Asking this question is a little bit like asking, “How much gain does an amplifier need?” or, “How much gas does it take to get to Tucson?” Without defining many other details, the questions can’t be discussed intelligently. But if enough other information is specified, you can come up with a reasonable estimate.
For retirement, people can use historical simulations or monte carlo simulations and examine how various investment portfolios (stock/bond allocations) would have performed over time. Such simulations include spending habits and inflation and can look at history and performance distributions in the US since 1871. (If you try to go back further than 1871, it’s hard to find useful and complete data.)
The short answer to the retirement question is that you will need investments (or present net worth of your investments if you have pensions, etc.) equal to about 25 times your current annual spending in order to survive the worst 30 year period in retirement history in the US. If you retired at the worst time in US history but withdrew only 1/25th of your investment portfolio that first year, then increased that withdrawal each year by the annual inflation rate, you would have been able to survive for 30 years without ever decreasing your lifestyle. There are a lot of assumptions about stock/bond allocations, rebalancing your investments, the future being no worse than the worst case past, etc. in that answer. But the answer gives a good first guess at your retirement needs. Notice that (1/25) is 4%. This general rule of thumb is sometimes referred to as the 4% Safe Withdrawal Rate (SWR) or the 4% rule.
If you are interested in running historical or Monte Carlo simulations to analyze your own situation, go to: http://www.golio.net/Chapter2.html
Visit my site: http://www.golio.net/
Saturday, May 3, 2008
Sunday, April 13, 2008
Fees and 401(k) or 457(b) Accounts
Common advice offered to investors is that they should contribute to available tax-deferred plans (like 401ks and 457bs) before investing in after tax accounts. In most cases, this is good advice. It is especially advantageous when company matching contributions are available. If your employer is providing matching funds to your tax deferred accounts, then when you fail to contribute, it is like voluntarily giving up salary. Make sure you get all the matching funds you can get or you are effectively taking a cut in wages.
Even if matching funds are not involved, tax-deferred plans are often better investments than contributions to an after tax account. Consider the following cases:
CASE #1 (After tax contributions):
Contribute $3000 per year to an after tax account for 30 years.
Then withdraw $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns 7% per year return with an expense ratio of 0.2% (typical of low-cost index funds)
Assume the pre-retirement tax rate is 28% and the post-retirement tax rate is 18%.
Withdrawals are tax free (since youve already paid tax on the money when you invested).
CASE #2 (Tax deferred account):
As in case 1, contribute $3000 per year to a tax-deferred account for 30 years.
Then, identical to case 1, withdraw the $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns at a rate identical to case 1 -- 7% per year return with an identical expense ratio of 0.2% (typical of index funds)
Assume the pre-retirement tax rate is 0% and the post-retirement tax rate is 0% (Consistent with 401(k) and 457(b) regulations).
Withdrawals are taxed at 18%.
CASE #1 describes typical numbers for a taxable index fund account while CASE #2 describes numbers that might apply for a 401(k) or 457(b). Of course every individuals experience and tax situation is different.
At the end of 30 years, the tax-deferred account of CASE #2 would be worth ~$295,000 while the after tax account of CASE #1 would be worth ~$208,000. Tax deferred treatment is worth ~$87,000.
Once the withdrawal phase is started (years 31 to 60), the taxable account has an advantage since withdrawals do not count as income and so are not taxed. Despite this advantage, at the end of year 60, the tax-deferred account is valued at ~$1.8M while the taxable account is valued at only ~$1.2M a $600,000 advantage to tax-deferred accounts.
But what happens if the 401k account is burdened with high fees? Using identical assumptions for the two cases except assuming the CASE #2 tax-deferred account expense ratio is 1% rather than 0.2% results in the complete annihilation of the tax-deferred advantage. With a 1% expense ratio, the tax-deferred account grows only to ~$256,000 in 30 years (an advantage over after tax saving of only $48,000). But even that slight advantage is lost entirely during the withdrawal phase. For higher expense ratios, a tax-deferred account is actually a bad investment when compared to the low-fee, equivalent returning fund in a taxable account.
