Forget Income Replacement, Focus on Supplying Cash Flow Needs

A version of this article previously appeared in May 2017.

When it comes to helping retirees figure out the financial aspect of their retirement plans, one of the conventions is "income-replacement rate." How much of the income you had while you were working will you need in retirement?

The discussion of income-replacement rates has its roots in the pension world, where an employee's pension income is typically expressed as being "X" percent of his or her final salary.

That convention has been ported over to the nonpension world, too. Rules of thumb for income-replacement ratios abound, with planners and financial firms urging retirees to shoot for replacing between 70% and 85% of their working incomes. Retirement planning experts arrive at those percentages by reducing gross income by taxes and savings, mainly.

State of Confusion
Such rules of thumb may be helpful to early and midcareer accumulators who need to plug in a desired in-retirement income when setting their savings targets for retirement. However, the whole concept seems to create more confusion than it helps, if my interactions with actual pre-retirees and retirees are any guide. When I asked a group of retirees how much of their working incomes they wanted to have in retirement, they didn't skip a beat. To a person, they said 100%.

That's probably because most of us who earn salaries are already thinking in terms of our take-home income, not gross. Most of us operate in a world where most of our tax bills are extracted directly from our paychecks. Much of our savings may be, too, if we're investing via our 401(k) plan contributions and other automated investments. Meanwhile, the foundation of the income-replacement rate is raw income before taxes and savings come out.

It's likely the group of retirees I interviewed said they wanted a 100% income-replacement rate because they were thinking about their actual incomes--the amount they had each month or each year to spend on their actual needs and wants, once taxes and savings were accounted for. Asking them to think about their gross incomes was going to create confusion in their minds, even though there wasn't any. The retirees had already asked the really important question: Did they want their standards of living to change in retirement? And their answer was no.

Your Mileage May Vary
There's also the not small matter that income-replacement rates can vary tremendously, making rules of thumb blunt instruments, at best. Research from David Blanchett, adjunct professor of wealth management at The American College of Financial Services, illustrates just how broadly income-replacement rates can vary, with factors such as pre-retirement income and savings rates serving as key swing factors. Blanchett's research notes that higher-income, higher-saving households may well need just 60% (or even less) of their pre-retirement income during retirement, while lower-earning, lower-saving households may need closer to 90%.

Confusion over income-replacement rates--combined with huge variations in actual income-replacement needs among different cohorts--highlights why I think most pre-retirees should bypass income-replacement rates and instead use their expected cash flow needs to help determine how much money they'll need in retirement. (Note that I've supplanted "income" with "cash flow" here, because income is another one of those words that just seems to confuse people.)

The following process is a reasonable way to do so.

Step 1: Start With Today's Expenditures
To help arrive at anticipated spending needs, begin with an assessment of household living expenses today, both fixed and discretionary. If you're saving on an ongoing basis but expect that to cease in retirement, you'll obviously want to adjust your cash flow needs downward to account for the subtraction.

Step 2: Consider Housing Changes
Apart from likely decreases in your savings, do you envision any other substantial changes in retirement? Housing costs are one line item with the potential to change substantially in retirement. Is your plan to come into retirement without a mortgage, for example? Or perhaps you intend to relocate or downsize in some fashion? Even though the main goal of downsizing may be to add the home-sale proceeds to your retirement kitty, it can have the salutary effect of reducing property taxes and lowering outlays for insurance, utilities, and maintenance. As a senior homeowner, you may also be able to qualify for a reduction in your property taxes, depending on where you live.

Of course, not every household sees a drop in housing costs during retirement; some retirees stay put in their primary residences while also purchasing second homes that actually add to their total housing-related outlays.

Step 3: Factor In Anticipated Lifestyle Changes
How about other living expenses? In his paper, Blanchett cited previous research pointing to food costs as one of the expense items likely to decline the most in retirement; one paper showed a 5% to 10% drop in food expenditures for households following retirement, while another showed a 6% decline. Not only do retirees have more time to prepare food at home than they did while they were working, the researchers conjectured, but they also have more time to shop for deals on groceries.

As with housing costs, lifestyle-related outlays aren't guaranteed to decline in retirement, so don't assume a reduction in yours without crunching the numbers. If a heavy travel schedule or an expensive hobby is on your retirement to-do list, you might see any cost reductions on line items like food offset by increased expenditures elsewhere. Bear in mind, however, that big spending on travel often occurs in the early years of retirement but then tapers off later on, as discussed in Blanchett's research.

Step 4: Add In Higher Healthcare Costs
Thus far, we've focused on ways that retirees might expect to see their expenses drop in retirement. But there's one major area where they're likely to increase, and that's in the realm of healthcare. A recent Fidelity study showed that the average out-of-pocket healthcare outlay for a retired couple was about $300,000, and that figure doesn't even include long-term care expenditures.

Of course, costs aren't a brand-new expense in retirement. Even if you had employer-provided health coverage, you likely had premiums and other out-of-pocket outlays. But healthcare expenditures are a bigger share of the consumption basket for older adults, as measured by the Consumer Price Index for the Elderly (CPI-E) in the Bureau of Labor Statistics' Consumer Price Index calculations. 

Not only have healthcare costs outstripped the general inflation rate over long periods of time, but they also tend to trend up through retirees' own life cycles. Higher healthcare costs later in life are the key reason that Blanchett identified what he calls the "Retirement Spending Smile." That's the tendency for household expenses to be on the high side just after retirement (when spending on travel and leisure is apt to be high), dip in midretirement, then head back up toward the end of life as healthcare costs increase. If you're someone who's going without long-term-care insurance, in particular, recognize that your household's total healthcare-related outlay could spike dramatically toward the end of your or your partner's lives.

Step 5: Add a Fudge Factor
Working through each of these line items may get you closer to your actual income-replacement rate rather than relying on rules of thumb such as 75% or 80% for income replacement. At the same time, it's worthwhile to approach the exercise with the knowledge that there's much about your future spending that you can't foretell. Long-term-care costs are the biggest wild card for people who don't have long-term-care insurance or for those who have policies that are capped at specific benefits. Many seniors have also been called upon to help their adult children or their families, unexpectedly increasing their financial outlays in retirement. Homeowners, too, can incur costly and unexpected repair bills at random times. All of these factors can send your expenditures out of line with what you thought they would be. The potential for those unanticipated expenses argues for nudging your own income-replacement rate a bit higher to allow for some wiggle room in your planning.

Some pre-retirees go so far as to model out their annual expenses in retirement using a spreadsheet. That allows them to depict how they expect their outlays for various expenses to change throughout their retirement years: Travel expenses may taper down, while healthcare outlays have the potential to jump up. Such an exercise also allows retirees to plan for lumpy, big-ticket outlays such as new cars or expected home repairs (new furnace, roof, and so on).