When preparing for retirement, this is probably the most widely asked question. The answer is actually quite simple. It depends on the lifestyle you want in retirement or the lifestyle that you have today. Everybody is different and nobody is typical.
The closer you are to retirement the more crucial the need to project your spending needs in retirement. You will also be better off trying to be more accurate in your approach.
Two methods of determining your retirement needs
There are two basic approaches to determining how much you will need. I call them the bottom-up approach and the top-down approach.
- The top-down approach. The top down approach is the easier of the two approaches. Essentially, you want to take your current income, account for taxes and investing to estimate your current lifestyle. For example, let’s say Sara and Dan are making about $80,000 per year combined between the two of them. They are paying about $24,000 in tax and saving $3600 per year into RRSPs. Essentially, if we assume that the rest of their income is used to support their current lifestyle, we can say that their lifestyle needs are about $52,400 per year. You could simply stop here and say that you need $52,400 in retirement in today’s dollars.The next step is to make some adjustments for expenses that will be different in retirement. The most common rule of thumb is to use a 70% ratio. This means that your expenses in retirement will be about 70% of your pre-retirement expenses. The 70% figure comes from the fact that your biggest expenses in your accumulation year’s, mortgage and dependent children will not be present in your retirement years. Hopefully by the time you retire, your mortgage will be paid off and your children will be independent.
The top down approach uses a figure we call the income replacement ratio. The income replacement ratio is simply the percentage of income that needs to be replaced in retirement.
Interestingly, for Sara and Dan, they were surprised at how much money they were spending in a year. They had no idea where that $52,400 was going. To take this step further, they looked into the bottom-up approach.
- The bottom-up approach. This approach is different in that you will need to be much more detailed in terms of knowing where you spend your money. If we continue from the example of Sara and Dan, the bottom-up approach requires that they understand where they spend their $52,400 and not just knowing that they spend that amount. The goal is to determine exactly how much money you are spending today by figuring out where you are spending this money.The bottom-up approach starts with tracking your cashflow. Sara and Dan needed to track where their money was being spent. Typically it is easier to categorize the types of expenses. For example, more people categorize expenses into home expenses, personal, transportation, medical, miscellaneous, financial, etc. It matters less what categories you use and more that you understand where your money is being spent. Once you have done this, you will have a better understanding of where the money is going over the top-down approach. The difference is you are ball parking your expenses into one general category in the top-down approach as opposed to understanding the specifics of where money is being spent in the bottom-up approach.
The similarity to the two approaches is the need to make adjustments for retirement. In the bottom up approach, you will know exactly what percentage of income goes to cover mortgage payments, children, etc. Some expenses will go down in retirement like mortgage, children, and clothing. Other expenses could be higher like health care, travel and leisure.
There is no right or wrong as to the approach you want to take in determining your lifestyle need. The younger you are, the less accurate you will need to be since the future is more likely to change. Thus, the income replacement approach might be more suitable. The top down approach is a good way of understanding not only how much you spend but also where you spend it.
The closer you are to retirement, the more important it is to understand where your money is going and what adjustments will need to be made when you retire.