When Can I Retire? A Practical Use of The Retirement Cash Flow Statement
The purpose of this article is to demonstrate how building a retirement cash flow statement can be used to answer common questions such as "when can I retire?", "am I on track to retire?", and "how much money do I need to retire?"
The Retirement Cash Flow Statement
A well-organized retirement cash flow statement can help answer important retirement planning questions such as:
When can I retire?
Am I on track to retire when I want?
How much money do I need to retire?
How much will my expenses be each year during retirement?
How much income will I need from my investment accounts each year to supplement social security and pension income?
How much of my investments should be allocated to cash and bonds?
Example Retirement Cash Flow Statement
Column A: Year
This column begins with the year that Joe and Jane expect to retire: 2022. The retirement cash flow statement runs for 30 years in this example through 2052.
Column B: Expenses
This column includes an estimate of Joe and Jane's annual retirement expenses.
Initially, their expenses are estimated to be about $90,000 per year in 2022.
This amount is assumed to inflate at an average rate of 3.5% per year. As a result of inflation, expenses are estimated to be about $127,000 per year by 2032. In 2042, expenses are estimated to be about $179,000. By 2052, expenses are projected to be $252,000 per year.
The 3.5% inflation assumption used here is much higher than the average inflation rate over the last 20 years. However, from the early 1900s through 2020, inflation of goods and services measured within the Consumer Price Index has averaged about 3% per year.
Healthcare costs have inflated at a rate of about 6% per year since the mid 1980s. Because a proportionally larger share of expenses go to healthcare costs in retirement compared to when working, a growing portion of your expenses may be inflating at a rate closer to 6% than 3% in retirement. As a result, using an inflation rate like 2% (the approx. average annual inflation rate for all goods and services over the last 20 years) may be way too low.
This example retirement cash flow statement assumes 3.5% average annual inflation, which works out to be an average of about 3% for all expenses other than healthcare and about 6% for healthcare. This is probably appropriate for planning today and can be revisited over time.
Columns C and D: Social Security Income
Joe's annual Social Security benefit is expected to be $33,000 initially in retirement. Jane's benefit is estimated to be about $35,000 per year initially.
Social Security income is assumed to increase by 1.3% per year in this example retirement cash flow statement. 1.3% is the cost of living increase Social Security recipients received in 2021.
Annual Social Security cost of living increases are based on a measure of inflation (the CPI-W) from the prior year. When there's higher inflation in the overall economy, Social Security recipients generally receive a larger cost of living adjustment.
The cost of living increase has been as high as 14.3% in 1980 and as low as 0% as recently as 2015. It's averaged about 3.7% per year since 1975, but the average has decreased to about 1.5% over the last 10 years. This is because inflation has been relatively low over the past 10 years.
Assuming a 1.3% annual cost of living increase on Social Security benefits is probably reasonable for planning purposes, although an alternative scenario can be built assuming no cost of living increase to be even more conservative.
Column E: Pension Income
Jane receives a pension of $8,400 per year.
Like most pensions, there is no cost of living increase. The $8,400 per year lasts for life but will never increase.
Jane knows she'll receive this $8,400 per year for life, but she doesn't know what this amount of money will be worth in the future due to inflation.
Column F: Gross Income
The gross income column adds up the columns for social security income and pension income.
This column shows the projected total amount they'll receive each year from fixed sources only, such as social security and pensions.
Investment income is intentionally not included yet, but will be later on.
Column G: Income After-Tax
This column uses a formula that multiplies the gross income column by the tax rate to determine after-tax income.
In this example, Joe and Jane's average tax rate is assumed to be 15% throughout retirement.
Assuming Joe and Jane are retired in Pennsylvania, their retirement income will not be subject to state taxes. Their retirement income will also not be subject to payroll taxes such as social security tax and medicare tax. It will be subject to federal tax.
Joe and Jane can look at a federal tax table to estimate their retirement income tax rate.
Based on Joe and Jane's income, their marginal tax rate would likely start at 12% initially during retirement. However, it may increase over time depending on how much money they're pulling out of pre-tax retirement accounts such as Traditional IRAs. It's fairly common for the tax rate to increase once Required Minimum Distributions begin at age 72.
A more precise version of the cash flow statement would apply a different tax rate over time as their tax situation changes, potentially increasing the tax rate once Required Minimum Distributions kick in depending on how much they have saved in pre-tax retirement accounts.
The above example uses 15% throughout retirement for simplicity, understanding that this assumption can be adjusted later as their situation evolves and as tax rates evolve too.
Column H: Shortfall / Surplus
This column subtracts the Expenses Column from the Income After-Tax Column.
When the figure displayed is green, it means the after-tax retirement income will exceed expenses without needing touch investment accounts. This isn't common, but does occur sometimes when there's a pension, strong social security benefits, and relatively low expenses.
When the figure displayed is red, as it is in all years in this example, it means expenses will exceed fixed income sources such as social security and pensions. This is common. Red isn't necessarily bad. The purpose of saving all along is to build up assets that will generate income to fill this shortfall throughout retirement.
