1. 1 Retirement Planning Financial Planners Chapter 2: Introduction to Retirement Funding

2. 2 Factors Affecting Retirement Planning  Remaining Work Life Expectancy (RWLE)  Retirement Life Expectancy (RLE)  Savings  Annual Income Needs  Wage Replacement Ratio (WRR)  Inflation  Retirement Income Sources  Investment Returns  Qualitative Factors

3. 3 Work Life Expectancy (WLE)  The period of time a person is expected to be in the work force.  Period during which one saves and accumulates for retirement.  Generally 30-40 years, but has been decreasing due to advanced education and early retirement.

4. 4 Remaining Work Life Expectancy (RWLE)  Work period that remains at a given point in time before retirement.  The number of years a client has to save for retirement.  93% of people retire between ages 62 and 65.

5. 5 Retirement Life Expectancy (RLE)  Time period beginning at retirement and ending at death.  Time period planned for by the financial planner and the retiree during the work life.

6. 6 WLE and RLE Relationship  Move inversely with each other: As WLE increases, RLE decreases. As RLE increases, WLE decreases. As WLE decreases, RLE increases. As RLE decreases, WLE increases.  A change in one variable could create additional funding needs, or decrease funding needs.

7. 7 Savings and Investment Issues  Savings Issues Savings Amount Savings Rate Timing of Savings  Too little, too late?  Investment Issues Asset Classes  Rates of return?  Exhibit 2.11 on Page 28 Inflation Risk Tolerance  Lake Tahoe or Lake Mattoon?

8. 8 Savings Amount  An individual should begin saving early (Exhibit 2.6 on page 23) Age Beginning Regular and Recurring Savings Savings as a percentage of gross pay 25-3510-13% 35-4513-20% 45-5520-40%

9. 9 Savings Rate  The average savings amount based on consumption.  In 2010, personal savings rate increased to 6% from 1% in 2005  Recall that even at the age of 25, an individual should be saving at least 10%.

10. 10 Timing of Savings  Earlier: more compounding.  Later: you will never catch up.  Assumption: Returns don’t vary from mean

11. 11 Investment Decisions  Asset Class Selection Varying Risks/Returns  Factors Age Risk Tolerance  See Exhibit 2.11 on page 28  Inflation Loss of purchasing power See Exhibit 2.12 on page 31

12. 12 Retirement Needs Analysis  How much income/money does an individual need during his retirement? Increased Needs  Health Care  Travel Decreased Needs  Mortgage eliminated…interest only mortgages???  Payroll/Social Security Taxes  Need to save  Work-related expenses (dry-cleaning, parking, lunches)

13. 13 Wage Replacement Ratio (WRR)  Estimate of the percentage of an individual’s income earned prior to retirement needed during retirement.  Methods of Calculating Top-Down Approach  Uses percentages and common sense.  “Best guess” when not close to retirement Bottom-Up (Budgeting) Approach  Determines which preretirement expenses are needed during retirement.  More accurate when close to retirement

14. 14 Sources of Retirement Income  Social Security  Company-Sponsored Retirement Plans  Personal Retirement Plans IRAs, Roth IRAs  Personal Savings Taxable Savings Accounts  Continued Employment

15. 15 Qualitative Factors in Retirement  Involuntary vs. Voluntary Retirement  Emotional and Psychological Factors Loss of esteem from job Boredom  Relocation Decisions  Travel

16. 16 Risks to Financial Independence (1 of 2) FactorRiskMitigator WLE Untimely death, disability, unemployment Insurance, education, training RLELengthened Adequate Capital Accumulation Savings Rate, Amount, Timing Too low and too late Save enough, start early Inflation Greater than expected Conservatively estimate inflation and needs

17. 17 Risks to Financial Independence (2 of 2) FactorRiskMitigator Retirement Needs UnderestimatedUse WRR Investment Returns Inadequate to create necessary capital Investment diversification and proper asset allocation Sources of Retirement Income Overestimation of Social Security, pension plans, or personal income Use conservative estimates and monitor projections and plans

18. 18 Capital Needs Analysis  The process of calculating the amount of investment capital needed at retirement.  Calculation methods Annuity Method Capital Preservation Model Purchasing Power Preservation Model  Utilizes many estimates. Increases risk of error.

19. 19 Annuity Method  Calculate WRR. Top-down/Budgeting Approach  Determine gross dollar needs.  Determine net dollar needs. Reduce gross needs by expected Social Security.  Inflate net dollar needs by CPI rate to retirement age.  Calculate capital needed at retirement age. Present value of the annuity due of preretirement dollar needs. What rate of return for investments?  See Example 2.7 on pages 47-49.

20. 20 Capital Preservation Model  Maintains the original capital balance needed at retirement for the entire retirement life expectancy.  See Example 2.6 on pages 37-38.

21. 21 Capital And Purchasing Power Preservation Models  Maintain the purchasing power of the original capital balance at retirement for the entire retirement life expectancy.  See Examples 2.8 and 2.9.

22. 22 To Reduce Estimate Risk  Sensitivity Analysis Changing variable assumptions to determine the effects to the retirement plan. Which variables matter  Example on page 43: inflation.

23. 23 To Reduce Estimate Risk  Monte Carlo Analysis Mathematical tool used to illustrate the unpredictability of the real world and its effects on an individual’s retirement plan.  Returns vary from median  What is likelihood plan will fail: outlive money? Sustainable withdrawal rate: 4%  Better to use historical patterns rather than random returns?

24. 24 Sustainable Withdrawal Rate  If I retire with $1 million in retirement savings, how much can I spend each year? Do you want spending to increase each year with inflation?  If withdrawals need to grow over retirement life expectancy, portfolio will be subject to volatility  Timing of volatility (negative returns) has huge impact on withdrawal rate  Amount of inflation also has significant impact  Research: historically 4% but may be high in low return environment