Let me guess.
You’re aching to retire, and you’d be counting the days...if only you knew how many you had left until you could afford to stop working.
You punch numbers into your calculator. The answers make no sense but you scribble them down anyway. Maybe they’ll look better in writing.
You wad up the piece of paper and throw it on the floor.
“When can I retire?” you ask the empty room.
You don’t know how much money you’ll need, or if you’ve already saved enough. And what about Social Security, didn’t you read something about maximizing your benefits? But how?
Tension jackhammers your skull. Fear sweeps through you as you contemplate a future living out of a shopping cart.
“Who can tell me, when can I retire?” you mutter. “And do I have enough money to retire?”
Generous Pensions Are Like Dinosaurs
Some of my clients were able to retire with very generous pensions. In fact, a few of them were able to actually increase their income after retiring because the combined income from their pension and Social Security was more than their paycheck. For these people, launching a successful retirement was simple.
For most of us, however, those days are long gone. You will need to be much more proactive, deliberate, and thoughtful if you are going have a successful financial retirement.
But you don’t need to be afraid to retire, either.
How To Know When You Can Retire
One great way to know when you can retire is by making sure you can answer the following questions before you even consider retiring.
- How will I know if I have enough income?
This is a straightforward calculation. All you need to do to see if your retirement income can replace your paycheck is to make a list of all the income sources you will have in retirement:
- How much will you receive from Social Security?
- If you have a pension, how much will you receive?
- Do you have any other income sources?
- Do you plan to work part time?
Add these all up and compare them to your paycheck.
If your combined retirement income sources are equal to or greater than your paycheck, that’s great. You are well on your way to launching a successful retirement!
But if they're not, don't worry too much just yet. Most of my clients’ income sources don’t meet or exceed their paycheck.
If your retirement income will be less than your annual income, you need to know exactly how much less it will be. Bridging this income gap will be one of the key elements in launching a financially successful retirement.
- Is it possible to lower my expenses?
There are two basic ways to close the gap between your retirement income and your paycheck: you can either increase your income or lower your expenses.
We will examine both of these strategies, but we will begin by seeing if and by how much you might be able to lower your expenses.
This might sound uncomfortable, but it doesn't need to be. There are some expenses that will naturally decrease once you stop working.
No More Saving For Retirement
One of these has to do with your 401k. After all, once you stop working, you will no longer be adding money to your 401k. That expense will disappear. The result being that you can live on less income.
For example, if you and your spouse have both been investing the maximum allowed in your 401ks, you would have been putting a total of almost $50,000 into your 401k accounts every year. But once you stop working, you will no longer be making those contributions. Once you stop working that expense will go away.
For example, if your combined working income had been $150,000 per year, you wouldn't need to replace it all. If you replaced just $100,000 of that income, you could have the same net income because you're no longer contributing $50,000 per year.
Pay Off Your House
Another way your spending might naturally decline is by paying off your house.
If the same couple in our example above were to time their retirement with paying off their mortgage, their retirement income gap would be even smaller. If their mortgage had cost $15,000 per year, their retirement income gap would now shrink from $100,000 to 85,000.
But remember, we only want to consider the amount you are paying toward the mortgage, not the portion that goes toward taxes. The mortgage portion will go away but the taxes will not.
Some of you might also benefit from paying less in taxes after you retire. This is because your lower income could put you in a lower tax bracket.
Being An Empty Nester
Others may experience savings because your children are now out on their own and self-sufficient.
For many of us it is likely that our expenses will decline after we retire. For some of you, the decline could be significant. These declines are one way you can close your retirement income gap and make it easier to launch a successful retirement.
- How Can I Maximize my Social Security Benefits?
The other way to reduce your retirement income gap is by increasing your retirement income. A great way to do this is to maximize your Social Security benefits.
But before I show you how to maximize your Social Security benefits, let's look at how Social Security works.
The age at which you are eligible for full Social Security benefits depends on when you were born. If you were born in 1960 or later, you are eligible for full benefits at age 67. For those of you born before 1960 it will be age 66 plus a couple of months depending on the year of your birth.
Although you can't receive full Social Security benefits until your full retirement age, you can choose to receive benefits as early as age 62. There is a penalty, however, for choosing this option and this penalty can be quite substantial.
The penalty for taking Social Security early is equal to approximately a 7% decrease for every year you claim your Social Security benefit early. This can add up to as much as a 25% reduction in your Social Security income if your full retirement age is 66 and a 30% reduction if your full retirement age is 67.
