3499: [Part 1] How to Model the Retirement Income Gap by Darrow Kirkpatrick of Can I Retire Yet

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This is Optimal Finance Daily.

How to Model the Retirement Income Gap.

Part 1 by Darro Kirkpatrick of caniretirea.com.

The textbook or fairytale version of retirement goes something like this.

You work your entire career until you save your retirement number

or reach the pension or social security age around 65 later for many boomers.

Then your paycheck stops and your retirement income starts.

This is a convenient fiction for discussing retirement in sound bite size chunks.

The only problem is that it isn't realistic for many of us.

That textbook version of retirement features a relatively steady and predictable cash flow.

One, you collect a paycheck for 30 to 40 years.

And then two, you collect pension, social security, or a newity checks for the rest of your life.

Unfortunately, the reality is that many of us in the boomer generation and succeeding generation

X and Y won't experience that steady fairytale flow of income in retirement.

Here are just three of the possible reasons why.

Number one, you may get laid off or retire early before a pension or social security starts.

Number two, you may decide to defer social security in order to increase your lifetime benefits.

And number three, you may have a spouse who retires on a different schedule with benefits

starting at a later date.

If your situation resembles any of these, then your retirement equation is a bit more complex

than the often recommended save some multiple of your expenses model.

Simply subtracting your guaranteed income from your expenses to see if you have enough savings

to cover the shortfall doesn't cut it since your income will change during retirement.

If you're serious about modeling and understanding your cash flow in retirement,

knowing if you'll have enough, how do you handle this kind of retirement income gap?

Is there really a single retirement number you can compute in this case?

First, the bad news.

This is going to require some math or some software tools and probably a bit of both.

Or you could pay a financial planner to answer the question for you.

However, I'd encourage you to try it yourself first because the good news is that it's relatively

simple. And by taking ownership of your own retirement model, you'll be in the driver seat

when inevitable changes happen and questions arise.

You'll be able to tweak the inputs and answer those questions quickly at home.

You won't have to find schedule, communicate with and pay a professional just to understand your

financial future. So let's get started. There are two fundamental ways that I know how to look at

this problem of uneven income in retirement. Cash flow and present value.

Mathematically, they're equivalent. One is not superior to the other, but they do require different

tools and one lends itself better to a detailed analysis while the other is better as a rough

estimate. If possible, use both at the start. That way, you can double check your own situation

and also form your own preference between the two. That's what I did.

Cash flow. This is the easiest technique to understand, but the hardest to perform without some

software support. Essentially, it's no different than balancing a checkbook, but on a longer

time scale. So you start with your current savings. Then, for each year of the rest of your life,

you simply add in your income and subtract out your expenses. For greater accuracy,

you must also add in investment returns for each year, while adjusting your expenses for

possible inflation and taking out taxes. The main benefits of this approach are that it's

simple to understand in theory and it provides a comprehensive view of your financial life.

For each year, you get a detailed snapshot of your financial position, seeing all the

inflows and outflows. And this approach can naturally handle an infinite variety of future

events. Your spouse is switched to part-time work in three years.

The new car you expect to buy six years from now. The start of your delayed social security

benefits in eight years, for example. The main drawback to cash flow modeling is that it's data

and time intensive. Done comprehensively, there are lots of inputs to be gathered,

a great deal of number crunching to be performed, potentially a dozen or more calculations for

each year of the rest of your life and reams of output data. Software tool support of some type

is essential. An electronic spreadsheet like Excel can be a good starting point for this type

of simple cash flow analysis. Rose and the spreadsheet represent a year in your life.

Columns might include your age, beginning asset balance, income like pensions, social security,

investment or rental, expenses, taxes, net cash flow and ending balance. This is workable for

a simple analysis. However, setting up the formulas for such a spreadsheet model can be time

consuming unless you're a spreadsheet whiz. Also, comparing different scenarios or modeling

advanced situations can quickly become unwieldy. That's where the dedicated retirement planning

tool comes in. The one I've used for years is the J&L financial planner. At its core is a simple

and powerful financial simulator. First, you set initial conditions such as current savings,

expected returns and tax rates. Next, you define a schedule for financial events such as rate changes,

deposits, transfers, loans, mortgages, debts and withdrawals. The program then takes the initial

conditions you've defined and applies your events in an annual loop, reporting and graphing

account balances and other metrics for each year along the way. The J&L financial planner also

offers professional planning features such as multiple accounts, asset allocation,

required minimum distributions, Monte Carlo and historic return analysis,

rules 72T distributions and scenario comparison. The program is offered in several versions,

including the entry-level regular version for $80, and you can try it for 21 days before buying.

Note, this is Windows desktop software that has been around for many years. There may be some

friendlier and more modern tools available on the web, but I doubt there is any more powerful.

Ultimately, what you wind up with from a cash flow analysis is a long-term picture of your net

worth year after year going into the future. If that net worth stays level or goes up, that's good.

If it trends down, then you're facing a sobering race against the calendar. Will your life or your

money run out first? To be continued. You just listened to part one of the post titled How to

Model the Retirement Income Gap by Darro Karpatric of Can I Retire Yet.com.

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Figuring out a good drawdown strategy is something discussed often in the fire community.

While I DIY my financial planning and investing now, I'm in the accumulation phase,

and things are pretty simple at the moment. I definitely see myself consulting a flat fee advisor

to help me with the kind of modeling described in this article.

However, I've heard from many friends who are currently drawing down on their portfolios

that in the face of an uncertain future, you're better off relying on general rules of thumb

rather than trying to suss out and predict every last detail for the rest of your life.

And that's what the 4% rule is. It's a guideline. The downside is that the model assumes that you

have no other income and will never have any other income from the rest of your life,

which for most people isn't true. Social security is going to kick in at some point if nothing else.

Also, early retirees oftentimes go on to create businesses or find other hobbies that end up

earning them some money that they didn't anticipate when they were retiring. It also assumes

that you'll never decrease your spending for any reason. It doesn't consider when Medicare

kicks in and reduces your health care costs, and it assumes that your personal rate of inflation

will match the overall rate of inflation, which for the frugal among us is laughable.

Rather than plan your withdrawals for the rest of your life based on the 4% rule,

it makes more sense to have flexibility and refine your retirement plan annually.

Some other tools that I've heard great things about for modeling include portfolio

visualizer and on trajectory. Well, that should do it for today. Have a happy rest of your day

in a great weekend, and I'll see you in tomorrow's show where we'll finish up this post

and where your optimal life awaits.