What percentage of pre-retirement income do your clients want to spend in retirement?
The so-called income replacement rate concept is often the first step in estimating a retirement savings plan. A 2012 Aon Hewett study suggested that retirees should try to replace 85% of their income during the first year of retirement. Many advisors take an 80% or 85% number for granted. If you earned $100,000 right before retirement, you’ll need an income of $85,000 to avoid cutting back during your golden years. But can one number really be right for all retirees? And does an 80% rule of thumb even make sense?
Let’s review the first assumption of the 80% replacement rate. People generally want to spend the same amount after retirement as they did before retirement. They don’t want to experience what economists call a “consumption discontinuity” after they retire, which is a fancy way of saying that they spend less.
I think that there are some important reasons why we might use the 80% rule. It’s easy, for one. Just multiply a nice simple fraction by your income. Second, and related to the first, it’s kind of hard to actually figure out how much a household needs in order to match their spending after retirement. The third is that it’s a generally conservative number that encourages workers to save a lot more during their working years.
Saving more is good, right? To an economist, this isn’t such an easy call. Every dollar that you save during working years has a tradeoff — it’s a dollar that you could have spent on home improvements, a family vacation, eating out, or a newer car. If you’re giving up a family vacation at age 35 when money is tight in order to buy a vacation at age 75 when you may have a higher income, are you getting the most out of life?
Economists following a life-cycle framework note that income is often at a peak right before retirement. In other words, families tend to be earning less in their 30s and 40s than they do in their 50s and 60s. A household that was a utility maximizing robot would smooth spending over all these years to avoid living it up in one life stage while living in poverty in another.
Ideally, we’ll want to spend about the same each year before and after retirement. For example, if we made $50,000 (inflation-adjusted) each year between 30 and 50, and $70,000 each year between 50 and 70, a reasonably smooth lifetime income might be, say, $45,000. So we’ll save $5,000 each year early in life, $25,000 each year in middle age, and then continue spending $45,000 a year into retirement. If we peg the replacement rate at 80% of $70,000 then we’ll be spending $56,000 each year after retirement.
In other words, we’ll be living better after retirement than we did when we were raising a family in young adulthood. And don’t forget that we’re often chipping away at a mortgage early in life that allows us to enjoy rent-free housing in retirement.
But most of us would have a tough time following a life-cycle strategy. If we become professionally successful later in life, we may become accustomed to a higher level of spending that we want to maintain in retirement. Few clients are going to be happy taking a big hit to their standard of living. If they have the resources to hire an advisor, then they want to enjoy themselves in retirement.
What It Takes
What does it take to maintain a post-retirement lifestyle? Let’s review the basics. A worker contributes 7.65% of his or her paycheck to Social Security and Medicare (make that 15.3% if you’re self-employed). That’s money that was never even available for spending. And what if we were saving a bunch of money before retirement in order to meet our 80% (or 85%) replacement rate? That’s money we were never spending either. A worker saving 15% of income would then start out by subtracting this 15% and the 7.65% Social Security. Now we’re down to 77%. Of last year’s income. If we were using the economics methods of average lifetime income, we might be closer to 60% or even less.
But wait, there’s more. Retirees don’t have work-related commuting expenses; they have a higher standard deduction, plus subsidized Medicare health insurance (although many have subsidized health insurance during working years); and Social Security is taxed at a slightly lower rate. But most importantly, higher-income retirees may be in a much lower tax bracket after they start living off investments and 401(k) assets.