Do You Know How Much Retirement Income You’ll Need?

Bob French, CFA

by Bob French, CFA

October 13, 2016

The following piece is by Bob French, who serves as Director of Retirement Research at McLean Asset Management.

Everyone wants to live comfortably when they retire. But what does that actually look like?

For most people, it means whatever Social Security and their portfolio can support when they get around to retiring. What they get in retirement just sort of happens.

But retirement shouldn’t “just happen.” Retirement should be whatever you want to make of it. To do this, you need a financial plan and specific retirement spending goals. Without these goals, you’re just throwing money at your portfolio (though that’s at least better than not throwing money at your portfolio).

Pinning down realistic spending goals for retirement is far easier said than done. Most people have no idea what they want to spend in retirement, and they don’t even really know how to begin figuring it out. If that’s you, it’s completely normal. But there are a couple different ways to approach the problem.

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Budgeting Approach

The first approach is the budgeting approach, in which you figure out a rough estimate of how much everything you want to do will cost and then shoot for that income (plus a little extra to be safe). This approach allows a good deal of precision in estimating your retirement income needs, but you need to have a very clear idea of what you want retirement to look like.

You don’t necessarily need to know exactly what your grocery bill will add up to when you are 74, but you should know what the big ticket items will be: Are you going to take up hang gliding? Go on tour with Phish? Or spend your days doing crosswords and sipping lemonade?

Budgeting also allows you to account for changes in spending over time. As you get older, you’ll probably be spending more time with the lemonade than your hang glider (and only going to the Phish shows that are close to you).

Replacement Ratio Approach

But most people under the age of 60 can’t map out what retirement will look like with much clarity. Of course you want to maintain your standard of living and spend time with your grandkids, but the details are still pretty fuzzy.

In that case, you can use a technique called the “Replacement Ratio,” which allows you to base your retirement income goals off your pre-retirement income.

There’s no universal answer here. Everyone’s ideal replacement ratio will be different, because all of us spend differently.

But one of the nice things about retirement is that you generally don’t need to spend as much as when you were working. You don’t have the same dry cleaning bills, you don’t need to pay for your commute anymore, and (a big one that most people forget about) you don’t need to save for retirement anymore.

Marlena Lee over at Dimensional Fund Advisors has done some really interesting research looking at both what people’s replacement ratios “should” be and what that means for how much their portfolios will need to support. As you can imagine, this looks different depending on your pre-retirement income.

Pre-Retirement Income Percentile
< 25th 25th – 50th 50th – 75th > 75th
Replacement Ratio 82% 72% 62% 58%
Percent of Income Replaced by Social Security 59% 38% 31% 21%
Percent of Income Replaced by Investment Portfolio 23% 34% 31% 37%

Data for illustration purposes only.

One of the interesting results is that even though people with higher pre-retirement incomes have lower replacement ratios, they get proportionally less from Social Security, and need to generate a larger amount of their retirement income themselves.

This is just a guide, and a pretty rough one at that. When looking at the replacement ratio approach, ask yourself these two questions:

  1. How much of your income do you currently spend on things that you won’t need to pay for after retirement?
  2. Roughly how much more or less do you want to be able to spend in retirement compared to your pre-retirement spending?

You Need to Plan

There’s no right answer here. Everyone is different, and everyone wants different things out of retirement.

These two approaches are great tools for figuring out how much you’ll need in retirement. But however you do it, you need to have specific goals so that you know where you’re going. Without a goal there’s no way to know if you are on track – are you saving enough? Too much?

With a goal and a financial plan, you can actually know where you stand.

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