At Cap Credit ™, we want to do more than help you secure a loan; we want to teach you how to create long term financial stability. This article is long and may even be boring at some points, but please take the time to read it and start planning to secure your financial future today. Once you finish this article, check out our 401(k) and IRA article in which we expand on this topic.
– How to Invest With Mutual Funds
Importance of Retirement Planning
If there is one thing that employed people fear more than working 7 days a week, it is their retirement . . . the idea that one day, you will cease to be employed and will no longer have the luxury of a dependable, regular pay check. Those who have made no plans for their financial security during retirement often avoid all discussion on the topic. However, retirement is a fact of life and sweeping the fact beneath the carpet is one sure way to attract financial troubles.
The right kind of planning at the right stage in life will make your retirement truly a time for relaxation and rest. These become your ‘golden years,’ the period when you get the opportunity to indulge in all the interests and hobbies you had to set aside for your career, a time for putting all your hard-earned money to work for your comfort.
Whether you have a happy retirement or one fraught with financial worries, the choice lies in your hands. Planning for your retirement lets you look forward to the years when you have no obligations to an employer and when your time is entirely your own. Postponing the inevitable by failing to plan for retirement in time will only leave you ill-prepared to face those years.
Why Planning is Important
It is in the hands of each and every person to ensure that they are financially secure post retirement. In fact, it is your responsibility to do so. With so many different professions and myriad opportunities and means available through which to earn, it is unreasonable to depend solely on Uncle Sam to provide for your retired life. In fact, in view of the growing concerns regarding the sustainability of the Social Security system, it is high time Americans took their retirement planning into their own hands.
Three Aspects of Retirement Planning
Retirement planning needs to have three important characteristics to make it effective: planning, perseverance and commitment. Planning for your retired life should be done at the right time of your life, preferably as early in your career as possible. Next, you need to ensure that you stick to your plan with perseverance, no matter how tempting it is to simply postpone retirement saving until later. Commitment to your plan will ensure success in creating the right kind of financial cushion to ease retired life. Responsible use of those hard-earned and painstakingly saved funds during retirement years will ensure that each and every dollar you have earned works to give you a comfortable life.
When your savings strategy has all these characteristics, you gain the best benefits of retirement planning. Even though in retirement, there is no longer any steady, regular income, you have the financial security that helps you accept the inevitable fact of retirement with grace rather than dread. With planning, your retirement becomes a time for enjoying the fruits of the hard work you have put in all your life.
Remember that average life expectancy has risen dramatically over the years so that today, you can expect to live for many more years more than your grandparents or even your parents. This means that any notions they might have had about what was adequate for their retired years will not work for you. The earlier you start planning and saving, the better your chances are of creating a reasonable fund to live out your retirement in peace and comfort.
Understanding Your Financial Situation
When it comes to planning, there are two specific areas that you need to focus on – how much you will need in your retirement fund and how to go about building the fund.
How Much Do You Need?
Experts say that, for a comfortable retired life, you will need up to 70% of the monthly income that you were earning before you retired. This will help you maintain a standard of living and quality of life in your retirement years that is comparable to your pre-retirement life.
Planning for at least 20 years of retired life is a sound idea. The fact is that life expectancy are rising steadily as a consequence of advancements in medical sciences. This means that you have a reasonable retirement period to plan for. Up to 40% of the total income or finances that are used during these 20 years come from your own personal planning for retirement. It is evident that, unless you take some effective steps, you could be forcing yourself into a retirement life that will have to be financed without this substantial portion of funds.
The following factors are very important when you are determining the size of your retirement nest egg:
- At what age do you plan to retire? This determines your total earnings over your lifetime as well the number of years of retirement.
- How long is your retired life likely to be? The duration of your retirement determines the amount that you’ll need to support it.
- What standard of living do you want to maintain post-retirement? This determines the living expenses you will need to provide for. If you have any plans for your retirement years such as making a world tour, studying or taking up a new hobby, these expenses will need to be factored in.
- What is the state of your health; do you have any chronic medical conditions that will require treatment? Any history of hereditary medical ailments that require expensive and prolonged medical care will also need to be taken into account.
