Your current and future household expenses are the fulcrum for your lifetime financial plan. Getting you savings and expenses lined up and in balance is the gateway to a secure retirement.
Last time (“Retirement Planning 101: Getting Your Bearings”) we covered the role your household balance sheet plays in locating your family’s lifestyle and not your investment portfolio at the center of your lifetime financial plan. Here we’ll talk about expenses as the key component of your household balance sheet that allow you to properly plan your savings, investment, and other financial matters.
A Simple Formula to Determine Your Annual Expenses
The easiest way to determine your current annual expenses is simply to add up all your income for the year (you can average over three or five years if yours typically fluctuates), and subtract all of your savings for the same period, whether in retirement accounts or in regular taxable accounts. The result is your annual expenses.
This is the simple formula: Expenses = Income – Savings
For example, let’s say you and your spouse both work and earn $175k combined in salaries. You have $2k in interest and dividends from taxable savings and investments. You have a small part-time business providing marketing advice to local businesses that now brings in about $6k a year.
You save $6k in your 401k with a $2k match. Your spouse saves $6k with a $3k match. Together, you save $5k in after tax accounts.
Here’s how that looks:
|Annual Expenses = Annual Income – Annual Savings Example|
|You and your spouse’s salaries||
|Interest and dividends||
|Total Annual Income||
|Retirement account savings||
|Regular taxable account savings||
|Total Annual Savings||
|$183,000 – 22,000 =||
The biggest chunk of these expenses is probably housing (mortgage/rent, insurance, utilities), taxes (income, property), food and clothing, transportation (car, insurance, gas, commuting/parking), and healthcare. These big items are typically essential expenses—you can’t live without food, shelter, healthcare and clothing. Once you’ve isolated taxes and the essentials, the rest is discretionary—education (some level of college tuition expense is arguably essential), entertainment, vacations, gadgets, etc.
Looking forward, especially towards retirement, you can see how some of these items may change. Over time, you might payoff your mortgage or refinance a smaller balance at a lower amount. You may need fewer cars, are past the college tuition years, aren’t commuting, and so forth. While these changes may lower costs in retirement, you may not realize how much more healthcare will cost in retirement than it does during your working years, both because you will typically need more of it and because you may also have to pay a larger share of those expenses directly or via a MediGap premium, since Medicare generally covers less than typical company plans cover.
In short, for rough planning purposes, you might save only 10% of your current expenses during retirement, especially given the ever-steady increase in healthcare costs. If you live in a high-tax, high-cost area, relocating to a lower-tax, lower-cost area may reduce your costs considerably. But more conservatively, you might not cut expenses at all—it depends on the kind of retirement lifestyle you envision and can afford. If you travel and engage in relatively expensive avocations, you may spend more in retirement than you do while you are too busy working to spend.
Now that you have a sense of your current expenses ($161k/yr in this example), and an estimate of retirement expenses (-10% = $145k/yr), you are ready to determine whether your current savings and savings rate will comfortably cover your estimated retirement expenses.
Getting your expenses and savings in order—which you control—will have far more impact on your retirement plan than taking extra risk and reaching for maximum returns in the stock market—which you can’t control—especially during this slow-growth deficit-encumbered economic period. That is why we put your household balance sheet and not your investment portfolio at the center of your lifetime plan.
We’ll cover the relationship of savings and expenses to retirement in more detail next time in “Can I Afford to Retire?”