One common mistake we see when people plan their own retirement is putting the cart before the horse. Too often people look at the investments they have and use a rule of thumb to estimate retirement spending. The 4% rule is the most commonly followed rule of thumb. This rule means setting your withdrawals each year to equal 4% of your initial retirement fund balance means the funds should last 30 years.
I describe this as putting the cart before the horse because the focus here is not on what they want to achieve, but the means they have to achieve it. Instead of this approach, we prefer to start by understanding our client's goals when making their financial plans. If there is a stark difference between their needs and their means, we can reevaluate their goals.
The problem with using a rule of thumb is they cannot possibly account for all the little details which make your position unique. The 4% rule is intended for a period of around 30 years, but does not address the returns of your portfolio, your risk tolerance, actual timeframes, interest rates etc.
Setting good goals puts you in a better position to understand what you need from your investments. Then you can decide what needs to be done to live your best life in retirement.
Putting Goals First
When we put our goals first, the idea is to:
Set goals describing what we want to achieve
Analyse our position to find out if these are achievable
Revisit our goals to ensure we are maximising the value from our investments.
We can repeatedly adjust our goals until they are both achievable and make the most of our investments.
For example, imagine a person needed $30,000 each year from their investments to cover their retirement expenses until they are 90. If they found their investments would not last over this period, they would need to adjust their goals. This may mean spending less or retiring later.
On the other hand, if their investments would balloon in value over this period, their goals were too conservative. This gives them the flexibility to pursue other goals. For some, they can view this as a surplus of capital, maybe to be spent on the big trip they always dreamed of, or to move into their dream home. Others may prefer to simply spend more or leave it to their kids.
When investors start by deciding how much they can withdraw each year, such as with the 4% rule, they lose some of the nuance. They have given themselves a budget of sorts to stick to, but if this budget doesn't match their lifestyle, it will likely create problems when retirement arrives. You do not want to stop working to find you can't realistically get by with the 4% rule. A big lifestyle shift like this is difficult and disappointing.
On the other hand, something we see far more often is investors having much more money than they need later in life. They work out with the 4% rule that they should have enough, but don't spend any of the extra capital. Nearly everyone wants to leave something behind for their kids, but without specific estate goals, their estates can grow large at the expense of their bucket list.
Developing Great Goals
We've talked about retirement above, as this goal is shared by nearly everyone. However, a goal-based financial plan can work for anybody, as long as they have worked out what they want to achieve.
It can be tough to nail down what you want in this way. As an example, nearly every client we see wants both financial security and a comfortable retirement, but these goals aren't quite ready for a plan.
A great goal is quantifiable, measurable and has a timeframe. For the goal of financial security, does this mean wanting a safety net in case of a job loss or unexpected expense? In this case, the goal may be better defined as having 3 months of expenses set aside for emergencies. A comfortable retirement usually means having enough income to cover regular spending, travel and the occasional car upgrade over the next 30 years.
Fleshing out your goals in this way makes it easier to plan ahead. Start with your values and decide broadly what you want. Next try to develop these wants into goals in dollar terms with timeframes. The you can begin analysing your position and refining your goals into a plan.
Examples of Common Goals
The most common financial goal, shared by almost all of our clients, is a comfortable lifestyle in retirement. To develop this goal into something usable in plans, consider the following.
Your general expenses will not likely change considerably when you retire. If you understand roughly how much you spend now, your goal can be to continue spending this much each year until you turn 90. You may also decide to treat travel expenses separately, such as $15,000 every two years until you turn 80. Spending could increase or decrease over time, depending on how you expect your lifestyle to change and what kind of care you want later in life.
As we mentioned previously, when clients of ours want financial security, to us this means a safety net for emergencies. This may be 3-6 months of spending set aside in a savings account, or more if you have certain emergencies in mind. At the end of the day, your goal should be to have enough money set aside to ease your doubts.
Other common goals are paying for your kid's education, saving up to purchase a house and donating to charity. In each of these cases, be as specific as you can. Which school will you children attend? How much will the house cost and when? Which charities will you support and for how long?
Once you fully understand your long-term financial goals, you will be better positioned to plan for the future. If you are unsure how you will achieve the goals you set, get in touch with an independent financial adviser.