Preparing for retirement involves analyzing your assets, income, and expenses, but it also includes knowing your risks and knowing how to relax.
Start relaxing about retirement by scheduling a 15-minute call with one of our advisors here.
By Michael Sharpnack
It’s no secret that most Americans are underprepared for retirement.
Studies show that less than 20% of people feel they can retire confidently.
Most people fear retirement—regardless of their assets and income—because it has so many unknowns.
Because of these fears, many people put off planning for retirement, thinking, “I’ll work forever!”
But that’s just not feasible for most of us. At the very least, health creeps up on us all.
Even if you love what you’re doing, wouldn’t you like to do it because you want to, not because you have to?
No matter your affection toward work, you will have to face the retirement question eventually.
But by taking the right steps, you can face retirement confidently, knowing that you’re adequately prepared.
Five Steps to Preparing for Retirement
- Align your assets.
- Identify your income.
- Calculate your costs.
- Reduce your risks.
- Relax about retirement.
After going through these steps, you’ll know where you stand and what you can do to prepare.
Align Your Assets
You’ve worked hard for your money, but when you retire, how do you get your money to work hard for you?
You want to protect your assets, but you also want to grow them. You want income from your assets, but you also want safety.
How do you meet these goals?
You must align your assets with the fundamental principles of investing. Most are unaware that over fifty years of academic research on investing and retirement portfolios exists.
In order to align your assets properly, we’ll look at two of the most important factors for setting up a portfolio: true diversification and the right kind of safety.
I say true and right because, while these are common investing buzzwords, most people don’t follow these principles properly.
Finally, I’ll address a common concern that arises at this point: What if I’m too old for stocks?
Thinking you are diversified when you have many different mutual funds is easy.
But that’s like saying I’m going to diversify my diet by eating at different locations of McDonald’s restaurants. You may have different mutual funds, but they might all be investing in the same kinds of stocks.
Truly diversifying your investment portfolio means owning distinctly different kinds of stocks.
The only way to do that is to own stocks that have a low statistical correlation with each other. Okay, that’s a mouthful, but all it means is the stocks don’t follow each other exactly. They may have a similar average return, but they don’t get there the same way. One zigs and the other zags.
Think of bathing suit sales and winter coat sales.
In a perfect world, negative correlation looks something like this:
When it comes to stocks, it’s a little more complicated than that, but the hard work has been done for us. Nobel Prizes have been awarded for these concepts.
Here’s what you need to know. There are eight distinct categories of stocks:
In other words:
- U.S. Large Growth
- U.S. Large Value
- U.S. Small Growth…
You can also do the same for emerging market stocks, which is a subcategory of international stocks.
Proper diversification means owning all eight categories.
The goal of diversification is to reduce risk, and this is especially important in retirement.
..Withdrawing money from your investments for income in retirement puts additional stress on your assets. A lack of diversification magnifies this stress. Large U.S. stocks, for example, had no after-inflation return from 1966–1982. That was detrimental to those retiring in the 1960s with no diversification.
So the first step to preparing for retirement is to build a retirement portfolio that is truly diversified.
The Right Kind of Safety
The first thing to say about safety is that complete safety is a myth.
You can be safe from one type of risk but still expose yourself to many more. CDs, bonds, and annuities can provide protection of principle, but they expose you to inflation risk. Stocks protect from inflation and longevity risk, but they expose you to the risk of market fluctuations.
You must balance inflation risk and the volatility of the stock market by choosing the right stock to bond ratio.
Retirement research shows that the best stock to bond mix is between 50% stocks and 75% stocks. Any less in stocks and you have too much exposure to inflation, and any more and you have too much volatility. The right mix depends on your specific situation.
The next key decision with safety is to choose the right types of bonds.
You must have short-term, high-quality bonds. When stocks go down in value, these bonds tend to go up. I know, those are paying the lowest interest rates, but higher-interest bonds—like junk bonds—tend to go down with the stock market, completely undermining your retirement plan.
