How Much You Need

When it comes to retirement lifestyle, most people we talk with want to maintain their current lifestyle, with perhaps some other pleasures, like travel, thrown in.  They want to have the lifestyle that they’ve grown accustomed to over the decades.  For those within five years of retirement, we can calculate with some precision how much it will cost to maintain their lifestyle.  For those who are 10 or more years from retirement, the calculations are less certain.  Life changes too much.

For people 10, 20, 30 or more years from retirement, there are two key issues:

How much income should I replace?
How much should I save?

Fortunately, we don’t have to rely on hunches to answer these questions.  Recent research by Maria Lee from Dimensional Fund Advisors and others provide evidence-based guidance.  This week we will look at answering the first question.

Dr. Lee states that the data, and common sense, tell us that one generally will spend less in retirement.  In retirement, we no longer are saving for retirement, and we pay lower taxes in retirement (i.e. no FICA taxes).  Additionally the research shows that people who have higher than the median income generally have an additional 10%-16% decline in spending in retirement.  This is not the case for those whose income is at the median level or below.

Economists have known for decades that median non-durable spending peaks around age 45 and steadily declines after that.  Durable spending (homes, cars, etc.) declines even more over time.  Non-durable spending includes such items as food, taxes, clothes, insurance, travel, hobbies, charitable contributions, medical care, etc.  What the research shows is that people, especially at the higher income levels, increase their discretionary spending (travel, charity, hobbies) throughout their retirement.  Medical costs, a non-durable spending item, also increase over time.  What is important to note is that even with increasing discretionary and medical spending during retirement, research shows that overall spending generally declines during retirement.  This decline in spending is typically voluntary.

The following table summarizes the results of Dr. Lee’s analysis of retirement income replacement rates.

Source: “The Retirement Income Question” Marlena Lee, Dimensional Fund Advisers

For the lower income levels, retirement income replaces a greater percentage of working income.  Social security makes up a greater share of retirement income for the lower income groups.  Retirement savings generate a greater proportion of retirement income for those at the higher income levels.

Dr. Lee’s research provides evidence-based guidance regarding retirement income replacement.  This information provides the basis for determining the answer to the question, “How much should I save?”  Next week we will explore that issue.