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The Three Things to Know About the Golden Years

The most obvious benefit of retirement -- that you don't have to work anymore -- is a pretty attractive prospect on its own. But many people are pleasantly surprised to find that reductions in their living expenses during retirement can further sweeten the deal. For example, once you retire you'll no longer have work-related expenses such as transportation to and from work, buying lunch every day, outfitting yourself for work, etc. People of retirement age may also see a general decrease in other living expenses: houses get paid off, kids finish school and begin supporting themselves, etc.

But a comfortable retirement isn't just going to come to you. Here are some things you'll need to consider about your retirement.

When To Check In

Deciding when to retire is the most important question you need to answer when planning your retirement investment strategy. Ultimately, you are the only one who can decide when you want to retire -- whether you'd rather take it easy early or continue working longer to build up your savings.

In the graph above, statistics from the Organization for Economic Cooperation and Development (OECD) suggest that the trend toward lower average retirement ages which began after World War II has tapered off. After declining sharply in the 1960s and 1970s, the retirement age bottomed out at 63 years in the mid-1980s, and has risen slightly since then. But it's not clear yet whether the population as a whole is choosing to work later in life.

There are several reasons people choose to retire later. For one thing, the longer you work, the more money you will probably have. Also, working longer shortens the time you will spend in retirement, which will allow you to spend more of your nest egg each year. Frankly, many people are finding they can't afford to stop working, even when they reach the traditional retirement age of 65. Finally, some people truly enjoy their work and simply don't want to retire.

Planned changes in Social Security benefit payments may also encourage later retirement. Full Social Security retirement benefits are now payable at age 65, with reduced benefits available as early as age 62. But the Social Security Administration plans to raise the age you can start collecting retirement benefits. Beginning in 2003, the normal retirement age will be increased incrementally for people born after 1937. By 2027, the age to begin collecting full benefits will have risen to 67; this change will effect people born in 1960 and later. (Reduced benefits will still be available at age 62.)

"Wait a minute," you may be thinking. What about all those stories about people who invested so successfully that they were able to retire at age 50, or 45, or even younger? Well, these are nice stories but they don't reflect reality for most people. The financial argument for retiring later is much stronger -- and if you have a house and kids, you may not have any choice but to work longer.

If an early retirement is your goal, you'll have to plan for it early, either by saving more now or investing more aggressively in pursuit of higher returns.

What Are the Room Rates?

Financial planners estimate you will need approximately 70% of your pre-retirement income to maintain your lifestyle during retirement. This "replacement" salary is usually based on what you earned in your last year before retirement.

Social Security, pension and other income sources will fund some portion of your income during retirement. However, for most individuals, these sources will be insufficient to provide for all of your retirement needs.

So how much can you expect to receive from Social Security? The Social Security Administration estimates that Social Security benefits replace about 42 percent of an average wage earner's salary. Here's what Social Security is paying to retirees today:

Earnings in 1997 Wage Earner Wage Earner and Spouse
$20,000/yr $ 784 $ 1,176
$40,000/yr $ 1,197 $ 1,795
$65,400+/yr $ 1,342 $ 2,013

The monthly benefit estimates shown above are based on a person who is 65 in 1998, and has had steady lifetime earnings from age 22 through the year before retirement (1997). Married workers can receive benefits based either on their own work record or their spouse's, whichever is higher.

Because of demographic shifts, however, Social Security benefits are not likely to remain this high. In particular, workers now in their 20s and 30s will reach retirement age at a time when the Social Security trust fund has been stretched to the limit. While there is talk of allowing the trust fund to grow by investing in something more lucrative than U.S. Treasuries, most proposals to "fix" Social Security involve reducing benefits or continuing to raise the retirement age. The bottom line is this: workers should be prepared for Social Security to cover a smaller portion of their retirement needs.

If you want to calculate what your Social Security benefits will be when you retire, you need to estimate what your salary will be during your final year of work. This is very difficult to do with 100% accuracy. There are some rules of thumb to help guide you, but they are not foolproof.

First, you could look at your current rate of salary increase and use that to calculate your salary when you retire. For example, if you are 25 years old, currently earning $20,000 per year, getting a 5% raise each year, and expect to retire at 65, your ending salary could be estimated at around $140,800 per year. (This may sound like a lot, but keep in mind that because of the effects of inflation, $140,800 won't go as far in 40 years as it does today.) Also, realize that very few companies provide regular annual pay raises anymore, and that the largest percentage salary increases often come early in your career, as you build skills and move to different positions. And finally, the whole equation could change if you change jobs.

Another, possibly more reliable method is to look at the annual salary of someone who is at the top of your chosen profession and aim for that. If you assume that you will stay in your current field until you retire, you can estimate that your salary will be somewhere around that level (adjusted for inflation).

But this method isn't foolproof either. You can't necessarily extrapolate your future salary from what somebody else is making today. If you are a programmer, you might argue that Bill Gates is at the top of your profession, but it's probably unrealistic to expect his salary.

In sum, there really is no completely reliable way to calculate how much annual income you will need in retirement. It depends on how much you will make in the future, how much impact inflation will have on your dollar and how long you will be in retirement. None of these can be reliably predicted. But it's prudent to expect you'll need more than you think you'll need now.

If you're stuck between saving too much and too little, go with too much.

When You Will Be Checking Out

The good news is that people are living longer than they used to.

The bad news is that people are living longer than they used to.

It is harsh to consider, but today's longer life spans complicate retirement planning. When Social Security was introduced in 1935, a person could assume he would live to be about 63. Today, the average life span for men is around 73 and for women it is almost 80. And most of us have at least one relative who has lived into his or her eighties or beyond.

Frankly, longer life spans are placing a huge burden on both our public and private resources. In order to support retirees, society needs to have large numbers of people working. But the ratio of workers to retirees is shrinking at a rate that will accelerate over the next few decades, as baby boomers reach retirement age.

In 1990, according to the U.S. Census Bureau, for every 100 workers there were 22 retirees eligible to collect Social Security benefits -- a ratio of almost 5 to 1. By 2025, the number of retirees for every 100 workers is expected to grow to more than 35; that's a ratio of less than 3 to 1. This is why many observers believe Social Security benefits will be curtailed in the next century.

For your own retirement planning, it is wise to assume a longer lifespan. That means not only estimating how large an annual income you'll need, but also making a guess about how many years you will live in retirement.

That's easier said than done. There is no way to know for sure how long you will live. All you can do is make a rough guess. Your best bet is to be prepared -- plan for a long life and a long retirement, and save accordingly.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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