Financial Abundance

Thanksgiving is a day of gratitude for our many blessings and a time to appreciate our abundance.   Do you live from a sense of financial abundance during the other 364 days of the year or do you often live in fear, from a belief in scarcity?

Our wealth far exceeds the basic human requirements of food, shelter and clothing.  In spite of this, I meet many people who do not feel that they live in financial abundance.  Why do some people live from a sense of financial abundance while others, often with more financial resources, live in fear of financial scarcity?

As a Certified Financial Planner (CFP^®), I strive to help my clients move from a fear of financial scarcity to a sense of financial abundance.  This transformation requires a commitment to actively manage, protect and control one’s financial activities.   Let’s review the “Seven Steps to Financial Abundance.”  While following these steps will not guarantee financial abundance, as a minimum, they should help reduce fear of financial scarcity.

1. Spend Less Than You Earn

The first step on the path to financial abundance is to create excess earnings.  If you contribute to a retirement plan, your contributions are included in excess earnings.

A reasonable goal is excess earnings of at least 15% of after tax income.  To meet this goal, consider the “pay-yourself-first” approach.  On payday, make the first payment to your excess earnings fund.  This fund can be used to buy your first house, pay for your children’s education or your help fund retirement.

If you have not already done so, use excess earnings to build an emergency fund. With an emergency fund, you will be able to survive a job layoff or short term disability, without prematurely using funds from you retirement account.

2. Maximize Your Financial Resources

The next step toward financial abundance is to maximize your savings income.  If you have a company sponsored retirement plan, as a minimum, contribute the maximum amount that your company will “match.”  When your company matches 50% of your contribution, the company’s contribution is “free money,” guaranteeing an immediate 50% investment return on your retirement savings.

If you are saving for your children’s education, Coverdell Education Savings Account and/or Section 529 College Savings Plans can help.   Your educational savings will grow and no taxes will be paid on the growth and income from these plans.

If you are responsible for your health insurance, a high deductible health insurance plan (HDHP) plus funding your Health Savings Account (HSA), to the maximum amount allowed, will virtually guarantee a lower (after tax) cost for your health care.

3.  Minimize Your Taxes

Using every legal method for reducing taxes is the next step toward financial abundance.  If you are married and your spouse has no earned income, you may be able to fund a “spousal IRA.”  With a spousal IRA, you may deduct an additional $5,000 ($6,000 if your spouse is over age 50) from your income taxes.

If you have children in college, be sure to claim the American Opportunity credit or Lifetime Learning Credits.  These tax credits can reduce your taxes by up to $2,500 annually to offset high educational costs.

Use appreciated long term stock for your charitable giving.  You pay no taxes on the stock’s appreciation and receive a charitable deduction of the stock’s full value. Establishing a Donor Advised Charitable Giving Fund makes this easy to do.

4. Manage Your Investments

Properly managing investments is a critical step toward financial abundance.  If you manage your own investments, implement an asset allocation that allows you to sleep well at night.  Low cost, indexed mutual funds or Exchange Trades Funds will provide superior long term results for most investors.

If you use an investment advisor, investigate potential conflicts between how the advisor is compensated and your best interests.  The advisor should always be a fiduciary, guaranteeing that they will put your interests ahead of their compensation.

5. Protect Your Financial Resources

Fear of the unknown can produce a sense of scarcity.  Proper insurance to protect your financial resources is important in keeping this fear at bay.  The requirement for health, life and property insurance is often well understood.

Disability insurance is sometimes overlooked.  Peter Ubel, professor of psychology states, “If people are smart, they will invest wisely in [disability] insurance.”   A serious, long-term disability can destroy even the best financial plan.

Protecting yourself from catastrophic financial risks is a necessary step in obtaining financial abundance.

6. Control Your Personal Finances

The stock market, tax codes, the economy or negative world events are outside of our control.  Things we cannot control increase the fear of scarcity.  We can control our spending habits, our prioritization of saving for our family’s future and our decision to plan for our financial well-being.

With this control, we have significant power over personal finances.  Once this power is recognized, fear of scarcity is diminished and a feeling of financial security begins to permeate our lives, leading us toward financial abundance.

