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Assessing Retirement Income

You can use replacement ratio and actual-expense methods to assess retirement income.

By Donald Ray Haas, CLU, ChFC, CFP, MSFS

Most Americans do not want their living standards to decline after they stop working. Thus, determining what it will take to maintain your client’s standard of living is important in the financial-advising process and is greatly desired.

Replacement ratio and actual expense are two methods that can be used to determine a client’s retirement income needs in order for him to maintain his pre-retirement standard of living.

Replacement ratio method
Most people need between 68 percent and 90 percent of their pre-retirement income to maintain the same standard of living after retirement. The actual percentage depends upon the income they earned before they retired.

A word of caution: The longer the period prior to actual retirement, the more your answer to the question of what it will take to maintain pre-retirement standards might be affected by the following: taxation changes, inflation rate, living standards improved through technology and health care advances.

When to use actual expense method
As clients get closer to their retirement date, more precise income planning is necessary. As their financial advisor, you should switch from using replacement ratio to actual expense calculations. The latter requires the client to make estimates of expected dollar outlays for each expense category.

After retirement, it is important to recognize that certain work-related expenses will disappear or be greatly reduced. For example, expenses for items like clothing, transportation and household furnishings usually decrease while expenses for items like rent, vacation and travel and long-term care insurance usually increase. Therefore, it will be necessary to reallocate income to these expense categories. Also, recognize that living expenses are a personal matter.

The ravages of inflation
Inflation is important in calculating how much income will be needed.

Of course, it is unreasonable to assume that your client’s income requirements in the first year of retirement will remain constant throughout his lifetime. In my practice, I assume a 3 percent annual inflation rate for the first 10 years of a client’s retirement and use 3.5 percent thereafter.

In the future, these rates may need to be altered, but historical rates currently support my assumptions. For the past 75 years (1926-2000), the inflation rate was 3.1 percent, and for the past 20 years (1981-2000), the rate was 3.6 percent.

The difference between factoring in nothing for inflation and an average of a 3 percent or 3.5 percent rate is striking. Here is an example:

Avoid the common mistake of thinking that when your clients reach their golden years, their expenses will be drastically reduced.

While the amount of expenditures may change categories, the total income amount may continually increase. Consider the following: A 90-year-old who drives his car less frequently but may use a more expensive means of transportation, such as an airplane. Retirees eat at home less but dine out more. Many people in their 80s and 90s participate less in recreation and entertainment events, but increase their financial assistance to relatives and charities.

Medical expenses and insurance continue to increase at a higher rate than all other expenses. With the many anticipated changes in the future, the cost of personal health care will certainly continue to accelerate.

There does not seem to be an end to the effects of technological advances and improvements on our lifestyles. If a person is to continue enjoying a certain standard of living in the future, this will entail expenditures for all that technology has to offer. These include digital television, “smart” homes and electrical appliances and computerized phones and cars. What items we view as luxuries today will become standard necessities of tomorrow. If your client cannot afford to have these things, he will perceive his living standard as substandard.

Consider the so-called luxuries of the past that are now viewed as standard: inside plumbing, automatic washing machines, clothes dryers, private telephone lines, talking movies, television and personal computers.

Now that you know how to calculate your client’s retirement-income needs, you will also need to figure out where that money will come from, and how to properly balance income to expenses throughout the client’s lifetime.

In my next column, we will explore both. Until next time, make your calculations wisely. Be sure your clients have enough money for a long, productive lifetime. And what is most important, help your clients carefully plan so that they will have money forever.

Donald Ray Haas, CLU, ChFC, CFP, MSFS, of Southfield, Mich., has been an insurance agent and financial consultant for 45 years. He can be reached at 248-213-0101 or at


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