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You may be familiar with the “rule of thumb” that says most people will need between 70% and 80% of their pre-retirement income each year after they retire. However, this estimate is overly simplistic and should only be considered a general guideline.
Many of my clients’ real needs are much more complex. In fact, as Americans continue to live longer and lead more active lives, many are finding they need as much as 100% of their pre-retirement income to continue supporting their lifestyle, particularly in the earlier years of life after work.
And of course retirement needs can change dramatically year by year. Consider how that first new home and its required furnishings stretched you as a young adult. Or how about when children entered the picture, then school and sports. How about that unexpected career change?
You see, each of these momentous life experiences often put large, but often temporary, burdens on household income. So too will be your experience during your retirement years. How much money you’ll actually need in retirement will depend on a broad range of moving variables, including how you plan to spend your time, where you reside, the state of your health, and how long you ultimately live.
These variables are why you need much more than a simple percentage of income to answer the question, “How much is enough?”
Over the years, perceptions about life in retirement have changed dramatically. When I began my career more than 20 years ago, the traditional retirement age was 65. And it was a rare concept back then that someone would retire from one career, only to pick up another.
However, today I talk to a growing number of people who are ready to retire from their current career much earlier, but aren’t quite prepared to stop working altogether. Some want to use the knowledge and experience they accumulated over the years to consult on a part-time basis; many are often just looking for a change of pace; and still others are fulfilling dreams in a completely different line of work.
One of my clients was a physical education teacher and HS baseball coach for more than 25 years. As a lifelong Milwaukee Brewer fan, one of his top bucket list goals was to someday work for his favorite hometown team. As they often vacationed in Arizona during spring training, an opportunity presented itself for him to work for the Brewers during the spring training season.
This opportunity was certainly a change in plans for my 62 year old clients, and we buckled down right away with some strategic retirement planning.
First we needed to establish how many years he wanted to work for the Brewers, and since they were not yet 65 , what was the best way to provide health insurance? We needed to create a strategy to maximize his pension benefit, as well as the couple’s Social Security benefits, without adversely increasing their tax liability while still working with the ball club.
Keep in mind, finding that home run solution right off the bat isn’t always feasible. Sometimes it involves lifestyle trade-offs. In this couple’s case, they were willing to sell their large home in the Milwaukee suburbs where they raised their family, and downsize to a townhome with space to accommodate visiting family and friends. By doing so, it allowed them to purchase a moderate single-family home in Arizona with a pool for visiting grandkids, all while keeping retirement spending in check.
With the help of financial planning software, we were able to weigh different scenarios and potential outcomes, eventually agreeing to a financial plan.
Before getting into how much you’ll need to save for retirement, it helps to understand the retirement income sources that may be available to you.
We have found that most people will rely on a combination of the following sources to provide most of their foundational retirement income:
Social Security: Of course, Social Security is the biggie. Most people rely on Social Security benefits to fund a portion of their expenses in retirement. However, according to the Social Security Administration, these benefits will only cover about 40% of the average American’s income needs.2 For higher earners, Social Security will replace even less of your working income.
What’s worse? Social Security may not be around much longer. CNBC says that according to a recent government report, Social Security will no longer be fully funded as early as 2033! Even though many younger adults today may want to completely disregard Social Security as a viable retirement income source, my guess is Congress will make necessary changes before then to extend its long term solvency.
Pensions: For public employees such as teachers, municipal, county, and state workers, pension income may be a more significant income contributor to consider. Many pension participants have well-funded plans and access to outstanding resources to help them make key benefit decisions.
*We will dive deeper into both Social Security and pension maximization in later chapters.*
Dividends, savings, and investments: Dividend-paying stocks, utilities, and municipal bonds and bond funds can all be effective sources of supplemental income during non-working years.
Retirement Plans: Retirement savings, such as 401(k)s, IRAs, 403(b)s and other tax-qualified accounts can be drawn upon during retirement to supplement other fixed sources of income, too.
Part-time work: While continuing to work in retirement can be fulfilling for many people, relying on work to bridge an income gap in retirement is not without risk. In a recent survey, 71% of workers said that they anticipated paid work to be a significant source of income in retirement. However, only 31% percent of retirees actually derive a portion of their retirement income from work.1
These figures suggest that relying on working to supplement income in retirement may be far from a sure thing and unfortunately, easier said than done. Many people are often forced to stop working earlier than planned due unforeseen events, such as a medical crisis, injury, layoff, or other circumstances outside of their control.
Other, less common sources of income people may receive during retirement include:
When considering how much you’ll need to sustain your lifestyle in retirement, start by looking at your pre-retirement life and write down a list of all the things you spend money on now. At a minimum, you will need to generate enough income to pay for your essential expenses on that list — in other words, food, clothing, shelter, transportation, and healthcare.