Assessing What You Have at Present
Once you have a fair idea of what you need to plan for, it is time to see where this money will come from. There are various sources from which you can add to your nest egg. Here are some of them:
1. Social Security
Many Americans make the mistake of depending on Social Security payments to fulfill all their needs during retirement. It is difficult to say what the future will bring as far as Social Security is concerned. It is prudent to avoid banking on these payments to fund your post-retirement living expenses.
However, you should factor in these payments just to gain an idea of possible future income. If you do not have a recent statement from the SSA detailing your eligible Social Security payout, use the calculator on their website to know how much you can claim. Factor in about half of your eligible Social Security to have a conservative idea about what you will stand to get from this source.
2. Pension from Employer
Company pension plans are yet another source of income during retired life. Your current and/or previous employer will have a record of the pension you will get post-retirement. Ask the company’s Human Resources department for an estimate of how much you can expect.
3. Investments & Savings
Any savings that you have accumulated so far will also need to be factored in when you calculate how far you have to go to save enough for retirement. Do not add college funds for your child or medical treatment funds that you have set up, as these funds are already earmarked for other expenses. These funds may even be exhausted by the time you reach retirement age. They will not be available for meeting post-retirement day-to-day expenses.
When evaluating your investments, gauging their value is a tricky job. You can take their market price as an accurate measure of their current value. But remember that at the time of your retirement, if the economy is recessive, your investments may not be worth as much as their current value.
A good way to measure the income from these investments is to use a reasonable returns expectation, based on average returns generated over the past 10-year period. Although there is no way to guarantee that this estimation will be accurate, this is more likely to match actual future returns than if you consider present day returns.
Your parents may be wealthy and own land and houses in many locations. Some of these assets and funds could be passed on to you in due course. However, this is not guaranteed. Your parents may wish to donate their assets to charity. Medical treatment and other expenses in their old age may also require liquidation of some of these assets. There may be other claimants to the property. Any of these factors can reduce what you hope to get from this kind of inheritance or even eliminate it completely.
5. Home Value or Other Asset Value
Many people buy homes as a part of their investment strategy. Although this is a sound move, home values fluctuate a great deal, which makes it difficult to say exactly what you can gain by selling your home in times of financial need. The same goes for other assets such as jewelry or expensive works of art.
6. Bonuses and Gifts
Bonuses paid by your employer or gifts are unpredictable. You may not get the bonus in a particular year, due to many different reasons such as recession. Although it is reasonable to factor in such funds or assets, there is no guarantee that you will receive them. It is best to consider them as ‘bonuses’ rather than hinging your retired life’s financial security on them. In this way, you avoid adding elements of uncertainty to your critical retirement fund. If these incomes do accrue, then you can simply add them to the retirement fund and consider yourself that much closer to your financial goal.
Effects of Inflation
When you are calculating your total retirement fund size as well as identifying sources of income to create this fund, it is very important to keep the effects of inflation in mind. Inflation skews all financial figures and it simply cannot be predicted with accuracy.
A person who covers all monthly expenses with $1,000 today may find that, owing to inflation, this amount is not enough to buy even half of the same items 10 years from now. This poses a huge problem when you need to determine how much money is needed for you to live a comfortable life in future.
One way to eliminate any rude shocks from inflation in the economy is to use real rates of return to see how much income you can expect from your investments. These rates take inflation into account and give you the returns after being adjusted for inflation. You can also opt for making all calculations as if retiring today, then apply inflation assumption to see what the figures will look like in future.
Creating a Savings Plan
One of the most important steps in planning for your retirement involves drawing up a plan for savings. To do this, you first have to identify the sources from which you can draw these savings. Next, you have to set up attainable goals and formulate a strategy that can be effectively implemented, both before and after retirement.
Step 1: Identifying Sources
There are many sources of income from which you can draw funds to create a retirement savings fund. Identifying these and assessing the amount of funds that can be drawn from each helps in formulating an effective savings strategy. It goes without saying any type of personal loans is not a good source for this purpose.
- The main source of money for your retirement savings is, of course, your salary. This is the single largest source of income for most people and consequently the source of the most savings too. When it comes to salary, there are many ready-made retirement savings options that are available such as IRAs, 401ks, company-sponsored pension plans, etc. These options may come with some special benefits and advantages that cannot be matched by conventional savings avenues like bank accounts, for example. The tax benefits alone make such special retirement planning programs a wonderful opportunity to maximize savings.
