Financial Briefs – The Problem With Retirement Calculators.

Finance Briefs are a new section here at retirement is possible. They are short posts, generally only 500-600 words, covering a very specific topic. The idea is that you can quickly see a bit of news, find out how to solve a problem, or get a new insight. Let me know what you’d like to see in future Finance Brief posts. To see more Finance Brief posts check out the Finance Briefs Index.

 

The Problem With Retirement Calculators.

 

Understanding how much money you need and how much you’ll have to meet your retirement needs are the hardest parts of retirement planning. Retirement calculators are a great way to estimate those needs. There are a lot of very good retirement calculators out there. Two of my favorite are Vanguard’s Retirement Income Calculator and FIRECalc.

 

Retirement calculators are a great place to start, but they can be very misleading. Especially as you gain a stronger financial base. You may need more or less than what they estimate. And you may have more or less when your retire than they estimate. Here are some considerations when doing your planning.

 

Replacement.

How much will you realistically need? Most people only need 50%-80% of their preretirement income. Many people need far less. Some with health issues may need more. As you get older that percent may change as well.

Your house.

If you own a home then you may have your house paid off when you retire. This can greatly reduce how much you need. You can also sell your house and move to a smaller home when you retire. This will reduce the amount of money you need in retirement and may add a bit to your savings account.

Pensions and Social Security.

Most calculators don’t take these into account, or they may not do it in a way that works for your situation. Social Security can be a large part of your retirement account. Check out my post The True Value of Social Security. Use the Social Security Administrations calculator to estimate what you’ll get.

New expenses.

Retirement may mean new expenses like travel and increased medical bills. Consider the roll of medical insurance and Medicare in your retirement funding needs.

Return in the market.

This can vary a lot. Even long term rates can be different. Retirement calculators use rates between 5% and 12% to estimate growth of your portfolio. They both can be real, but won’t match your unique situation. Use a calculator that runs several scenarios. FIRECalc does this. Many others do. A Monte Carlo simulation is one type. A Monte Carlo simulation doesn’t perfectly simulate the market, but it gives you a general idea of the range of possibilities.

Inflation.

Inflation is an unknown. Many calculators assume about 3% inflation. Depending on how you estimate the inflation rate the real inflation could be closer to 4.5% over the decades of your retirement.

 

What to do about all this?

This just scratches the surface. Look at your situation. Use a retirement calculator that allows you to make adjustments to the assumed numbers. Then check several different calculators. You’ll start to see trends. If you compare that to something like the 4% rule then you’ll be able to get a general idea on how much you’ll need to save. Finally, be conservative. It’s better to overestimate a bit. But don’t over do it. Estimating a range based on each of these factors can give you a better idea of what you really need to have and how much you’ll actually spend.

 

What are some other problems with retirement calculators? How do you adapt to them?

Five Ways Retirement Accounts Fund Your Retirement, and How To Maximize Them.

There’s always this goal of having enough money to not have to work again. Some people call it retirement. Some call it financial independence. Some people just call it freedom. But how exactly does that saved up money actually fund your life?

 

The common misconception is that you have this pile of cash, and you just spend it as you go. Hopefully you won’t spend it all before you die. But that is a misconception. That would require a huge amount of cash sitting in a savings account to fund the rest of your life. Especially if you wanted to retire early, or if you wanted to leave some for your kids. That also means that it can’t last forever. True financial freedom should be able to last forever. Theoretically anyway.

 

So how does your retirement account actually fund your life style? And how can it last forever? Well, there are five basic ways that your retirement accounts fund your life.

 

Dividends and Income

What it is

Dividends and Income are my favorite way to fund retirement. This is when you own a business and you get paid a bit of the profits regularly as an owner. For example, some stocks will pay a regular dividend every quarter. Coca-Cola has been paying a regular dividend for over 50 years. If you own shares of Coca-Cola then every three months you’ll receive a check from them. If you own enough shares of Coca-Cola then you could live off of the dividend checks that you receive. You can also pass those shares on to your kids and so on.

How to maximize it

The most common way to maximize this is to buy stocks in solid companies that are paying a higher dividend. REITs tend to pay higher dividends and sometimes utility companies do as well. Don’t be too swayed by really high dividends though since they can indicate that the company may be having problems. Do your due diligence and investigate the company.

A less common, but potentially more profitable way to do this is to start your own company and hire others to run it for you. Or buy into an existing one. This can give you a share of the profits without having to do the work. This can require a larger initial investment in money or time, but it can pay off well.

 

Interest

What it is

Most people, even without investment accounts, make a little money this way. This is the money you get from having a savings account or a CD. This usually isn’t a lot of money, but with a savings account the principal is safe. You can also make interest money by making loans with companies like Lending Club, carrying mortgage notes, or holding tax liens.

How to maximize it

For retirement account purposes it is usually good to hold some money in a safe place for those years when the market goes down. A savings account or CDs are safe even though they don’t provide a lot of return. You can increase the return by using online savings accounts and watching for special deals. If you’re willing to take on a little more risk you can lend money using peer to peer lending, lend money independently, or buy notes issued by companies. These have the potential to make more money, but your principal money isn’t guaranteed.

 

Capital Appreciation

What it is

This is when stock that you buy goes up in value and you use the extra money to pay your bills. For example, you buy $5000 in stock, it goes up to $6000, and you sell $1000 worth to pay for living expenses. This same concept can work for real estate, stocks, and many other investments. It works best though for investments that you can sell any part of, like mutual funds. When it comes to things like real estate and stocks you generally can sell only whole parts at a time instead of just the appreciated value.

