This is part 4 in our series on creating a financial plan for retirement. In this article, we’ll discuss the crucial considerations you need to make in budgeting for retirement.
“An investment in knowledge pays the best interest.”
As we’ve already seen, retirement without a purpose can quickly become a long slog through uneventful days instead of a vibrant, joyous capstone to a life well-lived.
The work you’ve already done to identify your passions and define your ideal retirement will help chart your course. (Note: You may also want to read this article, which explores specific non-financial factors for a happy retirement.)
Your homework from part 3 provided a much clearer picture of your current expenses and probably got you thinking about the costs of the retirement you want to live.
Helping you realize that vision is what this and the subsequent articles in this series are all about.
Think of it as an investment in knowledge, exactly the kind Ben Franklin was referring to in the opening quote above.
The interest you’ll earn? Confidence. The knowledge that, with careful planning and the help of a trusted financial advisor, you’re much more likely to bridge your income gap and enjoy the retirement you envision.
The Income Gap, Part Two: Factors That Affect Your Assets
In studying the income gap thus far, we’ve met Mary, a nursing professional who worried, like so many of us do, about affording retirement.
Instead of letting that fear paralyze her, Mary acted—and through her work with us, discovered that the key to a workable financial plan for retirement is considering many possible scenarios.
We’ve talked about how the Federal Reserve “stress-tests” its policy decisions to see which are the wisest, based on a host of factors. Similarly, we must consider all the factors impacting our personal finances in retirement. How do they increase—or help to bridge—your income gap?
This really captures the process we follow in building financial plans to take clients through retirement.
The personal budget you just completed has likely provided you with a deeper understanding of your income and expenses than you’ve ever had. That will serve you well as we shift our focus to factors that might impact your assets as retirement approaches.
Let’s start with a close look at the potential effects of inflation.
Meet Jim: The Reality of Inflation and Retirement
Jim first contacted us when he was sixty years old, having realized retirement planning could no longer wait.
Jim was married and in good health. Jim’s wife, Carol, was in good health, too, so we agreed it was wise to plan for a twenty-five-year retirement.
Based on information Jim provided about their lifestyle, housing situation, and the retirement they pictured for themselves, we projected Jim and Carol’s expenses during retirement to be $5,000 a month, an annual total of $60,000.
Sounds pretty straightforward, right? But additional factors can change this raw number over the course of retirement, and one is inflation.
We hear about the “inflation rate” in economic reports, but what is it, exactly? Inflation measures the combined effect of changes to the prices of everyday goods and services and in the purchasing power of money.
For Jim and Carol, we chose an inflation factor of 3 percent per year—a bit higher than the long-term trend of 2.26 percent—so we’d be safe.
Factored for each of the five years until Jim would retire at age sixty-five, that 3 percent inflation rate had a profound impact. It increased the couple’s total expenses in their first year of retirement to $69,556, almost $10,000 more than our initial figure.
If that seems surprising, hold on to your hat.
After ten years, inflation grew Jim and Carol’s annual expenses to $80,000. (That’s just five years into retirement because—remember—our calculations began the year Jim first sat down with me, five years before retirement.)
By age ninety, based on that conservative 3 percent inflation estimate alone, they’d need $125,000 per year. Adding up our inflation-adjusted projections across their twenty-five-year retirement produced a total $2,612,039.
That $2.6 million sounds scary, right? But it’s also very static.
Here’s what we mean by that. For one thing, if Jim or Carol dies before age ninety, there’ll be a decrease in living expenses for the survivor. We can’t know when or if that will happen, however, so we’re smarter to plan based on both reaching ninety.
Another consideration: The U.S. inflation rate in recent years has consistently hovered between just under 1 percent to just above 2 percent. So why have we used 3 percent as our touchstone? Are we being too conservative?
We don’t think so, and here’s why.
The Costs of Getting Older
The Consumer Price Index (CPI) was created to measure monthly changes in the prices of consumer goods and services. It uses two hundred categories to get a factor—an “index”—of how prices are behaving.
CPI is a real benchmark metric, one essential for calculating inflation. As we’ll see in the next section, the Social Security Administration uses CPI to figure the annual cost of living adjustments it provides to recipients.
While inflation has averaged just over 1 percent in the recent short term, it’s averaged 2.26 percent across the past twenty years, and closer to 2.5 percent if you go back even further.
On top of this, a retiree’s living expenses are going to be much different than someone who is younger, has a family, and is working.
In fact, the differences for retirees are significant enough that there’s a whole separate CPI for older folks, the CPI-E (the “E” is for “elderly”).
CPI-E tracks prices for people sixty-two and older. It has consistently hovered around 3.1 percent, and none of us should be surprised by what is perhaps the biggest reason: medical expenses.
That higher inflation rate for elders is why I hedge my calculations and round my inflation factor up to 3 percent for retirees. Doing so more than covers the overall inflation rate at its historical high, with over half a percent to spare. And when planning for retirement (or anything else), it’s always best to err on the side of caution.
We also suggest to clients that as they consider their individual expenses, they should use different inflation rates based on the individual expenses. For example, core living expenses most likely track close to traditional CPI.
However, medical expenses are accelerating at a much higher rate. Travel is another expense that typically increases faster than CPI.
Cost of Living and Social Security
We can’t fully consider the effect of retirement income and expenses on your income gap without discussing that old stalwart of the American retirement landscape, Social Security.
We’ll cover Social Security’s overall impact on retirement income later, but before we move on from inflation, it’s helpful to understand how it might impact your Social Security benefits.
Each year, the Social Security Administration calculates a cost-of-living adjustment (COLA) to the payments it makes to recipients. While “inflation” and “cost of living” may be used interchangeably in the media, there’s a fine difference.
