Retirement Planning

One’s desired annual spending in retirement is a more ideal choice for determining annual needs in retirement. Some methods argue for use of an income replacement rate, but this assumes that a single percentage would work for a large number of households and individuals. Instead, a planner can help a client think through this situation. There are several ways this is done. One such approach, from economic theory, assumes that households seek to smooth consumption across changes in the life cycle and that ideal annual spending is equal to average annual income—taking into account issues such as taxes and interest rates. Another approach is more introspective. This method begins with an existing and comprehensive income and expenditure statement. This process involves examining each expense and determining how it might change in retirement. Examples might include a mortgage being paid off, children who become independent, or increasing health care costs. Additional considerations for retirement spending needs include ties to family, obligations to children and parents, whether to continue some type of employment, creative use of leisure time, and community service. What a person will do once retired is at least partly a question about identity and meaning, but financial implications will affect such decisions.

One should also try to anticipate the impact of taxes. Even though there are some tax advantages for retirement savings and Social Security benefits, taxes will still be owed on all tax-deferred assets as distributions are taken. This is important because spending estimates show how much after-tax income is required for a household. However, distributions from most retirement plans will face taxation when withdrawn and as such, one should consider what pretax amount should be withdrawn to provide the after-tax spending requirement.

Resources expected to continue in retirement, such as defined benefit pension plans and Social Security, are used to help meet desired annual spending needs. For many households, this would still mean that there is an annual spending gap, which represents the amount of one’s desired annual spending not covered by continuing resources such as Social Security. The annual spending gap represents the amount of annual spending needs that is to be provided by investment proceeds and distributions from retirement savings. This gap is likely to be considerably higher for those who have enjoyed higher incomes throughout their working years. This is because higher income tends to indicate higher spending, and the income replacement rate of Social Security retirement benefits diminishes with higher levels of income. However regardless of a person’s pre-retirement level of living, Social Security is not likely to be sufficient as a sole resource for retirement spending needs. This makes investing for retirement essential for all households.

The annual spending gap estimation can be complicated by several issues. Since the starting age for benefits such as pensions and Social Security may differ, there may be different stages of retirement where different resources are available. For example, a husband and wife may retire in different calendar years, resulting in more than one annual spending gap. Other situations where there might be multiple planning periods include retiring before Social Security benefits are available and working during the early retirement years. Each of these stages should be considered and accounted for by discounting the annual spending gap for each year, up to the day of retirement.

The determination of retirement planning adequacy can then be thought of as comparing the annual spending gap with income from investments accumulated during the preretirement years. This comparison can be done by comparing the total value of the annual spending gap for all retirement years, adjusting them downward to reflect the future compounding they would have during retirement. The appropriate discount rate would be the expected portfolio rate of return for investments during retirement, based on asset allocation. The expected value of investments should be based on historical returns for the asset types. Calculations should consider that the asset allocation is likely to change over time. While average returns are most appropriate, some planners may also include an estimate based on a more pessimistic return for those who would like to be prepared for the worst case. If expected investment levels are equal to or greater than the discounted annual spending gaps, then the current investment strategy is adequate.

In the event of inadequacy, there are two potential courses of action that can be taken to improve the situation. The first possibility is to increase investment contributions to the required levels. However, this is only possible if the investor has additional investment capital and is not currently maximizing tax-advantaged contributions to retirement savings. If tax-advantaged contributions are already at the maximum allowed levels, then the investor may also use nontax-advantaged accounts. The second option would be to increase the aggressiveness of the portfolio, if prudent to do so. This could be accomplished by placing a higher percentage of the portfolio into equity investments. However, it is possible that a more aggressive portfolio might conflict with one’s risk tolerance. It is prudent for most investors to consider enlisting the advice of a professional to explain the risks and make recommendations regarding portfolio strategy. Others may simply have a planner perform a retirement adequacy assessment to ensure that the retirement plan is on target.

A second approach to determining adequacy uses advances in simulation methods and is known as a Monte Carlo approach. Often, individuals perceive risk as the likelihood of goal achievement or failure. The Monte Carlo simulation determines the odds of success of a specific financial plan. Most simulations will use several inputs, including asset allocation, bequest motives, pension plans, and desired annual spending. One advantage of this program is an estimation of odds of success, which has direct meaning to an individual. Further, if the odds of success are too low for an individual to accept, changing different inputs can show how the odds can be improved. One such change may include changes in asset allocation. However, while the programs will generate asset allocations, it is still up to an investor to select appropriate assets that conform to the recommendations. Many individuals may choose to use a professional for this.

Both of these approaches to determining asset adequacy require information about expected retirement benefits. Fortunately, this information tends to be readily available. Individuals age twenty-five and older who participate in Social Security will periodically receive a Personal Earnings and Benefit Estimate Statement (PEBES). This statement provides the taxpayer with information about his or her retirement benefits based on retiring at the age of full benefit eligibility, about the maximum delayed benefit, and about the reduced benefit obtainable at age sixty-two. The Social Security website (www.ssa.gov) provides online estimators for retirement benefits. Similar types of statements or calculators are available for most defined benefit pensions. This allows an individual or household to consider expected benefits when making planning decisions.