In the last installment, I gave a mathematical “proof” of why your retirement income target is nowhere close to 70 per cent of your final earnings. As we will see, there are exceptions, but if you are reading this it is unlikely that those exceptions apply to you.
Before we try to establish a better rule of thumb, it is important to understand what a retirement income target represents. It is usually defined as the level of retirement income that allows you to maintain the same standard of living as when you were working. This could mean the standard of living in your final year of full-time work, but more typically it would be an average taken over the final five, 10 or even 15 years. There is no consensus on this, even among pension experts.
As for the words “same standard of living,” they imply no diminishment in your personal consumption, which includes all spending to meet current needs such as food, clothing, grooming, transportation, entertainment, insurance and so on. Personal consumption excludes cash outlays on what can be considered “investments” such as paying off your Mortgage (an investment in your home), child-raising (an investment in your family) and, of course, saving for retirement. Personal consumption also excludes income tax.
This definition should give you a first inkling as to why the retirement income target must be less than 70 per cent. For most of our working lives, the money we allocate toward our “investments” leaves us with only a fraction of our paycheque, often less than 40 per cent or even 30 per cent of our gross income. This situation can prevail for decades and typically ends only when the mortgage is paid off and the children have left home. Investments aside, if you spent only 40 per cent of your gross income for your entire working life, it follows that your retirement income target will not be much higher than that.
But what if you pay off the mortgage early and the children are “off the payroll” well before you retire? This should enable you to ramp up your consumption in the final years before retirement, and it does, but not by as much as you might think.