In the absence of a personalized financial plan, conventional advice suggests that once retired, a household will need between 70 percent and 90 percent of its final year’s working income to maintain the same living standard throughout retirement. This popular benchmark has become known as the Income Replacement Ratio (IRR).
Researchers believe that retirees can sustain their pre-retirement lifestyle on less than 100% of their working income because they will pay lower taxes, maintain or reduce spending and no longer need to save. In my previous articles we tested the first two assumptions and found that in many instances they are overly optimistic and can cause individuals to underestimate their income needs. Now let’s examine the theory that once retired, individuals can forgo saving and still maintain their lifestyle.
First, target replacement levels assume an “average” savings rate in the years just before retirement. In reality however individuals differ in their savings habits. Those who set aside a substantial portion of their income while working may be able to maintain their preferred lifestyle by saving significantly less in retirement. Conversely, those who saved little prior to retirement, may need to increase their annual saving once the paychecks stop. Few Americans are “over-savers” so in most cases substantially reducing expected income needs to reflect a material reduction in savings needs is wishful thinking.
Second, during working years the impact of inflation (measured by the Consumer Price Index) on the family’s standard of living is mitigated by salary increases, so nominal inflation is not of paramount concern. For retirees, however, who must supplement Social Security with savings or fixed employer pensions, inflation can have a destructive effect. Making matters worse, medical costs, a large element of most seniors’ budgets is rising faster than overall inflation. Astute retirees recognize that to maintain their lifestyle in later years they will have to save part of their income to compensate for the corrosive effects of inflation.