Bay Area Planners 19925 Stevens Creek Boulevard Cupertino, CA 95118-2358 Tel: (408) 725-7135 www.retirementplannersonline.com
Your Retirement Plan: Fact or Fiction What you should know about how f inancial advisors plan your retirement
We all need help with f inancial planning… but will the plan be fact or f iction? Introducing a new way of planning and optimizing your results
We all need help with financial planning Your retirement savings will have to last you the rest of your life. Retirement planning is a complex mathematical problem, so unless you have a Phd in Economics, you probably need help figuring this out. However, there is an overwhelming choice of financial advisors and advice available to you – financial planners, big investment company reps, internet calculators, even your brother-in-law. How do you sort them all out and differentiate between fact and fiction?
Why should I pay for advice I can get for free? Because BAD advice is the most expensive of all. The TIAA-Creff website calculator determines how much life insurance you need based on only three questions; Fidelity’s myPlan website calculator determines your retirement saving needs after only five questions. Boston University economist Lawrence Kotlikoff says, “The Financial Industry is making incredibly crude and dangerous saving and insurance recommendations. Investment and insurance companies are recommending four to five times too much saving and insurance for many, if not most middle class households. To “help” workers meet astronomical retirement spending goals, investment companies recommend high yield, but also high risk (and high fee) investments.” You are going to pay one way or the other, so let’s take a serious look at what you get for your money.
The KEY QUESTION: How much should you be saving? Prior to retirement, you are accumulating the financial resources that you will tap once you retire. During this phase, you want to maximize the money that will be available to you in retirement and doing this means saving and investing. The key question is How much should you be saving? After all, if you get this wrong and save too little, it will cause you a problem later in life. Traditional financial planning is based on the assumption that you will need a certain percentage of your pre-retirement income. Most financial planners and wealth managers use a target of 75-85 percent of your pre-retirement income. Other planners suggest you set the target at 100 percent, and one recent report even calculated that you will need 126% of your pre-retirement income due to increasing health costs.
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The reason this is important is that satisfying your retirement spending needs comes at a price - namely not satisfying your pre-retirement spending needs. By using an arbitrary replacement rate to set your post-retirement spending, traditional planning seems not to care about the impact of that target on your pre-retirement spending.
Let’s look at an example Consider a recent article posted at CBSMarketwatch.com. The article describes a 45 year old single man, call him Dave, with a $250K mortgage who earns $50k per year. He saves $5K each year in his 401(k), invested at 6% and experiences 3% annual inflation. Dave is sitting on $100K in assets-$90K in his retirement account and $10K in his money market fund. Dave’s projected Social Security benefit is $1,408 in today’s dollars, based on his current earnings and expected retirement date. As indicated in the article, AARP’s on-line calculator tells Dave to save $20,124 to hit “his” spending target. Given his FICA, federal and state income taxes, mortgage payments, other housing expenses, and other bills, saving $20,124 instead of $5,000 would entail a dramatic reduction in Dave’s living standard - he’d starve if he were to follow AARP’s ‘advice.’ The problem with setting a target for saving like this is that if the target is wrong by only as much as 10%, you will receive bad advice for how much to save, how to invest the savings, and how much life insurance is needed. And when you think about it, why are they asking you to set the target anyway? Isn't this what you pay the advisor for? Or if all they are going to do is assume a one-size-fits-all number like 75% or 80%, does this really inspire confidence that they have your unique interest front and center?
How it should be done If you think about it, it’s clear that the real need is to have a smooth living standard per family member through time. You don’t want to starve now to splurge tomorrow or splurge now to starve tomorrow. You want a smooth transition between working and retirement; one that doesn’t involve a big reduction in living standard or a risk you will outlive your savings. At Bay Area Planners, we use planning software to find a living standard that can be maintained both before and after your retirement. The method used is called 'consumption smoothing'. Here’s how it works: based on your particular financial situation, the program calculates your ‘living standard’ number. This number is how much you can spend each year while maintaining a consistent living standard. It is mathematically derived from your current resources and your projected spending and savings plans. We all have our own number; most of us just don’t know what it is. Once you know your living standard number, you know how much to save. When your income is higher than your living standard number, you save the excess. When your income is lower than your living standard number, you spend your savings to maintain a constant living standard, and you do this over your whole projected lifespan.
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To see the difference between traditional planning and consumption smoothing, in our example case, we would have told Dave that his $5K in current saving is just about the right level needed to have a smooth living standard over time. In Dave’s case a 75%, let alone a 100% replacement rate target, is miles too high. For other households, replacement rate 'Rules of Thumb' might lead to targets that are too low. One size definitely doesn’t fit all.
What if I don’t like my living standard number? The living standard number acts as a yardstick to evaluate different options, different financial strategies. You can quickly see how different decisions affect your living standard, either increasing or decreasing your living standard number. Making the right financial moves - moves that mean more spending power - can often be worth a year or two of earnings. We will use the software in ‘What If’ mode to optimize your living standard number and your income in retirement. Evaluating options such as deciding how much to contribute to a 401(k), when to retire, when to start taking your Social Security benefits, etc. is impossible without the aid of sophisticated software. For example, should you take Social Security at 62 or wait to 66 or even 70? Together, we will run the options and in seconds you will be comparing the results. Suppose you don’t trust the politicians and expect a 25% reduction in Social Security benefits in 2019? We will change the assumptions and run these options again to see if your best choice is the same. We provide you with the opportunity to evaluate your life decisions and optimize your plan.
Summary Knowing your living standard number is the key to the whole process, since asking you to set the spending target is dangerous because even small targeting mistakes lead to: • Bad Savings Advice • Bad Investment Advice • Bad Insurance Advice And these all lead to - Major Consumption Disruption! Instead, at Bay Area Planners, we let the facts tell us how much you can spend for a consistent living standard, and then suggest ways to increase that number. We believe that is how retirement planning should be. If you are interested in learning more, we offer a complimentary consultation in which we can get to know each other and see if the chemistry is right. Call (408) 725-7135 or go to www.retirementplannersonline.com
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