Retirement Planning Essentials

Professional financial planners interview their clients carefully in order to tailor a plan to their specific needs. It is not possible to design a “one-size-fits-all” plan for retirement. Still, fundamental principles of economics and finance permit a skeletal framework for retirement planning to be devised.

Retirement Planning Starts Early

In the practical sense, retirement planning begins the minute you leave school, go out on your own, and start earning income. Of course, you don’t picture yourself as engaged in retirement planning. In fact, you don’t picture yourself retiring at all, because it’s hard enough to envision yourself aging, let alone retiring. As for death? Forget about it!

The assets you have available to generate income in retirement depend on your saving and investing behavior over the previous four or five decades. That depends on what you did to earn income, pay off your mortgage, put your kids through school, and make your way through life. The discipline and organization that met those goals also gave you the physical, mental, and financial wherewithal to cope with retirement. For example, the saving plan that accumulates the assets to pay for college bears a striking resemblance to the one that accumulates assets to finance retirement. With luck, you might even build a surplus in the college fund that can be held over for retirement.

One stylized fact of retirement planning applies to everybody: the earlier you start, the better off you’ll end up. Compound interest is the hardest-working asset you have because it doesn’t require a physical, mental, or financial sacrifice on your part. On the other hand, if you have to save a ton of money in middle age because you failed to start saving early enough, that will make quite a dent in your lifestyle.

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Youth Means Growth – and Liquidity

You need money to pay the rent or the mortgage. You need money to cope with the occasional setbacks dealt you by life – illness or accident or equipment failure. Three to six months of income set aside in liquid form, such as a money market account, should provide sufficient liquidity to tide you through.

Take every additional penny you can spare and devote it to growth-oriented portfolio investments, such as mutual funds. (Mutual funds give you instant diversification, unlike purchases of individual stocks.) Don’t be obsessed with the performance of these assets from month to month or even year to year. Whatever you do, don’t trade financial assets in order to improve your rate of return. If the world’s leading portfolio managers can’t consistently beat the rate of return turned in by market indices such as the S&P 500, how are you going to do it? If you can buy their services by incurring annual mutual-fund expenses, why not do it?

Know Thy Retirement-Investment Self

As you age, pay attention to how you handle the ups and downs of financial life. Gradually develop a mental picture of yourself. Are you security-conscious or willing to take risks to improve your chance of gain? If the risk didn’t pan out, how would you feel about that? What kind of lifestyle makes you happy? Where do you want to be, financially speaking, in twenty or thirty years?

As the answers to these questions emerge, they will enable you to refine your allocation of savings between more and less-risky asset categories. Studies show it is this allocation that determines investment performance, not the choice of particular assets.

Don't Just Shop, Implement a Solid Retirement Strategy

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In Late Middle Age, Hone In On Your Retirement-Investment Goals

When you pass age 50, you should accept the responsibility of making specific, committal choices for your retirement. For example, you should sate your desire for lifelong security by purchasing an annuity – a deferred annuity in your 50s or an immediate annuity at retirement. Life expectancies at age 65 have lengthened dramatically throughout the 20th century and will probably only get longer. Annuities are the classical way to insure against the risk of outliving your money.

Variable annuities become a good choice for people who have maxed out their tax-advantaged retirement contributions to 401(k)s, IRAs, 403(b)s, etc. They provide the benefits of tax deferral and growth. With a decade or more until retirement, there is enough time to outlast surrender charges and expect a decent equity return.

Regardless of your risk tolerance and need for growth, recognize that safety of principal will play a larger part in your plans now. With little working life left, you have less margin for error and less time to recover money lost to market downturns. Gradually tip the allocation of your portfolio towards safer investments such as bonds, CDs, and annuities.

Does Retirement Investment End at Retirement?

At retirement, many of your most important choices are already made. There is at least one remaining investment choice, however. That is how to deal with the problem posed by lengthening life expectancy.

That may not sound like much of a problem. After all, nobody is anxious to die. But neither are you anxious to live a life encumbered by the double burden of age and poverty. You want to withdraw enough money from your principal value to live comfortably but not so much that you run out of money years before you die.

Purchase of an immediate annuity is one way of solving this problem. Provided the insurance company is financially sound, this promises to provide income for the rest of your life. Alternatively, you can seek enough growth to offset your depletion of principal, thereby holding poverty at bay. This can be a tricky operation; mutual funds and indexed annuities are candidates for this role.

Summary

Even though a true financial plan cannot be formulated without attention to individual details, we can still say useful general advice about retirement planning. The most critical piece of advice is the need to start early, enlisting compound interest as an ally in wealth creation. Another piece is to pursue growth when young, while keeping a liquid fund on hand for emergencies. Even though the tradeoff between risk and return implies that safety is downgraded as a priority, youth allows time to recover from mistakes and recoup financial losses.

After age 50, the time has come to focus squarely on retirement. The security-conscious should strongly consider deferred or immediate annuities. Even growth-oriented investors should shift their portfolios more toward safety and less toward risk.

At retirement, the big choice is how to deal with the potential for longevity. Immediate annuities are one solution, while modified growth strategies employing indexed annuities or mutual funds are another.

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