Many people are taking a much closer look at retirement planning and retirement saving, and with good reason. The questions surrounding Social Security and Medicare, low interest rates on savings, volatility in investments, and the departure of pensions from most jobs, has changed the landscape of retirement planning and retirement savings. Regardless of our age, a retirement plan is necessary for that time in our lives when we retire or work in a reduced capacity. We can’t predict the future, but we can plan for the expected and the unexpected by evaluating our plans regularly with up to date information, and be sure that we’re taking into account all of the things that might affect our financial health. Here are a few mistakes that I often see in retirement plans.
A common mistake in retirement planning involves our annual expense amount in retirement. It might seem logical that expenses in retirement would be lower than preretirement expenses, but millions of Americans are finding out that this isn’t the case. Although we may not have a car payment in retirement, it may be replaced with a Condo maintenance fee or lawn care expense. When estimating an expense amount for retirement, we have to be careful not to short-change ourselves. It will be very difficult to increase our income if we begin to run out of money in the middle of retirement. Then, once we determine a realistic annual expense amount, we need to consider how this amount might change over the course of our retirement years.
Inflation is often overlooked in retirement planning and can have a major impact on expenses due to the long period of time involved. For instance, if my monthly expenses today are $3,500 or $42,000 annually, with a 2% inflation rate I can expect my expenses to be $42,840 next year. If inflation remains constant, after twenty years the same annual expenses will cost over $62,000. This is an increase of $20,000 in my annual expenses just due to inflation. And if I’m a younger person and won’t be retiring for another thirty years, and my life expectancy is thirty years beyond that, I can expect sixty years of inflation to impact my expenses through my lifetime.
The chart below shows the change in a $71,400 annual expense amount as result of 2% inflation for someone thirty years old, planning to retire at age sixty-five, with a life expectancy thirty years beyond retirement.
We can easily see from the chart that inflation has a great impact on the total amount we would need to retire.
The Total Retirement Savings Amount
Another common mistake in retirement planning involves the total amount that we need in our retirement savings, and overlooking inflation is one culprit as we’ve seen. If my annual expenses at retirement are $50,000, and I expect to live another thirty years, then without considering inflation I would need $1,500,000 in savings at retirement.
$50,000 x 30 years = $1,500,000
But my annual expenses will be increasing because of inflation, and if inflation is constant at 2% I will actually need $2,118,972. This is a difference of $618,972 that I would have overlooked.
Another area where mistakes are often made in determining the total retirement savings amount has to do with savings longevity. This is number of years that my retirement savings will last as I withdraw each year to pay expenses. This area is covered in detail in chapter 14 of my book Personal Finance Simply Understood, and I’ll note the areas that must be considered here.
- My life expectancy estimate must be realistic or I could outlive my savings
- My annual withdrawal amount will increase as expenses increase each year
- If I withdraw 4% of my savings each year, and my savings isn’t growing by at least 4%, then my savings is shrinking and could eventually run out
- If I use all or most of my savings to purchase an annuity, then I have no cash available for a financial emergency
- Social Security may be adjusted at some point in the future
Whether retirement is far or near, retirement planning and review is essential and must include all of the factors that affect our retirement savings. Obviously, waiting until the day arrives is not a good approach, and if we’re already retired then an annual review should be conducted to ensure that we’re on sound financial footing. The alternative is being unprepared for a time in our lives when we should have fewer financial responsibilities and should be applying ourselves to more personally fulfilling activities, and possibly outliving our retirement savings.
Thanks for reading.