When projecting how much income a retiree will need, common assumptions don’t always work.
This article is an excerpt from the paper “Estimating the True Cost of Retirement” by the author. The full paper is available at http://corporate.morningstar.com.
Retirement is the most expensive lifetime “purchase” made by most people. Therefore, it makes sense to understand how much retirement is actually going to cost, but it’s complex calculation. We will briefly explore the some common assumptions used when estimating the cost of retirement—such as generic replacement rates of 70% or 80%, the idea that retirement spending increases annually by inflation, and that retirement lasts 30 years—and find that these assumptions often do not pan out.
When determining how much someone will spend each year in retirement, a common starting place is to use a “replacement rate,” which is the percentage of household earnings needed to maintain a similar standard of living during retirement. Replacement rates such as 70% and 80% are commonly cited; however, in reality, the replacement rate varies considerably depending on the household.
Households have different sources of income and different types of expenses that will cease at retirement. For example, retired households no longer have to pay Social Security and Medicare taxes. Expenses such as saving for retirement and those associated with working are no longer concerns for retirees. There are also tax benefits available for retirees, such as a higher standard deduction, and new income sources, such as Social Security, that can be taxed more favorably than wages.
Actual replacement rates are going to vary, but most will range between 50% to 90%, according to our models. Lower income households are generally going to have higher replacement rates because they tend to pay lower (or no) taxes. Additional considerations include how much the household is saving for retirement and the relative tax efficiency of the retirement income sources. In summary, the replacement rate is a highly personalized decision and one size does not fit all.
Consumption Over Time
A common assumption in retirement planning software and research is that retiree spending (or consumption) increases each year by inflation. To test this assumption, we used data on retiree spending from the RAND Health and Retirement Study. The HRS dataset is unique because it tracks households over time, which allows us to track retiree spending changes over time.
For our analysis, the inflation-adjusted changes in spending are reviewed for five historical surveys and the results are averaged by household age. EXHIBIT 1 includes the results of the analysis, where the inflation-adjusted change in consumption is averaged by age for retiree households from ages 60 to 90, in one-year increments. A second order polynomial regression for the entire age range and for ages 65 to 75 is included to provide some insight into the strength of the overall relationships.