How much should I save for retirement? When can I retire? What quality of life will I enjoy in retirement? These are the key questions of retirement planning, and the answer to all of them depends on an accurate and reliable projection of your cash flows during retirement.
An oversimplified estimate of your retirement income needs simply won't do.
Think of it this way: If a financial advisor only asked you about your current income and not about your individual situation - housing expense (including any mortgages), children's college, in which state you plan to retire, or any major one-off expenses coming up - would their advice be any good? Of course not. This is exactly the problem with simplified estimates of your income needs in retirement that are based solely on your current income and some national statistics, without taking your individual situation into account.
For example, a calculator may suggest that a reasonable retirement income for you will be $70,000, based solely on the fact that you currently make $100,000. Similarly, they may suggest a retirement income of $27,000 for someone currently making $30,000. With that assumption, they will work out how much you need to save and when you can retire.
When a calculator only asks for your current income in order to estimate your retirement income needs, they most likely use the concept of replacement ratios. The replacement ratio is a person's gross income after retirement, divided by his or her gross income before retirement.
There has been considerable research into what would be an adequate replacement ratio - the ratio that allows you to maintain a comparable standard of living before and after retirement. The theory is that some of your pre-retirement costs will drop off (commute, mortgage, children, etc.) and new ones will be added (higher medical bills, more travel, etc.). Researchers have identified various rules-of-thumb to help decision-makers design large retirement systems for corporations, state and local government, or entire countries. The goal is to ensure that their retirement benefits will provide adequate retirement income to full-career employees, on average.
When used for large groups, this approach is useful. Some individuals will need a lower income during retirement while others will need a higher income, but it all averages out as a group.
However, this approach quickly starts falling apart when used in retirement planning for an individual. Each person has a unique basket of pre- and post-retirement expenses, while the rule-of-thumb replacement ratios are based on some national average. For example, you either have a mortgage or you don't, while the average is based on a weighted average of those who do and those who don't. Same with children expenses, health care costs, etc.
The second major issue is that replacement ratios assume your retirement income needs will be level over time. This is almost never the case, even if we ignore inflation.
If your mortgage is not paid off at the time you retire or you are still supporting your kids, you will need a much higher income in the first few years of retirement than in later years. If you retire before age 65 and purchase health insurance on your own, you may need an income that exceeds your pre-retirement income, until Medicare kicks in at age 65. Taking into account the unique timing of these and other major events for each individual is of critical importance.
You don't want to run out of retirement savings because the average replacement ratios in the United States didn't allow for your major expenses!
Another glaring issue with replacement ratios is the underlying assumption that you will maintain the same cost of living before and after retirement. Many people are able to lower their cost of living in retirement, while preserving or improving their quality of life. Why not invest in making your home more energy efficient? Move to a small condo in your favorite vacation spot now that the kids are long gone? Get away from the expensive urban area? All these choices show that your retirement income needs are not necessarily a function of your pre-retirement income.
Even with the best of calculators, you will still need to update your calculations on a regular basis. Every time your situation changes, your retirement plan needs to change, too.
However, regular re-calibration won't do much if your calculator has a systematic bias or ignores a major piece of your financial reality. If a calculator thinks you will need $70,000 overall income in retirement (just because you currently make $100,000), while in reality you will need $120,000 in the first five years, $90,000 in the following five years, and $75,000 afterwards, it won't matter how often you re-calibrate. Its assessment of your retirement preparedness will always be dangerously off the mark.
If using replacement ratios for retirement planning is an alarming oversimplification, do you then need to project every single expense in retirement, down to the most minute detail?
In our opinion, the best path lies in between these two extremes. All major required expenses should indeed be projected as diligently and accurately as possible. These include your housing expense, health care costs, child-related expenses, one-off expenses, and taxes. By factoring these projections, you can have the peace of mind that the important pieces of the puzzle will be taken care of.
Then your calculator can tell you how much free cash you can enjoy each month in retirement for personal and optional expenses (groceries, going out, having fun, vacations, club memberships, etc.). Going into more details than that will only unnecessarily complicate things. This gives you a ballpark number on how much you can spend per month, after taxes and required expenses, but leaves you the freedom to spend it as you wish.
It is tempting to use our current income needs as a guide to our income needs in retirement, or use national studies on adequate replacement ratios. Either of these approaches can produce misleading results. A retirement calculator needs to reflect your individual situation with all major moving parts modeled explicitly and accurately.
The importance of using a robust retirement calculator becomes clearer the closer we get to retirement, but by then we have limited time to make additional savings. The earlier you start using the right calculator, the more options you can create for yourself and your family.