Morningstar Advisor - Summer 2007 - (Page 15)

ment is 80% of net pre-retirement income— in this case 80% of $90,000. Using net income is a realistic approach for both retirees and planners. Workers can make small adjustments to their lifestyle in order to continue that adjusted lifestyle in retirement. Using gross income as the retirement income target forces individuals to save more and to make more-radical cuts in their lifestyle. Thus, they could find themselves with a higher standard of living in retirement than while they were working. Also, remember that your clients won’t need to replace the whole 80% of that net preretirement income themselves. Social Security will pay for a portion, so their goal is to simply fund the gap. That gap, however, will be significantly wider for individuals in higher income brackets. That’s not just because they earn more and, therefore, have more income to replace in retirement. It’s also because Social Security is capped at certain income levels. So people who earn more will have to save a greater percentage of their income than people who earn less because Social Security funds a disproportionately smaller amount of their retirement income. How much does my client need to accumulate to finance this standard of living in retirement? So what savings rate will get my client there? We assume that you will invest your clients’ savings to match the asset allocation of a typical age-appropriate target maturity fund and that their income increases with inflation over time. Using Monte Carlo simulations and Ibbotson forecasted returns, we then project pre-retirement portfolio returns. Based on those results, we calculate the appropriate savings rates in the accompanying table. The table has three dimensions: age, income level, and capital already accumulated. To determine the guideline savings rate for a client, match up age and gross income. Subtract the indicated amount for each $10,000 of retirement assets already accumulated. For example, a 45-year-old individual with gross income of $100,000 and who is just starting to save for retirement needs to put away 26.2% of his salary. If he already saved $300,000 for retirement, he would reduce his savings need by 11.1 percentage points (0.37 30). His annual savings rate guideline would then be 15.1%. For clients with age and income falling between the numbers shown in the savings rate table, a pro-rata method is a good approximation. For example, a 37-year-old with income of $50,000 can do the following to calculate her savings rate: 1 Estimate the savings rate of 35 years old with $50,000, and the number is (12.2% 14.6%) 2 13.4%. Estimate the savings rate for age 40 and $50,000, and the number is 16.2%. Estimate the savings rate for age 37 and $50,000, and it is 13.4% 60% 16.2% 40% 14.52%. Savings Rate: How to Fund a Comfortable Retirement Age Income Savings Rate Deduction for Each $10,000 in Portfolio 25 25 25 25 30 30 30 30 35 35 35 35 35 40 40 40 40 40 45 45 45 45 45 45 50 50 50 50 50 50 55 55 55 55 55 55 60 60 60 60 60 60 $20,000 $40,000 $60,000 $80,000 $20,000 $40,000 $60,000 $80,000 $20,000 $40,000 $60,000 $80,000 $100,000 $20,000 $40,000 $60,000 $80,000 $100,000 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 5.8% 8.2% 10.0% 11.2% 7.0% 10.0% 11.8% 13.6% 8.6% 12.2% 14.6% 16.4% 17.6% 10.2% 14.8% 17.6% 19.8% 21.4% 12.4% 18.0% 21.4% 24.0% 26.2% 28.2% 15.0% 22.0% 26.2% 29.8% 32.2% 35.0% 18.6% 27.2% 32.6% 36.6% 40.2% 43.6% 23.8% 34.4% 41.2% 46.8% 51.4% 55.4% 1.60% 0.78% 0.55% 0.40% 1.65% 0.79% 0.54% 0.42% 1.75% 0.86% 0.55% 0.43% 0.34% 1.67% 0.86% 0.57% 0.42% 0.35% 1.76% 0.90% 0.59% 0.45% 0.37% 0.31% 1.87% 0.97% 0.64% 0.48% 0.39% 0.33% 2.11% 1.04% 0.71% 0.53% 0.43% 0.36% 2.39% 1.23% 0.81% 0.61% 0.50% 0.41% To calculate this figure, we assume that the ending wealth value needed to fund retirement is the amount of money it would take to buy an inflation-indexed lifetime fixed-payout annuity that would provide a guaranteed payment equal to the gap between Social Security payments and 80% of net pre-retirement income. We’re not suggesting that everyone should put all of their savings in an immediate annuity at retirement, but we use the annuity formula as a reasonable and conservative way to estimate how much income the savings can sustain on an inflationadjusted basis through retirement. 2 3 Clients who receive company contributions to qualified plans, such as a 401(k), should treat the company contribution as part of their savings, thus reducing their personal contribution. For example, the individual age 35 with $40,000 income and $50,000 already accumulated should save 7.9%, but with a MorningstarAdvisor.com 15 http://www.morningstaradvisor.com

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Summer 2007

Morningstar Advisor - Summer 2007 Contents Letter from the Publisher Get to Know the Bond “All-Stars” Research Briefs Our Stewardship Test Gets Tougher Save It for Later Too Many Oranges Best of Both Worlds No Two Clients Are Alike When It Comes to VAs, It’s Seller Beware Hands On: Finding the Suitable Fund Share Class for Your Client Fund Style Can Drift Off Course Sticking to Their Style, Through Thick and Thin Marathon Man Growth, With a Chaser A Menu of Ideas to Fill Five Market Baskets Funds: Finding Funds with Conviction Stocks: So You Say You Want Income? All Eyes on China Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities What’s New at Morningstar and on the Web The Advisor’s Economic Moat

Morningstar Advisor - Summer 2007

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