Retirement can be one of the most active times in an individual’s life. However, it can also be one of the most expensive.
Attributed largely to lack of planning, many retirees are finding themselves in their golden years without enough retirement resources to maintain a decent standard of living. For these individuals, doing the things they’ve always dreamed of – starting a new career or hobby, traveling, buying a second home, spending time with friends and family, volunteering in the community – is not even a consideration. For some, even having enough money to pay for basic needs is out of reach.
These days, Social Security benefits are simply not enough.
And, because income is needed to offset the impact of taxes and inflation, as well as to meet current needs, part-time work is, unfortunately, becoming a requirement – rather than a choice – for many retirees.
It does not have to be this way. Taking the time to plan earlier in life can mean a world of difference later.
Retirement has come to mean much more than the final stage of life after years of earning a living. It is the time to enjoy the rewards of a long career and can be the most satisfying period of a person’s life. People should be able to enjoy this period in their lives.
True retirement planning entails accumulating and conserving sufficient resources to enjoy a desired lifestyle without the requirement of further employment. But planning does not end on the day an individual retires. On the contrary, retirees must plan to minimize taxes on their retirement income and employ strategies for keeping pace with inflation. During retirement, people must also begin planning their estates: how they will preserve and then distribute their assets among their heirs.
In addition, the face of retirement in the United States is changing:
Our society is “graying” at an increasing rate. By the year 2050, 86.7 million people in the United States will be over the age of 65, compared to 35.9 million in 2003, according to estimates from the U. S. Census Bureau. Our society is living longer. But living longer does not necessarily mean we are also working longer. Whether we can afford to or not, the Social Security Administration reports that we are retiring even sooner – 61 is the current average retirement age – and the baby boom generation is hoping to retire even earlier.
Americans of all generations and income levels need to be concerned with saving for retirement. Generally, we are living longer, retiring earlier, and saving less. On top of that, a significant number of baby-boom retirees will begin to collect from Social Security – a system that many believe is being depleted. The next generation, often referred to as Generation X, will likely have to struggle to support the system for their parents and grandparents.
Taking these facts and trends into consideration, one can begin to see why careful planning for retirement is a necessity.
Managing any financial strategy calls for gathering information and setting goals. Retirement planning is no different.
The first step is usually to identify financial assets, their tax status, and ownership. By doing this, individuals generally come to better understand their current financial situation.
Next, specific goals for the future should be established – from when a person wants to retire to what kind of lifestyle they want to lead. Once objectives are defined, they should also take the next step and look ahead to the future, developing strategies designed to meet those goals and plan for potential problems, as well as for deciding which assets can be set aside for retirement purposes and which are to be used to meet current needs.
This entire process is usually best accomplished with the help of a professional financial advisor. While today’s investors are smarter than ever, investment choices are also more complex than in the past. Experienced financial advisors have in-depth knowledge of investment alternatives and understand the need for asset allocation and diversification in portfolios. By analyzing their clients’ time horizons and risk tolerances, they can help them develop customized retirement plans.
Just as important as establishing clear goals is reviewing what obstacles could hinder success. Liabilities should be examined. Short-term liabilities, such as credit card debt and car loans, may interfere with the ability to save when a person is in his or her 30s, 40s, or 50s. Long-term liabilities, such as a home mortgage, will also enter into the retirement planning equation because they are likely to extend into retirement years.
Successful planning will take into consideration other variables that have the potential of influencing retirement years, including:
Making contributions as soon and often as possible can maximize retirement savings potential. For many, this can mean the difference between a secure financial future and a retirement of unsettling dependence on Social Security.
The amount of time until an individual retires also affects the amount that needs to be saved. For example, the shorter the time frame until retirement, the greater the amount of savings one may need to set aside each month.
Clearly, one’s desired standard of living while in retirement will also influence the amount he or she needs to save. If an individual is accustomed to a certain standard of living, and he or she wishes to continue this standard during retirement, appropriate planning and saving are critical.
Unless an individual considers inflation and learns to combat its corrosive effects, it will eat away retirement savings, both pre-and post-retirement. Individuals must be concerned that their retirement income will keep up with inflation.
The following table shows the hypothetical impact of inflation on $100 over the next 25 years, assuming a 4% inflation rate.
Income taxes can have a significant effect on retirement planning. Current taxation of one’s salary will not only impact the amount that can be saved but also the effective return earned on retirement savings. Because of the numerous income tax benefits, tax-deferred savings are seen as an important part of building a sound retirement plan.
