Having recently passed another birthday milestone, I realize that I am closer to the end of my working life than the beginning. As both I and the other members of the baby boom generation consider retirement on the horizon, it is wise to scrutinize some of our expectations to determine how they will impact us.
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Investors moving toward retirement are focusing on replacing earned income with investment income. Consequently, we move toward reliability of income as our primary focus, and less emphasis is placed on return on investment. Income planning calculations factor in the amount of investible assets at retirement, life expectancy, rate of return and inflation. Let’s look at these variables.
The Society of Actuaries annuity 2000 mortality table estimates that there is a 33 percent chance that one partner in a marriage at age 65 will live to be at least 95. Life expectancies for both men and women are getting longer, thanks to rising standards of living and new medical technologies. A study by the same Society of Actuaries found that a majority of pre-retirees underestimate their life expectancy. Expect to live longer — a realistic life expectation assumption is critical to accurate retirement planning calculations.
Fortunately for consumers, inflation has remained low over the past several years, and forecasted rates of inflation for the remainder of the year are benign. However, since 1970, inflation has averaged 4.9 percent. For those preparing for retirement, it is reasonable to expect inflation to rise during your retirement years and is a prudent approach to retirement planning. So how does this affect a retiree? Suppose you have recently retired and invest 1 million in bonds that earn 5 percent. You withdraw the $50,000 in income the first year and increase your withdrawal each year for an assumed inflation rate of 3 percent. You will run out of money in 25 years. Under the same scenario, if inflation increased to 5 percent, you would run out of money in 20 years. Remember, we are living longer and inflation has averaged 4.9 percent since 1970.
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The answer to this problem for many retirees has been to own equities to provide a growth component to their portfolio. The market environment during 2000-02 has vividly shown many of us the risks that can occur while holding equities. A trap that many can fall into is to assume a distribution rate that is too high relative to the historical returns of equities. For many of us, our investing experience is colored by the decade of the ’90s, where, according to Ibbotson Associates, large company stocks averaged an 18.2 percent return. If we broaden our perspective, however, from 1926-2002, the average annual return for large company stocks was 7.3 percent. Obviously, a realistic expectation of return on the equity component of your investment portfolio is essential to maintaining a healthy portfolio in retirement.
For most of us, retirement is a crucial juncture in our financial life. Establishing realistic expectations about our life expectancy, inflation and rates of return will help to eliminate unwelcome surprises in our retirement years. If retirement is imminent, get professional advice as to a realistic expectation of the income your retirement assets can generate. If you are already retired, get periodic updates from your financial adviser. Sound financial planning will help make the retirement years more comfortable for you.