5 Steps to a Retirement Plan

Basic guidelines exist to assist people in creating their retirement plans. These guidelines can either form the basis of a self-directed retirement investment strategy or can be used to help guide the investment process of an external financial professional. (For more, see our tutorial: Retirement Plans.)

1. What Is Your Time Horizon?

You current age and expected retirement age create the initial groundwork of an effective retirement strategy. First, the longer the time between today and retirement, the higher the level of risk that one's portfolio can withstand. If you're young and have 30-plus years until retirement, you should have the majority of your assets in riskier securities like stocks. Though there will be volatility, over long time periods stocks outperform other securities, like bonds.

Additionally, you need returns that outpace inflation so that you can not only grow your money in total, but also against your future purchasing power. (Bonds have actually outperformed stocks in the past 10 years. To read more, see: Get This: Bonds Beat Stocks After All.)

In general, the older you are, the more your portfolio should be focused on income and capital preservation. This means a higher allocation in securities like bonds, which won’t give you the returns of stocks, but will be less volatile and will provide income you can use to live on.

You also will have less concern about inflation. A 64-year-old who is planning on retiring next year does not have the same issues about inflation as a much younger professional who has just entered the workforce.

“Inflation is like an acorn. It starts out small, but given enough time can turn into a mighty oak tree. We’ve all heard – and want – compound growth on our money. Well, inflation is like ‘compound anti-growth,’ as it erodes the value of your money. A seemingly small inflation rate of 3% will erode the value of your savings by 50% over approximately 24 years. Doesn’t seem like much each year, but given enough time it has a huge impact,” says Christopher Hammond, financial advisor and founder of RetirementPlanningMadeEasy.com in Savannah, Tenn.

Third, although it is typically advised to begin planning for retirement at a younger age, younger individuals are not expected to perform the same type of due diligence regarding retirement alternatives as someone who is in his or her mid-40s.

Also, you should break up your retirement plan into multiple components. Let's say an older parent wants to retire in two years, pay for her child's education when he turns 18 and move to Florida. From the perspective of forming a retirement plan, the investment strategy would be broken up into three periods: two years until retirement (contributions are still made into the plan); saving and paying for college; and living in Florida (regular withdrawals to cover living expenses). A multi-stage retirement plan must integrate various time horizons along with the corresponding liquidity needs to determine the optimal allocation strategy. You should also be rebalancing your portfolio over time as your time horizon changes.

Most important, start planning for retirement as soon as you can. You might not think a few bucks here or there in your 20s mean much, but the power of compounding will make that worth much more by the time you need it. (The future may seem far off, but now is the time to plan for it. Check out 5 Retirement Planning Rules for Recent Graduates.)

2. What Are Your Spending Requirements?

Having realistic expectations about post-retirement spending habits will help you define the required size of the retirement portfolio. Most people argue that after retirement their annual spending will amount to only 70% to 80% of what they spent previously. Such an assumption is often proved to be unrealistic, especially if the mortgage has not been paid off or if unforeseen medical expenses occur.

“In order for retirees to have enough savings for retirement, I believe that the ratio should be closer to 100%,” says David G. Niggel, CFP®, Key Wealth Partners, LLC, in Lancaster, Pa. “The cost of living is increasing every year – especially healthcare expenses. People are living longer and want to thrive in retirement. Retirees need more income for a longer time, so they will need to save and invest accordingly.”

Since, by definition, retirees are no longer at work for eight or more hours a day, they have more time to travel, go sightseeing, shopping and engage in other expensive activities. Accurate retirement spending goals help in the planning process as more spending in the future requires additional savings today.

“One of the factors – if not the largest – in the longevity of your retirement portfolio is your withdrawal rate. Having an accurate estimate of what your expenses will be in retirement in so important because it will affect how much you withdraw each year and how you invest your account. If you understate your expenses, you easily outlive your portfolio, or if you overstate your expenses, you can risk not living the type of lifestyle you want in retirement,” says Kevin Michels, CFP®, financial planner with Medicus Wealth Planning in Draper, Utah.

The average life span of individuals is increasing, and actuarial life tables are available to estimate the longevity rates of individuals and couples (this is referred to as longevity risk). Additionally, you might need more money than you think if you want to purchase a home or fund your children's education post-retirement. Those outlays have to be factored into the overall retirement plan. Remember to update your plan once a year to make sure you are keeping on track with your savings.

“Retirement planning accuracy can be improved by specifying and estimating early retirement activities, accounting for unexpected expenses in middle retirement, and forecasting what-if late retirement medical costs,” Alex Whitehouse, AIF®, CRPC®, CWS®, president and CEO, Whitehouse Wealth Management, in Vancouver, Wash.

