One of the most important steps in planning for retirement is to estimate how much income you’ll need to cover your expenses when you retire.
We call the point where your sources of retirement income are large enough to cover your expenses “financial independence”. Once you reach this point, going to work every day becomes a choice instead of a need. The goal of a good retirement savings plan should be for you to achieve financial independence. To know when you’ve reached financial independence, you need to know how much you will spend in retirement.
Three common mistakes people make in the retirement planning process are assuming their expenses will go down in retirement, underestimating the impact of inflation, and including non-investment assets in their retirement pile.
Assuming your expenses will go down
One common assumption is that expenses always go down in retirement. It is true that some work-related expenses will go away at retirement, and that retirees may have a lower overall tax rate. However, in the early years of retirement, expenses for travel, recreation, and hobbies often increase. In the later years of retirement, as recreational spending slows, health care and long term care spending will often rise. A good retirement spending plan should take these factors into account.
Ignoring the impact of inflation
Inflation is an invisible tax and can be a cancer that will destroy your retirement plan if you ignore it. Here’s an example of the destructive power of inflation: a first-class postage stamp cost 34 cents in 2001. By the end of 2017, that same first-class postage stamp cost 49 cents. Imagine being a retiree who ignored inflation and planned their spending around 34-cent stamps! Living in a world where the things you need cost more than you planned could be very difficult. A small level of persistent inflation can make a big difference in the cost of living over a retiree’s life.
Including “non-investment” assets in your pile
A good retirement plan makes a distinction between retirement assets and non-retirement assets. Retirement assets are things like 401(k) plans, IRAs, brokerage accounts, and income-producing real estate. Retirement assets produce income, or are otherwise liquid and can provide you with income when you need it in retirement.
Your home is not a retirement asset! You can’t sell one room when you need cash to pay bills. Downsizing can be a valid part of a retirement plan, but keep in mind that you’ll still need to live somewhere. Cars, boats, recreational vehicles, and collectibles are difficult to sell quickly for full market value. These should also be considered “non-retirement” assets.
Estimating your retirement expenses is an important part of the retirement planning process. Spending patterns can change over the course of a long retirement. Simple estimates based on pre-retirement spending may underestimate your true retirement income needs. If you need help evaluating your retirement plan, contact a qualified financial advisor today.