The Elephant in the Room: Your Retirement Income Gap

Mar 12, 2019

Retirement Income Gap

This is part 3 in our series on creating a retirement plan. In this article, we’ll tackle the retirement income gapwhat it is and why it’s so crucial to prepare for it.


“A penny saved is two pence clear.”

Ah, good ol’ Ben. To say he was “thrifty” is an understatement. Franklin believed that creating personal wealth had as much to do with being fiscally prudent as with being a shrewd investor.

And, yes, you read correctly above. Bet you always thought Franklin said, “A penny saved is a penny earned,” didn’t you? Not quite.

So, what did he mean? And what’s “two pence” anyway?

“Pence” is the plural of “penny,” although today, here in America at least, we say “pennies” instead. (The Brits still use “pence.”) Franklin first wrote this oft-misquoted line in 1737, in a column titled “Hints For Those Who Would Be Rich.”

If we can resist spending a penny, his reasoning went, we are actually two pennies ahead of those who can’t resist, of those who give in to temptation and spend money on something they don’t need—especially if they’re spending on credit.

Let’s think about that in modern terms.

Resist spending, and you'll be ahead.

Franklin’s Two Pence Logic Today

A penny from Franklin’s time is worth forty-three pence today—so a dollar in 1737 is now worth around $43.

Imagine you’re walking down the street with your spouse one day, and she says, “Honey, look! A free wine and cheese tasting!” And in you both go. Forty-three dollars later, you’re back outside.

“The free wine and cheese was nice, but what a deal on this vintage bottle of wine!” Never mind that neither of you are connoisseurs of wine.

Once you went inside, you felt you should buy something rather than just be another freeloader off the street—even though that was, after all, your original plan. Of course, you were a little short of cash, so on the credit card it went.

From Franklin’s perspective, you wasted $43 on something you didn’t need, and you’re $86 behind those who walked right by that “free” wine tasting. How?

Well, they not only avoided owing $43, but by resisting temptation, they also had that much more to save. Forty-three dollars saved, $86 clear. It’s a counterintuitive way to think about money, but you have to admit that it makes a lot of . . . cents.

Practice saving habits.

Prudent spending and prudent saving are two sides of the same coin. Below, we’re going to  expose and explore the biggest obstacle to retirement planning most of us face.

Then we’ll consider how “practicing” for retirement helps us develop smart spending—and saving—habits.

If you’ve done your homework from the previous section, you have a pretty clear idea of your purpose for retirement. You’re probably even excited about the opportunities retirement offers.

If you also found yourself wondering where the money will come from to make your vision of retirement a reality, you’re far from alone. A 2016 survey by the Employee Benefits Research Institute (EBRI) showed that less than half of us (48 percent) have taken the time to figure out if we’ll have enough money for a comfortable retirement.

On the other hand, a more recent EBRI survey indicated 64 percent of workers feel very or somewhat confident when it comes to their financial status in retirement. But it turns out that confidence could be misplaced.

Maybe you identify with the 64 percent. Or, you might fall on the other end of the confidence spectrum. Either way, here’s what you should be aware of: There is a very real obstacle most of us need to address in making our retirement dreams a reality. It’s called the income gap.

Be aware of the income gap.

Mary’s Story: A Case Study of the Income Gap

Mary wanted to retire at sixty-three after being a nurse for nearly forty years. She had a small pension but would have no medical benefits post retirement; she’d have to go out and buy them on her own.

Because Mary earned $80,000 a year and her home was paid off, she did not have to worry about budgeting from month to month. There was always enough money in her bank accounts to meet her expenses.

But when asked how much she would need to support her lifestyle on a monthly basis, Mary answered with a question of her own: “Maybe $4,000 or $5,000?”

Making the Unknown Known: The Importance of Hard Numbers

Mary was obviously taking a guess. An educated one, perhaps—but still a guess. Mary needed   some concrete numbers developed for a few reasons.

First, Mary was sure to feel more confident in retirement if she understood her basic expenses. With that knowledge in place, we could determine a range of discretionary income—for things like travel—and reinforce her ability to do such things in retirement.

That’s important. Some retirees become scared to spend any money for fear of not having enough. Others, meanwhile, think they can spend more freely than their assets allow. Figuring out Mary’s reality was the key to boosting her confidence.

Another reason for determining the monthly cost of Mary’s lifestyle was that it would be hard to determine if she had enough saved without first knowing how much she needed.

Finally, there’s something we call “practicing retirement.” Until Mary became honest with herself about whether her projected monthly lifestyle expenses were realistic, she’d be setting herself up for an uncertain outcome.

Knowing the reality, however, would allow her to begin living within her retirement budget before she retired. To put it another way, she could groom the spending habits that would help her realize the retirement she wanted.

