How Much Do You Need to Retire?

The first question to ask when considering when to retire is whether you’ll be able to generate “enough” income to maintain your desired lifestyle after quitting your job.

The conventional wisdom for deciding how much income is “enough” will lead to answers which will unnecessarily delay retirement for the very people who are, in fact, in the best position to retire. In particular, the commonly accepted “rule” that a retiree needs to replace a certain percentage of his pre-retirement income (such as 80%) is likely to cause that retiree to unnecessarily delay retirement beyond the point where he could easily generate “enough” income. The problem with this rule is it focuses on replacing a percentage of pre-retirement income, rather than the more relevant goal of replacing his pre-retirement spending.

To illustrate why, consider two potential candidates for retirement: Mr. Spendthrift and Mr. Thrifty. Each man is 55 years old, and earns $60,000 per year. Each owns an identical investment portfolio of $800,000, which generates income of $32,000 per year. Thus, they each enjoy an annual income of $92,000.

Mr. Spendthrift owns a four bedroom house in an upscale neighborhood, and enjoys annual vacations to Aspen for skiing and Aruba for diving. As a result, he spends $7,000/month maintaining his lifestyle. Mr. Thrifty, on the other hand, owns a three bedroom house in a modest neighborhood, and enjoys gardening and long walks. As a result, he spends only $3,000/month maintaining his lifestyle.

A mutual friend tells Mr. Spendthrift and Mr. Thrifty he’s looking for a retiree to help run his bait shop starting next month. The work would be part-time, with earnings of $5,000 per year (10 hours per week for 50 weeks at $10 per hour). Both men love fishing, and would love to quit their full-time jobs to work at the shop.

Each man makes an appointment to visit Mr. Advisor, a financial planner, to discuss if he could retire next month. Mr. Advisor is a typical financial planner who believes a retiree needs to replace 80% of his pre-retirement income to maintain his living standard. What advice will Mr. Advisor give to Mr. Spendthrift and Mr. Thrifty? And will this advice differ?

Oddly, Mr. Advisor advises each man that he'd be making a big mistake to retire next month. Mr. Advisor started with his belief that a retiree must replace 80% of pre-retirement income to maintain his standard of living. Mr. Advisor calculated Mr. Spendthrift and Mr. Thrifty would each need to generate post-retirement income of $73,600 (80% of $92,000) to maintain his lifestyle, and this was $36,600 more than either client could expect to generate annually from his investments and bait shop work. Thus, Mr. Advisor advises each client to keep working full-time.

Mr. Advisor’s adherence to the conventional “80% rule” led him to give sound advice to his client in the worse position to retire (Mr. Spendthrift), but bad advice to his client in the better position to retire (Mr. Thrifty). To maintain his spending level after retirement, Mr. Spendthrift would need to generate $84,000 per year, but could expect to generate only $37,000 per year ($32,000 investment income plus $5,000 from the bait shop). Thus, Mr. Spendthrift would face a disastrous shortfall of $47,000 per year by retiring, so Mr. Advisor's advice was sound. In contrast, Mr. Thrifty would need to generate only $36,000 per year of retirement income to maintain his pre-retirement level of spending, and could expect to generate the same $37,000 per year after retiring next month. He would thus have a cushion of $1,000 per year! In this case, Mr. Advisor’s advice to Mr. Thrifty was too conservative.

Mr. Advisor would have given better advice by basing it not on his clients' pre-retirement incomes, but their pre-retirement spending. A better rule to follow would be a retiree needs to replace 100% of his pre-retirement spending to have “enough” income to maintain his pre-retirement standard of living. This rule may have little impact on people like Mr. Spendthrift who spend most or all of their earnings. But it would have a big impact on people like Mr. Thrifty who save much of their incomes. Mr Thrifty could take the bait shop position since he could expect to generate more than 100% of his pre-retirement spending.

If you’re more like Mr. Thrifty, consider ignoring the conventional rule focused on pre-retirement income and focus on replacing your pre-retirement spending.