Retirement planning is complex. There are many variables and uncertainties. This makes it hard to get started. One way to get started is to answer these four essential questions.
Question No. 1: How long will you live?
Nobody knows how long they will live. But a retirement plan needs an end point for the calculations to make sense. You need less money if you expect to spend 10 years in retirement than if you live 30.
As a default, simply pick an age. If you want to be conservative, pick a high number, like age 90 or 95. If you think those ages are unreasonable, pick a lower one.
How long you expect to live helps determine the optimal choices for Social Security and other pension-related decisions. Now you can determine how much money will come in. Compare this with the amount of money you need. The difference has to come out of your savings.
Question No. 2: What will you do?
Many people fantasize about their leisure time in retirement. It tends to be something pleasant, done in the moment. The fantasy collides with reality, however, when you have to fill in 30 years. You will need to establish new activities and habits to stay engaged.
Your physical and mental abilities are subject to “use-it-or-lose-it” rules. To maintain a high quality of life through your golden years you need to stay intellectually and physically active.
Social interaction is equally important. Medical studies show that loneliness can be as stressful as high blood pressure or diabetes on your system.
Take time to list the activities, interests and hobbies you would like to pursue. It is important to have a reason to get up each morning.
Question No. 3: How much will it cost?
Start with your current budget. Subtract expenses that you will not have during retirement. Add the cost of the new things. You can set aside a fixed dollar amount for travel or new hobbies and so on. Don’t forget property and income taxes.
Once you figure out how much you need to spend in a year, you can determine whether retirement is sustainable. One rule of thumb is to have at least 25 times your net annual expenses in liquid savings.
Your net annual expense is your annual expense less Social Security and other periodic pension or annuity payments.
For example, if you need $60,000 a year and you get $30,000 a year from Social Security the remaining $30,000 must come from your savings. Twenty-five times that would require at least $750,000 in savings to sustain your lifestyle.
Question No. 4: How to invest?
The best way to invest begins with how much you have saved relative to what you plan to spend. In the above example you would need to earn between 7% and 8% a year. You would withdraw 4%, need 2% for inflation and 1% to 2% to cover fees and real growth.
A low interest rate environment requires taking on investment risk to achieve an 8% return. More risk increases the likelihood of a loss in a given year. Once retired, you will have greater sensitivity to losses as there is no paycheck to ride out the declines.
More savings relative to annual expenses allow you to take less investment risk. For example, if you had $3 million in savings you need a 3% to 4% investment return to cover expenses. This can be achieved with long-term government bonds.
Answers to these questions help you get started with your own retirement planning. They provide a framework to answer the many other questions that arise as you plan out your retirement.
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