The 70% Replacement Rate In Retirement Is Rubbish

Summary

• The standard 70% replacement rate rule-of-thumb method of financial planning is miles off base and of no practical use in providing personal financial advice.
• I illustrate this fact by considering a version the simple household assumed in 2012 by Michael Kitces in his defense of the 70% replacement rate.
• The correct replacement rate for the household I consider is over 90 percent. But if you tweak assumptions, the replacement rate ranges from 68.2 percent to 134.4 percent.
• In seven of eight variations of assumptions about my simple household's circumstances, the right retirement-age asset target is zero even though the household has very high replacement rates.
• Unfortunately, conventional financial planning is asking the wrong questions, using the wrong methods, and is wholly unable to provide appropriate personal financial advice.

Michael Kitces’ 2012 article, “In Defense of the 70% Replacement Rate,” examines the validity of the personal financial planning industry’s 70-80 percent replacement-rate target. Kitces points out that the income-replacement ratio is really a spending replacement ratio – the ratio of post-retirement spending to pre-retirement income.

Kitces provides this illustration:

For instance, assume a couple of moderate means that earns $60,000/year in the years before retirement. Such a couple gives up approximately 18% of their income to taxes (roughly $11,000/year), between Federal and state taxes (after deductions, which lowers their effective rate), and the employee share of FICA taxes. In addition, if we assume savings roughly consistent with the national savings rate over time – e.g., about 3%, or $2,000/year – we find that the couple’s take-home pay that was being spent was about $47,000/year. Which means if the couple wants to continue their current standard of living in retirement, they need to replace $47,000/year of pre-retirement spending in their retirement years… and generating $47,000/year of income in retirement, after generating $60,000/year of income before retirement, is a replacement ratio of 78%.

I’m a big fan of Kitces’s blog. He’s by far one of the top personal finance writers in the country. But I need to take him to the woodshed on the replacement rate.

I checked Kitces’s calculation by running his hypothetical couple through www.maxifi.com -- my company’s life-cycle financial planning tool (www.maxifi.com). MaxiFi determines precisely what the household should save (and, therefore, spend) each year rather than simply assume something like a 3% saving rate. MaxiFi’s annual spending suggestions are designed to keep the household’s living standard per household member stable through time.

I considered an age-50 couple with no children, with both spouses earning $30,000. I also assumed they would both continue to earn the $30,000 in today’s dollars through age 65 and have maximum ages of life of 100. In addition, I assumed they both began work at 20 earning $15,000, with these nominal earnings growing smoothly to $30,000 in the current year. And I assumed the couple owns a $200,000 house with a 20-year, $100,000 mortgage, including monthly payments of $600 and other annual housings costs of $3,000. Finally, I assumed the couple has $25,000 in regular assets and $100,000 each in a 401(k) account to which they and their employer each contribute 3 percent of pay and on which the couple earns a 2.5 percent real return.

In the base case, I have the couple retire at 65, and take their Social Security and retirement account withdrawals at 66. Their optimal savings rate at 50 is 4.11 percent, not the 3 percent that Kitces assumed.

The ratio of the program’s age-66 total spending (not including federal and state taxes or Medicare Part B premiums) to age-65 total income is 91.5 percent – higher than Kitces’ 78 percent replacement rate. Of course, 91.5 percent is a long way from 70 percent, the figure Kites is defending. Moreover, the correct replacement rate is hypersensitive to the couple’s precise circumstances, effectively making the 70 percent "rule of thumb” essentially useless.

Some examples …

If the couple has no retirement account assets, its replacement rate is 68.2 percent, which is miles below 91.5 percent. If each spouse’s initial retirement accounts are three times larger, the replacement rate jumps to 134.4 percent. If the couple’s maximum ages of life are 85, not 100, the replacement rate is 110.1 percent. If the spouses and their employers contribute 5 percent to their 401(k)s, not 3 percent, the replacement rate is 102.5 percent. If each spouse earns $20,000, not $30,000, the replacement rate is 135.1 percent. If each spouse earns $60,000, not $30,000, the replacement rate is 62.3 percent. If the spouses earn 1.5 percent, not 2.5 percent real, on their retirement account, the replacement rate is 82.6 percent. Finally, if the two spouses earn 3.5 percent real on their retirement accounts, the replacement rate is 92.7 percent.

Now assuming an advisor or a household on its own could correctly guess the couple’s correct replacement rate (which is truly impossible), what does the replacement rate mean operationally? That is, how does knowing the replacement rate help us decide what our client or we as individuals should accumulate in regular assets by retirement age?

The answer is not much.

