One of the many complicated aspects of retirement planning is figuring out how much of your preretirement income you'll need to replace during retirement. The moral of the story is, one size does not fit all. Here are three main variables to think about when estimating the cost of the retirement.
Christine Benz, Head of Personal Finance for Morningstar.com, talks with David Blanchett, Head of Retirement Research for Morningstar Investment Management.
Variable I
The first is the replacement rate: How much do you need to replace of your preretirement pay when you retire?
A lot of people use what's called the 80% rule as a starting point for figuring out their income replacement rate. But there's a huge variation there. 80% does not fit all. For some people it could be as low as 54% or lower. And at the high-end close to 90%.
Lots of things change when you retire, obviously. You're no longer paying Social Security tax, Medicare tax. You're no longer saving for retirement.
If you're saving 15% of your pay before you retire, you're not used to consuming that money. When you retire, you don't have to replace that. Each person has a different perspective on what expenses go away at retirement. There are also tax benefits; there's a higher standard deduction. Things that make retirement cheaper--things like Social Security. Social Security isn't taxed the same way as income is.
Taken together, each person's replacement rate is going to vary. One trend that you do see, though, is that those individuals who tend to have lower income--so if you make $20,000 a year--have a higher replacement rate than those who make, say, $100,000 a year.
This has to do with taxes and the implications of Social Security. Social Security is the biggest component for most lower-income households when they retire, and it's not taxed. But they also weren't paying tax beforehand on their earnings based upon their overall tax code. So, much doesn't change for them at all.
Someone who is making $200,000 a year has to be saving for retirement. They've got to be saving probably 10% to 15% per year, and that expense goes away when they retire. So all of a sudden that's gone, and taxes change as well. Their replacement rate is going to be lower than someone who is making $20,000 a year.
Variable II
The second is, how does that need change over time? The most common assumption is that individuals have the initial need increased by inflation. So if you spend $40,000 in the first year, and inflation is 3%, you spend $41,200 in the second year, and so on.
We looked at how people's expenses change over time. There are the go-go years when you first retire; you can travel and do stuff. Then as you age, you slow down and your body says, hey, I'm tired, I'm not as healthy.
I looked at the actual changes in spending for actual retiree households in the U.S. What you see is that as people progress through retirement, they actually spend less and less and less. While the common assumption is that your spending increases with inflation every year, it's actually not the case. It actually goes down in real terms. So even if inflation is, say, 3%, your spending only rises by, say, 1%. It tends to tick back up at age 80-85 for health-care costs, but for the most part, you don't see this relationship where people are spending more and more each year based upon inflation.
I actually created four different groups. What I found was that, people who have matched spending to wealth--so those that have the same overall levels of wealth to spending--tend to follow the same path over time. Those individuals, though, who have either over-saved or under-saved tend to adjust over time. Individuals who have saved lots of money and realize, I have all this money, and I'm not spending a lot--they actually tend to spend more over time. Individuals who have under-saved spend less.
The overall theme, regardless of the group, is that, as you move through retirement, your increases go down. So you're spending less and less in real terms or inflation dollars over time.
Variable III
How long is this going to last? How long do I need to save for?
People commonly use 30 or 35 years as the retirement period, but that actually varies, as each assumption does, by each individual retiree. But this assumption is really important, because obviously saving for a 20-year period is a lot different than saving for a 40-year period.
A really good approximation and what I like to use is, 30 years. It's a great starting point. But the key is to go in every year and re-address the situation. There's one way we've talked about before, the RMD (required minimum distribution) method. You look at how much longer do I think I'm going to live. Let's say I have 20 more years to live. Well, then a good ballpark to take out for that year is 1-over-20 or 5%. That works for individuals and couples. The key is being conservative, but not too conservative, and going back each year and figuring out, does this still makes sense given my overall needs and lifestyle?
Update that as you go along. Because it's hard to make projections for 30 years. You've got to make sure that what you're doing makes sense for the long haul, and going in every year to revisit that ensures the safety of the overall strategy.
It's a fun exercise to make projections for 30 years, but it's kind of impossible. So, I think the best thing you can do is have a good starting point. Ask yourself realistically, what do I need to live off of when I retire? That number is going to be different for every single person. Then based upon that, make some reasonable projections, and figure out what you can live off of every year, because one thing you don't want to do is over-save or under-save. You want to make sure that every year you're consuming the right amount to maximize your happiness during retirement.
The article has been edited to make it applicable to an Indian audience. To watch the video or read the original transcript,
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