How Families Can Calculate Retirement Income Wants versus Needs
Perhaps the biggest fear of families is how they will “get paid” in retirement. Gone is the regular paycheck and the annual bonuses; and, after years of building a nest egg, the new retiree is faced with the extremely uncomfortable task of tapping in to the hard earned savings.
- Moving from the accumulation (working) to the decumulation (retirement) phase of life is one of the scariest and most worrisome transitions of individual’s lifetime
To help with this transition, let’s take a look at two things. First, let’s examine why the transition is so difficult. Second, let’s explore how you can “replace” the paycheck you are getting with a “new” paycheck and why thinking of things in terms of a “paycheck” is so important.
Let’s start with why it is so difficult to move from accumulation to decumulation. It boils down to one basic word – habit. While you are working you get in to a fixed set of habits:
- You get up and go to work every day
- You have the friends and stable support structure in the workplace
- Your time is “managed for you” by the daily routine
- Your paycheck comes in every month
- You pay the bills and save for retirement without giving it much consideration
During the accumulation phase of life you fall in to a very steady, predictable set of habits. Unfortunately, upon retirement, the proverbial apple cart is turned upside down. No longer do you have the fixed schedule, the stable support structure, and you must think explicitly about how you will “pay yourself” now that the company is no longer paying you. These changes make this transition extremely uncomfortable while a new series of habits emerge. There is a great book by Ernie Zelinski called “How to Retire Happy, Wild and Free” that talks through the challenges associated with what to do with your time and how to make sure that you have a solid social support structure in place during retirement. You can find my summary of the book here if you want to look in to either of these issues. However, we’re going to focus on the issue of getting paid in retirement….
When it comes to getting paid there are four questions that we need to address:
- What do we “need” to get paid?
- What do we “want” to get paid?
- What are we “guaranteed” to get paid?
- What can we “afford” to get paid?
The first two questions can be answered by reviewing your spending habits. I won’t bore you with a detailed description of how to do a budget analysis. However, I will state unequivocally that you absolutely must start the process by fully understanding (i) what your bare minimum living expenses are and (ii) what your desired living expenses are. The bare minimum expenses focus on Maslow’s basic needs. They include food, shelter, and “protection” (taxes and insurance in today’s world). The desired living expenses include your recreational pursuits and passions (think travel, dining out, golf, horseback riding, etc.). Identifying your spending needs and wants is the key first step in establishing your retirement paycheck.
The next step is to determine your “guaranteed” payments. For this we are looking at pensions, social security, and any annuity payments that you have already established. While there is always some uncertainty in life, these three sources are normally fairly secure. Comparing your “guaranteed” payments to your “need” and “want” expenses will give you the requirements for your retirement paycheck. An example:
- Suppose that between your mortgage payment, property taxes, income taxes, health care expenses, insurance premiums, utility bills, and your food expenses you spend $3,000 per month. This would be your “need” expenses.
- Suppose that between gifts to your family and friends, travel expenses, recreational pursuits, clothing purchases, luxury items and impulse spends you spend an additional $2,000 per month. Combining this with your $3,000 “need” expenses you would have $5,000 per month in total or “want” expenses.
- Suppose that between pensions, social security, and annuity payments you have a total income of $2,000 per month.
- Based on these numbers, your “needed” monthly paycheck in retirement would be $1,000 and your “wanted” monthly paycheck would be $3,000. Translating these to annual numbers you see that the “needed” paycheck is $12,000 per year and the “wanted” paycheck is $36,000 per year.
Now we turn to the final step of what can we “afford” to get paid. There are two ways that we can “afford” to get paid – from our time or from the wealth we have accumulated. Let’s look at each of these in turn.
We can use our “time” in retirement to get paid. That’s right; we have the option in retirement of taking a job and getting paid for it. Some individuals will immediately reject this possibility as they refuse to consider any form of work in retirement. Others will seek out this possibility via work that is near and dear to them. It may be as a starter on a golf course, it may be as a Walmart greeter, it may be as a clerk at the local grocery store, it may be via an occasional consulting engagement. The key is that you do have the resource of time and you may decide to use this resource to generate income in retirement. As our life expectancies stretch out, people are turning to this alternative more and more often. Some because it is their only alternative to generate the required income. Some because they derive significant personal satisfaction from the interactions they have in the workplace.
