When it comes to retirement, one of the most common regrets expressed by the recently retired in surveys is not having saved enough. Another regret is spending too much too soon. Although it’s not surprising that some wish they were paid more and were able to save more, it also suggests that we need to pay close attention to budgeting and spending during retirement.
Retirement expenses are challenging to anticipate for a few reasons. Most retirees are going from accumulation of assets to distribution of assets for the first time, thereby putting themselves in charge of their income instead of relying on an employer. Another is that retirement costs don’t stay the same across the entire period of retirement. Additionally, purchasing power doesn’t stay the same due to inflation.
Even if you’re already retired, it might be helpful to create a budget to consider if you are on track.
Breaking down the cost and income needs side
Every retirement is unique and unexpected costs can arise just as in any other period of life. However, there are ways to estimate a ballpark number to help begin planning.
Everyday living costs usually go down in retirement with the elimination of work-related expenses, such as commuting and business clothing, reduction in taxes due to lower income, and no longer using a portion of income for retirement savings. This has led some to estimate that to maintain your standard of living, you may need to replace 70% to 80% of your income from pre-retirement years. Given that many people have been able to eliminate the expense of commuting and some other business expenses if they are working from home, replacement income in retirement might need to tend toward the more conservative 80% or even higher.
So, someone currently earning $80,000 a year would want to be able to maintain their standard of living by replacing that with $60,000 or more in retirement income, or money to spend each year.
What about Social Security – will that cover it?
Remember the “three legged stool” for retirement? It was so popular that the Social Security Administration (SSA) created a website page to explore its origins and usage in depth. Basically, the concept is that you need to create your retirement income utilizing three sources: Social Security, private pensions, and personal savings and investments.
That concept has become a little dated though, given that most people in the private sector no longer have pensions, so they now need to come up with two of those legs on their own. One leg could be considered your retirement savings accounts such as 401(k)s or 403(b)s, and the other your after-tax general savings. No matter how you visualize it, the important thing to realize is that Social Security is only supplemental, and likely will not be able to provide enough for all the replacement income.
One can check on how much they should expect to receive from Social Security by visiting the SSA website here. Signing in and creating a profile will give you a more accurate estimate than the quick calculator because it will account for all your earning years and work history so far. Reduced early retirement benefits are available at age 62, and deferring benefits beyond full retirement age increases benefits until age 70. So, if you need Social Security to cover the weight of more than one leg, or more than 30% of your retirement income, you may need to consider waiting until you are 70 to take the benefits.
What amount of assets are needed to cover the rest?
In the example of the $80,000 pre-retirement income above, let’s assume that the Social Security benefit will be around $25-$30K. This will also be indexed for inflation, so that won’t need to be considered. To reach the $60K replacement income, $30-$35K must be generated from the personal retirement portfolio or savings each year.
For those concerned about exhausting their portfolio before they pass, they might want to consider the 4% rule suggested by William Bengam in a 1994 article in the Journal of Financial Planning. He back-tested a portfolio of 50% stocks and 50% bonds to find out the following–If one withdrew a given percentage of a portfolio each year and increased that withdrawal only by the amount of inflation, what percentage could an individual safely withdraw and have their savings last 30 years? The answer at that time was 4%. However, Bengen’s work was recently revisited by Christine Benz, Jeffrey Ptak, and John Rekenthaler for Morningstar magazine (“New Mix for Retirement,” First Quarter 2022. P 29). They found through back-testing that given the historically low bond yields in the 2010s, a 3.3% withdrawal plus inflation adjustments would be the safe number for the rule for a 30-year retirement.
Note that when markets are doing well, the 3.3% withdrawal may be more than covered by the portfolio’s total return. On the other hand, in bear markets the portfolio losses are magnified when withdrawals are made.
The RMD angle
When the retirement resource is in a tax-deferred account, such as a traditional IRA, there is an important tax rule to take into account. Once the account owner reaches age 73, a program of Required Minimum Distributions (RMDs) must begin, geared to the owner’s lifetime. That means small taxable withdrawals in the early years, growing steadily as the owner ages.
For example, for a 73-year old unmarried IRA owner, or a married owner whose spouse is less than ten years younger or whose spouse isn’t the sole IRA beneficiary, the RMD will be 3.77% of the account value as of the close of the prior year. At age 80, it would be 4.95%, at age 90, 8.20%. For more information on RMDs specifically, please check out our recent article – Facing the Music – RMDs.
These mandatory cash distributions can be used to meet expenses of daily living. If they are larger than needed, the excess can be reinvested in an after-tax investment portfolio.
Additional considerations
For many people, costs are going to be higher in the early years of retirement, due to more travel and accomplishing bucket list adventures, and in the later years of retirement, due to increased healthcare costs. The middle decade or two of retirement usually involves lower costs as activity diminishes. Our budgets generally don’t stretch into decades, but it is okay to consider spending more in the first few years on travel when many people are more physically capable, as long as that spending isn’t in a recurring category.
There are two kinds of retirees, those who need to consume their portfolio to cover the cost of their retirement, and those who could live happily off just the interest and dividends received, or other income sources. The former will need to worry about how much they consume, and the latter will need to worry about Required Minimum Distributions, where they need to accept gradual taxation of their retirement accounts.
Both need to consider how best to manage their retirement portfolios, which accounts to take gains from, and how to maximize their happiness throughout their retirement journey. For the money managing part of that, an Arvest Wealth Management client advisor can help. Retirement planning is a specialty. They can go through the options with you to help remove some of the stress, so you can make informed decisions. Schedule a consultation with us–we’d be pleased to share more strategies and information.
This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.
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Arvest and its associates do not provide tax or legal advice. The information presented here is not intended as, and should not be considered, tax or legal advice. Consult your tax and legal advisors accordingly.