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How to Calculate the True Cost of Retirement

The amount you'll need might be less than you fear

By Robert Powell | MarketWatch | December 17, 2013

In the past, experts routinely said you needed to replace 70 percent to 80 percent of your pre-retirement income for your golden years.

Plus, the experts said, your retirement income need was assumed to increase annually at the rate of inflation for the duration of your retirement. And experts would routinely use 30 years as the standard duration of retirement.
 
But David Blanchett, the head of retirement research at Morningstar Investment Management, says those rules of thumb/assumptions are shortcuts that, when combined, can overestimate the true cost of retirement for many investors. Here’s a look at some of the findings from his white paper.

(MORE: The Retirement Math That Matters Most)
 
What’s an Appropriate Replacement Rate?
 
According to Blanchett, a replacement rate of 70 to 80 percent may be a reasonable starting place for many households, but it doesn’t work so well when you model spending over a couple’s life expectancy rather than a fixed 30-year period.
 
In fact, the data suggest that many retirees may need 20 percent less in savings than what conventional wisdom would have you believe. That’s the good news.
 
The bad news: Blanchett found — as have other researchers — that actual replacement rates are likely to vary considerably by retiree household.
 
In his research, Blanchett found the replacement rate is sensitive to the proportion of pre-tax expenses (such as contributions to a 401(k) plan or an IRA) to post-tax expenses (such as contributions to a Roth IRA, college tuition for children, mortgage payments and work-related expenses) and ranges from 54 percent to 87 percent.

(MORE: Money Rules of Thumb You Need to Follow and Ignore)
 
So, for instance, a household with income of $150,000 where pre-tax expenses equal 6 percent of income and where post-tax expenses equal 12 percent would need to replace just 65 percent of their pre-retirement income to maintain their standard of living in retirement. But a household that saved twice as much (pre-tax expenses equal 12 percent of income) would need only replace 55 percent of their pre-retirement income in retirement.
 
In other words: “There is no ‘one-size-fits-all’ approach to gauging your replacement rate,” Blanchett said.
 
So, to figure out how much of your pre-retirement income you’ll need to replace in retirement you’ll need to look at all your expenses and figure out which will decline or disappear when you’re retired and which ones might rise (health care, for one).

Consider, for instance, that you likely no longer have to pay Social Security and Medicare taxes or save for retirement or have work-related expenses. What’s more, your household may also have a higher standard deduction and receive income (Social Security, for example) that is taxed more favorably than wages, according to Blanchett.

(MORE: Are You Saving Enough for Retirement?)
 
Inflation and Your Retirement
 
Another issue to consider is the composition of your expenses in retirement and the rate of inflation associated with those expenses.
 
According to Blanchett’s paper, expenses for retirees — as measured by the Consumer Price Index for the Elderly (CPI-E) — have increased at a rate greater than general inflation over the past three decades.
 
For instance, from December 1982 to December 2012, the average annual change in the CPI-E has been has been 3.07 percent vs. 2.92 percent for CPI-U, or general inflation. Therefore, Blanchett wrote, the costs of goods for retirees have increased by about 5 percent more, per year, relative to general inflation.
 
“If this relationship persists and general inflation is expected to be 3.0 percent per year, then retiree inflation would be 3.15 percent per year,” Blanchett wrote. “This difference would become increasingly important over longer retirement periods, which is likely a concern for retirees given increasing mortality levels.”

Weighing Your Expenses in Retirement

Two more factors to consider when looking at your expenses in retirement:
  • The relative amount spent on insurance and pensions decreases significantly at older ages.
  • The relative amount spent on health care increases significantly at older ages.
Health-care costs increase and grow at a rate greater than general inflation. Medical care costs have increased on average 5.42 percent per year from 1948 to 2012, vs. 3.63 percent for general inflation. In other words, medical costs have been increasing about 50 percent more than general inflation, according to Blanchett’s paper.
 
To be fair, Blanchett noted health-care costs are likely to affect retirees differently. In general, the median percentage of total expenditures spent on medical expenses increases from about 5 percent of total expenses at age 60 to 15 percent by age 80. But for low-income households, it increases from about 25 percent at age 60 to about 35 percent by age 80.
 
Consumption Changes Over Time
 
According to Blanchett, research on retirement spending commonly assumes consumption increases annually by the inflation rate, but he did not witness that relationship in his research.
 
Instead, he found that retirees' expenses decrease in real terms (after inflation) in the earlier years of retirement and then increase toward the end. So factor that, rather than straight-line spending, into your income-replacement equations.
 
And when in doubt about your spending in retirement consider this: “Households might be better off spending a bit extra when they can enjoy it,” he said.
 
Another important point: While the idea of a 30-year retirement period is a great way to simplify how long retirement is going to last, the actual period is going to vary by household, Blanchett said. So consider your household’s life expectancy when calculating your income-replacement need.
 
One Last Bit of Advice
 
Blanchett also said his research suggests that many households would benefit from claiming Social Security as late as possible. By delaying, you’ll get a higher inflation-adjusted benefit for life.
 
Blanchett said: “Let that be the ‘floor’ income, and then think about what’s left (savings) that could best be used to fund different lifestyle expenditures.”

Robert Powell is a MarketWatch Retirement columnist. He has been a journalist covering personal finance issues for more than 20 years. Follow him on Twitter @RJPIII.

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