New retirees frequently rhapsodize about the joys of tossing their alarm clocks into the trash and filling their days with whatever activities they find gratifying. But most new retirees find the financial aspect of the retirement transition to be a little jarring.
While retirees are often counseled to estimate that they’ll spend 75 percent to 80 percent of their working incomes in retirement, a paper by David Blanchett, formerly of Morningstar and now at PGIM, found that higher-income, higher-saving households may need just 60 percent, or even less, of their preretirement income during retirement, while lower-earning, lower-saving households may need closer to 90 percent.
Here are the key steps to forecasting your actual income-replacement needs:
Step 1: Find a realistic baseline for your income.
If you’re close to retirement and seek to maintain a standard of living in retirement similar to what you had while you were working, using your current salary as a baseline is reasonable. But if you’re younger — say, in your 40s — it may be wise to nudge up your baseline income for retirement-planning purposes, because your current income may not be reflective of what you’ll want to spend when you eventually retire.
Not only are you apt to receive cost-of-living adjustments as the years go by, but career gains could also lead to a higher salary over time, which you may want to “replace” in retirement. As Blanchett noted in his paper, the average college-educated individual will make a 50 percent higher salary at retirement than he or she did at age 25. Gains in salary over time are less pronounced for people with lower levels of educational attainment.
Step 2: Subtract your savings rate.
Take a look at what percentage of your salary you’re saving — or expect to save by the time you retire —and subtract that from your baseline salary amount.
It’s typically easier for high-income individuals to save a greater percentage of their salaries during working years than low-income individuals. A household saving 20 percent of its income will see its income-replacement rate drop to 80 percent right out of the box, even without factoring in any lifestyle changes, such as downsizing homes.
Step 3: Subtract any tax reductions.
Because they’re no longer paying Social Security or Medicare taxes, many people realize tax savings when they retire. Those gained savings tend to be more pronounced for higher-income workers than lower-income ones. More-affluent households may see a bigger percentage drop in taxes in retirement than lower-income households because they have greater control over their taxable income now that they’re no longer earning a paycheck; the less they pull from their portfolios, the less they’re taxed on.
Step 4: Subtract anticipated housing-cost reductions.
Housing costs are another line item with the potential to change substantially in retirement. Is your plan to come into retirement without a mortgage, for example? Or perhaps you intend to relocate or downsize in some fashion? Even though the main goal of downsizing may be to add the home-sale proceeds to your retirement kitty, it can have the added effect of reducing property taxes and lowering outlays for insurance, utilities and maintenance. As a senior homeowner, you may also be able to qualify for a reduction in your property taxes, depending on where you live.
Step 5: Factor in lifestyle changes.
Retirement-planning guides often urge retirees to factor in changes in other expenses, such as commuting, clothes for work, and meals out while on the job or due to busy work schedules.
Don’t assume a reduction in lifestyle-related expenses in retirement without crunching the numbers. A heavy travel schedule or an expensive hobby or other expenditures could offset cost reductions on line items like food.
Step 6: Add higher health care costs.
Health care is one major area where retirees are likely to see an increase in expenses. A recent Fidelity study showed that the average lifetime out-of-pocket health care outlay for a 65-year-old retiring today would be nearly $160,000, and that figure doesn’t include long-term-care expenditures.
Higher health care costs later in life are the key factor in what Blanchett calls “The Retirement Spending Smile.” That’s the tendency for household expenses to be on the high side just after retirement, dip in mid-retirement and then head back up toward the end of life as health care costs increase for some older adults.
