Will retirement be cheaper than you think? Maybe. A lot depends on your income replacement ratio. What’s that you ask? It’s the percentage of your current income that you will need during retirement to maintain your standard of living.
Some people will need 100% of their current income. Others will be able to get by on less. Ironically, the more money you make now, the lower your income replacement ratio will likely be. That’s because you probably aren’t using all of your current income for expenses that will still exist during your retirement years.
Here are three major expenses that will likely disappear from your retirement budget:
Savings: Retirement is a shift from the accumulation phase to the distribution phase. That means no more 401(k), IRA or savings account contributions. How much are you saving now? Five Percent? Ten? Fifteen? Once you’re no longer saving, you won’t need that income.
Payroll taxes: Looking at the glass half-empty, retirement means no more paycheck. Looking at the glass half-full, that also means no more Social Security and Medicare taxes on your earned income. Right now you’re paying a 6.2% Social Security tax on your first $114,000 in income and a 1.45% Medicare tax on all your income (7.65% total or twice that if self-employed). And if you’re a high-wage earner ($200,000 for singles, $250,000 for couples) you’re paying an additional 0.9% Medicare surtax. Those taxes go away when your earned income goes away.
Work expenses: Think of all the expenses you have that relate to your job: commuting, dress clothes, expensive lunches, a second car. Most of those expenses can be reduced or eliminated in retirement, which is probably the equivalent of hundreds of dollars each month that you can cut from your budget.
If I apply those three items to my own budget, I could eliminate more than a quarter of my expenses. How about you? How much could you get rid of? I’m guessing the amount is significant. If you’re able to pay off your house and retire debt free, you could eliminate even more. To be fair, you’ll also have some expenses that get added to your budget during retirement (e.g. travel, hobbies, etc.), but those likely won’t outweigh the cuts.
A common rule of thumb for your income replacement ratio is 85%. David Blanchett, head of retirement research at Morningstar, thinks that most people will be able to get by on less. Whatever the number, it is the primary driver of how big your nest egg needs to be. Shave 20% from your income replacement ratio and you’ll be able to shave 20% from your nest egg, which means you could save less and retire sooner.
One of the benefits of the exercise above is that it shows the direct link between expenses and retirement. The less you need, the sooner you can retire. Remember that your ideal retirement is not about age or work status. It’s about control. It’s a gradual shift from doing what you have to do to doing what you want to do. One way to speed that shift is to save more, but equally effective (and often overlooked) is to need less.
“When can I retire?” I get that question a lot. If you’re curious about the answer, look no further than your retirement budget. The more money you want to spend during retirement, the more you’ll need to save before you get there and the longer you’ll likely need to work. It stands to reason then, that you can probably retire sooner if you can figure out a way to spend less during your golden years. What are some ways to downsize your expenses without downsizing your dreams for retirement?
It has almost become dogma over the last decade that financial security comes by giving up things like your daily latte. That advice can certainly help you sock away a few extra dollars over the years, but if you’re getting close to retirement and find yourself tens (or hundreds) of thousands of dollar short of your goal, drinking Folgers instead of Starbucks isn’t going to solve your problem. It’s just not a big enough line item in your budget. If you want to make a big impact, you need to focus on big expenses.
According to a recently released report by the Social Security Administration, the two biggest expenses for most retirees are housing (35 percent) and transportation (14 percent). Said another way, almost half of your retirement budget will go to pay for the roof over your head and the vehicles in your garage. Let’s look at an imaginary couple to see how cuts in those areas can make a big difference.
John and Linda would like to retire next year. They decide to hire an adviser to look over their plan and, much to their dismay, the adviser tells them that they need to save another $300,000 to adequately fund their retirement. At the rate they are saving that would mean delaying retirement for another 10 years. Instead, they look at their retirement budget for ways to cut back.
With the kids gone, they have more space than they need, so they sell the house for $250,000, move into a $150,000 condo and pocket the extra $100,000. With carpooling and soccer games a thing of the past, they trade in their SUVs on two smaller cars (net gain $20,000) and even kick around the idea of sharing a car once neither of them is working. The smaller house and more fuel-efficient cars also means that they’ll be spending about $500 less each month ($6,000 per year) on taxes, utilities, gas and maintenance. Assuming a 4 percent withdrawal rate, that $6,000 annual savings means that they can get by with $150,000 less in their nest egg.
