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Retirement Planning Financial Planners

Chapter 2: Introduction to Retirement Funding

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Factors Affecting Retirement Planning Remaining Work Life Expectancy (RWLE) Retirement Life Expectancy (RLE) Savings Annual Income Needs Wage Replacement Ratio (WRR) Inflation Retirement Income Sources Investment Returns Qualitative Factors

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Work Life Expectancy (WLE)

The period of time a person is expected to be in the work force.

Period during which one saves and accumulates for retirement.

Generally 30-40 years, but has been decreasing due to advanced education and early retirement.

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Remaining Work Life Expectancy (RWLE)

Work period that remains at a given point in time before retirement.

The number of years a client has to save for retirement.

93% of people retire between ages 62 and 65.

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Retirement Life Expectancy (RLE)

Time period beginning at retirement and ending at death.

Time period planned for by the financial planner and the retiree during the work life.

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WLE and RLE Relationship

Move inversely with each other: As WLE increases, RLE decreases. As RLE increases, WLE decreases. As WLE decreases, RLE increases. As RLE decreases, WLE increases.

A change in one variable could create additional funding needs, or decrease funding needs.

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Savings and Investment Issues Savings Issues

Savings Amount Savings Rate Timing of Savings

Too little, too late? Investment Issues

Asset Classes Rates of return? Exhibit 2.11 on Page 28

Inflation Risk Tolerance

Lake Tahoe or Lake Mattoon?

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Savings Amount

An individual should begin saving early (Exhibit 2.6 on page 23)

Age Beginning Regular and

Recurring Savings

Savings as a percentage of gross

pay

25-35 10-13%

35-45 13-20%

45-55 20-40%

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Savings Rate

The average savings amount based on consumption.

In 2010, personal savings rate increased to 6% from 1% in 2005

Recall that even at the age of 25, an individual should be saving at least 10%.

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Timing of Savings

Earlier: more compounding. Later: you will never catch up. Assumption:

Returns don’t vary from mean

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Investment Decisions Asset Class Selection

Varying Risks/Returns Factors

Age Risk Tolerance

See Exhibit 2.11 on page 28

Inflation Loss of purchasing power See Exhibit 2.12 on page 31

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Retirement Needs Analysis

How much income/money does an individual need during his retirement? Increased Needs

Health Care Travel

Decreased Needs Mortgage eliminated…interest only

mortgages??? Payroll/Social Security Taxes Need to save Work-related expenses (dry-cleaning, parking,

lunches)

13Wage Replacement Ratio (WRR)

Estimate of the percentage of an individual’s income earned prior to retirement needed during retirement.

Methods of Calculating Top-Down Approach

Uses percentages and common sense. “Best guess” when not close to retirement

Bottom-Up (Budgeting) Approach Determines which preretirement expenses are

needed during retirement. More accurate when close to retirement

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Sources of Retirement Income

Social Security Company-Sponsored Retirement

Plans Personal Retirement Plans

IRAs, Roth IRAs

Personal Savings Taxable Savings Accounts

Continued Employment

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Qualitative Factors in Retirement

Involuntary vs. Voluntary Retirement Emotional and Psychological Factors

Loss of esteem from job Boredom

Relocation Decisions Travel

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Risks to Financial Independence (1 of 2)

Factor Risk Mitigator

WLEUntimely death,

disability, unemployment

Insurance, education,

training

RLE LengthenedAdequate Capital

Accumulation

Savings Rate, Amount, Timing

Too low and too lateSave enough,

start early

InflationGreater than

expected

Conservatively estimate

inflation and needs

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Risks to Financial Independence (2 of 2)

Factor Risk Mitigator

Retirement Needs

Underestimated Use WRR

Investment Returns

Inadequate to create necessary

capital

Investment diversification and

proper asset allocation

Sources of Retirement

Income

Overestimation of Social Security,

pension plans, or personal income

Use conservative estimates and monitor projections and plans

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Capital Needs Analysis

The process of calculating the amount of investment capital needed at retirement.

Calculation methods Annuity Method Capital Preservation Model Purchasing Power Preservation Model

Utilizes many estimates. Increases risk of error.

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Annuity Method Calculate WRR.

Top-down/Budgeting Approach Determine gross dollar needs. Determine net dollar needs.

Reduce gross needs by expected Social Security. Inflate net dollar needs by CPI rate to retirement age. Calculate capital needed at retirement age.

Present value of the annuity due of preretirement dollar needs.

What rate of return for investments? See Example 2.7 on pages 47-49.

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Capital Preservation Model

Maintains the original capital balance needed at retirement for the entire retirement life expectancy.

See Example 2.6 on pages 37-38.

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Capital And Purchasing Power Preservation Models

Maintain the purchasing power of the original capital balance at retirement for the entire retirement life expectancy.

See Examples 2.8 and 2.9.

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To Reduce Estimate Risk

Sensitivity Analysis Changing variable assumptions to

determine the effects to the retirement plan.

Which variables matter Example on page 43: inflation.

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To Reduce Estimate Risk

Monte Carlo Analysis Mathematical tool used to illustrate the

unpredictability of the real world and its effects on an individual’s retirement plan. Returns vary from median What is likelihood plan will fail: outlive

money? Sustainable withdrawal rate: 4%

Better to use historical patterns rather than random returns?

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Sustainable Withdrawal Rate If I retire with $1 million in retirement savings, how much

can I spend each year? Do you want spending to increase each year with

inflation? If withdrawals need to grow over retirement life

expectancy, portfolio will be subject to volatility Timing of volatility (negative returns) has huge

impact on withdrawal rate Amount of inflation also has significant impact Research: historically 4% but may be high in low

return environment