When it comes to your retirement savings, I find it helps to visualize a bucket. This Retirement Bucket has inflows (money coming in) and outflows (money going out) that’ll be critically important once you no longer count on your employment for income.
As you think about your Retirement Bucket, it’s critical to determine how much you’re going to depend on it during your retirement years. I call this your level of Retirement Bucket Dependence.
Until you know the precise level of that dependence (i.e. $6,000 per month vs. $11,000 per month), the amount you have in your Retirement Bucket is almost irrelevant to whether or not you can afford to retire. Here are five questions to determine your level of Retirement Bucket Dependence.
#1: What Does Your Ideal Lifestyle Cost?
First, you need to get an accurate measure of how much your lifestyle costs. It’s useful to parse everything spend money on into one of two categories: fixed or discretionary.
Fixed expenses are the boring things you have to do with your money on a regular basis to maintain and replenish your pantry, wardrobe, and garage.. You buy food and insurance, pay your taxes, and fuel your cars. These are all the “have to’s.” “Want to’s,” by contrast, are discretionary expenses, things like vacations and concert tickets.
Beyond the fixed/discretionary divide, you also need to account for typical and atypical expenses. If you’re going to buy a new car this year, you probably won’t need to again in the next five. If your fiftieth wedding anniversary is coming up, though, you might earmark funds for a lavish vacation. Maybe you want to put money into a 529 college savings plan for your grandkids or make an annual contribution to a favorite charity.
Getting specific on your yearly typical and atypical fixed and discretionary expenses is clearly not very exciting, but it is important. In retirement, the goal is to do whatever you want whenever you want. If you make only a cursory accounting of your expenses, you won’t trust your own numbers, and you won’t feel confident enough to join that tiny percentage of Americans able to spend what they’ve saved without anxiety.
You may not enjoy this exercise, but you will love the confidence of knowing that your answers as to whether you can retire and how much you can afford to spend are grounded in detailed, accurate data. With that data, you won’t have doubts.
#2: What Is Your Predictable Retirement Income?
There are three income streams that flow into The Retirement Bucket automatically: Social Security, pension payouts, and rental property income. Obviously, not everybody has all of these, but there are two vital pieces of information you must know about any you do have: exactly how much is coming in from each source and whether any include an automatic cost of living adjustment (COLA). Social Security, for example, gives everyone an annual raise tied to the inflation rate, but most pensions do not.
Rental property income is a bit trickier to predict. You will, most likely, raise rents, but you will also need to account for the mortgage on the property, if you have one, as well as property taxes, insurance, and maintenance costs. The critical figure here is net rent—how much you bring in minus what you realistically expect to pay out.
Here’s the Retirement Bucket Dependence Formula: subtract your predictable annual retirement income from your estimated annual lifestyle cost to determine your level of Retirement Bucket Dependence each year into the future.
#3: What’s in Your Retirement Bucket?
This is an easy part of our process. You inventory all your retirement savings vehicles and tally their value into a single number. Include everything you have in IRAs, 401(k)s, stocks, bonds, mutual funds, annuities, life insurance cash value, and bank accounts.
#4: What’s the Timeline for Your Retirement Bucket?
An accurate timeline needs to reflect more than significant specific expenses you’ve anticipated in the future like a child’s wedding, new cars, or an addition to your home. It also needs to figure in how long the money needs to last. How much you can spend each year is a function, in part, of how many years you’ll be spending.
For a sixty-year-old couple, the average joint life expectancy is 31.8 years, or until they’re ninety-two. For a seventy-year-old couple, it’s 22.6 years, which is 92.6 years old. If they’re in better than average health, the numbers get even bigger. Statistically, the average eighty-five-year-old couple still has 11.1 years for which to plan.
#5: What’s Your Plan to Combat Inflation?
With income, expenses, and duration factored in, inflation is the critical missing factor. The biggest risk you face is your income stream failing to keep pace with your inflation-driven rising lifestyle costs. Even at 3 percent inflation, a sixty-two-year-old couple whose desired lifestyle costs $100,000 per year today will need $243,000 in the last year of their average joint life expectancy to support that same lifestyle.
Here, our tool is historical precedent. As an example, in 1988 a first-class stamp cost twenty-two cents. Today, it’s fifty-five. In thirty years, the price of a stamp, and of most other things, has increased 250 percent. It’s not enough to have rigorously worked out the amount of money you have coming in this year if you want to feel confident that your Retirement Bucket will last. You have to account for inflation and its dangerous impact on your purchasing power. How do you ensure that the dollar in your pocket today isn’t worth just fifty cents in the future? You invest it strategically.
There are two ways to measure investment returns: the nominal and the real rate of return. The nominal rate of return is a flat measure of increase in value expressed as a percentage. The real rate of return is that number relative to the rate of inflation and its impact on your purchasing power. For that reason, when forecasting the longevity of your Retirement Bucket and evaluating how you should position your investments, the real investment rate of return you must earn is the figure to focus on.
A 7 percent nominal rate of return on your investments may sound appealing, but when you take inflation into account, you may reach a different conclusion. In 2017 inflation measured a mild 2.1 percent. In 1980 it was a punitive 13.5 percent. In this example, with the nominal rate of return on an investment at 7 percent, the real rate of return was a positive 4.9 percent in 2017, but a negative 6.5 percent in 1980.
If you’re counting on your Retirement Bucket of investments to offset inflation, you need to attend not to the nominal but to the real rate of return you must earn.
As legendary investor Warren Buffett once said, “Investing is the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power, after taxes have been paid, in the future.”
This article was adapted from the book The Relaxing Retirement Formula: For the Confidence to Liberate What You’ve Saved and Start Living the Life You’ve Earned.