Building a Plan

Posted February 14, 2010 – John Spitzer

This section outlines the major components of your financial plan for retirement and some considerations for its design. We then detail the steps to follow in building your plan, and conclude with some cautionary notes regarding common mistakes

Components of Your Plan

Your financial plan for retirement includes two major parts: your financial goals for retirement, and the plan for achieving those goals.

The financial goals include when you plan to retire, the level of income you wish to receive during your retirement years, and any one-time expenditures that you anticipate at the time of your retirement (the round-the-world cruise, for example).

The plan for achieving those goals starts with your current balances and your projected future contributions to your retirement funds (401k, IRA, etc). It also includes your projected Social Security income, income from other defined benefit pension plans, and income from rental properties and other such sources. A particularly important part of the plan is the projected return on your investments, which is largely a function of your asset allocation.

Design Considerations

Before we dive into the steps for building your plan, we need to briefly discuss a couple of design considerations. The first consideration concerns how to handle inflation. Inflation can’t be ignored – indeed, one of the two major concerns of retirees is that they may have their retirement income ravaged by inflation (the other major concern is that they will outlive their money).

The design problem is this: Suppose you want $50,000 in retirement income – in today’s dollars, you currently contribute $5,000 annually to a 401k, you project that the investments will generate a 10% return, and you anticipate that inflation will be 3% per year. In calculating whether you are on track to meet your goal, you can either:

  • Convert the $50,000/year income goal to future dollars (increase it by the anticipated 3% annual inflation rate), similarly convert the future $5,000 contributions to future dollars by adjusting them for inflation, and then use the 10% rate for investment returns.
  • Keep everything in today’s dollars, and adjust the investment return rate to 7% per year (by deducting the 3% inflation rate from 10%). The 7% rate is called the real rate of return.

We strongly recommend the latter method – keep everything in today’s dollars, and use real rates of return for your projections. We find this method much simpler to use.

The second design consideration is whether to specify your retirement income goal as a before-tax amount or an after-tax amount. We recommend using before-tax dollars because we tend to think in those terms, but either way will work. In either case, you will need to put your Traditional Accounts (where your withdrawals will be taxable) and your Roth Accounts (where withdrawals will be tax-free) on the same footing. If you follow our recommendation, you will adjust the projected Roth balances into taxable equivalent dollars. (If you choose to use the other approach, specifying your goal in after-tax dollars, you will need to adjust the projected traditional balances into after-tax dollars.)

Steps in Building Your Plan

  1. Identify the age at which you plan to retire.
  2. Identify the level of income you wish to receive in retirement. If you have more than 10 years before you expect to retire, we recommend using a percentage of your current income. If you are living comfortably on your current income, we recommend that you use 80-100% of that figure as your target for before-tax income. If you are within 10 years of retirement, you may do better by estimating your expenses directly, and then converting that figure to a before-tax amount.
  3. Determine how much of this income needs to come from your retirement accounts (the combination of your 401k plan, IRAs, and other investments that are earmarked for retirement) by deducting your estimated social security income, any pension income that you are entitled to receive, and income from rental properties and other sources outside your retirement accounts.

    You can use the Social Security website to estimate how much you will receive from social security, based on your contributions to date.  This estimate is in today’s dollars, since Social Security payments are indexed to inflation.

    If you have a pension, you will probably need to modify its projected income for inflation. Most non-government pensions provide fixed payments without any adjustments for inflation. If your pension does adjust payments by inflation, that’s great; otherwise you need to modify its projected level. A very rough method of adjustment is to reduce the projected pension income by 30% (this method is gives you the average real annual income, based on starting to receive pension income at age 67, a 3% inflation rate and an assumption that you live to age 90).

    We’ll call this remaining amount the target net retirement income (it’s the target income you want, in today’s dollars, net of social security and pension income).

    Example: Suppose you and your spouse are the same age, plan to retire at age 66, are earning $50,000 per year (about the median family income in the United States) and decide that you would like to have that level of income in retirement (100% of your current income). Let’s assume your projected income from Social Security is $1,400 per month, or $16,800 per year. And suppose you also have a pension that is projected to give you $500 a month, or $6,000 a year, without inflation adjustments.

    We would reduce the pension payment by 30% to $350 a month ($4,200 per year) to compensate for the lack of inflation adjustments after you start receiving the pension. We would then compute your target net annual retirement income at $29,000 ($50,000 – $16,800 – $4,200).

