How Much Money Does One Need to Retire?

The cost of retirement is rising. That means fewer people appreciate how much wealth they need to retire or to continue their current retirement lifestyle.

I’ve known this for several years, based on my careful study of retirees. But it was confirmed by a study funded by Aon Consulting and conducted by Georgia State University. The study found that in 1997 a 65-year-old earning $70,000 before retirement with a spouse three years younger needed 67% of that pre-retirement income to have the same spendable income in retirement. Today, that person in retirement needs 75% of the pre-retirement income to maintain spendable income.

But don’t apply those ratios to your situation. The replacement ratio one needs varies by income level. Someone earnings $250,000, for example, needs 87% of that income in retirement. In addition, these are averages. The income you need in retirement will depend on the lifestyle you want in retirement. That will vary for each individual.

The biggest mistake people make in planning for retirement is to incorrectly estimate their income needs. Perhaps the primary reason for that mistake is people tend to use a rule of thumb to estimate their needs. Traditionally, advisers estimate people will need 65% to 85% of their pre-retirement income in retirement. But that range covers a lot of ground. And that general rule doesn’t give a hint of how to determine which end of the range applies to you. The fact is that the higher your income, the higher the percentage of pre-retirement income you need in retirement. Those with six figure incomes often need 100% or more of their pre-retirement income in retirement.

I recommend throwing out the general rules. Don’t look at your retirement spending as a lump sum. Instead, draw up a budget for the lifestyle you want. How much do you want to travel? Play golf? Give to your grandchildren? Dine in restaurants? These are all retirement expenses that are likely to be higher than your pre-retirement spending. Many people spend more in retirement than pre-retirement. You have more time, and that time might be filled by activities that cost money.

Health care is a wild card in any retirement budget. The average retiree spends about $2,500 annually on medical expenses. That includes all costs, such as Medicare and insurance premiums, deductibles, co-payments, and non-covered expenses. But it is an average. You might spend more or less, depending on your health, family history, and insurance coverage.

Don’t overlook infrequent expenses. These include home maintenance and improvements, appliance replacement, automobiles, and help for family members. You can set a monthly amount in the budget for such items; that amounts to a sinking fund. Or, if you use a computer program to estimate expenses, the irregular expenses often can be inserted in the years they are expected to occur.

Next to consider is inflation. Remember, most folks are likely to be in retirement for at least 15 years, and many will be retired longer. Even modest inflation can devastate a standard of living during that time. Your spending must rise each year to preserve purchasing power against inflation.

You could apply a single inflation rate to your entire monthly or annual budget. If your spending breaks down the same way as the basket of goods and services that make up the Consumer Price Index, you can use an estimate of the CPI. But different budget items have different inflation rates. With the Baby Boomers about to retire, the cost of items bought primarily by older Americans is likely to rise faster than the prices of other items. Also, medical care is likely to be a bigger part of your regular expenses. Medical care prices rise faster than inflation, much faster in recent years.

To be accurate about inflation, you should assign a separate inflation rate to each budget item. The rate for health care might be 7% to 12%. Travel inflation might be 5% or more. Multiply the inflation rate for each item by its percentage of your budget. Then add these results, and that will give you a more accurate annual inflation rate for the entire budget.

The good news from a spending standpoint is that your spending is likely to decrease as you get older. It is natural to be less active. You’ll travel less and probably participate less in other activities that cost money. The spending decline usually occurs sometime after age 75 and depends on your health.

There are many ways to use the retirement spending projection to get an estimate of the income and investment capital you’ll need in retirement. Here’s a “quick and dirty” method. Suppose you need $60,000 income the first year from your investments. Other expenses are covered by Social Security and additional guaranteed income. You project an 8% annual return on your portfolio and 3% inflation. That means you can spend 5% of the return and re-invest 3% to maintain purchasing power. Divide .05 into $60,000, and you learn that you need a portfolio of $1.2 million at retirement.

But that’s a high estimate, because it assumes you’ll never dip into the principal. You’ll anticipate spending only a portion of the annual return. I’m going to show you some more accurate methods.

Everyone should estimate retirement income needs. If you already are retired, you should estimate future spending each year. Studies show that those who do some kind of an estimate are better prepared for retirement and save more than those who didn’t. If you are under age 50, a quick and dirty estimate is enough for now. That will give you a goal and get you working in that direction. As you get closer to retirement, you’ll want to get a tight estimate. Fortunately, there are many resources available to you.

Another ballpark estimating tool is available from the American Savings Education Council. You can use this tool on their web site at www.asec.org/ballpark. Or get a paper copy by sending a self-addressed, stamped business-size envelope with $1.07 in postage to American Savings Education Council, 2121 K St. N.W., Suite 600, Washington, D.C. 20037.

Most mutual fund companies and brokers also have retirement spending estimators of varying complexity, usually both on their web sites and available in paper form. Many publications’ web sites, such as www.usatoday.com, have simple retirement calculators. In fact, most of those calculators are built by only a few firms that license them to different web sites.

A tool that is mid-way between the simple and sophisticated tools is available at www.usnews.com. This planner lets you factor in future changes in taxes and Medicare among other things.

The major disadvantage of most of these tools is that they don’t concentrate enough on helping you get a good estimate on your likely retirement spending. They ignore or gloss over the key issues I’ve discussed here and devote most of their effort to computing how much more money you need to save and how to invest it.

But there are several tools that take additional steps and deal with many of the issues I’ve discussed.

T. Rowe Price has perhaps the most sophisticated of the mutual fund and broker tools. You can choose from a web site calculator, paper calculator, or a stand-alone software version that is more robust and sells for $9.95. The Quicken software from Intuit and Microsoft Money also have very good retirement planning modules that are better than those provided on the web. Another sophisticated tool, written by a retired engineer, is available for purchase and downloading at www.analyzenow.com.

The T. Rowe Price stand-alone program and the module in Intuit’s Quicken software I think are the best of the lot. They deal with most of the issues I’ve discussed and allow you to draw up a fairly sophisticated estimate.

Whatever your age, you should first determine your goals for retirement. Then compile a budget of what that would cost this year. Estimate an inflation rate for your spending. Then, do a rough estimate of lifetime spending using one of the simple paper tools or web sites. Finally, move to one of the more sophisticated computer programs.

None of this is a substitute for working with a financial planner. A good financial planner will have more sophisticated software and experience with actual cases. If you have the money, you eventually should spend some time with a planner to get a solid estimate of your income needs. If you don’t, working your way through the process will give you better results than most people have and get you on the way to a more secure retirement.