Chapter 5
You Must Have a Specific Financial Goal

In order to achieve financial success, you need to begin with the end in mind. And the more precisely you can define what that end looks like, the more likely you are to reach your desired outcome. Once you've crystalized your financial goal, you need to plot out the necessary steps to achieve that success and consider how each of the steps you take will impact other facets of your finances. Finally, you need to put your plan into action, and adjust as appropriate over the course of your working career and retirement. Get all this right and you can achieve victory, in the form of a successful and prosperous financial future. But fail at any of those tasks, and your future may not look so bright.

Success begins with planning, so this is the part of the book where I sound like an annoying teacher as I remind you, “Failing to plan is planning to fail.” Yes, I realize that you've probably heard something similar before. And yes, the concept is self-evident. And yet, when it comes to their finances, the vast majority of individuals fail to plan appropriately.

Think about that for a moment. Almost no one you know would head out on a summer road trip without at least some sort of planning in place. At the very least, people usually have a destination in mind! Not to mention a map or GPS to tell them how to get where they want to go. And they usually have a general sense of how long it will take them to reach their destination, and what they'll do when they get there.

And then, when it comes to something that will determine the quality of approximately one-third of their years on this planet, those same people don't plan at all! In fact, many of them don't even know what their destination is, let alone how long it will take to get there, or what things will look like when they arrive.

I'm talking of course about retirement. Statistics show that the average American retires in their 60s and lives well into their 80s. Given increasing life expectancy, for many retirees the golden years may last three or four decades.

A 35-year retirement, for someone who lives into their mid-nineties, represents a third of their time on this planet. And the entire course of those years will be determined by financial decisions that person makes in the years leading up to retirement. Sadly though, many people fail to make any decisions at all, and fewer still follow a practical approach to defining and planning their retirement goals.

With that in mind, let me walk you through a process that should allow you to determine, with a reasonable degree of accuracy, what retirement will look like for you and what you need to do to get there. The following approach is not as precise as completing in-depth financial planning where you map out future cash flows, expenses, taxes, and the like. But it does represent a good starting point and completing this exercise will at least give you a sense of whether you're on track to retire.

Step One: Determine Your Vision of Retirement

The first step in the retirement planning process is to determine what type of retirement you want to have. This may seem obvious, but many, many people fail to complete this basic task. Oh, sure, they know they want to “retire” someday, but they lack a clear vision of what that might look like. For many busy professionals, the result is a lack of satisfaction early in retirement, as the day-to-day challenges of the workplace give way to an open schedule and empty calendar. To be fair, many of these people do eventually find productive and enjoyable outlets for their time and energy, but wouldn't you rather get started on the right foot immediately, rather than enduring a lengthy transition process?

Furthermore, determining what sort of lifestyle you want in retirement can have important financial planning implications. Think of the following questions:

  • When are you planning to retire?
  • Where are you going to live? Are you going to stay in your current home? Are you going to move out and downsize? Are you planning to relocate to a new city, state, or country?
  • Are you going to work part-time in retirement? If so, is it for personal satisfaction or because you need the extra money?
  • Do you have children or grandchildren you want to move closer to or visit regularly?
  • Do you want to travel more? If so, what does that look like and how much will it cost?
  • Do you have new hobbies or activities you plan to pursue?
  • What about volunteering? Is that something you always wanted to do?
  • How is your health? Do you expect to have a long and healthy retirement, or for some reason do you have cause to suspect that health concerns may play an issue in your retirement?
  • Does your spouse or significant other share your views on these and other important lifestyle issues? Have you even discussed them together?

Things can change over the course of a lengthy retirement, but having some vision of your end goal will help your planning process immensely. At the most basic level, doesn't it make sense to have an idea of when you want to retire? And wouldn't the rest of those questions have an impact on how much money you'll be spending in retirement or how long you'll need your retirement funds to last?

So just to reiterate, the first step in retirement planning is to come up with a vision for what your retirement will look like, and the clearer that vision is, the better your chances of bringing your dream to fruition.

Step Two: Determine How Much You Spend Today

I personally don't believe that it's necessary to calculate exactly how much you spend on lattes, dry cleaning, movies, and so forth. If you want to do so, or if it helps you stay on track, that's fine. But when it comes to determining how much you spend today, the important thing is to get the big picture right.

