In our planning with clients, we like to employ a “pay yourself first” approach, especially as it relates to retirement planning. A frequent problem we often encounter is that by the time all other expenses such as the mortgage, rent, groceries, utilities, and entertainment are paid, there is not enough left over for savings — at least not until our next paycheck, we tell ourselves. This cycle can repeat itself over multiple years, resulting in minimal or no retirement savings.
You may have been contemplating starting contributions to a retirement plan, or you may have been contributing small amounts and are worried that you are behind in the game. Our topic today will cover aspects to consider when crafting your retirement plan and what to do to catch up if you are behind in saving for retirement.
Planning for retirement is a multi-step process with continuous updates and monitoring. The average age a person starts planning for retirement is age 31, according to the Motley Fool. A study from Morning Consult found that 40% of people started saving in their 20s, 25% started in their 30s and the remainder were more than 40 years of age.
A major key is to take advantage of the art of compounding and to start saving for retirement as early in your career as possible. Achieving gains upon gains can act as a strong catalyst in building your retirement nest egg.
In our experience, we have heard people say they procrastinated in saving for retirement due to their belief it required a large amount upfront to have an impact. Another common misconception is that people believe they must select the investments that generate the highest returns to build retirement funds.
While returns are important to overall growth, having the discipline to contribute on a regular basis over many years along with a well-diversified portfolio plays a more critical role in achieving a positive result.
If someone asked you if you would rather have a million dollars upfront or have a penny doubled every day for 30 days, most people would choose a million dollars upfront. However, a penny doubled every day for 30 days would grow to $5,368,709.
The same philosophy applies to investing in your retirement account as early as possible. The longer you wait to invest in a retirement account, the more money you need to contribute per month when you are in your 40s and 50s. The impact of increasing your contributions to catch up will result in a drastic reduction in your monthly cash flows in your 40s and 50s as you attempt to achieve a successful retirement. In addition, between the ages of 45 and 55, most people’s children will be nearing or in college, which can be a very costly time — and tuition costs are likely to continue to increase.
Let’s look at how this might play out assuming a 7% annual return rate, and your goal is $700,000 in your retirement account at age 65. If you start saving at age 31, you need to save $450 a month; starting at age 40, this jumps to $925 per month. If you wait until age 50, you will need to save $2,300 per month! This would be a difficult task for most people.
This illustrates the importance of starting to save for retirement early, even if in small amounts, as we turn our focus to crafting a retirement plan.
Let’s start by going back and looking at how our “pay yourself first” approach can reap big benefits. Pay yourself first is simply the process of making savings automatic, whether it is contributing to a 401(k) or another retirement plan, building an emergency fund or saving for our child’s education. While most people review cash flows at the end of the month and what money may be available for savings, the key is to flip the script and set up automatic deposits into your 401(k) and other accounts. Since you don’t see these amounts hitting your checking account and available to spend, the likelihood increases that you will not touch the designated account and it will grow for its intended purpose.
Understanding Your Time Horizon
What is your retirement age goal? Is it 55, 60, 65 or later? Depending on your personal risk tolerance level and the time until retirement, the more risk your allocation should include. As a rule, a person starting retirement planning at age 30 should be invested in more stocks, as they have historically generated better returns than bonds over an extended period of time.
Inflation is a major factor to consider in retirement planning. A million dollars thirty years from now will have a much lower purchasing power due to inflation than a million dollars today. In the beginning of your retirement planning, it is a good idea to hold more assets with the potential of generating excess returns to compensate for inflation, rather than holding lower-risk assets.
A small inflation rate of 3% will eliminate your purchasing power by 50% over 24 years. As you move closer to your retirement date and assume you are on track to reach your financial goals, you may look at shifting your asset allocation to less risky assets like bonds, which also provide income streams and help preserve capital.
Fortune Financial employs diverse types of private (alternative) investments that generate solid income streams for our clients while also helping to lower the overall volatility of portfolios.
Determining Retirement Spending Needs
It is essential to estimate how much money you plan on spending once you retire so you can determine how much wealth you will need to build for retirement. There is a common belief that people will spend less in retirement years than before retirement. However, this thought can be unrealistic if you are still paying on a mortgage, or if any unexpected medical expenses arise. Often, retirees will spend more money in the first few years on traveling and other leisure activities before they begin scaling back on these activities.
In our retirement planning with clients, we utilize existing cash flows in current dollars to extrapolate projected monthly and annual amounts during their retirement years and incorporate annual inflation in our calculations. Each year we update these projections based on current information such as changes in income, assets, inflation, etc.
