Kurt Brouwer October 28th, 2009
‘Life should NOT be a journey to the grave with the intention
of arriving safely in an attractive and well preserved body,
but rather to skid in sideways - Chardonnay in one hand -
chocolate in the other - body thoroughly used up, totally worn out and
screaming ‘WOO HOO, What a Ride’
I’m not sure who actually wrote this, but it does contain a very different perspective on planning for retirement, doesn’t it? My only quibble has to do with the wine selection. I always thought chocolate went best with a nice, full-bodied red.
Most of us do not have the perspective of the author of this pithy paragraph though. In fact, one of the key concerns — perhaps the key concern — people have about retirement is whether or not they will run out of money.
In answer to that question, the answer is almost certainly no. That is, you won’t run out of money.
Here’s why. Think of your gas tank in your car. If you were on a long trip and the circumstances were that you were getting low on gas and no gas stations were available, what would you do? Would you keep driving at high speed knowing that would burn gas quickly or would you cut back to the most efficient speed in order to conserve? Answer: you’d conserve.
The same is true of conserving your assets in retirement. If things looked tight, you would cut expenses and reconsider assumptions you had made long before a shortage would come about. You would make changes, consider new options and, in a variety of ways, you would think outside the box.
Retiring outside the box
As an example of thinking or even retiring outside the box, I was chatting with a client who complained that his retirement expenses were unsustainable given his steady income and savings.
I was kidding a bit, but I said, “You could always move to Guatemala.”
The thinking behind that statement is that many American and Canadian retirees have moved south of the border to expatriate enclaves in Mexico, Guatemala, Costa Rica, Panama and Nicaragua. Living expenses are generally much, much lower in those places. The client laughed and told me he had given some thought to living half the year in Mexico.
In other words, though you may think you’re going to retire and maintain all your present circumstances, that may not be the case either because you want a change or because you need to change.
You can have (almost) any thing you want, but not everything you want
In other words, there are definite tradeoffs in planning for retirement. If your primary goal is just to have the money for a simple, comfortable retirement, then that’s probably fine. But, if you begin adding on requirements, you may impinge on your primary goal.
Let’s say you are about to retire and you want to figure out how much you can spend each year during retirement. Before getting into formulas or related concepts such as inflation, in my view, the key question is this:
What do you want?
When I ask that question, people generally have a pretty clearcut plan on certain issues such as:
- I want to leave $_____ to my kids or my church or my charity while providing for a comfortable retirement
- I’m mainly concerned about retirement income and if there is anything left over, it will go to our kids
- I am worried that our retirement needs could become a burden to our children
- I don’t want to leave any money to anyone; so I want to write my last check on my deathbed
The details may vary, but your retirement goal should be clearly stated. For most people, the primary concern is providing for their own retirement expenses. Beyond that, they either want to pass on some of their wealth or they don’t.
Once that issue is addressed, the next issue is how much can you spend on yourself — on your lifestyle — during retirement? The viability of a retirement spending plan rests on three primary components — your spending, your steady income and your savings.
All three of these have to be considered together in order to come up with a coherent answer to the question, will you run out of money in retirement? Obviously, we cannot know the future, so we are speaking in terms of probabilities, but it is useful to go through this type of analysis:
I. Spending during retirement: Let’s say you are on the cusp of retiring. First, congratulations are in order. You made it. Next, let’s take a look at how you figure out what you’ll spend during retirement. The best place to start is to figure out how much you spend now. I know that sounds obvious, but many people don’t really know what they are spending.
We use a Microsoft Excel worksheet to help people go through this exercise so they don’t miss any major spending categories. One of the biggest spending black holes is your home. People spend a lot of money on upkeep and maintenance, insurance, property taxes, principal and interest payments and home improvements. It’s easy to miss something.
Your home: Are you planning to stay where you are? If so, home expenses may not change much, until you pay off your mortgage. If you plan to downsize your home, will you buy a condo or rent. For many retirees, renting is hard to imagine as they have owned a home for decades, but renting makes economic sense for many.
Your state or city? If you are planning to move, are you considering another state. If so, the cost of living in that state is important as are all the various taxes (income tax, sales tax, property tax). There are places around the country — and around the world — where your money may go a lot further than it does where you live now. Or, you may be considering a move to be close to family or even to bring about a lifestyle change. A change such as this complicates things, but that’s OK.
Other easy items to miss are expenses that come once a year (such as many types of insurance) or expenses that occur irregularly, such as replacing a car or a furnace or a roof. Once you have a good handle on how much your spend now, you can estimate what you will spend in retirement. In order to look forward in terms of spending, you have to make some decisions:
There are rules of thumb for adjusting your working level of income to see how much you will need in retirement, but I have not found them terribly useful. I think it’s much better to track your current spending and then go through and make adjustments to deal with your contemplated lifestyle changes during retirement.
One of the best ways to estimate retirement expenses is to talk with those who are already retired. This is not a huge revelation, but I have found that many folks are reluctant to ask family members or friends or others about what life in retirement is like or to find out how their spending compares to spending before they retired. Most retired folks that I know are happy to help others and share their knowledge. So, if you have questions, just ask.
