It often feels that we do not have the time to make financial plans, and if we do make them, the shifting sands of life conspire against us in fulfilling them; so, what is the point? Planning has a number of benefits, it focuses your attention – making your dreams more attainable, it allows you to manage and cope with change – without necessarily compromising those dreams and it provides you with a measure of accomplishment that people so often lack.
As a sidebar; it should be said that (in my mind at least) financial planning and budgeting are two separate, but related tasks. Financial planning deals with the attainment of long term goals and budgeting is a short term strategic response to circumstances to ensure financial obligations (including those ascribed to in your financial plan) are met. The realities of budgeting may make it necessary to revise your financial plans – but the two should not be confused.
As with any plan, in order for it to be successful the requirements must be realistic. Any plan which cannot be achieved from the outset is doomed to failure and it has little or no benefit as provides no reinforcing encouragement or the development of any discipline
Financial planning can be daunting, but it need not be overwhelming. Like so many things in life, financial planning can be broken down into manageable steps – each accruing some benefit even if the whole task is never completed. For instance, many people do not have clearly defined aspirations – without a set of goals a person is destined to feel unfulfilled and this is liable to engender depression and other forms of psychosis.
In order to ensure that your needs are met, financial planning should adopt a top down approach. This means that you should plan your retirement first, making sure that you will be able to maintain the standard of living that you want, and only then you should address the secondary and tertiary goals, even though these may feel more immediate. Once a set of basic plans are established it is relatively simple to tweak them, whilst not undermining their ultimate objectives.
We will start from the top, retirement planning can be the hardest thing that you will need to plan for – both in terms of the variables that you must consider and the length of time over which the plan must be executed. Ideally your financial plans should follow a strict hierarchy, reflective of your priorities, of which your minimum retirement must be paramount, then your children’s education, that lifetime trip etc. It cannot be stressed enough, however well intentioned you motives are, you must not make your retirement subservient to any other plan, this must be the dominant plan, it may be flexed but not comprimised.
Many people are willing to wing it, when it comes to retirement planning, they make an assessment as to how much they will require on retirement, more often than not the amount that they chose is woefully short of what they will really need. This often results in people living the remainder of their lives not able to enjoy life to the extent that they wanted to. There is also a tendency with the “baby boomers”, the last of which are retiring in the next decade, to look back to their parents and assume that they will need no more than they did. Unfortunately, for them many things have changed, the burden of risk lies with the retiree (not the former employer) with respect to their employment pension and many necessities (especially those related to health) have become a lot more expensive.
In the following I provide a high level overview of the decisions and assumptions that must be made, I will provide more expansive discussion of these in subsequent articles.
Of course, how much money you will need in retirement will depend on a multitude of factors. These include at what age you retire, how long you can expect to live, what your social security pension will be, where you are going to live and the cost of living needed to maintain a certain standard of living. Not all of these can be answered with certainty, but it is possible to get a conservative estimate and to use that as a solid basis for your plans.
Establishing your retirement age is probably one of the biggest factors over which you have control, the earlier you retire the longer your savings will have to last, and if you draw social security before the full retirement age this may be reduced (because life expectancy is now greater than it used to be, the full retirement age was increased, with it being higher for those born most recently).
Of course, you do not know how long you are likely to live for, but based on data from actuarial tables (from social security), we can make a good estimate. Based, on these tables assuming that you are a man retiring at 65 in good health your expected life expectancy is almost 18 years, but there is a 5.3% that you will still be alive at 95 and an almost 1% chance that you will make it to 100 (that is 35 years after you retire). For a woman these figures are marginally higher, life expectancy at retirement is over 20 years and there is a 10.2% that you will get to 95 and a 2.2% that you will get to 100. At the current time I assume a life expectancy of 100 (to be conservative), but that may need adjustment – depending on your circumstances.
Table 1: Life Expectancy (Sourced from Social Security 2016 data)
Current Age Expected Years Male Expected Years Female
59 22.34 25.39
60 21.58 24.56
61 20.83 23.72
62 20.08 22.90
63 19.35 22.07
64 18.62 21.26
65 17.89 20.45
66 17.18 19.65
67 16.47 18.86
68 15.77 18.07
69 15.07 17.30
70 14.39 16.54
71 13.71 15.79
Next, we need to decide what we will require to maintain the standard of living that we want, or that you have become accustomed to. A quick way to do this is to work backwards from your current income, deducting those expenses you may not have in your retirement, assuming that you are managing to put some money aside each month currently.
Current savings for retirement, you may still want to have some monthly savings to accommodate some spur of the moment expenses, but a large portion of what you are currently saving you will probably no longer required.
If you are a house owner, ideally you should enter retirement without a mortgage (you will of course still have property taxes and insurance, so do not deduct escrow payments). If you plan to down-size on retirement you may also want to make adjustments for lower household bills
· Social security, payments this is 6.2% on the first $137,700 and 0.9% on your whole salary.
· Cost associated with work, such as commuting, parking, lunch etc.
· All of these adjustments can be grossed up at your marginal rates, on the top slice of your income.
· Contributions for medical insurance, less any amount you will be required to pay for medicare (if you are eligible). This can get quite complicated
· Your expected social security pension, this figure can be obtained from the social security administration.
On the flip side there may be some additional expenses, for example you may have plans to travel or take-up a hobby – these will need to be accommodated for.
Next based on some investment assumptions we need to calculate what this amount is equivalent to at the date of your retirement, this going to depend on the expected rate of return (which depends on the investments). This means for instance if you have a required income (on top of your social security pension) of $50,000 and you assume an annualized return of 5%, you will need to have over $800,000 in your 401K (or IRA).
Table 2: Investment Multiplier
Rate of Return 3% 5% 8% 10%
65 21.49 16.37 11.65 9.64
66 21.13 16.19 11.59 9.61
67 20.77 16.00 11.51 9.57
68 20.39 15.80 11.43 9.53
69 20.00 15.59 11.35 9.48
70 19.60 15.37 11.26 9.43
On the other hand, if you are looking at cash-savings outside of a 401K, this can be significantly less. First the annual amount that you draw from your savings have already been taxed and secondly with greater flexibility in your choice of investments, you may be able to attain a higher level of return. It is likely that most people will retire with a combination of both 401K (or IRA) savings and should treat them as two separate pots.
Finally, we come to the question of how do we amass these savings. In effect we do the reverse to what we did in calculating the amount of funds needed. In this case it will be a combination of current savings or investments, monthly contributions and future savings that you may be able to safely assume. For instance, if your mortgage ends 5 years before you retire, you may be reasonably sure that you can save 80% of those payments, or when the kids finally leave the house you may think that extra-savings are possible. Everybody’s circumstances differ, so the details are very difficult to cover here, but future articles address some of the more common aspects.
This modelling is best done using a spreadsheet – if you have access to such software, then we will be happy to show you how to build this. We will discuss the details, in a later session, to help those who are not familiar with using spreadsheets (don’t be daunted by this – it really is a lot easier than it sounds). Alternatively, we can provide you with the necessary formula, so that you can do this with a pen, paper and a calculator
In future articles I will look in greater depth at each component of the calculation.