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When I was younger, I pictured retirement as a life much like our working years, minus child-raising and commuting costs, but with more travel and higher medical bills. That vision was easy. The harder part was translating it into a retirement income goal.
This is where confusion sets in, and why discussions about “income replacement ratios” often go in circles. People’s situations differ too widely for one-size-fits-all advice. Some work jobs with steady income, others have income which varies a lot each year. Some rent, some start retirement with a mortgage, some own homes outright (researchers factor “imputed rent” into replacement ratios). Some are big savers, others scrape by. Single vs. partnered, median vs. high income, pension vs. no pension—all change the math.
Even defining “base pay” is slippery. Should steady bonuses count? What about quarterly stock compensation that’s taxed like regular income? And which years of income do you use—your last, your peak five, or an average? Add to that some semantic confusion over whether base pay means gross or net of taxes, and you see the problem.
In fact, taxes complicate things further: effective tax rates are often lower in retirement, especially with Roth accounts, another way the replacement-rate metric might lead you astray.
After wrestling with all this, and gaining a few years of retirement hindsight, I’ve concluded the replacement-rate metric is more misleading than useful, unless your finances are unusually simple.
A better planning approach is bottom-up: go through a year of your actual expenses with Quicken, Mint, Excel, or your bank’s web site; adjust for what will rise or fall in retirement; be clear about fixed vs. discretionary; add a cushion for surprises. That spending target gives you a far more practical goal than chasing an abstract ratio.
After being retired for 10 years, I looked back. I made numerous calculations, some saying 80% of your earnings was the right amount to calculate your future. There is no easy way, and the numbers will change from whatever you calculate, as no one has a crystal ball. If possible, I suggest 100% of your average of your last 10 years. Work as long as long as you can to build up equity. Key, remain flexible, if you do not have the money cut back, if you have more than calculated, take a cruise. There are many pieces to this puzzle, be reasonable and all will work out.
Thanks David. I have been retired, essentially, since the pandemic hit. The bottoms up approach of knowing your expenses was the only thing I considered when adapting to a retirement that was sort of foisted on me. If you are a homeowner and retired, you must have a contingency fund set aside for all the additional, capital expenses a home generates. Since I retired in March, 2020, I’ve had to put on a new roof, replace my entire HVAC system, completely redo my pool (I live in a hot climate), replace my dishwasher, glass stove top, combo oven/microwave, repaint the interior of the home, replace an old car, etc. I can’t imagine being retired without the ability to pay for all these things with cash. Thus, retired homeowners have to plan for these expenses or face a retirement that disappoints.
Thanks for the post. I have three recommendations:
Don’t start until you reach age 50 or so,
Perform an individual calculation, and
The target should be at least continuation of the pre-retirement stream of income (take the average over the last three or so calendar years), net after taxes.
When we conducted pre-retirement planning seminars, I would create a confidential, individual, early retirement income replacement analysis for each participant – based solely on what I could see in HR/Benefits from their indicative data and benefits – their 401k savings rate, their 401k account balance paid in installments to match RMD (the RBD was age 70 1/2, but the tables go down to folks in their 50’s and below), their pension benefit, a guesstimated benefit from Social Security, the cost of retiree medical and retiree life insurance, etc. I leveraged their total rewards statement data as of the end of the prior calendar year (the RSVP authorized me to create the calculation).
If they were under age 55, I assumed they would continue their employment until becoming eligible for an immediately payable pension benefit and retiree medical and life. If they were under age 62 (most were), I used the pension plan’s level income feature to bridge them until reaching eligibility for SS benefits.
Those who had saved/were saving, who had 25 or more years of service and participation in the 401k, were almost all on track for a replacement rate sufficient to squeak by in early retirement.
The analysis had many disclaimers – three important ones were:
Most everyone was age 50+ when they attended the retirement preparation seminar, and many had a goal of retiring at the double nickel (55).
