Retirement: Planning Personal Finances for the Future

Whether retirement is coming up soon or is decades away, you need to do some planning.

In fact, what often surprises young people is that retirement planning is most important early in your career. That’s when savings will have the most significant impact on the amount of money you’ll have by the time you retire.

Retirement planning is a big topic, and this article covers:

1. How much retirement money you will need
2. Sources of retirement money
3. Saving for retirement
4. Investing retirement savings

This should help you understand how to retire with enough money to support yourself comfortably. 

How to Retire: How Much Retirement Money You Will Need

It’s easier to work towards a goal if you know what you’re aiming for. So a vital step in retirement planning is to figure out how much money you’re going to need.

Here are some of the key variables involved:

• Retirement living expenses. Your retirement lifestyle might be very different from how you live today, but your current expenses are a good place to start. Figure out how much you spend in a typical year now. Then adjust for how that might be different by the time you retire. For example, you may no longer have to save for your kids’ education or pay a mortgage. On the other hand, you may plan to travel once you retire, or pay for in-person care during your later years.
• Adjustment for inflation. When you think about what your retirement living expenses will be, keep in mind that prices tend to rise over time. Analysis of Consumer Price Index Data from the Bureau of Labor Statistics found that inflation has risen at an annual average of 3.93% over the past 50 years. That may sound like no big deal, but if inflation continues to rise at the same rate over the next 50 years, what costs a 25-year old $1 today would cost $6.87 when that person is age 75. So, your future living expenses have to be adjusted for inflation.
• Life expectancy at retirement. This is different from the average life span because just by reaching retirement age you’ll have outlived the early mortality ages that bring the average down. Also, plan for more than an average life expectancy at retirement. Otherwise, there’s a 50/50 chance you’ll outlive your money.

So, to estimate the amount of money you’ll need to retire, you’d have to figure out your retirement living expenses, adjust them for future inflation, and estimate how long you expect to live in retirement. 

If that sounds complicated, don’t worry. There are lots of online retirement calculators to help you figure this out. 

It’s a good idea to use a calculator that accounts for all the variables instead of just relying on a simplistic rule of thumb such as needing 80% of your current income when you retire. Those generalized rules fail to account for whether you currently are saving money or running up debts. Those would skew the relationship between income and expenses. 

Also, basing expected retirement expenses on current income ignores how different lifestyles and incomes are early in a person’s career as opposed to later on. 

How To Retire: Sources of Retirement Money

Once you’ve figured out how much money you’ll need to retire, you have to figure out where that money will come from.

The Social Security gap

Social Security benefits provide some retirement income, but generally not enough for people to live on. 

According to the AARP, the average Social Security benefit currently is $19,884 a year. And yet the Bureau of Labor Statistics reports that the average American aged 65 or older spends $47,579 a year. That leaves a $27,695 gap in annual retirement income.

Filling the Social Security gap

While the size of that gap is likely to change over time, to meet retirement expenses some percentage of your income is likely to have to come from sources other than Social Security.

While the dollar figures will change with inflation, based on current values here’s the percentage of average retirement expenses that Social Security covers, and what percent will have to come from other sources.

What this means is that most of your retirement money will probably have to come from somewhere besides Social Security: retirement plans, personal savings, working into retirement or other income sources.

Saving for Retirement

There are a few ways you can save enough money to meet the retirement expenses Social Security won’t:

• Employee-sponsored retirement plans
• IRAs or other individual retirement plans
• Taxable savings

Defined benefit pensions vs. defined contribution plans

There are two major types of employer-sponsored retirement plans:

• Defined benefit pensions. This is a type of retirement plan that pays a certain amount every year for as long as you’re retired. This is usually based on how long you were with the organization and your income while there. That amount may be adjusted for inflation, but more or less you know what you’re going to get when you retire. However, outside of government jobs, active defined benefit plans are pretty rare these days.
• Defined contribution plans. These don’t pay a set retirement benefit. Instead, the amount you get out of it depends on how much you and your employer contribute and how well that investment performs over years. An employer may contribute some money for you, but in most defined contribution plans you’re responsible for most of the funding and for deciding how the money is invested. 401k plans are common examples of defined contributions plans.

