Retirement seems like it’s been around forever, but it’s actually a relatively modern idea. While the current concept of retirement began with German Chancellor Otto von Bismarck in 1889, it took a long time for it to become commonplace. Here in Canada, OAS came into effect in 1952, and CPP in 1966. People born the year CCP started are only just old enough to begin collecting it this year. It’s clear that retirement is still an evolving concept.
The idea of retirement is to create future income that will continue after you stop working. And you need that income to pay for things, right? So you’d think that projected expenses in retirement would be a crucial factor.
But despite the fact that a whole industry has developed around this idea of creating future income, too few financial experts and firms haven’t put much effort or standards into determining your retirement income needs. We have highly sophisticated investment products, interconnected world markets, and entire TV networks dedicated to the financial industry, but most people’s retirement income needs are still calculated in one of three ways.
1. A percentage of pre-retirement income
This one seems to be the most common method. Fidelity suggests you need 70% of your pre-retirement income, adjusted to account for inflation. Does that mean you currently spend 30% of your income on costs associated with your job, like transportation or lunch money? No. While we do spend some money to work, they are assuming you’ll have no dependent children, no debt and won’t be saving for retirement anymore. So maybe this would be accurate for some people, but you don’t want to maybe get it right when you’re trying to fund your life. For instance, a single teacher who retires with a small mortgage might need far more than 70% of her pre-retirement income, while a debt-free oil executive whose household always had two professional incomes may need far less than 70%.
2. Your best guess
When your advisor or the person at the bank just asks you what you think you’ll need, it’s the scariest method. We are all prone to present bias, where we value things we can have right away over delaying gratification for long periods of time. Saving for retirement demands a lot of waiting for our rewards. Because of this factor, people tend to underestimate what their retirement spending will be like. After all, while some retirees will be debt-free, it’s not a given. You can’t assume you’ll pay it all off before you retire unless you can prove to yourself you’re on track and you check it regularly. The younger you are when you retire, the more lifespan your funds likely have to pay for. Many don’t realize that if they retire before 65, they’ll be paying 100% of the health insurance they used to split with their employer, which could easily be $400/mo. So thinking, “Well I won’t spend that much,” could trap you with a much lower income than you can actually live with in your golden years. This isn’t a method at all.
3. Totalling the income your current assets are expected to produce
While this might give you a more accurate projected income, it doesn’t mean it will meet your needs. This isn’t really planning; it’s a step in planning where you figure out what you already have. But it stops actually figuring out your options and how you could implement them.
Calculating retirement income need using these three ways isn't accurate enough. Retirement income need must be based on projected expenses.
It’s baffling that this isn’t the most common method, and more shocking still that this method only seems to be practiced by financial professionals who offer cash flow planning. If you want the most likely picture of your retirement income need, you’ve got to base it on projected retirement expenses.
But it’s not as simple as estimating what you’ll think you’ll spend. Present bias will creep in and make you forget things. And it will keep you from realizing that the cost of most things you will be paying for will continue to go up for the rest of your life. So if you’re serious about a retirement plan you can trust to get you the life you want when your working years come to an end, you should insist on a retirement cash flow plan as part of your overall wealth management strategy.
What is a retirement cash flow plan?
A retirement cash flow plan is an additional planning element that should be added to your financial or retirement plan. This process will include a few specific exercises to help you more accurately predict potential retirement expenses that help combat present bias. It also uses a behaviour-based approach that mostly involves one-time changes to how you set up your financial accounts, creating a lasting effect. A retirement cash flow plan not only helps you to develop a more accurate retirement income need, but it also helps you more easily fund your retirement savings. And when you’re ready to stop working and rely on that money you worked so hard to save, your retirement cash flow plan will help prevent drawing down your assets too quickly.
If you’ve got a financial advisor and don’t have a retirement cash flow plan, now is a good time to ask for one. If they don’t know what you’re talking about, maybe it’s time to find a financial professional who can ensure the purpose of saving for retirement is actually fulfilled.
About CacheFlo
CacheFlo is a financial education company that builds eLearning and tools to help financial professionals and individuals make behaviour-based changes, which allow them to get more life from their money. We want to make it easier for people to predict the impact of their financial choices before they make them.
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