The single most vexing question today concerning retirement is, how much money will I need? It is vexing because there is no simple answer. The amount any one individual will require is determined by a host of factors, including that most unknowable of all: how long that person will live. Interest rates prevailing at the time of retirement – a date that can be decades into the future – is another deciding factor.
Given such uncertainties, approaches to retirement planning now shun the concept of a specific “amount.” Instead, the focus is on creating an income stream sufficient to maintain the individual’s lifestyle in retirement, but again the question arises: how much should this target income be?
Several factors influence this, not least social security. Public pension income is the first building block in real retirement income replacement. Today, U.S. social security provides 35% of retirees’ income, but this varies dramatically from country to country. Other considerations include the availability of a defined benefit (DB) plan, the worker’s salary, home ownership, the tenure of employment and assumed retirement age.
Retiree medical cost coverage is also a significant factor. While workers outside the U.S. are far more likely to have retiree medical coverage via the government, only a small percentage of U.S. private employers cover retiree medical costs and this number continues to decline.
Given that the majority of employees in the United States lack both a DB and a retiree medical plan, what is the total replacement rate of the final salary that the median American worker should aim for? Experts consulted in the DC Consulting Support and Trends Survey (2016) on average suggested 80%, which means 40–45% needs to come from other sources such as savings, DB plans or housing.
CALCULATING INCOME REPLACEMENT RATES
Would a 65-year-old who has $400,000 in defined contribution (DC) assets have enough to deliver an adequate income in retirement? One way to answer this is to look at the income that could be delivered by an annuity. Based on average annuity quotes between March 2013 and December 2015, the employee would have received an annuity payout equal to a 6.5% to 7.2% return, providing an annual income of $25,899 to $28,665 a year. If we assume final pay was $75,000, the income replacement would be 35% to 38%, depending on the year of retirement.
But what if the employee wanted to actually purchase an annuity in which the payout is adjusted annually consistent with the Consumer Price Index? Over the period, real annuity quotes averaged 72% of the nominal payout. This would have delivered $17,885 to $20,501 a year, or 4.5% to 5.1% annually, in real terms. The real income replacement rate would then equal 24% to 27% of final salary.