Planning for Retirement: 3 Things You Need to Know
It’s not enough to simply save like mad for retirement. (Although that’s a big part of the equation, and a great place to start.) Coming up with an actual retirement plan requires considering the moving parts that determine how much money you’ll need, where you should stash it, and what investments will carry you through to your quit day and beyond.
Let’s tackle some key questions that will help hone your retirement savings strategy.
Retirement planning: What you need to know
Life, and retirement plans, are full of uncertainties. That doesn’t mean that you can’t make some highly informed guesses about what the future holds. The more blanks you can fill in, the more confident you can be that your retirement plan is on the right track.
These questions will help turn a fuzzy retirement target into a focused plan.
1. How much will you spend in retirement?
The standard thinking is that people should plan on spending 55% to 80% of their current income each year in retirement to maintain their standard of living. Of course, this rule of thumb is only helpful if you know what you’re spending right now.
Your current annual operating budget — the amount of money needed to keep a roof over your head, food in your belly, and a kick in your step — can give you a good idea of your future expenses. (If you don’t already have a budget or an easy way to grab at least a snapshot of your current spending, take some time to gather this information.)
Keep in mind that some expenses may increase in retirement. Perhaps you’ll develop a penchant for adventure travel or take up a pricey hobby. Home-related costs — energy bills, ongoing repairs and maintenance — don’t seem to be getting cheaper.
At the same time, some expenses may go down in retirement. If you’ve paid off your home, you’ll no longer have a mortgage. You’re no longer paying payroll taxes or sending a chunk of each paycheck to Social Security. And, this is a biggie: In retirement you’re no longer saving. So if you were diligently saving 15% of your income pre-retirement, that means you’ve been getting by all these years on 15% less of your income.
How does the average retiree spend their money?
There’s no better source for details on retirement expenses than actual retirees. Here’s a budget breakdown for those living in retirement today, according to the Employee Benefit Research Institute Spending in Retirement Survey.
- Housing: 30%
- Food: 25%
- Transportation: 12%
- Medical and health insurance: 8%
- Out-of-pocket medical costs: 5%
- Entertainment: 8%
- Clothing: 7%
- Other expenses: 6%
When asked how their retirement spending aligned with pre-retirement expectations, approximately 26% of retirees said they were spending more than expected on housing costs, health, and medical insurance. Providing for family members was also cited by many as a strain on the budget.
Your lifestyle choices can have a huge impact on where you fall on the 55% to 80% range. Also cash flow needs throughout retirement can — and will — change. For example, you may have heard that retirees spend the most in the early years, at which point spending levels off until it spikes again in the later years. It makes sense. Let’s call the early years the YOLO era where you’re taking advantage of your newfound freedom to travel, spoil the grandkids, and upgrade your pickleball equipment. In the latter years of retirement the spending’s less fun. Medical bills and assisted care can run up a big out-of-pocket tab.
Our advice: Aim high. It’s better to overestimate your retirement income needs than to come up short. If you want to play it safe, you might even assume that you’ll need to cover 90% to 100% of your current costs.
If you just swallowed your tongue at the idea of having to replace all that income on your own, consider that you’ll probably have more than one source of income in retirement. So now we turn to...
2. Where will the money come from?
Financial planners have long used the analogy of a three-legged stool to represent a retirement supported by three sources of income. The legs are:
- Personal savings: The future is in your hands. Literally. Meaning the money you’ve saved in retirement plans, like 401(k)s and IRAs, will likely be a huge source of your retirement income. That’s why it makes sense to max out your accounts, as much as possible while you’re in your earning years. Read How to Save for Retirement for tips on how to manage your retirement accounts like a pro.
- Pensions: Also known as defined benefit plans, pensions were the norm in corporate America several generations ago. Today roughly 20% to 25% of people are covered by a pension plan at work (think government workers). But in the private sector, defined contribution plans (where workers fund an account in exchange for tax breaks) have largely replaced pension plans.
- Social Security benefits: Introduced in the 1930s, Social Security was designed to supplement a person’s retirement income, not be the sole source of it. Today, Social Security provides about one-third of the average retiree’s monthly income, although it’s much more (50% to 90% of income) for a large portion of recipients, with an average monthly benefit of $1,825.
Even though you’re allowed to start claiming Social Security benefits at age 62, doing so before reaching full retirement age (67 if you were born in 1960 or later) is akin to taking a pay cut, reducing the amount you're entitled to receive by as much as 30%. On the flip side, every year you delay taking benefits beyond your full retirement age, up to age 70, increases your Social Security paycheck by as much as 8% per year. (Calculate how claiming benefits early or later affects your monthly benefit.)
Should I rely on Social Security?