7. Have Faith in Continued Abundance

Overcoming the fear of scarcity requires faith in continued abundance.

By implementing the first six steps, you have done everything in your power to control your financial abundance.   However, without faith that your abundance will continue, doubts and fears of the unknown and uncontrollable future can become overwhelming.

Living in financial abundance requires controlling consumer-driven consumption, maximizing and protecting financial resources and faith that abundance will continue.  If you do not feel that you can take these steps alone, find a knowledgeable and trustworthy financial guide to help you with this journey.

Once you escape the fear of scarcity, you may find true serenity.  When living in financial abundance, you may even decide to share more of your abundance with your favorite charitable organizations, spreading the gift of Thanksgiving.

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There has been a lot of recent press and political punditry about Bank of America charging $5/ month for the “privilege” of using their debit cards.  Arguments can be made over whether this fee is justified, after the Dodd-Frank bill lowered the allowed maximum debit card transactions fees, or whether Bank of America customers should find a new bank.  However, assuming that one is able to get a credit card, the correct question should be:  “Why would you ever want a debit card?”

Let’s explore some of the reasons for which debit cards are used and see if any of these are required.

1) Debit cards are a replacement for writing checks.  While debit cards were initially designed as a replacement for checks, modern technology has made checks almost obsolete.   Monthly bills can be paid by credit card or by direct payments from a bank account. No physical checks are required.  Any product that can be purchase with a debit card can also be purchased with a credit card.  If checks are required, the vendor requiring a check will typically accept neither debit or credit cards.  Thus, debit cards no longer serve exclusively as a replacement for checks.

2) Debit cards prohibit their users from spending more cash than they have. Debit cards (theoretically) do not allow for spending more than is in a bank account.  While debit cards usually limit spending to a bank account’s cash balance, there are other methods of achieving this same goal.  With a laptop or smart phone, bank balances can be accessed 24 hours a day.

If it is critical to your budgeting process that expenditures never exceed the cash on hand, consider the following approach.   Always have a small amount of cash for incidental purchases.  For all other purchases, keep track of credit card purchases so that you know to stop using the credit card when bank account limits are reached.  When the next pay check arrives, pay off the credit card balance and repeat this process.  This approach provides the same cash management function as a debit card, while eliminating any possibility of debit card overdraft fees.

3) Debit cards are a budgeting tool, helping assure that one does not spend more than they earn.  With the proliferation of free, online budgeting tools, such as mint.com, debit cards are one of the least effective budgeting tools available.  As with 2) above, using cash for small purchases and keeping track of the larger purchases that are made with a credit card provides considerably more budgetary control than a debit card.  The only “downside” of this approach is that it requires discipline to keep track of purchases and to stop spending when you cash is depleted.

To successfully eliminate debit cards and their associated fees, it is important that the credit card balance be paid in full every month.  Without discipline, credit cards can easily become an easy method of “budget busting.”   While quick and easy to use technology makes it possible to keep track of all credit card purchases as well as the remaining cash available in a bank account, implementing this technique requires both desire and determination for it to succeed.

The small amount of work required to enter each credit card purchase as it is made, coupled with the determination and desire to maintain a budget can break the debit card habit forever.

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One of the greatest blessings of my life was to be the father of two children.  When we become parents, it is understood that we are taking on a large, new financial responsibility.  Most young parents believe that their financial responsibility will end when their children graduate from college.  Many parents of grown children have found that these expenses can continue well past college graduation.

Many people who are approaching retirement, provide financial support for their grown children, even when doing so places their retirement at risk.  Regardless of your child’s age, you can decrease and eventually break your children’s financial co-dependence.  Here are a few approaches to consider:

