By Henry K. (Bud) Hebeler

4/22/04

I’ve long suspected the naivety of all of those young planners who say retirees should plan on a retirement income that is 70% to 80% of their pre-retirement income. Now that I’m over 70 and have been retired for fifteen years, I know that’s poor advice. Of course, the standard of living in the United States is so high that retirees could live on very small incomes, but to imply that people will be able to maintain comparable life styles before and after retirement with these assumptions is dead wrong.

Suppose the 70% to 80% implies that you can maintain the same living standards on $50,000. Some mom and pop analysts assume this means they can live on $50,000 when they retire. Let me disabuse planners of this error. They always assume that the $50,000 would increase by the amount of inflation, so that with 3% inflation for, say, ten years till retirement, that would correspond to $67,000. Forget the mom and pop error. What I’m saying is that it’s very unlikely that the $67,000 income, or whatever your corresponding value is, will provide the same life-style as before retiring.

An important ingredient in planner’s thinking is that retired people need less money because (1) they no longer have to save for a retirement account, and (2) will have a lower tax bill. That’s because they no longer get docked for payroll taxes and presumably have reduced income tax rates. Planners figure these things alone are close to 20% of working income.

This logic is really flawed. Most retired people still have to save part of their income to compensate for future inflation. (We’ll show some examples in a minute.) Further, retirees’ medical costs, previously paid by their employers, are more than payroll taxes. And retired people lose the benefit of a tax deduction for their savings and have to pay ordinary income tax on their savings withdrawals. These things unravel the basic assumptions behind the 70% and 80% values.

Planners live in a theoretical world and would do well to really put themselves in the position of a person well into retirement. They would find a host of items that would make them more conservative. Let’s go over some of these.

The first of these is likely to be the real cost of inflation. Retirees use a much larger part of their income on medical insurance and uninsured medical costs than when they were younger. Although a great deal of this is simply due to requiring more medical assistance with age, another important part is the large increase in uninsured elements which continue to mount. Teeth, eyes, and ears need more attention and are seldom covered by insurance policies. Drugs also largely are uninsured.

Then there is the cost of Medigap medical insurance. That has increased at an alarming rate, especially for those who have policies through their former employees. These costs are commonly deducted from pensions. Now the deductions can be so large that the pensions no longer cover the insurance bill for many retirees. Instead of getting money from their previous employers, they are paying money.

To develop a budget for the things that increase at normal inflation rates, you must first subtract the high-inflation-rate items from whatever you can afford as a bottom line number. The amount of the high-inflation-rate items is not simply their current costs. To do the math right, you have to subtract an effective amount that is greater than their current costs. This amount is approximately:

Current costs x (1 + 0.5 x A x Life-expectancy),

where "A" is the incremental inflation rate above the normal inflation rate.

Let’s illustrate this with an example. Suppose that the after-tax amount you can afford to spend this year is $40,000, and the high inflation items total $10,000. If your normal expected inflation rate is 3%, and your high inflation items are growing at 5%, then A = 2%. With a remaining life-expectancy of 25 years, the effective cost of the high inflation items is:

$10,000 x (1 + 0.5 x 2% x 25) = $10,000 x (1 + 0.25) = $12,500

Thus, the amount left in the budget for things that will increase at normal inflation rates is $40,000 - $12,500 = $27,500, not $40,000 - $10,000 = $30,000 as is commonly assumed in budgeting. In this current year, the actual amount you can afford to spend is $27,500 + $10,000 = $37,500. The extra $2,500 must be deposited to savings if most of your income is from social security and a pension. If most of your income will be coming from investments, it means that you will draw $2,500 less this year than if everything increased at normal inflation rates.

Another area often neglected by planners is the inevitable reduction in future social security benefits. Retirees who have already started collecting social security may feel that they are immune to future reductions because their current values will be grandfathered in new tax laws. Don’t count on this. First, take a look at what has happened to your social security checks as a consequence of the Medicare Part B deductions. These deductions have gone up much faster than normal inflation rates making the take-home part of social security less than the commonly assumed inflation protected value.

Next, don’t believe that the current social security tax deductions (from 15% to 100%) are going to continue well into the future. There is more than the incredible national debt that will cause the problem, particularly if interest rates go up. The already bankrupt Medicare program adds to the difficulty. Even more important is what is happening to the demographics. Our nation is aging with great increases in the number of people requiring or getting government assistance. There are only two ways out: (1) Increase taxes where ever possible, and (2) print more money to increase inflation to make the national debt, social security and Medicare trust deficits seem relatively smaller. Either of these solutions is deadly to retirees.