The total benefit, then, from cutting back in just those two areas was $270,000 (or 67,500 lattes). Not bad. They still have $30,000 to go, but at the rate they’re saving they should be able to set that aside and still retire next year as planned.
[Note: To consider ways to trim your own budget, you can download a free retirement budget worksheet at www.intentionalretirement.com/budget.]
Another way to increase retirement security and perhaps even retire sooner than expected is to eliminate debt. It used to be common for people to enter retirement with little or no debt. Unfortunately, that is no longer the case. According to a recent study by the Employee Benefits Research Institute, 65 percent of American families with a head of household age 65-74 had debt. The age group with one of the biggest spikes in debt was 75 and older.
Not surprisingly, debt makes it harder to fund your retirement. It cuts into your cash flow and increases the risk that you will run out of money. Again, let’s assume that you can draw 4 percent per year from your assets during retirement. That means that for every $1,000 in annual income that you want during retirement, you’ll need $25,000 in savings.
Look at your current budget. How much do you spend each year on debt payments (e.g. mortgage, car, credit cards)? Multiply that number by 25. How much is it? $250,000? $500,000? More? That’s how much you’ll need to save in order to service that same amount of debt in retirement. As you can see, retiring will be much easier if you retire your debt first.
So as you plan, don’t think of retirement as a particular age or work status. Think of it as the time in your life when you can afford to pay your bills through means other than your job (e.g. personal savings, pension, Social Security).
When you look at it that way, it becomes clear that you can reach your retirement goals from two different directions. “Save more for retirement” is certainly one way, but “spend less in retirement” can be just as effective.
Note: I first published this article in the Omaha World Herald.
Have you ever daydreamed about what you’d do if you won the lottery? Maybe take that trip around the world you’ve always wanted to take. Buy that little red sports car. Retire early.
For some reason, we’re conditioned to think that there isn’t a dream, desire or problem that a seven figure payday couldn’t solve. We’re guilty of this same thinking when it comes to retirement. We have a million things we want to do, but we tell ourselves that we can’t really do them until we’re worth millions.
Well, today is your lucky day, because you just won $10 million in the Intentional Retirement Lottery*. Woo-hoo! Time to call work and tell your boss you won’t be coming in today (or any day for that matter). Go ahead. I’ll wait.
OK, with that pesky day-job out of the way, let’s get down to business. Like most lotteries, we give you the option for a lump-sum payment rather than a lifetime annuity. If you take the lump-sum (which most do), you end up with half of the jackpot amount, which in this case is a cool $5 million.
Of course you need to pay taxes too. Now that you are officially part of the 1 percent, you are in the 35 percent tax bracket (congratulations!). That, combined with a typical state tax of around 5 percent, will lop another 40 percent from your winnings. Painful, but hey, that still leaves you with $3 million.
Of course your extended family is going to come out of the woodwork and want you to spread the wealth a bit. You’ll probably also want to take care of a few of your favorite charities. Drop around $500,000 on those and you end up with $2.5 million in the bank.
Since you just quit your job, you want that money to last. To make sure that happens, I would advise you to take no more than 4 percent per year from your portfolio. That comes out to $100,000 per year. “Hey, wait a minute,” you might be saying. “That’s close to what my spouse and I make right now.”
Exactly. You may not have a seven figure nest egg, but if you make at least $40,000 per year, you have the income that a seven figure nest egg can generate. What’s my point? Don’t use your portfolio as the scapegoat that keeps you from pursuing your goals and dreams.
You likely have the same income now that you’d have if you had millions in the bank. The only difference is in who signs your checks. Said another way, you have the same (or better) income now that you’ll have in retirement. Are you living that way? If not, then maybe—just maybe—money isn’t the key problem after all. Maybe it’s deciding what you really want to do with life and getting intentional about making it happen. Don’t defer the very best until the end. Keep building that portfolio, but until you get there, let your paycheck be your portfolio.
* Not really, but go with me on this one.
Photo by Paul Sapiano. Used under Creative Commons License.
