Thursday, October 4, 2012

Estimating How Much Income You Need to Retire

Is 70% of your pre-retirement salary a good rule of thumb for estimating how much income you will need after you retire? How about 80%?

Though these are the guidelines frequently suggested by financial planners and writers, household income replacement ratios actually range from about 75% to about 95%, depending on how much you earn (see chart below created from a 2008 Aon Consulting  study). Oddly, the replacement ratio is highest when your household income is very low or very high, and lowest when you make $70,000 to $80,000. 

(Click any chart to enlarge.)

The replacement ratio is the percentage of your final working salary that you will need to maintain your standard of living in retirement. Once you stop working, that percent of your final salary will need to be replaced by Social Security benefits, personal retirement savings1 and other sources of income.2

Based on the Aon numbers, 70% and 80% of pre-retirement income are not good estimates. You can see from the chart above that 70% never seems to work and 80% only works between about $50,000 and $120,000 of income. Earn more or less and 80% can be way off.

So, should we replace the 70% and 80% rules of thumb with the Aon tables?

Here’s the thing. Replacement ratios by themselves aren’t very interesting. As soon as someone says that you will need to replace say, 85% of your pre-retirement income when you stop working, you’re going to ask, “OK, so how much of that will Social Security cover?”

Because that’s what you really want to know, isn’t it? How much is your shortfall, or the amount of retirement income you will need that isn’t covered by Social Security?

The Aon study estimates shortfalls, too, and Social Security benefits. It even estimates your retirement savings, because you don’t have to contribute to retirement savings after you retire. So, if you’re earning $60,000 a year before you retire and you’re savings $10,000 a year in a 401(k), you only need $50,000 to maintain your standard of living after you retire.
From Aon Consulting report 2008.

Shortfalls, or the percentage of your retirement income that will not be covered by Social Security benefits, are indicated by the lighter blue stacks labelled "Other Sources" in the chart above.

Both the Social Security benefit and retirement savings assumptions have dramatic impacts on the shortfall that you calculate. The Aon Consulting study uses the average savings rate for each range of income, but we know that the average retirement savings rate is a pretty useless statistic.

Half of Americans about to retire have no retirement savings at all. Mitt Romney, on the other hand, reportedly has an IRA worth somewhere between $20M and $100M, and there are no doubt other very large IRA's at most income levels that distort the averages. That's why the median retirement savings account balance is much lower than the average at most income levels.

Your household may save a lot more or a lot less than the average for households with your income and that can throw off rules of thumb and the Aon estimates by a lot.

Similarly, Social Security benefits can vary widely between two households with the same income. The Aon study assumes that the household consists of a one-earner couple that will retire at full retirement age. Such a couple with an income of $50,000 just before retiring would receive an estimated $25,295 per year in Social Security retirement benefits. This is the Aon base case.

But a single retiree earning $50,000 and electing to receive benefits at age 62, as the majority or claimants do, would receive just $12,276 a year, and a couple delaying benefits until age 70 would receive over $32,000 a year. That creates a huge range of shortfalls.

The Aon tables provide a more accurate estimate than the 70% and 80% rules of thumb because they take income levels into consideration, but they don’t consider a range of Social Security benefits or savings rates, so they can still be highly inaccurate.

Ignore rules of thumb when planning for retirement. Either method can provide a dangerously incorrect estimate of your income requirements. At best, tables and rules of thumb are very broad generalizations. I recommend you calculate your own shortfall. I explain how to do that in my post, Closing the Shortfall — How Much to Save for Retirement.

With your shortfall you can calculate how much you need to save for retirement.

In my next couple of blogs, we'll look at how much personal retirement savings you will need to cover your shortfall.

1 401(k) accounts, IRA’s, etc.
2 Part time employment, a pension, rental income, etc.

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