Fund expense ratios as high as 1%, or even 4% to 5%, are not unusual. With only a 2.1% expense ratio on the tax-deferred mutual fund, all advantage is lost even in the 30 years of the contribution phase. During the withdrawal phase, this tax-deferred account would lose over $500,000 compared to after tax saving of CASE #1. It pays for investors to keep their eye on expenses. If your employer isnt offering matching funds and offers no low-fee mutual funds in their plan, you might be better off investing your money in a taxable account.
Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html
Visit my site: http://www.golio.net/
Even if matching funds are not involved, tax-deferred plans are often better investments than contributions to an after tax account. Consider the following cases:
CASE #1 (After tax contributions):
Contribute $3000 per year to an after tax account for 30 years.
Then withdraw $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns 7% per year return with an expense ratio of 0.2% (typical of low-cost index funds)
Assume the pre-retirement tax rate is 28% and the post-retirement tax rate is 18%.
Withdrawals are tax free (since youve already paid tax on the money when you invested).
CASE #2 (Tax deferred account):
As in case 1, contribute $3000 per year to a tax-deferred account for 30 years.
Then, identical to case 1, withdraw the $3000 per year from the account for 30 years.
(net contribution after 60 years =$0)
Assume the account earns at a rate identical to case 1 -- 7% per year return with an identical expense ratio of 0.2% (typical of index funds)
Assume the pre-retirement tax rate is 0% and the post-retirement tax rate is 0% (Consistent with 401(k) and 457(b) regulations).
Withdrawals are taxed at 18%.
CASE #1 describes typical numbers for a taxable index fund account while CASE #2 describes numbers that might apply for a 401(k) or 457(b). Of course every individuals experience and tax situation is different.
At the end of 30 years, the tax-deferred account of CASE #2 would be worth ~$295,000 while the after tax account of CASE #1 would be worth ~$208,000. Tax deferred treatment is worth ~$87,000.
Once the withdrawal phase is started (years 31 to 60), the taxable account has an advantage since withdrawals do not count as income and so are not taxed. Despite this advantage, at the end of year 60, the tax-deferred account is valued at ~$1.8M while the taxable account is valued at only ~$1.2M a $600,000 advantage to tax-deferred accounts.
But what happens if the 401k account is burdened with high fees? Using identical assumptions for the two cases except assuming the CASE #2 tax-deferred account expense ratio is 1% rather than 0.2% results in the complete annihilation of the tax-deferred advantage. With a 1% expense ratio, the tax-deferred account grows only to ~$256,000 in 30 years (an advantage over after tax saving of only $48,000). But even that slight advantage is lost entirely during the withdrawal phase. For higher expense ratios, a tax-deferred account is actually a bad investment when compared to the low-fee, equivalent returning fund in a taxable account.
Fund expense ratios as high as 1%, or even 4% to 5%, are not unusual. With only a 2.1% expense ratio on the tax-deferred mutual fund, all advantage is lost even in the 30 years of the contribution phase. During the withdrawal phase, this tax-deferred account would lose over $500,000 compared to after tax saving of CASE #1. It pays for investors to keep their eye on expenses. If your employer isnt offering matching funds and offers no low-fee mutual funds in their plan, you might be better off investing your money in a taxable account.
Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html
Visit my site: http://www.golio.net/
Saturday, February 9, 2008
Tax Efficient Withdrawal Strategy in Retirement
You may not currently have a retirement withdrawal strategy, and if you are still in the accumulation phase of your career, you might not need to put too much advanced thought into that strategy. When the time comes to enter the withdrawal phase of your financial life, however, it makes a difference what order you withdraw your funds. The primary issue for most retirees is to keep an eye on taxes. Taxes can potentially be the largest controllable expense a retiree faces. Withdrawing assets tax-efficiently as you manage your retirement is one simple way to save money over the long run.
Basic withdrawal advice is fairly straight forward:
- Educate yourself on your options and legal requirements. You should know, for example, what the minimum age for withdrawal without penalty is. You should also know that if you hold onto your tax-deferred accounts for long enough, the government will require you to take withdrawals. You cannot withdraw money from most tax deferred plans (like 401(k)s, 403(b)s, IRAs, etc) prior to age 59-1/2 without incurring significant penalties. If you are planning early retirement, you need to identify what source of funds you will use prior to that age. There are exceptions for certain kinds of withdrawals, and there is a tax loophole known as 72t withdrawals that get around the penalties – but the laws are very restrictive and specific about how to do this. If you hang onto your tax-deferred account for too long, the law forces you to withdraw a required minimum distribution (RMD) and suffer the tax implications of that withdrawal. RMDs are applicable at age 70–1/2.
