For many of us, retirement funding is a central fixture of our financial plan; and one of the most important considerations is determining the income necessary to sustain a desired lifestyle. Knowing the true income need for your lifestyle is the foundation of determining what capital resources must be acquired, which is then used to determine a savings and accumulation plan. It all starts with knowing lifestyle income need. Lifestyle income need is your financial plan’s point of origin.
For every complex problem there is an answer that is clear, simple, and wrong. – H.L. Mencken
I’ve learned over the years that many clients can easily answer the question, “How much have you spent per month on average, over the past year?” Unfortunately, that answer is often wrong. It’s not their fault – it’s human nature to underestimate our spending. In fact, every time I make a purchase I find myself surprised by the total. Just yesterday I mailed a 1lb package and bought a roll of stamps. The total for this purchase came to $66! Scale that experience all the way up to encompass our total household expenses and it’s easy to see why we typically underestimate just how much our lifestyle actually costs.
Often when someone makes an effort to estimate income need, they begin at the wrong end of the equation by attempting to itemize expense categories. Without accounting for the unexpected, this process is not only tedious, it’s doomed to fail.
The following is a very simple exercise to estimate income need for your current lifestyle. Step 1 is to identify your total bank account balances at both the beginning and end of last year. Next, total up all deposits – any income you put into your bank account(s), be it from paychecks, the boat you sold, etc. Next, we’ll apply simple arithmetic to learn some important things about your lifestyle.
Take your ending bank balance and subtract your beginning balance. We will call this your balance change. Is the number positive or negative? If the number is positive, you lived within your means. If it is negative, you spent more last year than you earned. Was last year an unusual year? Was there a large, planned expense you saved up for over several years? Were there any large, unusual expenses?
Now take the sum of all your deposits, what we will call take-home income, and subtract your balance change. The result should represent the amount of money you actually spent during the year. This is an important number because it represents the cost of funding your current lifestyle. No need to itemize. Last year you did all the things you usually do, and that’s how much it cost.
(Take home income) – (Balance change) = Funds Spent
Now there are just a few minor adjustments to make. If you have any major expenses today which you do not plan to have in retirement, back them out. For example, if you have a mortgage today that you will not have in retirement, subtract the principle and interest portion (leaving the taxes and insurance portion). Additionally, if you expect any new major expenses in retirement, add them. You now have a baseline number to begin your retirement planning.
Why is this number so useful for retirement planning? The answer is simple: your current lifestyle is the best proxy you have for your future lifestyle. People often anticipate a different retirement lifestyle with less spending. I don’t believe this is a prudent way to plan. When you retire you will be the same person you are today, and the lifestyle you are comfortable with now is the same lifestyle you will likely want to continue.
With a good income-need estimate in hand, you are now ready to begin the process of identifying the capital resources necessary to provide that income when you commence retirement. But it all begins with an honest and accurate evaluation of your current lifestyle expenses.
Financial Advisor