The Sustainable Withdrawal Rates Fantasy

Sustainable Withdrawal Rates (SWR) is a strategy for spending personal savings in retirement. It is sometimes referred to as the 4% Rule and it’s intended to create your own homemade fixed annuity without having to hand your principal over to an insurance company. Here’s how it would work.

You retire with a million dollars and invest it in a portfolio of stocks and bonds. You withdraw $45,000 (4.5%) to pay for the first year of retirement.  The second year, you withdraw $45,000 plus an additional amount that would cover the previous year’s rate of inflation.  SWR proponents say you can keep doing this for at least thirty years and not run out of money. 

In fact, the studies seem to show that you could end up with a lot of money.  Maybe even more than you started with.  And there’s “only” a 5% chance that you would go broke before you die.  Does that sound wonderful or what?

The strategy is based on statistical studies said to show that a retiree can invest his savings in a portfolio of stocks and bonds, withdraw 4.5% of the initial portfolio value[1], and continue to withdraw that same dollar amount annually with a 95% probability of funding at least thirty years of retirement.

But, they don’t show that at all.

Imagine you asked me how safe it would be to walk across the highway in front of my house.  I tell you that I watched 100 people try to cross in the last five years and “only” five of them were run over.  You might conclude that you have about a 95% chance of crossing safely.

Now imagine that I add, as you walk away, that I only watched people cross the highway who refused to check for oncoming traffic and ignored any cars they saw coming toward them after they began crossing.  I can’t tell you anything about the results for people who tried to avoid getting hit, I say, because I didn’t count them.

You would probably think that I was a little nutty, and then wonder why my statistics would be meaningful to you in any way.  You, after all, look both ways before you cross a road and if a car approaches while you’re still crossing, you damned well try to get out of its way. If we measured the fatality rates of pedestrians whose highway-crossing strategy was to dart into traffic without looking, common sense tells us to expect that they would be struck more often than pedestrians who would do everything possible to avoid danger. Otherwise, none of us would bother looking.

The SWR studies have a similar flaw.  They assume that a retiree would continue spending the same amount every year even when it would be obvious that they were about to go broke.  Consequently, they don’t predict the number of retirees who would go broke using this strategy. They show the probability of successfully funding at least 30 years for a retiree who would refuse to reduce spending to avoid going broke.

If I could clearly see that I would go broke if I didn’t cut back my spending, I would cut back my spending.  How about you? 

The logic of the SWR studies is flawed by what statisticians call the “unrepresentative sample fallacy of inductive reasoning”. A mouthful to be sure, it means that the sample we measure doesn’t represent the population for which we want to generalize.

An extreme example would be measuring the heights of players on an NBA basketball team and concluding that the average American is 6’ 6” tall and can dunk a basketball. Measuring the bankruptcy rate for people who would do nothing to avoid going broke and asserting that the rest of us share the same odds is another extreme example.

How to Improve Your Chances of Dying Broke

We would expect the probability of financial ruin for retirees who would try to avoid bankruptcy to be lower than for retirees who would simply continue spending until they
were broke and bankruptcy rates bear this out.

A 95% probability of successfully funding retirement in the SWR studies is a different way of saying there is a 5% chance of failure, and failure in these studies is defined as depleting one’s savings before retirement ends. That’s a 5% chance that the SWR retiree ends up bankrupt during retirement. Broke. Penniless. Ruined. Or, as Ray Charles so elegantly put it, busted.

While the SWR strategy predicts about a 5% probability of financial ruin with 4.5% withdrawals, according to Elizabeth Warren, a Harvard expert on personal bankruptcy, the bankruptcy rate for Americans aged 65 and older was recently about 0.43%[2]. That’s about 1/12^th of the rate of financial ruin promised by the SWR strategy for this age group.

Let me say that in a different way. The SWR studies predict that retirees who employ the strategy are about 12 times more likely to go broke than the typical American of retirement age.

The Yale Study 

A number of studies refer to a 1973 Harvard University study to determine how much their managers could safely withdraw from their endowment fund without eroding the principal. Though I have been unable to locate a copy of that oft-quoted study, it is reported that the answer was determined to be about 4%.  (The 2008 Yale Endowment report does state their spending policy is limited to 4.5% to 6% annually.)

Some argue that this supports the SWR findings, but this seems a better argument that 4% is not a safe withdrawal rate for retirees.

If the Harvard endowment, with its unequalled investment management talent, lower costs, non-profit tax status, and broader range of investment opportunities earns only enough to support 4% annual withdrawals, should individual retirees expect to sustain the same level of spending? Perhaps, but only if they are able to match or exceed the investment returns of the Harvard endowment. Most individual investors and money managers don’t even match average  market returns over the long term.

The Harvard endowment can also solicit new contributions from donors, an option I suspect is rarely available to retirees.

One would expect the Harvard endowment investments to outperform those of the typical retiree; otherwise, some extremely well paid investment managers would be fired. The consequences of major investment losses would also seem to be less severe for Harvard, since a retiree would be left penniless with few prospects of avoiding welfare, while Harvard can always go out and solicit donations from wealthy alumni. And, of course, the Harvard Endowment’s assets provide a larger margin of error— retirees with $26B in assets can probably feel good about spending $1.2B (4%) annually with little fear of bankruptcy.  Those of us with significantly smaller portfolios need to be more careful.

With greater risk and lower expected market returns, we should expect retirees to be able to spend somewhat less than Harvard’s 4%.

The 2007-2008 Stock Market’s Rebuttal of SWR

In the 2007-2008 market crash, many retirement savings accounts dropped nearly 50% in value. The financial press began to call 401K accounts “201Ks”. Workers who had planned to retire soon were forced to delay those plans, some for several years. People who had already retired and had planned to live off 4.5% withdrawals from their stock and bond portfolios were forced to reduce their standard of living or to try to re-enter the workforce. The shortcomings of the SWR strategy became brutally obvious.

SWR advocates have recently tried to explain to countless retirees whose SWR-based retirement plans were obliterated by the 2008 market downturn that the 4% Rule was never more than a rule of thumb.  Rules of thumb can be handy guidelines when we don’t have a lot at stake.  “Show up twenty minutes before the movie starts and you’ll probably get a ticket” works pretty well, while “fasten the engine to the wing with a handful of the biggest bolts you can find”, not so much.

Financial plans that fail in retirement can mean destitution with few options for recovery.  Retirees deserve better than rules of thumb.

A Few Other Rebuttals

In a paper entitled “The 4% Rule-- At What Price?”, written by Nobel Laureate, William Sharpe and others, the authors showed that the SWR strategy is much more expensive than its alternatives. In its conclusion the authors state, “Despite its ubiquity, it is time to replace the 4% rule with approaches better grounded in fundamental economic analysis.”

David Babbel of The University of Pennsylvania’s Wharton Business School refers to these strategies as fantasies.

Or, consider Dallas News finance columnist, Scott Burns.  Burns, who was an avid supporter of the SWR strategy for years as a columnist, recently co-authored a book with Laurence J. Kotlikoff entitled Spend ‘til the End in which he now refers to the 4% Rule of Thumb as a “Rule of Dumb”.

