How much do you need to retire?
How much do you need to retire? The usual suggestion provided by financial planners and retirement calculators is 75% to 85% (roughly 80%) of your pre-retirement income. But is that really enough money to retire with security? Does the 80% rule-of-thumb work under all circumstances, or is it merely a rough approximation to simplify the retirement planning process? Let’s examine these issues more closely…
Is 80% Of Pre-Retirement Spending A Realistic Budget?
The basis for the 80% spending rule is that your living expenses are expected to decline once you retire thus your spending should decrease without forcing you to lower your lifestyle. For example, you’ll no longer need to purchase expensive professional clothing and your transportation costs will drop without a daily commute to work. Additionally, your children will probably be grown and out of the house, and you will no longer have to fund your retirement savings. You may even have your home paid in full thus eliminating your mortgage payment and you may be in a lower tax bracket. All these factors indicate your spending should drop during retirement.
Unfortunately, the issue is not as clear as it might appear on the surface. The analysis above assumes certain types of spending will decrease while all other spending remains the same. That is not realistic. For example, many new retirees like to hit the open road and see the world thus increasing their travel budgets. Similarly, it is the rare retiree who does not face rising health care costs.
In short, the 80% rule of thumb is a generalization designed to simplify the retirement planning process at the expense of accuracy. It makes many assumptions about your future that may not be true for you. It is no substitute for making a real budget based on your actual plans for retirement, and it could actually jeopardize your financial security. To make this point clear we will examine five reasons why your expenses may actually increase during retirement instead of decrease…
Longer And More Active Retirements
People are living longer and more active retirement lifestyles than ever before. Increasing longevity has made 60 the new 40. If you plan an early retirement so you can sail around the world or take frequent wine-tasting trips to France and Italy, the cost of those leisure activities and travel can easily offset any decrease in work-related expenses. Alternatively, if you are planning an early retirement it will mean you need more money to support a longer life of leisure. A longer retirement means you can’t spend as much investment principal each month, and a more active retirement means you need more savings and income to support a more expensive lifestyle.
Health Care In Retirement
Health Care in Retirement
Health care costs have risen steadily and there is every reason to believe that trend will continue. Additionally, your chances of serious illness or need for expensive medications increases with age. A single medical event can be devastating to your retirement savings if you are not prepared, and if you don’t have long term care insurance then assisted living or nursing home expenses can deplete your retirement savings.
Other Ways Expenses Could Rise
Maybe you haven’t paid off your house, or possibly you took out a home equity loan to remodel. The 80% rule-of-thumb assumes you no longer support dependents, but you may still be paying a child’s college expenses. Alternatively, you might be caring for an aging parent who is living in your home. These expenses certainly won’t go away just because you retire.
Lower Taxes May Be Wrong
The assumption that your taxes will drop during retirement could be totally incorrect. After all, if your retirement income level is similar to pre-retirement income then where will the tax relief come from? In addition, growing budget deficits at all levels of government combined with entitlement program problems indicates a greater likelihood of rising tax rates rather than falling tax rates. In short, the idea that your tax rate will decrease during retirement may turn out to be just the opposite.
Spending Statistics Misrepresent Real Spending
Many research studies have been conducted on the spending patterns of the elderly. One of the more famous studies comes from Ty Bernicke in the Journal of Financial Planning where he cites numbers from the U.S. Department of Labor’s Consumer Expenditure Survey indicating that retirees spend less as they age. A typical 75-year-old spends about half as much as the average 45-to-54-year-old. Overall, spending declines about 25% each decade from age 55 to 75.
This appears to be conclusive evidence that spending does in fact decline with age during retirement; however, there are a couple of major flaws in the research. The first problem results from these figures failing to include long term care costs. You can solve that problem with insurance but there is no solution to the next problem…
Bernicke’s analysis was based on a snapshot in time thus it only compares nominal dollar spending and does not adjust for inflation. In other words, it compares the spending habits of a 75 year old today to the spending habits of a 45 year old on the same day. It does not track a 45 year old over a period of 30 years to determine if their spending decreases with time as the study would imply. Instead, it compares the two different groups at a single point in time.
The problem with this approach is it fails to adjust spending for inflation. A mere 3% inflation will double spending in just 25 years which will more than offset the expected reduction claimed by Bernicke’s research. In fact, it could potentially cause an increase in spending – contrary to what his research would imply.
