When to Plan for Retirement Income vs. Savings
Although many Americans worry about retirement and are doing everything they can to save for it, they commonly look at their retirement plan balances as means of measuring their progress. But the ultimate end of retirement savings is to generate income, so projecting your future cash flow can provide a more realistic indicator of financial preparedness. The key is to remember that there is a statistically a real chance that you could live well into your nineties.
Analyzing Desired Cash Flow
The first step to projecting your cash flow during retirement is to look at your current budget. If you are able to save at least 10% of your income now, then your retirement income will probably only need to be 90% of your current income level at most, with adjustments for inflation. But the amount of income that you will need after you stop working is not likely to be substantially less than what you need now. If you make $75,000 now and plan to retire in 10 years when you are 70 years old, then you will probably need to receive at least $65,000 a year after you retire unless your expenses are going to be a lot lower than they are now. If you plan on staying in your current residence and will have it paid off by retirement, then you can obviously reduce your monthly expenditures by the amount of principal and interest (but not insurance and taxes) that you are currently paying each month. (For more, see: Will Your Retirement Income Be Enough?)
Translating your nest egg into monthly income requires the quantification of several variables and the ability to perform some time-value of money (TVM) calculations. There are several TVM calculators available online at websites such as Bankrate.com, and these tools can help you to see how long you can realistically make your money last with a given set of assumptions. If you have $250,000 saved up and need to make your money last for 30 years, then you will need to allocate a significant percentage of your portfolio to equities. However, you may want to take a more conservative overall position in your portfolio during the first few years of retirement, because your draw down risk (the chance that you will significantly decrease the earning power of your portfolio from initial market losses) is the greatest during your early retirement years.
For example, if you have $500,000 in your 401(k) plan and your plan balance drops by $150,000 the year after you retire because of a market correction, then you have lost $150,000 of principal that you could have used to generate investment income for the rest of your life. Therefore, a more stable allocation at the beginning can help you to avoid large initial losses that can permanently cripple your portfolio. But if the numbers that you run show that you’re not going to have remotely the amount of income that you want to have when you retire, then you will need to start considering some major changes such as delaying your retirement or downscaling your future lifestyle. (For more, see: Protect Retirement Money from Market Volatility.)
Delaying your Social Security benefits can also increase your income in your later years if you are able to afford this option, but you may be better off taking it earlier and then socking that money away in a Roth IRA or other retirement vehicle while you continue to work. There is no one right answer to solving the retirement income equation, but some options are almost always going to be better than others. You may want to take a look at a longevity insurance policy that will provide a substantial guaranteed monthly payout after age 85 if you think that there is a good chance that you will make it into your nineties. This type of policy can allow you to map out the rest of your retirement plan with more precision, as you will usually only have to make the rest of your savings last until this payout kicks in.
Get Professional Help
Cash flow analysis is where a financial planner can really be of service. A comprehensive financial plan can show how long your money will last at a given rate of dispersion in your tax bracket. It can also incorporate other variables such as market performance and your estimated Social Security benefits. Perhaps most importantly, it can also show you what will happen with your finances if you live to be 95. About one in five Americans will. And a financial planner who also manages assets can help you to determine the correct mix of assets during each stage of your retirement so that you can get the most from your money over time. (For more, see: 5 Social Security Changes to Expect in 2016.)
The Bottom Line
Accumulating a nest egg is only the first step in effective retirement planning. If you don’t have a clear idea of how much monthly or annual income your portfolio can generate during your retirement, then you’re not ready to retire. A financial planner can help you to see exactly where you stand financially and what changes you may need to make in order to reach your retirement goals. (For more, see: Rebalance your Portfolio to Stay on Track.)