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Retirement Planning


Planning for retirement is a very important exercise for everyone.  While some people wait until they get close to retirement age to begin their serious planning, it should really be something that you start thinking about from the time you get your first job.  Unless your name is Brett Favre, you are probably hoping to stop working and retire at some point in your life.  You want your retirement to be a time to relax and enjoy life and your family.  You don’t want to spend every day wondering if you will die before you spend every last dollar you have to your name.

So what can you do to make sure this doesn’t happen to you?  There are two primary ways to attack retirement planning.  One plan of attack is to focus on your initial withdrawal rate at retirement.  Your initial withdrawal rate is the amount of your total portfolio that you will need to withdraw each year in order to pay for your living expenses.  There have been many studies over the years that have attempted to determine what a “safe” initial withdrawal rate is.  Most of these studies have come up with something in the 4-4.5% range.  This means that if you have a $1,000,000 portfolio when you retire, you would be able to safely withdraw about $40-45,000 per year throughout your retirement without running out of money. 

That gives you an idea of what you can withdraw if you are about to retire but what if you are many years from retirement?  You can still use the same analysis but you will have to make some assumptions and try to back into an ending portfolio value that you would need to reach before you can retire.  For example, say you think you will need $100,000 per year from your portfolio in retirement (in future dollars).  You would need to accumulate a total portfolio of between $2.2 and $2.5 million dollars, assuming a 4-4.5% safe withdrawal rate.  You could then make some assumptions regarding future growth rates to try to determine how much you would need to put away each year in order to reach this goal. 

Of course understanding how much you will need in retirement is the key assumption here and coming up with this number is much easier said than done.  We would suggest starting with a thorough analysis of your current expenses.  You can’t project your future expenses until you understand what you spend now.  You then need to factor in inflation, which is the general increase in prices that occurs over the years.  We have recently been in a very low inflationary period but throughout history this rate has been about 3-4% and this is typically what we use in our analysis.  You also have to factor in other expenses you might have in retirement.  While your mortgage might be paid off, you could have increased medical expenses or travel expenses.  It’s impossible to come up with an exact number of course but the exercise of determining a good estimate should help you in many ways.  

Withdrawal rates have been the subject of much debate recently as a result of the financial crisis.  One recent study looked at how closely tied safe withdrawal rates are to the markets and how much they can change due to market volatility.  This study looked at historic safe withdrawal rates over the past 100 years and suggested that withdrawal rates should be adjusted according to what the market valuations are at the time of retirement.  Under this thinking, the typical 4-4.5% withdrawal rate might be too conservative when low-valuation market conditions exist.  Of course there is no way to tell what market conditions will be when you retire but this can help those who are about to retire come up with a withdrawal rate that allows them the maximum amount of annual withdrawals while still having enough money to last through retirement. 

Another more detailed way to tackle retirement planning is to use financial planning software that utilizes what is called “Monte Carlo” analysis.  We use software called Money Guide Pro to accomplish this.  Monte Carlo analysis runs hundreds of different sequences of returns and calculates a probability of each outcome.  The goal in this type of analysis is to come up with a scenario where at least 80% of the outcomes are favorable.  You can enter many different factors into this software such as current annual savings, future pension income, future expenses, etc.  You also need to make a number of assumptions like future inflation rates, rates of return, and tax rates.  All of these factors can help you come up with an overall guide to determine how much you need to save or how much you need to cut back on expenses in order to reach your retirement goals.  While it is not a precise calculation it can give some very helpful insight into reaching retirement goals.

We think the most important part of planning for retirement is the planning itself.  This might sound counterintuitive but for many people the biggest challenge is finding the time to sit down and work through a plan.  Most people spend more time planning their next vacation than they do planning for retirement.  But if you don’t come up with a plan for retirement, then you might not be able to do some of the things you want in retirement which might include going on vacations.  Determining your goals should be the first thing you do.  When do you want to retire?  What do you want to do in retirement?  Will you have any source of income in retirement?  These are the kinds of questions you need to ask. 

After you have determined your goals, then you can begin to work on how you will reach those goals.  You can do a sophisticated analysis that will give you a detailed strategy for reaching your goals.  Or you can do a more general analysis that will give you some guidelines to keep you on track for reaching your goals.  Either way you will be well on your way to a happy and successful retirement.