In my blog titled: WHAT’S YOUR NET WORTH ? I spoke about the importance of formulating a Net Worth Statement.
A close second in importance to the Net Worth Statement is an Annual Spending Summary. (I am not speaking about a spending analysis or a budget.)
Current Annual Spending means all costs, expenses, and outgoings incurred during a year. It includes all outflows of money for living expenses, maintenance, lifestyle, taxes, etc. (Every dollar you spend in one year.)
Why is Current Annual Spending important?
Current Annual Spending represents one of the important numbers necessary for retirement planning.
An article from Fifth Third Securities states: “Since retirement spending is a future unknown, projected retirement annual spending is usually represented as some percentage of current annual spending. While the 70-80% Rule is a good starting point, the actual percentage can vary considerably depending on individual circumstances. A study of actual retirement costs found that while spending in retirement ranges from 54-87%, most retirees use 70% or less of their former income.”
If a person engages a financial planner, Net Worth and Annual Spending are considered part of the basic information needed to create a comprehensive financial plan.
It is important to understand that these percentages are a rough estimate of future spending. There is a large range of percentages represented. The financial planning community understands that lower pre-retirement annual income means a greater percentage of pre-retirement income will be necessary during retirement. (Example: Someone with a pre-retirement income of $300,000 needs only 60% of that amount to generate $180,000 retirement income annually. Someone with a pre-retirement income of $80,000 needs to replace 90% of pre-retirement income if they want annual spending of $72,000.)
These numbers and percentages can only have relevance after annual spending is calculated.
It is not necessary to know how much is spent on each item or category during the year. It is only necessary to know the current annual spending amount.
Consumers interested in a more granular approach that categorizes each dollar spent should look at Quicken, YNAB, MINT, Personal Capital, Goodbudget, EveryDollar, PocketGuard, Fudget, or Honeydue (Some of the most popular budgeting tools.)
Those not interested in knowing how and where every dollar is spent should take all dollars spent each month and subtract them from last month’s balance plus any deposits. Normally, the bank statement generated each month will have this information readily available. If bills are paid from multiple accounts, then each account will need to be reconciled in this manner and the balances of all accounts added together.
One month cannot simply be multiplied by twelve because different bills may be due monthly, quarterly, or annually. One month can be used as a very rough estimate, but the clearest picture comes with tracking one year’s worth of expenditures.
How is this information best applied?
In the same way, 25 or 33 times your net worth gives you a very rough estimate of the amount of money needed to retire, approximately 70 to 85% of your current annual spending would roughly equal the amount of projected annual spending during retirement.
How accurate is this projection?
It is better than no projection, but it is also far from being foolproof. Some people live on less than 50% of their pre-retirement income, and some people live on 150% of their pre-retirement income. It is also generally understood that most people will spend more money early in their retirement than later in retirement.
The estimate of projected retirement spending, just like net worth multipliers, is a starting point. if you know that you want to spend more for travel, home upgrades, family vacations, or any excess spending, you will need to increase the percentage of pre-retirement income needed. In the same way, if you know that you will not be traveling, will not be renovating your home, and have little or no family, your post-retirement income leads will be a lesser percentage of pre-retirement needs.
The fact that there may or may not be a mortgage balance and increased healthcare costs before Medicare initiation must also be factored into post-retirement annual spending.
Each person and each situation are unique, so retirement planning is not a one size fits all approach. As discussed in my initial post: FOUNDATIONS OF RETIREMENT: THE THREE-LEGGED STOOL– Life doesn’t work that way. Each person is unique and individual, and the answers to these questions for each of the approximately eight billion people living today will vary!
A future post of RWE will focus on combining Net Worth, Current Annual Spending, and age to simplify the path forward for pre-retirees.
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