How to Calculate the True Cost of Retirement
The amount you'll need might be less than you fear
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.
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.
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.
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.