CESI Personal Finance Guide - Chapter 6: Planning For Retirement
Chapter 6: Planning For Retirement
Prosperity is multi-faceted. Like a brilliant gem, it has many faces and aspects. Excellent health, secure housing, fulfilling relationships, inspiring adventures, and adequate financial resources are a few of the more popular themes that most people envision when defining prosperity.
Such ideas stimulate the creative juices and unleash the energy that drives us onward. For many, the overall objective is to arrive at a moment in our lives where we can step back and enjoy the pursuit of life’s simple pleasures without having to earn a paycheck. This chapter will discuss the basic components of planning for that moment, which for most, is retirement.
Regardless of one’s age, it is wise to identify our goals and implement a plan for achieving them. Waiting for the last moment to ensure that your needs will be met after you retire is irresponsible and foolhardy. We must pay as much attention to our future security as we do to satisfying immediate comforts and desires. It is recommended that you be prepared to replace 75% of your pre-retirement income after you leave the workforce to maintain your standard of living. To determine what this amount would be, simply multiply your current gross income by 75%. A person currently making $40,000 annually would compute the amount needed for retirement using the following guideline:
$ 40,000 x .75 = $30,000
Multiply this amount by 25 (estimated life expectancy beyond retirement). $ 30,000 x 25 = $750,000
$750,000 is the projected requirement. This guideline is not etched in stone. It is merely presented to help you arrive at a ballpark figure for evaluating retirement preparedness. Keep in mind that the money you will need can be gathered from many different sources. After retirement, a person can lower expenses by moving to a smaller home or to a less expensive area. Income can also be supplemented by a part-time job. The major areas to be considered when evaluating your retirement readiness package are savings, retirement plans, investments, and Social Security.
A Word About Social Security
Experts agree that the Social Security Administration has lost considerable ground in its ability to meet the basic needs of Americans throughout their retirement years. It is estimated that funds from Social Security can only replace about 20% of your pre-retirement income. The Social Security Administration sponsors a Web site to help people understand their Social Security income. The site explains how to calculate what your benefits will be and what steps should be taken to qualify for them.
The money you are able to save is a critical element of preparing for the future. Starting early and putting away 10% or more of every dollar you earn will lay the foundation for a sizeable nest egg by the time you get ready to stop working. Ideally, this 10% figure will be in addition to money earmarked for other investments, such as IRAs and job-related retirement programs. Studies have shown that most people wait too long before establishing good savings habits.
It is helpful to set a “savings goal.” For example, you can commit to having $3,000 in your savings account within two years. By depositing $125 each month for two years, you will reach your goal. When you reach your first goal, leave the money intact and set another goal. Keep building on your successes and you will arrive at a position where your savings will have a measurable impact on your retirement plans.
A friend who recently left his job told me how his simple savings plan allowed him to retire a millionaire. Bill worked for 43 years as a draftsman. At the age of 23, he began to put 12% of his income into a savings plan. He decided to put aside more than the recommended 10% to offset anticipated fluctuations in the annual rate of return. The rate varied over the years from about 3% to 8%. By staying the course year in and year out, Bill ended up with $1.5 million, a paid-up mortgage and a big smile of satisfaction when he retired.
For those who have considerable savings, there are many options available for investing your cash. Although you can research all the possibilities yourself, it is highly recommended that you seek the advice of a qualified, reputable financial advisor to assist you with making the right decision about your money. Let’s review the concept of risk before talking about investing your cash.
Before investing, it is important to know how much risk you are willing to take with your cash. Investing always involves some degree of risk. The degree of uncertainty that you are willing to deal with regarding your money defines your tolerance level for taking risk. How much are you willing to gamble in order to earn a certain return on your investment? The categories vary among financial experts, but the basic groups of risk takers are: low, moderate and high (or aggressive) investors.
The low level risk taker, or conservative individual, is not comfortable with any level of risk. This person is okay with very limited or no increase of their initial funds. Most people who are retired or soon to be retired fall into this category. Moderate individuals are willing to take a small amount of risk with their investment in order to go for slightly greater gains.
If you are at the moderate level, you understand that your investment will rise and fall in value. You are comfortable with the idea that you may get back less than you invest. Company shares, real estate and bonds are examples of investments preferred by the moderate risk taker. While the exposure to loss is greater, the potential for growth is more than for those who are low risk takers.
The high risk or aggressive investor is able to tolerate a higher level of speculation. They can comfortably ride out large fluctuations in the value of their investment. They understand and accept that they may lose some or all of their money. Typically, this person has 20 or more years before retirement and large amounts of discretionary cash. They feel that they have the time and the resources to regroup in case of a significant depletion of funds. Commodities, such as agricultural products, crude oil and gold are examples of high risk investments. Penny stocks – cheaply priced shares of marginal companies are also examples of high risk investments.
When determining your risk level, it is also important to understand what is meant by rate of return. The return on your investment is the profit you expect to receive from the money you contribute. In general, the higher the risk level, the greater the anticipated rate of return.
