Personal Capital is the next-generation financial advisor. We combine technology with world-class advisory services to deliver truly personalized investment advice. Personal Capital puts your entire financial life at your fingertips. We help you analyze where you are and how to reach your goals. We are also a registered investment advisor (RIA) offering comprehensive wealth management services.
Despite the prevalence of 401k plans offered by many employers, Individual Retirement Accounts – or IRAs as they’re better known as – remain one of the most popular retirement savings tools in America.
It’s not surprising why since IRAs enable almost anyone to save money for retirement – and possibly save on their taxes while doing so.
Traditional IRA Contribution Criteria
The criteria for contributing to an IRA is simple: If you or your spouse earns taxable income in a given year and you’re under 70½ years of age, you can contribute money to an IRA. That’s it!
Whether you can reduce your taxes by contributing to an IRA is a little bit more complicated. This depends on several different factors, starting with your access to a retirement plan where you work. If your employer doesn’t offer a retirement plan (such as a 401k plan), you can deduct the entire amount of your annual IRA contribution on your federal income tax return, which may reduce the amount of taxes you pay.
If your spouse doesn’t work outside the home, he or she can also contribute to a separate IRA and deduct the contribution, up to the annual contribution limit. In 2017 and 2018, this limit is $5,500 or $6,500 if your spouse is 50 years of age or over.
However, if your employer offers a retirement plan, your ability to deduct your IRA contributions will depend on how much money you earn. In this scenario, your deduction will start to phase out once your adjusted gross income (AGI) reaches $63,000 if you’re single or $101,000 if you’re married and file a joint tax return. The deduction vanishes once your AGI reaches $73,000 if you’re single or $121,000 if you’re married and file jointly.
Make Contributions Strategically
The deadline for making contributions to IRAs for tax year 2017 is April 17, 2018. This means you still have time to potentially lower your 2017 tax bill by making a tax-deductible IRA contribution if you qualify. You can even open a new IRA if you don’t have one between now and April 17 and make contributions for tax year 2017.
If you haven’t yet maxed out IRA contributions for 2017, it probably makes sense to allocate contributions you make between now and April 17 to tax year 2017. For example, if you’re 40 years old and you’ve contributed $4,000 to your IRA so far in tax year 2017, try to make an additional $1,500 contribution for tax year 2017 before the deadline.
Conversely, if you have already maxed out IRA contributions for tax year 2017, be sure you allocate any contributions you make between now and April 17 to tax year 2018. This will enable you to get a jump start on retirement saving this year and potentially maximize tax savings on your 2018 return.
Automate Your Contributions
One way to ensure that you max out IRA contributions every year is to arrange for money to be transferred from a checking account into your IRA electronically each month. This way, you don’t have to think about it – your contributions are made automatically. Sometimes this is referred to as “paying yourself first.”
For example, if you’re 40 years old, you can contribute up to $5,500 to your IRA in tax year 2018. Let’s assume you make your first 2018 contribution in March, which gives you 14 months to max out contributions for tax year 2018. Dividing $5,500 by 14 months reveals that by contributing about $392 every month, you’d max out your IRA this year.
Or you could contribute $550 every month and max out contributions for 2018 by the end of the year ($5,500/10). Then you could adjust this to about $458 a month next January ($5,500/12) to max out contributions for 2019 and subsequent years. Note that the annual contribution limit could be adjusted in the future to account for inflation, so be sure to factor this into your planning.
Now is a great time to plan your IRA contribution strategy for tax years 2017 and 2018. Be sure to speak with a tax professional for more details about the deductibility of IRA contributions given your particular circumstances. For more information, check out the IRS website.
Learn more about taxes, retirement accounts, and how they fit into your holistic financial life by reading our free guide Personal Capital Tax Guide for Holistic Financial Planning.
This blog is for informational purposes only; we are not in the business of providing specific tax or legal advice and we generally recommend seeking the advice and counsel of a tax professional before taking any action that may cause a material taxable event.
While-You-Wait Investing: Income vs Cash Flow - YouTube
Many people think successful retirement means living off the interest from bonds or the dividends from high-yield stocks. That sounds great, but when you put this methodology under the microscope, there are some critical flaws with this approach. When you plan for spending in retirement, you should also consider how so many other variables – such as, inflation, taxes, and risk appetite – will impact your cash flow.
