The hardest question when planning for retirement is always either, “Do I have enough saved?” or, “How much do I need to have saved?” The second toughest question in retirement planning is, “How much will I need each month to live on comfortably?” Some families have a detailed budget and can easily answer how much they need monthly, while many other families struggle with a specific number that accurately reflects their spending needs.
Many financial advisors rely on an old rule of thumb, which is simply 70%. So if you made $100,000 the year before you retired, then you need $70,000 the next year to maintain your lifestyle. The idea is that prior to retiring you were saving money, paying slightly higher taxes (particularly Social Security taxes) and had more clothing and entertainment expenses. The assumption is that these expenses will disappear during retirement and a new retiree can maintain approximately the same lifestyle they had before on 70% of the income.
We refer to this 70% number as a replacement ratio, so essentially you are “replacing” 70% of your income. I want to lead you through some research on replacement ratios and examine whether or not 70% is a good rule of thumb.
Let’s start by looking at some research done by Patrick Purcell that was published in the Social Security Bulletin in 2012. This is a graph of replacement ratios grouped by pre-retirement income.
Here we see that in the first year of retirement the highest 25% of income earners spend on average 74% of their pre-retirement income and the bottom 25% of income earners spend 72% of their pre-retirement income.
The 70% replacement ratio looks pretty good for the first two years of retirement. As your income increases the replacement ratio decreases, but only slightly.
This next chart is more interesting. Clearly some retirees spend more than others. This chart looks at the range of replacement ratios that were observed in the study.
Let me help explain the chart. During the first two years of retirement the average retiree spends 73%, but the range is enormous. 25% of retirees spend more than 101% of what they earned before retirement and 25% spend less than 48% of their pre-retirement income.
The rule of thumb tells us what the average person does. However, some retirees spend a good bit more than when they were working, while others spend less than half that. The rule of thumb doesn’t tell the whole story.
Bottom Line: Developing a spending plan or a budget for living during retirement isn’t just multiplying by 70% and learning to live with it. It is unique to each situation.
From the desk of Kris Carroll
Source: Purcell, PJ. (2012) Income Replacement Ratios in the Health and Retirement Study. Social Security Bulletin, Vol. 72 Issue 3, p37-58.Retirement Income, Social Security