Sustainable Withdrawal Rates strategies, though wildly popular in the financial press and among many financial planners prior to the 2007-2008 market crash, are voodoo economics and misapplied statistics.  Unfortunately for many people who neared retirement in 2006, and many others who had recently retired and expected to fund their golden years with the SWR strategy, the books, advertisements and web calculators that promote the strategy were quite effective.

Don’t fall for it.

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1² There are several “Sustainable Withdrawal Rate” studies and each calculates slightly different probabilities, but all project about 4% to 4.5% safe withdrawal rates for thirty years.

[2] Generations of Struggle, D. Thorne, E. Warren and T. Sullivan, AARP, June, 2008.

It's A New World

When I decided to retire a few years ago, I read enough books and papers on retirement planning to fill a small library.  I also talked to several financial planners.  I got some good advice, a little great advice, and a lot of very bad advice.

I read about Sustainable Withdrawal Rates, for example, a body of work that suggests retirees can invest their nest egg in stocks, withdraw 4½% of their total savings the year they retire, and continue to withdraw that same dollar amount annually with a 90% - 95% probability of safely funding at least thirty years of retirement.

Not only did I read books and papers about “SWR”, I built my own Monte Carlo simulation software.  In doing so, I realized that the statistical inferences are flawed and that, even if the statistics were correct, the strategy is not “safe”.  

Retirees who employ the SWR strategy are promised a rate of bankruptcy of “just” 5% - 10%, but the bankruptcy rate for households in the United States over the age of 65 is currently less than half a percent.  If your goal is to increase your chances of going bankrupt by more than an order of magnitude, SWR may be just the ticket.

It is easy to understand why the financial services industry likes SWR, though; its premise is that retirees will buy lots of stocks and mutual funds.

Next, I began to read academic papers written by economists.  Surely, they would be objective. I found one that explained the virtues of fixed annuities, contracts sold by insurance companies that promise to provide income for life, no matter how long that life might be.  Then I discovered that the academic who wrote them moonlights as a contractor for the insurance industry.  Maybe not entirely objective after all.

I considered hiring several financial planners and even hired one for a brief period.  Again, I heard some good advice and a lot of what appeared to be just plain wrong.

A highly regarded financial planner in the Washington, DC area gave me a lot of good advice regarding stock investments, but some terrible advice on mortgages.

When I asked if I should pay off my mortgage of several hundred thousand dollars, he replied, “I don’t see any reason why you should.”

 

Over the next few years, my taxes shrank dramatically, leaving little tax advantage to holding a mortgage.  Then the stock market tanked and that several hundred thousand dollars I had invested in stocks instead of paying off my mortgage began to evaporate.  Meanwhile, I was paying a bank nearly 7% a year in mortgage interest for the privilege of losing the principal in the stock market.

There are lots of people who want to help you plan retirement, but most want to sell you something, like mutual funds, stocks, or annuities.  It’s difficult to get an objective opinion on fixed annuities from someone who makes their living selling mutual funds.  Like asking a barber if you need a haircut.

Ultimately, I took the drastic step of becoming a financial planner myself, primarily to plan my own retirement, but also to help others.  We Baby Boomers started serious planning for retirement way too late.  We failed to understand the challenge of funding perhaps three decades worth of Golden Years and, in my experience, we find it far too difficult to find competent, unbiased retirement advice.

It isn’t surprising that we missed the memo.  During our lifetime, life expectancies have risen dramatically and company pensions have been replaced by IRA’s and 401Ks that shifted all of the financial risk of retirement from our employers to us.  We are the first generation to face potentially long periods of retirement without company provided pensions.  It’s a new world.

I hope to remedy this as best I can by providing unbiased, logical financial planning advice.  My goal is to provide information that is useful, easily understood and as enjoyable to read as retirement planning advice can be.

Retirement is a Risky Business

Funding a retirement that could last for decades is a very risky undertaking, not quite like Pilgrims planning to leave England to spend the rest of their lives in the unknown America, but not totally unlike that, either. They had to plan to provide for themselves for a very long time, they were heavily dependent upon themselves and their families, the risks were substantial, and turning back was extremely difficult if not impossible.

There are risks that we can’t foresee.  We didn't know until the 1980's, for example, that we need to protect ourselves against HIV and we didn't know until recently that some of the largest financial services companies in the U.S. could fail.

There are also risks we know about, like the risk of inflation, which we can prepare for. It's difficult to plan for unforeseeable risks, but there are things we can do to protect ourselves against the risks we can envision.  

Many households who had saved enough money to retire comfortably or were on track to do so saw those dreams vaporized by the stock market crash of 2007-2008.  Many others, people who thought they were quite wealthy, learned that Bernie Madoff had absconded with their dreams. As these people can tell you, hanging onto your retirement savings by carefully planning to mitigate risk is as important as saving enough money in the first place.

Inflation Risk

Imagine you retired in 1980 with a company pension (they were more common then) that had no cost of living adjustment (also common). Those monthly checks that seemed so generous in the days of Ronald Reagan have been battered by inflation. Each dollar of those pension checks that purchased $1 worth of goods back then buys only 38 cents worth of goods in 2010.

Careful planning to mitigate inflation risk can help you avoid a similar predicament at the end of your retirement thirty years from now. Inflation-protected Treasury bonds (TIPs), stocks, Social Security benefits and some fixed annuities offer inflation protection.

Longevity Risk

Financial planners call the risk that you will live a long life and outlive your savings “longevity risk”. A 60-year old man today has a 20% probability of reaching age 95 and a 60-year old woman has a 30% chance. However, there is a 40% chance that at least one member of a married couple of the same age will live until 95. That's a lot of years to fund if you’re lucky enough to live a long life.

We can ensure against longevity risk by assuming in our retirement plan that we will live to age 95. That means spending less of our savings each year in case we do live that long. Fixed annuities are insurance policies that protect against longevity risk, since they promise to pay a certain annual income no matter how long we live. Social Security benefits are an annuity with inflation protection that helps address longevity risk.

Foreclosure Risk

Owning our home at any stage of life entails the risk that we might not be able to keep our mortgage payments current. Ultimately, the mortgagor will foreclose and take our home. Foreclosure can be both more likely and more devastating after we retire because without a job we are less capable of recovering from an economic crisis.

Buying a smaller home after we retire can reduce the size of our mortgage and make foreclosure less likely.  We can also protect ourselves from foreclosure risk by renting instead of owning and eliminating the mortgage altogether.   Paying off most or the entire mortgage before we retire reduces foreclosure risk and often increases our standard of living. 

Retiree Fraud Risk

Retirees have long been the targets of fraud.  Many have lost their entire savings to shysters and Bernie Madoff recently showed that the wealthy and "financially sophisticated" are not immune. In fact, they are more attractive targets.

The best way to protect against retirement fraud is to educate yourself.  A good way to start is by reading Ken Fisher's book, How to Smell a Rat: The Five Signs of Financial Fraud.

Accumulation Risk

There is a risk that we won't save and invest enough money while we are working to fund retirement without accepting a lower standard of living than we enjoyed during our working lives.

