Planning for retirement? Use these three tests to estimate your income needs

The most common wealth-management question that clients ask involves retirement income planning. How much money do you need to retire?

To answer this question, first you need to know how much you will spend when you retire. We suggest using three tests to estimate retirement income needs.

First, it is imperative to knowhow much you spend now. We recommend tracking all of your expenses over 12 months. This can be a tedious exercise, but worth the trouble to make sure you get it right. Using a credit card for as many costs as possible is an easy way to consolidate your spending and monitor the "little things'' that you might otherwise overlook. Several websites and smartphone apps can also track your finances and help monitor your spending.

Second, assess the figure's accuracy by subtracting your annual savings from your annual income. This process is especially simple for wage earners, because year-end pay stubs include both income taxes and employer-sponsored retirement plan contributions. Simply subtract any additional savings (for example, IRAs, excess cash, etc.) to estimate your disposable income.

A third and final test to consider is a "replacement ratio'' - the percentage of your income earned in working years that you will need in retirement. The replacement ratio is normally around 80 percent or less.

Much of this reduction is the result of a lower marginal tax rate, favorable tax rates on qualified dividends and long-term capital gains, no Social Security or Medicare taxes and reduced state and local taxes. Furthermore, a retiree will no longer set aside income for savings.

The ultimate expense wildcard in retirement is health care (including long-term care). People who plan to retire before they are eligible for Medicare will face a major expense for health insurance premiums. As insurance companies continue to raise deductibles, the uncertainty of health care costs only escalates.

After estimating a figure for retirement spending, we subtract any retirement income sources - Social Security, pensions, annuities, real estate rental income, part-time work and so on. This leaves us with a net figure that must be covered with periodic withdrawals from your retirement savings - such as IRAs, 40l(k)s, 403(b)s or brokerage accounts.

The final step requires retirement evaluation software to estimate the probability that your retirement savings will cover these periodic withdrawals by projecting investment growth while accounting for inflation, cost-of-living adjustments to Social Security and pensions and assumptions for income and capital gains taxes.

A chief benefit of software analysis is a projection of long-term investment performance, even in a lackluster market. Periodic withdrawals during a poor market can be quite detrimental, so these projections are crucial since they model a multiplicity of scenarios based on random historical market returns.

Unfortunately, detailed retirement projections are only as good as the underlying investment strategy throughout retirement. When a retiree's paychecks stop coming, fear of capital markets seems to intensify, and we find that investors make two common mistakes.

The first mistake is buying "special'' retirement-oriented products that unscrupulous advisers peddle for fat commissions. Typically sold by advisers representing themselves as retirement income and tax-efficiency experts, these "guaranteed'' variable and indexed annuity products come with a variety of claims, when in reality they are always low-returning, punitive, highly complex and outrageously expensive. Remember the admonition, "If it sounds too good to be true, it probably is.''

For those retirees who wisely sidestep these retirement income schemes, a second, more subtle, mistake is implementing an asset allocation that is too conservative, given the long lives that Americans lead.

A greater allocation to higher-risk investments, such as equities, is typically more appropriate for investors with a time horizon of 10 years or more. Despite intuition to the contrary, retirement is a long-term endeavor, which can last 30 years or more. An outsized allocation to "lower-risk'' investments, such as fixedincome and cash, will be problematic over a multi-decade period, because inflation, taxes and expenses will do significant damage to the purchasing power of the portfolio.

But, with interest rates historically low, how do you invest in a traditional stock and bond portfolio to fund retirement? Over the last several decades, endowments - pools of dollars that charities invest in perpetuity - have adopted the concept of "total return'' investing.

This approach to investing accounts for two categories of returns: income and appreciation. Income consists of the coupon payments from bonds and the dividend payments from stocks, while appreciation is the periodic increase in the value of the stocks and bonds.

So, with a stock and bond portfolio, howmuch "total return'' can you expect? Although no one likes to admit the probability that future long-term stock and bond returns will be similar to historic returns, it is sensible to give history the benefit of the doubt.

Using Ibbotson data from 1926 through 2012, large U.S. stocks have returned 9.85 percent per year and U.S. government bonds have returned 5.36 percent peryear. Ifyou assume a portfolio of 60 percent stocks and 40 percent bonds, based on these historical returns, your portfolio would generate an average annual return of a little more than 8 percent. After backing out reasonable portfolio costs and an inflation factor, history suggests that a sustainable balanced portfolio withdrawal rate is 4 percent to 5 percent.

More than likely, there is little room for error regarding your retirement investments. For this reason, avoid headwinds; insist on alow-cost, transparent investment portfolio. Be wary of cure-all, pre-packaged products that claim to meet your needs; the complexity and fees will derail your best intentions.

Ben Atwater and Matt Malick partners at Atwater Malick LLC

Ben Atwater and Matt Malick are partners at Atwater Malick LLC, a registered investment adviser, which has offices in Lancaster and Dauphin counties. Email them at ben@ atwatermalick.com and matt@atwater malick.com.