There is also a mathematical way to approximate what less-than-inflation corrections mean to social security. Suppose that $20,000 of the $40,000 after-tax income comes from social security and that the government adjusts the rules that relate to social security so that the after-tax amount grows at, say, a 1% rate instead of a 3% inflation rate. (Many people feel that the social security increases already are 2% short because the inflation rate used by the government doesn’t reflect retiree’s costs.) The mathematical approximation for the effective after-tax social security income is then:

After-tax social security x (1 – 0.3 x B x Life-expectancy),

where "B" is the incremental percentage shortfall in the inflation adjustment.

In this example B = 3% - 1% = 2%. The effective after-tax amount of social security is then:

$20,000 x (1 – 0.3 x 2% x 25) = $20,000 x (1 – 0.15) = $17,000, a loss of $3,000.

This means that the retiree must save $3,000 this year to offset future inflation increases exclusive of the $2,500 budget adjustment for high-inflation items. We’ve lost $5,500 in a real-life projection, and that’s almost 14% in this simple case. Those with lower incomes would have larger relative losses.

Some would argue that it’s double counting to make an adjustment both for the high-inflation items and the social security reduction. That could be true unless the reason for the reduced social security is a gradual weakening caused by the small print in the tax law and the way the inflation index is measured. I believe that the future tax issues are so critical that there will be even more small print changes than we can possibly imagine now so as to avoid a major affront to the social security system and otherwise higher tax rates.

Still we haven’t come to the worst of the problems. Almost all retirement programs (except the Dynamic Financial Planning program from www.analyzenow.com) use exhaustion methods for retirement planning. Even the most elaborate Monte Carlo planning methods currently in vogue use exhaustion analyses. All of these calculate how long it will take to exhaust your investments if you start with a certain spending level and increase the spending each year by the inflation of that year. Unless your planner uses something like a life-expectancy corresponding to an age where it would be virtually impossible for you to live, you are going to be left in poverty when you get into your eighties and nineties.

The reason for this is that, statistically, you are expected to live to a greater age as you actually get older. The life-expectancy forecast for the earliest age to die is on the day you are born. You get the greatest expected age to die just before you die unless you are already on your deathbed. This effect, in turn, means that your investments must be stretched further than initially anticipated. For example, suppose at age 65 your planner used a 25 year life expectancy as is quite common. This means that you would expect to live to age 90 at which point you would have consumed all of your investments. When you got to be age 80, you would certainly recognize that you might live more than ten more years, so you would have to reduce you spending appreciably to get your money to last till another age horizon, perhaps 95 or 100.

I’ve seen numerous cases where people retired early and expected to have relatively short lives because their parents died young for one reason or another. Because they believed the heredity factor is so strong, they felt confident in using a life-expectancy corresponding to living to their early eighties. Now, late in their seventies, they are really struggling financially since they far overspent in their early years of retirement. Their parents didn’t have the benefits of modern drugs and sophisticated surgery repairs. Who knows what will happen as medical research continues to delve deeper into levels unimagined several decades ago?

Even without taking into account this moving life-expectancy target, if you went to a planner and asked for a simulation with a new budget calculation each year, you would find that the continued application of exhaustion analyses every year would cause your inflation adjusted budget to fall precipitously starting in your eighties. In order to preserve the same inflation adjusted spending capability in your nineties as in your sixties, in most cases you’ve got to cut the planner’s conventional exhaustion budget from investments by more than one-third. Or said differently, you’d need to accumulate 50% more savings. You can demonstrate this with the Dynamic Financial Planning program.

The majority of planners try to dismiss this subject with the comment that you don’t need as much income when you are eighty as when you are sixty. After having had to help support family members in their nineties, I can assure you that this isn’t true. Some elderly people are still quite active like a number of our friends in their seventies who ski almost every day in the winter or my father who was still golfing at age 95 and got his drivers license renewed for another three years. But, whether active or not, the medical bills mount, and those with disabilities need expensive assistance.

