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The Retirement Glass Is Half Full

Things look better after easing unrealistic assumptions.

John Rekenthaler, 12/20/2013

Details, Details
When it comes to estimating retirement costs, the wind always blows conservatively. Asset-manager companies would prefer having more money than less; financial advisors desperately wish to avoid having their clients go broke; and plan sponsors providing 401(k) tools would rather see their employees overshoot the market than undershoot. That makes sense.  Who would advocate better sorry than safe?

[Raises hand.]

Of course, I wouldn't phrase it that way. Rather, I would point out that the cautious approach is not without its faults. It can scare investors into avoiding the subject of retirement planning altogether. (The most common final screen for retirement-planning software is the gap-analysis page, when the user is shown the difference between what he or she is now doing and what is required. Upon seeing that, many exit the program, never to return.)

Also, conservatism generally implies simplified--and often unrealistic--models. One such example, which I've discussed in the past, is that retirees spend the same inflation-adjusted dollar amount each and every year, regardless of stock market behavior. It's possible, although peculiar, that somebody might wish for such an inflexible plan. More likely, though, the investor will be willing to accept a degree of flexibility in exchange for a lower target wealth goal at the time of retirement, as the withdrawal rate may be increased with flexible spending.

In a current working paper, "Estimating the True Cost of Retirement," Morningstar's David Blanchett addresses two additional items that may ease the burden of retirement savings: income replacement rate and the strategy of creating a "spending curve" for the retirement years rather than using constant real withdrawal rate. David didn't set out to deliver a happy pill--he's a spreadsheet junkie who goes where the numbers send him--but overall his message is a pleasant one.

Income-Replacement Ratio
Standard investment advice is that retirees should seek 70% to 80% of their pretax, preretirement income. That is, if a retired couple makes $80,000 combined before retirement, they would aim for $56,000 to $64,000 per year during retirement. Generally, this advice is given with the implication that the 80% mark (that is, $64,000 here) is the true goal, but, if the investor falls a bit short, that would be acceptable. Some even argue for higher amounts. David's paper cites a report by Aon Consulting that calls for income-replacement ratios of 78% to 94%.

David's research suggests that these numbers are high.

His analysis begins with the assumption that retirees will wish to maintain their preretirement level of take-home spending [my term, not his]. 

is vice president of research for Morningstar.

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