Chances are high you're going to retire one day, and equally high are the odds you'll live 20 or possibly 30 years beyond that. Relying on the investments you've made during your most productive years can be a complex maze that, if effectively navigated, will result in the right amount of money to last throughout your retirement. In order to properly navigate that maze, you need to fully understand exactly how much it will cost to retire.
Retirement Planning Overview
To begin with, most investors look at what is called the "replacement rate," for their income during their retirement. In other words, what percentage of their pre-retirement income will they need to live out their days in the lifestyle they have chosen?
For example, they may determine they will need a replacement rate of 80% and an annual increase that keeps pace with inflation over a fixed period of time – usually 30 years. There are three assumptions to this:
- The replacement rate
- A constant real consumption rate
- A fixed retirement period
Generally the replacement rate will be less than 100% of the earned salary because many of the expenses incurred during the working years decrease or disappear.
The most accurate way to analyze replacement rates is to calculate the total household income in retirement – such as Social Security, Roth IRA, taxable accounts, etc. – and divide that number by the pre-retirement income. Approximately 80% of retirement incomes are from pre-tax savings that are large enough to make up the necessary difference.
In most cases, there will be no dependents during retirement meaning retirees can claim only two exemptions. Using the 2013 tables the following assumptions can be made:
- The retirees itemize deductions when they are larger than standard deductions
- A state tax rate of 4%
- Ignore other tax considerations – like healthcare expense which are generally deductible
- The retirees no longer pay Medicare and Social Security taxes
- The goal is to have close to the same post-tax income during retirement
Depending upon pre-tax and post-tax retirement expenditures, calculations confirm that though 70-80% is reasonable, it isn't necessarily ideal. It is also clear that the replacement rate is dependent upon the proportion of pre-tax to post-tax expenses. This expands the range from anywhere between 54% to 87%
Must Retirement Income Rise with Inflation?
Once again, this is a factor based on spending habits of retirees. The Consumer Expenditure Survey (CEX) helps to determine income needs by focusing specifically on:
- Clothing costs
- Charitable contributions
- Personal Care
- Insurance and Pensions
- Education, and
When the expenditure for these categories are compared to different household ages it is evident that older retirees spend less on insurance and pensions as they get older, while healthcare costs increase significantly.
Taking into consideration the Consumer Price Indexes available, it is apparent that the retiree inflation rate is 3.15% per year. This is an important consideration given longer retirement periods that occur with lengthening life spans.
Consumption Changes over Time
Research into retirement spending generally assumes there will be an increase annually due to inflation. However, this isn't necessarily the case. What is apparent is that there is what is referred to as a "spending smile." Expenditures decrease for retirees then increase as they approach the end.
Studies also indicate that spending during retirement usually drops, but it is unclear if this is due to a change in expenditures or if it a choice or reaction to need.
In order to better understand the study, four groups were created based on consumption and total household net worth. The "matched" groups that had similar levels of spending and net worth experienced similar changes in expenditures from the ages of 65 to 75. Mismatched households tended to increase consumption or drastically reduce spending if their net worth was low.
Annuities, which generally provide a fixed amount of income over a predetermined amount of time, can often be a means of influencing consumption changes during retirement. Variable annuities present greater risk, but also greater potential returns. Before investing in annuities, though, you'll want to consult some videos about variable annuities that will help you weigh the benefits and drawbacks of these financial products.
Expected Healthcare Costs
Medical costs for retirees are going to be different according to each situation. While most will have their expenses covered by Medicare, others could incur considerable out-of-pocket expenses for things like long-term care and other items that Medicare doesn't cover.
Retired households are grouped into three tiers based on total expenditures:
- Low: households spending in the 95th to 65th percentile
- Mid: households spending in the 65th to 35th percentile
- High: households spending in the 35th to 5th percentile
Overall, there are no significant differences in the percentage of medical costs among these three groups.
The median percentage of the costs for medical expenses increased only 5% by age 60 and only 15% by age 80. For those in the 95th percentile, the rate was from 25% at age 60 to 35% at age 80. These findings suggest that overall medical expenses affect retirees in a similar manner in terms of total costs.
How much will Social Security Income Influence Retirement?
This is difficult to answer as it will depend on how much you have in other retirement savings accounts. As of 2013 the maximum amount a retiree could receive was $2,533 a month (if he retired at age 66).
If you are going to be depending heavily on Social Security during retirement the best way to ensure the highest amount per month is to delay your retirement. Each year beyond the age of 62 that you delay receiving Social Security benefits increases the amount you will receive by as much as 8 percent.
Currently, 23 percent of married retirees and 46 percent of unmarried retirees Social Security makes up 90% of their income. Those figures increase to 53 percent of married retirees and 74 percent of single retirees who receive 50% of their income from Social Security.
There are many variables to adequately preparing for you retirement. In order to properly prepare, talk with a financial advisor and learn more about the existing programs long before you're approaching those golden years.