05 - Do you have enough money for retirement?
This is the number one question I get asked when discussing retirement planning – “Do I have enough?” It’s a hard question to answer off-the-cuff as there is a lot of analysis that goes into it, and a lot of variables that can change the answer. However, there are two sides to the equation that should help everyone come up with an approximate answer: income and expenses.
What income are you working with?
In order to determine if you have enough to retire, you first have to understand how much income your assets will produce. Notice, I didn’t say savings or investments, but used the word assets, as income can come from various sources. While you have the traditional sources – pensions, 401(k), IRA, and Social Security, there are also non-traditional sources that often get overlooked: alimony, a reverse mortgage, royalties, future inheritance, and rental real estate income.
To understand how much income some of these things may produce can be challenging. A rental property with no mortgage is easy to determine – take the rent, minus taxes, insurance and upkeep, and you have the money in your pocket. A pension is also easy as the pension provider will tell you how much they are going to pay you each month. But how about looking at a 401(k) - how much income does a large sum of money provide over a 30-year retirement?
There are some rules of thumb when it comes to converting large sums of money into income, and not running out of money. The most popular – and easiest to calculate - is taking 4-5% of the saved amount as annual income. For example, if you had $500,000 in a 401(k), and it was invested in a diversified portfolio, you could take $20,000-$25,000 in annual income from this amount without depleting it. If you had $1,000,000, then it becomes $40,000-$50,000. If you coupled this with Social Security or a pension, your retirement income can start to become sizable.
It gets tricky when you factor in inheritances. When you are working, it’s best to not factor inheritances into your plans as it takes away the discipline of saving for your own retirement. There are also so many variables that can make an inheritance disappear and if you are reliant on it, it can damage your own financial future should it disappear or be depleted.
But what about when you are in retirement, and an inheritance is imminent? Then it becomes time to reassess what expenses you have, if this inheritance will now create income that exceeds those, and if it does, what’s the next step.
What expenses do you have, and how many will go away?
Once you have the income nailed down – or at least a good idea of what you might have to work with – it’s wise to understand what expenses you’ll have. This is similar to having a budget laid out while you’re working, but it should also factor in things that don’t occur during your working years: more time spent traveling, indulging in hobbies, and later in life, being spent on health care. While these things may cause expenses to increase, there are also things that will go away: gas costs and car repairs incurred from the daily commute, a mortgage as it gets paid off, and money being saved for retirement.
Side note: One amusing thing happens with some public-sector employees that I’ve worked with. If they have pension contributions taken out of their paycheck and they also save for retirement using tax-deferred accounts, they can find that their income goes UP in retirement and they have more money to spend. Bizarre but true.
Once you have this spending plan in place of what a typical month and year might look like, you can determine if you have saved enough or need to need to adjust to make retirement work. For example, if your monthly spending plan equals $6,000/month ($72,000/year) and you have income of $5,000/month ($60,000/year), you may find that you need to save more leading up to retirement, find some part-time work in the initial years of retirement, or revise what your spending plan will be. But knowing this is far better than having these all be unknowns.
Understanding Monte Carlo Analysis
But things aren’t always that easy. Just because you have enough assets to provide the income you need, doesn’t mean it’s all rosy.
There are a number of risks that come into play when withdrawing money from a sum of money that can derail even the best plans. Let’s say you had $1,000,000 and needed $40,000 of income from it each year. Initially, that’s not a problem. But what if you retired and the market dramatically declined for a couple of years. Now your lump sum is $650,000 and you still need $40,000 per year. Your annual withdrawal rate has now gone from 4% to over 6%. If your portfolio doesn’t recover to previous levels, you may at risk of depleting your money during your lifetime.
There is a way you can test your original scenario against various stock market scenarios to see how successful yours will be. This can be done by using Monte Carlo Analysis. Monte Carlo Analysis will take your scenario and run it 1,000 times using different stock market returns each time. Some years will start off low and gradually increase. Others will be a steep increase in returns, but then be a long recession. By looking at all 1,000 of these tests, you can then determine what probability your scenario has of succeeding. And by succeeding, we’re talking about having the money to achieve the goals you want to, or pay for all of your expenses.
What do you do now?
For some, reading this has charged them with setting up everything up and finding out how successful their retirement might be. For others, possibly yourself, it may leave you with a level of uncertainty. Many of my clients have told me while they understand the theory behind these things, they need guidance to get through it and be confident in the results.
As we’ve come to the end of our “Retirement Readiness” series. I will leave you with one question: Do you feel comfortable tackling all of this by yourself?
If you do, fantastic! Gather everything you need and determine what things need tweaking to achieve a successful retirement.
If not, that’s where my services can help. I offer a range of services: from one-time review of people’s situations in helping them prepare for retirement to full Wealth Management which involves me and a CPA designing a full financial plan, tax plan and ongoing investment management. I’m confident there is a service that would meet your needs and can have you feeling confident about transitioning into retirement.
If you’d like to make an appointment to discuss your situation, please do so here: http://www.meetme.so/retirementmatters.