Most retirement literature, unfortunately, doesn’t start with the big picture. It often jumps right into asset allocations or sustainable withdrawal rates. So, let’s take a step back and build a basic model of retirement finance, starting with how much the bills will be and how we will pay them.
Funding retirement begins with the simple observation that after one retires, the bills keep coming but the paychecks stop.
We then need to find the “best” way to pay the bills, with “best” being defined from an individual household's perspective. The plan one household considers best might be completely unacceptable to a different, even quite similar household. Given two households with identical finances, for example, one might find a life annuity to be "the best" solution while the other might not trust insurance companies and refuse to even consider annuities.
Paying for the expenses of retirement is the basic problem, so let's start with the cost. Expenses are also sometimes referred to in a retirement planning context as spending or consumption. I'll use them synonymously here.
One way to estimate retirement expenses is to assume that we will maintain our pre-retirement standard of living after we retire. We can subtract FICA taxes and retirement savings amounts from our pre-retirement paychecks because those are two items we will certainly not need to pay after retirement. The result is an estimate of the amount of retirement income needed assuming no changes to our standard of living. But, it isn’t a very good estimate for two reasons. First, our spending will change as we age (it typically declines). Second, living expenses aren’t entirely predictable.
Some living expenses are fairly predictable but some are random. I can predict that I will have a grocery bill, a housing bill and a Netflix bill next month and I can predict the amounts fairly accurately.
When my son needed $500 a while back to repair his car's ignition switch, we didn't see that coming. When my daughter needed an emergency appendectomy, that wasn’t in the plan. Living expenses have both unpredictable and predictable components, which means that your total annual living expenses are unpredictable.
The predictable part is simply the minimum. I can be pretty sure that my living expenses will be $50,000 next year, but I might also have a large unpredictable expense or two next year. So, my total expenses next year will actually be somewhere between $50,000 and some amount that could be much larger but is unpredictable.
This “expense risk” is the fallacy in looking at retirement planning simply as an income problem, such as a sustainable withdrawal amount from a portfolio of volatile investments.
[Tweet this]Retiring for an unpredictable number of years with unpredictable expenses and somewhat-predictable income.
Let’s say a planner (or an online calculator) tells you that you can spend 4% of your savings each year and your savings will likely last at least 30 years. That 4% provides you with a nice standard of living when added to your Social Security benefits until one day someone in your family becomes quite ill and you have $100,000 of uninsured medical bills or your adult child becomes unemployed and moves back home. Your retirement plan – and perhaps your retirement – is destroyed.
What went wrong? Your planner (or that online calculator) promised that you could spend 4% of your portfolio balance annually and your savings probably wouldn’t be depleted for at least 30 years. He (it) didn’t say what would happen if you should need to spend more than the 4% you planned. You thought 4% spending was safe, but how can you know that your retirement finances are “safe” without knowing how much you might have to spend? The income side of the equation alone doesn't show all the risk.
How long you will live in retirement is more critical than spending. If your desired standard of living costs $60,000 a year, you retire at 65 and die at 66, your entire retirement will cost about $60,000. If you live to 100, retirement will cost about $2.1M. (Those totals don’t include the aforementioned unpredictable expenses and the longer you live, the more likely you are to be hit with them.) A healthy person can't predict how long he or she will live and that means the total cost of retirement is highly unpredictable even without large, unexpected costs.
Life expectancy and spending are the two largest determinants of retirement cost and, as I have pointed out, both are unpredictable. So, when someone asks how much money they will need to retire or how much retirement will cost, the correct answer is, “We can't say with any certainty, at all. We can tell you what typically happens, but your retirement may not be typical.” That rules out waiting until you're certain you can afford it to retire. Certainty is absurd.
This doesn't imply that because retirement is largely unpredictable retirement planning has no value. We can't say with certainty that it won't rain June 2nd of next year but we can plan an outdoor wedding that has a better chance of success than simply hoping for nice weather.
Where will we find the income to pay our bills after we retire? It typically comes from Social Security benefits, pensions, part-time employment, and personal savings invested in income-producing assets like stocks, bonds, and real estate.
Income is more predictable than expenses or it can be if retirement is funded appropriately. Spending from pensions, life annuities, TIPS bond ladders and Social Security benefits is pretty predictable. Investments are less predictable, but the most you can lose from your investment portfolio is its total balance. Unexpected expenses can cost much more than your savings.
Imagine, for example, that you have saved $100,000 and have it invested in stocks and bonds. The most you can possibly lose in the market is $100,000 and it is extremely unlikely that you will lose all of it. On the other hand, it’s easy to imagine a medical bill exceeding $100,000.
This large amount of risk inherent in retirement finance is an unavoidable reality. Even if you fund retirement entirely with Social Security benefits and life annuities, making your expected income more predictable, retirement will still be very uncertain because some expenses are highly unpredictable. If you are very wealthy relative to your spending, of course, this matters much less.
Here, then is the first part of a retirement finance model:
The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses.Note that the primary goal is to maintain a desired standard of living throughout retirement and not to maximize wealth, income or an inheritance. Once the standard of living goal is achieved– itself alone a massive challenge for most households – any uncommitted resources can be applied to the other goals.
Standard of living, by the way, is also a moving target. We naturally become less active and spend less as we age. As David Blanchett showed, however, spending typically declines as retirees age when they spend appropriately for their savings level. Retirees who under-save tend to spend less over time and retirees who over-save tend to spend more as they age. The latter two tend to "correct" spending as they recognize that they are depleting savings too quickly or have more money to spend.
This is the beginning of the “big picture” and one of the reasons questions like “how much money do I need to retire” and “when can I retire?” are so difficult to answer and why retirement planning is so challenging. It also points out that most retirement planning focuses too narrowly on investment results.
Lastly, it points out just how risky retirement is. As financial planner, Larry Frank, frequently reminds me, “everything is stochastic.” By stochastic he means random or unpredictable. And, by everything he means the market, interest rates, inflation, expenses, taxes, Social Security benefits, how long we will live and most other significant factors of retirement financial success.
But, unpredictable life spans, income, and expenses aren’t the entire “big picture” of the retirement finance model. I'll expand the model in future posts, starting with Adding Risk to the Model, Part 2.