We began by detailing the income Mary’s pension would provide. Next, we discussed the advantages of waiting to claim Social Security and then looked at how much she would have to withdraw from her retirement accounts.

Mary had $750,000 of retirement assets, plus $10,000 of pension income each year; it was clear she’d need to make up a sizable portion of income.

Next we factored in medical insurance premiums of $6,000 until she reached Medicare age at sixty-five. Mary realized that retiring at sixty-three would put significant pressure on her hard-earned retirement assets, creating a $50,000 income gap.

On the other hand, working until sixty-five would allow Mary to save more. Her 401(k) would continue to build, helping decrease the risk of running out of money should she live an extended life expectancy.

We worked with Mary to consider the risks of retiring at sixty-three by accurately projecting how her income flow would look. She saw the prudence in working until sixty-five, and we even discussed whether that was her ideal scenario—or whether working until she reached her full Social Security retirement age of sixty-six made more sense.

Just as it was for Mary, the income gap is the elephant in the room for almost everyone when it comes to retirement planning. It’s something we all suspect is there but hesitate to talk about, due mostly to fear.

Rather than meet that fear head-on like Mary did, many families procrastinate because they’re convinced that taking action won’t make any difference.

Evaluate your income gap early.

The thing is, it does make a difference! It’s not only possible but essential to figure out and deal with your unique income gap, and the sooner the better.

By taking action, you make the crucial first step toward securing the rewarding retirement you’ve pictured, instead of having a retirement that doesn’t live up to your vision.

So What Is the Income Gap?

When you retire, you draw the funds you’ll need for living expenses—your retirement income—from fixed sources: pensions, 401(k)-type plans, IRAs, part-time employment, Social Security, guaranteed annuities. (We cover the sources of retirement income fully in Retirement Savings Options.)

Income Gap

If these income sources don’t cover your expenses—plus inflation, taxes, medical care, and a variety of unknown liabilities—then you end up with a “gap” between the money you have and the money you’re going to need as you get further into retirement.

That, in a nutshell, is the income gap.

Many studies have shown that almost everyone will experience an income gap at some point. How you fill it is one of the most important decisions you’ll make along the way, and you can’t decide how to do that with random numbers. You need to be using real numbers: your numbers.

It's time to budget.

Which Brings Us to Budgeting

Ugh! We know. You might think it’s a painful thing to do. But, hey, maybe you’ve heard of people who actually enjoy budgeting. Then again, they’re probably accountants.

Whether you love it or hate it, budgeting is the foundation of financial planning. You simply can’t put together a solid retirement plan without a detailed budget. In fact, you need not one budget but two: one for today and one for your retirement.

Remember David McClelland? He’s the Harvard professor who found that the key difference between successful and less-than-successful entrepreneurs is having a plan and sticking to it.

If you think about your finances in the same way a business views profits, you want your career to have been profitable enough that you can fund your retirement goals. That means there are two basic financial statements you should focus on: balance sheets and income statements.

A balance sheet lists your current assets and liabilities. Income statements (also called “profit and loss” statements or “cash flow” statements in the business world) are a little different.

They show that you have x amount of money coming in and y amount of money going out. They tell you whether you’re in the black or in the red. That’s pretty much what a budget is all about, right?

Like any business’s numbers, your personal finances change over time. Successful businesses do forecasting and planning to adjust for both good and bad market conditions. Doesn’t it make sense to adopt the same practices for your own financial well-being?

We mentioned that you really need two budgets, one for today and one for retirement. We’re going to start with the easy one, the “now” budget.

In Budgeting for Retirement, we turn to projecting expenses in retirement. The combined information you’ll garner will provide your full financial picture, which is the key to identifying and bridging your retirement income gap.

That’s because putting together and following a detailed “now” budget will prepare you to “practice” for retirement, when careful stewardship of your newly-fixed income will be critical in making the retirement you envision a reality.

Budgeting now eases the transition to reitrement.

Practicing adherence to a budget now will help ensure that the transition to retirement is as smooth as possible.

We’ll draw up your retirement budget a bit later. For now, let’s focus on fully understanding your current income and expenses.

Examine your current budget.

Putting Together Your “Now” Budget

The goal of your “now” budget is to get as clear and complete an idea of all your current expenses as possible and of how you allocate your income to meet them.

Housing is a major expense.

The Big Six

You’re going to have some fixed costs and some that vary, just as any business does. For now—while you’re still working—your biggest expense by far is the roof over your head. If your house is not paid off or you’re paying rent, make that the first item of your personal budget. (And even if your home is paid off, remember, you may still have real estate taxes to pay.)

Another big necessity, of course, is food. What do you spend per week (or month, or however you want to capture it for your budget) on groceries? We recommend tracking your grocery store spending for a full month to get a solid number.

