No matter where you are in your career, now is a great time to save for retirement. Whether you’re just starting out or approaching retirement, you have probably asked the question, “How much should I save for retirement?” Unfortunately, there’s no one true answer that fits everyone. Think of it as healthcare for your finances, everyone needs it, but everyone’s needs are different. The best solution is to come up with a plan that’s catered directly to you. To start; follow these steps:
A vital piece to any retirement plan is goal setting. You need to plan well defined goals that cover both the short and long term. Additionally, you should define what your goals are for the time leading up until retirement, as well as in retirement itself. One of the most important things to remember is to never lose sight of your long-term goals while you work towards your short-term goals. “Keep your eyes on the prize,” as they say, and the prize here is living comfortably in retirement. That may require making sacrifices and always considering what your short-term decisions mean for the long-term big picture. You will likely be faced with multiple decisions that can affect your retirement plan throughout your lifetime. “What should my budget be for buying a house?” “Should I start a fund for my children’s college education?” “How much do I have to spend on vacations?” These are all fair questions to ask yourself, and determining the potential impacts these questions have on your future can help determine what is most important to you.
Now that you have started thinking about your goals, it’s essential to start developing a “retirement vision.” Essentially, you need to picture what is it that you’re saving for. What do you want your Golden Years to look like? Where will you live? How will you spend your time? In addition to reviewing your expenses and thinking about what will remain, you’ll need to contemplate what new costs you will incur. Consider if you’ll have to carry debt into retirement. While often keeping your money invested to let it grow can be more economically beneficial, it is important to consider the emotional benefits from using that money to pay off your debt to lower your monthly need and provide a greater peace of mind in retirement. It is important to remember that not every decision needs to be made based on economics alone.
Another common consideration is downsizing in retirement. A common misconception here, is that “downsizing,” means cutting housing costs. While this can be true, it’s less common than you may think. Many housing transitions have costs that are equal to or more than what you’re “downsizing” from. Downsizing really means downsizing in space and upkeep effort, which in its own turn, costs money. Yes, you have less house, but usually this comes with an additional upfront cost or ongoing cost. For example, the cost can increase as a result of housing type, amenities provided, maintenance assistance, and/or personal care. Your state of residency can also have an impact on your retirement need. Consider if you will remain in your current state or move. Some states are more tax-friendly during retirement than others, and that could reduce your cost of living. This exercise is not only important to make sure you get everything you want out of retirement, but it also plays into identifying your retirement expenses.
Another common misconception, and one that can torpedo the effectiveness of your plan, is that your retirement expenses will be a fraction of what you currently spend. Often, your expenses stay the same or even increase in retirement. This is because most people are active in retirement, and most things we do are not free. Early retirees commonly spend money on things such as travel, hobbies, and activities. An unfortunate truth is that later on, those expenses are frequently taken over by healthcare costs. So, while your expenses change at different stages in your life, they are usually substituted with a new expense, rather than disappearing completely.
Certain expenses are out of your control but still need to be considered. As you age the chances of needing long-term care, and the expenses that come with, increase dramatically. Long-term care expenses can be catastrophic if not prepared for. One question to ask yourself is, will you self-fund, or purchase a long-term care policy to protect against such an event? These are considerations you need to think through now and weigh before you can identify your retirement needs.
Another vital retirement expense question to consider is legacy planning. Do you want to leave anything to your heirs or to charitable organizations? Will this be done during your lifetime or through your estate? While there are alternative strategies readily available, such as using insurance policies, you have to incorporate them into your planning and put the strategy in place as early as possible. Your answers to these questions could drastically change the amount needed to retire.
As you begin to answer these questions and put together your retirement picture, it is helpful to separate goals into needs and wants. Your “needs” are the minimum you need to survive. These are things that probably can’t be adjusted or eliminated. Your “wants” are things you would like to have or do but are not necessary for your survival. In an ideal world, we would all have enough money to fund all our wants and needs. However, not everyone is able to achieve this. So, the best thing to do is to put the list in order of priority and identify what’s most important to you. Are you willing to give up any of your wants? If the answer is no, what are the alternatives so you can achieve them? It is important to be honest with yourself and account for these types of questions in your plan.
