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. What Is Your Time Horizon?
Current age and expected retirement age create the initial groundwork of an effective retirement strategy. Firstly, 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+ 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. Read more here.)
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 for 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.
Also, you should break up your 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. You should also be rebalancing your portfolio over time as your time horizon changes.
Most importantly, start planning for retirement as soon as you can. You might not think a few bucks here or there in your 20’s 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 70-80% of what they spent previously. Such an assumption is often proven to be unrealistic, especially if the mortgage has not been paid off or if unforeseen medical expenses occur.
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.
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.
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, 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. 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 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. 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 with not only your financial advisor, but also with your family members.
5. What Are Your Estate Planning Goals?
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, they each require the expertise of different experts in their respective fields.
Tax planning is also an important part of the estate planning process. 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. 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, optimizing portfolio allocation and estate planning. These steps provide general guidelines regarding the procedures required to improve your chances of achieving financial freedom in your golden 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 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.