• Estimating a Retirement Budget

    This post has been cited by the Carnival of Personal Finance #218, hosted by Budgets are Sexy.

    This is the fifth in a series of posts on investment planning. For those who haven’t read the first post (or have forgotten), I’m soliciting feedback (tips, tricks, links, etc.) that I will cite and use in the final post of the series. Here’s a list of the other posts in the series:

    1. Investment Planning: The Series
    2. Household Budgeting the Easy Way
    3. Budget Tracking and Projections (with Quicken Tricks)
    4. Willingness, Ability, and Need
    5. Estimating a Retirement Budget [this post]
    6. Need for Risk: The Details
    7. Multi-Period Planning and Asset Allocation
    8. Investment Planning: Reader Tips, Tricks, and Links

    So far in this series on investment planning I’ve been vague about the event for which one might be planning. Everything has been completely general. That ends here. I’m now going to focus on investment planning for retirement because it is something everyone should do and it is the most challenging investment planning problem most of us face (second would be saving for a child’s college education, which isn’t something everyone needs to consider). Nevertheless, many concepts illustrated in subsequent posts are applicable to non-retirement investing.

    Retirement funding is about your budget, not today but in many years when you’re no longer working. If you’re going to be rational about planning for retirement you need to estimate that budget. The best place to start is your current budget (for advice constructing a current budget, see this prior post). By going through your current budget item by item and adjusting the entries so they correspond to expected values in retirement, you can estimate a retirement budget. Here’s an example:

    This spreadsheet includes the same figures as in the current year sample budget described in a prior post. I’ve added columns for estimated amounts in retirement (all in current dollars). I’ve also added one row for health care. Recall from my prior post that I assumed payment of health insurance premium was included in the current net paycheck for this example budget (your budget may differ). In retirement that’s not going to be the case so a new entry for this expense is required. In your own retirement budget you may want to add other entries for expenses you expect in retirement but do not have now (e.g. tourism costs, boat payments).

    One entry you may want to add is for income tax. The retirement income entries in my sample budget do not include the effects of taxation. Including taxes is tricky because (a) not all your retirement income will be taxed (e.g. Roth distributions are not taxed) and (b) you may not know what your tax rate will be years in advance. If you do want to estimate your retirement income taxes keep in mind that non-wage income does not include payroll taxes (Social Security and Medicare taxes). Also, do not confuse your marginal tax rate from your average tax rate. Even if your marginal rate  is substantial your average tax rate will be lower. For simplicity I have ignored income tax.

    Let’s go through my example and describe how retirement column entries are estimated. The first row is for non-investment income like that from Social Security and pensions. There are a variety of ways to estimate a value for this income. If you have a pension benefit you’ll have to find out the details on your own, as they will vary by company. As for Social Security, one estimate is the value contained in the statement you receive annually from the Social Security Administration. Another estimate can be obtained from this calculator (which I have not used). Use your own judgment about the likelihood of receiving the level of Social Security or pension benefit currently promised (better to be a bit conservative here).

    The second line in my example is for investment income (which could include the consumption of principal). Since this is what we’re solving for in this budget exercise, we’ll fill it in later so as to obtain zero on the TOTAL line for the “retired amount pro-rated to month” column. Going through the list of expenses in the example budget, many are zeroed out in retirement. When retired, one is unlikely to pay for child care, life insurance, or a mortgage (but if you expect to, don’t zero them out in your budget). It is reasonable (but not necessary) to keep values for the other expenses the same in retirement as in the current year budget except for health care, as described above. For that entry in the example I put in an estimate based on this value from Fidelity, inflated by ~50% to be conservative.

    After tweaking all the entries in the example I went back to the second line labeled “income: other” and inserted a value that caused the TOTAL to go to zero. This is the amount required from investment income to meet the estimated retirement consumption needs in the example. The value is $1,567 per month. Since the current monthly income is $6,917 (=$5,417+$1,500), income required from investments in retirement is just 23% of current income in this example. This is suggestive of how far off one might be by applying (or misapplying) a standard rule-of-thumb of the need for 70% of current income in retirement. Of course I have not included any margin for error in the retirement budget. As explained in the first post of this series, this is an important point but one I do not dwell upon.

    Your retirement budget will tell you how much investment income you will require (in current dollars) to meet your necessary retirement expenses. Your goal is to save enough to generate this income. Your retirement investment planning problem is to figure out how. The next post provides some guidance.

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