Both types of plans have tax advantages that allow your investments to grow tax-free while the money is in the plan.  

Individual Retirement Arrangements (IRAs)

Besides employer-sponsored plans, you can also set up your own retirement plan. 

The most common type of personal retirement plan is the Individual Retirement Arrangement, commonly known as an IRA. You’re responsible for funding these accounts and for investing in them. However, like employer-sponsored plans, they do allow your retirement money to grow tax-free while it’s in the plan. 

The way the tax advantage of IRAs works depends on what type you have: 

• Traditional IRAs give you a tax deduction on the money you put into the plan. Then your investment earnings can grow tax-free, though you will have to pay income tax on funds you withdraw from the plan in retirement. There’s also an added tax penalty if you withdraw money before reaching (in most cases) age 59 ½. 
• Roth IRAs don’t give you a tax deduction when you put money in, but withdrawals from the plan in retirement are not taxable. These plans also have a penalty for tapping htem early.

Taxable savings

In addition to saving for retirement in employer-sponsored and personal retirement plans, you may wish to have some personal savings outside of any retirement plan. 

These savings will not have the tax advantages of retirement plans. However, since there are limits to how much you can contribute to a retirement plan in any given year, you may wish to supplement that with some additional savings.

Also, if you think you might need to access your savings before reaching age 59 ½, having some taxable savings will allow you to do that without penalty. 

Investing Retirement Savings

Some of the money you’ll need for retirement can come from investing the money you’ve saved. 

You could spend a lifetime learning about investments, but the following is a brief introduction to some of the concepts you should learn.

Diversification

Diversification is a fancy word for the old adage “don’t put all your eggs in one basket.” 

When it comes to investing, this means spreading your money across different types of investments so you aren’t too exposed to any one risk.

Asset allocation

Asset allocation refers to how you divvy up your money among different asset classes (more on what those are in the next section).

Asset classes have various risk and reward characteristics. Also, most securities within an asset class tend to be affected by similar trends, for better or worse. 

Because asset classes have strong defining characteristics, asset allocation tends to have a bigger effect on investment performance than anything else. For example, someone who divides a portfolio into 80% stocks and 20% bonds is likely to see bigger swings up and down in value than someone who splits a portfolio into 60% stocks and 40% bonds.  

Asset classes and their roles

Here are some examples of asset classes people often invest in: 

• Domestic stocks. Stocks represent an ownership stake in a publicly-traded corporation. So, how a stock does depends on how the underlying company does -- or on how people think that stock is going to do. Stocks provide growth potential, which is great for long-term retirement investing. However, stocks as a whole are prone to steep downturns from time to time, and individual stocks may become worthless if the company goes out of business. 
• International stocks. Besides investing in US stocks, you can also invest in stocks from other countries. Since your job and most other facets of your household finances are probably affected by the US economy, it can be a good idea to diversify by investing some money in other economies.
• Bonds. Governments and corporations borrow money by issuing bonds. As a bondholder, you get periodic interest payments. And when the bond comes due, you’ll get your principal returned when the bond comes due. Bonds don’t generally have as much growth potential as stocks, but they can provide steady income. However, a bond is only as safe as the creditworthiness of whoever issued the bond.
• Cash. While cash can literally mean money in your pocket, in an investment sense it usually means savings accounts, money market funds, or other short-term liquid investments. These pay very low interest rates but provide stability and ready access to money when you need it. 
• Real estate. Real estate can have growth potential, and rental property may also provide steady income. Real estate is generally less risky if you invest in it through a diversified fund rather than in a single property, though the characteristics of the specific investment also matter a great deal.
• Speculative investments. People invest in some things hoping that someone will pay more for them in the future. These include cryptocurrencies, NFTs, art, and collectibles. These kinds of assets provide no earnings or income, but just the hope of making money if they go up in price.

Clearing Up Debts Can Before Retirement

Saving money for retirement is the process of building assets. However, your net worth is your assets minus your liabilities. 

That means that besides building assets, you need to take care of your debts. Part of retirement planning should be to get rid of most or all of your debts by the time you retire.

You may be able to do this yourself by budgeting, but don’t be afraid to get help like debt counseling if that’s what it takes to make it happen.