Retirement planning literature has several commonly referenced rules of thumb. In my experience in helping clients plan for retirement and successfully manage their financial lives throughout their retirement years, I have found most rules of thumb apply only by chance. Even if the rules were right on average, that would imply they are right about half the time and wrong the other half. Would you like a 50% chance that you will get your retirement spending right?
The rule states that you should calculate your retirement income goal based on replacing 80% of your pre-retirement income. For example, suppose you earned $100,000 right before you retire. You need $80,000 in the first year of retirement, increasing with inflation thereafter. The reasoning the need is generally less than 100% is because you are no longer contributing towards savings nor paying payroll taxes on income.
Problems with the Spending Rule
The goal of the rule is to have a level of spending into and throughout retirement consistent with your last year of work. Makes sense on the surface, right?
I will acknowledge that if you are an average income earner – only about $56K for a U.S. household in 2015 – this rule is more likely to be right. If you are the typical financial planning client I see and making much more than this, it likely does not apply for many reasons.
What if you have a mortgage that you carry into retirement but will stop in just five or ten years when your retirement may last 30 years or more? How do you adjust for that? What if you have one-time or infrequent lump-sum expenses attached to retirement goals like paying for your daughter’s wedding, buying that dream car, or making a large home repair or improvement?
What if you plan to downsize your home to something less expense? What if you intend go the other way and buy a second home? What if that second home is in Florida and you change residency to have no state income taxes?
What if you earn a lot of money and are saving 25% or more of your income and are in a much higher tax bracket today than in retirement? What if you have money not just in tax-deferred accounts like IRAs and 401ks but also in Roth IRAs or non-qualified accounts that will not be taxable like the tax-deferred accounts? These questions should show the problems of this rule.
Perhaps more importantly, studies from the Bureau of Labor Statistics and others generally show that inflation-adjusted spending (called “real dollars”) declines throughout retirement. So, even if you need $80,000 in year 1 of retirement at age 62, perhaps at age 75 you only need $75,000 in real dollars.
Spending tends to increase for healthcare and is generally constant for housing-related expenses. However, declines from the categories of education, entertainment, food and beverage, and transportation tend to be greater than offsetting healthcare increases. This phenomenon surprises many.
A Better Approach For Retirement Spending
A better approach is to fully understand and document your current lifestyle expenses. Some expenses are essential and others more discretionary. This distinction is important. As you stress test your retirement plan, you need assurance that, at minimum, your essentials are covered even if you may have to cut back on discretionary items. Then you adjust how your spending will likely change in retirement based on your unique goals and as you age.
High-income retirees may not experience a decline in real spending. Yet, the character of their spending often changes – more goes to discretionary items such as charitable donations and gifts to family. With the benefit of hindsight, these high-income retirees can afford to do more for others while not sacrificing their own long-term financial health.
Separately from your long-term retirement plan projection, you should have a yearly distribution plan specifying amounts required from your portfolio, what account(s) money will be pulled from, as well as the expected income tax for the year. After the year, you then check actuals vs. what was projected. Variances will happen. Yet, if spending is consistently higher or lower, then spending goals should be adjusted accordingly. You should repeat this process each year to ensure you stay on track and to execute proper tax planning, saving money on taxes.
The bottom line? The rule falls woefully short for most and is no substitute for having a well thought out plan to make your money last your lifetime.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent registered investment advisory and wealth management firm specializing in retirement, tax, and investment planning.