How much do you spend on housing, cars, utilities, and the like? And don't forget about the “oneoffs” that seem to recur pretty much all the time. Be honest, you may not go on that cruise to Alaska again, but you're likely to go somewhere. And while a new car for you may be a one-time purchase, your spouse may need a new car in two years. And at some point in the future, maybe you'll upgrade again. The same holds true for home repairs and even home improvements. One-time purchases are by definition one time, but you should try to incorporate them into your spending and average them out. For instance, if you spend $30,000 on a new car every six years, you spend an average of $5,000 per year on new cars.

Again, the key is to get an estimate of how much you spend. The more accurate you can be the better. If you're not sure, here is a simple exercise. How much income did you have last year? You probably know the answer to that. How much did you pay in federal, state, local, and Social Security taxes? You can get that off of your W2 form or tax return. Finally, how much did you save? You can figure this out by looking at your brokerage, retirement account, and savings account balances. Did they go up or down? By how much? (Don't forget to subtract market gains or add back market losses as you do this. You are only interested in determining your contributions and withdrawals.)

Once you know how much you made, what your taxes were, and how much you saved, you also know how much you spent, because the answer is simply this: Your income minus your taxes minus your savings equals your spending.

It's that easy. Money comes in. Some of it goes to the government in the form of taxes. Some of it (hopefully) gets saved. Whatever is left over got spent, unless there is a giant hole in your pocket, which I'm guessing there isn't.

  • Note: The only additional complication is that if possible you should try to separate your spending on liabilities (mortgage, car loans, student loans) from the rest of your spending. The easiest way to do this is to figure your total spending, then subtract out your spending on liabilities, which should be easy to calculate. You'll see why we do this when we get to Step Four.

Step Three: Determine When You Want to Retire

This step is as straightforward as it sounds. The date you come up with doesn't have to be written in stone, but you need to have at least a rough idea of when you'd like to retire from full-time employment.

  • Note: If your intention is to “work forever,” then in Step Three you should instead choose a date for when you want to achieve financial independence. In this case, financial independence would mean that you no longer have to work for money and instead have the choice of whether you want to continue working.

Step Four: Determine How Much Income You'll Need in Year One of Retirement

Okay, now you know how much you are spending today, and when you want to retire. Let's put those two together to determine how much you will spend your first year of retirement.

To start, take the number of years until you retire and figure out the impact of inflation over that time. Inflation has historically been around 3.5%, so that's a good number to use. An online calculator or Google search of, say, “cost of living adjustment 15 years from now with 3.5% inflation” should give you that impact. So can most handheld calculators or an Excel spreadsheet.

If retirement were in 15 years, you would need to increase your spending by a factor of 1.67-fold in order to maintain the same standard of living. Importantly, you only apply this inflation increase to your nonliability spending. Fixed liabilities like a mortgage shouldn't increase with inflation over time, which is why we separated those out in Step Two.

Say you spend $100,000 today, and $20,000 of that is your mortgage payment (the other $80,000 is nonliability spending). If you wanted to calculate your spending 15 years from now, you'd multiply 1.67 × $80,000 to come up with $133,600, and then add the $20,000 mortgage payment on top of that. (For this exercise your mortgage only includes principal and interest. If you escrow taxes and insurance with your monthly payment you should include them with “regular” spending, since they could increase with inflation.)

By the way: If you plan to retire prior to age 65, you won't be eligible for Medicare. So unless you have attractively priced continuing medical coverage from your former employer, don't forget to add in the cost of private medical insurance. Prices on these policies vary widely, but in many instances they can run $1,000 a month or more for each person in your household. Even worse, the cost of these policies has historically increased at a faster pace than the general rate of inflation. So the bottom line is that medical insurance, and how you'll pay for it, is an important consideration if you plan to retire prior to Medicare eligibility.

So, there you have it. A $100,000 lifestyle today will cost $153,600 upon retirement 15 years from now, based upon the preceding example. Of course, everyone's particulars are going to be a bit different, but the exercise remains the same.

Step Five: Determine Your Sources of Retirement Income

Will you receive a traditional defined benefit pension when you retire? What about Social Security or other government-sponsored income sources? Do you own rental properties that will provide you with cash flow?

