You can't plan for retirement without knowing what you'll need.
Retirement Budgeting Overview
A key part of overall retirement planning is to determine just how much you will be spending in retirement and the amount and source of income to meet these expenses. There are various rules of thumb regarding what percent of your pre-retirement income that you’ll need in retirement. These vary widely (50% - 90%) based on your pre-retirement lifestyle and retirement goals/plans.
Some good news from recent research shows that you may need less income as you age. According to a study from retirement researcher Wade Pfau, retires age 75+ spend on average 26% less than those age 65 - 74, who spend 20% less than those who are 55 - 64. This may be due to people becoming lest active, requiring less housing, and a shift of expenses to subsidized health care. On the other hand, it may be due to people having less money to spend.
Regardless of the amount of money you require to maintain your desired lifestyle, the biggest mistake is to underestimate retirement costs and overestimate income. For example, travel, entertainment, and health care costs could increase just as significantly as income taxes, savings, and work-related (e.g., clothing & transportation) expenses decrease. Also, keep in mind that most of your retirement expenses (food, housing, etc.) will probably increase each year with inflation while some or most of your income is fixed.
Instead of relying on rules of thumb to determine how much income you'll need in retirement, you will have a much more accurate estimate by developing a retirement budget and determining how many years of income you'll need.
Years in Retirement
You need to assume that you’ll live at least 15 years in retirement and therefore need to make sure that you don’t outlive your investments. Following are the Social Security Life Expectancy Tables:
Social Security Life Expectancy Table
|Year||Remaining Life Expectancy|
at Age 65
|Remaining Life Expectancy
at Age 75
Mandatory & Discretionary Expenses
The best way to develop a retirement budget is to start with pre-retirement expenses which should be readily available through your personal finance software (Quicken or Money) or manual check register. Start by determining which expenses are mandatory (fixed) and which are discretionary (variable). Mandatory expenses include food-groceries, health/medical, insurance, income taxes, transportation, and most housing-related expenses. Discretionary expenses include food-restaurant, entertainment & recreation, education, clothing (to a large extent), some housing, and miscellaneous/other.
As shown below mandatory expenses should be limited to those items that you are obliged to pay due to legal/contractual, health and safety reasons – e.g., taxes, insurance, groceries, utilities, etc. Whereas, you have a wide choice on how much to spend for discretionary items – restaurants, recreation, education, clothing, charity, etc.
Retirement Budget Items
Adjustments for Retirement
Once you’ve established a pre-retirement expense budget, you need to review each category of expenses and determine which are expected to increase in retirement, and by what amount, and which are expected to decrease. Use these estimates to come up with a tentative first-year retirement budget. This will need to be reviewed and adjusted once actual retirement data are available as well as occasionally to reflect changing spending habits and cost-of-living adjustments.
Armed with a retirement expense budget, you are now in a position to determine how much retirement income you will need and correspondingly when you’ll be able to retire (see Retirement Investing section). Retirement income is addressed in another section.