Retirement Income Planning

Can We Still Plan to Retire at a Specific Age?

Not too long ago it was common for pre-retirees to depend on two sources of retirement income: Social Security and a private or public pension. Both began at age 65, were expected to last for life, and typically met 50% or more of retirees’ financial needs.

With two secure sources of lifetime income, age 65 was the standard retirement age for many years. Retirement income planning focused on closing or narrowing the gap between one’s projected retirement income needs and what would be provided by Social Security and pension income.

Retirement Planning Milestone

The decline of defined benefit pension plans over the past 30 years eliminated one source of dependable lifetime income for most retirees. The replacement of these plans with 401(k) defined contribution plans was a milestone in the retirement planning world since it transferred the responsibility for funding retirement from employers to employees.

Retirement income planning has dramatically increased in importance in recent years as employees have realized that it isn’t easy to (a) accumulate sufficient assets in 401(k) plans to generate adequate retirement income and (b) convert 401(k) plan assets into sustainable lifetime income streams beginning at a specified age.

The shift from employer defined benefit to employee defined contribution retirement plans, combined with longer life expectancies, has made it much more challenging to plan for retirement at a specific age. While it’s definitely possible, it requires a different mindset and the assistance of an experienced retirement income planning professional to increase one’s opportunity for success.

Retirement Income Plan is Essential

As part of the change in mindset, it’s important to understand and recognize that a retirement income plan is an essential tool for helping individuals close or reduce the gap between projected retirement income needs and what will be provided by one source of sustainable lifetime income in many cases, i.e., Social Security. Unlike other types of financial plans, a retirement income plan typically isn’t a “one-and-done” exercise.

A successful retirement income plan generally requires an ongoing disciplined, systematic, approach beginning at least 20 years prior to retirement and continuing for the duration of retirement. The purpose of such a plan should be to make sure that sufficient assets will be saved at specified times using tax-advantaged investment and protection strategies that will increase the likelihood of providing adequate and reliable after-tax income to cover one’s planned and unplanned expenses beginning at a specified age for the duration of retirement.

With the shift from employer to employee retirement funding, can we still plan to retire at a specific age? I believe that it’s possible provided that we understand (a) the burden for making this a reality has shifted from employers to employees, (b) a retirement income plan beginning at least 20 years prior to retirement in most situations is essential, and (c) a lifetime commitment is required to monitor and update the plan in order to reduce the risk of outliving one’s assets.

Annuities Fixed Index Annuities Retirement Income Planning

No Pension? Create Your Own

Last week’s post, A Retirement Paycheck is Essential, emphasized that it’s imperative for each and every one of us to have a retirement income plan. The cornerstone of a retirement income plan is a retirement paycheck. Specifically, we need to know that when we stop working, we will receive a predetermined monthly payment for the rest of our life, and, if married, our spouse’s life. Furthermore, this monthly payment needs to be in addition to whatever Social Security benefits we may receive.

Given the fact that the majority of us won’t receive a pension from an employer’s defined benefit plan that our parents’ generation took for granted (see the November 21, 2011 post, Where Have All the Pensions Gone?), it’s incumbent upon us to create our own retirement paycheck. This isn’t an task and generally requires the assistance of an experienced retirement income planner.

As pointed out in the Where Have All the Pensions Gone? Post, the nature of many investment vehicles don’t lend themselves to plan for a predictable known future lifetime or joint lifetime stream of income. This is true, for example, whether you’re talking about a savings account, CD, bond, stock, mutual fund, or exchange traded fund.

Fortunately, there exists a long-standing, reliable, conservative investment solution that’s specifically designed to provide us with a predetermined monthly payment for the rest of our life. The payment will be made without interruption, no matter how the stock market is performing. This investment solution is commonly known as a fixed income annuity and is offered exclusively by life insurance companies.

Unlike a traditional defined benefit pension plan that pays a defined stream of income that generally doesn’t change beginning at retirement age and ending at death, a fixed income annuity strategy can be quite flexible. There are several types of fixed income annuities that can be used to customize a retirement income plan that dovetails with one’s retirement income needs. This entails both timing and amount of payment, including adjustment for inflation.

There are two broad classes of fixed income annuities that are distinguished by the timing of the commencement of the initial income payment: (a) single premium immediate and (b) deferred. A feature shared by both types of annuities is “annuitization,” or the conversion of an annuity to an irrevocable structured payment plan with a specified payout by a life insurance company to an individual(s) or “annuitant(s)” over a specified period of time through different lifetime and term certain options offered by the insurance company.

