In this post we will revisit the planning implications of research that finds that household spending may decrease in real dollars as retired households age. This week we became aware of research in the U.K. that, like several other research reports we have discussed, shows that spending in retirement does decrease in real dollars, on average. Unlike other research, however, this research measured the sources of spending decreases in retirement and concluded:
- Much of the decline in consumption is explained by falls in spending on “non-essential items” such as recreation, eating out and holidays.
- Spending on essential items remains relatively flat during retirement, which means essential items account for an increasing proportion of the overall household budget. Indeed, by age 80+, over 50% of expenditure is on essential goods and services.
- There does not appear to be a post-retirement spending boom on leisure and holidays. In fact, from age 50 onwards, spending on most non-essential items begins a slow decline.
We believe the conclusions of this research are consistent with the thoughts we expressed on the planning implications of possible spending decreases in retirement in our post of December 11, 2021 where we said,
“Our Thoughts on Spending Pattern Research and Implications for Personal Financial Planning
Since data generally used in retirement spending pattern research doesn’t distinguish between non-recurring and recurring spending or between essential and discretionary spending, we are uneasy applying general spending pattern observations of researchers (based in large part on averages) to personal financial planning situations for individual retired households. Is it safe or prudent to assume for planning purposes that all future expenses will decrease over time in real dollars? Our intuition tells us that most retirees would be more comfortable implementing a financial plan that anticipates constant (or increasing) real dollar spending, at least with respect to their essential recurring expenses.
Our Actuarial Financial Planner (AFP) allows you to input different rates of future increases for up to three types of essential recurring expenses and up to two types of discretionary recurring expenses, in addition to separately accounting for various types of non-recurring expenses. So, if you believe that your future recurring medical expenses or your future taxes will increase at a faster rate than general assumed inflation, you can separately determine the actuarial reserve for those items utilizing higher annual future increase assumptions. And, if you believe that some or all of your future recurring discretionary expenses will not increase, or even decrease in retirement, you can model the financial impact of that assumed future. Finally, the AFP will automatically model spending of non-recurring expenses over the relevant assumed payment period (and not your entire period of retirement).”
Safety-First (or Liability-Driven) Investment Strategy
In our website, we encourage you to consider funding your Essential Expenses by building a sufficient Floor Portfolio of non-risky assets. In order to do this, you need to identify and estimate expenses you consider to be essential vs. those that may be reduced in the future, if necessary (your Discretionary Expenses). By building a Floor Portfolio of non-risky assets, a retired household is using basic financial economics principles to attempt to match the market value (or cost) of their essential spending liabilities with the market value of their Floor Portfolio assets. It does this by matching the projected liability and asset cash flow streams in amount, timing and probability of payment.
By definition, discretionary expenses are not “essential” and since they can be reduced in the future, these liabilities can be discounted with a higher discount rate. Also, based on the research discussed above, these expenses frequently decrease as the retired household ages. Therefore, for planning purposes, we don’t have a problem with using more aggressive assumptions in determining the actuarial reserve needed to fund discretionary expenses.
Conclusion
If your, or your financial advisors’, planning model doesn’t distinguish between essential and discretionary expenses or between recurring and non-recurring expenses, you may not be efficiently funding your retirement expenses. We encourage you to use our Actuarial Financial Planner to match your expected future Essential Expenses with your future expected Floor Portfolio asset distributions. If you want to be more aggressive with the funding of your Discretionary Expenses and disbursements from your Upside Portfolio, we don’t have a problem with that as long as you understand that you may need to reduce these expenses in the future, if necessary.
Be sure to check out our recent Advisor Perspectives article
on using basic actuarial principles and Liability Driven Investing to
determine the asset allocation of your Accumulated Savings.
