Tuesday, August 22, 2017

Are You Over-Estimating Your Future Retirement Spending Needs?

In this post, we will focus on the future estimated spending liabilities (right-hand side) of the Basic Actuarial Equation, which is frequently shown in this website and is advocated by us to develop your spending budget.

Accumulated Savings
PV Income from Other Sources
PV Future Non-Recurring Expenses
PV Future Recurring Annual Spending Budgets

If you over-estimate your future spending liabilities, you run the risk of underspending today.  If you under-estimate your future spending liabilities, you run the risk of overspending today.  Clearly, the more “conservative” strategy is to over-estimate your future spending liabilities and spend less today.  On the other hand, if you are too conservative, you may be denying yourself the lifestyle you really want to enjoy today and may be unintentionally increasing the amount you ultimately leave to your heirs.  This is perhaps one of the most difficult trade-offs that you (possibly with the help of your financial advisor) will have to face in your financial planning.

We will address this important trade-off first for pre-retirees who may be considering retirement, and then for both pre-retirees and retirees.

Pre-retirees Considering Retirement

Some retirement “experts” tell us that we need to replace 70% - 80% of our pre-retirement gross income to enjoy the same lifestyle after retirement as before.  Other experts tell that we need to accumulate savings of 10 times or more of our pre-retirement gross pay to retire at age 67.  These “rules of thumb” frequently over-state post-retirement spending liabilities, particularly if, just prior to retirement, the individual (or couple) has been:

  • saving significant amounts, 
  • making large mortgage payments, or 
  • making large education payments
Since these types of expenditures are frequently not required throughout the entire period of retirement, it will generally not be required to consider them as recurring expenses to be replaced in retirement.  For this reason, we encourage pre-retirees to compare expected recurring spending budgets in retirement with expected recurring spending (in real dollar terms) just prior to retirement for retirement planning purposes.

The table below shows a distribution of mean spending by age and spending category.  The source of this data was the 2015 Consumer Expenditure Survey (table 1300) prepared by the U.S. Department of Labor Bureau of Labor Statistics.

click to enlarge

The first take-away from this table is that total mean spending decreases with age.  Mean spending (including taxes) for individuals (family units) age 65 - 74 of $54,465 was about 78% of mean spending for those age 55 - 64 ($70,059).

The second take-away from this table is that much of the decrease in mean spending between these two age groups may be explained from spending reductions generally associated with retirement:

  • Reduced FICA taxes 
  • Reduced taxes, and 
  • Reduced work-related expenses, including savings for retirement
This data suggests that a better target for an initial spending budget in retirement will be about 80% - 85% of one’s pre-retirement spending levels, if your goal is to approximately replace your pre-retirement living standards.  Therefore, you may wish to categorize your spending in a manner similar to that shown in the Consumer Expenditure Survey (CES) table for purposes of determining a more reasonable spending target and determining whether you can afford to retire.

The third key point from this table is that spending appears to decrease in real terms as we age after retirement.  This leads us to the next section, which discusses several approaches you can consider (either before or after retirement) to possibly avoid over-estimating your spending needs in retirement, when using the Actuarial Budget Calculator (ABC) or the Actuarial Approach to develop your spending budget.  These approaches are all designed to increase current spending budgets.  You should be aware, however, that increasing current spending budgets may also decrease future spending budgets, all things being equal, so these approaches should be considered more as “Budget Shaping” approaches.

Budget Shaping Approaches to Avoid Over-Estimating Your Spending Needs

Assuming Decreasing Real Dollar Spending

The CES survey data above and data from other surveys suggest that spending does not keep pace with inflation as we age.  While certain types of expenses may remain constant in real dollars, or even increase (like healthcare), total real dollar spending appears to decline with age.  Therefore, when using the ABC to develop your spending budget, you may wish to consider inputting a lower rate for “desired increase in future budgets” than you input for “expected rate of inflation.”

Use a Less Conservative Lifetime Planning Period (LPP)

For the Actuarial Budget Benchmark (ABB), we recommend using a lifetime planning period (LPP) developed using the 25% probability of survival from the Planning Horizon section of the Actuaries Longevity Illustrator assuming excellent health, non-smoker mortality.  If you are aware of health issues (or you are a smoker), you may wish to use average health or a shorter, more realistic, LPP to develop your spending budget.

Treat Certain Expenses as Non-Recurring

Many retirees want to travel and have that as one of their spending goals in retirement.  However, you may not want to travel as much when you are in your 80s as when you first retire.  Rather than plan on the same level of travel each year of your retirement (by spreading these expenses over your entire LPP), you should consider setting up a non-recurring expense reserve for travel that you plan to exhaust over a period shorter than your LPP.  You should consider doing this for other types of expenses that you do not anticipate lasting your entire retirement, such as mortgage payments that you intend to pay off before you die.

Spending After First Spouse Death

If you are married, you should consider what will happen to sources of income and spending after the death of your spouse (assuming you survive).  Some expenses may remain constant and some may be reduced.  We discussed how to adjust assets and spending liabilities to reflect different expected LPPs for married couples in our post of July 4, 2017.  It would not be unreasonable, however, to assume that recurring expenses drop by one-third after the first death.

Assume Lower Non-Recurring Costs

As we have previously discussed, if you are spending the budget determined under the Actuarial Approach and you are increasing your LPP as you age to determine such budget, it is likely that you will die with assets remaining.  As a result, you may be “doubling up” to a certain degree, by inputting a specific level of desired amount remaining at the end of the LPP.  Additionally, you may have other plans for near end of life care so that you may not want to build a large reserve for long-term care.

Use a Higher Discount Rate

If you believe that your investments will consistently achieve higher returns than those inherent in insurance company annuities with no additional risk, you can assume a higher discount rate than we recommend.  Unlike the items mentioned above, however, we are less enthusiastic about this option.


We are fine if you want to be conservative in estimating your future spending needs.  If you are still working, enjoy your job and have no trouble getting out of bed in the morning to go to work, we encourage you to keep working even if you might be able to afford to retire.  As we have indicated in previous posts, we estimate that an individual’s annual recurring retirement spending budget will generally increase by almost 10% for each year additional year of employment.  On the other hand, if you just can’t wait to retire, you might consider some of the Budget Shaping alternatives discussed above, to see if your retirement goals can be accomplished using somewhat more realistic assumptions about future spending needs.

By the way, if you are working and determine that you still can’t afford to retire even after trying some of the approaches above, we encourage you to increase your pre-retirement savings until it hurts.  Doing so has a double benefit.  It simultaneously increases your assets and decreases your post-retirement spending target.
We are also fine if you are already retired and just want to be more conservative in your spending.  We aren’t trying to push anyone to spend more now rather than later.  We are all about encouraging you to develop a reasonable spending budget that considers your specific situation and spending goals.  If you believe your current spending plan is not meeting your goals, however, you may wish to consider one or more of the Budget Shaping approaches discussed above.

Feel free to discuss meeting your spending goals with your financial advisor by applying these approaches, but don’t be terribly surprised if his or her planning software doesn’t handle some of them adequately.  You may also find it difficult to accomplish your spending goals if you use approaches that “cobble together” sources of lifetime income and involve strategic withdrawal plans (SWPs), like the 4% Rule or the Required Minimum Distribution (RMD) approach, as these approaches generally aren’t very flexible.  By comparison, if you are willing to do a little number crunching and are willing to live with the potential consequences of being a little less conservative, the Actuarial Approach can help you tailor your spending plans to better meet your anticipated spending needs and goals.

Happy Budget Shaping!