The transition from retirement saver to retirement spender can be overwhelming. A life spent earning income, deferring taxes and accumulating invested assets quickly changes to life on a fixed income — Social Security, a pension or 401k, portfolio withdrawals. Add in the market volatility associated with your investments and uncertainty about things like medical costs and life expectancy, and the transition can prove more than you care to deal with.
While most invest and save diligently during their working years, few understand what percentage of their gross income they’ll need as a retiree. Most retirees want to maintain the standard of living that they’ve become accustomed to, but as with many things, retirement changes how this is calculated. To effectively plan for retirement, it is important to ascertain what your spending needs are likely to be; and to do so we have only existing data to work with.
One common way to approach our calculation is to use a “replacement ratio,” which is based on the percentage of your pre-retirement gross income you’ll need to support your desired retirement lifestyle. Many retirees require significantly less income because:
- They fall into a lower tax bracket since they are not earning income.
- They no longer put aside money for retirement.
- They can eliminate job-related expenses like work clothing, gas for commuting, etc.
But while some expenses will be reduced or eliminated, you should plan for others, like travel and leisure spending, to increase.
Recently, Dimensional Fund Advisors (DFA), a provider of investment funds, published data for median replacement ratios based on pre-retirement income range:
In most instances, the higher a retiree’s pre-retirement income, the lower the expected replacement ratio. Social Security and retirement plan incomes will tend to fulfill a higher percentage of retirement income needs for lower career-earnings individuals, while investment portfolios are typically relied on more heavily for those with higher pre-retirement incomes.
Note that the data from the DFA study is designed to illustrate median replacement rates. Most importantly, the replacement ratio methodology for determining retirement income needs is merely a starting point to assess an individual’s ability to retire. Each individual retiree’s situation is unique and should be analyzed by a CFP® professional who can run a customized, retirement feasibility study.
The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. HBKS Wealth Advisors is not a legal or accounting firm, and does not render legal, accounting or tax advice. You should contact an attorney or CPA if you wish to receive legal, accounting or tax advice.