Ask Bud about the difference between reserves for complete unknowns vs. things that could happen but are not insured.

 

When planning your future retirement, itís good to make some provision for things that are complete unknowns.   These are provisions for complete surprises.  In the work I used to do in the aerospace industry, we called these unk-unks, or unknown-unknowns.  Perhaps an aging parent will run out of money, or a daughter with children gets divorced and has no one to help but you, or you lose your job, or you have a terrible accident with your house, etc.  There is no way of knowing how much to set aside, but an amount you might consider is the larger of (1) at least three months of wages or (2), 10% of your investments.  Putting aside 10% of investments will not reduce retirement income too badly, and if something terrible comes along, it may be a good start in coping with the problem.

 

Relative to things that could happen but are not unk-unks, you can use an old method borrowed from decision tree logic.  For example, if I thought there was a 60% chance I'd need $100,000 of long-term-care at age 85, I'd enter 60% x $100,000, i.e., $60,000, at age 85 in a retirement planning program.  Simply multiply your guess of the probability that something might happen times its cost.   Enter that at the age you think it might happen in your retirement program.  To do this, youíll need to know whether your retirement program wants inputs in todayís dollar values or less valuable future dollars.  If you donít have any idea when the event might occur, subtract the probability x cost from your current investments using the cost in todayís dollar values.

 

There is another class of reserves that is for highly probable events such as the ultimate need for replacing worn-out items such as an automobile, water heater, furnace or roof.  Such reserves mean that you will be able to pay cash for the worn-out replacement instead of borrowing money.  That way you earn money on what youíve saved and donít pay interest which adds appreciably to the cost.  The amount you should have in this kind of reserve is the current replacement cost multiplied by the age of the item divided by its expected useful life.  So a  water heater that would cost $1,000 to replace this year and is now three years old but is expected to have a 10 year life (from the purchase date) needs a reserve of $1,000 x 3 / 10 =  $300.

 

Use the investments less the reserves above as an input for calculating how much you can spend each year in retirement for things not covered by reserves.  Do you need all three kinds of reserves?  Since Iím conservative, Iíd answer yes, but you might want to take a little more risk by including just the replacement reserves plus the larger of (1) reserves for unk-unks or (2), reserves for things that could happen.  In general, itís best to have reserves in readily accessible money market accounts or short-term CDs and carry some insurance for insurable items.  There is a lot more information about reserves and insurance in the book, Getting Started In A Financially Secure Retirement.