An economic technique called "consumption smoothing" helps calculate the amount we should save before retirement to avoid a decline in our standard of living after retirement begins.

“Countdown” Risk

As we approach retirement, the risk increases that we won’t have time to recover from a market setback.

John was 63 years old in 2005 and had accumulated $500,000 dollars in his 401K account.  His son, Jacob, was 40 and had saved $150,000 in his retirement savings accounts. Both had all of their retirement funds invested in stocks.  That was perhaps an OK strategy for Jacob; for John, not so much.

John looked forward to retiring at age 65 with $25,000 a year in social security benefits and another $25,000¹ to spend annually from his stock earnings. He and his wife figured $50,000 a year would support the retirement they wanted.

By 2008, the market crash had destroyed nearly half the value of both portfolios.  Jacob had 25 more years of earning and investment returns to rebuild his savings before he retired, but John did not.

John knew that he would still receive the same social security benefits and realized he had dodged a bullet when recent attempts to privatize social security had failed— the last thing he needed was to have his social security benefits invested in the market, too. But, his stock portfolio was now valued at only $250,000 and would only support $12,500 of annual spending. He would either have to reduce his standard of living after retiring or work several more years to replace the $250,000 he lost in the market crash.

The most effective way to reduce market risk is to own more bonds and less stock. At about age 55, we should reduce our exposure to stocks. By that age, we should have saved most of the money we will need to retire and the focus then changes from making lots of money in the stock market to keeping what we have already accumulated.  

Early Retirement Market Risk

The first decade of retirement is another time we should reduce our exposure to stocks. At that point, we may still have more than two decades of retirement to fund and we can ill afford to lose our savings. The aforementioned pre-retirees who lost half their savings in the 2007-2008 market crash had to delay retirement by several years, but retirees who had left the workplace after 2000 found themselves in even worse shape. Having left their jobs already, they faced an even more difficult task of recovering financially.

Health Care Cost Risk

Perhaps the biggest risk we face in retirement is the cost of health care.  Health care costs are growing at a rate much higher than the general rate of inflation.

According to a recent study by Anthony Webb and Natalia Zhivan at the Center for Retirement Research at Boston College, long term care is by far the greatest portion of health care cost risk that we face.

According to the study, at age 65, a typical married couple free of chronic disease can expect to spend nearly $200,000 on remaining lifetime health care costs excluding nursing home care. There is a 5% probability that these costs will exceed $300,000.

The prospect of needing nursing home care worsens an already bad situation dramatically. Including nursing home care, the average cost of remaining lifetime health care costs at age 65 increases from $200,000 to $260,000, with a 5% probability of costs exceeding $570,000.

According to Webb and Zhivan, less than 15 percent of households approaching retirement have accumulated that much in total financial assets.  In other words, health care costs after age 65 could conceivably consume more than most households have saved to pay for their entire retirement.

Clearly, the greatest risk to retirement security regarding health care costs is nursing home care. Medicare benefits do not pay for most nursing home care costs. Long Term Care insurance is available but it is expensive and its cost-effectiveness for many families is debatable.  

Social Security Risk

Social Security has been under attack by fiscal conservatives since its inception in the 1940’s. Though they constantly argue it is about to "go broke", moderate changes like a two-year increase in the retirement age would leave these entitlements solvent for 75 more years.  So far, these attacks have been successfully repelled. Nonetheless, it would be unwise to overlook the risk that benefits might be reduced or delayed in the future.

These are some of the major foreseeable risks to successfully funding a retirement that could last three decades or more.  After retiring, we no longer have work income to help recover from financial setbacks and the longer we are retired, the more difficult it becomes to reenter the workforce.

You might not save enough for retirement, then again you might save more than you should.  If the stock market turns against you in the last decade of employment or the first decade of retirement, your plans for the Golden Years could be toast.  Social security benefits could be reduced, you'll be a fraud target, inflation will eat away at your purchasing power.  You or your spouse might need long term care that could cost more than you saved for all of retirement in the first place. If the risks don't scare the hell out of you, then you don’t properly understand the situation. 

On the other hand, nearly all of these risks can be mitigated or even eliminated if we plan retirement properly.  Avoiding these financial setbacks is as important as saving enough money for retirement in the first place.

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¹ About 5% of $500,000 savings.

The Biggest Retirement Planning Mistakes

Talk to retirees about their financial situation and some of the worst retirement planning mistakes tend to pop up over and over again.  Here is my list of the big ones to avoid, but the biggest mistake is not to plan at all.

1. Not Planning

Retirement planning may not be fun and the initial results may be discouraging, but without a plan your odds of optimally or even adequately funding retirement are greatly reduced.  With a plan, you can make the most of your economic resources, whatever they may be, avoid pitfalls and perhaps fix some of the problems you uncover in the planning process.

Find a fee-only planner who will work with you to develop a retirement plan but won’t try to sell you financial products he or she will profit from.  If you can’t convince yourself that a planner is worth the cost, use my website to develop your own plan.  As a friend of mine likes to say, “Bad breath is better than no breath at all.”  That’s true of retirement plans, too.

2. Using Life Expectancy for Planning

Composer-pianist Eubie Blake famously said, “If I'd known I was going to live this long, I would have taken better care of myself.”  Blake was born in 1887, when life expectancy for males was about 59 years.  He lived to age 96.  If Eubie had planned to fund his retirement only until his life expectancy, he would have been broke for the last 37 years of his life.

According to the Social Security Administration’s website, the life expectancy for a room full of 100 randomly selected men born in 1940 is now about 83 years.  About 50 of them will live longer than age 83 years. Around 25 will live past age 90, and 10 or so will live past the age of 95.  

Don’t ignore longevity risk. Plan on living a long time, just in case you do.

3. Believing in Sustainable Withdrawal Rates

A widely-touted retirement funding strategy says that you can invest your retirement savings in stocks,withdraw 4.5% of your nest egg on the day you retire and withdraw that same amount every year thereafter, adjusted for inflation, and safely fund at least 30 years of retirement.  This is voodoo finance.

If you don’t want to take my word for it, ask anyone who retired using this strategy and had their standard of living cut in half by the 2007-2008 stock market crash.  Or, ask Nobel Laureate, William F. Sharpe, who debunked the strategy in his paper, “The 4% Rule—At What Price?”  

Or, you can ask retired Dallas News finance columnist, Scott Burns.  Burns, who was an avid supporter of the "SWR" strategy for years as a columnist, recently co-authored a book with Laurence J. Kotlikoff entitled Spend ‘til the End in which he now refers to the 4% Rule of Thumb as a “Rule of Dumb”.

If this is the best your financial planner can come up with, find a new planner.

4. Ignoring Inflation

Even mild inflation averaging 3% a year will more than halve your income over thirty years.  If you have a pension or annuity that has no cost of living adjustment, you need to plan for its inevitable and constant decrease in purchasing power throughout your retirement.

5. Drawing Social Security Benefits Before You Need Them

The longer you wait until age 70, the greater your social security retirement benefits will be.  If you can’t retire without them, then by all means take them when you need them.

But if you can delay your benefits by working a little longer or by paying for the early years of retirement from your savings, you may be able to improve your standard of living significantly.