Watch our video to learn about how these variables can affect retirement.
To learn more and develop your retirement spending strategy, download Personal Capital’s Guide to a Better Financial Life.
The While-You-Wait video series goes over important financial topics when life puts us on hold.
Reheating your lunch? That’s the perfect time to watch. Leave a comment on what topics you’d like to see us cover next.
When we refer to your retirement number, most people think about how much money they need to save to meet their retirement goals. Knowing a specific retirement number is nice; it can provide you with a seemingly concrete, attainable goal. But is it truly valuable in the context of planning for retirement?
We’d love to say “yes,” but it may be an over-simplification. Believing that there is a perfect retirement number is just too simplified to be realistic, at least for most people. The retirement-number concept caught on precisely because it is so simple and carefree. Everyone wants to plug in a number, reach that number, and then move into retirement without a second thought.
Sorry folks, it’s usually not going to be that straightforward. It is crucially important for investors to understand the true, more complicated, nature of retirement.
Life is full of unexpected events, and that won’t change when you enter retirement. In fact, if you plan to retire at 65, you could spend 20 years or more in retirement. Just think how things can change over two to three decades. In 1998 (two decades ago from this post) the film Saving Private Ryan was released and seeing it in theaters would have cost a little more than $4.50. Compare that to the average price of a movie ticket today – nearly double the price at around $9.00 a movie! In 1988 – 30 years ago – the film Rain Main was released, and the average U.S. ticket price was $4.11 (as a digression, I’d be curious to know how much of this increase was related to 3D movies).
But let’s get back to the concept of a “retirement number”: If you retired with $1 million, you’d have a very different retirement experience depending on whether the stock market crashed the day after you retired or soared for the first decade of your retirement. Likewise, health problems or family issues could change your financial-security outlook. Even overspending during the early years of your retirement could throw a wrench into your plan.
These are great examples of why the highly simplified “retirement number” can be misleading, and possibly even dangerous, to your future financial security. A much more realistic approach is required.
Introducing Monte Carlo
No, we’re not talking about vacationing at a glamorous location. Monte Carlo simulations are mathematics-based analyses that attempt to make sense out of ambiguity and random variables-in other words, your retirement.
The concept of a retirement number makes planning appear to be black and white, but retirement planning is anything but. Monte Carlo simulations can help to add the necessary shades of grey that give you actionable knowledge.
These simulations use details based on your existing situation to analyze thousands of hypothetical retirement scenarios to determine your likelihood of success. For example, let’s say you want to retire at 65, you want to maintain your current lifestyle throughout your lifetime, and you want to do so using the assets you’ve already accumulated. A Monte Carlo simulation will run thousands of hypothetical market scenarios (thereby playing out situations in which the market tanks shortly after your retirement, or roars), and combines those market possibilities with your desired and planned cash flows. Personal Capital’s Monte Carlo software uses 5,000 scenarios. In the end, you will receive a probability-of-success ranking of low, medium or high.
The next step is up to you. There are many individual “levers” you and your advisor can pull to make your situation one that has a higher likelihood of success. For example, you may discover that you have a medium probability of successfully meeting your retirement goals. To potentially improve your probability of success, you could delay your retirement, save more now going forward, adjust your investment strategy and risk profile in the hopes of higher returns, or reduce your planned retirement spending. You could “pull” any or all of the levers to work towards increasing the probability that your investments sustain you throughout your retirement. Or, you can stick with your plan and acknowledge that some flexibly on your part may be required. This could mean actions such as downsizing your lifestyle later in your retirement, working a part-time job, or moving in with family. The choices you make entirely depend on your personal comfort level with flexibility.
Monte Carlo is an Ongoing Process
As you may have guessed, Monte Carlo-style planning is never done. Unlike a static retirement number, your actual life scenario is constantly changing, and your probability for retirement-goal success changes constantly, too. For example, inflation is a huge potential variable for retirees. Monte Carlo simulations can help you monitor the consequences, if inflation becomes a significant factor.
