Saturday, September 24, 2011


Figuring out your income-replacement rate is no easy task

BOSTON (MarketWatch) — It is the mother of unanswerable questions in the world of retirement planning. How much of your current salary will you need after you retire?

The replacement ratio rule of thumb suggests you might need 75% of your current salary from a variety of sources — be it Social Security, personal assets (a 401(k) and IRA, for instance), earned income (yes, you’ll likely be working in retirement), and the like — to enjoy the same standard of living while in retirement as before.

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But according to research conducted by Dan Ariely, people need 135% of their final income to live the way they want in retirement. The reason for this astounding difference has to do largely with the way Ariely, a professor of economics and behavioral finance at Duke University, did his research.

Instead of asking people to ballpark how much of their final salary they will need, he asked the following questions: How do you want to live in retirement? Where do you want to live? What activities do you want to engage in? And similar questions geared to assess the quality of life that people expect in retirement.

Ariely then took the answers and “itemized them, pricing out their retirement based on the things that people said they’d want to do and have in their retirement.” Using those calculations, he found that people want to retire to a standard of living beyond what they currently enjoy. (Who wouldn’t if money were no object?) Read Ariely's blog post on the topic here.

Ariely didn’t respond to emailed questions about his blog post. But I am fond of Ariely’s body of work and have quoted him often.

Needless to say, Ariely’s blog has the financial-advice community up in arms. For one, he suggested in his blog that financial advisers are getting paid far too much (1% of assets under management) to help people build a nest egg that’s “60% too low in its estimation.”  

Two, he criticized the use of those ubiquitous risk-tolerance questionnaires that label investors as aggressive, moderate or conservative. His research showed that people cannot accurately describe their attitude toward risk and as a result, questionnaires about risk attitude are essentially useless.

From my perch, however, the questions that Ariely’s research raises have to do with the current salary replacement ratio. How much of your current salary do you really need to replace in retirement? Is the salary replacement ratio a good or bad rule of thumb? If it’s a bad rule of thumb, what’s a better way to determine how much you need in retirement? And, what are the pros and cons of that “better” method?

How much is enough?

Experts say it’s very hard to estimate with any precision how much income you’ll really need in retirement.

“In some ways, life after retirement is relatively inexpensive,” said David Laibson, an economics professor at Harvard University. For one, the expenses associated with working, raising a family and maintaining a home prior to retirement are typically much less after you retire.

“On the other hand, life after retirement is also a time when expenses might be high,” he said. For instance, costs associated with travel, leisure and health care might rise.

“At the moment we don’t know which argument wins the day. Do we need more income in retirement or less? It’s really hard to say,” Laibson said.

Some — including Stephen Utkus, a principal with the Vanguard Center for Retirement Research — say that 75% is as good a number as there is.

A good reference on this, he said, is a series of studies produced by Aon Consulting and Georgia State University, which put the replacement ratio at 81% for those with a final salary of $50,000 and 84% for those with a final salary of $150,000.

“They make the rational point that when you are retired, you aren’t making large 401(k) contributions, aren’t paying payroll taxes ... and living expenses are lower,” said Utkus. “Hence 75%, or thereabouts.” Read the 2008 Replacement Ratio study (PDF).

Adjustments are needed

But the oft-quoted 75% replacement ratio — while good — needs to be tweaked based on one’s income, said Peng Chen, CFA charter holder and president of Morningstar’s global investment-management division.

The typical amount of money one needs to maintain the same standard of living in retirement as before is roughly 100% of one’s income after taxes and 401(k) contributions, Chen said.

“This make sense, as that is pretty much how much one is spending today in the U.S.,” Chen said.

But that’s the average. The salary replacement ratio is closer to 100% or even higher for lower income households (as they get subsidies) while the ratio could be 80% (or lower) for higher income households, as wealthier people do not spend all of their income, Chen said, citing government survey data.

Looking for a ballpark estimate? “My personal view is that households should generate enough retirement income to replace about 75% to 100% of their pre-retirement income,” said Laibson. “This estimate is as much art as science.”

A good or bad rule?

Experts say the salary replacement ratio is neither a good nor bad rule of thumb. “It’s a quick way to come up with a ballpark estimate,” Chen said.

Like every rule of thumb, it has pros and cons. On the pro side, it is easy and everyone understands it, he said. On the con side, Chen said, it’s not very accurate, especially at the individual level.

