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The OPERATIVE variable! Determining Your Retirement Cash Flow

The OPERATIVE variable! Determining Your Retirement Cash Flow

March 05, 2024

The transition into retirement can often be one of the most stressful and uncertain times in the lives of our clients.  Our ability to help them navigate this uncertainty so they can confidently make this next step is a critical component of the value we add as their financial advisors.  We consider cash flow planning to be the “operative variable” because getting it “wrong” can have devastating consequences with regards to a client maintaining their quality of life and being able to accomplish their financial objectives. 

If we underestimate expenses, it could lead to a reliance on an ongoing withdrawal rate from their assets that is too high to confidently maintain due to overexposure to sequence-of-returns risk. Ultimately, a plan like this can lead to the exhaustion of assets during a client’s lifetime and the need to drastically reduce spending to an uncomfortable degree.  Conversely, we must also address the consequences of a retirement plan that is “overfunded” where a client’s lifestyle is significantly below the level at which their assets can support.  In this case, we explain to our clients how much more they can afford to spend on either themselves, their loved ones, and/or charities that they care about.  Finally, we can illustrate the potential size of their estate at the end of their life depending on the spending decisions they make and discuss if the amount is in line with their objectives.  Oftentimes, the results are shocking to a client if changes are not made and illustrating the problem is the first step and helps us ultimately get it as “right” as possible! 

Incorporating both a qualitative and quantitative approach to determine a client’s retirement cash-flow needs is imperative.  Because we are making assumptions about what the future could look like in 12-15 years and beyond, a plan that simply looks at all current expenses and inflates them at an agreed upon rate would be inaccurate.  A plan needs to address the several changes to their expenses that we know will happen, as well as the expenses tied to their aspirations which will require further discussion.   

We can provide a quantitative analysis and recommendation by separating the “unknown” from the “unknowable” risks and expenses.  For instance, “unknowns” would be factors such as health care costs, inflation, and college costs for a client’s child (if applicable) which we don’t know at this point but can use our financial planning tools to make assumptions on those costs in the future.  Additionally, we can address the “unknowable” which refers to variables that are more qualitative in nature, such as: longevity, how a client’s adjustment to retirement emotionally could affect their spending, as well as the amount of financial support they may want to give their children. 

A starting point for quantifying the “unknown” and “unknowable” to help a client (at a minimum) maintain their quality of life in retirement would be categorize the fixed and variable expenses into two categories with the classifications provided:  

  1. Basic Needs: (taxes, housing, automobile loan, food, utilities, transportation, clothing, insurance premiums (medical and life), medical payments/insurance, travel & entertainment, and miscellaneous.     
  1. Wants:  Comprised of aspirational goals not part of current cash flow such which could be such as helping pay for college for a grandchild, costs relating to caring for an aging parent, or costs relating to travel or an expanded lifestyle. 

To determine cash flow needs, we feel it is necessary to employ a methodology that addresses the “unknowns” regarding inflation and how changes in lifestyle will affect the future cash flow needs to finance each expense category.  We cannot simply add an annual inflation increase for each expense because as research has shown from the U.S. Bureau of Labor’s Consumer Expenditure Survey - besides for healthcare, expenses for retirees tend to decrease mostly through because of decreased ability to spend during their later years.  This drastically reduces the impact of inflation on Monte Carlo simulation projections. 

Incorporating this methodology, we would recommend creating three separate retirement cash-flow scenarios for a client using financial planning software that will allow for changes to inflation and performing Monte Carlo simulations.  We would remove expenses that we know will no longer exist at retirement and would address the “needs” and “wants” categories identified previously.  Next, we would discuss which remaining expenses would maintain the base inflation rate, which expenses we believe would rise throughout retirement and which expenses we believe would fall.  Finally, we would discuss and agree to the ages at which these changes in expenses or inflation rates would take place.  For instance, since a client may no longer have a mortgage to pay in retirement, perhaps they would like to move that budgeted expense to another category such as travel, college funding for a grandchild, or increase their charitable gifts.  I would also have the client look at the remaining expenses in today’s dollars since the program will calculate inflation which would allow us to have a qualitative discussion without focusing on the effects inflation would have on the figures: 

Plan A: Base case - Plans relating to ongoing savings, sale of the business (if applicable)/ other cash infusion, longevity of both spouses all happen as we had hoped.     

Plan B: Bad scenario - Perhaps there is a negative change relating to a client’s business / income from employment, health or longevity leading to less money at retirement than originally anticipated.  Under this scenario, using the base case as a starting point, we would determine which expenses we would cut to coincide with the potential cut in ongoing pre-retirement savings and retirement income. 

Plan C:  Windfall - Under this scenario, we would have substantially more assets than anticipated for reasons such as a client’s business selling for more than anticipated or them receiving a higher than anticipated inheritance.  If this is the case and we have substantial extra assets and income at retirement, we would look for ways to increase spending in categories to give them satisfaction or build in an appropriate charitable/legacy plan.   

In summary, I believe there is no “cookie-cutter” approach to building a retirement cash-flow plan for a client that can deliver a better experience than a personalized approach.  Addressing various “what-if” scenarios to address the “unknown” and “unknowable” to build a retirement cash-flow plan incorporating the “reality” retirement planning methodology is crucial in providing a client with a plan they can rely on for their retirement.  In our approach, we address a client’s situation holistically with the benefit of flexibility which allows for a higher level of advocacy for them as we gain a deeper understanding of their goals throughout our relationship.