7 steps to forecasting your cash flow needs in retirement

New retirees frequently rhapsodize about the joys of tossing their alarm clocks into the trash and filling their days with whatever activities they find gratifying. But if they’re honest, most new retirees find the financial aspect of the retirement transition to be a little jarring.

While retirees are often counseled to estimate that they'll spend 75% to 80% of their working incomes in retirement, a paper by David Blanchett, formerly of Morningstar and now at PGIM, found that higher-income, higher-saving households may need just 60%, or even less, of their preretirement income during retirement, while lower-earning, lower-saving households may need closer to 90%.

It may be difficult to forecast your actual income-replacement needs, so here are the key steps to take as you do so:

Step 1: Find a realistic baseline for your income

If you’re close to retirement and seek to maintain a standard of living in retirement similar to what you had while you were working, using your current salary as a baseline is reasonable. But if you’re younger — say, in your 40s — it may be wise to nudge up your baseline income for retirement-planning purposes, because your current income may not be reflective of what you’ll want to spend when you eventually retire.

Not only are you apt to receive cost-of-living adjustments as the years go by, but career gains could also lead to a higher salary over time, which you may want to “replace” in retirement. As Blanchett noted in his paper, the average college-educated individual will make a 50% higher salary at retirement than he or she did at age 25. Gains in salary over time are less pronounced for people with lower levels of educational attainment.

Step 2: Subtract your savings rate

Take a look at what percentage of your salary you’re saving — or expect to save by the time you retire —and subtract that from your baseline salary amount.

It’s typically easier for high-income individuals to save a greater percentage of their salaries during working years than low-income individuals. A household saving 20% of its income will see its income-replacement rate drop to 80% right out of the box, even without factoring in any planned lifestyle changes, such as downsizing homes.

If you’re several years from retirement, it may be that you’ll kick up your savings rate if your income grows.

Step 3: Subtract any tax reductions

Because they’re no longer paying Social Security or Medicare taxes, many people realize tax savings when they retire. Those gained savings tend to be more pronounced for higher-income workers than lower-income ones. More-affluent households may see a bigger percentage drop in taxes in retirement than lower-income households because they have greater control over their taxable income now that they’re no longer earning a paycheck; the less they pull from their portfolios, the less they’re taxed on.

Step 4: Subtract anticipated housing-cost reductions

Housing costs are another line item with the potential to change substantially in retirement. Is your plan to come into retirement without a mortgage, for example? Or perhaps you intend to relocate or downsize in some fashion? Even though the main goal of downsizing may be to add the home-sale proceeds to your retirement kitty, it can have the salutary effect of reducing property taxes and lowering outlays for insurance, utilities, and maintenance. As a senior homeowner, you may also be able to qualify for a reduction in your property taxes, depending on where you live.

Step 5: Factor in lifestyle changes

Retirement-planning guides often urge retirees to factor in changes in other expenses, such as commuting, clothes for work, and meals out while on the job or due to busy work schedules. For some households, these changes may be minimal, but for others, they may be more substantial.

Don’t assume a reduction in lifestyle-related expenses in retirement without crunching the numbers. A heavy travel schedule or an expensive hobby or other expenditures could offset cost reductions on line items like food.

Step 6: Add higher health care costs

Health care is one major area where retirees are likely to see an increase in expenses. A recent Fidelity study showed that the average lifetime out-of-pocket healthcare outlay for a 65-year-old retiring today would be nearly $160,000, and that figure doesn’t even include long-term-care expenditures.

Higher healthcare costs later in life are the key factor in what Blanchett calls “The Retirement Spending Smile.” That’s the tendency for household expenses to be on the high side just after retirement, dip in mid-retirement, then head back up toward the end of life as healthcare costs increase for some older adults. If you’re going without long-term-care insurance, your household’s total healthcare-related outlay could spike dramatically toward the end of your or your partner’s lives.

Step 7: Add a fudge factor

Working through each of these steps may get you closer to your actual income-replacement rate. At the same time, it’s worthwhile to approach the exercise with the knowledge that there’s much about your future spending that you can’t foretell. Wild cards such as long-term-care costs, random home repair bills and providing help to adult children or families can unexpectedly increase your financial outlays in retirement. The potential for those unanticipated expenses argues for nudging your own income-replacement rate a bit higher to allow for some wiggle room in your planning.

This article was provided to The Associated Press by the investment research website Morningstar. Christine Benz is the director of personal finance and retirement planning at Morningstar. For more personal finance content, go to  https://www.morningstar.com/personal-finance