You read almost every week that most Americans have little, or nothing saved for their ever-lengthening later years, yet they will likely live a long time in retirement — at least 20 years. That challenge is to have enough income to pay for our living expenses, including healthcare needs, as we age. As we work during what I call our Striving Stage years, we need to accumulate assets, pensions, 401(k) assets and employment-based benefits that can be used to generate income to pay our bills in later life. At the same time, we are engaged in this effort, technology and medical breakthroughs are lengthening our life expectancies.
We are seeing more and more people live to age 100. We are pushing back what is considered old age to later and later years. Today’s 65-year-old is yesterday’s 50-year-old. Fundamentally, we are healthier today and have less chronic health-related issues than prior generations. The key issue that arises is how are we going to have cash available to pay our living expenses for these longer lifetimes? Let’s take a brief look at how we accumulate assets and benefits for later life.
The Three-Legged Stool of Savings for the Fulfilling-Stage Savings
In the FinancialVerse, you need to accumulate savings and income benefits to generate the income you will need in the Fulfilling Stage or later years of your financial life. Remember, once you stop working, you will likely be in this Fulfilling Stage for 20 to 30 years. For younger adults, I believe 30 years should be your planning horizon.
You will accumulate these savings and benefits from three major sources: government programs (e.g., Social Security Retirement benefits), employer programs such as 401(k) plans and defined benefit pension plans, and private savings (including bank accounts, annuities and cash-value life insurance). Many licensed financial professionals refer to these programs as the three-legged stool of retirement savings.
For many people, this stool is a little wobbly as not all the legs are of the same strength. For example, they may not have accumulated any employer related retirement benefits, or the amount of their non-retirement savings may be very low. The ideal situation is to have income available to you from each leg to fund your living expenses.
The Income Replacement Ratio
The key question people must answer is how much of their income they should plan on replacing for the later years of life. Financial professionals look at this issue by calculating an income replacement ratio. The concept is how much income does an individual need to replace to pay for their living expenses in retirement.
This ratio is a person’s gross income after they stop working divided by his or her gross income before this event. For example, assume someone currently earns $60,000 per year from their job. Further, let’s assume he or she stops working and receives $30,000 of Social Security and other income from their 401(k) plan and earnings from personal savings. This person’s replacement ratio is 50% ($30,000/$60,000).
Typically, a person usually needs less gross income after they stop working due to several factors:
Income taxes go down in your later years as earnings drop for most people.
Social Security taxes (FICA deductions from wages) end completely.
Social Security benefits are partially or fully free of federal and state income taxes. This reduces taxable income and, therefore, the amount of income needed to pay taxes.
Other forms of retirement income, like pensions, are often fully or partially exempt from taxation by certain states.
Saving for retirement is no longer needed.
The above savings items are offset by expenses that increase in our later years, such as health-related costs and related insurance premiums.
For all the reasons listed above, conventional wisdom has it that most people will need between 60% to 100% replacement ratio to maintain their standard of living. People with lower incomes will likely need to replace a higher percentage of their income than a high wage earner. There is debate in the financial planning community about what percentage to use. For those with lower incomes the ratio can be as high as 100%, while those at very high-income levels may need only 40% of their prior incomes.
The financial challenge that arises is matching the level of replacement income you will generate to your living expenses. Many older individuals are finding that their replacement ratio income does not cover their living expenses such that they must sometimes make dramatic changes to their lifestyles.
As people begin to look at their post-work situations, they begin to focus on finding ways to maximize sources of replacement income: Social Security, pensions, and retirement savings (401k, IRA, 403b, 457, etc.). They then realize that they are coming up short and will not achieve the replacement ratio they need to maintain their standard of living. In essence, many people find they cannot stop working as planned or they will need to adapt to a different lifestyle and/or standard of living.
Summary
Americans planning for retirement face a significant income challenge. They must accumulate assets and benefits that are able to pay living expenses for the years they won’t be working. Individuals must generate enough income to keep your standard of living at an acceptable level to pay for the activities they want to participate in in your later years. This challenge takes planning and the benefits of time to address.
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