Many retirement savers may be dumping too much cash into their pension plans because the calculations underlying their strategy are overestimating their needs.
Financial advisers feed data into complicated algorithms to predict how much individuals need to save for their later years.
But a study by David Blanchett, head of retirement research at the US firm Morningstar Investment Management says conventional wisdom may be flawed and savers are putting too much money aside in their pensions.
Blanchett explains in his paper Estimating the True Cost of Retirement that three key calculations – the replacement rate, a constant real consumption level, and fixed retirement period – are inflexible and can lead to wrong results.
The three calculations are the basis of working out retirement savings plans but, argues Blanchett, their end results sit at odds with analysis and government data based on the true cost of retirement.
Replacement rate
He points out the replacement rate – the percentage of retirement income needed compared to income while working – is generally set at 70% to 80% of final earnings, but this is coupled to a 30-year pension saving term rather than linked to life expectancy.
The longevity option often shows pensioners need 20% less income than the replacement rate suggests.
Blanchett’s analysis also revealed applying a one-size-fits-all calculation to all retirement savers does not give the right results because in real life, spending does not rise or fall according to an algorithm based on inflation or health care, but depends on household specific expenditure.
“Retirement spending depends on money coming in and how people spend it,” said Blanchett. “In a lot of cases the figure is individualised and not easily predicted by the calculations financial advisers use by default.”
Saving and spending goals
The study explains that people tend to earn less when they are younger and more before they retire, so smoothing out the replacement rate over someone’s expected life is a better way to predict the income they need in retirement rather than picking a 30-year working period.
“This can have unforeseen implications of saving and spending goals,” he said. “A college educated saver will make around 50% higher wages at retirement than they did when aged 25. So, if a financial advisor basis the retirement replacement calculation based on their income at aged 30, it’s likely the retirement income needed will be understated.
“But waiting another five years, when wages are higher may be the best time to start saving.”
