Determining the Cost of Retiring Early

By Elaine Floyd, CFP
Aug. 31, 2006

Tracking pre-retirees' standard of living or consumption—rather than monitoring their savings—may be the best gauge of how much clients will need in retirement.
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Is it possible to put a price tag on early retirement? If it were, you could tell clients how much it would cost them in terms of their ongoing living standard for each year they hope to move up their retirement date. Then they could decide, as they do for any other cost/benefit decisions, if the value of retiring early is worth the price they will pay in lifestyle reduction.

Although the theory is simple, the mechanics of determining the price of early retirement is anything but simple (see "Financial Advisers Miss Mark by Ignoring Dynamic Method.") Economist Laurence J. Kotlikoff asked a group of economists to estimate the price of one year of retirement for a hypothetical 50-year-old with a six-figure income who was thinking of retiring at age 61 instead of 62. First he asked how much the hypothetical family could spend this year (with the client at age 50) if they wanted to have the same living standard per person over time. Second, he asked how this spending amount should change if the client retired at age 61 instead of at age 62.

Using ESPlanner, software that he developed, Kotlikoff determined that the couple could spend $78,186 this year if the client retires at 62 and 3.2% less if she retires at 61. The economists, who were given only pencil and paper, turned in a wide range of guesses. Their recommended spending for this year ranged from $40,000 to $135,000 with a median response of $60,000. They estimated a reduction of 1.3% to 12.5% if the client retires one year early.

One purpose of the exercise was to show that accurate planning hinges on a wide range of data inputs and is not possible to do without sophisticated software. Being off with estimated projections by just 10%, because the figures apply to all the potential years of retirement and survivorship, can lead to huge mistakes in saving and insurance recommendations. Inaccurate assumptions can also lead to major disruptions—on the order of 30%—in living standards when a client retires. You have to wonder whether any software can pinpoint assumptions over a person's lifetime when tax rates, Social Security projections, and so many other factors are subject to change. But Kotlikoff does have a unique approach to retirement planning, and it may be worth exploring.
Focusing on consumption

Fundamental to Kotlikoff's formula is the idea of consumption smoothing, or the attempt by families to maintain the same standard of living throughout their lives. The overarching goal of retirement planning is to calculate clients' "sustainable lifetime standard of living." This means figuring out how much they can spend now in order to be able to maintain this same standard of living throughout retirement. Notice that the question is posed in terms of how much they can spend, not how much they must save—although one does, of course, follow the other.

Intuitively, we know that clients who live it up now may be forced to reduce their standard of living in retirement. We assume this is because they are not saving enough. But Kotlikoff would call it simply an unsustainable standard of living. He would recommend that the client's lifestyle be reduced to a point where it could be sustained throughout retirement. Based on a number of inputs relating to current income, state and federal tax rates, age, planning period (e.g., to age 95), and so on, his software would kick out the amount the client can spend now for a sustainable standard of living. Then, if the client wanted to know how the amount would change if he retired early, the software would calculate it in seconds. The client could then decide if he could live on that lower amount or if he'd rather work a few years longer in order to enjoy a higher standard of living throughout his lifetime.
Setting retirement saving goals

Kotlikoff claims that traditional financial planning methods, which focus on the establishment of an asset target designed to replace some percentage of income at retirement, are inconsistent with the standard economic doctrine of consumption smoothing. Traditional financial planning causes a smoothing in saving, not consumption, and so a household's living standard potentially can fluctuate wildly from year to year.

He says that in order to establish goals that are consistent with consumption smoothing, households need to consider a wide range of factors, including:

• Current and future household composition
• The age and likely lifespan of each spouse
• Current and future labor earnings
• Special expenditures and receipts
• Social Security benefits
• Current net worth
• Income from taxable and non-taxable assets
• Current and future contributions to retirement accounts
• Current and future federal and state taxes
• Asset returns
• Current housing and future housing plans
• Borrowing constraints.

Each of these factors interacts with others, and none can be evaluated appropriately in isolation.

See the table below for an example of consumption smoothing for a hypothetical couple named Al and Peg. Notice how consumption remains relatively level, changing only when family members leave the household. Consumption goes down when the children go off to college (college costs are calculated separately and are not part of the consumption figure) and when Al dies, in both instances reflecting the fact that there are fewer mouths to feed.

Saving, on the other hand, varies significantly from year to year. It is low to negative when the children are in college, jumps up after the children leave the nest, and turns negative again after Al and Peg retire. See Kotlikoff's paper for a more complete explanation of the couple's income, assets, and special expenditures that are not figured into the consumption figure, such as housing and taxes.
Consumption Smoothing for a Hypothetical Couple
Year Al's age Peg's age Non tax-favored saving Consumption
2000 50 45 1,751 58,018
2001 51 46 2,395 58,018
2002 52 47 2,591 58,018
2003 53 48 3,208 58,018)
2004 54 49 (18,153) 49,622
2005 55 50 (17,775) (20,162)
2010 60 55 21,981 40,486
2015 65 60 21,138 44,534
2020 70 65 (107,898) 44,534
2025 75 70 (11,297) 44,534
2030 80 75 (11,804) 44,534
2035 85 80 (12,334) 44,534
2040 90 85 (12,863) 44,534
2045 95 90 (18,441) 44,534
2050 13.55 95 (20,162) 27,834
Source: Setting Retirement Savings Goals, Bernheim, Forni, Gokhale, and Kotlikoff
What price early retirement?

Kotlikoff and his economist friends demonstrated that it is not possible to calculate the price of one year of retirement without sophisticated software and accurate data inputs. Even then, the answer depends on the client following through with the plan. If the software says that in order to retire one year earlier the client must reduce her annual consumption by 3.2% this year and maintain that lower standard of living for the rest of her life, she must be prepared to do that or to accept that the plan will fail.

It is worth noting that Kotlikoff's software does allow the client to plan for changes in consumption amounts in the future. For example, if the client wants to travel during the first few years of retirement, she can specify a 10% higher spending amount during those years, and the program will adjust current spending accordingly.

You can decide for yourself if Kotlikoff's method is superior to the traditional financial planning method of targeting an asset amount based on the desired income replacement ratio. Kotlikoff's emphasis on consumption may be more appealing to clients—wouldn't most people prefer to be told how much they can spend rather than how much they must save? But his method may be more cumbersome to apply because of the vast number of inputs required.

And therein lies one of the hazards built into all retirement planning, Kotlikoff's included: if your inputs are off by even a little bit, or if the assumptions for inflation, rate of return, tax rates, Social Security, or other factors turn out to be wrong, the whole plan goes down the tubes. Computers can crunch the numbers, but to ensure that the plan stays on track, there are no substitutes for human judgment, annual monitoring, and frequent adjustments in assumptions.