The New Reality of Retirement

“Retirement” is different now than it was for previous generations. Retirees used to be able to count on a solid pension, full healthcare benefits for them and their families, and relatively subdued inflation. Unfortunately, that is no longer the case. Companies are cutting back significantly on pension benefits, individual health care costs are skyrocketing, and some even fear a return of the 80’s hyper-inflation environment.

As a result, people are retiring much later in life (either by choice or not), and a significant percentage of the work force are working well into their “retirement” in order to maintain their standard of living. As a matter of fact, a recent survey conducted by Employee Benefit Research Institute and Matthew Greenwald & Associates shows that almost 70% of employed Americans expect to continue to work some amount during retirement.

In addition to dealing with the potential issues such as lack of pension, high cost of health care, and inflation, retirees are also living much longer than ever before. A study shows that if you are 65 today and married, there is a 91% chance that either you or your spouse will live to be 80 years old, and there is a 52% chance that one of you will live to see your 90th birthday (source: Society of Actuaries).

With the prolonged life expectancy comes the challenge of finding affordable health care options. Data indicate that only 27% of retirees are fortunate enough to have access to employer medical coverage, while the rest have to count on Medicare or Medicaid. For the 73% who retire without employer medical coverage, a recent study shows that it will cost approximately $200,000 in savings to fund out-of-pocket health care costs during retirement (Source: Employer Benefit Research Institute, Issue Brief No. 351, December 2010).

So how does one plan for the new reality of retirement?

The single most important decision individuals can make about retirement is to take responsibility for funding it themselves. Living costs, health care expenses, social security, pensions, and future employment income are all uncertain. But saving today is one concrete way to prepare for a more predictable retirement.

The question for most retirees is, what percentage of one’s own retirement should he or she be prepared to fund? You may have heard Financial Planners refer to the “3-legged stool” retirement income model. The 3-legged stool is a terminology used to describe the three most common, and somewhat equal, sources of retirement income — social security, employee pension, and personal savings. However, this income model is no longer the reality. For today’s retirees, diversifying their sources of income is as important as diversifying their investments.

According to a recent study, a typical retiree today will have 5 sources of income – social security (42%), pension/annuities (14%), personal savings (20%), work/earnings (20%), and other (rental, family support, etc). As the statistics suggest, retirees now have to fund close to 50% of their own retirement income through a combination of drawing down their personal assets and/or working in retirement.

It goes without saying that the sooner one starts planning for retirement the better. As a matter of fact, delaying your saving plan by as little as 5 years can have a significant impact on the end result. To illustrate the point, let’s take a look at several different scenarios.

As you can see, Susan is able to accumulate a significant nest egg of almost $850,000 by investing a total of only $50,000 between the age of 25 and 35 and let it accumulate. Bill, on the other hand, who delayed his saving plans by 10 years, has to invest significantly more ($150,000 total), and invest over a much longer period of time than Susan (30 years vs. 10 years), and still end up with a much smaller nest egg. Chris, the most diligent saver of the three, started early at age 25 and continued until his retirement age of 65. His consistency allowed him to accumulate a sizable nest egg of about $1.5 million.

Now that we have demonstrated the importance of saving, let’s talk a bit about spending. As most Financial Planners would attest, determining one’s spending needs in retirement is a complex exercise because there are numerous “unknowns”. One often has to make an assumption about not only life expectancy, but also tax rates, inflation, investment return, as well as other unforeseen costs.

As a rule of thumb, assuming a typical market return, a $500,000 portfolio consisting of 60% equities and 40% bonds can historically sustain a withdrawal rate of approximately 4% for well over 30 years, even in the worst historical time periods for investing. However, if a retiree ratchets up the withdrawal rate even by just 2 percent per year, the portfolio can now potentially only last about 21 years. The situation is even more dire if you happen to retire at the beginning of a cyclical bear market (see chart).

As we stated earlier, the only way for modern day retirees to ensure a comfortable retirement is to take responsibility for funding it themselves. With proper planning and sensible investing, it is still possible to enjoy your golden years. Remember, saving today is one concrete way to prepare for a more secure retirement.