RETIREMENT PLANNING

The vast majority of individuals and couples in the United States can look forward to their retirement—that period later in life when they are no longer working full-time and are supported by financial resources accumulated during their working years. The average retirement age in the United States, based on data from the 1998 Survey of Consumer Finances, is 62.7 years. At this age, in 1998, life expectancy in retirement for an unmarried male was 16.4 years; while for an unmarried female life expectancy at this age was 19.8 years; and for a married couple it was 23.9 years. This means that the typical American needs to be able to fund spending needs for about twenty years of retirement living. Since life expectancies are increasing with advances in medicine, younger generations will have even longer retirements to contemplate. The main implication of this is that longer life expectancies can represent an increase in the risk of a shortfall in financial resources, or in the risk of outliving one’s resources. The risk of shortfall can be greatly reduced with proper financial planning.

The idea that it is never too early to begin planning for retirement is a reasonable one. For example, one should identify employer-provided retirement plans as part of the job selection process. Starting to plan while younger allows one to plan a long-term strategy that can be maintained and adjusted over time. In a world that is uncertain and volatile, retirement planning must be an ongoing process, with decisions made and reviewed as conditions and life circumstances change.

Retirement planning, broadly conceived, means preparing for one’s retirement years, which could extend for two or more decades of later life. This includes consideration of issues such as long-term care and the provision of an estate to one’s heirs. Planning for retirement comes down to a comparison of needs and resources. The main goal is to ensure that one is able to meet annual spending requirements as well as any one-time expenses that may arise. This is done by not only considering resources such as Social Security and defined benefit pension plans, but also considering personal savings. Defined benefit pensions, also known as formula-based pensions, are typically fixed annual payments based on years of service and salary level. Personal savings may include an individual retirement account (IRA) and 401(k), 403(b), or Keogh plans. Due to high administrative costs and maintenance, many companies have opted for, or converted to, defined contributions plans such as a 401(k). These plans allow an employee to make tax-deferred contributions through a payroll deduction. In some of these types of employer-provided plans, the employer may match some level of the employee’s contributions, which provides a guaranteed return. However the investment assets selected or asset allocation must be decided, at least in part, by the employee. This places the responsibility on the employee to not only elect how to fund the account, but also to determine how the account will be invested—which may or may not be advantageous, depending on the individual level of investment knowledge.

Timing retirement

One factor that distinguishes retirement planning from other aspects of financial planning (such as risk management) is that the timing can be, in most cases, anticipated. While some individuals experience early retirements due to health reasons, the majority of Americans have some measure of control over retirement age. This provides an advantage for planning purposes, since a specific horizon is known for asset allocation. Further, it allows one to anticipate what other resources may be available. In fact, the timing of retirement is often related to the timing or availability of Social Security or any defined benefit pensions.

Social Security retirement benefits have gone through some changes, one of which is that the age of eligibility for full retirement benefits is scheduled to increase for most recent birth cohorts. As of 2001, an individual can elect to take a reduced benefit as early as age sixty-two. Thus, it is no surprise that the average retirement age is just over sixty-two. For anyone that retires prior to age sixty-two, there will be some period during which there is no Social Security benefit. This is certainly an issue that should be considered when choosing a retirement age.

Eligibility benefits from other defined benefit pensions adds an additional element to the timing issue, since these plans may lessen the financial impact of retiring prior to age sixty-two. Since eligibility is (as well as benefits from) typically based on years of service, an individual who was first covered by this type of plan in his or her twenties could be eligible for benefits at some point after age fifty. Some people might retire earlier as a result, while others might retire from their current careers but still work elsewhere.

Retirement adequacy

One’s desired annual spending in retirement is a more ideal choice for determining annual needs in retirement. Some methods argue for use of an income replacement rate, but this assumes that a single percentage would work for a large number of households and individuals. Instead, a planner can help a client think through this situation. There are several ways this is done. One such approach, from economic theory, assumes that households seek to smooth consumption across changes in the life cycle and that ideal annual spending is equal to average annual income—taking into account issues such as taxes and interest rates. Another approach is more introspective. This method begins with an existing and comprehensive income and expenditure statement. This process involves examining each expense and determining how it might change in retirement. Examples might include a mortgage being paid off, children who become independent, or increasing health care costs. Additional considerations for retirement spending needs include ties to family, obligations to children and parents, whether to continue some type of employment, creative use of leisure time, and community service. What a person will do once retired is at least partly a question about identity and meaning, but financial implications will affect such decisions.

