Adjust Your Retirement Savings Goal For Risks
September 18, 2008 – 5:58 amI’ve written quite a bit on how to estimate your retirement savings goals. In addition to figuring out your estimated “number”, it’s also valuable to run a few other scenario in order to gauge the likelihood of reaching your goal. There are numerous risks that could throw your plans off course. In the corporate world we call this type of review a “sensitivity analysis”. All this means is that we’re going to change a few of our input assumptions and then see how the answer changes.
Adjust How Much You Expect To Spend In Retirement
Part of figuring out your retirement savings goal is to determine what you expect to spend in retirement. Start by evaluating whether your spending assumptions in retirement are reasonable. Do they represent what you are spending now? Did you adjust your spending needs based on your new hobbies, travel, and new expenses like covering your own medical expenses? To create a best and worst-case scenario, I would recommend adjusting your estimate by plus or minus 20%.
Adjust Your Time Frames, and Don’t Forget About Your Spouse
What age do you plan to retire? 67? 45? Regardless of your answer, you should adjust this assumption up and down. If you plan to work until 67 you might think this assumption is conservative. But what happens if you get laid off at 55? How confident are you that you can find employment quickly with the same compensation? What if your health deteriorates and you can no longer work full-time? Hopefully none of these things will occur, but it would be nice to know the impact on your retirement plan if they do. I recommend adjusting your retirement age by plus and minus five or ten years.
Please don’t forget your spouse either! If they are significantly younger or older than you (2-3 years in my opinion), you need to make sure your assets last through THEIR lifetime as well as yours.
Adjust Your Assumed Rates of Return
How did you determine your assumed rate of return? Did you just pick 10% because that’s what most financial calculators put in initially? Do you know what YOU actually earned on your investments over the past five years? It’s quite likely that you’re not doing as well as you think, especially if you have:
- Actively-managed mutual funds, which usually have high expense ratios
- Investments in taxable accounts, which will have some tax impact dragging down your after-tax returns
- An inefficient asset allocation. Several studies have shown that a large number of employees that participate in a 401k or 403b at work are either too conservative or too aggressive (i.e. 100% company stock) with their investments.
The choice is up to you on expected investment returns, but please base your assumptions on some “facts”. The U.S. Stock Market averaged approximately 11% from 1926 to 1999, and this average was probably brought up a little bit by the bull market of the 90’s. In my own planning I use best/base/worst case returns of 11% / 8% / 6% (all before inflation), but you can do what you feel is best.
Adjust Inflation (up!)
What inflation adjustment did you use? 3%? It’s a nice round number, but inflation at times has been much higher. It even topped 7% on average for an entire decade (1970-1979)! According to InflationData.com, average inflation from 1913-2007 was 3.42% (and the extra 0.42% will probably have a big impact on your calculations). Using an average here is fine, since that’s what most calculators use as an input. You might want to adjust it up and down by 1-2% though just to see how that affects your real portfolio returns.
Note that adjusting the inflation rate up a percent or two is the same at adjusting your investment returns down a percent or two. Therefore this is going to have a BIG impact on your retirement plan, just like reducing your investment returns will.
Input Some Large, One-Time Costs During Retirement
I wish you all the best, but at some point you may get sick. You may need to stay in a nursing home for a year or two, or you may need to take time off work to help a loved-one. I would recommend adding one or two emergencies into your plan and see how it holds up. For a 30-something like me it could be 1-year loss in salary at 43 and again at 56. For you it could be a $50,000 expense for two years in a row around age 65 for in-home nursing care.
Here’s one quick example that used MSN’s calculator
This calculator doesn’t have the advanced inputs of a FIRECalc or similar calculator, so I wasn’t able to adjust inflation or put in some large one-time expenses during retirement. The results show what we would expect, namely that your investment returns and time frames are the key drivers to reaching your goals!
|
Inputs |
Conservative |
Base Case |
Aggressive |
|
Current Age |
35 |
35 |
35 |
|
Retirement Age |
60 |
67 |
67 |
|
Life Expectancy |
97 |
87 |
80 |
|
Current Portfolio Value |
10,000 |
10,000 |
10,000 |
|
Salary |
50,000 |
50,000 |
50,000 |
|
Savings % |
8% |
10% |
12% |
|
Retirement Income Needed (salary minus savings) |
46,000 |
45,000 |
44,000 |
|
Pre-Retirement Return |
6% |
8% |
11% |
|
Post-Retirement Return |
5% |
7% |
10% |
|
|
|
|
|
|
Results (including Social Security) |
|
|
|
|
Savings @ Retirement |
169,819 |
443,025 |
1,015,243 |
|
Age When Savings Run Out |
65 |
93 |
Never |
|
What’s Left to Heirs |
-1,450,671 |
159,784 |
1,966,901 |
|
|
|
|
|
|
Results (without Social Security) |
|
|
|
|
Savings @ Retirement |
275,727 |
443,025 |
1,015,243 |
|
Age When Savings Run Out |
63 |
79 |
Never |
|
What’s Left to Heirs |
-2,161,972 |
-390,744 |
1,586,651 |
There are no sure-things in life. You can’t insure, save, invest, or spend your way out of all trial and tribulations. You can plan and prepare, however, and reviewing the risks to your retirement plan will allow you to make better decisions at a time in your life where you can affect the outcome in a major way!
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5 Responses to “Adjust Your Retirement Savings Goal For Risks”
Great post! Its amazing how much info you have you packed in this post. I need to pound out these numbers ASAP! Thank you!
By Rick Vaughn on Sep 18, 2008
If I might add a little something to your post…
Adjust How Much You Expect To Spend In Retirement
This should be more like: how much of your plan do you intend on withdrawing in retirement. If a person sticks to 4%, many plans will not run out of cash. On the other hand, 4% won’t offer anywhere near what you would like in terms of post-retirement income.
Adjust Your Time Frames, and Don’t Forget About Your Spouse
If after focusing on 4%, you may want to adjust who will work and who won’t. If you are in good health – now the second most important part of any retirement plan, you might want to begin cultivating another career about mid-way through your current one. Working, studies have shown, is actually more healthy than not – provided you do something you like, at an enjoyable pace, and with people who appreciate your contribution.
Adjust Inflation (up!)
What about taxes, the cost of upkeep and insurances (outside of your health insurance). Those everyday expenses that inflict so much pain on our current income take an even larger hit when that income is fixed.
Input Some Large, One-Time Costs During Retirement
If you are looking at long-term care insurance when you are in your fifties, you better have the rest of your plan fully funded. If your kids are worried about their inheritances, let them foot the bill. The biggest one-time fund you need to take with you in retirement is $200,000 for health insurance. Another $100,000 will barely cover the other nagging expenses that you absorb so easily when you are employed. If you can afford your house (hopefully it is paid for) and your debt is well managed, you can probably squeak by with a $400,000 nest egg and out live some of it. Now readjust your savings to the reality.
Hope this helps.
Best
Paul Petillo
Managing Editor/BlueCollarDollar.com
http://bluecollardollar.com
By BlueCollarDollar.com on Sep 19, 2008