Retirement Planning is by far one of the most important areas of financial planning and one that we allocate a good portion of our time and resources to address. We break retirement planning up into two distinct phases:
1) Accumulation Phase
2) Distribution Phase
The accumulation phase is simply the phase in which you are still working and gathering assets to fund the distribution phase. Clients in the distribution phase are usually either retired or semi-retired, and are supplementing their pre-retirement income with distributions from their portfolios. This article is Part 1 of a two-part series on retirement planning and will address the Accumulation Phase of retirement planning.
Accumulation Phase
The Accumulation Phase can be outlined with three questions which will help identify your preliminary plan.
How much do I need to save for retirement?
The amount of assets you need to have saved upon retirement depends upon three factors:
- The first factor is the % of your pre-retirement income you anticipate needing in retirement. We typically recommend a plan that assumes a need of between 80-100% of pre-retirement income.
- The second factor is the amount of income that will be provided from sources other than your nest-egg. These sources include social security, defined pensions, fixed annuities and other guaranteed income streams. The amount of annual income your investment portfolio will need to provide is the difference between your annual income needs and the income provided from outside sources.
- The third factor is your expected portfolio rate of return in retirement. If you take the amount of annual income your portfolio needs to generate and divide it by the expected rate of return, you will arrive at your target retirement portfolio value. This is a simplistic calculation that can provide a general target portfolio value. More complex planning tools such as a Monte Carlo analysis can provide a more precise portfolio target that takes into consideration multiple market scenarios. Remember, the sequence of market returns in retirement can significantly impact an investor’s ability to draw a lifetime income. Two investors who retire at the same age and have the same portfolio value can experience substantially different retirement lifestyles depending on how the market performs in the first couple of years in retirement. The investor who experiences negative markets early on will be worse off than the investor who realizes positive market moves.
How should I be saving (taxable accounts vs. tax deferred)?
We typically recommend people maximize their contributions to their work retirement plans (401(k), 403b, etc.). Contributions to retirement plans save taxes today and grow tax-deferred until distribution. Many of our clients are in the 35% or 39.6% federal tax brackets, and can therefore save approximately $6,500 in taxes by contributing the maximum allowable deferral of $18,000. If they are over 50, they can defer an additional $6,000 as part of the IRS catch-up limits. Also, many employer retirement plans offer matching contributions based on the amount the employee contributes to the plan. It makes financial sense to take full advantage of employer matching funds since it is free money, and represents a significant return on investment. If there is additional money that can be saved after maximizing retirement plans, these funds can be saved in taxable (non-retirement) accounts such as individual or joint investment accounts. These accounts don’t impose a penalty to access your funds prior to a certain age. It is important to note that everyone should have an emergency savings fund, and in many cases this fund should be built up prior to saving for retirement. Also, regardless of tax brackets, a Roth IRA can also be used as a valuable savings tool for retirement. With a Roth IRA, contributions are not tax deductible; however earnings can be withdrawn tax free provided the account has met the 5 year rule and you are over 59.5. Contributions can always be withdrawn tax free regardless of your age.
What should my asset allocation be for my retirement nest-egg?
This is easily the most difficult part of formulating a retirement plan and yet is crucial to any plan’s success. We do not buy into the one size fits all allocation models. Rather, we customize all of our clients’ asset allocations to address their specific risk tolerance, time horizon, past experience and expectations. While all of our clients have equities, fixed income, alternative investments and cash in their allocations, the percentage allocated to each class is very different from one client to the next. It is important to educate investors on the relationship between their asset allocation and long term expected portfolio value, while also taking into consideration their tolerance for risk. Even the best laid out financial plan is destined to fail if an investor is not comfortable experiencing the higher volatility that comes with greater equity exposure, even with the expectation of higher returns.
Recent surveys show many Americans today do not feel they are prepared for retirement. Even if retirement is many years away, starting to plan for retirement today should be one of your top priorities in conjunction with the formulation of an overall investment plan. For those who do not have the desire, time or knowledge it may be prudent to engage a financial professional to help get you started.
Robert T. Martin, CFA, CFP®
(This article is for informational and educational purposes only and should not be relied upon as the basis for an investment decision. Consult your financial adviser, as well as your tax and/or legal advisers, regarding your personal circumstances before making investment decisions.)
