NCPA - National Center for Policy Analysis

RETIREMENT NEEDS ARE NOT WHAT THEY SEEM

May 14, 2007

A common rule of thumb in personal finance for most people is that when they retire, they will need 70 percent to 85 percent of the income they earn immediately before retirement.  For example, if you are earning $50,000 at age 65, you'll need, say, $40,000 in your first year of retirement, says economic columnist Scott Burns.

There are five reasons the conventionally used replacement rate is misleading and generally wrong, says Burns.

Debt service:

  • A young couple may spend 20 percent of their gross income on a home mortgage and an additional 10 percent on car payments.
  • That's 30 percent of income that won't need to be replaced when the mortgage is paid off and buying new cars is no longer a thrill.

Raising and educating children:

  • All those expenses -- from disposable diapers to college tuition -- are dollars that we've never had to sustain our personal standard of living.
  • But our adult standard of living -- the money we spend on ourselves -- is what we need to sustain in retirement.

New spending in retirement:

  • One example is the rapidly escalating Medicare Part B premiums could increase spending in retirement.
  • Another expense is living so long that nursing home care is needed.

Eventual widowhood:

  • We can be virtually certain that one partner will outlive the other; in typical marriages, women will survive their husbands by about six years.
  • As a consequence, part of future spending will reflect the lower expenses of a single-person household.

Spending principal:

  • The replacement rate assumes that we never, ever spend principal; in fact, most people do -- some do this out of necessity and others do it by choice.
  • Either way, spending principal -- that is, living off your savings, not just living off the interest off your savings -- works to sustain consumption.

Source: Scott Burns, "Retirement Needs Are Not What They Seem," Dallas Morning News, May 13, 2007.

 

Browse more articles on Economic Issues