New retirees often celebrate the freedom of leaving behind the grind of waking up early to an alarm clock, savoring the ability to engage in activities that truly bring them joy. However, many soon realize that the financial changes accompanying retirement can come as a bit of a shock.
Although it is commonly recommended that retirees plan to live on 75% to 80% of their pre-retirement income, research by David Blanchett, a financial expert formerly with Morningstar, indicates that those with higher income and savings can manage with only 60% or even less. In contrast, families with lower earnings and savings may require nearly 90% of their previous income for a comfortable retirement.
Forecasting your personal income needs in retirement can be challenging, so here’s a breakdown of essential steps to take during the planning phase:
Step 1: Establish a practical baseline for your income.
For those nearing retirement, using your current salary as a guide makes sense if your goal is to maintain a similar lifestyle. However, younger individuals, particularly those in their 40s, might want to raise their baseline to better reflect future spending desires. Factors such as cost-of-living increases and possible promotions can significantly impact your earnings over time. As studied by Blanchett, individuals with a college education often earn 50% more upon retirement than their earnings at age 25, a trend that tends to differ with varying educational backgrounds.
Step 2: Account for your savings rate.
Evaluate the portion of your salary that you are currently saving or hope to save by retirement and deduct that from your baseline income. Generally, individuals with higher incomes are able to save more effectively than those with lower incomes. For example, if a household saves 20% of its income, this would reduce their effective income replacement rate to 80%, even before considering lifestyle alterations such as downsizing their home. If retirement is still a few years away, an increase in income may allow for a raised savings rate.
Step 3: Adjust for tax reductions.
Upon retirement, many individuals notice tax savings, particularly from the elimination of Social Security and Medicare taxes. This effect is typically more pronounced for higher-income earners who can control their taxable income better once they stop receiving a paycheck; they can mitigate their tax burdens by withdrawing less from their sources of income.
Step 4: Consider housing-cost adjustments.
Housing expenses can greatly vary in retirement. Do you plan to retire mortgage-free? Or perhaps you intend to move somewhere more affordable? Downsizing can yield extra cash from home sales and reduce costs related to property taxes, insurance, utilities, and maintenance. Depending on where you live, seniors may also qualify for property tax reductions.
Step 5: Assess lifestyle changes.
Retirement planning often includes analyzing shifts in expenses such as commuting costs, work attire, and dining out due to busier schedules. While some individuals may experience minor changes, others could see significant expenses shift. It’s important to avoid assuming reductions in lifestyle expenses without thoroughly reviewing your budget, as frequent travel or expensive hobbies can offset savings on typical expenditures such as food.
Step 6: Include potential health care costs.
Healthcare expenditures frequently rise in retirement and are a primary component of what is referred to as “The Retirement Spending Smile,” a concept coined by Blanchett. This phenomenon describes how expenses tend to be higher soon after retirement, decrease during mid-retirement, and then increase again as health costs rise. A Fidelity study indicates that an average 65-year-old today may face nearly $160,000 in lifetime out-of-pocket healthcare costs, not factoring in long-term care costs.
Step 7: Incorporate a safety margin.
As you analyze your expenses through these steps, keep in mind that there will always be unforeseen spending needs in retirement. Unexpected expenses, such as home repairs or assisting family members financially, can arise. Therefore, it may be smart to slightly increase your income-replacement rate to accommodate these potential fluctuations in your financial situation.
By following these guidelines, you can better prepare for a financially secure retirement that appropriately meets your future needs.
