Journey Into Retirement

A lot is made in retirement planning about developing your own personal “magic percentage.” This is the percent of your pre-retirement income that you will need when you retire. Many articles have been written on this topic and the net is much confusion. I have seen articles that claim that you can live on as little as 30% of your pre-retirement income. I have seen others that put that estimate as high as 150%. The reality is that it is different for each person.

The retirement tools tab on this blog contains a spreadsheet that you can download to figure out what this percentage is for you. However, there is a catch. People make the broad assumption that whatever magic percentage you calculate for yourself will remain the same throughout your entire retirement. Yes, there are some considerations about additional costs that might come along because of declining health. But generally, the magic percentage stays relatively constant for the average person.

How Do Income Requirements Change

What if I were to tell you that your magic percentage will actually decline as you move through retirement, even with considerations for increasing healthcare expenses? Would you believe me? Well, this is exactly what a 2012 survey by the Social Security Administration found. Here are the highlights:

• The average retiree that they surveyed had a starting magic percentage somewhere around 74%. In other words, when they initially retired, they needed 74% of their pre-retirement income to cover their expenses.

• By year four of retirement, this average had dropped to only 65%. By year 10 of retirement it was round 58% of pre-retirement income.

• However, this drop in required income was not uniform. For higher income households, the magic percentage started out around the same place as everyone else, around 72% of pre-retirement income. However, it quickly dropped. By year 10 of retirement for this group, the magic percentage had stabilized at around 50%. This makes total sense. If you have higher income, you probably have more discretionary spending that can be shed in retirement.

• For the other income groups, the drop was not quite as steep and eventually settled in around 60% of pre-retirement income.

So What Does This Mean to You

First, I am not saying that the economics are wrong. Inflation will continue to push your income needs up year-to-year. That is just the reality. However, what this research is saying is that there is a counter-force to inflation – a tendency to push income needs down because you are buying less. This is an important, but partial offset to the effects of inflation.

The implications for you are very important as you plan for a successful retirement. This offset in income requirements will make it easier as your retirement goes on. Further, if you anticipate this offset to expenses you can factor this into your long-term planning. If nothing else, you retirement savings will last longer than if inflation had no counter-force. Let me show you some comparisons that I made to clarify this point. One of the analyses that I have done is to look at the effects of inflation on income needs. What dropping expenses will do is to relieve some of the pressure of inflation.

Let’s assume as an example that when you enter retirement, based on your magic percentage you estimate that you will need $50,000 in income to cover your expenses. Let’s further assume that inflation averages what it has for the past 50 years – around 4.2%.

• If your magic percentage stayed the same after 20 years of retirement given an average 4.2% inflation rate, you would need around $109,000 to cover what $50,000 did initially. After 30 years of retirement, that requirement would have jumped to a staggering $165,000.

• However, if you take the same assumptions about inflation and factor in the drop in income requirements estimated by the Social Security Administration for the average retiree, these income requirements drop substantially. After 20 years of retirement, you would need about $86,000 (vs. $109,000). By year 30 of retirement, you would need about $129,000 (vs. $165,000).

• Note that these increases in the cost of living are still something you need to plan for. However, they are moderated substantially from what they would be if your magic percentage stayed the same throughout the duration.

This is very good news indeed.

Will Expenses Really Go Down

OK, like any good social scientist I have engaged in a little fuzzy math. We do see expenses drop on an “Inflation-Adjusted Basis.” What does that mean? Well, if you mathematically adjust changes in expenses so that inflation is taken out of the equation (in other words if inflation were zero), you would see an actual drop in expenses. However, the possibility that inflation will rise is much more likely. So, the point of this discussion is that you will buy less, but inflation will push the cost of what you buy higher.

The good news is that the draconian effect of inflations will be reduced substantially and this will help you maintain your solvency in retirement. It will take you somewhat longer to deplete your retirement savings. I wanted to be the bearer of good news.