CHAPTER 13 RETIREMENT PLANNING The early years after retirement represent a period of transition for both income and expenditures. During the primary earning years, salary is usually the main source of income. Salary growth is usually matched by increased expenditures for additional commitments, amenities of life and increased investments to meet future financial needs. After retirement, salary either terminates, or is greatly reduced. While health still allows, we aspire to pursue activities for which time was not available during full-time employment. Travel, reading, recreation, hobbies and a possible new part-time career of our choosing, all become primary retirement activities. Expenditures associated with the pre-retirement standard-of-living continue. The cost of some items decrease while increased expenditures occur for retirement activities. Of immediate concern after retirement is the cash flow. Will retirement income exceed retirement expenditures? Are we financially able to enjoy our retirement years in the life-style we desire? What will be the source of income to replace the reduced salary income? One of the primary objectives of personal financial planning is to accumulate assets over the years to provide an investment portfolio for retirement income. Financial planning for retirement should be initiated well before the retirement decision and steps taken early-on to implement an acceptable retirement plan so that retirement expenditures will be affordable. To replace the loss of salary income, retirement income should come preferably from all three of the following sources: (1) a retirement or pension program, (2) social security and (3) an investment portfolio. Prior to the retirement decision, we need to take stock of our financial status to meet retirement income needs. How do we know with some confidence whether our planned retirement income will be adequate to meet our retirement expenditures? What compromises may be necessary to achieve an acceptable retirement financial plan? The analysis and solution of this type of personal financial problem is amenable to three approaches: (1) an approach to compare estimates of retirement income needs and retirement income, (2) an approach to compare a retirement expenditures budget with retirement income and (3) a financial planning simulation approach to analyze the interdependent retirement income and expenditures. Use will be made of annuity software developed in chapter 5. The personal financial planning simulation approach developed in Personal Financial Planning Made Easy (EZ-$-PLAN) is beyond the scope of this SHAREWARE Version, and will not be presented here. The objective of this chapter is to acquaint the reader with retirement planning and to demonstrate how to develop financial information pertinent to your retirement decisions. Information will be developed to assist in 41 Chapter Thirteen answering the following questions pertaining to retirement: (1) Is our financial plan adequate to allow us to retire in a particular year and to continue to live in the manner to which we have been accustomed and aspire to in retirement? (2) If not, what constructive changes should be made in the pre- retirement financial plan or in the timing of retirement? (3) If not, what feasible options are available after retirement to reduce expenditures and/or increase income? Will we be able to maintain our desired life-style? Voluntary retirement from lifetime work should be considered only after a financial retirement plan has matured. A retirement date is usually contemplated after the financial responsibilities of parents are significantly reduced and children have become independent. After children become independent, expenditures decrease significantly for some ordinary living expenses, e.g., food, clothing, transportation and children's college expenses. After retirement, expenditures also decrease for federal and state income taxes and the social security tax (FICA). Some expenditures after retirement usually increase, e.g., health care and travel. We will discuss three approaches to retirement planning: (1) an income need approach, (2) an expenditures budget approach (not included) and (3) a financial planning simulation (FPS) approach (not included). In the income need approach an estimate is made of a total retirement income needed for the first year after retirement. In the expenditures budget approach an estimate is made of the individual retirement expenditures for the first year after retirement. In the FPS approach a simulation is made of financial affairs at retirement and for subsequent years. The effect of inflation on future expenditures is included in all approaches. INCOME NEED APPROACH The income need approach to retirement planning is formulated in an Expresscalc file, RETPL1. We will discuss the application of RETPL1 by Bill and Hope Planner to their retirement planning. As a starting point for this example we assume that the Planner's have a current (1986) financial plan. We will use this plan as our pre-retirement data source for income. We further assume that Bill and Hope are each age 60 in 1986. We will estimate the retirement income need and the retirement income for 1988 and 1990 and discuss the feasibility of their retirement in 1988 and 1990. We start off by loading AS-EASY-AS into random access memory and then load the file RETPL1. A spreadsheet like table 13.1 (but with all zeros in B, C and D cells) will appear on the screen. We enter data into cells B4:B8 for their portfolio income rate (9% in cell B4) and inflation rates for 1986 (3%), 1987 (4%), 1988 (5%) and 1989 (5%) (in cells B5:B8). Some of these data are observed, others are "best estimates". 