We’re not comfortable making bold predictions about the future of Social Security. We will note, however, that if you’re young, most of the literature on this topic says to prepare for reduced benefits compared to what today’s retirees receive. How reduced? Who knows? (If you know, please email us.)
Some retirement calculators let you choose whether or not to include benefits in the results. We suggest toggling to see how the math plays out in both scenarios. You can get an estimate of your benefits on the Social Security website. (You’ll have to create an account.) If you’re not confident that the program will be as robust by the time you retire, then you’ll want to assume your savings will need to pick up the shortfall and save more.
As you can see, that three-legged stool of retirement income isn’t as stable as it once was. Those without access to a pension are forced to rely more on Social Security and personal savings to make ends meet. But there are other ways to augment your income, such as:
- Home equity: For many people, their home is their biggest asset. There are several ways your home can augment your income in retirement. The first is to simply sell it and downsize. Exchanging a $300,000 home for a $150,000 one provides a chunk of change you can inject into your retirement portfolio. Or you could buy a second small property to generate rental income.
Another option for those who own their homes outright is a reverse mortgage, whereby the bank buys your property and pays you a fixed amount each month as long as you continue to live there. (There are lots of pros and cons to consider with a reverse mortgage, so consult with a trusted financial pro to see if this option makes sense for you.)
- Part-time work: Your “human capital” is a valuable asset, and one that about a quarter of retirees continue to tap to generate income after they bow out of the full-time grind. Every additional dollar you generate in real-time retirement reduces the amount of money you need to withdraw from savings. Your savings, in turn, is left to incubate, continuing to compound and grow your nest egg.
So now you know about how much you’re going to want to spend each year in retirement, and where that money will come from. But there’s one big unanswered question left to answer.
3. How long will you be retired?
Or, less delicately, when are you going to die?
No one wants to dwell on their mortality, but the morbid truth is that we will all expire someday. The goal of retirement planning is to time it perfectly. Um, we mean, to ensure that your money lasts at least as long as you do.
Based on the Social Security Administration’s life expectancy calculator, I will die just shy of my 86th birthday. If I retire at age 67, that gives me roughly 20 years of life left I’ll need to fund with my savings. Of course, your mileage may vary. The SSA’s deathstimate is an average — plenty of people live beyond that average. Factors such as current health, lifestyle (I guess I won’t have cold pizza for breakfast anymore), and family history affect life expectancy.
Most retirement calculators take a slightly sunnier outlook and assume you’ll live into your early 90s. In retirement planning terms, that leaves 25 years of expenses to cover if you retire at age 67.
Most retirement calculators assume you'll live into your early 90s. That leaves 25 years of expenses to cover if you retire at age 67.
While you can’t cheat death, there are several ways to adjust your retirement plan to increase the odds that your money will last as long as your retirement:
- Retire later: Delaying full retirement provides three boosts. 1. It gives you more time to save and more years for your investments to grow. 2. It leaves you with fewer years of expenses to cover with your savings. (We’ll let you work out the dark reasoning behind this one on your own.) 3. Every year you delay filing for Social Security after you reach your full retirement age bumps up the benefit you’ll receive by as much as 8% per year.
- Bring in additional income in retirement when you can: Augmenting your income relieves some of the pressure on your savings to provide financial support. As we pointed out earlier, reducing the amount you need to withdraw from your retirement savings will extend the life of your portfolio.
- Take good care of your health: Besides improving your quality of life now and in the future, a healthy lifestyle will help cut down on out-of-pocket medical costs.
Even though retirement may be decades away, it’s never too soon to start thinking about how you’ll make it happen. Of course, plans can change; course corrections may be necessary. But the more details about your dream retirement you can nail down in advance, the more prepared you’ll be.
Next in this series, we tackle the money questions, specifically:
- How to save for retirement: There are a number of account types designed specifically for this purpose. IRAs, 401(k)s and the like all have features that help you multiply your savings (via access to investments) and save on taxes both now and in the future. Which one should you fund first? And after that? How to Save for Retirement provides a step-by-step game plan for funding retirement and non-retirement accounts in the order that gives you the biggest bang for each buck saved.
- How much to save for retirement: You’ve probably heard retirement savings rules of thumb, like “save 15% of your income,” or “aim to have $1 million to $2 million banked before you retire.” But what goes into those calculations? And do they apply to you? In How Much Should I Save for Retirement? we reveal the key assumptions behind these common benchmarks to help you see what adjustments you may need to make.
- How to invest for retirement: It’s not enough to just save for retirement. You must invest that money to help it multiply over time. Building a retirement portfolio — one that contains the right mix of assets based on your timeframe and future income needs — need not be overly complicated. In Investing for Retirement: A How-To Guide we present two simple approaches to investing your nest egg.
How to Save for Retirement