Retirement Income Calculations: What Many Are Missing - Rodgers & Associates
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# Retirement Income Calculations: What Many Are Missing

Quick rules of thumb can be a great way to start working on a problem.

Trying to figure out how much to tip? Take the first digit of the bill and multiply by two.

Need to count how many seconds something lasts and worried you’ll count too fast? Say the word Missis­sippi after you say each number.

Retirement planning has its own short cuts used by amateurs and profes­sionals alike. Let’s look at the hypothetical retiree below as an example of some common short-hand planning strategies put into action.

When you think about your retirement the three questions that matter the most are “what do you want to do?”, “what is it going to cost?”, and “how are you going to pay for it?”.

For simplicity, let’s assume the answer to the “what do you want to do” question is: live my current lifestyle but without that whole pesky going to work situation. If you’re maintaining your current lifestyle and don’t have a precise estimate of your spending, a good starting goal might be to replace your take-home pay (this method assumes you’re spending roughly all of your take-home pay, so if you’re currently managing to spend more than you earn, you’ll need to master that first). Your take home pay is the amount that actually gets deposited in your checking account while you’re still working. Let’s assume your current take home pay is about \$2,000 per paycheck and that you get paid every other week (26 pay periods a year). That means we have an annual spending goal of \$52,000 a year (\$2,000 x 26 weeks = \$52,000).

So now we know what we want to do (maintain your current lifestyle), and we have a rough estimate of what it will cost (about the same as your current lifestyle costs), now let’s look at how we’ll pay for it.

We’ll start with your known sources of retirement income, namely Social Security and pensions. Let’s say your Social Security is going to be \$1,500 a month. You can find an estimate of your Social Security benefit by creating a profile for yourself at SSA​.gov. We’ll also assume you have a small \$300 a month pension. So your combined retirement income is \$1800 a month or \$21,600 a year. When we subtract what you have coming in from what you’ll be spending each year (\$52,000 of spending — \$21,600 of income = \$30,400) we get the annual amount that your invest­ments will need to provide. A safe withdrawal rate from a portfolio with at least 50% in stocks and 50% in bonds is 4% a year[1]. That means if we need to get \$30,400 a year from the portfolio we need to have an investment portfolio worth about \$760,000 (\$30,400 / .04 = \$760,000).

So in about five or ten minutes we were able to calculate roughly what you’ll need to retire. So we’re done right? Not quite.

While the method I laid out here is a good starting off point, there are a number of factors it doesn’t fully take into account. One short­coming of this technique is that it doesn’t account for taxes. In our example above, their pension would be fully taxable, their Social Security would be partially taxable, and the taxes on the invest­ments would change depending on the type of account the invest­ments are held in or how much of a gain they’re sold for.

Additionally, this technique does not account for future inflation in your spending. Depending on how long you plan on working (or living) most of us should be planning for roughly 30 years of retirement. For someone who retired 30 years ago a first class stamp cost \$0.22. Today it costs more than double at \$0.47. While inflation has been fairly tame in recent years, it is definitely something that needs to be accounted for.

Our shorthand method also doesn’t include what you’ll need to spend on health insurance as a retiree. While we’re working, most of us have our health insurance costs taken out of our check before any money hits our bank account. Many of us also have employers who are paying for a portion of the cost of the health insurance we receive. So we’ll need to increase our spending goal to account for health insurance costs. For Medicare age retirees, it’s fairly easy to get a good idea of what your health insurance should cost just by looking up the current Medicare premiums. For early retirees, we’ll want to think about where your health insurance is going to come from as you wait to qualify for Medicare. Some people are lucky and have low cost health insurance available through their former employer, most others will be faced with a decision between COBRA and health insurance from Healthcare​.gov. Those aren’t neces­sarily bad options, but they might be expensive. They’re also difficult to estimate ahead of time.

So what shorthand technique can we use to account for all of these factors? Well there really isn’t one.

To truly under­stand if you’ve saved enough you’ll need to use some quality financial planning software and that’s generally not available unless you’re working with an adviser.

Additionally, access to the software is not enough. You have to be familiar enough with each of the assump­tions that software is making and have enough historical perspective of invest­ments and an under­standing of the tendencies of human behavior to really know if you’re coming to the right conclu­sions. That’s why we believe it is extremely important for most people nearing retirement to meet with a qualified financial adviser to provide you with an unbiased assessment of your level of preparedness.

[1]  The 4% rule for spending in retirement was proposed by William P. Bengen who published the October 1994 article in the Journal of Financial Planning called “Deter­mining Withdrawal Rates Using Historical Data”.