How Much Income Will You Need During Retirement?
How much will you need when you retire?
Finding a reliable answer to this question is one of the most stressful aspects of retirement planning, particularly for workers in their 40’s, 50’s and 60’s.
In this post, we’ll discuss some of the things to consider when determining your retirement income needs.
Where to start?
Many financial and retirement planners use a “70-80%” replacement level as a rule of thumb. So if you currently earn $100,000 per year, the assumption is that you will need $70,000 – $80,000 per year in income.
While this might seem like a reasonable place to start, it is an assumption with significant flaws.
A recent Morningstar study cited Aon Consulting’s “Replacement Ratio Study,” which found that replacement rates vary by income:
“… [A] household with pre-retirement income of $20,000 has a replacement rate of 94% versus a replacement rate of 78% for a household with pre-retirement income of $90,000.”
This makes sense, as the cost of goods and services aren’t adjusted by one’s ability to pay: if something costs $20, it costs $20 for everyone. The takeaway: the lower the pre-retirement income level, the higher the replacement rate.
So if a base “replacement rate” is a poor marker, how can those planning for their retirement more accurately “guess-timate” their income needs once their working days are over?
Focus on the raw numbers.
Rather than focusing on percentages, retirement planners need to focus on raw income needs, rather than arbitrary replacement level income.
Take stock of all of your current spending needs. Then, subtract all of the expenses that will disappear during retirement, including:
- Saving for retirement
- Mortgage (assuming the dwelling will be fully paid for prior to retirement)
- College savings for children (though many retirees save for the grandchildren, so adjust accordingly, if at all)
Think long and hard about your discretionary spending. Will you continue to spend at the same rate on things like:
- Home furnishings
- Cars & transportation
- Entertainment (theatre, concerts, cultural attractions, sporting events, cable, Netflix, etc.)
Don’t forget to account for taxes…
- Property and other personal taxes
- Income taxes (adjust tax rate for either the lower rate enjoyed by retirees, or if moving to a new state [such as Florida] where the state tax rates are lower or non-existent).
Then, add a 10% cushion to account for the unexpected.
Accounting for expenses such as health care is the biggest x-factor in this calculation. While Medicare covers the bulk of a retiree’s healthcare costs, it does not include some of the more routine services, including hearing aids, dental, chiropractic/acupuncture, and eye care.
Nor does it include long-term care – perhaps the biggest driver of health care costs for retired Americans.
According to an August 2016 report by Fidelity, a couple retiring in 2016 will need to budget for approximately $260,000 in health care-related costs. Add long-term care to the equation: a cool $400,000 total.
Add it up
Before an investor can know how much they need to save, they need to have the context that’s provided by a careful analysis of their expenses. Once investors know what income during retirement they need, it makes the task of figuring out what they need to save more certain.
Everybody wants to have a comfortable retirement.
A realistic understanding of expenses and the cash flows needed to meet them can help those approaching retirement to better understand what their retirement might actually look like.
Decisions such as whether to work part time, delaying retirement, and making difficult choices about spending priorities are made easier when the hard realities have been uncovered and laid bare for an investor and their advisor.