The Retirement Income Gap: What Does It Tell Us?
Many gaps have earned fame or infamy throughout world history. There is the Cumberland Gap that saw many a settler pass through the Appalachians on their way to the Midwest — much to the Native Americans’ chagrin. There is the Fulda Gap in Europe, where NATO troops stood watch for 40 years during the Cold War, on the lookout for a Warsaw Pact armor attack that never came. And of course, there is the gap between Madonna’s teeth.
Mind the gap dude. Seriously, get your face out of your phone before you fall on the tracks and ruin everyone’s commute.
However, I want to discuss a completely different type of gap today — the gap between your calculated retirement expenses and the income you expect from your fixed income (i.e., pension and Social Security). I call this your “Gap Number,” and in this article, I will show you how to calculate it. For those of you who’ve read my two articles on the GRO2W planning process, you’ve already had a preview of the calculation I used to determine my Gap Number. For those who’ve yet to read those articles, my equation is:
Gap Number = (Fixed Expenses + Discretionary Expenses) – (Pension Payments + Social Security)
Mathematically expressed: G = E – F
Example 1:
($50,000 Fixed Expenses + $25,000 Discretionary Expenses) minus ($40,000 pension + $10,000 Social Security) = $25,000 as the Gap Number
Why do you need to know that? I am glad you asked. You need to know your Gap Number so you can calculate how many investments you need to accumulate to safely employ the 4% rule. This will eliminate the gap between your fixed income and your expected retirement expenses. For those of you not familiar with The 4% Rule, you can check out JL Collins’s great explanation. The 4% Rule is an evidence-based financial rule of thumb that allows retirees to safely withdraw up to 4% of their investments annually, with a 96% or higher probability that they won’t run out of money over 30 years with a 50/50 stock-and-bond portfolio. I may go into the importance of the 4% rule in future posts, but for now, if you are not familiar with it and do not want to read JL Collin’s post, then you will have to trust me. I swear I am not wearing my tinfoil hat as I type this.
Thermopylae was a gap too, right?
Now, back to the math lesson: So, once you solve for G (as we did above) you can then plug that number into the 4% Rule’s equation, do a little algebra (and you thought you would never use it again after school! Me neither!), and spit out the total amount you need saved and invested in order to achieve Financial Independence (FI).
Example 2 (building on Example 1):
- If $25,000 = G (from above)
- then $25,000 = .04 x T (according to the 4% rule)
- or expressed differently $25,000 / .04 = T
- which means $25,000 / .04 = $625,000
- or expressed differently $25,000 / .04 = T
- then $25,000 = .04 x T (according to the 4% rule)
For the purposes of our example, a person who earns $50K in retirement from fixed income but has $75K in annual expenses will need ~$625,000 saved and invested in a 50/50 stock and bond split in order to safely withdraw $25K (4% Rule) so as to bridge their retirement income gap annually — with a low probability of running out of money. I italicized that last part to remind you that this number is not hard-and-fast but probabilistic. As in life, there are no absolute guarantees.
It is also important to keep in mind that this number is a current estimate of the amount a person would need to save, and does not account for inflation over the number of years it would take to save that amount. So if it is going to take a person 20 years to save $625,000, then that person would need to calculate inflation (the typical average is about 3% annually in the US) on $625,000. There are online inflation calculators that can do this math for you.
Now that you know why determining your gap number is so important, let’s discuss the steps to do so.
Step 1: Determining Expenses in Retirement
As shown above, the first portion in the Gap Number equation is the expenses. Thus, you need to make an estimate of the amount you will spend in retirement. Realistically, that cannot be done without determining how much you are currently spending. Fortunately, I wrote an entire article on the need to track your expenses for just this reason. If you have not read it, start there, then come back to this article when you are ready to move forward.
For those who’ve already read it, there are a few other things to consider when determining your retirement expenses. First, you need to consider which expense categories will increase and which will decrease in retirement. Some of those changes will be a personal decision based on the retirement lifestyle you expect to lead. For others, there is the universal answer. For instance, from what I’ve read, expenses usually go down once you stop working full-time. Less commuting, lack of a need for work clothes, and cheaper lunches all play a role. Some articles say that 80% of pre-retirement expenses is a good estimate for post-retirement expenses. I would rather you be aware of the research and make your own calculations.
To offset the decrease in the cost of living, you should plan for health care expenses to increase over time in retirement. How fast, and how it should be modeled, are subjects that are much written about on the interwebs. Start googling, and you should find plenty of information. Or again, head over to some of the websites I’ve previously mentioned, like Darrow Kirkpatrick’s, and you will find many well-thought-out articles on the topic.