6. Not Planning for Long Term Care

Medical expenses can destroy retirement savings, but the cost of long-term care, should you or your spouse need it, can be devastating.  Medical costs could easily total more than $250,000, but long-term care could cost more than half a million dollars.  Medicare helps with health care costs, but it doesn’t cover long term care.

7. Carrying Too Much Debt

Debt is a huge burden once the paychecks stop.  Try to pay off all consumer debt before you retire and consider paying down or paying off your mortgage.

8. Trusting Your Retirement Planning to a Salesman

Did you ever buy a car and drive off the lot thinking, “That nice salesman only cares about me driving away with a great car at the best possible price”?

Me, neither.

If your financial planner makes money by selling financial products, how can he or she have your best interests at heart?  If he sells stocks, for example, you can bet stocks will be a big part of the “right plan” for you – maybe even too big a part. 

As the saying goes, when you have a hammer everything looks like a nail.  Find a fee-only planner with an entire box full of tools and no incentive to pick the wrong one.

9. Saving Too Little (Or Too Much) for Retirement

Ideally, we would like to maintain about the same standard of living after retiring that we enjoyed before. We don’t want to scrimp through our careers in order to live a lavish retirement, or live beyond our means and then retire as paupers.

Consumption-smoothing software like ESPlanner.com can help determine the amount of pre-retirement saving that is required to achieve a similar standard of living after we retire.

10. Establishing the Wrong Priorities

Saving for retirement is important, but it isn’t always the top priority.  People with a lot of expensive consumer debt would be better off retiring that debt before retiring themselves.

Retirement savings may well be more important, however, than paying for your kid’s college.  Your children have a lot more time to repay college loans than you have to save for retirement.  Besides, what kid wants you to pay for their college tuition if it means having to move in with them when you’re 80?

Young people right out of college would be better off maintaining a decent standard of living, avoiding consumer debt and building an emergency fund than saving for retirement.

Not everyone has the same priorities, but understanding yours and putting them in perspective is critical to a successful financial plan.

This is by no means an exhaustive list of mistakes people – even professional financial planners – make when planning retirement.  Use it as a checklist when reviewing your retirement plan to make sure you have covered the obvious. 

How Long Will Retirement Last?

Perhaps the biggest challenge in planning retirement is dealing with the uncertainty of how long we will live.  Economists and financial planners refer to this as longevity and the possibility that we will outlive our savings as longevity risk.

We could spend more every year of retirement if we knew we would only live to age 75 than we could spend if we knew we would live to age 95.  Of course, we don't know.  In fact, most of us literally have no earthly idea when we will die, so we need to choose a way to plan for that uncertainty.

It's a very important decision.  No one wants to find themselves bankrupt in old age after it's too late to reenter the workforce.
 
There are two basic ways to fund retirement: with annuities or with rationing.

Annuities are contracts an insurance company will sell you that promise to pay you a certain amount monthly or annually for the rest of your life, no matter how long you live.  Social Security benefits are an annuity, too, except they are "sold" by the U.S. government instead of an insurance company.

Here is an example from immediateannuities.com. A 65-year old man living in North Carolina with his 65-year old wife could pay $100,000 today to an insurance company for a fixed annuity that would pay them in return about $538 a month for the rest of their lives, no matter how long that might be.

Annuities insure against longevity risk. They eliminate the risk of outliving your wealth. If all your retirement income came from annuities, your annual income would be the same no matter how long you lived. Of course, the people who buy these annuities and live to 95 will get much more for their $100,000 than people who buy the same annuity and only live to 70.  Those who live to 95 will get 360 monthly payments of $538 instead of just 60 payments.

A lot of people can't seem to get past that. They think, ". . . but what if I die before I get really old and the insurance company doesn't have to pay back that entire $100,000?" On the other hand, people who buy these annuities don't have to worry about outliving their savings.

The alternative to annuities is rationing. We can save money and instead of paying it to an insurance company for an annuity, we can invest it and ration it to ourselves.

Rationing, unlike annuitizing, is totally dependent on how long we believe we will live.  Imagine you were stuck on a desert island waiting for rescue and only had the food you brought with you. You would eat less each day if you expected to be marooned for a week than you would eat if you knew you might be stranded for a month.

Here's a point, though, that many of us miss when we think about retirement.  We have to ration for the longest time we believe we might be marooned on that island, not the average.

Suppose we knew that people marooned on islands are rescued  in one week on average, but some people have been stranded as long as a month.  We would want to ration our food to last 30 days, not 7.  If people rationed for the average duration, half of them would run out of food before being rescued.

Similarly, planning for retirement based on life expectancy— the average age people like us will attain— is too risky.  It leaves a 50% chance that we will outlive our savings.

Which leads us to the crux of the matter. We need to plan to live to a ripe old age, say 90 or 95, just like we would need to ration food on that island for the worst case, 30 days, because running out of money in old age and running out of food are both intolerable outcomes.

The Key Points

• If we buy fixed annuities, we are guaranteed a paycheck for life.  The risk is that we might die not long after purchasing the annuity and not receive many payments from the insurance company.

• If we don't purchase fixed annuities, we can invest our savings and ration them.  The problem with this approach is that we don't know how long we will live.  

• To avoid the possibility of outliving our savings with the rationing approach, we have to plan on a very long life, 95 years for example, and that means spending a lot less each year than we could spend if we assumed we would only reach our life expectancy.

• Annuities generally provide more annual income than the rationing approach, but the rationing approach improves the odds that we will leave an inheritance.

• And most important of all, a retirement plan has to assume that we will live much longer than our actual life expectancy, because we just might.

An Easier Way to Budget

This sample from Mint.com shows the level of detail needed for a retirement budget.

A good starting point for predicting how much money you will spend in retirement is an accurate understanding of how much you spend today. There are several methods to analyze your current spending, ranging from using a pad of paper and a calculator to logging on to a free website to purchasing computer software and any method will work.

The hard way to analyze your spending  is to gather your bank statements and your credit card statements, look at each individual transaction and classify it as "Gas", "Restaurants", "Electricity", etc., and then add up all the "Gas" transactions with a calculator and pad of paper.  Then you move on to "Restaurants".  If you're lucky, you'll have everything totaled before the next month's statements arrive.

The method I prefer, however, is free on the Web.  Intuit, the company that provides Quicken software, has a free version of Quicken on the Web at Mint.com.  Mint.com will perform the equivalent of gathering all your statements, classifying the types of expenses, and totaling the expenses by category.  Once it's set up, it's easy to do every month.

Mint.com will collect and analyze all your credit card, debit card and bank transactions, including checks. Mint.com is not the only site that does this. Kiplinger reviewed its favorite alternatives, including Geezeo, Buxfer and Wesabe.  You can see a video explaining how Mint.com works at https://www.mint.com/how-it-works/.

You may be aware that most banks and credit card companies have websites that provide access to your financial information for that particular institution.  You can access your Visa card's website, for example, register a username and password, and then you can access your transactions for that card from computers, smart phones and other devices any time.  I have an account online at my bank and one for each of my credit cards.  I even have one for my mortgage.