Now that you’ve identified your goals and expenses, you should look at your retirement income. You will need to determine how your income will offset your expenses. Evaluating wages, Social Security benefits, pensions, and retirement plans will allow you to develop a plan. Another factor in determining how much you need to retire is the type of accounts you have. For example, a Roth investment will go a lot further than a traditional investment with the same value because qualified withdrawals from a Roth are not taxable. That does not necessarily mean contributing to a Roth is the correct choice for everyone, but it will impact the amount needed.
Consider if you will be working in retirement. Usually, this is accomplished through a part-time job or reduced hours. This is often a good solution to fund a shortfall and have access to benefits for early retirees. However, retirees commonly work to stay active, begin a new career that interests them, or just because they enjoy working but would like to slow down.
Next, you should think about the objective of your portfolio. People often want to be conservative at retirement, but the fact is you are still planning for a longtime horizon. Portfolio construction will have a significant impact on how much you need, and in turn, influence how much you can feasibly withdraw. While most retirees fear market risk, inflation risk is often overlooked. Inflation risk is the risk of inflation outpacing the growth of your assets. While you won’t see the decrease to your portfolio on paper, it can negatively impact your retirement. Cash and some bonds carry inflation risk, but equities have typically beaten inflation over the long term. Slow and steady doesn’t always win the race here.
The most common fear of retirees is a market downturn, and justifiably so. No one likes losing money during a market downturn. However, your portfolio can be structured in such a way that you are not forced to sell assets that are significantly down during these times. The worst thing you can do is sell low after a downturn. While we understand it can be scary, making decisions in haste will be difficult to recover from, and all the previous planning could be affected. Therefore, liquidity is crucial to portfolio construction. It is essential to keep some assets liquid to fund your needs when the market is down. A diversified portfolio should have a mixture of cash, bond, and equity assets. Hopefully, the low correlation allows for a place to trim from, even when other areas are down, to keep yourself properly funded. Remember, it is not just younger investors who have time for portfolios to recover; older investors do as well. You still have a long runway ahead when you reach retirement. Do not lose sight of the value of time in a portfolio.
On the brighter side, life expectancies have continued to increase. That’s great! However, this also means it is necessary to factor in the length of your retirement. The younger you are, the lower the withdrawal rate needs to be. When comparing withdrawal rates to expected portfolio growth, consider the impacts. A withdrawal rate larger than the expected return will have a more significant impact on how quickly you spend down assets. However, even if your withdrawal rate is lower than the expected return, you still need to factor in future withdrawal rates, the possibility your portfolio doesn’t meet return expectations, and if your portfolio is outpacing inflation. Also, you will need to consider unexpected expenses. While it is harder to factor them into your plan, you need to be aware they will arise and to have a contingency in your plan for when they do.
What seems like such a small decision today can have a large impact on your retirement. After all, interest compounds. It’s imperative to focus on the things you can control. For example, you can control your asset allocation, asset location, savings, and spending. You have some control over earnings, employment duration, and longevity of need. However, you cannot control market returns, government policies, or taxes. Using conservative assumptions helps reduce the margin of error for the assumptions you cannot control.
While you can account for many things, there will always be factors outside of your control. The final step is to put all these variables into a projection and adjust as needed. Retirement plans commonly use a straight-line projection because they can incorporate many variables and assumptions Straight-line projections usually assume a set inflation rate, death age, and average portfolio return. These factors will not always be the same when you are actually in retirement, so it is important to pair this type of projection with a Monte Carlo analysis. Monte Carlo projections add variability to these factors and stress tests the straight-line projection. When used in unison, these should provide peace of mind for your retirement outlook.
While most factors to achieve a comfortable retirement are unique to the individual, and there is no one-size-fits-all retirement strategy, there are some baseline steps that everyone should follow.
As you can see, many factors go into determining “How much money do I need to retire?” Retirement planning goes beyond having a given amount of assets at retirement. It is necessary to consider everything and be honest with yourself. Avoid comparing yourself to peers and setting your goals based on what everyone else is doing. Plan for the retirement you want. While all this can be overwhelming, just remember you are not alone. Consult your CERTIFIED FINANCIAL PLANNERTM professional for assistance with determining how much you should save for retirement.
Author: Benjamin Grom, CFP® | Financial Planner | Allegheny Financial Group | October 2020
Allegheny Financial Group is a Registered Investment Advisor. Securities offered through Allegheny Investments, LTD, a registered broker/dealer. Member FINRA/SIPC.