One might think that with replacement-rate spending targets ranging from 68.2 percent to 135.1 percent, the couple should accumulate a lot of assets, which would throw off a lot of income to cover these seemingly high spending requirements. The answer in seven of the eight cases referenced above is that targeted retirement assets should be zero or very close to zero. In the event the couple has no 401(k) accounts, they should accumulate $205,043 (in today’s dollars) in regular assets by 65. The reason that the seven cases entail little or no asset holdings as of age 65 is that the couple’s Social Security benefits and retirement account withdrawals suffice to cover the couple’s annual spending, tax and Medicare Part B premium obligations.

As Kitces suggest, many if not most practitioners interpret the replacement rate rule of thumb as an income replacement rate. Interpreted in that light, this couple's replacement rate is not the vaunted 70 percent, nor the often higher 85 percent figure bandied about. Instead, it's zero or essentially zero in seven of the eight cases considered. There is, as indicated, no lost income to be replaced since the couple, except in one case, has enough Social Security and retirement account withdrawals to support and sustain their old-age spending. Even in the one case where significant asset accumulation is required, the income-replacement rate is extremely low and heads to zero over time.

A different operational question is what should the couple spend, in total, at age 50 under each situation. The answer ranges from $42,880 to $62,728. The retirement replacement rate in the former case is 135.1 percent and 91.3 percent in the latter case. No planner or household can, on their own, figure out the correct replacement rate at retirement age let alone convert the correct replacement rate into the correct current spending and saving recommendations.

I've been pushing economics-based personal financial planning for a quarter century when I started my software company. I believed then and continue to believe that conventional financial planning is asking the wrong questions, using the wrong methods, and is wholly unable to provide appropriate personal financial advice.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Joe Blow1277]

"Instead, it's zero or essentially zero in seven of the eight cases considered. There is, as indicated, no lost income to be replaced since the couple, except in one case, has enough Social Security and retirement account withdrawals to support and sustain their old-age spending."

Am I missing something, here? What else are they talking about as "income replacement", if it's *not* from Social Security and retirement account withdrawals? Anyone I've ever talked to that has heard the term interprets it to mean primarily, or even exclusively, those two sources of income in retirement. Anything else (e.g. rental properties, annuities, etc.) wouldn't be replacement - it would just be income.

I also don't see how your stated assumptions of income progression, real earnings, and 401k contribution % + employer match get the couple in your example to 401k balances of 100K each at age 50, unless you're assuming more inflation (i.e. higher nominal earnings) than historical averages would suggest. By my calculations - which despite your many assertions, require nothing beyond Excel (and not even that, if you remember all the math I've forgotten since middle school) - they'd each have closer to 80K in their 401k at age 50, not 100K. And that's with the wildly naive assumption that people pay as much attention to funding their 401k in their 20s as they do in their 40s and 50s.

[KMR holder]

I was very lucky in having been able to travel extensively after high school and before college. I worked my way through Europe the Middle East and North Africa, so my wanderlust was sated at low cost when I was able to enjoy all the experiences.

I hope to continue to enjoy life as long as it is granted me. Each day is a new experience.

[as10675]

"The biggest challenge now is to enjoy each multiple of 9 years going forward more than the past 9 and to maximize those multiples."

I have been retired for 4 years. It seems like only a year. I am age 64 so I am doing many things now while I can still enjoy them.

as10675

[KMR holder]

as,

The biggest challenge now is to enjoy each multiple of 9 years going forward more than the past 9 and to maximize those multiples.

[as10675]

KMR holder, sounds like you are enjoying retirement on your terms.

as10675

[as10675]

Posted the same in a related article.
I have been retired for 4 years. I have kept track of every penny that I spent in every category in EXCEL since 1996. After making a pre-retirement baseline adjustment for savings, and taxes, etc. this is my spend rate in comparison to the starting baseline:

2015; 104.4% Over spent

2016; 93.3%

2017; 92.7%

2018; 97.2% so far and that means that I am more on track for a 104% like number and increasing annually. Definitely will over spend because of inflation, repairs, and replacements and that will drive future year over spends even if I adjust the baseline for inflation.

Sooner or later things will wear out. I bought a new car last year, not a cheap one. Need a new roof on the house and other repairs now as well. Insurance and taxes go up each year.

What this really says is that my retirement life style is equal to 100% of pre-retirement after tax purchasing power even with house paid off and growing for inflation, repairs and replacements. I saved for 135% purchasing power at start of retirement.

For me it was why retire if I can't do what I want to do. Retirement for me is not a game to see how cheaply I can live, I did that for 40 years.

as10675

[KMR holder]

as10675,

Today in my 9th year of retirement at age 68, I am spending close to double what I spent before retirement. That is because I bought a house 5.5 years ago and had to put 20% down. I count that down payment as an 8% cost annually which is what I would be making on the money. At the time I bought the house, I started to receive social security which more than covers the entire mortgage and house maintenance costs.

With no pension and just social security payments to augment my investment income, my plan is to continue increasing my spending by 5% annually until age 70 or the next big market sell off and then increasing spending by an addition 1% or more each year including gifts.