As time progresses, the annual cost of living tends to rise from the effects of inflation. When individuals retire and are no longer working full-time, they tend to find activities to fill the time gap. These activities often entail spending money, whereas they previously would not have spent the money while they were still working. Some retirees will want to help fund their grandchildren’s education, which can be very costly as tuition continues to increase.
One major financial factor to consider is that longer lifespans tend to increase medical-related expenses during retirement years. As new medicines and technologies are developed, medical costs tend to outpace the core rate of inflation by several percentage points annually.
At Fortune Financial, we stress the importance of incorporating Health Savings Accounts (HSAs) into our financial planning. HSAs are the only current vehicles that have a triple benefit: 1) contributions reduce current year taxable income; 2) accounts grow tax-deferred; and 3) if funds are used for medical-related expenses, they are tax-free.
Here’s a quick example of why an HSA is more valuable than a pre-tax IRA for medical expenses. Let’s assume you have a $1 million IRA account and need to pull funds for qualifying medical expenses in the amount of $20,000. Assuming a 22% marginal federal tax rate and a 5% state rate, you would need to withdraw $27,397 to net $20,000 after taxes. If you have an HSA, you would need to pull only the $20,000 to cover the medical expenses.
All these factors should be considered when estimating your monthly expenses in retirement and when slightly overstating your projected expenses to provide a cushion for unaccounted expenses.
Calculating After-Tax Rate of Investment Returns
Once the time horizons and spending requirements have been estimated, you will need to determine your after-tax real rate of return to compare against the income-producing part of your portfolio. If you have a lower-risk retirement portfolio, you should not expect annual market returns of 7-10%. It would be more realistic to assume a 5-6% annual return.
If your retirement accounts are comprised of pre-tax assets, most of your distributions from the accounts will be taxed at your marginal tax brackets. This requires you to also determine your tax status once you start withdrawing funds and is an important part of the retirement planning process to accurately gauge cash flows. It is recommended to use a financial professional to help with these steps.
Determine Risk Tolerance vs. Investment Goals
Proper portfolio allocation should align with your risk level and return objectives. Determining how much risk you are comfortable taking to reach certain investment goals can be a challenging task. A high-risk return portfolio can severely be impacted if an economic and market downturn were to happen in the early years of your retirement. This is more common for people playing catch-up who were behind in investing for retirement and need to maintain a higher risk profile.
The unfortunate reality is it will be virtually impossible to overcome a significant reduction in your retirement assets should you experience it early in retirement. This is where professional guidance can make a difference in achieving a successful financial retirement.
Stay on Top of Estate Planning
Planning for how you wish your assets to be distributed upon death is not always an easy topic to address but is important for leaving a legacy. Having a proper estate plan that may include life insurance coverage ensures that your assets are distributed the way you prefer and that your loved ones will not endure financial hardship after your death. Staying on top of estate planning may also help to avoid an expensive and lengthy probate process. Tax strategies for your estate planning process are critical to minimize taxes upon the distribution of your assets. For example, the assets left for family members, or a charity may carry a tax implication. The tax implication of gifting or passing them through the estate process must be compared to all options to determine which one is most beneficial. These items usually require an expert in estate planning services.
What can you do if you are late to retirement investing?
Those who may have started late saving for retirement and are worried about not having enough money still have options to achieve a successful retirement. In 2022, people aged 50 and older who are part of a 401(k) plan can contribute an additional $6,500 in “catch-up” contributions bringing your total contributions to $27,000 for the year. If your organization does not have a retirement plan, you can contribute $6,000 to an IRA in 2022, and an additional $1,000 if you are over the age of 50.
Other items include working longer, eliminating debt, considering downsizing, reducing monthly expenses and creating a strict budget and sticking to it to generate more cash flows to allocate to retirement accounts. If you have concerns you are not financially skilled to analyze various options, it is highly encouraged to work with a qualified professional to guide you through all these steps.
In summary, to fulfill and live your best life, financial wellness is one of the most key factors to address. Within financial wellness, creating, updating, and adhering to your retirement plan is one of the most crucial factors for achieving financial success. The earlier you develop your plan for retirement the more likely you will be able to live your life with the knowledge you will be able to retire comfortably and spend quality time how you’d like, where you’d like, and with whom you’d like.
If ongoing monitoring, including minor adjustments, are made on a regular basis to your plan, you may have surplus assets to leave as a legacy to your kids, loved ones or charitable organizations so they can live their best life and hopefully leave a legacy for future generations that follow. For professional advice or guidance, please contact a Fortune Financial Advisor or scan the QR Code below.