💰Personal Financial Management Unit 11 – Retirement Planning Essentials

What's Retirement Planning?

• Process of determining retirement income goals and the actions and decisions necessary to achieve those goals
• Involves identifying sources of income, estimating expenses, implementing a savings program, and managing assets and risk
• Includes determining time horizons (how long retirement will last based on life expectancy)
• Considers future healthcare costs and long-term care needs
• Assesses the impact of inflation on purchasing power over time
• Evaluates the potential role of government benefits (Social Security, Medicare)
• Examines the role of employer-sponsored retirement plans (401(k)s, pensions)
• Explores the need for personal savings and investments to supplement other sources of retirement income

Why Start Planning Now?

• Compound interest allows early contributions to grow significantly over time (starting at 25 vs. 35 can result in 50% more savings by retirement age)
• Longer time horizon provides more opportunity for investments to recover from market downturns
• Establishing good financial habits early makes saving a lifelong practice
• Employer matching contributions to retirement accounts are essentially "free money" that can boost savings
• Tax advantages of retirement accounts ($19,500 annual 401(k) contribution limit in 2021) are more valuable the earlier you start contributing
• Delaying saving means having to save significantly more each month to catch up
  • Example: Saving $200/month starting at 25 can grow to$500,000 by 65 (assuming 7% annual return), but waiting until 35 would require saving $500/month to reach the same goal
• Unforeseen expenses or life changes (health issues, job loss) can derail retirement saving if started too late

Setting Retirement Goals

• Determine desired retirement age and estimate length of retirement based on life expectancy
• Assess expected lifestyle in retirement (downsizing, travel, hobbies) to estimate income needs
• Consider the impact of inflation on future purchasing power (3% annual inflation means $1 today is worth only$0.54 in 25 years)
• Factor in anticipated healthcare costs, which increase with age
  • A 65-year-old couple retiring in 2021 may need $300,000 saved to cover health expenses in retirement
• Evaluate the role of debt (mortgage, credit cards) and aim to enter retirement debt-free
• Assess potential sources of retirement income (Social Security, pensions, part-time work)
• Set target retirement savings goal and calculate required monthly or annual savings to reach it
• Regularly review and adjust goals based on changing circumstances or priorities

Understanding Retirement Accounts

• 401(k) and 403(b) plans are employer-sponsored retirement accounts that allow pre-tax contributions
  • Many employers offer matching contributions (50% of employee contributions up to 6% of salary is common)
• Traditional IRAs allow individuals to save pre-tax dollars (up to $6,000 per year in 2021, or$7,000 if age 50+) and defer taxes until withdrawal in retirement
• Roth IRAs and Roth 401(k)s are funded with after-tax dollars but offer tax-free growth and withdrawals in retirement
  • Income limits apply for Roth IRA contributions ($140,000 for single filers,$208,000 for married filing jointly in 2021)
• Self-employed individuals can use SEP IRAs, Solo 401(k)s, or SIMPLE IRAs to save for retirement
• Health Savings Accounts (HSAs) offer triple tax advantage (pre-tax contributions, tax-free growth, tax-free withdrawals for qualified medical expenses) and can be used to save for healthcare costs in retirement
• Taxable brokerage accounts offer flexibility but lack the tax advantages of dedicated retirement accounts
• Annuities provide guaranteed income in retirement but often come with high fees and complexity

Calculating Retirement Needs

• Estimate expected annual expenses in retirement (80% of pre-retirement income is a common rule of thumb)
• Factor in the impact of inflation over time ($1 today will be worth less in the future)
• Consider the 4% rule: withdrawing 4% of retirement savings annually (adjusted for inflation) provides a high probability of not outliving savings over a 30-year retirement
  • Example: $1 million in savings would provide$40,000 in annual income (in today's dollars) over a 30-year retirement
• Use online retirement calculators to estimate savings needs based on current age, retirement age, life expectancy, and expected investment returns
• Assess potential income from Social Security, pensions, and other sources
  • Social Security replaces about 40% of pre-retirement income for the average earner
• Determine the gap between estimated expenses and expected income sources to calculate necessary savings
• Regularly review and update calculations based on changing assumptions or circumstances

