Digging Into the 80% Rule for Income Replacement in Retirement

Note: This article is part of Morningstar's November 2013 Investor Starter Kit special report. An earlier version of this article appeared Sept. 10, 2012.

For years, the financial-services industry has drilled the "80% rule" into pre-retirees' heads, suggesting that they'll need to replace 80% of their pre-retirement income when they retire.

Other variations on setting an income-replacement ratio--simply the retiree's gross income from all sources in retirement divided by his or her pre-retirement income--come in around the same ballpark. For example,  T. Rowe Price Group (TROW) has proposed 75% as a good threshold for planning purposes. As the firm's senior financial planner Christine Fahlund discusses in this video, retirees will no longer have the "expense" of saving a portion of their income for retirement. And that factor is not insignificant: According to T. Rowe's recommendation, 15% of pre-retirees' income should be saved for retirement.

Nor will retirees have to pay FICA taxes for Social Security and Medicare, which amount to another 7.65% of incomes. That assertion is corroborated by Aon Consulting's Replacement Rate Study, which concludes that in 2008, a 78% income replacement rate would allow a 65-year-old with $60,000 pre-retirement income to retire in 2008 with the same standard of living he had while working. In that scenario, reduced taxes during retirement account for much of the difference between the amount of pre- and post-retirement income required to keep the standard of living stable.

These savings come without even redeeming a single Groupon, let alone taking bigger-ticket measures to reduce costs in retirement. Indeed, others spend substantially less than 75% or 80% of their working incomes during retirement, as many retired readers noted in this Discuss forum thread. Yes, there may be the often-discussed reductions in commuting costs, lunches out, and clothes that come along with quitting work. But retirees can also reduce their in-retirement income needs by making bigger-ticket changes such as downsizing or paying off their homes. And as Laurence Kotlikoff and Scott Burns assert in this blog post, retirees are also likely to be off the hook for child-related expenses like college tuition that they might have had while they were working. Moreover, retirees who were saving much more than the 15% pre-retirement savings rate that underpins the 80% rule also may be able to get by on much less than they did while they were working, simply because they're not saving as much, if anything.

Does that mean the 80% rule is just a plot by the financial-services industry to get people to sock more away than they actually need to, thereby increasing the assets on which they can charge fees? Not necessarily. After all, health-care costs have the potential to swing substantially higher during retirement than they were when a person was younger, so a conservative retiree might use a rate even higher than 80% for planning purposes. People with lower incomes before retirement should, by and large, also employ a higher income-replacement rate than higher-income workers. At the same time, very high-income earners will want to plan for a replacement rate that's well above 80%, for reasons I’ll outline in a moment.   

The fact is, any "rule of thumb," like the 80% rule for income-replacement, is a blunt instrument--a reasonable starting point, but one that can be refined with consideration of your personal circumstances. A useful starting point, especially if you're getting close to retirement, is to prepare an in-retirement budget. Here are some of the key swing factors to bear in mind when deciding how to set your own income-replacement rate.

Level of Pre-Retirement Income
The Aon study showed that a retiree earning $90,000 prior to retirement would need to replace 78% of his or her pre-retirement income during retirement to maintain a steady standard of living, while one who retired with a $20,000 salary would need to replace 94%. A retiree with a working salary between those two poles--$50,000--would need an 80% replacement rate to maintain his or her standard of living.

Why the big variation? For starters, less-affluent workers don't typically save at the same level as wealthier ones while working, given that living expenses consume a big share of the former group's budgets during the working years. They also pay less in taxes as a percentage of their incomes than their wealthier peers while working, so tax savings will provide less of a benefit to them in retirement than it will for wealthier retirees. Another factor driving higher replacement rates for less affluent retirees is that they're not likely to have as much leeway to bring their living costs down during retirement as their more affluent peers, because spending on basic needs is a bigger share of their budgets than discretionary items such as dining out and travel. Meanwhile, less-affluent retirees' health-care costs may be every bit as high as their wealthier counterparts. Thus, although it may seem counterintuitive, it's wise to nudge your replacement rate above 80% if your income falls toward the lower end of the levels described above, and perhaps slightly below it if your pre-retirement income is at or above $90,000. 

At the same time, it's worth noting that those with very high pre-retirement incomes--$150,000 and above--may need higher income-replacement rates than those with pre-retirement incomes of $60,000 or $90,000. Taxes are the reason, because a greater share of their in-retirement income will come from taxable sources of income such as traditional IRAs and 401(k)s.   

Savings Habits
Your pre-retirement savings habits should also figure into the assumptions you use. The Aon study assumed an average rate of savings--about 5% for those earning $60,000 and about 6% for those earning $90,000, according to the Bureau of Labor Statistics' Consumer Expenditure Survey data employed in the Aon study. If you were making $90,000 when you retired but saved less than 6% of your salary, you'd want to use a higher replacement rate for planning purposes than would otherwise be typical for your income band. Meanwhile, a $60,000 earner who was saving 25% of his or her salary while working could obviously get by with an income-replacement rate of 75% or even less.  

Medical Costs
The baseline case discussed in the Aon study assumed that people's medical expenses would increase by an average amount when they retire--$1,000 to $1,500 per year. Needless to say, many retirees' all-in health-care costs run substantially higher than that; a recent Fidelity study of health-care costs in retirement estimated that total out-of-pocket health-care costs during retirement could easily top $220,00 for many married couples. That argues for pushing your income-replacement rate up, and that's especially true if you're coming into retirement with a significant health condition. 

Housing Plans
The aforementioned income replacement rates don't assume any changes in standard of living. As such, they don't factor in the fact that many people realize significant cost savings in certain budget line items, especially housing, during retirement.

Many retirees and pre-retirees look to downsize their homes or relocate to cheaper locations (or both), thereby bringing a good amount of equity into their retirement nest eggs as well as reducing their ongoing outlays for taxes, utilities, ongoing maintenance, and association fees. 

And even retirees who stay put may find that their housing-related income needs are less than while they were working because they've paid off their mortgages. Thus, if downsizing, relocating, or paying off your mortgage are on your radar and you'll realize significant cost savings, you may run with a lower income-replacement rate than might otherwise be the case. 

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