Now that I've shown you how to decrease your Social Security income – exactly the opposite of what you want! - let me show you how you can maximize your Social Security.
Even though you are entitled to your full Social Security income at age 66 or 67, you are not required to begin receiving Social Security at that time. You can delay receiving Social Security if you choose.
The reason you might want to delay receiving your Social Security income is because you will receive an 8% increase in your Social Security income for every year you delay taking it.
You can't delay indefinitely, but you can delay until age 70 and you would obtain a significant increase in your income.
If your full retirement age is 67 and you delayed until age 70, you would receive 124% of your full benefit. If your full retirement age is 66 and you delayed until age 70, you would receive 132% of your full retirement benefit.
Thus, a powerful way to close your retirement income gap is to delay receiving your Social Security income until age 70.
- How will I pay for Healthcare?
Even though you aren't eligible for full Social Security benefits until age 66 or 67, some people would prefer to retire earlier. Some you are even wondering how to retire at age 55!
But one of the trickiest factors in retiring early is managing the high cost of healthcare. The reason this is so challenging is because most of us get our healthcare coverage from our employer. Once we stop working, we often lose this important benefit.
Replacing healthcare insurance on your own can be very expensive. This is why many people delay retiring until they are eligible for Medicare at age 65.
Although Medicare may cost more than you'd like to spend, it will certainly be less expensive than paying for medical insurance on your own. When you are considering whether you are ready to retire, make sure you factor this cost into the equation for yourself and your spouse.
The high cost of medical insurance can make it difficult, and sometimes impossible, to close the gap between your paycheck and your retirement income.
- How can I manage my taxes in retirement?
Prior to retiring, you probably don't think much about paying your taxes. This is because you don't need to. For most of us, taxes are automatically withheld from our paycheck. But once you stop working this will no longer be the case.
Your income will come from new sources and it will be up to you to make sure your taxes are paid.
One important source of income in retirement is Social Security. With Social Security, you can have taxes withheld just like you do with your paycheck. Tax withholding can easily be set up when you apply to receive your Social Security benefits.
The same goes for pension income. If you are receiving income from a pension, you can request to have taxes withheld when you apply to receive the benefits.
Most of you will also need to take distributions from your qualified accounts. These are accounts that qualify for special tax treatment. They include your IRAs, 401ks, and SEP IRAs.
I recommend that taxes are withheld every time you take a distribution from one of these accounts. This way, the taxes are paid over the course of the year, just like they were when you were working.
If you don't set up this withholding, all the tax will be due when you file your tax return the following year. This can be a painful surprise.
To make sure you don't end up with a big tax bill next April, be sure to have a conversation with your financial advisor and tax preparer about how much tax to withhold from your qualified account distributions.
- Will my spending be able to keep up with inflation?
When you are working, keeping up with inflation isn't much of a problem. This is because you receive periodic raises in pay. But what are you going to do after you retire? How will you give yourself a raise in income once you stop working?
Planning for inflation is important. After all, you might have paid more for your last car than you did for your first house. This is just one example of the corrosive effect inflation can have on your spending in retirement.
When factoring inflation into your retirement income plan, the first thing you ought to consider is how much your income will need to rise over the years to have a successful retirement.
The national average for inflation has been about 3%. If you want to be conservative in your retirement planning, you might want to consider 3 ½ or 4% as a target for how much your spending needs to increase every year.
Just like taxes and death, inflation is unavoidable, and it will require you to spend more as the years go by. As a result, you must be sure you can take ever-growing distributions from your investments as the years go by.
- How many years should I plan for?
Well, here you have a morbid question! How long do you plan on living?
If you are using your parents and grandparents as a guide, you may be in trouble. Life expectancy has been on an upward trend for many years.
If you use the prior generation as your guide, you might put yourself in a position where you run out of money before you run out of life.
One way to determine a reasonable age to plan for is by referring to a life expectancies table.
You might be surprised to learn that if you are a 65-year-old man, you have better than a 60% chance of living to 80. And if you are a 65-year-old woman, your chances of living to 80 years old are over 70%.
If you are married and both you and your spouse are 65, the odds of one of you living to 85 is 74%. And the chances of one of you living to 90 is 48%.
Remember, life expectancy tells us the age at which half of that generation is expected to pass away. But this also implies that half of that generation will live beyond that age.
Be sure to plan appropriately. The last thing you'll want is to be blessed with a good long life only to run out of money and be dependent on others in your golden years.
- Can I get enough income from my investments to cover my retirement income gap?
