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The First Step Towards a Successful Retirement

A successful retirement is a very desirable goal. Unfortunately, the first and most important step to ensuring a successful retirement is not what anyone wants to hear - creating a spending plan (aka a budget). While working, high earners generally don't feel compelled to create or follow a budget or to track spending. Income is high enough to cover monthly spending, and there is plenty of savings occurring too. Besides, they are busy with their careers and don't feel the need for another tedious and seemingly unnecessary job. However, there is no possible way to know if they are saving enough to sustain their desired retirement lifestyle because they have no idea what their current or anticipated retirement lifestyle is!

The First Step—What Are You Spending Now?
Of all the pre-retirement steps needed to ensure you are ready to retire, having a clear and realistic idea of your current spending is the necessary first step. It would be dangerous to embark on a new phase of life without knowing how much it really costs you to live. In fact, of all the variables used in your financial plan, it is your projected spending that is by far the most significant—even more than investment returns. But how can you estimate your future retirement spending if you are not really sure how much you are currently spending? You must first identify what your current pre-retirement spending is before you retire. You must have a baseline budget or starting point to evaluate how your spending may change as your retirement years unfold. Your current spending is the foundation upon which your future spending plan will be built. There is no way to know if you will have enough money to retire without first understanding your baseline spending.

Track Spending for a Year
How do you figure out how much you are currently spending? You do this by tracking your regular recurring spending over the course of a year. You need to capture only a few major categories (you can add more detailed line items later). Start with your Fixed Living Expenses such as home repairs, property taxes, charitable contributions, insurance, utilities, and groceries. These are the expenses that will remain quite stable into your retirement years. The second category would be Discretionary Living Expenses such as entertainment, eating out, gifts, and travel. Because these expenses are discretionary, they are adaptable as needed. The third category is simply Mortgage Payments. Separate these from your fixed expenses because it is a large expense that will likely disappear in retirement. The last category would be Medical Expenses. While medical expenses are part of your fixed living expenses, these should also be separate due to the significant changes in the amount of these expenses as you move from work to retirement, to Medicare age, and finally to old age. You only have four categories to track, so for now, we will ignore the big Capital Expenses such as home improvement and automobiles.

By far, the easiest method of tracking your baseline expenses is the use of Mallard's WealthWindow which is available to all of our clients. This personal financial website pulls in every spending transaction from all spending sources - checking, savings, credit cards - and places them into one register. With this data in one register, these actual expenses can be easily categorized into one of the four categories. Then, at the end of each month they can be totaled in a separate and very simple spreadsheet. This spreadsheet can then tell you your annual recurring lifestyle. Others may use Quicken, review year-end credit card/bank statements, or simply enter all expenses as they occur into a spreadsheet. Do whatever works for you.

Once you have nailed down your annual recurring expenses, you have accomplished a lot. However, it is the sporadic and large "surprise" expenses that, if ignored, will torpedo your financial security in retirement. Emergencies don’t stop just because you’ve retired. That septic system is still expected to fail, only now you’re not going to be able to generate extra employment income to pay for it. Therefore, it is important to build in a strategy for how you’re going to deal with these large expenses (both expected and "unexpected”) in retirement. You can't allow them to be a surprise. Instead, you must anticipate and plan for them by building a realistic ongoing estimate for them into your retirement lifestyle. However, because they are so sporadic, trying to figure these out by tracking your last year of spending will not work.

These big non-recurring expenses are called Capital Expenses and may include the purchase of an automobile every five years, remodeling of the kitchen, replacing the septic system or the roof. You may also include one-time "surprise" expenses such as weddings or helping the kids. Since historical data doesn't help much in estimating your future Capital Expenses, you need to estimate an average annual figure for these based upon expected purchases over the next ten years and include this in your retirement budget. At Mallard, we have a tool we use to help clients get to a reasonable estimate for their annualized capital expenses. For now, just start with a rough estimate.

Discover What You Want in Retirement
Once you have a baseline of your current pre-retirement lifestyle, you can begin to build an estimate of your postretirement lifestyle. However, you first need to know what you want your retirement to be like in order to estimate the cost. This is no simple task. While beyond the scope of this article, I think working with a retirement transition coach or therapist can be critical to designing a retirement lifestyle that reflects who you are, and what you desire during your retirement years. You certainly don't want to find yourself going from the rat race to total boredom.

