Almost every financial product advertisement geared toward retirement savings or income features a happy couple enjoying time in some exotic location. While that may be a reality for some, most of us have a different picture of retirement – either by choice or because we can’t afford to buy our own island. What this ubiquitous “ideal” picture of retirement has led to is a blurred line between required retirement income and desired retirement income.
Separating the two components of retirement income can be quite difficult from a behavioral perspective. For example, required income would be the amount of income you absolutely have to have for the necessities – food, shelter, clothing, utilities, medical premiums/co-pays, etc. – from my view as a planner. Inevitably, some of you will disagree and will contend that your travel budget is a necessity or that you need that second home in order to survive. The reality, however, is that while travel and that second home may make your retirement more enjoyable, they are not absolute necessities. So should you forget about planning to fund your desired level of retirement income? Of course not.
(At this point I want to recognize that I am attempting to inject some objectivity into something very subjective, so humor me for a few moments).
More often than not, investors lump these two categories of income together when preparing for planning discussions with their advisors or when using online planning tools. This is a great way to get an idea where you stand at a given point in time, however it could pose issues when it comes to long-term planning. Let’s look at a simple hypothetical example to illustrate the possible threat posed by failing to separate retirement income into the two categories mentioned above.
Suppose you have determined that your required retirement income is $30,000 annually and you believe this will cover the necessities discussed previously. Suppose further that you wish to do some traveling and you estimate the annual cost of travel to be roughly $15,000. This leads you to conclude that you will need to produce $45,000 of annual income in retirement in order to meet your needs. Your information is then entered into some form of financial planning software that will estimate the probability of success given your current situation and assumptions as well as give you a recommended asset allocation that will maximize your chances of reaching your goals. All of that probably sounds familiar.
Now take a closer look at the income assumptions from the example. The total amount of the retirement income assumption is 50 percent higher than the required amount. Here lies the potential issue. The recommended probability of success and asset allocation that was determined by the financial planning software mentioned above was determined by considering the total retirement income entered. The probability of success could be extremely high in relation to the required level of income, however it could be drastically lower when looking at both the required and desired income together. Depending upon an individual’s ability to increase savings, this could lead to a more volatile asset allocation for the entire portfolio in order to increase that probability of success. As a result, the investor could place the required level of income at risk in order to increase their chances of reaching the desired level of income. If the worst should happen, that “desired” income becomes moot: if required expenses aren’t covered, there is nothing left over to cover those desired expenses.
This obviously doesn’t change the fact that there is still a finite level of resources competing for each of these goals, and I’m certainly not suggesting otherwise. However determining – and protecting – that required level of income is a good first step. By separating out the required income from the desired income, you can focus on securing the former first and then move on to the latter. The likely result in most cases (with good planning and reasonable assumptions) is that both categories of retirement income can be achieved, although the desired amount may not allow you to buy the island – only visit it once in a while.