7 steps to estimate your retirement cash-flow needs

By Christine Benz |  19-08-20 | 

New retirees find the financial aspect of the retirement transition to be a little jarring. Estimating actual cash-flow needs is a tricky business.

While retirees are often counselled to estimate that they'll spend 75% to 80% of their working incomes in retirement,  there can be huge variations in income-replacement rates among retirees--with factors such as pre-retirement income and savings rates serving as key swing factors.

Higher-income, higher-saving households may well need just 60% (or even less) of their pre-retirement income during retirement, while lower-earning, lower-saving households may need closer to 90%.

Ultimately, it may be difficult to forecast your actual income-replacement needs with a great deal of precision. Even as you attempt to anticipate every in-retirement expense to the penny, unforeseen expenditures such as healthcare costs can buffet spending around on a year-to-year basis. But because anticipated income needs are such a key ingredient in the retirement-income puzzle, it's helpful to come up with as realistic a figure as possible while also being realistic that your own expenditures are apt to vary over time.

Here are key steps to take when arriving at your customized income-replacement rate.

Find a realistic baseline. Your current working income is a starting point.

If you're close to retirement and seek to maintain a standard of living in retirement that's similar to what you had while you were working, using your current salary as a baseline is reasonable.

If you're younger--say, in your 40s--it may be wise to nudge up your baseline income for retirement-planning purposes, because your current income may not be reflective of what you'll want to spend when you eventually retire. Not only are you apt to receive cost-of-living adjustments as the years go by, but career gains could also lead to a higher salary over time, which you may want to "replace" in retirement.

You probably will make at least a 50% higher salary at retirement than you did at age 30. Gains in salary over time are less pronounced for people with lower levels of educational attainment.

Subtract your savings rate. Look at what percentage of your salary you're saving--or expect to save by the time you retire--and subtract that from your baseline salary amount.

One of the reasons higher-income individuals typically have lower income-replacement rates than lower-income people is that the former are able to save a higher percentage of their salaries during their working years; they need less of their salaries to fund basic living expenses. A household saving 20% of its income will see its income-replacement rate drop to 80% right out of the box, even without factoring in any planned lifestyle changes, such as downsizing homes. If you're several years from retirement, it may be that you'll kick up your savings rate if your income grows.

Subtract tax reductions.

Many people realize tax savings when they retire. Those gained savings tend to be more pronounced for higher-income workers than lower-income ones. More affluent households may see a bigger percentage drop in taxes in retirement than lower-income households because they have greater control over their taxable income now that they're no longer earning a paycheck; the less they pull from their portfolios, the less they're taxed on.

As all types of households draw income from their portfolios to fund in-retirement living expenses, some may be able to have more levers available to keep taxes down, to stay within the lowest tax bracket.

Subtract home loan payments.

Housing costs are another line item with the potential to change substantially in retirement. It would be good to come into retirement without a home loan. Or any loan for that matter.

Factor in lifestyle changes.

Retirement-planning guides often urge retirees to factor in changes in other expenses, such as commuting, clothes for work, and meals out while on the job or due to busy work schedules. For some households, these expense changes may be minimal, but for others, they may be more substantial. Some studies point to food costs as one of the expense items likely to decline the most in retirement.

Lifestyle-related outlays aren't guaranteed to decline in retirement, so don't assume a reduction in yours without crunching the numbers. If a heavy travel schedule or an expensive hobby is on your retirement to-do list, you might see any cost reductions on line items like food offset by increased expenditures elsewhere.

Add higher healthcare costs.

One area where expenses are likely to increase in retirement is in the realm of healthcare. Healthcare expenditures are a bigger share of the consumption basket for elderly households. Also note the increase in healthcare costs that are higher than the general inflation rate.

So there are two aspects to consider: Healthcare costs outstrip the general inflation rate, and also tend to trend up through retirees' own life cycles.

This is what Blanchett calls the retirement spending smile. The tendency for household expenses to be on the high side just after retirement (when spending on travel and leisure is apt to be high), dip in midretirement, then head back up toward the end of life as healthcare costs increase. If you're someone who's going without long-term care insurance, in particular, recognize that your household's total healthcare-related outlay could spike dramatically.

Add a fudge factor.

Working through each of these line items may get you closer to your actual income-replacement rate rather than relying on rules of thumb such as 75% or 80% for income replacement. At the same time, it's worthwhile to approach the exercise with the knowledge that there's much about your future spending that you can't foretell.

Long-term care costs are the biggest wild card for people who don't have long-term care insurance or for those who have policies that are capped at specific benefits.

Many seniors have also been called upon to help their adult children or their families, in the case of divorce or death, unexpectedly increasing their financial outlays in retirement.

There could be an unexpected home bill cause by flooding or some calamity.

All of these factors can send your expenditures out of line with what you thought they would be. The potential for those unanticipated expenses argues for nudging your own income-replacement rate a bit higher to allow for some wiggle room in your planning.

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