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Income Replacement: What’s Your Number?

Michael Reid, CFA
March 13, 2018

What's Your NumberIn the next 7 days roughly 70,000 baby boomers will reach full retirement age. A similar number will cross that threshold next week…and the week after that, and the week after that, and pretty much every single week until the year 2032. For those of you doing the math at home, it works out to 3.64 million people reaching full retirement age in each of the next 14 years. What’s more, each year the life expectancy for those of us who do reach full retirement age inches out further and further. Longevity is a force multiplier that has material consequences every working American must take into account when contemplating their own income replacement number.

Unlike our great grandparents whose working careers ended at the dawn of Social Security (where "retirement" almost always translated to: impoverished, solitary, and brief), today's baby boomers are reaching full retirement age with a time horizon that's much longer than anyone would have thought. For better or worse, the “brief” element of the retirement equation is the relic of a bygone era. Unfortunately, the data also shows far too many boomers are approaching the onset of their golden years with a grossly insufficient pot of gold to sustain the lifestyle to which they've been accustomed. That's a problem that won't take care of itself. One thing is certain though, a Social Security check by itself isn't going to foot the bill. For all but the fortunate few, steering clear of an unwelcome erosion in lifestyle is going to take some advance planning.

While there isn’t clear consensus among the experts on exactly how much replacement income you’ll need to maintain your pre-retirement standard of living, that shouldn’t stop you from trying to make some headway to figure it out. The good news? It's probably not as hard as you're making it out to be. The bad news? You just might be your own worst enemy.

Beware the "rule of thumb"

Any friend, relative, or advisor who initiates a retirement income conversation by suggesting “a good rule of thumb” is to start with 80% (or some other seemingly plausible ratio) of your pre-retirement income should immediately be regarded as borderline negligent. When it comes to finding your own number, a pseudo-authoritative estimate of what everyone else seems to be doing ought to set off warning bells. Unfortunately, it doesn’t. In fact, just the opposite is true. Despite the fact the previous paragraph made it clear there is no expert consensus, it’s virtually certain you’ve already started anchoring on the 80% number referenced earlier and mentally started making minor adjustments up or down. The real problem with anchoring is that even after a number has been thoroughly discredited, there is solid academic research that shows the pernicious influence it has on your thinking is remarkably resistant to any new (and potentially more reliable) information. While it’s unlikely you’ll ever completely eradicate the effects of anchoring, awareness is always an important first step.

It’s not just an estimate, it’s a range

While competent financial planners don't see eye to eye on everything, there is certainly widespread agreement that 100% replacement of pre-retirement income is unnecessary. Importantly, individual circumstances vary considerably and there is no universal formula that reliably estimates replacement need. That means you'll need to work through a basic checklist and understand whatever works for Charles and Angie in your Saturday night euchre club probably isn't directly applicable in your circumstances. You'll likely come up with a few items on your own, but everyone's checklist of likely decreases should consider:

  • Payroll taxes
  • Retirement savings contributions (401-k, 403-b, SEP, IRA, Roth, 457, etc.)
  • Work related (commuting, wardrobe, etc.)
  • Housing (mortgage payoff)
  • Child rearing

Conversely, the checklist of likely increases should consider:

  • Health care (insurance, prescriptions, co-pays, etc.)

If you're like most people, you'll probably get out a note pad, make a few calculations, and arrive at a number that seems reasonable. Fair enough. But let's take a momentary diversion to understand why that approach is insufficient. Bear with me, I promise the point of this exercise will be self-evident.

Without resorting to Google, Siri, or Alexa, mentally estimate the distance between Earth and Pluto. Write that number down on a piece of paper. Now, express that number again using a range so you're reasonably confident you'll be accurate within a million miles on either side of your original estimate. Got it? Great, let's move on.

Earth and Pluto each travel in elliptical orbits. At the furthest point, we are 4.7 billion miles apart and at the closet we are a mere 2.6 billion miles away. That means on average, Earth and Pluto are separated by a distance of 3.65 billion miles +/- 950 million miles (assuming a 90% degree of confidence).

So how did you do? Unless you are a serious amateur astronomer, my guess is not so great. Even if you didn't know the average distance (which you almost certainly did not), your range didn't adequately account for natural variability in the distance much less your degree of uncertainty around those numbers. Moreover, if I had prospectively asked you how you thought your response might stack up against the general public, you wouldn't have hesitated to say "better than average". Congratulations, like every other homo sapiens on the planet, you are overconfident.

When the stakes of decision making are small (e.g. how much time will it take to get to work today?), the downside of overconfidence is usually a minor social annoyance and we just don't worry much. When the stakes are large (e.g. can I safely swim across this river?), the downside of misplaced confidence is understood to be catastrophic and we generally avoid taking those kinds of risks. But it's when the consequences of high severity decisions are poorly understood, miscalculated, or the interval between cause and effect is delayed, we're most vulnerable. Take note: such is often the case with pre-retirement planning. Research shows when it comes to planning for our future selves, we're just not that good at it.

To account for uncertainty and our own ineptitude, why not give yourself a margin of error and arbitrarily pad your estimated income replacement need by 30% or 35%? While there's nothing remotely scientific about this buffer, expressing your estimate as a range rather than a specific number underscores the variability of data and provides a valuable circuit breaker to help guard against a false sense of precision. Undoubtedly you'll be able to dial that range into better focus over time, but thinking about your number in terms of a range is always a more realistic way to start. Let's face it, in the face of unrelenting uncertainty, real world outcomes generally turn out to be a lot more lumpy than our neat little models would have us think. Do yourself a favor and plan accordingly.

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Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management who has firsthand experience with faulty range calibration: He habitually overestimates the amount of time spent exercising and underestimates daily caloric intake. This results in periodic episodes of radical (though temporary) alterations in his meal planning and patterns of food consumption. The opinions expressed in this article are his own.