How many times have you advised clients that the classic 70% to 80% income
replacement rate won’t be enough to cover all the travel, hobbies, and other
expenditures of many active retirees? Many advisors now recommend a replacement
rate of at least 100%, even though retirement savings, Social Security (FICA)
taxes, and work-related expenses will no longer be coming out of the retiree’s
“paycheck.” That’s because that 20% to 30% that is no longer going to the
retirement plan or the government (not to mention lunch vendors and parking
garages) will be absorbed by leisure activities like traveling.
It certainly makes sense to consider consumption goals when estimating
retirement income replacement rates—in other words, don’t stop warning your
clients about the need to set higher retirement income goals. But a new study by
the Employment Benefits Research Institute (EBRI) suggests that expected
consumption is just one of the factors to be taken into consideration when
estimating retirement income replacement rates. Three very real retirement risks
must also be incorporated into the calculation: investment risk, longevity risk,
and the risk of potentially catastrophic health care costs.
Now, you may already be dealing with these risks in a different way. After
you’ve estimated the amount a client will need to have saved by retirement age,
you may tack on an amount for anticipated health care expenses. For example, one
study found that most people will spend $190,000 just on health care in
retirement. So you might simply add this amount to the client’s savings goal.
Or, like the Center for
Retirement Research you might adjust for health care costs (and additional
taxes) by breaking the news that clients will need to work 2.5 extra years to
afford these higher expenses.
Adjusting the savings goal or retirement age may make the planning process
understandable and meaningful to clients, but translating everything to a
retirement income replacement ratio makes for a more consistent methodology. The
EBRI sponsors the Ballpark
Estimate, an interactive calculator that anyone can use to estimate their
retirement goals. The calculator is fairly simple, which may enhance its
usefulness among people who want a quick way to calculate their “number.”
There’s even a link to the Social
Security Quick Calculator so users don’t have to rummage around for their
latest benefits estimate.
The downside to all this simplicity, however, is that the final answer may be
misleading. As the EBRI has recently pointed out, the calculator doesn’t account
for investment, longevity, and health care risks in retirement. Once these risks
are taken into account, the replacement ratio changes considerably.
How replacement rates are affected
The EBRI ran 1,000 different scenarios incorporating investment risks,
longevity risks, and unusually high health care costs to determine replacement
rates under each scenario. The Issue Brief, “Measuring
Retirement Income Adequacy: Calculating Realistic Income Replacement Rates”
lays out some of the results.
For example, if a male wants to retire at age 62 with 75% assurance that he
will not run out of money, he will need a replacement rate of 97%. This means
that if his income just prior to retirement is $100,000, he will need to plan
for an annual income during retirement of $97,000 (plus annual cost-of-living
adjustments). If he retires at age 68, all other things being equal, the
replacement rate drops to 66%. If he wants 90% assurance that he will not run
out of money, the replacement rate rises to 149% if he retires at age 62 and 97%
if he retires at age 68.
The adjustment of the replacement rate shows at a glance the relative impact
of the various scenarios. The lower the replacement rate, the fewer assets the
client will need at retirement, and the easier the goal is to attain. The EBRI
is in the process of revising its Ballpark Estimator to incorporate this
research. Whether or not you use (or refer clients to) the Ballpark Estimator,
the EBRI’s way of dealing with the major retirement risks is worthy of your
consideration, as is the idea of thinking about retirement goals in terms of
replacement rates.
The three retirement risks are handled in building-block fashion to show how
each risk raises the replacement rate and give the prospective retiree the
opportunity to change the assumptions.
Investment risk
The first block is investment risk. While longevity and health care risks
remain static, various allocations to equities serve to change the replacement
rate. For example, Table 1 below shows the replacement rates generated by the
EBRI model for a high-income male retiring at age 65 who wants 90% assurance
that his money won’t run out.
| Table 1: Allocation to Equities |
|
| Allocation to equities % | Replacement rate % |
| 0 | 66 |
| 25 | 64 |
| 50 | 69 |
| 75 | 73 |
| 100 | 87 |
No. 297
Note that the EBRI treats investment risk in a different manner than most
financial advisors. The EBRI says that the higher the allocation to equities,
the more the client needs to save. This is because equity returns are uncertain.
