When you retire and are no longer getting a paycheck, you need to replace the income your employer used to provide you. As you set retirement goals, determining how much of your income you need to replace is key -- especially as most people's spending changes in retirement.
Unfortunately, many people aren't being realistic when they're estimating the amount of their pre-retirement income they'll need to cover their costs in their later years. And that can be a huge problem because if you set your sights too low and plan to live on an unrealistic budget, you could find yourself struggling as a retiree or drawing down your investment accounts too quickly.
Here's the big mistake current workers are making
According to recent research from the Transamerica Center for Retirement Studies, the mean amount of pre-retirement income that workers think they'll need to replace is 67%.
Unfortunately, those who are anticipating needing so little of their pre-retirement funds are going to be in for an unpleasant surprise. The simple fact is, expenses don't drop that much once people leave the workforce. In fact, while you may change what you spend money on as a retiree, most experts suggest you'll need to be able to replace between 70% and 85% of the income you were earning at your pre-retirement job in order to avoid a substantial decline in your quality of life.
That means even in a best-case scenario where they're able to make big budget cuts, most workers will have a shortfall if they aim to replace only 67% of pre-retirement income. And the reality is, there's actually a strong possibility you'll end up needing more money in retirement rather than less. In fact, past research has shown close to half of all senior retirees exceed their pre-retirement spending during their first two years of retirement, and about a third continue to spend at these higher levels six years later. And seniors who spend more after leaving work typically spend a lot more than they did before, with 30% of households spending 120% more during the first two years and close to a quarter exceeding pre-retirement spending by this amount even six years after retiring.
If you anticipate spending 67% of your pre-retirement salary and end up spending 120% or more, you're going to have a major financial shortfall. Chances are good you'll run through your retirement nest egg too quickly because you didn't plan for your investments to produce as much money as you need -- and then you'll be in real trouble if your money is gone.
Instead of shortchanging yourself, be realistic about your withdrawal rate. At a minimum, you should expect you'll need about 80% of your pre-retirement salary -- but if you want to be safe, assume your investments and other income sources (such as Social Security) will need to produce enough to cover 100% of pre-retirement spending. Then you can work from there to set your retirement savings goals so you have enough money saved.
Don't short-change yourself when it comes to your retirement plan
Underestimating the amount of income you need to replace in retirement could be devastating to your long-term security. Remember, it's always better to err on the side of anticipating you'll need to replace more of your pre-retirement income than you expect. That way, the worst that can happen is you'll have too much money in your retirement accounts -- which is a pretty good problem to have.