December 2, 2011

Are Your Clients Saving Too Much for Retirement?

Despite America’s dismal savings rate, traditional estimates might be wrong

It’s an oldie but goodie; part of a perpetual debate. What is the appropriate “replacement rate” to target when saving for retirement?

Conventional wisdom pegs it at 80%. But Reuters’ Linda Stern wonders if, despite the mountain of reporting about America’s lack of retirement readiness, it might be too much.

“[T]here's reason to believe that oft-quoted 80% figure is wildly on the high side,” Stern writes. “That, in turn, makes the retirement calculations based upon it also wildly off. And that means if you're trying to save enough money to produce that 80% figure, you may be putting away too much, or skimping unnecessarily on the early years of retirement.”

"It's a sometimes bizarre measure that could have absolutely nothing to do with your standard of living," Bonnie-Jeanne MacDonald, an actuary who currently holds two fellowships, one at Dalhousie University in Halifax, Nova Scotia, and another with the North American Society of Actuaries, told Stern.

And Stern points to a recent paper co-authored with Kevin Moore from Statistics Canada, the Canadian government's official agency, which find that traditional replacement rate calculations have so many limitations and fallacies that they shouldn't be counted on by workers trying to plan their retirement savings.

"For a financial adviser to say you will need 70% or 80% of your income, and here's how much you have to save, is not very helpful," MacDonald said in a recent interview.

For a more accurate calculation, Stern suggests the following:

Do your own math. Pre-retirees should try to calculate those discredited rules of thumb and estimate their own retirement needs more specifically, she writes.

“Look at how much you're spending now, and see which costs you think will disappear when you retire, or during your retirement. For example, when will you pay off your mortgage and finish helping your kids pay for college? How much will you save in taxes once you're not working? Add in more for costs, such as health care, that could go up.”

Look at the data. True spending patterns suggest your first years of retirement will be your most expensive. She cites the following figures from the Bureau of Labor Statistics' consumer expenditure survey for 2010:

The average household headed by someone age 45 to 54 spends $57,788 a year. Those years are typically the highest-earning, highest-spending years. Average expenditures for the 55-to-64 age group (which presumably includes workers as well as early retirees) are $50,900; 88% of the expenditures for the younger group. Heads-of-household aged 65 to 75 spent an average of $41,434 in 2010, or about 72% of the amount spent during those early prime-earning years. And households headed by those over 75? They only spent an average of $31,529, or 55% of their peak spending.

That means that even if you do need 80%, or more, in your first years of retirement, you will not need that forever. That changes the savings calculus.

You may be able to front-load your retirement spending. That's most likely what you would do anyway, because people in their first year of retirement often spend extra money on special trips, home repairs and new hobbies.

“Another retirement rule of thumb says you should pull out only 4% of retirement savings in your first year if you want your money to last 30 years,” Stern concludes. “So, if you've saved $500,000, you could withdraw $20,000, or $1,667 a month. But, if you're willing to curtail spending down the road, you could start with bigger withdrawals early, says Christopher Van Slyke, a money manager in Austin, Texas. He tells some of his newly retired clients they can start by pulling 5.5% or 6% out of their portfolios for a few years, as long as they understand that that rate isn't sustainable for three decades.”

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