Today, I’m writing about cash flow in retirement. I’ll develop a simple framework to document, display, and discuss basic components of retirement cash flow, and to suggest how it might change over the course of your retirement.
These projections are simple, but do require a systematic inventory of cash flow sources and will reflect several key decisions and assumptions. Depending on your situation, you are likely to identify areas deserving more detailed analysis.
To illustrate some issues, and put actual numbers into the discussion, I’m going to use a hypothetical couple, Jim and Karen, who are putting together a retirement cash flow projection. I am going to assume a typical, but simple situation.
Many people will have more complex personal or financial situations, but the basic framework developed here can be readily extended to accommodate that complexity.
Age, family, and personal status
Like slightly less than half of their age group peers (but a higher percentage of their college educated peers), Jim and Karen are married, and still in their first marriage. Their two-year age difference is typical.
Source: Business Insider
They have two children, both financially independent, no surviving parents, or unusual financial responsibilities. They have no mortgage or other significant debts. In summary, there are no anticipated material claims on their current assets.
Financially conservative, they have been steady savers, and have taken full advantage of 401k and IRA plans to build retirement savings.
Jim is 62 (born in 1956). He was a mid-level manager for a Fortune 1000 company until he took an early retirement package during a re-organization two years ago.
Karen is 60 (born in 1958). She worked as a database administrator for 6 years before becoming a stay-at-home mom, returning to work 12 years ago. She plans to retire this year.
Jim and Karen are in generally good health, and have no exceptional family medical history. After recently reviewing IRS longevity estimates, Jim and Karen determine that, on average, Jim can expect to live to about 84 and Karen to 87. Karen can expect to be a widow for about 5 years, but there is a material chance (about 20%) that Karen might live to 93, and hence be a widow for 11 years.
Sources of Retirement Cash Flow
Gallup polling data from 2018 describes actual reported income sources in retiree households:
Let’s discuss some of these in enough detail to see how they impact Jim and Karen, and perhaps provide a point of departure for your analysis.
Jim has a single-employer defined benefit pension plan, which provides a lifetime annuity. The default arrangement for such plans is a joint-and-survivor benefit which provides a monthly benefit during Jim’s life, and then 50% of that benefit to Karen as his surviving spouse, after his death. Other arrangements are usually available. The selection of benefit arrangement is a one-time and irrevocable choice.
When he retired, Jim chose the default joint-and-survivor benefit option. In hindsight, and after learning more about longevity projections, he regrets not having chosen the option that would have provided a slightly lower benefit during his lifetime, but paid Karen 75% of that benefit as his surviving spouse after his death.
Jim’s current pension benefit is $30,000 per year. In the event of Jim’s death, Karen will then receive 50% of that amount, or $15,000/year, for her lifetime.
Jim’s pension includes an annual Cost of Living Adjustment (COLA), intended to offset inflation. Not all plans have a COLA.
Many pension plans are underfunded, some very materially. Jim receives an annual funding notice letter, which indicates the plan is currently 92% funded. Further details are published at the Department of Labor as Form 5500 here. He believes his former company is likely to be able to continue to make any necessary pension contributions.
Jim’s pension is also insured by the federal Pension Benefit Guarantee Corporation (PBGC). PBGC insures about 25,000 private-sector pension plans, and has taken over administration of about 4,800 plans. Although PBGC currently runs a significant deficit, Jim feels it provides some additional security.
Jim and Karen conclude his pension plan is probably sound, and that it’s reasonable to include it in their retirement cash flow projections.
For a person who begins taking benefits at Full Retirement Age (FRA), the maximum Social Security benefit per person for 2018 is $2,788/mo ($33,456/yr). The average benefit for a worker is $1,404/mo ($16,848/yr), and for a couple $2,340/mo ($28,080/yr). Social security benefits receive an annual COLA.
Optimizing social security, particularly for a couple, can be complex, and there are many special rules. But the basics are understandable in the typical case:
- FRA is a function of birth date.
- Standard benefits are paid at FRA.
- Reduced benefits are available from age 62.
- Delaying benefit start (up to age 70) earns delayed retirement credits, yielding an increased benefit.
- Spouses at FRA can receive 50% of a living worker’s FRA benefit.
- A surviving spouse can receive 100% of a workers benefit.
- Delayed retirement credits are used to compute survivor benefits, but not spousal benefits.
Jim and Karen each qualify for Social Security on their own work records; $28,000 at FRA for Jim, and $15,000 at FRA for Karen. They would receive reduced benefits for early retirement, and increased benefits for delayed retirement. The table below summarizes their situation:
Jim and Karen are aware of the debate concerning the long-term stability of Social Security. The Trust Fund is projected to be exhausted in 2034; with no changes, benefits would be reduced by about 25% from that point.
However, Jim and Karen expect that something will be done to continue unreduced benefits, and that it is reasonable to include these benefits in their retirement cash flow projection.
Their intent is for Karen to begin SS benefits at FRA, and for Jim to delay SS benefits until 70, primarily to ensure the largest survivor benefit for Karen.
About half of private sector workers in the US are covered by defined contributions plans. Authorized in 1978 and widely adopted by the mid-80s, 401(k) plans allow per-tax contributions of salary to a tax-deferred retirement plan.
