Planning for Income in Retirement

One of the most important parts of retirement planning is figuring out how much income you are going to need and how much wealth is required to sustain that income. A common rule of thumb is that you will need about 70%-80% of your pre-retirement income to maintain your lifestyle after you stop working. This number is called the replacement ratio. The reduced income need post-retirement is due to a number of costs that tend to be lower for people once they quit work. First, there are the costs of commuting, business, attire, and restaurant lunches. For context, the average American worker spends between $5,000 and $6,000 per year on commuting. Second, many people have paid off their mortgages by the time they retire, which lowers monthly housing costs (although a growing number of people have mortgages in retirement). Third, retirees tend to cook more meals at home and have the time to bargain shop, lowering overall food costs (also see here and here). Fourth, retirees who are old enough to qualify for Medicare pay much lower total costs for healthcare. Some retirees have plans that will necessitate 100% or more of their pre-retirement income levels, however, so each person needs to estimate their own income replacement ratio.

Along with the idea of the replacement ratio, a common planning rule is that retirees should target constant inflation-adjusted income through their retirement years. Analysis of actual retiree spending shows a steady inflation-adjusted decline over time, from age 60 to the early 80’s, after which expenses start to climb due to increasing costs of healthcare. Accounting for potentially declining real consumption (inflation-adjusted expenses) can substantially reduce the amount that a household needs to accumulate for retirement. The oft-cited ‘4% rule’ for retirement income assumes constant inflation-adjusted consumption. Planning for constant inflation-adjusted consumption provides something of a safety factor.

Another important consideration for retirement income planning is taxes. In general, retirees have effective tax rates that are lower than when they were working. Part of this, of course, is that retirees tend to have lower income than in their working years. There are, however, other factors that tend to reduce a household’s tax burden. There are no payroll taxes on income drawn from retirement accounts and pensions. Federal payroll taxes paid by employees are a flat 7.65% of wages, so this is a substantial reduction in taxes. In addition, only part of Social Security income is taxable. One risk factor associated with taxes is that tax rates may rise over time, so planning on the basis of current tax brackets needs to include some flexibility. To start to estimate how your tax burden may change in retirement, run some cases through Turbotax’s online calculator, Taxcaster.

If you are committed to leaving a bequest to your family or to support one or more causes, this goal needs to be a part of long-term planning. Planning a bequest means that you can draw less income than would otherwise be the case. By planning to leave an amount in your estate, you also have a buffer against unforeseen circumstances. If you are drawing income at a rate that is expected to totally consume your savings by the time you turn 90, your financial well being is at greater risk than if your plan has you reaching age 90 with a substantial sum remaining. In other words, planning a bequest also provides a financial reserve from which you could draw in dire circumstances.

Making It Personal

Rules of thumb, also known as heuristics, are useful in helping people to simplify decision making. There is enormous variability in retirees’ personal and financial circumstances, however. Successful financial planning for retirement income necessitates getting into each household’s specifics.

The best place to start in making a personalized plan is to put together a budget of what your household expenses will be in retirement. Next, you can estimate how much your tax burden will change once you retire. A key issue at this stage of planning is whether you want to leave a bequest and to incorporate this into your plan. Finally, you can look at reasonable estimates of sustainable income draw rates to see whether your plans would have worked out in the range of historical periods. The ‘4% rule’, for example, indicates that you can plan to draw 4% of the value of your portfolio in the first year of retirement and then increase this in each subsequent year to keep up with inflation. In this case, the safe withdrawal rate (SWR) is 4%.

There are a few important things to remember when using this types of constant safe withdrawal rates (SWRs). First, these typically assume constant inflation-adjusted income draws. SWRs are calculated based on assumptions about future returns from stocks and bonds, and these assumptions may be inaccurate. Third, the average portfolio balance remaining after these SWR draws tends to be quite high. The SWR is set to protect against the worst cases.

I have calculated the historical SWRs using stock and bond return data from 1928 through 2021 (see table below). My results are generally in line with SWR calculations from Schwab. My calculations for SWR are slightly higher than Schwab’s because I have used purely historical data and many companies project lower stock and bond returns in the coming years.

Estimated safe withdrawal rates for a 2-asset portfolio (S&P 500 / Treasury bonds) (Source: Author’s calculations using stock and bond data from NYU-Stern)

For a 30-year retirement with a moderately aggressive portfolio allocation (which is 80% stocks and 20% bonds and cash), Schwab estimates a 3.5%-4.2% SWR. My value for an 80/20 stock/bond mix is 4.05% for a 30-year period. For a 20-year retirement, my SWR is 4.8% vs. Schwab’s suggested values of 4.8%-5.6%. Schwab includes allocations to international stocks and cash, as well as mid/small cap stocks, as opposed to my simpler formulation with just two asset classes. There is reason to believe that including these additional asset classes could increase portfolio risk-adjusted return and, as a result, modestly boost SWRs.

It is important to remember, however, that my results and those from Schwab do not include any investment / asset management fees, so the actual pre-tax SWR number will need to be adjusted downward accordingly. These results really highlight the important of keeping fees low.

The SWR is calculated to provide a high probability of not depleting your wealth in the worst circumstances. On average, using these SWRs will result in a substantial estate remaining when you die. For all of the cases for which I provide SWRs above, the average wealth at the end of the period (end of life) is at least 65% of the initial amount.

To summarize:

  1. Estimate your retirement budget
  2. Estimate your post-retirement tax rates
  3. Calculate your pre-tax retirement income need
  4. Subtract pensions and Social Security from the income need, if applicable
  5. Calculate a sustainable annual retirement income using SWRs, savings amount, and rough portfolio allocation
  6. If you want to make sure that you have a better-than-average chance of leaving a bequest that is more than 65% of you wealth at retirement, the SWR will need to be lowered (this calculation is beyond the scope of this post)
  7. If your SWR-based pre-tax income, accounting for investment fees, is sufficient to cover your income needs net of Social Security and pensions, your plan is reasonable

In practice, estimating your retirement tax rates can be difficult, depending on the specifics of the situation. The first year in retirement can serve as a test case, such that you only have a solid estimate of your retirement tax burden after the first year.

There are a number of ways to further customize a retirement plan, but the steps above a reasonable place to start. It is important to determine the degree to which you have flexibility in your consumption during retirement. If, for example, your budget allows for reduced consumption in bad market conditions (when your portfolio value declines), your retirement plan gains robustness. It is a good exercise to determine the percentage of your planned retirement income you could cut out if needed. If a significant portion of your retirement budget is on discretionary items (travel, entertainment, etc.), for example, your plan is safer. Similarly, if you plan to work part time in retirement and can adjust the number of hours you work, this also adds robustness to the overall plan.

This post provides the basics of a decumulation strategy, but the actual implementation requires additional details. Tax planning is a substantial concern for many retirees. The determinations of how much to draw from different account types is one example. While conventional wisdom suggests withdrawing as little as possible from tax-deferred accounts, there are situations in which drawing down these accounts before reach the RMD age is advantageous, for example. In addition, when people retire before they are eligible for pensions, Social Security or Medicare, they may draw substantially more from their savings in the earlier years of retirement than they will need after these additional benefits kick in.