Key Factors of Retirement Planning

Key Factors of Retirement Planning
by Alfred Kahl, PhD. — Independent Financial Consultant

The Problem – What Will You Do For the Rest of Your Life?
Americans are living longer. They also want to retire when they reach the normal retirement age. At that time, they can expect to live for another 20 or 30 years. During many of those years they will be in good health and want to do things that they have been putting off. Many worry that they may not have enough money to live on or that they may live longer than their money lasts. During their working life they worked for money, in retirement they need to have their money working for them.

The Solution – A Retirement Plan
For most people, a retirement plan is a necessity. Such a plan will help them accumulate a retirement nest egg during their working lives and select an appropriate withdrawal strategy for their golden years. Life is often divided into three ages: First, there is preparation. Second, from about age 25 to 67, there is work. Third, from age 67 to about 90 or even 100, is enjoyment of retirement.

The Process
First, estimate the value of the assets that will be needed to provide the income desired during the Third Age by deciding your future lifestyle. Do you want to live in the South during the colder months and in the North during the summer? Do you want to take a cruise around the world? Second, once the goal is established, consider the various means to achieve it: Social Security, Pensions, IRAs, Annuities, Mutual Funds, and Insurance. For most people, it will be necessary to save money regularly during many of the working years. It is never to soon to start!

The Means
Social Security: The government requires those who work to pay into Social Security. Employers are also required to pay. Self-employed people make both payments. When the worker retires, he or she is entitled to a monthly pension. In 2000, the average monthly payment to all retired workers is $804; to aged couples it is $1,348. Could you live on that? Not very likely, is it! So, you need more! It will have to come from your savings.

Pensions: Some people belong to pension plans where they work. Pension plans are of two types: Defined Benefit (DB) and Defined Contribution (DC). In DB plans the payments in retirement are determined by a formula, similar to social security. For example, the formula may be 2% times the number of years of work times the average salary during the last five years of work. Thus, if someone worked 35 years and earned an average salary of $50,000, they would qualify for an annual pension of 70% ($50,000) = $35,000. In a DC plan the worker usually contributes a percentage of pay (such as 6%) and the employer matches it. All the money is invested until the worker retires and the pension is based on the value of the portfolio at that time. It cannot be determined in advance. Pensions of this type are often called 401k plans after the law that created them.

Individual Retirement Accounts: IRAs are a type of DC pension plan that can be set up by an individual subject to limitations specified by legislation. There are 2 basic types: traditional IRAs and the newer Roth IRAs. IRA contributions of $2,000 annually may be tax-deductible when made if the person does not participate in a pension plan at work. Contributions to Roth IRAs are not tax-deductible and are not limited.

Annuities: Annuities are contracts that promise to make periodic payments for some period, such as life, or 20 years. Annuities can be deferred or immediate. Deferred annuities start at some date in the future, such as at retirement age, to provide more income. Investors in deferred annuities make periodic investments to build up the large sum, after which the payments begin. Immediate annuities make payments the following month (or other agreed date) and require a large, one-time investment, such as $100,000. Fixed annuities pay the same amount each month, while variable annuities pay an amount that depends on the investment performance of the investments held by the particular annuity. Thus, a fixed annuity is like a DB pension plan while a variable annuity is like a DC pension plan.

Mutual Funds: There are many thousands of mutual funds available to investors who still have some money to invest. Mutual funds are companies that sell their own shares to the public, and then invest the money in stocks and bonds.

Insurance: There is always a possibility of premature death. During the person’s working life there will be a need for insurance to provide money for the surviving children until they reach maturity or for the widow until she reaches retirement age. The traditional way to estimate how much insurance is needed is to estimate how many years of income support the surviving dependents will need. There are various types of insurance to fulfill this requirement. After retirement, insurance needs will likely change.

The Cost – There is no Free Lunch!
Each of the available means has different costs and benefits. The investor has to decide the appropriate combination of means to be employed.

When Should Someone Invest?
The answer, of course, is right now! Since no one can tell when is the best time to invest, it is whenever you have the money! One should first invest in any plans for which tax-deductible contributions can be made, such as an IRA, 401k, or Keogh, because these types of savings reduce current taxes. Then, any more surplus funds should be invested in a tax- advantaged way, such as in a variable annuity, and especially in equities so as to get the maximum growth of the capital.