Can I Afford to Retire? Part 2: Income

Once you’ve given some thought to what your ideal retirement looks like (see part 1), answering the question “When can I afford to retire?” becomes an exercise in comparing expected future expenses with expected future income over the rest of your life and your spouse’s life. In this second part, we’ll look at the income side of the equation and ask, “Where is the money going to come from?”

Your parents or grandparents’ generation may have had the benefit of an old-school pension plan. They were guaranteed a certain income for the rest of their lives, while the funding obligations, investment decisions, actuarial modeling, and risks were borne by the company and its professional managers. This system is basically what created the traditional model of retirement among the middle class in the modern industrial world; whereas before, you would have labored until you were physically unable, and then your needs in retirement would have been met by the younger generation with whom you resided for the (probably short) period until you passed. 

Now, aside from a lucky-few, almost everyone in the U.S. must be the manager of their pension fund!

All Retirement Plans Are Just (hopefully well-informed) Guesses:

When you’re young, your income and expenses are likely to be in flux, and so we’ve largely got to make educated guesses about what your life will look like decades from now. Don’t get me wrong, while you may not yet know specifics, this is the best time to be working out your retirement plan. When you are young, your ability to save and compound your investments over time is your greatest retirement asset. Relatively small adjustments now and good habits can make a major difference down the road.

If you’re within a decade of retirement, there’s less time to make big changes to the trajectory, but you do have a much better idea of what your expenses and future income will look like, at least in the medium term. After all, we’re still just making guesses about an unknown future where there are few if any, guarantees. Your ability to tolerate uncertainty and flexibility in responding to future events will play an important role in how you answer the titular question. Keep in mind, there’s likely still more than one path you could take, and it’s not too late to consider them. 

Where is the money going to come from?

For most people, this will only be from two sources: Social Security and your savings and investments. A few still have access to some amount of pension, but it’s likely not as generous as your grandparents’. Increasingly, there’s a fourth source of retirement income: earned income from part-time work or a passion job. Even a small amount of earned income can have a big impact on the amount you’ll need to have saved; to say nothing of the physical and mental health benefits that these engagements can provide. Let’s consider each of these sources in turn.

Social Security

You’ve paid into the system all your life to support the retirement income of those who came before you, and now it’s your turn to claim yours. The first thing you should do is sign up for a free My Social Security account and review your projected benefits, which are based on your highest 30 years of income that was subject to Social Security taxes. For 2023, the average monthly social security check is $1,827 per month, and the maximum monthly benefit is $3,627 (if you waited to claim your benefits at your full retirement age of 67 and earned over the Social Security Wage base throughout your career). Keep in mind, while you can claim social security benefits as early as age 62, you’ll receive up to 30% less monthly benefit than you would at your full retirement age (i.e. 67 years old, if you were born in or after 1960). If you have the means to delay claiming your benefit beyond full retirement age, your monthly benefit will increase by 8% per year until age 70; not a bad return! Social security was never meant to be the only source of retirement income, but it’s an important piece of the puzzle and most people rely on it for stability and protection against inflation. 

Traditional Pension

If you’ve got a traditional pension, you’ll receive a monthly paycheck for the rest of your life, and possibly your spouse’s life also. While this is typically a straightforward arrangement, it’s worth checking with your benefits administrator and getting your hands on the plan documents. Make sure that you understand all the terms and what your benefit will be under the various options. Depending on the age of your spouse and your life expectancies, it may make sense to choose payments based on your single life (typically a higher monthly benefit amount, but checks stop when you die), or based on a joint and survivor option, which will continue to pay your spouse for life if you pass away first (this will be a lower monthly benefit than a single life option, and benefits may step down further after the first spouse dies).  

Earned Income

With the decline of employer pension funds and the stable income they provide, more and more retirees find themselves going back to work in some fashion, either out of necessity or because they find meaning and purpose in it. This includes many individuals who thought they wanted the traditional “work until you’re 65 then never look back” model too. Therefore, it’s worth thinking about now, especially if you’re coming from a career as a “knowledge worker” or have skills and interests that are not as physically demanding. Often the higher your level of education or “success” in your career, the more likely you are to find the desire to engage in some type of meaningful work in retirement, even if it’s in a different vein than your prior career.

Having some amount of earned income, even if it’s relatively small, means you’re not taking that money out of your savings, and allowing it to continue compounding over future decades. It may enable you to “retire” from a job you dislike much sooner and start enjoying many of the benefits of retirement at a younger, more active age. A small amount of earned income may also enable you to put off taking social security benefits until you’re 70 when you’ll get your maximum amount.  

Retirement Savings

A helpful way to think about the amount of savings that you’ll need to retire is the concept of a “safe-withdrawal rate.” The classic rule of thumb is that you can safely withdraw about 4% of your pre-retirement fund balances each year. For example, if you have a retirement account balance of $2 million, you can safely withdraw about $80 thousand per year (adjusted each year for inflation) without fear of running out of money until beyond age 95 (i.e. 30 years of retirement). This basic model requires you to maintain an appropriate allocation to both stocks and bonds  (60/40, rebalanced annually) to keep up with inflation. Add the safe withdrawal amount to your Social Security benefit and any pension benefits and you’ll have a pretty good idea of what you’ll have available to spend each year in retirement at minimum. 

Like most rules-of-thumb, a 4% safe withdrawal rate is an oversimplification, but it’s a helpful concept and an easy point of comparison. Markets are not predictable in the short run, and there’s no guarantee that they’ll continue to grow at historical rates going forward. However, the static 4% initial safe withdrawal rate is fairly conservative, such that, even if you face a down market early in retirement, you’re still extremely likely to be just fine in the long run. Most retirees have the opposite problem: your retirement account continues to grow throughout your entire retirement as your real spending levels decline over time (see part 3).  I often end up encouraging retirees to spend or gift more of their wealth over time, and at rates that are above 4%.

If you’re approaching retirement, I highly recommend finding a good financial planner who can dig into your specific situation and help you think through your options, develop a plan, and adjust your distributions as your needs, goals, and markets change. You may be closer to being able to afford retirement than you think.

A Quick Note on Annuities:

Insurance companies love to sell annuities, and many individuals value them for the peace of mind they provide. An annuity is a purchased pension plan that is sold by and administered by an insurance company. You may pay into the annuity over time, accumulating a sizeable balance throughout your working years, or you may purchase an annuity with a single lump sum payment. Once you “annuitize” the contract, you’ll receive a fixed payment for the rest of your life (or your spouse’s life) whether you live 4 years or 40+ years. If you live longer than expected then you’ll come out ahead in this arrangement, but that means that many annuitants die before they’ve recouped their investment.  There are many options available, but this is the basic idea.

In general, I don’t often recommend purchasing an annuity because of the high fees and lower investment returns compared with investing your savings on your own. However, if you have already paid into an existing annuity, I highly recommend having a financial planner investigate the terms and advise on courses of action that you have. The annuity may be worth keeping, particularly if it was established during a period of higher interest rates, which will result in more generous benefits. Most often, however, you’ll do better by investing your savings outside of an annuity while also preserving the principal and the upside potential.