Don’t Retire Unless You Know This Number

Before you retire, you need to know how large your portfolio needs to be to support your desired lifestyle.

In today’s post, we’re going to discuss how we help clients determine their “magic number” by looking at a sample case study. And be sure to read to the end, where I’ll explain how to know if you’re on track to hit your target and how to close any existing gaps.

Step 1 – Determine Your Lifestyle Expenses

The first step is to determine what I call your lifestyle expenses – this is what you’re spending just to maintain your lifestyle without any “extra” spending like travel, health insurance, etc. From there, we add back in various expenses as needed to complete the picture.

You might be tempted to pick a number that “feels” right, but this generalized approach is wholly inappropriate for something as important as planning your retirement.

What we do for our clients is analyze their paystubs to determine what they’re currently spending to maintain their lifestyle. We then have to make detailed adjustments for health insurance, charitable giving, debts, travel, major purchases and, of course, taxes. All of these adjustments are very different from each other and can vary dramatically from one client to another.

If a client wants to retire before Medicare eligibility (age 65), for example, then we need to plan for a period of very high medical insurance costs in early retirement. Healthcare costs also inflate at a significantly higher rate than any other expenses you have in your retirement which will impact the math dramatically.

Another example would be liabilities carried into retirement, such as a mortgage. Not only will this not last a client’s full retirement (except in rare circumstances), but they also don’t inflate like all of our other expenses do.

To see how this all comes together, let’s look at the example of Michael and Holly Scott. Michael is 55 and Holly is 53. They want to retire in 4 years. Michael’s net pay is $3,812 semi-annually ($91,488/yr) and Holly’s is $3,615 semi-annually ($86,760/yr) for a total of $178,248/yr.

They don’t spend all of this, however. They refinanced their home into a 15-yr mortgage and have 8 years left on the note. The principal and interest on this note is $2,518/mo ($30,216/yr). Furthermore, the Scotts tithe 10% of their net income to their local parish ($1,485/mo or $17,825/yr). Finally, and it’s very important that this last part isn’t left out, they pay me a flat fee of $15,000/yr for their financial planning.

Taken together, this means that the Scotts are really spending $115,207/yr to maintain their lifestyle, which they’re very comfortable with.

Step 2 – Determine The Rest Of Their Spending

We’re on the right track, but stopping here would be premature. While their paystubs contain line items that they won’t have in retirement (payroll taxes, 401k contributions, etc), they also contain items that they will have in retirement that need to be added back in, namely health insurance.

Health insurance before Medicare eligibility is very expensive. Don’t let that stop you from retiring early, but make sure you have done adequate planning before doing so. According to my financial planning software, the national average per individual for private medical insurance is $17,555/yr. Once Medicare begins, we'll use the national average on Part B, D, and Plan G premiums for them.

Next, Michael and Holly want to spend their early retirement traveling far more than they currently are, mainly to visit their kids and grandchildren. Based on the travel they’ve already done, they believe a $15,000/yr annual budget will suffice.

Their retirement spending now looks like this:

And no, I haven’t forgotten about taxes. I promise we’ll get to that later.

In their early retirement, Michael and Holly are expected to spend far more than they currently are. Now you can see why it’s so important to be detailed and not rely on what “feels right” when it comes to retirement spending assumptions.

Step 3 – Account For Your Retirement Income

Spending is just one side of the picture, however. We also have to account for the income they’ll receive in retirement.

In Michael and Holly’s case, this is just social security which, according to their most recent statements, will be $4,216/mo for Michael and $3,950/mo for Holly at their Full Retirement Age (67). Social security optimization is beyond the scope of our discussion today, so we’ll just assume they both claim benefits at their full retirement age.

Step 4 – Determine Your Target Portfolio Balance

Armed with this context, we’re ready to determine their target portfolio balance. A lot of assumptions go into calculating this number and you have to know some pretty advanced time value of money concepts to get to the bottom of it. In my practice, we rely on calculators and other tools we've developed internally to help us determine this number for all of our clients.

It’s in this step that we also account for taxes. The methodology I employ behind this isn’t relevant, but the gist of it is that I take a lot of variables into account – including the tax-diversification of their portfolio, their age, their target spending and projected portfolio balance – to compute a tax buffer that gets added into the equation.

One last thing I’ll mention here is that we always plan for longevity and assume clients will live until the ripe age of 100. Obviously, this is conservative and will produce a higher target portfolio balance than if we assumed a shorter life expectancy.

Taking all of this into account, Michael and Holly’s target portfolio balance is $4,010,000.

BONUS Step 5 – Analyze Your Savings To Determine If You Are On Track

Knowing your target portfolio is just the first step, however. You also need to know if your savings habits combined with anticipated market growth is projected to reach your target balance.

We’ll assume that Michael and Holly have to pay for their daughter’s upcoming wedding and have budgeted $50,000 for this. They also need to replace Holly’s car before retirement and are budgeting $60,000 for this purchase. They also have a cash reserve target of $20,000. We need to make sure these short-term cash needs are excluded from what we’re counting in their retirement portfolio.

Michael & Holly’s current retirement portfolio value is $3,056,000.

At this point, the questions we have to answer are simple math problems. How much do Michael and Holly need to save to growth their current portfolio balance of $3,056,000 to their target portfolio balance of $4,010,000 over the next 4 years until their retirement, assuming a normal rate of return? In their case, it’s $0 per year, which simply means that market growth alone can be expected to grow their current portfolio balance to their target.

Finally, we just have to compare this to their current savings rate which we’ve broken down as follows:

If they keep saving at their current rate until their target retirement age, their portfolio can be expected to grow to $4,525,000, well in excess of their target balance.

What To Do Next

Once you know your target portfolio balance and have confirmed that you are on track to achieve it, you’ve completed a very important step of the retirement planning process. But you’re still only beginning!

You need to know how this portfolio is going to create an income for you in retirement, which will then tell you how to optimize your investments for long-term growth without taking on too much risk, which will then clear the way for you optimizing your plan for maximum tax efficiency.

And even after you’ve done all of that, you need to make sure that all of your assets and income sources are properly insured and that your estate is properly set up and organized. This entire process is the objective of comprehensive financial planning and it can make all of the difference between a retirement that is full or anxiety, uncertainty, insecurity, and failure, and one full of happiness, clarity, peace, and legacy.

If you’ve never gone through an exercise like this, reach out and apply to work with us! This is only one step in our comprehensive financial planning process which is designed to make sure that you get clear and comprehensive answers to the most important questions you can ask when you’re planning your retirement.