How Long Should You Plan For Retirement?
Conventional financial planning rules of thumb tell you to plan for approximately 20 years in retirement. This wisdom has changed dramatically since the inception of Social Security, when the retirement age roughly correlated to the contemporary life expectancy. Back then, you worked until the retirement age, got the golden watch, and, to quote Carl Hiassen, peeled the garlic shortly thereafter. In the timeline of mankind’s history, the concept of retirement is a very recent construct. Old-age retirement benefits have only existed in the United States since the 1920s. We’ve only had about 100 years of retirement plans in effect, and even fewer years where there were government programs to support self-reliance plans—such as 401(k)s, 403(b)s, and IRAs—rather than company or government pensions. ERISA, the law that enabled IRAs, was only passed in 1974, so if you were 22 when ERISA passed and funded your IRA in the first year you could, you still haven’t reached your Social Security-designated “full retirement” year (wait ’til 2018).
Because of this relative lack of history, we really don’t have all that much data to work with when it comes to determining how much we should save and how much we can expect to spend in retirement. Sure, we can back-test against market averages and historical norms, and Monte Carlo simulation can certainly give an idea of the extreme cases and where the bulk of outcomes will appear, but there’s simply not a lot of historical evidence to tell us what we should be doing.
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Furthermore, consider the trend in life expectancy. According to World Bank data, life expectancy (at birth) has jumped by more than 8 years over the past half-century, 69.8 in 1960 to 78.1 in 2009. In the 50 years between 1940 and 1990, the conditional life expectancy for the people who survive to age 65 increased 2.5 years for males and 5 years for females. Additionally, as most people can tell you, the largest growing segment of the population is the elderly, and that segment is also growing as a portion of the overall population.
What this shows is that we’re not particularly good at predicting how long we’re going to live by the time we get to an expected mortality point. In 2007, a 65-year-old female would have an expectation of living, on average, to 85 years old, but an 85 year old female could expect to live to almost 92. What does this mean? Young mortality is rolled into average numbers, so the fact that you’re alive and reading this blog posting means that you’re probably (statistically speaking) going to outlive the averages.
The 2007 actuarial life table from the Social Security Administration showed that the average life expectancy for a female was almost 84 and the maximum expected age was 113. This means that half of females died by reaching approximately age 83.7 and the remainder died between 83.7 and 113. That’s a lot of the population stuffed into the higher end of the age bracket in terms of age of death distribution.
Cumulative Probability of Death for a Male by online comprehensive financial planning service myFinancialAnswers
Cumulative Probability of Death for a Female by online comprehensive financial planning service myFinancialAnswers
If you’re a female who’s planning for your nest egg to last in retirement until your mid-80s, and you’re 65 now, there’s a 50% chance you’ll make it there, and a 50% chance that you’ll make it beyond that age, which means that you’re probably not planning for a long enough time horizon. You should be planning as if you’ll live to at least age 92, while also planning for the additional expenses that will come with those years (like skilled nursing care). You’d hate to find out that you’d planned your finances on reaching age 85, only to find out that your body had other ideas. Preserve your nest egg, and assume a long (and prosperous!) life.
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About Jason Hull, CFPⓇ
Jason Hull, CFPⓇ is the CTO of myFinancialAnswers, the online, comprehensive personal financial planning service. He is a graduate of the United States Military Academy at West Point and holds a MBA from the University of Virginia.
Nov 12, 2019 10:51 AM EST
You can do this.
Annuity sounds like it should be a financial code word. It should be traded with pork futures by men in smoking jackets and wingback chairs.
So here’s the dirty little secret: It shouldn’t. It isn’t. An annuity is a financial product for the average consumer, one typically designed to help you save for retirement. This is an asset that every savings-oriented investor should have their eye on.
What Is an Annuity?
An annuity is part insurance contract, part financial product.
The basic structure of an annuity has two parts: the accumulation phase and annuitization. During accumulation, you invest as you would a mutual fund or other financial product. At a later date the contract annuitizes and begins making steady payments based on the nature of the product and your overall investment.