No one can predict the future, not even the best Monte Carlo simulations. However, a mathematics-based approach to retirement planning can give you a realistic picture, which is an excellent starting point. The goal is to understand your situation and continually work toward improving it. If you use Monte Carlo simulations, you won’t be hitting the retirement switch and checking out, but you will have a higher sense of control because you’ll be continually evaluating the impact of new information-and adjusting as needed.
You’re not a number, and your retirement-planning approach shouldn’t be, either. If you want to develop a retirement plan based on your personal reality and adjusted as your life circumstances change, you may need some guidance.
Personal Capital Advisors Corporation is an investment advisor registered with the Securities and Exchange Commission (“SEC”). Any reference to the advisory services refers to Personal Capital Advisors Corporation. Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk.
How much you can afford to spend in retirement? It’s a question the majority of us inevitably
face; yet it’s an answer that can prove elusive. This is where the 4% Rule can help. The 4%
Rule is a general rule of thumb for how much you should be able to spend in retirement.
According to the rule, you should be able to spend about 4% of your starting nest egg value
each year. So if you begin retirement with a portfolio of $1 million, then that should support
roughly $40,000 in annual spending. Keep in mind, each situation will vary by investor, so
consult with your financial advisor to see if this makes sense for you.
Watch our video to learn about how the 4% Rule fits in to your long-term financial plan.
While-You-Wait Investing: The 4% Rule - YouTube
To learn more about the 4% Rule and 3 steps to take to manage your money, download the free Personal Capital’s Guide to a Better Financial Life.
The While-You-Wait video series goes over important financial topics when life puts us on hold.
Reheating your lunch? That’s the perfect time to watch. Leave a comment on what topics you’d like to see us cover next.
Retiring abroad is a lifelong dream for many. If you’ve contributed enough to a retirement account for most of your working life, the dream can turn into reality. But before you get your passport in order and start packing, there’s a long road of preparation to see if moving abroad is the right decision for you. Here are some points to consider.
Scout Your Location
Visiting areas around the globe where you may want to retire should be at the top of your to-do list before making the move. Perhaps you visited Thailand in your 20s and thought it was great. But things change over several decades, including yourself. The heat and pollution you didn’t mind as a young buck might just be a little too much for you now. If you can afford to visit for a few weeks, then do it.
While there, check out real estate prices and other livable factors, as well as the things that attracted you there in the first place: weather, activities, customs, peer groups, food, and walkability.
Rent Before Buying
Moving abroad isn’t always permanent. You may decide after a few months that your new homeland isn’t for you. A wise move is to rent first to test out the neighborhood. It generally takes at least six months to get an idea of your surrounding area. Only then should you consider buying.
Even if you decide to stay long-term, renting may be a cheaper option that can provide flexibility if you decide to move someday or decide that moving abroad isn’t for you. Who knows? You might even want to move to another country during retirement. Research the local rental customs as well. For example, in some countries it is common practice to pay for a full year of rent up front, so know what you’re getting yourself into in advance.
Consider Health Insurance
Since Medicare doesn’t pay for health care outside of the United States, you may have to buy health insurance or pay out of pocket for health care in other countries. Find out if the country you’re considering is known for quality medical care. Some countries allow retirees who have established residency to participate in their national health plans. (According to the IRS, U.S. citizens who live outside of the country for at least 330 days in a year are usually considered residents of that country.)
Learn the Language
While much of the world speaks English, you’ll only help yourself by learning the local language. Besides spending several months getting the basic phrases down through your favorite online language resource, consider renting a couple TV shows or movies in the local language to immerse yourself further. In addition to learning the language, spend some time studying the city’s map and major landmarks so you’re able to hit the ground running. The last thing you want to do is not speak the language and not know where you’re going.
Compare the Cost of Living
Comparing the cost of living of your hometown to your new global city will show you how far your dollar will go. Create a spreadsheet comparing the cost of rent, food, and transportation between your top five cities under consideration.
According to Forbes, Singapore is the world’s most expensive city to live in, followed by Hong Kong, Zurich, Tokyo, Osaka, Seoul, Geneva, and Paris. And while there are plenty of cities on the flip side, keep in mind that oftentimes, things are cheap for a reason. It’s up to you to find something in the middle that makes the most sense.
