Saturday, February 4, 2017

Five Ways to Increase Your Near-Term Spending, Part II

This post is a follow-up to our post of November 30, 2015 in which we talked about ways to increase your near-term spending in retirement.   In that post we discussed:
  1. Finding part-time work or other sources of income 
  2. Deferring commencement of Social Security or purchasing annuities 
  3. Using more aggressive assumptions in your calculations 
  4. Using more aggressive assumptions for non-essential expenses, and 
  5. Simply increasing your budget (or your spending) by x%
We also cautioned our readers that, all things being equal, increasing near-term spending increases the risk of declining real (today’s) dollar spending later in retirement.  In this post, we will focus on a subset of the third approach discussed above; lowering the assumed annual target rate of increase for future spending budgets to increase current spending budgets (or reduce the assets needed to fund a given level of spending). 

Within the past few years, several researchers and retirement experts have observed that retiree spending appears to decline in real dollar terms as individuals age.  We discussed this research and how retirees could use our spreadsheets to anticipate declining real dollar spending in developing their spending budgets in our posts of March 31, 2016, August 20, 2016 and November 4, 2016.  More recently, a retirement expert from the UK, Abraham Okusanya, argued in this article that spending in retirement does not follow a “U-shaped pattern” as previously thought, but rather declines in real dollar terms throughout the entire retirement period.

Considering the growing volume of research showing declining real dollar spending in retirement, several retirement experts have suggested that individuals should consider developing their spending budgets so that they also decline in real terms throughout retirement. For example, Mr. Okusanya implies that, based on spending research in the U.S., it would be ideal to target inflation minus 1% (or more) for purposes of developing future spending budgets in the U.S. 

The retirement experts have concluded that this lower target for future spending means that either near-term spending can be increased or the amount a person needs to save for retirement can be reduced, compared with assuming a constant real dollar future spending target.  The experts are less clear, however, as to exactly how much spending may be increased (or savings decreased) by assuming the lower future spending target.

As with all spending matters, we at How Much Can I Afford to Spend leave decisions of how much you spend in a year up to you and your financial advisor.  We simply provide you with tools that give you data points designed to help you make your spending decisions.  However, unlike the retirement experts, we can easily quantify for you how much your current spending budget will be increased (or your necessary savings decreased) if you assume that your future spending budgets will increase by inflation minus 1% in retirement, rather than by inflation. We determine the relevant percentages by first taking the basic actuarial equation that is the foundation for this website:

and manipulating it to obtain: 

To quantify how much This year’s spending budget will increase by targeting future spending budget increases of inflation minus 1%, rather than inflationary increases, we need to divide PV future years increasing by the assumed rate of inflation by PV future years increasing by inflation minus 1%.  The PV future year values are available in the Present Value Calcs tab of our workbooks. 

Similarly, the reciprocal of this ratio will give us the % decrease of needed savings to produce a desired level of spending.

The table above shows the results under our current recommended assumptions at various ages. So, developing a spending budget at age 65 under these assumptions and further assuming future spending budgets increase by 1% per year, rather than the recommended inflation assumption of 2% per year, would increase the actuarially calculated spending budget by 13.3% (or decrease the adjusted assets needed to provide the desired level of spending assuming retirement at age 65 by 11.8%), all things being equal.

Note that if you are, or your financial advisor is, determining your spending budget by adding the results from a Systematic Withdrawal Plan (SWP) to your income from other sources (including Social Security), it may be somewhat more difficult than as described above to develop a spending budget designed to increase at a rate other than inflation.  As discussed in prior posts, SWPs are not really designed to work well unless Social Security is the only other source of income in retirement and the retiree’s spending objective is to have constant real dollar spending in retirement.

While research may support decreasing real dollar spending in retirement, we encourage our readers to develop their future spending increase assumption (or assumptions) by separately examining expected future increases for the three types of future expenses in our Budget by Expense Type tab in our Actuarial Budget Calculator (ABC) workbooks:

  • Essential non-health expenses 
  • Essential health expenses 
  • Non-essential expenses
Since it is not unreasonable to assume that future essential non-health expenses will increase with inflation and essential health expenses may increase at a faster rate than inflation, you may not be comfortable assuming total future recurring spending budgets will increase at a rate of inflation minus 1% (or more) unless your non-essential expenses are assumed to be a relatively large component of your initial spending budget.