Now that we have explored some ways to lower your expenses and increase your income, it's time to see if you can close any remaining retirement income gap by taking distributions from your investments. To make this assessment, we are going to apply the 4% Rule.
The 4% Rule is a rule of thumb that says if you take income from your investments at a rate that is equal to or lower than 4% of the total of your investments, you should be able to continue taking those distributions for the rest of your life without running out of money. As well, you’ll have the ability to increase your income over the years.
We apply this rule by dividing the amount of money you plan to take from your investments annually by the total value of all your retirement investment assets.
Here’s an example: say you need $25,000 a year to close your retirement income gap, and you have $750,000 in retirement assets.
You begin by dividing $25,000 by $750,000. The result is 3.3%. In this case the 4% Rule shows that you should feel confident that you can safely close your retirement income gap and keep up with inflation.
Don’t Forget About Taxes
However, remember that if you need $25,000 a year in income, you will need to take more than that amount out of your qualified accounts. This is because of the taxes you will need to pay.
Thus, if 10% is the amount of tax you've decided to withhold, you would need to take an extra $2,500 out of your account. Your total distribution would be $27,500 a year.
Since $27,500 divided by $750,000 comes to 3.6%, you can still feel confident that you can safely close your retirement income gap and keep up with inflation.
What If I’m Over 4%?
If your result is greater than 4%, you have more work to do. The most powerful way to lower that number is by delaying retirement.
Although delaying retirement is not what most people want to do, you will create multiple benefits:
- You have the opportunity to continue contributing money to your retirement accounts. This alone can be significant.
- You will delay taking money out of your accounts so they can continue to grow and later support more income.
- You can increase the amount you are saving every year.
The quickest way for you can to move yourself into a better position for retirement is to take all three of these actions together.
- What do I do when the stock market crashes again?
Notice I say, "When the stock market crashes again" and not "If."
We know the market will crash again. The stock market’s nature is to periodically crash. Ignoring this truth is dangerous.
However, after every crash, the stock market has recovered and gone on to new highs. Every single time. This is another characteristic of the stock market.
We see these gyrations in the stock market because its movements are linked to the ups and downs of the economic cycle.
In other words, when the economy is doing well, and corporate profits are rising, the stock market will generally rise. This is known as a period of expansion.
But the opposite is also true. When the economy is doing poorly, which is often accompanied by a recession, the stock market will go down. This is known as a contraction.
Taken together, these periods of expansion and contraction are known as the business cycle.
Since you know that it is the nature of the stock market to crash every so often, it is crucial that you know in advance how you will navigate these ups and downs.
Getting caught in a bear market without knowing exactly where and how you will get the income you need from your investment portfolio after you have already retired is a recipe for disaster. In fact, it is a situation that you may not be able to recover from and could undermine your retirement.
But having said this, stock market volatility isn't your primary problem. Since we understand that the stock market will crash, recover, and go on to new highs several times throughout your retirement, we can easily put strategies in place to manage this risk.
The true problem you face as you approach retirement is that time is no longer on your side.
The Different Effects Of Stock Market Declines
When you were young, although market declines were uncomfortable, they weren't a problem. This is because you had plenty of time to wait for the market and your investments to go back up.
In fact, when you were young, market declines worked to your advantage. This is because as you continued investing money into your retirement accounts, you were able to accumulate more shares at lower prices.
But once you retire, things are very different.
Most of you will need to take money out of your investments on a regular schedule, whether the market is up, down, or sideways.
Once you stop working, you no longer have the luxury of waiting for the market and your investments to recover from a decline. Time is no longer on your side.
Once you retire, you must find a way to put time back on your side. Thus, you need a strategy that allows you to safely take money out of your investments even when the market is crashing.
You don’t want to be forced to reduce your spending because your investments are down. Or, God forbid, have to go back to work.
Introducing The Two-Portfolio Approach To Retirement Income Planning
One way to put time back on your side is to use the Two-Portfolio Approach. This is a method of managing risk by dividing your investment portfolio into two distinct parts. One part will be a diversified stock mutual fund portfolio and the other will be a diversified bond mutual fund portfolio.
My goal for you with the Two-Portfolio Approach is to get enough money outside the stock market – in other words, into bond mutual funds - that you can generate the income you need by selling shares of your bond funds.
Therefore, your goal is to get enough money into a diversified bond mutual fund portfolio so you can keep selling shares until the stock market has recovered.
After the stock market has recovered and gone on to new highs, you can sell shares of your stock mutual funds to replenish the bonds you sold when the market was down.
Managing your investments with this approach is an excellent way to provide the income you need during market declines and prepare for the next bear market.