Think About Transportation
Unless you really like driving in a foreign country, where driving rules can be different than in the United States, you’ll likely want to live somewhere that has good public transportation. The cost of cars can be sometimes triple the cost back in America due to hefty important tariffs.
Some questions to consider include: How often does the subway system you’re considering run? Does it run 24 hours a day like the Copenhagen Metro does? Is it as clean as Hong Kong’s? Does it have the technology (heated seats, Wi-Fi) that Seoul does? Or is the public transportation expensive and relatively non-existent like San Francisco’s?
Factor in Leisure Activities
The lack of American sports abroad can be one of the biggest disappointments for expats. Instead of American football, you’ll be relegated to soccer or rugby. If you’re a college basketball fan, you’ll unlikely be able to catch the March Madness action we so love here in the States.
But when retiring abroad, most people think of swimming in the ocean, relaxing next to the pool, going on a hike, lounging at a sidewalk cafe, or exploring new sites. It’s smart to find out the local festivities and traditions before going. Understanding seasonal weather patterns is also important since some countries experience heavy droughts or monsoon seasons.
Don’t Forget Taxes
Paying taxes is part of life. If you continue having income as a U.S. citizen, the IRS still expects you to pay U.S. taxes, no matter where you live.
U.S. citizens, or resident aliens of the United States who live abroad, are taxed on their worldwide income, but they may qualify for a foreign earned income exclusion for up to $104,100, which helps reduce taxable income. Your new country’s tax laws will still apply, and you may be able to claim any taxes you pay to a foreign country.
Take into Account Safety
The political stability of a country is a major part of your safety as a foreigner living in another country. Recent government upheavals may put you off moving there. You can look up a city’s crime index for more information.
Check Your Finances
Last, but certainly not least, finances will play a huge role into your retirement abroad plans. Even if you’ve saved enough for retirement and expect to be able to afford the cost of living when moving abroad, living the expat life can still turn out to be more expensive than planned. Perhaps you join a country club, hire a maid, and then a cook since labor is relatively cheap. Pretty soon, you’re blowing through your budget due to lifestyle inflation. Just because you’re abroad doesn’t mean you shouldn’t continuously stay on top of your finances.
If you’ve still got a little bit of adventure in you, and you don’t mind being far away from family, retiring abroad might be a fantastic choice. Why not leverage your buying power for a more comfortable retirement overseas?
If you’re thinking about retirement, you should also be thinking about the cost of healthcare during retirement. Most experts estimate that the lifetime average out-of-pocket expenses for a retired couple are approximately $275,000—and that price tag is rising. What’s more, if you plan to retire earlier than 65, before you are eligible for Medicare, the bill could be higher.
Are you suffering from sticker shock? It’s a tough pill to swallow (pun intended), but it’s much better to know the truth up front so you can plan for your future. There are really three main considerations—and the first has some good news attached, so we’ll start there.
A Lifetime Estimate
You do not necessarily need to set aside $275,000 for your healthcare costs before you retire. In fact, most healthy retirees spend much less during the early years of retirement and more as they age. This means a lot of out-of-pocket expenses can be paid in monthly installments over long periods, which can be accommodated within your monthly budget. So keep in mind you may not necessarily need to have this money set aside prior to retirement; however, you should ensure medical expenses are factored in to your retirement budget
Over the full course of retirement, that $275,000 number is an average-cost estimate. If you maintain good health throughout your retirement, you may not spend as much. On the other hand, you might spend much more if health issues become a major obstacle. Before you retire, you should weigh the possibilities. Is your health currently good? What is your family medical history? Do you practice healthy eating and excercise habits? Based on your information, you can create your personal estimate—but be realistic.
Retiring Early Increases Healthcare Costs
If you plan to retire before 65, your lifetime healthcare costs will, on average, run higher than the $275,000 estimate. In fact, these costs may run substantially higher. You will not qualify for Medicare until age 65, so you’ll be responsible for all your healthcare expenses until you hit the qualifying age.
