When planning for retirement, you need to make a lot of assumptions.  How long will you live?  What will your investment returns be?  How much income will you need?  When it comes to that last one, most people just estimate their first year of retirement expenses and then adjust that amount higher each year to account for inflation.  This seems like a logical strategy.  It’s predictable.  It provides a steady income.  It gives you a raise each year to account for rising costs.  There’s just one potential problem.  New research shows it’s not how the typical person spends money in retirement.

New spending research

David Blanchett, Michael Finke and other academics have studied how spending changes throughout retirement and what they found might surprise you.  Rather than starting at a certain amount and then moving higher with inflation, people spend more in their early years and then gradually decrease spending as they get older.  This trend typically continues until later in life at which point healthcare costs cause spending to rise again.

Why is this important?  First, your retirement plan is driven by assumptions and perhaps the most important assumption of all is how much you need to spend each year in retirement.  If you have that number wrong, your plan won’t be as accurate as it could be.

Second, most people, planners and software assume a static rate of spending in retirement that needs to increase every year with inflation.  If that’s not correct—and real spending gradually decreases instead—then we’re overstating the cost of retirement.  That means you might be able to retire sooner, retire with less or take a higher distribution rate.  Here’s an example to show you what I mean.

In his research, Blanchett found that a household that needed $50,000 in income at age 65 would decrease real spending by about 15% by age 80 and 20% by age 85.  Let’s assume you retire needing $50,000 in income and you plan on getting half of that from Social Security and half from portfolio withdrawals.  Even if your spending goes down, your Social Security won’t, so any spending reductions can be used to reduce portfolio withdrawals.  So if you want to decrease total spending by 20%, then you can decrease your withdrawals by 40%.  That means less strain on your portfolio which, as mentioned earlier, means you might be able to retire sooner than expected, retire with less, or spend a bit more early in retirement when you’re healthy and active, knowing that you’ll decrease spending later.

Applications

There are some important ways that you can incorporate this new spending research into your planning.

Make a Core/Discretionary budget: Not all spending changes equally during retirement.  Certain core spending on things like food and housing will be with you throughout retirement and are more likely to increase with inflation.  It is your discretionary spending—such as travel and entertainment—that will likely decrease as you move through retirement.  To better predict how your spending will change, make a budget that itemizes core spending (e.g. grocery money) and discretionary spending (e.g. travel or a new car).

Shrink core expenses:  Once you know how your spending breaks down, get rid of as much core spending as possible before entering retirement.  Housing is the largest retiree expense and more and more people are retiring with mortgage debt.  This is especially easy to justify in a low rate environment.  But the downside of servicing a mortgage in retirement is that you’re not servicing it from your paycheck, you’re servicing it from your investment portfolio.  If your portfolio drops, you still need to pay your mortgage.  That means selling into weakness and increasing your odds of running out of money.  Core spending is riskier because there’s little flexibility.  Discretionary spending, however, tends to decrease as you move through retirement and you can adjust it if necessary (e.g. postpone your vacation if the market drops).

Rethink your distribution rate:  In Blanchett’s research, he found that a 4% initial withdrawal rate over 30 years under the constant spending model has the same approximate probability of success as a 5% initial withdrawal rate if spending changes as discussed earlier (assuming $50,000 in initial spending).  If you can take 5% instead of 4%, then you would need 20% fewer assets when you retire.  For example, a 4% withdrawal from a $1,000,000 portfolio gives you the same dollar amount as a 5% withdrawal from an $800,000 portfolio.

Stay healthy:  Obviously you can’t prevent all illness, but do everything you can to be healthy.  This will improve your odds of a long, active retirement and can delay or even eliminate some of the health costs that cause spending to rise later in retirement.

Insure against rising costs:  You might be asking, “Why do health costs rise later in retirement?  Doesn’t Medicare cover those expenses?”  Medicare covers a lot of things, but with very few exceptions, long-term care—where you need help caring for yourself—is not one of them.

What are the chances you’ll need this type of care?  Seventy percent of the people who reach age 65 eventually require some form of long-term care.  Those are good odds.  It reminds me of the time I picked up a rental car in Dublin.  I found out the car was a stick, the steering wheel was on the right, you drive on the left, and the place we were going only had single lane roads.  The guy behind the counter asked <insert Irish accent> “Are ya gonna be wantin’ the insurance today then?”  “Yeah,” I said.  “Better give me everything you got.  There’s a good chance you won’t be seeing that car again.”  The lesson?  Insure against bad things that are likely to happen.

Enjoy life:  There’s a good reminder embedded in the research we’ve been discussing.  If spending decreases as you move through retirement, then for whatever reason, the typical retiree is doing less—either by choice or necessity—at 75 than at 65 or at 85 than at 75.  If you retire at 65 and stay healthy and active until 75, then you’ve got 10 years to do everything you’ve been putting off for the last 40.  That’s not much time.  Be ready to hit the ground running when you retire.  Yes, that means the early part of your retirement will be a little more expensive, but if incorporate this new spending research into your plan with the help of a competent adviser and the results hold up, then you should be in good shape.

~ Joe