Retirement income planning is a complex process with many moving parts and a lot of variables. Making educated assumptions is an important part of retirement planning, and if advisors get it wrong, the error can get compounded over decades.
Retirement planners are forced to forecast the future in a number of areas:
• The return on retirement assets.
• The cost of medical care.
• Housing costs.
• The rate of inflation.
• Life expectancy.
• Income taxes.
• General cost of living.
Incorporating these assumptions into the process can be problematic because the rate of increase varies by spending categories. Yet, assuming one rate of increase is often standard practice when planning for retirement.
Perhaps a more effective approach would be to consider these expense variables individually. This can help us more accurately consider accumulation strategies and distribution strategies because our analysis may be better aligned with a realistic outcome.
Longer life expectancies, for example, increase the pressure on retirement assets. According to the U.S. Department of Health and Human Services, a 65-year-old in 1950 could be expected to live to an average age of 77 for males and 80 for females. In 2009, average lifespans for 65-year-olds had increased to 82 for males and 85 for females.
This increase in years spent in retirement means people need retirement income for a longer drawdown period. A longer drawdown period can also magnify mistakes in our assumptions. If we assume our income needs will increase at 3 percent a year while they actually increase at 3.5 percent per year, over 30 years the effect can be substantial.
To demonstrate, let’s take a separate look at three variables—general living expenses (assuming a flat 3% inflation rate), the cost of health care, and income taxes—and apply them to a husband and wife who are both 65 years old and hoping to retire within a year. Their only retirement income sources are Social Security and traditional IRAs.
Separating the general living expenses
As they look forward to retirement, the couple has made a number of estimates of future expenses:
• Housing - $12,000 per year.
• Medical expenses - $12,000 per year (this includes Social Security part B premiums, part D premiums, Medigap premiums, co-pays, dental, vision, etc.).
• General living expenses - $59,597.
• Income taxes - $11,140.
They expect to receive $30,000 per year from Social Security and $64,737 from IRAs.
It’s important to note that, according to a report by the Employee Benefit Research Institute (“Expenditure Patterns of Older Americans, 2001-2009,” by Sudipto Banerjee), some general living expenses, such as food, transportation, and entertainment, could decrease over time or increase at a slower rate than the general inflation assumption of 3 percent per year.
If general living expenses do grow at 3 percent, the cost would be $140,445 in 30 years. If they grow at 2 percent per year, the cost in 30 years would be $105,835. The chart below outlines what it take to fund these expenses.
If general living expenses increase 1 percent per year and their investment return is 7 percent per year, it will take $875,000. If these expenses increase at 3 percent per year and the retirement assets only grow at 3 percent, they would need $1.79 million—a difference of $915,000. This is a clear example of just how great the difference can be when assumptions vary over 30 years.
Separating health care expenses
Rising health care expenses remain a significant concern for retirees. Consider that health care costs have increased an average of 6 percent per year since 2002 (“Budgeting for Healthcare in Retirement,” by David Francis, U.S. News & World Report, May 23, 2012), which is more than twice the general rate of inflation. Add to that the fact that the annual cost of living increase in Social Security income benefits is only 1.7 percent for 2013 and you can see how important it is to carefully consider how heath care costs fit into your client’s larger retirement plan.
If your client requires little medical care and the increasing cost of this care is held in check, they may see somewhat controlled cost escalation. If, however, you have a client that needs more medical care and the costs in the overall medical system increase rapidly, they may have a different outcome.
For this scenario, we’ll assume our hypothetical couple will spend $12,000 a year on health care expenses at age 65. This includes premiums, co-pays, deductibles, and any other medical costs they might have. If their health care costs in retirement start at $12,000 a year and increase at 5 percent a year, the couple would end up paying $49,394 in 29 years. If the assumption is for health care costs to increase at 6 percent, they would end up paying $65,021 in 29 years. Finally, if we assume the health care costs increase at 3 percent per year, the annual cost in 29 years would be $28,279. The chart below outlines what it take to fund these expenses.
If the couple has a 3 percent increase in health care costs and their investments make 7 percent a year, it will take $219,000 to fund 30 years of retirement. Conversely, if their expenses increase at 6 percent a year and the retirement assets grow at 3 percent a year, they will need $563,000—a difference of $344,000.
Separating income taxes
Variances in income taxes may be the most misunderstood. Unlike some of the other expenses facing retirees, tax-rate adjustments ripple through clients' finances and have a compounding effect. Tax-rate increases escalate the need for more income to pay the increased taxes. This additional income results in more taxes and further accelerates the drawdown of retirement resources. Underestimated retirement costs can be magnified because of the additional tax that must be paid on additional IRA withdrawals.
Using the same hypothetical case study, the couple will pay $11,140 in federal and state income taxes in the first year of retirement. This means their income-tax rate in the first year of retirement is estimated at 11.76 percent. Let’s look at three different scenarios to show the effects of tax rate increases and how an increase in living expenses can result in increased taxes.
The first scenario assumes that housing costs, health care costs and general living expenses each increase at 3 percent a year and that the tax rate does not increase. In this case, the couple will need $256,000 when they start retirement, growing at 5 percent per year, to pay those taxes.
In the next scenario, the rate of increase remains the same for housing, health care and general living expenses, but the tax rate increases at 1.5 percent per year. That relatively small yearly increase will mean the couple will need $325,000, growing at 5 percent per year, when they start retirement to cover those taxes—an additional $69,000.
In the final scenario, housing and general living expenses increase at 3 percent per year, but health care expenses increase at 6 percent a year and tax rates at 1.5 percent per year. Obviously, the couple will need more money to pay the increased medical expenses—$351,000 versus $256,000—but they will also need an additional $26,000 at retirement just to pay the additional taxes on the additional health care costs. This third scenario would require $377,000 when they start to cover their costs.
Next steps
Clearly, there can be significant differences when a flat rate of inflation is applied to retirement expenses versus the concept of separating the retirement variables. It’s our job as financial professionals to help our clients understand the importance of an ongoing tax assessment. Many people on occasion have situations that give them the opportunity to benefit from certain tax strategies. Some of these considerations include Roth IRA contributions and conversions, adjustments due to an anticipated tax bracket change in retirement, the 3.8-percent Medicare surtax and tax-deferred accumulation potential via a nonqualified annuity.
Another choice that can have a significant impact on retirement is failing to create a withdrawal strategy for retirement savings. You should review this with your client from the perspective of managing-the-tax-brackets and also noting potential issues with required minimum distributions from a portfolio. Encourage your clients to see their tax advisor for their personal situation.
Not thinking through the client’s specific situation can magnify the errors created when using flat increase assumptions in retirement. This is especially true for those retiring with modest living standards and those that are only marginally ready. Real rates of inflation can vary from age to age, family to family, and expense to expense. The further into retirement we go, the more impact inappropriate assumptions can have. It’s a good idea to fine tune our assumptions each year in order to reflect the most accurate projections possible.
Waldean Wall is vice president of Advanced Sales for Allianz Life Insurance Company of North America (Allianz Life). In this role, Wall employs his more than 30 years of experience speaking at conventions and top advisor meetings around the country. He helps financial professionals and their clients achieve financial, estate and retirement-planning goals.