Example Retirement Cash Flow Statement With Investments
Column I: Gross Withdrawal Needed to Fill Shortfall
This column shows the gross amount that Joe and Jane would need to withdrawal from their investment accounts to fill their retirement income shortfall.
This example assumes any money used to fill their shortfall is taxed at 15% when it's withdrawn from their accounts.
15% is used in this example because this is assumed to be their average income tax rate. Federal income tax applies when withdrawing funds from pre-tax retirement accounts such as Traditional IRAs.
15% is also the long-term capital gains tax rate. This rate would apply if they're realizing long-term capital gains on taxable investments to fill their retirement income shortfall in retirement.
If they're either selling investments with losses or simply withdrawing after tax money from their bank account to fill the retirement income shortfall, no tax would apply.
This example assumes all withdrawals are taxed at 15% for simplicity.
A more precise version of the cash flow statement could adjust this rate over time. For example, it may apply a lower rate or no tax rate at all initially in retirement if the plan is to use after-tax bank accounts first (which wouldn't be taxed at all when used), then apply a higher rate later on when its clear taxable IRA distributions will be needed.
Using simple assumptions is OK if you intend to update the retirement cash flow statement periodically over time anyway, which is highly recommended.
Column J: Start of Year Investment Value
This column shows how much money they are projected to start retirement with. Because they are not retied yet, we would use a time value of money calculator to determine this.
We'd start with the current amount they have saved, add in projected savings between now and retirement such as 401k contributions + company matches, and also assume a rate of return.
Column K: Investment Earnings
This column shows investment earnings assuming a 5% average return on all of their investments.
The S&P 500 index has averaged 10% per year since inception in the 1920s. The Nasdaq index has averaged about 10% per year since inception in the 1970s. However, their allocation will include cash and bond too which have much lower long-term expected returns, so we'd want to use something much lower than 10% for planning purposes.
5% was assumed in this example as a reasonable blended average return, but they could certainly run another scenario too assuming less than 5% to be more conservative.
Column L: Year End Investment Value
This column takes the start of year investment value (Column J) and adds the gross withdrawal needed to fill shortfall (Column I) + investment earnings (Column K).
The shortfall is a negative number in excel so it should be added, not subtracted, to determine the year-end investment value accurately.
Joe and Jane see that based on these assumptions, their accounts are projected to increase until about 2040 (see Year End Investment Value Column). In 2040, the accounts begin to decrease because the retirement income shortfall finally exceeds the projected investment earnings.
The "Year End Investment Value" (Column L) shows they started retirement with $1.4m and are projected to end retirement with $1.5m about.
This doesn't mean it's a failed plan because they should have spent more during retirement. They can certainly chose to spend more as they go along in retirement when it's clear they'll be financially secure for the long-term.
It does means there's a healthy margin of safety in their planning. A healthy margin of safety is important because it's fairly certain things will not go exactly as planned in retirement, for better or for worse.
Are They on Track to Retire?
This exercise showed Joe and Jane that, using reasonable assumptions, they're projected to end retirement with about as much money as they started with. This provides a healthy margin of safety to account for some of the things that will go wrong in real life.
This should not build complacency in Joe and Jane. While these assumptions are reasonable, things will not work out exactly as projected.
Inflation could be higher than assumed, tax rates could be higher than assumed, the social security cost of living could become subject to some asset-test that would disqualify Joe and Jane from these increases, or the investment returns may be lower than assumed. These changes would be unfavorable for Joe and Jane. Favorable changes could also occur, such as lower inflation or better investment returns than assumed in this example.
Joe and Jane should periodically review their plan and make updates as new information becomes available both about their own personal situation and about other outside variables that may warrant changes to their plan and the assumptions used.
Joe and Jane had about $1.4m when they retired. Does this mean I need $1.4m to retire?
Based on Joe and Jane's projected retirement income shortfall, that amount of money has them in good shape to retire when planned. The amount of money needed depends heavily on their specific retirement cash flow needs.
Someone who spends less or has a bigger pension may be okay with a lot LESS saved.
Someone who spends more and has no pension may need a lot MORE saved.
Retirement cash flow needs must be known first before being able to quantity how much you need saved to retire. The retirement cash flow statement accomplishes this important first step.
Am I On Track To Retire?
If you build a retirement cash flow statement using reasonable assumptions and it shows that you're going to end retirement with about as much as you started with, then you're probably in good shape from where things stand today. However, don't let this build complacency.
If you build the cash flow statement on your own, it would probably be smart to have a fiduciary retirement advisor review your work to make sure the assumptions are reasonable.
An experienced fiduciary retirement planner can also uncover blindspots in your planning. It's much better to learn from the mistakes of others than to make the mistakes yourself, especially once you're close to or in retirement.
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This is article is for informational purposes only and should not be considered as tax or legal advice. Advice is only provided after entering into an Advisory Agreement with the Advisor. See other disclosure here: Disclosures