Individuals preparing for life after full-time employment may find that planning for a particular range of inflation-adjusted retirement income is more effective than planning for a particular range of wealth. Wealth levels are unintuitive because they do not provide practical spending guidelines. They are also heavily influenced by random variables (market returns). Using one’s wealth as a primary gauge may lead to overspending in early retirement by those unprepared to manage a prudent withdrawal program, or underspending over the course of retirement by those overly concerned with outliving their savings.
In contrast, income level planning has several key advantages.
- Income levels are intuitive because they provide built-in budgeting guidelines.
- Estimating required future income can be tailored to individual circumstances and does not require specialized financial knowledge.
- Estimating a future income level (that would be attained upon conversion of one’s savings into income risk hedging assets) does not require guesstimating future market returns the way that estimating one’s future wealth level would.
- As a result of #3, there can be more certainty about one’s future income than about one’s future wealth, as long as some of one’s assets are managed to hedge income risk and more savings are devoted to those assets over time.
- Once a required future income level has been attained through the allocation to income risk hedging assets (essentially locking in future income), if other capital is available, it can remain invested for long-term growth without great risk of income impairment during market downturns.
In this post, I’ll cover steps #1 and #2 and show a simple way of estimating required future income.
Even if you do not do a great job of tracking current expenses, you can back into personal expenditures as long as you know how much you save and how much you pay in taxes. Every dollar earned must be either spent or saved, so if you know your savings and taxes paid, you can derive personal expenditures by subtracting savings and taxes from gross income.
Once you estimate current personal expenses, directly by logging receipts or indirectly through the method outlined above, you can adjust for expected changes in spending during retirement. For example, suppose the following.
- I currently spend USD 100,000 a year on personal consumption
- I estimate that in retirement my personal expenses may decrease by about USD 17,000
- -USD 10,000 because I will not need to save in retirement accounts
- -USD 15,000 because I expect to have my mortgage paid off
- -USD 2,000 because I expect lower clothing and commuting costs
- +USD 5,000 due to higher expected medical bills
- +USD 5,000 due to higher travel costs
Adjusting my current level of spending (USD 100,000) for changes in spending patterns after retirement equates to about USD 83,000 (in today’s U.S. dollars) to maintain my current lifestyle in retirement. USD 83,000 per year is therefore my estimated retirement income liability.
Next, we should take account of guaranteed retirement income, such as Social Security benefits. You can get an estimate of expected benefits from the U.S. Social Security Administration website calculator. Suppose the calculator tells me I should receive USD 25,000 per year under current assumptions. Then my net estimated retirement liability, the portion I will have to fund with personal savings in current U.S. dollars, is:
Having completed these calculations, I have a reasonable estimate of the income level that I need to fund in order to maintain my lifestyle in retirement. In my next post, I’ll show how to measure progress toward such a goal well ahead of one’s retirement date.