A financial plan can refer to a variety of planning topics or concerns. Perhaps the most popular connotation though is numerically forecasting your ability to retire on your terms. In other words, putting the vision of the rest of your life on paper to see if it is possible. This assumes you actually know what you want the rest of your life to look like. Some people don’t, or only have a vague idea and some people know what they want but feel restricted due to a family situation, pension vesting, or financial burden. This process is often avoided by people who don’t believe they will like the result. It needs to be done though. Only with an honest assessment can you come to terms with the adjustments that may be necessary.
Where do you begin though? Do you feel like you are too busy to go through the full planning process? With that in mind, here are a few necessary steps for building a back of a napkin financial plan, but by no means a comprehensive, retirement projection.
First you need to know the income you will have in the first year of retirement. Start with social security, if you and/or your spouse will draw social security, add up the monthly amounts. If you are anywhere close to taking social security, it is reasonable to assume it will be there for the foreseeable future as an income source. Next write down how much you would receive from pensions, if any. Even the small ones count and can do wonders for stability of cash flow.
If you are not sure if you will receive a pension or don’t know how much it will be, that is beyond the scope of this napkin. It is a red flag for needing a real planning process. The next step is writing down 4% of your total assets that you intend to use for income. Four percent is not a perfect amount because what you will need for income depends on your longevity, how much you are comfortable with, how much is really needed to cover your bills, and how much income your portfolio is producing through interest and dividends.
Investment values may rise or fall between now and retirement, and your contributions are an unknown variable, however, it’s a napkin so use the value you have now. We are simply trying to get an idea of the pace you are on. If you are fortunate enough to be maxing out, getting a match on your contributions, or have two savers racing to the finish line together it’s likely the amount could be higher in the future. In rare instances there is also rental income above the debt service, a known upcoming inheritance, trust income, or significant equity in a home you intend to sell in the future, all of which would be additional income you can put down. Add it all up for your total income.
Next are expenses, which are actually the harder part of the equation. Households often don’t really know what they are spending, or more importantly what their expenses will be later on in life. The immediate goal though is to determine the expenses in the first year of retirement.
There are a couple ways to estimate expenses. The first way is to assume your expenses will be what you are spending now and that they currently consume your net pay. This isn’t always the case but take the net amount of your paycheck and multiply it the number if times you get paid. You can use this as your total expenses.
Or the second way to estimate expenses is the replacement ratio method. This is the one you hear about in the news all the time that says to take some percentage of your pre-retirement income as what you will need for retirement income. Seventy percent and 80% are often used as the goal percentages. Maybe what you will really need is greater than 70% or 80%, or even less because you’ll be cutting expenses.
Perhaps you have a second napkin? Consider calculating your “involuntary” expenses. Maybe you plan on selling the house, so don’t put your current mortgage but put an estimate of your new one. Estimate what your utility bills, cell phones, car insurance, food, and all the other things might be in the future. Is it possible going from a full house to just the two of you will reduce those expenses? I recommend you round up to give yourself a cushion, and a few dollars for the fun stuff though. You might realize the total expenses on this second napkin aren’t as much as you thought. To either list you have to add taxes on the income you first totaled. That expense isn’t going anywhere. If you have accumulated some assets or have qualified for at least one pension it is probably not going to be much less than a 20% effective rate between federal and state.
So what is the difference between your projected income and projected expenses? Is there much of a cushion between them? Hopefully your income totaled more than the expenses. Hopefully it did by a great deal.
Now the next step, go show the napkins to a certified financial planner for a thorough review of your financial situation and to put a plan in place to secure the retirement lifestyle you desire.
Brian Kuhn CFP® is a financial planner at PSGClarity.com with 14 years of experience who exclusively works with those who do not feel wealthy. His business model is to avoid intimidating terms like “wealth management” and focus on those who truly need his services and with whom he enjoys working. He is the author of the books ‘Total Compensation: A Practical Guide to Federal Employee Benefits” and “The Personal Finance Handbook” both available on Amazon.com.
Securities offered through Triad Advisors, Member FINRA / SIPC. Advisory Services offered through Planning Solutions Group, LLC. Planning Solutions Group, LLC is not affiliated with Triad Advisors. PSG Clarity is a division of Planning Solutions Group, LLC.