1. Agree that you will only pay for in state college tuition.  When our children were young, my wife and I determined that Colorado had excellent state colleges.  When our children began to consider their college options, they were allowed to consider all colleges.  Our children knew that we would pay for any state supported college in Colorado. If they wanted to attend a more expensive school, they would be responsible for the increased costs.  This approach allowed our children to share the financial responsibility for their college choice.
2. While our children both chose state supported colleges, had they chosen more costly schools, they would likely have required student loans.  If your child requires a student loan, keep the loan only in the student’s name.  Even if you choose to help your child pay this loan after college, by keeping the loan in your child’s name, you avoid personal responsibility for a loan that would always be with you, even if you or your child declared bankruptcy.
3. Never co-sign any financial obligation with your child.  If you agree to co-sign a lease, a car loan, a mortgage or any other financial instrument, you are effectively taking 100% ownership of the obligation.  If the financial obligation is something that you wish to support, such as a mortgage, take the mortgage out in your own name and have a separate agreement with your child.  This gives you complete control over the property should things not work out as planned.
4. If your child requires on-going financial support that you are willing to provide, pay their bills directly to the party to which they are owed.  This will assure that your financial support is going to where it is intended.
5. Be sure that your grown child has medical insurance.  Many young people do not see the need for medical insurance.  If your grown child can no longer be on your medical insurance policy and you are financially able to help them, use the first dollars of your support to assure that they have adequate medical insurance.
6. If you are supporting your grown child, develop a mutually agreed upon plan to terminate this support.  While the plan may require months to complete, you are demonstrating to your child your faith in their ability to succeed financially.  Your faith in your child’s ability to succeed financially will be one of the best gifts that you can ever give.
7. If required, allow your grown child to fail financially.  It is human nature to learn more from failure than success.  While it is extremely difficult to see grown children struggle, by letting go and allowing them to determine how to get out of a financial jam, we allow them to grow as adults and we show our faith in their ability to solve their financial dilemma.

Parents wish for their children to be financially secure.  As counterintuitive as it may seem, one of the best ways to assure this is to let our grown children have the responsibility of taking care of their own financial well being.  While some critical financial support is often required, showing our faith in our children’s ability to be responsible for their own financial health is a gift to both your children and your retirement.

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The economy, government spending and debt, unemployment, housing foreclosures and our banking system all contribute to a fear of the financial future.  These fears are all outside of our control.  However, we can control many decisions related to our own financial future.

Financial Abundance Guide (available free at www.finabguide.com) identifies many areas of personal finance that can be controlled.  I also developed the Seven Steps to Financial Abundance to help people reach their financial goals.  With so much fear of the financial future, following the seven steps can help increase our power to control our financial future.

“Spend less than you earn,” is the required first step.  Over a 40 year career (age 25 to age 65), assume that your average income is $80,000 (in 2011 dollars) and the annualized investment real rate of return is 5%.  Saving 10% of income ($8K) each year will produce savings of over $1 million (in 2011) dollars at age 65.

By “maximizing your financial resources” (step 2) , savings can be increased with no negative impact on spending.  If a company offers a 4% of salary match with their 401(k) plan, by contributing at least 4% of salary, this amount is matched by the company. Using the previous example, annual savings are increased from $8,000 to $11,200, increasing the savings available at age 65 to almost $1.5 million.

“Minimizing your taxes” (step 3), also provides additional savings with no impact on spending.   Financial Abundance Guide provides many tax savings techniques available to people of all income levels.  One example is a spousal IRA, allowing a non working spouse to contribute $5,000 per year to an IRA.  For a couple paying 25% in federal taxes and a 5% state income tax, a $5,000 IRA contribution would yield $1,500 in annual tax savings.  Continuing with our example, the additional $1,500 in annual tax savings would  provide almost $1.7 million in 2001 dollars by age 65.

“Managing your investments” (step 4), can significantly increase investment returns.  This may require the help of an investment professional.  If so, carefully choose an investment advisor and be wary of anyone providing “free” advice.  A “free” advisor must be compensated through commissions on the investment products they sell.  Fee only advisors are compensated by the fees they charge to manage investments.  Continuing the above example, if the real rate of investment return is increase by only 0.5%, the couple would have almost $1.9 million at age 65.

Using the simplistic assumption that a couple, at age 65, can withdraw at least 4% of their investments each year and never run out of money, $76K (in 2011 dollars) can be withdrawn each year throughout retirement.  Since their previous annual expenses were $72K, with $8K per year in savings, even with no Social Security or other retirement benefits, our couple can more than maintain their lifestyle throughout retirement.