42 Chapter 13 Retirement Income Need Estimate The retirement income need is developed in section A11:D16 of table 13.1 for a potential retirement 2- and 4-years into the future (1988 and 1990). We use a rule of thumb to estimate the retirement income need, namely, that you can generally expect to live as well in retirement as you do now on 70% of your pre-retirement income (Planning your retirement - Figuring What You'll Need, by Eric Schurenberg, Financial Planning, Family Wealth, from the Editors of Money, Spring 1988, 29-31). The Planners enter their 1986 pre- retirement income for salary, interest and dividends in cells B13 and B14. The program RETPL1 then calculates the total income (B15) and estimates the retirement income needed for 1986 (in cell B16) by multiplying the 1986 income (B15) by .70. The program RETPL1 then calculates the 1988 and 1990 retirement income need (cells C16 and D16) as a projection from the 1986 retirement income need (B16) with the inflation factors provided (B5:B8), (e.g., C16=B16*(1+B5/100)*(1+B6/100)). Table 13.1. Retirement Plan - Income Need Approach (RETPL1) 2 A B C D 3 Input Data 4 Portfolio income rate (%) = 9 5 Inflation rate (%) Year 1 = 3 6 Inflation rate (%) Year 2 = 4 7 Inflation rate (%) Year 3 = 5 8 Inflation rate (%) Year 4 = 5 9 10 Item 1986 1988 1990 11 Retirement Income Need 12 Income - pre-retirement 13 Salary 74,112 14 Interest + Dividend 3,033 15 Subtotal 77,145 16 Retirement income need 54,001 57,846 63,775 17 18 Retirement income plan 19 Social Security, self 6,703 8,256 20 Social Security, spouse 6,193 7,589 21 Pension, self 11,082 13,667 22 Pension, spouse 6,478 8,415 23 Investments value 24 Employee Thrift Plan 62,575 85,728 25 IRA 7,752 12,500 26 Marketable Investments 128,719 170,000 27 Retirement Savings 12,757 27,914 28 Total Investments value 211,803 296,142 29 Portfolio income 19,062 26,652 30 Total retirement income 49,518 64,579 31 32 Retirement Income Minus Need -8,328 +804 43 Chapter Thirteen Retirement Income Plan The retirement income plan is next developed in section A18:D30 (of table 13.1). The Planner's retirement income includes income from social security, pension and an investment portfolio. Both Bill and Hope have worked more than the minimum of 40 quarters and qualify for social security income. They obtain an estimate of the social security income from the local office of the Social Security Administration. Alternatively, the Planners could have made their own estimate by utilizing information provided in pamphlets by the Social Security Administration (Estimating your Social Security Retirement Check, Social Security Administration) or Consumer Guide (Getting the most from Social Security, Medicare and other government benefits, Consumer Guide, December 1984, Skokie, IL, 192pp) and knowledge of their annual salary for each year social security tax was paid. A social security income estimate for Bill and Hope assuming that their retirement starts in 1988 or 1990 was entered in lines 19 and 20. The retirement income plan also includes a pension for self and spouse. For this example, the Planner's annual pension income was estimated as the average salary over the last 5 years times .014 times the number of years employed less 1/2 the social security income. An estimate of a pension for Bill and Hope starting in 1988 or 1990 was entered in lines 21 and 22 assuming that Bill will have worked 27 and Hope 22 years by 1988. The Planners next list in section A23:D27 those assets that will be available in their post-retirement portfolio to generate retirement income (these assets were extracted from the balance sheet in their most recent FPS program). Bill's employee thrift plan and Hope's IRA are entered in lines 24 and 25 of table 13.1. An estimate of the amount of marketable investments that will be available for their use in retirement is entered in line 26. In 1986, when the Planners first started seriously considering retirement in 1988 or 1990, (after their children became financially independent) they started a retirement savings plan yielding 9%, into which they invested $5,600 each year. The annuity due program ANNDUEF, discussed in chapter 8, calculates the asset values of $12,757 for 1988 and $27,914 for 1990; this data was entered in line 27. The total investments value is calculated by RETPL1 in cells C28 and D28. The portfolio income estimate for 1988 and 1990 (C29 and D29) utilizes the portfolio income rate entered in Cell B4 (9%) and protects the principal. Conservative investments are available that provide income rates of at least 9%. A somewhat larger portfolio income could be obtained by investing the portfolio in an ordinary annuity. The EZ-$-PLAN file ANNUITP provides alternative income values for table 13.1 total investment value (cells C28:D28): (1) $19,811 and $27,906 annual payments until the Planners reach age 100, or (2) $20,241 and $28,632 annual payments until the Planners reach age 95. 44 Chapter Thirteen The program RETPL1 calculates the total retirement income for 1988 and 1990, in cells C30 and D30, and the retirement income minus the income need in cells C32 and D32. The retirement income minus need is estimated as $-8,328 for 1988 and $804 for 1990. For the example presented, the cross-over of the curves retirement income vs time and income need vs time occurs during the year 1990. The $1,200 increased annuity income for a 1988 retirement is not sufficient to modify the retirement timing. Retirement in 1988 appears premature; retirement in 1990 appears financially feasible; retirement after 1990 should leave an annual income surplus of income minus expenditures available for portfolio investment. EXPENDITURES BUDGET APPROACH (Not included in SHAREWARE version). A SIMULATION APPROACH TO RETIREMENT PLANNING (Not included in SHAREWARE version). DISCUSSION The income need approach estimates the total retirement income needed to meet the expenditures as a percentage (70%) of the pre- retirement income; the expenditures budget approach estimates the retirement expenditures budget by a projection of the pre-retirement actual expenditures. Both approaches apply a financial plan to estimate retirement income. Let us comment on these two approaches. Various uncertainties are involved: (1) Estimating the post-retirement income needs as 70% of the pre- retirement income is rather imprecise. It does not take into account the differences in individuals life-styles. Some people spend all of their income while others have a significant surplus of income minus expenditures. (2) The assumed income rate from a portfolio (dividends plus capital