Journey Into Retirement

How much income will you need in retirement? One of the most important numbers that your need to know as you plan for retirement is your “Income replacement percentage.” This is the percentage of your pre-retirement that you will need to maintain your current standard-of-living when you retire. The good news is that there is a multitude of articles and books written on the topic that attempt to provide a useful guideline. The bad news is that there is nearly as many different guidelines as there are authors. I have seen income replacement guidelines as low as 35% of pre-retirement income and as high as 130%. This is not real helpful if you are trying to plan. It is critical to know this number as it applies to you because it is a key input when assessing your retirement financial situation and estimating how long your retirement savings will last.

So, what am I talking about? The question is how much of your pre-retirement income you will need when you retire. Most estimates suggest that your income needs will go down in retirement. The reason is that when you retire, even if you maintain your exact same spending patterns, expenses will decrease.

For example, if you are saving in a retirement IRA or 401K plan, these deductions from your paycheck will go away. If you are not working, some Federal, State, and local taxes will evaporate. Expenses associated with working could be reduced because you will not have the commutes, have to dress for success, etc. Expenses could also go down if you downsize your home and get serious about searching out the deals at the grocery store.

Of course, expenses could also go up if you adopt an expensive hobby, decide to travel extensively, or have health problems that increase your healthcare costs. Some people have suggested that you will need as much as 130% of pre-retirement income when you retire. The more likely scenario is that expenses will drop. However, is the correct “magic number” for you closer to 35% or to 130%?

A recent analysis published by David Blanchett, head of retirement research at Morningstar provides a glimpse into the answer. First, most financial analyses assume that relative spending will remain roughly the same over the course of a retirement and only will adjust upward to reflect the rate of inflation. However, most of the published research suggests that this is not so. Spending in retirement does not seem to be an inflation adjusted constant – it actually declines when adjusted for inflation. By some estimates, this decline could be 5% -10% on average over a 30 year retirement.

Blanchett’s analysis also suggests a drop in spending in real terms (after inflation), but this varies considerably by income level. For example, a household with a $37,500 pre-retirement income would have an expected drop in expenses of 8% over the course of a 30 year retirement. However, for people with incomes of $62,500 the drop could be closer to 20% and for those with incomes over $100,000 the drop could be 30% or more. This makes sense because higher levels of income mean more disposable income and if seniors become less active or involved in fewer activities, less disposable income might be needed.

So, yes you need to estimate the percent of pre-retirement income you will need. However, be aware that this number will change and is likely to drop. This is particularly true for expenses like food, but may not decline in other categories of spending, particularly areas like healthcare.

But, having said that, what percent of pre-retirement income will you need? Well, according to David Blanchett, this varies by your level of income and pre-retirement expenses. However, the range that he had identified varied between 54% and 87% of pre-retirement income. People with higher incomes tended to have a relatively lower percent income requirement.

It is still important to estimate your own anticipated retirement expenses and to compare them to your pre-retirement income and expenses. However, like many other things in retirement, everything is dynamic and constantly changing. The income replacement requirement is individual to you, so trash the guidelines.