Fear of the unknown often produces a sense of financial scarcity.  “Protecting your financial resources” (step 5), through appropriate, lower cost insurance products can help keep this fear at bay.   An insurance product that is often overlooked is a $1 – $2 million umbrella liability policy.   In our litigious society, one may be sued because someone was hurt on their property or by a car driven by a family member.  For very little money, peace of mind can be secured by adding an umbrella liability policy to your auto or home insurance policy.

Financial planning helps “control your personal finances” (step 6). There are many available resources to help you produce you own financial plan.  If you have neither the time nor interest in financial planning, engage a fee only Certified Financial Planner (CFP^®)  who will listen to your concerns and provide a comprehensive plan that enumerates the options available to meet your financial goals.  A financial plan helps increase control over personal finances.  Planning will reduce the fear of scarcity, providing more financial security on the path toward financial abundance.

“Have faith in continued abundance” is the seventh step. Implementing the first six steps addresses what you can control in your personal finances.   Faith that financial abundance will continue helps eliminate the doubts and fears of the unknown often caused by events over which you have no control.

Financial abundance is a lifetime pursuit.  There will always be ups and downs in the economy and markets.  By applying the seven steps and seeking appropriate outside support as required, you will be on the pathway toward financial abundance.

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On July 4 1776, our forefathers declared that we should be an Independent Nation.  Today, many of us would like to declare our financial independence.  As financial conditions continue to change throughout the world, it has become more challenging to attain this goal.  While there are no guaranteed methods to become financially independent, here are seven steps to help increase the probability of reaching this goal.

1) During prime earning years, the single most important step that can be taken toward future financial independence is to save at least 10% of after tax earnings.  If your company 401(k) plan matches your contributions, put at least the amount that is matched into your 401(k) plan each year.  This assures an immediate doubling of the amount saved.  Any additional available savings should be put into an “emergency fund.”   An emergency fund is an account that can cover at least six months of current expenses.  This fund is only to be used for true emergencies such a job loss or a short term disability.  Emergency fund investments should be stable in value and highly liquid.

2) When the emergency fund is in place, additional savings, up to the maximum amounts allowed by law, should be put into a tax deferred account such as a 401(k), 403(b), SEP IRA, etc..  This approach provides for a reduction in current taxes and allows the investments in these accounts to grow tax free until they are withdrawn.

3) When buying a house, use the shortest mortgage payoff period that your cash flow will allow.  A 15 year mortgage saves thousands of dollars in interest and provides for a much faster pay-down of your principal.  If you move or decide to upgrade your home, reinvest ALL of the equity that you receive from selling your previous house into the new house.  With this approach, your house will likely be mortgage free by retirement.   Remember, a house is NOT a piggy bank (at least at this point).

4) In determining when to retire, financial independence requires that income be maintained for as long as possible.  If your work is enjoyable, keep doing it past normal retirement age, while taking more vacations and working less hours.  If you dislike your work, explore options for creating a “retirement career.”  If you enjoy making furniture, make high quality furniture and sell it on ebay.  You will be doing what you love, receiving income and working as much (or as little) as you wish.

5) Upon reaching the age to begin receiving Social Security, carefully examine when you should start receiving these benefits.  Just because benefits are available does not mean that they should be taken.   A financial advisor who understands the vagaries of Social Security can help analyze your situation to decide the best time to begin taking Social Security benefits.

6) If the previous steps are followed, there should be no home mortgage remaining at retirement age.  At this point in life, many people find that they prefer to live in a smaller house.  Buying a less expensive house, frees up funds that can help insure financial independence throughout your retirement years.

7) In later life, if funds from savings, retirement accounts and Social Security are not providing adequate income for financial independence, it is time for the house to become a “piggy bank.” Your house can be sold and the funds received can be used for a retirement home or for nursing home care.  If you wish to remain in your house, a reverse mortgage will provide funds, based on the value of your home.  Reverse mortgages can be obtained through a commercial lender or even through your children.  By either selling the house or using a reverse mortgage, the home’s value can often replace the need for long term care insurance, saving thousands of dollars of annual premiums.

