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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Saturday, May 15, 2010

A Quality Retirement Plan Depends on Many Factors

Note: The article was originally published in the Oakland Press back in the fall of 2008. We feel the information contained here is more important than ever for those planning to retire in the near future. We’ve modified the original article slightly.

At some point in everyone’s life, they begin to think seriously about retirement. We’ve written several articles on various aspects of retirement (past articles are on our website: www.pattersonadvisorsllc.com) but have yet to discuss some of the more technical factors that can impact the quality of your retirement planning.

Numerous websites have retirement calculators to help individuals determine whether they will have enough money in their senior years. Some of our clients who have used some of these tools have expressed a lack of confidence in the results, due to the high variability of results from one calculator to the next. Much of the variability is likely due to differences in the assumptions each tool uses. A small difference in tax rates, the assumed inflation rate or expected rate of return for investments can yield significantly different results.

Perhaps some of you may have read an article or two discussing a “rule of thumb” regarding 4% withdrawal rates. Basically the rule says that at the beginning of retirement you can take out 4% of your total portfolio balance (including both principle and earnings) in the first year, then the first year amount adjusted by inflation the following year, and so on. According to the rule, following this approach will result in your funds lasting 20 to 30 years through all types of economic cycles. How long your funds last depends on the percentage mix of stocks and bonds in your portfolio. Using this approach to plan for a retirement years down the road still requires making assumptions about inflation, taxes and rates of return. So while this “rule of thumb” approach seems easy to apply, it can still require some complex forecasting.

And what if four percent of your savings won’t meet your retirement needs? How do you know what to do to fix the problem? You could save more, work longer, plan to spend less in retirement or be more aggressive with your portfolio.

A number of financial planning software programs in the marketplace analyze one’s ability to retire by creating detailed cash flow projections until life expectancy. The resulting projections represent one scenario based on one set of assumptions. While most planners are careful to be conservative in the assumptions used, it is difficult to predict how a projection will hold up in the myriad of possible future scenarios. This type of retirement planning is limited, since it only gives you a black and white answer to whether or not you can afford to retire.

More sophisticated financial software programs are now available to planners. Instead of doing just detailed cash flow analysis, some software programs on the market now offer goal-based planning tied into full cash flow analysis at retirement. It provides planning for multiple financial goals and the ability to add, remove or reprioritize goals easily. These programs also offer an extensive offering of assumptions that can be changed so that multiple scenarios can be quickly analyzed with little effort. Rather than answering a cold-hard “Yes” or “No” to the proverbial retirement question, these programs are able to work with you to show what it takes to get to “yes”. They can even give you the confidence that you can afford to spend a bit more!

As an example of how such a software program might work, let’s suppose that besides achieving a comfortable retirement, you have the additional following goals, in order of priority:

1. Take a trip every year in retirement
2. Make a home improvement every three years
3. Buy a second home in South Carolina
4. Help fund your grandchildren’s education

An initial projection might indicate that you will not likely be able to afford three of your goals. After discussion with your financial planner you decide that it would not be a big problem to work another couple years (to save more in your 401k and increase your pension payment), take a smaller trip than you originally planned every other year, and only make home improvements every four years. With those changes, a new software projection indicates that you now have a very high probability that you will meet ALL of your goals! What was unworkable becomes workable with a few “reasonable” modifications!

What’s even more important is that these advanced software programs provide the ability to do what is called Monte Carlo analysis. Monte Carlo analysis shows the probability that your retirement plan will be successful using statistical data. It does this by running thousands of iterations of your plan while varying the investment returns year-by-year. Another useful feature that some programs have is the ability to do stress testing, which re-runs plan scenarios using variable year-by-year returns, to see the effects certain market scenarios have on the results.

The bottom line is that whatever approach you take in your retirement planning, it needs to be sophisticated enough to determine a high probability of a successful retirement and should also allow you to easily evaluate a variety of retirement scenarios. With the right financial advisor and the right tools, you can have the financial peace of mind for every retirement decision you need to make.

1 Comments:

Anonymous Equity release mortgage said...

Those individuals that do not prepare for their retirement investments while working find it hard to survive without job. They tend to look for another work even if they are retired just to meet their needs.

June 30, 2010 at 10:12 AM 

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