Weekly Read: "Will You Outlive Your Retirement Savings?"

By Cheryl Holland

As with marriage, child rearing and career paths, America's baby boom generation is approaching retirement with expectations radically different from those of their predecessors.

The boomers are a generation characterized by unprecedented wealth, increased longevity and optimism regarding the intellectual, psychological and spiritual aspects of retirement. Yet, fewer than one-third of boomers are planning for retirement, according to a January 2002 survey by the Employee Benefit Research Institute (EBRI) and the American Savings Education Council (ASEC). Compounding this lack of planning is a surprising lack of knowledge about the building blocks of retirement (one of which is Social Security), the true cost of retirement, and the impact of inflation on one's retirement budget.

Without proper planning, the urban legend of going to work as a Wal-Mart greeter may become a reality. Still, the most recent Retirement Confidence Survey by the EBRI found that both workers and retirees spent more time in the past year planning for holiday and social events than planning for retirement. Is this lack of planning due to a disconnect between current behavior and the impact of that behavior on long-term financial security? Is it a lack of knowledge about the steps to take for a prosperous retirement? Or, are there so many choices and so much misinformation that the prospect of planning for retirement seems overwhelming?

For many boomers, it is a stultifying combination of all three. But as we show below, breaking the retirement planning process into discrete steps can make it easier to succeed. It can also help ensure that boomers don't outlive their retirement stash.

Step 1: Lifestyle and Age
The most important determinant of whether boomers will achieve their retirement goals is lifestyle. Most people expect to spend less in their retirement years, but any savings they expect are typically offset by increases in health care and leisure costs. And remember, boomers say they want a rewarding, active retirement. So, the first step toward a secure retirement is for boomers to assume that their post-retirement budget will not change dramatically from their current monthly needs.

One's age at retirement will also influence the cost of retirement. The earlier you retire, the lower your Social Security benefits, the longer you will live in retirement, and the greater the impact of inflation on your postretirement income and assets. Statistically, a woman retiring at age 60 can expect to live to age 81. If inflation holds steady at the 20th-century average of 3 percent per year, she can expect her daily living expenses to double during retirement. And, of course, since no one dies at the statistically required moment, it would be wise to add at least a 20 percent longevity factor to your life expectancy.

Planning a retirement that could easily last 35 years is a challenge, but ignoring the impact of longevity and inflation on your retirement needs can be devastating.

Step 2: Constructing Your Portfolio
With fewer employers today providing their workers monthly pensions at retirement, and more employers instead providing incentives to encourage workers themselves to save for retirement, a critical decision for retirees is how to construct the portfolio that will take them comfortably through their retirement years.

The recent stock market decline has created "wealth shock" for many retirees and pre-retirees, although the advantage for those who have not yet retired is a deeper appreciation for diversifying one's savings. But how does one choose the proper combination of investments for retirement, given all the uncertainty in the world today? The answer depends on longevity, inflation, income needs and, to some extent, tolerance for risk.

As happens once a generation, investors are re-learning the painful truth about investing for long-term growth. Stocks can -- and do -- experience protracted periods of negative returns and low returns. On the other hand, inflation and taxes will erode the returns on bonds and cash. Because there is never a completely safe harbor for investing, choosing how much volatility you can afford in your portfolio is not a simple decision. Coupling that decision with understanding your own comfort level with month-to-month, and sometimes year-to-year declines in the stock market, is enough to make you stop retirement planning before you start.

Two Examples
Let's look at an example of a 55-year-old couple planning to retire at age 66. Many prospective retirees are surprised that they will not receive full Social Security benefits at age 65. Since Social Security represents 42.1 percent of the average retiree's income, it is important to understand your benefits. You can find helpful information on the Social Security Administration's Web site, www.ssa.gov. In our example here, the husband will receive $8,000 per year in Social Security benefits, the spouse $4,000 annually.

Once retired, they plan to maintain their current lifestyle and spend $36,000 each year after taxes and adjusted for inflation. Their goal is to have enough in savings, exclusive of their home, by age 66 to keep from outliving their funds.

Of course, they cannot know enough about the future to make perfect decisions. The critical factors such as when they will die, the returns on the stock market during their retirement years, the rate of inflation, and the viability of the Social Security system, are unknown and unknowable.

A Conservative Approach
Being conservative with the forecasts is one approach to dealing with these uncertainties. The couple can assume that at least one of them will live to age 90. They may wish to live in their home as long as possible, and so they decide to exclude the proceeds from any sale of the house in their long- term projections. The couple can purchase long-term health care insurance to offset the risk of one or both spouses needing nursing care for a prolonged period of time. They can also be conservative by assuming that returns on the stock market will be about 6 percent above the rate of inflation during their expected 27 years of retirement. (To put this in perspective, this would mean stocks would return approximately 9 percent annually instead of the 11 percent returns that have been average since World War II.)

The couple can also decide whether to be conservative or aggressive with their retirement investments. For example, a conservative portfolio of 30 percent stocks and 70 percent bonds would generate a return of roughly 5.5 percent after expenses. Our couple would need to amass a corpus of approximately $560,000 to reasonably achieve their goal.

An Aggressive Approach
An aggressive portfolio (made up of 80 percent stocks and 20 percent bonds) constructed to generate an after-expense return of 7.5 percent would mean having to amass roughly $450,000 by age 66. The couple, however, would have to be cautious about withdrawals during bear markets, particularly in the early years of retirement, in order to avoid early depletion of the portfolio due to short-term volatility.

If our couple doesn't think they can save that much money, they can adjust their monthly budget, extend their retirement dates, or work part-time during the initial years of retirement. They can plan on spending more in the early years, and then cutting back as they age and are less driven to travel and accumulate. They can withdraw more funds when their portfolio is experiencing outsized returns, and withdraw less from their portfolio when their portfolio is diminishing in value.

Making Wise Choices
Retirees have control over many of the critical factors in retirement. As with everything in life, constructing a comfortable retirement is a matter of making choices. Choosing healthy financial habits is as important for longevity as choosing healthy living habits.

Cheryl Holland is a certified financial planner. She is president of Abacus Planning Group, Inc., a fee-only, comprehensive financial planning firm in Columbia, S.C.

Copyright Moore School of Business Jul-Sep 2003

From Business and Economic Review