A series of Replacement Ratio studies from Aon Consulting and Georgia State University found that the 80 percent rule allows retirees to maintain the same standard of living they had before retirement, and it takes into account that certain costs will rise and others will fall. This finding was published in President Reagan’s 1980 Commission on Pension Policy and has been treated as dogma ever since.
Here Are Some Costs That Typically Increase During Retirement
- Aging can be expensive, and no matter how well you eat or how much exercise you get, medical costs will likely be unavoidable. A study from Fidelity Investments estimates that couples who retired in 2014 will need an average of $220,000 to cover medical expenses in retirement (although other studies anticipate a higher sum). To make matters worse, healthcare costs are rising rapidly, and are on track to outstrip the amount retirees receive in Social Security benefits.
- Home maintenance, insurance, property taxes, as well as utility bills, if you a) keep your home and b) spend more time at home.
Here Are Some Costs That Typically Decrease During Retirement
- Many retirees choose to downsize their home
- There are often fewer child-related expenses (unless you have a child "boomeranging" back home)
- Retirees generally spend less on clothing since they don’t have to maintain a professional wardrobe
- Transportation costs may go down since it’s no longer necessary to travel to and from work every day
- Travel and entertainment expenses may also decrease, depending on how actively a retiree pursues these things in retirement
The 80 percent rule also factors in inflation, which is very important. Sadly, the dollars you save today will not have the same value in the future. Your cost of living could double during the course of your retirement, so to avoid the problem of your purchasing power dropping by half, you have to be smart about how you save. Follow these steps:
- To start, figure out how much, in today’s dollars, you need in retirement.
- Next, figure out how much that translates to with inflation by calculating an increase of 3-4% per year.
- Then look for investments that will grow faster than the rate of inflation. If your savings grows along with inflation, your purchasing power will be safe.
A good portfolio strategy (one with proper diversification and low fees) is essential when saving for retirement. Stashing away a sizeable chunk of savings is also critical. The more you save, the more you will ultimately reap. How much you need to save to achieve 80 percent replacement depends on a number of variables, but here’s a handy benchmark to follow:
- By age 35, have 1X your gross current salary saved
- By 45, have 3X saved
- By retirement, have at least 8X your ending salary saved
Americans are woefully unprepared for retirement. A 2014 report from the National Institute on Retirement Security found that retirement savings in the U.S. are “dangerously low.” More than 90 percent of working households do not meet conservative retirement savings targets for their age and income. Striving for the 80 percent rule requires discipline and sound financial advice, but the payoff will be well worth it.