Setting Up a Spending Plan for Retirement
Key Points – Setting Up a Spending Plan for Retirement
- Your Spending Plan Is One of the Most Important Pieces of Your Financial Plan
- It’s Pivotal to Truly Understand Your Expenses and Establish a Budget
- What Are Some of the Out-of-the-Ordinary Expenses You Need to Account for in Your Spending Plan for Retirement?
- How Will You Go About Managing Income Sources for Spending?
- 13 Minutes to Read | 24 Minutes to Watch
7 Reasons Why Setting Up a Spending Plan for Retirement Is Critical
Setting up a spending plan for retirement is one of the most critical components of a financial plan. Will Doty joins Dean Barber to help explain a few reasons why that’s the case on the Modern Wealth Management Educational Series.
What You Can and Can’t Control in Today’s Markets and Economy
Before Dean and Will address the importance of setting up a spending plan for retirement, they want to give a quick overview of exactly what’s going on in the economy and the markets. Being a do-it-yourselfer can be a great quality. However, it can also be dangerous to take that approach right now with financial planning.
“The economy, interest rate environment, inflationary environment, and what’s happening in the stock and bond markets has people’s focus in areas that they literally can’t control. We understand with financial planning that there’s an art and science to it,” Dean said. “It should also be used to help people understand what they can control and focus on those things. And for the things they can’t control, make sure your plan is set up in such a way to think through them and stress test for them.”
Creating a spending plan for retirement is something that is in your control. Let’s review how to go about setting up a spending plan for retirement so that you can gain the sense of control that is critical to living your one best financial life.
1. Understanding Your Expenses and Establishing a Budget
When our advisors first meet with clients or prospective clients, they often see that many of them haven’t created a budget in years. Typically, people think that budgets are for those who don’t have much money. Hopefully, the fact that it’s the first point on our list of setting up a spending plan for retirement helps to show that that’s a common misconception.
Why Is a Budget Necessary in Retirement?
Retirement planning is all about cash flow management. If you don’t know where your cash is going, how are you going to manage it?
“You need to start out by figuring out your daily expenses. What does it take to put food on the table, clothes on your back, gas in the car, and things of that nature?” Will said. “That can allow you to figure out what your budget needs to be. From there, you can figure out where your dollars are going and what’s being saved. That all can go into a plan.”
Two Different Scenarios
Let’s break down spending plans for retirement for those who are preparing for retirement and those who have already retired. Pre-retirees set up a spending plan well before retirement with the mindset of what they want their life to be like in the future. They’ll look at what they’re spending today and assess if that’s comfortable now and if it would be comfortable in retirement. There could also be things you’re forgoing now that you want to do in retirement. How much will those things cost?
“That’s a difficult thing to do. Oftentimes, it helps to sit down with a CFP® Professional, like Will,” Dean said. “He’s witnessed it and has helped a lot of people go through that timeframe. And it’s not just getting to retirement, but through retirement. The budgeting process—the spending plan for retirement—doesn’t change just because you retire. It’s really the beginning of a new phase of the plan.”
There are two parts of it—before retirement and after retirement. When Will is meeting with his clients to put together their plan, he wants them to map out their dream retirement. Will knows that all the hopes and dreams they list might not be possible, but he’d rather have them on the table rather than immediately discount them and have them go unfulfilled.
How Inflation Has Entered the Spending Plan Picture
Considering inflation’s impact worldwide over the past several months, it’s become even more important to our advisors to make sure that clients aren’t ruling out their dreams. There have been a lot of people who have created spending plans for retirement, but it didn’t include their cost-of-living increasing like it has over the past year. That can cut into discretionary spending and fun things that people would rather spend their money on.
That’s why our financial planners stress test financial plans through various economic periods to determine if they’ll be OK or if they might have to cut back on some discretionary spending. Unfortunately, there is no crystal ball to predict what inflation will do in the foreseeable future.
“All we can do is look back at history and say, ‘Here are some really bad time periods of inflation. Let’s model those time periods.’” Will said. “Can your financial plan survive when being stress tested through those time periods? Can you still do the things you want to do?”
That’s why it’s so critical to establish the spending plan for retirement in the first place. It allows you to live your life. The spending plan is the foundation of your overall financial plan.
2. Plan for Out-of-the-Ordinary Expenses, Such as Cars, Homes, and Education
There are a lot of things that can be missed when setting up a spending plan for retirement. Those include but aren’t limited to how often you plan to or need to replace vehicles or if your kids plan to have more children (do you want to help with paying for your grandchildren’s education?). There are things beyond your normal spending that come up every year. It’s important to look back on those out-of-the-ordinary expenses and determine how often you might need to pay for them.
“You may need a new roof at some point or replace a refrigerator or water heater,” Dean said. “Those aren’t normal expenses, but those home improvements and repairs come up. They are all things that you need to keep in mind.”
In Dean’s 35 years in the financial industry, he’s witnessed countless occasions where people think they will be fine with having their monthly income amount be the same amount as their monthly spending amount in retirement, especially if they’re saving during their working years. Dean’s counterpoint to that is, “Are you going to do something different in retirement than what you’re doing in your career?” Maybe you’ll get an opportunity to purchase a second home or want to take longer vacations in the winter. Those are going to cost more money and need to be factored into your spending plan for retirement.
