You’ve probably heard some financial “expert” say that you should work your retirement planning to target replacing 80% of your current salary. But following that advice can be potentially disastrous for you. So let’s think about this logically so you don’t make any big mistakes in your financial planning.
When meeting with my fee-only financial planning and money coaching clients, the topic of retirement often comes up at some point. When it does people often want help understanding what their target goal needs to be in retirement savings. Using the common “4% rule” it is easy math to take the required income and calculate an estimate of how much will be needed to draw that level of money each year from their investment accounts. The challenge then though is that few people have taken the time to understand what their spending requirements might be in retirement, so they use their current income level as a base. Sometimes this works but often it doesn’t.
What number actually matters the most when you are planning for retirement? Your annual spending level. How much you spend matters much more than how much you make. Specifically how much you plan to spend while in retirement – which could be a lot lower, or a lot higher, than what you spend today.
Let’s break this down and hit important points.
How Much Do You Spend Today?
Just because you make $50,000 per year doesn’t mean you spend $50,000 per year. Some people spend way less and save money each month. Some people (many, according to statistics) spend more than they earn by using debt to support their lifestyle. The first thing you really need to do is to build a cashflow plan. Yes, I mean a budget, but for whatever reason, that word scares people, so let’s just think of it as your cash flow plan.
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You first need to understand how much you spend today. If you “don’t want to live by a budget” – that’s fine, but still go through the exercise of collecting, calculating, and documenting all of your spending. I’m not saying you need to change how you spend (though you might) but I just want you to understand how much you are spending and what you are spending it on.
Unless you are already in retirement, there are likely expenses that will be different once retired than they are today. A couple of these expenses might be:
- Mortgage costs. It is very reasonable to have a fully paid for house by the time you retire if you make that a financial priority in your planning. The average mortgage payment in the United States is just over $1,000 per month. Once you reach the goal of having your house totally paid for, that’s $12,000 less than you need to spend each year.
- Car payments. Hopefully you don’t have any car payments, but in reality, most people do. The average car payment is right around $500 per month. So that’s another $6,000 each year you won’t have to spend if you knock out that payment.
- Retirement savings. If you already have a financial plan and are saving money toward retirement – in a 401k or any other type of savings or investment account – that money, of course, won’t be needed when you retire. You’ll be drawing down the retirement savings, not adding to it, so whatever you are saving now can be subtracted from the future budget.
- Healthcare costs. Unfortunately, this is one spending item that is likely to increase in retirement. It can be very difficult to estimate what your specific healthcare costs will be, but be sure to at least consider an increase. Beyond any health insurance payments, you will also need to pay for medical deductibles and prescriptions.
I believe that before you do any planning, you should ask yourself questions about your retirement lifestyle. Do you plan to sit inside the house and watch TV all day? Probably not, so then what do you want to do? Golf? Fish? Travel? Volunteer? Whatever you envision as your retirement lifestyle needs to be considered because that will impact on your spending needs too.
In retirement do you see yourself downsizing your house? If so, it is likely that you can work that out to enjoy the benefits of lower heating and cooling costs, lower taxes, and lower ongoing maintenance costs. Don’t forget though that even with a fully paid for house there are ongoing costs that need to be budgeted and paid.
Consider adjusting your emergency fund size once you reach retirement. Financial Advisor Nick Murray makes a very strong case – that I agree with – for having an emergency fund equal to eighteen months’ worth of living expenses. While that may sound large to someone who has never worked with a planner or coach before, there are good reasons for this recommendation. The biggest reason is that you don’t want to be living off of your retirement investments and be in a situation where you have to sell investments during a cyclical down period. The average downturn lasts right around eighteen months, so having an emergency fund of this size would allow you to live off the cash and leave your investments alone long enough for the markets to start their recovery phase.
As a fee-only financial advisor, I can help you clarify your dreams and priorities, then develop an actionable plan to achieve your goals. Having a financial plan for your life includes much more than just investing, but intelligent investing is definitely part of the solution. Reach out and let's talk about how I can help you maximize your money to achieve the life of your dreams.
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