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Retirement Planning: Focus on Covering Expenses Rather Than Replacing Income

I’m currently reading Charles Farrell’s book Your Money Ratios. In the book, Farrell suggests that once your retirement savings reach 12-times your annual salary, you should be able to retire. Interestingly, just a few weeks ago, I encountered an article in The New York Times stating that you need 20-times your annual salary in order to be able to retire.

That’s a huge discrepancy! The NYT writer (Teresa Ghilarducci) is suggesting you need 67% more money than Farrell says you need. So who is right?

Neither. (Or maybe both, depending on how you look at it.)

When we talk about retirement planning, there’s always a great deal of uncertainty: investment returns, how long you’ll live, how your tax rate will change over time, etc. But, by basing the how-much-do-I-need number on the reader’s pre-retirement level of income rather than spending, the writers above are adding yet another source of uncertainty and imprecision.

For example, the higher your income level, the greater the portion of your pre-retirement income that you’ll have to satisfy with your portfolio, because Social Security will replace a smaller portion of your pre-retirement income than it would for somebody with a lower earnings history.

Or, if you expect to pay off your mortgage shortly after retiring, you’ll be able to get away with replacing a much lower portion of your pre-retirement income than somebody who plans to rent throughout retirement.

Or, if you started saving very early, such that you’ve been able to use a low savings rate throughout your career, you’ll have to replace a higher portion of your pre-retirement income than somebody who was late to the game but who adjusted to living on just 60% of her pre-retirement income in order to catch up on retirement savings.

When expressed as a multiple of end-of-career salary, the multiple one person needs to reach in order to retire could be twice as high as the multiple another person needs to reach.

Focus on Expenses Rather than Pre-Retirement Income

If you want to get a good idea of how much you need saved in order to retire, it makes more sense to go about it directly — by looking at the expenses you hope to satisfy.

  1. How much will you be spending per year in retirement, and
  2. How large a lump sum will it take to finance that spending?

Even when you base your retirement calculations on your actual expenses, there are numerous uncertainties left in the planning. There’s no need to use a rule of thumb that adds yet another layer of potentially-wrong assumptions.

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  1. Mike,

    I was really annoyed by that Ghilarducci article, where the key statement that you quote (“To maintain living standards into old age we need roughly 20 times our annual income in financial wealth. If you earn $100,000 at retirement, you need about $2 million beyond what you will receive from Social Security“) is simply asserted as an unassailable fact without the slightest justification or support. Unfortunately no on-line comments were available so readers could contest this incredibly irresponsible assertion.

    Ironically, although at age 64 I do not have 20 or even 12 times my annual income saved, the “20 times” phrase links to an AARP calculator that tells me if I retire at 67, I won’t run out of money until I’m 88! (Not that I place any great faith in the calculator, which for one thing appears not to consider inflation.) Since my “official life expectancy” is 82, I’ll be more than happy to live to 88. But all that these numbers do is to impose a reductive and simplistic set of formulas for what has to be a dynamic and flexible approach to retirement that will have to adjust periodically as the retiree’s financial position changes.

    I have no doubt that many millions of near-retirees are nowhere ready for retirement, and there are always unpredictable factors like catastrophic health issues (negative) or an inheritance (positive) that could significantly alter my own financial picture. Nonetheless, I refuse to give in to panic just because some self-styled “retirement expert” comments on “our ridiculous approach to retirement” by offering her own ridiculous approach to retirement.

  2. Larry,

    Thank you for pointing the article out to me in the first place.

    I agree that a “dynamic and flexible approach to retirement that [adjusts] periodically as the retiree’s financial position changes,” is the best real-life answer.

  3. MB @ 12 Year Career says

    I 100% agree with the expense approach to retirement planning vs. the salary approach. My salary just prior to retirement will be just as irrelevant then as it is today. I never see that much money now and I won’t need that much money in the future! Beyond my current level of expenses, any excess salary is put in savings which I hope will eventually cover approximately the same standard of living in retirement. Of course, as you said, there are a number of unknowns that make it a moving target, but I feel much more comfortable with my approach than the salary-based metrics.

  4. Focus on the expenses not the salary. Our expenses change as we go thru life. As I age, health care expenses will grow larger but right now I am focused on travel so my savings for travel is higher now than it will be 13 years from now when I am 70. One of the best things we can do for our retirement savings is have no mortgage.

  5. Hi Mike,

    Glad to see that you’re reading “Your Money Ratios”. I personally found it very easy to
    read and extremely informative. I hope that you enjoy it too!

    I think that you are right about the focus on expenses as opposed to income. But I think that this opens a big can of worms: budgeting. For many people just starting out budgeting advise can come down to something like this:
    1. Create an emergency fund for 3-12 months of expenses
    2. Save 10%-20% of your salary in a retirement account
    3. Feel free to spend the rest of your income.

    However, I think that retirees, or those farther along, have another issue. They have a ton of money at their disposable – no one is “doling it out” the way a paycheck gets doled out. How to budget in this situation? What to do if you get a big raise?

    Have you tackled budgeting on your site yet? If not, I’d like to see you write a series on it.

    I’d also like to note that many of the early retirees (such as Jacob Fisker at attribute aggresive budgeting as the key to early retirement. Fisker, for example, worked for 5 years and, by living on $7k/yr, retired after something like 5 years of employment. The anonymous blogger at retired at around age 30 and supports a family of 3 on ~$2k/month.

  6. Anon,

    Yes, I am enjoying the book, despite disagreeing with his method on this topic. (In particular, I enjoyed the chapter on Social Security. I thought he gave a great explanation of the basics.)

    As far as budgeting, the truth is, we don’t do it. We track our spending to a) make sure no one category gets dramatically out of line with our priorities and b) get an estimate of a good number to use for retirement calculations. But that’s it. No actual forward-looking budgeting. We just make sure to use a savings rate that we’re comfortable with, then happily spend the rest.

    On a related note, I got to meet the writer of Mr. Money Mustache this weekend. Very nice guy.

  7. Mike,

    Do you recommend any particular software package or method for tracking spending? I have heard a few people recommend Quicken, and some recommend Mint. I’m not sure what the pros and cons of each are, or whether there are other ones to look at too.

  8. I like Mint a lot. It’s not perfect, but overall it’s pretty good. It imports data from your credit/debit card charges and categorizes them. It doesn’t always get the category right on the first try, but after you correct it, it will then know how to categorize that vendor in the future.

    (Note: I’ve never been super thrilled with its investment-related uses. We just use it for tracking spending.)

  9. I found those types of articles so mind numbing simplistic…What if your portfolio is made up dividend stocks vs growth stocks vs muni bonds vs junk bonds vs. index funds vs etc.

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