Dr. Daniel Crosby, Ph.D., President, IncBlot Behavioral Finance
It’s important to live by a household budget during your working years, but it’s even more important as you begin retirement. As you prepare to live on a fixed income, planning is key. According to a recent Survey of Consumer Finances, the median American married couple earns approximately $60,000 per year near retirement and has approximately $100,000 in non-housing wealth. However, your income and assets at the end of your career are just one component of your retirement budget.
Measuring the adequacy of a retirement plan depends on the retiree and his or her goals for retirement. While there is no ‘one-size-fits-all’ retirement budget, there is a realistic approach to shaping your plan. Certified Financial Planner Board of Standards, Inc. guidelines recommend a detailed personal cash flow forecast. But, even the best-laid plans change. Your budget starts with an estimate of your income replacement ratio.
Most experts estimate that you’ll need 70% of your pre-retirement income to maintain the same standard of living in retirement as you enjoyed throughout your working years. A bulletin released by the Social Security Administration detailed the difficulty of constructing this figure. It is generally calculated using household income, shared income, non-housing financial assets and potential income from financial assets. It sounds complicated, but it doesn’t have to be. At its most simple level, think of your replacement ratio as the sum of your retirement income sources.
Your replacement ratio is less than your pre-retirement income because of three factors:
- Income taxes are lower after retirement, as income is generally lower and retirement income, such as Social Security, is taxed at a lower rate.
- Your retirement saving approach has shifted.
- Work-related expenses are reduced or eliminated.
The sum total of your income must be enough to cover your everyday living expenses, healthcare, unplanned expenses and end-of-life arrangements. Your replacement ratio is unique to your household; it’s driven by your individual lifestyle expectations, health and ability to save throughout your career.
Identifying Retirement Income Sources
Retirement savings and Social Security benefits form the bulk of most retirees’ income. Additional income may be available via defined benefit pensions or supplemental work throughout retirement. Each income source deserves a thoughtful review of both risk and reward.
- Retirement Savings Plans: As you near retirement age, your portfolio should shift away from risk toward a conservative blend of assets. The goal is to maintain your wealth over the course of your twenty- to thirty-year retirement. Schedule consulting sessions with your financial advisor to ensure you’re on the right path.
- Social Security: This income typically accounts for 40% of a retiree’s replacement ratio. While you may draw benefits at any time between the ages of 62 to 70, depending upon your year of birth, you must be aged 65-67 in order to qualify for your full retirement age. Social Security withdrawals prior to full retirement age can reduce your benefits by about 30%. Choose the age at which you will begin drawing benefits carefully and monitor long-term trends affecting this program.
- Pensions and Defined Benefit Plans: Few companies today offer pensions, and even fewer offer retiree healthcare coverage. Read your plan thoroughly and identify the age at which you qualify for full benefits. Be aware that this income is dependent upon the business’ ability to thrive and thus pay out benefits over the long run.
- Work-Related Income: As a retiree, you may choose to work throughout retirement; either for the pay and health benefits or for the simple enjoyment of doing so. If you draw Social Security benefits prior to your full retirement age, the government will deduct $1 for every $2 you earn above a specified limit ($15,120 in 2013). Deductions are lessened as you near full retirement age. Calculate how these deductions will affect your income if you draw benefits early.
Identifying Retirement Expenses:
Retirement should come with some form of reward, whether it is travel or the pursuit of your passions. As you review the expenses related to everyday necessities, allocate a portion of your expenses to activities that you enjoy.
- Everyday Living: Calculate your monthly expenses for food, shelter, transportation, clothing and other necessities.
- Leisure and Travel: Many retirees overspend during their first year of retirement as they’re eager to take once-in-a-lifetime trips. Develop a strategic plan for travel and leisure activities, and you’ll be rewarded with more flexibility over the long run.
- Healthcare: Whether you’re in good health or managing a chronic illness, account for unplanned medical expenses that may occur. According to a study by the Society of Actuaries, the risk of paying for long-term care is the largest and earliest disruptor of retirement planning. Not only are these burdens hard to predict, they’re also significant in size and scope.
Completing an inventory of projected income and expenses will help you shape a realistic retirement budget. Its level of adequacy to support your everyday needs and to cover unexpected expenses depends on you. Your risk tolerance as well as your desire to leave a financial legacy shape how much ‘extra’ you’ll want in your retirement budget.
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