Whether your vision of retirement involves sandy beaches, spoiling your grandchildren or just relaxing at home, you need to manage your income to provide for yourself for several decades after you retire. Most people spend plenty of time imagining what they’ll do when they no longer trek to the office every morning but relatively little time planning how they’ll fund those activities.
There is a science to making sure that you’ll have enough to sustain your lifestyle in retirement. By taking a hard look at your expected income and expenses, you can determine what it will take to make your dream retirement a reality. Here’s a primer:
Retirement Planning: When To Start
That depends on whether you’re referring to saving money for retirement or making a precise plan for when and how you will retire. Both are important — first, saving, but eventually planning as well.
“Retirement probably isn’t on the radar for somebody in their 20s, but the more you can start putting away early, the better,” says Warren Arnold, a senior financial consultant in Northern Trust’s Financial Consulting Group. “The ability to use the markets and their compounding effect for your benefit is a very powerful tool.”
About 10 years before you want to retire, you should begin more specific retirement planning — assessing your income and assets and looking toward a potential date of retirement — as well as envisioning your lifestyle. The earlier you begin, the more time you’ll have to change course if your projected income is insufficient to fund the retirement you envision. The timing is dependent on your circumstances — your income and assets, and the lifestyle you hope to lead in retirement. Even if you’re on course, it’s good to verify that early in the process.
To make the retirement planning process easier and more efficient, consider talking to a financial advisor who is an expert in retirement planning. During an initial meeting, the advisor will examine your projected income in retirement, including items such as distributions from your portfolio, profit-sharing plans, deferred compensation, Social Security income, pension payments, and income from jobs in retirement, board directorships and rental income. You may be surprised to find a significant discrepancy between your advisor’s calculation of your projected income and the number you had figured in your head.
“Many people just don’t know those projected income numbers,” says Gregg Yaeger, managing director of the Financial Consulting Group at Northern Trust. “They know their salary and bonus while they’re working, but they don’t think about retirement income projections. While you’re working, you figure, ‘If I spend less than I make, I’m OK.’ But if you continue on that path and you retire, and you’re looking to replace that pre-retirement income, it’s a challenge.”
The advisor also will evaluate your planned spending in retirement. Often, pinning down future spending is even harder than estimating income, partly because many people don’t have a firm handle on their current spending.
“I ask couples how much they’re spending now, and the husband and wife look at each other and choose a number. Then we start adding up all of their particular expenses, and it’s always more than they thought,” says Mary Ann Sisco, senior vice president in Northern Trust’s Wealth Strategies Group.
When it comes to spending in retirement, Sisco presses for more specifics. For instance, if a couple announces plans to travel in retirement, she asks how frequently and how far. Often, the answers diverge widely between husband and wife. The goal of the exercise is to reach a reasonable working spending number to compare to the couple’s expected income. The size of the gap between the two figures helps to determine the feasibility of the couple’s overall plan. But before those findings can be translated into a specific retirement plan, there are a few other variables to consider.
Americans may be retired for a long time — in many cases, longer than the period they spent working. During your retirement years, there will be significant changes that affect your lifestyle. These range from aging-related shifts, such as less spending on travel and more on health care, to gradual changes in the economic climate — the cost of health care is projected to rise faster than the inflation rate, which could skew your retirement budgeting. There are also more seismic shifts in the cultural, political and economic landscapes to consider. For example, what if advances in health care cause the average life expectancy to increase and you live to 110? In response to these uncertainties, Northern Trust’s experts advise playing it safe.
“We can’t know what will happen in the next 40 years,” Yaeger says. “Look at all the changes that have happened in the last 40 years that no one could have fully anticipated. We can’t project that with certainty, so you just try to be reasonable. Your retirement plan has to be fluid, and you have to account for change conservatively.”
That conservatism is evident in the amount that Northern Trust recommends its clients draw from their portfolios during retirement. The percentage varies somewhat by circumstance, but Northern Trust’s advisors use 4% annually as a starting point, a number that surprises many clients. On the other hand, in the wake of the recession, they are more receptive to that number than they were in the past.
“People have discovered that they aren’t as risk-tolerant as they thought, and they’ve ratcheted down their risk levels accordingly,” Sisco says. “It comes down to finding your ‘sleep at night’ number — meaning, reaching a balance between risk and return with principal security. Over the past three years, due to declining portfolio values and subdued returns, clients already in retirement are finding they need to spend less than they originally thought. It’s not always an easy message to hear, but people are accepting it as the new reality.”
Your Retirement Plan: Strategy For Success
If your initial meeting with a financial advisor reveals little or no discrepancy between your projected retirement income and your planned expenses, then (A) congratulations are in order, and (B) your retirement planning will primarily involve maneuvering your portfolio into a configuration that protects you and your estate from risk and unneeded expense.
Some strategies may include taking out a life insurance policy to ensure that you have sufficient assets to pass on to your spouse, or, if you’re a business owner, shifting assets outside the company to reduce the concentration of your investment. As a result of the recession, many people have altered their estate plans to make sure there will be enough money for themselves prior to providing for their loved ones. This may have required hedging their commitments to charity, for example, instead of committing a fixed amount.
“I’ve seen a huge pullback in charitable commitments,” says Rhonda Macdonald, an estate planning attorney in Vienna, Va. “Often, people are now expressing those gifts as ‘the lesser of X-dollar amount or X-percent of the estate.’”
Of course, vigorous estate planning is the province of the comfortably retired. As Northern Trust’s Yaeger says, “For folks with a cushion, estate planning is a more robust discussion. If there’s barely enough money for people to take care of themselves in retirement, then that’s their only concern.”
However, if your examination of retirement spending and income turns up a sizable gap, you need to figure out how to bridge it. The two solutions aren’t complicated: either increase your income or cut your spending. The former strategy is attractive but dangerous, because a portfolio configured to yield larger returns probably also bears higher risk. “Risk doesn’t equal return,” Arnold says. “It just means more risk. You can expect more return, but it may not be the case. Increasing income may be dangerous because to yield large returns usually means bearing higher risk.”
Instead, Arnold recommends either cutting spending or adopting another equally unappealing strategy: delaying retirement. “It’s striking how drastic the effect can be if you work three to five more years,” he says, and suggests that clients use that time to transition toward retirement by reducing contributions to their retirement accounts and using that money to take some of the trips they had planned for retirement. It’s a wise plan, but Arnold acknowledges it’s not usually received with much enthusiasm.
If you’re set on retiring when you hoped, then the last variable to adjust is your retirement spending. Yaeger says it’s a common theme among his clients. “People are weighing their priorities. Is another vacation home more important, or would they rather give their favorite charity $20,000 a year? I show them that it’s one or the other, and it makes them think,” he says.
Whether your dream retirement is already within reach or you need to redefine your expectations or change your portfolio, the smart way to approach retirement is with an accurate idea of your financial situation and the amount required to retire in the manner you envision. Regardless of the outcome of your retirement planning meeting, it’s best to hear the news well in advance, so you and your retirement advisor can construct a strategy that will allow you a happy and stress-free retirement.