As we’ve just seen, the inflation rate is derived from the combination of the cost of goods (CPI) and the purchasing power of money. The COLAs that Social Security makes, however, are based on CPI alone—and lately, we’ve noticed some concerning changes in their enactment.
COLAs, for want of a better term, are essentially a “raise” for Social Security recipients; they’re an incremental annual increase designed to help benefits keep up with the prices of essential goods and services.
From 2009 going all the way back to 1975, when COLAs were first instituted, Social Security recipients got their raise: The program increased payments in every one of those thirty-five years.
More recently, however—in three of the seven years from 2010 through 2016—guess what? No raise.
According to a study by the Senior Citizens League in 2016, the cost of living for people over age sixty-five increased 74 percent between 2000 and 2015. Yet during that same period, COLAs from Social Security totaled just 43 percent. That’s a 31 percent shortfall. Take a look.
Clearly, Social Security is failing to keep up with increases to the cost of living. As we saw in the last section, we must compensate for that.
Beyond Social Security’s COLAs, what you pay for essential goods and services might also be affected by where you retire.
If you plan on living in a different region or country, the expenses particular to that locale must also be taken into account.
Living Expenses and Long-Term Debt
Wherever you retire, the types of expenses you will face remain constant. We identified the “big six” necessities of life in part 3:
Projecting your costs in these areas as you formulate your retirement plan—and taking steps now to keep them as low as possible—will prove crucial in holding your income gap to a minimum.
Consider each category carefully, and don’t forget seasonal, maintenance, and miscellaneous expenses.
It is critically important as you approach retirement to get a good handle on your long-term debt. Whether it’s a mortgage, credit cards, or something else, being locked into long-term payments puts real pressure on your monthly cash flow, especially in retirement, when you’re living on a fixed income.
And needless to say, the bigger the payment, the greater the impact.
A mortgage is usually the largest monthly obligation we face. We recommend exploring every realistic option for paying off your home by the time you retire.
But don’t forget, even paid-off houses come with continuing costs: taxes, maintenance, homeowners insurance, plus the cost of utilities. And the larger your home, the higher these costs will be.
If paying off your mortgage isn’t possible or cost-effective, consider changing your housing situation. Selling your large home and downsizing to one bought with the equity makes sense for many people, especially if it eliminates mortgage payments.
You might also invest the equity from your sold house and rent, using gains on your investments to help shoulder your rental costs. You’ll still have a monthly payment, but maintenance expenses will shift to your landlord.
Options do exist, but there may be fewer than you realize. Ranch-style, single-level living, particularly in areas not traditionally thought of as retirement meccas—like Minnesota—can be hard to find.
Homes and even apartments with ground-level access are in great demand. Even if you’re downsizing, you might pay the same or even more each month than you are now.
Clearly then, the living arrangement you choose for retirement depends on what is most cost-effective for your situation.
Just remember that “cost-effective” means a home in which you can be comfortable, preferably with a small monthly payment—or better yet, none at all.
We strongly discourage retirees from using a home equity loan or “reverse mortgage,” as they’re often marketed these days. That’s just robbing Peter to pay Paul, borrowing from yourself to pay yourself, while the bank collects some money in between.
It’s typically better to liquidate, to sell and use the equity for retirement income. (We’ll look more closely at reverse mortgages in part 5 of this series.)
Personal loans, auto loans, credit cards—we all use these sources of long-term debt at various points in our lives. But you really should make it a priority to mitigate and, to whatever extent you can, eliminate them as you head into retirement.
The simple point here? Long-term debt is extremely toxic in regard to preserving your sources of retirement income.
Longevity and Your Legacy
We’ve mentioned it already, but it bears repeating: We’re living longer than ever.
That means we must preserve our retirement savings as long as possible. By holding substantial balances in investment mechanisms as long as possible, you give your money its best opportunity for growth.
That’s crucial if your retirement income is going to last as long as you do.
The amount you need isn’t a static number; if it were, you could just retire in your fifties, withdraw a percentage each year, and be in great shape. But that’s just not realistic. Hypothetically, your withdrawal rate should accelerate as you get older, when you need it most.
It would be so much easier if we only knew how long we’re going to live! We can’t, of course, but we can plan conservatively, as we did with Jim and Carol above.
It’s best to plan on living longer than you think. If things don’t turn out that way, you can pass whatever’s left to family, friends, or a favorite charity.
Indeed, that’s the final consideration on the expense side of your retirement budget. Do you want to leave a legacy behind?
If so, you’ll want to factor it into your retirement expenses. If leaving a legacy is not as important, that might allow a slightly more aggressive withdrawal rate from your retirement accounts.
Homework: Your Expenses in Retirement
We’ve now looked closely at factors that can affect your expenses in retirement and learned, in a big-picture way, how they might affect your income gap.
We’ve seen the importance of eliminating long-term debt, but even then, inflation can and very likely will cause your living expenses to escalate during your retirement years.
To get an idea of how much, you must first project the expenses you’ll face in your first year of retirement.
Begin with the “now” budget you completed in part 3 and then adjust it. Your budget in retirement needs to reflect the expenses you anticipate when you’re ready to retire, based on whether your home will be paid off, the existence of other long-term debt, and where you plan to live.
Once you have what you feel is a solid number for that first year, use the following chart to quickly gauge the effects of differing inflation rates over various numbers of years in retirement.
This exercise will help you to understand how inflation, coupled with major expenses, can quickly expand your income gap.
Next, read part 5 in How to Stress-Test Your Retirement Planning. (Coming soon!) We’ll begin to delve more deeply into bridging your income gap and explore in detail all your options for saving and wisely investing, with the goal of building lifelong retirement income.
You can also learn more about Minnesota’s premier retirement planners, the financial advisors at Pine Grove Financial Group, or click below to contact an advisor today!