Debunking the Myth of Replacement Income

Hop on over to our favorite navy jet Fighter Pilot’s web-site where he is hosting this week’s Carnival of Personal Finance … it’s where you get to see what other people are saying about personal finance; particularly useful when you get sick of my daily diatribe … then, when you’re done, come right back here for another dose … 🙂


When you visit a financial planner, one of the first / most critical questions that they will ask you is:

When do you want to retire?

Now, that should be fairly easy for you to answer (at least, until after they have crunched all the numbers and you suddenly realize that you left your ‘financial plan’ a little late and will fall short, and have to keep working).

Their second question is the doozy:

How much income will you need in retirement?

Which is another way of asking how much you expect to spend in retirement?

Now, these are the $64,000 Questions (literally for some!) …

Since you will have no idea how to answer, and even if you think you do the financial planner will still trot out their firm’s trusty Rule of Thumb on this subject and proclaim:

You need 70% [or 75%, or 80%] of your pre-retirement income when you actually do retire.

How do they come to this ‘number’?

Well, it turns out that there is this one source for this piece of ‘holy gospel’ used by almost the entire financial planning industry:

There is an annual study conducted by Aon Consulting and Georgia State University’s Center for Risk Management and Insurance Research called the RETIRE Project.

Here it is in a nutshell:

The primary research focus of the GSU/Aon RETIRE Project is on the important question of ”How much income is needed at retirement in order to continue a person’s pre-retirement standard of living into the post-retirement period?”  In addressing this question, the RETIRE Project develops estimates for pre- and post-retirement taxes, rates of pre-retirement savings and examines certain key expenditures and changes in these expenditures between the pre- and post-retirement periods.

Now, that you know what it’s all about, here’s what they found (for 2008):

The current study finds that retirement income replacement ratios under the baseline scenario start at a high of 94 percent at the $20,000 salary level, progressively decrease to 78 percent at $60,000 and then remain essentially flat through $90,000—the highest salary examined.

There you go, you need to replace anywhere from 78% of your final pre-retirement salary to 94%, depending upon how much you earn.

Simple … but wrong!

Here’s why:

Micro: For a couple (no children, at least no longer at home or dependent) earning one income (ages 65 for the worker and 62 for the spouse) of $50,000 per year, the study assumes that their age/work-related expenses will decrease by $750 at retirement (e.g. no more commuting costs, presumably some extra health-related costs, and so on).

But, it doesn’t take into account the key difference: if you are not earning … you are spending!

How else are you going to absorb all that free time? Sitting on your rear-deck writing speeches  😉 ? Or, will you be out there playing golf, having coffee with friends, indulging your hobbies, etc.?

These all cost, Man!

Macro: More importantly, we know that we want to make fundamental changes in our lives so that we can “live life” … work is what we do while we are saving up to live that life.

In other words, our current life is a compromise in order to get us to the life that we want to live … how can ANY ratio of a ‘compromise life’ equate to a ‘real life’?

Of course it can’t, so here’s what to do next time your financial planner trots out his trusty Rules of Thumb… say:

Forget my current life … here’s the life that I want to live when I stop work, and here’s when I want to start living it .. now, can you draw me a plan that tells me what I have to do/sacrifice/be now in order to get what I want then?

If not, see another financial planner! Or, do it yourself … if you know how the life that you want to live looks:

1. Pull out a scratch-pad and start to fill in this worksheet.

2. Use these sample budgets to help you

3. Don’t forget to account for inflation BEFORE retirement (i.e. double the amount of income you think you need for every 20 years between now and your intended retirements)

4. Multiply by 20 (to then allow for inflation AFTER retirement)

5. There, you don’t just have a ‘number’, you now have The Number

Now, you just have to figure how you’re going to get there 🙂

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3 thoughts on “Debunking the Myth of Replacement Income

  1. AJC – Thanks for the shout out! 🙂

    I don’t know if you had a chance to finish Scott Burns and Larry Kotlikoff’s book “Spend ‘Til the End” but they make a very similar point about the inaccuracy that often occurs when making your financial plans centered upon spending targets (e.g. 80% of pre-retirement income).

    One big difference in their philosophy from yours is that thiers will give you a smooth life. One that is similar today and in retirement.

    I like your approach better. I want something much more than today and much earlier than when I’m 65.

    Keep up the great work

    Learn to manage money and mind your own business.

  2. @ Jeff – I am going to write a post about the Power of Follow-Up: the publishers contacted me to review the book and sent me a copy; I said it’s useless without a trial version of the s/w which they promised, but still haven’t sent me!

    Like most subjects written by technicians, this book focuses on the fine tuning: I suspect, that the s/w could help to improve my strategy by running it TWICE:

    Once pre-achieving your Number to smooth your lifestyle and help ensure you reach the target, THEN

    Again post-achieving your Number to smooth your NEW lifestyle through retirement.

    But, without the s/w, I cannot test this to make the appropriate recommendation/s 🙂

  3. @AJ – I learn something new every time I visit one of your sites.

    Consumption smoothing applied twice as you described could be an effective way to incorporate Scott’s ideas into your “Number” approach.

    If you get a copy of ESPlanner and it works well, I’d love to hear your thoughts on its value as a planning tool. I’m especially intrigued with the “Plus” version that incorporates a Monte Carlo analysis.

    All I’ve been able to find so far appears to be the standard review stuff companies put out to promote their product.

    Learn to manage money and mind your own business.

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