3. Build and Stress Test Your Plan
Once you create your spending plan, it’s time to go into your retirement plan and stress test it and your spending plan against all different types of scenarios. Now, we mentioned stress testing earlier, but it certainly bears repeating and having its own point on the list.
“Those scenarios can include stress testing against a market crash, Social Security going away, or inflation running rampant. We want to understand that if bad things happen, will your plan stay intact?” Will said. “We need to understand these things so that if they do start to unfold, we have an action plan. Maybe you need to cut back on travel for a few years until the issue subsides.”
For people who are just beginning to grasp the idea of setting up a spending plan for retirement, they might wonder how effective stress testing can really be. Well, part of the plan uses something that’s called a Monte Carlo simulation and part of the plan uses an historical audit. The Monte Carlo simulates 10,000 lifetimes. What percentage of the time would you have been successful and what percentage of the time would you need to make adjustments. The historical audit can take you back through certain timeframes and look at inflation rates, market returns, bond market returns, and see how you would have done. Let’s hear a quick example from Dean.
“If you have a plan that has an 85% probability of success, that means 85% of those 10,000 trials said you could do everything you wanted to do and never have to make a change in your proposed spending plan. But 15% of the time, you might have to make some short-term adjustments to that plan,” Dean said. “Some people think that they need to be at 100%. But if you’re at 100%, you’re overfunded and could be spending a lot more than what you think.”
Three Things You Can Do If Your Plan Is Overfunded
If you’re over 90%, you’re technically overfunded. Here are three things that Will suggests doing if your plan is overfunded.
- You can retire earlier.
- Spend more money.
- Take less risk with your investments because you don’t need a big rate of return to accomplish your goals.
4. Determine What Accounts to Spend from and when
Here’s another thing to carefully deliberate as you’re setting up a spending plan for retirement. How do you decide the order in which you’re going to spend your assets? Here’s how Will thinks through it.
“This is why tax planning is such a big part of what we do at Modern Wealth Management. We really want to understand how we’re going to draw down the assets that you’ve saved with keeping as little of it going to Uncle Sam as we possibly can?” Will said. “That’s a huge goal of ours. We need to identify the budget and how to start breaking down your assets. What bucket are we going to pull from in certain time periods?”
Those buckets Will is referring to are taxable, tax-deferred, and tax-free buckets. Then, you need to consider if you have pensions, Social Security, rental income, farm income, royalties, etc. So, what spending order do you take? Maybe you take a little bit out of each bucket to give you the highest probability of success with the lowest amount of tax? The less you pay in tax, the more you get to keep, which is obviously a big deal.
5. Monitor Your Spending Plan and Make Adjustments
So, let’s say you’ve now created your spending plan for retirement and feel like you’re currently in a good spot. That’s great! But just like with your overall financial plan, the sit-it-and-forget-it strategy isn’t going to work. That being said, how often should you update your spending plan for retirement?
“I would say you need to look at it at least every couple of years. I always urge my clients to review their spending plan for retirement about a year before their retirement,” Will said. “Go back through and look at your budget. Where is the money going? Are the numbers we put in your plan realistic or were we too low or too high? We need to understand that before you retire.”
This is where we want to circle back for a minute and discuss the importance of factoring in inflation to your spending plan for retirement. Up until the past few months, Will, Dean, and the rest of our team have been asked many times why inflation has been factored to a certain level into their plans when inflation had essentially been nonexistent. Well, the rampant inflation we’ve seen recently is exactly why. Without factoring it in, your plan can go south in a hurry.
Inflation Rates Vary Across Expenses
Inflating everything at the same rate within your plan can also lead to trouble. Our financial planners make sure to have different inflation rates for different expenses for all our clients’ plans.
“We inflate our average living expenses at one rate and inflate health care expenses at a different rate. Our cost-of-living adjustment on Social Security, we dampened that quite a bit, which a lot of people might not understand,” Will said. “For 2022, they got a huge cost-of-living adjustment. Well, guess what else happened? Medicare premiums went up, so that raise wasn’t as big as you thought it was going to be.”
There are also a lot of people who believe that they need to go into retirement with no debt. But remember, retirement planning is all about cash flow. Therefore, debt isn’t necessarily a bad thing within reason. You still don’t want to have tens of thousands of dollars in revolving credit card debt.
“If rates are low, having a mortgage or car loan isn’t necessarily a bad thing,” Will said. “You just want to understand that dynamic in your overall plan for your lifetime and what you’re trying to achieve.”
What Happens When a Plan Doesn’t Properly Account for Inflation?
There are several situations where being simplistic about things is the way to go, but your spending plan shouldn’t be one of them. For example, let’s say a plan is simply built and gives you a $5,000 monthly budget and has a 3% inflation rate on all your expenses. Dean shares just a few of the things that could quickly go wrong with doing that.
