I always hear you need to replace 70% of your pre-retirement income in retirement. But now that I'm getting close to retirement, my income is a lot lower than it was earlier in my career, although my lifestyle hasn't changed much as I've always lived pretty simply. So should I figure I'll need 70% of my earlier, higher income or 70% of my more recent, lower income once I retire?--J.S.
The rule of thumb you're referring to stems from "replacement ratios" -- or the percentage of pre-retirement income you need to replace in retirement to maintain the standard of living you enjoyed during your career -- that have been calculated over the years by researchers at Georgia State University and professional services firm Aon. The replacement percentages are based largely on household spending data from the Department of Labor's Consumer Expenditure Survey.
Although the 70% figure you mention is often cited -- indeed, some people refer to "the 70% rule" -- the research shows the replacement ratio may actually be more in the neighborhood of 80% for many retirees, and upwards of 90% or so for those with very low or very high incomes (although Social Security will provide the bulk of the retirement income for low-earners, while high-earners will have to rely more heavily on savings).
But while these percentages can be useful for planning purposes when retirement is decades down the road, you don't want to rely on them as much when you're within, say, five to ten years of retiring. At that point, you ideally want to have a more accurate idea of what your retirement expenses might be and how much income you'll need to cover them.
All of which is to say that rather than applying 70% or any other percentage to either your current lower or previous higher income, you're better off doing an actual retirement budget once you're within shouting distance of calling it a career.
Related: How do you tell when it's the right time to retire?
There are a variety of ways you can create such a budget, but I think most people would be best served by revving up an online budget tool like BlackRock's Retirement Expense Worksheet. Aside from the fact that it's pretty comprehensive -- it allows you to enter several dozen expense items in eight broad spending categories -- the tool also helps you see how much of your spending goes toward essentials (food, housing, health care, etc.) vs. discretionary expenditures (entertainment, dining out, charitable donations, etc.). Knowing that breakdown will give you a better idea of how much flexibility you have for cutting back expenses should you need to at some point in retirement to avoid outliving your nest egg.
Even with this approach, you won't be able to pin down your future retirement costs or income needs to the penny. Still, it's important that you try to be as accurate as you can, as research shows many people get it wrong. For example, more than a quarter of retirees polled for a recent LIMRA Secure Retirement Institute survey said their basic living expenses in retirement were higher than they anticipated prior to retiring.
And when it comes to health care, one of the hardest retirement expenses to get a handle on, half the retirees in a new Wells Fargo study said they were paying more than they expected.
Once you have a reasonable sense of what your retirement expenses might be, you'll then want to see whether you're actually on track to be able to retire when you'd like. To do that, you can go to a retirement income calculator that uses Monte Carlo simulations, which can estimate your chances of being able to retire on schedule with enough income to cover your expenses for as long as you're likely to live without depleting your nest egg too soon.
By going through this process every year or so -- and refining your budget estimates as you gain more information about your spending needs -- you should be able to get a pretty decent picture of whether you'll have enough to retire at the age you plan or whether you might be better off scaling back your retirement lifestyle or even postponing retirement a bit so you can build a larger nest egg.
Related: 4 signs you're on track for retirement
One final note: As you go through this process, you should also consider how you plan to live after you retire. Will you maintain the simple lifestyle you say you've led most of your life, or maybe kick it up a notch or two to enjoy the fruits of years of saving and planning for retirement? Do you think you'll remain in your current home or downsize to something smaller and less expensive to maintain? The answers to such questions can have a direct impact on how you much you spend.
And while you're at it, take a look not just how much you'll spend but how you'll spend after you retire. New research shows that money spent on leisure activities such as dining out, travel and entertainment generally leads to higher levels of happiness among retirees. Clearly, it would be foolish to spend so much on leisure that you jeopardize your financial security. But as you're putting together your retirement budget, don't forget to factor in some spending that can increase your chances of having a more satisfying and rewarding retirement.
The bottom line, though, is that at this stage of retirement planning you need to move beyond replacement ratios and start putting some numbers together that reflect, as best you're able, how much you'll have to spend to live an acceptable lifestyle in retirement.