- Your goal should be maximum growth. This involves different things depending on your personal situation but in general you want to draw down according to this priority list:
Before Age 70½
1. Taxable assets.
2. Tax-deferred assets (such as those in traditional IRAs and employer-sponsored retirement plans).
3. Assets in tax-free Roth IRAs.
After Age 70½
1. RMDs from qualified retirement accounts.
2. Taxable assets.
3. Tax-deferred assets.
4. Assets in tax-free Roth IRAs.
- Take other tax considerations into account. You might benefit from selling assets that have lost money from your taxable accounts – taking the tax deduction for the loss. Your decisions should not be based on simple minded tax minimization. Instead you should focus first on achieving sustainable growth. It is important to manage risk by rebalancing your portfolio if it becomes too heavily invested in a particular asset or asset class.
Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html
Visit my site: http://www.golio.net/
Basic withdrawal advice is fairly straight forward:
- Educate yourself on your options and legal requirements. You should know, for example, what the minimum age for withdrawal without penalty is. You should also know that if you hold onto your tax-deferred accounts for long enough, the government will require you to take withdrawals. You cannot withdraw money from most tax deferred plans (like 401(k)s, 403(b)s, IRAs, etc) prior to age 59-1/2 without incurring significant penalties. If you are planning early retirement, you need to identify what source of funds you will use prior to that age. There are exceptions for certain kinds of withdrawals, and there is a tax loophole known as 72t withdrawals that get around the penalties – but the laws are very restrictive and specific about how to do this. If you hang onto your tax-deferred account for too long, the law forces you to withdraw a required minimum distribution (RMD) and suffer the tax implications of that withdrawal. RMDs are applicable at age 70–1/2.
- Your goal should be maximum growth. This involves different things depending on your personal situation but in general you want to draw down according to this priority list:
Before Age 70½
1. Taxable assets.
2. Tax-deferred assets (such as those in traditional IRAs and employer-sponsored retirement plans).
3. Assets in tax-free Roth IRAs.
After Age 70½
1. RMDs from qualified retirement accounts.
2. Taxable assets.
3. Tax-deferred assets.
4. Assets in tax-free Roth IRAs.
- Take other tax considerations into account. You might benefit from selling assets that have lost money from your taxable accounts – taking the tax deduction for the loss. Your decisions should not be based on simple minded tax minimization. Instead you should focus first on achieving sustainable growth. It is important to manage risk by rebalancing your portfolio if it becomes too heavily invested in a particular asset or asset class.
Tax efficient withdrawal tools: Use the ORP Distribution Planner link in Section 8.3 at http://www.golio.net/Chapter8.html
Visit my site: http://www.golio.net/
Sunday, January 27, 2008
How long will I need to fund retirement?
One of the first issues a retirement planner has to deal with is answering the question, "How long will I need to fund my retirement?"
Of course the answer to this question is, "As long as you live." And how long will you live? Although most of us don't know the answer to that question, insurance companies are very aware of the distribution of longevity of the overall population. We can use that information to help define the probabilities that we live for X years longer.
If you have no significant others, heirs, or dependents, you can estimate the length of time you need to fund retirement using uniform lifetime tables like those available in Chapter 1 Section 3 (Annuities):
http://www.golio.net/Chapter1.html
Some longevity calculators use perturbation analysis to estimate how personal habits and diet impact longevity. There are several links to various types of longevity calculators under Section 1.3 at the url:
http://www.golio.net/Chapter1.html
Knowing how much longer the average person your age will live is better knowledge than nothing, but there are still important problems that knowledge does not address.
1) You don't care about the average person, you care about you. Although the average 50 year old will live another 33.7 years, ten percent of them will live another 47.3 years. If you planned to retire at age 50 and fund only 33.7 years, you could get really hungry and uncomfortable during the next 10 or 20 years. Being one of the fortunate people who live long lives could seem like something other than a blessing if you didn’t plan for it.
