Everyone dreams of a fun retirement – a phase in life where you get to travel to exotic places, have time freedom, and do all the things you love to do but couldn’t do during your working years.
However, the fun phase can only happen if you put in the necessary effort into the boring part, which is the planning phase.
As you probably already figured, retirement planning isn’t something you do in one sitting. It is a multistep process that can span a long time.
While this type of planning is usually not very exciting for many people, it is crucial for those who want to build financial security that will fund their dream lifestyle in retirement.
Read on to discover how to prepare for retirement with these easy-to-understand steps.
Why Retirement Planning is Important
According to a 2019 study from Northwestern Mutual:
About 21% of Americans do not have any retirement savings at all.
Only one in three Baby Boomers has up to $25,000 in retirement savings.
46% of American adults are not prepared for the possibility of outliving their savings.
While 16% of Americans have a large chunk of money stashed away for retirement, the larger population doesn’t seem to be prepared for retirement.
This is a worrisome trend, considering that life expectancy is higher in more recent times. Your post-career phase could last for up to 25 years or even more, which is why you need to have a concrete retirement plan.
Here are other reasons why retirement planning is crucial:
1. You Can’t Rely on Social Security
With an average monthly benefit of $1,544 in 2021, it might not be feasible to live your dream lifestyle based on Social Security alone. This is especially worrisome considering that the average American spends about $3,189 per month (or $7,092 per month for a family of four).
Your safest bet, even with Social Security, is to have a separate retirement income to bolster your financial security, whether that is an individual retirement account (IRA) or an employer-sponsored retirement plan, such as a 401k plan.
2. Enjoy Better Health in Old Age Due to Lower Stress Level
It is no secret that money problems are one of the major sources of stress. According to the American Psychological Association, more than 70% of adults say they feel stressed about money issues.
Of course, continuous stress can lead to health issues, such as heart disease, poor sleep, diabetes, and headaches. In worse-case scenarios, excessive worries can lead to anxiety and depression. These are not the states of mind that older adults will want to live with in retirement.
Since not everyone will be lucky enough to get a huge inheritance or win the lottery, the surest way to enjoy good health in old age is to plan for your retirement now that you still have the time.
3. Take Advantage of Compounding Interest
Planning and saving for retirement early lets you earn more interest on your retirement savings. But it’s not just any type of interest. Compounding interest means the interest on your contributions will also yield additional interests.
4. Not Being a Burden to Your Children
Spending time with your children and grandkids is great, but you don’t want to live with them because you can’t afford to live independently.
Saving enough money is the only way to avoid becoming a financial burden on your children in your golden years.
Start Saving on Time – Keep Your Time Horizon on Mind
A 25-year-old professional who is just entering the workforce and intends to retire at age 65 will have a different approach to retirement planning than a 50-year-old employee who plans to retire at the same age. In other words, your time horizon is the number of years between your current age and your expected retirement age.
Figuring out your time horizon is the first step in retirement planning. It allows you to put an effective retirement strategy in place, considering the number of years you have until retirement.
People with a longer time to retirement may consider having the majority of their assets in riskier investments, such as stocks. Of course, stocks have higher volatility but it performs better over long periods than bonds and other securities. If you have 10 years or more before retirement, stocks will make a good investment option.
Younger people can start saving early, even if they start with small amounts. Saving few bucks from your paycheck in your early 20s may seem too little, but the power of compounding can make it worth so much more in the future when you need it most.
If you have a shorter time horizon, it is better and safer to allocate the majority of your portfolio in bonds and other securities for the preservation of capital. While bonds won’t yield the type of higher returns available in stock, it is less volatile and will give you income to cover your living expenses.
One of the most important steps in how to prepare for retirement is starting on time – set the plan in motion now. It doesn’t matter whether you are young or have only a few more years before you retire; it is never too late to get started.
Be Realistic About Retirement Goal Setting
It’s easy to picture your dream retirement and set goals but you want to make sure they are not far-fetched ones. Your retirement savings must match up with your dream lifestyle if not it will be difficult to actualize the dream.
Social Security is not designed to support you 100% in retirement. It only provides about 40% of your average income in retirement. That means you have to be realistic about the level of support your current financial resources can provide in retirement.
Would your current resources be enough for the retirement lifestyle you want or will you need to find other ways to close the gap? Do you need to accumulate additional assets to support your plan or do you think adjusting your retirement goals to match your current resources is more realistic?
By carefully analyzing your current financial situation you will be able to set out a more realistic plan for the future, even if it is a more conservative one.
Figure Out Your Retirement Spending Needs
The next step in how to prepare for retirement is determining your post-retirement spending habits. This will help you to figure out the size of your retirement portfolio.
