How Much Will Retirement Cost? The WSJ May be Wrong

One of my favorite writers and thinkers is a behavioral economist named Dan Ariely. I heard him speak at a conference years ago, read his first book Predictably Irrational and am about half way through his most recent book, Dollars and Sense.

It may be a little hard to tell from the photo, but if you look closely, you can see that his face is disfigured from a third-degree burn that covered 70 percent of his body.

During his recovery, nurses would have to change his bandages regularly, and, unfortunately, it was a terribly painful process.  He wanted to know whether it hurt more to take the bandages off slowly or quickly, and was told that it was better to take them off quickly.It may be a little hard to tell from the photo, but if you look closely, you can see that his face is disfigured from a third-degree burn that covered 70 percent of his body.

He discovered in his research as a psychologist that people prefer a longer period of less intense pain than a shorter period of more intense pain – the opposite of what the nurses told him. He wondered why the nurses, who dedicated their lives to helping people like himself, could be systematically wrong in their treatment plan.

Ever since then, he’s focused his research on the irrational decisions that people make systematically.  He’s found, perhaps not surprisingly, that money is an area where people systematically make irrational decisions.

Last week, Ariely co-authored a piece in the Wall Street Journal titled: How Much Money Will You Really Spend in Retirement?  Probably a Lot More Than You Think. You can find the article here, although a subscription may be required.

As a big-time fan of Ariely, and someone who thinks a lot about retirement spending and its implications, I was very excited to read the article.  I wondered what irrational behavior I might be making as an advisor and how I could better serve clients.

Unfortunately, Ariely centers his article on the old rule of thumb that supposes that you need 70-80 percent of the salary that you earn in working years as income in retirement.

Although we really don’t use that particular rule of thumb, it isn’t terrible. The basic idea is that your basic spending rate probably won’t change much, but some of your expenses will go away.  You probably won’t have a mortgage, you don’t need to save for retirement anymore and you don’t have work related expenses like parking and dry cleaning.

Most notably, you won’t have income taxes, which, in the basic rule of them, probably amount to 20 percent of your income.  That’s where we stepped out of the tent, since most of our clients are in a much higher tax bracket.

Instead of assuming a replacement rate, this kind of thought process is sensible and we refer to it as the top-down approach.  When we ask about retirement spending expectations, we often start with someone’s salary and subtract the expenses listed above.

The bottom-up approach is better, but not many people seem to do it. This method relies on people to track their own expenses and add up the things that they want to continue to do and let that serve as an estimate.

What you spend in retirement is critically important.  For retired people, it’s the most important factor in whether their financial plan will work successfully.  If you’re not yet retired, it’s the second most important factor, behind when you retire, which ends contributions to your savings and starts the distribution from your savings.

Ariely is right to focus on this, but I also think this is where he goes astray in his suggestion that retirement is likely to cost a lot more than you think.

He does one study where he asks people what percentage of their income they will need, and, not surprisingly, they rely on the old rule of thumb and say 70-80 percent.

Then, he does a second study where he lists all of the things that people expect to spend money on in retirement.  Apparently, he didn’t tell them how much things cost and says, ‘we attached reasonable numbers to their preferences.’

When people were presented a menu of things that they ‘need,’ but don’t know what they cost, the respondents went for it and what they wanted turned out to be 130 percent of their salary.

Ariely draws the conclusion that people are drastically underestimating how much they will need in retirement.  I’m not so sure.  I think if the study were done differently (or, at least, my understanding of the study), and people know how much everything cost, they would reset their needs.

In general, in the 15+ years that I’ve been doing this, most people have a pretty reasonable sense for their spending and how it will change. Chris and I happened to talk about the article and he agreed, saying that he thought Ariely was off.

We’ve definitely counseled people to cut their spending, but most people knew that they needed to do it without us saying anything (you don’t need to tell me not to have that cheeseburger).

Ultimately, Ariely recommends that people spend some time thinking about their expenses and offers a spreadsheet to help guide you.  That’s good advice, although I wish he hadn’t gone for the click-bait headline or given people the idea that 130 percent is the new rule of thumb.

That said, I’m still a big fan of Ariely’s.  I’ll finish the book I’m reading and I discovered while writing this article that he has an app on iTunes.  It looks like it has a lot of interesting videos, games and articles. The rational question will be whether it’s worth the price or just another systematic way to waste money.