As a normal course of managing my retirement, I look at my savings at least once a year (I have to if for no other reason than to up my 401k to make the maximum contribution allowed) and I recommend that everyone do so at least annually. This piece, courtesy of Marotta Asset Management, explains why an annual review is a good idea as well as offers suggestions on how to manage special situations that may pop up and impact your retirement plans. Their thoughts:
It is important to know how much you should be saving. Every year you delay adequately funding your retirement cuts in half your retirement standard of living.
Imagine Fred and Wilma, now in their forties, with savings of $250,000 and an income of $55,000. They project that putting $1,036 a month into savings this year will meet their goal of retiring at 65. But that projection is only good for the coming year.
Projections are like blinking your eyes open as you are walking quickly. They give you a quick snapshot of where you are and what direction you are heading. They allow you to adjust your next few steps, but as soon as your situation changes you need to blink another snapshot of where you are to keep from tripping up, or something worse.
I used to play that game when I was young. On an open field I could last several seconds with my eyes closed, but on a tight sidewalk or where there were people around I needed to blink open constantly. Sometimes no correction was necessary. Other times the correction was small. The goal was zero mistakes. When I felt unsure, I would blink open.
Market conditions change significantly every six to eighteen months. An annual blink open allows you make critical adjustments in the steps necessary to meet your retirement goals. Sometimes the change can be in a direction you did not expect. Consider the following changes:
Getting a $10,000 raise
If Fred, earning $55,000 a year, receives a $10,000 raise from Bedrock Quarries, can he and Wilma continue their same savings plan? No. They have suddenly dropped 11% behind on their retirement savings.
When Fred and Wilma were earning $55,000 a year and saving $12,430 their standard of living was $42,570 and they had 5.87 times their standard of living saved (250,000/42,570). With the increased earnings of $65,000 a year and the same savings of $12,430 their standard of living increases to $52,570. Based on the increase though their saving pace would reduce to 4.76 times their standard of living (250,000/52,570). Initially their $250,000 nest egg had completed 54% of their retirement savings, but after adding the $10,000 raise to their standard of living they slipped to only achieving 43% of their retirement savings need.
If Fred and Wilma’s standard of living goes up more than inflation, they drop behind on what they have saved. In order to keep their retirement goals on track, Fred and Wilma need to save $3,863 of their $10,000 raise.
Inheriting $100,000
Now imagine instead of getting a $10,000 a year raise Fred and Wilma inherit $100,000. If Fred and Wilma spend a significant portion of this windfall they will increase their standard of living without an annual income stream to support that lifestyle in the future. Every dollar of inheritance that is immediately spent has the effect of increasing their standard of living and therefore diminishing that multiple of their standard of living they have saved for retirement.
A better way to appropriate a sudden influx of cash would be to apply the entire amount toward retirement savings and then lower your savings to enjoy a higher standard of living. If Fred and Wilma chose to add their inheritance to their existing $250,000 of investments they could lower their annual savings from $12,430 to $8,906 – allowing them to spend $3,524 of their $100,000 inheritance every year and still stay on track to retire at age 65. Living off 3.5% of their inheritance (3,524/100,000) would allow Fred and Wilma to take a Brontosaurus Tour to Mt. Crustaceous every year and still be on track for retirement. Yabba-dabba-doo!
Most people though don’t choose to live off 3.5% of their inheritance and save the rest. It is a well-established fact that the tendency of human nature is to spend windfalls frivolously. Studies have shown that those who receive large sums of money immediately begin spending large percentages of it and become accustomed to a higher standard of living. They mistakenly believe that so long as they spend less than their windfall they will come out ahead. But the fatter the dinosaur, the more it insists on being fed. Once we begin spending found money, the $70 “gift” often primes the pump for a reoccurring increase of lifestyle!
Investment Returns
If the markets perform poorly, you need to increase your savings. But if the markets perform well, you can reduce your savings. Like driving in reverse, most people turn the wheel the wrong way and make these adjustments exactly opposite from what they should. It is difficult to put more into the markets when they are going down. Such a contrarian approach requires tenacious discipline.
In our example, if Fred and Wilma’s savings grow from $250,000 to $300,000, they can reduce their monthly savings by $147. (When the market goes up their savings can be reduced.) But if their savings drop from $300,000 to $250,000 they would need to contribute an additional $147 per month. (When the market goes down their savings should be increased to absorb the shortfall.)
Tax changes
Most of these numbers are computed in after tax dollars. More is required when saving pretax dollars due to the forced shrinkage from taxes. Also, if your tax rate changes, the amounts you should save pre and post tax change. Changes in tax rates are especially important for those who are small business owners, doctors and dentists as their income can fluctuate widely.
And if your income drops one year, that is when you should consider a Roth conversion. Most people would not consider a Roth conversion because it increases their taxes in a year when their income is low, but the long-term income gains outweigh the short-term tax within a few years.
So whatever financial changes come your way, an annual reviews guarantees that the changes in your lifestyle are minimized and the chances of meeting your retirement goal are maximized. Study an annual snapshot of your progress with an advisor you can trust. And keep blinking open along the way.
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For more retirement tips, see Best of Free Money Finance: Retirement Posts.
"If Fred, earning $55,000 a year, receives a $10,000 raise from Bedrock Quarries, can he and Wilma continue their same savings plan? No. They have suddenly dropped 11% behind on their retirement savings."
I have a big problem with that statement. It's only true if their standard of living suddenly increases with the raise. If it stays the same, then immediately they're no further ahead or behind, and their retirement situation would improve in the future because they'll be able to save more.
On the other hand, if their standard of living increased without a concurrent raise, _then_ they'd be immediately behind in their retirement savings, and would get "behinder" in the future because they'd be saving less.
Retirement savings goals should be a function of your actual spending (or standard of living), not your income at the moment.
Even more so for someone whose income flucuates wildly, such as a salesman on commission.
The point about windfalls is correct only if it permanently changes your behavior. For example, spending your windfall on the Bahamas vacation you'd never taken. No problem if it's a one-time event, but it is a problem if you liked it so much that you began taking one every year thereafter.
Posted by: Mike | September 18, 2006 at 11:28 PM