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When you start planning for retirement, one of the first steps is to estimate how much income you think you will need to live on.
Our SuperGuide retirement planning articles often refer to a ‘rule of thumb’ that suggests you will need somewhere between two thirds (66%) and 80% of pre-retirement income to continue to enjoy your current standard of living.
This 66–80% rule is often quoted by financial advisers and in financial publications. Sometimes it is simplified even further to the 70% rule. Like most financial ‘rules’, it’s difficult to trace its origin but the rule endures because it does have a certain logic.
What is a ‘rule of thumb’?
A rule of thumb refers to an estimation based on practical experience or, in this case, population averages. It is not intended to be strictly accurate or reliable for every situation. But it is a good starting point to get you thinking about where you should set your target retirement income.
Recent support for the 66–80% rule
The government’s Retirement Income Review (RIR), which reported in July 2020, threw its weight behind the use of replacement rates, such as 66–80% rule, to estimate retirement income needs. While the 66–80% rule of thumb is the most widely used metric in OECD countries, the RIR suggested a slightly narrower range of 65–75% would be appropriate for most Australians.
The RIR argued that replacement rates are preferable to the most common alternative – budget standards – because they provide income targets based on the income a person earned while they were working. This has the advantage of ensuring you continue your pre-retirement standard of living throughout your retirement years.
While providing an adequate replacement rate for most Australians, the RIR conceded that a target of 65–75% of pre-retirement income would not be enough to prevent poverty in retirement for Australians in the bottom 20% of income earners. This is shown in the graph below, which was based on modelling done for the RIR using Australian data.
Projected target retirement income using replacement rates
Source: Retirement Income Review Final Report, July 2020.
Note: Target retirement income is based on the average in the 10 years before retirement and ‘system minimum’ is the maximum Age Pension for singles. Uses the review’s adequacy benchmark replacement rate of 65-75 per cent. Deflated to 2019 dollars using wages.
For low-income Australians, an adequate safety net in the form of the Age Pension and other government supports is necessary.
You may be wondering why your target replacement rate of income in retirement is not 100% of the income you enjoyed during your working life. Where did the figures of 66–80% (or 65–75%) come from?
The reason is simply it’s generally cheaper to live in retirement. Housing and other costs fall, while government support from the Age Pension and other benefits and concessions increases.
As well as making mortgage payments, pre-retirees may also be making voluntary super contributions that will cease when they retire or building wealth with the help of investment loans that will hopefully be paid off before they finish paid employment.
Hopefully your children will be independent by the time you retire so you are no longer paying for their education and living expenses. Work-related travel and clothing costs will also be a thing of the past.
Most retirees can look forward to paying little or no tax, so the starting point for your target retirement income is household income after tax in the ten years or so leading up to retirement.
How to calculate your personal target replacement rate
Assuming you have a home that’s fully paid for and are debt-free when you retire – which is a big assumption in these days of high housing debt but worth aiming for – you can deduct these costs from your target retirement income.
According to the Reserve Bank, in 2019 the median ratio of mortgage payments to household disposable income was around 12%. So simply deducting mortgage payments leaves you with target income equal to 88% of pre-retirement income.
The actual mortgage-to-income ratio tends to be higher in places like Sydney and Melbourne. It will also be higher for single people making repayments with one wage. So for households with a big mortgage, the starting point for a target replacement income may be closer to 70%.
Couples or singles who have paid off an expensive home with kids at expensive schools, and all the additional costs that come with having a large family, may need less than 70% in retirement when the kids are fully independent adults. Those who paid off a less expensive home or did not have kids may need a little more. If you rent your home or expect to retire with a mortgage or other debts, you may need closer to 80%. You get the picture.
When you are ready to prepare a detailed retirement plan, with a realistic retirement income target, you can deduct actual costs that you will no longer have to budget for rather than rely on a simple rule of thumb.