Bonds are there for safety, not return.
Insurance products, such as annuities, are commonly sold in the guise of safety, promising guaranteed principle and return, but insurance products have problems as retirement investments. Your principal can be locked up, they have high expenses and commissions, and they also have unnecessary complications.
Identify Your Income
The retirement question everyone wants answered is “How much income can I get?”
And while an income analysis is a core component of retirement planning, not stopping here is important. Knowing your income is only useful in relation to your costs and your risks. An income number that sounds great may not be so great if your expenses are high or it’s subject to a lot of risks.
That being said, to prepare for retirement, you still must have a clear picture of your retirement income.
There are four categories of income in retirement:
- Social Security
- Investment income
- Other income
Other income includes rental, business, side jobs, or executive benefit packages.
The goal of this step is to analyze each income source and then add them up to give a projected retirement income number.
Social Security is the foundation of retirement income.
Deciding the best age to file for Social Security benefits is one of the most important retirement decisions you’ll make. In many cases, taking your benefits at the wrong age can affect your plan by hundreds of thousands of dollars over a lifetime.
Not only is the amount of your Social Security benefit crucial for deciding when to file, but you also must consider how Social Security fits into the rest of your financial plan.
We identify four key factors that affect when you should file for your benefit:
- Life expectancy
- Your spouse’s benefit
- Retirement assets
- Desired retirement date
You don’t have to file for Social Security and retire at the same time. This is one of the biggest myths to dispel.
Delaying to file has many benefits, but what if you don’t want to wait that long to stop working? You could use a strategy called a spend down, where you retire early, delay benefits, and spend down a specified amount of assets to avoid a gap in income.
This strategy often results in greater income throughout retirement.
There have been rumors for years now that Social Security is going broke.
The truth isn’t as bleak as many make it out to be. The latest report has full benefits being paid until 2033, and then about 80% of benefits being paid from there.
But that’s if Congress does nothing to fix it, and many solutions are available; some are being talked about already. Seniors are the largest voting block, so it wouldn’t make sense for Congress to let a major income source for them be reduced.
Income From Investments
About as many different approaches to retirement income exist as there are advisors in the world.
But all these approaches can be boiled down into two broad categories: product-driven approaches and process-driven approaches.
The types of retirement investments used usually differ between the two strategies, but there can be some overlap.
We recommend a process-driven approach, not a product-driven approach.
At its core, product-driven approaches start with a handful of retirement products, and then look to fit those to the retiree’s needs.
Common products under the product-driven approach to retirement income include:
- Life insurance
- Dividend stocks
- Interest income investments (bonds, CDs, savings accounts, etc.)
Each of these retirement products has issues of which to be wary.
Usually, the issues with these products include some combination of loss of liquidity, low return, no inflation protection, high commissions, or high risk.
Process-driven approaches, on the other hand, start with the retiree’s needs, and then look to build a robust income strategy.
The most common strategy under the process-driven approach to retirement income is to use a diversified portfolio and then evaluate a sustainable withdrawal rate from the portfolio.
The diversified portfolio creates a great balance between return, safety, inflation protection, liquidity, and income.
Two key strategies guide the use of a diversified portfolio for retirement income:
- The 4% research
- The wells approach
The research clearly shows you can take 4% of a diversified portfolio’s assets per year as income, sustain the portfolio through an average retirement, and keep pace with inflation. Some have challenged this rule over the years, but the key word here is a diversified portfolio. That’s why we start with “aligning your assets.”
When a properly diversified portfolio is used, the 4% rule withstands the worst periods of history.
Then, when you add in the wells approach to taking income, you can reduce costs and increase return over the lifetime of the portfolio.
Some are hesitant to use a diversified portfolio strategy because of the market fluctuations associated with stocks. But in most situations, the benefits of the diversified portfolio outweigh the risk of market fluctuations. Market crashes are often short, and most retirees have enough time to weather even the worst market crashes successfully.
