Planning for Retirement? Start With These 5 Steps

Retirement planning is a multi-step process that evolves over time. It starts with thinking about your retirement goals and how long you have to meet them. Then you need to choose and contribute to retirement accounts that will help you raise the money to fund your future.

As you're planning, you should consider breaking up your retirement into multiple components. Let’s say that you're a parent who wants to retire in two years, pay for a child’s education at age 18, and move to Florida. From the perspective of forming a retirement plan, the investment strategy would be broken up into three periods: two years until retirement (contributions are still made into the plan), saving and paying for college, and living in Florida (regular withdrawals to cover living expenses).

Let's take a look at the five steps that everyone should take to build a solid retirement plan.

1. Calculate How Much You Need

Your first step is to determine how much money you need to retire. The answer will depend on many factors, such as your income and your desired lifestyle in retirement.

There's no fixed rule here, but there are rules of thumb. Some experts suggest saving about $1 million. Others say you'll need about 12 years of your pre-retirement income. Others recommend using the 4% rule, which states how much you can safely withdraw from your nest egg to sustain a 30-year retirement. It's 4% the first year, and then the same amount every year after that, adjusted for inflation. If you had a $1.5 million nest egg, for example, you could withdraw $60,000.

Another guideline is to estimate that your spending in retirement will amount to about 70% to 80% of what you spent before retirement. However, this may be unrealistic.

“For retired adults to have enough savings for retirement, I believe that the ratio should be closer to 100%,” says David G. Niggel, CFP, ChFC, AIF, founder, president, and CEO of Key Wealth Partners LLC in Litilz, Pennsylvania. “The cost of living is increasing every year—especially healthcare expenses. People are living longer and want to thrive in retirement. Retired adults need more income for a longer time, so they will need to save and invest accordingly.”

Your longevity also needs to be considered when planning for retirement, so you don’t outlast your savings.

“One of the factors—if not the largest—in the longevity of your retirement portfolio is your withdrawal rate. Having an accurate estimate of what your expenses will be in retirement is so important because it will affect how much you withdraw each year and how you invest your account. If you understate your expenses, you easily outlive your portfolio, or if you overstate your expenses, you can risk not living the type of lifestyle you want in retirement,” says Kevin Michels, CFP, EA, a financial planner and president of Medicus Wealth Planning in Draper, Utah.

Additionally, you might need more money than you think if you want to purchase a second home, travel the world, or fund your children’s education during retirement.

Since everyone's circumstances are different, it's worth sitting down to calculate the ideal retirement savings for your own situation. It's a good idea to update your plan once a year to make sure that you're keeping on track.

2. Understand Your Time Horizon

Your current age and expected retirement age create the initial groundwork for an effective retirement strategy. The longer the time from today to retirement, the higher the level of risk that your portfolio can withstand. If you have 30-plus years until retirement, you can have the majority of your assets in riskier investments, such as stocks. There will be volatility, but stocks have historically outperformed other securities, such as bonds, over long time periods. The key word here is “long,” meaning at least more than 10 years.

Additionally, you need returns that outpace inflation so you can maintain your purchasing power during retirement.

“Inflation is like an acorn. It starts out small, but given enough time, [it] can turn into a mighty oak tree,” says Christopher Hammond, founder of Hammond Wealth Advisory in Savannah, Tennessee.

“We’ve all heard [about] and want compound growth on our money,” Hammond adds. “Well, inflation is like ‘compound anti-growth,’ as it erodes the value of your money. A seemingly small inflation rate of 3% will erode the value of your savings by 50% over approximately 24 years. Doesn’t seem like much each year, but given enough time, it has a huge impact.”

In general, the older you are, the more your portfolio should be focused on income and the preservation of capital. This means a higher allocation in less risky securities, such as bonds, that won’t give you the returns of stocks but will be less volatile and provide income that you can use to live on. You will also have less concern about inflation. A 64-year-old who is planning on retiring next year does not have the same issues about a rise in the cost of living as a much younger professional who has just entered the workforce.

A multistage retirement plan must integrate various time horizons, along with the corresponding liquidity needs, to determine the optimal allocation strategy. You should also be rebalancing your portfolio over time as your time horizon changes—more about that below.

3. Calculate After-Tax Rate of Investment Returns

Once the expected time horizons are determined, the after-tax real rate of return must be calculated to assess the feasibility of your portfolio producing the needed income. A required rate of return in excess of 10% (before taxes) is normally an unrealistic expectation, even for long-term investing. As you age, this return threshold goes down, as low-risk retirement portfolios are largely composed of low-yielding, fixed-income securities.

If, for example, you have a retirement portfolio worth $400,000 and income needs of $50,000, assuming no taxes and the preservation of the portfolio balance, you are relying on an excessive 12.5% return to get by. A primary advantage of planning for retirement at an early age is that the portfolio can be grown to safeguard a realistic rate of return. Using a gross retirement investment account of $1 million, the expected return would be a much more reasonable 5%.

Some retirement accounts, such as traditional individual retirement accounts (IRAs) and traditional 401(k)s, are taxed upon withdrawal. Therefore, the actual rate of return must be calculated on an after-tax basis. Determining your tax status when you begin to withdraw funds is a crucial component of the retirement planning process.

4. Assess Your Risk Tolerance vs. Your Investment Goals

Proper portfolio allocation that balances the concerns of risk aversion and returns objectives is arguably the most important step in retirement planning.

How much risk are you willing to take to meet your objectives? Should some income be set aside in risk-free Treasury bonds for required expenditures?

You need to make sure that you are comfortable with the risks being taken in your portfolio and know what is necessary and what is a luxury.

“Don’t be a ‘micromanager’ who reacts to daily market noise,” advises Craig L. Israelsen, Ph.D., designer of 7Twelve Portfolio in Springville, Utah. “'Helicopter’ investors tend to overmanage their portfolios," Israelsen adds. "When the various mutual funds in your portfolio have a bad year, add more money to them. The mutual fund you are unhappy with this year may be next year’s best performer—so don’t bail out on it.”

5. Stay on Top of Estate Planning

Having both a proper estate plan and life insurance coverage ensures that your assets are distributed in a manner of your choosing and that your loved ones will not experience financial hardship following your death. A carefully outlined plan also aids in avoiding an expensive and often lengthy probate process.

Tax planning is another crucial part of the estate planning process. If an individual wishes to leave assets to family members or a charity, the tax implications of either gifting or passing them through the estate process must be compared.

A common retirement plan investment approach is based on producing returns that meet yearly inflation-adjusted living expenses while preserving the value of the portfolio. The portfolio is then transferred to the beneficiaries of the deceased. You should consult a tax advisor to determine the correct plan for each beneficiary.

“Estate planning will vary over an investor’s lifetime,” says Mark T. Hebner, founder and president of Index Fund Advisors Inc. in Irvine, California, and author of Index Funds: The 12-Step Recovery Program for Active Investors. “Early on, matters such as powers of attorney and wills are necessary. Once you start a family, a trust may be something that becomes an important component of your financial plan."

You should re-examine your plan as you age, with the assistance of a financial advisor.

“Later on in life, how you would like your money disbursed will be of the utmost importance in terms of cost and taxes,” Hebner says. “Working with a fee-only estate planning attorney can assist in preparing and maintaining this aspect of your overall financial plan.” 

The Bottom Line

One of the most challenging aspects of creating a comprehensive retirement plan is striking a balance between realistic return expectations and a desired standard of living. One solution is to focus on creating a flexible portfolio that can be updated regularly to reflect changing market conditions and retirement objectives.