent invested in the stock market, and the fees in your investment accounts are low. This eliminates many retirees who keep large sums in banks or credit union accounts earning less than 1 percent. It also eliminates people who do not have a balanced and diversified portfolio. A concentrated portfolio containing one or two stocks, with high-risk alternative investments, or with high investment expenses will not work with the 4 percent rule.
Bengen’s original work recommended setting the initial withdrawal (in the first year of retirement) at 4 percent of the portfolio and then increasing the withdrawal amount each year by 3 percent for inflation. If your investments total $1 million, the 4 percent rule would allow you to withdraw $40,000 in the first year. In the second year you would withdraw $41,200 (the additional $1,200 represents 3 percent inflation). In the third year you would withdraw $42,436 ($41,200 plus 3 percent inflation).
Bengen’s 4 percent rule has been challenged in recent years. Financial planner Jonathan Guyton released his analysis in 2004 that added “guardrails” to the annual withdrawal rate. The guardrails add flexibility, and require a person to reduce their annual withdrawal if the investment performance had been poor in the prior year and increase the withdrawal after a year with strong investment performance.
When faced with poor investment performance, Guyton suggested that people could reduce their discretionary spending by delaying a trip, or spending less on dining out or holiday gifts. This flexibility allowed for a significantly higher average withdrawal rate than 4 percent – generally between 5 percent and 6 percent.
Following the 2008-2009 financial crisis, the recommended withdrawal rate was reduced below 4 percent. Financial experts David Blanchett, Michael Finke and Wade Pfau released research in 2013 based on their assumption that low interest rates on bonds (now and in the future) will impact sustainable withdrawal rates for retirees. Their research suggested using only a 2.8 percent withdrawal rate during retirement.
Recent research articles have been focusing on how spending levels change during retirement. The 4 percent rule assumes a constant level of spending each year, but research conducted by the Center for Retirement Research at Boston College found that spending declines by about 1 percent per year during retirement.
Research by David Blanchett of Morningstar suggests that spending increases slightly in the early years after retirement, and then begins to decline. This research suggests that a “dynamic” approach that can be adjusted during retirement may be more valuable than the static 4 percent rule.
Customized retirement plans that include extra spending for travel (shortly after retirement), replacement cars, anticipated home improvement and maintenance, and health care/dental expenses (all in addition to the estimated annual budget) are valuable. Revising the plan on an ongoing basis results in the “dynamic” approach that is recommended.
A bottom up approach
The 4 percent rule can be used in reverse for a “bottom up” approach. Let’s assume you create your estimated budget for retirement, and you determine you will need $60,000 per year in retirement for living expenses. You estimate your average tax rate will be 20 percent (federal and state combined). (Average tax rate is significantly lower than your marginal tax bracket).
To determine the pre-tax amount you will need, divide $60,000 by 1 minus the average tax rate (1 – 0.20 = 0.8). $60,000 ÷ 0.8 = $75,000. Let’s further assume that Social Security benefits will provide $25,000 per year, and a pension will provide $20,000 per year. When $25,000 and $20,000 are subtracted from the $75,000 per year (pre-tax) needed, the result is that you will need $30,000 each year from your investments.
You would then multiply $30,000 x 25 = $750,000, and $750,000 is the amount you would need in investments. Note this is the inverse of the 4 percent rule; $750,000 x 4% = $30,000.
If your retirement nest egg is not as large as you would like, there are several recommended strategies. One is to delay retirement a few years. Another is to plan to work part time during retirement. Another is to significantly reduce your standard of living.
Simplifying your lifestyle has many rewards, including allowing you to save far more now (because you are spending less), and possibly to retire sooner than you had planned. And, reflecting back on last month’s column, the key to preparing for retirement is that we want to retire to something rather than retire from something. Plan ahead for a joyful retirement!
Donna Skeels Cygan, CFP, MBA, is the author of “The Joy of Financial Security.” She has been the owner and financial planner for her own firm in Albuquerque for 19 years. Visit joyoffinancialsecurity.com.