A More Accurate Approach For Determining How Much Money You Need To Retire
In summary, you would be wise to forget the oversimplified rules of thumb when trying to figure out how much money to retire. Your financial security is at stake and you deserve better. Instead, it is far more prudent to develop a realistic budget for your retirement spending based on your actual retirement plans. You don’t have to make it perfect because nobody can predict the future, but you do want to make it as accurate as you can.
Personal Budget for Retirement is a Must
A personal budget for retirement is necessary because your life situation is unique. Only you know the financial situation facing your maturing children and aging parents that might affect your budget. Only you know about your globetrotting plans to travel the world for a decade or two before slowing down. That means you will need to add that expense into your budget for a decade or two before removing it. If you have long term care insurance then add the premiums as an expense into your budget, and if you don’t then build a cushion into your savings for self-insurance. In short, develop a plan for retirement and then develop a budget to reflect your plan.
When you complete the budgeting process you may be happily surprised to learn you only need 60% of pre-retirement income making you better off than expected – or your dreams could require 140% of pre-retirement income causing a challenge. This is key to your financial security because the difference between these two numbers can either break the back of your retirement savings or make a meager nest egg look plentiful. Because the range of outcomes is so wide and the stakes are so high, the only realistic solution is to replace the rule of thumb with a carefully developed retirement budget based on your unique needs.
It is the only prudent thing to do.
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About The Author =
Todd R. Tresidder is a financial coach who blogs about retirement planning, wealth building and investment strategy. He wrote the book How Much Money Do I Need To Retire teaching you how to overcome the hidden problems behind retirement calculators that threaten your financial security.
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as a matter of simple prudence i am working to have as much money as i can in retirement. I read a personal finance book about how expenses increase with age and the very important things like healthcare and food increase exponentially. The author was advocating that people start investing for retirement as soon as possible and for as long as possible and i agreed with him. The upside is that even if i dont finish all the money saved up before i pass on, my kids will have some inheritance. The downside is that there is going to be a lot of delayed gratification and frugality all through life, buy hey, the end justifies the means huh??
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The intro paragraph mentions 80% of pre-retirement income, while the next paragraph referenced 80% of pre-retirement spending. That is an important distinction. Retirement assets that produce 80% of pre-retirement income may be enough if you have no debt, including mortgage. But assets that produce 80% of your pre-retirement spending may not be enough, even if you have no debt, especially if you were living a frugal existence before you retired. The key is to examine your personal position, not follow a general formula.
For someone who is younger, and doesn’t have a good idea of their retirement needs, I think a formula is good – if just to give them a target for the time being. But people who are closer to retirement age should definitely visit with a professional financial planner to discuss their retirement needs and plans. There are many different variables which may affect their goals.
As for me, I have 30 years before I reach the “traditional” retirement age, so I plan to contribute as much as I can to my retirement accounts, pay off my mortgage, and have income producing assets to help prepare for retirement. I’m on the right path, but who knows what will happen in the next few decades!
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@kenyantykoon – Delayed gratification and frugality is not sacrifice as long as the focus is on “what you want”. My experience is when you are heading toward what you want there is no sense of sacrifice – instead, it is fulfilling and enjoyable. Stuff is overrated – freedom is where the real value lies.
@Patrick – Thanks for adding the clarifying distinction.
Todd Tresidder´s last blog ..The Parable Of The Mexican Fisherman And Investment Banker
This is a great article. I am really concentrating on trying to ensure that I will be able to retire at a decent age. My dad is almost 65 but will most likely have to keep working as he didn’t make sound financial decisions regarding his retirement.
Thanks for sharing!
80% represents a decent starting point, and as a back of envelope calculation seems to assume pre-retirement savings of 12% or so, and 7.5% FICA.
Ironically, the more one saves, the less they’ll need at retirement.
The first year after our daughter was born, our income went 20% to the mortgage (not bad) 20% to retirement savings, and 20% to child care and college savings. We were living on a pretty small slice of our gross and figured that the 80% replacement rate was far higher than we’d really need. The plan is to have that mortgage paid a year before college starts, and college fully funded when she goes into freshman year.
Your point about the statistical fallacy of comparing a current 75 year old to a current 45 year old is excellent. Too many statistics are tossed around and not questions. Nice piece.
JoeTaxpayer´s last blog ..More on Estate Planning
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