Most families have not planned for their retirement. They may save toward their retirement, but without a plan their saving is random and haphazard. Retirement decisions today can only be made in the context of accurate math projections that span decades. Saving what you can and hoping for the best is an expensive and dangerous approach.
Every seven years you delay can cut your retirement assets in half. That means that if you under fund your retirement for the next seven years you will have to save double what you should have saved in the following 7 years in order to catch up. The price of procrastination is expensive.
Retirement projections are not simple. Assumptions are everything.
Consider the following algebra story problem: Imagine you knew for certain that you would earn $60,000 after taxes for the next two years but then would be unemployed the third year. How much would you spend the first year?
a) $38,065 b) $38,632 c) $40,000 d) $48,000 e) $56,400 f) $60,000
Even simple algebra can make financial planning intimidating. Those who enjoy math see the answer: $40,000. The equation is: 2 * $60,000 / 3 = $40,000.
But as inflation keeps pushing expenses up the buying power of a constant income goes down. At 5% inflation, $40,000 will only have the buying power of $38,095 in the third year. In our three year example, if we spend $40,000 each year, our buying power and therefore our standard of living will drop by the amount of inflation each year.
Adjusting for inflation, to keep our buying power constant, the three year spending amounts should go up by 5% each year: $38,065, $39,968, and $41,967. When we add compounded inflation the math grows more complex: first year spending = $120,000 / (1 + 1.05 + 1.1025) = $38,065. Using 5% inflation, you might assume that $38,065 is the right amount to spend the first year.
But when we save over a third of our salary the first year, we should invest that amount and earn interest. Investments that will be spent within the next two years should be invested in secure non-volatile investments. For example, we could invest the first year’s savings in a 2-year CD and the second year’s savings in a 1-year CD.
Assuming that a 2-year CD earns 3% and a 1-year CD earns 2.5% we should be able to spend a little more of our income the first year and allow what we have saved to grow the second and third year. Long-term investments usually make more than inflation, but short-term investments often do not. Also, our inflation estimate of 5%, though it is the historical average, is higher than the actual inflation of the past few years. We are being conservative in order to maximize the chances that we will achieve our goal of funding our third year.
Adjusting for what our investment will gain, the equation grows even more complex: What our first year savings will grow to plus what our second year savings will grow to equals what we can spend in the third year. In algebra the equation is: ((60,000 – x) * (1.03) * (1.03)) + ((60,000 – 1.05x) * 1.025) = 1.1025x where x is equal to the first year spending. After solving for x, we have the first year spending at $38,632.
That’s a very complex formula for a very simple three-year plan. Without a plan some people would save 6% and spend the remaining $56,400. Others would save $1,000 a month and hope it will be enough because $1,000 a month sounds like a large amount. Those most blind to their coming unemployment would spend the entire $60,000 and run up their credit card debt when they are laid off.
Many retirement decisions are also blindly made without a plan.
In addition to inflation and interest, retirement planning needs to take into account taxes, capital gains, and the different savings vehicles: taxable and tax sheltered. Retirement planning also involves projections of accumulating assets for 40 years and spending during retirement nearly as long. The math may get complex, but the answers that you should know are simple.
First, you should know what percentage of your retirement goal your current assets can grow and cover. Second, you need to know how much to save this year toward your retirement. Finally, you should know what rate of return will assure that you reach your retirement goal.
These projection need to be updated annually. A plan older than two-years old is hopelessly out of date. As your savings change they cover a different percent of your retirement goal. While market returns fluctuate and your standard of living increases, your monthly savings may need to be adjusted. And your investments should grow gradually more conservative as you get closer to retirement.
Retirement planning isn’t simply a matter of putting some money in a retirement account. It requires periodically working through the mathematical assumptions and projections required to ensure you will meet your retirement goals. Annual financial physicals ensure that your portfolio remains strong and healthy as long as you do.
Failure to plan for retirement is the primary reason why retirement plans fail.
The original version of this article was published October 25, 2004 under the title “Retirement Wisdom Part 1 – Plan Ahead.”
Photo used here under Unsplash Creative Commons Zero.