That’s why step three of our 5-Step Retirement Revelation process is all about closing the gap between your retirement spending and your retirement earnings. We developed our 5-Step Process around how you can make decisions in a certain sequence to help you make the best decisions for your retirement.
Step one of the process involves determining how much you’re spending in retirement, while step two involves discovering how much you’re earning in retirement. The next step, number three, is about figuring out what you need to do to make up the gap between the two.
Unfortunately, we no longer live in the good old days where you could work a nice job and then retire early and all you needed was your pension and maybe the interest off your bank account. Now there is normally a gap between earnings and spending — that’s the reason why many people save in 401(k)s and other savings accounts.
You may even have a gap because you and your spouse are retiring at different times and have decided that although you’d receive enough money from your Social Security or pension, you’re going to wait a few years to start collecting so you can get more money later.
Whether the gap in your spending and earnings is only short term or not, you must consider what you need to do in order to make up that difference between what you’re spending and earning for however long that might be.
Changing Income Expectations in Retirement
Many people are used to getting money from a paycheck bi-weekly or bi-monthly. When you transition into retirement, however, your income often turns into a monthly situation. Your pension shows up once a month, your Social Security shows up once a month, and oftentimes, when you're taking money out of your investments, you end withdrawing on a monthly basis. Your new paycheck schedule can then turn into a once-a-month system from all these different areas — and that can take some discipline to change and get used to.
However, at the same time, we try to get the timing of your income to be as close as possible to how it was pre-retirement. So instead of having a year’s worth of income in your savings account for you to take from every month, we encourage you to get into a new regular habit.
Maybe your new regular habit will be receiving that income once a month. Or, you could even stagger your income. For example, if you're getting a Social Security check and you know when it's coming, you can take your retirement check two weeks after that. That way, you're on a schedule to receive income every two weeks, just like before.
In addition, pensions often pay out on the first of the month, so clients will usually ask us to pay out their investment money on the 15th or 20th, while Social Security will come on either the second, third, or fourth Wednesday of every month.
Turning Your Investments Into Retirement Income
As for how you can close the gap between spending and earning in retirement, you may believe that the best option is to use your investments. However, the stock market is great for accumulating money for the long term, but when you need income to fill the gap, we’re talking about the short term. If you need money next month, next year, or in the next two years, do you really want to rely on money that might not be up in the market that month?
According to some statistics, the stock market's up about 53% of the days. It’s almost like flipping a coin and hoping that the market will be up when you need the money. But if you need money out every single month, and the market's down 37% of the time — which is what history has indicated over the last 90 years — it might not be best to rely on this for your day to day income.
That’s why we like to keep the stock market for the long run and, instead, have set money set aside for the short term.
Figuring out How Much You Need for the Short Term
The first part of figuring out how much money you’ll need in order to close the gap involves going back to step one of our 5-step process and making sure you’ve figured out how much money you need to spend in retirement.
We like to project out through your lifetime. What does your spending level look like? What does your income level look like? When we can see that on a year-to-year basis, we can then determine: What is that gap? What's that amount in the red that we have to take out from the investments?
We also don't like to think of how much you need in terms of percentages or dollar amounts. Instead, we believe you're better off making decisions based on the number of years you want to have. Do you want to have the next one to two years of your income set aside out of the market? Or maybe the next three to five years of your income set aside out of the market? Decide how comfortable you are with allowing your long-term money to stay long term.
Think through how much risk you want to take, whether you want to have a really big short term or if you want to have a smaller short term. The answer may be right in front of you based on years. If you wait three years before collecting Social Security, maybe you set aside those first three years in shorter-term interest-rate types of investments that you can rely on because you know that in three years you'll have Social Security to rely on for that money.
In addition, you may want to have a little bit more set aside for the beginning of retirement than you would for later on because it’s a big deal if the stock market drops at the beginning of your retirement. It's less of a big deal if it drops at the end of your retirement. So at the beginning of retirement, when it's the riskiest financial time of your life, you could counteract that risk by being a little bit more conservative than usual and then once you’ve made it a few years into retirement, you can dial down that short-run money and rely a bit more on your long-run funds.
When Does Money Go From Being Long Run to Short Run?
I often get asked by clients: “When does my money go from being long run to short run?”
Our answer is that it's usually about five to 10 years ahead of time. The first five years before your retirement and the first five years into retirement are a really big deal. If the stock market happens to be horrible or great for those 10 years, it’ll make a huge difference for you — even though you can't control what the market's doing.
That’s why we encourage you to start thinking about how you can bring down your risk as you start approaching retirement. The way to do this is to ignore the different formulas and strategies touted by financial magazines. Don't go with a formula that's supposed to fit everybody. Because if it's fitting everybody, it's fitting nobody. Instead, think of what’s right for you and your circumstances.
If you’re seven to 10 years away from retirement, maybe start pulling some money out of the market and set it aside for a certain number of years in savings. We think it's a better choice to think, “I need 40 grand a year for the first two years of retirement” and when the market’s up, you start shaving off some of that profit and set it aside in an interest-rate type of account. That way, you’ve got your first two years covered and you can feel more comfortable retiring knowing that if the market’s down, you’ve got the money on-hand.
Then, over the next two years, hopefully the market will start to rebound and come back up, which allows you some flexibility. If you see that the market is going down and that the economy is getting a bit worse, you can tighten your belt a bit if needed.
Another important part of planning for the gap is recognizing that when you go from having a long run while saving for retirement to having both a long- and a short run in retirement, it’s incredibly important to decide how long your short run is and whether that's the right number for you. Whether it's two, four, five, or seven years, make sure you carve that money out of the stock market. That way, whatever your short run is, you don't have to rely on the stock market.
The 4% Rule
You may have heard of a strategy for taking money out of your investments for retirement income called the 4% rule. The idea behind this strategy is that all you need to do is withdraw 4% of your money each year and you'll be able to keep up with the ups and downs of the stock market.
This idea sounds nice, but in reality, I haven't met anyone who has spent 30 years in retirement and has spent the exact same dollar amount at the beginning as they do at the end with no fluctuations in their spending, taxes or healthcare costs. So while this strategy may look nice on paper, it doesn't quite line up with reality, especially for people who retire before 65. If you retire before 65, you can't get Medicare yet. This means you have to figure out your health insurance on your own, and a lot of times those health insurance costs are higher than if you were having it subsidized by your corporation.
So whatever your expenses might be, hopefully they won’t last for your whole retirement, but make sure you take that money out and set it aside in a place that you can rely on.
If you’d like to learn more about closing the gap between your retirement spending and income, listen to the full episode of The Retirement Revealed Podcast on this step of our 5-step process, "Closing Your Retirement Spending & Savings Gap." You can also learn more about our 5-Step Retirement Revelation process on the ‘Our Process’ page right here on KeilFP.com!