The ChoosaBroker Trading Academy
4.4. Retirement Planning
Retirement has radically changed over the past several decades. Years ago, you were expected to work most of your life for a single, big employer, who provided for pension once your work-life was over. Today, the odds are you will be living in retirement on money you yourself had to save. This transformation from institution-funded to self-funded retirement represents a paradigm shift in responsibility. In this lesson, we will learn:
- What is Retirement Planning?
- Necessity to Plan for Retirement
- Stages of Retirement Planning
- Retirement Planning Mistakes to Avoid
What is Retirement Planning?
Retirement planning can be defined as the process of determining your retirement income goals, and then managing your short-term and long-term finances to help achieve those goals. The planning process is highly personalised, and should ideally begin long before you retire. Your “magic number” – the amount of money you will need to retire comfortably, is dependent on numerous factors. But there are a number of rules of thumb that can provide a rough estimate of how much you need to save.
Many financial advisers recommend you allocate at least 10% of your pay check to a retirement corpus. This should work if you are an early starter. More aggressive advisers suggest you follow the 50/30/20 rule – 50% of income to cover for must-haves, 30% for non-essentials, and 20% to save for retirement. By conservative estimates, a well diversified retirement portfolio consisting of stocks, bonds and cash equivalents is likely to double in value once every 10 years. So, if your plan is to accumulate $1 million, you must have savings of $500,000 a decade before your target retirement age; $250,000 about two decades before, and so on.
Importance of Retirement Planning
Before we begin discussing the various stages of retirement planning, it is important that we understand why people need to seriously consider about their post-retirement expenses.
- Longer Life Expectancy – Advancements is medical science has ensured that our generation will live longer. A longer life will incur greater expenses. Pension – Unlike the United States and the United Kingdom where they have state social security benefits, a number of less-developed countries don’t offer such federal retirement schemes. Essentially, you are really on your own.
- Medical Emergencies – As you grow older, health issues are bound to crop up. With medical insurance often falling short, failure to account for such emergency expenses could force you to liquidate your assets.
- Inflation – Inflation slowly erodes the value of your money. As the years pass by, merely saving for retirement won’t be enough. You will need to invest wisely to beat inflation. Essentially, you are really on your own.
- Fragmentation of Nuclear Families – Today, more and more families, even in the traditional societies, are opting for the nuclear way of living. With no family to provide financial assistance, retirement planning becomes even more critical.
Stages of Retirement Planning
Planning for retirement can be broadly consolidated in to a four stage process, each demanding a different strategy.
Stage #1 – I WANT IT ALL
This phase typically lasts from 10 to 30 years before retirement. It is characterized by multiple priorities – the desire to accelerate career growth and augment income, arrange for children’s education, upgrade lifestyle, and plan for retirement. With diverse targets to achieve, the short and medium-term objectives tend to get precedence, pushing goals like retirement planning to the background. Prioritisation is key; so is the need to recognize trade-offs. Drawing specific investment blueprints so that each goal is met is the prudent strategy during this stage.
Stage #2 – CLOCK IS TICKING
This phase usually sets in 3 to 10 years before retirement. It is characterized by the feeling that there are many things to accomplish, but time is running out fast. Saving for retirement takes on increased importance. As retirement nears, it becomes necessary that you start moving a portion of the retirement portfolio in to defensive assets like bonds and money market funds. However, a segment of your investments still needs to be kept in growth-oriented assets like equities and commodities to ensure inflation-beating returns post-retirement. Another key task during this phase is to eliminate all outstanding debt.
Stage #3 – WHAT TO DO WITH MY TIME?
This phase generally lasts for the first 5 years after retirement. Since it follows a period where you were short on time, you tend to make the most by visiting new places, dining out more often and developing new hobbies. All this comes at a steep cost, necessitating that you manage your expenses accordingly. In this stage, it is important that you accept your cash flows will be a combination of fixed sources (like interest, annuities) and variable sources (like dividends, rental income, capital gains). Therefore, cash flows will inevitably fluctuate, unlike the salary you drew earlier, which tended to be largely fixed.
Stage #4 – TIME TO GIVE BACK
Once you have settled in to a retired life, you are likely to become more reflective. With advancing age, the willingness to be active drastically reduces. In this stage, it is important that you prepare for the loss of a lifelong partner, and face a reduction in assets due to health-linked draw downs. Consolidating your assets is vital so that managing them becomes simpler. Update your Will and succession plan. You may also need to determine which of your assets you want to pass on while you are alive, and which later.
Five Big Retirement Planning Mistakes to Avoid
Outlining retirement goals can be an overwhelming experience. What if I run out of money? What if health costs spiral more than anticipated? What if I have to go back to work? These fears are common, yet easily overcome with some careful planning that avoids the following five mistakes.
Retirement Planning Mistake #1: NOT STARTING EARLY
The golden rule of retirement planning is to start early and stay invested. The sooner you start, the more time you give compound interest to work its magic in your favour. Here’s how the math works: Assuming a conservative 8% rate of return, a 25-year-old will need to save $345 a month for 20 years to have $1 million at age 65. In contrast, a 45-year-old will need to save $1,698 a month for the next 20 years to reach the same milestone.
Retirement Planning Mistake #2: NOT SAVING ENOUGH
Another golden rule is “Earnings – Savings = Expenses”. Making savings a priority is critical; more so if you have just started out in your career. The liabilities are that much lesser, enabling you to save more at regular intervals. Saving for retirement is about making the right choices. Do you take that five-star vacation now, or instead buy extra luxuries in retirement? A few trivial inconveniences today can compound to a secure retirement tomorrow.
Retirement Planning Mistake #3: MAKING BAD ASSUMPTIONS
An integral part of retirement planning is creating cash-flow forecasts to determine the probability of meeting your future financial goals. These forecasts are based on certain assumptions that can decidedly impact the outcome. Unrealistic expectations, most notably about post-retirement expenses, can skew the result. If the assumptions are too low, which is typically the case; the retiree runs the risk of either exhausting the nest egg, or having to make do with drastic, unwanted changes.
Retirement Planning Mistake #4: DISREGARDING HIGHER MEDICAL COSTS
One of the most neglected aspects of retirement planning is estimating what health care costs would be post-retirement. More and more employers are eliminating retiree health care benefits, while medical insurance firms are increasingly demanding co-payments, and refusing to cover certain medical costs. Smart retirement planning dictates setting aside additional health care funds. You can no longer assume it will automatically be covered by either your employer or the government.
Retirement Planning Mistake #5: NOT UPDATING THE PLAN
Income and expense levels rise and fall, making it imperative that a retirement plan be revisited once every couple of years to account for the changes. If your last retirement plan was done five years ago, prior to your spouse’s promotions, and before your second child was born, chances are your retirement plan is based on a lifestyle that has ceased to be relevant.
Final Few Thoughts
Retirement planning is one of the most important financial tasks you will undertake. Considering the stakes, it becomes essential that the process be not left for the later stages of life. The key to a successful retirement plan is to assess your retirement needs, chart out a financial roadmap, start early, and stick to the plan. Do it right and your sunset years will be filled with freedom and peace of mind.
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