2) If you want to plan for your spouse or other dependents, you are more concerned with joint life expectancy. On average, a 50 year old will live for 33.7 years, but if there are two 50 year olds, on average at least one of them will live another 40.4 years. If you plan your and your spouse's retirement based on uniform lifetime expectancies, make sure you die first. The last 6 or 7 years could get uncomfortable for the survivor.
The best link I have found to look at joint life expectancy is the Vanguard Joint Life Expectancy Calculator. You can find a link to it under Section 1.3 of the url:
http://www.golio.net/Chapter3.html
This calculator gives you probabilities that two people of same or different ages live X years longer. For retirement planning purposes, this is pretty useful.
You can get the official government joint and last survivor tables from a few places online. These tables are necessarily very long. You have to scroll through a lot of pages to find the one that has both you and your joint survivor’s ages in a top row and 1st column. Also, this tells you the 50% probability only. As mentioned, for retirement planning, you might want to plan for better than the 50 percentile problem.
IRS publication 590 includes a joint and last survivor table in Appendix C, Table II. For the IRS form, this table is not used unless spouses are separated by more than 10 years of age, but the data you are interested in is available in the table. The same government table that covers joint life expectations for ages 0 to 115 can also be found in the document available in Chapter 1 Section 1 (Publication 590 IRAs):
http://www.golio.net/Chapter1.html
The joint life tables start on page 104 of that document and continue to the top of page 126. To use any of these tables you need to find your age along the top row and your joint survivor’s age along column 1. The number in the intersection is the life expectancy from the present (ie. one of you is likely to live that many more years).
Use of the longevity tables described above helps provide guidance regarding the length of time your retirement plan should target.
Visit my site: http://www.golio.net/
Of course the answer to this question is, "As long as you live." And how long will you live? Although most of us don't know the answer to that question, insurance companies are very aware of the distribution of longevity of the overall population. We can use that information to help define the probabilities that we live for X years longer.
If you have no significant others, heirs, or dependents, you can estimate the length of time you need to fund retirement using uniform lifetime tables like those available in Chapter 1 Section 3 (Annuities):
http://www.golio.net/Chapter1.html
Some longevity calculators use perturbation analysis to estimate how personal habits and diet impact longevity. There are several links to various types of longevity calculators under Section 1.3 at the url:
http://www.golio.net/Chapter1.html
Knowing how much longer the average person your age will live is better knowledge than nothing, but there are still important problems that knowledge does not address.
1) You don't care about the average person, you care about you. Although the average 50 year old will live another 33.7 years, ten percent of them will live another 47.3 years. If you planned to retire at age 50 and fund only 33.7 years, you could get really hungry and uncomfortable during the next 10 or 20 years. Being one of the fortunate people who live long lives could seem like something other than a blessing if you didn’t plan for it.
2) If you want to plan for your spouse or other dependents, you are more concerned with joint life expectancy. On average, a 50 year old will live for 33.7 years, but if there are two 50 year olds, on average at least one of them will live another 40.4 years. If you plan your and your spouse's retirement based on uniform lifetime expectancies, make sure you die first. The last 6 or 7 years could get uncomfortable for the survivor.
The best link I have found to look at joint life expectancy is the Vanguard Joint Life Expectancy Calculator. You can find a link to it under Section 1.3 of the url:
http://www.golio.net/Chapter3.html
This calculator gives you probabilities that two people of same or different ages live X years longer. For retirement planning purposes, this is pretty useful.
You can get the official government joint and last survivor tables from a few places online. These tables are necessarily very long. You have to scroll through a lot of pages to find the one that has both you and your joint survivor’s ages in a top row and 1st column. Also, this tells you the 50% probability only. As mentioned, for retirement planning, you might want to plan for better than the 50 percentile problem.
IRS publication 590 includes a joint and last survivor table in Appendix C, Table II. For the IRS form, this table is not used unless spouses are separated by more than 10 years of age, but the data you are interested in is available in the table. The same government table that covers joint life expectations for ages 0 to 115 can also be found in the document available in Chapter 1 Section 1 (Publication 590 IRAs):
http://www.golio.net/Chapter1.html
The joint life tables start on page 104 of that document and continue to the top of page 126. To use any of these tables you need to find your age along the top row and your joint survivor’s age along column 1. The number in the intersection is the life expectancy from the present (ie. one of you is likely to live that many more years).
