Why should you want to build a retirement income plan?
Because you need to know how to efficiently spend your savings to make them last the rest of your life. Without a plan, you could spend too much and then spend the rest of your life restricting your lifestyle.
Also, without a plan you may think that you can’t spend as much as you actually could. You may live your whole retirement being way too conservative and not enjoying the fruit of your labor.
That would be a shame too.
A retirement income plan can help you figure out the best way to use your assets to pay for your retirement lifestyle. The goal is to use your hard earned savings in such a way as to get the most out of them (i.e. efficiently use them) in the lowest cost, lowest risk way possible.
But whenever you build something, you need to do it right. If you build a house start with the foundation. If you mess up that stage the whole structure could collapse later on.
So it is with a retirement income plan.
So let’s go over the 5 easy steps you can take today to build your own retirement income plan.
#1: Determine How Much Income You Need
The first step is to figure out how much income you will need to live the lifestyle that you want in retirement. This is simple enough.
Add up your monthly expenses. This includes housing, property taxes, various insurance costs, utilities, food, etc.
Use your credit card bills and your checking account to see a history of where your money goes.
Will these expenses stay approximately the same once you retire? Will your health insurance costs go up or down once you retire? How about when you turn 65 and get on Medicare?
Will you spend less in gas because you no longer commute to work? Or will you spend more since you may start traveling?
Start considering these things so that you can come up with a good number for what your monthly expenses will be once you retire.
Write that number down.
#2: Determine Your Lifetime Guaranteed Income Sources
The next important step is to determine what your lifetime income sources will be in retirement. For most people this will include Social Security. Usually both spouses will have their own Social Security benefit. Write these figures down.
If you are so fortunate, you may have a pension from your former employer. If so, count this as a lifetime guaranteed income source.
A quick note about pension payouts… make sure you understand how it will continue to pay to your spouse after you die. Some will reduce by 50% or go away entirely. And then others may continue to pay 100% to a surviving spouse. You need to know this.
Another source of income may be from an annuity. If you have purchased an annuity in the past, then it will have some type of annuitization option. Or if you purchased an annuity in the past with an income rider attached, it will have a lifetime payout option as well. You need to include these income sources in your calculation.
What about other sources of income? Do you have rental properties that generate income for you? If you plan on holding the real estate for the rest of your retirement you can count these. To be conservative I would only count 75% of the rents as income available to you. This factors in the reality of vacancy.
#3: Determine Your Income Gap
After you have added up your lifetime income sources in retirement and your required expenses, you may now determine what your income gap is.
This is simple. All you do is take your retirement income and subtract the required expenses from it.
If you have more expenses than income, that means you will have a “gap.” That also means you are quite normal. Most people will have a gap.
#4: Determine The Effects Of Inflation On Your Income Needs
After you have completed Steps 1-3 you should have your income gap for the first year of retirement. But what about for the following 20 to 30 years of retirement?
You must consider inflation. I can’t tell you how many times a soon-to-be-retiree has said to me, “My mother had plenty of income her first few years in retirement, but prices kept going up and now her dollars don’t stretch as far.”
Most people I talk to are aware of what inflation will do to their purchasing power. But how do you account for this in an income plan?
I would build a simple Excel spreadsheet to handle this. It’s a good free option to help you determine your income needs. It’s not as comprehensive as some financial planning software out there. But it’s better than nothing… and really a pretty good option.
An inflation rate of 3% is good to use for your expenses. But only for expenses that will increase. If you are paying off a fixed rate mortgage on your house over the next 30 years, that will not increase with inflation. So you need to differentiate between expenses that will go up and those that will not.
Most expenses will increase with inflation.
So start with 3%. But don’t forget that some of your lifetime income sources will also increase with inflation. Social Security has a built in cost of living adjustment (COLA). It will increase to help keep pace with inflation.
You need to account for this in future years. You can use 3% as the COLA for Social Security. But if you want to be more conservative use a 2% rate.
Most pensions do not have a COLA. So they will typically remain static.
If you have rental properties you could assume the rents you receive will go up with prices in general. As you renew your lease agreements with tenants you may raise the rent over the years if your neighborhood will handle it.
Most annuity payments will not go up with inflation. However, some annuities may include an inflationary increase.
Using a simple Excel spreadsheet will allow you to increase your expenses by a specific amount each year, say 3%.
You can also break out your different income sources (Social Security, pensions, annuities, rents) and increase those each year too if they have cost of living adjustments attached to them.
What you will probably find is that as your expenses increase each year by 3% (or whatever figure you use for inflation), your income sources are not able to grow at as fast a pace.
This means your income gap will very likely get larger as the years go by.
By knowing this you can better plan for in your retirement income plan.
#5: Determine How You Want To Fill The Income Gap
The last step is figuring out what strategy you want to use to fill in the income gap. There are different methods to do this. None are absolutely right or wrong. That will depend on what you feel comfortable with.
On one extreme is the method of investing all your funds in the market and sticking to a withdrawal strategy. This may mean withdrawing a certain percentage of the portfolio each year, or just withdrawing the dividends only. This may be the best strategy for you, especially if your plan is going to require a certain level of portfolio growth in order to fund your lifestyle.
- Pros: Since growth potential is stronger than fixed investments, you could potentially meet your goals with less dollars used. (Unless you are only withdrawing dividends and not touching your principal. Then you’ll probably need more money to generate sufficient dividend income.)
- Cons: Since growth is not guaranteed your portfolio could lose value and not be big enough to meet your required spending level.
On the other end of the spectrum is to use all guaranteed options, such as fixed annuities, bank CD’s, or no-risk government bonds. This option may be good for you if you have enough funds to make it work.
- Pros: Since the accounts are guaranteed you would not need to fear losing money in them. Also, using fixed annuities with income riders you could know to the penny how much income would be generated from each account at any point in the future.
- Cons: Since growth potential will be less under these options (when compared with market investments) you will need more assets to be able to fill in income gap over your 20 to 30 year retirement.
And then there are many options in between these two polar opposites. You can guarantee a certain level of income using annuities. And you can put a portion of your funds in market investments to have better growth potential.
The choices you make here will be based on your risk tolerance. How much of your income do you want guaranteed? And how much are you willing to not be guaranteed? Everyone is different.
I hope that helps you in building a retirement. No matter which methods you choose for Step #5, make sure it is in line with your goals and your risk tolerance.
And if you know anyone that is near retirement and needs help putting together a retirement income plan, be sure to forward this article to them. You can even share it with your friends easily by clicking the Facebook icon at the left of the screen.
It may help them out tremendously. They may even be so grateful they’ll buy you dinner one night. Who knows?