A lot of ad money has been spent trying to make people worry about their “retirement number.” It’s pretty brilliant marketing, actually. Retirement is this big unknown for so many folks, if someone offers to nail it down to a concrete number, of course people will line up.
The only problem is, it’s meaningless. It’s more placebo than planning tool.
There’s no right number that ensures you a good retirement. Everyone is different.
We all want different things out of retirement. We will all have different spending needs (and wants). We’re all going to live different lengths of time. And we’re all comfortable with different levels (and types) of risk.
Any one of these differences makes a generic rule about your retirement number useless.
Let’s look at the first of these issues – your spending in retirement. Everyone’s spending patterns are different. What your neighbor thinks is an essential expense may seem like a luxury to you. Universal rules can’t account for differences in personality and goals.
Most of the time, people who try to guess what your spending will be like in retirement are using replacement ratio calculations. Don’t get me wrong, replacements ratios can be great tools – if used correctly.
The idea behind them is that you only need to replace a certain percentage of your pre-retirement income to ensure you maintain your current standard of living into retirement.
This is (generally) absolutely true – as far as it goes. After you retire you don’t need to worry about commuting to work, you don’t have all of those random incidental work expenses, you don’t have to dress to impress, and you don’t need to save for retirement anymore.
All these factors taken together point out that a replacement ratio can be a great starting point, but it’s just that – a starting point.
You owe it to yourself to dig deeper and figure out what you really want out of retirement. If you dream about sitting on your porch sipping lemonade and playing the occasional round of golf, you don’t need as much retirement income as someone who wants to make up for all of the travelling they missed while working.
Think clearly about what retirement actually means to you. Knowing what you want to do is the first step toward reaching it.
Your Life Expectancy
Ideally, you’re looking at a long and healthy retirement. Unfortunately, your health and lifespan are huge retirement risk factors.
Longer retirements cost more, so from a simple numbers perspective, the longer you live, the more money you will need to fund your retirement. That’d be no problem if we knew how long you were going to live. But we can’t. You might live another thirty years, you might only make it five. No one knows. That’s okay, but it also makes income planning difficult.
One of the common ways to approach this is to use life expectancy tables to figure out how long you are “expected” to live given your current situation. That’s all well and good, but it’s important to remember that those tables are based on big statistical groups.
If your median life expectancy is another thirty-nine years, that means half of the people in your situation are expected to die before that point, and the other half afterward. It’s helpful, but it’s not reliable enough to stake your entire retirement income plan on. Like a replacement ratio, it’s just a starting point.
You should be looking at yourself. Are you in better health than other folks your age? Did your Aunt Gertrude live until she was 110? Is she still around? Or do your relatives tend to live shorter lives?
No matter what, there’s always going to be a huge amount of uncertainty around this. You could walk out the door tomorrow and be hit by a bus. Or you could be the first person to live to 150. We just don’t know. So you need to prepare for either circumstance.
Your Risk Tolerance
We often talk about risk tolerance in the context of investing, and that plays a part in this discussion. But risk is broader than your investment portfolio alone. You want to think about the total level of risk in your financial plan. Just how at risk is your retirement income?
Your assets are typically thought of in three different buckets: reliable income, diversified portfolio, and reserves.
Reliable income, like the name says, is reliable. It’s the stuff you can count on paying out short of some extraordinary event. This typically comes in the form of Social Security benefits, fixed annuities, pensions, etc. Something has to go pretty seriously wrong for these income sources to be threatened.
Your diversified portfolio is what most people think about when they talk about a retirement portfolio. It’s all of your investments. It’s what those retirement number folks are talking about.
You have a lot of flexibility in how you structure this, but typically, you’ll have a higher level of risk and reward in your diversified portfolio than with your reliable income. This means there’s the possibility that you can fund a nicer retirement than you planned, but there’s also the chance you may not have enough for the retirement you were planning on.
The last bucket, reserves, is essentially your emergency fund – though in a lot broader terms than most people think about emergency funds. Cash you’ve set aside is definitely part of it, but it also includes your insurance policies, home equity line of credit or reverse mortgage, and your family and social safety net. These resources can be counted on if something terrible happens.
The ratio between the different types of assets makes a huge difference in the level of risk your retirement income faces throughout retirement.
If you’re comfortable taking some risk (and putting some variance in your income levels), then you may want to have more of your assets in the diversified portfolio bucket. If you need that certainty of knowing where your money is coming from next quarter, then you might want to have more of your income come from the reliable income bucket.
This is a balancing act, though. If you want all of your retirement income to be from reliable sources, you need to be comfortable accepting a lower level of income – you’re paying someone to get rid of the risk for you.
If you are looking for growth, and the potential for a higher level of income in retirement by putting more in the diversified portfolio bucket, then you need to be prepared for the possibility that you’ll lose money, and end up with a lower level of income.
There’s no right answer here. And that’s the point. Everyone’s different. And that means everyone’s retirement will be different. And anyone talking about retirement numbers is missing the point, and probably trying to make it easier for their sales folks to sell you something.
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