Archives For how much to save for retirement

The 80% or 90% of Income for Retirement Rule Is Stupid

Corey —  November 3, 2010

Using Rules of Thumb for Retirement Planning? FAIL       In my post on why the save 10% of your income for retirement rule is stupid I mentioned that expecting you’ll need 80% (or 90% or any other %…) of your pre-retirement income in retirement is stupid as well. How much income you’ll need in retirement is one of the major variables in calculating what you should save for retirement, so it’s important to use the most accurate estimate you can. Relying on a percentage rule of thumb is likely to steer you in the wrong direction for several reasons. Here are a few.

Housing

       Do you plan on downsizing in retirement? Or maybe you’re thinking about upgrading. Planning to move? That’s going to change more than just your housing costs. If you’re going to be renting or still paying a mortgage in retirement, you’ll need to figure that in as well.

       Consider maintenance costs as well. If you’re a handyman now and do most of your own repairs, how long will you be able to keep that up in retirement? Eventually, your physical abilities are likely to become limited and then you’ll need to hire others to do those repairs.

       You can’t plan for every possible variable in your housing costs, but these are the kinds of things you need to consider when figuring out how much income you’ll need in retirement. Housing is the highest cost for most people, so it’s even more important you get this one as accurate as you can.

Transportation/Travel

       Have you thought about how your transportation and travel costs might change in retirement? I’m guessing they’re probably not going to mirror your pre-retirement spending. The lack of a commute and the desire to travel more may offset each other for some people but not for most. This one might be difficult to figure out all at once, but if you take each aspect at a time you can come up with a reasonable estimate.

Food

       Will you be more likely to eat out in retirement, or do you want to improve your culinary skills and cook more at home? You’ll have an excellent opportunity to lower your food costs in retirement by cooking more from scratch, but many retirees look to eating out as a way to engage in social life and get out of the house. Depending on your preferences, skills, and plans, this could be another area that you’ll need to consider carefully.

Health

       During retirement, you’re going to be shouldering more of your health insurance expenses. Your health will also be at a higher risk of declining as you age, so you’ll have to expect more health costs overall. This is one area where many retirees experience a large increase in spending – especially as retirement goes on.

Income Taxes

       Depending on your personal situation and how you decided to save for retirement, your taxes in retirement could look quite different than before retirement. This is especially true if the income you’ll need in retirement is very different from your pre-retirement income. There are a number of variables that affect income taxes and they change from person to person. Assuming you can count on an average to help you might the right decision for your retirement is foolish.

Savings

       This is at least one area where the percentage rules directly account for some changes in retirement. But there’s still a problem. Maybe you waited until 10 years before retirement and had to save 30%, 40%, or 50% of your income to catch up. That’s going to drastically change once you enter retirement, so you need to look at your unique circumstances. Or maybe you hit a windfall sometime in your life and haven’t been saving anything for retirement. Following one of these rules of thumb won’t work for your situation either.

       It doesn’t matter if you don’t fit into one of the examples I shared above. The point is that your situation is different and unique to you, and you need to plan accordingly.

So How Should You Figure Out How Much Income You’ll Need in Retirement?

       I think it should be clear by now that the only prudent way to figure out your retirement income needs is to carefully consider your own situation by looking at your circumstances and expenses alongside your goals. When I was creating my free retirement calculator, I wrote an article specifically designed to help you start thinking about how much income you’ll need in retirement based on your situation. It doesn’t cover every possibility, but it will help you get started.

       My goal in pointing out how stupid these rules of thumb are is not to make things difficult for you or to make fun of others who give this kind of advice. I want you to see that your financial decisions involve factors that are unique to you. You shouldn’t risk making a wrong decision because you followed an easy rule of thumb. Take the time to really think about your situation, learn what you need to know so you can make a smart choice, and use that knowledge to manage your money well.

photo credit: (Hans Gerwitz on Flickr)

This article was included in the Best of Money Carnival.

This article was included in the Carnival of Financial Planning.

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The Save 10% for Retirement Rule Is Stupid

Corey —  October 6, 2010

Cracked Nest Egg Because of Stupid Retirement Rules       The “save 10% for retirement” rule is absolutely stupid. And so is “save 15% for retirement” (sorry, Dave Ramsey) or “save 20% for retirement” and any other “save #% for retirement” rule you’ll come across. Now I don’t doubt that the people giving this advice meant no harm. They probably just want to get you to start saving for retirement, and offering a simple % of your income solution is a quick, easy answer for a difficult question.

