Retirement Planning 101 (Part 1) – A Simple Analytical Framework
I’ve modeled hundreds of retirement projections for clients and I’ve found that there are four key factors that directly impact your ability to retire. I call these the Core Four Factors and I use these factors as an analytical framework for how to best think about retirement when working with clients.
In short, the Core Four Factors are:
Core Factor #1: How Much Do You Save? Not how much you make.
Generally speaking, if you earn $1 million a year and spend $1 million a year, it’s unlikely that you’ll be achieving financial freedom anytime soon, unless you already had it to begin with. Simply put, the more you save now, the more you will have in your retirement to spend.
At times, it may not feel like what you save on a monthly basis will be meaningful to your retirement. However, if saving is done consistently and sensibly over a number of years, it really adds up. Additionally, if you invest your savings at a reasonable rate of return, you’ll have even more to spend during retirement, which leads to Core Factor #2.
Core Factor #2: What is The Return On Your Invested Assets?
The higher the return on investment (ROI) is for your assets, the faster you’ll reach your retirement goals because the faster your money will grow. The opposite is true as well.
The key here though is not what your ROI is in any one year, but what your ROI is over your investment time horizon. In short, it’s the compounding effect of your portfolio returns combined with a disciplined savings/investment strategy that will help you reach your financial goals.
This is NOT to say that you should invest all of your money in the prospectively highest returning investment possible since you also need to balance the risks associated with any particular investment. A trusted financial advisor can help you analyze your specific situation and help you develop an investment plan based on your specific goals, needs, return requirement, as well as your risk tolerance.
Core Factor #3: How Much Will You Spend In Retirement?
The less you spend in retirement, the less money you’re taking out of your retirement assets and the more you’re allowing those assets to continue to grow. The more you spend, however, the faster your retirement assets will decrease because you’re spending them down.
The tough part here is that unless you’re close to retiring, it’s very difficult to estimate your retirement expenses. These expenses could be upwards of 80-90% of your current expenses and let’s not forget that in the first few years of retirement “every day is a Saturday” when it comes to spending. When estimating, it’s best to rely on a more conservative spending estimate (e.g., higher spending in retirement) as prematurely running out of money in retirement would NOT be ideal.
Core Factor #4: At What Age Can You Retire?
The earlier you retire, the earlier you need to start drawing down on your retirement assets.
Assuming you have reasonable estimates of the first three factors, you will then be able to determine when you can potentially retire using a simple retirement projection or a more advanced Monte Carlo retirement simulator (I will be reviewing a sample client retirement analysis in Part 2 of this mini-series).
If it appears that there is a relationship amongst the four factors, you are absolutely correct! The chart below illustrates how each of the first three Core Factors ultimately affects the numbers of years until you can retire. The chart can be read either from left to right OR right to left.
While there are a few other factors to consider when modeling out a retirement analysis, such as inflation and life expectancy, these are largely uncontrollable, albeit important, factors. Since historical inflation has run about 3% annually, I would typically input this number and move on. As it relates to life expectancy, overestimating (say living until age 95 or 100) tends to provide a more conservative result as I am looking to model out situations where the client does NOT run out of money.
Additionally, insurance plays a key element in financial planning as a hedge against the unexpected. Under the “Core Four Framework”, insurance would be used to protect the financial plan in the event of unexpected events such as disability, health issues, premature death, lawsuits, or some other personal emergency. Insurance would be purchased to act as a backstop for unexpected circumstances under this model.
Stay tuned for Part 2 where I will showcase how these factors all come together when I work through a sample client retirement analysis.
If you have any questions/comments or suggestions for future topics, please feel free to email firstname.lastname@example.org.
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