While there are many other methods to help insure financial independence, following these straightforward steps throughout your lifetime will dramatically increase the odds of living a lifetime of financial independence.  On July 4th, let’s celebrate both our nation’s independence and our journey toward financial independence.

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Those of us, who were adults in the 1970s, remember a concept called the misery index.  The misery index was easy to compute, being merely the sum of the unemployment rate and the CPI.  This index was so named because it was believed that this combination of government statistics was a good indicator of the US economic health and an especially good indicator of the “misery” that our citizens were experiencing.

The misery index hit an all time high in June of 1980 at 21.98, during the final year of the Carter administration.  After 1980, this index declined until December 1986, when it hit its modern day low of 7.7.  In April 2011, the misery index was 12.16, 4.46 points above its 1986 low, but 9.28 points below the all time high.  The current index is most similar to the index value in 1990 – 1991.

These comparisons beg the question: “If the misery index is relatively low, why does our current economic malaise feel more like the late 1970s than the early 1990s?”

One answer may be that high unemployment produces more “misery” than high inflation.  In the March 2001 American Economic Review, a research report presented data, compiled through interviews of both Americans and Europeans, concluding that:  “people would trade off a 1-percentage-point increase in the unemployment rate for a 1.7-percentage-point increase in the inflation rate.”

Another explanation can be found in the manner that the government has changed its measurement of CPI since the early 1980s.  Let’s look at these changes, and how they have modified the measurement of CPI over the past 30 years.

In 1983, CPI was changed to use homeowner’s equivalent rent instead of housing prices.  This change was made because it was felt that home prices combined both the “consumption” of a place to live with an investment component, whereas the rental equivalent ignored the investment component.

In 1998, the CPI was adjusted to allow for the lowering of prices due to product quality enhancements.  Thus, when a bigger TV came to market, its price was adjusted, using an estimate of what an older TV would have cost if it were that size. Approximately 1/3 of the CPIs basket of goods was affected by this change.

In 1999, the CPI was again adjusted to allow for product substitution.  This adjustment assumed that if the price of sirloin steak increased, the consumer would buy flank steak instead.

All three of these changes served to lower the amount shown as the annual CPI increase.   The changes also helped lower annual adjustments to the government sponsored entitlement payments whose increases were linked to the CPI.  In June, 2010, the Deutsche Bank Group published a paper that estimated that the changes to the CPI made after 1990 had effectively lowered the CPI by 3.25%.  The combined changes, made since 1980, were estimated to have lowered the CPI by an astounding 7.35%.

If the Deutsche Bank estimates are accurate, current CPI (as measured before 1983) is actually 10.51%.  Adding this to our current unemployment rate of 9.0%, one could make the argument that our “true” misery index, in comparison to the June 1980 high, is actually 19.51%, the highest it has been since December 1980.

Whether the “misery index” truly measures how well (or poorly) our economy is performing is a question I will leave for economists and politicians.  From my perspective, the current economic malaise feels more like the late 1970s than the early 1990s.  Perhaps the changes in the manner in which we measure the CPI component of this index may help explain this apparent disconnect.

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Memorial Day is a time when we thank those members of our armed services, both present and past, for their service to our country and remember those who gave the ultimate gifts of their own lives in our country’s service.  As I picked up my paper this morning, I could not help but feel blessed with the abundance that we share as Americans.

When I founded Financial Abundance, LLC,  I wanted to help my clients learn to approach their financial lives from a sense of abundance instead of from a fear of scarcity.  In spite of all of the financial turmoil and the current atmosphere of destructive political dialogue, on this Memorial Day weekend, it is important to remember how truly blessed we are.

To maintain our sense of abundance, let’s look at some ways that we can help maintain and increase our financial abundance:

1) Pay yourself first.  The first of my seven steps toward financial abundance is to spend less than you earn.  The easiest way to accomplish this is to “pay yourself first.” Before spending your earnings on anything else, you should “pay” a portion of your income into a retirement or savings account.  This savings provides a cushion to protect you in case of a financial emergency and will ultimately help provide for a more financially abundant retirement.

