For most people, the decision to retire is not one that they can easily change. One of the biggest mistakes a retiree can make is beginning their retirement before they know if they can actually afford it. With the average life expectancy over 80 years, before you take the big jump, make sure you can meet the expense of what might be a 20, or even 30-year retirement.
How can you know if you can afford to retire yet? Run a retirement “cash flow” projection. A cash flow projection can help you determine how much money you think you will need annually, and where it will come from. The following 3-step process may help you secure a comfortable retirement.
Step 1. Determine how much monthly income you will need in retirement. You will want to make sure that this estimate is realistic, so that you will be able to maintain the standard of living that you envision in retirement. The easiest way to calculate this amount is to look at what you are currently living on, and then make some adjustments for your retirement years.
First, find out what income is currently coming into your checkbook monthly (after taxes and all deductions). Then make adjustments to this amount based on what may change between now and the near future. For example, if your mortgage or other debt will be paid off in the next few years, you could subtract that amount, since you will no longer have that payment. The same can be assumed with other expenses that may end, such as those associated with childcare.
Second, determine what may be some potential expenses. One of the biggest, and often overlooked expenses, you will need to consider is health care. Because this is one of the largest expenses for many retirees, you will want to ensure the estimate is realistic. According to a 2015 HealthView Services’ report, the average lifetime premium cost for health-care in retirement for a retired married couple is $266,589. This amount is ABOVE the cost of supplemental insurance, as well as Medicare parts B and D coverage. (This estimate is based on current life expectancy of men and women.)
Third, when making your income projections, make sure you are taking into account inflation. Over time your expenses will increase, and your cash flow projections will need to take that into account. For example, at a 3% inflation rate, your expenses would DOUBLE after 24 years!
Step 2. Determine your fixed sources of retirement income. Depending on where you worked, most retirees will be eligible for some sort of government pension such as Social Security, PERS, FERS, STRS or Railroad Retirement System. Some retiree’s may be eligible for a pension from their private sector employer. While these plans are quickly disappearing for younger employees, it can still be a significant source of income for current retiree’s. It is important to get accurate estimates on any of these benefits, since they may be a significant source of income in retirement.
Tip: If you are married you will want to make sure you thoroughly understand all of the different benefit options and how they may affect your spouse. Depending on your situation, you may want to consider taking a “joint and survivor” benefit, that leaves your spouse a continuing benefit in the event you pass away first.
Step 3. How much income will your investments need to produce? Now that you have estimated how much retirement income you will need, and your sources of fixed income, the next step is to calculate any short fall you may have. For most retirees, the difference between what income they will need and how much will come from government plans and pensions will have to come from their investments.
In this step, you need to determine if the amount you may need monthly from your investments is realistic. This part can be tricky since several variables need to be considered, such as current interest rates, the overall investment environment, your age and health, and your own personal tolerance for risk.
Keep in mind that the more income you want your investments to provide, the more risk you will need to accept, especially in this current low interest environment. The reality is that most retirees are not very eager to take on much risk in retirement, especially as volatile as the markets have been over the past 15 years. At the end of the day, it becomes a balancing act of how much income would I like to have in retirement, versus how much risk am I willing to take to achieve it.
Tip: The financial planning profession typically recommends limiting your annual withdrawals to somewhere between 3 – 4% of your total investments on a long term basis. For example, on assets of $500,000, your annual withdrawals would be somewhere between $15,000 to $20,000.
As you can see, the process of developing a retirement plan is quite simple—unfortunately no one said it’s easy! Many variables come into play—age and health, the stability of your fixed sources of income, future inflation rates, not to mention the volatile nature of investing.
There are no second chances when it comes to retirement. That is why working with a qualified professional financial planner can help you to navigate through the maze of variables, and help put your mind at ease that your retirement is on the right track.