“What are you spending that $5,000 on? Some of it needs to be for health care costs and those are going up a lot higher than 3%,” Dean said. “Some of that $5,000 could be a mortgage payment right now. Maybe it’s $1,500 a month. Well, $1,200 of that is the mortgage and $300 of it is taxes and insurance. How much is that going to inflate by? The $1,200 isn’t going to inflate at all and there’s a finite ending period. That needs to be built into the plan that way or you’ll get bad information coming out of the software.”
The mortgage is a perfect example of using different inflation rates within your plan. Most people have the principal and interest part of your payment and then you have your escrow. After the principal and interest is done, the escrow is going to continue and it’s going to inflate over time.
6. Your Spending Plan Is Crucial to a Successful Retirement
The spending plan for retirement is part of the planning process that’s the most tedious, but it’s also the most important. There aren’t any shortcuts that will cover all your bases.
“I see so many online tools that ask you how much money you’ve saved, how old you are, and how much are you saving now? They won’t ask you about different tax buckets, what your Social Security is going to be, or if you’re going to have a pension,” Dean said. “It just says that you’re spending a certain amount and need to replace your income, so you need to be saving X. Then it will tell you if you’re going to be OK to retire. Those online tools are junk.”
It takes some time to get the right answers for your spending plan for retirement. It’s not as simple as just plugging in a few numbers and being set within five minutes.
7. Other Items to Be Aware of
Dean and Will covered a lot of the main points for setting up a spending plan for retirement, but there are a few more things that they want you to be aware of. They can’t emphasize enough how important it is to be as specific with your budget as you possibly can.
The Two Largest Expenses in Retirement: Health Care and Taxes
While people are working, they oftentimes don’t fully realize the importance of health insurance in a spending plan for retirement because it’s just coming out of your paycheck. It’s different when you retire.
Another point that Dean wants to emphasize is how taxes come into play when setting up a spending plan for retirement.
“Your two biggest expenses in retirement are taxes and medical, yet those kind of get lumped into the whole mix. You want to believe that you and your spouse will live a long, happy, and healthy retirement,” Dean said. “Your hope is that you’ll pass away within a few months of each other, and everything will be great. That doesn’t happen very often, though. Usually, one spouse might get sick and pass away, so the surviving spouse then becomes a single taxpayer. Their tax burden increases at a time when you’ll lose the smaller of the two Social Security checks. That needs to go into the spending plan for retirement as well and is a part of the stress testing.”
A lot of people also don’t look a tax rates enough to truly understand the differences between married filing jointly and single. When our financial planners are doing stress tests of a plan, one thing that jumps out to them immediately is how tax rates for a surviving spouse can quickly increase. That can cause the plan to begin to fail or for the surviving spouse to greatly alter their standard of living.
Long-Term Care Stays Can Lead to Long-Term Financial Issues for the Surviving Spouse without a Proper Spending Plan for Retirement
And staying on the topic of health care, budgeting for a potential long-term care stay is also something that isn’t fun to talk about. Dean thinks that you can look at this from one of two ways. Are you self-insured so that you know you have enough money so if one spouse does need to go into a long-term care facility for a few years, the surviving spouse will still be OK financially? Or would something like that devastate the surviving spouse so that they’d need to consider insuring that risk with either a life insurance policy that has a critical care writer on it or long-term care insurance itself.
Of course, that isn’t something that’s comfortable to discuss. When reviewing health care costs in setting up a spending plan for retirement, you’ll likely find stress testing to be helpful.
“Maybe the current expenses are higher than normal or you or your spouse has a stay in a long-term care facility than longer than normal for that age. You want to make sure that the surviving spouse is going to be OK financially,” Will said. “For example, if I’m 80 and plug into my plan that I’m going to end up in a long-term care facility for three years for an extra $120,000. Is my wife going to be OK financially until she’s 95 if that’s the case? Understanding that dynamic of the plan is important.”
Not only can the surviving spouse be impacted, but don’t forget about any children that the couple has that will be trying to help the surviving spouse.
Creating a Spending Plan for Retirement Should Be Exciting!
While health care expenses and taxes are vital components of setting up a spending plan for retirement that aren’t very fun to talk about, the overall process of setting it up should be exciting. After all, this is helping your dream retirement come true.
“You’re entering a phase of your life where you’re no longer working for your money but are asking your money to work for you,” Dean said. “It almost changes all the rules of how you think about financial planning and investing because mistakes that are made after you retire could force you to go back to work. That obviously isn’t something that is a part of the plan.”
Three Phases of Your Financial Life
The way our Modern Wealth Management team views it, there are three phases of your financial life.
- Your growth phase: You’re working and building up everything for retirement.
- Your transition phase: That’s when you’re really setting up your spending plan for your retirement. This is where many mistakes can be made if you don’t account for everything in your spending plan for retirement.
- Your maturity phase: That’s your retirement.
Don’t Fall into the Transition Phase Trap
One of the main retirement pitfalls Dean always tries to caution people about is the thought of being OK with spending less in retirement.
“That is typically the symptom of someone who hates their job and just can’t wait to retire,” Dean said. “They lull themselves into a false sense of security by thinking that what they’ve done over the last 40 years is magically going to change. Our job is to make a reality check when that starts to happen.”
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