When you’re thinking about retirement planning and what your goals are for life after work, it usually boils down to a few key questions: when can I retire, how much am I going to need, and will those assets last long enough? According to data from the Social Security Administration, approximately one out of every four 65-year-olds today will live past age 90 and one out of 10 will live past age 95, so you might need those assets to last longer than you think.
These are tough questions to answer because it’s impossible to know how long you (and your spouse if you’re married) are going to live, how the markets will perform, and what your expenses will be each year. You can estimate your expenses and it might be fairly accurate, but it’s impossible to know with 100% certainty what the future holds.
What you can do is think through some of the probable outcomes and then plan accordingly to reduce the risks if you’re wrong. At TD Ameritrade Investor Education Day Matt Sadowsky, Director of Retirement and Annuities, shared these six steps to take action and keep you on the road to pursuing your retirement goals.
1. Identify Retirement Expenses
The further away from retirement you are, the less precise you need to be with determining your retirement expenses. Even if you’re in retirement, you don’t have to be exact, although you do want to make sure you identify the big expenses. Generally, a good starting estimate of your retirement expenses is 85-90% of your ending salary. Another approach to estimate your retirement expenses is with a retirement planning worksheet for a more bottoms-up approach.
To estimate your retirement living expenses, think about your essential expenses (housing, food, transportation, etc.) and separate them from your discretionary expenses that are wants and wishes (travel, a fancy convertible, a vacation home, and so on). Doing this helps determine a minimum level you’ll be able to get by on if the circumstances require it.
2. Assess Retirement Income Sources
A planning worksheet can help you assess your potential retirement income sources such as Social Security, pensions, and annuities that provide income for as long as you live. It can be a good practice to match lifetime income sources with the expenses you’ll always want to be able to pay (your essential expenses and more if desired). You don’t want to include estimated income from investments and savings here because those investment returns can fluctuate greatly compared to your stable sources of income (Social Security, pensions, annuities, etc.).
3. Determine the Gap
Next, determine the difference between your income and expenses. Keep in mind expenses will change over time and one-off, surprise expenses may pop up. Establishing an emergency fund in retirement with easily accessible cash is helpful for managing those surprise expenses so you don’t have to dip into your retirement savings.
In addition to your expenses, your non-guaranteed income from investments can also change. Whenever your income or expenses change significantly, or you expect them to in the future, it’s a good idea to revisit your plan to see if any adjustments need to be made.
Another thing to consider is your cash inflows from annuities, Social Security, and pensions may also change, or be completely eliminated, if they're tied to the life of your spouse. It might not be easy to think about that, but part of retirement planning is preparing for different outcomes, especially worst-case scenarios.
4. Estimate Your Retirement Assets
Include all of your savings and investments, not just what’s in retirement accounts. A retirement calculator is an easy way for you to examine a range of possible outcomes based on your inputs for starting assets, time frame, growth rates and future savings. If you’re retired and no longer saving, it’s easier to assess your assets than someone still saving, who will have to make more assumptions.
If you’re still working and saving, don’t just assume you’ll be able to work longer or retire on the exact date you planned. Corporate events like downsizing and mergers as well as health issues can arise for you or a loved one, impacting plans without warning.
5. Calculate How Long Your Assets Will Last
If you can’t generate enough cash flow from dividends and interest, you’ll need to draw down your assets to address the gap. For example, if you had $500,000 in assets and a $25,000 gap between income and expenses, your nest egg should last 20 years assuming no growth and no inflation at a 5% withdrawal rate. However, if your expenses grow in excess of inflation or your income decreases, your assets might not last 20 years.
The goal of planning for retirement is typically to offset that risk and ensure you’ll have enough money and that it’ll last as long as you need. But you can’t be certain of future portfolio growth rates and timing of returns, two things that can impact the sustainability of your retirement income. If you experience negative performance early in retirement, there’s less in your portfolio to bounce back when the markets recover. To minimize that risk, a conservative asset allocation early in retirement might help reduce volatility and potentially avoid a big market drop that will have a lasting effect on your retirement. Figure 1 below shows how adjusting withdrawal rates can have a big impact on how long your assets might last.
6. Adjust Your Plan as Needed
Don’t plan for how long you think you will live, plan for how long you could live. If you're using median life expectancy figures for your planning, that's just the midpoint for the population and you could end up living much longer. If you’re of normal health and plan to only live until the median life expectancy, you’re going to be wrong 50% of the time. On top of that, many people don’t have realistic expectations about how much they can safely withdraw from their portfolio in retirement because it’s easy to overestimate investment growth rates while underestimating expenses and the impact of inflation.
Overestimating income and underestimating expenses can lead to an unpleasant surprise. A retirement calculator helps you examine your personal situation and evaluate a range of possible outcomes to prepare for, not just what you think will happen. It’s important to consider worst-case scenarios because you can’t count on your assets being at the exact level you planned on.
If you’re looking at the possibility of a shortfall sooner than you want, consider working longer, saving more, reducing expenses, or some combination of the three. There may also be ways to organize your assets and structure income streams to address multiple objectives and prepare for longevity, market and inflation risk (Figure 2 below). And remember, when anything major changes that impacts your finances (whether you’re retired or not), it’s a good idea to revisit your retirement plan and be proactive with adjustments. You don’t want to find yourself in a position where you’re emotionally reacting in a market downturn or having to sell assets because of unanticipated changes to your income and expenses.
Ultimately, everyone has unique financial goals and a different vision of what the perfect retirement looks like. There’s no one-size-fits-all approach to retirement planning, but we all want to be comfortable and live the life we want. Following these six steps is a good starting place to make sure you’re on track to living your perfect retirement.