Step 1 - Determining Your Spending Needs

If you have a runner in your family, you know how they can sometimes be a little obsessive about lacing ‘em up and heading out. It could be “too hot” or maybe it’s cold, dark and rainy, but still they have to get some miles in. “Why?” is a question often asked that rarely has a good answer.

I received the following from a Patagonia promotional email headed “Where can you go in an hour?” and wanted to share. It may be the clearest answer to the question I’ve ever heard.

Sometimes, an hour is all you get. Sometimes, an hour is all you need. But you need it–fundamentally, excruciatingly, and for those 60 minutes every question gets answered, and new ones get asked. Knots get untangled, and everything makes sense, even if you’ve forgotten it all by the time you get home.

Running has had a huge impact on my life. One way, in fact, was that I did a lot of knot-untangling about starting Ridgeview Financial Planning during long runs on our local roads and trails. There’s just something about solitude and natural beauty that inspires creativity and optimism (or maybe delusions of grandeur). But enough about that… let’s talk about investing in retirement…

Last week I laid out a framework for several posts about backing into your retirement asset allocation. As wonky as this sounds, if done right, the process will help get you through different parts of the market cycle while keeping your spending goals intact.

Asset allocation, or the process of finding and managing your optimal blend of stocks, bonds and cash, is challenging during retirement. The reason is that you’ve entered the decumulation phase after spending decades accumulating retirement savings. Everything seems backwards and it’s a difficult and complicated psychological transition.

The first step we’ll look at is projecting your spending needs for a typical year in retirement. Ideally, this would come from reviewing recent bank and credit card statements, or perhaps money management software like Quicken. You want this projection to be as accurate as possible because a lot will ride on it.

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Looking through the numbers, ask yourself, “Is this spending typical?”. If it seems high, mark one-off expenses as such. You’ll come back to those.

Break your remaining spending into two categories: fixed (mortgage, taxes, utilities, food, etc) and discretionary (dining out, entertainment, and so forth). Then add up the one-off or non-recurring expenses such as home improvement, travel and gifting. This makes up your third spending category. Knowing the difference between these three categories allows you more budgeting flexibility, so don’t simply lump it all in together.

Once you’ve determined your typical spending needs, write this number down. Then add any upcoming one-off expenses, such as that big trip, new roof or bathroom remodel to get your total cash needs for the coming year.

Next you’ll need to total up sources of income, typically Social Security, part-time work, maybe a pension, annuity payments or rental income. Also include income from your investments. (An entire post could be written just on investment income, but the correct way is to look at actual dividend and interest income received in the past year and carry this forward. You shouldn’t include investment growth assumptions, just income received.)

Subtract the planned income from planned expenses to determine your annual surplus or deficit. If you have a surplus, congratulations! But since a deficit is more typical, we’ll look at a simplified example:

Annual spending need - $75,000

Travel budget - $5,000

Painting the house - $6,000

Landscaping project - $4,000

Total planned spending = $90,000

Social Security for both spouses - $40,000

Other income - $20,000

Investment income - $15,000

Total planned income = $75,000

We can see that this couple needs to come up with $15,000 for next year’s spending. We also see that their basic needs are met, but it’s the extra stuff that tips the scale. This is one of the common mistakes people make. They lump their regular spending together and forget about other non-recurring expenses. Maybe it’s a new car (they don’t last 20-30 years, right?), home maintenance, weddings or scarier subjects like taxes and increasing healthcare expenses.

Where will the extra money come from? If you’ve set things up right, you should have an emergency fund of at least six months’ spending. This could either be a multiple of your recurring expenses ($37,500 to $45,000 in the example above) or, as a lower hurdle, six months’ worth of the planned deficit ($7,500). The former is the more conservative approach, while the latter is maybe the textbook way to do it.

Your emergency fund can help cover the deficit the first time, but ultimately the extra money will come from selling shares of your investments. This is where backing into your asset allocation starts.

The idea is to determine how many years of planned spending deficits to keep sheltered from stock market volatility, while still allowing your savings to work for you a little harder than sitting at the bank. But how many years do you need? What investments are appropriate?

Next week we’ll address these questions by looking at the length of typical market downturns and recessions, as well as prudent investment options to see you through.

Have questions? Ask me. I can help.