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SJun 6, 2008

The “N” Factor and Retirement Planning

Scott Burns

How does the cost of raising a family affect your retirement planning?

The answer is good news, in a backhanded kind of way.

When we have children we voluntarily reduce our adult standard of living so we can raise the kids. Since our adult standard of living is lower than it would otherwise be, we don’t need to replace as much income at retirement.
We could figure this out by using actual estimates--- you can get them by Googling “cost of raising a child” or by checking the links below.

But let’s try a simpler method.

I call it the “N” factor. While there is a great deal of research on how the size and age of a household affects its cost of living, a simple algorithm comes pretty close.

Here’s the algorithm: The cost of living for a household is the square root of the number of people in the household. So if you are single, your cost of living is the square root of 1 or… 1.

But if you are recently married, your cost of living is the square root of 2, or 1.414. Yes, two can’t live for the price of one. But they can live for only 42 percent more than the price of one. Economists call this “economies of shared living.” As economist Laurence J. Kotlikoff and I show in “Spend ‘til the End,” to be released by Simon and Schuster on June 10th, the size of your household while working has a major impact on your retirement needs.

You can understand this by figuring out the cost of raising children.

Using the “N” factor, your cost of living with one child is the square root of 3, or 1.73. Have a second child and your cost of living is the square root of 4, or 2.

So how much of your cost of living is accounted for by having two children?
Answer: About 30 percent. You and your spouse account for the other 70 percent of your cost of living.
Now let’s consider a more concrete example--- a young single-earner couple with an income of $100,000 a year, two children, and the usual assortment of debts. They’ll pay 7.6 percent of their income in employment taxes, about 8 percent in federal income taxes, and they’ll save perhaps 4 percent in a company 401(k) plan

.The conventional wisdom of the financial services industry says they might need to replace as much as 85 percent of income in retirement because the usual 70 to 85 percent rule ignores two of the largest realities of life in America--- debt and children.

Talk about major omissions.

About 25 percent of this couple’s income will go for debt service--- their mortgage, car loans, credit card and education debt. With a bit of attention they can manage to pay off all these debts by the time they retire.

That leaves about 55 percent of their income to pay all their other expenses, including the cost of the kids. But the “N” factor tells us that the kids cost about 30 percent of that--- call it 16 percent of their gross income--- leaving 39 percent for the parents.

Of course, adding taxes back in might increase the percentage of gross income that must be replaced, but the total is still a ballpark away from the 70 to 85 percent used by the financial services industry.

In fact, this household probably won’t pay taxes.

Social Security benefits at full retirement age will replace about 24 percent of a $100,000-a-year worker’s wages. (They will replace a higher percentage for workers who earn less.) The worker’s spouse will be entitled to a spousal benefit equal to half the worker’s benefit, if he or she is the same age. That’s another 12 percent, for a total of 36 percent.

Note that 36 percent is pretty close to 39 percent--- the income they had to spend on themselves most of their adult lives.

Indeed, under current law they could take $18,000 a year (another 18 percent of replacement rate) from their retirement savings plan and still pay zilch in federal income taxes. That means they can spend 54 percent of their pre-retirement income, well over what they had while raising children!

Maybe our collective futures aren’t as dismal as the financial services industry wants us to believe.

On the web:

Department of Agriculture figures

Cost of Raising a Child Calculator

Website columns about consumption smoothing

Spend ‘til the End on Amazon

Filed Under: Consumption Smoothing