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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

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But that’s the average. The salary replacement ratio is closer to 100% or even higher for lower income households (as they get subsidies) while the ratio could be 80% (or lower) for higher income households, as wealthier people do not spend all of their income, Chen said, citing government survey data.

Looking for a ballpark estimate? “My personal view is that households should generate enough retirement income to replace about 75% to 100% of their pre-retirement income,” said Laibson. “This estimate is as much art as science.”

A good or bad rule?

Experts say the salary replacement ratio is neither a good nor bad rule of thumb. “It’s a quick way to come up with a ballpark estimate,” Chen said.

Like every rule of thumb, it has pros and cons. On the pro side, it is easy and everyone understands it, he said. On the con side, Chen said, it’s not very accurate, especially at the individual level.

Others agree. “Replacement-rate calculations are overly simplistic and potentially inaccurate because they often are based on methodologies limited to replacement of preretirement cash flow after adjustment for taxes, savings, and age and/or work-related expenses,” wrote Jack VanDerhei, a Temple University professor, fellow at the Employee Benefits Research Institute, and author of a 2006 research report on the subject.

“One of the biggest weaknesses of replacement-rate models is that one or more of the most important retirement risks is ignored: investment risk, longevity risk, and risk of potentially catastrophic health-care costs.” Read VanDerhei’s report, "Measuring Retirement Income Adequacy" (PDF).

Consider, for instance, just the risk of outliving your assets. Saving to replace your salary for life based on life expectancy is very different from saving to replace your salary to age 95. In the living-to-life-expectancy scenario, you might need to accumulate a nest egg of, say, $500,000 while in the living-to-age-95 scenario, you might need a nest egg of three times that or $1.5 million.

135% isn’t the number

While the experts quibble over whether the replacement rate is 75%, 100% or somewhere in between, they generally agree that 135% is not the right number.

“As for Ariely’s survey, one of the principles of behavioral economics is there is a difference between what people say and what they do,” Utkus said. “I don’t buy his study’s conclusions at all. I’d be curious to know: Were all of the people who wanted to retire at 135% of income saving 30% of their income each year...in order to achieve that goal? Probably not. So it’s just a wish list, nothing more.”

Others are of the same mind-set. “One shouldn’t glibly reject Ariely’s 135% number, but there are quite a few reasons to be skeptical of that calculation,” Laibson said.

“When economists do their best to work through these issues, we generally conclude that your annual income in retirement should be a bit lower than your annual income before retirement,” he said. “I use the word ‘should’ in the sense that an optimizing household would save enough during their working life so their income in retirement is a bit lower than their income before retirement.”

Another expert said it’s not reasonable to try to replace 135% of your current salary. One couldn’t cut spending and save enough now to generate that sort of income later, said Wade Pfau, an economics professor at the National Graduate Institute for Policy Studies in Japan.

“There are just too many trade-offs in getting to the point where a 135% replacement rate is feasible,” said Pfau, who wrote a blog and a paper on the subject. Read Pfau's blog post responding to Ariely. Read more: Getting on track for a sustainable retirement.

No magic number

There is no single, correct replacement rate, VanDerhei and others said. In fact, there’s really no substitute for doing precisely what Ariely did: crunching the numbers. It’s not quick, but it’s more accurate than any rule of thumb. According to Chen, individuals should look at their own spending habits to decide how much of their salary they’ll need to replace.

This is easier said than done. “Most people do not start to think about how they would live in retirement until they are close” to it, Chen said, “and this type of financial planning has to be done a number of years before that.”

Others criticize the use of salary replacement ratios altogether. “Ariely’s calculation is as bad as what he’s criticizing,” said Larry Kotlikoff, an economics professor at Boston University and president of ESPlanner, a financial-planning software company that uses the economic concept of consumption smoothing in its calculations.

“What people want or need is irrelevant. The only issue of relevance is what they can afford to spend on a sustainable basis. The goal is not a number,” he said. “The goal is a smooth living standard through time. If financial planners haven’t gotten this straight by this point, they should hang it up. They are disserving their clients using a methodology that not a single trained economist would endorse.” You can get a free version of Kotlikoff's planning software here.

Maximum utility

Ariely raised another point in his blog that is at the crux all things money. In essence, he asked: How do we use our money to maximize our current and long-term happiness? And that of course prompts the question: Just how the heck is one supposed to do that?

“This is definitely the crux of the question,” Chen said. “I am not sure anyone knows for sure, just like everything in life. This not only touches on how much you should save for tomorrow or spend for today, but also on how much you should work to generate more income, or relax and enjoy life.”

For his part, Utkus said the key to striking a balance between saving more now to spend more later, and spending more now to spend less later is this: One, “we need some amount to make us feel secure (in other words, happy), and it’s not unreasonable that that is something like a 75% replacement ratio as a starting point.”

Second, we know that many affluent individuals want a more active lifestyle when they first retire. “If they aren’t willing to shift their consumption patterns — from Westin Resorts to the Ramada, from [first class] to flights in economy on Tuesday — then, yes, they’ll need 100% or more,” Utkus said. “But few actually seem to act on this desire by saving the requisite amount.”

Three, at the other extreme, it’s probable that many individuals can be just as happy with less (except for those with low incomes) because they can make choices about living on less.

Said Utkus: “Happiness is broadly tied to intangible elements beyond financial security...such as family and social relationships, purpose of life, spirituality, and so on.”

Robert Powell is editor of Retirement Weekly, published by MarketWatch. Learn more about Retirement Weekly here. Follow his tweets here.

Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.

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