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3 Factors to Evaluate the True Cost of Retirement

Money treeRoughly 10,000 Baby Boomers will turn 65 every day for the next 14-and-a-half years. And many of them are preparing to retire. For some, this prospect is daunting—how much money do they need to maintain their current lifestyle? Can they afford to retire? The answer, very often, is “it all depends.”

From an asset perspective, these are trying times to retire. Yields on bonds and forecasted returns for equities are low, significantly affecting the safety of a withdrawal strategy. Many financial planners note the safety of the “4% Rule,” in which a retiree withdraws 4% of his or her initial balance upon retirement and then increases the amount of each withdrawal over 30 years—while factoring in inflation. The market has shifted, however. If we use a model that better approximates our current market and incorporates forecasts, a lower initial withdrawal rate—3%, for example—would be necessary to achieve the same financial outcome.

Clients want to know how much retirement will really cost, so they seek objective advice from CPAs and CPA financial planners. Cost is dependent on three important factors: replacement rate, spending inflation rate and the length of retirement.

Replacement Rate: This is the percentage of a retiree’s income that will be replaced upon retirement. While certain replacement rates, such as 80%, are common, in reality, the actual replacement rate is going to vary significantly based on the unique situation of the individual (or couple). For example, a woman who saves a large portion of her wages is living off less of her current income than someone else who is saving less, and therefore might require a lower replacement rate to maintain her current standard of living.

Inflation Rates: For retirees, a key risk factor is inflation. If inflation is high, the cost of retirement increases and vice versa; therefore, it’s important that the portfolio is optimized to directly incorporate this risk. Doing so can lead to very different allocations than traditional optimization approaches. However, it is commonly assumed that a retiree’s spending increases in retirement by the rate of general inflation, when in fact, the average retiree tends to increase spending by less than inflation. For example, if inflation during the previous year was 3%, spending the following year may only increase by 1%.  

Length of Retirement: Retirement is typically assumed to last 30 years; a couple might retire at age 65 and pass away at age 95. According to an article in The Wall Street Journal, life expectancy for the wealthiest segment—the top 10% of Americans—is about 5 years longer, on average, than the typical American. This suggests planning for a longer retirement may be necessary for higher income/wealth households—who are also the most likely to consume financial planning services.

How can you use these three types of information to help guide your clients?Retirement is an incredibly complex goal that requires a personalized approach to determine its true cost. Using mean-variance optimization, the typical approach for creating portfolios, ignores the risk attributes of the goal the investor is trying to fund.  The bottom line is that CPAs will want to take into consideration the replacement rate, inflation rates and length of retirement while reviewing a wide-variety of options with their clients to ensure all bases are covered.

Learn more about evaluating the true cost of retirement

I presented a comprehensive session on this topic at the 2015 AICPA Advanced PFP Conference. To obtain a recording of this session, visit the AICPA Conference Materials website. Conference attendees may download any session’s handouts and recordings at no cost; non-conference attendees may download for a fee.

Additionally, the AICPA PFP Section will be holding several free webcasts in 2015 on best practices and thought leadership from CPA financial planners on retirement planning (including estimating cash flows and withdrawal strategies in retirement); registration information is available here.

David M. Blanchett, Morningstar Investment Management. David is head of retirement research, where he works to enhance the group’s consulting and investment services. He conducts research primarily in the areas of financial planning, tax planning, annuities and retirement plans, and serves as chairman of the Advice Methodologies Investment Subcommittee.

Money tree courtesy of Shutterstock.


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