**Social Security and Medicare are Not Enough**

As we saw in Part 1 and Part 2 of this series, Social Security benefits and Medicare insurance will likely not cover all of your needs in retirement:

- Social Security provides roughly 46% of preretirement income for the average worker, and negligible amounts for higher wage workers.
- When you retire your benefits may be lower than expected due to funding problems.
- Your spending power may decrease over time due to inadequate cost of living adjustments.
- Medicare is not free. In addition to the money you paid while working, you are also responsible for paying premiums, deductibles, copays and other out of pocket expenses while retired.
- Fewer doctors are taking Medicare patients – you may pay more to see the doctor you want.

So this means that if you want to have a more comfortable retirement than what Social Security and Medicare provide you may need to take matters into your own hands. But how do you do that?

**The Basics of Retirement Savings**

Let’s begin by assuming that you will earn money over a period of time, you will have fixed expenses, and that there is a certain amount of money you save periodically. Let’s further assume for now that there is no inflation of expenses or salary, and that you do not have any investments – the savings you make earn no interest. We will also leave out any tax effects for the time being.

Let’s also assume that your only source of income is from your paycheck.

For example one let’s say you earn $50,000 per year after taxes and your expenses are $25,000 per year. You save the remainder for 10 years and then stop working. How many years will your money last after you stop receiving a paycheck?

$25,000 saved per year over 10 years is $250,000. If you then stop working at year 10 you now begin to pay your expenses from your savings. $250,000 with $25,000 expense payments per year will last you 10 years.

So there you have it. If you save half of your pay for 10 years you can live off of that savings for another 10 years after you stop working.

This is what it looks like on a graph:

The green line represents your after tax income. The red line your expenses. The purple bars represent the total cash you have accumulated. The x-axis represents time. As you can see, every year you are earning a paycheck you are adding to your savings in the amount left over after subtracting your expenses from your pay.

Let’s say instead of 50% you save 25% of your after-tax pay. Here’s what that looks like:

Some things are immediately obvious here. First of all, the total amount that you saved over 10 years is now lower. This is a result of the fact that the amount you are saving per year is less – You expenses as a percentage of income are higher. So instead of $250,000 you have $125,000 saved. As a result after you stop working you have a much smaller pile of cash to pay expenses.

In addition since your expenses are higher than in the first example, you will be burning through your cash at a faster rate, the end result being a much shorter retirement.

Please note that we are not implying that a person will, can, or should work for 10 years and retire. They are free to work more or less as they desire. We are simply using a 10 year time frame for ease of comparison.

There is a clear mathematical relationship between your cash saved, expenses, length of time saving cash, and time in retirement. It is this:

L.O.R. = L.O.S. x S/E, where:

- O.R. = Length Of Retirement
- O.S. = Length Of Savings
- S = Savings rate
- E = Expense rate

For example one: L.O.R. = 10yrs x 50%/50% = 10yrs.

Example two: L.O.R. = 10yrs x 25%/75% = 3.33yrs.

Note how the relationship holds over various time periods. A 50% savings rate saved over 10 years will buy you 10 years of retirement. A 50% savings rate over 1 year will buy you one year over retirement. Save 50% for one day? You guessed it – it buys you one day of retirement.

Note also the fact that even though you are saving half as much in example two vs example one, your LOR is actually reduced by 67%, not 50%. That is due to the fact that your expenses are higher during retirement in example 2 vs 1.

Let’s apply this to a few scenarios.

Saving 10% for 10 years:

L.O.R. = 10yrs x 10%/90% = 1.11yrs.

Saving 90% for 10 years:

L.O.R. = 10yrs x 90%/10% = 90yrs!

Let’s now consider how certain life events may affect your savings.

**Layoff**

In this example a person is earning $50,000 after tax and saving $25,000. In year five he becomes unemployed for two years, and then re-employed in year seven. In year 10 he retires. His length of retirement is six years, a reduction of four years had he been employed continuously.

In this scenario the retirement reduction is four years even though the layoff was two years. That is because not only were no contributions made to savings, it was actually reduced to pay expenses during that time.

**Multiple Wage Earners**

If instead of a single wage earner with an income of $50,000 there were two wage earners each earning $25,000, then a loss of one income would still allow the bills to be paid without depleting savings. As a result retirement would have decreased by two years instead of four as we can see in the graph below.

**Divorce**

In this example we see a family of husband and wife with two kids saving 50% with a single male earner. Beginning year 6 they divorce and the man is now paying child support. His expenses are now 90% of his pay.

You can see from the chart that the rate of savings accumulation has slowed compared to the first example and now instead of having $250,000 at the end of 10 years he now has $150,000 – a 40% loss.

The result of which is now 3 years 4 months of retirement instead of 10 years – a 67% reduction!

**College Expenses**

This example is the same as example one with the exception that in years 7 – 10 college expenses for a child eat up the remainder of the income ($25,000 per year). The net effect is a four year reduction in retirement time.

