Photo by Max van den Oetelaar on Unsplash
A big concern for people seriously thinking about retirement is whether they are on track for the retirement they want. The question is particularly relevant today as financial gurus talk about a possible new normal, with low-interest rates potentially indicating low future returns. Consider this situation: You set a goal, estimate your annual savings towards retirement, and have a target year in mind. You use a retirement calculator and find that at the current rate of savings, you fall short of your goal. What do you do?
You need a budget
The first place to start is to make a budget. Most often people think that they need to replace close to what they are making now. But that’s rarely the case. In reality, a lot of costs go down in retirement. Your kids graduate from college and get a job, your house may be paid off, you may be past your midlife crisis spending, and other expenses may go down too. Having a budget can help you both set realistic goals and find additional savings.
Planning for retirement is making a tradeoff between spending during your pre-retirement years and spending during your post-retirement years. Budgeting is the first step to make you quantify the tradeoff and set a meaningful income goal. As you do this, you may find that your retirement income goal is more in line with your savings than you thought it would be.
Make an income projection
You need three pieces to make a retirement income projection: a realistic goal, the account value of your current savings, and an estimate of your potential monthly savings towards retirement. You project the amount of savings you can accumulate by the time you retire and then estimate how much income that savings can generate throughout your life in retirement. That is not an easy calculation but can be done easily using a retirement calculator. It is important to understand the assumptions behind the calculator, that’s why we host our own calculator, powered by Dimensional Fund Advisors.
Suppose you are 52, have accumulated about $500k across your retirement accounts, and would like to retire at age 65. You can save about $1,000 a month and your employer contributes $500 a month to your 401(k) plan. After budgeting, you find that $70k pre-tax income would be enough to sustain a comfortable retirement, and would like to plan until age 90. Your Social Security benefit is estimated to be $28,000. Here are the results from the retirement calculator.
Source: DESMO Wealth Advisors, LLC. Powered by Dimensional.
The projected income, including Social Security, falls short of the $70k goal. What can you do?
Use all your levers
As you can see from the calculator, you have three key levers: you can save more (and consume less pre-retirement), lower your target income (and consume less-post retirement), or change your retirement date. By using all three, the adjustments needed are likely to be smaller. One way to do this is to start by planning to retire one year later and increase savings by 1%. See where that gets you. If still short, plan to reduce spending in retirement by 2% (a 1-1-2 approach). This approach can do the job in many cases.
The single change that has the most impact is postponing retirement. In the example, by retiring at age 66 you have one more year to save, one less year of retirement expenses, and a bump in Social Security benefits. In our example, this single change increases projected retirement income to over $70k, including an increased Social Security benefit of about $30k. Saving an extra $100 a month increases retirement income by over $1000 a year (assuming retirement at age 66). Try this out with our calculator!
Check your investments, and take more risk?
All this assumes you have a sound and cost-effective investment plan appropriate for your situation, including your risk preferences. The current low-interest environment may mean lower returns in the future. So what can we do with our investments to increase the likelihood of a comfortable retirement? The first step is to make sure your investment plan is aligned with your ability to bear risks and with your goals. That’s where you are going to make the biggest gains in terms of increasing the likelihood of meeting your retirement goal.
The next question is whether there is something you can do to increase potential returns in your portfolio. That may be possible, but remember that there is no free lunch. Higher returns compensate for higher risk. If not who would ever accept the lower returns? Yes, interest rates on safe government bonds are historically low right now. But government securities are the safest investment available. So if someone offers you some investment that promises a higher return, there must be a cost, as investors in Auction Rates Securities during the financial crisis may remember.
Increasing the allocation to equities is another way to increase potential returns. But again, that increases the likelihood of low returns as well. The lesson is that you can try to increase potential returns by taking more risk, but you have to have plan B in case your returns fall short of expectations. You have to be ready to make bigger adjustments down the road. That’s why we always start with the other levers first.
What we outlined here is a good way to get a simple reality check for your retirement plan. The purpose is not to be accurate to the penny, but rather to have a simple way to make sense of your plan and to see if you are more or less in line with your goal. Any big deficiencies in your plan will come out with this simple analysis; and so will the impact of meaningful changes. However, it’s not the end of the plan, or even the beginning. Consider improving the efficiency of your savings with a tax-efficient strategy, and make sure your asset allocation is in sync with your goals.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
