By: Joseph Goldy, AAMS®
For someone saving toward retirement, one of the most fundamental questions is, “How much of my preretirement income will need to be replaced once I am no longer working?”. Determining an accurate answer to this question is essential because it is directly linked to another critical question, which is, “How much should I be saving?”. Using a one size fits all approach to answering these questions could be detrimental to your financial plan since everyone’s situation is unique.
Additionally, having a good handle on your savings rate has taken on even greater significance in recent years. Many companies have shifted away from Defined Benefit pension plans toward Defined Contribution profit-sharing plans, where more responsibility for planning shifts to the employee and away from the employer.
Rules of Thumb for Determining Your Income Replacement Rate
There are many rules of thumb when it comes to trying to find a reasonable income replacement rate. However, due to the variance in a person’s or family’s situation, rules of thumb tend to be insufficient and could cause someone to easily under or overestimate their savings needs and income replacement rate.
Tax brackets, family size, lifestyle expectations, health, and career trajectory are just some of the variables that feed into the income replacement equation.
Rather than relying on a generic approach, working with your financial advisor to analyze your current spending, and what that would look like on day one of retirement takes a more thoughtful approach and will likely provide the best chance of success.
2-Steps to Determine Your Income Replacement Rate
According to a 2013 paper by Marlena I. Lee, PhD and Vice President of Dimensional Fund Advisors, determining your income replacement rate can be broken down into two steps.
Step one: begin with estimating your spending needs. Once an accurate picture of cash flow is formed, you calculate your savings rate to support that spending need once in retirement.
In her paper, Dr. Lee looks at a common misconception that people should target the same level of preretirement spending as they enter retirement to maintain their lifestyle. However, a more accurate way to view this is to aim for the same living standard since some costs may decline or go away in retirement, such as paying less in taxes or a mortgage being paid off.
When Dr. Lee looked at spending patterns in retirement, there were some notable findings. Despite median nondurable spending declining with age, discretionary spending, and healthcare increased across all income quartiles. The overall decline in spending is attributed to mortgages being paid off, as mentioned earlier, along with costs associated with working, such as clothing, commuting, and office expenses, no longer being paid. All these variables factor into a household’s spending picture and must be analyzed carefully since each is unique to the person or family situation.
Step Two: Ascertain the savings rate needed to achieve your goals and lifestyle expectations in retirement.
As with determining one’s spending, many factors go into figuring a person’s savings rate.
Age, risk tolerance, current financial situation, career, retirement account mix, and family longevity are only some of the variables looked at to create a clear savings goal.
Studies have also shown that high-income earners require more of their retirement income to come from personal savings than low to middle-income earners. This disparity is expected since social security is replacing a smaller overall percentage of retirement income for higher earners.
Moreover, since lower-income earners are already spending a higher portion of income on necessities preretirement, there is less of a spending decline seen in retirement due to less “excess” that can be reduced. The chart below highlights this disparity.
Determining your income replacement rate in retirement will be very tailored to your specific situation, lifestyle, and goals. Dr. Lee’s research pointed to income replacement rates that ranged from mid 50% of income for higher earners to low 80% for people in the lowest income quartile.
The earlier you can determine the level of spending that will get you to the standard of living your targeting in retirement, the better.
Once your spending needs are determined, then quantifying your savings rate to get you to where you need to be at retirement is the second step in the process. After working through this exercise, you will have a clear picture of the amount you will need in retirement and what it will realistically take to get there.
Author’s Bio
Joseph Goldy, CFP®, is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ at Highland Financial Advisors, LLC, a fee-only fiduciary wealth advisory firm based in Wayne, New Jersey.
Joe specializes in working with newly independent women because of divorce or losing a spouse. He understands firsthand the value of having a clear financial picture pre- and post-divorce and a plan to restate goals as a single person. When he is not helping clients, Joe enjoys spending time with his two sons outdoors and volunteering to help raise money for Type 1 diabetes organizations.