Why Your Retirement Savings May Be Enough After All

If you're in your fifties or sixties, retirement is looming large on the horizon. Many people are worried about accumulating a large enough nest egg to say good-bye to their careers. The conventional wisdom passed along from financial planners is that in retirement you'll need to replace 80% of your pre-retirement income. Now, a new study published by the National Bureau of Economic Research says that may not be true after all. Two top retirement experts co-authored the study, Susann Rohwedder and Michael D. Hurd. If what they say is true, the amount you need to save for retirement may be far less than you had thought. In fact, you may already have enough savings to retire. The study found that 71% of 66-69 year olds already do. This would indeed be welcome news for many Americans.

Conventional theories on retirement planning say that you should replace 80% of your pre-retirement income in retirement. What this means is that if you earn $80,000 per year just before you retire, you should aim to have income of $64,000 in retirement to live comfortably. Carrying this out further, if you assume that Social Security will cover $1500 per month or $18,000 per year, you'll need to come up with $46,000 per year in income from your own savings or from a company pension, if you're lucky enough to have one. So, in order to produce $46,000 in income, you'll need a nest egg of approximately $1,150,000, assuming a 4% annual withdrawal rate. The 4% rate is another conventional guideline that should allow your money to last until the end of your life.

You can see that this large number is overwhelming and seems near impossible to achieve, especially if your highest salary was $80,000 a year. Many people see this number and give up completely.

What the study found is that consumption is a more important factor in determining the income required in retirement than is replacing a set percentage of pre-retirment income. In retirement, you'll no longer be paying Social Security taxes, contributing to your 401k or IRA, paying high rates of income tax, or encountering work-related expenses. If you have children, they'll (hopefully) be done with college and independent, no longer relying on you for support. Your home may also be paid for. In fact, that's an excellent goal to strive for before retirement. And finally, services that you relied on as a busy worker, such as someone to clean your house and mow your lawn, may no longer be required since you'll have more time in retirement to do those things yourself. All of this leads to much lower monthly expenses in retirement than when you're working and this is what should be considered.

So instead of using the 80% guideline, it makes more sense to look at your patterns of consumption. Take the time to track your monthly expenses for three to six months to really get a feel for what you spend. Then take a look at those expenses and decide which of them would be reduced or eliminated completely in retirment. Also consider which expenses might increase in retirement. For example, your health care costs and entertainment and travel expenses may increase. Then, use your consumption number, padded a bit, to arrive at your target retirement income. This number is likely to be a lot less than the one derived via conventional methods of retirement planning.

For example, let's say that in the above example, you're making $80,000 per year but you're actually living on only $40,000 per year after taking out retirement contributions, mortgage payments, social security taxes, and other work related expenses. Subtracting the $18,000 from Social Security leaves $22,000 per year that needs to come from your own investments. $22,000 divided by the 4% withdrawal rate equals $550,000 required in your nest egg to retire. That's a lot more attainable than the greater than $1 million dollars calculated the conventional way. Reducing your consumption and monthly expenses will result in an even smaller nest egg requirement. It pays to live small.

In addition to saving an adequate nest egg to generate enough income to cover your consumption, you should also plan to set aside some funds to cover the inevitable emergency. In retirement, the biggest risk is related to unexpected health care costs. It's wise to ensure you'll have enough money in a separate fund to cover out of pocket expenses should you or your spouse become sick. This number will vary according to your insurance plan but should not be ignored.

So instead of focusing on replacing a set percentage of your pre-retirement income, work to understand your consumption patterns and plan to cover those, with a cushion for emergencies. Using this method, you'll have a lot more control over your required nest egg because you can control your consumption to a large degree. You might even find that you have enough money saved to retire earlier than you ever thought.