Step #5-Retirement Preparedness Checklist: Create Enough Cash Flow to Cover Retirement Expenses
Think about this. Most companies don't go bankrupt because they are not profitable. They don't go bankrupt because the value of their assets has declined. They go bankrupt because they do not have sufficient cash flow to pay their creditors and employees.
A company can lose money, on paper, but stay in business indefinitely so long as it has sufficient cash flow to meet its obligations. But without cash flow to pay employees, suppliers and creditors, a business' days are numbered.
The same is true of your family. Most families that declare bankruptcy do so because the incoming cash flow, from paychecks and other sources, is not sufficient to pay the bills. But as long as cash flow exceeds monthly obligations, a family is fine.
For most of your adult life, the necessary cash flow to meet expenses will have come from your paycheck. But what happens when you retire and you no longer have a paycheck coming in?
Whatever your expenses in retirement, you must have enough cash flow, from sources other than your job, to cover those expenses indefinitely into the future. For the average 65 year old, non-smoking couple, that means an average of thirty years.
For most of us, there are three main sources of cash flow in retirement: Social Security, pensions and investment income. While many view Social Security as the primary source of retirement income, we recommend to our clients that they wait until age 70 to begin taking Social Security. We view it not as a source of retirement income but as a source of longevity insurance.
(For more details on our thinking on this subject, download our free special report, "It's All in the Timing: Evaluating the Best Time for You to Begin Taking Social Security" on SniderAdvisors.com)
The first step, in creating the cash flow you will need in retirement, is to know how much cash flow you will need. This means putting together a personal income statement (Step #1) and projecting forward the expenses.
Then begin adding up the sources of cash flow you will have, including Social Security, pensions, annuities, cash flow from rental properties, oil and gas royalties, settlements and any other ongoing sources of income. Subtract the total from your projected expenses. The remainder, if any, will have to come from investment income.
For example, let's imagine you are projecting your total expenses in the first year of retirement to be $100,000. You add up all on-going sources of income listed above and they total $40,000 per year. The remaining $60,000 per year will need to come from investment income.
The next step is to determine the assets required to generate the needed investment income with, if possible, an almost zero chance of outliving those assets. Many financial planners use a 4% withdrawal rule of thumb that gives you a 95% chance that you will outlive your assets. But that is a 5% chance you will end up old, broke and at the mercy of others.
My view is even a 5% chance of running out of money is too high. When evaluating probabilities, you don't just look at the odds but also what academics call the "magnitude of failure". If the magnitude of failure is great, as in the case of running out of money before you run out of breath, then any chance of failure is too much.
(Again, you can get much more information on the 4% withdrawal rule of thumb and why we think it is wrong by downloading another free special report, "The Four Percent Withdrawal Fallacy" on Snider Advisors.com.)
The reality is, in some cases, it may be too late. If you did not begin this process early enough, you may have to accept some risk of running out of money. But the goal is, if at all possible, to create the cash flow needed to have an almost certain probability of being able to sustain your lifestyle indefinitely into the future.
If you need help determining what this level of assets is, Snider Advisors offers a free web application called My Financial Plan, which will help you to understand various retirement cash flow scenarios.
You will also have to account for the effects of inflation, which most people badly underestimate. For example, assuming a 3.5% rate of inflation, a $100,000 lifestyle today, will cost approximately $200,000 twenty years from now.
Healthcare is the other X factor, especially when projecting future expenses in retirement. Healthcare costs have been rising at a much faster rate than core inflation. This is where a solid insurance plan (Step #2) comes into play.
A comprehensive insurance plan, which covers major medical, outpatient, and long-term care, protects your nest egg and allows you to plan for more predictable and reasonable expense levels. Without a solid insurance plan, it is almost impossible to project how much money you will need in the future and therefore almost impossible to meet the goal of a zero probability of running out of money.
Once you know your starting income requirement and inflation assumptions, then you can back into a required rate of return. This is the average return your money will have to earn to be able to pay you, pay Uncle Sam and keep up with inflation.
Many people approach this backwards. They start by throwing together a portfolio of various investments without any idea what return is required. This is a little bit like stumbling on a pile of bricks and saying, "Gee, I wonder what I can build with these bricks?"
The required rate of return will dictate what building materials you will need to construct your financial house. The investments you choose should be specific to your income and expense projections.
Once you know what return you need, you only take on as much risk as is required to get that return. If you can get by on bond returns, then you shouldn't be investing in the stock market.
Unfortunately, many people discover they need a much higher return than traditional investment income portfolios are capable of. In my experience, most people who do the math will find they need low double-digit yields in order to create enough cash flow to maintain their lifestyle indefinitely.
This may seem scary at first. But understand, your biggest risk is not the fluctuations in the stock market or the economy - it is living too long.
Figuring out how much money you need is not a guess. Getting this wrong can be disastrous.
Take advantage of the My Financial Plan web app, available for free at SniderAdvisors.com to calculate the assets required to support your lifestyle. Do not retire until you have enough assets and know how to use them to generate sufficient cash flow to support your lifestyle indefinitely into the future.
No statement in this article should be construed as a recommendation to buy or sell a security or to provide investment advice unless specifically stated as such. All investments involve risk including possible loss of principal.