Friday, July 17, 2009

Retirement Planning: Making Realistic Assumptions about Retirement

The act of assuming is much like the act of predicting. It is subject to unknowns and is based on what we know happened, with a healthy dose of optimism thrown in for good measure. In retirement planning, the assumption of what you will need to live long enough to outlast your money can be a recipe for disaster that will not materialize until you are no longer able to do anything about it. In other words, you will be too old to fix the problem of not having enough money.

It is a common practice among advisers to suggest the following: You will have $20,000 in Social Security benefits annually; you will withdraw 4% of your retirement income per year; your retirement account will grow by 8% during the years you contribute and continue that pace after you stop working; the inflation will remain relatively stable at around 3.5%; and you will have no other source of income available such as a pension.

Each of these assumption may be wrong and this rate of incorrectness can lead to problems early into your retirement but late enough in it to do anything about it.

Let's begin with Social Security. The assumption that it will somehow go away is just not accurate. It will be there. But the earlier you tap into those funds, say at sixty-two instead of your mandated full retirement age, a target that is guaranteed to move further away as time passes, the smaller amount of those estimated funds can be assumed. So assume the worst and that you will not be able to tap that social program until you are well beyond 65. And if you do, it might be less than you had previously assumed, even if you will not outlive the benefit.

Now for the withdrawal rate. This is key to the long-term health of your retirement plan. I, along with numerous other people in this field have suggested that 4% is the rate you should chose when attempting to outlive your retirement savings. This however is based on a fully funded retirement plan that has you entering into retirement debt free.

The problem with debt
is not what you owe on a loan(s) - although it is definitely troublesome to any income calculation whether you are working or not - it is what you will need to finance the rest of your days. Taxes will not go away. Both personal and property taxes will continue to act as a debt on your income and will rise in the future. Insurance will also create a debt-like obligation, not only for health but for property coverage for your home, your car, and any other property you might have. Upkeep on those properties will also increase over time acting as another strain on your income.

The growth number we often assume
, the 8% return we are expecting on our investments may be too high. As we all know now, if you were to retire now or worse, be drawing on retirement investments, you are withdrawing money at a faster rate than the money can recover. Based on the last decade of returns, the number may be closer to 4%.

Inflation is another major concern.
It is not going away and is even expected to climb in the years to come. While 3.5% may be an workable average and a fair assumption, it is not worthy of a worse-case scenario projection. The fact that your money will be worth less in the future should be calculated closer to 5%. This allows for some reverse growth and allows you to plan much better with fewer surprises later in life.

While the pension assumption - the fact that so few of us have one and even if we do, a plan that is not currently in trouble - is safe guess to make. Less than 25% of the working population has one. If you do, assume that it will pay 25% less or more, if you are beyond the cut-off point that the Pension Benefit Guaranty Corporation or PBGC insures. Pension plans pay the PBGC to insure these plans and they will only guarantee a certain amount. If you have a pension, calculate the worse-case scenario here as well. The 2009 PBGC guarantees can be found here.

The next post here will discuss the hard numbers.

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