Did You Know Your Pension Isn’t Guaranteed?
Sometimes when I talk to people about financial planning, their response is ‘Oh I have...
We want to be transparent about how we are compensated. Some links in articles are from our sponsors. Learn more about how we make money.
With a nod to Ben Le Fort for mentioning in an article this Wall Street Journal (WSJ) tool for estimating retirement costs, here is why I think you should absolutely use the tool, but also how to fix it so the results it gives you have a chance of working out.
There’s an old joke that says, “This is not your real life. This is just a practice life. If this was your real life, it would come with an instruction manual!”
Well, unfortunately, life doesn’t come with practice runs or instruction manuals. We just have to do our best, and winging it isn’t a good plan for getting from here to where you want to be.
One of the largest financial concerns for almost all Americans is (or at least should be) developing a realistic retirement plan, and then making it happen. The grim news is that very few of us have significant savings, even for those approaching their nominal retirement date.
As grim as that is, it’s not surprising given how few even bother to try to figure out how much they need to set aside for this goal, mostly because it’s decades away (until it’s too late to do much good), and we’re not very good at figuring out what we’ll need to spend next year, let alone 20, 30, or 40 years from now.
Personally, I’ve been working on our retirement plan for about 20 years, continuing to tweak and refine it as I read more about financial planning, learn more, and see how our family finances evolve over time.
As Le Fort says in his article, the folks at the WSJ figured out that answering the question, “How much do you think you’ll need/want to spend in retirement?” with any degree of realism is beyond most of us.
Realizing that, they broke it down to more specific and easily answered questions, like “How many times a week will you want to eat out in retirement?” “How many times a month will you want to get a massage” “How many times a year will you want to go on a cruise?” etc. They also plugged in typical costs for those and many other spending items, all in an easy-to-use Excel spreadsheet.
All you need to do is put in the number of times per week, month, or year you will want to do these and many other things in retirement, and the spreadsheet will tell you how much you’ll spend per year. It also calculates how much you’ll need to save to fund that level of spending for any given number of years in retirement.
First, and most obvious, the tool uses average costs for each item. Those may or may not fit your individual situation. Are you super-frugal, only eating out during happy hour at low-cost local eateries in a rural area? If so, the default sum of $100 per restaurant visit is way too much.
Are you a foody planning to retire in Manhattan who loves going to trendy celebrity-chef restaurants? In that case, $100 per visit is unlikely to be enough by a long stretch.
The fix here is simple. If you have a good idea of what you spend on average per visit to a restaurant, go to the relevant cell in the spreadsheet and modify the “amount per item” for “Restaurants.” Similarly, review the amounts per item for all other items, and tweak those you have reason to believe are much too high or low your individual situation.
Next problem is that the tool simply assumes a default of 20 years in retirement. This is not far from the 18-year average according to government data, but as explained in this Forbes article, the length of your retirement is highly dependent on your age at retirement, and your longevity. Your longevity is in turn dependent on your genetics (does your family tend to live to relatively old age, or not so much?); lifestyle choices (e.g., do you smoke, eat more red meat than veggies, and never exercise; or the opposite?); and luck (think accidents).
Forbes says that, on average, those who retire at age 65 have a better than 3 chances in 4 of living 10 years or longer in retirement, 38% chance of making it past 20 years in retirement, and one chance in 20 of living through 30 years in retirement. On the other hand, those who delay their retirement to age 75 have slightly less than 50% chance of living 10 or more years in retirement, one chance in 14 for a 20-year retirement, and about one chance in 1000 of lasting 30 years.
If you plan to retire late in life, suffer from health issues, and have nobody to leave a bequest to, assuming a 20-year retirement may push you to shortchange yourself now as you attempt to amass much more money in your nest egg than you need.
On the other hand, if you plan to retire early, are in good health, have a genetic predisposition for longevity, and want to leave money for your kids or a favorite charity, you may run out of money if you plan for a 20-year retirement.
Thus, depending on your health, gender, how long your family tends to live, what age you plan to retire, and whether you want to have a shot at leaving a bequest, you may want to change the default 20 years to something else, either higher or lower.
The tool assumes that inflation will average 0% between now and when you retire. To fix this, you’ll need a bit of math (but thankfully no advanced calculus ????).
Over the past century or so, inflation varied between negative numbers (i.e., prices dropping over time) to over 10% increase per year. However, on average it’s been ~3% per year. To correct the tool’s predictions for inflation, multiply the cost per year provided by the tool by 1.03 to the power of N, where N is the number of years between now and when you expect to retire (in Excel, if you assume 25 years until retirement for example, it looks like this: “=1.03^25”).
If you only want to know the predicted amounts in today’s dollars, you can skip this correction. However, be aware that over time, you will need to correct the costs per item to keep up with how prices evolve.
As mentioned above, the tool doesn’t correct for how prices will increase between now and when you call it a career. Further, it also ignores prices continuing to rise through the years and decades of your retirement. It also doesn’t account for the fact that your nest egg should be invested and providing returns that beat inflation.
The best fix for this problem is to use a much fancier retirement calculator. However, there is a simple fix you can apply within the WSJ tool, that should give you a conservative estimate good enough until you approach retirement.
This fix is based on research that showed that historically, through good markets and bad, withdrawing 4% of your nest egg each year (adjusting for inflation) was a successful strategy, where success was defined as not running out of money before your death.
To apply this so-called “4% rule,” go to cell P1 in the tool, and change the default calculation there (“=K1*P1”) to “=K1/0.04” which then also obviates the need for getting the number of years in retirement right, since that number is no longer used to calculate anything.
The last issue I take with the WSJ tool is that it doesn’t account for taxes. This is not surprising, because your tax rate depends on where you will live in retirement; how you will earn your money while retired (e.g., Social Security benefits, bond coupons, stock dividends, stock appreciation, rental income, etc.); what fraction of your nest egg is in Roth IRAs and/or Roth 401(k) plans; and how federal, state, and local tax laws will change between now and your appointment with God.
Danish physicist Nils Bohr, who won the 1922 Nobel Prize in physics, is quoted as having whimsically paraphrased an old Danish proverb, saying that “it’s very difficult to make accurate predictions, especially about the future.” If even a physics Nobel laureate shies away from making predictions, who are we to go there?
Instead, just add between 25% and 33% to the amount estimated by the tool as what you need to save up. While it’s unlikely that your taxes will be exactly offset by this correction, it should be conservative enough for early planning.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.