Bad Assumptions?

People who haven’t been saving the way they should got some good news recently – those fancy retirement savings calculators may have been exaggerating their retirement needs.

That, at least, was the assertion of a new report on retirement savings, which ran in the June issue of the Journal of Financial Planning, but which got picked up in the Wall Street Journal and The Associated Press (and that put it in a lot of newspapers). The study, by financial planner Ty Bernicke, claims that people spend less in retirement than they do prior to retirement – and that they spend less in retirement the older they get. Now, that isn’t all that radical a notion – for years planners have been telling us to plan on needing 70% of our pre-retirement income. But Bernicke, who cites data from the US Bureau of Labor's Consumer Expenditure Survey to make his point, takes issue with retirement planning calculators that push spending higher each year (by about 3%) just by keeping the current levels “even” with inflation. He also highlights statistics that suggest that workers spend less not because they have to, but just because they do, at least looking back over the past 20 years.

Bernicke’s study really only deals with that one aspect, of course – and by assuming that the spending assumptions are far too high, he is able to claim that we don’t need to have nearly as much set aside as most savings calculators claim. He calls his version “reality retirement planning.”

Well, assumptions, after all, are just that, and if the Federal Reserve with its near obsession with tracking inflation can’t predict that gauge with precision, I’m not sure that we should expect more from these calculators. But even if we spend less in retirement, what we spend money on is still subject to the vagaries of things like inflation. It’s also fine to say that Americans have tended to spend less in retirement, but the truth is that we also spend differently. Health care is perhaps the most obvious difference, and we all know that those costs have been moving well ahead of inflation in recent years. I don’t think it is beyond the realm of possibility to suggest that, as we get older, we may well be spending more on things whose costs will rise faster than that imbedded rate of inflation.

Not that I “buy” all the imbedded assumptions in these retirement calculators. That inflation assumption does more than influence the cost of living in retirement – generally, it also imputes a regular (and generally annual) rate of salary increase during one’s working career – and the projected rate of savings deferral (and employer match) is similarly “inflated” for workers who no longer receive those annual merit increases. On top of that, most calculators have a default rate of return that is wildly optimistic given most participant portfolio allocations. Mr. Bernicke may not have had issues with those “inflations” of the savings accumulation projections, but I think that may well be the greater flaw.

Speaking of assumptions, I was struck by the fact that, in Bernicke’s hypothetical example, a couple that retired (or wanted to) at age 55 already had accumulated an $800,000 balance in their 401(k) – a balance that continued to earn 8% for the next 30 years – supplemented by two social security checks (beginning at age 62) – subjected to a combined federal/state tax rate of less than 10%. With THOSE kinds of assumptions, no wonder spending isn’t a problem for his hypothetical would-be retirees.

Unfortunately, that “reality” still appears to be a fiction for many – who may well spend less in retirement, but not by choice.

- Nevin Adams

You can read the executive summary of Ty Bernicke's Reality Retirement Planning: A New Paradigm for an Old Science at http://www.fpanet.org/journal/articles/2005_Issues/jfp0605-art7.cfm

Comments

  1. The whole 70% replacement rate thing strikes me as so rule-of-thumbish as to be useless. Much better is to have some idea of what you really spend. My wife and I charge most expenses (pay off every month, of course), and thus the credit card statement tells us how much we spend per month pretty accurately -- without keeping track of every penny, which would be way too boring. This is the basis for our expenditure planning, not the 70% rule.

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  2. Frankly, I don't know a single Baby Boomer who is likely to (willingly) live on less than 100% of his/her pre-retirement income. Aon has done what I think is much more interesting work in the Retirement Replacement Ration study. See Are Expert Assumptions Faulty? at http://www.plansponsor.com/magazine_type3?RECORD_ID=11804

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