It's All about What We Spend
October 25, 2006

It's All about What We Spend

Q. I have often heard that a couple should plan on replacing 70 to 85 percent of pre-retirement income in retirement. I have questioned that guidance because I believe it is more important to replace expenses than it is to replace income. Of my current income, I spend 30 percent for living expenses. I also spend 25 percent on taxes and save 45 percent.This has been the case for the last 5 years. Why does it not make sense to replace expenses--- 30 percent of income in my case--- plus an allowance for taxes and inflation? What am I missing?

---W.B., by email from Dallas

A. You're not missing a thing--- the personal finance press and many financial planners are the ones missing something.

I hope other active savers will take note. The conventional figure of 70 percent to 85 percent comes from a study that is repeated at regular intervals at Georgia State University for AON Consulting, an international employee benefits consulting firm. Sadly, the folks who repeat the 70 percent to 85 percent figure have probably not read the footnotes and methodology of the study. If they did, they would learn that how much you save is of primary importance.

In fact, professor Bruce A. Palmer, the researcher for the study, has regularly pointed out that households saving a great deal of money before retirement will need a much lower income replacement rate because they are saving so much money!

We don't have to replace income we are not spending.

The study is an exercise in reverse engineering. They start with pre-retirement earned income. Then they subtract employment taxes, federal income taxes, and state income taxes to get pre-retirement after-tax income.

Then they make two adjustments. They subtract savings based on national survey data. Pre-retirement savings ranged from 2.4 percent of income for a $20,000-a-year couple to 5.2 percent for a $90,000-a-year couple. Single earners saved about the same amounts.

In fact, many pre-retirement couples save at much higher rates. Each additional percentage point reduces the replacement income needed for retirement.

The researchers also add or subtract to account for spending changes for age- and work-related items. In the most recent 2004 study, for instance, they found that expenses rose by $30 for a $30,000 annual income couple with one earner. But expenses for a similar couple with a $60,000 income declined by $1,516.

Those adjustments produce the "income needed for post-retirement consumption"--- the 30 percent you spend on living expenses.

Then they calculate the federal and state income taxes you would pay to net your post-retirement spending. For many people, taxes virtually disappear.

The fact that only 30 percent of your income is spent on living expenses makes you very unusual. You're probably saving more than necessary. You didn't say what your income was or whether you were married, so I can only give you a hypothetical example.

Suppose you earned $100,000 a year and paid $25,000 a year in taxes. Your joint Social Security benefits, alone, could exceed the $30,000 a year you spend on living expenses. That means your standard of living would rise when you retired, unless you simply hoarded the return on your many years of saving.

What most of us try to do is keep our standard of living stable over our lifetimes, avoiding big drops as much as possible. We do this by saving and investing to smooth our spending.

You may have an opportunity to increase your standard of living now and when you retire.

Q. My wife and I are both 74 and in very good health. We have an ample diversified portfolio with over half in tax-deferred accounts. We also have wills, now nine years old, that provide for a marital deduction trust in order to get the benefit of full marital deductions for estate tax purposes.

Our net worth is now well below the threshold for estate tax application due to tax relief provisions. But maybe the estate tax relief will go away in 2011. Or maybe it won't. Should we revise our wills now to eliminate the provision for the marital deduction trust?

---R.R., by email from Richardson, TX

A. The best comment I've seen on this issue came from Roger Lowenstein in the October issue of Smart Money. In it, he points out the absurdity of having both political parties spend so much time arguing over the estate tax, which affects only a small minority of Americans, when they should be dealing with issues like education and jobs, which affect all of us.

As long as your total estate is below the estate taxation threshold, marital deduction trusts are moot but not financially harmful. I suggest a consultative visit with your attorney to review your wills and estate.

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