A wise man once told me “if you don’t know where you’re going then you’re lost.” I think this statement just about sums up retirement planning for most people. Now there’s certainly something to be said about not having responsibilities to tie you down each day in retirement but the basis of building a solid retirement plan, a plan in which you can have real confidence, is to map out the details of the lifestyle you hope to live – the big things like when will you retire, will you continue to do something that generates an income (part-time work or a hobby), where will you live and lastly, what do you envision yourself doing?
Building this map should actually be pretty fun. After all, we all enjoy day dreaming, right? But it’s very important to do this so we can apply appropriate cost estimates (different expenses have different rates of inflation), match cash flows (annual income to match your spending) and stress test your probability of success (not running out of money!).
It should also go without saying that the earlier you begin your planning, as in years in advance, the easier the transition into retirement will be. There are a few reasons for this but it mainly comes down to having enough time to implement certain changes that will make your plan more effective and thus eliminate the risk of having to delay retirement because of some external event like a falling stock market.
The way my firm likes to approach planning is to first stress-test your current path to see if you’re on track and if it can be improved. We’ll start by identifying if and when you might have an “income gap.” This is the difference between your annual sources of income (Social Security, pensions, etc.) and your desired annual spending. Even if you don’t have an income gap in year 1 of retirement, you will most likely see them later on because most sources of income are either fixed or are increasing at a much slower pace than expenses. This is the long-term impact of inflation – just think about rising cost of healthcare! This is where your investment portfolio comes into play. We’ll need to use your assets to generate enough income each year to fill your annual income gap.
Next we stress-test various plan alternatives. How do things look if we invest extremely conservatively? How does your plan look if we invest very aggressively? What if we add in another source of guaranteed income? We’ll test all sorts of plan alternatives for two reasons: 1) We have to know if it will work, and 2) We want to know if you’ll be comfortable with it. Just because a plan has a very high probability of success doesn’t mean that you’ll be able to emotionally handle the volatility if you’re invested beyond your risk tolerance, and if you bail at the wrong time it can derail your entire retirement plan! So, the only way that this planning process will be valuable to you is if we can find the right plan for you – the plan with a high probability of success that you’ll be able to stick to for the long haul.
Mapping Out Your Plan
Here are what I consider to be the important topics to think about when you begin planning for retirement – the “When, Where, What & Why of Retirement”
- When would you like to retire? For some people this is a cut and dry date of being totally finished working; for others it’s more of a slow transition into part-time work. I like to consider “retirement” when you’re standard source of employment income ends/decreases and needs to be supplemented from other sources (when you’ll begin drawing money from your investment portfolio) because new investment risks arise once you flip from the accumulation phase of investing to the distribution phase.
- Where do you plan on living in retirement? Will you remain in your current home? Do you plan on down-sizing? Do you plan to move to another state or country? Or maybe have a second home in which you will split time throughout the year? We want to pinpoint the location for two primary reasons: 1) if you’re changing your state of residency there may be state income tax implications (and possibly benefits), and 2) different locations have different costs of living
- What do you see yourself doing in retirement? This goes beyond your required expenses like food and utilities, and gets into your real desires. What type of lifestyle do you want to live? What are your hobbies? Do you want to travel? Is there something you’ve always wanted to do and now have the chance to tackle it with all of this extra free-time in your day? After you’ve built the list of things you want to do, the next step is to apply accurate cost estimates to determine the total monthly/annual budgetary needs and project how these will grow overtime due to inflation.
- Why do you want to retire? Are you sick of work and just want to be done with it all? Or do you enjoy what you do but are looking to spend more time with family, friends, hobbies, etc.? This is more philosophical than quantitative but shouldn’t be overlooked. Spending some time to figure this out will allow you to make decisions regarding work for the right reasons, which will make the transition easier and ultimately make retirement much more enjoyable.
So how does one make it happen? In summary, this comes down to points: 1) Having the confidence to retire, which comes from outlining what you want your retirement to look like and then stress-testing your plan against various alternatives to know the probability of success of each path, and 2) Implementing effective investment strategies ahead of retirement that will set you up for a successful transition that won’t be delayed by external forces that are out of your control – like falling investment markets.
The next few posts will discuss some of the common planning approaches to retirement as well as some of the investment strategies that I feel are especially effective in today’s investment landscape.
Thanks for following!
-Nick
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