Basic guidelines exist to help assist people in creating
their retirement plans. These guidelines will either form the premise of a
self-directed retirement investment strategy or can be used to help guide the
investment process of an external financial professional.
1. What Is Your Time Horizon?
Current age and expected retirement age create the initial
groundwork of an effective retirement strategy. Firstly, the longer the time
between today and retirement, the higher the level of risk that one's portfolio
can withstand. If you're young and have 30+ years until retirement, you should
have the majority of your assets in riskier securities like stocks. Though
there will be volatility, over long time periods stocks outperform other
securities, like bonds.
Additionally, you need returns that outpace inflation so
that you can not only grow your money in total, but also against your future
purchasing power. (Bonds have actually outperformed stocks in the past 10
years. Read more here.)
In general, the older you are, the more your portfolio
should be focused on income and capital preservation. This means a higher
allocation in securities like bonds, which won’t give you the returns of
stocks, but will be less volatile and will provide income you can use to live
on.
You also will have less concern for inflation. A 64-year old
who is planning on retiring next year does not have the same concerns regarding
inflation as a much younger professional who just entered the workforce.
Thirdly, although it is typically advised to begin planning
for retirement at a younger age, younger individuals are not expected to
perform the same type of due diligence regarding retirement alternatives as
someone who is in their mid-40s.
Also, you should break up your retirement plan into multiple
components. For example, a parent may wish to retire in two years, pay for
their children's education when they turn 18 and then move to Florida. From the
perspective of forming a retirement plan, the investment strategy would be
broken up into three periods: two years until retirement (contributions are
still made into the plan), saving and paying for college, and living in Florida
(regular withdrawals to cover living expenses). A multi-stage retirement plan
must integrate various time horizons along with the corresponding liquidity needs
to determine the optimal allocation strategy. You should also be rebalancing
your portfolio over time as your time horizon changes.
Most importantly, start planning for retirement as soon as
you can. You might not think a few bucks here or there in your 20’s mean much,
but the power of compounding will make that worth much more by the time you
need it. (The future may seem far off, but now is the time to plan for it.
Check out 5 Retirement Planning Rules For Recent Graduates.)
2. What Are
Your Spending Requirements?
Having realistic expectations about post-retirement spending
habits will help you define the required size of the retirement portfolio. Most
people argue that after retirement their annual spending will amount to only
70-80% of what they spent previously. Such an assumption is often proven to be
unrealistic, especially if the mortgage has not been paid off or if unforeseen
medical expenses occur.
Since, by definition, a retiree is no longer at work for
eight or more hours a day, they have more time to travel, go sightseeing,
shopping and engage in other expensive activities. Accurate retirement spending
goals help in the planning process as more spending in the future requires
additional savings today.
The average life span of individuals is increasing, and
actuarial life tables are available to estimate the longevity rates of
individuals and couples (this is referred to as longevity risk). Additionally,
you might need more money than you think if you want to purchase a home or fund
your children's education post-retirement. Those outlays have to be factored
into the overall retirement plan. Remember to update your plan once a year to
make sure you are keeping on track with your savings.
3. What
After-Tax Rate of Return Do You Need?
Once the expected time horizons and spending requirements
are determined, the after-tax rate of return must be calculated to assess the
feasibility of the portfolio producing the needed income. A required rate of
return in excess of 10% (before taxes) is normally an unrealistic expectation,
even for long-term investing. As you age, this return threshold goes down, as
low-risk retirement portfolios are largely comprised of low-yielding
fixed-income securities.
If, for example, an individual has a retirement portfolio
worth $400,000 and income needs of $50,000, assuming no taxes and the
preservation of the portfolio balance, they are relying on an excessive 12.5%
return to fund retirement. A primary advantage of planning for retirement at an
early age is that the portfolio can be grown to safeguard a realistic rate of
return. Using a gross retirement investment account of $1,000,000, the expected
return would be a much more reasonable 5%.
Depending on the type of retirement account you hold,
investment returns are typically taxed. Therefore, the actual rate-of-return
must be calculated on an after tax basis. However, determining your tax status
at the time you will begin to withdraw funds is a crucial component of the
retirement planning process.
4. What Is
Your Risk Tolerance and What Needs Have to be Met?
Whether it's you or a professional money manager that's in
charge of the investment decision, a proper portfolio allocation that balances
the concerns of risk aversion and return objectives is arguably the most
important step in retirement planning. How much risk are you willing to take to
meet your objectives? Should some income be set aside in risk-free treasury
bonds for required expenditures?
You need to make sure that you are comfortable with the
risks being taken in your portfolio and know what is necessary and what is a
luxury. This is something that should be seriously talked about with not only
your financial advisor, but also with your family members.
5. What Are
Your Estate Planning Goals?
Life insurance is also an important part of the retirement
planning process. Having both a proper estate plan and life insurance coverage
ensures that your assets are distributed in a manner of your choosing and that
your loved ones will not experience financial hardship following your death. A
carefully outlined will also aids in avoiding an expensive and often lengthy
probate process. Though estate planning should be part of your retirement
planning, they each require the expertise of different experts in their
respective fields.
Tax planning is also an important part of the estate
planning process. If a parent wishes to leave assets to either their family
members or even to a charity, the tax implications of either gifting the
benefits or passing them through the estate process must be compared. A common
retirement plan investment approach is based on producing returns which meet
yearly inflation-adjusted living expenses while preserving the value of the
portfolio; the portfolio is then transferred to the beneficiaries of the
deceased. You should consult a tax advisor to determine the correct plan for
the individual.