Start with the end in mind.
By Justin Pritchard, CFP®
One of the most critical steps in retirement planning is figuring out how much income you want in retirement. How much will you spend each month or year? You need a goal to aim for when you’re using your favorite financial planning calculator or software.
But this is more than a numbers exercise. It’s about envisioning your ideal retirement, and you’ll have a better experience if you give this the attention it deserves. So start with the following:
- What do you want retirement to look like?
- What will you “do” during all of that free time?
- Who will be in your life, or who would you like to have close by?
- How will you find fulfillment?
- And more
As the saying goes, if you don’t know where you’re going, how can you make a plan to get there? Another snappy way of putting it: Failing to plan is planning to fail.
Decide What You Want
To eventually get those critical income numbers, do some basic soul-searching. Talk about this with whoever you plan to spend your retirement with (if anybody). And get clear on what’s important to you—regardless of what anybody else says.
Perfect is the enemy of done: You don’t need to predict the future flawlessly. You couldn’t do that, even if you tried. Life will bring surprises, and your preferences may change over time. But this is a first step in getting you in the right direction. You can (and should) repeat the process periodically to verify that you’re still moving in the direction that matters to you.
3 Ways to Choose Income Needed in Retirement
With your ideal retirement in mind, it’s time to settle on some numbers. There are several approaches to arriving at that number, and they’re all valid. The most important thing is to find a method that makes sense to you. That way, you believe in it, and you are more likely to follow through on the plan and give it the attention it deserves.
1. Income replacement: The income replacement method calculates a retirement income as a percentage of your current income. In other words, you plan to live on 80 percent (or whatever) of your current gross earnings. A 2016 GAO study found that most researchers who use this approach suggest replacing between 70 and 85 percent of income in retirement. Clearly, more income gives you more to work with, and you don’t necessarily have to take a pay cut. But it’s hard to replace your full income, so you need to save more or work longer to retire for the highest replacement rates.
|Sample Replacement Rates|
Why replace less than 100 percent of your current income? Besides the difficulty of success, you might not need that much. In your retirement years, you shouldn’t have to pay payroll taxes. Plus, any mortgage and student debt might be paid off, and the kids are on their own. By knowing your numbers, you may find that you can retire on $500,000 or so, instead of needing $2 million.
2. Retirement budget worksheet: Another approach is to create a hypothetical budget of what you’ll spend money on. Again, you can’t predict this perfectly, and you’ll probably base your spending on current spending categories (how much you eat out, travel, spend on utilities, pay in taxes, etc.). To use this method, build a worksheet for monthly expenses, add in irregular annual or quarterly payments (life insurance premiums, property taxes, etc.), and multiply by twelve to arrive at the required annual income you’ll need for retirement.
The benefit of this approach is that you can really get detailed. If you know when you’ll pay off your mortgage, for example, you can account for that and reduce your spending need once you’re debt-free.
3. Lifestyle ranges: If you don’t have the patience for a detailed budget worksheet, you can just pick an annual income range. For example, is $50,000 per year enough, or do you need $150,000 to be happy? You probably have some idea what your number is, and that’s a reasonable way to start. As always, the more you want, the harder it is to reach that goal—but anything possible. Evaluate your wants and needs, and remember that your needs may change in retirement.
What About Inflation?
If you pick an income or budget that supports your lifestyle today, inflation (the tendency of prices to rise over time) will most likely erode your spending power. Retirement might be many years away, and it might last for several decades after you start—so it’s wise to plan for higher costs.
Retirement calculators and financial planning software should automatically account for inflation, but verify this if you don’t know for sure. As with everything else in planning, your inflation assumption is just an assumption, and it might end up being too high or too low. Being conservative (assuming double-digit inflation, for example) may help protect you, but it’ll also require significantly more savings to satisfy your retirement income needs.
What About Healthcare?
Healthcare costs and long-term care are arguably some of the most troublesome expenses for retirees. Those costs are high, unpredictable, and rising—and the landscape keeps changing. Medicare and other programs cover a portion of your charges, but you’ll still pay substantial out-of-pocket costs. So, how much will you need?
Fidelity Benefits Consulting releases an annual study of projected healthcare costs. In 2020, that number was $295,000 for a couple ($155,000 for women and $140,000 for men). That amount covers out-of-pocket premiums, copays, and deductibles, but it does not take long-term care expenses into account. Specific healthcare funding is beyond the scope of this article, but it’s worth noting that for a 25-year (or longer) retirement, a couple would be wise to earmark at least that much just for healthcare. You can plan for that amount as a lump sum, or assume that you’ll pay annual expenses over a 25 or 30-year retirement (with some years being more expensive than others).
Retirement Spending Patterns
We’ve repeatedly discussed how you’re predicting the future, so you can only be as accurate as you are clairvoyant. But the point is to move in the right direction and review the plan over time. Imagine a pilot before the days of GPS: They didn’t always have the plane pointed in exactly the right direction, but they started off right and made adjustments as information became available to eventually arrive at the destination.
Some describe retirement spending in phases (although this might not fit you perfectly):
Go-go years: Immediately after you retire, you might expect to spend on more frequent vacations, new hobbies, or other luxuries that you put off during your working years. You’re as active as you’re going to be for the rest of your life, so you might as well make the most of it.
Slow-go years: Over time, your spending may slow down. You’ve been to most of the places you want to visit, and health problems may begin to slow you down (but only a little bit). You have all the toys you need to enjoy your hobbies, and you’re less eager to go through airport security.
No-go years: Eventually, some lose the energy to travel and do things that cost money. However, healthcare costs increase, and you face a growing risk of “spending shocks” for health events. Consumption spending can be low, but healthcare spending typically increases during this phase of life.
Ultimately, your spending pattern will be unique. It will depend on how you spend your time and what you value. Whether or not you’re fortunate when it comes to health and other factors also play a role, and that’s where planning gets especially challenging.