Finding the right target retirement income for you
When you’re planning for retirement, one tough question you have to answer is how much monthly income you will need in retirement: your “target retirement income.”
If you were to tackle this on your own, there are several different ways to estimate what your target retirement income should be. You could develop a line-by-line budget that identifies your expected spending needs for each year of your anticipated retirement. This makes for a complex exercise, since it’s challenging to predict detailed spending patterns over long periods of time, especially those that may start years from now.
A more straightforward approach involves setting a retirement income “replacement rate,” where you estimate what percentage of your current income you will want during your retirement years. This is the method that my65+ uses to help you figure out and set your target retirement income.
Before we get into the details of how this number is calculated, rest assured that my65+ does the math for you with just a few key pieces of information – your age, the age you plan to retire, and your salary or annual income. Using evidence-based, financial planning assumptions, we can set your retirement income goal. If you’re older and have a more precise idea of what your retirement budget will be, you can edit this amount in your plan.
The “replacement rate” approach
By setting your target retirement income as a percentage of your current income, this “replacement ratio” can be a useful way to estimate your income needs in retirement. It’s based on the idea that your overall spending during retirement will likely be lower than your overall spending during your working years. The suggested rate is calculated based on your pre-tax, pre-retirement income.
Here are the replacement rates that my65+ uses:
|Target replacement ratio
The goal of a target replacement rate is to approximate the income you will need in retirement in order to maintain your lifestyle. The target replacement rate is higher for modest- and middle-income members than for upper-middle and upper-income members because moderate earners are likely to:
- Have a lower savings rate pre-retirement
- Be renters rather than homeowners
- Continue paying a similar level of taxes in pre- and post-retirement because many will already be in the lowest tax bracket during their working years
The 60-85% figures are based on a study that economist Keith Horner conducted for the federal government, with slight adjustments upwards for higher-income groups to account for out-of-pocket health care costs such as home care and long-term care, which were not included in Horner’s study, and to allow for a margin of conservatism. i The study was done across a large group of Canadians, and individual circumstances can dictate a higher or lower income replacement ratio.
The suggested target replacement ratios are just that – suggestions. With my65+, you can choose to increase or decrease your target retirement income depending on what kind of lifestyle you anticipate and wish to keep during your retirement years. For some, your actual spending needs might drop in retirement; for example, you may no longer have a mortgage to pay off, your children may no longer be dependent on you, and you may no longer need to contribute more to savings once you’re retired. For others, some expenses might increase during retirement years compared to working years; for example, you might travel more often, and you might need to spend money on home care and health care expenses that you didn’t have during your working years.
Having a retirement savings goal is important because if you have not saved enough as you approach your retirement date, it will likely be difficult to make up the difference in your remaining working years, and you will likely need to lower your retirement income drawdown rate and adjust your living standards.
i Keith Horner, “Retirement Saving by Canadian Households” (Finance Canada, Report for the Research Working Group on Retirement Income Adequacy, December 2009)