Achieving and Keeping a Secure Retirement!!!

This past weekend I coordinated a free, pro bono financial planning clinic in Scotts Valley. This is a free, pro bono, no marketing event sponsored by the Scotts Valley Chamber of Commerce and provided as a service to the community. Together with 5 other financial service professionals we offered 1-on-1 financial planning sessions for individuals and couples. More information about the 3^rd Scotts Valley Financial Planning Clinic is available at Facebook

The event started off with a seminar given by myself and Bob Finke, CFP®. The topic was how to prepare for and maintain a secure retirement. Over the next few weeks I will provide a summary of the presentation. This week I focus on what to do before retirement.

Before Retirement

Determine your Life Goals: retirement, new home, travel, college funding, etc. Estimate how much these will cost and when those costs will occur. Then develop a financial plan to achieve these goals. Review and update your plan periodically to track your progress and incorporate major life changes. Remember that without such a plan you really do not know if you will be able to achieve your goals!

Unless you are extraordinarily wealthy and have inexpensive goals you will need to start saving to build your nest egg to fund your retirement and other goals. The earlier you start saving the better! The combination of compound earnings and regular savings can allow you to build a significant nest egg during your working years. Time is the critical factor. The longer you are able to save before using the funds, the bigger it can grow.

For example earning 5%, $100,000 grows to $265,000 in 20 years. If you also contributed the $17,000 to your 401(k) each year your nest egg grows to $827,000!

Also due to compounding, the portfolio grows quicker in absolute terms in later years when the portfolio is bigger. For example, that 5% earning on $100,000 in year 1 is $5000. In year 19 when the portfolio is $770,000 earnings at 5% is $55,000!

The amount you will need to save to achieve your goals depends on many factors. A mix of social security, other pensions or other lifetime income may provide for some of your retirement spending needs. However most people will need to fund a significant portion of their retirement spending from personal savings. This savings will provide you more choices, more security and a higher standard of living in retirement.

The amount of time until retirement, your annual savings rate and your investment choices will all have an impact on how much your nest egg will grow. A higher savings rate and more aggressive investments will build a larger portfolio in the long term. However if you are closer to retirement it may be more appropriate to have a less aggressive portfolio since you will be withdrawing from it sooner.

Challenges to Savings

There are many challenges to growing your nest egg. If you are currently ‘just getting by’ it is hard to think about being able to save at all. However even saving a small amount regularly can grow nice nest egg over time. Typically the best method is to have these savings taken out automatically before the money reaches your checking account. Of course if you have significant debt you may need to deal with that first!

Debt is of course one of the challenges to savings. Unexpected expenses due to health issues, weather, accidents and other issues may also take their toll. Part of your financial plan should include appropriate risk management strategies such as insurance. An Emergency Fund is also an important cushion to prevent you needing to dip into your savings.

Another ubiquitous challenge to savings is Inflation. Even though you are savings your actual purchasing power with the saved funds may be eroded due to increases in the cost of living. Having an investment return above inflation will help with this problem.  Let’s look at an example:

Assuming an 8% return and 3% inflation your real return is only 5%. $4 earning 8% for 24 years gives you $24. However the purchasing power of that $24 is only $13. That is because a $4 loaf of bread today whose cost increases 3% with inflation each year will cost $8 in 24 years.

Future Spending Estimate

A good place to start in estimating your retirement spending is your current spending as most people will want to maintain their current standard of living. Your spending will typically be reduced in a number of ways including not needing to save more, no long contributing to FICA (Social Security and Medicare), lower income tax, and no need to spend on clothes, equipment or travel related to work. You may also reduce the number of vehicles you own or move to a less expensive house or area.

Other expenses may grow. Travel is a typical goal especially early in retirement. You also must plan for higher medical expenses and potential long term care needs especially later in retirement.

A big factor in our savings is your life expectancy. A secure retirement means not running out of money so the amount of time involved is critical. We can make a reasonable estimate but it is very possible you will live longer. So it is important to build a plan that will support you even if you do live to a ripe old age!

The timing of investment returns is also important. As discussed earlier, your savings grow faster later in retirement than earlier, assuming the same earnings rate. So a poor return as you approach retirement will really impact you!  The first years of retirement are also bad years to have poor returns as it reduces the base for long term earnings. Moving to a more conservative portfolio that has less risk will help protect you but not completely.

All of this is very complex to deal with. That is why some financial advisors, including myself, use a tool called Monte Carlo Simulation in developing your financial plan. This is a complex software program that incorporates many variables about the markets, inflations, volatility and your investment portfolio. It generates hundreds or thousands of patterns of investment returns and uses the results to determine the probability of you running out of money. Thus a financial plan can be validated against a large range of possible return patterns. This is more realistic and far superior to using a static expected return every year.

Next Time: What to Do Now that you are Retired.