This first blog of a two-part series about retirement readiness looks at the rule-of-thumb numbers cited as guidelines for income replacement in retirement. Part 2 will discuss how adequately 401(k)s and Social Security will meet those target numbers.
The oft-cited figure of 70% likely sounds familiar as the default guideline for preretirement income replacement. But how helpful is it for retirement planning purposes? Let’s look at different approaches to evaluating retirement income needs to find out.
The origin and adequacy of 70%
The 70% figure apparently derives from ongoing studies of retiree spending habits conducted by global consulting firm Aon. The 30% reduction from preretirement income level reflects elimination of many expenditures workers incur during their careers— for example, saving for retirement or childrearing expenses. In addition, FICA taxes don’t apply to retirement income, and federal and state (if applicable) taxes are typically reduced in retirement.
While a few estimates are lower than 70%, more often they’re higher — a few equaling or exceeding 100% of income. Several studies urge raising the target percentage beyond 70%, if affordable, for three basic reasons:
1. People tend to underestimate how much they’ll spend in retirement.
2. Detours can happen on the way to retirement — for example, layoffs or market crashes.
3. The need for more income for retirees who intend to pursue expensive activities such as travel.
Higher or lower?
While a study by the Employee Benefit Research Institute found that household expenditures generally decline later in life, retirement outlays can vary widely depending on many factors, including:
- The degree to which retirement lifestyle mirrors lifestyle while working.
- The amount saved for retirement and college expenses.
- Mortgage or other debt upon retirement.
- Availability of employer-provided medical coverage in retirement.
- Career earnings amount.
More personalized approaches suggest first zeroing in on the amount of Social Security benefits based on earnings (and when benefits will begin) and pension amount, if applicable. Savings, including 401(k) accounts, will have to fund the rest of the retirement income. Some financial planners offer a different take, maintaining that retirees need savings of at least 10 times their annual income to live comfortably.
But alternative methods for estimating retirement income needs do share some common ground, including:
- Starting early. An early start means compound interest could decrease the amount of savings needed monthly.
- Evaluating expenses. Estimating anticipated outgo is as important as estimating income.
- Consulting a financial advisor. A skilled financial advisor can review individual situations, set interim savings targets and help evaluate progress.
As a practical matter, though, the one-size-fits-all income replacement percentage won’t fit many retirees because so many personal variables — current age, life expectancy, earnings and intended retirement age, for example — must be factored in.
Invesco is not affiliated with Aon.
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