Will You Really Need to Replace 80% of Your Preretirement Paycheck?

How much you save for retirement now and how much you plan to spend in the future are two factors driving your personal income-replacement rate.

Piggy bank
(Image credit: Getty Images/iStockphoto)

If you have sought advice on how much to save for retirement, you've likely run across the "80% rule." For a secure retirement, the theory goes, you should aim to replace roughly 80% of your preretirement paycheck with portfolio withdrawals, Social Security, pensions and other sources of income.

Yet recent studies suggest that the 80% rule may be way off the mark for many retirees. People approaching retirement may want to abandon the idea of income-replacement rates altogether, focusing instead on how much they're likely to spend in retirement.

To maintain their standard of living in retirement, many people don't need to replace 80% of their gross income, according to researchers. That's because they lived on far less than that amount during their working years, when they were making retirement-account contributions and in many cases paying heftier tax bills than they'll pay in retirement. And since most people don't move straight from full employment to full retirement but instead move through some period of part-time work, unemployment or disability, it can be difficult to even sort out what should be counted as "preretirement" and "post-retirement" income when calculating an income-replacement rate.

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The 80% rule is "imprecise and encourages people to save an amount of money that may not be needed for spending in retirement," says Michael Finke, professor of personal financial planning at Texas Tech University. What's more, he says, it "may create a sense of anxiety among workers whose current savings may seem woefully inadequate."

Some advisers say a 70% to 80% income-replacement rate is still a good guideline, particularly for people who are years from retirement. T. Rowe Price, for example, suggests that savers aim to replace 75% of preretirement income. Since the firm suggests workers stash 15% of their salary in retirement accounts, and taxes tend to be lower in retirement, a 75% replacement rate should allow retirees to maintain their lifestyle, says Judith Ward, a senior financial planner at T. Rowe Price. But as you get closer to retirement, she says, "it's important to sit down and figure out what you truly will need in terms of managing expenses."

Hitting the 80% income-replacement mark may seem especially daunting in an era of low interest rates. Given current annuity rates, for example, a 65-year-old man can generate about $33,000 of annual income for every $500,000 he has saved. So "if they think they're supposed to replace 80% of gross income, you can see why many savers might be discouraged," Finke says.

Many Expenses Decline in Retirement

The good news: Many retirees can be happy spending far less than 80% of their preretirement income. Indeed, the top 20% of earners spend only about 40% of their gross income in the year before they retire, Finke says. Expenses that decline or disappear when you retire include not only retirement-account contributions and Social Security and Medicare taxes but also work-related expenses, such as commuting. Other big-ticket expenses may also fade out, such as kids' tuition bills.

Plus, you may have a higher standard deduction and get a greater share of your income from sources, such as Social Security, that are taxed more favorably than your work paycheck. In a 2014 T. Rowe Price survey, retirees said they were living on 66% of their preretirement income, on average -- and most said they were living as well or better than when they were working.

But personal factors, such as how much you're contributing to your 401(k) plan, can make a huge difference in the income-replacement rate you need to maintain your lifestyle in retirement. Couples may need to replace anywhere from 54% to 87% of their preretirement income, depending on such individual factors, according to a study by David Blanchett, head of retirement research at investment-research firm Morningstar.

Consider a couple where one spouse earns $100,000 and the other earns $50,000. They're spending 15% of their income on pretax expenses, such as 401(k) contributions, that will disappear when they retire. They're spending another 12% of income on post-tax expenses, such as Roth IRA contributions, that they'll no longer incur when they retire. To have the same after-tax income when they retire, they need to replace only 55% of their preretirement income, according to Blanchett's study.

A couple earning the same amount but making no pretax retirement contributions and spending only 3% on post-tax costs such as commuting, however, needs to replace 80% of their preretirement income. "The more you save for retirement, the lower your replacement rate," Blanchett says. Replacement rates will also vary with income level. Lower-income households generally have higher replacement rates because they tend to pay lower taxes during their working years, according to Blanchett's study.

Health care spending is a wild card for retirees. Still, rising health care costs in later years won't necessarily torpedo their plans. Although health care spending may become a bigger part of total spending later in retirement, Finke says, overall spending still tends to decline during retirement. To get a firmer grip on health costs, use a realistic life expectancy estimate when calculating your total retirement spending -- rather than, say, a fixed 30-year period -- and consider long-term-care insurance to cover the worst-case scenarios.

People looking for an accurate estimate of their retirement-income needs will have to tally how much they're likely to spend in retirement. If you're on the brink of retirement, you can use your current spending as a starting point. Subtract expenses that will definitely disappear when you retire, such as retirement-account contributions -- and perhaps your mortgage payment, if you're planning to pay off your mortgage. Consider other areas, such as travel, where spending might increase when you retire. But for most spending categories, your expenses are likely to be the same, Finke says. "It's very difficult to break your spending habits," he says. When you go to the grocery store in retirement, "you go to the same aisles and buy the same things."

Once you have a good estimate of your retirement spending needs, you can add up your Social Security, pensions and a sustainable level of portfolio withdrawals to see if your savings are on track. To find out how much you can safely withdraw from your portfolio while minimizing your odds of running out of money, see Return Your Retirement Plan to Solid Footing.

Eleanor Laise
Senior Editor, Kiplinger's Retirement Report
Laise covers retirement issues ranging from income investing and pension plans to long-term care and estate planning. She joined Kiplinger in 2011 from the Wall Street Journal, where as a staff reporter she covered mutual funds, retirement plans and other personal finance topics. Laise was previously a senior writer at SmartMoney magazine. She started her journalism career at Bloomberg Personal Finance magazine and holds a BA in English from Columbia University.