Last Monday I wrote a post in response to the TRowe Price article about retirement planning, talking about the approach that one should take when saving for retirement. This is something that I’ve talked about numerous times, but the basic principle is simple: Don’t ask yourself “How little do I need to save in order to scrape by in retirement?”, but instead, “How much can I possibly save?” See the difference?
As I mentioned, the catalyst for the post on Monday was the TRowe article, which as I already mentioned, talked about the retirement planning strategy of using your pre-retirement income to calculate your retirement income (or how much money you need). Edward Antrobus brought up a great point in his comment that the biggest issue that he had with the article wasn’t the idea of encouraging the lack of aggressive retirement savings, but instead the use of income to calculate the needed retirement nest egg. And I couldn’t agree more. I realize that I didn’t address this at all in my previous article and it’s time to give it its due attention.
Reasons Why You Should Not Base Retirement Planning on Pre-Retirement Income
# 1 – You Don’t (or shouldn’t) Spend All Your Income
The first, and most obvious reason to not base retirement planning on pre-retirement income is the simple fact that you are or should be saving a portion of your income for retirement. Kudos to you if you want to keep saving for retirement while in retirement, but your income is not an accurate picture of how much you need to survive. Again, one should never fall into this mindset of how little do I need, but if you are going to do it, you might as well do it right.
For example, if I earn $100,000 before retirement, the simplistic rule would suggest that I need $75,000 in retirement to live off of. What this simple calculation failed to consider is that some people who earn $100k might very well save $50k each year and live off the other $50k. So, why would anyone suggest that someone who had been living off of $50,000 each year needs to MORE money in retirement than after. But, this is not the critical breakdown in the argument – because they may very well be increased costs in retirement (healthcare, illness, assisted living, etc.). Instead, the error comes in the failure to consider the expenses. Using the same example, someone earning $100k, may be saving $10k each year and spending $90k. So, this rule of thumb is telling both individuals that their recommended retirement income to shoot for is the same. How does that make any sense at all?
# 2 – It Fails to Consider All of Your Lifestyle Changes/Situation (Future Expenses)
On top of the fact that it fails to consider the actual expenses of individuals, it also fails to consider the other financial elements that are determined by key life situations or changes. One of the biggest examples of what I mean falls in real estate. If someone owns their house outright, it makes a lot of sense that this person would need less money in their retirement accounts than someone who is paying rent or a mortgage payment each month. Another fine example is the idea of moving to a state or location that is more affordable. The fact is that judging how much money you need in retirement based off your income falls short because it not only considers the current/past expenses of the individual, but the future changes as well.
# 3 – It fails to take into consideration Inflation, Returns, etc.
Last, but certainly not least, this rule of thumb falls short because it also fails to consider other variables in the economy. Inflation and rate of returns on your investments will impact the worth of your money. If there is a significant uptick in inflation, it means that the money that you have is worth less – or has less “buying power”. Similarly, if the market tanks and you get a low return, that means you have to either lower your expenses or dip into your nest egg (instead of living off of the returns), which would reduce your potential returns in the future. While I’m not suggesting that you can predict all of these factors, it may not be a bad idea to consider this other variables when deciding how much money you need – and it’s clear that the 75% of pre-retirement income falls short once again.
If it’s not already obvious, the idea that you can figure out how much money you need for retirement based on only your income is ludicrous! If you have been using this to calculate your retirement needs, stop whatever you are doing and try a new formula. I don’t have a magical formula (at least not to present to all of you, just yet), but I am urging you to consider other variables other than just income.
Readers, what elements should people use to calculate their retirement needs?