The ultimate retirement- planning question is simply stated but not necessarily easy to answer: How much in savings is needed to secure a comfortable retirement?
In a recent survey from Ameri-prise Financial Inc., working Americans 50 to 70 with at least $100,000 in investible assets esti- mated that what they needed to retire comfortably is, on average, $930,000.
But what does “the number” really mean? How important is it?
What assumptions are clients making about the amount that they will need to meet expenses during retirement?
Financial advisers have an opportunity to find the right answer.
AN INEXACT SCIENCE
Projecting future spending is an inexact science, at best. There was a time when many professionals settled for a general approach that estimated that living costs in retirement would equal anywhere from 70% to 90% of what was needed during working years.
Yet this oversimplified assumption doesn't accurately reflect what spending will actually be in retirement.
Although some expenses may go away, retirees also have more time to spend money. There are also expenses that could greatly increase in retirement, such as medical costs.
One of the best predictors of future spending patterns is to look at how clients manage expenses during their pre-retirement years. An old saying that remains appropriate is, “the secret to living within your means after retirement is living within your means before retirement.”
Using today's spending habits as a starting point, and asking clients about their existing and anticipated medical needs as well as family medical history, advisers should be able to help clients draw up a realistic list of anticipated living costs during retirement.
There are two primary categories to review in this regard: essential expenses and lifestyle expenses.
Essential expenses are the required costs associated with daily living — food, shelter, utilities, transportation, insurance and taxes — that most likely will persist throughout retirement. Help clients estimate what the monthly cost of basic living will be, annualize it, factor in an inflation assumption and extrapolate it throughout a reasonable life expectancy.
Lifestyle expenses include interests that clients want to pursue such as golfing, travel, owning a vacation property or starting a business.
Rather than trying to assess whether a single lump-sum amount is sufficient to meet income needs in retirement, it may be more practical to match specific assets (or sources of income) to various expenses.
The highest priority is the essential-expenses category. Clients should enter retirement with a virtual guarantee that the expenses they identify as required living costs are going to be met without interruption no matter how long they live.
There are two obvious sources of guaranteed income for retirement: Social Security and a defined-benefit plan, when available.
Of course for younger clients, Social Security shouldn't necessarily be viewed as a long-term guaranteed source of income because of potential changes as budget discussions unfold in Washington. If these income sources don't produce enough income to meet required expenses over time, additional income could be generated in another way, such as an annuity that provides a guaranteed income stream.
Using this approach, future income isn't subject to the variability of the markets.
Remaining available assets can be used to fund lifestyle expenses. A client may choose to invest this money more actively with a strategy of drawing down assets over time using a sustainable withdrawal rate, typically in the 4% to 4.5% range.
Suppose a client determines that he or she wants to spend $4,000 per month (in pretax dollars) to pursue interests in retirement. That adds up to $48,000 in the first year of retirement, with that amount adjusted for inflation each year.
A simple way to calculate the actual savings needed to meet the client's lifestyle goals is to multiply the annual need by 24. This represents the equivalent of a 4.17% annual withdrawal rate from savings that is assumed to rise consistent with the inflation rate and provide sustainable income for 30 years.
In this example, 24 times $48,000 equals $1,152,000. Therefore, it is a reasonable assumption (though not guaranteed) that clients with $1.2 million available to fund lifestyle expenses would have sufficient savings to meet their needs.
Craig Brimhall is vice president of retirement wealth strategies at Amerprise Financial Inc.