A couple asks, "Do we have enough?" You cannot answer without a retirement needs analysis, and getting it wrong by a small margin compounds into a six-figure shortfall over 30 years.
The replacement ratio method estimates retirement income as a percentage of pre-retirement gross income. Standard range: 70% to 80%. The logic, payroll taxes stop, retirement contributions stop, commuting costs vanish. These offsets typically cover healthcare increases.
HIGH-FREQUENCY: The replacement ratio is quick but treats all clients identically. A client who saves 30% of income may only need a 55% ratio. A client who spends everything may need 90%+. Higher earners generally need lower ratios.
The expense method builds a bottom-up retirement budget. Catalog every projected expense, housing, food, healthcare, travel, insurance. More precise because it reflects actual spending, not a generic percentage. The exam favors this method when detailed spending data is provided.
Capital preservation lives entirely off investment returns. Principal passes to heirs intact. If you need $80,000/year at a 4% real return: $80,000 / 0.04 = $2,000,000.
Common mistakes
- Confusing the 4% rule mechanics. Candidates often think 4% is withdrawn from the current balance each year. Wrong. 4% applies to the initial balance only. Subsequent years adjust that dollar amount for inflation. Year 1: $2,000,000 x 4% = $80,000. Year 2: $82,400, not 4% of the new balance.
- Mixing real and nominal returns. If income needs are in today's dollars, use the real return. If needs are in future dollars, use the nominal return. Mixing them (discounting today's-dollar needs at 7% nominal) dramatically understates the capital requirement. Trap: capital need roughly half the correct answer.
- Applying the replacement ratio without adjustment to high savers. A physician earning $500,000 who saves $150,000 and pays $70,000 in taxes spends $280,000. An 80% ratio produces $400,000, but actual need is $280,000. Trap: $10,000,000 ($400,000/0.04) instead of $7,000,000 ($280,000/0.04).
Bottom line
- Replacement ratio (70-80%) gives a quick estimate; the expense method builds a precise budget from actual spending. Use whichever the scenario provides.
- 4% rule withdraws 4% of the initial portfolio balance, then adjusts that dollar amount for inflation each year, never 4% of the current balance.
- Capital preservation keeps principal intact for heirs; capital liquidation spends it down and needs about 30% less starting capital.
- Monte Carlo simulation captures sequence-of-returns risk; 80-90% success is the comfort zone.
Exam shortcut
When a question gives an annual income need and asks for capital required, divide by 0.04 immediately. Need $173,000? Answer: $4,325,000. For Monte Carlo: below 75% = fix it, 80-90% = acceptable, above 95% = may be underspending. "4% of FIRST, then INFLATE", the anchor is the initial balance. Heirs = Preserve, No heirs = Liquidate. Inflation rule of 72: purchasing power halves in 72 / inflation rate years.
The full lesson (about 2,470 words, 16 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- F.44
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