Don’t forget the shirt on your back. Clothing is a necessity many people overlook when doing a personal budget because it’s so easy to pull out a credit card. Paying it off, however, is the trick, especially if you haven’t set the money aside to do so.

After these basic necessities—housing, food, and clothing—comes utilities: electric, cable TV, Internet, water, trash collection, all the services that provide the creature comforts of life.

Car payments, vehicle maintenance, and other transportation costs are another major category.

What about insuring these assets, along with yourself and your family? Homeowners insurance, car insurance, life insurance, and health coverage, right?

Together, these comprise what we call the “big six” categories of living expenses:

  1. Housing
  2. Food
  3. Clothing
  4. Utilities
  5. Transportation
  6. Insurance

Miscellaneous But Important

We’re still not done. There are miscellaneous expenses—like lawn care—and “unexpected” ones we really should expect: things like car repairs and replacing a hot water heater or a roof.

To budget for such seasonal and maintenance-related expenses, it’s wise to set funds aside on a regular basis and let them build. It sure beats pulling out a credit card.

Regularly set aside funds for emergencies.

Don’t forget out-of-pocket medical costs. Assuming you’re relatively healthy and have health insurance through your employer, use last year’s total as a guide. Include things like co-pays, diagnostic tests that your plan may not cover, and fees for dental and eye care.

Medical expenses, especially for retirees, constitute a huge expense. We address their impact during retirement in Budgeting for Retirement, but be warned: an extended illness at any age can quickly drain your assets.

In this area perhaps more than any other, it makes tremendous sense to err on the side of caution by setting aside extra funds and thereby help protect your retirement savings.

Don't forget vacation expenditures when looking at your budget.

Variable and Discretionary Expenditures

The final area to factor into your budget is variable and discretionary expenditures: club memberships, dining out, entertainment (movies, sporting events, theater, museums, etc.), personal travel expenses (like vacations and family visits), donations to charities, and gifts to friends and relatives.

This category is likely to increase when you retire and have exponentially more time on your hands, especially early in retirement, when you are healthy.

Budgeting is all about anticipation. You know you’ll have certain expenses, but many are easy to overlook. Whatever you do, don’t try to capture them all from memory.

Sit down with your checking account records from the last year and add up your expenditures in each category. And don’t forget those maintenance items! You know they’re coming too. Saving for them now could save you long-term debt later.

Credit card statements are another good source of information about purchases you’re making; don’t overlook automatic payments that might be charged to a card or those that might be drawn from your savings account instead of your checking account.

Once you’ve identified all your expenses—ongoing and potential—put together a full breakdown of where and when your money is going.

Don't downplay expenses.

Finally and perhaps most important, don’t downplay or “lowball” your expenses. Instead, be conservative. Figure you’ll spend a bit more than you have in the past because, after all, when was the last time the cost of anything went down?

The knowledge you’ll gain from assembling and tracking all your expenses in one place will help you spend more wisely. That’s going to be very important as you close in on retirement.

There’s another plus. By writing out a budget and then comparing it to reality once or twice a month when you pay your bills, you may begin to silence that uncertain little voice that keeps saying, “You’ll never afford retirement.”

Following a budget builds confidence and uncovers places where you’re overspending or buying things you really don’t need—money that instead could be put toward filling your retirement income gap.

People procrastinate planning for retirement because they fear being unable to afford it, but without a budget, they really don’t know. With one, they quickly realize that being deliberate about saving a “penny” is the key to becoming “two pence clear.”

Prepare your budget.

Homework: Prepare Your Personal Budget

Nearly all of us will have to overcome an income gap in retirement. Creating a “now” budget is the first step in doing so. In Budgeting for Retirement, you’ll take the second step: identifying your expenses during retirement and learning how things like medical expenses, inflation, and personal debt contribute to your income gap.

Your homework for now is to get a detailed understanding of your current expenditures and how you meet them. This will lead to spending more wisely, allowing you to set more money aside for your future.

Will you miraculously discover a spare million dollars? Of course not. But even if it’s $40 a week, that’s over $2,000 a year. Along with your 401(k) at work, tax strategies, and other approaches, that can become a foundational part of your total retirement plan.

Sharpen your pencil enough, and you might find $60, $80, or $100 per week—or more. But you won’t know—you can’t know—without putting together a thorough, detailed personal spending plan.

Budget Worksheet

Using the descriptions in the last section and the worksheet above, identify every expenditure you make to create a budget that is easy to update as your expenses change. Treating your personal finances like a business will serve you well for the rest of your life and never better than in retirement—the potential expenses of which we discuss here.

In the part 4, we’ll address budgeting for your actual retirement.

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!

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