Part Three of Three Parts
Many people think (in most cases erroneously) that their living expenses will be lower in retirement than when they were working.
Certainly, some people make a strong effort to downsize at retirement and work hard to reduce debt before retirement.
The unfortunate truth is that it will almost always cost more than you plan on to retire. Therefore, your retirement portfolio should provide for this.
Living expenses will be higher in retirement than you think, and your investments will earn less than you hope, particularly when you add income taxes to the mix. You can look forward to some of your living expenses dropping or going away completely when you retire.
This is the third of a three-part series on investing in retirement. There are links to the other articles in this series at the end of this article.
Retirement usually means no more work clothes to buy, no more commuting expenses, and lower or no expenses for children. That's the good news.
The bad news is that items like health care, travel and hobbies will likely increase and at a pace higher than the rate of inflation. Thanks to inflation and a consumer-driven economy, prices keep going up on many items you will need during retirement.
For example, assume you will need $50,000 before taxes (but not including Social Security) a year to cover expenses in retirement. Your portfolio needs to generate this much cash each year. Without drawing down any of your principal, you will need almost $850,00 in your nest egg (assuming a 6 percent return).
If inflation holds at 3 percent, your cash needs to grow by at least that much every year. Many investors believe a 3 percent return is not a big obstacle under most circumstances. However, a different picture emerges when you go into the second year of retirement and beyond. Your portfolio must cover 3 percent inflation every year, in addition to the original $50,000 goal.
In Year 2, inflation pushes your cash needs to $51,500 ($50,000 plus 3%). Now, your portfolio needs to earn a better return each year just to stay even with inflation.
You can see the problem. Every year you have to earn a better return than the previous one just to stay even.
To complicate the matter, this scenario assumes a static 3 percent inflation rate. While that is possible, history suggests it would be unwise to assume inflation is going to remain contained for the duration of your retirement.
In addition to inflation, certain costs historically rise faster than the rate of inflation, such as health care and real estate. Inflation reflects an overall cost increase, but it does not account for rapid increases in specific costs for all products or services.
There are obviously some alternatives to this scenario. One is to draw down on the principal (unless you are committed to leaving the entire amount to your heirs) for some of the annual living expenses. This is one of the more common solutions.
The concern here is that every year you withdraw principal, there is less money working harder to meet the cash needs the next year.
Another alternative is to structure your portfolio to include some growth stocks or mutual funds, even in retirement, in an effort to keep pace with annual expenses plus inflation and taxes. Growth stocks have historically beaten inflation, although there is no guarantee they will in the future.
It may look like there is no way out of this dangerous mine field, but that's not the case. Many people find that it is helpful to pay a financial planner to help them devise a retirement plan that considers all the possibilities and gives them a plan of action to work on.
A wise financial advisor once wrote, "The best time to start investing was yesterday. The second best time to start investing is today."
Time is your best ally when building a strong retirement program. Don't wait for the perfect time to start investing - it is already behind you - start today.