Are you on track to have income that lasts throughout your retirement? Learn six steps to help answer this question and create a retirement income plan.
How much income will you need in retirement? It’s a common question that’s tough to answer because no one knows for certain how long they’ll live, how the markets will perform, or what expenses they’ll actually incur. But with this basic framework, you can get a general sense of whether you‘re on track to have savings that lasts all your retirement years.
The first step is to estimate how much you might spend each year in retirement, which you can do a couple of ways. You can use an income planning worksheet to help identify your large expenses and project future spending. Or you can use a general guideline such as 85%-90% of your ending salary. Of course, the actual amount needed will vary depending on your lifestyle, financial situation, and other factors.
Regardless of which approach you use, ask your spouse for input as well as other family members who might depend on you in retirement. It’s important to make sure everyone’s on the same page about the future and that you’re capturing the right expenses so you can plan properly.
You may also want to separate your costs into three buckets: needs, wants, and wishes. Needs are your essential expenses, which include your living expenses and “must haves.” Wants and wishes are discretionary items that could be cut from your budget in the event of a market downturn or unexpected costs.
Next, you’ll want to identify any income you’ll have, besides your savings and investments, to help maintain your lifestyle in retirement. Most likely, you’ll have Social Security and possibly a pension or an annuity. All three offer lifetime income so you may want to earmark them for your essential expenses. Other possible sources include alimony and rental income.
By matching your lifetime sources to your essential expenses, you will know whether you have a solid foundation of certainty. If you have enough lifetime income sources to cover your essentials, then all of your remaining assets are available to cover your wants and wishes (your discretionary expenses). You can reduce, postpone or eliminate these expenses if needed in retirement. But what if your lifetime income sources are not enough to cover your essential expenses?
From there, if you do have too little lifetime income to cover your annual essential expenses, determine how much lifetime income you will need each year, and look to fill that gap. Insurance products designed to provide lifetime income like annuities, longevity insurance, QLACs, and long term care insurance can help cover your essential expenses while allowing your remaining assets to be available to help cover your discretionary expenses.
Your expenses are likely to change and shift over time. Many retirees tend to spend more during the go-go early years of retirement and then again in the late or no-go years due to increased medical expenses and long-term care. Additionally, you may incur unexpected costs, like storm damage to your home or a loved one moving in.
Your income stream could also fluctuate depending on when you decide to start receiving Social Security or your pension and upon the death of your spouse. Plus, some sources, like rental income, aren’t guaranteed to last. Planning now for these possible fluctuations, some of which could be significant, may help keep you on track later in life.
Now that you have addressed your essential needs, let’s turn to covering your discretionary expenses. That’s where your savings and investments come in. To estimate how much you may have in assets at retirement:
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Be sure to also include your emergency savings fund in the estimate. While not earmarked specifically for retirement, it’s another way to help manage any shortfall. You might also use a retirement calculator to project the potential growth of your portfolio assuming different rates of return and time frames.
Once you have your estimate, consider bucketing your assets by time horizon to help you pursue your goal that you’ll have enough money to cover discretionary expenses throughout your retirement. (Remember, as noted above, lifetime income sources are typically used for essential expenses.) For example, you might break your retirement into three time segments: 1-5 years, 6-10 years, and 11+ years, with your more conservative investments earmarked for the early years and more aggressive ones for later on to help maximize the potential for growth. Many investors who bucket their assets choose to create a bond ladder for the first 5 years of discretionary expenses. A bond ladder can help to mitigate the risk in your portfolio and potentially reduce the sequence of return risk. Be sure to do your research about bond ladders prior to investing to determine if this is appropriate for your financial situation.
Once you have the estimate, you’ll need to figure out how long this money might last in retirement. The answer depends on several things, including the size of your income gap, how you filled it, and your draw-down strategy. For example, if you had $500,000 in assets and a $25,000 gap, your nest egg might last 20 years assuming no growth or inflation ($500,000/$25,000 = 20). Keep in mind you may need to increase the amount you withdraw over time due to inflation and higher expenses. To help offset the impact of these events, you might put a portion of your savings in growth-oriented investments, like stocks, depending on your risk tolerance.
It’s important to focus not on how long you think you’ll live but rather on how long you think you could possibly live. If you’re in good health, your retirement could last 30 years or more. So you may want to test different withdrawal rates to see how much the change may help extend the longevity of your assets; a 1% difference could have a 7 to 8 year impact on your savings. (See Figure 1). And remember to include your spouse’s needs and any other household members that depend upon you. However, pulling out too little each year might keep you from doing the things you want to do. Consider the potential trade-offs for each withdrawal rate to help find the level that makes the most sense for you.
Another potential factor is market performance. Extended downturns could shorten the longevity of your assets because you have less time to bounce back. To help manage this risk, many people tend to take a more conservative investment approach as they get older. Obviously, this concept conflicts with the idea of having more aggressive investments for farther out in time, an alternative mentioned above.
It’s generally a good idea to periodically review your plan to make sure you’re not underestimating your expenses and overestimating your assets. Market fluctuations, legislative developments, and job changes can all impact your potential income over time while unexpected events, such as medical expenses, could drive up costs. Based on your review, you might decide to make changes to your asset allocation or your withdrawal amounts to better address any shortfall and to help improve the sustainability of your income.
Estimating your income needs is an essential part of retirement planning. It can help you set your savings goal and develop an effective withdrawal strategy when the time comes. If you're looking for more in depth information on the guiding principles that underpin a retirement income plan, watch my webcast replay from our May 2018 Education Day.
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