Let’s talk about pensions. I’ve found that many of the simple retirement planning programs assume that all pensions have cost-of-living adjustments (COLA). If you suspect this, you can get a more realistic result for a pension without a COLA if you multiply your pension quote times your age divided by 100. This means a retiree with a $10,000 pension at age 65 should enter $6,500 in an analysis that assumes the pension has a COLA.

In fact, as a practical matter, a 65 year old should be saving 35% of her after-tax fixed pension or annuity, or an 80 year old should be saving 20% of her after-tax fixed pension or annuity. This continual saving process will build up enough savings to offset inflation until very late in life. Once again, we find that these retirees are still saving part of their retirement income. In a planner’s vernacular, savings end when retirement starts and has to start living off savings. Retirees can’t think that way. They have to refrain from spending all of their social security and pension to say nothing of putting aside some money to offset the extraordinary growth of medical costs.

We’re not done yet. Things will be worse if your planner didn’t account for some kind of reserve for unknowns. Any number is strictly a guess, but I’ve found that practically every retiree has several major unforeseen events such as a cry for financial help from aging parents or a recently divorced daughter with children and no job. People with large investment balances might set aside 10% of their investments for such a reserve. Those whose investment levels are less than a year’s living expenses probably should use 100% of their investments for reserves, that is, not count on regular draws from investments to support retirement except possibly the interest and dividends.

Then there is a budget item for replacing expensive equipment often ignored by planners. In a sense, this too is a guess, but you can apply some science to it. Simply divide the current price to replace each high value item (less any trade-in value) by its expected life and add them together. So if your $1,000 furnace might last 10 years, and your $10,000 roof 20 years, and your $25,000 automobile 5 years, you would need a replacement budget item of $100 + $500 + $5,000 totaling $5,600. Before year end, you should deposit this reserve contribution to an investment account. This account should not be subject to large market fluctuations or be difficult to obtain cash as required.

It’s even better to use a comprehensive method like the Dynamic Financial Planning program where you can insert your estimated replacement cost for each item in the year it might occur. Then you don’t have to budget the replacement as in the paragraph above.

In addition to a reserve for unknowns, part of your investment should be a reserve for replacement of high value items. Unlike the reserve for unknowns, you can calculate how big this reserve should be by multiplying the annual replacement budget by the number of years you have already owned the item. Suppose that you have already owned that $30,000 (current price less trade-in) automobile for three years. Then the amount that should be in the automobile part of the reserve would be 3 x $5,000 = $15,000.

Replacement reserves are a great way of saving money. Instead of buying items on credit and paying someone else the interest, you can pay cash, save the interest cost, and get interest on your own reserve balance. This should be a fundamental part of any financial plan, yet it seldom is.

As one final point, retirees have to be very cautious about the return on investment and inflation assumptions used by planners and common references. They seldom account for the investment costs (perhaps 2% or more), the almost inevitable reverse dollar-cost-averaging losses, and the possibility that investments may well not do as well in the future as they have averaged in the past. Be sure to ask you planner about your concerns here.

Well, I’ve probably scared you to death. Your planning method might not have all of the difficulties mentioned above, but I can almost guarantee you that you won’t have anywhere near the same comfort level in retirement as you have when working if your plan is based on only 70% or 80% of your working income. It’s really not possible for someone younger than 40 to make a competent retirement needs estimate, so I’d recommend that they use 100% of their working income and increase that by more than 3% inflation in their projection.

Those who are older than 40 have a much better vision of what they might need in retirement and have enough experience to analyze the components of a future retirement budget. They should be sure to adjust the likely high-inflation budget items as we have done above, and they should use a projection calculation that provides for less than perfect social security increases as well as reserves for both unknowns and replacement costs of high-value items. Importantly, planners should use conservative estimates of life-expectancy. Try out www.livingto100.com to see what good living might do for you. Then add a few years for future medical improvements.

Finally, I believe that everyone benefits from an occasional review by a professional planner who may add a different perspective. By doing your own planning first, and then asking for comments, you save the planner a great deal of time and therefore the related expense. Take advantage of any review to ask lots of questions about your investment allocations, deferred or tax-exempt benefits, individual elements in the projection, prospective returns, inflation, tax effects, etc. Look for a different planner if the answers sound weak. Unlike getting a second opinion from a doctor, you can find out in advance what the cost is likely to be with a simple phone call by explaining what you will bring and what you want.

Copyright © 2004 Henry K. Hebeler

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