Section 1: Know What You Owe

Step 1:  How do I live? Get yourself a Budget

Here’s a definition I use:

Standard of Living: This is the amount of money you spend in a year.

Investment Advisors can manage your assets; You must manage your money. What you have and what you need.

Think about it: After you retire, you don’t want to give up on your life.   But a big fear is that you will outlive your savings. You have to balance your needs (eating breakfast) with your desires (having bacon with every meal).

The advice I see does not focus on your Standard of Living. Two Rules-Of-Thumb and why I despise them:

The 4% Rule:   This says that you can take 4% of your assets each year to pay for expenses. But, it doesn’t consider that the market goes up and down, you have taxes to pay and so forth. Your mortgage, food bills and everything else simply doesn’t work that way. Do you want your life to be determined by Mr. Dow Jones?

The 60% Income Rule:  Here folks suggest that your after-retirement income should be about 60-80% (or some other number) of your pre-retirement income. Ask yourself this – could you take a 40% reduction in pay and still pay your bills today? If you can, then save that 40%!

My problem is that rules such as these are based on what you have, not what you need. No one wants to touch the emotional third rail of how much you spend – they are not responsible for how you live your life – YOU ARE. But be honest – it is what you spend that determines your Standard of Living – that is what you need.

I am not disrespecting investment advisors by saying these things. They simply have limits on what they can do to help you. If you know what you need, advisors can help you get to those needs. You do your job, and they’ll do theirs.

With this in mind, my idea starts with creating a budget. Here are the thoughts behind a budget for retirement:

• Before you retire, your income is outstripping your expenses, so you don’t worry much. After retirement, you have no income and need to figure out how much to take from your savings.
• You have a pretty good idea what you spend. Now take the time to write it down.
• You will spend what you gosh-darned want to. No financial planner, investment guru or I will tell you how to spend your money. Nor will anyone take responsibility for your actions – you are on your own.
• I separate budget into “Fixed” and “Flexible” income and expenses.

Fixed vs. Flexible Income and Expenses

What I’m doing is trying to increase the amount of information I get from the numbers. To do so I like to consider two categories (Fixed vs. Flexible), defined as follows:

Fixed Income and Expense:   These are any payments you have that occur on a regular basis and are essentially out of your control.  You will always have to pay these as a minimum.  So, your pension (if you’re lucky), your house payments, groceries, and so forth.

Flexible Income and Expense:  These are those payments that you have direct control of, in timing or amount. Some of these are necessary payments (clothing), others are not (vacations).  And some are both (ostriches – you didn’t need them, but now you must feed them; kinda like your kids but way more polite).

You don’t have to do this extra effort to split up fixed/flexible costs, so… Why do this?   Because it helps you understand where you are on the spectrum of retirement – are you living on your pension or are you living on your savings or some of both?

It seems to me that longevity risk is increasing, and not because we’re living longer. Our parents had pensions they could not outlive. We may have some pensions, but we’ll need to manage our money. Our kids, well, they’ll likely be living off savings, having to manage their money with no guarantees that they won’t outlive their savings.

Some comments to think about:

• Transfers:  Moving money from one account to another is a transfer.  For example, when you are paying off your credit card, you are transferring money from your checking account to the credit card company to reduce your balance. It is all the individual charges that you make that are your actual expenses.
• Minimum Required Distributions are Transfers: Your buddy IRA has been freeloading off Uncle Fed for a long time (good for him).  Uncle Fed wants his rent, so he forces you to transfer money from your IRA into a non-tax-free account and treat that transfer as income for tax purposes only.
• Loans are transfers from Flexible to Fixed Expense: If you have the $ on hand to make a large purchase, why take a loan and pay interest?  Actually, there are some good reasons to being able to manage your cashflow and investments. BUT, once you’ve taken that loan, you’ve lost the flexibility and have to pay that amount off. 
• Inflation is not just price: Really, your expenses increase not only by the cost of goods, but by the extra stuff you buy over time to ‘feather your nest’. Ask yourself this – do those ostriches really need to stream Hulu without commercials?

Step 2:  Balancing the Balance Sheet – What Savings do you Have?

A balance sheet is simply all the assets you have and all the debts that you owe.  The difference is your pre-tax net worth.

Your Savings is sort of these things:

• Spending accounts:  checking, basic bank savings, tin can trust (thank you Los Lobos).
• Invested Assets:  These are where you are earning money.  They come in two basic forms:
  • After-Tax Money:  Money that is only taxed on interest when withdrawn (including Roth IRA).
  • Pre-Tax Money (You’re Buddy IRA):  These are the monies that are taxed when withdrawn – IRA’s, 401(k), 457, and so forth.
• Other stuff that I personally ignore:  Value of your home, cars, jewels and ostriches. I ignore them because you can’t spend them.

For your Invested Assets:

• All interest earned is taxable.
• Both Pre- and After-Tax money can be invested in stocks, bonds, mutual funds, whatever.
• The difference is the tax on your contributions. If you need, say, $1000, you must withdraw more than $1,000 for these taxes. The ‘Math’ in Appendix 1 will adjust for that.

What is your net worth?

• For the Bank:  The total sum of all your savings (including your house) less the sum of your loans.
• Your real net worth:  Your Spending and Invested Assets, less your loans.  This is what you can really spend and live on.

The reason I suggest this is simple – if your “real net worth” is less than zero, then you’ve committed all of your money to paying off debts, plus some portion of your fixed income.  I think this is worth consideration before you take on any more loans.

Now that you have all this wonderful information, it is time to do some math (I promise it won’t be that bad…..)

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