Income Replacement Rule of Thumb
The received wisdom in financial planning is that you should make sure that your income in retirement is more than a percentage of your pre-retirement income.
Most defined benefit pension schemes work on the assumption that you will need between a half and two-thirds of your salary, before you retired, to be comfortable in retirement.
It is tempting to believe that the income replacement rule of thumb is right – after all, if it were, it would make it easy to work out roughly how much income you need when you stop work.
But it doesn’t stand much scrutiny – mostly, because it’s wrong.
I imagine that, when defined benefit schemes first became available to employees, the income replacement rule would have made sense. Those employees lucky enough to make it to retirement age wouldn’t have huge aspirations, and they were unlikely to have the energy of today’s retirees.
But retirement has evolved from one stage of life into three – the “Go Go”, “Slow Go” and “No Go” years. When defined benefit schemes first started, there was certainly no expectation of a “Go-Go” phase of retirement.
An academic study, back in September 2016, concluded that “the conventional final earnings replacement rate measure has little predictive value for living standards continuity between working life and retirement.” This statement is a polite, academic way of saying that the rule is wrong!
But, indeed, you shouldn’t need to be making long term savings when you retire, and you won’t be commuting any more. However, your household bills may go up as you will be at home more.
Why Doesn’t the Income Replacement Rule work?
It is common for there to be a period before retirement when the expenditure has fallen, and income remains high.
Mortgage repayment dates don’t coincide with our retirement dates (it’s typical for the mortgage to be repaid sometime before retirement) and children don’t become independent at the same time as we retire.
The trend towards partial retirement compounds this.
Your expenditure during retirement will be made up of two types:
Essential and unavoidable spending; for example, council tax, utility bills.
Discretionary expenditure; for example, holidays and gifts.
Some items of expenditure are semi-discretionary – food and drink, for example. We could live on Tesco Value, but we often choose Finest!
Essential and unavoidable expenditure tends to increase in line with inflation, and payments are often made regularly by direct debit. Your necessary and unavoidable spending is probably going to be very similar after you retire to the amounts you spent before you retire. You may well spend more time at home, so some of these costs could go up.
Discretionary expenditure is more “lumpy” – made of irregular, more significant amounts. And it is a matter of choice. You can get by without spending any money on these items at all.
Importantly, you are much less likely to rely on “income” in retirement than when you are working. Your discretionary spending can be funded by making lump sum withdrawals from capital (using a discretionary spending fund).
And it’s increasingly common to use capital to support the essential items too – this trend has been encouraged by the pension freedom reforms.
You might not need any income at all, to fund a comfortable retirement as you could be using capital to finance your spending.
What is the Answer?
As with so much in Financial Planning, the answer starts with an analysis of your spending.
You should start by breaking down your current annual spending into essential, discretionary and “semi-discretionary” items. You will then be able to decide how each of the expenditure items will change over the coming years – some will cease before retirement, and some might increase in retirement.
You may want to spend more on some of them (e.g. holidays) in retirement. You’ll find that one or two of the items do change when you stop work (e.g. work clothing and the cost of commuting), but these are the exception.
Having completed this analysis, you will then be able to work out what your expenditure is likely to be when you stop work. A good Financial Planner can help you with this.
Having decided upon your likely post-retirement expenditure, you can then start to work on a plan to ensure that your spending is covered.
This plan will need to take account of all your retirement resources, including state pensions, retirement savings, second property equity, etc., and take account of your objectives about legacies and care in later life.
It would be tough to do this without the expertise of an excellent Financial Planner.