One should also try to anticipate the impact of taxes. Even though there are some tax advantages for retirement savings and Social Security benefits, taxes will still be owed on all tax-deferred assets as distributions are taken. This is important because spending estimates show how much after-tax income is required for a household. However, distributions from most retirement plans will face taxation when withdrawn and as such, one should consider what pretax amount should be withdrawn to provide the after-tax spending requirement.

Resources expected to continue in retirement, such as defined benefit pension plans and Social Security, are used to help meet desired annual spending needs. For many households, this would still mean that there is an annual spending gap, which represents the amount of one’s desired annual spending not covered by continuing resources such as Social Security. The annual spending gap represents the amount of annual spending needs that is to be provided by investment proceeds and distributions from retirement savings. This gap is likely to be considerably higher for those who have enjoyed higher incomes throughout their working years. This is because higher income tends to indicate higher spending, and the income replacement rate of Social Security retirement benefits diminishes with higher levels of income. However regardless of a person’s pre-retirement level of living, Social Security is not likely to be sufficient as a sole resource for retirement spending needs. This makes investing for retirement essential for all households.

The annual spending gap estimation can be complicated by several issues. Since the starting age for benefits such as pensions and Social Security may differ, there may be different stages of retirement where different resources are available. For example, a husband and wife may retire in different calendar years, resulting in more than one annual spending gap. Other situations where there might be multiple planning periods include retiring before Social Security benefits are available and working during the early retirement years. Each of these stages should be considered and accounted for by discounting the annual spending gap for each year, up to the day of retirement.

The determination of retirement planning adequacy can then be thought of as comparing the annual spending gap with income from investments accumulated during the preretirement years. This comparison can be done by comparing the total value of the annual spending gap for all retirement years, adjusting them downward to reflect the future compounding they would have during retirement. The appropriate discount rate would be the expected portfolio rate of return for investments during retirement, based on asset allocation. The expected value of investments should be based on historical returns for the asset types. Calculations should consider that the asset allocation is likely to change over time. While average returns are most appropriate, some planners may also include an estimate based on a more pessimistic return for those who would like to be prepared for the worst case. If expected investment levels are equal to or greater than the discounted annual spending gaps, then the current investment strategy is adequate.

In the event of inadequacy, there are two potential courses of action that can be taken to improve the situation. The first possibility is to increase investment contributions to the required levels. However, this is only possible if the investor has additional investment capital and is not currently maximizing tax-advantaged contributions to retirement savings. If tax-advantaged contributions are already at the maximum allowed levels, then the investor may also use nontax-advantaged accounts. The second option would be to increase the aggressiveness of the portfolio, if prudent to do so. This could be accomplished by placing a higher percentage of the portfolio into equity investments. However, it is possible that a more aggressive portfolio might conflict with one’s risk tolerance. It is prudent for most investors to consider enlisting the advice of a professional to explain the risks and make recommendations regarding portfolio strategy. Others may simply have a planner perform a retirement adequacy assessment to ensure that the retirement plan is on target.

A second approach to determining adequacy uses advances in simulation methods and is known as a Monte Carlo approach. Often, individuals perceive risk as the likelihood of goal achievement or failure. The Monte Carlo simulation determines the odds of success of a specific financial plan. Most simulations will use several inputs, including asset allocation, bequest motives, pension plans, and desired annual spending. One advantage of this program is an estimation of odds of success, which has direct meaning to an individual. Further, if the odds of success are too low for an individual to accept, changing different inputs can show how the odds can be improved. One such change may include changes in asset allocation. However, while the programs will generate asset allocations, it is still up to an investor to select appropriate assets that conform to the recommendations. Many individuals may choose to use a professional for this.

Both of these approaches to determining asset adequacy require information about expected retirement benefits. Fortunately, this information tends to be readily available. Individuals age twenty-five and older who participate in Social Security will periodically receive a Personal Earnings and Benefit Estimate Statement (PEBES). This statement provides the taxpayer with information about his or her retirement benefits based on retiring at the age of full benefit eligibility, about the maximum delayed benefit, and about the reduced benefit obtainable at age sixty-two. The Social Security website (www.ssa.gov) provides online estimators for retirement benefits. Similar types of statements or calculators are available for most defined benefit pensions. This allows an individual or household to consider expected benefits when making planning decisions.