The majority of Jim and Karen’s assets are in 401k plans. Both have consistently contributed to 401(k)s at work, and are receiving an employer match.
Vanguard published a detailed report on the 1,900 defined contributions plans they administer for 4.6 million participants, which provides a large sample of all US participants. Target date funds are increasingly popular – in 2017, they account for about 1/3 of all defined contribution plan assets at Vanguard, and more than 1/2 of new contributions. Among Vanguard participants in the 55-64 age group, the average 401k balance in 2017 was about $190,000.
Fidelity found that among participants for plans they administer, those with 15 years of participation in a 401k, the average balance reached about $380,000 in Q1 2018. They also noted the growing popularity of target date funds, with more than half of participants holding only a target date fund.
Jim and Karen decide to roll their respective 401(k) assets into their traditional IRAs, and consolidate their accounts into single target date fund.
Jim’s IRA value is $750,000. Karen’s IRA value is $250,000.
How to invest those funds is a key asset allocation decision. They both choose the Vanguard Target Retirement 2020 Fund (VTWNX). With a current asset allocation of about 54% stock, 41% bonds, and 5% TIPS, this fund provides a current yield of 2.14% (paid annually) and an average total return of 6.43% over the last 10 years. Similar funds are available from other major brokerages.
I’ve written previously about expected rates of return from pension funds and similar portfolios. With the increasing bond allocation in this fund going forward, Jim and Karen choose to assume a conservative 5.0% return during their retirement.
They are willing to make limited IRA withdrawals before Required Minimum Distributions (RMDs) kick in at 70, but would like to limit the withdrawals to the amount of dividends the IRAs generate, leaving any additional gains to maintain the value of the IRA against inflation. Using the current 2.14% yield, this means $16,050 annually from Jim’s IRA, and $5,350 from Karen’s.
I’ve written about IRA RMD withdrawals. Assuming $750,000 for Jim’s IRA at age 70, his initial RMD will be about $18,900; Karen’s IRA with $250,000 at age 70 will generate an RMD of about $6,300.
On the death of the first spouse, the surviving spouse will assume the deceased spouse’s IRA (i.e., merge it into theirs). Given their small age difference, distributions will continue at a similar level.
With the assumed 5% rate of return, the IRAs should provide 30+ years of ~ constant inflation adjusted cash flow.
Jim and Karen have $100,000 in checking, savings, money market, and CDs. This comprises their routine monthly cash flow buffer, an emergency fund, and one year cash reserve (expenses – pension). In aggregate, it yields 1%, or $1,000/yr.
Jim and Karen have $250,000 in income producing assets in taxable accounts. It includes a $50,000 capital reserve fund, earmarked for roof replacement and a new car, which they anticipate spending in about 5 years. They assume no yield from this reserve fund. The balance is a portfolio of large cap dividend stocks, yielding 3%, or $6,000/yr, and expected to grow at or above the rate of inflation.
The estimated value of their home is $350,000, based on local tax assessments and recent sales in their area (130% of the US median, but typical for their suburban area). They assume no recurring cash flow from this source, but note that it could provide funds to cover end-of-life assisted living or memory care expenses.
Other potential sources might include annuities, alimony, inheritance, part-time work, rents, or royalties. I’m going to say none of these apply to Jim and Karen, and exclude them from the example here, but it should be obvious how to include them if needed.
Putting it all together
Putting this all together, we get the following matrix (below). We have identified five periods, with each new period initiated by a key decision, age limit, or death. Each period has with different cash flow characteristics. For simplicity, all numbers are rounded to the nearest $1,000.
A comment on inflation: In this example, the pension and social security amounts will have an explicit COLA to offset inflation. The IRA RMD analysis referenced above suggests that for reasonable rates of return and inflation, the increasing RMD payout reasonably offsets inflation. Thus, we elect to assume constant dollars as a reasonable approximation.
Jim and Karen are now ready to make some decisions.
Conclusions and Investor Actions
It’s important to understand and quantify post retirement cash flow; it should be done early enough to support deliberate and timely decision making.
A reasonable estimate today is more useful than a precise result too late to influence decisions.
Identify key decisions and understand their impact – when to retire, pension payout options, Social Security start dates, asset draw down rates, asset allocation, and major spending decisions. Some of these decisions are irrevocable.
If you will retire with a defined benefit pension, carefully consider the joint-and-survivor benefit choices; higher income married spouses should particularly consider an option yielding a > 50% residual benefit to the surviving spouse.
In cases where the surviving spouse Social Security benefit would be materially higher than their own earned benefit, the higher earning spouse should consider delaying their benefit start to age 70, in order to maximize the benefit to the surviving spouse.
The surviving spouse in a couple will probably be the wife. She can typically expect to be a widow for 5 years on average, quite possibly 10 years.
Compared to the retired couple’s cash flow, a surviving spouse will usually have a reduced cash flow.
Remember these are before tax cash flows.
Consider using a more sophisticated model, particularly if your results from a basic projection like this are “on the bubble”.
Disclaimer: I’m not a lawyer or financial advisor, and this is not legal or financial advice. Pleases consult your own advisor before making any legal or financial decisions.
Disclosure: I am/we are long VTTHX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.