II. Steady Income: Figuring this out is generally the most straightforward part of the process.
Social Security: Most people will have Social Security income during retirement and the Social Security administration sends out a specific statement for your personal Social Security benefit at retirement. The only big decision for Social Security is whether or not to take it immediately or to wait until full retirement age. This chart from the Social Security administration illustrates how your initial monthly benefit can change depending on your age when you start taking Social Security.
Source: Social Security Administration
As you can see, assuming a retiree has a full benefit of $1,000 per month at age 66, the actual benefit could be higher or lower depending on what age the retiree actually elects to start taking the benefit. Many articles I have seen recommend waiting until age 66 to get the full benefit. That may not necessarily be the best choice for many people because you have to give up four years of Social Security benefits to get the higher amount. The reason it may not make sense for you to wait until full retirement age is that the crossover point could be about 12 years. That is, it takes 12 years at the higher benefit amount to make up the amount you missed by not taking benefits at 62.
For example, using the numbers in the chart above, at age 62, you would get $750 per month for four years for a total of $36,000. On the other hand, if you wait until age 66 for full benefits, you would get an extra $3,000 per year ($250 per month). Without getting too fancy, in actual dollars it would take 12 years to make up the money you missed by waiting.
If you plan to work until 66, it probably makes sense to wait to take benefits until that age. However, many people may want to take benefits at 62 just to bring in some income. That method will give you more money until the crossover point is reached in about 12 years.
Many folks will have some part-time or full-time employment income during the early years of retirement and that could impact your decision on when to take Social Security benefits among other things. For more on this issue, you can go to the Social SecurityAdministration’s Retirement Benefit site.
Other pension benefits: If you are lucky enough to have an outside pension plan from your employer, then that is an additional source of income during retirement. In addition to the pension income, you may also be eligible for additional benefits such as retiree health insurance. One very important question to consider with an outside pension is whether to take the monthly income option or to take a lump sum distribution, assuming that option is available to you. If you are at all concerned about the level of funding for your pension, taking a lump sum may make sense.
III. What assets do you have?
This refers to your investments, whether IRAs, 401(k)s or personal savings or investments. We typically include retirement assets if you have them in an account in your name. We include monthly pension income above under Steady Income. Looking at your assets means you would also potentially include other assets such as your home or a business or anything else you have that is valuable. You may want to remain in your home now, but it is still a resource if you have some equity in it.
If there is a gap between your spending (Section I) and your steady outside income (Section II), then your portfolio has to be tapped to make up the difference, if you cannot cut expenses that is.
People often ask what is a reasonable return for retirement assets and that is hard to forecast because returns vary dramatically from year to year and from one type of asset to another. If you have your investments in a diversified portfolio, then you could consider historical rates of return, that is the long-term average return for each type of investment. We look at those historical returns and then make adjustments according to our view of conditions in the future.
What kind of spending assumption should I make?
What we often do is look at a 4-5% withdrawal rate from your portfolio. That is, if someone has a long-term portfolio, then he or she should be able to withdraw 4% per year from that portfolio without drawing it down to zero over the course of a normal retirement. The way the math works on this is to assume a return from a diversified portfolio of say 8%. Then, from that 8% return, deduct your inflation assumption. Say, that’s 3% and the remainder, 5%. Assume some income taxes, albeit at a fairly low rate, and 4% is left that can be spent without dipping into your principal on an inflation-adjusted basis. In this scenario, you would be able to pull out 4% per year and also to keep your principal intact even with the ravages of 3% inflation.
However, you may not be as concerned with inflation as you get older depending on your initial goal. For example, if you plan to write your last check when you check out, then keeping your principal intact will not matter much to you. Or, if your primary concern is your own retirement span and whatever is left over, if anything, could go to your children or a charity, then again keeping up with inflation may not concern you too much.
In these cases, you could spend quite a bit more than 4% because you don’t mind dipping into principal and because you don’t care if the portfolio value does not keep pace with inflation.
Another alternative we have seen is that retired folks take out more than 4% in years when investment returns are good, but they cut way back on withdrawals from the portfolio in down years. That can work if you are disciplined.
Living longer & margin for error
One point to bear in mind also is longevity. The good news is that life expectancy is going up and people are living much longer. Initially, most recipients of Social Security did not last all that far beyond 65. Now, people are routinely living well into their 80s or 90s. That is one reason why Social Security funding is a problem. But, it is also a problem we need to consider as part of a retirement plan. How long are you planning to live? Or, what life expectancy would you like to assume. A reasonably healthy couple, each of whom are at age 65, will likely be around for quite a while, and one member of the couple could easily live 20 years or more. Therefore, retirement planning needs to account for a potentially long life span.
I believe you also need to have a cushion in your planning to account for the possibility of getting lower investment returns or other factors such as higher inflation or a long, long life.
Summing it all up
When you begin thinking about these issues, the temptation is to go right to one of the retirement calculators you can find online (see here or here or here for examples). That’s fine. Do it.
But then, you actually have to sit down and do your own personal math. Track your expenses. Make adjustments based on what you hear from retired family or friends. Add in your steady income from Social Security or other sources. And, finally, make a conservative assumption of what you can take from your portfolio to make up any difference between spending and steady income.
As you can see, this is a very personal decision as your goals could be quite different from those of family members or friends. If your situation is complicated or if you want a more rigorous retirement analysis, you would need to go to your CPA or financial advisor for help.
Have fun and if you have an interesting tale let me know.