Even if I do that, I don't expect to run out of money in my lifetime even if I don't touch the 20% of my investments that are in my Roth account.

[Laurence Kotlikoff]

I agree. This is a key input into an appropriate sustainable spending decision. best, Larry

[droubal]

For health care you have to figure about $700 per month, which is a lot for a couple spending $47,000 a year. Medicare withdraws $135/mo./person, this next year, going up every year. Then a gap or Advantage plan will cost about $200/ person, also going up each year. So, currently, we are looking at a starting cost of about $700/mo. which will double in about 12 years.
Conclusion: people need more savings.
Health care is a huge disaster, in the future. Medical tourism may be our best bet.

[Donald van Deventer]

Larry, another gem! Keep 'em coming!

[Laurence Kotlikoff]

Thanks, Don. best, Larry

[TDune75]

Didn't anyone notice the key assumption made by the author of this article? "... and have maximum ages of life of 100." Once I read that statement, skimmed the rest of the article and read the comments above, which make a lot more sense that the article.

Sure, we'd all like to have more income in retirement than while working, but I don't think the general population NEEDS the higher income. The only caveat is if Congress messes with Medicare and Social Security for the elderly, in which case 99% of the American +65 segment are screwed. The larger issue is so many baby-boomers retiring with completely inadequate retirement savings, with vast majority not able to replace even 70% of their pre-retirement income.

[Laurence Kotlikoff]

You can't count on dying on time. Far too risky. Economics says that's strictly forbidden. So if you are now, say, 70 and you think you have it all worked out to make it to 70, all I can say is you are surely spending too little or too much relative to what's sustainable. And you may be off by a mile. Again, happy to run you through our software to compare what you are doing with what the program says. There aren't two answers to the sustainable level of spending and I certainly can't make that calc for me or for you or anyone else in my head. best, Larry

[DAKelsey]

Mr. Kotlikoff would like to take Mr. Kitces to the woodshed. I have great respect for both these individuals, but perhaps the author would like to join Mr. Kitces in the same shed on the subject of replacement rates.

I learned years ago through preparing a pre-retirement financial roadmap for my wife and I and by preparing similar financial roadmaps for clients, that any "rule or guideline" regarding replacement rates is likely to be highly misleading to people thinking about retiring.

The reason for this is straightforward: generalities, whether produced by complex computer programs or by authors of financial articles, do not adequately address the specific financial lives of individual clients. There is no substitute for working with clients on their specific individual financial situations, documenting all the relevant facts, figures, projections, and assumptions, and then coming up with an approach that gives them a reliable picture of their financial futures. This is especially relevant for pre-retirees and retirees.

I learned this around fifteen years ago when I decided to ignore the conventional wisdom in the financial press on the subject and then prepared our own projections which showed that we could retire early from Corporate America. Since then, we have maintained our pre-retirement standard of living on less than 70% of our pre-retirement income. And happily continue to do so.

Mr. Kotlikoff concludes his article by stating conventional planning is asking the wrong questions, using the wrong methods, and is wholly unable to provide appropriate personal financial advice. That's a bit strong. I believe we can do better as planners by being skeptical of computer modeling and by working with specific client data and showing clients reliable pictures of their future financial lives. I know this works as I've seen it work.

[Ed_H]

DAKELSEY - My wife and I prepared an analysis that is very similar to your approach, prior to retiring four years ago. We started with a review and analysis of the prior five years of expenses, and then researched expenses that we knew would change during our retirement. We tried to be conservative and realistic about such items as healthcare, health insurance, long term care expenses, travel, housing expenses, transportation, etc. So far, our actual expenses are tracking at less than 70% of our pre-retirement expenses (largely due to relocation from a very high cost of living area to a less expensive area). We re-examine and update our budgets on a quarterly basis, and track our actual expenses against the budget monthly. This helps my wife and I to be on the same page regarding spending priorities and to plan for the same. So far, this approach has helped us to have a satisfying retirement!

[DAKelsey]

Congrats - this approach will serve you well throughout your retirement! And it has another huge benefit - you can risk manage your investments by determining what you need to withdraw from them to meet your planned expenditures, and then you can choose your investments accordingly.

You might be surprised how many retirees never consider taking this approach. Some are too aggressively invested when in fact they don't need the income or the risk, and some are too conservatively invested when they might need income or future appreciation when they live longer than they planned for.