Accessing your accounts online may make gathering the statements easier, but you still have to categorize the transactions and consolidate the category totals for all of your accounts.  Some credit card websites attempt to classify your transactions, but most do not.

To consolidate all of your bank account and credit card transactions in one place, you first have to register at the different websites for your bank and credit card companies. Then you input these username/password combinations into Mint.com.

I bank at Wachovia and use an American Express card, so I had to create an online account at Wachocia.com and another at AmericanExpress.com.

Mint.com asks you for the username and passwords for these individual websites and logs into every website for you, consolidating the information from all of them.  Mint.com even makes an attempt to categorize each transaction by the expense type (restaurant, grocery, gas station) based on the type of store where the purchase was made and, in my experience, it does a pretty fair job.  When it's wrong, you can easily fix it and it will be correct for all future transactions.

If you're not asking yourself right now how secure these websites are, you should be.  You will be storing your login credentials for all of your financial institutions at the Mint.com website.  My answer is that I don't think we know.  The website owners go to great lengths to keep our data secure, but then we read about major security lapses.  I've been using sites like these for over ten years with no problems, but whether you believe the convenience is worth the security concerns is a personal decision.

You can also buy money management software like Quicken that runs on your computer or a free alternative, GnuCash.  It will download transactions from your various account websites just like Mint.com does, but the username/passwords will be stored on your personal computer instead of a website.

Once you have set up an account at Mint.com and entered all of your financial accounts, you can click on the "Transactions" tab, select any or all of the accounts at the left, and get a listing of all of your credit card transactions and check transactions.  You can use Mint.com reports to see your spending by category, or you can download them into an Excel spreadsheet.

I do the latter because there always seems to be one or two things I can't get from the Mint.com reports.  I know my way around a spreadsheet pretty well, so I scroll down the the bottom of the Mint.com Transactions page and click the "Export transactions" link on the right. 

In fact, you can manually consolidate all of your online accounts, if you prefer.  Got to each bank account or credit card website and export your transactions in spreadsheet format, then import them into a spreadsheet.  Mint.com is a simpler process, but you will have more control over your own spreadsheets.  I find the consolidation of accounts and the classifying of transactions ("Groceries," or "Restaurants", for example) provided by Mint.com saves a good deal of time.

Cash transactions, of course, show up only as withdrawals or ATM transactions, so you'll have to itemize cash expenses some other way, perhaps with that pad of paper and calculator.  When you're finished, though, you will have a pretty good accounting of your current spending.

The next step is to modify that spending to account for changes you anticipate in retirement.

The Key Points

• Predicting retirement spending by adjusting how much we spend before retiring requires a detailed list of current expenses by category (utilities, mortgage payments, groceries, etc.).

• You can track and budget your spending with a pad and pencil, but if you trust the security of websites, there are much faster ways to accomplish this.

• You can automate budgeting and avoid the security risk of storing all your financial websites' usernames and passwords by purchasing a computer application like Quicken or by using freeware like GnuCash.

If You're Playing Along at Home

If you are developing a retirement plan as you read these, find a recent copy of your detailed budget of current spending by category.  If you don't have one, follow the steps above to begin developing one.

The Quick and Dirty Way to Estimate Overall Spending

Your final pay stub and your tax returns from last year can provide insight into your current spending, but only at the highest level.  For retirement planning, you will eventually need to break down your spending by category (utilities, mortgage, groceries, etc.), but overall spending is a good thing to know.

A quick estimate of overall spending can be compared to the ballpark estimate of expected retirement income we just calculated, letting us know if we have a retirement funding problem and how big it might be without having to generate a detailed budget first.
 
Second, after you create that detailed budget, the mortgage, utilities, groceries and other categories should add up to a number pretty close to the overall spending estimate.  If it doesn't, you're double-counting or omitting some of the categorized expenses.  It's a good way to cross check our figures.

The pay stub will quickly show your gross income, how much you paid in FICA taxes, and how much you withheld for taxes.  Your withholding was probably more or less than your actual taxes, though, resulting in your having written a check to the IRS or having gotten a refund, so your tax return is a better place to find your actual taxes paid.  Don't confuse the amount you had withheld from your paycheck with the amount of taxes you actually owed.  Only the latter is relevant.

Your pay stub will also show how much you saved in 401K, Flexible Spending Accounts and similar savings accounts. 

Lastly, identify any additional savings for that year.  Did your checking account balance grow substantially by the end of the year?  Add that to savings.  Find the January 1^st checking account balance on your January bank statement for that year and subtract the December 31^st balance reported on the December statement. The same goes for any savings accumulated outside your company retirement savings plan that wouldn't show up on the pay stub.

The amount you spent for that year equals your gross income less any amount you saved.  Let's say your gross income from your end-of-year pay stub (or W-2) was $60,000 and you paid $4,300 in FICA taxes.  Your Form 1040 tax return shows you paid $9,000 in federal taxes and your state return shows you paid $3,000.  Your pay stub shows your  401K contributions totaled $4,000.

Your spending for that year was $60,000 income - $4,000 savings = $56,000.  Your checking account balance, however, increased $2,000 between January 1^st and December 31^st.  That's a form of saving, so you can subtract $2,000 from the total above, leaving your total spending at $54,000.

Of course, a decrease in your checking account balance means the opposite. You borrowed from your checking account to spend more.  If your balance decreased over the year, you must add the amount of the decrease to total spending.

You can also see from these figures that you paid $16,300 in Federal, state and FICA taxes, so your spending on everything except taxes was $37,700.  You won't pay payroll taxes after you retire, assuming you stop working altogether, and your Federal and State taxes might be lower.  In planning a budget for retirement, it's important to separate out expenses like this that may vary significantly after you retire.

Pay careful attention to "gross income" on your pay stub and make sure that your 401K contribution hasn't already been deducted from that amount.  If it has been you are looking at taxable income, not gross income.

Also, the principal paid toward loans, including your mortgage, is technically a repayment of principal and not an expense.  You're saving the money as equity in your home instead of cash in a savings account, but it's savings, nonetheless.  The interest portion of the mortgage payments, the property taxes and insurance, on the other hand, are all expenses.  You can subtract your total mortgage principal payments for the year from the $37,700 to get your true total expenses.

In our example, let's assume you check your end-of-year mortgage statement and determine that you paid $7,700 toward your mortgage principal during the year.  Your actual non-tax spending was then only $30,000.

You may have had some extraordinary expenses (a kid in college, a new car) that will skew your annual spending estimate.  Ultimately, these "non-recurring" expenses will need to be accounted for.  You have to decide whether you will need to spend these amounts after you retire (you will probably buy a few cars over the years) or they are one-time expenses (like college tuition).

Second, knowing your total expenses is interesting, but it doesn't help identify how your expenses will change in retirement.  To predict retirement cost this way, you need to know that you spent $2,500 on travel this year and plan to double that in retirement, and that you spent $5,000 on commuting expenses and will spend significantly less after we retire.  You will no longer pay payroll taxes and you won't need to save for retirement. That requires a more detailed accounting of spending by category and I'll cover that in the next chapter.


