Iowa State University Extension

How does your financial picture with this early retirement package compare with that you would see if you waited to retire?
Thoroughly examine the finances, considering all of the following factors:

1. Impact of a longer retirement
2. Income availability before age 62 or 59-1/2
3. Balance income and expense for the long haul
4. A hidden cost: missed years of contributions

To assist you with your financial projections, you will find links to ISU Extension retirement publications.  You might also choose to try the Ballpark E$timateÒ of Retirement Needs, which offers an interactive tool for calculating your retirement needs in different scenarios.  Sponsored by the American Savings Education Council and ChoosetoSave.org.

1. Recognize how a longer retirement will affect your financial well-being.

A person who retires at 55 and lives to be 95 will have a 40-year retirement! Even without an early retirement, many Americans plan for an unrealistically short retirement, forgetting how long they might live. If you retire early, the duration of your retirement is magnified even further.

Start with statistics as you consider your life expectancy.

• The average 55-year-old will live another 25 years.
• The average 75-year-old will live another 11 years.
• Women live longer than men, on average.

Then look at your own family history and your own health status. If your grandparents lived to a ripe old age, then it will be smart to plan for the possibility that you'll live longer than average.

To be financially safe, be prepared for a long life.

Why think about how long your retirement will be?

a. Your assets will need to provide income for that many more years. A retirement "nest egg" of $500,000, invested to earn a 7% annual return, will provide $47,000 per year income over a 20-year retirement before being depleted. But when spread over a 30-year retirement, you can only draw $40,000 per year in order to make it last 30 years. (35 years - $38,600) (25 years - 42,900)

b. Inflation. Even at a low inflation rate, costs multiply dramatically over several decades. If your desired lifestyle costs $30,000 per year today, how much would it cost after 35 years of inflation at 3%? Nearly $85,000. If inflation averaged 4% per year, the cost in 35 years would be over $118,000.

2. What income sources are available if you retire early?

• The earliest you can be eligible for Social Security Retirement benefits is age 62, and benefits taken at 62 are lower than they would be if you waited till your full retirement age of 65 or higher. Before deciding to retire, contact the Social Security Administration  for accurate estimates of what your retirement benefits would be if taken early, compared with what they would be if taken later.
  
• Most tax-advantaged retirement plans (IRAs, 401ks etc) cannot be accessed before age 59-1/2 without a penalty. There are a few qualified exceptions. The Internal Revenue Service provides details in Tax Topic 558.
  
• Pension - If your early retirement offer includes a defined benefit pension, find out if annual cost of living increases are guaranteed. What method is used to calculate cost of living increases?

Note: Increases are typically based on the consumer price index (cpi).  But in recent decades the cost of health care has increased significantly more than the general cpi.

Since health insurance and health care costs are major expenses during retirement, it is smart to expect that cost of living increases in pension and social security benefits may not actually keep up with your living costs. If pension and social security benefits are important parts of your retirement income plan, keep in mind that as years go on you may need to increasingly rely on other income sources to cover your actual costs.

Retirement Income: How Much Do You Need? - PM 1818a (pdf) provides information and guidance on planning for retirement income.

3. What do the financial projections look like? Will your resources be adequate to meet your needs and goals?

If you begin now to draw from your retirement funds, how much can you withdraw while still allowing for your full life expectancy... will you want to (or be able to) live on that much?

The first step is to estimate your retirement expenses (in today's dollars). Keep in mind that many retirees experience several phases of retirement:

• an active phase during early retirement, which can involve relatively high costs
• a less-active phase during mid-retirement, which is usually relatively low-cost
• a need for extra support or care in late retirement, which can be a high-cost phase.

Remember, too, that you may owe taxes on some of your retirement income.

Over a long retirement, inflation will have a significant impact on cost of living, even if the annual inflation rate is low. Examples:

• A vacation that costs $2,000 today will cost $5,600 after 35 years of inflation averaging 3% per year.
• A lifestyle that costs $35,000/year in today's dollars, will cost over $138,000/year after 35 years of 4% inflation.

As you project how well your available retirement income and assets will meet your retirement needs and goals, you may discover a gap. Being informed and prepared with your financial projections enables you to make plans to accommodate that gap:

• increase available retirement assets
• reduce planned retirement expenses
• delay drawing from retirement funds (if you draw from them for fewer years, you will not need as large a lump sum)

Three ISU Extension publications will guide you through the financial planning process for retirement:

• Retirement Income: How Much Do You Need? - PM 1818a (pdf)
• Estimating Your Retirement Expenses - PM 1818b (pdf)
• Money Math - PM 1819 (pdf) -provides tools for use with the Retirement Income publication

4. Even if you decide to leave your retirement funds intact until age 62, 65, or later, what is the cost of not making contributions during what would have been the last few years of your career?

Your employer may offer comparisons of how the package they are offering compares to what you would receive if you were simply laid off. That comparison has some validity, especially if being laid off is likely for other employees.

In an optional early retirement decision, the fair comparison, however, is with what you would receive if you stayed on the job until the retirement age you originally planned on.

Example: Suppose you are 60 years old, offered the chance to retire 5 years earlier than planned. You are planning to live until age 90. Your 401(k) plan has a current balance of $400,000 and earns average annual returns of 8%. The combined 401(k) contributions made by you and your employer equal $600/month.

a) If you remain employed and continue those contributions for five more years, your account would reach $640,000 by the time you retire. That sum would provide income of $60,000/year for 25 years before being depleted when you reach age 90.

b) If you retire five years early, but do not withdraw from your retirement funds during those five years, then when you reach age 65, the value of your 401(k) account will be $588,000. That would provide income of $55,000/year for 25 years before being depleted at age 90.

c) If you retire five years early and begin immediately taking withdrawals from your 401(k) account, your 401(k) account will provide annual income of $35,500 per year for 30 years before being depleted when you reach age 90.