REFILE-Stern Advice - A grain of salt for those retirement projections

Wed Jul 3, 2013 9:22pm EDT

By Linda Stern

WASHINGTON, July 3 (Reuters) - Only cave dwellers have missed the boom in retirement-planning studies: what seems like a daily barrage of industry-funded surveys and white papers pointing to an aging population so woefully unprepared they will have work until they are 90, brown-bagging cat-food lunches when they do.

Now one of those new studies, from a respectable and data-focused investment firm, is taking some of the pressure off individuals who may worry that they can't possibly save enough.

"The savings rates we show (as necessary for retirement) can be achievable," said Marlena Lee, the researcher who did the study for Dimensional Fund Advisors, an Austin, Texas, company that is known for its low fees and highly analytical approach to designing mutual funds.

To understand Lee's research, you have to understand the math behind retirement planning. Here are the basics: A pre-retiree should estimate how much annual income she will need in retirement, subtract projected Social Security and pension income, and then aim to accumulate roughly 20 to 25 times the amount that is left by retirement. That is a conservative way to insure that you can pull 4 percent a year (plus an inflation adjuster) out of your portfolio every year and not run out of money over a long retirement.

Typically, retirement studies guesstimate the amount you will need by deciding what percentage of your final salary you need to replace. The replacement rate is often an alarmist 75 percent or 80 percent - yielding a figure that can make pre-retirees throw up their hands (and 401k statements) in despair.

Lee's research debunks that figure with actual data on retirement spending. She finds that the more you make, the lower your replacement rate needs to be, because of line items like high working-year taxes that disappear in retirement for high earners. The less you make, and the higher your presumptive replacement rate, the more of it Social Security will cover. That is good news for both groups.

It is only the bottom quartile of earners - those who make under $26,000 - who need as much as 82 percent of their working income to live comfortably in retirement. Social Security will replace the bulk of that, leaving that group to replace 23 percent of their final salaries - a maximum of $7,280 a year from savings - without any future belt-tightening.

By the time you are earning between $50,000 and $87,000 you only need 62 percent of your last salary to live on, and Social Security will supply half of it. The top earning tier will need 58 percent of income. Of that, Social Security will cover 21 percent, leaving 37 percent to be replaced through savings, pensions or cost-cutting, according to Lee's research.

All of which means the amount of savings needed is less than you might expect. Lee's conservative calculations suggest that to have a 90 percent certainty of covering a 40 percent replacement rate, low earners starting young would need to save 5.3 percent and the highest income groups 12.8 percent of their salaries annually.

But most people probably wouldn't need to save as much as that because (1) nobody in Lee's study turns out to need a replacement rate as high as 40 percent; (2) she uses a conservative stock/bond allocation model that has investors holding large amounts of lower-earning bonds instead of higher-earning stocks as they get older; (3) she uses conservative estimates of returns for stocks and bonds; and (4) she isn't counting on employer matches in 401(k) savings or any other sources of retirement savings or income. An investor could make up a savings deficit by investing a higher percentage in stocks - or by earning more on them - than Lee assumed.

The takeaway for workers is not to give up saving, of course. The more cash you have when you hand in your employee ID, the easier your post-work life will be - and nobody knows exactly how much healthcare costs could eat up in the future, with medical costs often rising faster than overall inflation. Last year U.S. healthcare costs rose 3.58 percent, according to the Labor Department.

The other important lesson for pre-retirees is that you should worry less about the scare studies (like a recent one from the National Institute for Retirement Security that showed the typical "near retirement" household had only $12,000 in savings, but excluded other household assets and did not adjust for income level) and think instead about the particulars of your own situation.

Consider how much you will actually spend in retirement based on your own tax rate and lifestyle, instead of plugging in a replacement rate. Factor in any inheritances, pensions, company matching payments and higher salaries as you age. Lee suggests younger, low-earning workers can save less to start and make it up later as their earnings increase.

"Some advice can be oversimplified," said Lee. "The focus of our research was to figure out, out of all these moving parts, which are the important ones to consider." Your own income determines how much you can afford to save. That, it turns out, is key.