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May 25, 2014

Estimating your retirement income needs

Accumulating sufficient assets for retirement is a lifetime undertaking involving 40 or more years of saving to support 30 or more years of spending. How much retirement income is enough to support spending in retirement? For those who define a successful retirement as the ability to preserve a pre-retirement lifestyle, the question should be, How much will I need each year to maintain my standard of living once I stop working?

Since the mid 1900s, much has been studied and written about retirement income goals. Common advice from policymakers and retirement researchers suggests that a typical household target between 70 percent and 90 percent of their last year’s pre-tax working income in order to preserve their pre-retirement standard of living.

This is based on the assumptions that many older Americans have fewer debt payments, reduced family expenses, smaller tax bills and lower savings needs. For instance, using the 70 percent figure, someone who retires from a job with a $100,000 annual salary would be expected to need $75,000 a year in retirement income from all sources, including Social Security, employer pension and savings. These percentages, which have become known as income replacement ratios (IRR), are primarily derived from studies conducted by Aon Consulting and Georgia State University that examine how U.S. consumers, including older households, spend their money.

Estimating the amount of retirement income is an essential step in achieving a secure retirement. Because of its simplicity, the IRR has understandably become a popular measure used in the retirement planning process. The reality is, however, that the assumptions underlying the recommended replacement rates are complex and variation in the recommended replacement rate targets is highly dependent upon a household’s unique circumstances. Individuals who fail to understand how those assumptions relate to their personal situation risk adopting a “rule of thumb” that may not support their retirement needs.

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