The Key Points

• You can determine how much you spent in a given year by finding your gross income and subtracting how much you saved. Gross income can be found on your W-2, your year-end pay stub, or your tax return for that year. Taxes can also be found on your tax returns.  Don't confuse the amount of taxes you paid with the amount of tax withholding shown on your pay stub.

• After subtracting what you saved and taxes you paid from your gross income, what's left is the amount you spent for the year.

• This high-level analysis of spending needs to be further refined before we can provide effective retirement planning.

If You're Playing Along at Home
 
If you are developing a retirement plan as you read these, find a recent copy of your detailed budget of current spending by category. If you don't have one, follow the steps above to begin developing one.

Here are the steps again:

1. Determine your gross income for the year by checking your W-2, Tax return (1040), or your final pay stub for the year. (GROSS INCOME)

2. Determine your retirement account contributions (401k, IRA, 403b, etc.) from your W-2 or other records. (SAVINGS)

3. Check your account statements for any additional savings you deposited in non-retirement savings accounts, CDs, investment accounts, etc. (add to SAVINGS).

4. Determine the change in your checking account balance by comparing your January and December bank statement. (If balance increased, add the amount of the increase to SAVINGS.)

5. Determine the amount of principal you paid by checking your mortgage and other loan statements.  (add to SAVINGS).

6. Add the amount of Federal and state taxes you paid by checking the TAXES OWED lines of those returns. (TAXES)

7. Determine the amount of FICA taxes you paid by checking your W-2 or final pay stub for the year. (add to TAXES).

8. Subtract total SAVINGS and total TAXES from GROSS INCOME to calculate your SPENDING for that year.

9. If the balance of your checking account decreased through the course of the year, add the amount of the decrease to SPENDING.

10. Consider any large expenses like a new car purchase or college tuition.  Once your children leave college, tuition won't show up in your future budgets.  You will buy more cars, though, so you will need to convert that one-time cost to an annual amount.

How Much Will Retirement Cost?

The last few blogs laid out a strategy for estimating how much money we will have available to spend in retirement. The next big question is "how much will retirement cost?"  If we know how much money we'll have to spend and what our expenses will be, we can develop a budget.

There are a number of ways to approach a cost estimate and I will tell you up front that none of them will be particularly accurate.  Retirement planning is about predicting the future and humans are demonstrably poor at doing that even for a few years, let alone for thirty.

Retirement costs depend on many factors, including how you plan to spend your time (fly fishing is cheaper than traveling the world), how healthy you and your spouse will be, how long the two of you will live, how much financial help your children or grandchildren may need and a host of other possible expenses both within and beyond your control.


Income Should be the Upper Limit on Spending


We can place an upper bound on our retirement spending by looking at the income we estimated in previous blogs, because our spending shouldn't be more than that.  If we overspend, our savings will eventually be depleted and our standard of living will almost certainly decline if we are fortunate enough to live for a long time. To state the obvious, whatever our retirement will cost, it can't be greater than our income, at least not for long.


Back in Where Will Your Retirement Income Come From? Part 2,  we estimated that the combined personal savings and Social Security benefits at full retirement age for our fictitious retiring couple, John and Sara, would total $47,950 per year.  Their expenses, therefore, shouldn't exceed that amount for any prolonged period.  If they do, our retired couple will need to reduce their standard of living and tighten the budget.


You might be thinking, "I'm not an idiot, I know my income needs to exceed my expenses", but bear with me.  It's a starting point. If John and Sara's expenses are currently $90,000 a year and they know they'll have only half that much income in retirement, then basing an estimate of retirement expenses on how much they spend now is somewhat irrelevant.  They will have to spend less in retirement.


The Percentage Estimation Method is Flawed


One way we could anticipate retirement expenses is to look at how we spend before retirement and try to adjust for some of the changes that our new lives will bring.  Many financial service companies suggest that we estimate future expenses as a percentage of pre-retirement expenses.  For example, they suggest that we will spend 80% of our pre-retirement expenses after we retire.  These recommendations are flawed for a number of reasons.


First, these financial experts sometimes recommend 70%, sometimes 80% and a few even recommend 100% or more.  A range that large is useless.


Second, annual spending isn't a single amount.  It varies throughout retirement.  We may spend 100% of pre-retirement levels for a few years, then drop down to 80% as our desire to travel the world wanes, and increase to 120% when a child needs help with medical expenses.  Our spending needs may decline again, only to increase with our own medical expenses late in life. Those unknowns make costs really difficult to predict, especially thirty years into the future.


Lastly, and perhaps most importantly, basing our retirement budget on pre-retirement spending levels assumes that we were spending the "right" amount before we retired.  In reality, we may have been spending an unsustainable amount and saving too little, or saving too little and limiting our standard of living. 80% of the wrong number is just another wrong number. 

The "percent of pre-retirement spending" estimate, though simple and attractive, doesn't provide a good estimate of future spending.  It vastly oversimplifies the problem.


How Will Our Spending Change after We Retire?


Another method for predicting how much we will need to spend in retirement is to evaluate pre-retirement expenses and modify them to account for spending changes we can anticipate.  In other words, look closely at what we're spending before retirement and think about how spending will change after we retire.


This approach suffers one of the same problems as the percentage method described above. It assumes that we are spending "the right amount" before retirement.  This is a major flaw, but we'll look at fixing that in a future session.  (I will show you how to determine a sustainable spending level in a later installment.)


In other ways, this approach is better.  As we consider how our spending might change in retirement, we can take into account how spending levels may vary in late retirement due to increased health care costs, or decline in mid-retirement as we become less active.  Instead of assuming that we will spend 20% less after we retire, we can identify precisely what those cost reductions might be.  And this approach provides a useful bonus for many of us— it forces us to create a detailed analysis of how we are actually spending money today.


We need to start the estimate with a detailed accounting of current spending. If you have an accurate budget already, that's great.  If not, I'll discuss ways to create one in my next blog.


The difficulty in using this approach is the dramatic differences of spending requirements among retirees.  Some will retire and spend their days fishing or visiting the grandkids.  Others will take long-awaited trips around the world. And others, myself included, still have kids in college.


Some general trends have been noted.  Retirees tend to be more active, travel more and spend more on recreation in the first decade of retirement.  You might plan on spending a little more during that time.  In fact, some retirees spend more during this first ten years than they spent before they retired.


Between the ages of about 75 and 85, though, many retirees become less active because they're less capable of handling the physical demands of an active life.  Some costs may drop during those years.


Lastly, between ages of 85 and 95, or thereabouts, retirees are less active but may experience a dramatic increase in medical costs.  Studies have shown that many people spend the majority of their lifetime medical expenses near the end of their lives.


These are generalizations, but they do point out that retirement expenses not only vary dramatically among retirees, but also can vary significantly at different points during retirement for the same retiree.  When we modify pre-retirement spending to estimate expected spending after retirement, the result is actually a list of expected expenses by year for thirty or so years of retirement.  That's thirty answers, not one, and that's one of the reasons the percentage rule of thumb method many financial planners want to use doesn't work.


To recap, one way we might estimate retirement expenses is to first calculate expected income in retirement.  Our expenses can't exceed that income for a prolonged period, no matter how much we spent before retiring.


