R101 #6 - Is Your Retirement Funded?

Now that you’ve figured out your retirement personality, and I’ve totally depressed you with all the risks you may face, let’s figure out if you actually need to worry about how you’ll fund retirement.

Am I going to be okay? This question is at the root of all the retirement planning calculations we need to do. When clients ask if it’s ok to retire now, I tell them there are likely a set of assumptions we can make where the answer is “Yes!”. For example, if you have a place to live, plenty of people to take care of you for free, guaranteed lifetime income to cover your expenses, and never experience any unforeseen circumstances, then you can retire with confidence. Are those assumptions your reality?

I’m guessing this is not the case for you. So how do we go about starting to answer the question?

The big picture is this. Life costs money (expenses), it has to be paid for (income and assets), for a period of time until you die (longevity), and maybe leave some money leftover (legacy). In this exercise, we need to figure out one big number for lifetime spending, and one big number for assets. If spending is higher than assets, your retirement isn’t fully funded, yet. If assets are higher than spending, you may be able to breathe easier.

Legacy

I’m actually going to start at the end here because no one likes to talk about budgeting and cash flow. I’m joking, sort of.

There are those who wish to leave money to family or charity when they pass away. There are those who want to bounce their last check. You need to figure out which one you are. If you want to leave a legacy, your retirement spending plan will cost more to account for this. If you don’t want to do that, it costs less (but it’s actually pretty difficult to plan to “Die With Zero” - great book if you like this idea). If you don’t care, then we have some flexibility to work with.

One more thing to discuss about legacy before we move on. It’s possible that you may want to give gifts during your lifetime. There can be real satisfaction in doing this from an emotional perspective, and actual financial benefits to doing so (like lower taxes). If this is your goal, then we treat this as part of expenses and it brings us back to budgeting and cash flow (sorry!).

Expenses

I’m going to try and make this as painless as possible. And to some extent I’m going to let you off the hook because your spending in retirement may not resemble your spending before retirement at all. Your retirement spending is also going to fluctuate over time as you age. The goal with this exercise is that we come up with a set of projections for one big spending number during retirement (and realize that at the end of the day, we are just making it up!).

That being said, we need to figure out how much you spend now, use some reasonable assumptions to translate that into retirement, and decide how it might change.

To figure out how much you spend now, it can be helpful to use a tool to capture your expenses. I’m currently using Monarch Money, but you can use other apps or a spreadsheet. You need to divide your transactions into categories that make sense to you, allow you to analyze them for future projections, and decide if they are discretionary or not. For example - expenses related to kids - these will hopefully (mostly) go away in retirement. Other expenses - like healthcare - may go up, and may grow faster than inflation. Food is not discretionary, but dining out and Starbucks are.

One challenge with spending, and tracking it on a short-term basis, is that there are expenses that come daily, weekly, monthly, annually (property taxes, vacations), every couple of years (big trips, cars), and once in your life (weddings, big home renovation, long-term care). It’s important to capture round numbers for all of these to include for retirement spending.

Two concepts you may have heard of - “Replacement Ratio”, and the “Go Go, Slow Go, No Go” years. Replacement ratio is a concept for estimating retirement expenses based on a percentage (like 70 or 80%) of your pre-retirement spending. I don’t love this because I don’t think it’s very accurate. The Go Go, Slow Go, No Go years refers to spending more early in retirement on travel and experiences, less in the middle because your health is declining, and then spending rises in the final years of retirement due to additional care and health expenses. This one I do like, and I refer to it as the “Retirement Spending Smile” method of estimating when I work with clients.

Final thought about expenses and budgeting - estimate high. Better to be conservative in your estimate than “aspirational” for keeping your expenses low. We can decide later if there are expenditures you could live without, if you had to.

Above I said we need one big number for lifetime spending. It can get complicated translating many years of spending into one number today. A dollar that you spend tomorrow is technically worth less than a dollar today (due to the time value of money), but it's also potentially more because a dollar today doesn’t buy as much as a dollar tomorrow (because of inflation).

