As a Financial Planner focused on retirees, this is one question I hear all the time. It’s of course reasonable that individuals who are starting to think about retirement are concerned about their money lasting. The question comes in numerous variations, but they all mean roughly the same thing: Do I have enough money saved to retire? How much money do I need to retire? Can I retire at 55 or 60 or 65? How much money can I spend in retirement? And while the industry has its “4% rule,” unfortunately like most things in life, it’s not quite that simple.
Yes, starting with a sustainable distribution of spending no more than 4% of your savings is a decent place to begin your analysis on addressing the questions above. However, financial planning is a much more dynamic process than simply calculating 4% of your savings as a target spend each year. It’s important to look at four additional variables that can potentially derail a successful retirement plan.
When it comes time to retire, the key is to stack as many factors in your favor in order to give yourself the best probabilities for success. The one variable that the majority of retirees are familiar with, and unfortunately is often the most widely peddled by the media, is of course market risk and investment performance. The “market” can come in different forms but often it is a combination of stocks, bonds, real estate, and more recently, esoteric investments like cryptocurrency. While investing is an important factor, it is certainly not the only variable that will determine how long your money will last in retirement. The reason being, as renowned economist Milton Freidman popularized, “there’s no such thing as a free lunch.” Simply put, risk and reward (investment return) are related. To increase performance, you generally must increase risk. And for a retiree, that is not a sustainable solution to the question, how long will my money last? So, with that said, the remaining three factors that retirees should address in a retirement plan are: longevity, inflation, and taxes.
Longevity, in its simplest form, is how long you (and your spouse) will live. With modern medicine, we see more and more people living into their 80’s and 90’s. Depending on the age you choose to retire, your money may need to last 20, 30, or even 40 years. That’s as long as most individual’s working years. A fact that is often easily overlooked. Creating your own paycheck for that many years is not a simple task by any means.
In recent history, inflation was not much of a concern for most retirees. When I sit down with clients they tell me their expenses today, but don’t think much about their expenses ten years from now. With inflation dramatically spiking these last two years, we are hearing more about how it can impact the success of a retirement plan. In the US, historic inflation has been in the ballpark of about 3.25% percent on average. Last year, depending on where you live, it was almost double that number. The problem is most fixed income sources like pensions or Social Security don’t offer a tightly correlated cost of living adjustment (COLA) that keeps up with inflation. So, what we tend to see is, a retiree’s expenses may be mostly covered by these sources at the beginning of their retirement, but as time goes on, there is a larger and larger shortfall between what is coming in and what is being spent. This means more and more money needs to come from your investment savings to maintain the same standard of living.
Lastly, and in my opinion one of the largest expenses often overlooked in a retirement plan, is taxes. For the most part, taxes never go away. We pay them every year we have income. And we tend to hear that taxes will be lower in retirement. However, that is not necessarily the case for many people. Oftentimes we see clients in a similar tax bracket in retirement as they were when they were working. That’s because your Social Security, pension, real estate rents, and any distributions from your 401k or IRA are all taxed at ordinary income rates. If you are making $100,000+ a year while working, you are in the 22% federal tax bracket (filing jointly). What I’ve found over the years is that people generally spend about as much money as they make, minus some savings into their retirement accounts or children’s college plans. People tend to adjust their lifestyle to their income. The more we make the more we spend. It’s a generalization that many don’t want to hear, but after reviewing thousands of financial plans, I find this to be true. So, if you are making $120,000 a year, odds are you are probably spending $90,000-$100,000 on total living expenses. Well, if you need $100,000 of living expenses, and all your sources are taxed at ordinary income, you are right back into that 22% federal bracket. We are currently at historically low tax rates, and with national debt skyrocketing, in my opinion chances of tax rates going down in the future are slim. Odds are tax rates will probably increase over time.
When it comes to mapping out your retirement, these are all additional factors that I suggest you incorporate into your calculation. There are ways to address and mitigate each of these hurdles. Going through how to approach each one, however, will take its own separate article and unfortunately, we are out of space for today! But we have accomplished the first step, which is to identify these retirement planning detractors. Stay tuned for more….