Taking Care of Mom and Dad: Spending Patterns and Locations

In the late 1990s and early 2000s, hundreds of thousands of Americans took some form of early retirement and headed to Florida, Nevada and other low-tax states for a long life of leisure. The booming U.S. stock market had pressed the retirement accounts of many people earning $30,000 to $60,000 a year into the $500,000 range. Real estate prices in most regions had held up nicely, further increasing paper net worth.

Armies of part-time financial planners had positioned middle-class people to profit from the flush markets...and many decided it was time to take the money and run.

Within three years -- by early 2003 -- the stock markets had lost many of the gains they'd earned in the 1990s. And interest rates were so low that they kept the money earned on bonds and government securities down. Many early retirees who'd left money in the stock market (even through mutual funds) had lost as much as a third...or even half...of their savings.

To many financial advisers, the late 1990s and early 2000s looked like the 14-year decline in the stock market following 1968. Many workers who retired in 1968 -- and withdrew 5 percent of their retirement portfolio annually -- ran out of money within about 12 to 15 years. This is the main argument against the 4 to 5 percent rule.

How can you make sure your parents avoid the problem?

Divide up your parents' expenses into two groups: essentials (food, clothing, housing, medical costs and the like) and discretionary (leisure travel, entertainment, gifts and charitable donations). Then ask: Can they cover the essentials with income from fixed lifetime sources like Social Security, corporate pensions and annuities? Then, do they have any money left for discretionary items?

The main retirement expense reductions come from lower taxes and savings needs -- and, sometimes, housing. The savings reduction comes from not having to put money away for college...or retirement. Most other expenses remain as they were during working years. And other costs -- think medical costs and prescription drugs -- will increase for your parents when they retire.

According to a March 2001 study, published by Chicago-based human resources consultants Aon Consulting and Georgia State University, a one-earner family of a retired worker aged 65 and a spouse aged 62 and a pre-retirement income of $50,000, overall spending declines only $603 a year in retirement.

The study used data from the Bureau of Labor Statistics' consumer expenditure survey, which had data on some 5,000 working singles and families and more than 3,000 retirees. It calculated what it called the "replacement ratio" needed to maintain a pre-retirement standard of living at various income levels.

Among the study's other findings:

• Post-retirement spending was rising, so the replacement ratio at most income levels was rising. In 1997, a couple with pre-retirement income of $60,000 could maintain their standard of living on 67 percent of that amount. The 2001 study put the level at 75 percent.
• Saving by active workers as a percentage of income was declining. In the 1997 study, a couple aged 50 to 64 and earning $60,000 was saving an average of 5.1 percent of income. In 2001, they were saving 4.2 percent.
• Taxation of Social Security benefits -- or lack of it -- played a key role in how retirees fared.

The study assumed that retirees would receive the normal Social Security benefits specified by law and that the remainder of their income would come from taxable sources. Social Security benefits for low-income people generally are not subject to federal income taxes. Only after certain thresholds are passed does 50 to 85 percent of the benefit become subject to tax.

As a result, middle-income retirees generally see their taxes drop drastically as payroll taxes end and a big chunk of their remaining income becomes exempt from income tax.

In the early 1990s, a new law boosted taxation of Social Security benefits for higher-income retirees, and it added 3 to 5 percentage points to the replacement ratio of people in the $70,000 to $90,000 income range. So, low-income and high-income workers need more retirement income relative to pre-retirement income than do those in the middle.

Taxes (or the end of them) cause this inverted bell curve. Lower-income workers pay lower taxes, so when they stop having to pay them, their expenses don't fall all that much. High-income workers pay a lot of tax but also have higher incomes in retirement. These higher incomes mean they are in higher tax brackets, but they also result in more of their Social Security benefits being subject to tax.

A one-earner couple with pre-retirement income of $20,000 a year would need 83 percent of that income to maintain their standard of living in retirement. Likewise, a couple with pre-retirement income of $150,000 would need 85 percent of that amount to maintain their standard of living and a $250,000 couple would need 87 percent.

Marital status plays a significant role. For example, in the lowest income levels, pre-retirement taxes are higher for singles than for married couples, so when taxes cease, there's a bigger impact on singles and the replacement ratio is less than for a couple.

Singles at higher incomes face much higher taxes in retirement than couples. For them, the thresholds for taxation of Social Security benefits are lower and the income tax brackets rise more rapidly than for a couple.

At higher incomes, replacement ratios are generally lower for two-earner couples than for one-earner couples, both because their Social Security benefits are greater and because there have been two payroll taxes on both incomes.