Making the Right Plans for Retirement

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Mangingmoney.com recently asked an interesting quesiont, “is 10% enough for retirement?”

A common rule of thumb when planning for retirement is to save 10% of your gross income during your working years. Since this rule of thumb has been around for a long time, it’s logical to question whether it’s still an appropriate guideline. Several trends suggest that it is probably on the low side:

• Fewer individuals are covered by defined-benefit plans. The 10% guideline anticipated that a retiree would receive a defined-benefit pension as well as Social Security benefits. But a substantial portion of the work force is no longer covered by a defined-benefit pension.

defined benefit pension plan is a type of pension plan in which an employer promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age, rather than depending on investment returns. It is ‘defined’ in the sense that the formula for computing the employer’s contribution is known in advance. In the United States, 26 U.S.C. § 414(j) specifies a defined benefit plan to be any pension plan that is not a defined contribution plan where a defined contribution plan is any plan with individual accounts. A traditional pension plan that defines a benefit for an employee upon that employee’s retirement is a defined benefit plan.1

The most common type of formula used is based on the employee’s terminal earnings. Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of a worker’s career.

• The Social Security system will face increasing pressure in the future. Due to the unprecedented number of baby boomers that will be retiring in the near future, there will be fewer workers to pay the benefits for each retiree. By 2037, unless changes are made to the system, benefits will need to be reduced by approximately 25% to equal revenues collected (Source: Social Security Administration, 2009).

• Life expectancies are continuing to increase. Average retirement ages have been decreasing, while life expectancies have been increasing. Currently, at age 65, the average life expectancy is 82 years for a man and 85 years for a woman, compared to 78 years for a man and 81 years for a woman in 1950 (Source: Journal of Financial Planning, August 2008).

• Plans for retirement have changed. Another common retirement planning rule of thumb is that you’ll need 70% of preretirement income during retirement. However, that guideline assumed a relatively inactive retirement lifestyle. Increasingly, retirees view retirement as a time to travel extensively or engage in expensive new hobbies. Thus, more and more retirees are finding little change in their income needs after retirement.

All these trends point to the fact that future retirees will be responsible for providing more of their income for a longer period of time. Thus, you should consider higher, not lower, savings rates. While 10% of income may sound like a lot of money, consider how many years you expect to work compared to how many years will be spent in retirement. Assume you start working at age 22, work until age 62, and then die at age 82. Thus, you work 40 years and are retired for 20 years — for every two years you work, you need to support yourself for one year in retirement. If your retirement expenses don’t go down and you don’t have a defined-benefit pension, you’ll need to save significant sums to support yourself for that length of time.

Contrast the current situation with a typical scenario in 1950. At that time, the average retiree worked 47 years before retiring for nine years. Thus, that person worked over five years to support one year of retirement.

For many people, then, the answer may be to extend their working years. In the above example, if you wait until age 70 instead of age 62 to retire, you will work for 48 years and be retired for 12 years. Thus, you will work four years for every year of retirement. While preretirees may not have the mathematics down, many realize that working longer, rather than retiring earlier, may be the only way to ensure that they don’t run out of retirement funds. Almost all recent surveys of baby boomers indicate that the majority expect to work at least part-time during retirement.

These stark realities don’t mean that you can’t retire, just that you need to plan carefully. Thus, you should start saving as much as possible, as soon as possible, for your retirement. Waiting even a few years to start saving can substantially increase the annual amount you need to save.

Trying to gauge whether your retirement savings are on track? While there’s nothing like going through a thorough analysis, you can take a quick look by adding up all your retirement assets and multiplying that balance by 3% or 4%. These withdrawal percentages should ensure that your retirement assets last for several decades.

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