The Simplest Retirement Plan for Retirees

By Henry K. Hebeler 7-30-05

Several times in the past I’ve shown a very easy way to establish a retirement budget for those who can’t use a computer but can cope with a hand calculator. However, I’ve failed to include examples to help along the way. So let’s revisit the subject.

Here is a simple way to determine how much you can spend each year assuming that you are retired and want the amount you can spend to be able to grow with inflation and your investments to last until you die. Each year your establish a new annual budget based on the sum of your annual after-tax Social Security plus your annual after-tax pension times your age divided by 100 plus your after-tax investments divided by the number of years you expect to live. Now let’s go into some detailed examples and add some refinements to account for Social Security shortfalls and savvy investors:

**(1) First, estimate your life expectancy and future tax rate: **We’ll
illustrate this with an example supposing you are a 70 years old couple with
Social Security, a pension or life-time annuity, investments, debts and a house.
To get your life-expectancy, you can go to __www.livingto100.com.__
Now suppose you estimated that the longest one of you might live is age 95 which
is equivalent to a 25 year life-expectancy. (95 – 70 = 25.) To get an estimate
of your future tax rate, you can divide last year’s income taxes by last year’s
adjusted gross income, but it’s probably prudent to increase that a little.
Let’s suppose your estimated future tax rate is 0.20, or 20%. We’ll use
these values as your own in the calculations below.

**(2) Social Security:** Calculate the after-tax value of your annual Social
Security payments. You can spend all of those. Not all of Social Security is
taxed, so you’ll have to look at last year’s tax return to find whether 0%,
50%, 85%, or whatever was taxed. If you and your spouse will get $25,000 Social
Security this year, and 50% of that is taxed at your tax rate of 20%, then the
tax would be 0.20 x 0.50 x $25,000 = $2,500. The after-tax amount you could
spend this year from Social Security would then be $25,000 minus $2,500 =
$22,500.

**Refinement Note:** Those who have Part B withheld from their Social
Security know that you are already getting less than a full inflation
adjustment, and that shortfall is likely to increase for other factors as well.
If you felt that Social Security will not keep up with inflation, multiply your
Social Security budget by the quantity (1 – 0.4 x life-expectancy x inflation
adjustment shortfall). In the example above, if Social Security would lag the
actual inflation by 1% or 0.01, then the amount of Social Security you could
spend this year would be $22,500 x (1 – 0.4 x 25 x 0.01) = $22,500 x (1 –
0.10) = $19,800. This would leave $22,500 - $19,800 = $2,700 to be reinvested in
savings to compensate for inflation later on.

**(3) Pension or annuity:** If your pension or annuity payments are fully
adjusted each year for inflation (few are), use the method above for Social
Security. If the payments are fixed for life, multiply the after-tax annual
value of your payments times your current age divided by 100. So, if you were
getting a $30,000 fixed pension each year, a 20% tax would be 0.20 x $30,000 =
$6,000 and the after-tax amount would be $30,000 - $6,000 tax = $24,000. The
amount you could afford to spend this year at age 70 would be $24,000 x 70 / 100
= $16,800. That leaves $24,000 - $16,800 = $7,200 to be reinvested to compensate
for future inflation.

**A Practical Note: **Rather than save a certain amount from each Social
Security and pension check, it’s usually more practical to spend the entire
after-tax amount and reduce the amount that you would otherwise draw from
investments by a comparable amount. In this example case the amount you would
subtract from the amount you can draw from investments would be $2,700 (if you
used the Social Security refinement) as well as $7,200 for a year’s pension
withdrawals. Next we’ll calculate how much you project you can afford to draw
from investments before such reductions.

**(4) Investments:** You do not want to run out of money before you die, so
the amount you can spend from investments in the coming year is simply the
current after-tax value of the balance of investments (less reserves for
emergencies) at the end of last year divided by life-expectancy. This theory
assumes that deferred-tax investment returns equal inflation, and after-tax
returns on taxable accounts also equal inflation. This is likely to be
conservative for savvy investors, but could be optimistic for others in adverse
situations. Some studies have shown that the average retiree has difficulty
keeping up with inflation. Savvy investors will want to use the Investment
Refinement Note below to adjust for higher returns.

Now let’s illustrate this with an example. Suppose that at the end of the year, after setting aside some amount for emergency reserves, you have $100,000 in taxable investments and $200,000 in a tax-deferred account such as an IRA.

**Taxable (or tax-exempt) accounts:** Let's also assume that the taxable
investments have $20,000 in untaxed capital gains, that is, the current market
value less the original cost. If your capital gains tax rate is 15%, then the
current after-tax value of the taxable investments would be $100,000 less
$20,000 x 0.15 tax = $97,000.

