I’m in Florida on Spring Break this week so here’s an excerpt from my book Everything You Need to Know About Saving For Retirement.
When you first set out to save and invest your mindset is often stuck on the idea of becoming rich. As you age and priorities shift, that mindset turns into a fear of dying poor.
Do I have enough money saved?
How much will healthcare cost during retirement?
When should I take Social Security?
What if there is a market crash right after I retire?
How can I be sure my money will last?
These are all legitimate questions worth considering but this goes to show you the uncertainties of the retirement planning process don’t end once you reach retirement age. Stock market crashes and
recessions can be scary to live through, especially for retirees who no longer have the human capital or time to wait out a prolonged downturn. But your biggest risk is not market or economic volatility,
but running out of money before you keel over.
Managing your finances in retirement requires a balance between the need for stability in the short term versus the need for growth in the long term. Even a 2% inflation rate would nearly cut your purchasing power in half over 30 years in retirement if you simply buried your money in the backyard. Most investors will be forced to take some risk and accept some volatility in their portfolio to ensure they have enough money to see them through the long haul.
Daniel Kahneman once asked, “How do you understand memory? You don’t study memory. You study forgetting.” This is how to think about the problem of figuring out how much money you need for retirement as well. How do you understand how much you need for retirement? You don’t figure out a number. You figure out how much you spend and save. It’s pointless to try to figure out how much you’ll need in savings or income if you don’t have a good understanding of how much it costs for you to live.
Where you are in your lifecycle will obviously have a lot to do with how you think about these factors. In your younger years, it’s almost impossible to plan ahead for the exact amount you’ll need based on the exact amount you’ll spend during retirement. There are simply too many variables to consider, many of which can and will change by the time you do decide to accept that gold watch and retire.
As you approach retirement you’ll have a much better grasp of how much you spend on an annual basis and what your wants, needs, and desires will be in your retirement years. From those numbers, you can
come up with a better estimate to determine how much of a nest egg you’ll need to cover your annual expenditures from your portfolio.
You’ll never be able to figure out how much enough is in terms of your retirement savings if you don’t have a deep understanding of your spending. Your monthly burn rate is a pretty good starting point when thinking through how far your savings will take you. And it’s not only the things you spend your money on that matter but the things you don’t spend your money on.
- Is your mortgage paid off?
- Do you have any other outstanding consumer debt?
- Are the kids off your payroll?
The combination of a high savings rate going into retirement along with a dearth of debt obligations can make your savings last much longer than the alternative. Going into retirement with little in the way of debt increases your financial flexibility enormously. High fixed costs are your biggest enemy when seeking financial independence.
Investing during retirement does introduce some new variables and risks to the equation you have to be aware of. Getting a handle on your spending helps but you still have to figure out how much to take from your portfolio each year, which investments to take from and which accounts offer the most tax-efficient withdrawal strategy.
Financial markets never move in a straight line so this process requires some flexibility depending on how things shake out in the markets and how your spending evolves throughout your retirement. Your investment plan doesn’t need to change every time stocks rise or fall but you do have to incorporate real world market performance with your built-in expectations. Any useful investment plan takes into
account the need for course corrections on occasion. As the old saying goes, “Plans are useless but planning is indispensable.”
It will be nearly impossible to implement a sound investment plan if you don’t have a handle on your sources of income during retirement. For some people this could simply include Social Security
and investment income from their portfolio. Others could have a pension plan, an inheritance, rental income from a second home or a part-time job to supplement their spending needs.
There are all sorts of risks to consider during retirement including outliving your money, inflation, emergencies, unplanned one-time expenses, healthcare costs, the sequence of your investment returns
and general market volatility. This is why diversification among stocks, bonds, cash and other assets is so important. It helps you plan for the wide range of outcomes life tends to throw at you.
The financial aspects of retirement can seem overwhelming but the first step in the process boils down to figuring out what you want to do with your life during your retirement years. You’ll never be able to figure out your finances if you don’t first figure out what you want to buy with your life savings. The entire reason you’re saving in the first place is to purchase your freedom. You’re buying your own time.
So what are you going to do with that time? Travel? Volunteer? Read more? Spend more time with family? Only work on projects that interest you? Even the greatest retirement planning in the world won’t get you very far if you haven’t decided how you’ll spend your time and money. People often spend decades investing their money without giving a second thought to how they’ll invest their time. Studies have shown that experiences and giving back to others often bring the greatest happiness to retirees and help ward off the potential depression which can afflict many who leave the working world.
You can run through all the calculations and spreadsheets you want but life will inevitably get in the way as some of your assumptions will be proven wrong. This is an unfortunate side effect of trying to plan in the face of irreducible uncertainty. In a way, there’s a lot of guessing involved in the process. This is why financial planning is a process and not an event. You don’t simply set a course of action and follow that exact plan for your remaining days. Financial plans should be open-ended because there will always be corrective actions, updates, changes in strategy and difficult decisions that have to be made.
There’s never a perfect time to retire just like there’s no such thing as a perfect portfolio. If you have your personal finances in order, understand how much it costs you to live, where your income will be coming from during retirement and how you’ll spend your days, that’s a pretty good start.