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) )

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[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.

Part 2: The Two-Legged Stool: Where Will Your Retirement Income Come From?

 

Part 2: Personal Savings

One of the first steps of retirement planning is to figure out how much we can expect to spend after we bid our working life adieu and the paychecks abruptly cease. Those pension checks from your employer and the gold watches are now mostly the stuff of black-and-white movies, so most of us will depend on Social Security benefits and personal savings.

In Part 1, I explained how to estimate your future Social Security benefits. The second common source of retirement income is personal savings, whether you saved them in a taxable account, like a bank savings account or stocks in a brokerage account, or you accumulated them in a tax-advantaged retirement account like a 401K or an IRA.

The amount of income we can generate from personal savings is trickier to predict than Social Security benefits for two primary reasons. First, we don’t know how long we will live. Social Security promises to pay us a monthly amount no matter how old we get, but our personal savings make no such guarantee. After we spend our savings, they’re gone.

The second difficulty is that there are a variety of ways to invest our personal savings and the better our investments perform, the more we can spend. Unfortunately, if they perform poorly we must spend less.

Here are some important differences between Social Security benefits and personal savings:

1.         You can outlive your personal savings, but you can’t outlive Social Security benefits.

If you spend or lose all of your personal savings, they are gone forever. If you live a very long life or you overspend, you can outlive your personal savings. Only in personal financial planning do we consider living a long time a problem.  We even have a name for it—longevity risk.

Social Security checks will keep coming for the rest of your life, no matter how long you live. (Remember this when politicians tell you that you would be better off keeping your FICA payments and investing them in the stock market to pay for your retirement.)

2.         Social Security payments will remain constant throughout retirement, but the amount you can spend from personal savings can shrink or grow over time.

Social Security benefits won’t shrink or grow as you age except for the inflation adjustment (not without an act of Congress, anyway). The amount of the check will grow to offset inflation, but your purchasing power will remain the same.

The amount of your personal savings that you can spend, however, depends on how well the money is invested and how long you live. You can invest your personal savings in stocks and bonds and if your investments perform well, you will be able to increase your spending over time. If the market performs poorly or you spend too much, you will have to reduce your future spending. 

Invest those savings in something safer than stocks, U.S. Treasury bonds, for example, and the amount you can spend won’t grow much, but it won’t shrink much, either.

3.         Unspent personal savings can be passed on to your heirs at your death, but there are no “unspent” Social Security benefits.

When you die, there are no “leftover” Social Security funds[1], even if you paid a gazillion dollars in FICA during your career but are only around long enough to collect a couple of monthly retirement checks. Your unspent personal savings, on the other hand, can be inherited by your heirs when you die.

So, if you retire with a million dollars in savings, how much of it can you spend each year of retirement? An estimate depends largely on how long you will live and how you will invest your savings.

The first question we have to ask is how long we will live. We discussed that in a previous chapter. The consequences of outliving our savings might be catastrophic, so we can’t take that risk. We have to assume for retirement planning purposes that we will live to be very old, just in case we do. Some planners recommend using age 95 and some 100. 

Your life expectancy won’t work for financial planning because that’s the average life expectancy for people like you. If we used the average, then half the people for whom we prepared retirement plans would outlive their savings.

How Will You Invest?

The second question we have to ask in order to estimate how much of our personal savings we can spend in retirement is how our savings will be invested.

If finance isn’t your strong suit, your first thought might be that for a thirty-year retirement, you could spend 1/30^th (3.33%) of those savings every year. Just divide that pile of savings into thirty stacks, one for each year of retirement. Label each stack with the year it is to be spent, put rubber bands around them and stick 29 of them under the mattress.

Fortunately, the savings we don’t have to spend this year can be invested and can grow in certificates of deposit (CDs) or mutual funds until we need it, allowing us to increase annual spending. The stack labeled for spending next year can earn interest for one year, but the stack labeled for spending 29 years from now can earn interest for 29 years.  A stack of money can earn a lot of interest in all that time and we don’t have to wait 29 years to spend it.  We can spend more now, knowing that we will replace some of what we spend today with future interest earnings.

Even investing in the safest, lowest yielding investment portfolio available instead of sticking that money under the mattress, we can spend 33% more than that 1/30^th of our savings each year.

Increasing a small percentage like 3.33% by a third may not sound like a big difference, but when you look at the annual spending amounts, you see that it is. If we were limited to 1/30^th of our million dollars of personal savings each year, we could spend $33,333. An additional one-third increase of that 3.33% to 4.43% raises $33,333 to $44,333, or $10,000 more per year we can spend.

Once we retire, we might leave our personal savings in stocks and bonds, “save” it in a savings account or certificate of deposit, or even use it to purchase an insurance contract that provides a certain level of income for as long as we live (a “fixed annuity”). Each option has its own risks and provides its own level of income.

In keeping with the “start simple” theme from Part 1, though, let’s estimate how much income we might receive from the safest alternative and try to improve on it later in the planning process.

A Portfolio of Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities (TIPs) are U.S. Treasury bonds that pay interest that is adjusted for inflation. Real yields, the interest rate paid after inflation, are historically around 2% for TIPs bonds, but the U.S. Treasury compensates investors for inflation. If inflation runs 3%, for example, these TIPs bonds would actually pay 5%. If inflation is 4.5%, the bonds will pay 6.5%.

Said differently, the U.S. Treasury is promising to pay you 2% interest (the “real” interest rate) plus whatever rate of inflation you experience until the bond matures. 

