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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.