Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
One commonly cited rule of thumb is to plan to replace 80% of your pre-retirement income when you actually retire.
Joining me to discuss the 80% income-replacement rule is Michael Kitces. He is partner and director of research for Pinnacle Advisory Group.
Michael, thank you so much for being here.
Michael Kitces: Thanks, Christine. It's great to be here.
Benz: So Michael, a lot of people in the retirement research area talk about this 80% rule. Let's talk about where it comes from and why it is often thrown out there as sort of a starting point when thinking about income replacement during retirement?
Kitces: The origins of the rule actually are pretty straightforward. It started with the concept, somewhat surprising to people, that we simply assume retirement spending is going to look pretty similar to what your spending was while you were still working and that you're going to continue all of your ongoing spending. The difference, of course, as we transition to retirement is that there are certain factors that do fall off the plate.
If we used to earn a certain amount of income, out of that came income taxes, employment taxes, savings we were actually making into retirement accounts, and even perhaps some nominal amount of other spending--the suits and clothes we wear, our transportation to and from work, and so forth. So those expenses begin to disappear. And it's sort of popular in today's political discussions of even recognizing people's effective tax rates, which for a lot of people is somewhere in that range around 10%, 15%, 20%, 25%, as income rises.
And so if we start with, I had 100% of my income, and I subtract out, say, 15% to 20% for taxes, a little bit for savings, a little bit for those ancillary expenses, what it means in essence was, I was probably spending somewhere around 70% to 80% of my actual income to maintain my lifestyle. So, if I need to figure out how much of my income to replace in retirement where taxes, savings, or some of those expenses are gone, they say I need to replace 70% to 80%.Read Full Transcript
I've seen a lot of confusion with this number, where the implication has been well, people are going to live on 70% of their pre-retirement expenses, and why would I take a step down in my standard of living, and that's actually not what the rule says. It's not a replacement of your pre-retirement expenses. It's actually a replacement of your pre-retirement income, out of which came taxes, savings, and other items to get to your expenses and your standard of living. And it's essentially just a rule of thumb to try to figure out about how much of your income do you currently spend, and about how much of it will you likely continue spending in retirement.
Benz: So maybe you start with this 80% rule, but you say that there are ways that people can kind of customize it based their own situation. So let's talk about those factors.
Kitces: We do see it move a little bit, because one of the primary driving factors is simply backing out income taxes. Our income tax schedule is progressive, which means lower tax rates on lower incomes, and higher tax rates and higher incomes. So if we sort of reverse that around, what it actually means is, folks with lower incomes tend to have higher replacement ratios: Less of their income was going to taxes, more of it was being spent. So the replacement ratio in retirement tends to be higher. So as the income drops down, we tend to see the replacement ratios move up towards 90%, and conversely as income rises higher and higher, we tend to see the replacement ratios drop down towards 70%.
Any other extraordinary expenses or activities will also modify that number, one of the biggest drivers of which we see is simply boomers in particular, who have hit their peak earnings years, in their late 50s and into their 60s, who are doing very large savings relative to their income, trying to make it up and catch up so that they can retire. So, in some cases we'll see situations where people's spending might actually only be 50%, 40% of their income, because they're saving and banking almost half their income trying to catch up. And there's nothing wrong with that. That's great that they're getting there, but it simply means if you're really doing sort of extraordinary savings activities, an 80% or 70% number may not be particularly representative for you.
Ultimately where we would really get everyone is, if you really want to get a clear hand on what your retirement spending is going to look like, sit down, figure a little of what that lifestyle is going to look like, put some numbers down, kind of budget around it, and not that you're budgeting for the sake of putting constraints on what you're going to spend in retirement, but simply trying to put pen to paper and numbers to it of what do we think these cash flows are really going to look like, and what are we going to spend as we maintain that lifestyle.
But if we're trying to just get a rough estimate, start getting close, we find for a lot of people, these replacement ratio numbers are actually remarkably close.
Benz: So, I'd like to discuss another sub-topic in this whole area, which is whether you see spending trend in any certain direction as people age in retirement. So there was that old saying that the early years are the go-go years, then the slow-go, and no-go. Is that borne out by reality when you look at sort of aggregated retirement spending trends? Do you see anything like those patterns?
Kitces: So, yes and no. We do have some data around this. We have some pretty robust national statistics around consumer expenditures. It's been studied a few times. The Journal of Financial Planning had an article about this a couple of years ago, looking at these spending patterns. Frankly what we saw in that research looked a little bit less like activity, slower, and nothing, and more like a slow, steady, gradual decline through your 60s and your 70s and your 80s.
Now part of that is because you have got a large enough number of people, population-wide, the trends smooth out a lot. But we do seem to see that kind of general spending transition, which is that, spending slowly comes down over the years as people age, and is really driven by lower overall activity levels. So, the 60s might be consumed with a whole bunch of travel and other activities. Sometimes there's even an uptick from pre-retirement spending. We go see the world and do a lot.
But then by the time we get to our 70s, the international travel dies down a little, maybe we're doing a little bit of domestic travel. By the time we get into our 80s, we're not even doing so must domestic travel anymore. We're not even necessarily going out very much. Eating out expenses have declined, travel expenses declined, if we had two cars we have probably gone to one, we might have gone to zero. These expenses just slowly keep coming out.