So a person who wants 90% assurance that his money will not run out will need a
replacement rate of 87% if he allocates 100% of his portfolio to equities, but
only 66% if he earns a guaranteed fixed rate.
The higher replacement rate is needed for an all-equity portfolio to absorb
volatility shocks throughout retirement. This is a distinct departure from other
calculators which indicate a lower savings requirement for a higher allocation
to equities. Such calculators are basing their assumptions on the historical
higher average returns earned by equities but without taking into account the
possibility that those returns may not be achieved in the future.
Longevity risk
The EBRI deals with longevity risk by considering whether or not the client
chooses to annuitize all or part of his portfolio. Once again, the risk analysis
is different from the way most advisors consider annuitization. Advisors are
accustomed to discouraging annuitization because the income doesn’t keep up with
inflation and an early death forfeits the funds to the insurance company. But
annuitization does reduce longevity risk because the income continues for life.
So the EBRI assumes that clients who outlive their life expectancy are better
protected if they annuitize. This is reflected in lower replacement rates for
higher levels of annuitization.
Table 2 presents the replacement rates for a high-income male retiring at age
65 who wants 90% assurance that his money will last. Note that longevity risk
(Building Block 2) is added onto investment risk (Building Block 1), which
considers the allocation to equities.
| Table 2: Annuitization Level |
|||||
| Equity investment % |
Replacement rate with 0% annuitization | Replacement rate with 25% annuitization | Replacement rate with 50% annuitization | Replacement rate with 75% annuitization | Replacement rate with 100% annuitization |
| 0 | 87 | 74 | 67 | 63 | 58 |
| 25 | 76 | 72 | 66 | 61 | 58 |
| 50 | 76 | 67 | 63 | 59 | 58 |
| 75 | 78 | 70 | 63 | 59 | 58 |
| 100 | 86 | 75 | 59 | 66 | 58 |
No. 297
Long-term care risk
Retirement planning assumes that prospective retirees can make reasonable
predictions about spending patterns in retirement—except when it comes to
long-term care costs. No one ever really knows if nursing care will be needed,
for how long, and at what cost. With this building block, the EBRI incorporates
a situation that could prove financially catastrophic to a retirement plan that
has otherwise dealt adequately with investment and longevity risk. As an
example, the replacement rate for a 65-year-old male with zero allocation to
equities and zero annuitization is 87% before long-term care costs are
considered and 119% after—a difference of 32 percentage points.
Table 3 below adds the building block of long-term care risk to the table
above, showing replacement rates for a high-income 65-year-old male who wants
90% assurance that his money won’t run out. It should be noted that these
assumptions do not take into account the possible purchase of long-term care
insurance, which is obviously one way of mitigating this risk.
| Table 3: Health Care Expenses in Retirement |
|||||||||||||||||||||||||||||||||||
| Equity investment % |
Replacement rate with 0% annuitization | Replacement rate with 25% annuitization | Replacement rate with 50% annuitization | Replacement rate with 75% annuitization | Replacement rate with 100% annuitization | 0 | 119 | 106 | 94 | 89 | 87 | 25 | 107 | 96 | 89 | 82 | 88 | 50 | 96 | 90 | 87 | 84 | 85 | 75 | 98 | 92 | 87 | 80 | 87 | 100 | 111 | 97 | 84 | 83 | 86 |
No. 297
The tables provided here are just a sampling of those contained in the EBRI
Issue Brief. The idea is first to estimate future spending patterns and then
build on the retirement goal by understanding how the three major risks impact
the calculation of replacement rates. A high allocation to equities, a low level
of annuitization, and the incorporation of long-term care costs all serve to
raise the replacement rate. A low allocation to equities, a high level of
annuitization, and no accounting for long-term care costs all serve to lower it.
Of course, these risks are uncertain. It’s impossible to know for sure what
rate of return the assets will earn, how long the client will live, or how much
health care the client will need or what the costs will be. This means you and
the client together must assess how the client wants to plan for them. The
decision is not unlike any insurance decision; the client decides how much risk
he wants to assume and how much he wants to transfer to the insurance company
based on costs and personal circumstances that might help define the risk. You
can offer guidance and number-crunching, but in the end, clients must decide for
themselves how to plan for risks that are unknowable.
