Investor Alert

Robert Powell

Sept. 8, 2011, 12:02 a.m. EDT

Will you need 135% of your salary in retirement?

Figuring out your income-replacement rate is no easy task

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By Robert Powell, MarketWatch

BOSTON (MarketWatch) — It is the mother of unanswerable questions in the world of retirement planning. How much of your current salary will you need after you retire?

The replacement ratio rule of thumb suggests you might need 75% of your current salary from a variety of sources — be it Social Security, personal assets (a 401(k) and IRA, for instance), earned income (yes, you’ll likely be working in retirement), and the like — to enjoy the same standard of living while in retirement as before.

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But according to research conducted by Dan Ariely, people need 135% of their final income to live the way they want in retirement. The reason for this astounding difference has to do largely with the way Ariely, a professor of economics and behavioral finance at Duke University, did his research.

Instead of asking people to ballpark how much of their final salary they will need, he asked the following questions: How do you want to live in retirement? Where do you want to live? What activities do you want to engage in? And similar questions geared to assess the quality of life that people expect in retirement.

Ariely then took the answers and “itemized them, pricing out their retirement based on the things that people said they’d want to do and have in their retirement.” Using those calculations, he found that people want to retire to a standard of living beyond what they currently enjoy. (Who wouldn’t if money were no object?) Read Ariely's blog post on the topic here.

Ariely didn’t respond to emailed questions about his blog post. But I am fond of Ariely’s body of work and have quoted him often.

Needless to say, Ariely’s blog has the financial-advice community up in arms. For one, he suggested in his blog that financial advisers are getting paid far too much (1% of assets under management) to help people build a nest egg that’s “60% too low in its estimation.”

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Two, he criticized the use of those ubiquitous risk-tolerance questionnaires that label investors as aggressive, moderate or conservative. His research showed that people cannot accurately describe their attitude toward risk and as a result, questionnaires about risk attitude are essentially useless.

From my perch, however, the questions that Ariely’s research raises have to do with the current salary replacement ratio. How much of your current salary do you really need to replace in retirement? Is the salary replacement ratio a good or bad rule of thumb? If it’s a bad rule of thumb, what’s a better way to determine how much you need in retirement? And, what are the pros and cons of that “better” method?

How much is enough?

Experts say it’s very hard to estimate with any precision how much income you’ll really need in retirement.

“In some ways, life after retirement is relatively inexpensive,” said David Laibson, an economics professor at Harvard University. For one, the expenses associated with working, raising a family and maintaining a home prior to retirement are typically much less after you retire.

“On the other hand, life after retirement is also a time when expenses might be high,” he said. For instance, costs associated with travel, leisure and health care might rise.

“At the moment we don’t know which argument wins the day. Do we need more income in retirement or less? It’s really hard to say,” Laibson said.

Some — including Stephen Utkus, a principal with the Vanguard Center for Retirement Research — say that 75% is as good a number as there is.

A good reference on this, he said, is a series of studies produced by Aon Consulting and Georgia State University, which put the replacement ratio at 81% for those with a final salary of $50,000 and 84% for those with a final salary of $150,000.

“They make the rational point that when you are retired, you aren’t making large 401(k) contributions, aren’t paying payroll taxes ... and living expenses are lower,” said Utkus. “Hence 75%, or thereabouts.” Read the 2008 Replacement Ratio study (PDF).

Adjustments are needed

But the oft-quoted 75% replacement ratio — while good — needs to be tweaked based on one’s income, said Peng Chen, CFA charter holder and president of Morningstar’s global investment-management division.

The typical amount of money one needs to maintain the same standard of living in retirement as before is roughly 100% of one’s income after taxes and 401(k) contributions, Chen said.

“This make sense, as that is pretty much how much one is spending today in the U.S.,” Chen said.

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