Case Study: Wealth Gap
Many individuals, especially business owners, struggle with assessing their retirement readiness, or determining how much money they actually need to retire comfortably.
“Have I saved enough?”
“How long do I need to continue to work?”
“How much do I need to sell my business for to be able to retire today?”
These are many of the questions people ask themselves as they approach retirement. What they are really asking is, “What is my Wealth Gap?” Your wealth gap identifies how much more money you need to retire comfortably today. The Wealth Gap can be broken down into a simple equation:
(What do you need?) – (What do you have?) = Your Wealth Gap
Let’s unpack that equation…
What do you need?
Determining what you need to retire comfortably starts by confirming your annual retirement consumption level, and this is the most critical part of the wealth gap equation. Most people underestimate how much they will spend in retirement. The best place to start is to analyze your current monthly spending:
Which of your current expenses will you continue to have in retirement?
Will any of your current expenses drop off in retirement?
What additional expenses will you pick up in retirement?
You also want to consider the large expenses that may occur randomly throughout the year and are not captured in your current monthly expenses – charitable donations, family support, travel, etc. And if you are a business owner, what expenses are currently paid by the business that you will continue to incur even after the business is sold?
Once you get a grasp on your total annual retirement consumption, you then need to factor in inflation, taxes, life expectancy, investment returns, asset allocation, and the list goes on. However, a quick way to estimate your total retirement need, without going into much arithmetic or attempting to use the financial calculator you haven’t touched since college, is using the 4% rule.
The 4% rule is a well-regarded guideline on how much you can safely withdraw from a retirement portfolio without exhausting your assets. Let’s look at an example using the 4% rule, assuming your total annual retirement consumption level is $200,000. Using the 4% rule, we would divide $200,000 by 4% to determine total retirement need.
$200,000 / 0.04 = $5,000,000
Using this simplified 4% method, your total retirement need would be $5,000,000. This is often referred to as your “Retirement Number” or the value of assets you need to maintain your lifestyle in retirement. Now that you know how much you need, let’s focus on how much you have already accumulated…
What do you have?
Now you want to calculate the total value of investments and income producing assets you have already accumulated (not including your business, primary residence, or non-income producing property). Yes, you may be able to liquidate those other items, but the wealth gap exercise is attempting to quantify your current retirement readiness, as it stands today.
Let’s assume you have a total of $2,750,000 of total investments and income producing assets already accumulated.
So, what is your Wealth Gap?
Given your $5,000,000 “retirement number” and having $2,750,000 already accumulated in investments and income producing assets, your wealth gap is $2,250,000.
Let’s breakdown how we got there:
(Your $200,000/year desired retirement consumption) / (4% rule) = ($5,000,000 Retirement Need)
($5,000,000 Retirement Need) – ($2,750,000 You Have Accumulated) = ($2,250,000 Wealth Gap)
Well, what about Social Security?
Without overcomplicating it, let’s apply the same 4% rule to your Social Security benefit. Let’s assume you are receiving $30,000 per year in Social Security benefits. That income stream is extremely valuable, especially since it makes up for 15% of your desired annual retirement spending ($30,000 / $200,000 = 15%). When we apply the 4% rule to your $30,000 Social Security benefit, it values that benefit at $750,000, thus cutting your Wealth Gap down to only $1,500,000.
Now that you know what your Wealth Gap is, you can start to build out a plan to answer the following questions:
What is the bottom-dollar I can sell my business for?
How much longer must I work to be able to retire comfortably?
How much do I need to save per year to close my Wealth Gap?
While the Wealth Gap example above was oversimplified (by not addressing taxes, holding many variables constant, and treating all investment assets/income the same), the overall Wealth Gap concept is very straightforward. Your Wealth Gap equals what you need minus what you have already accumulated. Quantifying your wealth gap is the first step in building out a retirement plan. The sooner you quantify your retirement shortfall, the easier it will be to plan for how to eliminate that wealth gap.