Flexibility instead of hard-and-fast rules can help solve retirement spending woes.
When it comes to estimating retirement costs, the wind always blows conservatively. Asset-manager firms 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.
Separately, Michael Kitces, the well-known financial planner whose blog Nerd’s Eye View is popular with advisors, and David Blanchett, Morningstar’s head of retirement research, have arrived at the same conclusion. Blanchett says that the true costs associated with retirement are often overstated and don’t need to be as burdensome as is commonly accepted. Kitces argues that retirees should increase their exposure to equities as they grow older— a counterintuitive glide path that goes against most industry thinking.
If you see the beginnings of an interesting discussion here, so did we. I talked with Kitces and Blanchett on April 9. Our discussion has been edited for clarity and length.
Let’s jump right in with a question that continues to confound retirement experts: How much money do people need at retirement?
Michael Kitces: In practice, it’s a piecemeal process because we’re simultaneously drawing from several different pools of money or income streams. For most people, we’re planning around some level of liquid assets and Social Security. We may need to fill that picture in with anything from additional pensions to some amount of home equity. Things like Social Security and pensions are pretty straightforward; we know what the dollar amounts will be. When we get to a portfolio asset, we have to try to convert it into some reasonable income stream to align with the rest. That’s where some safe-withdrawal conversations start coming to the table. Often the starting date for income streams don’t line up perfectly, but it’s a starting point. Though in the rare situation where someone comes to us, and they’re 66 years old, and every single income stream is about to start, and they’ve got a completely liquid portfolio and everything lines up perfectly, we can often get to a pretty darn good estimate of reasonable total retirement spending, or conversely, how much money we’ll need at the start of retirement.
David Blanchett: Say you make $100,000. You’re saving 20% annually for retirement. You have other expenses. The savings are going to grow by a certain amount for the next 10 years. What is that consumable number when you retire? How long are you going to live? And what is your level of certainty for achieving that income goal? These are all important assumptions you make along the way.
Another very common assumption is that costs, on average, increase by inflation. I still use that assumption in my general research, but if you look at the actual data on spending by retirees, there’s this thing called the “retirement consumption puzzle.” People as they age actually tend to spend less in real terms over time. Obviously, this has really interesting implications for how much people really need to save for retirement. But it also affects things like what is the best type of annuity, because a lot of classical economists talk about real-inflation-adjusted annuities being the best option. But if spending does not increase with inflation, maybe nominal are actually more attractive, because one they’re a better hedge against spending, and two because they have more attractive payout rates because there’s a larger pool of insurers offering them.
Kitces: A couple of things to add to your comments, David. The replacement ratio rate is one of those things that is often maligned in the media. But when I sit down with a lot of clients, it still turns out to be amazingly accurate. Certainly for the subset of baby boomers, they go into these massive savings bursts in their final years before retiring; in their peak income years, they’re saving 50% of their income, and that much saving throws off those replacement ratio numbers.