By Mark Miller
CHICAGO Jan 16 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.
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, new research suggests the rule of thumb is off target most of the time. A paper by David Blanchett, head of retirement research at Morningstar, found that the actual needed replacement rate varies from under 54 percent to over 87 percent.
"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.
"As people age, they don't spend as much," he says. "They're not up for long, expensive vacations - instead, they might just want to go to the beach. They cut back at a faster rate than less affluent households that are already stretched relatively thin."
Using 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.
Blanchett's findings echo several other research papers, most recently one by Wade Pfau, a professor of retirement income at The American College in Bryn Mawr, Pennsylvania, which trains financial professionals. Pfau found that retirees age 65-74 spend 20 percent less than those who are 55-64; retirees over 75 spend 40 percent less than those who are 55-64, and 26 percent less than the 65-74 crowd. He finds that discretionary spending on travel, dining out and entertainment decreases with age and encroaching health problems.
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, Blanchett says. "How much will I need to live? Will I still have a mortgage? Am I staying where I am or moving to a lower-cost location? How much can I rely on from Social Security?"
Healthcare is the biggest wild card. Medical expenses tend to rise substantially during retirement, and healthcare inflation has for decades outpaced general consumer price increases - although cost increases have moderated over the past few years. Still, Medicare insurance adds stabilization and predictability to that cost for most seniors - the one big exception being a long-term care need.
Medicare covers only 100 days of care in a skilled nursing facility, and overall market penetration for commercial long-term care policies is less than 5 percent of the total possible market, according to LIMRA, the insurance industry research and consulting firm. That leaves Medicaid, which covers only very low income households. (Income eligibility rules vary by state, but an individual can't have more than $2,000 in "countable" assets, which includes everything but personal possessions, one vehicle and the patient's principal residence.)
Although roughly two-thirds of seniors will need some form of long-term care, much of it is delivered in the home and often by family members or friends; just 1percent of people in their late 60s, and 3 percent in their late 70s lived in nursing homes in 2011, according to the U.S. Census Bureau. (The numbers were much higher for people beyond those ages - 20 percent for seniors in their lower 90s, and nearly 40 percent for centenarians.)
"Long-term care is the elephant in room," Blanchett says. "But it won't be a factor for most households. One approach is to think of your home equity as a means of last resort in case it does happen - either by using a reverse mortgage or tapping into your home equity in some other way."