       But they’re all absurd, useless rules for one simple reason: they completely ignore your situation. For most people, a simple rule like “save 10% of your income for retirement” is likely to be wrong (and blindly following dumb advice like that can have nasty results). The right answer depends on seven major factors that are specific to you and your situation. Specifically, they are:

  1. Your Current Age
  2. Your Retirement Age
  3. Your Life Expectancy
  4. Your Current Savings
  5. Your Investments
  6. How Much Income You Need for Retirement
  7. Your Current Income

       All of these factors work together to determine how much you should be saving for retirement each year. Let’s break them down.

Your Current Age & Retirement Age

       The difference between your retirement age and current age determines how long you have to save and invest. If you’re 25 now and don’t plan on retiring until you’re 70, then you’ve got 45 years until retirement. But if you’re 50 and want to retire at 65, well then you’ve only got 15 years. That’s a huge difference!

       The longer you have until retirement, the less you’re going to have to save. But these simplistic rules ignore this completely. If you’re young and just starting out, these rules might be OK for you. But if you’re older and haven’t done so well with saving for retirement, you’re not going to be happy when you realize you can’t retire because you didn’t save enough.

Your Life Expectancy

       Trying to guess your life expectancy can be a shot in the dark. You don’t really know when you’re going to die. But your health, your habits, and your family history do affect how long you can expect to live. Obviously, the longer you’re likely to live, the more you should save for retirement. But these dumbed-down % rules don’t account for this at all.

Your Current Savings

       If you’ve been wise and have already been saving a lot for retirement, you may not need to save 10% of your income. But if you’re 50 years old and haven’t saved a dime, then even 15% or 20% are unlikely to cut it unless you’re willing to make some major changes to your life and retirement plans. How much you already have saved can drastically affect how much you should save for retirement, but once again these % of your income rules won’t help.

Your Investments

       Are you so afraid of risk that you’ve vowed only to use CDs to save for retirement? Well, I can tell you that you’re going to need to save a whole lot more than 10% of your income even if you’re starting at 18 and don’t plan to retire until you’re 75. Your investment returns (which are connected to the risk you’re willing to take) will drastically affect how much you need to save. Based on what I can figure, the % rules assume you’re going to invest in a moderately aggressive mix of stocks and bonds that you tone down as you get closer to retirement. So if your risk tolerance is higher or lower, these rules won’t work for you.

How Much Income You Need for Retirement

       How much income you need for retirement is also a huge factor in figuring out how much you should be saving. Are you going to get a pension? Well, you’ll need less income from your own savings (lucky you). Do you plan to downsize and cut way back on some major expenses? Then you probably won’t need to save as much. Want to travel the world extensively? You might have to plan on saving more if your retirement expenses are going to drastically exceed your current income.

       You see, these % rules assume you’re going to need about 80% or so of your income in retirement. (That’s a stupid assumption for some other reasons, but I’m saving that for a different post.) So if you’re going to be different, these rules just won’t work for you.

Your Current Income

       Finally, and this should be obvious, your current income will affect the % you should be saving. Once you consider all these other factors I mentioned above, you can figure out exactly how many dollars you should save for retirement this year. But depending on what you make now, that could be 5% or 25% of your current income. (Or even more!)

The Solution

       So how, exactly, should you calculate how much you need to save for retirement? Well, I’d like to say that my handy little retirement calculator is the perfect answer, but it’s not. (It’s free by the way!)

       My calculator assumes you’re going to invest using a diversified portfolio of low-cost index funds (also a free calculator) with a moderate-slightly aggressive stock/bond mix. It also simplifies the taxes and doesn’t allow for “lumpy expenses” or significant changes in your retirement spending. Finally, it’s based on some other assumptions that I just can’t know will be absolutely correct. I did my best, but I know it’s not perfect.

       My free retirement calculator is certainly an improvement over these stupid % of income rules, but it’s still no replacement for sitting down with a good fee-only financial planner and working it out. So definitely try it out, but do yourself a favor and find a qualified professional to help you as well. And you need to do this more than once. Every few years you should revisit this plan with your advisor and update it as needed.

       I know that’s not an easy answer, but at least you’ll have a better chance of actually meeting your goals! Plus, I tried to make my calculator as simple as possible without making it too simple. And trust me, it’s better than most of the other free retirement calculators you’ll find out there because I used hundreds of thousands of Monte Carlo simulations to develop it. So it’s based on assumptions that mimic real market returns (which vary from year to year) instead of assuming a straight % return every single year (like 8%, 8%, 8%, …).

       Try it out, let me know what you think, and feel free to share your results here! What % of your income should you actually be saving to reach your retirement goals?

(photo credit: Nina Matthews)

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