In short, tax deferral means delaying when taxes are paid to a time when – hopefully – doing so will have less of an impact. With a tax-deferred investment, not only will one’s contributions grow without taxation, but returns from the investment that are reinvested will grow without taxation, as well. Of course, funds do become taxable upon withdrawal.
Tax deferral can be achieved through various means, including fixed and variable annuities, individual retirement accounts, and employer-sponsored qualified retirement plans, such as profit-sharing, ESOP, 401(k), and defined benefit plans.
The advantage of using a tax-deferred account rather than a taxable alternative for retirement planning purposes is illustrated in the following graph. Assuming an 8% rate of return, a $100 investment made at the beginning of 2005, an effective tax rate of 28%, and a time period of 30 years, consider these hypothetical results.
Managing Retirement Assets
Once reasonable and quantified retirement objectives are established, available investment classes in which to invest retirement funds should be assessed.
Both risk tolerance and time horizon play an important part in deciding which investments are suitable. Determining the appropriate asset allocation – the diversification of assets among different investments and asset classes – may help achieve one’s stated objectives while potentially reducing risk exposure.
Next, the specific investments within those classes should be selected. Because the sole constant in life is change – changes in an individual’s personal circumstances and family needs, as well as changes in the financial climate – one must periodically review and revise how his or her retirement assets are being managed to ensure they remain in line with overall goals.
The resources that are available in retirement planning can be seen as a “three-legged stool.” Each leg represents a potential source of retirement income that may be available to support retirement expenses.
The three legs of the stool are:
In an effective retirement plan, each leg plays a role. Unfortunately, there has been a growing need for the use of a fourth leg: part-time work. The chart below illustrates the amount of today’s average retirement income acquired from each leg.
A Paycheck of Sorts, Even After Retirement
A qualified retirement plan is a plan by which part of the compensation one might otherwise receive currently is deferred and deposited into a fund by the employer. The benefits from the fund are then paid upon retirement. A qualified retirement plan is, therefore, a plan of deferred compensation that receives special tax benefits that are not available on other investments.
Qualified plans are either defined-benefit or defined-contribution plans. As the names imply, the type depends on whether the plan guarantees a specified “benefit” level or specifies an employer “contribution” rate.
It is important to remember that an employer does not guarantee the amount of the benefit the employee will receive from a defined-contribution plan when he or she retires. Rather, the amount will depend almost entirely on investment results.
Social Security is another source of retirement income. For retirement planning purposes, it is important that individuals take an active role in understanding how the Social Security system works and what it may provide during retirement. This includes becoming familiar with the eligibility requirements and the amount of retirement benefits actually paid to retirees.
An individual is eligible for Social Security retirement benefits if he or she has 40 “quarters of coverage.” A quarter of coverage occurs when a person works during a calendar quarter and earns wages. The amount of the retirement benefit received is based on how long the individual has paid into Social Security and the amount of earnings obtained during that period.
The maximum benefit a 65-year-old retiring in 2005 will receive is $1,939 per month, up from $1,825 in 2004. If an individual is 62 and wishes to receive benefits early, the maximum amount will be reduced. Given the maximum benefit amounts that are paid to retirees, it is easy to see why Social Security should only be considered a supplement to retirement income.
Getting “Personal” About Retirement Savings
Personal savings and personal investments represent an ever-growing part of retirement planning. In fact, these should be the largest sources of retirement income for retirees. The amount of savings needed – in addition to contributions at work – is expanding because the retirement benefits available through employer-sponsored plans and Social Security are decreasing.
Conceptually, types of assets for retirement investment can be broken down into two basic types: fixed income and equity. Each type of investment will play a role in the retirement planning process.
Investors may purchase these assets in several different ways. They may be purchased individually or they may be held through mutual funds, annuities, or asset managers.
To potentially reduce the risk and maximize the value of a retirement strategy – or any financial plan – one should diversify his or her portfolio. Diversification, or spreading assets across a variety of different investments, is perhaps the single most important rule an investor can follow. The value of diversification is often underscored by events in the financial markets, such as a sharp drop in stock prices.
Diversification offers a dual benefit because each kind of investment follows a cycle of its own. Each responds differently to changes in the economy, so if an investor owns a variety of assets, a decline in one may be balanced by stability or increased value in another.
Diversification does not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal.