Q: I am 56, married, and have a mortgage that I’d like to pay off before I retire at age 62. I used an online calculator on my 401(k) plan’s website to determine if I could retire and learned that I’ll need to replace 85% of my household’s current income. Is that unrealistic? Also, I did some calculations with and without Social Security if I retired at 62. Without it, the calculator indicates about a 20% shortage per month in income. Based on this, is that something I should be concerned with?
– Kevin Vande Yacht, Kaukauna. Wisc.
A: For starters, disregard anything you learn using an income replacement ratio calculator. Replacing 85% of your pre-retirement income is rule of thumb and not necessarily a good one – especially for you.
“Sadly, this is the problem with the way financial services companies have framed the entire retirement planning discussion – in terms of income rather than in terms of spending,” says Don St. Clair, a certified financial planner with St. Clair Financial. “Rules of thumb suggesting retirees need to replace some percentage of their pre-retirement income conceal a fundamental concern, namely: ‘Will I be able to maintain my current standard of living (that is, spending) when I'm no longer earning an income? That's a question of replacing spending, not replacing income.”
So there are at least two reasons why you especially don’t want to use income replacement ratio.
One, a big portion of your expenses – your mortgage – gets eliminated if, as you indicate, you pay it off before retirement. Most income replacement ratio calculators use averages where housing – a mortgage, property taxes, property insurance, and maintenance – represents about one-third of total expenses in retirement. In your case, the expense of the mortgage goes away, but the calculator doesn’t know that. “Those planning on paying off their mortgage at retirement might find 85% to be an unnecessarily high target,” says St. Clair.
Two, saving for retirement is another expense that likely goes away after you retire. To be fair, most income replacement ratio calculators take that into account. But the “larger one's 401(k) contribution the smaller the percentage of income needs replacing,” says St. Clair.
So what’s the better (best) way to determine if you can maintain your standard of living in retirement? Do a cash flow analysis: Capture (in a spreadsheet or with pencil and paper) all of your expected expenses (housing, health care, transportation and the like) and all your sources of income (Social Security, pensions, personal assets, earned income) in retirement, over the course of your planning horizon.
And, if there’s a mismatch between your income and expenses, you’ll need to make some adjustments. For example, you might have to delay retirement, save more now, invest more aggressively, and/or reduce your standard of living.
As you go through this exercise, consider the following as well.
One, your planning horizon can be a bit tricky. Some planners like to use age 95, while others like to use two different planning horizons – one for the husband and one for the wife. Use the Living to100 calculator to get a sense of the probability of you living to various ages. No matter what, don’t use your life expectancy as your planning horizon. Using that number means you’ve got a 50% chance of being wrong – of outliving your planning horizon.
And two, claiming Social Security at age 62 means not only that you’ll receive a reduced benefit, but your spouse will also receive a greatly reduced survivor’s benefit. Consider, if you can make it work, delaying Social Security for as long possible, to at least your full retirement age and, if possible, age 70. Doing so will give you and your spouse the highest possible monthly benefit.
To make this work, you might have to start taking money from your IRAs and/or taxable accounts from age 62 to full retirement age or to 70 to create the income you would have otherwise received from Social Security. There are two benefits to this strategy: One, it reduces the amount of requirement minimum distributions that you have to take from your IRA at age 70½ and two, it increases your monthly Social Security benefit.
“In the end the real target is not income at all, but – after-tax, after debt-service, if any – spending,” says St. Clair.
One final note: I and others have written extensively on the use and value of income replacement ratios. Read, for instance, Pain-free methods to calculate retirement costs.