First, if you don’t make a reasonable attempt to predict your retirement living expenses, you will not be able to predict if or when you can afford to retire. Second, you can factor inflation into your hypothetical retirement budget by using one of two strategies. The first strategy is to predict an average inflation rate and apply that rate mathematically to your current predicted amounts.

The second strategy is to design your retirement portfolio so that you fund at least your basic living expenses with assets that produce income that adjusts with inflation.   Examples would include Social Security income, annuity income with an inflation rider, and government-issued TIPS and I-Bonds.

I prefer the second strategy because it removes at least one significant prediction (inflation rate) from the equation.

Many so-called retirement planning experts like to use income replacement ratios instead of actually predicting retirement expenses.  I  believe this is a silly, arbitrary,  and potentially dangerous approach to retirement planning that is not based on good science. It’s just another rule of “dumb” that permeates the financial planning industry.  Some of these “experts” use the income replacement approach to frighten us into making more risky investments that just happen to  pay them higher fees and commissions.

None of us can really know with certainty what we will spend when we retire no matter how diligent we are in maintaining and updating our hypothetical retirement budget. This is where knowledge of the experiences of those who retired before us can help.  Fortunately for not-yet-retired baby boomers, that real world data is increasingly available. We can use this data to cross-check and quality control our own predictions.

Recently the Employee Benefit Research Institute (EBRI) published a paper entitled “Expenditure Patterns of Older Americans 2001-2009. The EBRI used data gathered by other organizations and its own survey of 5,000 retired households.  The study broke down these seniors’ retirement expenses into seven categories:  home-related, food, health, transportation, clothing, entertainment, and other.

Here are some of the EBRI survey and analytical results that I found to be the most compelling:

1.  The median annual expenses for all retired households aged 50+ declined with age. Interestingly, the decline is almost linear.  For example, median expenses at age 65 were approximately $35,000 then declined by 34% to approximately $24,000 at age 85.  (The expense  figures are expressed in 2010 dollars.)

2.  While retired households have a median income that is 57 percent that of working households, these retired households spend 80 percent of what working households spend.  For these numbers to actually work, a retired household must have retirement assets that can be used to close the gap between their income and their spending.

3.  For all retired age groups, home-related expenses were the largest category, by far.  Housing expenses increased as a percentage of total retirement expenses from 38% in 2001 to 47% in 2009.  This is another red flag that signals the importance of killing that mortgage (or downsizing) before retiring.

4.  Health care expenses increase with age. This should not be surprising. What you may not have considered – but the survey shows – is the long term care expenses and private health insurance premiums are significant components of this increase.

I encourage everyone to read and digest the EBRI report. Use what the EBRI provides – and what our predecessors have actually spent – to reconsider your own retirement plan and budget.

You can find a link to the EBRI report here.

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The historical annualized gain for stocks dating back to 1926 is approximately 9.9%. (This would include dividends.) Bonds returned 5.4% annually on average during the same period. If you use these two numbers in a hypothetical portfolio of 60% stocks and 40% bonds (a ratio often proposed by financial advisers), the overall portfolio return would be approximately 8%. This is the expected return that many retirement calculators (and so-called advisers) default to.

The problem is that bond yields are far below historical numbers. So are dividend yields, which in the past have contributed as much as 50% of the annualized gains achieved by stocks. Accordingly, many experts say that expectations for future market returns should be downgraded to 5% annually or less. If you believe as I do that a retirement investor needs to be more conservative and realistic, the important question becomes:

Is your retirement calculator or adviser using unrealistically high market returns when analyzing YOUR situation?

Bloomberg recently published an article on this very topic and, among other warnings, had this to say:

More sober return realities aren’t reflected in all of the online retirement calculators. Some, such as ones offered by Principal Group and Yahoo! Finance, use 8 percent as the default rate. Others, including the AARP and Bloomberg calculators, default to 6 percent. The Labor Dept.’s calculator plugs in 5 percent. Vanguard’s gives savers a slider to play with that’s initially set at 5 percent. It labels 5 percent “conservative” and describes a return anywhere from 6 percent to 9 percent as “moderate.” That’s a mighty wide range.