A common rule of thumb is that you can live in retirement on about 70 percent of your pre-retirement income. Should you bank on that? Will you really spend less in retirement? Well, I’ve got good news and bad news.
The good news is, yes, you will spend less in retirement. The bad news? Most people spend less because they have less to spend, not because they couldn’t use the extra income.
Even with the house paid off and outlays on things like work clothes a thing of the past, many retirees still spend the same or more (especially during the first 10 years of retirement) because other expenses go up. Two categories that often increase dramatically are: 1) Travel and recreation and 2) Health care.
So as you plan for retirement, don’t put too much stock in generalities or rules of thumb. Think about what you actually want to do during those years and what your expenses are likely to be. Then put together a well thought out budget that realistically matches those expenses with the necessary income.
How much is enough (a.k.a. How much do I need to have saved to fund my retirement)? When it comes to retirement, that’s the question I get asked the most. The answer is (not surprisingly) different for everyone. Some can live like kings on $50,000 per year. Others would have a hard time scraping by on ten times that amount. It all depends on the type of lifestyle you want to live.
Because there is no hard and fast rule, people often end up saving randomly and then hoping that it will be enough. This is a little like traveling without knowing where you’re going: Great if your only criteria is to get “somewhere,” but less than ideal if you have a particular destination in mind.
So how do you figure out how much you’ll need? Here’s a quick and easy calculation that will give you a track to run on:
Step 1: If you were to retire today, what would you want your annual income to be?
That’s a much easier question to answer than “How much is enough.” Think about your plans for retirement. Are you on track to have your house paid off? Do you want to travel more? Planning on moving to the beach? Imagine that today is your last day at work (Hooray!). Retirement starts tomorrow. What kind of annual income do you need? This Retirement Budget Worksheet can help.
Step 2: Subtract pension and Social Security income.
Take the number you came up with in Step 1 and subtract any income you expect to receive from a pension or Social Security.
Step 3: Multiply the answer from Step 2 by 25.
Research shows that if you want your retirement portfolio to last for 30 years, you should limit initial withdrawals to about 4 percent per year and then give yourself a “raise” each year based on the inflation rate. Multiply your answer from Step 2 by 25 and you’ll have a portfolio big enough to generate the income you need assuming 4 percent withdrawals.
Step 4: Adjust the answer from Step 3 for inflation.
The answer you came up with in Step 3 is the portfolio you would need if you planned on retiring today. If you plan on waiting awhile, you’ll need more money because things get more expensive over time. If you’re not retiring for another five years, multiply the answer from Step 3 by 1.22. Ten years to go? Multiply by 1.48. For 15 years and 20 years, multiply by 1.80 or 2.19 respectively.*
That’s it! You now have a rough idea of how much you’ll need to fund your retirement. And as G.I. Joe would say, “Knowing is half the battle.” The other half is saving! Touch base if you have any questions or if there’s anything I can do to help. Have a great week.
* These numbers assume an annual inflation rate of 4 percent.
(Note: This is Part 2 in a three part series that I did for the Omaha World Herald on retirement planning for different life stages. I’m re-posting it here for all of you who don’t live in snowy, freezing Omaha!)
Forty-five is an interesting age. It’s like the Junior High of aging. Too old to fit in with the kids at the Kanye West concert, but too young for the senior discount crowd at Denny’s. Exactly halfway between 25 and 65, it’s like a weigh station between the carefree and exciting days of your 20s and what will hopefully be the carefree and exciting days of retirement.
With 20 years to go, it’s a good time to reflect on the planning you’ve done so far and see if you are on the right track. If not, you’ve still got time to do something about it, but the clock is ticking. Here are 20 ways to make sure you’ll have enough in 20 years.
1. Actually figure out what you need. Too many people retire based on their birthday instead of their bank account. Knowing how much you’ll need will help you save with purpose and intention. A good rule of thumb is to shoot for a nest egg that is 25 times larger than the amount you want to take from it each year.
2. Get out of debt. No one in the history of the universe has gotten rich spending money they don’t have on things they don’t need. You won’t be the first to crack the code.
3. Perform budget triage. Most budgets don’t bleed to death from a gaping wound, but rather a thousand little cuts. Wasting $20 per day for 20 years will shave about $334,000 from your nest egg (assuming an 8 percent annual return).
