Why retirement planning is more about cash flow than net worth

Net worth is a snapshot; cash flow is what funds retirement

Planning for retirement often focuses on having a large enough net worth—the higher the number, the better. While net worth is important, it’s not the only nor the best predictor of retirement success. For example, let’s look at two retirees who have the same net worth and different retirement outlooks:

What net worth measures and what it misses

Net worth is a simple measure of your overall financial position. It includes the value of everything you own minus what you owe, and includes both fixed and liquid assets. Examples of fixed assets are homes, land, and vehicles, while liquid assets may include cash, securities, and retirement funds. Net worth does not show how much income your assets may generate, how much money comes in and goes out each month, or the potential tax effects of withdrawals from tax-deferred accounts. It may also include assets that may be difficult or costly to convert to cash. In addition, net worth alone does not show how market returns and the timing of withdrawals may affect a retirement portfolio. That’s why it’s important to consider retirement income withdrawal strategies.

Why a high net worth can still feel tight

It’s possible to have a net worth in the millions but still feel the pinch in retirement. Large portions of your net worth may be tied up in assets that are difficult to convert into spendable cash. For example, a retiree may own a valuable home but have limited monthly income outside Social Security. Selling the home, borrowing against it, or drawing more from investment accounts may involve costs, taxes, market risk, or changes to the retiree’s living arrangements. The value of a home adds to net worth, but it does not automatically provide cash for monthly expenses.

How cash flow reframes the question from “How much do I have?” to “How much can I spend?”

Cash flow shifts the focus from the total value of your assets to the money available for spending. It compares income and withdrawals with expenses and taxes. This view can help show whether projected income may cover essential and discretionary costs, how much spending depends on market-based withdrawals, and whether a plan may need to be adjusted when markets or expenses change.

Building a retirement income strategy around your expenses

Building a retirement cash flow plan around expected expenses can make the plan more practical. It connects recurring bills and discretionary spending with expected income and withdrawals. It does not eliminate uncertainty, but it can help identify potential gaps.

Start with retirement spending needs, not a withdrawal rate

By starting with your spending needs rather than a withdrawal rate, you can plan more accurately. You want to make your plan suits your lifestyle rather than attempt to make your plan fit a pre-set number that may not adequately cover your lifestyle.

Separate essential from discretionary expenses

It’s important to match needs and bills you can’t avoid with predictable income. Wanted and non-essential spending can be matched to flexible income. The following examples show how essential and discretionary expenses may be matched with different income sources. The categories are illustrative because the reliability and tax treatment of each source can vary.

Essential expenses such as mortgages, rent, property taxes, and homeowners association (HOA) fees require the stability of predictable income. Social Security, pensions, and annuities are examples of predictable income that will allow you to meet your needs dependably. This stability reduces the likelihood that you may have to sell securities when the market is down to make ends meet.

Use investment assets for flexible spending

A few general rules of thumb have become well-known among investors:

• One common rule of thumb is the 4% rule. It generally suggests withdrawing 4% of a portfolio in the first year of retirement, then adjusting that dollar amount for inflation in later years. It is a starting point, not a guarantee, and an appropriate withdrawal rate can vary with market conditions, time horizon, expenses, taxes, and other income sources.
• The 7% rule maintains that investors should automatically sell a stock or investment when it drops by 7% in value.
• The $1,000-a-month rule states that for every $1,000 of monthly income you want in retirement, you need to have $240,000 saved.

These rules are often used as general guidelines for managing and drawing down portfolio assets. Investment assets are often best suited to discretional spending. If the market takes a downturn, you can cut back on discretionary spending to avoid or reduce the amount you sell to help protect your savings.

How timing and sequencing can affect budgeting in retirement

In retirement, how and when you receive your money can be as or more important than the total amount you saved. Social Security and pension payments may arrive on a regular schedule, while dividends, required minimum distributions (RMDs), and investment sales may occur at different times. Comparing those inflows with monthly and annual expenses can help identify periods when cash reserves or portfolio withdrawals may be needed. Tax payments also affect cash flow. Creating a tax-deferred retirement plan may help with future cash flow management.

Sequence-of-returns risk in simple terms

Sequence-of-returns risk is the risk that poor investment returns early in retirement, combined with withdrawals, may reduce how long a portfolio lasts. Possible ways to manage this risk may include maintaining liquid reserves, adjusting discretionary spending, and coordinating withdrawals across income sources and accounts.

Reviewing your spending in retirement each year

An annual review can compare actual spending and income with the assumptions made in a retirement plan. It can also account for changes in inflation, healthcare costs, taxes, market performance, and major life events.

A yearly cash flow review checklist

The following areas can help organize that review:

Audit last year’s return

• Categorize wants vs. needs.
• Track inflation and its effect on your budget.
• Consider any major life events and healthcare needs.

Identify and layer your income sources

• Total your fixed (predictable)-income sources.
• Subtract your guaranteed income from your expenses to identify how much your investment portfolio must generate.

Determine your withdrawal strategy and account sequencing

• Decide how much money to pull from taxable, non-taxable, and tax-deferred buckets.
• Review your RMDs if you are of age to make sure the requirements are met.

Assess and refill your cash buffers

• Ensure you have 1–2 years of baseline living expenses securely kept as cash or other liquid assets.
• If the stock market had a strong year, you may be able to harvest gains and refill your buffer. If the market took a significant downturn, you may want to consider freezing stock sales and living off your cash buffer.

Common cash flow mistakes and how to avoid them

Common mistakes that retirees make and possible ways to address them include:

• Assuming Medicare covers all medical expenses and omitting out-of-pocket costs from baseline cash flow projections. Create a dedicated line in your budget for supplemental insurance, deductibles, and dental/vision care.
• Treating early retirement as a perpetual vacation and overspending on travel, entertainment, and hobbies in the first few years. Set up a system where a certain amount is transferred into checking every month to help cap discretionary spending.
• Holding too much cash in low-yield checking accounts in fear of market volatility. Limit cash to 1–2 years of expenses.
• Not drawing down tax-deferred balances until RMDs kick in and force highly taxed withdrawals. Withdrawal sequencing can help and it may be a good idea to discuss Roth conversions with a financial professional to see if they are appropriate for your circumstances.
• Making large, lump-sum withdrawals from traditional retirement accounts to fund major purchases, which may increase taxable income and could affect Medicare premiums. Sourcing large, one-time cash needs for items such as cars or home repair from Roth accounts or taxable accounts could help avoid this issue.
• Selling securities during a market downturn. It may be a good idea to use your pre-established cash buffer or bond maturities.
• Sticking to a rigid withdrawal amount each year. Adapt your spending strategy to protect your resources by cutting back on discretional spending during market downturns.

Net worth can help you understand what you own, but retirement expenses are paid with available income and assets that can be converted to cash. Reviewing your expected income, spending, taxes, and access to savings can provide a more complete picture of how your retirement plan may work over time. A financial professional can help you explore options that align with the retirement lifestyle you envision.

Retirement cash flow FAQs