August 2007 |
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Not that long ago individuals in this country simply weren't required to become amateur pension experts in order to gain a reasonable comfort with their retirement planning. But that day has passed us by and we've entered a new reality. Today, more and more people realize they must rely on themselves and their own private advisors in order to adequately meet their needs in retirement. Doing so takes a new set of skills and education and the stakes couldn't be higher.
If we boiled down the main question on the minds of most of our clients, it would have to be, do I or will I have enough money? Now, it doesn't get much simpler than that and we wish we could say that it was just as simple to answer. The purpose of this article is to take you through the factors that matter in answering this question intelligently.
As a former actuary with a congenital disposition for analyzing everything, the "Do I have enough?" question is largely an exercise in long-term risk management. In the past, a single employee was part of a diversified pool of other future beneficiaries within a pension plan. Money was contributed by both employers and employees with it earmarked for satisfying the eventual and ongoing payments to retirees. The risk of meeting those obligations was borne by the company that made the promises.
As in any insurance situation, the many risks of managing this process were spread over a large numbers of individuals. As you'd expect, some pensioners passed on sooner than expected and some lived beyond their estimated lifetime. However, with enough numbers, the overall range of probabilities was not all that wide. So, as long as the necessary contributions were collected and the investment returns were achieved, they were very able to properly meet their known liabilities (retiree payments). While it is far more complicated that just explained, this is basically what it means when it's said that a pension plan is fully-funded or in balance.
Today, aside from Social Security, a typical retiree is not participating within a larger pool. It is a mostly a pool of one or two depending on marital status. Therefore, the range of probabilities is unnaturally wide. A person or couple might live for 10 years in retirement or need to fund up to 40 years of retirement spending. And, since a person cannot predict the length of time their money needs to last with certainty (or near certainty) professional advisors are understandably erring toward using conservative assumptions. In many cases, this leads to retirees sacrificing financially a bit more than they should. We've all seen this first hand and frankly, it is sad to see. However, given the possibility of outliving their money, being conservative is the only rational way to behave. All in all, it is a lot to manage.
As people move from a pure "wealth accumulation" stage to a point nearer to the day where their nest egg is meant to replace their earned income, their minds begin to grapple with some important questions. We've seen it happen and it can be stressful without a doubt. Systematic planning helps and understanding the nuances of their choices becomes really important. Here are the key factors that need to be clarified when reaching this stage.
After organizing a list of all of your assets and debts, we aim to isolate the "available resources" you have at your disposal to fund your retirement spending. As you can imagine, not all assets may be available for this purpose and must be set aside from the analysis. Over time some resources may shift from unavailable to available, so it is a dynamic exercise as time passes by.After the available resources are identified, the next question to contemplate is the time until those resources are expected to begin replacing your earned income. For those already retired, there isn't much left to discuss on this front, but for those still preparing, consideration of this factor is critical.
Naturally, yet another part of the picture is the "ongoing savings" assumptions for those still building up to the retirement decision. Many are surprised by the powerful combination of delaying the time until retirement and therefore continuing to save along the way. While this choice to delay and save cannot easily be made by everyone, the compounding effect can truly alter a client's retirement income for years to come.
Layering on the "financial factors" of inflation expectations and investment returns comes next. As any pension fund manager would say, the investment return assumption must be long-range in nature. With regard to investment return assumptions, we find it is makes sense to err lower than hoped for and let any upside surprises be the icing on the cake. As far as the inflation assumption is concerned, while it is still just an estimate, we do happen to have a market based estimate readily available each day imbedded in TIPS (Treasury Inflation-Protected Securities) prices. Today, the markets are telling us that 2.5% inflation is a fair bet.
Yet another factor is "other outside sources of income" such as private pension benefits (if you are lucky enough to have one), Social Security and other annuity distributions. These are all considered "income burden reducers" in our minds. The more of these, the less stress placed on the available resources described above.The final piece that we consider quite important is a client's plans or wishes regarding their "monetary legacy" at the end of the life. This important consideration obviously ties into our "advisable percentage draw" from their available resources. As a general rule, the higher the monetary legacy one hopes to leave behind, the less the income draw we are comfortable advising.
The biggest question of how much an individual or couple can afford to spend in retirement is not an easy cookie-cutter answer away. It is our opinion that no software program that kicks out 20 pages of analysis or even quickie calculator on the internet is going to give you the "right" answer. While easy to follow rules-of-thumb, such as only spending 4% of your resources each year, are quite enticing to rely on, the overall management of the risks of retirement demand a more robust process.
The factors described above are somewhat subjective in nature and certainly depend upon one other in many ways. We've always recognized that each individual or couple is unique in their goals and their risk taking ability. And, this is important to reflect on, we also keep in mind that each may react differently to a similar set of future outcomes and risks. With these nuances in mind, we very much see ourselves as being partners in the management of our clients' retirements. In all honesty, it is an enjoyable job wrought with challenges, emotion and thankfully, real meaning. For those who know what an actuary does, this is a far cry from my cold number crunching days a decade ago!