Just in case the title has you thinking this article is about The GAP clothing company, I want to let you know “the GAP” I am referring to is something much more important to your financial success. In my 20 years of financial planning experience with clients and training advisors, planning for your retirement starts with determining whether or not you have a “gap.”
So, in financial planning terms, what do I mean by “gap”? “Gap” simply refers to the difference between the income sources you will be drawing from in retirement minus the expenses continuing through your retirement. If the result is a negative number, you have an income “gap.” Simple right? Maybe not. Common retiree complaints I hear occur when income sources are not sufficient to meet expenses or expenses exceed income sources, both of which force retirees to access savings sooner than they expected. As a result, a retiree no longer feels as confident about the longevity of their savings and their ability to meet their income needs over what may be a 25-35 year retirement. Maybe you know people who have found themselves in this scenario or you have this concern yourself.
How does one avoid falling into this scenario? There are several steps, but it is my opinion every pre-retiree should develop a retirement income plan before they retire as a first step. Some may be able to do this on their own, but I would recommend utilizing a financial professional to help address the plethora of issues retirees face and must consider before actually retiring.
One should start by understanding what income sources you have available and the timing of when those sources will start. Typical income sources include pensions, Social Security, rental income, and investment income. Many individuals neglect factoring how taxes will reduce annual income and the impact taxes may have on income through retirement.
Unfortunately, many plan their retirement income thinking of their income sources in terms of “gross” income instead of “net” income. This mistake can create a shortfall immediately in retirement and jeopardize income security throughout retirement. The following is a laundry list of things to keep in mind when looking at your retirement income sources:
- Social Security Income Strategy:
- When will it start?
- Should an annual Cost of Living Adjustment (COLA) be included in your Social Security income projection?
- If yes, what is COLA amount should be used?
- Will income be reduced by Medicare premiums?
- How will taxes reduce your Social Security income?
- Pension Income:
- Is a COLA available?
- Is it guaranteed?
- Is there a reduction due to spousal income benefits?
- Part-time work
- Rental income
- Investment income
- How will taxes reduce each of these income sources?
Understanding your income sources is only half of the equation. Before retiring, it is prudent to spend some time really understanding the expenses you will have through retirement. I like to break expenses into two categories: Basic expenses and Quality of Life expenses.
Basic expenses are required expenses and include items like utilities, mortgage, health insurance, other insurance, food, etc. These expenses will be constant throughout retirement. Quality of Life expenses include things like travel, entertainment, gifts, one-time purchases, etc. These expenses are one-time or discretionary in nature. If income needs change, often reducing these expenses will be the first course of action. When considering your expenses, realize expenses will go up over time with inflation. A common mistake made in planning is neglecting to understand the impact inflation will have on your Basic and Quality of Life expenses over time.
As you evaluate your Basic expenses, most understand they need to ensure money is always available to pay for the “necessities” of life. Will your guaranteed sources of income cover your Basic expenses? If not, you have found yourself in the “gap.” Addressing this issue has to be priority #1 before you submit those retirement papers to your employer. If your guaranteed sources of income do cover your Basis expenses, the next step is to test the longevity of the surplus against inflation.
When I am providing planning services for a client, this is where I initially focus my attention. Even if there is a surplus, I want to determine how my client can expect to have a surplus. After considering COLA amounts and inflation on expenses, I can determine when the income sources no longer keep pace with rising expenses. Depending on when this occurs, different planning strategies can be employed to provide new sources of income to fill the income gap. This part of retirement income planning creates the foundation for the rest of your retirement. It is very important to understand how strong your foundation is before committing to what could be a 1/3 of your life spent in retirement.