When you're trying to determine how much retirement income you'll need, you'll probably find experts advising you to aim to replace between 70% and 90% of the money you were earning before stopping work.
At first glance, this seems to make sense. You won't have to devote money to saving once you're already retired, so that will free up some cash. And you'll theoretically see your expenditures fall once you aren't commuting to work every day.
There's just one problem. The data shows that many people don't end up reducing their spending after retiring. And if you think you'll require between 10% and 30% less money, but it turns out your expenses are the same, you may face a financial shortfall.
Most retirees don't cut spending very much
According to recent research from asset manager Schroders, around 51% of retired survey respondents indicated their spending didn't fall in retirement. Instead, it either stayed the same or went up.
Sometimes, this happens because you choose to enjoy your newfound freedom by traveling or participating in high-priced activities. In other cases, you'll have to shift some of your money to covering healthcare expenditures, which tend to grow as you age. For many retirees, leisure and recreational purchases are their primary expenses early on, but healthcare takes their place over time.
Retirees also can't just stop saving entirely. While you don't have to sock away funds in a 401(k), you should still have a fully stocked emergency fund. And once you've tapped yours, you'll have to save to rebuild it. You may also want to save for big purchases you can't afford to cover all at once on a fixed income. And you should be setting aside money to cover deductibles, co-insurance, prescription expenses, and other healthcare costs.
All of this means that planning your retirement around reduced expenses may not be the best approach.
How can you make sure you have enough?
If you don't want to face a financial shortfall as a retiree, your best bet is to assume you'll have to replace 100% of pre-retirement income -- the amount you'll earn right before leaving the workforce.
You can estimate your pre-retirement income by taking the amount you're earning now and figuring it'll increase an average of 2% each year until retirement. That accounts for periodic salary bumps. If you're earning $45,000 now, assume you'll be earning $45,900 next year and $46,818 the year after that, and so on until your retirement age.
If you expect your final salary to be $60,000, bank on continuing to require $60,000 in income. From there, it's easy to determine how big your retirement accounts need to be.
Your investments will probably be your sole source of income to supplement Social Security. If you're trying to hit that $60,000 income target and your Social Security benefits will produce $20,000 annually, your savings must provide the other $40,000. (You can use your mySocialSecurity account to find out your likely benefit amount.)
If you're going to follow the 4% rule and withdraw 4% from your investment account each year, multiply $40,000 by 25, and you'll find that you'll need a $1 million nest egg.
By planning to replace your full pre-retirement salary, you'll substantially reduce the likelihood of having too little money to enjoy your later years. If you end up with more than necessary, that's not a bad problem to have.