The other alternative is to use our accumulated wealth to generate income. This is where we tap in to the 401(k), the IRA, the traditional savings, the equity in our homes, or the equity in our insurance policies. The challenge that most individuals face in accessing these resources is three-fold. First, we are back to our old friend “Mr. Habit”. We have NOT accessed any of these funds for years. Rather, we have been saving/accruing to these for years. It just does not “feel” right to start accessing these funds. Second, many individuals do not understand the “how” on the accessing the funds. Accessing the funds may require selling stock, submitting withdrawal requests to financial institutions, or making decisions on which asset to access. Third, there is often significant fear in accessing these funds as when we reverse the flow, we become worried that the asset will become depleted prematurely. The key to addressing each of these concerns is education. The primary sources of education are through individual study, discussions with friends and family, or consultation with advisors (normally insurance agents, tax accountants, lawyers, and financial planners).
Thus far, I have conveniently avoided the issue of how large of a paycheck you can withdrawal from your assets and be “safe”. Here I insert the standard disclaimer – each situation is different and you need to review all of your facts with a professional advisor prior to making any decision of this magnitude. However, there are some rough “rules of thumb” that can be used to determine the size of the”paycheck” you can draw from your wealth. These rules are as follows:
- The widely published guidance is that you can withdrawal 4% from your investment assets and be fairly safe – over a thirty year horizon – that you will not deplete your investment assets. We refer to this as our “Safe Withdrawal Rate” (SWR).
- The normal conservative guidance is that you should target a 3% withdrawal from your investment asset to be much safer – over a thirty year horizon – that you will not deplete your investment assets. We refer to this as our “Conservative Withdrawal Rate” (CWR)
Let’s now turn back to our example. Remember that we had a “needed” annual income of $12,000 and a “wanted” annual income of $36,000. Suppose that we had investment assets of $500,000. Then our SWR would be 0.04 * $500K = $20,000 and our CWR would be 0.03 * $500K = $15,000. In this case, we would have assets to cover our “needs” but not our “wants”.
Many times the question people want answered is phrased slightly differently.
- If I know that I want a $36,000 “paycheck” in retirement, what amount do I need to save?
To calculate this, we can do the following:
- To calculate the required savings to support the “Safe Withdrawal Rate”, take the amount required annual amount and multiply it by 25 (e.g. if you want $36,000 per annum, the required savings you will need is 25 * $36,000 = $900,000).
- To calculate the required savings to support the “Conservative Withdrawal Rate”, take the amount required annual amount and multiply it by 33.4 (e.g. if you want $36,000 per annum, the required savings you will need is 33.4 * $36,000 = $1,200,000).
Accessing the wealth that is stored in insurance policies or your home is a bit more complicated; however, the same basic principles apply. For analysis of how to access these wealth reserves, I would strongly recommend that you reach out to your financial advisor.
Finally, we turn back to the question of why it is helpful to think of a “retirement paycheck”. At the beginning of this article I suggested that the biggest challenge in moving from accumulation to decumulation is one of changing habit. By thinking of retirement in terms of drawing a paycheck from our assets, we (i) leverage our familiarity of the “habit” of receiving a paycheck (i.e. we are used to receiving and like paychecks) and (ii) it establishes a new habit (the withdrawal process) that allows focus on living within our retirement paycheck versus focusing on how long our money will last. While it is a subtle difference it is significant in that helps to put most retiree’s minds at ease.
Moving from the accumulation to decumulation phase is challenging. This challenge is best overcome by focusing on establishing new habits that enable you to focus on living versus worrying about how long your retirement nest egg will last. Taking the time up front to define your needs and wants, looking at what guarantees you already have in place, and establishing an affordable monthly paycheck is a great way to ease the transition.