AVOIDING A FINANCIAL HURRICANE BY CREATING AND UNDERSTANDING A FINANCIAL PLAN

When you live along the Southern coast of the USA, it’s vitally important to know and understand the category and status of any hurricane approaching the coastline. 

A Category 5 hurricane is the most powerful and potentially destructive type. The following information could be considered Category 5 financial information. It is powerful information, and misunderstanding, or disregarding the information could be very destructive to your financial well-being.

If you haven’t read FOUNDATIONS OF RETIREMENT: THE THREE-LEGGED STOOL , HAVING A “PLAN”, PLANNING ENEMY- TEMPORAL DISCOUNTING, PLANNING ENEMY- TEMPORAL DISCOUNTING #2, QUITTING WORK- WHAT’S YOUR NUMBER?, WHAT’S YOUR NET WORTH? and ANNUAL SPENDING- DID I SPEND THAT MUCH ? now would be a great time to catch up. Understanding the information provided in previous blogs provides the foundation for this blog.

It’s also important to understand that no one, even the Financial Advisor working with you, will provide a precise retirement date, precise budget, or permanent Plan of Record. Your Financial Advisor will provide you with a Plan of Record and guidance with the implicit understanding that his recommendations are guidelines only, and the plan must be reviewed and updated over time. The Financial Advisor’s primary function is not to direct or dictate actions, but to assist in the decision-making process, provide the necessary information, and provide guidance in a format easily understood. Financial Advisors help the client with the decisions the client must make.

This decision-making process is the same whether you have engaged a Financial Advisor, or have chosen to create your Plan of Record. You will always be the captain of your ship. There are many people in both camps, with many becoming clients of Financial Advisors, and many personally creating their retirement Plan of Record.

If you have followed along with previous blogs you will have a basic understanding of the major pieces of the retirement equation. That doesn’t mean that it is an easy concept to master. There are several parts to this equation and the parts are always in motion. For example, tomorrow you will be one day older. Next year your salary may go up or down. Your net worth can change daily with stock market gyrations. Your spending is always fluid. (You don’t spend the same amount each day, month, or year.)

It’s a process of continually attempting to hit a target that is in constant motion.

Below is an illustration that will hopefully create a better perspective.

When you use mapping technology on your phone, this is equivalent to “HAVING A “PLAN”.” Your mapping technology will create a plan, or route, to get you from where you are to where you want to go (Your destination.) When planning for retirement you want to get from where you are to the destination called financial independence (and eventually retirement.)

On the map, the blue dot is equivalent to your current Net Worth (WHAT’S YOUR NET WORTH?.) The dot tells you where you are currently. Your Net Worth also gives your current position (Financially.) Just like the dot that shows your current position on the map, Net Worth is also important because it shows your current financial position. But, it does not indicate where you are going, how fast you are going, and when you will arrive at your destination. (Net worth becomes more valuable as it is periodically updated, just like the blue dot on your map will give you a sense of your progress as your trip (plan) progresses.)

When you enter the address of your final destination the mapping technology will tell you the number of miles and estimated time of arrival at your destination. This is equivalent in retirement planning to “QUITTING WORK- WHAT’S YOUR NUMBER?.” The number of miles, and the estimated time of arrival (Your Number), are a time and numerical approximation of instruments needed to get to your destination (Financial Independence.)

There are dropdown boxes that indicate speed and direction of travel. In retirement planning, these equate to current annual spending (ANNUAL SPENDING- DID I SPEND THAT MUCH ?) These instruments correlate how fast you are moving towards your destination and how much energy is expended.

So, if all the information gathered from the map is fully utilized, one can determine the present location, where they are going, when they will arrive, and how fast they are moving towards their destination. But it’s important to remember that the map doesn’t program itself. Two steps must be completed before benefitting from the map technology: The needed information must be identified (address and location), and the information must be correctly entered and interpreted.

But what happens if you slow down? How about if you get off course? Stopping your vehicle will also change the time of arrival and average speed. Any change in the map parameters (“Plan”) will affect the journey, and time of arrival. Changes to your financial journey ( Plan) will affect your arrival at your final destination (Financial Independence.)

So now that you have a better understanding of how these things work in concert, we’ll look at how the pieces fit together in a financial map (OUR PLAN.)

Net Worth represents the financial position (How much you have) at a given point in time. As net worth is updated periodically it indicates movement in a positive direction towards financial independence or a negative direction towards increased debt.

Most financial planners indicate that net worth should equal 25 times annual income. If you earn $100,000 per year, your net worth should be $2.5 million. Many financial planners currently feel net worth should equal 33 times annual income. In this example, the Net worth would need to be $3.3 million.

All of these assumptions are based on what is called “The 4% Rule.” Investopedia states the concept of the 4% Rule is attributed to Bill Bengen, a financial adviser in Southern California who created it in the mid-1990s, and has since complained that it has been over-simplified by many of its adherents.

For example:

If your portfolio at retirement totals $1 million you would withdraw $40,000 in your first retirement year. If the annual cost of living rises 2%, then the withdrawal would increase by 2% the following year, withdrawing $40,800, and so on for the next 30 years.