Use of the longevity tables described above helps provide guidance regarding the length of time your retirement plan should target.
Visit my site: http://www.golio.net/
Friday, January 18, 2008
Family Equivalence Scale
The US Bureau of Labor Statistics (BLS) has developed an estimate of how family size and type affects budget. You can use their estimates to evaluate cost of living changes along a typical family life cycle. All estimates are normalized to the costs for a family of four (two adults and two children). All other budget entries represent the normalized funding required for the specified family to maintain an equivalent lifestyle to the base family.
Family Type--BLS Normalized Family Budget
Single Adult--0.360
Two Adults--0.600
Two Adults, One Child--0.820
Two Adults, Two Children--1.000
Two Adults, Three Children--1.116
One Adult, One Child--0.570
For a single young person prior to marriage the cost of living is 36% that of a normalized family of four. The cost of living for a married couple increases to 60% of the normalization base. When one child is added, the family budget is at 82% of the base. A second child puts the family at base budget level. A third child places the couple at 111.6% the cost of a family of four. For cases not shown in the table, the equivalence family budget can be roughly approximated using the expression:
E = [(A + pK)^F]/2.751
where A is the number of adults in the family, K is the number of children, p=0.92 and F=0.75.
The USBLS equivalence scale indicates how difficult it is for a family to grow, maintain a lifestyle threshold, and continue to save for future retirement. If you hope to maintain a constant lifestyle, your family of three (two adults and one child) requires a 36.7% higher budget than a married couple with no children. If you (and your working spouse if he/she works) earn a salary increase of 5% over inflation per year, your income does not reach a level to support a first child until you’ve worked for more than 7 years. To achieve an income that would support a second child at the same standard of living would take an additional 4 years on the job.
A single engineer who wants to marry, or a couple that desires children have other options. You can choose to lower your lifestyle and carry on with family plans. You can choose to invest less money toward retirement, maintain your standard of living with family additions, and work more years before retirement. You can do a combination of both. When going from single to married, a couple consisting of two wage earners might easily exceed the required 66.7% income increase implied by the table simply by combining salaries. Although two cannot live as cheaply as one, two wage earners can live a more comfortable lifestyle or can save more toward their long-term goals.
Visit my site: http://www.golio.net/
Family Type--BLS Normalized Family Budget
Single Adult--0.360
Two Adults--0.600
Two Adults, One Child--0.820
Two Adults, Two Children--1.000
Two Adults, Three Children--1.116
One Adult, One Child--0.570
For a single young person prior to marriage the cost of living is 36% that of a normalized family of four. The cost of living for a married couple increases to 60% of the normalization base. When one child is added, the family budget is at 82% of the base. A second child puts the family at base budget level. A third child places the couple at 111.6% the cost of a family of four. For cases not shown in the table, the equivalence family budget can be roughly approximated using the expression:
E = [(A + pK)^F]/2.751
where A is the number of adults in the family, K is the number of children, p=0.92 and F=0.75.
The USBLS equivalence scale indicates how difficult it is for a family to grow, maintain a lifestyle threshold, and continue to save for future retirement. If you hope to maintain a constant lifestyle, your family of three (two adults and one child) requires a 36.7% higher budget than a married couple with no children. If you (and your working spouse if he/she works) earn a salary increase of 5% over inflation per year, your income does not reach a level to support a first child until you’ve worked for more than 7 years. To achieve an income that would support a second child at the same standard of living would take an additional 4 years on the job.
A single engineer who wants to marry, or a couple that desires children have other options. You can choose to lower your lifestyle and carry on with family plans. You can choose to invest less money toward retirement, maintain your standard of living with family additions, and work more years before retirement. You can do a combination of both. When going from single to married, a couple consisting of two wage earners might easily exceed the required 66.7% income increase implied by the table simply by combining salaries. Although two cannot live as cheaply as one, two wage earners can live a more comfortable lifestyle or can save more toward their long-term goals.
