Most of us get up and work hard every day so that someday we don’t have to. That day is called retirement. Getting to that point requires you to learn how to manage your money week to week and month to month. Retirement is a whole new game; it requires a lifelong perspective. Your early decisions will impact the next 20 or 30 years. Many people don’t give retirement planning the time it deserves until too late in the game.
When asked about their retirement plans, most retirees talk about moving to the sun and the fun. When asked further about their plan, they usually know their Social Security income and how much they have saved. When asked if that’s enough, the answer is almost always, “I hope so.” Hope is not a plan. I’ve met plenty of retirees who have enough money and too many who don’t. I have yet to meet a retiree who has too much money. An effective retirement plan will focus on more than just when, where and how much income you expect. Don’t focus on planning for retirement income. Income is not the problem. You won’t run out of money because of your income. Running out of money is caused by spending. So, let’s begin by solving for that with a basic retirement planning formula:
Annual Spending = Income + Retirement Co-Pay
Annual Spending
Let’s start with your annual spending, which is all of the money you’d like to spend on an annual basis. Some experts say that in retirement you can plan to spend about 80% of what you’re spending before retirement. I don’t know about you, but when I take two weeks off work, I tend to spend a lot more than if I’d worked. When I look at my pre-retirement budget, the only expense I don’t expect to continue into retirement is my dry-cleaning bill. You can start with a detailed budget or just look at how much you are spending now and add in retirement expenses like travel, entertainment, hobbies, and activities.
Income
Our next variable, income, represents the annual amount that is automatically transferred into your bank or your mailbox from Social Security, a pension if you have one, annuity payments, etc. There is not a lot of room for imagination here. “It is what it is,” as they say. Unless you go back to work, perhaps part-time, there usually isn’t much you can do about your income once you retire. Having a job isn’t a horrible solution, but it’s better to plan for that earlier rather than later. Don’t add in interest and dividends yet, that’s part of the next step.
Retirement Co-Pay
The final variable can be thought of as your retirement co-pay. This is where your savings and investments help. This copay is the amount you’ll need to withdraw annually to cover that shortfall between your recurring income and your spending.
Now that the formula is complete, for the sake of this example, let’s use $50,000 for the annual spending. On the other side of the equation, let’s assume we have $30,000 from Social Security for your income. We then solve for the co-pay, we see you need $20,000.
$50,000 = $30,000 + $20,000
If you have $20,000 in investments, you're good, for at least the first year. But how much do you need if you want to spend at that level for more than a year, say 25 years? The simple method is to multiply your total savings and investments by 25. This has to do with something called the 4% rule, but for simplicity’s sake let’s just say you’ll plan to spend that amount for 25 years. In this example, the $20,000 x 25 equals $500,000. So, if you have savings and investments of at least $500,000 you’re okay so far. We’ll save the inflation discussion for another time.
No Savings or Investments?
By the way, if you don’t have any savings or investments, then it’s easy to calculate your annual spending because, in that case, your annual spending needs to equal your annual income. It’s a simple answer, but it may not provide a solution you are happy with. Looking at the other variable, the income, if you don’t believe Social Security will be there for you when you file, it’s all copay. Without an income to help out, annual spending simply equals your retirement co-pay. If you want to fund 25 years of spending at $50,000 a year, you’ll need to plan on starting with $1,250,000 in savings and investments, that’s $50,000 x 25. You can visit my Social Security | SSA to get an estimate of your social security income.
The fun part about algebra for us nerds is that you can solve for any one of these variables. If you want to solve how much spending you can cover based on your income and savings you can do that. Let’s say you know your Social Security is $25,000 and you have $600,000 in savings and investing. To convert that $600,000 to your co-pay, simply divide it by 25. So, $600,000 divided by 25 is $24,000. When plugged into the formula: Annual Spending = Income + Retirement Copay to solve for Annual Spending, we get
Annual Spending = 25,000 + 24,000
or
$49,000 = 25,000 + 24,000
I realize this is a simplified approach, but it is a start, and it helps you focus on the biggest culprit in failed plans, the spending in retirement, not income. Admittedly, there are plenty of other factors to consider for an effective plan, but this will get you started. After this step, you’ll want to consider other factors like health care, inflation, market returns, and various strategies for collecting Social Security, etc. For now, if you do nothing else to plan for your retirement, at least work your numbers through this formula. If you’re not yet retired, you now know where your plan needs some work. You can grow those earnings to grow your social security or grow your savings and investments to grow that co-pay. If you are already retired, how long can you continue to carry that co-pay? Is it invested to balance the risk and returns required?
Financial planners spend most of our time on these issues, and none of us really know what’s going to happen in life. However, we do believe that people with a plan will have better outcomes and more choices regardless of what happens. We don’t plan because we know what’ll happen, we plan because we don’t know what’ll happen.
Our goal is to get you to and through a retirement that feels like a long-term vacation rather than old-age unemployment. It’s always time for a plan and we’re here to help.