But, not everyone is in total agreement with the 4% Rule, According to Charles Schwab:

• It’s a rigid rule. The 4% rule assumes you increase your spending every year by the rate of inflation—not on how your portfolio performed—which can be a challenge for some investors. It also assumes you never have years where you spend more or less than the inflation increase. This isn’t how most people spend during retirement.
• It applies to specific portfolio compositions. The rule applies to a hypothetical portfolio invested in 50% stocks and 50% in bonds. Your actual portfolio composition may differ, and you may change your investments over time during your retirement.
• It uses historical market returns. Analysis by Charles Schwab Investment Advisory, Inc. (CSIA) projects that market returns for stocks and bonds over the next decade are likely to be below historical averages. Using historical market returns to calculate a sustainable withdrawal rate could result in a withdrawal rate that is too high.
• It assumes a 30-year time horizon. Depending on your age, 30 years may not be needed or likely. According to Social Security Administration (SSA) estimates, the average remaining life expectancy of people turning 65 today is less than 30 years.
• It includes a very high level of confidence that your portfolio will last for 30 years. The rule uses a very high likelihood (close to 100%, in historical scenarios) that the portfolio would have lasted for 30 years.
• It doesn’t include taxes or investment fees. The rule guides how much to withdraw from your portfolio each year and assumes that taxes or fees, if any, are an expense that you pay out of the money withdrawn. If you withdraw $40,000 and have $5,000 in taxes and fees at year-end, that’s paid from the $40,000 withdrawn.

Projected Annual Retirement 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 spending in retirement ranges from 54-87%.

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.)

Social Security Benefits reduce the amount of money needed monthly in retirement. If Social Security benefits equal $2000 per month, then $2000 less is needed from retirement funds. (When claiming Social Security benefits before full retirement age, benefits are reduced based on the amount of time before full retirement age. Delaying Social Security claiming past full retirement age increases benefits until age 70.)

Age at Retirement, Health, and Longevity also factor into the retirement equation. An increase in retirement age means fewer years of retirement will need funding. Someone who retires at age 70 will generally have a shorter lifespan than someone who retires at age 50.

Health and longevity go hand-in-hand. Someone who is healthy and has a positive family history should expect to live longer than someone in poor health or exhibiting a family history of short lifespans.

Fidelity states: Expect 15% of your living expenses to be related to health care expenses after you retire, year in and year out.

Lifestyle will also affect retirement spending. Someone who anticipates increased travel and lifestyle expenditures in retirement will need to replace a higher percentage of Current annual spending.

An article from Fidelity states: If you plan an active lifestyle in retirement, expect to ratchet up your annual retirement budget by six percentage points compared with a less active lifestyle.

Part-Time Work has much the same effect as receiving Social Security benefits. If you work part-time and your monthly income is $1000, then $1000 less is needed from retirement funds. The more earned income, the less you have to withdraw from available retirement funds. For many people, the problem with part-time work is that it’s still working!

Below is an example of how to put this all together:

*If you have a Written Plan, you have some basis for retirement lifestyle and spending.

• Take your current annual spending and use that as a guide for retirement spending. If you want to be conservative, estimate replacing a higher percentage of pre-retirement spending.
• Using an 85% replacement rate would provide an estimated retirement income of $85,000 per year for someone with current annual spending of $100,000 If retirement income needed is $85,000, then Net Worth should equal ($85,000 x 33) approximately $2.8 million. (Withdrawing 3% of $2.8 million= $84,000.)
• If Social Security benefits are estimated to be $2000 per month, the savings from annual retirement fund withdrawals would be $24,000 ($2000 x 12.) So now, instead of $85,000 needed, the annual number is reduced to approximately $60,000. (This reduces the net worth number to under $2 million.) If you replace 70% of current annual spending instead of 85% of current annual spending, this would reduce the Net Worth needed after deducting Social Security benefits to a little over $1.5 million.

Starting with a estimated retirement income of $85,000 and deducting Social Security benefits and part time income (If applicable) would equal the Annual Retirement Income that needs to be funded with retirement funds ($49,000.) This number would be changed by different percentages of current annual spending, actual Social Security benefits, and any other income sources such as rental income or pension income. These would be added or subtracted. This number would also be increased or decreased depending on health, longevity, and lifestyle spending. (Remember the direct reduction of retirement funds needed when earned income from part-time work is present is omitted when a person is fully retired with no earned income.)

Completing the example above would be the computation of the amount of money needed (Net Worth) to fund the retirement income not provided by other sources. Using a multiplier of 25 would equal a Net Worth of $1,225,000. (4% of $1,225,000 = $49,000.) Using a multiplier of 33 would equal a Net Worth of $1,617,000. (3% of $1,617,000 = $48,510.)

A more aggressive investor may feel comfortable with a Net Worth of $1,225,000 and a 4% withdrawal rate annually. A more conservative investor may feel more comfortable with a Net Worth of $1,617,000 and a 3% annual withdrawal rate.

If the aggressive investor has a Net Worth greater than $1.225M, then he is considered to be Financially Independent. (This means that this person could quit work tomorrow.) The same could be said for the conservative investor with a Net Worth of more than $1.6 M.

Net Worths less than these amounts for these particular examples would indicate that there are not enough financial reserves (Retirement Funds) available to support a thirty year retirement.

These individuals would need to find other income sources, work in retirement, live on less income, or work for a longer period of time, or save more to increase Net Worth. These are endless variations to the equation, and multiple solutions can be derived. Some solutions are less desirable than others, but are still viable solutions. (Finding out at fifty-eight years old that you need to work three more years is infinitely better than finding out at eighty-nine that in one year you will have no more money, with no way to increase retirement funds.)

Even with the amount of detail in the above examples, it should be obvious that different retirement numbers can be derived depending on how different factors are manipulated. It is not one size fits all, nor is it precise to a high degree of predictability. However, Working with these numbers and making different assumptions will help to narrow the focus, and isolate a more precise Retirement Number.

Gather your Plan, Net Worth, Current Annual Spending Number, a calculator, pencils, and paper.

Spend time going through all of the different facets of your retirement plan and try different numbers, percentages, variations, and values. (There are online retirement calculators that may be beneficial with this part of the process.)

Doing this exercise will give you a greater appreciation for your current position, and multiple possibilities for a brighter future.

This should also help you to avoid any Category 5 financial hurricanes!

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