Visit my site: http://www.golio.net/
Monday, January 7, 2008
Planning a Retirement Budget
Once I learned a minimal amount about investments, risk and inflation, I came to believe that the biggest unknown facing the retirement planner (at least this retirement planner) was trying to predict the budget they would need in order to support a satisfying retirement.
The first step in getting a better grip on this is to understand how much you are spending today and on what. A lot of affluent technical professionals make enough money that they don't track expenses very well if at all. That’s the reward for all that hard work studying math and science in college. You don’t have to budget. But the absence of an accurate expense record makes this problem even tougher. If you know how much you spend today on each aspect of your life, you can go down the list and estimate whether you are going to spend more or less on that item in retirement. Finally, you can estimate how much more or less you expect to spend.
Here's a starting list for expense tracking from the US Bureau of Labor Statistics:
- FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
- HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
- APPAREL (men's shirts and sweaters, women's dresses, jewelry)
- TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
- MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
- RECREATION (televisions, pets and pet products, sports equipment, admissions);
- EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
- OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses.
One advantage of using a list that conforms to the USBL list is that you can monitor inflation rates by spending category more easily. This allows you to estimate your own personal rate of inflation relative to the published CPI-U. Many people feel that the inflation rate they experience is very different than CPI-U because their purchases do not conform to the category mix used by the Bureau.
If you have a thorough understanding of what each category and sub-category costs you today, you can start to make a pretty good estimate of how much you might spend in retirement. Go through the categories one at a time.
The FOOD AND BEVERAGE category may not change much in retirement if you think your eating habits will remain the same. On the other hand, if you dine out a lot today because you’re too busy to prepare food and do dishes, you might reduce this category by quite a bit in retirement. Or maybe you want to spend more time dining at gourmet restaurants and expect this expense to rise.
HOUSING, utilities and home insurance may not change much unless you are planning on moving from your current conspicuous McMansion to a smaller retirement home. If so, make sure you capture that savings in your estimates.
APPAREL expenses may decrease a little since you won’t have to dress for the office.
TRANSPORTATION costs are likely to change significantly – either reduced because you can eliminate an expensive commute, or increase because you plan on traveling extensively when you retire.
MEDICAL CARE is a very important category to consider. If you are retiring with a paid medical insurance benefit from your ex-employer, consider yourself extremely lucky. That will help keep this cost manageable. If not, plan on an insurance expense that will rise more than the inflation rate every year. This is a tough cost to gauge with our current medical situation in the U.S.
A RECREATION budget is clearly very important to most retirees and possibly the most difficult to anticipate. Prior to retirement I knew exactly what I was spending on recreation, but that did not help me much when it came to planning that budget for retirement. While working, I only had weekends and vacations to spend any serious time on recreation. How much more time would I need to devote to this category to create a satisfying retirement? While working, I often spent money on recreation/travel services in order to save my precious, but limited vacation time. In retirement, I can choose to do many things more slowly (and less expensively).
Because I planned on traveling a lot, I broke out VACATION & TRAVEL as a separate item. I looked at several different kinds of trips I make: 1)day-long field trips, 2)camping trips, 3)road trips (travel to sites and stay in low-cost accommodations) and 4)city visits (air travel, city hotel rates, rental cars, etc). Then made an estimate of how often I thought I would want to make each type of trip, and budgeted accordingly. I then split the vacation & travel sub-budget into appropriate categories: mostly TRANSPORTATION or RECREATION.
You can continue through the remainder of the items in a similar fashion. For each category that you think might change significantly, you need to estimate the expected change. If you have the figures on your current spending by category, that’s not too difficult. When I was in doubt, I would simply guess that a 10% perturbation on the current cost was a good guess. Being an engineer, I over estimated my cost increases and underestimated my cost savings by a little. On the other hand, so far I’ve traveled a lot more than I thought I would in retirement.
Some people recommend using some simple rule-of-thumb guessing for your budget. For example, you might read that you will spend 80% as much in retirement as prior to retirement, or that you should plan to need 70% of your pre-retirement take-home pay to live off in retirement. I don't think it is wise to approach the problem this way. Those rules certainly didn't work for me – not even close.
For those who have not yet developed a detailed accounting of where their current spending is going, you may want to check out the url: http://www.golio.net/Chapter3.html
Scroll down to Section 3.3 and click on “download all excel spreadsheets”. There are also several other budget tools available through that page.