A second way to estimate how much we will need to spend in retirement is to determine how much we are spending before retirement and modify that amount to account for changes we expect to make to our spending patterns after we retire.


There is yet another way to consider retirement spending forecasts that is based on the assumption that most people will want to have a standard of living after retiring that is similar to their standard of living before.  This approach uses an economics technique known as consumption smoothing, which we will consider in the next blog.


The Key Points

• Predicting expenses thirty years into the future is a formidable undertaking.  It is impossible to do with any accuracy.

• There is a "right amount" to spend in retirement.  It is the amount of spending that we are capable of sustaining throughout retirement.  Basing retirement budgets on our pre-retirement budget assumes we were spending the "right amount" before we retired, which may not be true at all.

• One thing is certain, we won't be able to spend more than the expected retirement income we calculated previously. Not for a prolonged period, anyway.  That income is an upper bound on spending estimates.

• The financial services industry's "rule of thumb" that you will spend 80% of pre-retirement income after retirement is deeply flawed and should be ignored.

If You're Playing Along at Home


If you are developing a retirement plan as you read these, find a recent copy of your detailed budget of current spending.  If you don't have one, follow the steps in the next blog to develop one.

A Quick Recap of Retirement Income

The intent of the three recent columns, Where Will Your Retirement Income Come From? Parts 1 through 3, was simply to identify where we can expect retirement income to come from once we leave the happy world of biweekly paychecks, and to estimate how much that income might be.


While several topics were covered and a lot of information was provided, the highlights are these.


The most common sources of retirement income are going to be personal savings and Social Security retirement benefits.  Relatively few fortunate families will also be vested in a corporate pension plan, technically known as a defined benefit plan.  Retirement benefits for these plans are defined in advance by the plan and are usually determined by how much salary you earned while you were employed, not by how well your investments performed after you contributed them.


Most company retirement plans since the 80's have been defined contribution plans.  That means that you made contributions to IRAs, 401Ks and similar retirement plans and and how much you can spend in retirement depends on how well your investments have performed.  These are tax-advantaged personal savings accounts.  You may have saved money in regular savings and investment accounts, as well.  Combined, these tax-advantaged and taxable accounts make up your personal savings for retirement.


You can determine how much Social Security benefits will be for you and your spouse using various calculators at the SSA website.  Your benefits will vary significantly depending on the age you decide to start receiving them.  This was covered in Part 1.


If you invest your personal savings conservatively in U.S. Treasury TIPs bonds or mutual funds when you retire, you will be able to spend about 4.46% of the amount of those savings on the day you retire every year with a high probability that those savings will last for 30 years.


If you retire with $75,000 in your 401K and $25,000 in a bank account, for example, your personal savings would total $100,000 and you could expect to spend $4,460 annually for thirty years.  This was covered in Part 2.


You can calculate a pretty good estimate of your expected annual income in retirement by adding your expected annual Social Security benefits to 4.46% of you total expected personal savings on the day you retire:

Annual Retirement Income =  Annual Social Security Benefits + (.0446 x Personal Savings)

Many public employees (teachers, municipal workers and railroad workers, for example) have their own retirement plan in lieu of Social Security.  They need to substitute expected annual benefits from those plans for Social Security in the retirement income equation above.  This was covered in Part 3.


Public employees covered by a public pension plan may have their Social Security benefits reduced.  Retirees who keep working and have income from a job or self-employment will also have their Social Security benefits reduced until they reach full retirement age.


That covers the basics on expected income retirement.  Next, we'll look at expected retirement costs.

Part 3: The Two-Legged Stool: Where Will Your Retirement Income Come From?

Part 3: Tying Up a Few Loose Ends

In Parts 1 and 2, I discussed Social Security and personal savings, because they will be the two most common sources of income for most retirees.  They are not the only two sources, though, so let’s discuss some other possibilities.

Public Employee Retirement Plans

Most of us spend our entire career seeing “FICA” deductions on our pay stubs. Those are tax payments that qualify us for Social Security and Medicare benefits.  Many public employees, however, see deductions for  “Railroad Retirement”, “Teacher’s Retirement Plan”, or something similar on their pay stubs, instead.  They’re covered by a public employees retirement plan and not by Social Security. 

(If neither you nor your spouse were ever public employees, you may wish to skip this section.)

Back in the 1930’s when was Social Security was conceived, the federal government wasn’t sure it would be constitutional to tax municipalities and similar public entities, so they excluded them from Social Security and help set up separate retirement plans.  As a result, some teachers, railroad workers and other public employees are not covered by Social Security.  As I mentioned in Part 1, teachers in fourteen states currently do not participate in Social Security.  These are Alaska, California, Colorado, Connecticut, Illinois, Kentucky, Louisiana, Maine, Massachusetts, Minnesota, Missouri, Nevada, Ohio and Texas.

Of course, people can work as public employees for some of their career and in jobs that contribute to Social Security at other times, paying into more than one retirement plan over the years. Employees who are covered by a public retirement plan but have also paid into Social Security for at least 40 quarters may be eligible for benefits from both. 

Social Security benefits may, however, be reduced for those workers who held both types of employment by the Windfall Elimination Provision.  Likewise, people covered by a public pension and eligible for spousal or widow’s benefits under Social Security will have their benefits reduced by Government Pension Offset.  Both laws were intended to prevent “double-dipping” from both Social Security and a public pension.

Workers covered by a public pension plan should contact their plan provider to determine their expected benefits.  If they also paid FICA for 40 quarters for some part of their career they may be eligible for Social Security benefits, but they will also need to contact SSA or review the WEP on the Web to determine if Social Security benefits will be reduced.  Those who have a public pension and might also be entitled to spousal benefits under Social Security will need to check the Government Pension Offset to determine how much their Social Security benefits will be reduced.

Your Home

Many families have most of their wealth tied up in home equity.  Home equity is the amount of money you would have left over if you sold your house and paid off your mortgage.

Not surprisingly, homeowners planning retirement often ask if they can include their home equity as personal savings when they determine how much they can spend after retiring.  As you will recall from Part 2, a good estimate of annual spending available from personal savings is 4.46% of total savings on our retirement date.  But, does total savings include home equity?

The answer depends on what you plan to do with your home.  Retirees who plan to live in their home until they pass it on to their heirs cannot include that home equity amount in the personal savings total for purposes of estimating how much they can spend.  You can’t spend home equity until you convert it to cash and these retirees don’t plan to do that in their lifetime.

Those who plan to downsize their home in a few years and buy something less expensive or even rent a home can include some or all of home equity in the spending calculation because they will be converting that illiquid home equity into cash that they can spend in retirement.  They need only ensure that they have adequate liquid¹ funding to cover their spending until they plan to sell the home. 

There are ways to turn home equity into cash without selling the home, like taking out a home equity loan or a reverse mortgage, but both methods have drawbacks. It’s harder to qualify for home equity loans after you retire and have limited income to qualify for them, they have relatively high interest rates, and they have to be paid back beginning immediately.  Your home is used as collateral and that increases the risk of losing it to foreclosure.

