A third of Americans have almost no retirement savings. Workers need a “reality check.” They’re also “deluded”[i]. All these dire conclusions (and more!) stem from a recent retirement survey. For the concerned, the media has two popular suggestions: save more or work longer. But in our view, these well-intended instructions overlook a key determinant of whether you really have enough for retirement: the size and impact of your future withdrawals and expenditures. Planning for your future cash flow needs will help set realistic expectations about what your retirement portfolio can provide, decreasing the likelihood of nasty surprises. Like running out of money.
MORE: Do you know how much your retirement will cost? Do you know how to generate the retirement income you’ll need? The Definitive Guide to Retirement Income will help you find answers to these and other important questions.
Many folks approach retirement by asking, what percentage of my current salary will I need to replace? That percentage is usually less than 100, as most envision costs falling in retirement—the kids are grown, big loan obligations are almost complete, they aren’t commuting anymore and life gets simpler. A majority of workers surveyed believe they can live off of 70% of their pre-retirement income. Yet some warn folks are vastly underestimating their future expenses. Who’s right? Well, it depends—everyone’s situation is unique. There is no one cookie-cutter salary replacement ratio that will work for everyone. Consider another of the survey’s findings: Among retirees, 20% are currently providing financial support to a relative or friend. In this group, 58% is going to children over 18; 24% to grandchildren; 10% to children under 18; and 5% to parents or in-laws. Financially supporting a parent versus a grandchild is vastly different—just consider the time horizons and expenses. We suggest thinking not about an arbitrary number, but rather, what are your personal expenses going to be? Then you can design a plan to meet your needs.
Targeting a set percentage of your final salary ignores a key fact: Your expenses will likely change throughout retirement. Health care spending—which includes hospital services, medical care and drugs—tends to increase as folks grow older, for example. Also, many retirees help out with their grandchildren’s education. Retirees planning for these and other costs should consider how the rate of inflation has impacted certain goods and services compared to others. Since 1990, CPI, a broad inflation gauge, has risen 87%[ii]—housing[iii] (88%) and electricity (80%)[iv] rose at similar rates. But college tuition (357%), hospital services (344%) and pharmaceuticals (173%) all greatly exceed those figures.[v] To highlight how personal situations differ, consider the following scenarios: A 60-year old couple living in San Francisco, California and supporting one child in college faces the Bay Area’s high-priced housing and rising tuition costs. On the other hand, a 60-year old single retiree in Peoria, Illinois may not be dealing with a hot property market, but rising health care and medical expenses instead. Now, this doesn’t mean all retirees’ expenses are going to be higher than they think. If you’ve accounted for inflation all your life but end up with mostly fixed costs in retirement, you may have overshot—a nice problem to have! But everyone’s expenses are going to be different.
This also needn’t be a big bad surprise. Taking stock of your current costs and income sources and projecting them forward can give you a better idea of what you’ll need from your portfolio during retirement. First, you’ll need to figure out your costs, both fixed (like a fixed-rate mortgage or medicines) and variable (utility bills). You should also identify discretionary costs, too—if an unexpected expense arises or if returns aren’t what you projected, this would be the first place to make adjustments. Factoring in your current costs, as well as planning for future ones (e.g., a grandchild’s tuition, traveling the world and/or remembering health care expenses rise as you age) will give you a sense of what your portfolio needs to provide. Granted, nobody can predict their future expenses perfectly—life changes. But having a plan in place will put you in a better position to avoid any nasty surprises.
Likewise, be realistic about how your withdrawals affect your portfolio. While not exceeding a 5% annual withdrawal rate[vi] is a good rule of thumb, diving deeper can shed more details on what you, personally, will need and what you should aim for as you save for retirement. First, consider your cash flow needs. Then divide that by different percentages to determine a portfolio size that can provide that cash flow. (For example, if you need $50,000 annually, and you want to begin with a 5% withdrawal rate, divide 50,000 by 0.05, and you will arrive at a $1,000,000 starting value.) You can test how those different portfolios would fare over the long-term with “Monte Carlo” simulations, which use thousands of random combinations of real historical market results to estimate how long your nest egg will last. The results will give you an idea of just how realistic your expectations are—and whether or not you need to adjust them. (Though they aren’t perfect, there are a number of free Monte Carlo simulators on the web.)
Another point to be realistic on: your portfolio’s overall growth potential. Even if your portfolio has a large equity allocation for growth purposes, it won’t negate the impact of consistently big withdrawals. Investment returns vary, especially year to year, and just because stocks have a big positive year doesn’t mean your expenses can correspondingly go up, too. Large withdrawals—like taking $160K from a $2 million portfolio every year—run the risk of depleting your portfolio too soon. That’s a risk you must weigh and understand how it may impact your savings’ longevity and other goals.
While you can’t foresee unexpected expenses or market performance, figuring out realistic future costs can improve your portfolio’s long-term prospects. Given your unique situation, there is no quick-and-easy solution—but putting in the work to figure out what’s realistic may save you (and your loved ones) a lot of future anxiety.
[i] That is not a nice thing to say about people, so we want to make sure you know it’s their word, not ours. We like our readers and people in general.
[ii] Source: FactSet, as of 12/31/2014. From 12/29/1989 – 12/31/2014.
[iii] This is a national average, as those living in the San Francisco Bay Area or New York City will vouch.
[iv] Source: FactSet, as of 12/31/2014.
[vi] Note, this doesn’t mean 5% of the prior year’s 12/31 portfolio value every year. It means 5% of your current portfolio value, adjusted for inflation over time.