Is it possible to put a
price-tag on early retirement? Sometimes. Defined-benefit plans regularly reduce benefits for those who want to leave work before reaching their magic number. And most clients realize CPP benefits will be reduced if they tap into them prior to age 65.

But what if you could tell those clients how much their standard of living would shrink if they move up their retirement dates?

Earlier this year, to test some financial planning software he had developed, Boston University professor Laurence J. Kotlikoff asked a group of fellow economists to estimate the price of one extra year of retirement for a 50-year-old who was thinking of retiring at age 61 instead of 62. He wanted to know how much a family with an annual income of $100,000 could spend now if members wanted to maintain the same standard of living down the road. Then he asked how the family budget might change if the breadwinner retired a year earlier.

Using his software, Kotlikoff determined the family could spend roughly $78,000 in the current year if the client retired at 62 and 3.2% less if he or she retired at 61. The economists, who worked only with pen and paper, were all over the map. Their spending recommendations for the current year ranged from $40,000 to $135,000, with a median response of $60,000 — which was at least 23% too low, Kotlikoff maintains. Their estimates for the ongoing reduction in the living standard ranged from 1.3% to 12.5%, with a median reduction of 5% — again inaccurate, according to Kotlikoff’s findings.

Kotlikoff’s calculations are based on the life-cycle consumption model formulated by Nobel Prize winner Franco Modigliani. According to this model, people typically have relatively low earnings in the early part of their lives, reach their peak in middle age, then see earnings drop in retirement. It further assumes most people would prefer to smooth their levels of consumption by using credit to spend more than they earn when young, saving more in middle age, then drawing down savings in retirement.

Smoother is better, according to Modigliani, as the really good times never quite make up for really bad times. It’s an appealing notion in the real world, too, as most people would prefer to be told how much they can spend rather than how much they have to save.

So, how can clients calculate how much to trim from their regular spending to be secure in retirement? Not too easily. The short list of interconnected factors includes household demographics, earnings, taxes, housing, mortgages, economies of shared living, medical expenses, retirement accounts and estate plans — to say nothing of unforeseen events.

And clients have to keep a close eye on both private pensions and government benefits. Most people plan for an unrealistically short retirement, forgetting how long they might live. If they retire early, the duration of retirement is magnified even further. Having a year’s less earnings can reduce retirement and survivor benefits, depending on past earnings and service. And there’s the RRSP. Working one year less means fewer contributions, lowering future withdrawals.

Kotlikoff claims financial planning exercises centred on saving to replace some percentage of income at retirement don’t jibe with this notion of “consumption smoothing.” And this all stems from the fact that the financial services industry has always focused on accumulation. By locking in savings targets, spending becomes the swing factor, rising and falling erratically as income and expenses vary. But it really has to be the other way around, he maintains.

Does it really matter? Probably. Without an accurate price placed on the timing of their retirement, most people have trouble making sound economic decisions, Kotlikoff argues. Provided with the correct data, some people — thinking the price might be a significant drop in their current standard of living — would choose to work another year. Others, recognizing the price of the extra year might be merely a 3% drop, would gladly take the additional year away from the yoke.

The issue is not only about costs and benefits of retiring early. It’s about lifetime consumption and this smoothing process, Kotlikoff claims. It means reaching retire-ment needs by adjusting the amount saved over time, based on changing realities of a client’s life.

@page_break@Advisors need to spend more time helping clients develop a reasonable benchmark to make major life decisions and less time admonishing them simply to save and then save some more, he says. IE