CHAPTER 12 PLANNING FOR RETIREMENT AND FINANCIAL INDEPENDENCE

LEARNING OBJECTIVES

After completing this chapter, you should be able to do the following:

  Determine the assumptions necessary to facilitate the needs analysis for retirement and financial independence planning.

  Identify the concepts of life expectancy and probability of living until certain ages for individuals and couples.

  Differentiate the modeling techniques necessary to perform an analysis for retirement and financial independence planning.

Introduction

The concept of retirement has become pervasive in modern society. As a result of successful advertising campaigns by organizations such as the AARP, it now seems that everyone’s expectation is to retire after roughly 40 years of work, if not sooner. Politicians reinforce this idea by making Social Security and retirement benefits top issues in many political campaigns and speak often about protecting retirees. Investment firms do their part by spending countless millions of dollars annually researching and promoting the need to fund—and to protect—an adequate retirement. From this media deluge, it may be reasonably inferred that society views retirement as a natural right—a belief that is universally accepted and cannot be repealed or restrained by law.

What most people do not realize—perhaps because the media does not promote it—is that the concept of retirement is a fairly recent phenomenon. We can trace it back only to 1883, when Otto von Bismarck, then chancellor of Germany, established a pension plan available to all nonworking Germans over the age of 65. It was really just a way to gain popularity and avert a challenge to his leadership—never mind that at the time few people managed to live to 65—but it set a precedent for how governments provide for their aging populations.¹ Before Bismarck, people generally worked right up until their death. Today, though, most people assume that they will simply stop working sometime around age 65–70, regardless of other circumstances, and their life of ease will then commence.

This rosy perception of retirement is, in fact, not a practical goal for personal financial planning. Working for 40 years and then doing nothing to generate income for the next 35 years (ages 65–100) is an unrealistic goal, as is evidenced by the number of retirees returning to the workforce and the increasing attention being paid to the widespread lack of proper savings for retirement, and the inability of Social Security to make up the difference. Personal financial planners have a responsibility to help clients set more realistic expectations and goals.

What, then, is the more realistic goal? The authors would suggest achieving financial independence. Financial independence is the point in time at which you earn income because you choose to work, not because you have to work. This may sound similar to what occurs at retirement, but there is a key difference: With financial independence, work is no longer necessary to support one’s lifestyle; work has become a vocational, not an occupational, choice.

Note that retirement is, effectively, a type of financial independence. It just happens to be financial independence that occurs at a very specific time (generally after age 67) and is written into Internal Revenue Code, Department of Labor, and Social Security regulations. We will be discussing financial independence in general in this chapter.

There are several avenues to financial independence. One is a more traditional route and occurs when an employee’s qualified retirement plan offers employer stock as one of its investment options. Should the company be sold, there is potential for the employee to become financially independent overnight, regardless of age. Another route involves entrepreneurs, such as developers of websites and mobile applications, who have become financially independent at an early age.

Lastly, there are those who spend less than they make. They create spending plans based on 50 percent of their gross income, instead of 100 or 125 percent of income, which a high number of Americans choose to spend. They faithfully save 10 percent of their entire income annually, and arrive at financial independence 20–25 years after they have entered the work force.

Financial independence takes a great deal of work and planning. In this chapter, we discuss this type of planning and related issues.

PFP Assumptions for Financial Independence

The first step in properly planning for financial independence is to perform a needs analysis. What kind of lifestyle does your client want to lead? How much yearly or monthly income will it take to support that lifestyle? How much can your client save? What other sources of income exist? Although it may sound as if the needs analysis is all about asking questions, it’s really more about working with assumptions—of both the client and the planner.

Exhibit 12-1 shows the five assumptions that must be assessed and determined by the personal financial planner in order to complete a needs analysis for the client’s plan for financial independence. All of these assumptions must be effectively communicated to the client, and the personal financial planner must provide a reasonable basis for the assumptions. We’ll discuss them each in turn.

EXHIBIT 12-1	NEEDS ANALYSIS ASSUMPTIONS FOR FINANCIAL INDEPENDENCE PLANNING

INFLATION

The first assumption concerns inflation. In economics, inflation is an increase in the general level of prices for goods and services over a period of time. As inflation rises, every dollar buys a smaller percentage of goods and services. Although inflation may be broadly measured, it affects each individual uniquely. No one set of inflation parameters applies to everyone; one size does not fit all. An individual’s personal inflation rate may diverge from the actual rate of inflation due to unique individual factors such as expenses for food, housing, and medical care, and the differences can be notable. Inflation has as dramatic an impact on a financial independence plan as the rate of return on investments and the client’s individual tax rates. As a result, financial planners have to make assumptions about what inflation will be, and how it will affect a client’s plan for financial independence.