This is another area of retirement planning where you need to be realistic. Most people erroneously assume that their annual spending in retirement will be far less than what they spent during their working years. After all, they are retired and there are fewer things to spend money on.
Unfortunately, this is not a realistic assumption. There are many things that can come up in retirement, including unforeseen medical expenses. People tend to develop health issues more frequently as they grow older and this can eat away at their retirement funds. It gets worse if the mortgage hasn’t been paid off.
In addition to these obvious expenses, many retirees tend to spend the first year of retirement splurging on bucket-list goals, including touring the world.
Factor in the yearly increase in the cost of living when you are working out your post-retirement spending needs. This means for many people, a more feasible saving that will cover their expenses in retirement will be almost 100% of their current expenses, at least if they want to thrive when they retire.
Diversify Your Retirement Funds and Invest for Growth
A well-balanced investment portfolio is necessary to keep your retirement funds safe regardless of market downturns. This is why you should not only focus on investing for growth but also to reduce risk.
While investing in the stock market can generate huge profits in the future, consider maintaining a proper mix of assets, such as mutual funds, bonds, and different industries that suit your liquidity needs, risk tolerance, and investment time horizon.
Different financial instruments and assets react differently to the market, and by diversifying your investment, you can grow your funds while protecting your investment against huge losses when a particular market comes tumbling down.
Here’s how to plan for retirement using diversification as an investment tool:
Invest in multiple asset classes: Allocate your assets across different classes to help you balance potential risks and possible returns. Investing in only one asset class can be very risky.
Be wary of high-risk companies: While you could potentially have higher returns by investing in companies with higher share prices, higher stock price volatility is risky and can lead to huge losses pretty quickly. For this reason, it is best to limit the number of high-risk companies in your retirement portfolio to keep you on the safe side. Blue-chip companies are generally considered low-risk and safer investments. This is particularly a more appealing proposition for older investors who are closer to retirement.
Invest in a variety of industries: By spreading your stocks investments across various industries and a few different sectors, you limit your risks in the event that one industry takes a nosedive. Consider investing in cash, equities, and properties in addition to securities and bonds.
Keep your Debt in Check
Here’s the thing; you can’t possibly have enough money to build a solid financial nest for the future if you keep digging holes in your plans in the present.
You need to cut down on your debt. A good way to start is by paying cash for most of your purchases. This will go a long way to reduce new credit card debt. Also, it will downsize the amount of retirement income that will go into interest payments.
Another good practice that can help you keep your debts in check is to accelerate your mortgage payments. The earlier you pay off your loan before retirement, the less of your retirement funds will go toward repaying the mortgage.
Don’t Ever Touch Your Retirement Funds Prematurely
Lastly, you need to resist the urge to withdraw your retirement funds early. Remember that planning is of no use if you don’t stick to your plans.
If you take money out of your retirement account prematurely, you risk attracting some consequences, including:
Losing principal and interest on the money you withdraw. In other words, you will miss out on future earnings.
You may have to pay a 10% penalty for early withdrawal.
You can’t repay money into an IRA account. If you take money out of your individual retirement account and don’t it pay back within 60 days, it is considered a permanent withdrawal and will attract penalties and tax consequences.
Creditors can claim the amount if you are in debt. That’s because the distribution may not be protected from creditors.
Withdrawing money from a 401k may trigger a higher tax bill because the amount is considered taxable income. This is especially the case if the withdrawal pushes you into a higher tax bracket.
You may change jobs a few times during your 30 or more years’ career. But you can still leave your savings in current your retirement plan.
Alternatively, you can roll them over to your new employer’s plan or an Individual Investment Account (IRA).
An IRA is a tax-advantaged account that allows you to invest in a wide range of financial products, such as stocks, mutual funds, bonds, and exchange-traded funds (ETFs).
Making the switch to defined contribution plans means that employees need to learn how to prepare for retirement. They also need to manage their investment portfolio instead of relying on their employers to do it for them.
In creating an all-inclusive retirement plan, you must be realistic and even conservative in balancing your desired retirement lifestyle with your expected return on investment. Make sure to keep your plans flexible so that you can update them to reflect current market realities and your retirement goals.
John E Chambers is an experienced financial advice expert. Born in Chicago, he has a master's in Industrial Finance, but he has spent decades offering investment advice to businesses and individuals alike. He is the founder of RetireeWorkforce.com and wants the website to be valuable for retirement advice. In addition, he writes articles that help users jump-start their retirement plans and choose the best investment options. If not pondering over stock market statistics or reading some magazines, you can find John spending time with his family. As an early retiree, John also offers unique insights into what post-retirement life is like.