If you invest $100 in the ACME Broom Company, then $100 is your capital. Let’s say that after a year, your stock is valued at $110. This would mean that you have realized a 10% return on your investment. The rate of return can be calculated using the following formula:
((Return – Capital)/ Capital) x 100% = Rate of return
Amounts from the above example: (($ 110 – $ 100) / $100) x 100% = 10%
Knowing how to calculate the rate of return will help you to evaluate and compare a variety of investment tools.
For those close to retirement (within 15 years) it is best to choose low risk investments. The most frequently recommended low risk investments are CD’s, bonds, online savings accounts and money market accounts. These types of accounts are considered safe because they are insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC is an agency that is supported by the US government. It is your guarantee that if your financial institution were to become insolvent, you would get your money back up to $250,000. The FDIC does not insure accounts for investment purposes, such as mutual funds, annuities or stocks. Money in checking accounts and savings accounts are protected along with IRAs and CD’s.
- A money market account, also known as a money market deposit account, is a savings account that pays a slightly higher interest rate than a regular savings account. It is insured by the Federal Deposit Insurance Corporation (FDIC). A money market account usually requires a minimum balance. This can vary from $100 to $3000. There are limits on the number of withdrawals that can be made.
- Online savings accounts are another safe haven for retirement funds. Online savings accounts offer higher interest rates than the local bank or credit union without the restrictions of the money market account. Check to be sure that the financial institution is backed by the FDIC before sending any money.
- Bonds can also be counted on to provide shelter for your dollars along with the potential for some increase in capital. When you purchase bonds you become a lender. Whether it is the U. S. Government, ACME Bottle Works or the City of Happy Dreams, the outcome is the same. You may be lending money to build bridges, expand the physical plant or buy new equipment. Government bonds, including municipal bonds, are considered the most reliable bond investments. The price you pay for the bond is its “face value.” The issuer promises to pay you back the face value when the bond matures plus interest accrued during the life of the agreement. For example, let’s say you bought a $1,000 bond with a 5% rate of interest and a maturity date in 10 years; you would collect $50 a year for 10 years and then you would get back your initial $1,000 at the end of 10 years. Bonds are considered low risk because, with few exceptions, bond holders are able to recoup the interest promised as well as their initial investment.
- A Certificate of Deposit (CD) is an investment offered by banks, credit unions and other financial institutions. The holder of a CD has loaned money to the financial institution for a set length of time in exchange for a predetermined interest rate. Funds cannot be tapped before the CD matures without incurring a huge penalty. If you do plan to put your money in CD’s, be sure you are investing funds that will not be needed before the end of your agreement. If you have extra cash to stash, CD’s remain a good, low risk choice. Your money is insured by the FDIC and you earn interest at a slightly higher rate than you would in a savings account.
There are many different methods for investing funds to boost your retirement cushion. A few of the more popular investment choices are discussed here.
- An IRA, called an Individual Retirement Account, provides tax advantages. Anyone under the age of 70 1/2 with earned income is eligible for and IRA account. The Roth IRA and the traditional IRA are the most widely used versions.
- The Roth IRA allows you to contribute money after it has been taxed. The advantage of this type of IRA is that the funds and all earnings are tax free at withdrawal. The traditional IRA (like a 401(k)) allows you to get a tax break in the year you make the deposit, however, all funds are taxed when withdrawn with this plan. The Economic Growth and Tax Reconciliation Act called for adjustments in contribution limits over the last few years. In 2018, the limit was increased by $500 from $18,500 in 2018 to $19,000 in 2019. If you are age 50 or over, the catch-up contribution limit will stay the same at $6,000 in both 2018 and 2019. Employer match or profit sharing contributions aren’t included in these limits. Money from work related retirement plans can be easily rolled into (transferred to) an IRA.
- The Simplified Employee Pension (SEP) is available for people who own a small business or have some type of independent business income. The SEP gives employers a way to set aside retirement money for themselves and their employees. With the SEP, the employer contributes directly to a traditional IRA for all employees including the employer. The SEP is a favorite among small business owners because it has low start-up costs and flexible contribution regulations.
- A 401(k) is a retirement plan that is sponsored by an employer. You contribute a percentage of each paycheck into a retirement account. You do not pay taxes on the money when it is deposited. Taxes are levied when funds are withdrawn. Often an employer will match your contribution up to a predetermined percentage of your salary. The funds are invested on your behalf. Usually 60% to 70% of the funds will be invested in stocks. The rest of the money will be invested in bonds. Participating in a work-related retirement plan is no safeguard from loss. Because these programs are tied to the stock market, you can lose your cash. Be sure you are able to control how your funds are allocated. You should be able to state the level of risk you prefer and choose an appropriate portfolio.
- A 403(b) plan is a retirement program that is sponsored by educational institutions, nonprofit organizations and religious groups. Funds are deposited before they are taxed. The money grows tax-deferred until withdrawn at retirement; you can think of it as a 401(k) for non-profit organizations.
