Some of the big brokerages suggest that your income in retirement should be a certain percentage of your pre-retirement income. Usually I see a range of 75 to 85 percent. So if your pre-retirement income is $100,000, then you would need $75,000 to $85,000 in annual income in retirement, at least by this way of thinking.
What’s wrong with this?
The most obvious thing is it does not take into consideration your spending. In the rare case someone is actually frugal with their money, this method can result in a very large retirement number. That is, the higher the salary and the higher the level of frugality, the bigger the difference.
Below are some examples I came up with just to see what it looks like. To calculate the retirement number (that is the amount of money you will need in retirement) I simply multiplied the annual salary times 25 or annual expenses column by 25 (more on this calculation below).
When you look at the high earner with an income of $200,000 per year (not out of the question of someone in their 30’s or 40’s in a specialty career). This person is frugal and only spends $65,000 per year. If she uses 80 percent of her annual salary to determine her retirement number then she would have to save $2,375,000 more than she would if she based it off her spending number! As a mid-career professional making a high salary, I can say that the high salary comes with lots of pressure and stress. If this were me it would be safe to assume that I would rather check out at $1,625,000 than work several more years to get to $4,000,000.
In the case of the average salary, the 80 percent calculation gives her less than what she spends by $85,000. You could say that in her case she would be retiring short and would need to look for additional income to cover this gap.
As for the average 40 something, the 80 percent calculation puts him $390,000 over his spending number. In the big scheme of things this is probably close enough, if not a nice safety cushion.
So in summary you have three different people with different wages and levels of spending, each yielding a different retirement number.
Let’s assume a simplistic example where each of these people live in the same city, so they have the same cost of living, and they have the same annual expenses of $40,000 annually. Equalizing spending across all three makes it even more apparent that the higher the salary, the more out of range the retirement number is if it is based on percentage of income.
Retirement Number Based on Spending
It is pretty standard in the FI community to base a retirement number on spending as opposed to income. The most common method stems from the 4 percent rule where you take your annual expenses, multiply by 25, and the resulting number is what you can safely withdraw on in retirement at a rate of 4 percent per year. I use the term safely carefully here because there are caveats to the 4 percent rule that should be understood before diving in.
I also think it’s easier to model your retirement number off expenses even if you expect your expenses to fluctuate in retirement. A simple spreadsheet model can help with something like this.
Another way to look at this is with spending, you can at least control it. You can buy cheaper things, fewer things, or you could move to a lower cost of living area. There’s a lot of control when it comes to spending.
Leave a Reply