Larry Kotlikoff, BU Professor and co-author of "The Coming Generational Storm" and "Spend Til the End"
When we use "rules of thumb" we are making an approximation instead of a precise measurement. That's what rules of thumb mean, literally, using your thumb as a measuring stick or ruler. Then why are we surprised when those measurements don't add up?
Robert Powell has written an article about a new study by two University of Wisconsin-Madison professors showing just how badly use of a common rule of thumb regarding income replacement rates in retirement turned out to be. Their findings were about what you would expect:
The rule of thumb is that you'll need to replace 70% of your pre-retirement income on average once you retire, but evidence continues to mount that this assumption by many professionals and retirement savers is way off base.
Now, a new study by two professors casts further doubt on the idea that the widely used replacement-rate figure is a sound basis for building a retirement plan.
"The rule of thumb that replacement rates should be above 70% to maintain living standards in retirement is conceptually flawed," wrote John Karl Scholz and Ananth Seshadri, two University of Wisconsin-Madison professors, in their paper "What Replace Rates Should Households Use?"
In fact, no more than 15% of the population Scholz and Seshadri studied need to replace 65% to 90% of their pre-retirement income. And almost 50% of the population needed to replace less than 65% of their pre-retirement income.
In short, the authors said: More refined guidance is needed to serve households well.
Target replacement rates are less than 100% for three main reasons, according to the study published by the Michigan Retirement Research Center.
"First, upon retirement, households typically face lower taxes than they face during their working years, if for no other reason than Social Security is more lightly taxed than wages and salaries. Second, households typically save less in retirement than they do during their working years, so saving is a smaller claim on available income. Third, work-related expenses generally fall in retirement."
Still, that ignores a whole host of issues related to coming up with the right replacement rate.
For instance, consider what effect children likely have on your expenses prior to and in retirement, the authors wrote. Most calculators use the same replacement rate regardless of the number of children in a household, the authors said. But the number of children you have matters when it comes to calculating your replacement rate. In fact, all things being equal, a household with lots of children will have a smaller replacement rate than a household with no children, because the couple with kids, once retired, will face far lower child-rearing costs than they did while working. (Of course, the kids' ages at the time of retirement will affect that calculation.)
What is needed for your real number is not back-of-the-napkin calculations but something the authors refer to as the life-cycle model. To be fair, the author's study did note that replacement rates -- even when using the life-cycle model -- did confirm some commonly held beliefs. Specifically, "replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families."
But even then you still need to take into account the effect of federal taxes, medical expenses, education, and what the authors call earnings shocks or -- in laymen's terms -- layoffs and big salary increases.
When all is said and done, the authors suggest that optimal replacement rates could range anywhere from 23% (for single parents with several children and a negative late-in-career earnings shock) to 240% (for low-income, married households with a few children and a substantial positive late-in-career earnings shock).
In other words, "conventional advice may overstate optimal targets by a factor of two, or understate retirement consumption needs by a factor of three depending on the idiosyncratic experiences of households," Scholz and Seshadri said in their study. See the study (PDF).
That's especially the case when it comes to online calculators, the authors said. With the life-cycle model, the replacement rate depends on factors often ignored by online calculators. "The savings requirements of two households with the same earnings profile, retirement age and life expectancy would be given an equivalent target by the online planning tools regardless of whether one household raised five children and other had none," the authors said. They said the optimal replacement rate for married couples is 75%, but just 55% for singles.
Put another way, if you're using an online calculator to plan your retirement, you might be under-saving or over-saving by a wide margin, though the consequence of over-saving might not be as bad as under-saving.
'Rules of dumb'
Experts, meanwhile, seemed to agree with the conclusions reached by Scholz and Seshadri.
"The use of replacement rates to form financial plans does not meet a reasonable fiduciary standard," said Larry Kotlikoff, a Boston University professor.
"Rules of thumb are, quite simply, rules of dumb," he said. "Their use violates the financial planner's Hippocratic oath: First do no harm."
Kotlikoff also said the model used in Scholz and Seshadri's study is not without its warts. "But it's fine for its purpose, which is comparing conventional financial planning with economics-based planning."
Rick Miller, a certified financial planner with Sensible Financial Planning, cautioned against using any rules of thumb. "Using rules of thumb can be very dangerous, if they significantly understate the requirement, or can risk significant regret, if they overstate the requirement."
The summary for this article (and indeed the whole study) is simple: When you need to determine numbers regarding things far out in the future you can't use rules of thumb! You actually have to crunch the numbers!
See your trusted tax advisor or financial planning professional for advice in this area.
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