Asset allocation

While several factors need to be considered for asset allocation, including risk tolerance, the investment horizon is a key factor. This is because of the law of large numbers. As it relates to investing, the law of large numbers states that the longer an asset is held, the more the average annualized return can be expected to behave like the historical average for that asset type. This means that, while in any given year the return may be positive or negative, on average it should earn a return close to the historical average. This is important since, in the long run, stocks outperform all other asset types and small stocks tend to have the highest average return. One caveat is that this concept assumes that one holds a portfolio that is representative of the data. That is to say that owning one stock is not necessarily sufficient to assume that it should perform the same as the overall market. The idea is that one has a well-diversified portfolio that mitigates or eliminates any company-specific risks. This can be easily accomplished through the use of mutual funds, especially funds that are broadly based. One example of such a portfolio might be an index mutual fund that is based on the Standard and Poor 500.

The risk tolerance of an individual is the amount of risk that one is willing to assume in investment choices. This may be thought of as being related to the proportion of wealth that one would be willing to place in riskier assets such as stocks. Many financial planners will use some subjective measure of risk tolerance based on hypothetical scenarios. Using results from these measures, the planner formulates investment recommendations. However, a good planner will not only consider the client’s risk tolerance, but also more objective measures such as investment horizon (time until retirement).

A person’s asset allocation choice will determine the composition of the investment portfolio, that is the allocation of portfolio shares to stocks, corporate and government bonds, and money market instruments. Since stocks outperform all other investments in the long run, younger investors saving for retirement can take advantage of the time that they have before retirement and invest more aggressively. Some would say that individuals with at least twelve years or more to retirement should consider a portfolio heavily weighted with equities. However, as retirement looms closer and the horizon grows shorter, an all-stock portfolio is no longer an optimal choice because the confidence that stocks will have a higher return in the shorter-term decreases. At that time, it becomes prudent to shift some of the equity to fixed-income securities such as bonds or bond mutual funds. This uses the fixed return on the bonds to offset the increased volatility of the equity holdings. Therefore, in early working years, investors should be more aggressive when saving for retirement, and as investors approach retirement (within ten years or so) they should become more conservative.

At retirement, investors can spend accumulated asset to purchase a life annuity. This insurance contract promises an annual or monthly payment for the rest of one’s life in exchange for a lump sum payment. This eliminates the risk of outliving one’s assets, since the payments would be assured for one’s remaining life expectancy. There may be survivorship provisions as well in these contracts that provide income for surviving spouses or others. However, there is minimal control over the investment management of the annuity. Another potential disadvantage is that the annuity would not allow for advance payments which might be needed should any large one-time costs arise.

Other methods provide more control over assets. An alternative, the perpetuity approach, involves holding accumulated investments and using their proceeds for spending purposes. This gives the individual more control over distributions and investment management. However, without proper guidance, this approach increases the risk of outliving one’s assets. Some combination of both approaches may be more ideal, but is not necessarily feasible for households without significant wealth. A choice between the two approaches must therefore often be made. This choice can be made by comparing the perceived risk of asset shortfalls with the perceived risk of having any need for large distributions. One other consideration is the perceived opportunity cost of reduced management control. While annuities greatly reduce the shortfall risk, and the perpetuity approach allows the distribution amount to be determined by the investor. Another factor influencing this choice may be the desire to leave a bequest to heirs. While annuities may provide for survivorship, the ability to leave assets to heirs is much simpler when assets remain in the estate.

During retirement, assuming one does not annuitize all wealth, asset allocation becomes essential. Assets must maintain a level of return that will be sufficient to avoid shortfall and, potentially, provide for a desired bequest. The retirement asset allocation needs to include some highly liquid investments, as well as ones that will provide a reasonable rate of return. The use of money market transaction accounts might be advantageous, rather than a checking account, since money market accounts usually provide a real rate of return slightly higher than a regular savings account. Use of laddered Certificates of Deposit (CDs) can be useful as well. The laddered approach is to purchase CDs of varying maturities so that they mature as they are needed. Since there are other assets available in an emergency, these CDs should typically be able to be held until maturity. The remaining portfolio should be well diversified to minimize risk. Again, mutual funds may be ideal for this situation, as they bring inherent diversification.

