Retirement Planning

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Common Factors Affecting Retirement Income

When it comes to planning for your retirement income, it's easy to overlook some of the common factors that can affect how much you'll have available to spend. If you don't consider how your retirement income can be impacted by investment risk, inflation risk, catastrophic illness or long-term care, and taxes, you may not be able to enjoy the retirement you envision.

Different types of investments carry with them different risks. Sound retirement income planning involves understanding these risks and how they can influence your available income in retirement.

Investment or market risk is the risk that fluctuations in the securities market may result in the reduction and/or depletion of the value of your retirement savings. If you need to withdraw from your investments to supplement your retirement income, two important factors in determining how long your investments will last are the amount of the withdrawals you take and the growth and/or earnings your investments experience. You might base the anticipated rate of return of your investments on the presumption that market fluctuations will average out over time, and estimate how long your savings will last based on an anticipated, average rate of return.

Unfortunately, the market doesn't always generate positive returns. Sometimes there are periods lasting for a few years or longer when the market provides negative returns. During these periods, constant withdrawals from your savings combined with prolonged negative market returns can result in the depletion of your savings far sooner than planned.

Reinvestment risk is the risk that proceeds available for reinvestment must be reinvested at an interest rate that's lower than the rate of the instrument that generated the proceeds. This could mean that you have to reinvest at a lower rate of return, or take on additional risk to achieve the same level of return. This type of risk is often associated with fixed interest savings instruments such as bonds or bank certificates of deposit. When the instrument matures, comparable instruments may not be paying the same return or a better return as the matured investment.

Interest rate risk occurs when interest rates rise and the prices of some existing investments drop. For example, during periods of rising interest rates, newer bond issues will likely yield higher coupon rates than older bonds issued during periods of lower interest rates, thus decreasing the market value of the older bonds. You also might see the market value of some stocks and mutual funds drop due to interest rate hikes because some investors will shift their money from these stocks and mutual funds to lower-risk fixed investments paying higher interest rates compared to prior years.

Inflation is the risk that the purchasing power of a dollar will decline over time, due to the rising cost of goods and services. If inflation runs at its historical long term average of about 3%, the purchasing power of a given sum of money will be cut in half in 23 years. If it jumps to 4%, the purchasing power is cut in half in 18 years.

A simple example illustrates the impact of inflation on retirement income. Assuming a consistent annual inflation rate of 3%, and excluding taxes and investment returns in general, if $50,000 satisfies your retirement income needs this year, you'll need $51,500 of income next year to meet the same income needs. In 10 years, you'll need about $67,195 to equal the purchasing power of $50,000 this year. Therefore, to outpace inflation, you should try to have some strategy in place that allows your income stream to grow throughout retirement.

(The following hypothetical example is for illustrative purposes only and assumes a 3% annual rate of inflation without considering fees, expenses, and taxes. It does not reflect the performance of any particular investment.)

Long-term care may be needed when physical or mental disabilities impair your capacity to perform everyday basic tasks. As life expectancies increase, so does the potential need for long-term care.

Paying for long-term care can have a significant impact on retirement income and savings, especially for the healthy spouse. While not everyone needs long-term care during their lives, ignoring the possibility of such care and failing to plan for it can leave you or your spouse with little or no income or savings if such care is needed. Even if you decide to buy long-term care insurance, don't forget to factor the premium cost into your retirement income needs.

A complete statement of coverage, including exclusions, exceptions, and limitations, is found only in the long-term care policy. It should be noted that carriers have the discretion to raise their rates and remove their products from the marketplace.

As the number of employers providing retirement health-care benefits dwindles and the cost of medical care continues to spiral upward, planning for catastrophic health-care costs in retirement is becoming more important. If you recently retired from a job that provided health insurance, you may not fully appreciate how much health care really costs.

Despite the availability of Medicare coverage, you'll likely have to pay for additional health-related expenses out-of-pocket. You may have to pay the rising premium costs of Medicare optional Part B coverage (which helps pay for outpatient services) and/or Part D prescription drug coverage. You may also want to buy supplemental Medigap insurance, which is used to pay Medicare deductibles and co-payments and to provide protection against catastrophic expenses that either exceed Medicare benefits or are not covered by Medicare at all. Otherwise, you may need to cover Medicare deductibles, co-payments, and other costs out-of-pocket.

The effect of taxes on your retirement savings and income is an often overlooked but significant aspect of retirement income planning. Taxes can eat into your income, significantly reducing the amount you have available to spend in retirement.

It's important to understand how your investments are taxed. Some income, like interest, is taxed at ordinary income tax rates. Other income, like long-term capital gains and qualifying dividends, currently benefit from special--generally lower--maximum tax rates. Some specific investments, like certain municipal bonds,* generate income that is exempt from federal income tax altogether. You should understand how the income generated by your investments is taxed, so that you can factor the tax into your overall projection.

Taxes can impact your available retirement income, especially if a significant portion of your savings and/or income comes from tax-qualified accounts such as pensions, 401(k)s, and traditional IRAs, since most, if not all, of the income from these accounts is subject to income taxes. Understanding the tax consequences of these investments is important when making retirement income projections.