Most everyone who attended, kept working and many delayed retirement until the combination of Social Security and their defined benefit pension (without tapping into the 401k plan) was sufficient to maintain their pre-retirement standard of living (stream of net income, after taxes).
Today, at that same employer, the benefits remain generous, there is still a pension plan, but, not so much – folks would have to save for 35+ years, and defer retirement to their Social Security Full Retirement Age or later in order to be able to maintain their pre-retirement standard of living (stream of net income, after taxes) using only the pension benefit and Social Security.
You make some good points David.
One thing that is difficult for homeowners is irregular, but large expenses like replacing the roof or HVAC. They do not happen often, but can have a large impact on your budget.
One other thing I found is larger dental expenses like root canals and crown replacements which happen too often for me.
I live on a 2 acre heavily wooded lot. I have many large and beautiful trees. Trees are like people. They get sick and die, and it is very expensive to remove them. This is unique to people like me, but everyone has some type of expensive issues they must deal with in retirement. A cookie cutter approach does not work.
We ran into $8,000, in dental plus taking down two large trees. Life in retirement is not all that different, stuff happens which is why I harp on good income replacement, an additional emergency fund and ongoing saving to replenish it.
I just can’t see how anyone can retire on say 70% replace and still deal with the events of life unless they have a large stash of cash in addition to retirement income generating investments.
That would depend on how high your income was and how much you were saving. If you were making $500K, and saving $200K, you could probably live pretty easily on $350K. But if you were making $100K and saving $10K, then you might get into trouble. However, if you stop saving, no longer have to pay FICA, and get favorable tax treatment on your retirement income, you will probably close to even.
The real world is more like a household earning under $80,000, modest, if any savings. Likely not taking advantage of Roths.
Roths were too late for me. All my income except dividends is taxed as ordinary income. We never stopped saving between 529 plans, gifts and building up and keeping emergency funds.
I think retirement planning should be based on your actual spending, not your peak income. The goal isn’t to replace what you earned, it’s to replace what you spent. If you consumed 100% of your income while working, then yes, you’d need to replace all of it. But in my case, for example, earnings far exceeded my spending needs. If I’d tried to replace my entire income, I probably never could have retired. Having a large cash reserve is also imperative.
Never suggested replacing all income. My total compensation (income) during the last five years before retirement was more than fifty percent stock awards and bonuses. The stock, of course, was not cash. Before the five years it was salary only.
None of that incentive pay was used for living expenses. It was saved or on a couple of occasions used for a one time expense.
So, my salary was what drove all spending and lifestyle. Thus, salary less taxes, less saving (10%) equaled spending (lifestyle).
I just didn’t see the need for more detail. I had the answers I needed.
I did not anticipate nor did it happen that expenses (spending) would decline in retirement. Different, but not less including discretionary spending. I still pay taxes, my health premiums went from $197 a month to over $2,000.
Absolutely. If I had waited to retire until I could replace all my income I would likely still be working. Oh, wait, ageism would probably have stopped that. Fortunately, retiring the mortgage, stopping saving and seeing my tax bill plummet meant I needed much less than my final year’s salary to support my lifestyle. I would have missed fifteen years of travel, too.
Say your annual income, in peak earning years before retirement, was regularly high six figures or seven figures, and you’d learned to stop moving the lifestyle goal posts, you’d safely and happily live on a lot less than 70% while still saving in retirement.
People with pensions have a replacement rate 20 percentage points higher on average than those without, but only roughly 15% of private sector employees today have one. People’s income and life circumstances can be so very different.
Dental expenses, yikes! I’ve had clients with $30K worth of dental expenses. You’re right, all those things are hard to budget for.
You’re not alone. We’ve not yet hit expensive dental work — hope you’re out of the woods with that. But I know what you mean about the cost of tree work — pruning or removal. We had a powerful storm last November which took down dozens of trees across our town, known for its trees. Power was out for a week. Cleanup costs were not cheap.