Congratulations! These fixed income sources represent money you'll have coming in each year in retirement and will reduce the amount you'll need to withdraw from your savings and investments.

For some folks, the goal isn't complete retirement, but rather stepping back from a career they are no longer passionate about. Maybe the work has grown dull, or you just want a little less stress in the office. Maybe you still want to work, but on your own terms and at your own pace. Perhaps 40 or 50 hours a week no longer fits your lifestyle, but 20 or 30 hours can keep you engaged while leaving time to pursue your passions.

If any of these applies to you, you'll also want to consider any income you generate from working. Importantly, you'll need to keep in mind that though you may enjoy your new work, you're unlikely to do it forever. Even the best of us often reach a point where we are physically unable to work. With that in mind, my advice is to include income from your new employment for the first portion of your retirement, but to also run the numbers with that income sliding off during the later stages of your life.

Step Six: Determine How Much You'll Need from Your Savings and Investments

Once you've completed Step Five and determined the aggregate amount of fixed income you'll have, subtract it from the retirement spending number you came up with in Step Four. The remainder is the amount you'll need to withdraw from your accumulated savings in order to fund your retirement lifestyle.

In Step Four, we hypothetically determined that our retiree would need $153,600 the first year of retirement. If we further assume that in Step Five our retiree had $75,000 a year coming in from Social Security and pensions, they would need to generate the difference ($78,600) from their portfolio in order to live their desired lifestyle in retirement.

Step Seven: Determine a Sustainable Distribution Rate

The term sustainable distribution rate refers to the rate at which you can draw down your portfolio without running out of money before you run out of breath. To use extreme examples, a 70-year-old pulling $500,000 a year from a $1,000,000 portfolio (a 50% distribution rate) is obviously going to run out of money well before they reach average life expectancy. On the other hand, if that same individual were only withdrawing $10,000 a year from that same portfolio (a 1% distribution rate) it seems quite likely that their money would last for the remainder of their lifetime.

Anytime you are making forecasts, there is, of course, an element of uncertainty involved. Nevertheless, a sustainable distribution rate can be calculated with some degree of accuracy by engaging in cash-flow planning, which involves running simulations that model your income, expenses, taxes, inflation rate, and investment returns for each year of your projected life expectancy.

A simpler though less accurate method of determining a sustainable withdrawal rate is to use a rule of thumb. The most common rule of thumb is that a portfolio distribution rate in the neighborhood of 4% gives a retiree a high probability of not running out of money. There are numerous assumptions that go into this, and opinions vary as to the accuracy of the 4% number. Some argue that 5% may be sustainable, as long as investment returns are reasonably strong. Others postulate that 3% is a better number, particularly if you retire earlier or have a longer life expectancy.

For the purposes of this book we'll stick with the 4% estimate, but do keep in mind that it could be a bit too high in some circumstances, whereas for others a portfolio may be able to withstand a distribution rate slightly north of 4%.

Step Eight: Determine How Much Money You Need to Retire

All right, now the rubber hits the road and we come up with the number you've been waiting for: How much money do you need in order to retire?

The answer to this vital question is actually quite simple to calculate if you've been following the steps laid out in this chapter. All you need to do is take the annual amount of income you need from your portfolio, which we calculated in Step Six, and divide that by your sustainable distribution rate.

Our hypothetical retiree in Step Six needed $78,600 per year from their retirement account. So, we'll divide that by a sustainable distribution rate, which we'll assume to be 4%.

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So, our retiree needs just under $2,000,000 in savings in order to be able to live the lifestyle they desire in retirement, with a relatively high degree of confidence that they will not run out of money or need to reduce their standard of living later in life.

Step Nine: Determine Your Plan to Accumulate the Money You Need to Retire

This is a chapter on planning, after all, and so now that you've determined exactly how much you need to retire, you'll need to come up with a plan to accumulate that amount. The bad news is that, in the earlier example, $1,965,000 is a lot of money. The good news is that you won't need to save that entire amount.

If you properly invest the money that you save, market growth and compound interest will play a large role in accumulating the amount you need. In fact, depending on when you begin to save and invest, and when you plan to retire, it may turn out that you only need to save half, or even a quarter, of the total amount.