2) Buy what you need and delay what you want. It is often very hard to differentiate our needs from our desires. If you are considering purchasing something that you want but don’t necessarily need, delay the purchase for a week and see if the urge to have it passes.  I have found that many things that I thought that I required, often become unimportant soon thereafter.

3) Invest for after tax returns. Often, investments that appear to have excellent returns, will leave you with a very high tax bill and a lower than anticipated after tax return.  If you are considering an investment using taxable funds (as opposed to tax deferred funds), determine the after tax return of each investment.  To provide a comparable after tax return, investments providing ordinary income will often need to have over twice the returns of investments taxed at long term capital gains rates.

4) Keep a well diversified investment portfolio. Many investors believe that if they have 20 different mutual funds, they are well diversified.  In most cases, the investor would have better returns and be just as diversified with the Russell 3000 stock index ETF.   Whether you manage your own portfolio or have an investment advisor, remember that diversification comes not from the number of funds that you own but from the diversity of investments that the funds represent.

5) Begin Social Security Payments when they will provide the most benefit. As baby boomers reach age 62, many retired boomers believe that they should begin taking Social Security payments.  Most people in good health will receive more in lifetime Social Security benefits if they wait until at least their full retirement age (FRA) to begin their benefits.  If you are not sure when to begin your benefits, consult a knowledgeable financial advisor to help you make this important decision.

6) Have at least $1 Million in “Umbrella” liability insurance. Most homeowner’s and auto liability insurance policies may not fully protect you if you are responsible for a serious accident or injury.  For approximately $200 per year, you can add $1Million in umbrella liability coverage to these policies.  While you will likely never need this insurance, if you do, it will be the best $200 you have ever spent.

The only guarantee that we have in life is that it will someday end.  Between now and then, we can choose whether to live in a constant fear of financial scarcity or from a sense of financial abundance.  I urge you to use whatever ideas will be helpful in finding your path to a more prosperous financial future.

Happy Memorial Day!

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The April issue of Money magazine included an article addressing when it is appropriate to DIY (do it yourself) certain financial tasks.  Two of the tasks included were “Managing a Portfolio” and “Creating a Retirement Income Plan.”  Money did not distinguish between the types of personal financial support available, implying that two different professionals may be required to perform these two services.

If you are interested in personal finances and are willing to invest the time required in learning how to manage personal finances, DIY may be appropriate.   Financial Abundance Guide was written as an aid for these individuals, helping them identify strategies to effectively manage their financial resources.  Unfortunately, I have found that most people have the same amount of interest in learning how to manage their finances as I have in learning how to re-tile my roof.  None!

If you are not interested in learning to DIY personal finances, here are some ways to identify the financial advisors that can meet your requirements.

The first area to consider is the type of advisor who fits your needs. There are basically three types of financial advisors:

1.    Commissioned based financial advisers typically present their services as “free.”  These advisors sell commissioned financial products such as mutual funds and deferred annuities. Sometimes, it is difficult to identify the commissions being paid to the advisor, such as mutual funds with12b-1 fees or products which must be held for several years to avoid a reduction in payout.

2.    Fee based advisors usually work for a broker/dealer.  These advisors charge a fee that is often based on a percentage of the assets in your brokerage account(s).  When an advisor is “fee based,” part of their compensation also comes from commissions for selling mutual funds and proprietary products.

3.    Fee only advisors receive compensation either on an hourly basis or based on a percentage of the assets they are managing.  These advisors receive no commissions.  They are only compensated by fees paid by their clients.

The second area to consider when choosing a financial advisor is the scope of personal financial services they offer.  These services also fall into three categories:

1.    Investment management firms provide services related to managing your investments.  While they may be compensated in any of the three methods described above, their financial services are often limited to helping clients manage their assets.

2.    Wealth management firms primarily focus on helping their clients effectively manage their assets.  However, a wealth management company typically provides other personal financial services such as creating retirement income plans, retirement planning and risk management (insurance) assessments.

3.    Financial Planning firms provide asset management services as a component of a comprehensive financial planning process.  While most financial planning firms provide an a la carte selection of services, they will have at least one CFP^® who is capable of providing comprehensive financial planning for their clients.

