By Dana Anspach, CFP®, RMA®, Kolbe Certified™ Consultant
While saving for retirement, most people have a target number in mind. Perhaps it’s $1 million by age 55, or maybe it’s $4 million by their mid-60s. Having a target number is a good start, but it's not telling the whole story.
As you prepare to exit the workforce, you’ll need a retirement income plan that shows where your cash flow will come from, when each income source will begin, and how long it will last. It's like the difference between a photo and a movie. A photo captures a moment in time; a movie tells a story, progressing through time.
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A thorough retirement income plan will incorporate the ebb and flow of cash flows and help you match your assets with your living expenses throughout retirement. To build an effective plan, start with these five steps.
- Watch this YouTube video on How to Make a Retirement Income Plan.
Build an Income Timeline
Most retirees will have one or two sources of steady income. The most common is Social Security, followed by pensions, annuity income, and deferred compensation payments. Cash flows may begin at different ages. A timeline illustrates these changes in a way that's easy to see.
Take the example of a hypothetical couple, Sam and Sally, who will retire together when Sam turns 64 and Sally is 62. The couple determined that given their income and longer life expectancies, they will not claim Social Security retirement benefits early. Sam, the higher wage earner of the two, plans to claim Social Security at age 70 to maximize the survivor benefit payable to Sally. Sally plans to begin Social Security at her full retirement age of 66 years and 10 months.
Sam is vested in an employer pension that will start paying out at age 65. Sally inherited $200,000 from her mother a few years ago and invested the money in a deferred income annuity that will begin paying her a monthly check when she’s 65.
When you add this together, the amount of fixed-income they'll receive gradually builds up to six figures annually by their eighth year in retirement.
- Build a retirement plan customized for your unique financial situation.
Identify Your Expenses Over Time
When you retire, your spending will vary from year-to-year as your needs change. Here are just a few examples:
- Payments on a fixed-rate mortgage won’t rise and will disappear once you've paid off the loan. However, taxes and insurance don’t go away and will increase with inflation. And don’t forget you'll have home maintenance and repairs.
- If you retire prior to age 65, you'll need to budget more to cover health insurance premiums for the years before Medicare coverage begins.
- Most retirees spend more early in retirement, called the "go-go" years, with spending declining in mid-retirement.
Sam and Sally group their expenses into four main categories: home, health care, travel and living expenses, and taxes.
Their mortgage will be paid off about seven years into retirement, but they expect property taxes and insurance to rise about 3% a year. Monthly health insurance premiums will take a significant chunk of their budget for the first few years, dropping by nearly half once Medicare begins. They also plan to front-load their travel, but cut back at age 70 and beyond. And they figure they will have three more car purchases during retirement.
Sam and Sally also assume they will be in a lower income tax bracket in the early years of retirement but will get pushed into a higher tax tier as each of them reaches age 72 and must start taking distributions from tax-sheltered retirement accounts.
Sam and Sally realize they will need more cash flow early in retirement. However, as they shift to Medicare, pay off the mortgage, and reduce travel, spending will decline and reach its lowest level in the eighth year of retirement.
Their expense timeline allows them to easily see this pattern of expected spending.
- Stress-test your retirement income plan with these 3 steps.
Calculate Withdrawal Needs
To customize your withdrawals, take your expense timeline, which shows total annual expenses including taxes, and subtract out the amount of corresponding fixed income coming in for each year. When laid out year-by-year, this gap shows you how your needed withdrawals from savings and investments will change over time. You rarely see an orderly pattern, such as a withdrawal need that matches 4% of financial assets.
After comparing their timelines, Sam and Sally see they will need to withdraw about $207,000 from savings and investments their first year of retirement, but only about $66,500 in year eight. Do they have enough to support their desired withdrawals?
To find out, they take their starting nest egg of nearly $3 million, subtract their withdrawals at the beginning of each year, and test it against annual investment returns of 3%, 4%, and 5%.
At a 3% average annualized return, they may come up short and would need to cut spending. At 4%, Sam and Sally can cover their expenses but may gradually spend down principal if their inflation projections prove correct. At 5%, shown in the visual below, they have enough and retain most of their principal throughout retirement.
- Get a free guide on 4 Things Near-Retirees Must Know About the 4% Rule.
Fine Tune Your Assumptions
To fine-tune your projections, you'll need realistic assumptions. Should you assume living expenses rise 3% a year, as Sam and Sally did? Research shows that retirees spending $100,000 or more a year don't need their spending to go up at the same pace as inflation. If you are a higher income household, consider applying an annual increase of 1% to 2% to your future expenses. On the other hand, it’s possible that health care expenses will rise faster than general inflation, so you may want to plan for that.
Also, will you plan for an annual cost of living increase to your Social Security benefit? And what about investment returns? If you invest conservatively, an estimated rate of return of 1% to 2% a year may be realistic. If you keep at least 60% of your portfolio in equities, a 4% to 5% annual return may be reasonable.
When developing assumptions, be cautious of unrealistic scenarios. It can be tempting to assume a high inflation rate and a low return on savings; however, interest rates are also typically higher during times of high inflation, making such a scenario an outlier. And if you keep less than 50% of your portfolio in stocks, or if you let money languish in cash accounts because market volatility spooks you, you’re unlikely to see savings grow at 5% or more a year. Your assumptions need to match your behavior.
- Learn how to build a retirement portfolio that will stand up over time using one of these four methods.
Weigh Your Options
Once you've constructed your retirement income model, you're in a perfect position to evaluate your choices. Some people choose to work longer to build up their nest egg. Others downsize their lifestyle to be able to afford to retire earlier.
During retirement, many of the outcomes you desire are on opposing sides of a teeter-totter. For example, you can choose a withdrawal strategy that maximizes cash flow, but not while simultaneously increasing the reliability of that income stream. If your goal is to preserve wealth for the next generation, you may have to spend less in retirement. You can purchase income annuities if you’re concerned about outliving your money, but they might not keep up with inflation. And though a greater allocation to equities offers the potential for higher cash flows, that’s not guaranteed, especially if you abandon stocks in volatile markets.
When you have a timeline and realistic assumptions in place, and you're clear on the outcomes that matter, you'll be ready to make objective decisions about how to achieve your retirement lifestyle. That is the power of a well-designed retirement income plan.
- Discover how to squeeze every penny out of your retirement savings. Download the Don’t Cheat Yourself guide today.
Dana Anspach is the founder and CEO of Sensible Money, LLC. Practicing as a financial planner since 1995, when Dana began working with people in their 50s and 60s, she realized that a different type of planning was needed to align one’s finances for a transition out of the workforce.
As Dana says, “The retirement income planning process is alive with choices and variables. To make the best decisions you need a way to understand the interactions of the choices you make and the corresponding impact on your future. You need an independent voice. You need information free of the influence of politics, financial products, or advertising incentivized media articles. Thus, was born the vision for Sensible Money.”
You can also read the first chapter of Dana Anspach’s book, Control Your Retirement Destiny. And listen to this podcast.
This content was provided by Sensible Money. Kiplinger is not affiliated with and does not endorse the company or products mentioned above.