That is because, at a growth rate of 7%, $500,000 invested for 10 years will grow to approximately one million dollars. In 20 years, a $500,000 investment growing at 7% would turn into approximately two million dollars. That is the power of compound interest, and it is why one of the most important steps in planning for any financial goal is to properly invest your savings.

The key point is that once you've identified the amount you need for retirement, you'll want to evaluate where you're at today, and then come up with a game plan for getting to where you want to go.

Remember, failing to plan is planning to fail! But the good news is that if you follow the steps laid out in this chapter and summarized in Figure 5.1, then at least you have, for perhaps the first time in your life, a clear vision of what your destination actually is. And having that clarity around your goal is a vital necessity if you're going to achieve success.

Flow chart summarizing the retirement planning steps - a process that allows one to determine what retirement will look like and what needs to be done to get there.

Figure 5.1 Summary of Retirement Planning Steps

SOURCE: Analysis by Brian Perry.

Putting It All Together with a Step-by-Step Example

Because correctly identifying how much money you need is such an important element of your financial planning, I'd like to review this process again using a step-by-step example.

For this exercise, let's use a hypothetical married couple named Susan and Bob Smith. Bob is 57 and Susan is 54. Bob makes $120,000 a year working as an engineer, and wants to retire at age 67. Susan is a teacher making $65,000 a year, and would like to retire at the same time as Bob. They live in a home they own, valued at $600,000, with 17 years left on their mortgage. Given this profile, let's run through the steps Bob and Susan should take in order to determine how much money they will need to retire.

  • Step One: Determine their vision of retirement: To begin, Susan and Bob will sit down together and discuss exactly what they want from retirement and how they want to spend the next three or four decades of their life. Let's assume that they have this conversation and decide that they want to stay in their current home, and that neither wants to work once they retire from their full-time jobs. Instead, they'd prefer to travel more, and Bob would like to improve his golf game while Susan wants to explore volunteer opportunities.
  • Step Two: Determine how much they spend today: Susan and Bob do not keep a strict budget, and to begin, they do not know how much they are spending each year. But they do know that their combined incomes are $185,000 per year. They also know, from looking at their tax returns and pay stubs, that last year they paid $50,000 in taxes, spread across federal, state, Medicare, and Social Security. Furthermore, Bob contributed the maximum allowable amount to his 401(k), which at the time was $24,000. Susan didn't quite max out her retirement plan, but she did contribute $14,000. The Smiths also have a savings account they've been building up, so they check last year's beginning and ending balances. At the start of the year, the balance was $85,000 and at the end of the year the balance was $105,000. So they saved $20,000 there. When we combine the retirement accounts and savings account, we get:
    equation

The Smiths earned $185,000, paid $50,000 in taxes, and saved $58,000, which means that the difference, or what they spent, was $77,000. However, upon closer inspection, the Smiths also have a credit card that they carry a balance on, and last year that balance increased from $12,000 to $22,000. That $10,000 increase represents additional spending, so we need to add it to the previous figure to get:

equation

So, the Smiths have now determined that they spend $87,000 per year. Furthermore, by looking at their mortgage statement, they have determined that $24,000 of that spending comes from their monthly mortgage principal and interest (P&I) payments. The remainder, or $63,000, represents spending on everything else. This breakdown will be important in Step Four.

  • Step Three: Determine when they want to retire: This one is important, but in the case of the Smiths, easy to determine. They are both quite clear that they want to retire in 10 years. Of course, things can always change and many people wind up retiring earlier or later than planned, which is why ongoing financial planning and the ability to adjust according to circumstances is so important. But for the purposes of this basic exercise, we'll assume the Smiths do indeed retire on schedule.
  • Step Four: Determine how much they will spend in year one of retirement: The Smiths now know that they are currently spending $87,000 a year, and that they want to retire in 10 years. They also know (because they read this book!) that using an estimate of 3.5% for annual inflation increases is a reasonable assumption. So, they do some math and calculate that 3.5% inflation, compounded over 10 years, increases their cost of living by a factor of 1.41.

    The Smiths apply this factor to their nonmortgage spending, which in Step Two they determined was $63,000 ($87,000 total spending minus $24,000 for principal and interest payments). When they multiply 1.41 times $63,000, they come up with $88,830. This represents their spending in year one of retirement, on everything other than their mortgage P&I. They then add the mortgage P&I back in, but do not inflate those amounts, because for most people one of the benefits of home ownership is that it “fixes” a portion of housing costs so that they are not subject to inflation.