Using a professional

Having access to some level of retirement advice has become easier than it once was. The Certified Financial Planner (CFP) designation has become the symbol for a financial advisor; a CFP practitioner has passed a comprehensive exam covering all major financial planning topics and is bound by a code of ethics that is strongly enforced by the CFP Board of Standards. Some of the known benefits of using a professional include improved asset allocation and asset choice. Planners can more efficiently evaluate adequacy of current financial plans than can most individuals, and they can provide advice on how to improve the likelihood of success by finding ways to improve the current plan. CFP practitioners can be found at most large financial institutions, including brokerage houses and investment companies.

Not every individual is comfortable with, or needs, formalized planning when other alternatives might be useful. Individuals with Internet access can find a wide variety of information and strategies online, for example. However, the majority of these strategies will come down to asset allocation based on investment risk tolerance and horizon. Common themes will include stocks for the long run and some level of liquidity in retirement. Some websites even have information for contacting representatives who are qualified to answer questions. Benefit counselors can typically answer basic questions and provide simple interpretations of information. Employer-provided counselors can also clarify issues related to any employer-provided benefits that exist, including pension plans and health benefits.

Special considerations

One important issue in retirement planning is the gender and marital status of an individual. Women tend to have a higher life expectancy than men, and married couples should consider the increased likelihood of shortfall for women— due not only to increased life expectancy but also because one or more of a couple’s retirement resources will be lost with the passing of a spouse, which may place an even greater importance on investments after this point.

Another source of concern is that women may have lower risk tolerance than men. While this difference is still under dispute, it has important implications for women preparing for retirement. Women may tend to be too conservative in their investing, and they therefore are less likely to be invested in stocks. Financial planners should be certain to spend time explaining the ideas behind the strategy of investing in stocks for the long run.

Historically married women have been able to rely on a husband’s savings, even when their own employers have offered defined contribution plans. However, given the increased likelihood of divorce today, women should be certain that they are contributing to assets in their own name and are part of the decision-making process. Then, should they find themselves on their own, they will not only have begun accumulation of their own resources, but will know why those decisions were made and will be able to participate in future investment choices.

Another important issue is the consideration of health concerns. While one may accumulate a significant amount of wealth prior to retirement, this wealth could easily be diminished because of illness. Medicare is generally not available until one is sixty-five years of age, and anyone retiring prior to this age should therefore make arrangements for some protection. However, Medicare is not all-inclusive and currently does not provide for nonhospital prescriptions or long-term care needs beyond 120 days. Therefore any long-term illness could quickly use up any personal savings. The financial effect of such an illness can be mitigated through the use of private insurance plans. This may include continued participation in private health insurance plans through a previous employer. However, a more common trend has been for households to acquire long-term care insurance. These plans can typically be purchased for five different levels of coverage, including skilled nursing care, intermediate nursing care, custodial care, home care, and adult day care. These policies can be quite costly, but lower rates may be attainable for those who elect to enroll at younger ages, such as in their mid-fifties. Despite their cost, these plans may prevent the diminishing of an otherwise sufficient investment portfolio.

Overall the key elements to a retirement plan include choosing a retirement age and level of living, making investment choices, and assuring proper health care coverage. Taking advantage of time and investing principles can lead to higher levels of accumulated savings by retirement, and thus a higher level of living in retirement.

MICHAEL S. GUTTER

See also RETIREMENT, DECISION-MAKING; RETIREMENT, EARLY RETIREMENT INCENTIVES; RETIREMENT PATTERNS; RETIREMENT PLANNING PROGRAMS; RETIREMENT, TRANSITION

BIBLIOGRAPHY

GARNER, R. J.; YOUNG, E.; ARNONE, W. J.; and BAKER, N. A. Ernst and Young’s Retirement Planning Guide: Take Care of Your Finances Now . . . And They’ll Take Care of You Later. New York: John Wiley and Sons, 1997.

MSN Money. Available on the World Wide Web at http://moneycentral.msn.com

American Association of Retired Persons (AARP). AARP Webplace. Available on the World Wide Web at www.aarp.org

mPowerCafe. Available on the World Wide Web at www.mpowercafe.com

KIYOSAKI, R. T., and LECHTER, S. L. Retire Young, Retire Rich. New York: Warner Books Inc., 2001.

SIEGEL, ALAN M.; MORRIS, V. B.; and MORRIS, K. M. The Wall Street Journal Guide to Planning Your Financial Future: The Easy-To-Read Guide to Planning for Retirement. New York: Fireside, 1998.

STANLEY, T. J., and DANKO, W. D. The Millionaire Next Door: The Surprising Secrets of America’s Wealthy. New York: Simon and Schuster, 1998.