Farm Management Update

Quarterly Publication of Ohio State University Extension

Fall 2002

By Warren Lee,

Retirement Planning

Retirement planning can be approached in three steps: 1) Recognize the planning period, 2) Estimate living costs during retirement, and 3) Design an investment program to try to cover these living costs.

The Planning Horizon

Estimating the planning horizon is illustrated for the "Joneses" who plan to retire when the husband is 65 and his wife is 60 years old. Based on average life expectancies, the husband can expect to live for another 15 years and his wife about 22 years. However, mean life expectancies are not a reliable basis for retirement planning because about half of all individuals live beyond their mean life expectancy. If the Joneses are willing to assume a 30 percent chance of living beyond their planning horizon, they should plan on another 20 years for the husband and 32 years or more for his spouse. A life expectancy calculator that incorporates your age, general health and lifestyle can be found at http://www.ces.purdue.edu/ retirement/ under the topic "Are You Ready to Retire?"

A realistic estimate of the planning horizon is important because over a 30-year period, living costs will increase significantly due to inflation. If the average inflation rate is 3 percent per year, it will take $2.43 after 30 years to buy what $1.00 will buy today. A 5 percent inflation rate will increase that amount to $4.32. The "Rule of 72" is a useful rule of thumb that will estimate how fast income needs will double due to inflation. Divide the interest (inflation) rate into 72 to estimate the number of years it will take for living costs to double. For example, if the inflation rate is expected to be 4 percent per year, living costs will double approximately every 18 years (72 / 4).

Estimating Living Costs

A general rule of thumb is that living costs during retirement will be 75 to 80 percent of present living costs. Some expenses such as clothing and commuting to work may decline; however, other expenses such as medical care will likely increase. Families who plan on an active living style during retirement should plan on 100 or more percent of present living costs. For retirement income calculators, please refer to "How Much Will Your Expenses Be in Retirement?" at http://www.ces.purdue.edu/ retirement/.

Designing an Investment Program

Social Security and employer pensions are the base for retirement income planning. Generally they provide a fixed income for our lifetime and for the surviving spouse. Amounts received may or may not keep up with inflation. For a good overview of Social Security and pensions, please refer to "All about Money: Retirement Planning" at http://ohioline.osu. edu/mm-fact/index.html.

The rest of our retirement income must come from IRAs and other tax deferred accounts, securities, our home, life insurance, liquid savings and other investments such as real estate, collectibles, a business, etc. The primary criteria for selecting and managing the investment portfolio over time are returns, risk and liquidity.

The investment portfolio should contain a mix of investments so our eggs should be put into different baskets. For information on selecting investments see http://ohioline.osu. edu/mm-fact/index.html. Here are some sample investment portfolios and expected returns based on past performance:

Lower Risk: 55% Cash, 20% Fixed Income, 25% Stocks - Average Return = 6%.

Medium Risk: 20% Cash, 35% Fixed Income, 45% Stocks - Average Return = 8%.

Higher Risk: 0% Cash, 35% Fixed Income, 65% Stocks - Average Return = 10%.

The Joneses have estimated that they will need $40,000 per year during retirement. They estimate that their income from Social security and pensions will be $30,000 per year, so they will need to generate $10,000 per year from their investments. They have a "medium risk" investment portfolio that may earn 8 percent per annum; however, they expect that the average annual inflation rate will be 3 percent, so the real rate of return on their investments may be 5 percent.

In order to generate an annual income of $10,000 from earnings alone with a 5 percent real rate of return, they will need a retirement nest egg of $200,000 ($10,000 / .05). They can generate an income of $10,000 from a somewhat smaller nest egg if they plan to gradually liquidate their investment portfolio during retirement. A portfolio of approximately $154,000 earning 5 percent real return will generate about $10,000 per year if the principal is used up over a 30-year period.

Clearly, retirement planning should begin well before age 65. The Joneses estimate that they can put aside $5,000 per year for retirement and that they can earn a 5 percent real rate of return on their investments. If they start saving 10 years before they plan to retire they will have less than $63,000 saved up when they retire. If they start saving 20 years before they retire, their retirement fund will have grown to over $165,000.