The N Factor
September 12, 2008 – 5:51 amScott Burns wrote a wonderful article titled “The’N’ Factor For Retirement Planning” that has some very interesting points. The article proposes that a family’s consumption rate is approximately the square root of the number of people in the household. Don’t freak out on me you math-phobes, square roots aren’t that hard.
For example, a single person’s spending is sqrt(1) = 1. For two people it’s sqrt(2) = 1.4. So two people can live less expensively together than apart (shared rent, utilities), but they cannot live as inexpensively as a single person. Make sense? Another way of saying it is that it is 40% more expensive for two people to live together than for one person to live by themselves.
When kids enter the picture the rule still holds. Two kids + two adults will spend sqrt(4) = 2, or double that of a single person. [If you spoil them rotten you'll spend more. 
]
Based on this premise, Scott makes the argument that you may not need to replace the “70 to 80% ” of your current income that most financial planners recommend. I’ve done quite a bit of research on this topic for my own families’ finances, and I tend to agree that the 80% rule is not appropriate for everyone.
My view of the situation puts people into two basic groups:
Group 1 includes people who spend everything they earn. They have the ability to save, but they don’t make the effort or have the discipline to do so. Clearly some people cannot save given a low income or other financial burdens that they are addressing. I’m not talking about people who are buried in debt and are in the process of digging themselves out. I’m referring to people who buy what they want without consideration or planning for the future. I’m sure if you’re not in this position now you were at some point (like the rest of us!)
The 80% rule applies to group one, potentially, if they pay off their debt or currently have kids in college. Costs should go down a bit once you stop working, provided you don’t start any other activities that eat up those savings. If you had a country club membership during your working years, those costs are already in your financial baseline and therefore would not necessarily increase when you retire. If you joined a country club after you retired then clearly these costs would be incremental and might overshadow any gas or clothing cost savings from your working years.
Assuming group one gets out of debt before they retire (and a lot of people can’t or don’t), it’s conceivable to believe that the cost of running their household would be less than 100% of their pre-retirement income.
Group 2 includes people who live below their means, and sometimes well below their means. The 80% rule is meaningless to those in group 2, because it’s their EXPENSES rather than their INCOME that is most relevant. After all, your total cost of living = your total expenses, not your total income. If someone lives on 80% of their income now and is paying off debt, why would they need 80% of their INCOME at retirement? If their debt load was 20% of their income then they would only need 80%-20% = 60% of their income without even reducing their expenses.
Scott makes a solid case that you may only need ~40% of your preretirement income if you currently:
- carry some debt (25%)
- have more people in your household now than you will at retirement (kids, parents, etc)
If you’re married and social security still exists he further argues that social security (with 2 social security checks) may pay 35% or more of your pre-retirement income. Wouldn’t that be great, having to only save enough to earn 5% or a bit more of your pre-retirement income!
Scott’s argument is completely reasonable and well articulated. If you are single or don’t have kids your best bet is still to live on less than you earn (obviously) and then use your expenses to estimate the income you will require in retirement. Then try to keep the cost of kids down when the arrive!
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