Don't base your projections off of your income
By Paula Pant
Updated October 11, 2016
One of the most difficult parts about retirement planning is that the general rule of thumb based around how much money you might need for retirement tends to reflect your level of income.
This presents a number of problems for those trying to plan for retirement.
For example, many financial experts say that you want to replace between 70% to 85% of your pre-retirement income. So if you earn $100,000 a year, your goal should be to create enough retirement income that you would be able to live on somewhere between $70,000 to $85,000 per year.
The Problem With Basing Your Retirement Needs Off Current Income
Unfortunately, this type of rule of thumb isn't helpful for people who are in the early stages of their careers. If you're in your 20s or 30s, you may be earning an income that reflects an entry level salary.
Plus, if you were in the middle of your career and decided to make a career change, you may also temporarily experience lower income years.
When you're not sure what your pre-retirement income is going to be, how can you possibly make any projections as to the amount you'll need during your senior years?
Another Problem: What if You're a Saver?
Before we address this question, let's introduce one more problem with the "replace your income" rule of thumb. This advice hinges on the assumption that you spend the majority of your income.
After all, if you typically save 10% to 15% of your income for retirement and perhaps another 10% to 15% of your income for other non-retirement types of savings, then the implication would be that you spent somewhere around 70% to 85% of your income.
It makes sense under that very specific set of circumstances that if you spend the majority of what you make and you don't expect your spending habits to change whatsoever during retirement, then you would need to create enough money such that everything would stay the same. This seems to be a shaky assumption.
It isn't necessarily the case that people spend the bulk of what they make. Some people spend more than what they earn, ending up in credit card debt, while others spend significantly less than the amount that they earn.
This is the second, and perhaps more compelling reason why basing your retirement projections on your income rather than your expenses might not be the best framework for planning.
What's the solution?
Focus on Spending, Not Income
I would suggest that you base your retirement projections on your level of spending rather than on your income. This solves both of the two problems addressed above.
Now with that being said, it's also true that your spending in retirement will be different than your spending today. In retirement, for example, you may not have a mortgage payment. Your children may be grown up and living on their own, and you'll no longer need to support them. Costs related to your work such as childcare, business attire, and commuting costs will also dissipate.
That being said, you may have other expenses that you don't currently have today. Out-of-pocket prescription and medical costs might be a bigger concern. You may also want to outsource home-related tasks that you currently do yourself such as cleaning gutters, raking leaves, or shoveling snow when you're in your 70s and 80s.
You may also choose to travel more, using your retirement to explore hobbies that you couldn't pursue during your working years.
All of this leads us to a second quandary, which is that while income is not a suitable basis for determining how much money you should have in your retirement portfolio, expenses are not a perfect option either. However, in lieu of better alternatives, expenses may be the best benchmark for how large of a portfolio you should aim to create.
If we accept the fact that some of your current expenses will decline, but others will grow, and we ballpark those two to be a wash, then it is relatively reasonable to state that the amount that you currently spend now might also be the amount that you spend during your retirement years.
How Much Money Will You Need to Retire?
Now that we've established that, how much money will you actually need to retire?
Here's a broad rule of thumb: multiply your current annual spending by 25. That's the size your portfolio will need to be in retirement for you to safely withdraw 4% of that portfolio amount every year to live on.
For example, if you currently spend $40,000 per year, you will need an investment portfolio that's 25 times that size, or $1 million at the beginning of your retirement. This is a large enough sum such that you can withdraw 4% of that $1 million portfolio in your first year of retirement, and that same 4% adjusted for inflation every subsequent year, and maintain a reasonable chance that you won't outlive your money.
This may sound daunting, but if you begin saving for retirement at an early age, as early as your 20s, you could amass a $1 million portfolio even on a salary of only $30,000 to $40,000. (Check out this article for a detailed breakdown of the math behind how to become a millionaire on a $40,000 salary.)
What if You Got a Late Start With Saving?
If, however, you are starting later in life, don't despair. The key thing that you need to remember is that the best way to compensate for getting a late start is to aggressively contribute to your accounts.
In other words, save more and save harder. The tactic to avoid, however, is increasing your risk exposure as a way of making up for lost time. Don't over-allocate a portion of your portfolio to stocks on the grounds that you need riskier investments to compensate for lost decades of savings.
After all, risk works both ways, and if that were to turn against you, you won't have as much time to recover.
Look for low-fee index funds and spread your investments between a reasonable mix of stocks and bonds. Keep continuing to do that regularly through the rest of your working career with a goal of saving 25 times your current level of spending by the day that you retire.
Use retirement calculators to make sure that you are on track, and don't pay too much attention to scary headlines in financial news. You are playing a long-term game, and getting caught up in the daily turbulence of the market will only curb your progress.
If you are saving for retirement with a late start, focus on ways that you can either boost your income or lower your expenses. If you can, do a combination of both. Here's how these strategies can help you bridge the gap.
Redefine What Retirement Means
These days, it's not uncommon to hear about people who are "half-retiring" from the workforce, either because they can't afford to fully retire, or because they want to keep busy.
If you got a late start to saving and need to earn more to make up the difference between what you need and what you have, consider a few alternatives before you "officially" retire.
For example, if you love your job, it could make sense to stay and take advantage of employer-matching contributions alongside catch-up contributions to your 401(k). Not to mention, you get to keep your other benefits a little longer.
Maybe you don't love your job, but you love the field you work in. Is it possible to work part-time as a consultant for a few years while your money continues to grow?
Perhaps you don't want to quit working completely, but want to start a second career in something you've been passionate about for a while. If taking a pay-cut allows you to be on track to meet your retirement savings needs, embark on a new journey in a new industry for a few more years.
Redefine Lifestyle in Retirement
Maybe you didn't get a late start with saving but can't spare the extra change to build a portfolio that reflects your current level of spending.
If earning extra money isn't possible, then you might have to redefine what kind of lifestyle you want to live in retirement.
For example, when most people think of retirement, they think of endless relaxation, tropical scenery, golfing, or playing card games with friends.
That doesn't have to be what your retirement looks like, though. There are plenty of ways to cut costs and maintain an interesting lifestyle in retirement.
Instead of keeping the house you currently own, it may make more sense to downsize and retire to a state with no income tax. You could take it a step further and retire someplace overseas that has a lower cost-of-living. You could even decide to become a nomadic traveler and sell your home, buy an RV, and see all the U.S. has to offer.
There are plenty of ways to make retirement work, you just need to play with the numbers to see what's possible for you. So if a $1 million portfolio isn't in your future, figure out what is, and adjust your lifestyle based on that.