10 STEPS TO A SECURE RETIREMENT
By Mary Lynne Dahl, CFP®
May 06, 2014
If you have been saving and investing for this goal, there will come a point when you will have to measure whether the money you have accumulated for this purpose is going to be adequate or not. This article will show you how to do this, step by step, using an example at the end of the article. First, however, we need to explain some basic concepts so that our example makes sense.
Decades ago, a retiring worker would have his or her Social Security, possibly an old-fashioned pension and maybe a little bit of savings, and this was usually enough. Guess what? Things have really changed! Today, very few workers have a pension. Many are unsure of Social Security, and of those who do expect to get it, most do not expect it to provide them with a lot of security.
Today, most pensions are only offered by government employers and a few very large corporations. It is very rare for a small employer to offer a pension, due to the costs associated with them that most small businesses cannot afford. A pension promises a specific amount monthly, is based on the number of years worked and uses a formula that calculates the average salary of the employee during the last 5 years or so of employment. Pension plans have no “present value”; they simply pay a benefit amount at retirement, from the employer’s pension trust funds set. Most pensions require vesting, which means that the employee earns rights to the benefit over time, not immediately, because the employer has made most or all of the contributions to the plan. The employer owns the pension, makes all of the investment decisions and has full control over it.
Instead of a pension, today’s workers are more likely to have a defined contribution plan, like a 401(k), 403(b), a profit-sharing or a deferred compensation plan. Defined contribution plans have a real, measurable, present value, stated in dollars. Employees get a statement showing what the plan is worth, make the investment decisions, take on all of the risks associated with those investment choices, own their own vested accounts entirely and have full control of the plan, financially. Employees with defined contribution plans make most of the contributions, but in some plans the employer contributes some kind of match, which usually requires some vesting schedule. In a defined contribution plan the employee makes the investment decisions and has a great deal more control over his or her plan account. The end result is that employees need a lot of education and guidance with their retirement plans today, but most employers do not assist their employees in getting competent investment advice.
The question of how to know if you will be able to retire is answered by starting with an estimate of how much money in the future will be approximately equal to the amount of money you need to today to live comfortably. If you need $4,000 per month today, you should plan on needing the same amount in retirement. You will need it in future dollars, however, due to inflation. Even mild inflation will erode the purchasing power of your money, so you will need more actual dollars in the future than what you require today.
For example, inflation of 4% will reduce the value of today’s dollar to only 50 cents in 14 years. So if you need $4,000 per month today and we have inflation of 4% per year for 14 years, you will need $8,000 per month in 14 years to have the ability to buy the exact same things then that $4,000 buys today.
Does this seem overwhelming? An impossible task not worth the effort? If you think that way, banish those thoughts now. Money is just a tool. Learn how to use this tool for your purposes and you will find that the goals are attainable. Giving up before you try is foolish and will lead you down the path to greater insecurity than you can imagine. This article will outline a step by step strategy; all you have to do is do it.
Step #1. Target a date for retirement. For example, let’s say that you are 44 today and want to retire at 62. That means that you have 18 years to save and invest enough to be able to stop getting a paycheck and still live comfortably.
Step #2. List your resources. Let’s say you plan on getting Social Security and you have a 401-k plan plus a duplex with a mortgage.
Step #3. Value your resources. Social Security has informed you that your monthly benefit will be $2,150 at age 67 and $1,575 (75%) at age 62. Your 401-k plan is currently worth $281,000 plus you are adding $14,000 per year, in 28 paychecks per year at $500 per paycheck. Your duplex is valued at $300,000, is rented out at $1,200 per month per unit, for $2,400 per month total rental income. You paid $200,000 for the duplex 12 years ago, and have 18 years left on the loan, which costs you $1,900 per month (principal and interest). Taxes and insurance cost about $3,500 per year for the duplex and your maintenance on it runs about $1,000 per year on average.
Step #4. Add up your current monthly income requirements. The total, including your income taxes, is $6,250 per month, or $75,000 per year. This is the amount you should target as your goal for retirement. If you will have paid off your mortgage on your home by then, you may need less but you at this point it is safer not to count on needing less.
Step #5. Calculate the total future amounts you will have in a lump sum at retirement age. If you don’t know how to do this using a financial calculator or computer program, you may need help with this. In this case, your $281,000 401-k, with additions of $14,000 per year, will, at a 6% annual average return, have grown to a value of approximately $1,050,000*. In today’s dollars, that’s a lot of money. In 18 years, it may or may not be; it depends on inflation. We will factor that in to the picture later on in these steps.
Step #6. Calculate what income is reasonable to expect from the future lump sum you will have. At normal withdrawal rates of 4% - 5% per year, this amount will produce between $40,000 and $53,000 per year indefinitely. You should be relatively secure that you will not run out of money at this rate of withdrawal. Add to this amount the Social Security benefit of $18,900 and your total monthly income at age 62 is estimated to be between $58,900 and $71,900 per year. Sound good? Wait! Those future dollars will buy less than the same dollars today, because of inflation. Next step!
Step #7. Factor inflation into the picture. Here you may need help again, unless you are skilled at this kind of calculation, which is a future value/present value calculation. The bottom line is that because of inflation, even at only 3% per year, you will need $127,682 per year to equal the $75,000 you enjoy today. OK, so you will need more than you will have with just your 401-k and Social Security.
Step #8. Explore your choices. Option #1 is to wait until age 67 to retire. Your Social Security will be $25,800 instead of only $18,900. In addition, you will have been in the 401-k plan for 5 additional year, adding up to a new value of about $1,450,000*, which could, under the same withdrawal rates, produce between, $58,000 and $72,500 per year, for a new total of about $83,800 - $98,300 per year and last indefinitely. Now you are closer to your goal. You also have a duplex producing monthly income, currently $2,400 per month before mortgage, but in 23 years, the duplex will be paid off. If you still own it when you retire, the rents will probably have risen and could very well make up any shortfall you might have at retirement. Option #2 is to sell the duplex, invest the money for income and use that for additional income. You may prefer this to owning rental property, or you may wish to continue as a landlord; it’s up to you. Either way, your duplex will have become important to your ultimate retirement security. Take care of it now and it will take care of you later.
Step #9. List some solutions to problems you know will prevent you from reaching your goals. For example, if this process indicates that you will be very short of money at retirement, begin a savings and investment plan now. If the problem is that you have too much debt today, make a plan to pay it off as fast as you can, then when the debt load is paid off, use that money that was going towards debts as money to use for savings and investment. If you are not contributing the maximum to your retirement plans, up the amount of your contributions to the max. These are just a few examples of problems needing a fix; you may have others.
The bottom line is to be proactive; do something about this issue. Remember, if you only live paycheck to paycheck, you can never stop working! Make the sacrifice now, not later. Being comfortable and secure in retirement is a choice that you make on an ongoing basis. Apply the discipline today and enjoy a good retirement later.
* Compounded return calculated at 6% per year and rounded.
©2013 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.
Mary Lynne Dahl©2014