A calculator that uses Monte Carlo analysis can help eliminate a bias toward unrealistic past returns. The calculator that I use most (Financial Engines) employs a Monte Carlo system. However, even this system has its faults, as the Bloomberg article points out. For that reason, I like to cross-check my expectations using other calculators that let you plug in your own, more conservative expected returns and compare.

I believe the best advice here is that when you are using a retirement calculator yourself or relying on advice from an adviser, make sure you know what is being assumed to be the expected market returns for your portfolio. If you see or hear something in the range of 8%, ask to see the results for 5% or less.

Here is a link to the Bloomberg article: That Retirement Calculator May Be Lying to You.

Related posts:

1. Small Tricks to Boost Your Retirement Savings

A common negative thought pattern that impairs retirement saving is the idea that we can only afford to make small changes in our spending and saving and that these small changes aren’t significant.

That’s not the case.

Coincidentally, I learned this week about an online calculator that the New York Times publishes called the “1% More Savings Calculator.”   The calculator has a very specific purpose. Using sliders in your browser, you input your current retirement savings balance and savings rate (based on a percentage of your earned income). The calculator uses those numbers to display a future retirement savings balance over time at your current rate and the balance if you increased your savings rate by 1%. It provides excellent visual feedback of just how powerful a small change in retirement saving can be.

You should check it out and maybe share it with your adult children as well.  Here is the link: The 1% More Savings Calculator.

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I have written in the past of how our 401(k) plan provider allows participants to have their retirement investing strategies evaluated by Financial Engines. I continue to use this benefit and receive a quarterly FEAdvisor “Retirement Update” email.  This email provides clear statements to me on two specific topics, with links back to a more comprehensive report.  The two topics are: (1) Can you reach your retirement goal based on your existing retirement investment allocations? and (2) Can you you do better?

The Financial Engines analytical software has direct access to current information about our 401(k) plan investments.  I input and update information about our other retirement investments so that the Financial Engines tool has a complete picture.  I also input our retirement goal. More specifically, I tell the software (a) how much retirement income we will need (including Social Security) and (b) the age at which we will “retire” and therefore need this income.  I chose age 66 for me although I may work – at least part-time – beyond that age. I want to know that we will enough income available at that age so that I won’t be forced by financial necessity to keep working if I don’t care to.

The Financial Engines software runs its analysis based on our current investments and communicates a probability of reaching our retirement income goal. The maximum probability range is “greater than 95%” which is what my recent report stated. That’s satisfying. It hasn’t always been that high. It dropped to 36% probability in February 2009 but moved back to 70% probability by May.

The second component of the report  - should I make any changes to our investments – has always included recommendations for changes, until last week. Instead, I received this message in my FEAdvisor email:

At your current risk level, we cannot suggest any changes to your investments that would significantly improve your retirement outlook. Any changes we could suggest would provide about the same chance of reaching your goal.

Honestly, I was surprised by this. Although I do a lot of research and analysis before arriving at our investment decisions, I assumed that a computerized investment wizard running millions of Monte Carlo simulations could do better. Apparently not this time. I think one aspect of our plan that is in my favor is how little risk I am willing to take of being unsuccessful. At age 60, that’s the way it should be. If our risk tolerance were greater, the Financial Engines software might make some recommendations for changes.

I don’t claim to be an investing genius but this does give me confidence that with some learning and due diligence, any one of us can create a proper retirement investing plan.

Even if you don’t have the time to learn about retirement investing or trust yourself enough to do it, it would still be wise to use an analysis tool on your own portfolio, after the portfolio is designed by your financial advisor. If the analysis does not confirm that your plan will likely achieve your retirement goals, warning bells should go off in your brain. You should definitely raise the issue with your adviser and have him/her explain how the success of your plan is predicted.

The Financial Engines tool is available to anyone but if your employer doesn’t provide access, it requires a fee-based subscription.

There are other options to get your own retirement plan confidence boost. One that I have been aware of but haven’t tried yet is NestEgg Software. It is free for individual consumer use. I plan on giving it a workout this month. I have created an account and can tell after a quick look that it will take some effort to set everything up.

What do you to build confidence that your retirement plan is likely to be successful?

