One of the more important concerns for investors is planning for the accumulation of wealth to support retirement. In some cases, investors may have little control over pension investments while accumulating funds; in others, individuals may directly control the funds during the accumulation phase.
In this article, we focus on estimating the amount of funds that will be available after retirement, taking into account self-directed funds (IRAs and Keoghs), company pension plans, Social Security payments and the effects of future inflation.
As input, the spreadsheet requires only a small amount of information. You must determine the current value of your retirement portfolio or your expected monthly annuity, the amount of Social Security for which you are eligible, and the current market value of any other funds you will have for generating retirement income.
This spreadsheet is designed to take advantage of readily available information. It is not meant to be a complete financial planning worksheet. It is designed to provide the basic information needed to estimate whether you will have an adequate source of funds for retirement. From that base you can determine how to acquire those funds.
One of the most important things to remember, and one of the easiest to ignore, is the effect of compounding on savings value. The sooner you start saving for your retirement, the more those funds accumulate and compound over time. At 6% annual interest, a dollar saved 40 years before retirement is worth more than three times as much as a dollar saved 20 years before retirement and six times as much as a dollar saved 10 years before retirement. Table 1 shows the impact of compounding at different rates for different periods of time.
As this table shows, it becomes more and more difficult for an investor to accumulate funds the longer he waits to start. With only a short time before retirement, it may be tempting to take high-risk investments to earn a higher rate of return. The problem with this strategy is that the high-risk investments may not pay off. The greater the risk involved, the longer the period of time it takes to recover from an investment casualty. This is the principle of "time diversification," allowing a longer period of time to average out short-term variability in returns.
As an example, the S&P 500 has offered an annually compounded return of 10% per year since 1926, while T-bills have only offered a 3.5% annual return. Although the premium in return on stocks has been substantial, the year-by-year data shows that the minimum period necessary to guarantee that stocks would earn at least as much as Treasury bills is 18 years. In other words, even though common stocks have offered substantial rewards to investors, it can take a long time to be reasonably sure of actually earning more from stocks than by simply rolling over your investments in Treasuries.
Sources of Retirement Income
Most individuals will have retirement income from a number of sources. The most obvious of these are Social Security; any company-sponsored pension plan; individual tax-deferred retirement savings from 401(k) plans, ESOPs, profit-sharing plans, IRAs and Keoghs; and direct individual savings and investments. Not as obvious, perhaps, are funds generated from the sale of a principal residence (if you no longer need the five bedroom home that was necessary when children were around) or income from paid-up insurance.
For many individuals, especially those who are relatively young now, Social Security is not likely to provide a significant portion of retirement income. People who are retired now can get up to $11,712 a year in today's dollars in Social Security payments. These payments are adjusted periodically for changes in the cost of living. However, the baby boomers are funding these benefits through their Social Security taxes. When the baby boomers reach retirement, there will likely be a lot fewer workers paying Social Security taxes. The number of workers depends on future demographic trends, but for those retiring early in the next century, rent trends are not encouraging.
The status of future Social Security benefits will be the result of the political process, and that could be nearly anything. One possible scenario is that benefits are reduced more and more as retirees have other sources of retirement income. A conservative way for younger investors to deal with this potential problem is to simply factor in nothing for Social Security benefits in the worksheet. The only worse scenario is for retirees to not only get no Social Security benefits if they have other sources of retirement income, but to also have to pay Social Security taxes on that other income!
Other than Social Security, most individuals will rely on a company-sponsored pension plan for the bulk of their retirement income. These plans vary considerably. Some are vested immediately (which means that you have an immediate claim on those funds); by law, all such plans must be fully vested in five years. Vested pension money is yours, but generally you will only be able to claim the funds at retirement. In addition, some pension funds are "portable," which means that they will transfer with you if you change jobs. Typically, corporate pension plans are not portable; this feature is generally available only for workers in not-for-profit enterprises.
Many corporations sponsor other forms of retirement savings plans, some of which may be tax-deferred. In addition, some companies may match employees' contributions to these plans. These tax-deferred plans are usually known as 401 (k) plans, named after the section of the Internal Revenue Code that authorized them. As a general guideline, money invested in a tax-deferred plan is worth more than other savings because you do not have to pay taxes on that income currently. This rule of thumb, however, must not be treated cavalierly. If you can earn substantially higher rates of return on other investments that are not tax-deferred, then those higher returns can offset the benefits of deferring taxes. This becomes especially true when you get close to retirement, since the present value of the tax savings decreases. In other words, if it is getting very close to the time when you will be drawing retirement income from tax-deferred sources, then the value of tax deferment is reduced. Finally, most of this retirement income will be taxed in some form or other, depending in part on how much other income you have.
Other Factors in Retirement Planning
Once you have anticipated your financial needs and made some plans to provide for those needs, you can begin asking what could happen to ruin your plans. This is an area in which spreadsheets shine, since the problem invites examining different scenarios. There are many factors you could explore, but there are three variables we will focus on here--the number of years you will need to rely on the accumulated funds after retirement, the rate of return you can earn both pre- and post-retirement, and the rate of change in purchasing power over time. To deal with each of these issues, we will set up different data tables.