Reverse mortgages, or Home Equity Conversion Mortgages (HECMs) as HUD refers to them, work differently². These are a special type of home loan that lets you convert a portion of the equity in your home into cash. Unlike traditional home equity loans or second mortgages, no repayment is required until the borrower and spouse no longer uses the home as their principal residence.

HECM’s are often criticized because they are difficult to understand and upfront fees can be expensive.

I am not recommending home equity loans or reverse mortgages, though they may be appropriate depending upon the retiree’s specific financial situation.  I am merely identifying them as potential sources of funding for retirement.

For planning purposes, it’s better to begin a retirement plan foregoing these alternatives and to simply decide if you want to spend the rest of your life in your home, as about 80% of elderly Americans say they do, or if you might prefer to sell it at some point and buy something less expensive, thereby freeing up some cash to spend.

Simply stated,

o      If you plan to live in your home for the rest of your life, you can’t count on your home equity to increase your retirement spending.  Don’t include home equity in personal savings.

o      If you plan to sell your home at some point and buy a less expensive one, you can count the cash that will be left over as personal savings and increase your annual spending by about 4.46% of that amount.

o      A reverse mortgage might allow you to spend some of the equity in your home and still live in it for the rest of your life.

Inheritance

I sometimes speak with clients about their retirement plans and they mention to me that they expect to inherit some money from their parents.  I recommend they be very cautious about including a presumed inheritance in their retirement plans.

There is, of course, no predicting when those inheritances might materialize. Some people live far longer than the average life expectancy for their age group and an inheritance delayed 15 or 20 years could devastate a retirement plan depending on it.

Most of us aren’t completely familiar with our parents’ financial situation.  We can’t know for sure how much wealth they might have to leave their heirs.  For many Americans, a large portion of their lifetime medical expenses will accumulate in their last year of life.  It is entirely possible that much of the wealth our parents intend to leave their heirs will be spent on health care in their final year or on long term care in their last several years.

I know a family that met with their matriarch’s executor only to learn that there simply wasn’t much left to inherit.  Unknown to most of the family, granny had co-signed a loan for one of the grandchildren a few years before her death.  The grandchild was unable to repay the loan and when she passed away, the executor was required to pay off that loan before any monies could be inherited by the family.  The payoff amount consumed most of her wealth. 

Despite the grandmother’s obvious wishes that her wealth be divided among her children and grandchildren upon her death, nearly all of her money went to the benefit of one grandchild and the other family members were left to divide up the paltry remains.  I assume grandma just didn’t understand that co-signing a loan could destroy her estate plans.

The point is that inheritances are at best unpredictable and shouldn’t be given a major role in retirement planning.  They are best considered a pleasant surprise and I wouldn’t count on them until the check is actually cashed.

A Second Career

The financial press is fond of recommending continued employment, either part or full time, as a means to address a shortfall of retirement savings or, more recently, to make up for stock market losses in the 2007 crash. 

They told you for years to invest your retirement savings in the stock market. After you did— and lost half of it— they now suggest you simply redefine retirement as a time to get another job.  It’s much more fulfilling than wasting your time on a trout stream somewhere. Besides, if you work longer, you’ll have more money to buy more stocks!

I have nothing against working for as long as you want, but I find the advice a bit disingenuous. How do you fund retirement?  Don’t stop working!

You also need to be aware that the SSA will reduce your Social Security benefits significantly if you are under full retirement age and keep working.

If you begin to receive Social Security benefits before full retirement age (66 if you were born between 1943 and 1954), continuing to work will reduce your Social Security benefits. If you were younger than full retirement age during all of 2011 and held a job or were self-employed, the SSA deducted $1 from your benefits for each $2 you earned above $14,160. If you worked and were full retirement age or older, you could keep all of your benefits, no matter how much you earned.

Continued employment at some level is a legitimate alternative to be considered, especially if you just enjoy your work or want to delay Social Security benefits to get a bigger check. 

Financing retirement by continuing to work, though, sounds a lot like not retiring to me.

The Key Points

Here are the key points to remember from Part 3:

• Social Security and personal savings are not the only sources of retirement funding; they’re just the most common.
• Some public employees (e.g., teachers, railroad workers, municipal employees) have separate retirement plans, don’t pay FICA, and aren’t eligible for Social Security benefits.  They need to determine expected benefits from those pensions by contacting the plan administrator.
• Some public employees covered by a public retirement plan may also have paid FICA from other employment.  They may be eligible for both their own retirement plan benefits and Social Security benefits, but the latter may be reduced by the Windfall Elimination Provision federal law.
• You can include home equity in your personal savings for purposes of estimating how much you can spend in retirement if you plan to sell your home and buy a less expensive one, or to rent a home.  If you plan to live in your home until you pass it on to your heirs, you cannot include it.
• Don’t count on an inheritance until the check cashes. An inheritance can take many wrong turns between the best estate plan and the executor. 
• Yes, you can fund retirement by working longer or taking a part-time job, but is that really retiring?

If You’re Playing Along at Home

If you are calculating retirement income for your own plan as we go along, you should review your calculations thus far. Data for the light blue rows can be copied from the table at the end of Part 2.

You can download a copy of this spreadsheet here.  Click File | Download As | Excel.

If you are eligible for both a public employee pension and Social Security, go to the Windfall Elimination Provision website and determine how much your Social Security benefits may be reduced.  Enter this reduction amount in row (f).

If you are pretty sure you will sell your home and buy a less expensive one after retiring, enter the surplus cash you expect in row (i).  Otherwise, enter zero in row (i).

If you included an expected inheritance in your personal savings (row h), I recommend you remove it from the total for now.

Copy entries for rows (a), (b), (c), (d) and (h) from the table in Part 2.

	You	Spouse	Combined
SOCIAL SECURITY BENEFITS
(a) Monthly benefits at earliest retirement age ____
(b) Monthly benefits at full retirement age ____
(c) Monthly benefits at age 70
COMPANY PENSIONS
(d) Company pension benefits
PUBLIC EMPLOYEE BENEFITS
(e) Public employee pension benefits
(f) Reduction of benefits for public employees with pension and Social Security3
TOTAL EXPECTED INCOME FROM PENSIONS AND SOCIAL SECURITY
(g) Total annual Social Security/Pension benefits (add rows (b), (d) and (e) minus row (f) )
INCOME FROM PERSONAL SAVINGS
(h) Expected personal savings at retirement
(i) Surplus cash from downsizing current home4 or zero if you don’t plan to sell
(j) Spendable savings (add row (h) and row (i) )
(k) TIPs portfolio income. (Multiply row (j) x .0446)
TOTAL EXPECTED RETIREMENT INCOME
(g) Total expected retirement income at full retirement age. (add rows (g) and (k) )

---

[1] Liquid assets are assets easily and inexpensively converted into cash, like stocks, bonds, CD’s and mutual funds.

[2] Additional information on reverse mortgages is available at American Bar Association and U.S. Department of Housing and Urban Development.

[3] Reductions due to Windfall Elimination Provision for employees covered by both Social Security and a public pension, or by Government Pension Offset for public employees with Social Security spousal benefits.

[4] (Market value of current home x 0.94) - (expected cost of new home).  0.94 accounts for 6% closing cost on sale of home.