Ryan Yamada, CFP®, Senior Wealth Planner
It was late one afternoon when I received the call from a retired client.
“I hate to bother you, but would you transfer another $6,000 into our checking account? I’m afraid we’ve blown our budget again.”
A tinge of guilt rang in her voice.
“I don’t know how this keeps happening. We filled out our budget worksheet just like you asked and were really meticulous about tracking our expenses. But now that every day is Saturday, things just keep coming up!”
This wasn’t the first time I had received a request like this. In fact, these types of incoming calls were becoming more and more routine from clients who recently transitioned into retirement.
After urging her not to worry and promising that we’d fulfill her request within the day, I sat back in my chair. Why were our clients not sticking to their budgets? After all, weren’t they the ones who painstakingly wrote every expense down to the penny and then vowed to adhere?
Clearly something was not working.
In the years that followed, I took a hard look at redeveloping my approach to budgeting in retirement – one that has since been beneficial to many client conversations. But to understand what works, we also must understand the traditional way retirement budgeting is often done and the limitations to this approach.
Fixed, Discretionary and One-Time Expenses in Retirement
The first step of creating a retirement budget is to list all expected expense and then sort them into one of three categories:
- Fixed expenses are typically the non-negotiables of your budget. Do you have a mortgage? What does your average electric bill look like? Do you plan on paying for health insurance before Medicare starts? Listing out these expenses can be helpful in determining the minimum level of income you’ll need; it may also lend a hand in choosing your retirement income strategy.
- Discretionary expenses are what make retirement fun. Are you looking forward to spending quality time with your grandkids during the summers? Do you enjoy working on DIY projects around the house? Discretionary items are distinct in that, should situations warrant, they could be minimized or altogether cut. What’s discretionary to one person may be fixed for another, so if you find yourself unwilling to cut some of these expenses, go ahead and either sort them in order of priority or add an asterisk (*) next to those that are least negotiable.
A note for those married or planning with a partner – don’t assume that you and your partner will create identical lists. Carve out some free time in a nice, relaxed setting to make your own lists and then compare. You might be surprised by what the other will say is most important!
- One-time or large purchases are those things that you’ve been saving for retirement. New countertops for the kitchen? How about that Alaskan cruise you’ve always talked about?
Listing the method by which you’ll pay for these expenses is equally as important as listing the total dollar amount for each purchase.
The Margin – Setting a Baseline
Many well-intentioned clients and their advisors have gone through this process only to find themselves off-target. Why was it that the most detailed Excel spreadsheets seemed to fall short, while others that were more loose-fitting hit their mark? After studying dozens of client situations, the answer came in the margin.
Income – Savings – Actual Expenses = Margin
Or stated another way:
Income – Savings – Margin = Actual Expenses
When my client who called had created their retirement budget, she was very good at listing out all of their fixed expenses. But their discretionary budget was hopeful, at best. Although they thought they had done a great job creating their budget, they had never actually lived on that amount. And they’re not alone!
Sure, there are some people who are natural-born savers, but for the average person, our budget ends up being whatever is deposited into our checking accounts. Add on the occasional raise and the annual cost-of-living adjustments and it’s not hard to see that the budget was now 30-40% higher due to “lifestyle creep” spending that filled up the margin.
Let’s put some numbers to this. Prior to retirement, my clients earned about $150,000 (income), from which they contributed approximately $25,000 through their employer-sponsored plans (savings). At the end of each month, they put whatever monies were left into their joint account, which averaged approximately $750 per month (margin). My client had told me that she expected that they could live on $4,500 per month or $54,000 per year. But how did that actually match their current situation?
In reality, the couple was spending more than $72,000 per year – 33% more than their projected budget of $54,000. When they both finally retired and began living off the $4,500 per month, they quickly found themselves with more “month” than they had money and subsequently began tapping into cash reserves.
In addition, new home projects, higher utility usage and more frequent trips to their favorite restaurant downtown had increased their discretionary spending, further accelerating their portfolio distributions.
Had we first investigated the margin rather than asking the client to itemize her projected expenses, we would have had a clearer idea of the actual cost of their current lifestyle. This approach prioritizes being realistic on what your current spending looks like before determining whether your sources of income can support your current lifestyle.
Dress Rehearsal for Retirement
In an ideal world, everyone would retire with the same level of income as their final working years, or better. But quite often people must make sacrifices to give their finances the best shot at funding a 20-, 30- or 40-year time horizon.
For clients who will likely need to reduce their spending in retirement, I recommend a dress rehearsal.
No show on Broadway would go live without doing a dress rehearsal first, so why not see how your retirement budget performs before going live with retirement?
To start, have your paycheck deposited into a separate account from that which you normally spend or withdraw money. Ideally, paychecks would be directed first into your savings account. Then, a recurring transfer deposits your budgeted amount into your checking. If you’re able to customize the timing of your transfers, try to replicate the cadence of your current paychecks like on the 1st and 15th of every month.
Did you end the month with excess cash? Or did you have more “month” than you had money? Over the course of a few months, you’ll be able to recognize your spending patterns. This information can help you adjust your retirement budget to ensure that it more closely matches your actual spending.
Is Your Retirement Income Stream and Retirement Spending Sustainable?
Now that you’ve determined the cost of your current lifestyle relative to your fixed expenses and tested your budget during the dress rehearsal of your retirement, you can begin thinking of whether your sources of income can sustain this level of spending through a 20-, 30- or 40-year retirement.
If you need help formulating your retirement budget or adjusting your plan, reach out to your advisor or schedule a consultation.