The three key drivers involved in determining how your (or your household’s) assets will be spent in retirement generally are:
- Your (or your household’s) future lifetime(s),
- Your future investment returns, and
- The pattern of your current and future spending
This post will focus on item 3. We will discuss recent research into actual observed spending patterns and possible implications for your financial plan.
Background
As noted many times in this blog, the general rule of spending in retirement is that you can spend your assets now or you (or your heirs) can spend your assets later. The primary purposes of this website are to help you develop:
- reasonable assumptions about the future,
- a strategy for spreading your spending over your remaining lifetime in a way that best meets your retirement spending goals, and
- a plan for adjusting your spending strategy when actual experience deviates from your assumptions or your spending goals change.
We also encourage you to periodically stress test your plan to assess and to consider actions that may possibly mitigate risks to your spending strategy.
Using Monte Carlo models, many financial advisors calculate probabilities of being able to spend specified levels of constant annual real dollar amounts in retirement. On the other end of the budget development spectrum, Strategic Withdrawal Plans (SWPs) are primarily designed to spread withdrawals from accumulated savings over retirement in a systematic manner. When combined with other non-linear sources of income, these SWP approaches may or may not produce linear annual income levels (or spending budgets) from year to year. Since neither of these approaches anticipates non-recurring spending, it is quite likely that they will fail to meet real-world spending goals.
By comparison, the Actuarial Approach advocated in this website anticipates that some of your spending may be non-recurring. For example, you may:
- Incur extra medical costs prior to becoming Medicare eligible,
- Plan to pay off your home mortgage five years into your retirement,
- Plan significant travels until you reach age 80,
- Plan to improve your kitchen,
- Buy a vacation home or a boat (or both),
- Buy a new car,
- Assist children or grandchildren with education costs,
- Incur long-term care costs, etc.
While non-recurring expenses like these may reduce a retiree’s (or a household’s) assets, they generally don’t belong in the determination of a retiree’s recurring expense budget. For example, if you expect to pay off your mortgage five years after retirement, your spending plan shouldn’t anticipate accumulating sufficient assets at retirement to fund this expense over your entire remaining lifetime.
Many academics and researchers have studied retiree spending patterns and have concluded that total retiree spending generally decreases in real dollars as we age (until perhaps when long-term care costs are incurred and/or remaining assets are “spent” as bequest motives). This pattern of spending in retirement has sometime been referred to as the “spending smile” or “go-go, slow-go, and no-go” phases of retirement. The next section summarizes the results of one such report recently published by T. Rowe Price.
Decoding Retiree Spending
T. Rowe Price recently released this interesting article, authored by researcher Dr. Sudipto Banerjee, which summarized findings of a study of actual spending by 1,470 retired households over the period of 2001-2015. For the purpose of the study, spending was separated into Discretionary Spending and Non-DiscretionarySpending, and annual non-discretionary spending was measured against guaranteed income (income from Social Security, pensions and annuities). The key results of the study included:
- Total mean real spending for the group declined by about 2% per annum over the measurement period, but observed rates of decrease of non-discretionary spending were somewhat different for higher net worth households vs. lower net worth households in the group.
- “While spending goes down for most retirees as they age, the extent of this decline varies widely.”
- “The data shows that the decline in overall retiree spending is primarily driven by a decrease in non-discretionary spending.”
- “After a short adjustment period, we see that retirees set their nondiscretionary spending to match their guaranteed income, rather than choose their guaranteed income to match their nondiscretionary spending.”
- “The most likely reason behind such behavior is wanting to preserve existing assets.”
- “This behavior suggests that retirees are reluctant to bridge any spending gap (between nondiscretionary spending and guaranteed income) by buying additional guaranteed income such as annuities.”
- “…the first step of any retirement income strategy will be to understand why retirees choose to preserve their assets. Whether it is a behavioral inability to spend down, a fear of high expenses late in life, a mix of both, or something else.”
We note that while this study categorized certain types of expenses as discretionary and non-discretionary (what we call Essential), the categorization of expenses was not made by the households themselves, but rather by the researchers. Therefore, it is possible that households are willing to reduce certain expenses classified by the researchers as non-discretionary that they consider (or reconsider during retirement) to actually be discretionary.
Further, there was no attempt in the study to distinguish between recurring expenses and non-recurring expenses. So, for example, the study indicated that mortgage payments were non-discretionary (which probably most individuals would concur), but paying off one’s mortgage early in retirement would be viewed in the study as a reduction in one’s non-discretionary spending. We note that most of the decline in non-discretionary spending for higher net worth households appears to take place in the first few years of retirement, supporting the notion that these expenses may be non-recurring expenses.
The study implies that once retirement occurs, households are reluctant to spend down their accumulated savings, and they don’t view the purchase of life annuities as an investment decision but rather as an undesirable diminution of their accumulated savings. Why households may exhibit this observed behavior, however, remains an open question and we wonder if it will continue to apply in the future when more retirees will not have guaranteed lifetime income other than Social Security in their portfolios.
The years included in the study (2001-2015) included two periods (3/2000-10/2002 and 10/2007-3/2009) where the S&P index decreased by approximately 50% and interest rates used to price life annuities consistently declined during this period making them more expensive. Therefore, it may be expected that households included in this study would be conservative in their spending and their desire to preserve assets.
As noted in the study, results summarized are “mean” (half above, half below) results and may vary widely for individual households.
Possible Implications of Observed Retiree Spending Behavior on Your Financial Plan
So, what do these “mean” observed behaviors mean for your financial plan?
We agree with Dr. Banerjee that it is important for retirees, as part of their goal setting process, to determine their preference between asset preservation and spending preservation. If fear of higher expenses later in life is a significant factor driving your decision, we encourage you to include reasonable estimates of all your future expected liabilities (amounts and future increases) in your budget calculations so that you can better determine how much you can afford to spend.
If your goal includes leaving a significant amount of your assets to your heirs and not spending these assets yourself, then your plan should specifically provide for funding this specific goal.
When developing a financial plan for retirement, we believe it is important to distinguish between recurring expenses and non-recurring expenses as well as between expenses you consider to be essential and expenses you consider to be discretionary. We acknowledge that your classification of these expenses may change over time.
We encourage you to consider establishing a Floor Portfolio of low-risk assets to fund what you consider to be your future essential expenses. If you believe asset preservation is more important than spending preservation and do not want to adequately build a Floor Portfolio, you may be subjecting what you consider to be your essential expenses to increased risk for poor investment returns. This is fine, provided you are ok with possibly adjusting what you consider to be your essential expenses in the future.
Conclusion
Our Actuarial Budget Calculators are very flexible and are designed to help you efficiently fund your spending goals in retirement. We encourage you to select what you consider to be your essential expenses and build a floor portfolio to fund them. If your goal is to preserve your assets during retirement, you should input this goal as a bequest motive in the Input/Results tab. Increasing your intended bequest motive will generally decrease the amount you can spend during retirement, all things being equal. If you don’t want to build a floor portfolio of non-risky assets to fund your essential expenses, you can decrease your current essential expense spending and/or you can assume future decreases in real essential expenses using the percentage increase inputs in the Asset Reserves by Expense Type Tab.
Financial planning for your retirement involves setting goals, making reasonable assumptions about the future and adjusting those goals and assumptions as actual experience emerges. Ultimately, it is up to you to decide how to balance your current spending vs. your future spending. We provide tools and recommended processes in our website to help you do this.