**Large Medical Expenses**

Note also that the example above on college expenses could also represent the effect of large medical bills associated with a major illness, assuming a high deductible insurance plan ($25k deductible, expenses for 4 years).

The effect of such an illness is significant and can dramatically reduce your retirement savings. Thus the importance of maintaining your health should not be overlooked!

**Kids Grow Up / Move Out, Mortgage Paid Off**

In the chart below we can see the effect of having a home mortgage paid off and the kids grown up and moving out of the home both in year 10 which cuts expenses by 50%. As you can see the fact that your expenses are now half of what they were previously results in a retirement twice as long.

Here’s what happens if the mortgage is paid off but the kids don’t move out and you are paying their food bill and utilities ($521/month):

This shaves off 6.5 years of retirement – from 20 years down to 13.5.

**Mortgage Paid Off, Kids Move Out, Sell Home, Move to Smaller Home**

In this example we see the effects of having paid off the mortgage and selling the home in year 10 after the kids are grown up and have moved out. You use the proceeds of the sale ($500,000) to buy a smaller home ($250,000) and add the $250,000 extra from the sale to your savings. Even though your yearly expenses have been reduced from $25,000 to $12,500, you use the extra $12,500 per year to travel the world (net effect is that your total expense amount stays the same).

In this scenario adding the extra cash to your savings provides for 20 years of retirement AND you have money to travel the world.

**Social Security Income**

Here’s an example where you receive $12,500/yr in Social Security benefits beginning in year 11:

The net effect is the same as adding $250,000 to your savings in one lump sum in year 10 (doubling your length of retirement). This shows that having some Social Security income can help extend your retirement significantly.

**Inflation**

Let’s now take into account the effect of inflation. Let’s assume that you are accumulating savings with a 50% savings rate and that your wages and your expenses both increase at a rate of 3%/year, but that the money you are saving goes into a 0% yielding bank account:

Even though you have saved more than in prior examples ($280,000 vs $250,000), your retirement is reduced by just over two years (a 20% reduction!!!) because your expenses are growing at the rate of inflation but your savings account is earning 0%.

Here’s the same example with your savings account earning 3%:

As expected with the savings account yielding 3%, the same as the inflation rate on expenses and wages, the effects cancel each other out and we end up back with 10 years of time in retirement. This is why it is so important to have your savings, investments, and assets keeping up with or exceeding the rate of cost inflation.

And what if you could exceed the inflation rate on your savings? Here’s an example at 6%:

As we can see you have increased your retirement time by 4 years.

**The Effect of Fixed Expenses in an Inflationary Environment**

We now begin looking at more typical examples assuming someone works for approximately 40 years.

Let’s assume that a person begins working at age 25, they retire at age 65, they save 6% of their income per year, they have a home mortgage with fixed payments for 30 years, the inflation rate is 3% on their earnings and expenses, and their savings earns 3%. Here’s the result – 13 years of retirement:

You can see the effect of paying off the mortgage in year 30 – the expense line drops, which results in extra money added to the accumulated savings which then grow even faster, but take a closer look at the beginning years on the graph:

And let’s compare this to the situation where ALL expenses rise at 3% inflation, including housing (i.e. no fixed cost mortgage):

This is a HUGE difference! We are looking at more than twice the amount of savings accumulation due to the fixed cost nature of a mortgage (for a fixed rate mortgage the payments stay the same throughout time, they do not rise with inflation as do other costs).

And by the way, if you did NOT have a fixed cost expense like a mortgage and instead your expenses rose at the same rate of inflation you would only enjoy 2.5 years of retirement vs 13 after working for 40 years in this example!

**Prepaying Expenses – Does it Make Sense?**

Let’s say you have an expense that you know will increase in the future. Is it more advantageous financially to prepay that expense?

Let’s assume you have $10,000 invested with an after-tax return of 8%. And let’s say your rent which is currently $1000 per month will increase 25% beginning next month (new rent will be $1250 per month). Let’s compare leaving the $10k invested vs using it to prepay rent at today’s rate.

__Keep the Money Invested__:

$10k invested for one year at 8% = $10,800. $50k yearly after-tax income – $15k rent ($1250/mo x 12) – $33k other expenses = $2000 saved. __Total at end of year 1 = $12,800__ which is then invested at 8% beginning year 2.

__Prepay Rent at Lower Rate__:

$10k used to prepay for 10 months of rent at current rate of $1000/month. $50k yearly after-tax income – $2,500 rent ($1250/mo x 2) – $33k other expenses = $14,500 saved. __Total at end of year 1 = $14,500__ which is then invested at 8% beginning year 2.

In this example we can see that it is more beneficial from a net worth standpoint to prepay expenses as they are rising faster than the rate of return on investments.

**Effect of Tax Deferral**

Let’s take the Fixed Expenses example and assume that the savings receive the same rate of return but are now invested through a tax deferred plan. We will assume that the wages in the previous example were taxed at an effective rate of 25% and the investments at 15% (passive).

