If you won’t be collecting a traditional pension and must rely on a combination of social security and a 401K/IRA portfolio to fund your retirement, you’ll want to be very conscious of both your pre-retirement spending and the size of your portfolio so you can support that level of spending after retirement.
I am focusing this blog on the danger of lifestyle creep because the current level of spending has a significant impact on both the ability to save pre-retirement and the level of spending needed during retirement to maintain a lifestyle you’ve become accustomed to.
Back in the day when traditional defined benefit pensions were the norm and workers stayed with the same company for years, retirement planning was relatively straightforward. Workers could generally count on a pension that, when supplemented with social security, would more or less replace their pre-retirement income. But today most people typically fund retirement through defined contributions (401Ks, IRAs, etc.) and are responsible for their own saving and investing. In the process they hope to accumulate a portfolio large enough to support what could be a very long retirement with enough of a cushion to withstand severe market corrections.
There are three basic variables in constructing a retirement plan.
- First is how much can you save pre-retirement and what kind of return can you expect to earn.
- The second variable is how long to you expect to work.
- The third is how much will you need to draw from your portfolio to supplement your social security benefit and achieve your desired lifestyle.
How you balance those variables and construct your plan will depend on your priorities as an individual or as part of a couple.
There is never a single “right” answer since everyone has their own priorities.
In working with clients on their retirement plans, we work through scenarios, tweaking the three variables above to provide options. The goal is to find a scenario that feels right to the client and where it is highly likely that they can meet the goal of the spending plan. I use a statistical tool that runs hundreds of iterations of the plan based on various market conditions to determine that probability. That scenario then becomes the initial roadmap that is updated each year as the client’s situation changes.
To ensure that the portfolio will last in the event someone lives to a very old age and withstands any plausible market corrections, the withdrawal rate needs to be fairly modest. A rough guide for a safe withdrawal rate is 4%. Here is an example using vastly simplified math:
A couple with a $50,000 of combined social security benefit that wants to spend $100,000 per year would need a portfolio at retirement of $1.7 million (assuming a 25% marginal tax rate) to be able to count on having an additional $50,000 per year to spend (adjusted annually for inflation). A couple who would like to spend $150,000 per year would need a $3.6 million portfolio (assuming a 30% marginal tax rate). Each $1,000 per month of spending would require $400,000 added to the portfolio.
As you can see, maintaining a relatively small increase in monthly spending throughout a thirty to forty year retirement requires a significant increase in the size of the beginning portfolio. Some may be willing to accept a lower standard of living during retirement but I think the safer bet is to not let your current lifestyle get to an unsustainable level in the first place. Some may think that a solution will be to simply work longer but that is often a risky bet, particularly in the corporate world. If a job disruption occurs late in a career it is especially difficult to rebound. And you may tire of doing the same type of work after many years and starting something new often results in a significant drop in income, at least initially.
The best approach is to identify as early as possible a spending level that is comfortable and at the same time sustainable throughout retirement (adjusted for inflation). The hard part of course, is sticking to that level especially when your current income allows you to spend more if you choose to. The key is prioritizing what is most important. My family went through this exercise when I decided to start my own business. We’ve found that most of what we cut from our budget we didn’t really miss all that much.
It helps to do some planning so you can see how this might all play out over time. My clients who have done this have found the peace of mind it offers to be of great value. Many find that they are actually in better shape than they believed. I realize that this is something that is easy to keep putting off, but if you have not yet put together a retirement plan, you will be glad when you do.
As always, feel free to reach out if you would like some help.