Most investors use an annuity to save for retirement. They make investments over the course of their working life and structure the annuity to pay them back after they turn 65. The structured nature of an annuity’s returns allows the investor to use it as a replacement for a paycheck if they choose.
How Do Annuities Work?
Annuities are typically sold by an insurance company which guarantees the payments. This guarantee is why it’s considered part insurance contract. Hereinafter we will refer to “management companies,” however, as some annuities are sold by financial management firms as well.
The specific structure of an annuity can vary. Investors can choose products which have annuitization over a fixed term of years or which attach to specific life events (such as retirement or death). They can even choose to receive their payment in the form of a lump sum. The details of each contract depend on the specific product.
Types of Annuities
The amount your annuity pays back can change depending on how you choose to collect your return. However, there are two main types of annuities: Variable and Income (otherwise known as “Fixed”).
1. Variable Annuities
A variable annuity is more like a structured mutual fund than a traditional annuity. Instead of guaranteeing a set payment, the return on this annuity returns scheduled payments based on the performance of a series of investments.
This means that you could reap potentially higher rewards if these investments do well, but also risk losing some (or all) of your money if the market fares poorly. A variable annuity exchanges predictability for potential income benefits.
A variable annuity also typically is more expensive than an IRA or 401k, which performs essentially the same function.
2. Fixed Annuities
A fixed annuity is the traditional format. In exchange for a specific investment, the institution guarantees fixed, periodic payments. As noted above, most investors use this as a supplemental retirement account due to the set and predictable nature of the payments.
Tax Advantages of Annuities
Annuities come in two taxable forms: Deferred and Immediate.
Most annuities are what is known as “tax deferred.” This means that the earnings of the annuity compound without paying taxes. This allows your investment to grow faster than it would otherwise. For variable annuities, this can mean a higher rate of return. For fixed annuities it can mean a higher contracted payment upon annuitization.
Further, when you receive payments from an annuity, you do not pay taxes on the amount you originally invested (your “cost”).
While specific vehicles may differ, the tax advantaged annuity is intended as a retirement asset. As a result, withdrawing funds too early can incur a 10% IRS tax penalty. At time of writing that trigger age was 59 1/2. This is a general rule which the IRS applies to early distributions from retirement plans other than IRAs.
A deferred annuity doesn’t contemplate withdrawal for years, if not decades. An immediate annuity allows the investor to begin receiving payments within days of initial investment.
While it tends not to have the tax advantages of a deferred annuity, with the exception of cost recovery, an immediate annuity can be useful to several types of investors. Workers who are nearing retirement may invest in an immediate annuity as they will need the income soon. Investors looking to turn lump sums of cash into steady income may do the same thing, as this is often a secure (if relatively low-yield) way to ensure that a sum of cash provides long term benefits.
Pros and Cons of Annuities
The benefit of an annuity is financial structuring. It allows you to create a supplemental retirement account or to manage lump sums of money with the promise of future payouts. You also, in the case of a fixed annuity, get the added comfort of guaranteed rates and the resulting predictable income return.
Even setting aside the risks inherent to a variable annuity, there are still some downsides, however.
An annuity is a highly illiquid asset. Except for some immediate annuities most contracts begin payments on a fixed date many years in the future. If you withdraw money from an annuity before that date you usually trigger a “surrender payment.” This is a fee which the management firm charges for early withdrawal. You may also, as noted above, incur a tax penalty.
An annuity is typically a fairly expensive asset. Since this is a contract, not strictly an investment vehicle, the management firm will often charge fees and commissions to buy into the annuity. This can eat a considerable portion of your initial investment, while management fees for variable annuities can run to 3%, 4% or more.
An annuity is a contract, not a deposit. As a result it is not FDIC insured. This is relevant because many investors are looking to hold an annuity for a period of decades or more.
This can create a risk of the company holding their contract goes under.
