The top factors in retirement planning

(MoneyWatch) When planning for retirement, most investors and financial advisors alike tend to focus on how much to allocate to risky stocks and safer bonds. A recent working paper out of Boston College's Center For Retirement Research examined whether this is the right approach or if other metrics are equally, or even more, important to achieving one's goals. Specifically, the authors looked at how allocating assets, delaying retirement, tapping housing equity (through a reverse mortgage), and controlling spending impact the ability to retire having saved enough money to allow a targeted level of spending.

The RETIRE Project at Georgia State University has been calculating required replacement rates for decades. As of 2008, the project estimated that households with earnings of more than $50,000 needed about 80 percent of pre-retirement earnings to maintain the same level of consumption. People typically need less for several reasons:

• They pay less tax. They no longer pay Social Security and Medicare payroll tax, and they pay lower federal income tax because -- at most -- only a portion of their Social Security benefits are taxable.
• They no longer need to save for retirement.
• Most households pay off their mortgage before they retire, or soon thereafter.

Households earning less than $50,000 need more in pre-retirement earnings because they generally save very little for retirement and pay much less tax while working.

The amount that individuals have to save to end up with an 80 percent replacement rate depends on a number of factors:

• Earnings level -- The lower the earnings, the greater the portion provided by Social Security and the less that the individual would have to save on his own
• Rate of return -- The higher the rate of return, the lower the required saving rate
• Age when savings begins -- The earlier the individual starts saving, the lower the required rate for any given retirement age
• Age of retirement -- The later the individual retires, the lower the required saving rate

The following is a brief summary of the Boston College paper, "How Important is Asset Allocation to Financial Security in Retirement?" As you review the findings, keep in mind that they are based on the average American family, which typically has little in the way of financial assets. The greater one's financial assets, the greater the impact the asset-allocation decision will have.

• Starting to save at an early date has a large positive impact. Starting to save at age 25, rather than age 45, cuts the required saving rate by about two-thirds.
• Delaying retirement has a large positive impact. Moving retirement from age 62 to age 70 reduces the required saving rate by about two-thirds.
• The combination of saving early and retiring is so powerful that an individual who starts at 25 and retires at 70 needs to save only 7 percent of earnings to achieve an 80 percent replacement rate at retirement -- one-tenth of the rate required of an individual who starts at 45 and retires at 62 -- a nearly impossible 65 percent.

Retiring later is a powerful factor for several reasons:

• Because Social Security monthly benefits are actuarially adjusted, they're more than 75 percent higher at age 70 than age 62. As a result, they replace a much larger share of pre-retirement earnings at later ages -- 28.6 percent at 62 and 51.5 percent at 70 in the author's example -- reducing the amount required from savings.
• By postponing retirement, people have additional years to contribute to their 401(k) or other retirement plans and allow their balances to grow.
• A later retirement age means fewer years for a portfolio to support.

The analysis then looked at how important asset allocation was relative to the impact from the other factors. While a higher expected return from a higher stock allocation means that smaller contribution rates are required, it's not a free lunch -- it comes with more risk. The authors found that even ignoring risk, the required saving differentials are less than those associated with ages for starting to save and the age of retirement. They found than an individual can offset the impact of a 2 percent return instead of a 6 percent return by retiring at 67 instead of 62. And the further along people are in their careers, the more effective working a few years longer becomes.

The authors concluded that for the average individual, starting to save early and working longer are far more effective in ensuring a secure retirement than earning a higher return. This strategy of saving for a longer period of time is especially effective given the greater risk that comes from trying to earn that higher return.

For example, they found that working six months longer -- from 66.5 to 67 -- produces the same outcome as having all assets invested in "riskless equities." (Here, the authors are assuming a 6.5 percent return on stocks with no standard deviation. Basically, they're saying that if you knew for certain that stocks were going to return 6.5 percent, you would be just as well off working six months longer as you would if you had all your assets invested in stocks returning 6.5 percent.) Taking risk into consideration shifts the balance in favor of working longer.

The authors also looked at the top decile of the wealth distribution -- households with more than $500,000 of financial wealth. Since these households are wealthier, a lower percentage of fall short at 62 in the base case -- 39 percent for the top decile. versus 74 percent for the population as a whole. If top-decile households worked until 67, the share falling short drops to 17 percent. If these households take out a reverse mortgage, the 17 percent threshold is reached at age 66. The relative impact of a reverse mortgage is smaller for the wealthy, because their home is a much smaller component of their total wealth. If households reduce spending by 5 percent, the percent at risk falls to 17 percent at age 66. Finally, investing all assets in "riskless equities" (again, stocks with a guaranteed return of 6.5 percent, which can't actually be guaranteed) allows the top decile to reach the 17 percent threshold at about 66.5.

As you can see, working longer, taking out a reverse mortgage, or spending 5 percent less all have the about the same impact as moving to a riskier all-stock portfolio. A combination of these tools would be far more powerful.

In summary, when planning for retirement, it's critical to consider all of the tools in the toolkit, not just what might be called the "hammer" of asset allocation. Individuals and financial advisors should also consider the broad array of available tools -- including working longer, controlling spending, and taking out a reverse mortgage. (The use of a "Monte Carlo simulation" allows one to provide estimates of the impact of marginal changes in each of the factors available.) Without using such a tool, it's extremely difficult to make an informed decision.

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