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7 steps to forecasting your cash flow needs in retirement

New retirees often rhapsodize about the joys of throwing their alarm clock in the trash and filling their days with the activities they find fulfilling. But if they’re honest, most new retirees find the financial aspect of the retirement transition a bit jarring.

While retirees are often advised to estimate that they will spend 75% to 80% of their earned income on retirement, an article by David Blanchettformerly of Morningstar and now at PGIM, found that households with higher incomes and more savings may need only 60%, or even less, of their pre-retirement income during retirement, while households with lower incomes and less savings may need closer to need 90%. %.

It can be difficult to predict your actual need for income replacement, so here are the key steps to take:

If you are nearing retirement and want to maintain a standard of living in retirement that is similar to that of when you were working, it is reasonable to use your current salary as a basis. But if you are younger, such as in your 40s, it may be wise to increase your basic income for retirement planning purposes, because your current income may not reflect what you want to spend when you eventually retire.

Not only are you likely to receive cost-of-living adjustments over the years, but career gains can also lead to a higher salary over time, which you may want to “replace” in retirement. As Blanchett noted in his paper, the average college-educated person will earn a 50% higher salary at retirement than he or she would at age 25. Salary increases over time are less pronounced for those with lower levels of education.

Take a look at what percentage of your salary you’re saving (or expect to save by the time you retire) and subtract that from your base salary.

It is generally easier for high-income earners to save a larger percentage of their paychecks during their working years than it is for low-income earners. A household that saves 20% of its income will immediately see its income replacement rate drop to 80%, even without taking into account planned lifestyle changes such as home downsizing.

If you are a few years from retirement, you may want to increase your savings rate as your income grows.

Because they no longer pay Social Security or Medicare taxes, many people realize tax savings in retirement. The savings achieved are generally more pronounced for higher-income workers than for lower-income workers. Affluent households may see a larger percentage tax reduction in retirement than lower-income households because they have more control over their taxable income now that they are no longer earning a salary; the less they take out of their portfolios, the less they are taxed.

Housing costs are another area that can change significantly after retirement. For example, do you have plans to retire without a mortgage? Or are you planning to move or downsize in some way? Even though the main purpose of downsizing is to add proceeds from the sale of your home to your retirement pot, it can have the beneficial effect of lowering property taxes and reducing expenses for insurance, utilities, and maintenance. Depending on where you live, as a senior homeowner you may also be eligible for a property tax reduction.

Retirement planning guides often urge retirees to take into account changes in other expenses, such as commuting, dressing for work, and eating out while at work or due to busy work schedules. For some households these changes may be minimal, but for others they may be more significant.

Don’t assume a reduction in lifestyle-related expenses in retirement without crunching the numbers. A heavy travel schedule or an expensive hobby or other expenses can offset the cost savings on items like food.

Healthcare is a key area where retirees are likely to see an increase in spending. A recent Fidelity study found that the average out-of-pocket health care spend for a 65-year-old retiring today would be nearly $160,000, and that figure doesn’t even include long-term care spending.

Higher healthcare costs later in life are the key factor in what Blanchett calls ‘The Retirement Spending Smile’. That’s the trend for household expenses to be on the high side shortly after retirement, decline mid-retirement, and rise again near the end of life as health care costs rise for some older adults. If you don’t have long-term care insurance, your household’s total health care expenses could increase dramatically toward the end of you or your partner’s life.

Going through each of these steps may help you get closer to your actual income replacement rate. At the same time, it’s worth approaching the exercise knowing that there’s a lot about your future spending that you can’t predict. Wildcards like long-term care costs, random home repair bills, and providing support for adult children or families can unexpectedly increase your financial expenses during retirement. The potential for those unexpected expenses makes a case for setting your own income replacement rate a little higher to give you some wiggle room in your schedule.

This article was provided to The Associated Press by investment research website Morningstar. Christine Benz is director of personal finance and retirement planning at Morningstar. For more personal finance content, visithttps://www.morningstar.com/personal-finance