Retirement Income Needs Analysis

Retirement Income Needs Analysis

Seniors often need help with evaluating the financial impact of a decision to retire early. For instance, many baby boomers wish to retire in their 50s. From a financial perspective, reviewing projected retirement income and expenses should clarify the optimum timing for retirement versus the advantages of continuing to work. Middle-class seniors are likely to require retirement nest eggs of $ 1 million or more to maintain the financial independence of their current lifestyles during the extended years of their retirement.

A retirement income needs analysis usually starts by preparing a cash flow statement listing cash inflows from employment and investments as well as cash outflows (expenses). Outflows are generally in three categories:

  • Fixed outflows are difficult to change. Examples include taxes, insurance premiums, loan payments, and housing costs such as rent or mortgage payments.
  • Savings and investments are deposits made to investment and bank savings accounts. Examples include elective (voluntary) contributions (deferrals) to 401 (k) accounts and one-time or periodic deposits into mutual funds, bank account, and other investment vehicles.
  • Variable expenses are those an individual may be able to change. Examples include food (including dining out), clothing, entertainment, and travel.

Cash Flow

Cash Flow Statement

When it comes to preserving or improving lifestyle during retirement, cash flow is often an issue. A retiree who wishes to travel extensively or enjoy expensive hobbies obviously needs more money than one whose preferences are less costly.

If a senior is already retired, completing a cash flow statement reveals his or her approximate cash needs. If the client is still working, the current cash outflows should be adjusted for potential changes in the postretirement years. For example, if a senior currently makes mortgage payments but anticipates that the mortgage will be paid off by retirement, the fixed outflow representing the mortgage payment would be eliminated from the postretirement projection. However, expenses for property tax and property insurance would still appear as projected postretirement outflows.

Addressing Cash Flow Problems

Older seniors, especially those on fixed incomes, may struggle to find the means to pay their bills. Analysis of current cash outflows may reveal ways to better meet expenses. For example, if a senior spends substantial amounts dining out, variable outflow can be reduced if the client goes only to restaurants offering senior discounts and early bird specials.

How Much Income Will Seniors Need in Retirement?

The college for Financial Planning, the insurance industry, and the AARP-institutions that analyze seniors’ financial issues-agree that individuals should plan to retire on no less than 80 percent of their preretirement, before tax income. (Few middle-income seniors report they can live on $ 2,000 per month.)

According to these institutions, when income falls below approximately 80 to 85 percent, retirees may not be able to afford the lifestyles they perceive they have earned. Seniors need to understand how much of a retirement nest egg is required to support a comfortable retirement that statistically could be 30 to 35 years-all without a paycheck.

Seniors should be encouraged to avoid credit card debt because the high interest rates associated with credit card balances can reduce money otherwise available for expenditures. The good news is that many older Americans who lived through the Great Depression avoid debt of any kind. However, retired baby boomers accustomed to carrying credit card debt may struggle with credit card management in the retirement years. Financial planners should encourage seniors to pay off credit card balances whenever possible.

Successful advisors learn about local programs that provide cost savings to seniors. Many states sponsor subsidies to help lower and (sometimes) middle-income seniors pay for prescription drugs. As another example, the city of Chicago provides certificates for reduced-fare cab rides.

Cash Flow Is Only an Estimate

It is not practical to calculate cash inflows and outflows precisely. In practice, planners should expect to encounter significant differences in expense projections. Each client’s ultimate postretirement spending pattern may differ significantly from projections. Certain clients will wish to provide college funding for grandchildren or financial help for siblings in their retirement years. Other clients will enjoy dining out more than during their working years.

Recall that spending differs greatly according to lifestyle and the three phases of retirement. Nevertheless, analyzing current and projected or actual postretirement spending is a logical springboard to a retirement income needs analysis at almost any stage of retirement.

Use Conservative Assumptions to Forecast Retirement Income

Professional financial planners generally concur that it makes good sense to use conservative assumptions when analyzing retirement income needs, including the following guidelines.

Overestimate Life Expectancy

We cannot presume that clients will live only to their statistical average life expectancy and not longer. Conceptually, average life expectancy indicates that half of the population will outlive this age. Thus, conservative assumptions factor that seniors (or spouses) will live 10 or more years beyond the statistical average life expectancy.

Overestimate the Rate of Inflation

In recent years, the rate of inflation has been lower than in most of the years following World War II. This may mislead planners to assume 2 percent inflation rates in retirement income needs analysis. Generally assuming n inflation rate ranging between 3 and 5 percent I considered conservative practice.

Underestimate the Rate of Investment Returns

Although historical studies of the rate of return on stock market investments may show average returns around 10 or 12 percent, the stock market can have extended periods of poor performance. Conservative assumptions about equity (stock) investments often presume an 8 to 9 percent rate of return, reduced by 2 to 3 percent for federal and state taxes. The conservative approach to retirement income needs analysis is likely to use an after-tax compounding rate of 5 to 6 percent on the equity (stock) portion of a moderate risk portfolio. The bond portions of the same portfolio should be expected to earn less.

Again, keep in mind that the objective of financial planning for seniors is financial independence. If assumptions are too aggressive, clients will outlive their money. If assumptions are ultimately too conservative, clients will leave some wealth behind, although that is generally not considered to be as problematic.

The information above is reprinted from Working with Seniors: Health, Financial and Social Issues with permission from Society of Certified Senior Advisors® . Copyright © 2009. All rights reserved.