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How to Crush Retirement Planning

How to Crush Retirement Planning

Recently we simplified saving for college by helping you narrow down what financial assumptions to use. For my next trick, I’ll tackle an even more complex topic- retirement planning!

In this post we’ll do the same analysis for retirement planning that we did for saving for college, and simplify the process for you. I’ll walk you through the process of creating a budget, thinking through your financial goals and help you figure out what assumptions to use for retirement planning. I’ll also highlight why it is so important to start saving for retirement as soon as possible.

Creating a budget

It’s not sexy, but the first step in retirement planning is creating a budget. A well thought out budget accomplishes several important things:

    1. Highlights areas of your spending that you may want to reduce. I know my family spends too much money on takeout and delivery, and the occasional electric guitar
    2. Shows you how much you are can save each year.
    3. Helps you figure out how much money you need to accumulate to retire.

Additionally, if you can automate most of your bills then it should be relatively easy to figure out your budget. For us, all our paychecks and bills go through one bank, so it’s easy enough to track our income and expenses over time. It shouldn’t take longer than 15-20 minutes to create a budget, and once you’ve done this process a couple times you can probably get it down to about 5 minutes. That’s a great return on your time!

Thinking through your financial goals

It’s really valuable to think through what your financial goals are. Are you motivated to retire early so that you can travel the world or relax and play a round of golf every day? Do you love your career and want to keep working until you’re 65?

Either way, really set aside some time to think about what your financial priorities are. If you have a partner, make sure that you are both aligned on the same goals. If retiring early is your goal, then obviously you need to be more focused on reducing your expenses than someone who plans to work longer.

toon 1931

For my wife and I, our goal is to be financially independent by age 50. To us that means we won’t need to rely on our salaries after that point. That doesn’t mean we’ll both quit our jobs and move to a tropical island which sounds great, but likely we would continue working part-time, do some mentoring or coaching, or take on new challenges outside of work.

Our son will likely be starting college around that time, so that’s a good milestone for us to have most of our financial goals wrapped up by: college paid for, mortgage paid off, and enough money set aside to retire. If it takes a little longer to accomplish our financial goals, that’s fine too, but it’s highly motivating for us to know where we want to get to and then work backwards to figure out how to accomplish those goals.

We’ve made financial sacrifices to help us achieve our goals: buying used cars and keeping them for a long time (hello 2009 Toyota Corolla!), sticking to our budget when buying a house last year, and saving and investing aggressively. I know these habits will serve us well over the long run.

As Morgan Housel writes in his new book The Psychology of Money: “The highest form of wealth is the ability up every and say, I can do whatever I want today.” That quote nicely summarizes why we would like to retire early.

Calculate your results

Once you’ve created your budget and thought through your financial goals, you can plug in the numbers from your budget into my retirement planning calculator, to analyze how long it will take to save enough to retire. Don’t anchor too strongly on the outputs in the model, especially if you plan to work for at least another 20 years, but this can be a useful starting point.

You may notice as you play around with the inputs, that there is a large range of values for how much you may accumulate over time. For example, the following chart shows you how much you would have accumulated over 30 years given the following annual contributions and average annual rate of return. Values range from $1.7 million to $4.7 million!

retirement calcs

What assumptions should I use?

To narrow down this range let’s look at some of the assumptions involved in retirement planning.

I don’t pretend to know what inflation will be over the next 30 years or what investment returns will be like. If anyone tells you they know for sure, run the other way! But here are the assumptions I use and the rationale for why:

Inflation: I use a 2% inflation rate which is based on historical inflation in the U.S. and the Federal Reserve’s recent policy announcement. The Federal Reserve recently introduced a 2% average inflation target, meaning that they plan for U.S. inflation to average 2% per year going forward. The Federal Reserve doesn’t directly control inflation, but if U.S. inflation is below 2% in some years, then the Federal Reserve would undertake monetary policy actions to try and stimulate inflation above 2%. This framework was just announced, and it is not entirely clear how the Federal Reserve will pursue this policy. The Federal Reserve’s current economic projections don’t have U.S. inflation hitting 2% until 2023.