Without going into the calculation weeds - you take all the projected spending and “discount” it back to todays dollars using a rate of return that excludes inflation (a “real” interest rate). The rate you use needs to be something conservative - like 1.5%. We’ll talk about why later.

Income and Assets

I lump income and assets together, but they aren’t the same thing. We need to talk about this a little because when you don’t have a paycheck from an employer in retirement, it becomes tricky. The reason I lump it all together though is that our end goal is to figure out one big asset number today to compare back to our discounted lifetime spending number from above.

Some assets are easy to value today, because they are what they are. Like cash. Other assets can be converted to cash and are somewhat easy to value - Certificates of Deposit, brokerage accounts, retirement accounts, cash value life insurance. Real estate can be converted to cash as well, but isn’t easy to value (and not easy to convert). You may also have other assets like your collection of Beanie Babies that are not easy to value and also not easy to convert, and really, should that even be counted as an asset for retirement???

“Reliable” income sources can also be counted as like pensions and social security. Ongoing income streams are basically assets. However, they aren’t 1 to 1 because Social Security grows over time due to COLA increases whereas many pensions do not. So to turn those income streams into one asset number today, we discount the future income at different rates. A growing income source is better than a fixed one.

What we aren’t including in income is that which comes from assets. Back in the day, my grandma funded her retirement by “living off the interest” income from her investments and didn’t touch the principal. If you can do that, more power to you. I’m operating under the assumption that at some point in your retirement, you will need to convert your assets (including principal) to income.

(I’m going to ignore taxes for this post by just saying that you can either count taxes as an expense, or discount income and assets for taxes. No all income is taxed the same. And not all assets are taxable. But we’ll cover all that later in a post about tax planning in retirement.)

Longevity?

To get your one big number for spending and one big number for assets, you need to figure out how many years you’ll live. We already talked about longevity in a previous post, but we know this is just a guess. One comment I will add is that your retirement personality dictates how you pick this number. If you are more concerned about outliving your money, you’ll chose a longer life expectancy. If you are more concerned with enjoying your early retirement and willing to make cuts later, you can chose a relatively shorter life expectancy.

Is your retirement funded or not?

So you have your big spending number, and you have your big asset number. Are Assets > Spending?

If Assets are significantly bigger than the Spending number, you’re probably going to be fine, as long as you chose a conservative discount rate. You can dig into your numbers to identify any risks and optimize your legacy. For example, some people in this situation have significant assets that are invested aggressively - they may want to de-risk their portfolio. Others may want to adjust their distribution/income strategy to leave more tax-efficient assets for their heirs.

If Assets and Spending are about equal, you are also probably going to be fine. This is especially true if you are comfortable with market risk and your investments end up earning more than the conservative discount rate we chose above. If your retirement personality is more conservative, this is where you can dig into your assets and figure out how to convert more of them into reliable income now, or plan to in the future. This situation is also a great opportunity to use tax-efficient planning strategies.

If Spending is bigger than Assets - you’re going to need to do something different. This is where retirement planning before you retire can make a big difference. Can you work a few more years? This is the most effective way to improve your situation because it can increase your assets, and decrease the number of years in retirement. It helps on both sides of the equation. Can you save more? That will increase assets. Can you plan to move in retirement? That can decrease lifetime spending. The most important thing here is - DON’T PANIC. There are a lot of moves that can be made (even if you’re already in retirement) to improve your situation.

Nannette - this seems complicated, can you do this for me?

Believe it or not, this is what I consider the REALLY simplified way to do it. But yes, you can hire someone to do this (or something similar) for you. This is one big reason I got the RICP® designation. I wanted an educational foundation for providing these services to clients, not just one based in my experience or industry norms and “rules of thumb”.

This post is really important. It provides the framework for understanding all of the other topics I’ll be covering in the rest of the R101 series. We’ll dig into all the big topics that retirees need to understand - investments, annuities, Medicare, Social Security, housing decisions, long-term care, estate planning, and tax planning. It all comes back to how these topics affect the Spending compared to Assets equation above.

Stay tuned for more fun stuff!