The “When Can I Retire” series is the most important set of articles I’ve written thus far in The Retirement Manifesto. Anyone within 10 years of retirement should run the exercises outlined in this series, and take the time required to understand the methodology, before making your decision to retire. At a minimum, run a detailed online calculator (I’ll have a future article on this topic), which will require much of the same information outlined in this series.
It’s critical to be certain, before you retire, that your spending can be supported without a paycheck. Achieving this key milestone is what I consider “Financial Independence”, and is the earliest date you should consider for potential retirement. Determining when you have reached this critical point in your life is the primary focus of my four part series on this topic (today’s article is #3 in the series).
As a refresher, following is the outline of the “When Can I Retire” series. Note that article 1 and 2 are hyperlinked, you can simply click on the titles below to review the article:
When Can I Retire – Outline:
- Spending Plan – Estimating your post-retirement spending requirements
- Retirement Income Plan – How much income you can assume from your resources?
- Contingency Plan – Today’s focus
- Putting It All Together – The Retirement Cash Flow Model
* If you’ve not yet read or completed Step 1 (The Spending Plan), and Step 2 (The Retirement Income Plan), plesae click on the links above to review these steps – your plan must be completed in sequence, and you should complete these steps before moving forward with Steps 3 and 4.
Now that you’ve completed your Spending Plan and Income Plan, the logical next step would be to put it all together and determine when you can retire!
Not so fast.
Before jumping to the conclusion, there are some very serious considerations you need to think through. You must understand various risks and their implications associated with your retirement planning before you can make any final decisions. These risks, as well as potential contingency plans to offset these risks, will be the focus of this week’s article.
Following are some key risks for consideration as you close in on finalizing your retirement cash flow plan. This is not intended as a comprehensive list, and I’m sure there are others you could add. Each risk is addressed in detail below:
- Longevity Risk: No one knows when they’re going to die.
- Inflation Risk: High inflation can devastate a retirement plan.
- Unplanned Spending: Spending “shocks” can derail the best laid plans.
- Sequence Risk: What if there’s a major stock market correction early in your retirement?
- Cognitive Decline: How are you going to handle things if your mind decays?
- Poor Investment Return: What if your investment returns are below your plan?
1. Longevity Risk: It would be much easier to finalize your retirement cash flow plan if you knew when you were going to die. Since you don’t know, you must face the reality that your funds may need to last well into your 90’s or beyond. I suggest you assume a long life, and build your plan accordingly. If that means working several more years before you can retire, do it. It beats the alternative of running out of cash when you still have 3-4 years of life left. There are also financial strategies (e.g., deferred annuities) to address this risk, but they’re beyond the scope of this article and will be addressed in future posts.
2. Inflation Risk: In your “Spending Plan”, you should have an inflation adjustment to automatically increase your spending in every category, every year. For example, if you have a 2% inflation assumption on a $1000/year item, the following year it should show as $1,020. To get a sense of how damaging the increase of COMPOUNDED inflation can be, increase the adjustment to 4 or 5%, and look at change in your spending 10-20 years out. A small annual change in inflation, when compounded over many years, makes a huge impact. When your income sources are essentially fixed, inflation increases in your spending can ruin your plans. I would encourage you to run various scenarios of your spending plan, including at least one scenario with a higher than expected inflation assumption.
3. Unplanned Spending: Any “spending shock” beyond what you’ve assumed in your Spending Plan can deplete your resources more quickly than planned. The biggest shock risk is likely to be health care, especially in your latter years. Other areas of risk: those “one off” surprises that tend to come from time to time. I’d suggest you build in a spending category to pick up “unbudgeted” spending, and monitor it from year to year. For health care risk, you should have at least one “Spending Plan” scenario where you face significant health care costs within the last 5 years of life. Make sure you have a buffer to handle these shocks, as you’re likely to face a few over the course of your retirement.
4. Sequence Risk: A major stock market downturn, especially early in your retirement, can devastate the potential of your portfolio to generate sufficient income throughout retirement. To offset this, I strongly encourage a minimum of 2 years living expenses be transferred into a safe and liquid asset class (e.g., money market fund) prior to retirement. I’ll have a future post on withdrawal strategy, but in general a long enough “cushion” should be maintained to ride out market downturns.
5. Cognitive Decline: If you manage your own investment portfolio, be aware that cognitive ability declines with age. Also, if your spouse will be assuming responsibility for your investments after your death, recognize their skill set may not match yours. My plan to address this: I’ll be moving to Vanguard’s Personal Advisory Service in my early 70’s, at latest. You could also consider moving management of your funds to a qualified financial planner.
6. Poor Investment Returns: If the markets return less than you’ve assumed in your “Retirement Income Plan”, the ability of your portfolio to cover your spending needs will decline. To offset, insure your assumptions are conservative, and be prepared to reduce your spending if the markets suffer low returns over a sustained period.
Having identified these risks, I’d encourage you to review both your Spending Plan and Retirement Income Plan to incorporate any revisions before we move to the final step (putting it all together) within the next 1-2 weeks. You can, and should, also run two or more variations of your Spending and Investment Return plans to show a “Projected” and “Conservative” scenario. Another option is to use Monte Carlo simulations, available in some online calculators or from a Personal Investment Advisor, to model various scenarios and ranges (more on this when I review online calculators in a future post).
In my own planning, I’ve made conservative return assumptions, somewhat escalated inflation assumptions, and built buffers into my spending plans “just in case”. I’ve also prepared a “worse case” scenario to insure I’ve recognized potential risks. Finally, my wife and I are also prepared to reduce spending if investment returns fall below projected levels for an extended period of time.
In the next, and final, post in this series, we’ll put it all together. The output:
You’ll know “Your Number” – how much you’ll need to save to generate the income required to be Financially Independent, and the earliest point at which you should consider retirement. You’ll also get a sense of “Your Date”, or the earliest date at which retirement is economically feasible for you.