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By Clark Randall

With more than 10,000 people turning 65 each day in the U.S., a common question I encounter as a certified financial planner is, "How much can I spend in retirement?" The answer to that question is complex since it is mostly determined by six interdependent variables:

    Investment account balance

    Investment account tax status and taxation rate

    Expected portfolio return

    Expected inflation rate

    Non-portfolio income, and

    Your life expectancy

    Each of these variables is critical in determining the success of your retirement plan. And since most of these variables are not static, your spending needs to be periodically re-evaluated. Sometimes people view a financial plan or retirement plan as a stagnant document when, in reality, it is a fluid process. It is imperative to adapt and respond to changes that may impact your income, and ultimately, the amount you can spend.

    Investment Account Balance: Your investment account balance is relatively straight forward. It is the sum of all of the assets that will be used to generate retirement income. Obviously, the more investment assets you have accumulated, the more you are able to spend in retirement. When calculating your account balance, only include assets that can be used in retirement. You will probably want to exclude assets like your home, collectibles, or automobiles unless you plan to sell these to generate income.

    Investment Account Tax Status and Taxation Rate: Each investment account can be largely categorized into three tax groups: tax-deferred, tax-free and taxable investments. Tax-deferred investments include traditional IRAs and 401(k)s. Tax-free investments include Roth IRAs and 401(k)s and the interest earned on most municipal bonds. Taxable, or non-qualified, investments are pretty much everything else. While traditional IRAs and 401(k)s allow for income tax deductions during the accumulation stage, they can be a burden in retirement since all of the distributions are generally taxable. Anytime there is taxation on a distribution, it eats into your spendable income.

    For example, if you are in a 22% tax bracket and need to spend $50,000, you will need to withdraw $64,103 from your IRA ($50,000 / [1-22%]). The tax due on the $64,103 is $14,103 ($64,103 X 20%), leaving you with the needed $50,000 ($64,103 - $14,103). If, however, you are able to take the entire distribution from a tax-free investment, like a Roth IRA, then you will only need to withdraw the $50,000 since there is no tax to pay.

    A non-qualified investment is divided between your contributions and the investment earnings. Some earnings like dividends and interest are taxed annually and will not be taxed again upon liquidation. Other earnings like capital appreciation will be taxed when you sell the asset. Generally, capital gains enjoy a lower tax rate than ordinary income like interest. Depending upon your income level, capital gains rates are 0%, 10% 15% or 20% (some less common gains are taxed at 25% or 28%). All of these tax differences can impact the amount you can spend since the taxes paid are part of your expenses. It is, therefore, extremely important to diversify your investment accounts among various tax strategies. This allows you to select the best source of income each year depending upon your tax rate in that year. As tax laws change, your withdrawal strategy can change with them.

    Portfolio Expected Return: It is very difficult to determine the expected return for an investment portfolio. While past performance is never a guarantee of future returns, history does provide some indication as to the long-term expectation of various types of investments. A common method to project expected returns in a portfolio is to use a weighted average of the long term returns of each underlying asset class by using the applicable index. Assume a simple portfolio includes 30% large company stocks, 15% international stocks and 55% U.S. corporate bonds. A weighted average calculation based upon long-term historical returns might look as follows:

    In this case, you might project an average annual return of 6.41% for your portfolio.

    (*Morningstar data through 06/30/2018) These examples are hypothetical and for illustrative purposes only. Any investment involves potential loss of principle.Indices mentioned are unmanaged and unable to be invested in directly.

    Expected Inflation Rate: Inflation is the rate at which prices of goods and services increase. It is important to project price increases in your retirement plan because these increases will affect how much you must withdraw from your portfolio to meet needs in the future. There are many different indicators of inflation. Some of the more common measures include Gross Domestic Product (GDP), Personal Consumption Expenditures (PCE), Producer Price Index (PPI) and Consumer Price Index (CPI). The Federal Reserve is charged with monitoring and managing inflation through its monetary policy. The stated goal of the Fed is to maintain a two percent inflation rate (measured by PCE) over the medium term. If inflation is two percent and your expenses are $50,000 today, you would need $51,000 next year to purchase the same amount of goods and services that you do today ($50,000 X 1.02). In 10 years it would take almost $61,000 for the same exact consumption. It is important to not only project inflation but to adjust the projections periodically as the actual rate of inflation changes. If inflation ends up higher than projected, then your spending plans might need to be adjusted downward.

    Non-Portfolio Income: Having a guaranteed income that is derived from a source other than your investments is probably the most critical factor to help preserve your investment portfolio. A guaranteed source of income reduces reliance on your portfolio and increases the probability that you will not outlive your resources. The most common sources of guaranteed income are a company pensions and Social Security. It is important to note that, while some company pensions increase to keep pace with inflation, most do not. Social Security benefits, however, do have an annual cost of living adjustment. If your expenses are $50,000 per year and you have a monthly income of $1,000, then your required portfolio distribution is now only $38,000 ($50,000 - $12,000). This allows you to reduce your portfolio distribution by 24% (1 - [$38,000 / $50,000]). This reduction means that your portfolio can last 24% longer with this income source than it can without it.

    Life Expectancy: The final factor in determining how much you can spend from your portfolio is life expectancy. The longer you live, the more resources you will need in retirement. There are several methods to determine the life expectancy you might consider in your plan. You can use life expectancy charts. The advantage to using these is that they are very reliable on average. According to the life expectancy table published by the Social Security Administration, a male aged 66 can expect to live to 83, while a female could plan for age 86. Once you have this baseline projection, you can adjust it for your family history, your current medical condition and lifestyle. I recommend to my clients to rely heavily on family history. If your family typically lives into their nineties and you are in good health, then you should probably adjust this number upwards. Increasing your life expectancy will make your planning assumptions more conservative, preserving assets for later in life. The downside to overestimating your life expectancy is that you might be forced to scrimp on expenses and find, in the end, that you could have spent more and enjoyed your hard-earned money.

    Once you have analyzed these six factors and established your assumptions, you can put together a spending plan. A common metric to utilize in retirement spending is the withdrawal rate. Many financial planners say you should not withdraw more than 4%-6% of your portfolio annually. The actual withdrawal rate you should consider is one that your portfolio can support based upon the expected return and inflation. Using the previous example, if your portfolio is expected to return 6.41% annually and inflation is expected to be 2.0% per year, then you should withdraw no more than 4.41% (6.41% - 2.0%). If you have a $1 million portfolio, you could withdraw $44,100 in the first year ($1,000,000 X 4.41%). The remaining 2.00% earnings would remain in the portfolio. The second year you can withdraw 4.41% of $1,020,000. This increases your withdrawals each year to keep up with inflation.

    There are several methods to project your retirement. If you are handy with spreadsheets, you can create a spreadsheet like the one above that projects inflated expenses and account balances using the expected inflation rate and portfolio return. Alternatively, you can use software programs that will do the number crunching for you.

    Either way, the most important piece are the assumptions. Make certain that you have thought through each assumption carefully. A projected investment return that is higher than the actual return will give you a false sense of security, as will an inflation assumption that is lower than reality.

    About the author: Clark D. Randall, CFP® is a financial planner and registered representative with Financial Enlightenment. Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, member FINRA/SIPC to residents of CA, CO, FL, NY, TN, & TX. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Financial Enlightenment and Cambridge are not affiliated. Cambridge does not offer Tax/Legal advice.