Others agree. “Replacement-rate calculations are overly simplistic and potentially inaccurate because they often are based on methodologies limited to replacement of preretirement cash flow after adjustment for taxes, savings, and age and/or work-related expenses,” wrote Jack VanDerhei, a Temple University professor, fellow at the Employee Benefits Research Institute, and author of a 2006 research report on the subject.

“One of the biggest weaknesses of replacement-rate models is that one or more of the most important retirement risks is ignored: investment risk, longevity risk, and risk of potentially catastrophic health-care costs.” Read VanDerhei’s report, "Measuring Retirement Income Adequacy" (PDF).

Consider, for instance, just the risk of outliving your assets. Saving to replace your salary for life based on life expectancy is very different from saving to replace your salary to age 95. In the living-to-life-expectancy scenario, you might need to accumulate a nest egg of, say, $500,000 while in the living-to-age-95 scenario, you might need a nest egg of three times that or $1.5 million.

135% isn’t the number

While the experts quibble over whether the replacement rate is 75%, 100% or somewhere in between, they generally agree that 135% is not the right number.

“As for Ariely’s survey, one of the principles of behavioral economics is there is a difference between what people say and what they do,” Utkus said. “I don’t buy his study’s conclusions at all. I’d be curious to know: Were all of the people who wanted to retire at 135% of income saving 30% of their income each order to achieve that goal? Probably not. So it’s just a wish list, nothing more.”

Others are of the same mind-set. “One shouldn’t glibly reject Ariely’s 135% number, but there are quite a few reasons to be skeptical of that calculation,” Laibson said.

“When economists do their best to work through these issues, we generally conclude that your annual income in retirement should be a bit lower than your annual income before retirement,” he said. “I use the word ‘should’ in the sense that an optimizing household would save enough during their working life so their income in retirement is a bit lower than their income before retirement.”

Another expert said it’s not reasonable to try to replace 135% of your current salary. One couldn’t cut spending and save enough now to generate that sort of income later, said Wade Pfau, an economics professor at the National Graduate Institute for Policy Studies in Japan.

“There are just too many trade-offs in getting to the point where a 135% replacement rate is feasible,” said Pfau, who wrote a blog and a paper on the subject.

No magic number

There is no single, correct replacement rate, VanDerhei and others said. In fact, there’s really no substitute for doing precisely what Ariely did: crunching the numbers. It’s not quick, but it’s more accurate than any rule of thumb. According to Chen, individuals should look at their own spending habits to decide how much of their salary they’ll need to replace.

This is easier said than done. “Most people do not start to think about how they would live in retirement until they are close” to it, Chen said, “and this type of financial planning has to be done a number of years before that.”

Others criticize the use of salary replacement ratios altogether. “Ariely’s calculation is as bad as what he’s criticizing,” said Larry Kotlikoff, an economics professor at Boston University and president of ESPlanner, a financial-planning software company that uses the economic concept of consumption smoothing in its calculations.

“What people want or need is irrelevant. The only issue of relevance is what they can afford to spend on a sustainable basis. The goal is not a number,” he said. “The goal is a smooth living standard through time. If financial planners haven’t gotten this straight by this point, they should hang it up. They are disserving their clients using a methodology that not a single trained economist would endorse.”

Ariely raised another point in his blog that is at the crux all things money. In essence, he asked: How do we use our money to maximize our current and long-term happiness? And that of course prompts the question: Just how the heck is one supposed to do that?

“This is definitely the crux of the question,” Chen said. “I am not sure anyone knows for sure, just like everything in life. This not only touches on how much you should save for tomorrow or spend for today, but also on how much you should work to generate more income, or relax and enjoy life.”

For his part, Utkus said the key to striking a balance between saving more now to spend more later, and spending more now to spend less later is this: One, “we need some amount to make us feel secure (in other words, happy), and it’s not unreasonable that that is something like a 75% replacement ratio as a starting point.”

Second, we know that many affluent individuals want a more active lifestyle when they first retire. “If they aren’t willing to shift their consumption patterns — from Westin Resorts to the Ramada, from [first class] to flights in economy on Tuesday — then, yes, they’ll need 100% or more,” Utkus said. “But few actually seem to act on this desire by saving the requisite amount.”

Three, at the other extreme, it’s probable that many individuals can be just as happy with less (except for those with low incomes) because they can make choices about living on less.

Said Utkus: “Happiness is broadly tied to intangible elements beyond financial security...such as family and social relationships, purpose of life, spirituality, and so on.”

Robert Powell,
09 23 2011

Robert Powell is editor of Retirement Weekly, published by MarketWatch.
Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.