There are various indexes used to measure inflation. The two that directly track the cost of living for individuals are the Consumer Price Index (CPI), and the Consumer Price Index for All Urban Consumers (CPI-U). The CPI is a statistical measure developed by the Bureau of Labor Statistics (BLS) used to monitor the change in price of a set list of products. By measuring the fluctuations in the price to purchase a set basket of goods, the BLS is able to track the cost of living for most individuals. The CPI-U is the CPI value for urban consumers and represents about 80 percent of the U.S. population. It excludes rural populations.

EXAMPLE

LIFE EXPECTANCY

Our second assumption is life expectancy. How long can a client realistically expect to live? Although estimating how long someone will live might sound a bit morbid, it’s actually incredibly important. If a client plans to live to 85 but then lives to 95, there’s a very good chance that he or she will not have saved enough money to cover the extra 10 years (this is what’s known as outliving one’s money). Personal financial planners therefore must be familiar with life expectancy data.

It seems that each year in the U.S., the average life expectancy reaches a new high. The most recent data available from the Centers for Disease Control (2013) states that “life expectancy at birth in the United States for the total population was 78.8 years: 76.4 years for males and 81.2 years for females.”² However, the numbers for life expectancy do change over time. The older an individual is, the longer his or her actual life expectancy becomes. According to data compiled by the Social Security Administration,

•a man reaching age 65 today can expect to live, on average, until age 84.3; and

•a woman turning age 65 today can expect to live, on average, until age 86.6.

And those are just averages. About one out of every four 65-year-olds today will live past age 90, and one out of 10 will live past age 95.³

Life span averages from the CDC and Social Security Administration are not the only factors to consider when estimating life expectancy. Exhibit 12-2 shows other considerations. Based on facts and circumstances, you might need to consider performing a formal life expectancy evaluation. A life expectancy evaluation may be thought of as a reverse physical exam. If, through a medical underwriting process, it is determined that an insured has a shorter life expectancy than mortality tables would predict, than an insurance company may offer a higher lifetime annuity income stream to the insured. The process is involved and is specific to facts and circumstance. Indicators for this type of analysis would be a chronic condition, and the need for guaranteed income not subject to market fluctuations.

EXHIBIT 12-2	LIFE EXPECTANCY CONSIDERATIONS

The longer an individual anticipates being financially independent and out of the labor force, the more assets he or she will need to set aside to cover expenses. Life expectancy is therefore an extremely important, and difficult, assumption. To avoid underestimating life expectancy, consider adding an additional five to 10 years to the estimated life expectancy for the personal financial plan. Another alternative is to model life expectancy to age 100. And if the client is married, or in a committed long-term relationship, model the plan to age 100 of the younger of the two.

FINANCIAL INDEPENDENCE SPENDING PLAN

Our next assumption concerns creating a realistic financial independence spending plan. The key to successful planning for financial independence is to accurately estimate income needs by completing a comprehensive spending plan, cash flow statement, or budget. What kind of lifestyle does your client wish to lead, and how much will it cost? This analysis will assess current expenditures, and project future expenses of the client throughout the period of financial independence. There are several important expenses to consider.

EXAMPLE

Using a guideline income ratio such as 75 percent is popular among consumers and personal financial planners. A guideline ratio gives a quick and simple look at an individual’s spending during the period of financial independence. It is as simple as taking 75 percent of the client’s current spending to project spending during the period of financial independence.

Guideline ratios should not be used alone; it does not create a reasonable expectation for the prospective client. Additionally, a comprehensive spending plan should be monitored periodically to reflect changes in the client’s current situation, goals, and objectives.

MODELING TECHNIQUES

Our next assumption involves modeling techniques. This assumption is really something of an extension of the financial independence spending plan assumption because it, too, seeks to solve for a standard of living and annual income for the client. In addition to creating a spending plan, a personal financial planner may also model a standard of living for the prospective client. The model uses projected cash flows from income sources and accumulated savings to determine potential cash flows. There are two modeling techniques used to solve for the annual income amount, as follows:

1.Pure annuity. This method assumes that the accumulated savings will be depleted at the end of an individual’s lifetime. The payment (annual income in financial independence) is calculated by entering the future value [FV] as zero.

2.Capital preservation. This method assumes that all, or part of, the accumulated savings will remain at the end of the financial independence period [N or n]. This calculation is typically performed for a prospective client who wants to leave a bequest, or who only wants to live off of the earnings, of the accumulated assets. The payment (annual income) is calculated by entering the future value [FV] as the lump sum the prospective client desires to have at the end of life [N or n].