One of the more important issues is the erosion of investment value through inflation. While many investments are touted as "inflation hedges," that is a much abused term. Usually, an upsurge in the rate of inflation will initially cause the values of real assets to increase, while the values of financial assets decrease as rates of return go up to compensate for the increased inflation. Eventually, however, the increased returns on financial assets should translate into higher values. For equities, as companies increase prices, revenue growth and cost containment measures will eventually (hopefully) lead to increased profitability and dividends. Ultimately this should lead to increased stock values. For debt securities, increases in market returns will cause newly issued debt to be offered at higher initial interest rates. Older debt, issued at lower coupon rates of interest, will not recover in price until inflation decreases and interest rates drop. If rates do eventually drop, however, debt at the higher interest rates will increase substantially in price, especially long-term debt.
The impact of inflation on your retirement planning is not limited to its impact on your spending power. Inflation has a real impact on your asset allocation and on your ability to generate the necessary funds for retirement. Many financial planners would be comfortable with the assumption that the real return (the actual return minus the decrease in purchasing power) offered by different classes of investments remains constant. With your spreadsheet, however, you can examine other possibilities. This is essential, since it may be many years before financial markets "return to normal."
The period of time from the late 1960s (starting about 1968) through 1982 is illustrative in this regard. This period was marked by high inflation, external economic shocks like the oil embargo and the consequent increase in oil and other energy costs, and by internal economic shocks caused by trying to fight a major war as well as substantially increase spending for social programs. While all this was occurring, the Fed was trying to maintain economic growth, and the result was high inflation, stagnating stock prices and very high interest rates. It was not until 1982 that interest rates started to drop significantly and stock prices recovered. Thus, we experienced a 14 year period in which "normal" was not normal, so planning based on normal considerations would not work.
The spreadsheet will not allow you to predict when such periods are about to occur; it will, however, allow you to examine the impact of inflation on your retirement portfolio.
The Effect of Time on Retirement Income
While most investors are aware that longer lives mean a greater need for retirement planning, there are many factors that will affect this need. With most pension plans, there are a number of options you can choose for your retirement payout. Some involve a commitment to provide income to yourself, others have a commitment to provide income to your spouse, still others may have a minimum numbers of years of payout guaranteed. While individual family circumstances will have a significant impact on your choices, you should examine what you are giving up for the extra security involved with a guarantee or alternative payout methods.
There are at least two factors involved here. First, any kind of guarantee or minimum payout increases the actuarial risk of the company, and therefore lowers the dollar payout to you. In addition, though, you must weigh the potential return you could earn if you chose the higher payout option. If invested wisely, this could more than compensate for the guarantee. It is necessary, however, that the excess payments be invested. Second, in all of these scenarios you must consider the likelihood of living longer (or shorter) than the actuarial average.
You must be especially careful when dealing with the income generated by your own investment portfolio. Remember that the way present value formulations work, once you specify a period of time for the income stream, it is exhausted when that period expires. That is, the income stream depletes not only interest income, but principal as well. If you want to live solely on the income generated by your portfolio, your cash flow will be less. The income provided by pension plans is structured differently, so the income stream remains constant. The difficulty with fixed pensions, though, is that inflation can destroy their purchasing power quickly. The only way of making up this difference is through your own investment portfolio. (OK, Social Security payments are currently still being adjusted for inflation. But a wise investor will realize that Social Security is a relatively small part of the retirement income.)
Setting Up the Spreadsheet
You must enter the current date (cell C2), your date of birth (E5), anticipated retirement age (E6), current income level (E9), and an anticipated annual percentage raise (E10). Headings for cells with calculated data are shown in regular type. The spreadsheet determines your current age and years until retirement, estimates the income anticipated when you reach retirement, and from that estimates your necessary retirement income. The estimated retirement income is assumed to be 70% of your pre-retirement income, a standard rule of thumb, but you can modify that percentage (cell E14).
Once this information is entered, you must enter the anticipated level of benefits from Social Security (in today's dollars) in cell E17, the inflation rate at which Social Security benefits will increase (E18), and your company pension benefits (E37) . The anticipated Social Security benefits shown in cell E36 are determined by compounding the current benefits (E17) at the long-term rate of inflation (E18). As an alternative, you could just use the current level of benefits (by entering a zero rate of inflation in cell E18), or even enter a zero amount into cell E17. Either alternative would give a more conservative estimate of future retirement income. Finally, you must enter the current value of your personal retirement savings portfolio (E24), and the number of years you will need retirement income (E20). The spreadsheet then determines if there is any discrepancy between your estimated retirement needs and your available income sources. Any discrepancy is indicated.
At this point you must indicate what you expect to be able to earn on your investment portfolio (E25). The spreadsheet then determines what (if any) additional capital you need to add to your savings each month until retirement. This is based upon the values you entered in cell E32 for your post-retirement rate of return (we used 6% as a reasonable low-risk return) and the number of years you expect to need this income (E20).
This, of course, is not a complete solution to all your retirement planning needs. Rather, we have tried to design a spreadsheet that will allow you to get a handle on what it will take to generate the level of retirement income you desire. From that, you can see whether this level is feasible, and begin planning to achieve it. One fact the spreadsheet illustrates is the large amount of capital required for retirement. To the extent that you must provide this capital yourself, discipline and a coherent plan are critical. Most investors do not have to be reminded that there are many demands on their funds over a lifetime. Putting a low priority on retirement just because it is (relatively) far off can be disastrous.