Many people do not fully realize how much of their medical costs are subsidized by their employers. If you are planning to retire early, you need to find out just how much you will pay if you’re not covered by your employer. Unless your employer will continue to pay your healthcare, an increasingly rare scenario, you’ll be responsible for the full amount. If you are near 65, you may be able to use COBRA to cover the gap in coverage or you may need another solution. For example, you can opt for a higher deductible policy to bring down monthly costs, but you are accepting that additional risk if you need to use your healthcare coverage.
When you consider this additional expense, you might be convinced to work longer, which is a very reasonable solution. Working longer can extend your subsidized medical care coverage from your employer and you gain more time to save for retirement. A financial advisor can help you determine how many additional years you might want to work. In many cases, just a couple more years can make a big difference.
Long-Term Care is the Wildcard
That $275,000 estimate does not include any long-term care expenses—and health insurance, even Medicare, does not cover these costs. In short, a lengthy stay in an assisted living facility or nursing home can quickly drain your retirement savings.
One solution is long-term care insurance, but you need to start thinking about this option in your 50s or 60s—it won’t be available if you wait until you need the services. Generally, the younger you are when you obtain a policy, the less you will pay for the monthly premium. However, there are some other things to consider besides the premium.
First, you’ll want to stick with a reputable insurer. You will, most likely, be paying a premium for years, even decades, before you need the service. You want those premiums to go to a stable company. Keep in mind, that most long-term care policies allow for the insurer to raise your premiums, often significantly during the life of the policy. You also need to look carefully at how the policy works. For example, most policies do not kick in until the patient has needed assistance for 90 days, and the qualifying guidelines are quite specific. Policies also have a daily cap, which needs to closely match the long-term care costs for your area or you’ll still be stuck with a big bill.
Lastly, standalone long-term care insurance is “use it or lose it,” meaning if you never have long-term care needs, you could end up paying for expensive insurance for no reason. Some carriers offer hybrid life insurance/long-term care insurance policies that are a little more flexible. You should work with your financial advisor to determine which type of policy is appropriate for you.
Because long-term care insurance is so expensive, many retirees choose to self-insure this risk. While Medicare does not cover the cost of long-term care, Medicaid does. However, to qualify for Medicaid you will need to significantly spend down your assets which can leave your loved ones in a difficult position. If you chose to self-insure this risk, it is important to understand all of the implications to you, your partner and your heirs.
As you can see, healthcare costs are a prime factor in retirement planning and you may need help with your decisions. Personal Capital does not offer healthcare products, such as long-term care insurance, but our skilled advisors can provide you with an assessment of your personal options and help you come to some reasoned conclusions.
It’s a new year, so it’s time to consider boosting contributions to your employer-sponsored retirement savings plan—and the federal government is willing to help (a little.) The maximum contribution has increased this year, so you can shelter a bit more money from taxation, if you choose, to maximize your retirement savings.
For most workers, the 401k is their standard employer-sponsored retirement plan. Some workers, however, are enrolled in 403b or 457b plans, instead. While there are some minor differences between these plans, they are generally treated in a similar manner, and they usually have the same maximum contribution limits. The main difference between these plans is worker classification. Generally, 401k plans are used by for-profit businesses; 403b plans are used by tax-exempt groups, such as schools or hospitals; and 457b plans are for government workers, although there are some non-governmental organizations that also qualify to use these plans.
For simplification purposes, this discussion will refer to the most common plan, the 401k. The information is still relevant, though, if you are enrolled in either a 403b or 457b plan.
What are the new maximum contributions?
According to the IRS, If you are under age 50, your maximum 401k contribution is $18,500 in 2018, which is an increase of $500 over 2017 limits. For workers 50 and over, the catch-up contribution of $6,000 remains constant, which means you can contribute a total of $24,500 in 2018.
These amounts do not include any contributions from your employer. If you include all possible contributions from your employer, the total maximum amount you can shelter in your employer-sponsored tax-deferred plan in 2018 is $55,000 for those under 50 and $61,000 for those 50 and over.
If you are enrolled in a 403b and 457b plan, there are some minor differences in the “catchup provisions” in these plans. You should check with your plan administrator to learn about the specific provisions of your plan.
As you can see, investing in your 401k, 403b or 457b is a valuable, easy way to reduce your taxable income, while building your future retirement funds.
But do those numbers sound daunting?
