Why retirement will be cheaper than you think.

income replacement ratio

Will retirement be cheaper than you think?  Maybe.  A lot depends on your income replacement ratio.  What’s that you ask?  It’s the percentage of your current income that you will need during retirement to maintain your standard of living.

Some people will need 100% of their current income.  Others will be able to get by on less.  Ironically, the more money you make now, the lower your income replacement ratio will likely be.  That’s because you probably aren’t using all of your current income for expenses that will still exist during your retirement years.

Here are three major expenses that will likely disappear from your retirement budget:

Savings:  Retirement is a shift from the accumulation phase to the distribution phase.  That means no more 401(k), IRA or savings account contributions.  How much are you saving now?  Five Percent?  Ten?  Fifteen?  Once you’re no longer saving, you won’t need that income.

Payroll taxes: Looking at the glass half-empty, retirement means no more paycheck.  Looking at the glass half-full, that also means no more Social Security and Medicare taxes on your earned income.  Right now you’re paying a 6.2% Social Security tax on your first $114,000 in income and a 1.45% Medicare tax on all your income (7.65% total or twice that if self-employed).  And if you’re a high-wage earner ($200,000 for singles, $250,000 for couples) you’re paying an additional 0.9% Medicare surtax.  Those taxes go away when your earned income goes away.

Work expenses: Think of all the expenses you have that relate to your job: commuting, dress clothes, expensive lunches, a second car.  Most of those expenses can be reduced or eliminated in retirement, which is probably the equivalent of hundreds of dollars each month that you can cut from your budget.

If I apply those three items to my own budget, I could eliminate more than a quarter of my expenses.  How about you?  How much could you get rid of?  I’m guessing the amount is significant.  If you’re able to pay off your house and retire debt free, you could eliminate even more.  To be fair, you’ll also have some expenses that get added to your budget during retirement (e.g. travel, hobbies, etc.), but those likely won’t outweigh the cuts.

A common rule of thumb for your income replacement ratio is 85%.  David Blanchett, head of retirement research at Morningstar, thinks that most people will be able to get by on less.  Whatever the number, it is the primary driver of how big your nest egg needs to be.  Shave 20% from your income replacement ratio and you’ll be able to shave 20% from your nest egg, which means you could save less and retire sooner.

Start Today

One of the benefits of the exercise above is that it shows the direct link between expenses and retirement.  The less you need, the sooner you can retire. Remember that your ideal retirement is not about age or work status.  It’s about control.  It’s a gradual shift from doing what you have to do to doing what you want to do.  One way to speed that shift is to save more, but equally effective (and often overlooked) is to need less.

~ Joe

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