Evaluate the Viability of Your Retirement Plan

The following is part of our 21 Days to Improve Your Financial Life special report.

"Am I on track for retirement?"

There are few more important questions in financial planning, but getting good answers can be elusive. Even people who are comfortable tackling sophisticated financial tasks like determining their asset allocations and conducting due diligence on individual stocks and funds may struggle with assessing the soundness of their plans.

It's not hard to see why. The right level of savings in the years leading up to retirement--and the "right" withdrawal rate over your specific retirement time horizon--depends on a huge gamut of factors, many of them highly dependent on each individual and others simply unknowable. We don't know how much of a helping hand market returns will provide over our holding periods, both in the years leading up to retirement and during it. And then there's the mother of unknowables: the duration of our retirement years, which requires us to forecast our own life expectancies.

While there's no way to answer most of these questions with any degree of precision, there are tools and other strategies you can use to assess whether your current savings--combined with the amounts that you'll save on an ongoing basis and withdraw during retirement--put you in the right ballpark. Using those tools as a baseline, you can then tweak the specifics of your plan based on your own variables.

How Accumulators Can Tell if They're on Track For people who are still in retirement-savings mode, there's no shortage of rules of thumb available to gauge savings rates and, by extension, the soundness of an investment plan. Investors may have heard that they should be saving 10%, 15%, or 20% of their salaries.

But those rules of thumb can be dramatically affected by the assumptions underlying them. For example, a study from the Center for Retirement Research at Boston College suggests that individuals earning an average wage who save 15% of their annual earnings from age 35 to 65 will be able to retire at age 65 with financial security, assuming a 4% real return on investments. But if they're able to delay retirement (and portfolio withdrawals) until age 70, their anticipated savings rate drops to just 6%, according to the study.

In attempting to help investors address the "how much is enough?" question, Fidelity Investments suggests that investors could reasonably target a retirement nest egg amounting to 10 times their ending salaries at age 67. By age 35, investors should aim to have set aside a retirement kitty equal to two times their current salaries, with retirement assets escalating to four times current salary by age 45 and seven times salary by 55.

Those guideposts are useful starting points, but they're blunt instruments: Asset allocation, income-replacement rate assumptions, and the expected length of retirement all have an impact on whether a pre-retiree's savings rate is adequate. For that reason, it's valuable to assess your retirement preparedness using your own data. Here are the key steps to take.

Step 1: Gather your inputs. The first step is to pull together data about your current plan, including the following items:

• Current investments earmarked for retirement
• Annual retirement savings
• Expected retirement date
• Other expected income sources in retirement

Step 2: Find your current asset allocation. Because the asset allocation of your portfolio will be a key determinant of what sort of return you earn over your time horizon, it's helpful to start with a clear view of your current stock/bond/cash mix. (Don't include any assets you have earmarked for nonretirement goals, such as college savings.) Plugging your holdings into Morningstar's Instant X-Ray is an easy way to gauge your portfolio's current asset allocation.

Step 3: Plug it all into a holistic calculator. Because savings targets will be so sensitive to individual-specific inputs, online calculators that allow investors to adjust these inputs are the best way for investors to determine the adequacy of their savings rates. Most of the major financial-services providers offer some type of tool to gauge retirement preparedness, including Vanguard's Retirement Income Calculator, T. Rowe Price's Retirement Income Calculator, and Charles Schwab's Retirement Calculator. The Bogleheads site provides a helpful overview--with links--to both free and paid retirement-planning calculators.

Because all of these calculators are a bit different--and because retirement readiness is such an important issue--be prepared to sample a range of calculators rather than settling on just one. Also, focus on the most holistic tools you can find; for example, the T. Rowe Price tool incorporates Social Security income and also takes into account the asset allocations and tax treatment of various asset pools in the investor's portfolio.

Step 4: Customize and course-correct. As you work with these calculators, it's also valuable to tinker with the inputs--rather than relying on any preset inputs--so that the calculator is factoring in your own situation. If it looks like you'll fall short based on your starting assumptions, you can make adjustments to help improve your probability of success.

Among the variables you will be able to customize--and that have a big effect on the success or failure of a retirement plan--are the following.

Income-Replacement Rate: Generally speaking, higher-income workers and heavy savers will need to replace a lower percentage of their working incomes when they eventually retire than will lower-income workers with lower savings rates. This article discusses the topic in depth.

Anticipated Retirement Age: As discussed here, being willing to work longer can deliver a benevolent three-fer; the person who delays retirement can continue to accumulate savings, while also increasing Social Security benefits and decreasing portfolio withdrawals. All three steps can have a powerful effect on a portfolio's staying power.

Life Expectancy: Predicting your own life expectancy is the trickiest business of all. This article provides some guidance on getting yours in the right ballpark.

Expected Rate of Return: Be conservative here, especially if your portfolio is bond heavy, and customize your expected return based on your asset mix. This article provides reasonable estimates from experts like Jack Bogle, as well as researchers at Morningstar and Vanguard. Bear in mind, however, that these forecasts typically cover the next 10 years or even fewer; most retirement accumulation periods are much longer than that. To calculate your portfolio's expected return based on its asset allocation, simply adjust your anticipated return for an asset class based on its weighting in your portfolio. For example, if you have a 60% equity/40% bond portfolio and you expect 6% (nominally) from stocks and 2% from bonds, your portfolio's expected return is 4.4%. (The 6% equity return times its 0.6 weighting (3.6%) and the 2% bond return times its 0.4 weighting (0.8%).)

