Retirement Income Needs Vary

The paper, “Estimating the True Cost of Retirement,” was written by David Blanchett, head of Retirement Research for Morningstar Investment Management, who is based in Chicago. According to Blanchett, a common approach to estimating the total amount of savings required to fund retirement is to first apply a generic replacement rate to pre-retirement income (e.g., 70% to 80%) to get the desired retirement income need.

However, Blanchett finds the actual replacement rate is likely to vary considerably by retiree household, ranging from 54% to 87%. He notes that while a replacement rate between 70% and 80% is a “reasonable starting place,” the actual replacement goal can vary due to a number of variables that are dependent on differences between pre-retirement and post-retirement expenses.

For instance, Blanchett tells PLANSPONSOR, a participant that has been annually putting away 25% of his income for retirement is used to not spending as much and may only need a fraction of his pre-retirement income level during retirement. Other factors may also come into play, such as paying less in taxes and no longer having mortgage payments because the mortgage has been paid off.

“In helping participants estimate what they’ll need for retirement, it’s important for plan sponsors to understand the costs that will be unique to each person,” says Blanchett. “Plan sponsors are in a great position to make use of research about their participant population. And what they can’t get from research, they shouldn’t be afraid to ask the participants themselves. Since everyone is different, the variables that need to be factored in for spending patterns will be unique to each participant.”

Health care costs can be hard to predict, says Blanchett. Generally though, he says, research indicates people will spend more on health care costs as they get older. For example, he cites one estimate that for those around the age of 65, 10% of their consumption will be spent on health care costs. Upon reaching age 85, this figure is likely to double to 20%. “Annually, medical costs will always increase more than inflation,” says Blanchett.

In terms of factoring regular inflation into estimates for retirement savings, Blanchett says, “Inflation is not as scary as it’s made out to be,” adding that people do not tend to increase their spending based on inflation and that annual inflation of health care costs is a far greater worry.

When asked how to respond to those in the retirement industry who say the income replacement rate needs to be in the 70% to 80% range, Blanchett explains, “Retirement is the most expensive purchase you’re ever going to face. But the problem is that everyone is different in their financial situation and financial habits.”

Plan sponsors can make efforts to ensure participants have a more holistic view of their finances by offering them financial literacy and financial wellness education, he adds.

A copy of Blanchett’s paper can be downloaded here.