  4. The next step is to estimate the size of the portfolio needed to generate this income. We recommend basing this estimate on how much it will likely cost to buy an inflation-adjusted annuity that will generate this level of income. You may decide against buying an annuity and choose to draw upon your portfolio of investments. But, for planning purposes, we like basing calculations on a market-priced instrument that will provide income as long as you live and also offers protection against inflation.

    The price of the annuity depends upon your age when you buy it – the older you are, the less it costs to buy the annuity (the annuity pays you as long as you live so an older retiree will, on average, receive fewer payments). We don’t know what the prices will be in the future, so we use the current price as our best estimate.

    The table below shows, for different ages, the cost to purchase $1 of annual income with inflation adjustments.

    Age Cost Withdrawal Rate*
    50 $30.74 3.25%
    55 $27.53 3.63%
    60 $23.89 4.18%
    65 $20.66 4.84%
    66 $20.02 5.00%
    67 $19.38 5.16%
    68 $18.75 5.33%
    69 $18.22 5.49%
    70 $17.60 5.68%

    * The withdrawal rate is the annual income as a percent of the cost of the annuity. Since these figures are for annuities with inflation adjustments, the percentages represent real rates (today’s dollars).

    Example. Continuing our example from above, we see that it currently costs $20.02 to purchase each $1 of annual annuity at age 66. So, since the target retirement age is 66, and your target net income figure is $29,000, we would estimate that you need 20.02 x $29,000 = $580,580 in your portfolio at the time of retirement to generate your desired retirement income.

  5. Next, add in any one-time expenses you expect to have at the time of retirement. This figure would include the round-the-world cruise if you are planning one. It would also include, if you plan to retire before some years prior to drawing Social Security, a lump sum to cover the additional need during those years. With this addition, we have what we call the Target Retirement Account Balance.

    Example. To continue our example from above, suppose you do wish to have $30,000 for extensive travel after you retire. You would add the $30,000 to the $580,580 (from step 4), giving a Target Account Balance of $610,580.

  6. The next step is to project how much money you will have in your retirement accounts at the time you retire. This projection is based on your current balances, your projected contributions, and the projected return on your investments. For these calculations, you need to use a spreadsheet or one of the web-based retirement calculators that are available online. We have included a spreadsheet that we like as part of this website – it is in the “Tools” section.
  7. The final step is to compare the Target Retirement Account Balance (from step 5) with the projected amount of money you will have (from step 6). If your projections show a shortfall, you can use the spreadsheet to figure out what steps you might take. You may need to contribute more each year to your retirement accounts, retire later, reduce your goal for retirement income, or a combination of those factors. You may wish to examine your asset allocation and gauge whether you are in a position to take more risk, and whether you are willing to do so.

    If you are projected to exceed the target, you can infer that you are generally on track to meet your goal. We say generally because the margin for error is so great – we don’t know what the future holds. In that vein, it is important to remember that “low probability” does not mean “impossible” – as we observed in the economic crisis of 2008.

Some Important Cautionary Notes

In projecting how much money you will have in your retirement accounts, the calculator applies a projected return rate to the initial balances and the projected contributions. It is tempting to use a constant return rate for all of these calculations, and many calculators do this.

We are entirely in favor of simplicity and we emphatically agree that projections far into the future must be viewed as quite rough indications. Even so, we feel it is important for people with more than 10 years to retirement to recognize that they would be wise to shift their asset allocation to a more conservative mix as they approach retirement, with a consequent change in the rate of return. As a result, these people would do well to use a lower projected return rate for those years immediately preceding retirement.

We recommend a fairly simple approach: split the time horizon into a “more aggressive” period (where it is reasonable to have a higher allocation to stocks), and a “more conservative” period (where there is a high allocation to bonds). In our view, it is reasonable to anticipate shifting to the “more conservative” allocation 5 years before retirement.

In using retirement calculators, you also need to be careful on several other points:

  • Be sure that you are consistent in your specifications of future dollar amounts – they all need to be either in today’s dollars or in amounts that reflect inflation. As noted above, we recommend specifying everything in today’s dollars.
  • Be sure that your projected return rates are consistent with your treatment of inflation in the future balances – if you specify everything in today’s dollars (as we recommend), you must use real rates of return (net of inflation).
  • Be sure you are consistent on whether the dollars are before-tax or after-tax. If you have both Traditional Accounts and Roth Accounts, you must adjust one or the other. We recommend working with before-tax dollars, and adjusting the Roth balances to equivalent taxable balances.