The Pre-retirement question while planning for retirement is: “How much do I need to Retire?” The post-retirement question is: “Will my money last throughout retirement?”
I used to tell clients: “If you knew you had one year to live, be healthy for that year, and then die in an instant, you would live your life one way, both personally and financially. On the other hand, if you knew you would live until 100 and be healthy until 99 and 364 days, you would live your life differently, both personally and financially. We are just trying to find some middle ground.”
The first year of retirement is pretty easy for which to plan. For example, if a retiring couple, each age 65, has no debt and $40,000 of living expenses with an expected total state and federal income tax of about $5,000, a gross retirement income of $45,000 should maintain their lifestyle initially at retirement. If this retiring couple has expected social security benefits of $30,000 and $500,000 of retirement assets, I would suggest their retirement picture is favorable. The withdrawal of $15,000 from retirement assets for additional annual income along with social security benefits brings the total income to $45,000. In this scenario, the Rate of Withdrawal is 3% which would be considered a moderate Rate of Withdrawal with a good margin for error.
- Note: See article on Rate of Withdrawal for discussion on withdrawal rates.
On the other hand, if the same couple has living expenses of $60,000 plus $8,000 of expected state and federal income taxes they need almost $70,000 to maintain lifestyle after retirement. Subtracting $30,000 of social security benefits, this couple would need to $38,000 of annual income from their retirement assets to reach their income objective. This is a Rate of Withdrawal of almost 8% which is likely to be unsustainable over a long period of time and may eventually lead to a depletion of assets. This couple has several options.
- Defer retirement until a later age. This will give the couple more time to save for retirement and also more time for their current retirement assets to hopefully to grow. In addition, their social benefits will increase each year they wait to retire maxing out at age 70.
- Take a hard look at their budget and reduce living expenses from $60,000 to $49,000 plus $6,000 of estimated state and federal income taxes. This would reduce the Rate of Withdrawal to a reasonable 5%.
- A combination of 1 and 2.
But this is just the beginning of “Will my money last”. According to one joint life expectancy calculator, for this couple, again both age 65, the probability is one will live to age 88 or longer is 50%. In other words, out of a 100 couples each 65, at least 50 couples will have one or the other spouse or both reach age 88. [See discussion of Life Expectancy.] Many retirees believe their personal life expectancy will be less than average for health reasons, but for planning purposes, I would suggest individuals or couples assume life expectancy of age 100.
In long term retirement planning, it is important to understand the margin of error from inception of retirement to the end of it. A retiree whose potential income is significantly greater than living expenses plus income taxes has a substantial margin for error. By comparison a retiree whose living expenses plus income taxes is equal to potential income, has minimal if any margin for error.
Why is margin for error important? There are a variety of reasons.
- Increasing expenses due to inflation or related reasons.
- Lower than expected investment returns.
- Health related expenses not covered by Medicare or insurance.
- Lump sum expenses. Examples include travel, a new vehicle, treating a pet, buying a new residence, or helping children financially.
Most if not all of the above lump sum expenses are discretionary in that they are lifestyle choices. Let’s go back to first example. A couple with a 3% Rate of Withdrawal who withdraws an additional $10,000 in a given year for any of the above, is not going to affect their long term financial security. The total withdrawal of $25,000 [$15,000 for living expense plus $10,000 for a lump expense] means the Rate of Withdrawal for the year is 5% which is reasonable. [Possible slightly higher when possible income taxes are included on the additional withdrawal.] But let’s say in one year the couple decides to withdraw $10,000 for a trip, then decide the family pet needs veterinary care for another $10,000 and finally they give one of their children $25,000 for emergency expenses for total lump sum withdrawals of $45,000. This is addition to the annual income withdrawal of $15,000 for a total annual withdrawal of $60,000. Now the Rate of Withdrawal is 12% and if only happens once, may not be an issue. But if happens more than once, then it becomes increasingly likely assets will deplete and they will not be able to maintain their lifestyle throughout retirement.
By the way, do the above examples seem unreasonable? A “trip of a lifetime” probably starts at $10,000. I have clients spend well over $10,000 treating a pet. I have watched clients withdraw six figures from their portfolio to help a child. I have also seen clients withdraw tens of thousands for improvements to an existing or new residence. Some could afford to do so. Some it clearly affected their long term financial security. The reality is clients rarely or ever ask in advance if a withdrawal will affect their long term financial security. It is their money and they can do as they please. If they did ask, we discussed, but in most cases, they had made their decision because the decision was based on emotional factors, not financial.
There are factors that can increase the margin for error. For example, many retirees plan and actually do down size after retirement selling a residence they no longer need for a less expensive residence with the cash left over added to the retirement portfolio. It is also not unusual for retirees to own two residences with the plans to sell one at some point again creating cash to be added to the retirement portfolio.
- Though inheritances take place, it is never a good idea to plan for inheritance until it has actually happened.
At the beginning of retirement or any specific time during retirement, it is not possible to positively answer the question, “Will my money last throughout retirement?”. It is important to understand the margin for error at the beginning and actually throughout retirement. If is also important, possibly more important to be honest first with yourself, and then your family and finally others on what you can and cannot afford during retirement.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.