Rules of Dumb
Traditional financial planning is replete with “rules of thumb,” none of which provides a reliable basis for financial planning. No rule of thumb is repeated more often than the proposition that you need to target your retirement spending at 75-85 percent of your pre-retirement income. Some planners suggest you target to spend in retirement 100 percent of your pre-retirement income.
But why stop there? Your retirement “needs” may be considerable. Why not target to spend 300 percent of pre-retirement income or 500 percent or 8000 percent? After all, if traditional planning is about satisfying your retirement spending “needs,” why not set those needs really high?
The reason is that satisfying your retirement spending needs comes at a price—namely not satisfying your pre-retirement spending needs. Once one sees this, it’s clear that the real need we have and can afford to satisfy is having a smooth living standard per family member through time. We don’t want to starve now to splurge tomorrow or splurge now to starve tomorrow. We seek a smooth ride. ESPlanner’s consumption smoothing finds that smooth ride. Traditional planning, in using an arbitrary replacement rate to set your post-retirement spending, seems to care less about the impact of that target on your pre-retirement spending.
To see the difference between traditional planning and consumption smoothing, 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 invests $5K each year at 6% in his 401(k) 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. ESPlanner, in contrast, tells Dave that his $5K in current saving is just about the right level needed to have a smooth living standard over time. Given his FICA, federal income, and state income taxes, mortgage payments, other housing expenses, and current retirement account contributions, saving $20,124 instead of $5,000 would entail a dramatic decline in Dave’s living standard—indeed, he’d starve were he to follow AARP’s “advice.”
In Dave’s case a 75%, let alone a 100% replacement rate target, 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. 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 insurance policies. `