One of the main obstacles to effective retirement planning is the process of estimating retirement spending. Here is the approach that I use with my clients, consistent with my philosophy to start with the easiest method and move to more difficult, intensive methods only if the previous method doesn’t provide the needed answer.
It’s usually safe to assume that, while you’re working and saving, your income is going to one of four destinations: You are saving it, spending it, losing it to taxes or giving it away. If you take your gross income, subtract your pretax savings, then subtract your tax burden, then subtract your post-tax savings, you should be left with a good estimate of the cost of your current lifestyle. If you are borrowing money as unsecured debt — like credit card debt — you’ll need to add this to your spending estimate. Note: If during the year you contributed $10,000 to your Thrift Savings Plan account but rang up $5,000 in unsecured debt to make ends meet, then you really didn’t save $10,000 for the year.
Let’s say you earned $150,000, before taxes, during the past 12 months. Subtract the $15,000 you contributed to your TSP account and you’re left with $135,000. You lost 25 percent of that amount, or $33,750, to income taxes, which left you with $101,250, after taxes. You contributed another $10,000 to your discount brokerage account and you carried no unsecured debt that you didn’t pay off during the year. You must have spent, or otherwise disposed of, about $91,250 during the year. If you borrowed money to pay your bills, then you would add this amount to your cost of living.
Once you’ve estimated the amount of money you are currently spending annually, you can allow for any special adjustments. You may subtract the unusual expense you incurred in paying for your only daughter’s wedding, for example. You may also want to add allowances for periodic expenses like home repairs and car purchases. If you know you’ll need to repaint your home every five years at a cost of $5,000, you can add $1,000 to your annual spending needs. You can also adjust for things that will change once you’ve retired by accounting for increased travel spending or paying off a mortgage, for example.
Once you have completed this exercise, which I consider the “top-down” method, it might be a good idea to cross-check your result by adding up the largest, predictable spending items, like a mortgage payment or rent, car payments, insurance costs, utilities, food and clothing to see what’s left for discretionary spending. If all expenses seem to fit comfortably, then your estimate is probably good enough for long-term planning.
Keep in mind that spending lots of time and effort — or money if you’re paying someone else to do it — on predicting your spending needs years into the future is not likely to be productive. There’s too much uncertainty in these long-range predictions, and being meticulous doesn’t reduce that uncertainty. It is wiser to make sure that your retirement planning and management is designed to deal with inaccuracies in your predictions.
Finally, if you plan a drastic change of lifestyle in retirement or you’re getting questionable results using the previous methods, you can resort to the most difficult estimation method: building a line-item budget from scratch — the “bottom-up” method. I’m not a fan of this method for two reasons: First, it is tedious and can be frustrating. Second, it is susceptible to serious errors and omissions. You should avoid relying solely on this method and should use it only with the benefit of having the “top-down” results for comparison.
The goal is to come up with a reasonable and conservative — that is, erring on the high side — ballpark annual spending amount. It is not necessary to pin down every element of a budget.
Developing a budget is one means to an end, not the end itself. Having a reliable spending needs estimate is an essential component of retirement planning and management, and developing one doesn’t have to be difficult.