It’s nice that workers can put away relatively hefty sums of tax-deferred money each year, which is earmarked for their future selves. But not everyone is worried about maximum contribution levels. Some people are more worried about saving anything at all, or scraping together enough to capture their entire employer match. If that sounds more like you, it’s still a good time to take a fresh look at your contributions to an employer-sponsored retirement plan.
Some of the best advice you can embrace for your future financial self is to save as much as you can and start as soon as you can. Your employer-sponsored retirement plan is a natural starting point. It is particularly important to try to qualify for all matching contributions, which essentially creates an instant return on your investment.
If you have trouble saving, look for ways to decrease your monthly expenses and make saving a priority. If you’re not feeling the pinch at least a little each month, you could probably save more—and you probably should. Your retirement account will play a major role in the financial security of your future self. Saving now can help make that account turn into a worthy safety net and give you some financial peace of mind.
Second 2018 bonus for savers: Recent tax changes
If you have diligently saved money in a tax-deferred account, pat yourself on the back. The 2018 tax reform bill is giving you a little bonus—in addition to higher maximum contribution limits. Tax reform put many workers into a little bit of a lower tax bracket, which means the money you’ve already socked away escaped being taxed at the previously higher rates. For those that begin retirement distributions this year, they will likely be taxed at the new lower rate.
This blog is for informational purposes only; we are not in the business of providing tax or legal advice and we generally recommend seeking the advice and counsel of a tax professional before taking any action that may cause a material taxable event.
If you are like lots of investors, you’ve probably never heard of sequence risk — also called sequence-of-returns risk — but it is a particularly pertinent concept for those nearing or just entering retirement.
Simply put: Sequence risk refers to the order or the timing in which your investment returns occur. It specifically relates to the risk of early declines and ongoing withdrawals impacting your spending during a certain period of time, most often in retirement.
It is this concept that helps explains why two retirees with the same wealth levels might not have the same retirement experience, even if their long-term return averages look the same.
An Example of Sequence Risk & Retirement
Let’s say your friend, Sam, retired five years ago with a $1 million nest egg and at the end of his first year in retirement and every year thereafter, he withdrew $50,000 per year as part of his annual income. If his nest egg grew 10% each year for the first three years, but dropped 5% each year for the next two years, at the end of five years his remaining nest egg would be $954,364. Overall, he weathered the two-year downturn fairly well.
Now, what if you retired with the same $1 million nest egg and you withdrew the same $50,000 each year, but your nest egg dropped 5% per year for the first two years and grew 10% per year for the next three years? Your remaining nest egg would be $905,955.
In this scenario, you didn’t fare as well as Sam. Overall, each person experienced the same amount of growth and the same losses, but your portfolio is $48,409 behind Sam’s results because of sequence risk—you experienced losses early in the five-year cycle.
This example illustrates how two retirees with the same wealth levels can experience different retirement results—sometimes significantly different results.
Consider the bad timing of a person who retired September 29, 2008, when the stock market fell 777 points, the largest single-day drop in history. While every investor faced the same drop that day, our newly retired individual had an added challenge. At some point, he must make a withdrawal for living expenses, and he must continue to make an annual withdrawal if he sticks with his retirement plan.
When you take withdrawals from your portfolio, instead of making contributions, the timing of gains or losses can make a significant difference in your overall results, despite long-term averages. The most critical time is right before or right after you retire—generally within a five-year period on either side of retirement. This period is so important because an early reduction in your nest egg could impact your future for years to come. That’s because you subject the portfolio to a double dip (returns and withdrawals) at the same time and that leaves less money to recover over the long term.
What Should You Do if You Encounter Sequence Risk?
First, don’t panic. You need to keep your assets invested to earn sufficient returns to maintain your retirement lifestyle. And trying to time market cycles is a nearly impossible task.
Fortunately, understanding the impact of sequence risk on your portfolio means you can take steps to diminish any potential negative impact. The crux of the sequence-risk challenge is the need to systemically drawdown assets—which is an element you can control through planning.
One potential solution is to build a retirement plan that incorporates some flexibility regarding how you obtain your annual withdrawal. For example, keep some funds – perhaps enough to equal at least one year’s withdrawal – in cash or cash equivalents, such as money market funds. This flexibility helps keep your investment portfolio on the same footing as other long-term investors during market downturns, which allows you to alleviate much of the significance of sequence risk.