Related posts:

1. Small Tricks to Boost Your Retirement Savings
2. Is Your Retirement Calculator Telling You Lies?

This is actually going to be a six month performance review. In July, when we switched banks, I transitioned from using Quicken as our primary personal finance tool to using a custom Google Docs spreadsheet. I started with a net worth tracker and expanded the spreadsheet to include all of our assets, income, and accounts. I still have data from previous time periods in our Quicken file but because I use multiple computers at different locations to run our finances, I just don’t use Quicken anymore. The simplicity and ease of cloud computing  is wonderful.

So let’s summarize how we did. Our total net worth increased by 4.91% over the second half of the year. I am satisfied with this because during this period, we closed on the purchase of our condo. This caused us to burn through some cash, converting some of it to equity and some used to buy furniture and supplies. Fortunately, the condo appraised for more than our purchase price.

The total value of our retirement assets increased 7.39%. This is from a combination of additional retirement account contributions and increases in the market value of our investments. I am still fine tuning my spreadsheet so that it will accurately display the internal rate of return for each of our investments. At this point, I remain pleased with the non-correlated performance of the core holdings in my 401(k) account. We bought some TIPS in the last half of the year and intend to buy more in 2011, as part of our guaranteed retirement income plan.

Another metric I want to use to track progress toward retirement is the value of our retirement portfolio if it were annuitized into monthly retirement income for life.  I ran those numbers at the end of the year and will check them again monthly. This annuity income metric will reflect a combination of annuity returns and changes in the value of our retirement nest egg.

Do you track your financial performance in a similar way? Thoughts and suggestions for me?

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The kit includes a 20-minute educational video from Chuck Bentley (the CEO of Crown Financial Ministries), a “Money Restoration Guide” (a budget planning guide), a Crown Money Map™ (not sure what that is), and “other tools that will assist you all year long.” This kit is available online directly from their website.

I can’t vouch for Crown Financial Ministries (since I don’t use its services) or the Money Restoration Kit (I haven’t tried it). But, because the kit is free (you will have to surrender a name and email address) and claims that it will “position you spiritually with the right perspective on money and possessions, and help practically restore what may have been lost in 2010,” I thought some readers may be interested.

Here is the link: Crown Financial Ministries.

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The new online comparison tool that learned about this week is provided by ING. It’s called “INGCompareMe.” Don’t worry – although ING wants your business (annuities, etc.), you can use the tool completely anonymously. When you are finished, you can download a report summary. This is an excellent feature because if you decide to track your progress compared to your peers, it gives you a historical record.

Other features that I liked:

• When you set up a personal profile on age, gender, and income, the tool tells you how many other users are in that same profile window, i.e., the size of your peer group.
• The tool measures and compares retirement and financial planning attitudes as well as numbers.
• The tool doesn’t scold you or try to sell you something while you are entering data or reviewing outputs.

Here are some results that I found interesting when I ran our comparison:

• We are ahead of “people like us” in retirement saving but my estimate of how much we will need to retire is almost identical with our peers ($2,000,000).
• 48% of people like us monitor retirement assets weekly. (That surprised me. I thought it would be lower.)
• On average, folks in our group spend over $8000 annually on vacations. That’s a lot more than we spend but not if you take into account use of our lake house as a vacation home.
• 70% of our peers are, like me, DIY investors.
• 65% of our peers are like us with no credit card debt. The other 35% carry average balances over $5000.
• 77% of our peers are like us and have no car loans. The other 23% have average loan balances over $16,000.

I would enjoy hearing back from readers who try the INGCompareMe tool. (FYI – I have no relationship of any kind with ING). Any reader who leaves a comment here with some personal comparison information that he/she found interesting will win a free download of my Failsafe Retirement System. I will draw a random number and announce the winner on Friday, October 22, and email the winner a free download code.

Here is the link to the tool:  INGCompareMe:Home.

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The “magic number” of course is a lump sum size of your retirement nest egg that is necessary to provide a lifetime of adequate retirement income. To start with a lump sum and work backwards toward income requires some serious assumptions. The 4% rule is based on those assumptions.