gains distributions) has investment risk. The 9% rate assumed in cells B4 of tables 8.1 and 8.2, however, is a conservative estimate (the current 30-year Treasury bond rate is 9.3%). (3) Future inflation rates have a major effect upon budget expenditures. A large increase in future inflation rates combined with a fixed annuity retirement income can cause a future shortfall in retirement income minus desired expenditures. Neither approach includes non-linear effects of inflation on the financial plan after retirement. A hedge against future inflation is desirable in the retirement financial plan, e.g., some part of the portfolio should be invested in equity mutual funds with risk matched to the Planner's financial ability to withstand risk. 45 Chapter Thirteen (4) If there is no cross-over between the planned retirement income and expenditures budget during the time frame when you desire to retire, one alternative is to increase the annual pre-retirement savings amount or to start the retirement savings plan at an earlier date. Other alternatives involve compromises, e.g., to reduce the retirement expenditures budget, to increase retirement income by part time employment or to delay the retirement date. (5) Having a pension in your retirement plan (line 21 and 22 of table 13.1) is very important. This can best be demonstrated in terms of an equivalent ordinary annuity. If the sum of the two pensions for 1988 ($17,560) and for 1990 ($22,082) are entered into the ordinary annuity program ANNUITP and assuming a periodic rate of 8% and a term of 38 years (for 1988) and 36 years (for 1990) for the Planners to reach age 100, the present value of this ordinary annuity would be $207,714 in 1988 or $258,739 in 1990, respectively. If the Planners had no pension in their retirement plan, the amount of past annual savings to achieve the equivalent value of the pension can be determined from the program ANNDUEF. The value of $207,714 can be achieved over 15 (20) years by saving $7,083/yr ($4,202/yr). The value of $258,739 can be achieved over 17 (22) years by saving $7,098/yr ($4,320/yr). It is perhaps obvious that it is very desirable to initiate a retirement plan well in advance of the desired retirement date for the retirement income to match the desired retirement expenditures budget. The income need approach to retirement planning, as summarized in table 13.1, arrived at the result that 1990 would be an appropriate date for the Planners to retire. The expenditures budget approach, summarized in table 13.2, arrived at the result that retirement in 1988 would be appropriate. The retirement income plan for both approaches is the same for pension and social security income although income differences occur in investment income. Both the income need and expenditures budget approaches assume a 9% income from the portfolio. A large difference in approach occurs with respect to the estimate of expenditures. The income need approach approximates the total annual expenditure, while the expenditures budget approach estimates the individual expenditure line items. In 1988, the estimate of expenditures was $57,846 and $45,000 for the income need approach and the expenditures budget approach, respectively. Neither of these approaches include the effects of inflation on expenditures after retirement. It is believed that the expenditures budget approach, starting from the Planner's actual expenditures history, provides a better estimate of post-retirement expenditures than the income need approach which estimates the total retirement expenditures as 70% of the pre- retirement income. However, for retirement planning the approaches complement each other. 45a Chapter 13 SAVING FOR A COMFORTABLE RETIREMENT How much money do we need to fund a comfortable retirement? How much savings should we set aside each month so that our retirement fund is ready for us when we are ready to retire? The file RETPL4.WKS helps you answer these questions in a basic yet powerful way. First input your current gross income in cell B8 of RETPL4.WKS. You may wish to prepare a joint plan for you and your spouse, or to prepare separate plans. Next, from the income need spreadsheet, (RETPL1.WKS) input your planned retirement income in current dollars (B16 of RETPL1) into cell B9 of RETPL4. Then, project your annual Social Security benefits at retirement and enter this value in cell B10 of RETPL4. RETPL4 calculates additional retirement income needed in today's dollars beyond that available from Social Security. Next enter the planned number of years to retirement in cell B12. Select only 10, 20 or 30 for this simple and quick analysis. A retirement age of 65 is assumed. RETPL4 then calculates, in cell B13, the additional income needed during year 1 of retirement beyond that provided by Social Security (in inflated dollars, 4% inflation is assumed). It is assumed that social security payments will keep pace with inflation. Next estimate your annual pension benefit at the start of retirement and enter this value into cell B14. Then enter the estimated annual percentage increase in your pension in cell B15 (many pensions are fixed annuities and thus do not keep pace with inflation). Enter 0 if you have a fixed pension. Next, RETPL4 calculates the amount of assets needed at the start of retirement to fund the income need minus social security plus pension benefit in cell B16. Income needs during retirement are assumed to inflate at the assumed rate of 4% per year. Next, input in cell B17 the value of current assets you have reserved to fund retirement. RETPL4 calculates the additional assets needed at retirement (in cell B19) to fund the gap in income need minus social security + pension benefit + income from current assets. Finally, RETPL4 calculates the annual and monthly savings needed from current income (in cells B20 and B21, respectively) from the present until retirement, assuming an 8% annual growth, to provide for this additional income need during an assumed 25-year retirement (age 65 to 90). If a negative value results in cell B19, your present retirement plan will satisfy your planned retirement income without additional savings.