Investment returns: For expected investment returns, I use a 5% expected nominal return and I believe 5-6% is a reasonable estimate over time. No one can predict how financial markets will perform over time, but given the challenging investment environment with low expected returns on bonds and equities, I would rather be conservative and be able to retire based on a 5% average return than hope for 10% and be disappointed. It’s easy enough to modify your financial plan as your situation and financial markets change.

Desired annual retirement income: In terms of how much you need for retirement, think about your financial goals like we discussed above. A great starting point is to take your current spending from your budget and subtract any expenses that will be eliminated in retirement such as childcare expenses, 529 contributions, and mortgage principal and interest payments (assuming you plan to have your house paid off in retirement). From there add healthcare related costs and any other expenses you might expect in retirement such as traveling, golfclub membership, etc. Quite frankly, it’s hard to know what your desired spending will be in retirement, but this is a good starting point.

Tax rate in retirement: Your tax rate in retirement will likely be much lower than it is currently. For married couples, the first $24,000 you earn is tax free due to the standard deduction. Additionally, married couples don’t have to pay any income tax on the first $78,750 of capital gains. Finally, any assets that you have in a Roth IRA or Roth 401K can be withdrawn tax free. As a result, it’s possible to earn more than $100,000 in retirement without paying any federal taxes, although you would likely owe some state taxes. Of course, the tax code will likely change over the next few decades, especially given our current fiscal deficit. As a result, I use a 10-15% tax rate in retirement, to be conservative.

Start saving as soon as you can

A popular Chinese proverb says: “The best time to plant a tree was 20 years ago. The second best time is now.”

We discussed this message with saving for college, start saving as soon as you can. Even small contributions add up over time. Maximize contributions to your retirement accounts (401K’s/IRA’s) first, and make sure you have an adequate emergency fund (middle of that page), before contributing to a brokerage account. Once you are able to maximize your retirement account contributions, then it’s entirely up to you how you decide to allocate remaining funds between your financial goals: debt reduction, saving for college, or contributing to a brokerage account.

Let’s look at the power of starting to save early. We’ll compare two people who each save $1.45 million and each earn a 7% annual rate of return, but start saving at different ages. Early Eric starts saving at age 25 and ends up with $4.9mn saved at age 60. Late Louie starts a decade later at age 35 and accumulates $3.5mn at age 60. As you can see Early Eric has accumulated $1.4mn more despite contributing the same amount and earning the same annual rate of return as Late Louie.

To finish with the same $4.9mn, Late Louie would have had to contribute 42% more than Early Eric over time to also finish with $4.9mn at age 60.

the power of saving early

Starting to save early and saving at a high rate also provides a hedge against an unknown future. Quite frankly sh*t happens! Unexpected medical expenses, expensive home repairs, or job losses are more common that we would like. This pandemic has clearly brought to light how unpredictable and unstable life can be. However, by continuing to save and invest aggressively you can help cushion yourself and your family from difficult circumstances.

Additionally, savings gives you options such as pursuing another career, launching a business, or even taking some well needed time off. All of these decisions have to be weighed against your financial goals but can only really be pursued if you have adequate savings readily accessible in a savings account or brokerage account.

To start investing check out my asset allocation suggestions here as well as this recent blog post on asset allocation strategies.

Conclusion

If you haven’t started saving yet or are just starting the process, don’t worry about it. There’s nothing you can do about your past financial decisions, other than to learn from them. We’re all guilty of spending too much money on frivolous things, but the budgeting process will help you identify areas where you can reduce your spending. Additionally, it’s important to think through your financial goals, and make sure your actions are aligned with those goals. If you want to retire early, you’ll want to avoid buying a new car every few years! Finally, I recommend rerunning this analysis on an annual basis. It shouldn’t take too long for most people to rerun this analysis, looking at your account balances, and any changes to your budget.

 

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