We tend to think about retirement, naturally enough, in terms of saving. And as we get closer to the day we plan to retire, we start to think about retirement spending - or at least we should. But a disconnect happens for most people when they try to match what they have saved to what they think they'll need to cover their living expenses in retirement.
The reason is that throughout our working lives, income and spending are paired together. We know how much we make, and therefore we know that our spending should be equal to or (preferably) less than our income. When it comes to retirement, relating the lump sum in our savings accounts to spending is neither simple nor clear.
How Much Dough for a Cup of Joe?
Here's an example: What if I told you that $9,701 for a cup of coffee is a good deal? Before you decide I'm crazy, consider this scenario:
Let's say you are 55 and one of your favorite things to do on weekends is walk to your local coffee shop, buy a large cup and chat with friends. When you think about retirement, which you plan to do at 65, you imagine doing this every day. How much will that cost? Let's assume that today your coffee costs $1.95 per cup. And for simplicity's sake, let's remove inflation from the equation and assume the price of your cup will not change. That means:
- Each year of coffee will cost $711.75.
- Ten years of coffee will cost $7,117.50.
- If your retirement lasts 30 years, you will eventually spend $21,352.50.
Fortunately, you don't need all $21K at once. But how much do you need to save before you retire to fund your daily cup of coffee? You could use any number of financial tools to calculate the rate of return on a given savings amount and a drawdown rate that may deliver $711.75 a year.
I did something simpler; I used CoRI. (Full disclosure, it's a BlackRock tool.) If you are 55 to 64, you can check CoRI daily for the estimated cost of a dollar of annual lifetime income beginning at age 65. (Check the CoRI site if you are interested in how the tool works.) Let's say based on your age of 55, today's estimated cost per dollar of future income (beginning at age 65) is $13.63.
So if I multiply the estimated cost ($13.63) by the approximate yearly income needed to buy coffee ($711.75), I find the annual income I need to buy my daily coffee in retirement would cost an estimated $9,701 today. (The figures provided here are for illustrative purposes only, assume no other variables, and are subject to change over time.)
This "translation" helps in two ways. First, estimating the cost of retirement income (by using CoRI or some other method) helps you estimate the future income your savings may produce, and that in turn lets you measure your estimated income against your projected retirement living expenses. That exercise helps you look at your retirement readiness in much the same way you measure your current spending against your paycheck.
The second way it helps is that you start to think about retirement income (from whatever source) as a "cost", something you "buy". And that may change how you think about retirement saving. Rather than putting money aside and hoping it is enough, you can now think of saving as buying something today that you will use tomorrow. And that subtle shift can help you set savings goals based on the income you think you'll need in retirement.
Chip Castille, Managing Director, is head of the BlackRock US Retirement Group. You can find more of his posts here.
The CoRI tool does not guarantee future income or protect against loss of principal. Although the CoRI tool provides an estimate of the amount of money you need today for every dollar of annual income you want in retirement, this estimate is not a guarantee. A number of factors may contribute to variations in retirement income.