Waldean Wall for FA-mag.com writes: Retirement income planning is a complex process with many moving parts
and a lot of variables. Making educated assumptions is an important part
of retirement planning, and if advisors get it wrong, the error can get
compounded over decades.
Retirement planners are forced to forecast the future in a number of areas:
• The return on retirement assets.
• The cost of medical care.
• Housing costs.
• The rate of inflation.
• Life expectancy.
• Income taxes.
• General cost of living.
Incorporating these assumptions into the process can be problematic
because the rate of increase varies by spending categories. Yet,
assuming one rate of increase is often standard practice when planning
for retirement.
Perhaps a more effective approach would be to consider these expense
variables individually. This can help us more accurately consider
accumulation strategies and distribution strategies because our analysis
may be better aligned with a realistic outcome.
Longer life expectancies, for example, increase the pressure on
retirement assets. According to the U.S. Department of Health and Human
Services, a 65-year-old in 1950 could be expected to live to an average
age of 77 for males and 80 for females. In 2009, average lifespans for
65-year-olds had increased to 82 for males and 85 for females.
This increase in years spent in retirement means people need retirement
income for a longer drawdown period. A longer drawdown period can also
magnify mistakes in our assumptions. If we assume our income needs will
increase at 3 percent a year while they actually increase at 3.5 percent
per year, over 30 years the effect can be substantial.
To demonstrate, let’s take a separate look at three variables—general
living expenses (assuming a flat 3% inflation rate), the cost of health
care, and income taxes—and apply them to a husband and wife who are both
65 years old and hoping to retire within a year. Their only retirement
income sources are Social Security and traditional IRAs.
Separating the general living expenses
As they look forward to retirement, the couple has made a number of estimates of future expenses:
• Housing - $12,000 per year.
• Medical expenses - $12,000 per year (this includes Social Security
part B premiums, part D premiums, Medigap premiums, co-pays, dental,
vision, etc.).
• General living expenses - $59,597.
• Income taxes - $11,140.
They expect to receive $30,000 per year from Social Security and $64,737 from IRAs.
It’s important to note that, according to a report by the Employee
Benefit Research Institute (“Expenditure Patterns of Older Americans,
2001-2009,” by Sudipto Banerjee), some general living expenses, such as
food, transportation, and entertainment, could decrease over time or
increase at a slower rate than the general inflation assumption of 3
percent per year.
If general living expenses do grow at 3 percent, the cost would be
$140,445 in 30 years. If they grow at 2 percent per year, the cost in 30
years would be $105,835. The chart below outlines what it take to fund
these expenses.
If general living expenses increase 1 percent per year and their
investment return is 7 percent per year, it will take $875,000. If these
expenses increase at 3 percent per year and the retirement assets only
grow at 3 percent, they would need $1.79 million—a difference of
$915,000. This is a clear example of just how great the difference can
be when assumptions vary over 30 years.
Separating health care expenses
Rising health care expenses remain a significant concern for retirees.
Consider that health care costs have increased an average of 6 percent
per year since 2002 (“Budgeting for Healthcare in Retirement,” by David
Francis, U.S. News & World Report, May 23, 2012), which is
more than twice the general rate of inflation. Add to that the fact that
the annual cost of living increase in Social Security income benefits
is only 1.7 percent for 2013 and you can see how important it is to
carefully consider how heath care costs fit into your client’s larger
retirement plan.
If your client requires little medical care and the increasing cost of
this care is held in check, they may see somewhat controlled cost
escalation. If, however, you have a client that needs more medical care
and the costs in the overall medical system increase rapidly, they may
have a different outcome.
For this scenario, we’ll assume our hypothetical couple will spend
$12,000 a year on health care expenses at age 65. This includes
premiums, co-pays, deductibles, and any other medical costs they might
have. If their health care costs in retirement start at $12,000 a year
and increase at 5 percent a year, the couple would end up paying $49,394
in 29 years. If the assumption is for health care costs to increase at 6
percent, they would end up paying $65,021 in 29 years. Finally, if we
assume the health care costs increase at 3 percent per year, the annual
cost in 29 years would be $28,279. The chart below outlines what it take
to fund these expenses.
If the couple has a 3 percent increase in health care costs and their
investments make 7 percent a year, it will take $219,000 to fund 30
years of retirement. Conversely, if their expenses increase at 6 percent
a year and the retirement assets grow at 3 percent a year, they will
need $563,000—a difference of $344,000.
Separating income taxes
Variances in income taxes may be the most misunderstood. Unlike some of
the other expenses facing retirees, tax-rate adjustments ripple through
clients' finances and have a compounding effect. Tax-rate increases
escalate the need for more income to pay the increased taxes. This
additional income results in more taxes and further accelerates the
drawdown of retirement resources. Underestimated retirement costs can be
magnified because of the additional tax that must be paid on additional
IRA withdrawals.
Using the same hypothetical case study, the couple will pay $11,140 in
federal and state income taxes in the first year of retirement. This
means their income-tax rate in the first year of retirement is estimated
at 11.76 percent. Let’s look at three different scenarios to show the
effects of tax rate increases and how an increase in living expenses can
result in increased taxes.
The first scenario assumes that housing costs, health care costs and
general living expenses each increase at 3 percent a year and that the
tax rate does not increase. In this case, the couple will need $256,000
when they start retirement, growing at 5 percent per year, to pay those
taxes.
In the next scenario, the rate of increase remains the same for
housing, health care and general living expenses, but the tax rate
increases at 1.5 percent per year. That relatively small yearly increase
will mean the couple will need $325,000, growing at 5 percent per year,
when they start retirement to cover those taxes—an additional $69,000.
In the final scenario, housing and general living expenses increase at 3
percent per year, but health care expenses increase at 6 percent a year
and tax rates at 1.5 percent per year. Obviously, the couple will need
more money to pay the increased medical expenses—$351,000 versus
$256,000—but they will also need an additional $26,000 at retirement
just to pay the additional taxes on the additional health care costs.
This third scenario would require $377,000 when they start to cover
their costs.
Next steps
Clearly, there can be significant differences when a flat rate of
inflation is applied to retirement expenses versus the concept of
separating the retirement variables. It’s our job as financial
professionals to help our clients understand the importance of an
ongoing tax assessment. Many people on occasion have situations that
give them the opportunity to benefit from certain tax strategies. Some
of these considerations include Roth IRA contributions and conversions,
adjustments due to an anticipated tax bracket change in retirement, the
3.8-percent Medicare surtax and tax-deferred accumulation potential via a
nonqualified annuity.
Another choice that can have a significant impact on retirement is
failing to create a withdrawal strategy for retirement savings. You
should review this with your client from the perspective of
managing-the-tax-brackets and also noting potential issues with required
minimum distributions from a portfolio. Encourage your clients to see
their tax advisor for their personal situation.
Not thinking through the client’s specific situation can magnify the
errors created when using flat increase assumptions in retirement. This
is especially true for those retiring with modest living standards and
those that are only marginally ready. Real rates of inflation can vary
from age to age, family to family, and expense to expense. The further
into retirement we go, the more impact inappropriate assumptions can
have. It’s a good idea to fine tune our assumptions each year in order
to reflect the most accurate projections possible.
Tuesday, March 26, 2013
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