Crunching Numbers On Replacement Rates


Laurence Kotlikoff's latest post looks at replacements rates, the percentage of salary that people should seek to generate from Social Security, portfolio income, pensions, part time work or any other source once in retirement. The rule of thumb that is frequently thrown around is 70%; if you make $5000/mo you would presumably need $3500/mo when you retire. Kotlikoff says he is taking that idea to the woodshed but candidly, his post doesn't actually make sense. He cites a scenario he conducted through software he sells (unfortunately the driver for his posts at Seeking Alpha seem to be overly motivated by selling software, maybe it is a web subscription, I am not sure). The article is written like screen shots of the output are included but they are not. I read it several times and still am not quite following what he is saying exactly other than 70% is too simplistic (agreed) and that the personal finance industry is asking the wrong questions (maybe). He appears to be saying that the replacement rate might range from "68.2 percent to 134.4 percent." I put that in quotes because it is pasted from the article but it is not clear those are the actual numbers.

This is a fun topic to write about because because more than portfolio returns and Social Security dynamics, we are have a better chance of controlling spending and so if there is a problem we do have more control with spending to try to improve our situations.

It might be possible to debunk 70% of gross income in one sentence. What is your gross income, what is your net income, then subtract the mortgage you would hopefully have paid off when you retire and subtract however much you're savings and that might be what your replacement rate should be. The answer to that run on questions could be 40% of gross income. Granted not everyone will be lucky enough to have paid their mortgage before retiring.

The following is a breakdown of our fixed monthly expenses;

  • Mortgage 1350
  • Health Ins 801
  • Quest 320
  • APS 60
  • Internet 160
  • Directv 180
  • Groceries 600
  • gym 46
  • dog food 120
  • gas 300
  • Total 3937

The mortgage will be long gone by the time I hit my mid 60's (likely paid off in my mid 50's). With no mortgage payment but figuring property tax and homeowner's insurance I would add $200/mo back in (Arizona is a cheap place to live). This gets the monthly figure to $2787. There are two other big expenses that I pay all at once not monthly; car insurance and propane to heat our house. That would add another $300/mo so now where at $3087 in today's dollars. Our discretionary spending is probably around $1500/mo which does not include travel. There are small things left out like $15/mo for me for a haircut but the list captures the basics. I personally wouldn't try to budget the one-off expenses but the smaller ones are embedded in the $1500.

I said in a recent post that this exercise would take just a few minutes which is all this has taken. You can just as easily do the same with your numbers. There is no accounting for the unknowable because it is...unknowable. You can prepare for that to a certain extent by living below your means.

We might need $4500 month. That number will seem like a lot to some and like a tiny amount to others. Also we might need to replace our cars in 10-15 years (we try to keep cars as long as possible) and if we finance them then that could add significantly to our numbers, like maybe $1000/mo.

None of the above speaks to how much income we make now working. The above is the fixed lifestyle that we have and enjoy. You don't know whether we make $1 more than that or $20,000/mo more than that and it doesn't matter. If we don't have enough money for that total then something would have to give.

Hopefully you have some general idea like above of your financial footprint and then track how it changes over time. All aspects of long term financial planning are dynamic as personal needs (like needing a car) change, our health can change, there can be both good and bad things that happen to portfolios. Don't focus on a percentage of your income for planning, focus on how much you will actually need.