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Of all the major changes in life, retirement may pose the greatest long-term challenge. But for a life stage that can last to age 95 or longer and raise significant financial questions, the planning tools and steps required to help you succeed are, for the most part, straightforward.
BUILD A STRATEGY FOR SPENDING AND SAVING
At the core of a strong retirement plan is a spending and saving strategy that will help you live within your means today, and at the same time, prepare you for retirement. "Think of your strategy as a map," says Christine Fahlund, CFP®, a senior financial planner with T. Rowe Price. "Knowing where you are now and where you want to go will help you understand your future income needs and how to get there."
ESTIMATE YOUR EXPENSES. Begin by writing down an inventory of current expenses, both essential and discretionary. Then add a "projected" column to get a sense for what you may spend in retirement. Consider changes in your spending patterns that may occur. For example, you won’t be commuting to work each day, and you may have paid off your mortgage. Ask yourself if you plan to stay in your current home and how you plan to spend your time. "Dream about the life you want to lead," Fahlund says. "It will help you see the steps you need to take now to move toward your goals."
SAVE FOR YOUR FUTURE INCOME. "Our research shows that you can build a sound retirement income plan if you follow some standard guidelines," Fahlund notes. The rule of thumb is to plan on replacing 75% of your preretirement income. As much as 50% of that income may come from investments, 20% from Social Security benefits, and the rest from other sources such as a pension or part-time work. Most people need to save 15% of their annual income, including any employer contributions, to achieve those percentages. On the other hand, your savings percentage may need to be higher if you’re getting a late start. Creating a spending and saving plan will set you on a path to achieving your goals.
ESTABLISH AN APPROPRIATE ASSET ALLOCATION
The precise mix of stocks and bonds in your portfolio will depend on how close you are to retirement and your personal circumstances. Investors more than 15 years away from retirement should consider a portfolio with more than 80% allocated to stocks, since they provide the long-term growth potential you will need. As investors near retirement, they should gradually shift their allocation toward a more balanced mix of stocks, bonds, and short-term investments to dampen volatility.
HOLD A DIVERSE PORTFOLIO. You should hold a wide range of stock and bond sub-asset classes, including exposure to domestic and international equities, and select small, mid-size, and large firms. Likewise, spread your bond holdings among domestic and international bonds that vary by maturity and credit quality. This broad diversification can help insulate your portfolio from sharp declines in any one segment of the market. And it can help you balance the risk and return of your portfolio. Of course, diversification cannot assure a profit or protect against loss in a declining market. "Globalization has made investing more complex," Fahlund says. "In turn, it’s become more important than ever to prepare for a wide variety of potential events—including changes to the tax code, political unrest around the world, and rising inflation. Preparing for the unknown requires diversification."
INVEST IN ROTH ACCOUNTS TO DIVERSIFY YOUR TAX EXPOSURE. The majority of your retirement savings likely is held in a tax-deferred, employer-sponsored plan. You may have an opportunity to convert some of these assets to a Roth IRA and/or contribute to a Roth IRA or Roth 401(k) to provide you with some tax diversification. "Roth IRAs and Roth 401(k)s give you the greatest long-range flexibility and control over your after-tax income both in retirement and afterwards for your heirs," notes Fahlund, who points to these advantages:
- Tax-free withdrawals. Contributions to Roth IRAs and Roth 401(k)s are made with after-tax dollars, and withdrawals of contributions and earnings are free of income tax as long you are age 59½ or older and have held the account for five years or more. Roth IRAs can be an ideal source of contingency money later in retirement. If you suddenly have large medical bills, for example, you could tap in to the account without increasing your tax liability.
- No required minimum distributions (RMDs). You will not have to take required distributions from a Roth IRA. Roth 401(k)s, however, do have RMDs. For this reason, many investors choose to roll over their Roth 401(k) assets to a Roth IRA prior to reaching age 70½.
- Future generations. Under current tax laws, Roth IRAs can be passed along to your heirs with many of their tax advantages intact, "stretching" the account and its potential growth for future generations. Heirs may take tax-free withdrawals of earnings from the account, as long as the combined amount of time the original account and the inherited account have been open is at least five years (contributions may be withdrawn tax-free at any time). Inherited Roth IRAs may have RMDs based on the account’s value and the age of the inheritor. If the recipient is young, those withdrawals may be small, giving the majority of the assets in the account time to benefit from tax-free potential growth up to at least age 80 if the beneficiary chooses.
If you have a Traditional IRA, consider converting part of the account to a Roth IRA either prior to retiring or when you have retired and may be in a lower tax bracket. Since you will have to pay income taxes on some or all of the conversion amounts when you file your income tax return for that year, making several partial conversions over a number of years may make it easier. Says Fahlund, "Having assets in a Roth IRA will provide you with more freedom to control your withdrawals later in life because you will not be subject to required minimum distributions. Instead, the assets in this account have the potential to grow while you focus primarily on tapping your taxable and tax-deferred accounts."
