by Marvin Appel, PhD, and Brian Hufford, CPA, CFP
The years 2000 and 2001 destroyed the confidence of many savers because of losses in the stock market. Likewise, fixed income investments, such as money market accounts, certificates of deposit (CDs), and bonds currently have the lowest interest rates in two decades. Even a multi-millionaire would have to watch living expenses if forced to live on interest from CDs in today's environment without depleting capital.
Let's compare this gloom with investor expectations just three short years ago. A study from 1999 indicated that average expected returns for college-educated investors during their lifetimes were 33 percent per year. Today when I ask seminar participants what return they expect over the next 10 years, most say they would be happy with 5 percent annually. What a difference!
Losses are devastating to an investor's commitment to saving. Why save when it's likely when the risk of losing money in the stock market looms large? Recently, while having my car repaired, a salesman told me that one of his customers had cancelled his new car order since he had lost "the price of two new cars last month in the stock market." I wondered how this person would feel about continuing to save in his retirement plan. We encourage you to continue saving for retirement and will present some hints about how to stay on track.
How much will you need?
Two rules of thumb are very helpful when estimating the amount needed for a comfortable retirement. The first is the 1.3 Rule, which states that the before-tax income needed for retirement is about 1.3 times your estimated annual spending during retirement. In other words, if you plan to spend $100,000 per year during retirement, then you will need $130,000 of before-tax income ($30,000 of federal and state income taxes, with $100,000 left over.)
The second rule of thumb is what we call the "Magic 20 Rule." This rule says a relatively safe retirement requires saving 20 years of expenses before retiring. The above example would require saving 20 years x $130,000 or $2,600,000. Under this arrangement, an investor would draw 5 percent of retirement assets each year. Although future investment results are not guaranteed, in the past you would not have had to take outsized risks with your savings to maintain this withdrawal rate.
A second-best and more risky plan would be to have 15 years' of expenses saved. The annual withdrawal rate in this case would need to be 6 to 7 percent of retirement assets each year. This additional withdrawal rate leaves a smaller margin of safety. Professors Cooley, Hubbard, and Walz of Trinity University in San Antonio, Tex., published a timely study about the probability of success during retirement at different withdrawal rates. With an investment portfolio of half stocks and half bonds and a 20-year retirement period, the professors determined that the probability of success at a 5 percent withdrawal rate is 90 percent. With a 7 percent withdrawal rate, the potential of success drops to 50 percent. Higher withdrawal rates increase the risk of failure.
How much should you save?
The American Savings Education Council estimates that retirees, on average, live on 70 percent of their pre-retirement budget. In our experience, dentists who retire wish to maintain their preretirement lifestyle. Housing, automobile, and clothing expenditures may be less; however, travel, medical costs, and expenditures such as assisting children and grandchildren can easily make up the difference. Many of our clients spend more during retirement than when they were working. One client said it honestly: "I probably need to continue working as long as possible since I spend too much when I'm not working."
Another interesting rule of thumb we have discovered is that most dentists tend to spend about 20 percent of gross annual collections. This would indicate that at about $500,000 of annual collections, you probably spend about $100,000 on living expenses. Is your current spending more or less than this percentage? Which items of your current budget would be cut during retirement?
Dentists reflect the savings habits of all Americans. Many save too little. How do you determine if you are a good saver or not? To determine if your current savings puts you in the class of saving adequately, multiply the gross collections from your dental practice by 10 percent.
In other words, if your gross collections were $500,000, you should save $50,000 per year. If you are saving less than this amount, you are in all likelihood not saving enough to provide adequately for retirement and college for your children. And, yes, you can retire with less savings, but why? The savings potential that exists in a well-managed dental practice can mean an abundant and gratifying retirement.
How to catch up if you're behind
The Bush administration has made it possible for those who are behind in their savings to catch up for retirement. Under new pension laws, most dentists who are under the age of 43 can save and deduct $40,000 in a defined contribution retirement plan. Many dentists who are over 45 can save and deduct as much as $80,000 per year or more under new laws for defined benefit pension plans. Because these plans are tax deductible, the actual savings needed to fund the plan is achievable for most dentists. For instance, in the combined 40 percent federal and state marginal income tax bracket it takes only $24,000 "real" dollars to fund $40,000 in a retirement plan, due to the $16,000 of income tax savings generated!
We have identified the three most important steps to achieving adequate savings:
Step 1:Increase production per hour by $35
A production increase of $35 per hour can be achieved easily by attention to fees and by employing scientific appointment scheduling. This increase in production per hour alone will fund a qualified retirement plan.
Since approximately 80 percent of a production increase drops to net income, this is the first place to look for more savings potential. Approximately 75 percent of your home budget is fixed and unalterable. The fixed items of income taxes, housing, and transportation may be 75 percent of your entire home budget. To produce more savings from the rest of your budget, you would need to cut items like food, vacations, eating out, and dependent expenses. This hurts!
Step 2:Manage debt and capital expenditures
Our firm has discovered that most dentists lose between $30,000-$50,000 per year of cash flow through improperly structured debt payments and capital expenditures. With a low-risk investment approach, most doctors would be better served by paying debt more slowly. This would allow for earlier savings with the benefits of compound growth and more safety. What determines risk for debtors is the amount of cash in savings
Step 3:Use a well-designed pension plan
A well-designed pension plan achieves $40,000 or more for the doctor in a deductible pension plan, while limiting staff costs to 30 percent or less of the total amount saved in the plan. In dentistry, the staff-to-doctor ratio requires expert help in designing an appropriate plan. Many times, IRA-based plans such as SIMPLE plans and SEP-IRAs can't achieve this goal. The best plans for dentists typically require the use of more sophisticated help.
In summary, you can save much more than you thought possible. You can reach your retirement goals. The time to start planning is now!