ANTICIPATING UNANTICIPATED FINANCIAL NEEDS

INVESTMENT RETURNS

Our final assumption is investment returns. Once you know how long your client plans to live and the money necessary to maintain a desired lifestyle, you have to determine how to accumulate enough assets to fund financial independence. The answer lies in investments. Which ones will provide enough returns? The investment return assumptions for the financial independence plan should be consistent with the client’s risk tolerance and recommended portfolio allocation. To provide a realistic expectation for the client, the personal financial planner should create several planning models for financial independence. The four most popular models are the following:

•Probability Analysis. A Monte Carlo simulation is used in personal financial planning to calculate the percentage probability of specific planning scenarios that are based upon a set of assumptions and standard deviations. It is used to project the likelihood of the client achieving a goal of financial independence and to determine whether or not the person will have sufficient income to live on for a lifetime, given a wide range of possible assumptions. Some of the underlying assumptions might include interest rates, the client’s age, anticipated time to reach financial independence, and the present value of assets set aside for financial independence. The analysis runs thousands of iterations using actual historical financial data. The results are presented in the form of a bell curve, where the middle part of the curve represents the most likely scenarios to succeed.

•Historic Returns. This planning model uses historic assumptions to illustrate a plan for financial independence. The current assumptions (inflation, asset allocation, taxes, spending needs, and so on) are modeled from a historic perspective. Said another way, given the client’s current set of assumptions, would the plan for financial independence work if it began at some past date? An example would be to select 1970 as the historic beginning point. If the client followed the personal financial planner’s advice since 1970, would the plan work? One caveat: “Past performance is not indicative of future results.

•Stress-tested Historic Returns. Often times, a historic model is stress tested. Stress testing typically involves placing the worst two years (from a portfolio return perspective) at the beginning of the historic model. Stress testing places tremendous downward pressure on the model because it forces the model to withdraw assets when stocks in the portfolio are undervalued.

•Straight-line Returns (Linear). The majority of personal financial plans rely on straight-line returns: investment performance, inflation, and income needs are not adjusted, and remain constant throughout the plan. This method is simple and may be accomplished in short order; however, straight-line returns do not accurately reflect financial systems.

The personal financial planner, whenever possible, should run all four models for each client. Each model provides a different perspective on the financial independence plan, and the different perspectives will facilitate dialogue between the planner and the client. Additionally, if the anticipated spending plan survives all four models, providing expected cash flow to mortality, then the goal is more likely to be achieved.

Income Sources

Investments are essential to planning for financial independence and generating income, but as we alluded to in our discussion of modeling techniques, there are other sources of income available as well. Just because someone has stopped working doesn’t mean income can’t still be generated; it just takes some planning. That’s why it is critical that financial planners be knowledgeable about potential income sources and effectively communicate them to the client.

A variety of income sources are available. Note that some of these income sources are available only for retirement, not for financial independence achieved at any other time. The following are the main income sources to consider when planning for financial independence:

•Defined Benefit Plans. These are pension plans under which a participant receives a defined benefit (set payment) in retirement based upon preretirement compensation, age at retirement, and years of service with the employer. The benefit is guaranteed by the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a federal agency created by the Employee Retirement Income Security Act (ERISA) of 1974 to provide protection for pension benefits in private-sector defined benefit plans. If a defined benefit plan is terminated without sufficient assets to pay the promised benefits, the PBGC’s insurance program will pay the benefit that was to have been provided by the defined benefit plan up to certain limits. The PBGC is not funded by taxes, but rather financed by

  insurance premiums paid by defined benefit plans;

  PBGC investments;

  the assets of pension plans that the PBGC takes over as trustee; and

  recoveries from companies formerly responsible for the defined benefit plans.

Note that a defined benefit plan is insured even if the plan sponsor failed to pay the required insurance premiums.

•Part-time or full-time employment. Many people actually return to the workforce after transitioning into financial independence. There are many reasons for doing so, but the most obvious is the need for additional income. Another reason may be to obtain benefits only available to an employee, such as free theatre tickets provided to part-time ushers at a local venue. Also, for many who are truly financially independent, the “life of leisure” could be boring, and a return to the labor force can provide opportunity for social interaction.

•Potential Inheritance. Potential inheritance should never be considered as a possible income source for financial independence. The unexpected and the unanticipated may interrupt the potential inheritance, and the anticipated assets may never materialize.

•Retirement Plans. Retirement plans are a significant source of income for most retirees. The personal financial planner should be well-versed in the tax rules, regulations, and strategies of this specific asset in order to facilitate its effective use. Exhibit 12-3 shows some of the more important rules and regulations to know.