4. Beware any sentence that begins with “Hey dad. Can I…” People in their teens and twenties are incapable of ending that sentence with anything that doesn’t cost you money and put a hole in your nest egg. Whatever the request, just answer with a firm “Yes, as long as I can move in with you in 20 years because I had earmarked that money for retirement.”
5. Make your saving automatic. Saving is like going to the gym or eating your vegetables. You know you should do it, but it takes discipline. Make it easy on yourself by having money automatically deducted from your checking account or paycheck each month.
6. Focus on the basics. Saving and investing doesn’t need to be complicated. You can contribute $17,000 to a 401(k) and $5,000 to an IRA each year. Start there. Maxing out your contributions for 20 years would add about $1,006,000 to your nest egg (assuming an 8 percent annual return).
7. Refinance. Interest rates are at historic lows. If you still owe money on your house, consider refinancing into a loan with the same payment, but a lower rate and shorter term. You’ll save thousands in interest and you’ll enter retirement with no mortgage.
8. Get healthy. In 1900 the three leading causes of death were influenza, diarrhea, and tuberculosis. Today they are heart disease, cancer and stroke. All three of those diseases are expensive (even with insurance) and heavily dependent on things like diet, exercise, smoking, drinking, and stress.
9. Beware midlife crisis purchases. If you’re tempted to buy a Hemi powered midlife crisis-mobile, don’t. Buy a nice used grocery getter instead and put the difference in your IRA.
10. Add up everything you’ve spent during the last 12 months on beverages (e.g. soda, red bull, alcohol, venti non-fat no foam double shot hazelnut lattes, etc.). If the number is greater than the world median annual income (about $1,700), reacquaint yourself with the benefits of water.
11. Make it personal. You’re not planning “retirement,” you’re planning “your retirement.” Once you realize that and spend some time thinking about the things you are really looking forward to, you’ll be incredibly motivated to make it happen.
12. Avoid mistakes, especially those that result in large investment losses. At 20 you had plenty of time to recover. At 45, large losses are like meteors to dinosaurs. They are extinction level events. Don’t put all your eggs in one basket (like your own company’s stock) or make questionable investments (like that can’t miss tip from your brother-in-law).
13. Meet with a trusted adviser annually. Answer three key questions at each meeting: How did my investments do this past year? Am I still on track for retirement (see number 1)? What changes do I need to make?
14. Work on your marriage. Middle age is a risky time for you and your spouse. Having a happy marriage is reason enough to put forth the effort, but if you need something more, remember this: A sure fire way to derail your retirement is to divide all your assets in half.
15. Don’t be too conservative. The markets have been crazy these last few years and a lot of people responded by moving everything to cash. That may help you sleep well, but it won’t help you grow your assets and outpace inflation. Repeat after me: Safe is risky.
16. Review your asset allocation. If instead of moving to cash, you ignored your investments through the recent market turmoil, there’s a good chance that the ups and downs threw your portfolio out of balance. Research shows that your asset allocation is responsible for 90 percent of your investment returns. Work with your adviser to rebalance to a more appropriate allocation.
17. Downsize. Once the kids are gone, reconsider the necessity of having a house big enough to have its own gravitational field. A smaller place means that you’ll be spending less on your mortgage, heating, cooling, insurance and property taxes. Invest that savings for retirement.
18. Take advantage of peak earning years. You’ll likely make a lot of money in your 40s and 50s. As the kids grow up and move on, be sure to make your peak earning years your peak savings years as well.
19. Beware of fees. A good adviser or mutual fund can add value, but pay close attention to the fees you are paying. It’s not just the fees, but the compound interest those fees would have earned had they stayed in your account. Over a 30 year period, an extra 1 percent in fees is enough to shave 25 percent off the ending value of your investments.
20. Don’t retire early. Calling it quits before your full Social Security retirement age could mean a 20 percent permanent reduction in benefits. It’s worth remembering that the number one reason people retire early is poor health (see number 8).
Unless you’re a trust fund baby or a lottery winner (and let’s be honest, they all quit reading after number 3), you’ve probably got a little work to do. But have no fear. You can do a lot in 20 years. The key, as with most things, is to start. Ready? Go.