However, if they are strapped every month then this scenario may be the best that they can do. This creates a dismal retirement for the Smiths. Therefore, let us examine some financial planning strategies that will help the Smiths to achieve their goals.
When one examines the Smiths' investments, they are only relying on what is available from their employers as the basis for their savings. The 401 (k) is not considered to be an aggressive investment strategy. They typically only manage to match or slightly outperform inflation by 1-2%. This means that using a 401(k) as a sole means of retirement income will only yield a little more or less than one year's salary at the beginning of the retirement. This is hardly better than a passbook savings account, and in some cases is less. However, the real advantage to the 401 (k) is the matching contribution from the employer. This adds money that they otherwise would not have had access to. One should never look a gift in the mouth and should use their 401(k) to their best advantage, but they should not count on it as a sole means of retirement income.
The Roth IRA and 529 plan are more aggressive than the 401 (k), but as we saw they still were not able to generate enough so that the Smiths could live comfortably. The Smiths combined income was only able to help them achieve one of their goals, putting their kids through college. Let us examine some ways that the Smiths may be able to use to achieve both of their goals.
For the first scenario, we will assume that the calculation is correct and that the Smiths will need 90% of their pre-retirement income to live. If this is the case, then, as we determined previously, they will need to generate $175,142 annually to live at their current lifestyle. If they wished to devise a plan to live entirely off of investments then they would need to invest approximately $3,000,000. This would generate a passive income of $180,000 per year and they could live comfortably on passive income and have a $3,000,000 income to pass on to their children. If the children were smart they would use this to generate passive income as well. However, three million dollars is a large chunk of money and without some aggressive strategies, it is unlikely that the Smiths will be able to achieve this.
The other way to look at this problem is that the mortgage will be paid off and the Smiths will have a much lower income needed to survive. In order to do this we will have to make some basic assumptions about the mortgage. We will assume that they mortgage is 60% of the Smith's annual income. If this is true, then if we eliminate this expense at retirement the Smiths only need $52,542 per month to live. Let us assume as in the previous scenario that social security and pensions will cover an additional 30% then they will only need $31,525 to live.
Under their current plan they will have an income of $30,734. That is reasonably close and is probably correct considering that our inflationary indices and other factors may be off. If the Smiths can find additional ways to cut back then they can probably make this budget work for them. They now can live on the passive income and have about $312,760 to pass onto their children.
Using this strategy, the Smiths will be able to leave their children a nest egg of $312,760. They wish to devise a plan to help their kids manage their money successfully. Therefore they have decided to set up a trust that distributes quarterly payments. The trust is expected to generate an annual return of 9%, compounded monthly. Their children will receive $7,035 per quarter for the rest of their lives.
This analysis relies on many assumptions about what will happen over the next 30 years. There are many factors that could influence inflation rates and returns on the Smith's investments. Many of these factors are due to general trends and macroeconomic factors. The current rates that have been used to calculate retirement are based on assumptions and current economic trends. Life is not a straight path and there are certain to be bends in the road. As time goes on, the Smiths will have to re-evaluate their strategy from time to time. They may have to devise a plan in order to cope with factors such as higher than expected interest rates, or to take advantage of an opportunity that presents itself.
The global economy has been around for many years. However, advances in communications have changed the face of the global economy in recent years like never before. A world that used to be only for the large corporation has now opened up to become a part of the world of the small and medium business. This will have many effects on the macro economy including increased competition, greater access to substitute goods and many other factors that may have an impact on the U.S. inflation rate.
In regards to the sensitivity of the assumptions of this report, a change of 1-2% would not change these results drastically. However, a change of 4-5% in either direction could mean the need to alter the plan significantly. As the economy reacts to shocks, the size and duration of the shock determine the effect that it have on interest rates. The same can be said of shocks that are experienced by the Smiths themselves.
There are a number of things that could happen which could interfere with this plan. The loss of a job or long-term illness that is not covered by insurance could have a drastic effect the outcome of the plan. The severity and length of the shock will be the determining factor in whether it affects the outcome or not. A shock can be positive or negative. However, for the most part one is concerned about negative shocks.
The lower interest accounts would be more sensitive to shocks than higher interest ones. Even a small shock could place the smaller interest account into an even situation, where it loses as compared to inflation. The key to retirement savings is to make gains that are greater than the inflationary index. It may appear as if an account is increasing astronomically if one considers it at the current inflation rate. However, when one considers that the cost of living goes up with the increases in salary then it soon becomes apparent that it is possible to lose money even if the account continues to rise.
If other items have risen at the same rate as salaries, then no gain in real terms has been made. This is the key to understanding retirement savings, it is not simply a matter of putting money into accounts, and it is a matter of beating the inflationary index and the many factors that can affect it. The following shows movement of the Prime Rate over time.
Source: MOneycafe.com (2006)
In general, 401(k) plans and other retirement plans do only slightly better than inflation. In many cases they only keep pace, which means that at least one does not lose money in the long run. However, 401(k) plans are not the answer to wealth in the golden years. They are considered a conservative move for those that are adversarial to risk and that may not be suited for riskier, but higher return investments. Roth and traditional IRAs tend to perform better than 401 (k) plans, typically twice the rate. However, one has to be careful that the earnings from these investments do not get consumed in taxes, whether it now or in the future.
The plans chosen by the Smiths in this case study represent the types of investments that are utilized by a majority of Americans. They are safe and one at least knows that they will not lose money in the end. However, as we saw in this case study, these low risk investments are also low yield as well. In some of the scenarios depicted in this study the Smiths actually ended up broke as soon as they retired. In other cases, they were able to live comfortably in their golden years and their children will be quite spoiled by the trusts that they left them.
Alternative Investment Opportunities
401(k) plans are an excellent way to protect savings. However, as we have seen in recent years, there have been cases where 401(K) plans have been plundered by unscrupulous upper managers. People have lost their retirement savings and had to start over at a time when they were in no position to do so. IRAs are fairly safe, but tax rates on them tend to change with Presidential administrations. These types of investments should not be avoided and they provide a nice stable base for other…