- Any investments you have in excess of what you deem necessary for specific expenses can be earmarked for your retirement fund. While setting aside funds for retirement planning, remember that there will be critical expenses throughout your life that have to be met. Buying a home, educating a child, professional training for yourself or your family members, and care of dependents are all examples of such unavoidable expenses. Your current investments will have to meet these expenses too.
Step 2: Formulating Attainable Goals
Once you have a clear picture of your finances and earning capacity, it is time to assess if your retirement savings plan is achievable. It is very important to follow a manageable retirement saving strategy when formulating attainable goals.
- Feasibility of Goals
To see if your goals are feasible, analyze if they can be achieved given the sources you have available for retirement saving. For example, owning a super luxury yacht to go on a world cruise is not an attainable goal for most people, whereas buying adequate medical insurance to cover all possible treatment costs during retirement is quite possible if you plan correctly.
- Practicality in Goal Setting
When you are evaluating the feasibility of your goals, ensure that the practicality of these goals is also considered. Saving money for mountain climbing in the Andes may be an attainable goal, but is it really a practical objective for a retired 65-year old?
- Practicality in Goal Setting
Enhancing Earnings to Increase Potential Savings
Once you have identified practical and attainable goals and matched them to your savings plan, you know exactly where you stand and how far you have to go. If there is a serious shortfall in what you can save and what you actually need, it is time to consider other earning options.
Part-Time Work, Paying Hobbies: You can opt for part-time work in addition to your regular employment so that you have extra income and, consequently, extra savings. Alternatively, you can extend your working years by postponing retirement, or you can take up a hobby that pays, such as painting, or offer consultancy based on your work experience.
Budgeting: Reducing current expenses is another good way to make sure you save every penny you can. Make a budget and cut down all unnecessary expenses. What you save each month can go into your retirement fund. There is another advantage of budgeting. You get used to a more sustainable lifestyle and this goes a long way in helping you adapt easily to post retirement life when finances are tighter.
Effects of Compounding and Taxes
When it comes to savings, compounding and taxes are two aspects that significantly impact exactly how much money you have for your expenses. The effects of both these on your savings have to be understood clearly so that your savings strategy is effective.
Compounding occurs when interest is earned on interest; thus, any returns on your original investments simply multiply with time. The longer the time that passes from the date of investment, the greater the compounded earnings will be. Compounding is your greatest ally when it comes to saving for the future. And the sooner you start saving for your retirement, the more help you get from compounding.
Taxes negate the benefits of savings to a significant extent. Simply put, the bigger your income from your savings, the greater the taxes owed. However, this is not the case with all savings or investments. By understanding the tax implications of various savings and investment plans, you can choose those that are most tax-friendly for you.
Remember that tax rules may change, skewing all your carefully thought out savings plans. So keep yourself updated with tax laws and regulations and tweak your savings strategy when necessary to avoid unpleasant shocks in the future. Make optimum use of government-sponsored retirement funds that offer tax refuges, but fully understand their implications while doing so.
Play it Safe with Your Retirement Fund
Your retirement fund is not your risk capital, no matter how soon you start saving. Of course, starting when you are 20 gives you much more leeway in choosing riskier investments than if you start at the age of 40. But always keep in mind that your retirement fund will be your primary source of income to meet your living expenses post-retirement.
Another aspect to keep in mind is that you will need a buffer over your estimate of the size of your retirement fund. It is a good idea for you to keep a margin of safety to cover unexpected contingencies such as medical emergencies.
Unpredictable markets also add to the element of uncertainty in retirement planning. Your estimates of what your investments or assets will yield in future may be drastically different from reality. In such cases as well, contingency savings will help bridge funding gaps.
Starting your retirement planning early lets you use diversification to even out the risks while getting best possible returns. Even if a portion of your retirement fund is wiped out with a failed high risk investment, you have sufficient number of earning years ahead to make up for it. This high tolerance for risk is the greatest advantage of starting retirement planning at a young age.
In the current scenario, it is quickly becoming evident that complete dependence on Social Security for retirement expenses is sure to end in disaster. Even if the system does survive and payments are continued, Social Security is woefully inadequate to finance your entire post retirement life. A company pension plan may also fail if the company takes a beating in a future recession. The only way to ensure that your retired life is free from financial anxiety is to plan early, persevere and stay committed to your personal retirement savings plan.