Can I afford to retire? How much do I need? When can I retire? These are the big questions we all struggle with when retirement age approaches. Obviously enough, there’s no do-over, either for the years saving and preparing for retirement, or after you pull the trigger—you’ll be hard pressed to get your old job back, or maybe any job, if you find out you still need to earn income.
Some suggest that retirement planning is the central focus of all financial planning—I don’t disagree. Fortunately, lifetime financial planning methods can help you find the answers to these critical questions.
Last time (“Household Spending And Your Retirement Plan”) we used a simple approach to figure out annual household expenses (annual expenses = annual income – annual savings). Then we made some adjustments to estimate how that annual expense might change in retirement and came up with an annual retirement expense number—in our example, $145k/yr. Also in our example, there are savings of $22k/yr in taxable and tax-deferred retirement accounts.
Determining Your Retirement-Readiness
Expanding the example, let’s assume that from a similar savings habit over the years, which you left alone to grow prudently in diversified no load funds, and with the help of a small inheritance, you now have $1 million in household savings (financial capital) as you and your spouse near retirement age.
At retirement, you both plan to stop working. To keep things simple, we’ll assume you and your spouse are the same age and both plan to take Social Security at full retirement age (FRA) of 66, with combined benefits of about $44k/yr. You have a small pension of $10k/yr from a job earlier in your career, when pensions were more prevalent than they are today.
At retirement, therefore, you will have $54k/yr in household income from your ‘social capital’ ($44k SS + $10k pension). Since you and your spouse will both stop working, your income from social and human capital (human capital comes from income from your work) is $54k against estimated annual retirement expenses of $145k/yr, leaving $91k/yr in ‘uncovered’ expenses.
That uncovered $91k/yr in expenses must come from your savings (financial capital). We talked about these three different sources of household capital in the introduction to your household balance sheet earlier ( “Retirement Planning 101: Getting Your Bearings”).
So, do you have enough savings to cover? We use a simple formula to find out:
Retirement-Readiness % = (Annual Retirement Expenses – (Social + Human Capital)) / Financial Capital
Using our example, annual retirement expenses less Social Security and pension (no earned income) equals $91k in uncovered annual expenses. Financial capital (savings) is $1 million. So using our example, the formula looks like this:
Retirement-Readiness % = (145,000 – (54,000 + 0)) / 1,000,000
This reduces to:
9.1% = 91,000 /1,000,000
Therefore, in our example, Retirement-Readiness is 9.1%. Based on the need to support a projected 30-year retirement, here is the Readiness scale:
[imageeffect type=”frame” width=”600″ lightbox=”yes” height=”284″ alt=”Retirement-Readiness Scale” url=”http://www.lonierfinancial.com/wp-content/uploads/2012/07/retirement-readiness-01.png” ]
As you can see in the chart, 9.1% is greater than 7%, which means that in our example, your Retirement-Readiness is in the under-funded red-zone. This means you don’t have enough financial capital to fund your retirement over a 30-yr period—you will run out of money.
For Readiness to fall in the yellow caution zone between 3.5%-7%, you would need $1,820,000 in savings to cover annual expenses of $91k to score a Retirement-Readiness of 5%.
You may be more familiar with Retirement-Readiness expressed as a multiple of annual expense. 5% is equal to 20x in our formula, so 20 x $91k = $1,820,000. Using multiples of annual expense, the Retirement-Readiness scale looks like this:
[imageeffect type=”frame” width=”600″ lightbox=”yes” height=”322″ alt=”Retirement-Readiness Scale” url=”http://thefinancialpreserve.com/credence-dev/wp-content/uploads/2012/07/retirement-readiness-02.png” ]
You can, of course, work this backwards, from your savings or savings target, to determine how much you can afford to spend annually, based on your savings plus Social Security and pension benefits. This might help you size up the effect of moving to a lower-cost area, for instance, if that’s something you are considering.
If this is the first time you’ve seen retirement funding framed in this way, you may be shocked by the amount of savings that you need to support your lifestyle. In future blogs, we will talk about various approaches for getting out of the red and yellow zones and into the more comfortable green zone, so we’ll leave that for later.
For now, one important take-away is don’t plan to make up the shortfall by taking more risk in the market. That is a poor plan that may make a bad situation very much worse. As you near retirement, you need to de-risk and move into secure risk-free or low-risk (depending on where you are on the Retirement-Readiness scale) income vehicles, and not put your life savings at risk in the capital markets.
If you’re in the red zone, you should consider working longer if you can, saving more, and/or reducing expenses. We will talk about annuitizing savings as a way to safely maximize your income for those who are in the danger zones, in upcoming posts.
There are different strategies that make sense for households based on their Retirement-Readiness score, both in early and mid-career and as you near or are in retirement. How you safely manage your savings and convert savings to retirement income varies considerably whether you are under-funded, constrained, or well-funded, so there’s plenty for us to cover in future posts.
Note that in this series we have not yet begun to talk about investing. It’s not that investment isn’t important—it’s a crucial part of building your savings over your lifetime. But it’s not where good planning starts. Only when you have a firm sense of your household balance sheet and your lifetime human capital can you design a sound investment plan that makes the most sense for you and the amount of risk you can afford to take.
An investment plan is the result of a good lifetime financial plan, not the starting point. That is why you should be wary of advisors and planners who start by talking about your savings and investment portfolio with little or no understanding of your household balance sheet, your lifestyle, and your goals.
They’ve put their cart in front of your horse. Don’t get run over on the way to the market by these kinds of advisors.
Next up (“Inside Your Household Balance Sheet”), we’ll go into your household balance sheet in more detail as we begin to refine your retirement plan.