TIPs are the safest investment available, since they are backed by the U.S. government and have no inflation risk. They’re also as easy to purchase as a CD. You can buy individual bonds from the U.S. Treasury online or you can buy them in mutual funds[2] or ETFs[3] from any broker.

The Safest Estimate is 4.46%

One very safe way to invest our retirement savings would be to invest them in a TIPs portfolio. Nobel Laureate and economist William Sharpe has shown[4] that retirees could spend 4.46% of the initial value of a TIPs portfolio every year with high certainty that the principal would last for almost exactly thirty years. A million dollar TIPs portfolio, therefore, would support $44,600 of annual spending after inflation and its balance wouldn’t reach zero for thirty years.

Investing our personal savings in TIPs when retirement age nears is a simple and safe way to ensure that our personal savings last as long as we do and to protect ourselves against inflation. Depending on each retiree’s unique financial situation, TIPs may or may not be the ideal way to invest, but they are a great starting point for planning purposes. Any other approach will involve more risk, so this approach provides a safe and conservative estimate that we may or may not be able to improve upon.

A Strategy for Estimating Spending Capacity

These assumptions of how long we will live and how we will invest our savings provide us with a basic strategy for estimating how much of our personal savings we can spend each year in retirement. First, we will plan to live to be 95 or 100 years old to make sure we won’t outlive our savings. Second, we will invest our savings as conservatively as possible so we earn a return that can keep up with inflation and increase our annual spending. 

Lastly, since we probably won’t actually live to be 95 or 100, but have to plan for it just in case, we will assume that some of our savings will be left over and pass to our heirs when we die. 

Add Personal Savings Spending to Social Security Benefits

Based on these assumptions, we have a reasonable estimate of how much income our personal savings can generate throughout a thirty-year retirement. Add annual Social Security estimates from Part 1 to 4.46% of expected personal savings at retirement.  If you’re lucky enough to have a company pension, add the annual benefit you expect it to pay and you have a pretty good estimate of your retirement income.

Here’s an example.  Assume my wife and I plan to retire at age 66 and the retirement calculator at the Social Security Administration’s website says I can receive benefits at that age of $1,200 per month.  The calculator tells me that my wife is also entitled to her own benefit at that age of $1,200 per month.  That’s $2,400 per month in social security benefits, or $28,800 per year.

Also assume my wife and I have saved a combined $100,000 in our 401K plans, 4.46% of which is an additional $4,460 per year that we can spend from our savings.

Social security benefits plus spending from savings will provide about $33,260 per year in retirement income.  There are trade-offs we can make to increase that income, but for now, an initial estimate of expected income is a good first step toward their financial plan.

For now, an initial estimate of expected income is a good first step toward their financial plan.

The Key Points

Here are the key points to remember from Part 2:

o      You can’t outlive Social Security benefits, but you can spend all your personal savings before you die.

o      You have to ration the spending of personal savings in case you live a very long time by planning to fund retirement to age 95 or even 100.

o      A safe portfolio of TIPS bonds should allow you to spend 4.46% of the amount of your personal savings the day you retire each year of retirement and have your savings last 30 years.

o      Add this 4.46% of your initial retirement savings to your expected annual Social Security benefits, plus any pension benefits you might have to provide an estimate of how much you will be able to spend each year in retirement.

o      You won’t have any leftover Social Security when you die, but you will probably have leftover personal savings unless you live to be very old.

If You’re Playing Along at Home

You can estimate your own expected income from personal savings now if you wish.

A simple estimate of how much you will be able to spend in retirement is the sum of your expected Social Security benefits from Part 1 and 4.46% of your expected personal savings account balance on your retirement date. If you are vested in a pension plan, you can add that, too.

Expand the table from Part 1 by entering your expected personal savings balance on the day you will retire in row (d). Calculate 4.46% of your expected personal savings and enter in row (e). 

If you are vested in a company’s pension plan, add the expected annual income in row (f). Add the amounts in the “You” column to those in the “Spouse” column and enter the sum in the “Combined” column.

We will develop a better estimate later, after we have decided when to retire and how best to invest our personal savings after retirement, but for now, we have provided an initial rough estimate of expected income.

	You	Spouse	Combined
(a) Monthly benefits at earliest retirement age ____
(b) Monthly benefits at full retirement age ____
(c) Monthly benefits at age 70
(d) Expected personal savings
(e) TIPs portfolio income. (Multiply row (d) x .0446 then divide by 12)
(f) Pension benefits
(g) Total expected retirement income at full retirement age. add rows b, e and f.

For reference, here is the table completed for John and Sara from Part 1:

	You	Spouse	Combined
(a) Monthly benefits at earliest retirement age 62	$1,410	$993	$2,403
(b) Monthly benefits at full retirement age 66	$1,927	$1,423	$3,350
(c) Monthly benefits at age 70	$2,607	$1,892	$4,499
(d) Expected personal savings	$1,000,000		$1,000,000
(e) TIPs portfolio income. (Multiply row (d) x .0446 and divide by 12)	$3,717		$3,717
(f) Pension benefits	N/A	N/A
(g) Total expected retirement income at full retirement age. Add rows b, e and f.	$5,644	$1,423	$7,067

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[1] Some of your heirs may be entitled to Social Security survivor’s benefits based on your lifetime earnings, but these are independent of how much you collected in Social Security retirement benefits during your lifetime, so they aren’t really “leftover” money.

[2] Vanguard Inflation-Protected Securities Fund Investor Shares (VIPSX), for example.

[3] iShares Barclays TIPS Bond ETF (TIP), for example.

[4] “The 4% Rule - At What Price?”, p. 8, April 2008. Social Science Research Network