Rethinking retirement income replacement rules
Current 80% savings target may be too high — unless you get sick.
I sympathize with financial professionals who try to advise their clients on how much to save for retirement when the traditional 80% of pre-retirement income target is being questioned. Some research suggests that the rule of thumb, based on gross earnings in prime career years before retirement, is too high. Others say it is too low, given rising out-of-pocket health care costs.
But one thing is clear: Planning to work longer as a way to forestall retirement and minimize savings needs may be little more than wishful thinking. Many workers say they intend to work passed the traditional retirement age of 65, even though most current retirees retired sooner than they had planned, according to a new study from the Transamerica Center for Retirement Studies.
“The new vision of retirement among workers is a tremendous departure from the experiences of those already in retirement,” said Catherine Collinson, president of the nonprofit research organization. “Many retirees stopped working before 65, largely for reasons outside of their control,” said Collinson, referring to findings from the new report “The Current State of Retirement: Pre-Retiree Expectations and Retiree Realities“.
Among the more than 2,000 participants in the retiree portion of an online survey, the report found that the median retirement age was 62. Sixty percent of retirees surveyed said they retired earlier than planned because of employment-related reasons such as losing one’s job, being unhappy at work, receiving a buyout offer or because of health reasons— including family caregiving responsibilities. Only 16% of respondents said they retired early because they had enough money to do so.
Meanwhile, over two-thirds of the more than 4,500 working-age Americans who participated in the Transamerica survey said they either planned to work beyond age 65 or did not plan to retire. And more than half of participants said they planned to work, at least part time, after retirement. Those intentions are dramatically different from the reality of current retirees. Just 5% of retirees in the survey reported being currently employed or self-employed.
Based on personal experience, retirees in the survey offered some advice to those still working. Their primary caution: save more money. More than three-quarters of retirees said they wished they had built a bigger nest egg, and 41% regretted not relying more heavily on a financial professional to monitor and manage their savings.
But how much is enough to retire?
Michael Finke, coordinator of the doctoral program in personal financial planning at Texas Tech University, suggests that the standard 80% to 85% of gross pre-retirement earnings may be too high of a savings target for most retirees. In the August 2015 issue of Research magazine, Mr. Finke argues that retirees no longer have to pay 7.65% of their wages (or 15.3% of their self-employment earnings) in Social Security and Medicare taxes. Workers saving the recommended 15% of gross income in a retirement plan would then start out by subtracting this 15% and the 7.65% in Social Security taxes, bringing the replacement rate down to 77% — and that assumes they spend all of their take-home pay.
Retirees also eliminate commuting expenses, have a higher standard deduction and subsidized Medicare coverage, reducing the replacement rates even further, he noted.
“Like a lot of handy rules of thumb, replacement rates are ripe for re-examination,” Mr. Finke wrote. “In today’s low-interest rate environment, it may lead many near retirees to believe they haven’t saved anywhere near enough for retirement.”
But an 80% or 85% replacement rate may not be enough to cover retirement income needs when health care costs are included, said Ron Mastrogiovanni, chief executive of HealthView Services, which provides health care cost projections for financial services companies.
Health care costs in retirement can exceed those covered by heavily subsidized employer health insurance plans that pay 75% of premiums on average. And health care inflation is running at about 6% per year, twice the historical rate of inflation. High-income retirees, defined as those with annual income, including tax-free interest, in excess of $85,000 for singles and $170,000 for married couples, are also subject to monthly Medicare premium surcharges.
“The stark reality is that health care is going to cost more than most retirees have saved using traditional income-replacement-rate based plans,” according to the HealthView Services report “Retirement Health Care Costs and Income Replacement Ratios” that I reported on back in August.
Bottom line: Retirement income planning requires line-item budget crunching to determine actual expenses in retirement and match guaranteed or predictable sources of income to cover those costs. Savings can be used to cover any gaps in cash flow, emergency funds and provisions for legacy planning and long-term care.
Mary Beth Franklin is a certified financial planner.
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