Consider these retirement risks

Your Money

October 15, 2006|By Humberto Cruz | Humberto Cruz,Tribune Media Services

The conventional wisdom that you can have a comfortable retirement with 75 percent to 85 percent of your pre-retirement income has been exposed for what it is.

It is an overgeneralization that may work for some but can leave other retirees woefully short of cash, if not broke, in old age.

"For many individuals, that is far from the case, unless they are willing to accept a 50 percent chance that they will run out of money," said Jack VanDerhei, a Temple University professor and research director of the Employee Benefit Research Institute Fellows Program.

A study by VanDerhei pokes holes in such "overly simplistic and potentially inaccurate" rule-of-thumb formulas.

"Given the huge variation of individual circumstances, a simple one-size-fits-all replacement rate will not work for most Americans," the study said.

I'll give you an example. Say you made $60,000 a year before retirement, and between your savings, a pension and Social Security benefits you can generate $51,000 in income the year you retire, which is 85 percent of $60,000.

Are you all set? Don't be so sure. Relying solely on such a replacement-rate formula will ignore what VanDerhei calls the most important financial risks retirees face.

Those risks include:

Investment risk, or the risk that the investments you rely on for your spending money won't perform as you expect.

Longevity risk, or the risk that you will live longer than expected, so your money will have to last longer and keep up with inflation longer.

The risk of catastrophic costs for health care.

Once these risks are factored in, the study in many cases finds "the sobering [if not staggering] amounts of money needed to provide a reasonably high chance of being able to afford retirement."

For example, a single man retiring at age 65 who made less than $15,000 a year may need to nearly quadruple his pre-retirement income for a 90 percent chance of making it in retirement. An earner who made more than $40,450 a year may need 1.28 times as much.

Before you get too depressed, let me suggest what I consider the most reliable way to estimate income needs in retirement, and the only one I use.

Rather than rely on a single annual figure, break down anticipated retirement expenditures by category, taking inflation into account and allowing for emergencies. Some expenses may go down, such as for driving to and from work and lunches out. Others may go up, such as travel, hobbies and health care.

Rules of thumb to the contrary, my wife, Georgina, and I are spending far more in semi-retirement than we ever did, much of it on travel and fun things. But we know in a pinch we could cut out the nonessentials. And we understand our spending plan is only a best-estimate projection subject to all the above risks.

How to mitigate those risks? Using some of our retirement savings to buy an immediate annuity that pays an income for life can guard against longevity risk and reduce the overall amount of money we need, but at the cost of liquidity and giving up access to principal.

Without such a guarantee of lifetime income, we could invest our money so we can reasonably expect it to last as long as we live. But if our plan is based on average life expectancies (82 years for men and 85 years for women now age 65) there is, by definition, about a 50 percent chance of living longer and risking running out of money.

We also can increase the odds of success by a proper asset allocation, including putting money in stocks (but at the cost of increased volatility and short-term risk of loss).

VanDerhei's study, accessible online at as the institute's issue brief on "Measuring Retirement Income Adequacy," includes tables with different annuitization rates and asset allocation models.

Again, no one formula will work for everyone.

"It absolutely does depend on your situation," including financial condition and risk tolerance, VanDerhei said.

He said the institute plans to roll out a free online tool next year at that will improve upon the current "Ballpark Estimate" for retirement savings.

The improved tool will allow users to estimate their retirement income and savings needs, and the odds of success, by entering their sex, age, percentage of retirement savings to be annuitized, asset allocation, pre-retirement income and initial Social Security or other defined benefits.

Humberto Cruz writes for Tribune Media Services.

Baltimore Sun Articles
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.