Determine how much money you need to meet your needs and be happy in retirement.
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“To be comfortable in retirement, you need a retirement income that equals 70% to 80% of your gross, pre-retirement salary.” I hear that rule of thumb mentioned frequently by retirement advisers, and I often see it in the publications prepared by financial institutions.
The trouble is, most older American workers who are approaching their retirement years will fall short of that target income, as evidenced by a recent study from the Stanford Center on Longevity (SCL). The SCL report documents that the vast majority of older workers haven’t accumulated enough savings to retire full time at age 65 with even 70% of their pre-retirement level of income.
According to the SCL report, about 30 percent of baby boomers had saved nothing for retirement by 2014. For the boomers who had some savings, the median account balance was about $200,000. But the amount of lifetime retirement income that $200,000 can generate ranges from (very roughly) just $8,000 to $12,000 per year for a 65-year-old retiree, depending on how the retiree deploys their savings to generate income. These amounts, together with Social Security income, won’t come close to replacing 70% to 80% of pre-retirement salaries for most workers.
To make matters worse, the SCL report also documents that boomers have more debt going into retirement compared to previous generations of retirees.
As a result of these trends, most older workers will either need to work beyond age 65, reduce their spending in retirement, or do some combination of the two.
What’s behind this rule of thumb?
The 70% to 80% replacement rule of thumb assumes you need the same level of after-tax, spendable income in retirement that you enjoyed while you were working. But why don’t you need to replace 100% of your pre-tax salary?
Here are a few key reasons it’s not usually necessary for retirees to replace 100% of their gross pre-retirement income:
- Retirees don’t pay FICA and Medicare taxes on Social Security benefits or on withdrawals from retirement savings.
- You’ll pay significantly lower federal and state income taxes, since a large portion of your Social Security income is exempt from income taxes. In addition, taxpayers age 65-plus enjoy larger tax deductions.
- You no longer need to save for retirement.
For the above reasons, a gross retirement income that “replaces” 70% to 80% of your pre-retirement gross pay might still deliver approximately the same after-tax, spendable income.
Whether falling short of these conventional-wisdom goals is a problem depends on your goals and circumstances. You might find that you don’t need as much after-tax, spendable income in retirement, compared to when you were working. For example, you’ll no longer have work-related expenses, such as those related to commuting, and you might pay off your mortgage or downsize to a less expensive residence. Also, many retirees no longer have the expense of paying for their children’s living or college expenses.
You might also decide that living on less income is an acceptable price to pay for your retirement freedom and cut back on other living expenses to do so.
A better goal
Instead of relying on a rule of thumb that doesn’t work, determine how much income is really enough both to meet your basic needs in retirement and to make you happy. Next, find out where you stand with respect to the amount of retirement income you can reasonably expect to receive from all sources, including Social Security, your pension (if you have one), and retirement savings. Then you can make realistic plans about when you can afford to retire and how much you can spend in retirement. If you need help with this assessment, find an adviser or financial institution you can trust.
You might face some tough financial choices regarding your retirement, but it’s better to wrestle with these issues before you retire, rather than wait until you find yourself in a financial crisis years later.