Meet the Halls

Meet the Hall family – Steve is 33 and Carol is 28. The Halls have no “real” financial plan in place. They have come to Sensible Financial™ for assistance in building a plan to help them reach their financial goals. In practice, we could develop a plan for them in a few of weeks of elapsed time. For this newsletter, we’re going to do a little bit every few months, and we won’t try to forecast how long it will take. We start with a look at retirement savings.

Sensible Financial develops strategic financial plans focused on a few major decisions:

• How much to save, this year and in future years;
• How to invest the savings (existing and this year’s additions):
  • Which accounts to use (e.g., 401(k), Roth IRA, deductible IRA, 529 College Savings Plan, etc.;
  • Which investment securities to purchase;
• How much life (and disability) insurance to buy.

To focus on a key idea, we’re going to simplify the Halls’ situation as we start. We’ll reintroduce the complications next month. For now, we’ll pretend that:

• The Halls both work at jobs that make them ineligible for Social Security benefits (so Social Security taxes and benefits are both zero)
• The Halls cannot earn any interest on their savings (interest rates are zero)

We start with their financial resources. After a stint as a Peace Corps volunteer, Carol has just graduated with a Masters in Engineering, and has a new job as a project engineer at $45,000 a year. Steve earns $35,000 a year as a private school teacher. Both Carol and Steve believe that their jobs are stable and secure. They haven’t thought much about their financial situations before, and they haven’t saved any money. (Their employers both offer 401(k) programs, but neither Carol nor Steve has participated yet.) In fact, between them, they have $30,000 of student loans yet to pay off. The Halls’ only major fixed expenditure is the rent on their apartment in a (somewhat distant) Boston suburb – $1000 per month.

In this (so far highly artificial) situation, the only major financial issue facing the Halls is retirement. The key question for the Halls is: “When do you plan to retire?” Even though retiring (early) is a goal for many people, it’s also a resource decision from a financial perspective: each additional year the Halls work generates $80,000 in spending power, before taxes.

The Halls, like many of Sensible Financial’s clients, have found the notion of a sustainable living standard very attractive. This is the spending level after taxes, and after housing , that their earnings will enable them to enjoy, year in and year out, while they are working and after they retire. The chart illustrates the concept . With this spending level, their lifestyle won’t decline after they retire. Nor will they spend their entire working lives scrimping and saving so they can live in luxury after retirement.

It is worth noting that your quality of life depends on factors other than financial spending power. Health, relationships and family are all extremely important. Working longer may cause you to miss opportunities to spend time with family, to travel, or to undertake charitable or other activities that you had planned. A financial planner can advise you on the financial implications of the decisions you make. Only you can decide about the importance of the non-financial dimensions, and how to choose the amount of spending power you need to enjoy your life most fully.

With their Sensible Financial planner, though, the Halls focus on two questions from a financial perspective – when should they retire, and how much should they save until then? It turns out that the answers to the two questions are related – the later the Halls are willing to plan to retire, the less they need to save each year.

The chart illustrates some of the alternatives available to the Halls. They can retire early, at 62, at the traditional retirement age of 65, or when full Social Security benefits would be available to most people their age, at 67. Not surprisingly, more annual spending power is available to them the later they choose to retire. Retiring at 62, they can spend almost $15,000 per year sustainably. If they wait, and retire at 67, their annual spending can be over $19,000 per year.

In fact, as the chart shows spending power grows very smoothly as the number of working years. If the Halls retire at 62, they can spend about $14,900 every year, while if they retire at 63, they can spend about $15,760 annually. Working one more year allows the Halls to spend about $860 more every year, from retiring at 62 up to retiring at 67.

Why $860? The Halls are now 28 and 33. They each plan to live to be 100. They can (and must) spread their spending power over 71 years. In each working year, they earn $80,000. They pay roughly $18,000 in taxes. In addition, when they plan to work longer, they should protect the anticipated earnings with more life insurance. At the ages we are talking about, the additional life insurance premium is about $960 over their remaining working lives.

Netting out taxes and life insurance costs, one more year of work provides about $61,000 in lifetime spending power. Dividing by 71, we get $858 in annual spending power.

In effect, to live a sustainable lifestyle, the Halls should spread every dollar they ever earn evenly over the 71 years in which they plan to be spending. That is the fundamental lesson of financial planning in our view –

Budgeting your spending power over your lifetime, not just over the year, is the key to financial peace of mind.

Reintroducing the various factors that we pretended didn’t exist will naturally make our planning work more complex. Social Security taxes money away during the earning years and returns it during retirement. The ability to earn interest on savings and investments allows saved spending power to accumulate more rapidly than in this example. So, $1 saved will be worth more than $1 of spending power by the time the Halls actually spend it. In addition, the taxability of investment income makes it worthwhile to use tax deferred savings programs, such as 401(k)s, that aren’t valuable in this example. The Halls already may have done some saving (as perhaps you have), and that spending power can be used for their retirement years.

We’ll be addressing all of these complications (and perhaps some more) in future issues of Sensible Thinking.