With your assets aligned, the first step is to total your investments and then multiply by 4%.
This gives you a number in the vicinity of how much income you can generate per year and not run the portfolio dry.
But keep in mind that every situation is different, and other factors must be considered when choosing the withdrawal rate.
Only about a third of Americans have a pension now, but for those who do, pensions can be an excellent source of retirement income.
First, you must decide when—what age—to start the pension. Pensions have different formulas for how they calculate the benefit, but they almost always factor in years of service and salary. Sometimes working a few extra years can significantly increase the benefit, and sometimes it has minimal impact, depending on the formula.
Research how your formula works, and how retiring at different ages will change the benefit.
The next decision for pensions is how to take it—which payout option to choose.
Many payout options exist, with even more variations of each, but the most common types are single life, lump sum, and joint and survivor. The single life benefit will have the highest payment, but it ends when the pension owner dies. The joint and survivor will pay to the pension owner at a reduced amount, but it continues on to the survivor after the owner dies.
Deciding which option to take depends on many factors, including other income sources, assets, expenses, and planned retirement date.
You’ll also want to calculate the internal rate of return on the pension. This allows you to compare different options to each other—particularly the lump sum with the single life. This calculation tells you the return they are assuming on your pension payment, and it helps you know which option to choose.
Once you’ve chosen the when and how of your pension, you should be able to estimate your benefit accurately by either using the benefit formula, or an online calculator if your pension has one available.
Total Your Income Sources
The final step in identifying your income is to, well, identify it.
Add all the income sources together and arrive at a final number.
- Total investment income
- Total in Social Security benefits
- Total pensions
- Other income: rental, part-time work, annuities, royalties, etc.
Add that all up and you have your retirement income number.
Calculate Your Costs
You don’t want to retire only to realize you can’t keep your favorite TV subscriptions, have to stop eating out, or need to give up golf.
In this step, you estimate your expenses in retirement to determine if your income sources will cover your costs.
While most of your expenses will stay the same from your working years to retirement, there will be some key differences. For one, once you’re in retirement, you don’t need to save for retirement. Work-related expenses—such as travel and clothing—also drop off. And finally, you typically pay much less in taxes in retirement.
Some expenses do increase, however, so go through the process to discover what you’ll really need.
The first step is what we call a “top down” method.
Start with the income you make now and then subtract how much you’re saving, total taxes paid, and temporary expenses (such as a mortgage or kids’ education). Then, you’ll need to estimate your retirement taxes, and add those back into the calculation.
You can also create a budget for your retirement expenses, but many people have a heavy aversion to the b-word, and it’s possible to leave things out, so that’s why we recommend the “top down” approach.
However, the budget method can be a great supplement to the “top down” approach. If they arrive at different numbers, evaluate why that’s the case, which gives you a more holistic picture of your retirement spending (as well as your current spending).
Strategies for Reducing Taxes
Unfortunately, taxes don’t go away when you stop working.
But several strategies to save taxes in retirement are available under the right circumstances.
Most of the strategies have to do with minimizing required minimum distributions (RMDs). RMDs start at age 72 and require you to take money out of your pre-tax accounts. They increase each year and can often be higher than what you need to live on, thus creating an unnecessary tax burden.
To understand the strategies for managing RMDs, you must understand how taxes in retirement work. You must understand the income tax tiers, FICA taxes, Social Security taxes, Medicare premiums, and taxes on the different types of retirement accounts.
Then we can make a strategy for which accounts to draw out of in order to control taxes and reduce them over the length of your retirement.
One common strategy involves calculated Roth conversions. Early in retirement, you convert some pre-tax money into a Roth IRA. You pay taxes on the conversion, but it reduces your taxes every year after. It’s a way to frontload taxes, and, when done right, can save thousands in taxes over your lifetime.
Income Minus Expenses
One of the most important steps to preparing for retirement is understanding if your income will cover your expenses.
