How much retirement income do you need? It’s a question you can read in plenty of blogs about retirement planning. On the face of it, it sounds like a sensible question. You probably know how much income you’re making before retirement. Maybe you have a fair idea about how much you’re spending before retirement. You may also have aspirations about what you want to spend after retirement. From that you can easily work out the future income you’ll need, right? Wrong!
The fallacy of income replacement
Some time ago, I wrote an article about the so-called 80% rule. This described the rule of thumb whereby you need to plan on replacing 80% of your pre-retirement income. Whether it’s 80% or 75% or any other figure doesn’t matter. The fallacy is that you should first determine your required post-retirement income, and then figure out how to generate it.
What’s wrong with this? The simple answer is that the income you pick may be the wrong one. If it’s too high it will force you to take too much risk. If it’s too low you’ll miss out on spending you could have afforded.
Okay, you say, then make sure you pick just the right level of retirement income. Well, a fixed percentage of your pre-retirement income doesn’t work, as I previously explained. Is there a more complicated formula that will work? Possibly, but this shows that we’re starting from the wrong place.
Retirement spending not retirement income
Focusing primarily on retirement income is simply wrong. The primary focus should be on spending. It’s only after you’ve worked out your likely spending patterns both before and after retirement that you should start thinking about income replacement.
There are two types of spending:
- Essential spending, about which you can’t (or maybe won’t) be flexible.
- Discretionary spending, on luxuries that you could flex up or down if necessary.
Once you’ve identified all of your essential spending, in theory it should be possible to pick a sustainable level of discretionary spending. This would also depend upon things including your existing assets and debts, you’re current income, and your planned retirement date.
An impossible calculation?
I say ‘in theory’ because this calculation is really hard. It’s hard because there are so many variables. It’s even harder because there are so many uncertainties; these include how long you (and your partner if you have one) will live, future inflation, and future investment returns.
Unlike the 80% rule the calculation needs to be tailored to your particular circumstances, and be based on explicit assumptions. Financial advisors would love to have a tool that could do this. Fortunately such a tool is at hand. What’s more, you don’t need to be a finance professional to use it. And you can start using it for free. It’s the EvolveMyRetirement® Intelligent Financial Planning Calculator.