One note about this approach: don't plan to get your income from the dividends that the bond mutual funds pay. For most of you this won't work because you probably don't have enough money to put into bonds to generate enough dividend income to meet your needs.
How To Implement The Two-Portfolio Approach
To implement the Two-Portfolio Approach, the first question you need to answer is how many years of income do you want to have outside the stock market?
In other words, how many months or years do you think it will take for the stock market to recover from a decline?
If you do a little research, you will find that the average bear market lasts about 14 months. So, you might decide that putting enough money in bonds to cover 14 months of income will be enough. But is this true? Probably not.
Even if the next bear market lasted only 14 months, like the average, that is only counting the time it took for the market to decline from its high to its bottom. It doesn’t take into account the time the market takes to recover and reach a new high.
When you use the Two-Portfolio Approach to get the income you need, be sure to put enough money into bond mutual funds so you can sell them every month (or quarter) to provide sufficient income until the stock market rebounds and gets to its new high.
How long does this take? Let's use history as our guide.
The most recent bear market began in December of 2007 and took about six years to move from high to low to new high.
In our lifetime, the longest it has ever taken the market to recover was also a fairly recent event; it was the bear market which began in 2000. This market took seven years to move from high to low to new high.
If you decide that you'd like to have seven years of income protected from stock market volatility, calculate the total income you will need from your investments over the next seven years.
You can do this by calculating how much money you will take from your investments in years 1, 2, and so on. Add them all up and that is your number.
For example, if you need $50,000 every year, you will need to put $350,000 in your bond mutual fund portfolio ($50,000 per year X seven years).
If you know how to calculate the present value of money, you could do that calculation and use a lesser amount, but that is a topic goes beyond the scope of this article.
How This Approach Works
See how this works? When creating your retirement income plan, you need to decide just how much risk you are willing to take.
In other words, how many years of income do you want to protect from stock market volatility by investing in bond mutual funds?
Some of you may be tempted to invest solely in bond mutual funds. But you need stocks or stock mutual funds in your portfolio because they protect you from inflation.
Just imagine if, when you were working, your boss never gave you a raise. How would you pay your bills if you were still earning the same amount of money as you did back in 1990? It would be impossible.
The same principal will apply once you retire and stop working. Prices will increase as time goes by and you will need a way to give yourself a periodic raise in income. Stocks are one of the few investments that have been able to outpace inflation over time.
Not only do you need to have stock mutual funds in your investment portfolio, you need to make sure you put enough in them so your investment portfolio can continue grow over your retirement.
Get Ready For Your Successful Retirement
You may be feeling overwhelmed right now.
Creating a retirement income plan on your own isn’t simple.
Retirement can be a confusing and potentially dangerous time.
You will face totally new risks.
You will have to address many critical decisions that will have a huge impact on your life and on your family’s future.
But I want you to know that I believe in you. I believe that you can achieve your goals and take control of your future.
None of this is beyond you; you have the power to succeed!
With knowledge, a solid plan, and some discipline, you can navigate the retirement waters safely.
You’ve been working hard for many years. You owe it to yourself to make sure you're able to enjoy this time in your life.
Using the ideas in this article, you will feel confident about being able to successfully retire. Your fear and stress will fade away, because you know now what you’re doing, why you’re doing it, and where you’re going.
You Don’t Have To Do This Alone
You do not have to go on this journey alone!
For more than 25 years, my team and I have had the privilege of helping hundreds of great people like you enjoy this wonderful time in their lives.
I’d love to help you, too. That's why I offer a complimentary consultation when you will have the opportunity to ask me your questions. The meeting will take less than an hour. We will get together in person or online; your choice.
You don’t need to bring anything. There is no pressure, and you have my word we will not try to sell you anything.
Most people tell me that after we meet they feel smarter and happier.
Smarter, because they got answers to their questions. They learned some new things.
Happier, because they feel like they've made progress on some very important decisions.
To make this as easy as possible for you if we meet in person, I am willing to meet with you wherever it is convenient for you. This could be your home, office, or the local coffee shop. It’s up to you.
When we meet, one of three things will happen:
- We decide we would like to work together. In this case we would begin to discuss specific strategies and ideas right away.
- We decide that although we like each other that the time isn't right, and we agree to meet again sometime in the future.
- We decide we don't like each other and run screaming from the room. (Kidding!)
There is never any cost or obligation for this meeting. It is simply a way for you to talk with an expert and have some of your questions answered.
We get the chance to know you better. And you get the opportunity to see if the Hafner Financial Group can help you launch a successful retirement.