This article was originally published on Jan. 24, 2016 and was updated on Jun. 12, 2016.
You're probably looking forward to the considerable freedoms that come with your retirement. The freedom to set your own schedule, to avoid rush hour traffic, to dress how you'd like, and to have far more choice in who you spend your days with are just a few of the highlights of retirement.
Unfortunately, the downside of retiring is that when you stop working, your paycheck stops showing up, too. If you're like most Americans who've worked a full career, you'll likely retire with some benefits from Social Security, but that program's typical payment is around 40% of a retiree's average income. If you don't have a significant income coming in from another source, that's a massive pay cut heading your way. You need to be prepared so you're not caught off guard.
What you can do about that massive pay cut
You have two major levers to pull when it comes to dealing with the financial reality of retirement. You can come up with income from another source or you can reduce your costs. Chances are, you'll be able to get some help from each of those levers, but you'll need to plan in advance if you expect to use investments to generate a substantial part of your retirement income.
From a cost reduction perspective, some of it may come 'naturally' as you approach retirement age. For instance, if your mortgage is paid off, your housing costs will shrink. Similarly, if you can move to a lower cost neighborhood due to not having to worry about location for your commute or for your now-grown children's educations, that move can save you housing costs, too. Grown and independent children also mean fewer mouths to feed and bodies to clothe, thus reducing those expenses as well.
You can also make active choices to cut your costs during retirement -- particularly in the early, active years of your retirement -- by doing more yourself what you may have hired out while working. For instance, if you never had time to cook while working, you can cut meal costs substantially by cooking more from scratch. Likewise, formerly hired-out yardwork can become a great way to keep active in retirement, and doing your own household maintenance can keep those costs down, as well.
From an income standpoint, just because you've left the career rat race doesn't automatically mean you're done working for pay. You may be able to work part time, switch to working at a non-profit that you've long supported, or find that you're happy to continue working full-time, though in a less stressful role.
Any income you earn in a retirement job can help cover your costs of living, but be careful if you're younger than your full retirement age and collecting Social Security. There's a penalty of $1 off your Social Security check for every $2 you earn above $15,720 if you're below full retirement age, collecting Social Security, and still working. In the year you reach your full retirement age, that penalty drops to $1 for every $3 you earn above $41,880.
What about your investments?
In addition to the costs you can cut in retirement and the income you can earn in a retirement job, you can also spend from your investments to cover your costs of living. Relying on your investments in retirement takes a different mind-set and plan than you followed when accumulating your money, however, and you need to adjust your portfolio accordingly.
For instance, you'll want to be sure you own high quality bonds -- such as via a bond ladder -- to cover your near term expenses. With bonds, you'll trade off the higher potential returns of stocks for a higher certainty of income that comes from bonds' position as higher in the corporate payment priority list.
Partially because of those lower potential returns in bonds and in part because the market's returns are never certain, you'll want to limit your draw-down of your portfolio to better assure it will last as long as your retirement does. A common rule of thumb in retirement planning circles uses 4% as the basis of your withdrawals. Based on that 4% rule, if you:
- Start with (and maintain) a properly diversified portfolio,
- Withdraw 4% of your portfolio's starting balance in your first year of retirement, and
- Increase your withdrawals annually for inflation,
... you can have a very good chance of seeing your money last at least as long as your retirement does.
If you are using that 4% rate to plan your retirement spending, it means you'll need to have saved up 25 times the annual spending dollars your portfolio needs to cover prior to your retirement. So the sooner you can start saving for that retirement nest egg, the better your chances will be of being able to count on your savings for a significant portion of your retirement spending needs.
Start planning today for a better tomorrow
Whether it's by cutting your costs, working a retirement job, spending down your nest egg, or some combination of the three, you need a plan to deal with the massive pay cut heading your way in retirement. The sooner you get started planning for it, the better your choices are along the way, and the better your chances will be of reaching a successful retirement.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.