Of course, every investor’s circumstance is different, so finding the most effective investment positioning is highly individualized. That’s where seeking advice comes in. If you are nearing retirement, it would be a good time to consult with a financial advisor regarding the asset mix in your investment portfolio. During your working years, you may have been primarily focused on investment growth, but you may now want focus on smoothing out volatility by taking a bit more conservative approach.
Remember, that does not mean abandoning the stock market because you are still a long-term investor—you could spend one, two or more decades in retirement, so you’ll still need a focus on growth to combat inflation and increase the longevity of your assets.
Like most people, you’ve probably wondered, “How much income will I need during my retirement years?”. You’ve also probably wondered why you never seem to run across an answer to that ubiquitous question. So how much do you need to ensure you can retire comfortably?
Why the Answer is Hard to Find
There is endless information about building a retirement nest egg and almost nothing about how big that nest egg should be. Two common reasons why the size of your nest egg is the subject of endless debate include:
The amount is different for everyone because a “comfortable” retirement is entirely subjective
No one can agree on how much of your nest egg you can spend each year to sustain a comfortable retirement
As an individual, the first reason is straightforward and can be answered relatively easily. On your own, or with the help of a financial advisor, you can develop an estimate with some back-of-the envelope math.
What to Consider When Determining Your Retirement
First you must decide what you consider a “comfortable” retirement. This answer is, of course, different for everyone. But with a little addition and some simple multiplication, you now have a reasonably accurate estimate of your required annual income needs in retirement.
Some basic things to consider when calculating how much you need for retirement include:
Basic Needs: If you want a basic income to cover those needs, then you should identify your monthly necessities and multiply by 12. These items include: mortgage, groceries, insurance, utilities, car payments, and other expenses.
Added Luxuries: If you want more luxuries, you should define the specific desired activities and estimate their approximate costs based on frequency, equipment needed, or any other related. These costs should be added to your monthly budget. Examples of these luxuries can include hobbies, a vacation home, a boat, and travel.
Inflation: Additionally, you’ll need to consider inflation. There is plenty of information available to help establish a reasonable inflation estimate, but 3-4% is a good long-term inflation number you can use for your calculations.
The Challenges of Predicting the Future
There is more to retirement planning; however, it’s not often so easy to calculate. To decide how much you can spend each year to sustain your retirement, you need to know how long you will live in retirement and how much your investment portfolio will earn. If you retire at 65 and die at 80, you’ll need income for 15 years. What happens if you live to be 100? You don’t want to live without resources for 20 years. So, how much will your investment portfolio earn? That depends on stock market/economic conditions and the asset mix in your portfolio. You’ll also need to consider other individualized factors, such as how long you will work, social security, pensions, home equity and, of course, financial market cycles during your retirement years.
Now you can see why the “how-much” question generates endless debate. How long you will live and how much your portfolio will earn are simply unanswerable questions.
The “4% Rule”
For more than 20 years, financial professionals have been loosely guided by what is called the 4% rule. If you follow this rule, you withdraw 4% of your portfolio in the first year of retirement and then you annually withdraw that same dollar amount, adjusted for inflation, for the next 30 years. The idea is that if you follow this rule, you minimize your chances of running out of money in retirement.
While this rule is a good starting point, it has been hotly debated since it was established. Some argue that it is too conservative. Others argue that today’s low-interest environment and longer life expectancies make it too risky. Meanwhile, your financial future hangs in the balance. If the rule is too conservative, then you’ve unnecessarily constrained your retirement lifestyle. If the rule is too risky, you could run out of money just when you need it most.
The Definitive Answer to an Indefinable Problem
While the debate rages on, there is a one-word answer to this how-much question: flexibility.
And while it would be convenient to have a magic number to shoot for, that number is going to fluctuate constantly throughout your life based on a multitude of factors. So, the best answer is to maintain your flexibility—beginning when you are young by ensuring the decisions you make allow you to have more flexibility when you are in retirement. Review your retirement annually, consult with your financial advisor, ask questions, and be open to changes based on both individual and outside factors.
