The primary goal of retirement planning is to ensure you have enough money to stop working and live the lifestyle you desire during your retirement years. Unfortunately, this is more complicated than ever with pension plans becoming more scarce, Social Security becoming uncertain, and people living longer on average than in the past.
A guideline that has been popularized over the years is that you only need a certain percent of pre-retirement income to live on during your retirement years. This is referred to as the wage replacement ratio, with 70% being a common threshold that is often used.
For example, if you are making $100,000 per year and use a 70% wage replacement ratio, you will need $70,000 per year (adjusted for inflation) throughout retirement. Although this can be a good starting point, it’s important to complete an in-depth analysis when determining your true retirement income needs. Everybody has different goals, and you need to plan specifically for your unique situation.
Many assumptions must be made during the process, making retirement planning more of an art rather than an exact science. However, by making some assumptions and doing some analysis with various variables, we can determine a more accurate estimate of what your actual retirement needs and likelihood of success will be.
Assumptions to be considered include, but are not limited to:
Life Expectancy
Life Expectancy refers to how long you expect to live. The longer you live, the more money you will require throughout retirement. Your life expectancy can be influenced by many factors such as family medical history, gender, and lifestyle choices. Though these factors are unique to you, there is a general trend we can see. Life expectancy overall has been steadily increasing as we achieve further medical advancements.
According to the Centers for Disease Control and Prevention, the average U.S. life expectancy is about 79 years of age. This can be a good starting point, but it is extremely important to note this is only an average. That means half of the U.S. is expected to live past 79 years old. It is generally a good idea to be conservative when assuming your life expectancy. For example, if you assume you will live to age 79 but end up living to age 100, you might run out of money since you did not plan on the extra 21 years of life. By increasing your life expectancy when planning for retirement, you can lower the risk you will outlive your money.
Inflation
Inflation is the increase in general prices for goods and services. Each year, on average, it costs more to buy the same goods and services than the year before. This makes living the same lifestyle more expensive as time goes on. The long term inflation average since 1913 has been 3.09% according to in2013dollars.com. Again, this 3.09% is just an average and will change year to year. There have been decades when inflation has averaged over 9% and decades when inflation has averaged about -2% (known as deflation). Although you cannot predict exactly what inflation will be going forward, it is important to analyze the current economic environment to make as close an estimate as possible.
Expense Goals
Expense Goals are based on the lifestyle you expect to live during retirement. To determine expense goals, you must create a budget for all retirement needs and desires. These expenses should include items such as vacations, housing costs, food, hobbies, medical expenses, and more. Make sure to include one time expenses as well as ongoing expenses. While you cannot predict exactly what you will spend during retirement, you should make a list of all reasonably predictable expenses to at least get a closer estimate.
Returns
Returns must be estimated for the years leading up to retirement as well as during retirement. The return assumptions will be set as you develop your portfolio strategies and goals. As you near retirement, expected returns will generally become lower as your portfolio becomes more conservative in order to protect your capital. Although you can assume an average rate of return, it is important to realize that actual returns will fluctuate from year to year. This can be accounted for by using probability analysis, which will be briefly covered later in this post.
Income
Income can come from a variety of sources. The most common retirement income sources include Social Security, pension plans, and annuities. You should determine what age you will begin receiving payments from your various income sources before plunging into retirement. It is also important to determine if there is any cost of living adjustment to help keep up with inflation, or if you will be receiving a fixed amount forever (generally Social Security receives a small adjustment, while pensions and annuities typically do not).
While there are additional factors that should be considered, these are pertinent variables that will have a significant impact on your retirement plan. A small change in any of the variables above can have a massive impact on your expected success in retirement.
This is why it is important to run a probability analysis via Monte Carlo simulation rather than a straight line analysis. In a straight line analysis, we assume you receive the exact same return each year and no variables ever change – but this is not how the real world works. Probability analysis (Monte Carlo simulation) takes into account various scenarios to show you a range of returns rather than a static single return year after year. This helps illustrate what we would expect a portfolio to do in best and worst case events.
After the various scenarios are run, we see what the probability of success is given the changing factors. For example, what if you plan on achieving a 5% average return per year, but only achieve a 2% average return the first few years? Would you still be ok going forward, or would you need to reduce expenses so you don’t run out of money? Running a probability analysis can help us explore these types of scenarios before making any decisions.
There can be many nuances when it comes to retirement planning. In the end, you must be emotionally as well as financially prepared. Creating a plan can help on both fronts by placing your long-term well-being ahead of the temptations of making short-term adjustments, leading you to be able to more accurately predict that you are financially ready to retire with your desired lifestyle once that day comes.
It is never too soon to start thinking about retirement, so make sure to start planning early and track your progress often to ensure you are able to achieve your retirement goals.
Ben Webster, CFP® and Derek Prusa, CFA, CFP®
Co-Founders and Owners of Aspire Wealth
Why You Need an Investment Plan