EXHIBIT 12-3	EXAMPLES OF RETIREMENT PLAN RULES AND REGULATIONS

•Reverse mortgage. This is a special type of home loan for homeowners that requires no monthly mortgage payments. However, the homeowner continues to be responsible for the property taxes and homeowner’s insurance. The reverse mortgage allows the homeowner to access the value of their home’s equity without selling the home. The interest is added to the loan balance each month. At the death of the homeowner, or the homeowner’s absence from the home for a period of 12 months or more, the loan must be paid back.

There are a variety of ways in which the equity in a home may be accessed through a reverse mortgage, such as the following:

  Lump sum payment

  Fixed monthly payments for a specified period of time, such as a term certain annuity

  Fixed monthly payments for as long as the home is occupied, such as a life-only annuity

  Credit line, such as a home equity line of credit (HELOC)

  Combination of monthly payments and a line of credit

Note: Monthly payments may affect eligibility for government benefits, and the decision to elect payments should be made only after a careful analysis of the client’s facts and circumstances.

•Social Security benefits. For many who have retired under Social Security, the benefits are an area of great confusion. They are contingent on specific facts and circumstances, including how much money the recipient earned over his or her working career and the planned age of financial independence. Social Security benefits are addressed in chapter 13.

•Annuities. As we have seen in earlier chapters, an annuity is a contractual obligation to make periodic payments to an individual. The payments may begin immediately; for example, the winner of a lottery may elect to receive annuity payments instead of a lump sum payment amount. Conversely, the payments from an annuity may be paid at some future date. The period of time when an annuity is being funded, and before the payments begin, is referred to as the accumulation phase. Once payments have begun, the annuity is in the annuitization phase. A single life annuity provides guaranteed income for the lifetime of one person: the annuitant. The income stream cannot be outlived. However, this income will cease at the death of the annuitant. The single life annuity provides the highest income stream to an individual. Exhibit 12-4 shows other available annuity options that do provide a benefit to survivors.

EXHIBIT 12-4	ANNUITIES THAT PROVIDE SURVIVOR BENEFITS

Time Value of Money and Inflation-Adjusted Return

Planning for future financial independence and calculating an appropriate savings plan obviously involves time value of money calculations, so the time value of money concepts introduced in chapter 3 are essential. A personal financial planner can formulate reasonable expectations for the prospective client by using the inflation-adjusted return, which is a measure of return that accounts for the return period’s inflation rate. It is calculated as follows:

[(1 + return on investments / 1 + the inflation rate) − 1] × 100

EXAMPLE

The best way to understand the inflation-adjusted return is through a more detailed case study.

MINI CASE STUDY

Carolyn Johanson, CPA, is returning to the labor force at age 47 after an eight-year hiatus to rear her children—twin girls. As a result of her absence from the labor market, Carolyn feels that she is late in saving for her financial independence. Carolyn’s hope is to be financially independent by age 67. Her mom is 88 and fully planning to see 100. Carolyn feels that she will achieve the age 100 milestone as well.

Carolyn has some experience with investing. She has $100,000 in a 401(k) from a previous job. Over the last 20 years, her 401(k) has achieved an average return of 8 percent. Also, during this same period of time, inflation has averaged 3 percent. Carolyn’s goal for financial independence is $60,000 per year. She is confident that her Social Security, as well as her husband’s, will meet half of this need.

On an annual basis, how much money should Carolyn invest to achieve her goal?

Step 1: Calculate the future value of the income need

Inflate [I/YR | i] Carolyn’s present annual income need [PV] to the first year of financial independence and solve for that future value [FV].

Note that present value [PV] is always a negative number unless you are amortizing a loan. Also, the number of years [n] until financial independence is 20 (67 − 47 = 20).

Step 2: Calculate the present value of the serial payments

Solve for the present value [PV] of the amount necessary to fund Carolyn’s goal for financial independence.

Step 3: Calculate for the total amount needed

Solve for Carolyn’s annual payment [PMT] necessary to achieve the future value (FV) (PV from Step 2) at a known interest rate [i].

Chapter Review

The concept of retirement is a fairly recent phenomenon, and it is not always entirely realistic. Without proper planning, individuals cannot simply stop working after roughly 40 years and expect to start living a life of ease. A more realistic goal is financial independence. Financial independence is the point in time at which you earn income because you choose to work, not because you have to work. When setting up an engagement to discuss financial independence, the personal financial planner should recognize and set realistic assumptions and effectively communicate them to the client. Lifestyle plays a key role in planning for financial independence, and longevity is a significant consideration. The personal financial planner should take both into consideration when helping a client to plan for financial independence, as well as sources of income and potential investments.

