Will you suffer if your retirement income is only 60 percent of your earnings before retirement?
A recent article on the Bankrate.com website suggests just that. I beg to differ--- as I have for decades. The financial services industry claims that we need to replace 70 to 85 percent of our pre-retirement income. But simply isn’t true for a great amount of people.
As you’ll soon see, the figure for typical households is closer to 60 percent. Do that, and your standard of living in retirement will be the same as it was while you were working. Maybe higher.
The Bankrate article argued that we need 70 percent of pre-retirement income when we retire. It then did a state-by-state comparison of median income from age 45 to 64 with median income at 65 and older. In only three states--- Alaska, Hawaii and South Carolina--- was retirement income over the 70 percent target. The biggest drop was Massachusetts, where retirement income was only 49 percent of pre-retirement income.
Nationwide, the figure was 60 percent.
Sounds like a big drop, but it isn’t what it seems.
The problem here is that “retirement income replacement rate” is a flawed concept. It’s a top-down number. It’s good for pension administrators and Social Security actuaries because they need a general measure of income replacement. It suits their broad purpose.
The replacement rate percentage doesn’t measure how we actually live (and spend) our lives. It doesn’t consider where our money goes when we are working, saving and paying off mortgage debt. It forgets little things like the cost of children.
You can see this by following the money for a middle-income couple. With a pre-retirement median income of $65,016 this household would have paid $4,974 in employment taxes. Also, after saving six percent of income in a 401(k) plan, another $3,901, they would have paid $5,135 in federal income taxes. (All figures calculated using the online calculators at smartasset.com.)
So $14,000 of that $65,016 income is money this working couple has never seen. It’s also 22 percent of their income. The money they have left for spending is $51,016. That’s a bit more than 78 percent of their gross income.
Now let’s see what comes off the top of their 60 percent replacement rate retirement income, about $39,010. Assuming Social Security replaces about 40 percent of their pre-retirement income, or $26,006, and the remaining $13,004 comes from retirement savings, a couple would pay $0 in employment taxes, would no longer be saving, and would owe $0 in Federal income taxes. They would have $39,010 to spend.
That’s $12,006 less than their net income while working. A shortage that big could be painful.
But the shortage doesn’t exist. Here’s why.
The couple has never had all of this money to spend on their personal standard of living. During their working lives they had to take more money “off the top” to repay student loans, take out and pay off a home mortgage, take out and pay off car loans and home improvement loans and cope with the expense of children. That’s just how it is.
How much money could that involve? Sorry, there is no exact figure. How this spending is timed and how much it totals varies from household to household. Some spend up on houses; others spend up on cars. Everyone spends more on their children than they thought they would.
So here’s a challenge. Make a wild guess. Do you think they might have averaged $1,000 a month on home mortgages, car loan payments, plus feeding and clothing children, not to mention work-related expenses?
Here are some data points to help with your guestimate:
- A $73,000 mortgage at 10.7 percent interest in June 1986 would have cost $679 a month, or $8,148 a year. For 30 years. That would have paid for a median priced existing home after a 20 percent down payment at that time.
- A $20,000 car loan at 4 percent costs $368 a month or $4,416 a year.
- A rough current estimate of raising two children, ex-shelter, is about $13,560 a year for a household with a bit over $60,000 in income, according to the Department of Agriculture.
However you slice it, the total will be more than $1,000 a month.
That means a 60 percent replacement rate, for middle-income retirees, could actually mean a higher standard of living.