Calculating Your Retirement Income Target:
The Rule-of-Thumb Approach Revisited
by Armaan Zaffino, Product Manager, and Pauline Shum Nolan, Founder
When it comes to setting retirement goals, there is no shortage of discourse debating how much you should save to retire comfortably. Retirement planning is complex and it can be a real challenge to understand whether you are setting the right goals and if you will meet them.
Your retirement income target is the level of income that affords you the same standard of living as that during your working years. To calculate this target, many financial planners suggest a rule-of-thumb approach. It assumes that you will need 30% less income when you retire, which implies that your retirement income target should be 70% of your final earnings.
In reality, however, no two retirements are the same, and adjustments need to be made depending on your personal circumstances and your perception of a successful retirement lifestyle.
Traditional Rule of Thumb
The "Rule of 70" says that if you are making an annual income of $100,000 just before you retire, you would need $70,000 after you retire. The underlying logic is that your spending needs will be less in retirement than in your working years due to lower recurring expenses like commuting or living in the city. But why 70%? Is it that simple? No, probably not.
Let’s think about your cash outlays during your working years. You can divide them into two categories: personal consumption (e.g., food, clothing, and entertainment) and investments (e.g., mortgage, child-care, and retirement saving). So after investment expenses and taxes, most households typically retain only a fraction - about 30 to 40% - of their gross income to fund their personal consumption. This circumstance will persist for two to three decades until the mortgage is paid off and the kids have left the nest. Therefore, if you have been consuming 40% of your gross income for most of your career, it is logical to assume that your minimum retirement income target should be around that mark.
Should anyone have a 70% target at all?
Are there any situations where a household should have a retirement income target of 70%?
Low-income households may need more than 70% given their comparatively low threshold. Another exception are households who commit little of their gross income to investment expenses. That is perhaps because they do not own a home and will continue to rent, or they were gifted a property. It could also be because they do not have children. Those who fit this scenario can afford to spend a larger portion of income on personal consumption and may continue doing so in retirement.
Lastly, consider the scenario where parents change their consumption pattern once they become empty nesters. According to an Oxford University study (Rottke and Klos, 2016) that examines the role of children in retirement planning, although overall household consumption drops significantly once the children move out, some parents may actually reallocate the funds to upgrade their personal lifestyle (to that of childless couples), instead of bolstering their retirement savings. In this case, a higher retirement income target may also be appropriate.
Therefore, there are indeed households where a 70% retirement income target is applicable. These exceptions, however, may not represent your situation.
How low could I go?
To conclude, your retirement income target largely depends on what fraction investment expenses represent during your working years. As a general rule, go lower if you are making significant investments during your working years and do not plan to ramp up your lifestyle once the children move out or take expensive holidays once you retire - perhaps to 60% or less.
In the Wealthscope Retirement Blueprint, there are alternative ways to gauge your retirement income target, which are especially useful when you have no idea what your final earnings will be.
Rottke, Simon & Alexander Klos. 2016. "Savings and Consumption When Children Move Out," Review of Finance, vol. 20(6), pp. 2349-2377.
Vettese, Fred. 2015. “Forget 70%: How to Calculate Your Actual Retirement Income Target,” Financial Post. Retrieved on April 26, 2022, from https://financialpost.com/personal-finance/family-finance/forget-70-how-to-calculate-your-actual-retirement-income-target.