The prior examples all assume that income from all sources is after-tax therefore using the same examples with a tax-deferred plan results in more income (expenses are the same but taxes are less therefore there is more money left over). This extra income is added to the investments.

After-tax income on amount saved = 0.75 x gross income saved = $3k (6% of $50k total net income). Therefore, gross income saved = $3k/0.75 = $4k.

After-tax investment return = 0.85 x gross investment return = 3%. Therefore, gross investment return = 3%/0.85 = 3.53%.

Here’s the effect of deferred taxes on the investment savings and yield. In retirement the investment income is again taxed at the regular effective rate of 25%:

The effect of using a tax-deferred investment vehicle in this example results in approximately $240k more saved (an 18% increase), and 3 years and 3 months more of additional retirement (a 25% increase).

**Combining the Examples**

Here’s an example that includes the following conditions:

- 2 wage earners working for 40 years then retire
- Combined after-tax income is $50,000 in year 0.
- Each is laid off 3 times in their careers (staggered yr 15,20,24,25,30,35)
- The wife takes off 6 months each while their 2 kids are born 2 years apart begin yr 10
- Wage and expense inflation is 3%
- Investments are earning 6%
- College expense for kids of $25k each starting year 28, ending year 33
- Expenses are 94% of net income year 0 (they save 6% of their income)
- They secure a no money down loan at 3% over 30 years to purchase a home for $294,000 year 0
- Home rises in value 3% per year
- They pay off the home in year 30, no more mortgage payments
- Year 34 kids move out (drops expenses), house sold, proceeds used to buy smaller home for cash
- They put the extra cash from the sale of the home into their investments
- They get hit with large medical expenses over 4 years when in retirement (wife suffers a stroke age 75, goes to nursing home to recover)

What does their retirement look like financially?

You can see in the graph how significant the effect is of large medical expenses are in years 50 – 53. Even with those however they still have 20 years of comfortable retirement and they still own a small home. And that is without considering Social Security income.

This example shows how powerful the cumulative effects are of saving over a long time frame exceeding the inflation rate, coupled with the rise in home value while paying for that home in non-inflationary payments (a mortgage). The large rise in investments in year 34 is the result of investing the net proceeds from the sale of the home (which is now larger than necessary as the kids are self-supporting adults and have moved out), account for the fact that some of the money was used to pay for a smaller home.

**Mini Retirements**

But what if you don’t want to wait until you are “old” to retire? How about mini retirements along the way? Instead of a big block of work followed by a big block of retirement, you break it up – work and save for 9 months then take 3 months off every year. Doing it this way means you enjoy the ride while young and healthy. After all, who knows when your time is up?

Here we show an example of working for 3 years and then taking a year off and repeating that pattern. This is for a single earner making $50k/year after taxes with 3% cost and wage inflation and a 5% return on investments. This person saves and invests 23% of his take home pay. This person also has a fixed cost mortgage of $15,000/year for 30 years. After year 30 the home is paid off:

The scenario above results in the person having 9 mini-retirements throughout their working life, in addition to a fully funded retirement, and owning their home.

**Using What We Have Learned to Our Advantage**

Throughout this article we have seen the effects of multiple scenarios on a person’s retirement plans. We have learned the following:

- Social Security retirement benefits will likely not provide enough income to maintain a comfortable retirement lifestyle.
- Social Security benefits may be reduced in the future due to funding challenges.
- Medicare health insurance is not free. If you utilize health care services when you are retired it is likely that you will pay premiums, copays, and other out of pocket expenses which could be significant.
- Save and invest. The more you save as a % of income the quicker you can retire.
- Having two earners protects against savings erosion in the event of a layoff.
- Have your income from wages rise equal to or ahead of inflation. That way your purchasing power is protected.
- The return on your savings and investments should exceed the rate of inflation otherwise you are losing purchasing power and your wealth will be worth less tomorrow than it is today.
- Utilizing fixed expenses (such as a mortgage) in an inflationary environment helps you save for retirement faster.
- Prepaying expenses (or paying off high interest debt such as a credit card) that are rising faster than your rate of return on your investments will help you grow your retirement funds.
- Saving and investing through a tax-deferred vehicle can help you reach retirement faster.
- A divorce can significantly deplete your retirement savings due to splitting the assets and any child and spousal support you may pay. Aim for income parity (at least) to reduce the negative effects (i.e. in California if you have 50/50 time share of the children and you and your ex-spouse earn the same amount of income then you will likely pay no child or spousal support.)
- College expenses for children can consume a large portion of your retirement funds. Scholarships can reduce the negative effect.
- Having adult children be independent as soon as possible (moving out or paying you for rent, utilities, food, and anything else you are providing for them while they live with you) helps protect your retirement funds.
- Stay healthy to avoid loss of income and depletion of savings due to medical expenses.

We wish you the best as you plan for retirement. We hope you have found these articles helpful and invite you to explore our other articles on personal finance and investing.

**Sources:**

Life expectancy: https://agingstats.gov/docs/LatestReport/Excel/healthstatus.xlsx Table 15a. Life expectancy at ages 65 and 85.