You've no doubt heard many of the old adages about building a retirement nest egg: Aim to save $1 million, withdraw 4% a year to live on, plan for expenses that are 75-80% of your pre-retirement expenses. But a lot has changed since these rules were created, including a massive financial crisis. So is it time to tweak our retirement rules?
The question isn't at what age I want to retire, it's at what income
George Foreman, boxer
There has been much talk recently about "new rules" for retirement saving. In truth, there are no specific formulas, says Cathy Pareto, a certified financial planner. Pareto says retirement planning, just like financial earning, is excessively subjective.
"I'm not a big fan of having these rules of thumb, if you will," she said. "Retirement planning is a very complex puzzle. You can't just do a broad stroke that applies to everybody. I think most planners might agree that you really have got to put pen to paper, run the numbers, do the calculations, which is one of the reasons why I sit down with my clients at a minimum -- especially if they're in retirement -- once a year to see if they are on track."
Some historic retirement saving recommendations include saving a $1 million nest egg, counting on a 4 percent annual withdrawal from investments, and figuring expenses will be around 75 percent of pre-retirement spending.
Pareto acknowledges those old rules remain what they were: fairly decent guidelines.
"It's very fluid," said Pareto. "Life changes, needs change -- you may not be able to predict out 20 or 30 years what your life might be, so I think that some level of flexibility is needed."
More on 4 Percent
Pareto said the 4 percent rule is still relevant for many clients.
"I don't know if there are specific circumstances per se, but we run specific analyses for our clients and we typically use 4 percent as a ballpark starting point of distributions from a portfolio," she said. "We find in most of the cases that it is doable."
Circumstances can also force changes in a 4 percent plan. Say your retirement begins at the exact time the market starts to collapse, and for two or three bad years there's no growth in the market. At that point you're just invading your principle, says Pareto.
"I would say in a circumstance like that 4 percent withdrawal is a little generous; you might have to cut it back," Pareto said. "If you're starting out your retirement program in negative territory, then 4 percent is not going to be sustainable."
On the other hand, if your retirement kicks off during a really strong bull market, the 4 percent distribution, or maybe more, might be viable.
"Even if someone retires and they start off with a 4 percent target, if the markets tanked and we realize it might take three years to recover, the client might have to make some adjustments," Pareto said. "So while I think it still applies, you have to be flexible in how you incorporate it."
She recommends not exceeding a 4 percent distribution for planning purposes.
$1 Million Question
Certified financial planner Jack Patterson says when he started in the business 16 years ago, $1 million was the oft-quoted round number recommended to save for retirement. That figure, he said, is no longer tenable.
"It really depends on how old you are," said Patterson. "If you are my age, around 40, you're going to need $5 million. But if you're retiring today, you're going to need almost $2 million (if you) want a modest retirement (of) say $6,000 or $7,000 a month. Not that you need a portfolio that size. Social Security will help you with at least, on average, about $600,000 to $800,000 of that. So you just need to come up with another ($700,000) from other sources."
"People are really alarmed by that number, but (it) depends on your circumstances," she said. "Maybe you've made $40,000 your whole life and so -- if we use $2 million as a simple variable, the 4 percent times $2 million -- that is a distribution of about $80,000 a year, roughly. So $2 million would probably be way too much money accumulated for somebody who could live on $40,000 a year."
Pareto recommends saving at least 10 percent of your annual discretionary income to reach that figure.
Social Security is the major source of income for older Americans and the influx of 76 million baby boomers threatens to bankrupt the historical safety net. According to the nonpartisan National Academy of Social Insurance, as of January 2012, the average retired worker got $1,230 a month from Social Security. Nearly two-thirds of them get half of their income from the program. NASI's research also showed Americans age 65 and older lack significant income from other sources such as pensions or investment portfolios.
In addition to the threat of diminished benefits beginning in 2033, tax code changes in recent years have redrawn some retirement rules.
"In retirement planning we're taught, 'Oh, when you retire, you're going to be in a lower tax bracket,' and that's not necessarily true in today's environment," Patterson said. "The Bob Hope generation didn't have retirement plans; there (were no) 401(k)s (and) IRAs didn't exist. Before, when you retired, your Social Security was tax free and your savings was tax free. The only thing taxable you had was the pension. And if the pension was small enough, you actually paid no taxes."
These days, all savings is tax deferred, Social Security is taxable, the pension is taxable and that has really changed the game, Patterson said.
Best Retirement Philosophies
Boxer George Foreman once said, "The question isn't at what age I want to retire, it's at what income." His line carries practical punch among retirement planners. Pareto and Patterson say you have to know your income goals and keep on top of your cash flow.
"It's not about what you make," Pareto said. "So you've got a $200,000 household income? It's great money but what are you keeping?" .
Pareto sings the praises of tools such as Quicken and Mint.com, which aggregate financial data such as 401(k), bank accounts and mortgage into one hub.
"You have to be actively managing that process," she said. "Let's be real, you can't even have a conversation about how much you should be putting into your 401(k) if you don't know realistically what you can afford."
Confronting health care is critical, too, said Patterson. He recommends injecting an additional cushion in any savings for it, as well as investing in a long-term care insurance policy. This is the one issue, other than Medicare, that derails retirement nest eggs. The average long-term care expenses cost $400,000.
"In the last four years of your life, there's a good likelihood that you will not be able to take care of yourself," Patterson said. "You're going to need a nurse or nursing home, and that's something that Medicare won't cover."
Certified financial planners Cathy Pareto and Jack Patterson have some specific strategies for your portfolio. It calls for a diversified strategy that is "global in nature -- maybe bonds for your downside protection," Pareto said.
Index funds for the invest-it, forget-it types: Index funds are varieties of mutual funds and are a low-cost way -- they tend to have low operating costs, so they can pass on these saves to consumers -- to capture a piece of the market.
"Rather than someone trying to buy stocks on their own, like individual companies, this is a better way to achieve diversification and less risk," Pareto said.
Patterson emphasizes tax planning with an eye to retirement. He recommends a Roth IRA.
"You can put $5,500 into a Roth every year. If you're over 50 you can put $6,500 into the Roth," he said.
Patterson says you can invest in a Roth through a contribution or a conversion. In a conversion, you take an existing IRA or 401(k) and move it into a Roth. There was once a $100,000 limit on conversions, but they've been uncapped since 2006.
As a middle road approach, say for a moderately-aggressive investor, Patterson recommends a diversified spread of 65 percent in the market and 35 percent in bonds.