When planning for your retirement, consider these common factors that can affect your income and savings. While many of these same issues can affect your income during your working years, you may not notice their influence because you're not depending on your savings as a major source of income. However, investment risk, inflation, taxes, and health-related expenses can greatly affect your retirement income.

 

Deciding When to Retire: When Timing Becomes Critical

Deciding when to retire may not be one decision but a series of decisions and calculations. For example, you'll need to estimate not only your anticipated expenses, but also what sources of retirement income you'll have and how long you'll need your retirement savings to last. You'll need to take into account your life expectancy and health as well as when you want to start receiving Social Security or pension benefits, and when you'll start to tap your retirement savings. Each of these factors may affect the others as part of an overall retirement income plan.

Retiring early means fewer earning years and less accumulated savings. Also, the earlier you retire, the more years you'll need your retirement savings to produce income. And your retirement could last quite a while. According to a National Vital Statistics Report, people today can expect to live more than 30 years longer than they did a century ago.

Not only will you need your retirement savings to last longer, but inflation will have more time to eat away at your purchasing power. If inflation is 3% a year--its historical average since 1914--it will cut the purchasing power of a fixed annual income in half in roughly 23 years. Factoring inflation into the retirement equation, you'll probably need your retirement income to increase each year just to cover the same expenses. Be sure to take this into account when considering how long you expect (or can afford) to be in retirement.

  Men Women
At birth 76.4 81.2
At age 65 82.9 85.5

Source: NCHS Data Brief, Number 168, October 2014

There are other considerations as well. For example, if you expect to receive pension payments, early retirement may adversely affect them. Why? Because the greatest accrual of benefits generally occurs during your final years of employment, when your earning power is presumably highest. Early retirement could reduce your monthly benefits. It will affect your Social Security benefits too.

Also, don't forget that if you hope to retire before you turn 59½ and plan to start using your 401(k) or IRA savings right away, you'll generally pay a 10% early withdrawal penalty plus any regular income tax due (with some exceptions, including disability payments and distributions from employer plans such as 401(k)s after you reach age 55 and terminate employment).

Finally, you're not eligible for Medicare until you turn 65. Unless you'll be eligible for retiree health benefits through your employer or take a job that offers health insurance, you'll need to calculate the cost of paying for insurance or health care out-of-pocket, at least until you can receive Medicare coverage.

Postponing retirement lets you continue to add to your retirement savings. That's especially advantageous if you're saving in tax-deferred accounts, and if you're receiving employer contributions. For example, if you retire at age 65 instead of age 55, and manage to save an additional $20,000 per year at an 8% rate of return during that time, you can add an extra $312,909 to your retirement fund. (This is a hypothetical example and is not intended to reflect the actual performance of any specific investment.)

Even if you're no longer adding to your retirement savings, delaying retirement postpones the date that you'll need to start withdrawing from them. That could enhance your nest egg's ability to last throughout your lifetime.

Postponing full retirement also gives you more transition time. If you hope to trade a full-time job for running your own small business or launching a new career after you "retire," you might be able to lay the groundwork for a new life by taking classes at night or trying out your new role part-time. Testing your plans while you're still employed can help you anticipate the challenges of your post-retirement role. Doing a reality check before relying on a new endeavor for retirement income can help you see how much income you can realistically expect from it. Also, you'll learn whether it's something you really want to do before you spend what might be a significant portion of your retirement savings on it.

Some employers have begun to offer phased retirement programs, which allow you to receive all or part of your pension benefit once you've reached retirement age, while you continue to work part-time for the same employer.

Phased retirement programs are getting more attention as the baby boomer generation ages. In the past, pension law for private sector employers encouraged workers to retire early. Traditional pension plans generally weren't allowed to pay benefits until an employee either stopped working completely or reached the plan's normal retirement age (typically age 65). This frequently encouraged employees who wanted a reduced workload but hadn't yet reached normal retirement age to take early retirement and go to work elsewhere (often for a competitor), allowing them to collect both a pension from the prior employer and a salary from the new employer.

However, pension plans now are allowed to pay benefits when an employee reaches age 62, even if the employee is still working and hasn't yet reached the plan's normal retirement age. Phased retirement can benefit both prospective retirees, who can enjoy a more flexible work schedule and a smoother transition into full retirement; and employers, who are able to retain an experienced worker. Employers aren't required to offer a phased retirement program, but if yours does, it's worth at least a review to see how it might affect your plans.

  Age Don't forget ...
Eligible to tap tax-deferred savings without penalty for early withdrawal 59 ½* Federal income taxes will be due on pretax contributions and earnings
Eligible for early Social Security benefits 62 Taking benefits before full retirement age reduces each monthly payment
Eligible for Medicare 65 Contact Medicare 3 months before your 65th birthday
Full retirement age for Social Security 65 to 67, depending on when you were born After full retirement age, earned income no longer affects Social Security benefits

*Age 55 for distributions from employer plans upon termination of employment

The sooner you start to plan the timing of your retirement, the more time you'll have to make adjustments that can help ensure those years are everything you hope for. If you've already made some tentative assumptions or choices, you may need to revisit them, especially if you're considering taking retirement in stages. And as you move into retirement, you'll want to monitor your retirement income plan to ensure that your initial assumptions are still valid, that new laws and regulations haven't affected your situation, and that your savings and investments are performing as you need them to.