David, I don’t yet have your experience, but I’m sure you’re right. We could think about approaching the money side of retirement the same way we would any large purchase: After shopping for style, color and so on, we’d eventually want to know the price. As you state, the cost of retirement is our actual expenses. From there, we can work out how robust our savings need to be to handle the price. During our working years, we can even back up the calculations to include a target savings rate, using a retirement calculator.
Still, I do understand wanting to have an idea of how much spending pressure our assets will bear. Adam Grossman spoke to this as part of a recent article. That might be a way reassure ourselves that our plan is safe. The other, that I favor, is being another one that keeps the withdrawal rate on the low side.
I think either bottoms up or income replacement planning can work. We employed bottoms up towards the end of our working days. One has to be very honest about what future expenses are likely to be; low balling expenses could land you in big trouble.
When I was working on our retirement needs/budget in the last few years before Spouse retired, I thought the same as Jack. We are naturally frugal and had been living on much less than what was coming in. So I thought we could live on that much in retirement with our various sources of income. So far things have worked out even better than I thought they would financially. The bottom up approach was a good one.
I did also want to comment on what you said, David, about what you thought retirement would be. I thought the same as you, that it would be more fun and travel, but it has not. I am hoping next year will be better, but know we will still have our sandwich generation life. Hopefully Spouse’s mom will be in assisted living soon. So far retirement is not what I thought it would be. Chris
Chris, there’s been plenty of sandwich life here, too. Wishing you strength and peace through the lows of it. Eventually the clouds part and the sun comes out.
I like your approach. We knew how much after-tax cash we consumed annually for 5 years prior to retirement. Not surprisingly, it increased a bit each of those years. Our goal was to fund our annual budget for the first year in retirement with the same amount we had used in the year immediately beforehand, adjusted for inflation. It was straight forward to calculate the amount needed to withdraw each year, which when combined with SSA benefits, and after subtracting taxes would produce that amount of cash. While many use some version of the “4%” method to determine the amount to withdraw, we chose 3% to provide a margin of safety. We divided the needed amount by 0.03 to reveal our “Number”.
It was the amount of after-tax cash required to continue to fund our annual budget, once retired, which we sought to replicate, not some particular percentage of our salary. We can easily calculate what that percentage is, but we derived the amount we needed instead. While we now spend proportionately more on some things, less on others, my reasoning was that we ought to be able to live on what we had been living on before, adjusting for inflation, of course.
I meant to write “margin of safety”, not error.
That’s our plan, too, Jack, keeping it under 3%. Life’s surprising.
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Thanks for the editing tip.
In my opinion, bottom-up is the only possible way of working out your retirement consumption needs. Income replacement ratios are a poor substitute. It’s the difference between a bespoke, tailored suit and an off-the-peg one from a discount retailer. Sure, as a sanity check you might try on an off-the-peg suit to check out the style before going all in on the bespoke. The stakes are just an order of magnitude more serious: a poor suit ruining your look versus a poor plan ruining your retirement.
Unless there is a significant known, guaranteed reduction in spending upon retirement – like no mortgage or major decrease in saving, why would spending be less? Different, perhaps but not significantly less?
So, if you live on your net income, don’t you know what net income you still need? What is so complicated?
Base pay or salary is pretty clear unless you are self employed. A steady bonus is not really a bonus is it, but in any case if any compensation is regularly used for a standard of living related to ongoing expenses it needs to be counted. We never used none base salary for ongoing expenses even though compensation beyond base salary was often more than 50% of total income, but that is not typical.
As as been explained to you many times – you effectively use net income as a proxy for budget (because you hate the latter word). But for most people net income isn’t the same as what their spend requirements are because they will have been saving, paying now redeemed debt etc. And on the flipside perhaps they have deferred capital projects or relocation or increased travel ambitions to fund.
Then there is the other issue of constructing net income from a variety of sources with different tax treatments. It certainly won’t be the same as drawing the equivalent gross employment income.
You propose simplicity but a considered bottom up approach beats a clumsy replace gross income approach not least because of the years of life it possibly frees up to those not wedded to their jobs.