What Is Your Retirement Number And Why Does It Matter?
What is a “retirement number” is and why is it important?
When we say retirement number, we mean the amount of savings one needs to retire at a desirable date and with a desirable lifestyle. This is probably the most important variable for financial planning purposes, as it drives major decisions such as spending and saving, investments, career longevity, etc. Having a well thought out financial plan and sticking to it over time goes a long way of ensuring financially secure retirement.
How does someone calculate their retirement number?
A retirement number is a very individual target and can vary over time as life evolves. It is a fairly nebulous one earlier in life (the more, the better), and firms up to a concrete number as we near retirement age. There are three main factors to consider: desired income per year, life expectancy, and potential portfolio returns once in retirement. With all these, it is wise to make conservative assumptions in order to minimize regret, which in this case is running out of money during retirement. Allow for some flexibility in case of unforeseen expenses; life expectancy is a big unknown, but a solid financial plan should run all the way to 90-95 years of age; consider your risk tolerance when it comes to asset allocation and do not factor in overly aggressive portfolio returns.
There are multiple retirement calculators available for free, usually provided by the big financial services companies. The AARP also has a calculator on its web-site for quick and simple scenario analysis. Of course, a financial planner or an investment advisor will be able to devise a more detailed, person-specific financial plan, and an investment policy to go with it.
How do Social Security and pensions factor into retirement calculations?
Both Social Security and other pension sources are important inputs into retirement calculations and could be particularly meaningful for lower earners. Put simply, they help pay the bills! But in addition, they may also inform one’s asset allocation, tax planning, and other financial decisions. For instance, if you expect sizeable income from a private pension, you can afford to be more aggressive with your portfolio asset allocation during retirement. When it comes to taxes, no more than 85% of Social Security payments are subject to federal income tax, and for some people this number can be quite lower depending on their combined income. This may inform one’s decision to claim social security instead of tapping early into an IRA for example, from which withdrawals are 100% subject to federal income tax. Further, Social Security payments as well as some pensions have bult-in inflation escalators, which provide protection against cost-of-living increases. All-in-all, do not dismiss your Social Security and pension benefits, every financial plan needs to take them into consideration.
Are there any rules of thumb investors can use to estimate their retirement needs (the 4% rule, for example), or do you recommend a personalized approach for everyone?
One way of thinking about retirement needs is in terms of the percent of pre-retirement income that one needs to replace after retirement. The widely quoted rule-of-thumb is that a reasonable income replacement ratio is around 75%. However, this may vary from as low as 50% to as high as 100% depending on income level (lower for higher earners and vice versa), specific expected expenses (e.g., young children yet to go to college, or chronic health condition), desired lifestyle (e.g., international travel), etc. In other words, this is a very person-specific number. Further, one person’s needs will vary at different stages of retirement. Earlier on, people tend to be more active, travel more, and hence their spending may be elevated. Later on, spending and income needs are likely to decline, before they rise again later in life due to higher medical costs, home care, assisted living, etc.
Once we have spending level in mind, we need to cross-check versus revenue generation potential. Many commentators quote the 4.0% rule as a good rule of thumb for that. The rule suggests that retirees can withdraw 4.0% from their portfolios annually without risking running out of money. Specifically, one withdraws 4.0% from the portfolio the first year of retirement and then adjusts that number up for inflation each subsequent year over a 30-year assumed retirement period. While this may be a good crude first pass at the problem, it has some shortcomings. First, it assumes 30 years in retirement, which may not work for early retirees. On the flip side, if one retires at 70, one can safely withdraw more than 4.0%. Second, capital markets may not provide the required rate of return for the math to work. This is particularly so if returns are poor very early in retirement (the so call sequencing risk) which will excessively deplete the portfolio. Third, the straight-line, flat-level of income this method produces has no flexibility for unexpected expenses or varying spending needs over time. Bottom line, the 4.0% rule is a rather crude one. There are better methods that allow for personalized approach and better flexibility when determining appropriate level of spending in retirement.
How do you recommend someone adjust their retirement number for lifestyle and risk?
In investing, the biggest tradeoff is between return and risk, i.e., how well you want to eat versus how well you want to sleep. Taking too much risk may result in bigger gains (you eat better) but at the expense of higher volatility and risk of permanent loss (you lose some sleep). Taking too little risk may not be optimal either. Your lifestyle and your portfolio should ideally be in synch. If you target a particular lifestyle, you should work hard, save enough, and invest wisely to build the portfolio to support it. If not, adjust your lifestyle to your portfolio. It is always wise and preferable to have a more conservative lifestyle than your portfolio allows. That gives you peace of mind, flexibility, and financial security, all very important for a long and happy retirement.
If someone wants to (or is forced to) retire earlier and with a lower amount, what advice would you offer them?
Given the discussion so far, it is clear that unexpected early retirement will require some adjustments. One obviously cannot adjust the life expectancy variable, so the solution should be on the revenue side, or on the expense side, or a combination thereof. The latter is the preferred way. One should review the budgeted expenses and try to find savings that will not substantially jeopardize the desired lifestyle. Those would be very personal and specific to each retiree. On the revenue side, one should resist the urge to ratchet up the risk level of the portfolio excessively high. While more aggressive asset allocation may be considered, it should be done on the margin, within reasonable risk parameters. Retirees can also consider other sources of income such as part-tome job, side gigs, etc. For many people, their house is their major asset. Consider downsizing to a smaller one and using the proceeds to beef up your retirement portfolio. Claiming social security earlier than targeted may be another solution that would prevent retirees from dipping into their portfolios too early and allowing them to grow for a few more years. An astute tax management is also a must have. Consult with a CPA or a financial professional to explore potential savings from your tax bill.
How often do you recommend investors reassess or recalculate their retirement goal?
A good financial plan once put in place could be valid for years. However, changes and updates must be made at each major life event that somehow alters the revenue or the expenses side of the plan. For example, another child would require budgeting for extra education and other expenses; a sizeable inheritance provides additional degrees of spending freedom; loss of a job or chronic illness would necessitate a rethinking of the retirement goals.
Life can get busy and hectic, but do not allow inertia to derail your plans. Be proactive, start early. Achieving your retirement goals relies heavily on one resource that is free but no one can buy – time.