If the firm which sells you an annuity goes bankrupt you have no protection. You will become a creditor entitled to a share of the insolvent firm’s assets, but no more than your initial investment cost (and the odds of getting that back would probably be slim). Make sure you feel good about the longevity of a firm before buying a 20-year contract with them.
Why You Should Use an Annuity
Setting aside lottery winners who need to portion out their wealth, the main value of an annuity is for savers who have hit their maximum 401k or IRA contributions. It allows you to build a tax-advantaged retirement account beyond those traditional vehicles. It also allows you to invest in an account built around replicating the structure and surety of an income.
An annuity is expensive, which is why most investors should consider their traditional retirement vehicles first. However, after those options have been exhausted, this can be a good way to begin building conservative, predictable income for the years to come.
Retirement benefits are a must in the modern workplace, and they attract the top talent. Here’s how to offer an employee retirement plan for your small business.
By: Nicole Fallon, Contributor
In the modern workplace, retirement benefits are a must. An Aflac survey found that 75% of employees expect their company to provide a 401(k) or other pension plan as part of their benefits package — and yet, just 53% of companies with fewer than 100 employees offer this option, according to the Bureau of Labor Statistics.
Many small business owners are hesitant to offer retirement plans because the research and implementation can be complicated and time-consuming. However, offering some kind of retirement option for employees helps attract the best candidates.
Types of retirement plans
There are many resources for small businesses looking to set up a retirement plan for their employees. The first step in finding the right type of plan for your business is understanding the different retirement plan options available to you. There are two primary structures your plan can follow: defined benefit plans and defined contribution plans.
- Defined benefit plans. These plans offer employees a defined monthly or yearly amount during retirement. You can, for example, set up a plan where an employee receives $100 per month during retirement. Companies will typically set up arrangements where employees receive a certain percentage of their former salary per year.
- Defined contribution plans. Unlike the defined benefit plans, defined contribution plans don’t have a specified monthly or yearly amount for employees to receive. Instead, both the employee and the employer can contribute to these types of plans. Money is usually invested on behalf of the employee, and the employee will receive access to the funds in retirement.
Some popular retirement plan options that fall under these two categories include:
- Simplified Employee Pension (SEP):In this plan, workers make tax-favorable contributions to an overall retirement account.
- Profit sharing plan: Some companies offer profit sharing plans, where company profits and other money are allocated to employee retirement accounts.
- Employee Stock Ownership Plan (ESOP): These plans include retirement contributions in the form of company stock options.
- 401(k): A 401(k) plan is an employee investment plan where a portion of each employee’s salary is held back and invested in an individual investment plan. Many companies will match employee contributions as part of the arrangement.
- Cash balance plan: In this plan, employees receive their contribution in the form of an account balance: both pay credit and interest credit. This agreement protects employee money from investment fluctuations.
Make sure you explore all your options before going out on your own to set up your business’s retirement plan.
Sponsoring a retirement plan
Once you understand the different types of plans for your business, it’s important to take the proper steps to set it up. Below are the four main stages of implementing a retirement plan, according to the IRS:
- Choosing. In this stage, you’ll review the different plan options and determine what is ideal for your business. You’ll want to research your options carefully and select a plan that makes the most sense from a tax perspective, both for you as an employer and for your employees.
- Establishing. Once you’ve chosen a plan, it’s time to implement it. You’ll need to create a written plan, arrange fund transfers, notify your employees of their options and develop a recordkeeping system to keep track of everything.
- Operating. Actual plan operation requires following best practices to keep employee money growing while staying compliant with your plan’s terms. In this step, you’ll make contributions, stay up-to-date on retirement plan laws, manage plan assets and distribute benefits.
- Terminating. An important part of a good retirement plan is constantly auditing and adjusting where necessary. If your plan is no longer working for your employees and business, choose and implement a new one.
Finding the right retirement plan can be a challenge. Make sure you explore all your options before going out on your own to set up your business’s retirement plan. Many third-party companies can work directly with you to set up a plan that’s best for you and your company.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
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