Understand what retirement really costs

Retirees’ spending can vary widely, shaped by location, health care needs and lifestyle. And creating a strong retirement plan starts with capturing your actual expenses for housing, food, clothing, health care and other essentials.

Putting your purpose at the center of your plan can help clarify your goals, account for key expenses, ensure your plan is sustainable, and prepare for any risks that could derail it.

In practice, putting your purpose first means deciding which expenses are essential and which are flexible. This is more than an organisational exercise. It helps you determine which expenses should be covered by guaranteed income and which can be adjusted depending on market, economic or other changes.

Making your money last

If there is one figure really worth understanding, it’s your ‘withdrawal rate’. That is the percentage of savings you withdraw from your portfolio each year to cover expenses beyond what reliable income sources will pay for.

For example, if you have $1 million in retirement savings and use a 4% withdrawal rate, you would withdraw $40,000 in your first year of retirement.

In following years, that amount is typically adjusted for inflation so your spending power keeps pace with rising costs. If we used the same figures, if you experienced a 2% inflation rate in your first year, you would withdraw $40,800 in your second.

The higher your withdrawal rate the more income you can enjoy now, but the greater the risk your savings may not last as long.

Analysis outlined in Vanguard’s Principles for Retirement Income report shows that a withdrawal rate of roughly 3.5%-4% can support retirement for 30 years or more for many households. If your withdrawal rate is too high, it can significantly reduce how long your money will last. If it’s too low, you may miss out on enjoying your retirement as much as you could.

Safeguard against potential risks, including longevity

Life is unpredictable. You can never be sure whether inflation will rise or fall, whether markets will boom or bust, or if an illness or injury will leave you with a big medical bill.

But you can lessen the chance that events like these will throw your retirement off course. Incorporating an inflation estimate into your spending projections and holding a diversified portfolio of retirement assets (ideally across shares, bonds and cash) can help you cope with inflation, for example. Your contingency fund can cover unexpected expenses.

One surprisingly big risk is the number of years you will spend in retirement. People are living longer, healthier lives. That’s a positive development, but it means your retirement income likely will need to last for many years. Outliving your savings (known as longevity risk) may pose a bigger risk than weak investment returns.

The key to retirement income? It may not be a number