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The first rule in retirement planning is simple but for some reason very few people seem to understand it and follow it: You cannot know how much you will need in retirement if you do not know how much it costs you to live now!

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To come up with an accurate budget, you must review your checkbook for at least three months and write down every single expense.   Noting that you paid $300 to a credit card is not recording that expense.  You need to identify what you bought: was it clothes, food, gas or a monthly payment on a big-ticket item? If you truly want to get a handle on your budget, you must also account for all the cash you spend each week.  During this budgeting period, I recommend you use a debit card rather than cash so you will have an accurate paper trail to work with when recording expenses. 

You need to create two separate budgets:  nondiscretionary budget, those items you absolutely cannot do without, such as household expenses, food, transportation, and healthcare, and then the discretionary budget.  So let us begin with the nondiscretionary items.  The household expenses come first.

Another crucial budgetary item in retirement is healthcare.  If you work for a major company or a government agency, it is likely that your current health costs are subsidized.  Once you retire, providing for your own healthcare (if you retire early) or subsidizing Medicare with a supplemental policy means you will spend more for healthcare than you are now currently paying.  It might be beneficial to supplement your healthcare insurance with a Long Term Care policy (LTC) to help defray the costs of assisted living, at-home healthcare, or if necessary nursing home care. Because of the effect LTC can have on retirement and possibly your financial legacy, this issue will get its own section on the website.
Finally, savings and investments.  This is the easiest part of the retirement budget since it probably already makes up a big part of your pre-retirement budget.  Unfortunately, if you are like most people, even if you are actively participating in your retirement plans at work you still might not be saving enough.  However, every dollar that is put into this category will reap great rewards when you finally work through the post-retirement numbers. 

DISCRETIONARY EXPENSES

Your discretionary budget covers items such as gifts to help your children (assisting on down payments on a house, buying a car, etc.).  Paying tuition for a grandchild’s camp, private school, and even college all fall into nonessential expenses.  Extra travel, eating out frequently, heavy entertaining all should be designated as nonessential expenses.  Although many of us are lax when it comes to setting up a true budget, it is the single most important step in creating a successful retirement plan.  Following are a few items to get you started, and some tips in managing their cost:

 

* Vacations: Opt for expensive trips only if last year’s investment return exceeded expectations, otherwise a reasonable expense is appropriate.

* Clothing: Again, a moderate amount should be set aside depending on the prior year’s return.

* Home improvement: This includes projections for maintenance as well as any other plans you might have for upgrading your home.

* Cars: Keep one car an extra year if you can and consider leasing (understand the pros and cons such as lower monthly payments but a sum that is hard to pay off).

* Entertainment: Limit dining out to only once a week, unless your investment return is above expected.  Movies, theatres, clubs should all have minimum and maximum expenditures noted. 

* Family related travel: (I am separating that from the regular vacations since visiting the children is not the same as visiting Europe.) More trips can be made in good years.

* Grandkids’ education: If you have not taken care of this with a 529 plan, do not make promises that will be difficult to keep.  Budget for a fair amount and add extra only in good years. 

We must also never forget the effect of inflation on our retirement.  The biggest unknown that impacts the answer to the question “Will you outlive your money or will your money outlive you?” is inflation.  Even if inflation is only 3% per year, your post-retirement costs will likely double over the course of retirement.  How will that affect your income needs? If you don’t understand that over time inflation really adds up, then I have a little homework for you. 

Watch the classic 1948 comedy “Mr.  Blandings Builds his Dream House.”  It is a poignant tail of economics gone wrong.  Unlike most movies, specific dollar amount are quoted throughout, and although set in 1948, pay attention and you will see how even 3% per year inflation costs quite a lot.  In the movie are many examples of how much prices have risen, but the moral here speaks volumes:  inflation over time – even in the one-digit range -- is a large problem.  Like a frog placed in a pot of cold water, it sits there until it boiled.  If the temperature rises slowly the frog doesn’t notice the problem until it is too late.  Well, that’s how inflation affects us, little-by-little each year that over time becomes a significant problem.  If this movie does not put inflation into the proper context for you, you may never get it.