So, you’ve built an investment portfolio over the last two to three decades and you’re headed for retirement. Now what? Some investors think they should raise their hands in victory, crash through the finish-line tape, and then sit back and collect their rewards.
Not so fast, you might say, as most investors actually have anxiety about how to make what they spent most of their lives accumulating, last long enough in retirement
Building a retirement portfolio is, essentially, the halfway point in the race. The second half is sustaining the retirement lifestyle you imagined. Even if you are still in the accumulation phase, it is not too early to begin thinking about the second half of the race—building a sustainable retirement.
Why? Because creating a sustainable retirement is a highly complex planning challenge.
Retirement planning has completely changed over the past few decades, and it continues to evolve. One of the biggest changes was the shift from pension plans to individual retirement plans. This is where the complex challenge begins for many of today’s investors.
Pension Plans vs. Individual Retirement Plans
Pension plans offer the advantage of statistics-based management. A pension fund is just a large pool of money that is managed based on averages, with the average lifespan being the most significant statistic. For a pension fund, a single individual’s lifespan isn’t relevant; instead the key to successful management of the money pool is to correctly gauge the average lifespan for everyone in the pool. (Successful pension funds must correctly estimate many other factors, too, but the major factor is lifespan.) Once a pension fund has some accurate averages, investment decisions can be made based on the rate of return needed to satisfy its obligations. While that can be a daunting task, it’s not as daunting as the task facing individual investors.
An individual investor starts with a much smaller pool of money and a statistically undefinable problem. They are faced with the same issues as pensions – making investment decisions based on the rate of return needed to satisfy obligations; however, individuals usually cannot accurately gauge the size of their specific obligation. For example, an individual who lives for just five years after retirement needs far fewer financial resources than an individual who lives for 30 years after retirement. To plan a sustainable retirement, an individual investor needs to correctly estimate a single lifespan – his or her own – which will probably not fit the statistical average. To further complicate matters, lifespan statistics can change. For example, medical advances tend to add a few years to an average lifespan. Additionally, an individual’s spending expectations, which differ widely, should be part of the overall planning process.
Unlike pension plans, where answers lie in correctly interpreting group statistics, the answers to an individual retirement plan are as unique as the individual. Add market uncertainty and a low interest-rate environment to the equation and you have created more anxiety to retirement planning.
That’s why building a sustainable retirement can be so hard.
How to Build a Sustainable Retirement
So, what’s an investor to do?
For younger investors, fully grasping the elusive nature of retirement planning is the first step. Effective retirement planning involves much more than contributing to your 401k. It’s a journey that benefits from thoughtful planning and expert advice. That’s why investing early, continually tracking your assets, and adjusting your strategy can help you go the distance in your retirement.
The key is to find a disciplined investment strategy that strikes a balance by providing the diversity, risk-tolerance, and flexibility you need.
For investors who are nearing retirement, or are already retired, take a deep breath. Anxiety-driven investors can become more short-term focused, which could damage your long-term goals. The key is to find a disciplined investment strategy that strikes a balance by providing the diversity, risk-tolerance, and flexibility you need.
Yield-seeking is currently in vogue for many older investors. The concept is simple: Invest for yield and spend only that income, leaving your original nest egg untouched. Voilà, you have created a stable income source and you haven’t touched your original nest egg. Your future is secure, right? Maybe.
In today’s low interest-rate environment, finding yields that will meet your income needs can be difficult. Purchasing high-yield debt is one approach, but that debt carries substantial risk. High-yield bonds tend to get relabeled as junk bonds during periods of high default. Perhaps a safer approach to income generation is purchasing dividend-paying stocks, but those options may also erode your nest egg. Dividend-paying companies tend to be concentrated in certain industries and usually high-growth companies do not pay dividends, so you give up some diversification if you concentrate on dividend-paying stocks.
While a yield-seeking strategy can be beneficial, it can also be deceptive, so you should fully understand the complexities behind this seemingly simple strategy before making decisions that could inadvertently erode your investment portfolio.
A skilled advisor can help you understand the relationship between portfolio growth and income generation. At Personal Capital, we take a holistic approach to investing and planning for your long-term financial goals.