I have written about the 4% rule in the past. It is based in large part on statistical analysis of historical market returns and asset allocation theory. Then we had a “Black Swan” event in 2008-2009 where correlations converged on 1:1, meaning that every asset category- stocks, bonds, real estate, commodities, etc. fell at once. Even some money market funds “broke the buck.” No 4% rule can survive such an event. Moreover, we can’t assume that the recent Black Swan event is over and/or will not recur in our retirement lifetime.

As further evidence of the refocus on income planning instead of the “number”, have a read of this recent article from CNN/Money: Retirement: Whats your magic number?

Note the reference in the article to “wealth illusion” whereby individuals tend to overestimate the amount of sustained retirement income they can expect to derive from a pile of money.

The article also mentions Putnam’s new “Lifetime Income Analysis Tool.” I have not tried this tool, as it is apparently available only to Putnam customers or at least serious prospects. There is also a link to the T.Rowe Price Retirement Income Calculator which is available online to anyone. I tried it and found its output useful. The problem is that it doesn’t adequately explain the assumptions that are used.

In general, I am pleased to see this increased emphasis on income over the magic retirement number. As I have in the past, I encourage you to run a theoretical retirement spending budget of your own as a first planning step.

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I wrote a short post for the On Retirement blog at U.S. News and World Report stating my views on why net worth tracking is helpful for the baby boomer. One problem that I acknowledge exists for some folks is that they do not have the resources to easily monitor their own net worth. For many of these people who struggle with the concept of net worth tracking, I suspect that the tools and resources exist. They just don’t know how to use them.

I have recently changed the methods by which we track all of our accounts and compile the data into a simple net worth tracking tool. I will be writing a more detailed post about this in the near future. I may make the tool that I developed (a Google Docs spreadsheet) available to others. I am in the process of expanding the tool to the point where I can ditch Quicken.

The problem with Quicken is that you must install it on single computer. Your data also resides on that computer. If you regularly use more than one computer (as I do), you must have multiple Quicken installs and transport your data with you. That is not efficient. Using an online spreadsheet means I can access the net worth tool and other data from any computer, from any location. More on this later.

Meanwhile, you might want to read the full newt worth post I wrote. Here is the link:  3 Reasons You Should Track Your Net Worth

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The engineer in me looks for quantitative signs and analytical answers to the  ”Am I prepared for retirement?” question. Not long ago I presented my own simple way to determine retirement readiness. More recently, Jonathan Pond, a financial writer for AARP, proposed a list of “you know you can retire when” signs and circumstances. (I don’t have a link to share for this.) I found the list simple yet well thought out. Thus, I thought I should share it with readers here, with some brief commentary of my own.

You know you can retire when ….

1. You won’t run out of money until age 95. This is the basic quandary of money and longevity. Some folks rationalize spending with “I have to enjoy life now because I won’t live forever.” If you live to 95 and your money gives out at 85, that last ten years may seem like “forever.” (Here are some resources on life expectancy.)

2. You can wait for Social Security. Much has been written here and elsewhere about the best age to claim Social Security retirement benefits and the downside of claiming before full retirement age. Being in a position to wait means that you can implement the economic concept of “consumption smoothing.” Basically, this concept may cause you to spend more of your nest egg early if necessary to claim Social Security later.

3. You own your home. Living in a mortgage-free home can solve so many different financial problems for retirees. Here are some resources to consider whether you should have a mortgage in retirement. We are mortgage-free with our vacation home (which we will use as a part-time retirement residence) and are moving in that direction for our condo purchase.

4. At least 40% of your income is guaranteed. I actually think this percentage should be a lot higher – 100% actually – for your basic retirement income needs. That’s why I am working on our own plan for guaranteed retirement income. If you have your basic needs met with a pension and/or Social Security, that’s fantastic.

5. You can cut one-fifth of your spending in hard times. I suppose this means that 20% of your spending is 100% discretionary. Perhaps more important is that it means that you are willing to make those cuts when the need arises. Too many people are too proud, too stubborn, or are in denial and wait until it’s too late to make needed cuts. Can’t do that when the income is fixed and the nest egg is shrinking faster than anticipated.

As I said, I appreciate the value of this list. I plan on re-visiting it regularly when evaluating our own retirement readiness.

What about you? Are you looking for signs of being prepared for retirement? What are they?

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