That’s going to cost ya …
For US readers, part of that calculation will obviously include healthcare insurance plans. If your plan is currently connected to your work, you need to ensure you’ve investigated your post-retirement options and costs through your state or the federal government’s healthcare insurance market. They are likely to be much greater, especially if you have a pre-existing condition. Make sure you pay attention to any changes made to the healthcare system (currently the Affordable Care Act) and remodel your expenses as necessary.
The second consideration regarding retirement expenses is that your tax situation is likely to change, possibly drastically, when you retire. That may end up being a good thing, as you will most likely pay fewer taxes. However, you need to run the calculations as best you can to determine your tax situation. You may even want to use an accountant if you are not comfortable doing it yourself. Despite being comfortable with my tax projections, I am still running my retirement plan by my accountant.
Finally, if you are unfamiliar with the term Geo-Arbitrage as it pertains to retirement, you should probably start researching it. Needless to say, it doesn’t cost the same to live in Southern California as it does to live in Texas or Central America. As with all major decisions in life, there are pluses and minuses to where you choose to live. Access to free or cheaper medical care may outweigh the need to live in a place with no income tax. Good public schools might take priority over cheaper housing. These are personal decisions best worked out within your family, but once made, they can all be modeled to a certain degree of accuracy. As future military retirees, access to military treatment facilities, commissaries, base exchanges, and state benefits for military retirees all played a role in our decision to choose our three potential retirement locations.
Step 2: Determine Your Pension Benefits
It took me 16 years to actually look at the cold, hard facts surrounding the retirement benefits I would earn after 20 years of military service. I generally knew the key features of military retirement, but up to that point, I had never looked into the details. The only reason I started was that a co-worker of mine decided to retire and passed on what he had learned to me. It turned out I had many misconceptions about my retirement benefits. So I started to educate myself, but even that process has proven uneven. As recently as last week, I was still learning new facts about insurance and tax effects from various portions of my retirement benefits.
Does it seem odd that someone would work for decades in a job and not bother to investigate their benefits? As it turns out, it is not that odd. I may have been a bit older than most when I started investigating, but the Pew Charitable Trust recently reported that it is quite common for state and local government workers in their 20s and 30s to understand little about their pensions. That understanding seems to improve as the workers crest 40, and as retirement becomes real and tangible. I find that knowledge both enlightening and disappointing.
It appears that the phenomenon is not isolated to state and local government workers either. The 2015 Blue Star Family Report, an annual survey of military families, reported significant concern among military families about financial issues, but low participation rates among active-duty members in DOD- and command-sponsored financial literacy programs. In other words, we, active-duty military members, are worried about our retirement finances but don’t do much to educate ourselves about our benefits and options. The 2015 report also found:
“Respondents indicated that military family retirement planning was complicated by the uncertainty surrounding future benefits and the perception that military families could not afford to save for retirement.”
It’s a good thing that all the Services require separating or retiring members to attend Transition Assistance Programs (TAP). However, those programs are usually provided to personnel within 12 months of retirement or separation, which does not allow for the strategic financial planning that I espouse on this site. Assuming a military member had meandered in their financial journey as I did, but didn’t have the same luck when they finally woke up to the need for a plan, 12 months would leave them with essentially zero time to research and execute a retirement plan.
So with that, can we agree on the need to understand your retirement benefits earlier in your career? Good. How do you do that? Unfortunately, I cannot answer that question with any amount of specificity for anyone outside the military. However, if the information is not available on the interwebs, I would recommend you contact your local Human Resources Department or representative. For those of you in the military, all you need to do is check out the DOD retirement web page. They have calculators and a wide range of resources. Don’t forget to check out the VA page for disability payments as well.
Regardless of where you work, the obvious question you want to answer about your pension benefits is how much you will get paid in retirement. However, there are several other questions you should seek to answer in your research as well. I’ve listed a few below:
- When will your pension payments start?
- How safe is your pension? Many pensions are under threat due to mismanagement or budgetary pressures at the state and local levels.
- If you determine it is not safe, is there a lump sum option?
- Assuming an 8% rate of return (without inflation), how does the lump sum’s projected investment return compare to the annual pension payout?
- Do your pension payments adjust with the cost of living? If so, how much?
- Does your pension provide any other benefits (i.e., medical insurance, life insurance) that would affect your expected retirement expenses calculations?
- Is your pension taxable at the Federal or State level? Does that apply to all potential States you might retire to? What about the Social Security tax?
- Does your pension have a survivor benefit? If so, how much does it cost? Are those costs tax-deductible?