How to maximize it

To maximize this you need to maximize your capital appreciation. That means investments that are going up faster. This can be small, new companies, hot companies at the time, or starting something from scratch. Do balance this with risk though. The more potential to go up usually means the riskier it is. That’s why mutual funds can be a great way to grow and fund your retirement. It provides protection because your money is spread out between a lot of companies. You can also sell parts instead of individual shares of stock so it is easier to continue to grow. You won’t have to worry about selling your last share as much.

 

Annuity/Pension

What it is

Annuities are where you pay an insurance company a large block of money and then they pay you a set amount for the rest of your life. A pension is similar except that it is usually funded by an employer over the course of your employment. A pension used to be an important way that people funded a retirement after working for 40 years. Ideally you’d work at a company for your career and then you’d get a pension from the company when you retired. Today there are very few companies that still pay a guaranteed pension. The federal government still does. As do several local governments. Only a handful of large companies still have the option for new employees. Most have transitioned to 401k type investments.

Social Security falls into this category as well. You pay into it over the course of your working life. When you reach retirement age the government pays you for the rest of your life. In this case it is based on how long you worked, the age you retire and the amount you put in.

How to maximize it

If your employer doesn’t have a pension option then your options are to either switch to an employer that does, make more money so that you pay more in Social Security taxes, or save money to buy an annuity. Your best options to maximize it though are to double dip. By that I mean pay into Social Security and get an employer that pays a pension. That way you can collect both. You can also save money to buy an annuity as well. Just make sure the employer is large enough that they will be around when you retire. If you buy an annuity make sure that you buy with a company that will likely be around for a long time.

There isn’t much protection for either of these if the supporting organization goes out of business. Annuities typically pay in the 2% range so you may be better off with dividends or other investments.

 

Principal

What it is

This is the money I talked about at first. This is the actual money that you put into your retirement account. I don’t recommend using this if possible. This is usually the money that is working to make you more money. However, this is your money. And you won’t have any use for it when you die.

How to maximize it

Since this is the money that you put into your savings and retirement accounts you can maximize this by saving more. To do that you may need to make more. You can check out my post Way Too Many Ways to Make More Money for ideas.

 

These are the key ways that retirement accounts fund your life. Dividends and interest are usually the ones that can make you more money in the long run and help you create a legacy for your descendants. An annuity or a pension can provide you with lifetime income, however you are dependent on the company that controls them staying in business and well-funded. They can also be less stressful during market down turns.

 

How do you plan to use your retirement accounts to fund your retirement? Do you plan to use your money other ways?

The True Value of Social Security

The other day I posted a short article on HubPages called Can Social Security Turn A Meager Retirement Account Into A Million Dollar Portfolio. In it I talked about what Social Security is really worth when it comes to planning for your retirement. Below I talk a bit more about Social Security and using it in your retirement planning.

 

In its simplest form Social Security is money that the government sends you when you’re old to help you pay your bills. The Social Security Act that sets that up covers a number of social welfare and insurance programs, but for today we’re going to focus on the retirement benefits.

 

How Social Security works, in a nut shell

When you get paid by your employer some of that money is taken out for Social Security. It’s one of the many taxes. You end up paying 6.2% of your income to Social Security for all money you make up to $118,500. Your employer pays 6.2% of your income up to $118,500 to Social Security as well.

 

That money is used to pay the Social Security benefits of retirees and people on disabilities. Anything left over is saved in reserve by the Social Security Administration (SSA). When you reach retirement age the money current workers are paying will go to pay your benefits. That amount of that benefit is based on a formula set up by the SSA. It is based partially on how long you worked about how much you paid in.

 

The problem

For the most part this has worked fairly well. Unfortunately, now the SSA is paying out more than the taxes it’s bringing in. Estimates vary, but at the current rate the SSA will use up all of its reserves in the 2030s. That means that if nothing changes benefits will have to be reduced after that date.

 

It’s not all bad

Over the years policies have changed. It’s pretty much guaranteed that policies will change again to make sure that Social Security still exists in the future. So even if you have decades until retirement age you will most like still receive benefits.

 

So what’s it worth?

So then the question is what is it worth? Well, when you calculate how much money you need to have saved to retire you look at how much you need per year. Then you figure out how much you’ll need to have in your retirement account to make you that much every year. For this example we’ll follow the 4% rule. The 4% rule says that you can safely withdraw 4% of your retirement account the first year. And maintain that same amount each year adjusting for inflation. So let’s say you need $40,000 per year to live off of. To figure out how much we need to retire to have $40,000 we divide the 40,000 by 0.04 (4%). 40,000/0.04 = 1,000,000. So to safely withdraw $40,000 each year you will need to have $1,000,000 in your retirement account to retire.

 

So how does Social Security play into this? Well, once you reach retirement age Social Security pays you. According to the SSA the average Social Security payment last year was $1,335 per month. That comes out to $16,020 for the year. So that means that since Social Security will cover $16,020 of your $40,000 you won’t have to actually save the entire $1,000,000. Using the 4% rule how much is that $16,020 worth? 16,020/0.04 = 400,500. The average Social Security retirement benefit of $16,020 per year is the same as having $400,500 in your retirement account. That’s nearly half of the amount that you need to save. That also means that the average worker in America has a retirement nest egg worth about $400,000 thanks to Social Security.

 

So what do you really need to save?

That means that if you want to live off of $40,000 per year in retirement, and you count on Social Security, you really only need 1,000,000-400,500 = $599,500. Social Security could be half of your retirement account.

 

A truth to remember

I don’t want to stop you from working to reach your maximum goal. Social Security is pretty reliable, but the government can change the program at any time. That means the benefit could be reduced, either through legislation or because it doesn’t have the funding. But don’t discount it completely.

 

Do you plan to use Social Security? How do you account for it in your retirement planning?