Return home: http://www.golio.net/
The first step in getting a better grip on this is to understand how much you are spending today and on what. A lot of affluent technical professionals make enough money that they don't track expenses very well if at all. That’s the reward for all that hard work studying math and science in college. You don’t have to budget. But the absence of an accurate expense record makes this problem even tougher. If you know how much you spend today on each aspect of your life, you can go down the list and estimate whether you are going to spend more or less on that item in retirement. Finally, you can estimate how much more or less you expect to spend.
Here's a starting list for expense tracking from the US Bureau of Labor Statistics:
- FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
- HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
- APPAREL (men's shirts and sweaters, women's dresses, jewelry)
- TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
- MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
- RECREATION (televisions, pets and pet products, sports equipment, admissions);
- EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
- OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses.
One advantage of using a list that conforms to the USBL list is that you can monitor inflation rates by spending category more easily. This allows you to estimate your own personal rate of inflation relative to the published CPI-U. Many people feel that the inflation rate they experience is very different than CPI-U because their purchases do not conform to the category mix used by the Bureau.
If you have a thorough understanding of what each category and sub-category costs you today, you can start to make a pretty good estimate of how much you might spend in retirement. Go through the categories one at a time.
The FOOD AND BEVERAGE category may not change much in retirement if you think your eating habits will remain the same. On the other hand, if you dine out a lot today because you’re too busy to prepare food and do dishes, you might reduce this category by quite a bit in retirement. Or maybe you want to spend more time dining at gourmet restaurants and expect this expense to rise.
HOUSING, utilities and home insurance may not change much unless you are planning on moving from your current conspicuous McMansion to a smaller retirement home. If so, make sure you capture that savings in your estimates.
APPAREL expenses may decrease a little since you won’t have to dress for the office.
TRANSPORTATION costs are likely to change significantly – either reduced because you can eliminate an expensive commute, or increase because you plan on traveling extensively when you retire.
MEDICAL CARE is a very important category to consider. If you are retiring with a paid medical insurance benefit from your ex-employer, consider yourself extremely lucky. That will help keep this cost manageable. If not, plan on an insurance expense that will rise more than the inflation rate every year. This is a tough cost to gauge with our current medical situation in the U.S.
A RECREATION budget is clearly very important to most retirees and possibly the most difficult to anticipate. Prior to retirement I knew exactly what I was spending on recreation, but that did not help me much when it came to planning that budget for retirement. While working, I only had weekends and vacations to spend any serious time on recreation. How much more time would I need to devote to this category to create a satisfying retirement? While working, I often spent money on recreation/travel services in order to save my precious, but limited vacation time. In retirement, I can choose to do many things more slowly (and less expensively).
Because I planned on traveling a lot, I broke out VACATION & TRAVEL as a separate item. I looked at several different kinds of trips I make: 1)day-long field trips, 2)camping trips, 3)road trips (travel to sites and stay in low-cost accommodations) and 4)city visits (air travel, city hotel rates, rental cars, etc). Then made an estimate of how often I thought I would want to make each type of trip, and budgeted accordingly. I then split the vacation & travel sub-budget into appropriate categories: mostly TRANSPORTATION or RECREATION.
You can continue through the remainder of the items in a similar fashion. For each category that you think might change significantly, you need to estimate the expected change. If you have the figures on your current spending by category, that’s not too difficult. When I was in doubt, I would simply guess that a 10% perturbation on the current cost was a good guess. Being an engineer, I over estimated my cost increases and underestimated my cost savings by a little. On the other hand, so far I’ve traveled a lot more than I thought I would in retirement.
Some people recommend using some simple rule-of-thumb guessing for your budget. For example, you might read that you will spend 80% as much in retirement as prior to retirement, or that you should plan to need 70% of your pre-retirement take-home pay to live off in retirement. I don't think it is wise to approach the problem this way. Those rules certainly didn't work for me – not even close.
For those who have not yet developed a detailed accounting of where their current spending is going, you may want to check out the url: http://www.golio.net/Chapter3.html
Scroll down to Section 3.3 and click on “download all excel spreadsheets”. There are also several other budget tools available through that page.
Return home: http://www.golio.net/
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