The Problem with the Replacement Method

Traditional retirement planning is based on how much income you need in retirement. Just go to any big financial company website and look for their retirement planning calculator. Either they will ask you to estimate much you will need to spend in retirement, or they will assume you need a certain percentage of your pre-retirement income. The most popular “rule of thumb” is 75 percent. This ‘Replacement Rate’ method is used by most financial planners and wealth managers.

Satisfying your retirement spending needs comes at a price - namely reducing your pre-retirement spending. By using an arbitrary ‘one-size-fits-all’ replacement rate to set your savings target, traditional planning seems not to care about the impact on your pre-retirement spending.

As an example, consider a recent article posted at CBSMarketwatch.com.

The article describes a 45 year old single man, call him Dave, with a $250K mortgage who earns $50k per year. He saves $5K each year in his 401(k), invested at 6% return and experiences 3% annual inflation. Dave is sitting on $100K in assets - $90K in his retirement account and $10K in his money market fund. Dave’s projected Social Security benefit is $1,408 in today’s dollars based on his current earnings and expected retirement date.

As indicated in the article, AARP’s on-line calculator tells Dave to save $20,124 to hit “his” spending target. Given his FICA, federal and state income taxes, mortgage payments, household expenses and other bills, saving $20,124 instead of $5,000 would entail a dramatic decline in Dave’s living standard – indeed, if he were to follow AARP’s “advice”, he’d starve!

The problem with setting a target for saving like this is that if you get the target wrong by only as much as 10%, you will receive bad advice for how much to save, how much to insure, and what type of investments to purchase. The financial services industry, for the most part, is making incredibly crude and dangerous recommendations by using the ‘Replacement Rate’ method.

We don’t want to starve now to splurge tomorrow, or splurge now to starve tomorrow. Once you see this, it’s clear that the real need is to have a smooth living standard per family member through time. This is called 'consumption smoothing' and is the planning method we use at Bay Area Planners to identify your ‘constant living standard’. When your income is higher than your living standard number, you save the excess. When your income is lower than your living standard number, you spend your savings. You use your savings as a reserve to maintain a constant living standard, and you do this over your projected lifespan.

As an example of the difference between traditional planning and consumption smoothing, we would have told Dave that his $5K in current saving is just about the right level needed to have a smooth living standard over time.

In Dave’s case, a 75% replacement rate is miles too high. For other households, replacement rate 'rules of dumb' lead to targets that are too low. One size definitely doesn’t fit all.

Key Take Away:  Internet calculators that utilize replacement rates aren’t really interested in giving you good advice - they are interested in giving you quick advice, advice that will speed you along to buy their mutual funds and their insurance policies. Consider using ‘consumption smoothing’ instead of ‘replacement rate’ when planning your retirement.

 To discover your correct savings level, c all (408) 725-7135 or click here.

Return to Free Info