- Mutual funds also provide an opportunity for financial growth. It is also possible to increase one’s retirement funds by investing in the stock market through a mutual fund. Experts recommend taking advantage of the index funds. Fund managers buy shares of stocks in many different types of companies. Index funds are relatively inexpensive and allow for diversification. Mutual funds come in two varieties – load and no-load. Load funds have commissions that are paid to sales people. No-load funds are dispensed by the investment company therefore they do not have any commissions or sales charges attached.
- An annuity is an investment tool issued by an insurance company. It allows you to deposit funds that will earn interest for a specific number of years. The account is funded with pre- tax dollars. When it is time to withdraw your money, you can select to be paid in a lump sum or through a monthly allotment. Fixed annuities are the safest choice. A fixed annuity comes with a guaranteed rate of return, although usually at a low rate. A variable annuity is also available and is tied to the performance of the stock market with no guarantee on the return of principle or interest. This type of annuity is usually higher risk, but there is also no cap on the amount of gains.
- Buying stock in a company is another investment maneuver. When you purchase stock, you own a piece of the company’s assets. You are a shareholder. A company issues stock to raise money. By selling shares, a company raises money for operating costs that it does not have to pay back. As a shareholder, you get to “share” in a percentage of the company profits. If the shares go up in value, you can reap great rewards. If however; the value of the company decreases, your shares will decrease in worth and you could lose a large amount, if not all of your investment. The company does not guarantee a return and your money is not protected by the FDIC.
Insurance can protect a person’s standard of living in the event of a loss of income. Insurance can also help a person prepare for the future. The decision to purchase insurance should be based on the needs of the individual. Analyze your current situation carefully before making a decision. A person whose home is paid for and who has very few financial obligations will not have the same insurance needs as someone who has a mortgage and a young family to support. While there are many different types of insurance policies, most life insurance policies will fit into one of three categories – whole life, term life or universal life. For research purposes, A. M. Best issues ratings which measure the strength of an insurance company. This rating is an analysis of the company’s ability to pay claims. It also rates the financial instruments, such as bonds, and notes issued by the insurance company. If you are thinking of doing business with a particular insurance company, check out their rating first.
A whole life insurance policy pays a sum of money to a beneficiary upon the death of the insured. It provides coverage for the “whole life” of the insured. The insured is covered until death or until the policy matures. The policy matures or endows when the insured becomes 100 years of age. At this time, the insured receives the full face value of the policy and no additional premiums are paid. Because of its various features, whole life is usually the most expensive type of coverage. Many whole life policies build cash value which can be tapped in an emergency. The funds can often be converted into an annuity, or the entire policy can be surrendered for its cash value.
Term life insurance offers coverage for a certain period of time – usually 5, 10, 15 or 20 years. A basic term life policy will pay a sum of money to a beneficiary upon the death of the insured. The term policy is beneficial for someone who wants to be sure a large debt such as a mortgage is paid for at the time of their death. A term policy has helped many families maintain their lifestyle upon the death of the primary breadwinner. Term insurance is usually the least expensive type of coverage, however there is no cash value associated with term life policy.
This type of policy earns cash value. It maintains flexibility which allows the insured to change the components as their needs change throughout life. A universal life policy or flexible life policy gives the insured numerous options in terms of benefit amount, investment choices, and premiums. This type of coverage is attractive because it is less expensive than whole life and it provides versatility that allows the insured to make adjustments as circumstances change.
Protecting Your Dwelling
It is also important for homeowners and renters to protect themselves against losses in connection with their place of residence. Homeowners insurance can provide coverage in the event of damage to property. It can also protect the insured against liability for injuries that involve other people at their home. Basic policies include coverage for the structure of the home, personal belongings, payment of expenses if you have to get temporary housing due to a disaster, and liability protection. Renters insurance protects the belongings of the renter. The owner of the property usually carries a policy to cover structural damage.
A good health insurance policy is another wise investment. Health insurance can protect your financial cushion in cases of serious illness. Most policies carry a provision to cover medical expenses, disability, long-term care, and prescription drugs. If you are shopping for health insurance, take some time to assess your needs. Be sure to select a company that has a reputation for honesty, excellent customer service, and for handling claims efficiently.
Education Is the Key to Successful Planning
Adequate, up-to-date information is an essential part of making wise decisions. Books and articles offering suggestions for retirement planning are readily accessible. There are calculators available at several Web sites that allow you to evaluate progress based on your current financial information. Enter “retirement calculator” in your search engine window for a list of these sites.
There are many strategies to help us answer the question “How can I be sure I will have enough money to live comfortably after I retire?” The key steps are to set goals, take action and to stay informed. Remember to consult a professional before making any major decisions regarding your finances.
In This Chapter You Learned:
- How and why to save for retirement.
- Tips on investing for the future.
- Calculating risk tolerance.
- Details about employer-sponsored retirement accounts.
- What you need to know about Individual Retirement Accounts.
- How to plan for your insurance needs.
- The basics about Social Security benefits.