Retirement Needs Analysis

Retirement needs analysis is the foundation of retirement planning—determining how much income a client will need in retirement and whether their accumulated resources can provide that income throughout their lifetime. For CFP exam purposes, you must understand both the calculation methods and the critical risks that can derail even well-funded retirement plans.

Two Primary Calculation Methods

The Replacement Ratio Method

The replacement ratio method estimates retirement income needs as a percentage of pre-retirement income. Research shows that financial planners and educators generally recommend targeting 70-80% of pre-retirement income, with mean and median recommendations of 74-75%.

Why less than 100%? Retirees typically no longer have:

• Payroll taxes (7.65% FICA)
• Retirement plan contributions (potentially 10-15% of income)
• Work-related expenses (commuting, clothing, meals)
• Mortgage payments (often paid off by retirement)

Example: A client earning $120,000 pre-retirement, using a 75% replacement ratio, would target $90,000 annual retirement income.

The Expense Method

The expense method (also called the budget method) calculates actual projected expenses rather than using a percentage. This approach:

1. Categorizes current expenses (housing, food, healthcare, transportation, entertainment)
2. Adjusts for expenses that will change in retirement
3. Adds retirement-specific expenses (travel, hobbies, increased healthcare)
4. Projects forward with inflation adjustments

The expense method is more accurate but requires detailed client data. It's particularly valuable for clients with unusual spending patterns or specific retirement goals.

Inflation Adjustment

Inflation erodes purchasing power over a 20-30 year retirement. A 3% annual inflation rate means purchasing power is cut in half in approximately 24 years.

Inflation-adjusted income planning typically uses either:

• Historical average inflation (approximately 3%)
• Expected future inflation based on Treasury Inflation-Protected Securities (TIPS) yields
• Conservative higher estimates for safety margin

Critical Retirement Risks

Longevity Risk

Longevity risk is the danger of outliving retirement resources. Key planning considerations:

• A 65-year-old couple has approximately a 50% chance that at least one spouse will live to age 90
• Planning horizons should extend to at least age 95 for individuals, potentially age 100 for couples
• Women face higher longevity risk due to longer average life expectancy

Sequence of Returns Risk

Sequence of returns risk (SORR) is the danger that poor investment returns early in retirement, combined with ongoing withdrawals, will significantly reduce portfolio value and limit recovery potential.

Research by Pfau (2013) estimates that 77% of final retirement outcome is explained by returns in the first 10 years of retirement. The first five years are considered the "danger zone."

Mitigation strategies include:

• The "bucket approach" with 1-2 years of expenses in cash
• Reducing equity allocation as retirement approaches (glide path)
• Dynamic withdrawal strategies that adjust spending based on portfolio performance
• Guaranteed income sources (Social Security, pensions, annuities)

Monte Carlo Simulation

Monte Carlo simulation runs thousands of different market scenarios against a retirement plan to determine the probability of success. Unlike simple linear projections, Monte Carlo accounts for:

• Variable investment returns
• Inflation uncertainty
• Different sequence-of-returns scenarios
• Spending pattern variations

Interpreting Monte Carlo results:

• 90%+ success probability: Conservative, high confidence
• 75-90% success probability: Reasonable safety margin
• Below 75%: May require plan adjustments

Monte Carlo should be revisited regularly as assumptions change and actual results unfold.

Capital Preservation vs. Capital Utilization

Capital Preservation Approach

The capital preservation (or capital retention) approach:

• Maintains the principal throughout retirement
• Lives only on investment income and growth
• Leaves assets to heirs
• Requires a larger nest egg
• Works well with very conservative withdrawal rates (3-3.5%)

Capital Utilization Approach

The capital utilization (or capital depletion) approach:

• Systematically spends down principal and earnings
• Plans to exhaust assets over the retirement period
• Allows higher withdrawal rates
• Requires accurate longevity estimation
• May use annuitization to manage longevity risk

Most retirement plans fall between these extremes, partially depleting principal while maintaining some legacy.

Safe Withdrawal Rates

The traditional 4% rule (Bengen, 1994) suggested withdrawing 4% in year one, then adjusting annually for inflation. Recent research has updated this guidance:

Flexible withdrawal strategies that adjust spending based on market performance can increase sustainable withdrawal rates to 5.7% or higher.

Healthcare Cost Planning

Healthcare represents one of the largest and most variable retirement expenses. Fidelity's 2025 Retiree Health Care Cost Estimate projects:

This estimate:

• Assumes Medicare coverage (not employer-provided retiree health insurance)
• Includes Medicare Part B premiums, Part D prescription drug costs, and out-of-pocket expenses
• Excludes long-term care costs

Long-term care can add $50,000-$100,000+ annually for nursing home or assisted living, making it a separate planning priority.

On the CFP Exam

Expect questions testing your ability to:

• Calculate retirement needs using both replacement ratio and expense methods
• Identify which risks (longevity, sequence of returns, inflation, healthcare) apply to specific scenarios
• Recommend appropriate withdrawal strategies based on client circumstances
• Interpret Monte Carlo probability results
• Distinguish between capital preservation and capital utilization approaches