Resolution: Rethink your retirement spending plan

David Blanchett, head of retirement research, Morningstar

David Blanchett, head of retirement research, Morningstar

This is the time of year when many of us take stock of our financial plans. New Year’s resolutions are in place, and tax season is just around the corner.

But when it comes to retirement planning, the resolutions shouldn’t just revolve around how much you’ll sock away this year. It’s just as important to get a handle on how much you’ll need to spend when you retire, says David Blanchett, head of retirement research at Morningstar.

One common approach is to estimate the “replacement rate” – the percentage of household income you would need to maintain your current standard of living in retirement. And the rule of thumb is a replacement rate of 80 percent. The Internet is littered with retirement calculators that let you plug in your expected final pre-retirement income, and most use the 80 percent replacement rate to generate an income target.

The rule is problematic for near-retirees who suffered investment losses in the market meltdown of 2008 and 2009, or lost jobs near retirement. It doesn’t start with the right questions: What lifestyle will you want in retirement? And what will you be able to afford?

Just as important, a recent Blanchett research paper suggests the rule of thumb is off target most of the time. He finds that that the actual needed replacement rate varies from under 54 percent to over 87 percent (video discussion here).

“I like rules of thumb – you need them because most people don’t want to spend a lot of money thinking and planning for retirement,” Blanchett says. “The problem is that retirement is the most expensive purchase you’ll make in your lifetime, so it’s worth sitting down to figure out what it really will cost.”

Blanchett’s key finding is that spending actually falls over the course of retirement, especially for wealthier households, which have more discretionary pre-retirement spending, and thus have more flexibility in retirement to cut back if funds aren’t available. This is especially true as people reach advanced ages, when their interest and ability to spend on travel, entertainment and clothes declines.

Retirement-income-replacement---BlanchettUsing actual retirement expenditures from the U.S. Bureau of Labor Statistics’ Consumer Expenditure Survey, Blanchett shows that real (inflation-adjusted) spending for a household with an initial annual retirement spending target of $25,000 will drop 8 percent by the end of a 30-year retirement. For a household initially spending $50,000, annual outlays will drop 20 percent; for a household spending $100,000, the number plunges 30 percent (see accompanying chart).

For planning purposes, the research is pointing to the need for a careful projection of what you expect to spend – especially if retirement is close enough to estimate with some accuracy.