All of us hope that at the end of a long career we will be able to enjoy retirement secure in the knowledge that we can support our desired lifestyle without ever running out of money. Given that Americans are living longer than ever before, however, the risk of outliving our money in retirement is real. Diligence, careful planning and realistic expectations are therefore essential to achieving a successful life once our working life is done.
Here are some key areas to focus on as you plan ahead for your retirement.
1. Save Enough
In order to realize our desired retirement lifestyle without fear of outliving our money, we need to accumulate enough savings. But how much is enough? That depends on the annual cost of our desired lifestyle. For many, maintaining their current lifestyle in retirement is the goal, so knowing what it currently costs to support that lifestyle is important.
Once we have determined a target annual income in retirement, we can calculate how much of a nest egg will be required to support that income.
One way to calculate the size of the required nest egg is to back into it using a common rule of thumb known as the “4% Rule.” This rule is typically used to determine a “safe withdrawal rate” in retirement but is also useful in determining the required savings amount to support a target retirement income stream.
The 4% rule states that a retiree aged 60-65 can safely withdraw 4% a year from a reasonably diversified portfolio divided equally between stocks and bonds (adjusting that rate by annual inflation) and not run out of money for at least 30 years.
Using this rule of thumb, one would need to accumulate $1.5 million by the start of retirement in order to safely withdraw an inflation-adjusted $60,000 per year for 30 years. This is certainly not an insignificant sum. Supporting an inflation-adjusted income of $100,000 per year requires an accumulation of $2.5 million, an even more imposing amount. (Note that the 4% rule has been refined over the years and is also being called into question by some in light of the current low yield environment for bonds.)
While Social Security can provide additional income to supplement a portfolio in retirement, it is clear that saving as much as we can during our working lives is key to being able to afford a quality retirement. Taking advantage of workplace retirement savings plans, such as a 401K, and supplementing that by additional tax-deferred and taxable savings is essential. Target saving at least 10% of your gross annual income throughout your working life and remember that the key to accumulating wealth is to save as much as you can for as long as you can in order to allow the power of compounding to work for you.
2. Tax Diversify Your Savings
The effect of income taxes on our retirement should not be forgotten. Taxes are another “cost” impacting retirement cash flow. It is therefore important to minimize this impact as much as possible through good tax planning.
One way to achieve tax efficiency in retirement is to diversify pre-retirement savings across taxable, tax deferred and tax-free accounts. This practice of “tax diversification” will allow one to fine-tune portfolio withdrawals in retirement, depending on their relative tax impact, and carefully choose which “buckets” to tap for ongoing income needs.
Tapping taxable accounts first often makes the most sense given that this strategy typically enables a retiree to pay less income and capital gains tax while allowing savings to continue to grow in tax-deferred IRA and Roth accounts.
Ongoing tax planning is crucial for single retirees, given how quickly income tax rates rise for single people, as well as for married couples since it is inevitable that one spouse will predecease the other at some point in the future.
3. Use Effective Social Security Taking Strategies
The future of Social Security is often called into question raising concern regarding whether this program will be available to supplement our portfolio income in retirement.
It is true that current projections show Social Security benefit payouts starting to exceed program revenues beginning in 2016. However, even if no reforms are implemented, it is expected that Social Security will continue to be able to pay out 100% of benefits until 2033, and approximately 75% of benefits thereafter.
Social Security is therefore likely to remain a resource in retirement and maximizing this benefit is important. The fact that Social Security benefits are indexed for inflation throughout the benefit period and continue to be paid to surviving spouses make this program unique and an important supplement to an investment portfolio.
A discussion of the array of Social Security taking strategies is beyond the scope of this article. It is important to note, however, that there is a penalty of approximately 8% for each year benefits are taken before full retirement age. This reduction is permanent and also impacts surviving spouse benefits.
Deferring Social Security at least until full retirement age (age 66 for those born during 1943-1954) can result in significant additional retirement income. Waiting until the maximum deferral age of 70 will increase benefits by an additional 8% each year, to a maximum of 132% of the full retirement age benefit for most baby boomers. This strategy is recommended for the higher earning spouse in a married couple.
4. Have Realistic Expectations
Perhaps the biggest key to retirement success is to have a realistic expectation of the lifestyle we can afford. If savings and other sources of retirement income fall short of our goal as we near target retirement age, we need to assess our options. These essentially come down to living a more modest retirement lifestyle, working longer, or some combination of the two. Rarely is it prudent to swing for the fences by increasing the risk of our investments in an effort to overcome a savings shortfall. This strategy can backfire, leaving you in a deeper hole with no time to recover.
Retirement planning is fraught with complexity. There are no guarantees that we will achieve our goal and lots of risk of falling short given the vagaries of the stock market and the uncertainty around Social Security. The above discussion did not even touch on healthcare costs and the cloudy future of Medicare.
It can be daunting to try to navigate the retirement planning maze on one’s own. Consider working with a fee-only financial adviser to be your guide along the way and increase the chance that you will achieve your retirement goals, whatever those may be.
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