Planning for how much income you need in retirement is one of the most difficult things to do. It’s difficult, because we have to make some goals, predictions and assumptions about the future. The further you are from retirement, the more difficult this process is because changes occur so quickly and frequently in our lives. In our adult lives, so many things can impact our financial future – changing jobs, paying off debt, unexpected expenses, bonuses, inheritances, moving to different cities, marriage, children, houses, economy, etc.
Related article: Three steps to a retirement plan
Whether you are planning to retire in one year or twenty years, one of the first questions you will need to answer is how much income do you need for retirement. There are a few different strategies when trying to figure this out.
Many financial advisors feel that most people spend 70% to 85% of their pre-retirement income in retirement. The rationale behind this thinking lies in the assumption that you have higher expenses in your pre-retirement stage, like a mortgage payment for example. Typically in retirement, you will not have a mortgage payment and your kids will be independent. This may not always be the case, hence why these are called rules of thumb. Remember that for some, retirement may be more expensive. If you want to be conservative in your projections, you should assume you would need 100% of your pre-retirement income.
The bottom-up approach
Another, more commonly used term for the bottom up approach is budgeting. To figure out how much money you will need in retirement, you must start by figuring out how much money you are spending today. The only way to figure this out is to keep track of your expenses for three to six months. It’s not rocket science. You've probably heard this many times before.
Related article: Know your spending
In this approach you will need to make adjustments for expenditures in retirement. For example, let’s say your dry cleaning expense totals $35 per month. You might assume that you would no longer have this expense in retirement since you no longer need to dry clean work clothes. On the other hand, you might want to get a golf membership in retirement but do not have one now. In this instance you might add $5000 as an annual expense in retirement.
The top down approach
Quite often, I will use this approach with clients. The reason I use this approach is because most people hate the notion of budgeting. Also, when I ask the question how much money are you spending or how much do you need, the answer is usually “I don’t know”.
The easiest way to figure out your spending is to start with your net pay, then subtract annual savings (including RRSPs, pensions, investing) done after your get your paycheques. The result should be your lifestyle expenditures, otherwise known as what you are spending. The simple premise is ‘If you are not saving it, you are spending it.'
Let’s run through an example. Say your combined net paycheques are $70,000 per year. Let’s assume you are investing about $12,000 per year in investments. In this example, you are spending $58,000 per year (or $4833 per month) to support your current lifestyle.
Don't forget inflation
In addition to these three approaches you must be aware of inflation as it is a very important retirement planning issue that can complicate matters.
As most of you know, a dollar today is not the same value as a dollar ten years from now. Every year, the cost of living gets more expensive. You need to look further than the price of gas to understand this. In the previous example, if you are spending $58,000 per year today, and retirement is five short years away, you must compensate by factoring inflation. Historically, inflation has been on average 3.1% since 1924. In the last decade, inflation has been lower at under 2.0% per year but in the 1970’s inflation was running about 7.9%.
Related article: Inflation and retirement planning
As I said before, the closer you are to retirement, the easier it will be to understand how much you will need in retirement. Regardless, it is a very important and sometimes a complicated step. Knowing how much you will need to save for retirement depends entirely on how much income you will need in retirement. Take the time to figure this out and you will have taken the biggest step towards planning for your retirement.