Savings Rate: This will be a bigger swing factor if you're earlier in your savings career and have more time to benefit from compounding. This Center for Retirement Research study demonstrates that older individuals looking to make up for a savings shortfall will need to ratchet up their savings significantly to get their plans on track; they will improve the viability of their plans more if they're willing to delay retirement and/or reduce their planned in-retirement spending per year.

How Retirees Can Gauge How They're Doing If you're already retired and drawing living expenses from your portfolio, it's too late to gauge savings-rate adequacy. Instead, your main lever at this life stage--and indeed the main determinant of the success or failure of your retirement plan--is your spending rate. How much can you spend in retirement without outliving your money?

That's a head-scratcher for many, according to a survey from the American College of Financial Services. Seven in 10 individuals between the ages of 60 and 75 with at least $100,000 said they were unfamiliar with the oft-cited 4% withdrawal-rate guideline. Meanwhile, 16% of survey respondents pegged 6% to 8% as a safe withdrawal rate.

Because setting a sustainable withdrawal rate--or spending rate, as I prefer--is such an important part of retirement planning, pre-retirees and retirees who need guidance should seek the help of a financial advisor for this part of the planning process.

And at a bare minimum, anyone embarking on retirement should understand the basics of spending rates: how to calculate them, how to make sure their spending passes the sniff test of sustainability given their time horizon and asset allocation, and why it can be valuable to adjust spending rates over time.

Step 1: Determine your current spending rate. To determine your own spending rate, simply tally up your expenses--either real or projected--in a given year. Subtract from that amount any nonportfolio income that you're receiving in retirement: Social Security, pension, rental, or annuity income, to name a few key examples. The amount that you're left over with is the amount of income you'll need to draw from your portfolio. Divide that dollar amount by your total portfolio value to arrive at your spending rate.

Say, for example, a retiree has $60,000 in annual income needs, $28,000 of which is coming from Social Security and the remainder of which--$32,000--she will need to draw from her portfolio. If she has an $800,000 portfolio, her $32,000 annual portfolio spending is precisely 4%. But if she needs to draw $50,000 from her portfolio, her spending rate is 6.25%.

Step 2: Run a basic sustainability test. One of the best starting points for testing the viability of your current spending rate is the "4% guideline." The notion that 4% is generally a safe withdrawal rate was originally advanced by financial planner William Bengen; it has subsequently been refined--but generally corroborated--by several academic studies, including the so-called Trinity study.

Before retirees take the 4% guideline and run with it, however, it's important to understand the assumptions that underpinned it.

First, the research assumed that retirees would wish to maintain a consistent standard of living, drawing a steady stream of income--in dollars and cents--from their portfolios each year. Thus, the 4% guideline assumes that the retiree spends 4% of his or her initial balance in year one of retirement, then subsequently nudges the amount up in subsequent years to keep pace with inflation.

Additionally, the 4% guideline assumes a 60% equity/40% bond asset allocation and a 30-year time horizon, and that the 4%, whether it comes from income and dividend distributions or from selling securities, is the total withdrawal.

Step 3: Factor in your own situation. Because not every retiree's profile matches the assumptions Bengen used in his research, not every retiree should take the 4% guideline and run with it.

Just as calculators can help accumulators gauge the adequacy of their savings rates, so can online calculators help you see if your withdrawal rate is sustainable. Tools like T. Rowe Price’s Retirement Income Calculator allow you to harness your own variables to address the viability of your plan. Whether you're tweaking the 4% guideline or using an online tool, be sure to take the following factors into account.

Time Horizon: Retirees with time horizons of longer than 30 years should plan to take well less than 4% of their portfolios in year one of retirement. On the flip side, older retirees--those 75 or older, for example--might consider taking a higher withdrawal rate. David Blanchett, head of retirement research for Morningstar Investment Management, has suggested that retirees consider their life expectancies when determining their spending rates.

Asset Allocation: A retiree's asset allocation should also be in the mix when calibrating sustainable spending rates. The 4% guideline, as noted above, is centered around a 60% equity/40% bond mix. But investors who want to employ a portfolio that includes more bonds and cash should be more conservative in their spending rates, as Blanchett discussed in this video.

Step 4: Be ready to course-correct based on market conditions. Retirees greatly reduce their portfolios' sustainability potential when they encounter a lousy market early on in their retirements and don't take steps to reduce their spending. That's because if they overspend during those lean years, they leave less of their portfolios in place to recover when the market does. Sequence-of-return risk can be mitigated, at least in part, by having enough liquid assets to spend from early on in retirement so that the more-volatile assets that have slumped (usually stocks) can recover.

Because sequencing risk poses such a threat, much of the recent research on sustainable withdrawal rates supports the idea of tying in withdrawal rates with portfolio performance. The retiree takes less out in down-market years and can potentially take more out in years when the market performs well, as it has recently. This article takes a closer look at tying withdrawal rates to market performance.