If the only financial support you require is investment management, virtually all financial advisory firms can provide these services.  If investment management is your only financial concern, you need only to decide whether you wish to pay for this service through commissions, fees or a combination of the two.

If more than investment management support is required, you must determine if the advisory firm is capable of providing the required services.  A Certified Financial Planner (CFP^®), offering comprehensive financial planning services, will typically be capable of supporting your planning requirements.  A CFP^® will also have completed extensive financial planning educational training and will have met both the experience and ethics requirements of the CFP^® Board of Standards.

Whether you need only investment advice or require a complete financial analysis and plan, be certain that your adviser listens to and understands your tolerance for risk.  If you find an investment adviser or financial planner who treats your financial future as well as they treat their own, you should be well on your way to a prosperous financial future.

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A common question of the baby boomer generation is “when I can retire?”  At Financial Abundance, LLC, we have a detailed, proprietary approach to help our client’s answer this question.  However, there is an easy to perform, 9 Step calculation that may help you answer this question.  Here is how it works.

Step 1: Separate expenses into either essential or discretionary expenses.  Essential expenses include food, clothing, housing, property and casualty insurance, taxes and medical expenses.  Essential expenses should also include all “required” expenses, including telephones, cable, internet, pet care, hair care, etc.  All other expenses, including expenses (such as travel) that you would like to increase in retirement, are classified as discretionary expenses.

Step 2: Identify available lifetime income streams.  This annual income will include pensions and Social Security (starting as early as age 62) as well as any lifetime annuity or trust income.  If these income streams are not inflation adjusted (as is Social Security), use only 2/3 of the annual amount to adjustment for future inflation.

Step 3: Subtract the amount in Step 2 from annual essential expenses.  This provides the essential income gap.

Step 4: Identify annual income expected from sources other than the lifetime income streams.  This would include income expected from taxable and tax deferred investment accounts, income from rental properties, post retirement employment income and all other income sources available during retirement.

Step 5: Subtract the amount in Step 4 from annual discretionary expenses.  This provides the discretionary income gap.

Step 6: Add the values found in Step 3 and Step 5 to determine your Total Income Gap.  If the sum is negative, you should have more than adequate resources to retire and meet your income requirements.  Most people will find that this number is positive.

Step 7: Sum all of your investible retirement assets including taxable accounts, tax deferred accounts, Roth accounts and the net sales value of any properties or other assets that might be sold in retirement.  If you included income from rental properties in Step 4, do not include those properties in Step 7.

Step 8: Divide the amount calculated in Step 7 by the Total Income Gap (Step 6) to determine the number of years that investment resources will last after retirement.

Step 9: Add your planned retirement age to the number found in Step 8.  If this sum is over 90, retirement in the planned year may be possible

Let’s look at an example of how this would work:

The Smith’s are both age 60 and plan on retiring at their full Social Security retirement age of 66. After examining their current expenses, the Smith’s have determined that their “essential” expenses are $50,000 per year and their “discretionary” expenses are $30,000 per year.  This figure includes an additional $10K per year that they will spend on travel after they retire. Total retirement expenses are $80,000 per year.

Based on current Social Security statements, their combined monthly Social Security income at age 66 will be $3,225 or $38,700 annually.  Mr. Smith will receive a non inflation adjusted $500/mo pension from a previous employer.  The annual inflation adjusted pension amount is  12*$500*2/3 = $4,000, for a total lifetime income of $42,700.  Subtracting this amount from the essential expenses of $50,000 leaves a $7,300 essential income gap.

The Smiths have approximately $600,000 in taxable and tax deferred retirement accounts, yielding 2.5%% annually.  These investments provide an annual income of $15,000.  Since their discretionary expenses are $30,000, their discretionary income gap is $15,000.  The Total Income Gap is $22,300.

By dividing $600,000 by $22,300, the Smiths find that their savings should last 26.9 years after they retire at age 66.  Since they will be 93 at that time, their current savings will likely be sufficient.

While this is a rudimentary approach to determining retirement preparedness, it is an easy method of estimating one’s ability to retire at a given age.  Next month, we will consider some approaches to help close the income gaps and reduce the age at which you can retire.

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