CASE STUDY REVISITED

Let’s return to Rob in the Port of Seattle. Rob’s question for you is: “All things being equal, how much more will the management position need to pay me in order to replace the ILA’s defined benefit check?” In order to make things easy, Rob tells you to use the long bond rate of 5 percent [i] for your math.

From the information on Ron’s situation provided at the beginning of this chapter, we know the following:

1.He is 55 years old and plans to be financially independent at age 67. Number of periods to financial independence: 12 [n] (age 55 to age 67)

2.He aims to live to 100. Number of periods of financial independence: 33 [n] (100-67)

3.Rob anticipates a defined benefit of $18,000 per year ($1,500/month × 12). [PMT]

4.His assumed rate of return is 5 percent [i]

5.We must solve for the annual payment [PMT] to a 401(k) to achieve this goal

STEP 1: AT 5 PERCENT, HOW MUCH IS NEEDED TO PROVIDE $18,000 PER YEAR FOR 33 YEARS?

Solve for the present value [PV] of the amount necessary to fund Rob’s goal.

Using these numbers we can see that the PV is $302,448.18.

STEP 2: AT 5 PERCENT, WHAT IS THE ANNUAL PAYMENT TO ACHIEVE $302,448.18 IN 12 YEARS?

The management position will need to pay Rob an additional $19,001.43 (plus gross up for Social Security withholding on the elective deferrals) in order to replace the ILA’s defined benefit check. This is well within the elective deferral and catch-up contribution limits.

ASSIGNMENT MATERIAL

REVIEW QUESTIONS

1.Mr. Roberts wants to achieve financial independence in 20 years. He has guessed that he needs an additional $500,000 to fund this goal. He anticipates 7 percent after-tax return on any potential investment. What annual payment should he make to the hypothetical investment?

A.−$17,511.46.

B.-$12,196.46.

C.$17,511.46.

D.−$22,848.46.

2.The general rise in the level of prices of goods and services is

A.An economy.

B.The CPI.

C.The CPI-U.

D.Inflation.

3.The annuity provides the highest income stream to the individual.

A.Installment refund annuity.

B.Joint and survivor annuity.

C.Period certain.

D.Single life annuity.

4.The key to successful planning for financial independence is to

A.Accurately estimate an inheritance.

B.Accurately estimate lifestyle needs.

C.Accurately estimate the Consumer Price Index.

D.Accurately estimate the economy.

5.Which are true regarding an annuity?

I.It is a contractual obligation to make periodic payments.

II.The payments may be paid at some future date.

III.The payments must begin immediately.

IV.The single life annuity provides the highest income stream to an individual.

A.I, II.

B.I, II, IV.

C.I, III, IV.

D.III, IV.

6.All of the following are correct as to how the PBGC is financed except

A.Assets of defined benefit plans which have been taken over.

B.Insurance premiums paid by plan participants.

C.PBGC investments.

D.Recoveries from plan sponsors.

7.Which of the following is a probability analysis?

A.Historic returns.

B.Monte Carlo.

C.Straight-line returns.

D.Stress testing.

8.If a personal financial plan’s assumed rate of return is 7 percent and the assumed inflation rate during financial independence is 6 percent, what is the inflation-adjusted return for the plan?

A..9434.

B.−.9346.

C..9346.

D.9.4340.

9.Which of the following models projects the likelihood of the client achieving a goal of financial independence?

A.Historic return.

B.Probability analysis.

C.Straight-line return.

D.Stress-tested historic return.

10.Which federal agency was created by the ERISA?

A.Bureau of Labor Statistics.

B.Department of Labor.

C.Pension Benefit Guaranty Corporation.

D.Social Security Administration.

INTERNET RESEARCH ASSIGNMENTS

1.Find the CPI-U.info website. What are the detailed housing categories?

2.Visit the Bureau of Labor Statistics’ website. There is a link to the Office of Publications and Special Studies. Select five publications that would be of interest to personal financial planners and their discussions with a prospective client seeking information on financial independence.

3.Find the link to “Types of Retirement Plans” on the Department of Labor’s website. What is the difference between a defined benefit plan and a defined contribution plan?

4.Go to the PBGC’s website and research Eastern Airlines. What is the plan termination date for the airline’s pilots plan, and how many participants are in the plan?

5.Also from the PBGC website: What is the maximum monthly guarantee for a 70-year-old’s straight-life annuity for the current year?

6.Based on the Social Security Administration’s life expectancy calculator, what is your life expectancy? Do you feel the age is valid, based on your family history?

7.What is the mission of the National Institute on Aging (part of the National Institutes of Health)?