    Once they've done the math, the Smiths come up with $88,830 + $24,000 = $112,830.

    That figure, $112,830, represents the amount that the Smiths can expect to spend the first year of their retirement.

  • Step Five: Determine their sources of retirement income: Bob has been paying into Social Security his entire career. He logs onto the Social Security website and determines that his projected annual award at age 67 would be $32,000. Of course, he has options around when to take Social Security and there are pros and cons to each choice, but for this exercise we'll assume Bob takes Social Security at his full retirement age of 67. Susan has mainly worked as a teacher, and has not paid into Social Security. However, as a teacher she is eligible for a pension. She speaks with her HR administrator and determines that her annual pension if she retires in 10 years would be $17,000 per year.

    So, between Bob and Susan they have $32,000 + $17,000 or $49,000 in annual income scheduled to come in during retirement.

  • Step Six: Determine required portfolio distributions: In Step Four, the Smiths determined that they'd need $112,830 the first year of retirement. In Step Five they figured out that they would have $49,000 coming in from Bob's Social Security and Susan's pension. The difference, or $112,830 – $49,000 = $63,830, will have to come from their accumulated savings and investment portfolio.
  • Step Seven: Determine their sustainable distribution rate: As previously discussed, 4% is a general rule of thumb for a sustainable spending rate. Since the Smiths are retiring at a relatively “normal” age, they decide to use the 4% number, but they understand that they will have to monitor that and adjust as necessary.
  • Step Eight: Determine how much money they need to retire: Now Susan and Bob need to figure out how much money they need to retire. They'll start with their projected portfolio withdrawals for the first year of their retirement, which in Step Six they determined was $63,830. Then they'll divide that number by 4%.

    So, $63,830/0.04 = $1,595,750.

    That amount, $1,595,750, is the amount the Smiths should accumulate prior to retiring in 10 years if they want to have a high probability of not running out of money while living a similar lifestyle to what they enjoy now.

  • Step Nine: Determine their plan to accumulate the money they need: The final step Bob and Susan will take is to formulate a plan to get to that $1,595,750 they need to retire. Their plan going forward will take into account the savings they've accumulated so far, projected savings in the years to come, and reasonable investment growth rates. Then they'll take a look and see if they are on track or not. If it appears that they'll have a bit more than $1.5 million in 10 years, then great! They are on track.

If it looks like they'll have a significant surplus, they can consider retiring earlier or enhancing their lifestyle. If, on the other hand, they're coming up short, then Bob and Susan will need to have a further discussion and make some difficult choices. Possible solutions to a projected shortfall might include:

  • Retiring later
  • Cutting expenses and saving more today
  • Working part time in retirement
  • Altering the projected retirement lifestyle, such as by spending less or relocating

In reality, when faced with a potential retirement shortfall, the optimal solution depends on individual priorities, but usually involves some combination of the aforementioned options. The important point is that it's better to know about a potential shortfall, because it can then be managed or corrected. Sticking one's head in the sand is seldom a successful strategy, regardless of how hopeless your finances may feel.

Already Retired?

What if you're already retired? Does this exercise apply to you? Well, if you're already retired you can reverse engineer the preceding steps in order to determine how much money you can spend each year without running out. Basically, you add up your fixed income sources and then add in 4% of your accumulated savings.

The concept is the same, it's just that you aren't working anymore and so the amount of your accumulated savings is locked in. So rather than starting with how much you want to spend, if you're already retired, you start with how much you have and then figure out how much you can spend.

The Bottom Line

The bottom line is that financial success, like anything else in life, requires careful planning and implementation. The good news is that it really isn't that hard to crystalize your vision of what you want from your finances, or to create a roadmap to get you to your destination. Then, when life happens, as it inevitably will, you'll have a plan to fall back on in order to see if you're still on track. You'll also have a compass to measure your progress against, one that is far more relevant to your future than some arbitrary conception of the market. Best of all, when you combine a clear vision of your goals with careful planning and periodic checkups, taking a long-term approach while ignoring the chaos around you becomes far, far easier.