A key component of every financial plan is a retirement projection mapping out the type of lifestyle the client would like to enjoy, and how they are going to obtain their goals. This calculation depends on several key factors: the client’s current age, size of their nest egg, expected retirement date, desired lifestyle during retirement, and a projected life expectancy. Other variables to consider are the rate of return the client’s investments can achieve (both before and after retirement), how much the client can contribute to their nest egg before retiring, and the effects of inflation.
One term you should hear your financial advisor say frequently is “conservative.” Being conservative when constructing a financial plan is critical — after all, would you rather end up living a more lavish lifestyle than you anticipated and leaving a legacy to your heirs, or bankrupt and unable to pay for basic living materials such as food and health care? Consequently, the assumptions made in your plan should always be conservative and achievable.
Putting It All Together
How do these factors come together to create a valuable tool for the client? Let’s assume the clients are 55 years old, plan to retire by 65, and would like to maintain their standard of living during retirement which requires $60,000 per year. The clients expect a total of approximately $40,000 per year in Social Security payments, so they will need the inflation-adjusted equivalent of $20,000 per year to meet their needs. These clients have a strong history of saving, and have already accumulated a nest egg of $300,000 between their IRAs and 401(k)s. These are the facts.
At this point, conservative assumptions need to be made. Even though the stock market has averaged a rate of return of 10% over the last 100 years, an experienced financial planner might assume the clients can achieve an 8% return until retirement, and a 6% return during retirement (as the clients age, the portfolio should become more conservative, lowing both the risk and return of the investment). Additionally, the planner might assume inflation will average 3% per year (average over the last 100 years). Finally, although the 55 year old clients are statistically likely to live until age 90, the planner will assume they will live to age 95 –after all, the goal is to not run out of money!
Using these inputs we run a Monte Carlo analysis which runs thousands of simulations to determine the chances the clients will have assets to support themselves until death. The analysis indicates that the clients only have a 35% chance of not outliving their money.
However, we can now create a schedule for retirement contributions that will increase the clients’ odds of success. For instance, if the clients contribute $5,000 to an IRA each year until retirement, the chance of not outliving their assets increases to 87%. Moreover, we can now start asking questions such as “What if the clients wants to retire early?” Our retirement plan indicates that if the clients contribute $12,000 per year to their retirement accounts, they can successfully retire at age 63, or contribute $18,000 per year to retire at 62.
The Benefit of a Financial Plan
This is an example of how financial advisors utilizes retirement planning tools to ensure their clients are on pace to live the retirement they envision. Together, the clients and planners can then follow the strategies and schedule determined to best accomplish the goal. This process is then repeated at least annually to reflect changing circumstances in the market and changes in life. Frequently updating the financial plan maximizes the probability the client’s goals will be achieved.