There was a day when retirement was synonymous with shuffleboard and early bird suppers. That day is done. In fact, a growing number of Americans are planning to maximize travel, adventures, and new activities—realizing some of the dreams they didn’t have time for between work, kids, and all the rest of it. Retirement is being redefined, and that has big implications for retirement planning.
“Today, someone who is considering how much to save now and how much to spend when they are done working has to consider a lot of trade-offs,” says Steve Devaney, director of financial solutions in Fidelity Strategic Advisers. “People increasingly expect to be more active, but that has implications for the amount of money they will need. In addition, many people are failing to factor in health care costs—the result is that we need to look beyond the conventional wisdom to find the right retirement plan for each individual’s situation.”
The key to building a realistic retirement plan is figuring out how much you are going to spend after you stop working. One method used to describe this need is to estimate the percentage of the after-tax income you lived on while working that you will spend each year in retirement.
The challenge is that research shows people who are working have a hard time estimating the expenses they will see in retirement. Our rule of thumb is that most people can expect to spend about 85% of their after-tax working income in retirement. For example, a woman who earned a salary of $50,000 before she retired was living on $42,500 after taxes (assuming a 15% effective tax rate). So, if she needed 85% of the income she had before retirement, she would need to generate $36,125 after taxes each year in retirement.
The 85% income replacement rate is just a starting point—each individual’s circumstances and planning assumptions could cause this replacement percentage to be significantly higher or lower. That’s why it is so important to get a sense of how your personal situation will affect your income needs, and why it may be beneficial for individuals to perform a budgeting exercise as they approach retirement. (Try our “Retirement income needs” widget below.)
“Most people see their standard of living increase throughout their working lives, and look to at least maintain that in retirement,” says Steve Feinschreiber, senior vice president in Fidelity Strategic Advisers. “Determining the amount of income they will need, expressed as a percentage of their after-tax preretirement income, is the first step in creating a plan to achieve that lifestyle goal. Once you estimate what you are likely to need to spend, you can make some assumptions about your likely investment returns and how long you will be living in retirement, and figure out what amount you need to have saved when you retire. With that savings goal in mind, you can estimate how long you will work and the returns you can generate on your savings to calculate how much you need to put away now.”
Retirees spend a lot less on housing and a lot more on health care
When it comes to planning your future income needs, one of the big factors to consider is your current income. In general, the more money you make, the smaller a percentage of your working income you may need to replace when you stop working. For example, a person making less than $50,000 a year might need to replace 90% of his or her preretirement income on average when in retirement, while someone making more than $200,000 may need only 60%. One big reason for that has to do with taxes. Higher-income households generally see their tax rates fall dramatically in retirement, more so than lower-income households do.
“Higher-income earners use less of their income for essential expenses and more of their income for savings and discretionary purchases—that gives them the flexibility to reduce their income more in retirement than lower-income households can,” says Devaney. “For someone looking to get a sense of what they need, it makes sense to look beyond the 85% starting point, factor in income, and adjust their likely replacement rate. That might make planning more useful.”
But beyond income, there are a few key spending categories to consider. For one, most working people save a significant amount of money for retirement, especially during their last years of work. Obviously, that’s a major expense some people eliminate as they move into retirement. For many others, college for their children is taken care of, the mortgage may be paid off or the home sold for a new low-cost residence, and any work-related expenses may disappear.
That should free up a lot of cash, right? Well, on the other side of the ledger come increased expenses, most notably health care costs. Health care costs are frequently underestimated—but Fidelity figures that on average they could reach more than $220,000 for a couple over the course of retirement.1 For planning purposes, you may want to factor in an even higher number, because many people experience above-average expenses, particularly if they live longer than today’s average life expectancy or incur long-term care costs, factors that are not reflected in the estimate. Data from the Bureau of Labor Statistics suggest that spending on health care increases by 25% during the first decade after age 65—even while overall spending drops.2
If you have a chronic health condition or, because of your family history, you suspect that you will need to deal with one—that will drive expenses even higher. In general, the more health issues you expect, the higher the replacement rate you may want to work into your plans. For example, Fidelity estimates an active individual with income around $80,000 who expects to have five chronic conditions during retirement and needs five prescription medications may have an income replacement ratio of 102% of his or her preretirement income each year, while the same person in excellent health might need just 82% (see the interactive chart disclosures for more details).
The lifestyle factor
Lifestyle is another big factor here. Each individual will make trade-offs and choices about how he or she wants to live after working. Some might choose activities that are relatively easy on the wallet, such as spending more time with grandkids, or gardening. But increasingly people want to tap into their savings to create a more active lifestyle that includes travel, adventure, and new activities.
These decisions have a big impact on the bottom line. For jet setters who plan to see the world or take up new activities, expect to ratchet up your income replacement rate significantly. For those preparing to enjoy the simple life, this number may be significantly lower. Consider, for example, a person in good health who earned $100,000 a year before retiring, but plans to travel for two months each year during the first five to seven years of retirement—roughly quadrupling their preretirement travel spending. Our research suggests they may want to ratchet up their replacement ratio by six percentage points compared with a less active lifestyle—a difference that would equate to tens of thousands of dollars in savings at the time of retirement.
“We often hear about people who are worried about the market taking a chunk of their savings in the first few years after they stop working. What they may not realize is that their own travel plans could eat up just as much of their savings,” says Devaney.
Setting your number
The 85% rule is a good jumping-off point, and using income, anticipated lifestyle, and health expectations to modify that can help you generate an even more relevant estimate of retirement expenses. Still, before you really retire, you may want to dig into your own budget and see what you think. Once you know the goal, you can make a plan to get there.