accumulation – Retirement Income Center

Last week, in Retirement Planning Risks, I discussed six risks associated with retirement planning in general. In order to understand and appreciate the value and importance of retirement income planning and its associated strategies, let’s take a closer look at retirement asset planning.

As was presented in The Retirement Planning Paradigm Shift – Part 2, the focus of retirement asset planning is on the accumulation and “spending down” of one’s assets. The accumulation phase is common to various financial planning areas, not just retirement, including house purchase planning and education planning, to name a couple. With most types of planning, you’re typically designing a plan for the purpose of accumulating funds for either (1) a single expenditure at some specified, or target, date, in the future, e.g., a down payment on a house, or (2) a series of expenditures for a limited and specified series of target dates, e.g., a four-year college education.

With all types of financial planning, there are two major stages: (1) design, and (2) funding, or plan implementation. Similar to an architect, a financial planner, after consultation with his/her client(s), designs a financial blueprint, or plan, for achieving a particular goal, or series of goals. Assuming that the client approves the recommendations, the plan is generally funded with a single lump sum or a series of payments over a specified period of time, depending on the plan’s goals, the client’s current and projected resources, and various other factors.

With most types of financial planning, when you reach the plan’s target date, you immediately, or over a limited number of years, e.g., four in the case of college education, see the results of your plan. What distinguishes retirement asset planning from other types of planning and adds to the complexity of the plan design and funding strategy is the “spend-down” phase.

Unique to retirement asset planning, the timeframe of the “spend-down” phase is undefined. It can last for less than a year and, although it is unlikely, it can go on for as many as 60 years, depending upon when it starts and a host of many variables.

Unlike most types of financial planning where you get to see the results of your plan after reaching a specified target date, this is not the case with retirement asset planning. As a result of all of the risks discussed in last week’s post, there’s an inherent uncertainty associated with retirement asset planning. Even if you’ve done an excellent job of accumulating what appear to be sufficient assets for retirement, you generally won’t know if this is true for many years.

While retirement asset planning can provide a solid foundation for a successful retirement plan, unless it is accompanied by a customized retirement income plan at the appropriate stage in your life, there is a higher likelihood that your retirement income will fall short of your needs and that the plan, itself, may not succeed.

Before I write about the specific risks associated with retirement asset planning and the strategies that retirement income planners use to address, and, in many cases, mitigate, these risks, let’s take a look at risks that are common to all retirement planning. While many of these are uncertain and/or uncontrollable, each of them needs to be addressed in a retirement plan.

The risks that will be discussed are as follows, with the first three common to all types of financial planning, and each one intended to be a brief introduction vs. a comprehensive discussion:

Inflation
Investment
Income tax
Longevity
Health
Social Security benefits reduction

Inflation

Although it is unpredictable as to amount and fluctuation as it pertains to individual and overall variable expenses, a key risk that must be considered in the design and funding stages of all retirement plans is inflation. Unlike most types of financial planning where it is a factor only in the accumulation phase, inflation is equally, if not more important, during the withdrawal stage of retirement planning. The longer the time period, the more magnified are the differences between projected vs. actual inflation rates insofar as their potential influence on the ultimate success of a particular retirement plan.

Investment

Unless you are living solely off of Social Security or some other government benefit program, you are directly or indirectly exposed to investment risk. Even if you are receiving a fixed monthly benefit from a former employer, although it isn’t likely, your benefit could potentially be reduced depending upon the investment performance of your former employer’s retirement plan assets and underlying plan guarantees. Whenever possible, investment risk should be maintained at a level in your portfolio that is projected to sustain your assets over your lifetime while achieving your retirement planning goals, assuming that your goals are realistic.

Income Tax

Even if income tax rates don’t change significantly as has been the case in recent years, income tax can consume a sizeable portion of one’s income without proper planning. With the exception of seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) that have no personal income tax and two states (New Hampshire and Tennessee) that tax only interest and dividend income), the rest of us need to be concerned about, and plan for, state, as well as, federal income tax. In addition, if you have a sizeable income, it is likely that income tax legislation will be enacted that will adversely affect your retirement plan on at least one occasion during your retirement years.

Longevity

Unlike other types of financial planning, the time period of retirement planning is uncertain. Although life expectancies are often used as a guide to project the duration of a retirement plan, no one knows how long someone will live. The risk associated with the possibility of outliving one’s assets is referred to as longevity risk. In addition, life expectancies, themselves, are changing from time to time. The August 19, 2009 edition of National Vital Statistic Reports http://bit.ly/pAgRk announced a new high of nearly 78 years for Americans. Planning is further complicated for married individuals since you are planning for multiple lives.

Health

An extremely important risk that is sometimes overlooked or not given enough consideration in the design of retirement plans is health. Under-, or uninsured, long-term care events as well as premature death in the case of a married couple, can deal a devastating blow to an otherwise well-designed retirement plan. It is not unusual for a prolonged long-term care situation, such as Alzheimer’s, if not properly planned for, to consume all of one’s retirement capital and other assets. Inadequate life insurance to cover the needs of a surviving spouse can result in dramatic lifestyle changes upon the first spouse’s death.

Social Security Benefits Reduction

Once considered to be unshakable, the security of the Social Security system, including the potential amount of one’s benefits, is questionable. In addition, it was announced in May that for the first time in more than three decades Social Security recipients will not receive a cost of living adjustment, or COLA, increase in their benefits next year. While beneficiaries have received an automatic increase every year since 1975, including an increase of 5.8% in 2009 and a 14.3% increase in 1980, this will not be the case in 2010.

Each of the foregoing six risks needs to be considered, and appropriate strategies developed, in the design and implementation of every retirement plan to improve the chances of success of the plan.