The financial world is changing, and some popular pieces of wisdom don't hold up quite as well as they used to. The rules that worked in previous decades might not lead to the same outcomes thanks to forces such as inflation, changing interest rates, and stock market volatility.
One such idea is that you need to replace 75% of your income in retirement. Below, I'll explain why and then consider some alternative approaches to this traditional retirement planning strategy.
Rule to forget: You need to replace 75% of your income in retirement
Following this rule opens the door to some key retirement risks, and it's not the best way to think about goal setting during retirement planning. There are three main reasons that you can improve upon the 75% income replacement goal.
- It's a long term strategy that still requires a retirement plan with numerous intermediary steps. It's often easier and more manageable to focus on those intermediary steps instead.
- Some households can comfortably surpass 75% of earned income in retirement, so this rule would actually be aiming low for them. By doing the right things throughout your working life, you can optimize cash flows during your senior years.
- Retirement can last a long time, and the buying power of 75% of your income could decline significantly over the course of multiple decades, thanks to inflation. Rising healthcare costs can also squeeze budgets as people age, causing the target to move even higher, compounding the risks posed by inflation.
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To be clear, seeking to replace 75% of your income isn't a bad goal in itself. It became popular for a reason. However, it's a broad rule that skips a handful of important steps, and it might not result in the best possible outcome. Here are two rules that will put in a better place to guide your financial decision making.
Rule to embrace No. 1: save at least 15% of your earned income
Consistent saving habits are the cornerstone of any good retirement plan. You have to amass wealth that will generate income once you stop working. That's only realistically possible if you're saving the right amount, and most studies indicate that households should strive to retain 15% to 20% of earned income each year. This is a classic "early and often" situation. The most costly years to skip are typically the earliest ones -- the longer you delay setting those goals, the bigger the impact will be.
The best practice is usually a systematic and measurable approach. If you keep track of your net income and spending habits, it's easier to track progress and correct any inefficiencies. Without quantifying these behaviors, everything becomes disorganized and uncertain. Most people struggle with saving because they don't actually know how much is hitting their bank account each pay period and where that cash goes when it leaves the bank. Some strategies to improve household savings rate include:
- Setting a household budget
- Using cash flow tracking apps
- Splitting direct deposits into separate dedicated spending snd savings accounts
- Taking full advantage of employer retirement account contribution matching programs like 401(k) matches
There are numerous other strategies, too, but these are a great place to start. Households that save the right amount should have more than enough to cover cash flow needs. A household with $100,000 of annual income would retain nearly $600,000 over their working lives if they've hitting that 15% goal. That number can get much larger with the right investment strategy, providing plenty of cash flow in retirement.
Rule to embrace No. 2: Take withdrawals using the 3% rule
Years of good savings will put you in position to retire comfortably. As you approach the end of your career, the 3% Rule is more precise than the 75% income replacement guideline. The 4% rule traditionally indicated how much income a household should expect to generate in retirement. It suggested that people could safely spend 4% of their accumulated liquid assets each year without running out of money. That has been challenged in recent years, thanks to rising life expectancy and low interest rates. This prompted many financial planners to revise the magic number downward to the 3% Rule.
Long-term financial plans usually fare better with some level of flexibility and respect for the fact that things can change. Interest rates have moved higher over the past year, relieving pressure on income investors. It's hard to predict what will happen with interest rates or inflation over the next two or three decades, so people who are entering retirement today need a plan that's designed to work regardless of the situation. Replacing 75% of your final income doesn't necessarily meet that criterion.
Planning with the 3% rule in mind can be a powerful step. Before you retire, think about whether 3% of your retirement savings is enough to realistically pay for your basic needs and lifestyle goals. If so, then you're in a good spot. If not, you may need to consider working a few more years.
