After decades of hard work, a question on many people’s mind is “when will I have the financial means to do what I want to do?” For many that means a traditional retirement much like our parents enjoyed. For others it may mean working with charities, living in Florence (Italy, not Kentucky), moving to a farm, or continuing to do the best parts of what they have always done on a more relaxed schedule, leaving additional time for a more diversified lifestyle.
Unfortunately, there is no one-size-fits-all answer to this question, but there are guiding principles that can help lead you to an answer. The first and potentially most difficult part of this process is to decide what you really want out of the next phase of your life. By considering your personal and family goals, current financial position, income needed to achieve those goals, and sources of income to fund those goals during both good and bad markets, you will have a solid foundation to build on.
How Much Income Will You Need in Retirement?
Preparation can take many forms such as replacing your wage income with a pension or Social Security, pulling money from retirement and/or brokerage accounts (as tax circumstances may dictate), increasing or decreasing spending, and properly managing debt going into retirement. Most financial planning textbooks will suggest that you will need about your pre-retirement income to live comfortably in retirement. While this can be a useful place to start, it’s important to remember that the amount of income you will need depends entirely on what you want to do in the next phase of your life.
How you fund the next phase of your life when you are not working full time depends on a variety of factors. When you can access your assets in a tax efficient manner depends on your age and the year you were born. Most retirees will have tax-deferred accounts in 401(k)s and IRAs. As tax-advantaged accounts, they’re useful savings vehicles, but distributions are taxed at your highest marginal tax rates when you take income from these accounts. Also, in most cases, if you take distributions from these accounts before specified ages (usually 55 or 59 ½) you will incur a 10% penalty. Additionally, these accounts have Required Minimum Distributions after age 72, which need to be planned for. Social Security is a function of how many years you worked before retiring, your earnings during those working years, your date of birth, and when you choose to begin taking payments. A beneficiary’s Primary Insurance Amount is a function of up to 35 years of a worker’s indexed earnings which is then increased or decreased by how much earlier or later a worker starts taking benefits after their Full Retirement Age (FRA). Roughly, for every year before your FRA that you draw Social Security, your benefits are reduced by 7%, and for every year you wait after your FRA to claim benefits, your amount is increased by 7%. Also, either for increased financial stability or to pursue an interest or activity, many people are continuing to work either full- or part-time in retirement.
Budgeting for Health Care in Retirement
Health care continues to be one of the biggest expenses for people in retirement. People who want to retire before 65 who have health insurance through their employer need to plan carefully and consider their options before leaving their careers. Common solutions include COBRA, the public marketplace, or a private plan to maintain continuous insurance. Once you are eligible for Medicare, you’ll need to consider your current and projected health needs and compare those to what Medicare will cover and what supplemental insurance (Medicare Advantage, Medigap, etc.) would best suit your needs. Another substantial item to consider is Long-Term Care insurance, which is not covered by Medicare. Premiums on Long-Term Care insurance tend to increase dramatically the longer you wait to obtain insurance, so it can be very useful to lock in a lower rate early and factor that in to your retirement expense budget.
How We Calculate When You Can Retire
Now, you might be wondering: how can we tailor a solution for you specifically? At HCM, we use what’s known as a Monte Carlo analysis. This is a risk analysis that assesses the likelihood of success for your retirement plan. Think of the Monte Carlo analysis as a way to provide the potential retiree a range of possible outcomes and the likelihood they will occur for any choice you make. A more detailed explanation of Monte Carlo analysis can be found at Palisade Monte Carlo Simulation.
An example of this in action may help clarify. With the help of their advisor, John and Jane Smith, each 57 years old, have thoroughly compiled and discussed their finances. Important inputs into the Monte Carlo retirement tool include their expected retirement ages, asset balances and types of accounts those dollars are in, expected growth rates on those accounts, anticipated living expenses both before and after retirement, and life expectancy. Those factors, coupled with their expected Social Security income when they reach full retirement age, go a long way in compiling the success picture for John and Jane.
Once all the information is entered into the software, the end result is the statistical probability their plan will succeed, that they will not run out of money before they die or need to make adjustments along the way. For John and Jane, that number came out to be 94%, a respectable number for a base plan of someone retiring in the next few years. The term ‘base plan’ is important because one of the real benefits of running a Monte Carlo analysis isn’t simply getting a single number, but rather testing scenarios around your plan. For example, what if the Smiths wanted a higher comfort level than 94% and would like to understand how to improve their success rate? In that case, the advisor can run scenarios whereby he or she increases the retirement age, decreases spending, or increases current savings levels, all of which should help their success rate.
Another key aspect of Monte Carlo retirement simulation is the ability for stress testing your plan. Stress testing involves adding scenarios that have an adverse effect on the success rate. Some of these you might be able to control such as increasing your travel spending or buying a nicer home. Others you may have less control over such as increased spending due to health problems or decreased market returns while beginning your retirement (something known as ‘sequence of returns’ risk). It is very important to know how unexpected changes to your plan may affect your overall success and to be able to plan accordingly if you want to protect for that.
Next there are the considerations of what to do after retirement. If you have spent your entire career in a given field, especially one involving frequent personal interaction, retirement can feel like a tectonic shift to your psyche. Many successful retirees we talk with said that in the months leading up to their actual retirement, they began to visualize how they were going to spend all their free time. While it may be easy to say you are looking forward to relaxing, we have found most retirees consider themselves nearly as busy as when they worked, but without the stress and headaches associated with their job. Successful retirees have a sense of purpose and direction going into retirement and while that can be simply spending more time with loved ones or giving attention to the hobby you love; it will always play to your benefit to have a plan before you walk out the door.
As can be seen, there are many considerations to ponder when it comes to retirement. For some, pondering these will lead to a clear-cut answer as to when you can retire, while for others it may lead to more questions or further introspection. As it should, because retirement will likely be one of the, if not the, biggest changes of your adult life and is a decision that should be approached and handled with care. While the focus is often on the income that will be going away from your job, it is also critically important to consider all the other factors that surround such a life changing event.
| Jim Eutsler, CMA, CFP®, ChFC®®
Jim Eutsler has been with HCM Wealth Advisors since 2015. With 15 years’ experience at P&G working primarily in corporate finance and accounting, he enjoys working with P&G alumni, retirees and employees. Outside the office Jim enjoys coaching his kids’ baseball teams, reading classic literature, and spending time with his wife, two children, and puppy.