[Laurence Kotlikoff]

Hi, I'm with you that one needs to have all the client-specific facts and assumptions. But then what do you do with them? Economists have been working this problem for literally a Century. The answer is take all those facts and assumptions and find a path of spending and saving and insurance that produces a stable living standard through time. This requires particular math and particular computer algorithms and particular software. I see none of what's needed in these three areas being used by the planning profession. In your case, you may be spending your life spending too little because it's not clear that you can spend more. Or, worse, you may be on a path of spending down your assets and need to adjust down your living standard. One can't, for example, intuit what future taxes or Medicare Part B premiums will be. Those factors alone require careful, integrated lifetime planning. I'd love to run you through my software and compare what you are spending with what the program says. Fell free to contact me at [e-mail]. best, Larry

[user4447]

The replacement rate rule of thumb may be helpful for anyone planning to retire who does not have any handle on their actual spending. A better way to plan is to determine what your actual current annual spending is and then adjust this for expenses that will not occur after retirement and new expenses in retirement. I suggest that this analysis start 2-3 years before retirement so that you can adjust and update the current spending map. I found that it took 2-3 years of analysis to capture a really accurate map of expenses but with current electronic records there is a lot of information to work with to create this tracking. I found the most difficult part is tracking spending of cash. I also found that my replacement rate is 35% which is well different than your analysis. The reason for 35% is that our income has increased dramatically in last 5-10 years but we kept our spending flattish and saved the increased earnings.

[Laurence Kotlikoff]

Hi, With all due respect, your calc starts with what is surely the wrong current spending to determine what is surely the wrong future retirement spending. Then you are likely miscalculating future taxes.

Our maxifi.com code is the size of a NY phone book. You can't make these calcs correctly in your head. You just can't. No economist can either. I suggest you compare what you think you can spend with what you actually can spend as indicated by maxifi.

[D.S. Leach & C.E. Leach]

Laurence,

I'm of the strong opinion that user4447 has a much better approach outlined than anything that a black box computer program can spit out including maxifi. Your comment that the maxifi code is as big as a phone book confirms for me that it is likely worthless.

Before you conclude that i'm a software luddite, you should know that I'm vary familiar with programming and code development. I studied Fortran IV and WATFIV under the guidance of one of the original developer of the Fortran programming language. I have one piece of software that is still in use today supporting the restart of nuclear reactors following a shutdown. So, I'm very comfortable with software.

I'm also familiar with the garbage in = garbage out problem with large complex computer codes. The idea that you can make meaningful assumptions about a person's or family's spending after retirement, the rate of return available in the market or the rate of inflation for the next 20 - 30 years, and emergency costs they might incur is naive. To advertise that you can use those assumptions to provide an meaningful estimate of a savings rate before retirement, an asset base needed in retirement, or a spending rate throughout retirement is bordering on criminal.

A much better approach is for the individual or family to spend the necessary time to thoroughly understand where their money goes before retirement and build a financial model of known expenses during retirement without the costs associated with work, kids, college, etc. Once done, it is easy to estimate the investment income needed to supplement social security and/or pension payments during retirement.

This process is much easier to accomplish today by using a couple of credit cards and a single bank account to capture all outgoing costs for a couple years before retirement.

Cheer$!

[Hardog]

"The idea that you can make meaningful assumptions about a person's or family's spending after retirement, the rate of return available in the market or the rate of inflation for the next 20 - 30 years, and emergency costs they might incur is naive"

I agree, each person's financial situation is complex depending on their behavior, future beliefs , savings at hand, income and expense flows. etc. Individuals need to flesh out their situation a few years before retiring to at least get a minimal idea of what they will be left w/ or need in retirement. ya don't need a financial advisor to do that one is totally financially inept w basic math.

[KMR holder]

Personally, I have not considered replacement rate in my retirement planning. While I have not received a salary since age 58, I felt comfortable leaving the salaried work force in 2008.
By saving and investing a large portion of my pay over my salaried years, I was able to accumulate enough assets before age 50 to generate more money from my investments than I was earning in salary. By spending less than my salary every year, retiring at age 58 actually incurred little risk. In fact I have been able to increase my spending budget by 5% annually since. By leaving the workforce at age 58 near a market bottom, I felt very confident I would achieve a successful retirement and in the past 9 years been able to increase my investment assets 2.5 times despite having no other income than Social Security starting at age 62.5.

[Laurence Kotlikoff]

Well done! You saved enough and were cautious after retirement with your spending and, I wager, with your investments, that you're in good shape. Stay that way!

best, Larry

[KMR holder]

The greatest danger I feel that I face in retirement beyond health problems, is the likelihood of leaving a very large estate. I know that my situation is not typical, but at 68 even if I continue to increase my spending at a 5% real rate annually I have more than enough.

How would I determine how much I can safely distribute in gifts and charity?

[Hardog]

you can look at your state and the Fed Estate(for gifts after death), or gift taxes during your lifetime (14K to each donee). point is one would have to be intimate with your income and spending, and your health situation ln order to give u a real answer.

Me, I use the old tithing % of 10, as my income vs my needs (food, utilities, meds, doctors, health insurance payments etc) is about 110. INcome ignores for now the RMD and rental income etc.