So when we look at that, at least in the aggregate, we absolutely see this sort of declining level of spending. Now there are even a few wildcard factors we find that adjust beyond that. Folks who are sort of higher income overall and have more discretionary spending as a part of their total pie, seem to experience this decline more rapidly. I say that mostly from anecdotal experience that we see in practice with our own clients, because we don't have a lot of really good data that slices into spending at that level. But we do seem to notice that spending in discretionary categories, in particular, comes down even more rapidly, just again as those activity levels decline.
The hardest wildcard to it, I think is, for most people, is they don't necessarily experience it as a gradual decline. It tends to be more sudden. We used to do a lot of traveling, go out a lot, and do all this stuff until granddad broke his hip and now he is not so mobile anymore, and so [you had] high activity level, high activity level, high activity level, health event, big change, new lower activity level from that point forward.
That makes it a little bit more difficult to plan around, because we don't certainly know when these health events and transitions are going to come. But certainly when we look at most people and see where are they in their 80s, compared to where they were in their 60s, particularly once we adjust out for inflation, we pretty consistently see lower overall spending levels, as the activity level comes down.
Benz: So it seems that one potential risk of extrapolating out from that trend in your own planning is, could health-care costs balloon at the end of life or toward the end of life in one's later years. What's your take on that question?
Kitces: So, fantastic question and issue, and I think it's crucial that we break this in two categories that we actually see as late-life expenditures. One is actual raw medical expenses--prescription drugs, hospitals, doctor treatments--things that, frankly, for better or for worse, are covered by a wide range of insurance options that we have available. We can get our Medicare Part A, Medicare Part B, Medicare Part D for prescription drugs, a Medicare supplemental policy, a Medigap policy.
By the time we put all of those together, that's not cheap. We might spend $5,000 a year for a person or even $10,000 for a couple to get the premium level of all of that coverage across the board. But once we actually get to that number, almost all the contingencies that are possibly out there are actually insured and covered. So we see very little spike in actual outflows of dollars for health-care expenses. Certainly the claims ramp up--if you're in the insurance company, you're noticing the uptick--but not necessarily for the individual.
Now on the other end of things we have what are called long-term care expenses, our custodial care expenses--being in a home, being in a facility, having people come in and help out in the house, having people come in to help out administer drugs, medication, etc. Those are not covered by medical insurance. At best, they are covered by their own type of insurance, called long-term care insurance, which unfortunately many people don't have.
Those expenses themselves can be very high, depending on states and areas that you're living in. We see people that quickly get to $100 a day, $150 a day, $200 a day, or more. You do the math, that's suddenly $5,000, $6,000, $7,000 a month for some areas. That's a huge expense for people.
So we do see long-term care expenses that often ramp up in the later years, and actually is one of the reasons why advisors, in particular, like to recommend long-term care insurance, so that, like on the medical end, we can start to smooth some of that out as well and eliminate that unknown potential of, "boy, it's going to really mess with either my wife's assets or inheritance or just our standard of living if suddenly I add on $50,000-plus a year of long-term care expenses for a couple of years at the end on top of everything else that we were doing."
So we do see a ramp-up in long-term care expenses, particularly for people who haven't insured it. We actually don't see as much of a ramp-up for medical expenses. Now certainly, for the average person, in population-wide statistics, where Social Security is still a huge dominating portion of their retirement income and is not necessarily all that flexible, even just the ongoing medical expenses can sometimes put pressure on cash flow and household expenses.
But when we look at people who are mixing Social Security and some savings and other assets, and drawing from lots of different sources, and have that depth of resources, we don't quite see the same pattern. The medical expenses tend to smooth-out a little bit, the long-term care expenses become the dramatic wildcard, and one that becomes appealing to insure.
Benz: At the happier end of the spectrum, it seems like one other potential risk factor to [assuming] that expenses generally trend down during retirement, especially discretionary expenses, what if I am that 87-year-old who wants to take a cruise when I'm later in my life? Then I won't fit with this trend, but I have maybe planned that my expenses would trend down. So it seems like that's another risk as well.
Kitces: And that's the challenge for people around how they want to plan. We see a lot of people that absolutely insist, well, I want to be able to maintain the standard of living all the way through. I want to be able to have the same amount of money and cash flow when I'm 88 or 92 as I did when I was 62.
And certainly we can do that and plan around that. But the caveat and trade-off becomes that might mean you have to save 5% or 10% or 15% more. That might mean you have to work one, two, three, four, five more years. And what we see for a lot of people is, yes you can do that, but there is a trade-off here in how long you have to work. So do you really want to work for three to five more years to make sure that you can still travel the globe at 87, in case you're really so healthy and able that you want to do so? And that is a trade-off decision.
We see some people say, yes I want to plan for that. We see some people say, no I don't. There was a famous story that had gone around a couple of years ago, of a woman who was actually getting ready to go to an assisted-living facility, because it was getting hard for her to live on her own, and she actually decided, rather than the assisted-living facility, she would just go on around-the-world cruises continuously, because they make all your food and they take care of your room and they even have doctors on board.
So people go in very interesting ways about how they ultimately want to do those final years, and certainly we'd encourage anyone to plan around that, but just be aware there are trade-offs, and for better or for worse, you are making some assumptions about really bucking the trend, if you're really going to assume the same kinds of higher expenses in your late 80s and into your 90s as you did in your 60s.
So if you want to plan for that, by all means, go ahead and plan for that, but be aware of those trade-offs and that you are assuming something that's a little outside the parameters what we really see happening in practice with people.
Benz: It's all about the trade-offs.
Benz: Thanks so much, Michael, for sharing your insights.
Kitces: My pleasure.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.