ORGANIZE YOUR ESTATE
"Like every feature of your retirement strategy," Fahlund observes, "the goal of your estate plan should be to provide you maximum flexibility and control over the future distribution of your assets." Consult with your estate planning attorney and review the elements of your current plan, including titles on your investment accounts, beneficiary designations, and distribution provisions in your will and/or revocable living trust. Your plan should:
- Include an up-to-date will and/or living trust;
- Authorize both financial and medical powers of attorney to appropriate people, in the event you’re unable to make decisions for yourself;
- Minimize estate taxes if your estate exceeds either the federal or your state’s exemption amount (or amounts, if you are married); and
- Coordinate beneficiary designations on retirement plans and insurance policies with your overall estate plan. Choose which assets to hold in joint tenancy with right of survivorship since these designations and titles take precedence over your will or living trust.
Think carefully about your options when designating minor children as beneficiaries. Most state laws require money left to children to be held by a custodian only until the child reaches the age of majority, typically age 18 or 21. Consider setting up a trust if you would like to maintain control over how and when a child is eligible to receive distributions of principal and income.
EVALUATE YOUR INSURANCE NEEDS
No retirement plan is complete without insurance to protect against catastrophic events and liability. Some of the largest threats to your assets in retirement likely are expenses related to health care, long-term care, and accidents. The right insurance policies, with appropriate coverage, can keep certain events from jeopardizing your long-term financial security.
HOW MUCH COVERAGE DO YOU NEED? The answer depends on your individual situation. "Start by looking for coverage against expenses that could potentially wipe out your savings," Fahlund says, "and search out policies with premiums you can afford."
Health. As you approach age 65, review the Medicare application process and take note of the deadlines. If you expect to remain employed after you attain age 65, check with your employer to determine whether you (and your spouse, if applicable) can delay applying for Medicare benefits until you terminate your employment. Medicare covers only about 50% of medical costs in retirement, so you will need to explore your options for purchasing a supplemental insurance policy to cover the rest, including coverage for prescription drugs. Check with your current employer to see if there will be any options to continue coverage under the company’s health care plan once you retire.
Long-term care. "Long-term care insurance is important for many people, but especially so if there is a history of long-term, care-intensive conditions such as dementia in your family," Fahlund says. "Paying out of pocket for years of institutional care is likely to place a significant strain on your family’s assets." It’s important to investigate your options early and consider enrolling in a plan while you are in your 50s or early 60s when premiums are lower and you are still insurable.
Liability coverage. Make sure you have purchased enough liability coverage to protect your assets. You should consider buying an umbrella insurance policy, which can increase your auto and homeowners insurance liability coverage and provide you with overarching financial protection in the event you are ever sued. You may be surprised at the reasonable prices of many of these policies.
Life insurance. Ask yourself whether your family would have enough income to meet its various goals, such as college and retirement, if you pass away sooner than expected. A financial advisor can help you determine the coverage you’re likely to need. If you are close to retirement, with grown, self-reliant children, you may not need life insurance. In fact, you might redirect the amount you would have spent on life insurance premiums to coverage such as long-term care.
UPDATE YOUR PLAN REGULARLY. Retirement planning is a dynamic and continual process that should enable you to achieve your ambitions. Your vision for what is important in retirement will evolve as your children become adults, your career progresses, and you are introduced to new ideas and experiences. Begin the planning process as early as you can, and as you approach the year you hope to retire, consider embarking on a retirement transition strategy—when you continue working but at the same time try out the life you envision for yourself. Doing this will help you adjust emotionally to future changes as well as sharpen your vision for what you want to do next.
*EXPLAINING ASSUMPTIONS AND MONTE CARLO ANALYSIS USED IN FUTUREPATH® OUTCOMES
Social Security and Pension Benefits
Any Social Security estimates are based on your current annual salary, current age, and stated age at retirement. The estimates are based on current law; the laws governing Social Security benefits and amounts are subject to change. The accuracy of the estimate depends on the pattern of your actual past and future earnings. The estimate may not be representative of your situation. Visit socialsecurity.gov for more information.
FuturePath estimates each person’s Social Security benefits independently. When one spouse or planning partner predeceases another, FuturePath assumes the surviving spouse/partner is eligible to receive the higher of the two estimated Social Security benefit amounts through the end of the couple’s retirement horizon. If your planning partner is not your legal spouse, federal law may preclude you from receiving Social Security benefits associated with the deceased partner’s work history.
For pension benefits, FuturePath allows you to assume that a portion of the pension benefit amount will be paid to a surviving spouse/partner. Federal/state laws may preclude a surviving spouse/partner from receiving pension benefits associated with the deceased spouse’s/partner’s work history.
MONTE CARLO SIMULATION
Monte Carlo simulations model future uncertainty. In contrast to tools generating average outcomes, Monte Carlo analyses produce outcome ranges based on probability, thus incorporating future uncertainty.
MATERIAL ASSUMPTIONS INCLUDE:
- Underlying long-term rates of return for the asset classes are not directly based on historical returns. Rather, they represent assumptions that take into account, among other things, historical returns. They also include our estimates for reinvested dividends and capital gains.
- These assumptions, as well as an assumed degree of fluctuation of returns around these long-term rates, are used to generate random monthly returns for each asset class over specified time periods.
