Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Figuring out how much you are going to spend in retirement is an important part of the retirement planning process. I'm here with Christine Benz, our director of personal finance, and she is going to explain why it helps to go beyond just these rules of thumb.
Christine, thanks for joining me.
Christine Benz: Jeremy, great to be here.
Glaser: Let's talk about why this is important, first. Why do you need to know how much you are going to spend in retirement?
Benz: It's really one of the key inputs into the formulation about whether your retirement plan will be viable. I always tell investors to start with looking at their anticipated spending in retirement. Then they will want to subtract out any certain sources of income like pensions, like Social Security. The amount that they are left over with is the amount that their portfolio will need to step up and replace on an annual basis. You would take that amount and divide it by the portfolio's value to determine your withdrawal rate, and then you can do some testing around whether that, in fact, is a sustainable number, whether your planned withdrawals are sustainable. Really, it's the linchpin for doing any sort of calculation about your retirement portfolio's viability.
Glaser: That's a really straightforward calculation, but some of those inputs aren't all that straightforward. How do I know what I'm going to spend? Where do I start to get that number?
Benz: Really, the starting point is to look at your current income today, which is not to say you will spend all of your current income while you are working, but that's kind of your baseline that you'd want to start out with. If you are a younger person who is well under retirement year, you probably want to take a step back and think about nudging up your baseline starting amount. If you are expecting that you will get cost of living increases down the road, or if you expect that some of the categories that you will spend on in retirement will inflate, you will, of course, want to nudge up your number. But that's the baseline. Say, you are someone who is a couple of years away from retirement, start by looking at your current income from your job.
Glaser: There's going to be some expenses you don't have in retirement. One of the big ones is saving for retirement.
Benz: That's exactly right. To use a really simple example, let's say, someone is making $100,000, and they are saving 20% of their salary. Well, that means that they have an income need in retirement that's just $80,000 because they have been a heavy saver in the years leading up to retirement. Our colleague David Blanchett, who is head of retirement research for Morningstar, has found that generally speaking, the more affluent you are, the higher your pre-retirement savings rate is. That means that your income replacement rate can be that much lower.
Glaser: What about tax savings?
Benz: That's another factor to bear in mind. Some retirees do realize significant tax savings in retirement. One of the line items that comes off the top for nearly all of us is that if we have been paying FICA taxes, if we've been paying Social Security and Medicare taxes and they have been getting deducted from our paychecks, well, that's 7.65% of our paycheck. That's another percentage that you can take off the top when looking at your anticipated in-retirement spending.
Glaser: Finally, if retirees are dreaming of taking that big cruise or another big vacation, or how their lifestyle changes, how do you factor that in to what that income requirement is going to be?
Benz: There are a lot of different factors in the mix, certainly. One of the big ones to look at though is housing-related expenses. If your plan is to stay in place, to age in place throughout your retirement years, you probably won't see any big changes. But if your plan is to downsize or to relocate to a cheaper part of the country, you may, in fact, realize some significant cost savings. Start with housing costs because that will be one of the bigger line items in your budget.
In terms of other types of costs, food is another category to look at. David Blanchett found in his research on retirement spending that that's one area where we tend to see retirees find cost savings. Maybe they don't have lunch out as much or they have more time to prepare food at home or shop for food, shop for values in food, whatever it might be. We tend to see like a 5% or 6% reduction in terms of the outlay for food costs.
Then in terms of all of the other leisure expenses, I think, it's up to each retiree, pre-retiree to take a step back and think about what their plans are and how costly those plans are, whether it's travel or golfing every other day or whatever it might be to take stock of what those hobbies and what those great leisure activities could actually cost and what effect they might have on the budget.
Glaser: Finally, I have to ask about the elephant in the room, which is healthcare. Those costs are somewhat unknowable. How do you factor that in?
Benz: They are unknowable. But I do think that Fidelity's annual research where they look at the expected outlay for healthcare costs for a 65-year-old couple is a good starting point or at least food for thought when thinking about how much to set aside for healthcare expenses.
The most recently released number was $280,000 for a married couple 65 years old throughout their retirement years. That encompasses supplemental insurance policies. Medicare doesn't pay everything. It encompasses prescription drug costs. It encompasses co-pays. Dental is another big surprise cost for many retiree households if they have been covered by insurance in the past. Typically, if you add dental insurance to your supplemental policy coverage, you are going to pay for that coverage. $280,000 was the most recent estimate and it does not include long-term care costs. If you have unfunded long-term care costs, you would obviously want to set those aside as well, and that's another huge consideration. But that's certainly one of the numbers that when we look at retiree budgets, we tend to see expenses go up there.
Glaser: Christine, thank you.
Benz: Jeremy, thank you.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.