The primary focus of this website is helping retirees develop a reasonable spending budget in retirement. However, the Actuarial Approach can also be used by individuals who are close to retirement (and by their financial advisors) to see whether they are financially ready to retire. This is done by comparing the spending budget developed by the Actuarial Approach with desired levels of spending in retirement. I last discussed this process in our post of November 19, 2014 and why I thought a savings target of eight to ten times salary was a better target than four to six times pay in our post of May 24, 2014.
Last December, Fidelity released revised recommendations for how much savings you should have at age 67 in addition to your Social Security benefit in order to be able to retire and maintain your pre-retirement standard of living. In the past, they had recommended accumulating 8X gross pay for this purpose. In their most recent study, they increased this target to 10X salary.
Some experts believe that the Fidelity estimates are way too high for most people. For example, in a recent article, Frederick Vettese, an actuary, argues that both Fidelity’s 10X salary savings target and the 70%-80% income replacement target rule of thumb are “unrealistically high and clearly wrong for a majority of savers.” So, let’s take a look at some numbers and you can decide for yourself.
Let’s assume Rita is single, age 67 and considering retirement. Her annual salary is $60,000 and her accumulated savings is $600,000 (note we are assuming that this figure may or may not include the equity in her home that she could pull out if she chose to downside or rent). Thus, her accumulated savings is ten times her annual salary. We will also assume that her Social Security Normal Retirement Age is age 67, her annual benefit is $22,800 and she has no other sources of retirement income. She also has no bequest motive.
Rita and Rita’s financial advisor go to the Actuarial Budget Calculator V 1.1 spreadsheet and, using recommended assumptions, they determine Rita’s total assets to be $1,097,821 ($600,000 plus the present value of her Social Security benefit of $497,821). This amount is the present value of her future spending budgets. They estimate that her long-term care costs for the final three years of her life will be $180,000 in today’s dollars, but since her other expenses will be reduced for this three-year period, she will reserve for only 60% of this cost and because she believes these costs will increase by 3.5% (inflation + 1%) in the future, she determines the current reserve (present value) for LTC costs to be $85,000. She also establishes a reserve for unexpected future expenses equal to $50,000.
Rita’s current medical expenses are about $7,000 per year. She assumes that these expenses will increase by 4.5% (inflation + 2% per year) and develops a budget for future essential medical expenses (present value) of $196,000 based on her expected retirement period of 28 years. This leaves Rita with $766,821 ($1,097,821 - $85,000 -$50,000 -$196,000) as the present value of her future non-health and non-essential expenses (including taxes). If she wants this portion of her budget to increase with inflation each year, her initial year’s budget for this item will be $35,120 and her total spending budget for her first year of retirement will be $42,120 ($35,120 + $7,000 in medical expenses). This amount represents about 70% of her gross $60,000 salary.
If she retires, she will no longer have to pay 7.65% of her salary in FICA taxes. She will also no longer have to save for her retirement and she will no longer have work-related expenses. If we assume that she was contributing 15% of her salary to her 401(k) plan and her work-related expenses were about 10% of her salary, then her comparable post-retirement standard of living would be about $40,400 (and that assumes that she would not increase her spending for other items such as traveling or entertainment).
Bottom Line: In my opinion, a savings target of 10X salary and a 70% replacement target is not outrageously high for the majority of savers. Why? 1) the numbers above don’t indicate that this example retiree will be living a profligate lifestyle if she retires at age 67 with accumulated savings of 10X salary, 2) we are facing potential 25% benefit reductions in Social Security down the road and 3) there is a real possibility that individuals younger than 67 won’t be able remain employed until age 67. Yes, a 10X pay savings target is a tough target to achieve, but just because it is tough to achieve doesn’t mean it isn’t a reasonable target.