3. What After-Tax Rate of Return Do You Need?

Once the expected time horizons and spending requirements are determined, the after-tax rate of return must be calculated to assess the feasibility of the portfolio producing the needed income. A required rate of return in excess of 10% (before taxes) is normally an unrealistic expectation, even for long-term investing. As you age, this return threshold goes down, as low-risk retirement portfolios are largely comprised of low-yielding fixed-income securities.

If, for example, an individual has a retirement portfolio worth $400,000 and income needs of $50,000, assuming no taxes and the preservation of the portfolio balance, he or she is relying on an excessive 12.5% return to fund retirement. A primary advantage of planning for retirement at an early age is that the portfolio can be grown to safeguard a realistic rate of return. Using a gross retirement investment account of $1,000,000, the expected return would be a much more reasonable 5%.

Depending on the type of retirement account you hold, investment returns are typically taxed. Therefore, the actual rate of return must be calculated on an after-tax basis. However, determining your tax status at the time you will begin to withdraw funds is a crucial component of the retirement planning process.

4. What Is Your Risk Tolerance and What Needs Have to be Met?

Whether it's you or a professional money manager who is in charge of the investment decisions, a proper portfolio allocation that balances the concerns of risk aversion and return objectives is arguably the most important step in retirement planning. How much risk are you willing to take to meet your objectives? Should some income be set aside in risk-free Treasury bonds for required expenditures?

You need to make sure that you are comfortable with the risks being taken in your portfolio and know what is necessary and what is a luxury. This is something that should be seriously talked about not only with your financial advisor, but also with your family members.

“Don’t be a ‘micro-manager’ who reacts to daily market noise,” advises Craig L. Israelsen, Ph.D., designer of 7Twelve Portfolio in Springville, Utah. “‘Helicopter’ investors tend to over-manage their portfolios. When the various mutual funds in your portfolio have a bad year – add more money to them. It’s kind of like parenting: The child that needs your love the most often deserves it the least. Portfolios are similar: The mutual fund you are unhappy with this year may be next year’s best performer – so don’t bail out on it.”

“Markets will go through long cycles of up and down and, if you are investing money you won’t need to touch for 40 years, you can afford to see your portfolio value rise and fall with those cycles. When the market declines, buy – don’t sell. Refuse to give in to panic. If shirts went on sale, 20% off, you’d want to buy, right? Why not stocks if they went on sale 20% off?” says John R. Frye, CFA, chief investment officer, Crane Asset Management, LLC, in Beverly Hills, Calif.

5. What Are Your Estate Planning Goals?

Estate planning will vary over an investor’s lifetime. Early on, matters such as powers of attorney and wills are necessary. Once you start a family, a trust may be something that becomes an important component of your financial plan. Later on in life, how you would like your money disbursed will be of the utmost importance in terms of cost and taxes. Working with a fee-only estate planning attorney can assist in preparing and maintaining this aspect of your overall financial plan,” says Mark Hebner, founder and president, Index Fund Advisors, Inc., in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

Life insurance is also an important part of the retirement-planning process. Having both a proper estate plan and life-insurance coverage ensures that your assets are distributed in a manner of your choosing and that your loved ones will not experience financial hardship following your death. A carefully outlined will also aids in avoiding an expensive and often lengthy probate process. Though estate planning should be part of your retirement planning, each aspect requires the expertise of different experts in that specific field.

Tax planning is also an important part of the estate-planning process. If an individual wishes to leave assets to family members or to a charity, the tax implications of either gifting the benefits or passing them through the estate process must be compared. A common retirement-plan investment approach is based on producing returns that meet yearly inflation-adjusted living expenses while preserving the value of the portfolio; the portfolio is then transferred to the beneficiaries of the deceased. You should consult a tax advisor to determine the correct plan for the individual.

The Bottom Line

Retirement planning should be focused on the aforementioned five steps: determining time horizons, estimating spending requirements, calculating required after-tax returns, assessing risk tolerance vs. needs for portfolio allocation, and estate planning. These steps provide general guidelines regarding the procedures required to improve your chances of achieving financial freedom in your later years. The answers to many of these questions will then dictate which type of retirement accounts (defined-benefit plan, defined contribution plan, tax-exempt, tax deferred) are ideal for the chosen retirement strategy

One of the most challenging aspects of creating a comprehensive retirement plan lies in striking a balance between realistic return expectations (for example, few retirees today have a defined-benefit pension) and a desired standard of living. The best solution for this task would be to focus on creating a flexible portfolio that can be updated regularly to reflect changing market conditions and retirement objectives.