One of the benefits of having a financial plan is that you can see how little tweaks in your plan can have a big impact on how much you need to save for retirement.  One important variable is how much you plan to spend each year once you retire.

Sure, this is a hard number to estimate since it is far out in the future.  And many people aren’t even sure how much they spend today, much less how much they will spend X number of years from now in retirement.

But taking the time to think through the numbers when designing a plan makes it more likely you’ll make trade offs that are right for you.

You may not need as much as you think when you retire

Determining how much to save for the future versus how much to spend now is a tricky balancing act. You want to retire at a reasonable age and you would like to retire comfortably. But you work hard everyday and would like to spend some of your income enjoying your free time.

The rule of thumb for estimating your spending in retirement is that you’ll need about 80% of your pre-retirement income.  But that number will be different for each individual.  Some people may only need 50% to 60% of their preretirement income.

To figure out your number try envisioning how your spending will look when you stop working. Start by looking at how much you spend today and then look at which expenses will change during retirement.

Some expenses that may decrease once you retire are takeout food, transportation costs, and clothing budgets.  Your mortgage will probably be paid off in retirement and child expenses will also have gone down. You’ll also have more time to look for deals and take on do it yourself projects.

Some expenses may increase depending on how you envision spending your retirement. You may decide to travel more, take up more expensive hobbies, and spend more on entertainment. Healthcare costs will also go up.

Making a plan

Here’s an example using Monte Carlo simulation that looks at thousands of possible market returns and estimates the probability of reaching your goals.

Jen and Doug started saving early in their careers and contributed 10% of their incomes to their retirement accounts. They’ve each managed to save $400,000 ($800,000 total). They are 45 years old and starting to think about when they may be able to retire.

They both now earn $75,000 and contribute 10% of their income to retirement accounts. They plan to continue contributing 10% until they retire. Their employers also match up to 3% of their contributions.

After contributing to their retirement accounts and paying taxes (27% effective rate) they currently live on about $98,000 a year.

Jen and Doug have looked over their budget and think they could live on about $80,000 (today’s dollars, after tax) during retirement. They hope to retire at age 65 and estimate their social security income to be $20,000 each starting at age 67.

Using the above assumptions, Jen and Doug have a 94% chance that they will be able to spend $80,0000 each year throughout retirement.  (Their portfolio going forward is projected to grow 5%.)

Spend 10% less during retirement and retire 3 years earlier or spend more now

Now let’s see what happens if they decide to live on a little less during retirement.

Jen and Doug look again at their current expenses and think they may be able to live on less.  They enjoy cooking at home when they have time, the kids will be out of the house, and their mortgage will be paid off.

Assuming they plan to spend only $72,000 a year in retirement, they now have a couple of options open to them.  One option is that they can retire three years earlier at age 62 and still have a high probability (90%) of reaching their goal of spending $72,000 each year during retirement.

Or they can plan to still work until 65 but instead start saving less (and spending more) right now.  Their savings could go down to 2% of their income and they still have a 90% chance of having $72,000 to spend per year during retirement.  That would be $12,000 more each year that they could spend today instead of saving for retirement.

Have a plan so you know your options

Working through how much you’ll spend in retirement and coming up with a plan gives you a better understanding of your options.  It’s important to save for retirement, but it’s also important to enjoy your life now.  Knowing the tradeoffs will help you better balance the future with today.