- The monthly returns are then used to generate 1,000 scenarios, representing a spectrum of possible return outcomes for the modeled asset classes. Analysis results are directly based on these scenarios.
- Required minimum distributions (RMDs) are included. In the simulations, if the RMD is greater than the planned withdrawal, the excess amount is reinvested in a taxable account.
MATERIAL LIMITATIONS INCLUDE:
- The analysis relies on return assumptions, combined with a return model that generates a wide range of possible return scenarios from these assumptions. Despite our best efforts, there is no certainty that the assumptions and the model will accurately predict asset class return ranges going forward. As a consequence, the results of the analysis should be viewed as approximations, and users should allow a margin for error and not place too much reliance on the apparent precision of the results. Users should also keep in mind that seemingly small changes in input parameters (the information the user provides to the tool, such as age or contribution amounts) may have a significant impact on results, and this (as well as mere passage of time) may lead to considerable variation in results for repeat users.
- Extreme market movements may occur more often than in the model.
- Some asset classes have relatively short histories. Actual long-term results for each asset class going forward may differ from our assumptions, with those for classes with limited histories potentially diverging more.
- Market crises can cause asset classes to perform similarly, lowering the accuracy of our projected return assumptions and diminishing the benefits of diversification (that is, of using many different asset classes) in ways not captured by the analysis. As a result, returns actually experienced by the investor may be more volatile than projected in our analysis.
- The model assumes no month-to-month correlations among asset class returns (correlation is a measure of the degree in which returns are related or dependent upon each other). It does not reflect the average duration of bull and bear markets, which can be longer than those in the modeled scenarios.
- Inflation is assumed to be constant, so variations are not reflected in our calculations.
- The analysis assumes a diversified portfolio, which is rebalanced on a monthly basis. Not all asset classes are represented, and other asset classes may be similar or superior to those used.
- Taxes on withdrawals are not taken into account, nor are early withdrawal penalties.
- The analysis models asset classes, not investment products. As a result, the actual experience of an investor in a given investment product (e.g., a mutual fund) may differ from the range of projections generated by the simulation, even if the broad asset allocation of the investment product is similar to the one being modeled. Possible reasons for divergence include, but are not limited to, active management by the manager of the investment product or the costs, fees, and other expenses associated with the investment product. Active management for any particular investment product—the selection of a portfolio of individual securities that differs from the broad asset classes modeled in this analysis—can lead to the investment product having higher or lower returns than the range of projections in this analysis.
- The primary asset classes used for this analysis are stocks, bonds, and short-term investments. An effectively diversified portfolio theoretically involves all investable asset classes, including stocks, bonds, real estate, foreign investments, commodities, precious metals, currencies, and others. Since it is unlikely that investors will own all of these assets, we selected the ones we believed to be the most appropriate for long-term investors.
- Results of the analysis are driven primarily by the assumed long-term, compound rates of return of each asset class in the scenarios. Our corresponding assumptions, all presented in excess of inflation, are as follows: for stocks, 4.90%; for bonds, 2.23%; and for short-term investments, 1.38%.
- Investment expenses in the form of an expense ratio are subtracted from the return assumption as follows: for stocks, 0.70%; for bonds, 0.60%; and for short-term investments, 0.55%. These expenses represent what we believe to be a reasonable approximation of investing in these asset classes through a professionally managed mutual fund or other pooled investment product.
ASSET ALLOCATION AND WITHDRAWALS FROM INVESTMENTS:
- The asset allocation for the investments we’ve included in FuturePath has either been selected by you or, for aggregated assets, is provided using the Morningstar classification of individual securities and holdings within mutual funds to categorize them as stocks, bonds, or short-term investments. Any percentage of holdings classified by Morningstar as "other" has been assigned to stocks.
- Your target asset allocation presents a suggested allocation based on your age or the age of your spouse/partner if he or she is older. This target reflects a suggested allocation of investments that has the potential to help your portfolio keep pace with inflation while reducing market volatility. There is no assurance that the recommended asset allocation will either maximize returns or minimize risk or be the appropriate allocation in all circumstances for every investor with a particular time horizon.
- Your withdrawal amount from investments is displayed in today’s dollars for the current year and is assumed to increase by 3% each year throughout the retirement horizon. These amounts do not take any taxes into account that may be due upon withdrawal.
- The modeled asset class scenarios described above and your projected withdrawals from investments may be calculated at, or result in, a Simulation Success Rate. Simulation Success Rate is a probability measure and represents the number of times our outcomes succeed (i.e., has at least $1 remaining in the portfolio at the end of retirement). This Simulation Success Rate is the primary component of the Confidence Number.
IMPORTANT: The projections or other information generated by FuturePath regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The simulations are based on assumptions. There can be no assurance that the projected or simulated results will be achieved or sustained. The charts present only a range of possible outcomes. Actual results will vary with each use and over time, and the potential for loss (or gain) may be greater than demonstrated in the simulations.
The results are not predictions, but they should be viewed as reasonable estimates.
Source: T. Rowe Price Associates, Inc.
ILLUSTRATION by michael austin