How much retirement income is enough is the most important question facing anyone trying to plan for retirement.
Many people want to know if they can maintain the same lifestyle as when they were working. If you go back to and listen to episode number 23 (7 most common retirement dreams), you will find that this is dream number one.
There are two ways to figure it out.
- Figure out living expenses:
The first and most reliable way, and the way I suggest for anyone getting very close to retirement is to figure out your expenses and adjust these expenses for inflation.
Since the majority of people do not have a budget or spending plan, there is another way to dial in. We call this the replacement rate.
- Income replacement rate:
What percent of preretirement income is needed to sustain your current lifestyle? It depends on how much you earn right before you retire. Let’s use Mark as an example. Mark earns $75,000 per year. The money he earns goes towards saving, taxes and spending. When Mark retires he no longer will be saving for retirement, will pay less in taxes. His spending also decreases since the kids may have moved out, and more time to shop for deals or cook at home. Mark might only need 65% of his $75,000 to live the same lifestyle as when he was still working.
This decrease in spending is well documented in studies the last 40 years. When we dig into the data, these spending declines depend on your income. Steepest declines happen with higher incomes, and this directly impacts the replacement rate.
Laura earns $100,000 per year. She saves at a higher rate than Mark, pays more in taxes and has more spending. When Laura retirees, her replacement rate may only be 50%. The study separated high earners ($100,000 and over), middle earners ($50,000 to $100,000) and low earners (under $50,000). The replacement rate is 50% for high earners, 65% for middle earners and 80% for low earners. Low earners are the highest because the spend more on necessities before and after retirement.
So once you find out your replacement rate, you need to figure out how to fund it. The good news for is social security has the greatest impact on low earners. For high earners, most of their retirement need to come from savings such as 401(k), IRA, and savings accounts.
Why is it important for households to think about their replacement rate? Having a goal is the very first step when deciding how much you need to save to have a successful retirement.
What is your income replacement rate?
