The “replacement rate” is the amount of retirement income you’ll need post-retirement to replace your salaried monthly income. Analysts tend to think that the replacement rate is 80%. They believe that by determining your replacement rate, you can surmise how much you need to save, in order to reach a withdrawal rate that equals 80%.
But is 80% a realistic replacement rate? If it is too high, you may be saving too much pre-retirement, or living more frugally than necessary during retirement.
Saving too much now means that you may potentially be sacrificing your current standard of living to maintain a higher standard post-retirement. While it may be easy to say that during retirement you may need less money since your work-related expenses will be decreased, this rule of thumb may not be applicable to everyone.
For example, business owners and independent contractors might not realize how much of their personal expenses are paid by the business. This means that they may need more than 80% of their salary to meet their retirement living expenses. And if you plan to travel during retirement, depending on your destination, your living expenses may be greater (or lower) than your current expenses.
Additionally, a standard figure for the “replacement rate” may not reflect the reality that retirees tend to spend more in the early years of retirement when they may travel or begin new (expensive) hobbies. Spending trends of retirees also show that living costs may increase towards the end of retirement when healthcare costs may escalate.
Focus on specifics, not generalities
Perhaps, instead of blindly following rules of thumb, it pays to look at your actual cash-flow and, using a financial plan, project those figures into the future. Look at your actual current spending and see which expenses will disappear, diminish, or increase during retirement. Add in extra healthcare costs and any other retirement expenses that you may not currently have. Then, when you have a sense of your total inflow-outflows, you can ask your financial planner what investments/savings plans can best help you to meet your anticipated expenses.
DOUGLAS GOLDSTEIN, CFP®, INVESTMENT ADVISOR, IS THE CO-AUTHOR WITH GRANDMASTER SUSAN POLGAR OF RICH AS A KING: HOW THE WISDOM OF CHESS CAN MAKE YOU A GRANDMASTER OF INVESTING.
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published September 2, 2012.