Mar 09, 2009

Post-Retirement Income (Part 1): What Percentage of Pre-Retirement Income Will You Need?

Articles in the daily press, commentaries by financial planners, and "retirement kits" published by mutual fund and insurance companies all tell us that to live comfortably after retirement we will need a big annual income for at least 30 years. For example, a recent Associated Press article by Dave Carpenter quotes an AON consulting report stating that most employees will need an average of 77 to 94 percent of their pre-retirement income to maintain their lifestyle. No surprise there, as most insurance and investment outfits who want to sell us their products use 80% as the amount of income that must be replaced.

Since many of us have no hope of ever saving the megabucks needed to produce this yearly cornucopia, the main effect of these messages is to make us anxious. Fortunately, these "you'll need at least $1,000,000 to retire happily" articles more accurately reflect the biases of the investment industry than they do the spending patterns of real retirees. As a result, they greatly exaggerate the amount you'll really need to spend post-retirement.

Start figuring out how much you'll really need to spend after retirement by understanding that retirement planning is best done with a dash of black humor. That's because, no matter what the investment industry claims, it's impossible to predict with anything approaching accuracy how much you or anyone else really needs to save. For example, unless you are currently in the last stages of a terminal illness or plan to poison yourself next Friday, you can't know how long you will live or how healthy your mind and body will be in your retirement years, both essential facts to accurately determine how much money you'll need.

True, actuarial tables predict that at 65 the average retired man can expect to live 20 more years, and the average retired woman, 23. So what? Even if the world avoids a killer flu, a nuclear catastrophe, or a colliding comet, all these tables really tell us is that half of us will live to be older than 85 or 88 and half will die younger -- some much younger. To make this same point in a more down-to-earth way, if you live until you're 106 and spend your last 25 years in a pricey nursing home, you will obviously need piles more retirement income than if you are run over by a truck at age 62, three years before you retire. Of course, this is where your sense of humor needs to kick in, since if you fall victim to the accident, every penny you've struggled to save would have been better spent on a trip to Paris.

Read articles in personal finance mags closely and you'll see that many begin by claiming that millions of people are at high risk of becoming destitute in their old age. Then, in paragraph two, the author typically goes on to discuss how much income a retiree will need to maintain a second home, travel the world, eat at lovely restaurants, and pay dues at social clubs. A big reason for this schizophrenic approach to retirement advice is that the writers try to simultaneously pitch their message to people with vastly different incomes and expectations. The first sentence discusses the potential financial problems of ordinary working people, many of whom will in fact be at risk of a financially insecure retirement unless they embark upon a sensible savings and investment plan. The next addresses upper-middle-income people (most of the magazine's readers) whose only retirement worry will be whether they can afford to step up from an Audi to a BMW.

So keep in mind two essential points whenever you come across a piece of retirement advice:

  • There is a huge difference between the income it will take to meet your honest retirement needs and how much you would need to buy everything you want.
  • Assuming you agree that many, if not most, elements of a good retirement really can't be bought, it follows that it only makes sense to save and invest enough to be able to purchase what you really need. Or put another way, it's just plain nuts to sacrifice important present needs (for example, quit your mind-numbing second job) so you can afford luxuries later.
Enough background. So, if 80% is an overly cautious number, what percentage of your current income will you need after retirement? I'll explain how to think this through in some detail in parts two and three of this discussion, but for starters consider this: If you are a parent and your kids will be fledged before you retire, you can free up about 25% of your current income right there. And if you have a mortgage that will be paid off before you retire, you'll likely liberate another 25%. No question, if you have neither house nor kids, your spending needs probably won't drop as much. But as I'll detail soon, there are lots more savings available to even moderately frugal retirees.