Retirement lifestyles depend on your financial success — but financial success is part reality and part perception. In fact, if you moderate what you perceive as financial success, you could improve the financial reality of your future.
It's particularly important to consider this as you approach retirement, but this dynamic actually starts well before you're ready to retire. It has to do with what kind of lifestyle you think you need.
People tend to raise their lifestyles as their income levels rise, but taking this too far can be destructive to both the perception and reality of your financial future. To understand why, just look at the arc household income tends to take over the years.
Three key factors to consider
1. Age and income
According to the US Census Bureau, median household income when the primary earner is between 25 and 34 is $54,243. This climbs to $66,693 when the primary earner is between 35 and 44, and to $70,832 when the primary earner is between 45 and 54. As you might expect then, income tends to rise as people get farther along in their careers. So far so good.
After that, though, income takes an abrupt U-turn. When the primary earner is between 55 and 64, household income declines to $60,580. It plunges further to $45,227 for households whose primary earner is between 65 and 74, and continues to decline when the primary earner is 75 or older, to just $28,535. This last figure represents a decline in household income of some 60 percent from the prime earning years of ages 45 to 54.
You might expect income to decline somewhat as you enter your retirement years, but a 60 percent drop could come as a shock to your lifestyle. The continued decline upon reaching age 75 implies that resources become even more limited as people move through what has traditionally been thought of as the golden years or retirement. That decline is partly because more and more of this population is unable to continue to work, but it also suggests that retirement savings may start to run out as people age.
2. Age and expenses
A traditional financial planning assumption is that retirees need less income than people in their working years, and to some extent this is true. For the most part, retirees are no longer supporting their children, their homes are often owned outright, and they no longer have to save for retirement. However, figures from the Bureau of Labor Statistics show that the drop-off in expenditures in people's retirement years is not as great as the drop-off in income.
Like income, annual expenditures peak for people aged between 45 and 54, at a national average of $60,524. However, while household incomes drop by about 60 percent when the primary earner is 75 or older, expenditures for that age group are only 43 percent lower. In other words, for retirement planning purposes it is significant to note that expenses don't typically fall as fast as income. One reason for this is health care expenses, which usually increase rather than decrease as people enter retirement.
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3. Income level and lifestyle
What income level is the basis for your lifestyle? The impact of age on household income and expenses is important to remember as you consider how closely to tie your lifestyle to your current income. Unless you are prepared to cope with a substantial decline in your lifestyle as you get older, it does not pay to link your spending too closely to your income as you enter those peak earning years of ages 45 to 54.
Unfortunately, many people not only raise their lifestyles to match their incomes, but they are lulled into a false sense of security by the trajectory of their income growth. Seeing their incomes rise steadily as they move through their 20s, 30s, and 40s gives people the impression that they will continue to be better off financially in the future. Consequently, they tend to believe they can afford to take on debt now and pay it off when they are earning more later.
In these cases, people not only raise their lifestyles to match their incomes, but they are pushing their lifestyles beyond the level of their incomes. This makes the gap that results when incomes start to fall all the more jarring.
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How to live comfortably (and happily) in retirement
Consider an alternate approach to matching your lifestyle with your current income. Take the long view and consider what your income is likely to average over your remaining years.
For example, taking national averages as a guide, a person in the 45-to-54 age group may be earning $70,832 now, but averaging this with the incomes for the subsequent three age groups results in a figure of $51,293.50. Basing your lifestyle on this income assumption rather than your peak earnings will allow you to save more for the future, while also subjecting you to less of a downshift in lifestyle as you grow older.
More savings and less of a come-down in lifestyle — that's an improvement to both the reality and the perception of your financial condition in the future.
What do you expect your retirement experience to be like — and, more importantly, how do you set the guidelines for your lifestyle level?
Richard Barrington, CFA, is a 20-year veteran of the financial industry, including having served for over a dozen years as a member of the Executive Committee of Manning & Napier Advisors, Inc.