Single premium immediate annuities, or “SPIAs,” make periodic payments, typically monthly, for a specified number of months or for an individual’s lifetime or joint lifetimes as applicable. The payments generally begin one month after purchase of a SPIA, hence the name “immediate.”

The second broad class of fixed income annuities, deferred income annuities, or “DIAs,” although they play an important role in a retirement income plan, aren’t as prevalent in the marketplace as SPIAs. Like SPIAs, DIAs pay periodic income for a specified period of time or over one’s lifetime or joint lifetimes as applicable. Unlike SPIAs, the start date of the payments for DIAs is deferred for at least 13 months from the date of investment.

SPIAs and DIAs can be used alone or in combination to create a retirement paycheck. In addition, a rider, or endorsement, can be added to a fixed index annuity to generate a retirement paycheck. This retirement income planning strategy, which is striking a chord with more and more people the last few years, will be introduced in next week’s post.

Social Security

Your Social Security Retirement Asset – Part 3 of 3

Part 1 of this post made the point that Social Security is a retirement asset, specifically, an annuity. Part 2 took this concept one step further and stated that, similar to a commercial annuity contract that has been annuitized, the value of the future payment stream can be calculated and included on every qualified Social Security recipientTM‘s personal financial statements. The question is, who is a qualified Social Security recipientTM?

There are two types of qualified Social Security recipientsTM when it comes to Social Security retirement benefits: (1) current recipients and (2) future recipients who are vested in their benefits.

Current Recipients

Although as stated in Part 2, the valuation of Social Security benefits as an asset isn’t straightforward, it’s easiest to do for current recipients. These individuals are currently receiving a defined monthly payment. What isn’t known and must be determined is (1) the number of payments that will be received going forward, i.e., life expectancy, (2) projected Social Security cost of living adjustments (“COLA’s”), and (3) an assumed interest rate. In the case of a married couple where one spouse currently receives or will receive 50% of the other spouse’s benefit, the 50% spouse’s life expectancy must also be determined.

Future Recipients Vested in Their Benefits

For those of you who participate, or who have participated, in defined benefit pension plans, you’re familiar with the concept of vesting. Simply stated, vesting as it pertains to pension plans, is the non-forfeitable right to receive a defined benefit based on one’s salary and the number of years of service performed by an employee. How do you vest, or qualify, for Social Security retirement benefits? Assuming that you were born after 1928, you need 40 quarters, or 10 years of work and associated payment of Social Security taxes.

Once you hit the 10-year mark, you become vested in Social Security. At this point, although it isn’t likely to be your actual starting benefit, an estimated retirement benefit can be calculated based on your earnings to date. Each year, the Social Security Administration mails statements to all American workers age 25 or older who aren’t yet receiving Social Security benefits approximately three months before their birthday. Each statement includes an estimated retirement benefit for three different retirement ages: (1) age 62, (2) full retirement age, or “FRA,” which varies from age 65 to 67 depending upon when you were born, and (3) age 70.

In addition to the age at which you start receiving benefits, your actual benefit payment will be based on the 35 years in which you earned the most. The closer you are to age 62, the more likely the benefit on your Social Security statement will approximate your actual starting benefit. Whether you’re 30 or 60 years old, assuming you’ve worked for 10 years and paid Social Security taxes, a defined benefit is determinable and readily available.

While your actual benefit is likely to be much greater than what is shown on your statement if you’re 30 years old assuming that you will continue to work for several years, in my opinion, this is the figure that should be used to calculate the current value of your Social Security benefits for inclusion as an asset on your personal financial statement. Future salary increases, although likely, should be ignored for purposes of this calculation. A basic principle that is used in the preparation of any financial statement, whether it be for business or personal purposes, is conservatism. Since there’s a possibility, although not likely, that even if you’re 30 years old, your current estimated Social Security benefit will be your actual starting benefit, this amount should be used since it’s known and non-forfeitable pending future potential changes to the Social Security system, itself.

The calculation of the value of Social Security benefits for a future recipient vested in his/her benefit is more complicated than for a current recipient. In addition to the three variables listed above for current recipients that must be determined to calculate the value of Social Security benefits, future recipients must also project their retirement age. This is used for to calculate two values: (1) the projected value of retirement benefits at retirement age and (2) the current value of #1.

Whether you’re a current or future recipient vested in your benefit, the calculation of the current value of your Social Security retirement benefits is referred to as determining its “present value.” Present value, as defined by Wikipedia, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk. While the calculation of present value of Social Security benefits is complicated, it can and should be done for every qualified Social Security recipientTM with the resulting value included as an asset on the individual’s personal financial statements.