Part of designing your retirement lifestyle is getting some clarity around what you will be doing. You need to build a budget based upon the life you envision in retirement. Do you plan to travel first class or coach? Do you plan to live a life of full-time RVing? Or do you see yourself spending most of your time with your children and grandchildren? Do you plan to downsize to a small cottage in the woods? If you don't know what type of things you want to be doing in retirement, then you won't be able to build a retirement budget.

Time to Adjust Your Baseline Budget
With your current baseline budget in hand, and with some understanding of what you will be doing in retirement (and therefore the cost), you can now begin to make some adjustments to each of the five budget categories. Perhaps you will spend less on your children. If you elect to pay off the mortgage, that expense will disappear for good. Perhaps your spending on travel will double. If you are retiring prior to Medicare age (65), it is likely your medical insurance and related costs will go up. There will naturally be a variety of adjustments from your current baseline as you transition into retirement.

What Are Your Retirement Spending Phases?
Now that you have your baseline budget, do you project each expense line item out year by year until the end? Don’t bother. Instead, choose the phases when major spending shifts occur, and build your budget with line item changes only at each phase. For example, if you are currently age 55 and plan to retire at age 58, then age 58 is clearly your first phase. You would then be retired and ready to spend money in a whole new way based upon your envisioned retirement lifestyle.
However, it is your medical costs you should get the best handle on. If you are moving from employer subsidized health coverage to Healthcare.gov where you will be 100% responsible for the costs, you may be shocked at the new cost of the medical expense line item (unless you qualify for a premium assistance tax credit due to low taxable income). This is why getting a handle on this particular line item at this phase is crucial.

Previously, while employed, your employer might have heavily subsidized your health insurance costs (average of $5,300 per year). Now, this employer subsidy will be gone unless you are one of the few lucky ones with pre-65 retiree insurance from your employer. Retiring prior to your age 65 without employer-provided coverage generally means you will either elect COBRA coverage, or more likely, you will obtain your insurance from the HealthCare.gov Marketplace. For example, let’s assume the total cost of pre-65 health care is $25,000/year (for two) and is made up of a nonsubsidized premium of $15,000, and $10,000 of out-of-pocket costs. Prior to retirement, it may have only been $5,000/year, so this is an increase in annual health care expenses of about $20,000/year. The good news is this jump in cost is temporary. This is because at age 65, when Medicare kicks in, medical expenses could drop to (for example) $15,000/year (which includes both Medicare premiums and Medigap coverage). As you reach age 65, this becomes your second phase.

The next big change in spending might be when you see your travel and entertainment budget settling down. Perhaps you are no longer spoiling the grandkids. This will be your third phase, which I will assume occurs at age 80. The age you use will depend on your health and proclivity to travel. Essentially, you are settling into lower expense activities.

Finally, it may be prudent to include a fourth phase. That is the point where, if you live long enough and you can't take care of yourself, someone else is paid to do so. In that event, many other expenses drop. Your house has been sold and all of the ongoing expenses disappear. Travel and entertainment stops altogether. Likely, you are left only with the cost of the long-term care expenses, some Medicare/Medigap premiums, and some expenses for personal care and gifts to the grandchildren.

On the first page, you will see a table summarizing the expense categories and amounts at each phase as discussed in this article. This table has also been converted into the graph below. All numbers are in today’s dollars (i.e., not inflation adjusted). While each phase shows a big change in spending, naturally these changes will likely be more gradual through these phases. We are not trying to capture a year-by-year budget, but instead we are trying to capture a realistic spending pattern over time based upon your wants, hobbies, health, and goals.

The changes over time used in my example are not arbitrary, but are consistent with the experiences of my cents. More importantly, the retirement spending research also shows that spending decreases similarly over time (again in today’s dollars) by about 10% per decade in real dollars (just like the graph).

Financial security is having a high degree of confidence that you have accumulated enough assets and/or income to sustain your desired retirement lifestyle for the rest of your life. With this retirement budget in hand, you will have taken the first (and most important) step towards a successful retirement. This is because only now can you get an idea of exactly how much you will need to accumulate in order to retire and sustain these expected retirement expenses.

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