Investment Strategies for Retirement

• Diversify investments across asset classes (stocks, bonds, cash) to manage risk and optimize returns
  • A common rule of thumb is to hold a percentage of bonds equal to your age (60% stocks/40% bonds at age 40)
• Consider target-date funds that automatically adjust asset allocation based on expected retirement year
• Rebalance portfolio periodically to maintain desired asset allocation
• Invest in low-cost index funds to minimize fees and expenses that can erode returns over time
  • A 1% annual fee can reduce portfolio value by 28% over 35 years compared to a 0.25% fee
• Understand risk tolerance and adjust portfolio accordingly
  • More conservative portfolios (higher bond allocation) may be appropriate closer to retirement
• Take advantage of catch-up contributions to retirement accounts starting at age 50 ($1,000 extra for IRAs,$6,500 extra for 401(k)s in 2021)
• Consider the role of annuities in providing guaranteed income in retirement (but beware of high fees and complexity)
• Regularly review and adjust investment strategy based on changing goals, risk tolerance, or market conditions

Social Security and Pensions

• Social Security provides retirement, disability, and survivor benefits based on lifetime earnings
  • Replaces about 40% of pre-retirement income for the average earner
• Full retirement age (FRA) for Social Security is 66-67, depending on birth year
  • Claiming benefits before FRA (as early as 62) results in permanently reduced monthly payments
  • Delaying benefits past FRA (up to age 70) results in higher monthly payments
• Spousal benefits are available for married couples and divorced individuals who were married for at least 10 years
• Social Security is funded through payroll taxes (6.2% each for employees and employers) and is not means-tested
• Pensions are becoming less common but still offer guaranteed income in retirement for some workers
  • Defined benefit plans provide a set monthly payment based on years of service and final salary
  • Defined contribution plans (like 401(k)s) do not guarantee a set payout in retirement
• Pension Benefit Guaranty Corporation (PBGC) insures most private-sector defined benefit plans
• Regularly review Social Security statements and pension plan documents to understand expected benefits and claiming strategies

Risks and Challenges in Retirement

• Longevity risk: the risk of outliving retirement savings
  • A 65-year-old couple has a 50% chance of at least one spouse living to age 92
• Inflation risk: the risk that rising prices will erode purchasing power over time
  • A 3% annual inflation rate will cut purchasing power in half over 24 years
• Market risk: the risk that investment returns will be lower than expected or that a market downturn will occur at the wrong time (sequence of returns risk)
• Health risk: the risk of unexpected health expenses or long-term care needs
  • A 65-year-old couple retiring in 2021 may need $300,000 saved to cover health expenses in retirement
• Cognitive decline risk: the risk of diminished capacity to manage finances and make decisions in later retirement
• Policy risk: the risk that changes to government programs (Social Security, Medicare) or tax laws will impact retirement plans
• Family risk: the risk of unexpected financial obligations to family members (supporting adult children, caring for aging parents)
• Regularly assess and plan for potential risks in retirement
  • Consider long-term care insurance, annuities, or other products to mitigate specific risks
  • Maintain an emergency fund to cover unexpected expenses
  • Keep retirement plans flexible and adaptable to changing circumstances

Creating Your Retirement Plan

• Start by setting clear retirement goals and estimating income needs
• Assess all potential sources of retirement income (Social Security, pensions, savings, investments)
• Determine savings needed to fill the gap between income and expenses
  • Use retirement calculators or work with a financial advisor
• Choose appropriate retirement accounts (401(k), IRA, Roth) and investment strategies
  • Automate contributions to ensure consistent saving
  • Take advantage of employer matching contributions and catch-up contributions if available
• Develop a plan for claiming Social Security benefits
  • Consider the impact of early or delayed claiming on monthly benefits
• Plan for healthcare expenses and potential long-term care needs
  • Consider purchasing long-term care insurance or saving in a Health Savings Account (HSA)
• Create a retirement budget and plan for managing expenses in retirement
  • Consider downsizing, relocating, or other cost-saving measures
• Regularly review and update retirement plan based on changing goals, circumstances, or market conditions
  • Adjust savings rate, investment strategy, or retirement timeline as needed
• Work with a financial advisor or use online resources to create a comprehensive written retirement plan