We’ve all heard the problems with relying on numbers: garbage in, garbage out; liars figure, and figures lie; 87.2% of statistics are made up; and so forth. Yet some individuals do their retirement income planning by answering some questions in an online calculator, reviewing the results, and checking the box that their retirement planning is complete. They think they’re good because the software says so.
Retirement income planning starts well before crunching the numbers. You may know when you want to retire, how much you want to receive each month, and what you want to do in retirement. But before deciding that you’re good to go, you should address some key variables in your planning: specifically, how you feel about returns, taxes, timing, and risks. In other words, what are you planning to earn on your investments, how much of your income will get taxed, how many years will you need the income, and what might go wrong that would change your retirement income target? Answering these questions not only helps you calculate whether you’ll have enough in retirement but also facilitates the development of strategies that will make your plans more realistic and more secure.
So before crunching the retirement income numbers, first consider tackling the assumptions you’re using, and how you feel about them.
Returns
Once you’ve started to decumulate your investment portfolio during retirement, you’re using a new set of assumptions. Sure, you still want to maximize your yield while minimizing your risk. But your yield isn’t what shows up on your brokerage statement – it’s how much you pay yourself each month. And the risk is that you run out of money before you run out of oxygen. Further, because you’re decumulating your portfolio in order to support a standard of living in retirement, return on the assets in your portfolio should really be thought of in terms of spread – what’s the spread between what you earn on your assets versus the cost of living? Since you can’t invest your way out of an income deficit in retirement, it makes sense to target an overall return on assets that’s a few percentage points above the increase in inflation. Tactically that leads to two approaches. If you’re risk averse, lock in income sources you can’t outlive – for example, by purchasing annuities. If you’re risk tolerant, invest to yield a positive spread generated by a diversified portfolio of fixed and equity assets. Whichever route you go, have a backup plan in case inflation or bad markets unexpectedly chew up your wealth.
Taxes
Retirement income is an after-tax proposition. Retirees need to know how much they’ll have, in hand, to spend each month. The challenge is that taxes in retirement are insidious. Pre-retirees assume their earned income will go away once they leave work, and with that, most of their taxes. The problem is that there are retirement-centric taxes lurking in the background, such as the Social Security tax torpedo and Medicare’s Income-Related Monthly Adjustment amount (IRMAA). And for more affluent retirees, there’s the net investment income tax and the federal estate and gift tax. While this represents a maze of complications, there are four guiding principles that can help you determine how you feel and deal with tax planning:
– While taxes are inevitable, the amount of tax a retiree pays is highly subject to planning. With ongoing tax management, you can legally reduce your taxes in retirement, often by a considerable amount.
– Your taxes will not be the same each year in retirement. There are age-based taxes such as required minimum distributions (RMDs), IRMAA, and taxation of Social Security provisional income. Tax planning is not a “one and done” strategy.
– Asset location – in other words where, not how, your money is invested – has a dramatic effect on the amount and timing of your taxes. In general, retirement assets are located in taxable accounts (your after-tax investments), tax deferred accounts (your IRAs and 401(k)), and/or tax-free accounts (primarily your Roth IRAs). Your net, after-tax retirement income each month will be highly dependent on which account you draw from.
– Finally, the higher your net worth and income, the higher the proportion you’ll likely pay in taxes. This is not just a function of the higher marginal tax rates associated with increases in income. It also relates to taxes and surcharges targeted at affluent individuals. This includes so-called “cliff” taxes – such as the IRMAA or gift tax – where an additional dollar results in a tax spike in the range of 40%.
Timing
How long will you live in retirement? Web calculators often assume you will retire at 65 and die at 90. Is this realistic in your case? First, define “retire.” There is a trend toward phased retirement where the worker cuts back, continuing employment for several years for reduced earnings. This added wrinkle affects Social Security filing, tax strategies, and health insurance decisions. Second, for married couples, the retirement income calculus changes considerably. Not only are you dealing with two life expectancies, but additionally, there are quirky tax and benefit rules dealing with the death of the first spouse.
In the current environment where employers primarily offer defined contribution plans such as 401(k)s, a key timing challenge is that your retirement income payments may not match up with your life expectancy – your income may stop before you do. Americans have far fewer guaranteed lifetime income sources than in the past. They have Social Security and, if they’re lucky, a defined benefit pension plan. Otherwise, most retirees are looking to their 401(k)s and investments for systematic withdrawals of income. This means the individual, not the employer, bears both the risk of investing the 401(k) proceeds and matching up their withdrawals with life expectancy.
For many retirees, important income sources will be periodic. Examples include installment payments from the sale of a business, withdrawals from life insurance cash values, reverse mortgage tenure payments, deferred compensation arrangements, and other income streams that are finite. You should be prepared for a time in which some of your income sources stop but you’re still alive.
Risks
How much risk?
When you retire, risk remains. But like a snowflake, no one retiree has the same risk profile. That’s why a standardized retirement income calculator can only take you so far. Before you lock into your plan, ask yourself what risks you’ll face in retirement, and which ones are particularly relevant to you. It may help to divide the common retirement risks into groupings:
– Outliving your resources is obvious, but it’s causes are not. Beyond living longer than you expect, other culprits can be inflation and spending more than what is sustainable.
– Risks associated with aging can be deceptive. Increased health care costs are clearly a monetary risk, but there are also expenses associated with frailty and long-term care. It’s sometimes the little things that can break a budget – meal preparation, help with finances, making your home wheelchair accessible. It all adds up. And with aging also comes the particularly scary proposition of elder abuse.
– Investment risks are always a concern, but peculiar to retirement planning is the sequence of returns risk. The issue here is when you retire. The risk is that your portfolio will experience lower returns at the same time you retire and begin drawing down assets. Say you retired a year ago. You may have withdrawn 4% from your 401(k) for retirement income, but your underlying assets may have declined 20% because of the current bad stock market. When this happens early in retirement, there is little opportunity to recover these losses; remember, your portfolio is intentionally being decumulated to pay for your retirement income needs.
– Work and family risks are unique to the individual retiree. With work, the issues may include forced early retirement, loss of employability during phased retirement, or the insolvency of the employer. With family, the big issue is often the loss of a spouse, but there is also the risk of unexpected family responsibilities such as raising a grandchild. These family risks are not only challenging emotionally, but also financially.
Retirement risks don’t lend themselves to easy analysis. For example, who can plan for such variables as the Social Security system running out of money or Medicare premiums going up? While retirement planning software can do amazing things with calculating income, and creating investment and tax strategies, there is no algorithm that can precisely quantify your retirement risks and predict how you feel about them.
Before you do the numbers
Retirement income planning should be put in context. You are fortunate enough to have choices in how you approach creating your standard of living during your golden years. You have a say in investing, tax planning and managing risk. You get to look into the future and assess your outlook, prospects, and opportunities. The challenge, though, is that much of this must be addressed before you can crunch the numbers. Ask yourself the tough questions, make your best guess at assumptions to use, and then work your magic with retirement income software.