If you are one of the 78 million Baby Boomers rolling into retirement in the next 20 years, you might want to sit down and do a little math. Retirement is a lot more complicated than it used to be.
So, before you quit your job and venture into the next stage of your life, stop for a minute to consider a set of numbers that could make the difference between retiring comfortably and well, not so much.
1. What is a reasonable estimate of your cost of living? This should be obvious, but most Americans dramatically underestimate their living expenses. Be honest and thorough. What do you pay for housing, including property taxes and insurance? What about utilities? And what about medical expenses or insurance premiums not covered by Medicare? What do you spend in a given month on restaurant dining and entertainment, or on the grandkids?
Whatever total figure you come up with, tack on an additional 25 percent. No matter how thorough you are, I promise you will forget something. The total you come up with here is the single most important figure. It’s the dollar amount you’ll need to generate from your portfolio investments and/or pension and from Social Security.
2. How much can you expect to receive from Social Security? According to the Social Security Administration, 53 percent of married couples and 74 percent of unmarried beneficiaries depend on Social Security for at least half of their income. A shocking 46 percent of unmarried beneficiaries rely on Social Security for 90 percent or more of their income. Social Security matters.
3. How much do your other investments need to earn to meet your retirement expenses? Take your expense estimates from above and subtract the after-tax Social Security payout from question two. Also subtract any other fixed income streams you expect, such as from a traditional pension or a trust. The amount left over is what you’ll need to generate from your investment portfolio. This number is critical because it will determine what type of returns you need to generate and what type of risk you can take.
Let’s look at an example. Say you need $100,000 per year to maintain your lifestyle in retirement and that Social Security will pay both of you a total of $50,000. After taxes, that $50,000 becomes around $36,000, meaning you’ll need your portfolio to throw off $64,000 in after-tax income. On a $1.5 million portfolio, that amounts to a return of 4.3 percent after tax, or a little less than 6 percent before tax, assuming a 28 percent tax rate.
Oh, you don’t have a $1.5 million portfolio? Hmmm, that could be a problem, if these are your numbers. You may need to downsize your retirement goals or postpone retirement for a few more years to build a bigger nest egg. Personally, I wouldn’t want to bank on generating a 6 percent return, given that the 10-year Treasury yields less than half that now. I wouldn’t be comfortable assuming much more than about 4 percent, which in our example here means that we need a larger portfolio or a smaller retirement.
4. What do you expect the inflation rate to be? Inflation is the single most dangerous figure for would-be retirees because it is the one they never see coming. Inflation creates a nightmare scenario where your expenses rise while your income remains fixed.
This means that your investment portfolio will need to generate enough to make up the difference. If you assume an inflation rate of 3 percent, your $100,000 per year in living expenses will be $103,000 after the first year. That may not sound like much, but remember that inflation is like interest. It compounds over time. To compensate for this, you need portfolio growth and, more importantly, adequate exposure to income-producing asset classes that have built-in inflation protection.
I used very conservative numbers in this column, and I encourage you to do the same. It’s better to be too conservative and end up with a bigger cushion than expected in retirement than to find yourself strapped for cash.
If this all sounds ominous and serious, it is. Retirement is far too important to leave to chance. If you haven’t done what you need to do, it’s never too late. Start now. If you don’t know what to do, get with a good financial adviser to help you.
Nick Massey is a financial adviser in Edmond, Okla. Reach him at nickmassey.com.