It is often said that 25 times your desired retirement spending is a good rough guide to how much investment wealth you need to accumulate to be able to support your desired retirement lifestyle indefinitely or for financial independence.
Of course, the usefulness of this proposition depends on having some idea of what you want to spend in retirement. The reality is many pre-retirees don’t know what they are spending now and have given little thought to the cost of their hazy view of retirement. Multiplying a poorly considered view of retirement expenditure by 25 will result in a poorly considered view of how much you need to support that expenditure.
A failure to think seriously about your likely retirement spending shortchanges you on at least two fronts. First, you will not know how much you need to accumulate. And second, you forego the opportunity to really examine what your retirement may look like.
Estimating and regularly refining your expected retirement spending forces you to think how and with whom you will get the most out of this period of your life. It often exposes inadequate preparation not only from a financial but also a personal point of view. Will a life of reading, golf and travel provide you with sufficient purpose and mental stimulation? Does your partner share your expectations or will you be encroaching on time and activities they value and wish to maintain?
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Your retirement spending estimates will reflect the lifestyle you want
Pre-retirees, regardless of their current age, should consider how much they are spending now and also what they would like to spend in retirement. It’s important to go through a list of likely household expenditures line by line and over time, on the understanding that the pattern of spending may change.
For example, more time (and money) may be stgoted to travel, sports and entertainment in the early years of retirement. Spending may reduce in later years as mobility and, perhaps, enthusiasm for such activities decreases, but expenditure on medical costs and support for children/grandchildren may rise.
One area of spending that receives special focus is what we call capital maintenance. This usually refers to the cost of updating the family residence and replacing motor vehicles. These generally imply lumpy, irregular outflows that are often overlooked when determining expected ongoing expenditure.
No client has ever told us that they want to run their existing motor vehicles into the ground or let their house fall down around their ears in retirement. The general expectation is that these capital items will be refurbished or replaced so that their pre-retirement standard is at least maintained. We use a couple of rules of thumbs to take account of this expectation.
For motor vehicles, we include a replacement allowance of 10% of the new value of the desired vehicle/s in the estimate of annual retirement expenditure. For residences, we include an allowance of about 2% of the estimated replacement value of the building and contents in annual expenditure.
So, if the desire is to own motor vehicles with a new value of $100,000 and the residence replacement value is $1 million, we would include a capital maintenance allowance of $30,000 in estimated annual retirement spending. We cannot guarantee the accuracy of this methodology but it does explicitly recognise that there is a cost to maintain capital and it is potentially significant.
In some years, little of this allowance will be required and should reflect in lower than estimated draw downs on investment capital. But in years when vehicles are replaced or major updating of the residence occurs, spending could be well in excess of the allowance.
So a retirement expenditure estimate of $100,000 a year increases to $130,000 a year (in the example above), once capital maintenance is taken into account. The investment wealth to support this expenditure goes from $2.5 million to $3.25 million – a very significant change in wealth required.
A fulfilling retirement is unlikely to happen by chance
Failure to:
Make a realistic estimate of desired retirement spending;
Take account of capital maintenance; and
Apply a retirement expenditure multiple at least as high as our rule of thumb of 25
will result in a significantly lower retirement wealth target. Unfortunately, it will also greatly increase the probability that your retirement lifestyle expectations will not be met.
For some, the accumulation targets implied by our analysis look both unrealistic and unachievable. We know they are not. But meeting the targets generally requires planning and disciplined implementation of that planning over extended periods of time.
A belated focus on accumulation a few years out from an intended retirement date in most cases will mean that expectations will not be met. It also implies that insufficient thought has been given to what retirement may look like. But at least some realistic financial advice and focus on your financial future at that time will ensure that you enter what should be a wonderful phase of your life with your eyes wide open.
