AUSTIN. Getting the right answer to the wrong question isn’t helpful. So I’ve come to visit with Marlena Lee, a young Ph.D. at the headquarters of Dimensional Fund Advisors. I’ve come to ask how she works her way through the complicated problem of retirement savings.

Dr. Lee is part of the brain trust DFA has assembled for its entry into the place where most of us save and hold our money: defined contribution plans like 401(k)s and 403(b)s. I’ve come because the dismal failure of 401(k) plans has been widely trumpeted over the last year in spite of the fact that the poverty rate among seniors has been dropping steadily for more than three decades.

And in spite of recent and encouraging research by Dr. Lee. You probably haven’t heard much about Dimensional Funds. One reason is that their funds aren’t available ‘retail’ as funds from Fidelity, T. Rowe Price, Vanguard and other firms are. Until recently, you could only invest if you were an institution or, as an individual, through a registered investment advisor. But now, with their entry to defined contribution plans, variable annuities and 529 plans, you’ll be hearing more. Much of it will be good news.

Her first bit of good news was that the conventional wisdom on how much income we need to replace at retirement, usually called the replacement rate, is too high. We don’t need to replace 75 to 85 percent of our income at retirement; a more realistic figure is 60 to 80 percent, depending on your income level while working.

This finding is a big, big deal. Every bit of income that we don’t need to replace at retirement takes pressure off the need to save. Add the fact that Social Security benefits provide a hefty slug of income replacement for most Americans and what may seem to be an impossible project becomes possible.

You should know that Dr. Lee isn’t the first person to observe that industry estimates of needed replacement rates are too high. The idea, confirmed multiple times by Consumer Expenditure Survey data, can be traced to the late M.I.T. Nobel Laureate Franco Modigliani, research by M.I.T. economist Lester Thurow and a variety of others, including Boston University economist Laurence J. Kotlikoff.

Why is the rate she calculates so much lower? “There are only a handful of variables that are important to the calculation of the replacement rate,” she said, “savings, taxes and spending. It’s also important to recognize that there is a life cycle associated with spending. In the average household, spending declines as they approach retirement.” We also tend to pay off debts before retirement.

How can we be sure that people don’t spend less simply because they’re broke? Easy. The same surveys show that as our spending on core items decreases, we increase our spending on nonessential items. 

Building this reality into her models, Dr. Lee found that our need to save is somewhat lower, particularly for households at the lower end of the income scale. Lower income households have a larger part of their income replaced by Social Security benefits. For instance, while Social Security will replace about 59 percent of pre-retirement income for households in the bottom 25 percent of income, it will replace only 21 percent for households in the top 25 percent of income.

Retirement: Not As Difficult As Many Think

This table shows how much income needs to be replaced at retirement and the amount that must be saved to meet the replacement rate goal. Lower income households have to replace a higher amount of income, but also receive proportionately higher Social Security benefits.


Percentile of Pre-Retirement Income

  Under 25th Ptile 25th to 50th Ptile 50th to 75th Ptile Over 75th Ptile
Pre retirement income range <$25,870 <$49,941 <$86,882 >$86,882
Median Tax Rate 8% 14% 18% 21%
Savings Rate 9-11% 13-15% 12-14% 13-16%
Replacement Rate 81-83% 71-73% 61-63% 57-59%
Social Security 59% 38% 31% 21%
From Savings 22-24% 33-35% 30-32% 36-38%

Readers who don’t save much are likely to think her calculated savings rates are punishingly high. In fact, they are close to what real people actually do. When employer contributions are counted, she points out; the Survey of Consumer Finances shows that median total plan contributions range from 8 to12 percent of income, not much lower than her calculated need of 10 to 15 percent.

Have a plan with a good employer match, and getting to a well-funded retirement becomes a “we can do this” project.

The big surprise in her work, which I’ll cover next week, is that this is just the beginning of the good news.