The Color of Money: Calculating the ‘replacement rate’

Michelle Singletary
Columnist December 31, 2013

If you resolved to save more for your retirement in 2014, you may be happy to hear about some new research on estimating the income you’ll need.

To have enough money for when you are no longer working, you have to know your “number.” That is a calculation based on factors such as the rate of inflation, how much you are expecting from Social Security, an estimate of how much your investments might earn and how long you think you might live. The calculation also estimates the percentage of pre-retirement income you’ll need to replace. That percentage is called your “replacement rate.”

Michelle Singletary writes the nationally syndicated personal finance column, “The Color of Money.” View Archive

Retirees used to estimate they could make do on 40 percent to 50 percent of what they used to earn a year because they wouldn’t have the same costs they did while working. Their children are grown and on their own. They probably wouldn’t have a mortgage or all the expenses associated with working, such as commuting costs.

But many of today’s retirees want to live life more abundantly. Their children and grandchildren may not be close by, so they need to budget to travel to see them. And many won’t pay off their mortgages before they retire. Their retirement calculations may suggest they need to replace 70 percent to 80 percent of their yearly pre-retirement income, because their expenses won’t greatly be reduced in retirement.

Still, the higher assumptions so common now might be too high, leading people to overestimate how much money they will need to fund their retirement, according to David Blanchett, head of retirement research for Morningstar Investment Management, a unit of Morningstar.

“While a replacement rate between 70 percent and 80 percent may be a reasonable starting place for many households, when we modeled actual spending patterns over a couple’s life expectancy, rather than a fixed 30-year period, the data shows that many retirees may need approximately 20 percent less in savings than the common assumptions would indicate,” Blanchett writes in his research paper.

Some people may find that their actual replacement rate is under 54 percent, he notes. Part of the reason that people may need less is that their consumption tends to decline as they settle into retirement. Many expenses also go away, such as Medicare and Social Security taxes.

But before you breathe a sigh of relief, understand that how much you need is contingent on many factors. For example, if a high-income couple who saved a lot while they lived in a high-income-tax state such as California retires to Florida or Texas, where there is no income tax, their replacement rate might be closer to 60 percent.

However, if a low-income couple who hasn’t saved much retires to a high-cost area, they might need a higher replacement rate.

“Although a ‘rule of thumb’ replacement rate of 70 percent to 80 percent is clearly reasonable, it isn’t ideal and, moreover, it is clear that the replacement rate is sensitive to the proportion of pre-tax expenses to post-tax expenses,” Blanchett writes.

When people ask me how much they need to save for retirement, or what percentage of their income should they be saving every paycheck, my standard response is: “It depends.”

“You need to look at your own situation, with help if you need it. And then totally own what you commit to do for your and your family’s financial security today and in the future,” says Don M. Blandin, president and chief executive of the Investor Protection Trust, a nonprofit organization that provides investor education.

You’ve got to do the calculations, making the best-informed estimates you can and understanding that you don’t know how long you are going to live. We can estimate the rate of inflation, but we don’t know for sure what it will be over the length of retirement, which might span 30 years or more.

From what I’ve seen personally and the studies I’ve read, most people aren’t saving nearly enough to retire. So keep that resolution to save more for retirement on your list. Better to err on the side of too much rather than too little.

Readers may write to Michelle Singletary at The Washington Post, 1150 15th St. NW, Washington, D.C. 20071 or singletarym@washpost.
com. Personal responses may not be possible, and comments or questions may be used in a future column, with the writer’s name, unless otherwise requested. To read previous Color of Money columns, go to postbusiness.com.

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