Old age financial independence is the ultimate goal of retirement planning. Whether you are a twenty-something year old student or the parent of a young adult, the process of ensuring that you have sufficient funds to maintain a desired standard of living through the "golden years" is worth considering. Naturally, depending on an individual's stage in life, the planning process will be different and contingent on one's unique circumstances. Basic guidelines exist to help assist people in creating their retirement plans. These guidelines will either form the premise of a self-directed retirement investment strategy or can be used to help guide the investment process of an external financial professional.
TUTORIAL: Introduction To Retirement Plans

1. Time Horizon
Current age and expected retirement age create the initial groundwork of planning a retirement strategy. Firstly, the longer the time horizon between today and retirement, the higher the level of risk that one's portfolio can withstand. The negative effects of return volatility are mitigated with a long term time horizon. Secondly, stretched periods of retirement portfolio accumulation must factor in inflation. A 64-year old who is planning on retiring next year does not have the same concerns regarding inflation as a much younger professional who just entered the workforce. Thirdly, 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 their mid-40s.

Finally, and most importantly, a longer time horizon breaks up the overall retirement plan into multiple components. For example, a parent may wish to retire in two years, pay for their children's education when they turn 18 and then 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. (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. Spending Requirements
Having realistic expectations about post-retirement spending habits will define the required size of the retirement portfolio. Most people argue that after retirement their annual spending will amount to only 70-80% of what they spent previously. Such an assumption is often proved to be unrealistic, especially if the mortgage has not been paid off. Since, by definition, a retiree is 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.

Similar to the need to create a breakdown of multiple-time horizons, the time-specific spending needs must be determined as well. For example, a retired couple might determine that they will spend around $50,000 per year on basic life expenses while alive; actuarial life tables are available to estimate the longevity rates of individuals and couples. However, if the couple wants to purchase a home or fund their children's education, those outlays have to be factored into the overall retirement plan. Establishing the regular and miscellaneous spending estimates at the beginning of the process should help in ensuring the suitability of the portfolio allocation.

3. After-Tax Rate of Return
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. One of the biggest risks an individual can face is having their retirement portfolio be depleted too early. This is referred to as longevity risk, the risk of living too long and thus outliving your investments. A required rate of return in excess of 10% is normally an unrealistic expectation 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, they are 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. Under the same assumptions as above, but 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. The above discussion omits the impact of tax implications in order to simplify the analysis. However, determining your tax status is a crucial component of the retirement planning process.

4. Portfolio Allocation
Whether it's you or a professional money manager that's in charge of the investment decision, a proper portfolio allocation that balances the concerns of risk aversion and return objectives is arguably the most important step in retirement planning. A somewhat common segregated approach breaks down spending objectives into multiple allocation components. Required fixed expenditures such as college tuition are funded with risk-free treasury bonds. Using the figures from the above example, a mandatory tuition outlay of $100,000 would be segregated from other portfolio assets, thus reducing the actual retirement portfolio to $900,000. This remaining amount would be invested in "normal fashion" to produce returns that match the expected cost of living expenses.

"Normal fashion" has ranging definitions for different people. Although retirement portfolios are generally focused on either domestic blue chips or fixed incomes, depending on one's risk tolerance, international investments and small caps may be included. The proportion between the assets will also vary from person to person, especially when the time horizon until retirement is considered. Stable dividend paying stocks are also popular for retirees as these investments provide a consistent tax-efficient income stream.

5. Estate Planning
Having a proper estate plan and life insurance coverage ensures that your assets are distributed in a manner of your choosing and 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. Despite that estate and retirement planning are separate financial responsibilities, requiring the expertise of experts in different fields, the two procedures must be considered in tandem with one another. In other words, a well-defined estate plan complements a thoroughly structured retirement plan.

A substantial retirement portfolio indicates a decreased demand for life insurance, yet a greater emphasis on vigilant estate planning. Because a large accumulation of financial assets can be passed on to the family of the deceased, the financial impact of funeral costs is mitigated with a hefty inheritance. However, if a parent wishes to leave assets to either their family members or even 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 which meet yearly inflation-adjusted living expenses while preserving the value of the portfolio; the portfolio is then transferred to the beneficiaries of the deceased.

Conclusions
Retirement planning should be focused on the aforementioned five steps: determining time horizons, estimating spending requirements, calculating required after-tax returns, optimizing portfolio allocation and estate planning. These steps provide general guidelines regarding the procedures required to improve your chances of achieving old age financial freedom. 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 and a desired standard of living. The best solution for this task would be to focus on creating a flexible portfolio which can be updated regularly to reflect changing market conditions and retirement objectives.

We'll show you how to choose between Roth IRAs, Traditional IRAs and 401(k)s. See Which Retirement Plan Is Best?

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