Want A Realistic Retirement Number? Before Anything Else, Consider Your Expenses

By Roger Nusbaum :

Earlier in the week someone tweeted a link to this article where a behavioral finance guy chopped down some of what the financial advising business is all about. I believe this can be useful to both financial advisors and do-it-yourselfers because do-it-yourselfers are also financial advisors, they simply cater to one client, themselves.

The first thing that Ariely (the behavioral finance guy who wrote the article) attacks is the notion of basing a financial plan on what percentage of pre-retirement income is desired. Ariely believes that the right way to come at this is what type of lifestyle does the person want in retirement? He says that by framing the question that way, many people will conclude they need much more income post retirement than pre-retirement.

I've covered this before. A goal based on income has never made sense to me. Ariely's idea, as laid out in the article seems incomplete in that if you believe we are collectively financially illiterate then what type of lifestyle do you want will lead to a lot of time wasted targeting exotic and expensive trips, a $150,000 sedan, a $500,000 motorhome and so on.

The starting point should be expenses. Some expenses will go down and some will go up--some will go away altogether. My saying that such and such will be less is futile; we each have our own circumstance and what might go down for you might go up for someone else. Look at your expenses and figure out your own likely outcome. I say likely because at 50 or 55 you can't know with complete certainty what your expenses will be when you are 65 or 70. But you can have an idea what your budget will look like.

From there, what pursuits will you devote time to do and how much is that likely to cost? If your recreational interests require things with motors in them then that is going to be somewhat expensive. If a big trip to someplace new (to you) and far from home is a regular part of your preferred routine then that will be expensive. If you do these things then you already have an understanding of the costs involved.

OK, add it all up and what is the total? Now double the figure you used for health costs. Then inflate the whole thing by some margin of error that upon further reflection seems reasonable Now what is the total? Divide that number by 0.04 which tells you how big the portfolio needs to be. This assumes the 4% rule so you can use a smaller or bigger number depending on how conservative or aggressive you are.

If the numbers work then you may only need to be on the lookout for changes or threats to your situation. If the numbers don't work then something needs to give (lifestyle, working longer, both). That all sounds reasonable (I think) but at no point touches on a percentage of salary. We all want what we want. We either can afford what we want or we can't. On that basis I think it is a simple equation. Human emotion and behavior is what complicates things.

The other item that Ariely attacks is asking clients to score their risk tolerance on a scale of 1-10. Most people will not have the correct answer until the market drops a lot. I've commented before about people learning after a large decline that they had too much in the wrong thing (for them) .

I think a step closer to usefulness could be quantifying what a large decline would actually do to your portfolio and to try to envision your reaction/emotional state. A portfolio that is $500,000 with a 65/35 split favoring equities might drop by $97,500 if the SPX drops by 30%. This assumes no defensive action, fully invested and merely tracking the market with a couple of broad index funds. Any value that might be added could make the drop a little smaller but of course attempts to add value might not work.

Again this seems reasonable (I think) but it can be difficult to take this look in the mirror seriously as far more people say they can tolerate market volatility than can actually tolerate it when it does drop.

The key here is to remember what large declines feel like, the mood and fear they create--this is easier said than done as the 2008 decline scared the hell out of a lot of people despite something similar only a few years prior.

The above is what I would call common sense type things but not a substitute for real financial planning for people with a lot of moving parts in their financial lives. If you don't know whether your financial life has a lot of moving parts then you need to figure that out and either hire some help or learn how to do an adequate job on your own. Complicating factors include having a lot of money, a lot of real estate, large families, a lot of stock options from the company you work for, a successful small business that you own and the list goes on. There are solutions involving insurance products, tax planning, spending hierarchies and other things that I don't know much about. Remember that portfolio management is not financial planning. To steal a line from Mohamed El-Erian, common sense and sound portfolio strategy are necessary but may not be sufficient to financial success.

The first picture is from the wolf versus bear series (humor attempt) and the wolf has a piece of the buffalo carcass and the second picture is of the arch at the entrance in Gardiner, MT.

See also AT&T: Trading At A Technical Bottom And Yielding Over 6% on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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