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By Christine Benz | 09-19-2012 10:20 AM

Calibrating Income Replacement in Retirement

Investors should study the broad spending trends and weigh the trade-offs when they plan for income replacement at different stages of retirement, says Pinnacle Advisory Group's Michael Kitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

One commonly cited rule of thumb is to plan to replace 80% of your pre-retirement income when you actually retire.

Joining me to discuss the 80% income-replacement rule is Michael Kitces. He is partner and director of research for Pinnacle Advisory Group.

Michael, thank you so much for being here.

Michael Kitces: Thanks, Christine. It's great to be here.

Benz: So Michael, a lot of people in the retirement research area talk about this 80% rule. Let's talk about where it comes from and why it is often thrown out there as sort of a starting point when thinking about income replacement during retirement?

Kitces: The origins of the rule actually are pretty straightforward. It started with the concept, somewhat surprising to people, that we simply assume retirement spending is going to look pretty similar to what your spending was while you were still working and that you're going to continue all of your ongoing spending. The difference, of course, as we transition to retirement is that there are certain factors that do fall off the plate.

If we used to earn a certain amount of income, out of that came income taxes, employment taxes, savings we were actually making into retirement accounts, and even perhaps some nominal amount of other spending--the suits and clothes we wear, our transportation to and from work, and so forth. So those expenses begin to disappear. And it's sort of popular in today's political discussions of even recognizing people's effective tax rates, which for a lot of people is somewhere in that range around 10%, 15%, 20%, 25%, as income rises.

And so if we start with, I had 100% of my income, and I subtract out, say, 15% to 20% for taxes, a little bit for savings, a little bit for those ancillary expenses, what it means in essence was, I was probably spending somewhere around 70% to 80% of my actual income to maintain my lifestyle. So, if I need to figure out how much of my income to replace in retirement where taxes, savings, or some of those expenses are gone, they say I need to replace 70% to 80%.

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