**Deferred-tax accounts: **Using the example future tax rate of 20% (not what
it might be if you withdrew the entire IRA at one time), the after-tax value of
the IRA would be $200,000 less $40,000 tax = $160,000.

**So the total after-tax investment value** at the end of the last year would
be $97,000 from taxable accounts plus $160,000 from deferred-tax accounts =
$257,000.

Now, if a conservative estimate of the life-expectancy of the surviving spouse was 25 years, then the amount you could budget to spend for everything except taxes this coming year would be $257,000 / 25 = $10,280. In addition, you could afford to pay whatever taxes were due on the $10,280 draw.

Of course your draws from an IRA are subject to certain rules. If you are under 59 1/2, you would draw from the taxable account only (with some exceptions). If you were over 70 1/2, you would have to withdraw the required minimum distribution. In the latter case, if that IRA draw would give you more than $10,280 after tax, you would reinvest the difference in a taxable account.

**Investment Refinement Note:** If you expect that you can invest to beat
inflation, then you could increase the amount that you can spend by multiplying
the amount you calculated above by (1 + real return x life-expectancy / 2). In
this example, someone who expects investment returns could beat inflation by 2%
or 0.02, i.e., 2% real return, would have an after-tax annual draw to spend from
investments of:

$10,280 x (1 + 0.02 x 25 / 2) = $10,280 x (1 + 0.25) = $12,850.

**(5) Your total budget: **This would be the sum of the three elements above:
$22,500 from Social Security, $16,800 from pension, and $10,280 from investments
which total $49,580. (If you applied the refinement notes modifying your
expectations, the total budget would be $19,800 from Social Security + $16,800
from pension + $12,850 from investments which total $49,450.) This would be the
budget for everything except income tax. You would still be able to pay your
income tax in addition because we subtracted income tax when we calculated
after-tax values.

**(6) What if you have debts?** It’s always nice to think that people won’t
have any debts after retirement, but they often have a mortgage and possibly
debts for automobiles or other expenses. One thing you can do is to assume that
your budget has to include the debt payments. However, when your debt payments
end, you will have a sudden jump in what you can spend for everything besides
debt.

**If you do not plan to take on additional debt** after paying off your
existing debts, a more sophisticated way to account for debts and avoid the
sudden disposable income change is to divide the debt by your life expectancy
and subtract it from your total budget above. So suppose you have a mortgage
with a remaining balance of $100,000. Dividing this by your 25 year life
expectancy means that you will have to reduce your total annual budget by
$4,000, thereby netting $45,580. Even though $4,000 is likely to be less than
your actual debt payments, the resulting budget of $45,580 is what you can
really afford to spend for everything excluding debt payments and income taxes.
So if your actual debt payments were, say $8,000 and your income tax was
$12,000, your affordable total cash outlays would be $8,000 debt payments +
$12,000 taxes + $45,580 spending = $65,580. This means that you would end the
year drawing the following amount from investments: $65,580 – $25,000 gross
Social Security –$30,000 gross pension = $10,580 net from investments. This
number can vary widely from the after-tax contribution to affordable spending
that comes from investments alone depending on the size of debt payments and
whether draws are made from taxable or deferred-tax investments. In general,
when a choice is possible and allocations are similar, there is a slight
advantage to making draws from taxable accounts instead of deferred-tax accounts
until very late in life when estate taxes may be a concern.

Some caution is advised if you use the approach above to evaluate the effects of debts even if you don’t plan on taking on additional debt. It is conservative if the after-tax return on your investments is greater than the after-tax interest rate you are paying for the debts. However, if the debt balance is greater than the after-tax value of investments, it is not conservative, and you should use some other method to analyze the effects of debts.

**(7) Your home as a source of retirement money.** It’s generally not wise
to plan on using your home equity as a source of retirement money because you
always need some form of housing and a home may be the ultimate source of funds
for unseen events late in life. However, if you do plan on downsizing in the
near future, you could include the cash you would get from downsizing as a
taxable investment in (4) above. If you plan on using a reverse mortgage in the
near term, you could include the payments from the reverse mortgage as an
annuity in (3) above. Professional financial help would be useful here.

**There is no certainty in this or any other projection method.** None of us
can see the future and know what economic conditions are ahead of us.
Investments may behave badly, inflation may be rampant, tax laws can change for
the worse, Social Security and pensions may not be paid in full, and unseen
events may demand much of our savings. Retirement can be a hazardous venture, so
it is wise to plan with caution and avoid being overly optimistic because
joining the work force again may be very difficult indeed. You may take some
comfort in the fact that similar logic to that used here was used to develop the
"required minimum distributions" from IRAs, and presumably the method
was well considered before making it law. Still, it may be wise to seek a
professional advisor’s help that can go beyond the things we’ve covered here
including investments, insurance, estate planning, etc.