BOSTON — The rule of thumb is that you'll need to replace 70 percent 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 percent to maintain living standards in retirement is conceptually flawed," wrote John Karl Scholz and Ananth Seshadri, two professors at the University of Wisconsin in Madison, in their paper "What Replace Rates Should Households Use?"
In fact, no more than 15 percent of the population Scholz and Seshadri studied need to replace 65 percent to 90 percent of their pre-retirement income. And almost 50 percent of the population needed to replace less than 65 percent 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 percent 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 before 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. All things being equal, they say, 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.
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. You 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.
The authors suggest that optimal replacement rates could range anywhere from 23 percent (for single parents with several children and a negative late-in-career earnings shock) to 240 percent (for low-income, married households with 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.
That's especially the case when it comes to online calculators, the authors said. In other words, if you're using an online calculator to plan your retirement, you might be undersaving or oversaving by a wide margin.
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