Take your income number and subtract your expense number from it.
(Total retirement income sources) – (Total retirement expenses) = Retirement surplus or shortfall
If your income number isn’t enough to cover the expenses, don’t panic, many options exist for making up the shortfall.
All of the options fit under two categories: increase income or decrease expenses.
Options for increasing income:
- Increase savings rate
- Additional job for increased savings
- Part-time work in retirement (even for just a few years)
- Adjust Social Security strategy
- Downsizing home
- Reverse mortgages
Options for decreasing expenses:
- Delay the retirement date (even just one year can make a big difference)
- Cut back spending
- Budget more spending to the first few years of retirement, and then cut back a lot in the following years
- Moving to a lower-cost-of-living area
- Paying off debt before retirement
At this point, an experienced and qualified financial planner can be indispensable for understanding the options and helping choose the best one.
Once you have an income number that exceeds your expense number, congratulations! Most of the work is done. However, you still need to manage your risks before you can relax about retirement.
Reduce Your Risks
- Sequence of returns
Inflation can destroy a retirement plan if you don’t take it into account. Retirement lasts longer than most people realize, and inflation cuts your purchasing power down each year. On average, prices double about every twenty years.
Related to the risk of inflation is the risk of living too long.
While living a long life is a goal for most, it does create added risk that needs to be prepared for. The longer you live, the more money you need. In addition, the more inflation impacts the money that you need. Longevity also creates a higher chance of significant health care costs.
Finally, sequence of returns risk is simply the risk that a downturn will occur early on in retirement.
Two retirees can have the same average return throughout retirement, but if one of them experiences a downturn early on, and the other experiences the downturn much later, the one with the downturn early will fare worse. This is because—unlike a downturn while you are working—when you are retired, you need to draw income from the portfolio even if the market is down.
Stocks help protect from inflation and longevity risks while bonds help protect from sequence of returns risk.
Understanding and addressing these risks is essential if you’re going to prepare for—and relax about—retirement.
Relax About Retirement
Preparing for retirement isn’t all financial—it’s psychological too.
It’s common to focus solely on preparing for the retirement date, but then to forget to prepare fully for the next 20–30 years.
Retirement is ranked as one of the top ten most stressful events in a person’s life. While it can be an amazing new journey, the initial stress makes sense because it’s an unknown. It also forces change in many areas of life.
Unknown plus changes equals stress.
This is why it’s important not only to have a financial plan for retirement but a holistic retirement plan.
You need to prepare in the five spheres of life:
You need to replace more than a paycheck. You also need to replace your time, and often a source of identity and social life as well.
Think through each area of life and visualize what it will look like in retirement. What changes will there be? What stays the same? Are there any gaps?
One of the most important questions to ask: What will a typical day look like?
Do you need to take any steps now to prepare more adequately in the other four areas of life?
It may not seem like it, but we don’t expect you to know all the details when it comes to retirement planning.
We do, however, believe you should be a partner in the process, because when you understand the decisions, you buy into the decisions.
I could crunch the numbers and tell you that you’re on track, and you might believe me, but you wouldn’t have full peace of mind. Eliminating the anxiety in the back of your mind comes from going through the process and understanding it for yourself.
But all details must be accounted for, and that’s where we come in.
We are coaches in this process. We come alongside and educate as we build the plan together. But we are also there to know the details that you don’t need to know and to think of the things you don’t know to think of.
That’s why, at Paul Winkler Inc., all of our advisors have financial planning designations and many years of experience.
We are experts in retirement planning and have walked hundreds of clients through it. We also use sophisticated software to help us analyze your situation, stress-test, adjust variables, and assist us in the creation of a plan.
It takes a combination of both expertise and software to make it happen.
When you have a clear plan that you understand, you can relax about retirement.
Want to talk with us directly?
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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), an investment advisor registered with the State of Tennessee. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase of sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.