However, to live a more fulfilling retirement, it will take more than just bread and butter expenses. You’ll obviously want to have enough money to pay for the things you want to do above and beyond your basic living expenses. These are considered discretionary expenses and may include travel, dining and entertainment, club memberships, hobbies, and more. If you want to leave a legacy to your children, grandchildren, or the charitable organizations you support, you may need to budget that too.
An experienced financial advisor will have retirement calculators and supporting materials to help you think about not only what you spend money on now, but also additional expenses you may encounter in the future.
Whether your money will last through all your retirement years comes down to two main determinants: how long you will live and how you intend to spend your money.
Of course, because none of us know how long we’ll be around, it makes it challenging to determine a realistic timeline. It may be hard to imagine, but many people spend more years in retirement than they spend working. This is why I overemphasize the importance of having a tax-efficient withdrawal strategy in place. Your plan should be fully aligned with your specific needs and goals to help ensure the money you require will be there for as long as you need it.
A systematic withdrawal calculator, like this one, can help you determine how long your funds may potentially last based on regular withdrawals. However, it’s important to remember that retirement may not be a linear path. Instead, retirement will have its ups and downs where you may have varying income needs depending on the month and year.
Spending tends to be at its highest during the early years of retirement when people are more active. Maybe you plan to travel; purchase a boat or a second home; or enjoy a golf, swim club, or gym membership. But, as you get older, discretionary spending may level off. You may not be traveling as much, or perhaps you’ll spend less time engaged in social or community activities. Finally, spending typically picks up again in the later years of retirement due to increased costs for healthcare and other expenses associated with aging.
Cookie-cutter retirement solutions, like the “4% rule,” don’t typically work long term because, as mentioned, your spending needs will likely change over time. In addition, these uniform strategies don’t account for external factors, such as changing market conditions.
Here’s a simplified look at why this strategy does not necessarily “fit all”:
The 4% withdrawal rule relies on drawing down a fixed percentage (4%) of your assets each year, adjusted annually for inflation. In a period of rising financial market values, taking 4% may be enough to cover the monthly expenses that Social Security and a pension (if you have one) do not, while leaving enough assets in your portfolio to continue seeking growth potential that you’ll need for future distributions.
However, withdrawing the same fixed percentage in a declining market not only cements losses, but also makes it harder for your portfolio to generate future growth. This can be especially concerning if a down market occurs in the early years of your retirement because it can lead to prematurely depleting your portfolio.
Your withdrawal strategy must also take inflation and taxes into account. We know that even small increases in inflation can begin to erode your income, as the price of goods and services rise over time. A prolonged period of rising inflation could necessitate higher-than-anticipated increases in your withdrawal rate, just to pay for the same amount of goods and services. This is especially true when it comes to healthcare spending, which has outpaced the rate of U.S. economic growth for decades.3
Taxes can also take a serious bite out of your income, resulting in the need to take larger distributions from your portfolio than may otherwise be necessary to achieve the same level of net income.
Ultimately there is no single magic formula. Determining how much is enough to accomplish all your wants and needs in retirement can’t be solved by a simple rule of thumb and is best accomplished by working with an experienced and independent financial advisor. There are certainly retirement calculators available on the internet today, however the old adage, ‘garbage in-garbage out’ certainly applies to financial planning.
Often people feel paralyzed and overwhelmed and are not sure where to start.
Start by simply writing down the following:
A good advisor will take it from there and help you formalize your thoughts and questions with structure so it doesn't feel like you're just swinging blindfolded.
Ultimately your Financial Advisor has access to the sophisticated resources needed to calculate that elusive “how much do you need?” number many are looking for. But more importantly they will be able to conduct a comprehensive analysis of a bigger picture for you including individual goals, income sources, projected expenses, risk tolerance, and legacy objectives. This organized information will be used to develop a retirement plan customized to your family’s needs that can be monitored and adjusted over time as your life changes.
To learn more about how retirement planning can help ensure a smooth transition to and through retirement, watch for additional posts and planning tips in the weeks ahead. You can also contact us anytime to talk about your planning needs.
Social Security is a pay-as-you-go system, which means today's workers are paying taxes for the benefits received by today's retirees. However, demographic trends such as lower birth rates, higher retirement rates, and longer life spans are causing long-run fiscal challenges.
For investors approaching retirement, it is important to begin thinking about retirement income planning. To determine retirement income needs and develop strategies for creating income streams, pre-retirees should consider the following factors:
Now that you've officially joined the ranks of pre-retirees — people who are around five or ten years away from retiring— you probably have a much better idea of what you want. It's time to put that perspective to work. Here are eight steps to get you started.
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