As you can see, there is a lot to consider when it comes to pensions and retirement benefits. It may seem overwhelming at first, but trust me, as you whittle down the answers, you will get to a suitable number you can plug into your planning calculations.
Keep whittling
Step Three: Social Security
Can you rely on Social Security to be there when you retire? It is another much-debated question in the blogosphere. Some say yes, some say no, and some say partially, depending on your age. Others argue that some of it may be there, but you are safer making your retirement calculations without relying on it. Honestly, I do not have an answer. There are problems with Social Security that must be addressed for everyone to receive 100% of their benefits. Whether they will be given the current state of US politics, I don’t know. If Social Security is fixed, it will affect taxes, requiring us to redo our retirement calculations. If it is not fixed, you will need to use your best judgment about how much you expect to receive by the time you reach Social Security age.
I realize younger generations, social media is akin to a security blanket but I was speaking of something different.
I can tell you what I did for my Social Security retirement calculations. Based on my age (early 40s) and research, I assumed that my wife and I would receive approximately 75% of our Social Security benefits at age 70. Do my calculations work without Social Security? Not all of them. In fact, very few of my retirement scenarios work without some form of Social Security kicking in at age 70. Is that risky? Potentially. However, I ran the numbers through numerous calculators, and we can get by with a high probability of success with as little as 20% of the Social Security owed to us. That is a risk I am willing to take.
There are several other Social Security considerations worth noting for your calculations. One of them is when you plan to start your distributions. Currently, the full (100%) Social Security distribution point for most people is 67 years old. You can delay up to 70 years and earn 8% more on your total distribution for each year you delay. Conversely, people can start receiving their Social Security benefits as early as age 62. When they do, they are choosing to receive a reduced amount for life by upwards of 25%. Strategies for when to start distributions usually center on your projected longevity based on family and medical history. However, the issues surrounding the stability of Social Security may begin to trump (no pun intended) longevity considerations in the future.
If you are still married when your Social Security point rolls around: congratulations! However, you will need to consider the best strategy for you and your spouse. If your spouse worked a full career, it probably makes more sense for each of you to take what you are owed from your separate pots. However, a spouse is also entitled to half of the other spouse’s payment, in lieu of using their own pot. This rule was created for homemakers, but currently, all spouses are eligible. So if half payments from the larger breadwinner’s Social Security pot are more than a full payment from the smaller breadwinner’s pot, it obviously makes more sense to take the larger amount.
Alas, this section was not meant as a full-blown review of Social Security. Since so many FI bloggers and financial experts dive deep into Social Security, I just wanted to give you a taste of the many considerations when calculating your fixed income for your Gap’s mathematical model. I would encourage you to log onto the Social Security Administration’s website if you have never done so. Take a look not only at current projections for your payments but also at information on the Social Security Trust Fund’s viability. Good luck with this complicated topic.
Step Four: Putting It All Together
Hidy Ho Campers. Time to glue everything together.
OK, we’ve talked generally about what your Gap Number tells you and what you can do with it. We then discussed how to determine each subcomponent of the equation. Just to review, though, remember you calculate your Gap Number by:
Gap Number = (Fixed Expenses + Discretionary Expenses) – (Pension + Social Security Payments)
Mathematically expressed, it looks like: G = E – F
Where G is the Gap Number, E is your annual expense, and F is your annual fixed income.
The most important thing your Gap Number gives you is the crucial value to divide by .04 in order to calculate the total amount of money you need saved and invested in order to safely employ the 4% rule. Mathematically expressed, it looks like:
T = G / .04
Where T is the total amount of money you need saved and invested, G is your Gap Number, and .04 is the decimal equivalent of 4%.
It’s worth noting that these equations are not exclusive to pension and social security inputs. You could have rental, annuity, and/or dividend income (just to name a few) as inputs and still use the Gap equation to calculate your Gap Number. All you essentially need to know is your monthly or annual expenses and income to solve for G. Once you know G, you can solve for T. Once you know T, you can start running tests through any number of high-powered retirement calculators to test its feasibility. Knowing whether T is viable can be powerful, as it technically represents your FI point.
I say technically for several reasons. One, if you used fixed income in your equation, then you obviously need to make it to the point where you are eligible to receive it. Or have a plan to bridge until that point with other income opportunities. Two, and more importantly, you must remember that these numbers are based on your best estimates of the future and the probabilistic math behind the 4% Rule. Given that no one can predict the future, and that probabilities are not certainties, I urge you not to fall in love with any one number. Use your numbers as planning tools and update your calculations as new data becomes available or your life changes. If you do that, I have no doubt you will succeed.
