Grumpus Maximus Comment: I originally wrote this post with the intent to create a clear and concise step-by-step on how to calculate your Gap Number.  Turns out I wrote another tome.  Some of you may prefer my ramblings.  If so you are probably one of my relatives or friends.  Or maybe you are waiting to laugh at another of my $750,000 dollar financial mistakes.  Fair enough, all I can do is laugh about it too.  But in case you don’t prefer my ramblings, I thought I would quickly refer you to some other resources that are clear and concise.

First off, check out Darrow Kirkpatrick’s website Can I Retire Yet?.  I’ve talked about him before, so I won’t rehash my book and website review for him.  On his site under the Index link, if you scroll down to the Retirement Equation section, he walks you through everything you need to do in order to make your calculations.  The Mad Fientist also has a Planning section under his archive, which has several useful articles.  Finally, check out the two booklets I reviewed in my book review section entitled Early Retirement Solutions: How Much Money Do I Really Need to Retire & Achieve Financial Independence?  and Retire Sooner!: How to Optimize Your Plan to Achieve Financial Freedom by DJ Whiteside.  They are what I used to make my calculations. 

For the rest of you gluttons for punishment, please read on …

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 mid-West — 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 which in Medieval days would have been seen as a sign of lechery — totally fitting!

However, I want to discuss a completely different type of gap today — the gap between your calculated expenses in retirement and the amount you expect to earn through your fixed income (i.e. pension and social security).  I call this your “Gap Number” and in this article, I am going to 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 then calculate the number of investments to accumulate in order to safely employ the 4% rule.  This will eliminate the gap between your fixed income and your expected expenses in retirement.  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 whereby retirees can safely withdraw up to 4% of their investments annually, with an above 96% mathematical probability that they won’t run out of money over 30 years if using a 50/50 stock and bond investment 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.

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

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 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 this number is a current estimate of the amount that a person would need to save, and does not consider inflation for the number of years it would take a person to save this amount of money.   So if it is going to take 20 years for a person to save $625,000 then that person would need to calculate inflation (typical average is about 3% annually in the US) on $625,000.  There are online inflation calculators which can do this math for you.

Now that you know why determining your gap number is so important, let’s discuss the steps to take in order to determine it.

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, you need to start there, and 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 what categories of expenses will increase and 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 counterbalance the decrease in cost of living you should plan for health care expenses to go up over time in retirement.  How fast, and how that should be modeled, are subjects 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.

For US readers, part of that calculation will obviously include healthcare insurance plans. If your plan is currently connected through your work you need to ensure that 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 what your tax situation may be.  You may even want to use an accountant to assist you if you are not comfortable trying to do 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 a future military retiree, access to military treatment facilities, commissaries, base exchanges, and state benefits for military retirees all played a role in choosing our three potential retirement locations.

Step 2:  Determine Your Pension Benefits

It took me 16 years before I actually looked at the cold hard facts surrounding the retirement benefits I would earn after 20 years of military service.  I generally knew about the most important features of military retirement, but up to that point, I never looked at all the details.  The only reason I started is that a co-worker of mine decided to retire, and he passed on what he learned to me.  It turned out I had a lot of 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 to investigate, but the Pew Charitable Trust recently reported it is quite common for state and local government workers in their 20s and 30s to understand little about their pension.  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 phenomenon is not isolated to state and local government workers either.  The 2015 Blue Star Family Report, an annual survey of military families, reported high concern within military families over 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 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 like I did, but didn’t have the same amount of luck when they finally woke up to the need for a plan, 12 months would leave them essentially zero time to effectively research and execute a plan for retirement.

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 all sorts 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:

1. When will your pension payments start?
2. How safe is your pension?  Many pensions are under threat from mismanagement or budgetary pressures at state and local levels.
3. If you determine it is not safe, is there a lump sum option?
4. Assuming an 8% rate of return (without inflation),  how does a lump sum’s projected investment return compare to what you would earn annually from the pension pay out?
5. Do your pension payments adjust with cost of living?  If so, how much?
6. Does your pension provide any other benefits (i.e. medical insurance, life insurance) that would affect your expected retirement expenses calculations?
7. Is your pension taxable at the Federal or State level?  Does that apply to all potential States you might retire to?  What about Social Security tax?
8. 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 think about with regards 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.

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 calculations for retirement without relying on it.  Honestly, I do not have an answer. There are problems with Social Security that must be addressed in order for everyone to receive 100% of their payments. Whether they will be given the current state of US politics, I don’t know.  If Social Security does get fixed, it will impact taxes, thus requiring renewed retirement calculations for all of us.  If it does not get fixed, then you will need to use your best judgment on how much you think you will receive by the time you hit Social Security age.

I can tell you what I did for my retirement calculations when it came to Social Security.  Based on my age (early 40s) and research; I assumed my wife and I would receive approximately 75% of our earned Social Security payments 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 considerations regarding Social Security worth noting for your calculations.  One of them is when you plan to start your distributions.  Currently, the full (100%) distribution point for Social Security for most people is 67 years old.  You can delay up to 70 and earn 8% more on your total distribution for each year you delay.  Conversely, people can start taking their Social security payments as early as 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 that you each take what you are individually 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 is more than 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 on Social Security, I just wanted to provide you a taste of some 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 at not only the current projections for your payments but at the information regarding the viability of the Social Security Trust Fund as well.  Good luck on this complicated topic.

Step Four:  Putting It All 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 figure out each of the sub components 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%.

A good thing to know is 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 what your monthly or annual expenses and income will be in order to solve for G. Once you know G then you can solve for T.  ‎Once you know T you can start running tests through any number of high-power retirement calculators in order to test its feasibility. Knowing whether or not T is viable can be a powerful thing 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 these numbers are all based on your best estimates for 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 to you, or as your life changes. If you do that then I have no doubt you will prove successful.