Retirement Spending Assumptions and Net Worth

In my last post, Spending Typically Declines as We Age, I reviewed the results of research by David Blanchett (PDF) and Sudipto Banerjee (PDF) that shows expenditures in retirement typically decline as we age. Most retirement spending strategies assume, as I noted in that post, that future real spending will remain constant throughout retirement.

The amount that we can safely spend from retirement savings in the current year depends heavily on the assumptions we make about future spending trends. If our future spending needs will decline, spending rules that assume constant real spending will be unnecessarily conservative and, of course, if future spending will increase, those spending rules will recommend spending that may not be sustainable.

What assumptions should our retirement plan make about future spending? The two papers I reference offer some clues.

First, Banerjee reports that spending in retirement increased for only 16% of the households in the data he studied, while it declined for 66% of them. It is significantly more likely that your expenditures will decline as you age, but they might not, so our retirement plans should also consider worst case outcomes.

We could assume a worst case, that expenditures will increase perhaps 1% per year on average, but that would significantly increase the predicted cost of retirement. If we assume we will live 30 years or more, that our market returns will be quite conservative by historical standards and that our expenses will grow in retirement, we will quickly realize that hardly anyone could afford that retirement. Making lots of conservative assumptions doesn't make a very good plan.

Blanchett offers additional insights by segmenting the data based on the level of annual spending relative to net worth. He creates four categories of consumption: low spenders with high net worth, low spenders with low net worth, high spenders with high net worth and high spenders with low net worth. By figuring out into which group you best fit, you may be able to narrow the field of spending assumptions for your plan.

The dividing line for high and low spenders was $30,000 per year and the hurdle for high net worth was $400,000 in Blanchett's study. These are the median values for his data sample, not for the population of retirees. In other words, more than $30,000 of annual spending made households in the data sample high spenders relative to other households in the sample, but that amount wouldn't make you a high spender relative to all other retirees in the U.S. today. The breakpoints for the larger population of retirees would likely be much higher. Blanchett is showing that expenditures in retirement depend on the relationship between annual spending and net worth; he is not claiming that these are the dividing lines for all retirees.

Blanchett notes that two of these groups, Low Spending, Low Net Worth and High Spending, High Net Worth retirees, consume efficiently (green), while the other two groups consume too much (red) or too little (yellow).

Following is a diagram from Blanchett's paper plotting these four segments. Please note the very important point, as I explained in Spending Typically Declines as We Age, that these graphs show annual rate of change in spending and not annual spending, itself. With the exception of Low Spending, High Net Worth households (the red squares on Panel B) almost all of the annual changes in expenditures are negative, meaning spending declines throughout retirement for the other three groups. (Double-click the chart for a larger image.)

Notice that the following graphs of annual spending are quite different than Blanchett's graphs of annual spending change above. Because some readers have mistaken the Blanchett "smile" rate-of-annual-change graphs for annual expenditures graphs, I provide both in the examples below.

In fact, Blanchett's paper shows this in his Figure 7, though most of that paper addresses annual spending change and not annual real dollar spending. My graphs will show typical real dollar annual spending that is derived from the rate-of-change graph to its right. I place the spending function on the left because I believe that information will be more meaningful to most of my readers, and I switched Panels A and B in Blanchett's Figure 7 for consistency – the charts on the left always show annual spending.

Let me be very clear about this. The Blanchett smile curves, like Panel A above, show how quickly typical spending changes each year. The spending curves, like Panel B above, show how much spending changes in real dollars and, in most cases, spending goes steadily downward throughout retirement, like the curves in Panel B.

Now, let's look at Blanchett's four spending/net worth classifications.

Low Spending, Low Net Worth households likely spend a large portion of their budget on non-discretionary expenses with little opportunity for reducing expenses later in retirement. We usually give up some discretionary items later in retirement, like extensive travel and sports, and these households have fewer of those to eliminate, so expenditures don't decline a lot with age.

High Spending, High Net Worth households also consume efficiently and will likely see greater declines in spending than Low Spending, Low Net Worth households, because they will have more discretionary spending to eliminate as they age.

Low Spending, High Net Worth households appear to have the highest probability of increased expenditures throughout retirement, but they can afford it. They are underspending. A likely cause for such an increase in expenditures, in fact, is recognition over time that they have the resources to spend more.

This graph also demonstrates the key point that increasing expenditures don't necessarily mean that retirement is getting more expensive and decreasing expenditures don't mean it is getting less expensive. They mean that retirees are spending more or less. Expenditures, the subject of this analysis, are not the same as expenses. Sometimes expenditures change because retirees have to spend less and sometimes it is because they can spend more.

High Spending, Low Net Worth households also consume inefficiently and they are likely to recognize as they age that their level of spending is unsustainable. This realization will eventually lead to declining expenditures later in retirement, as can be seen in the following chart.

The next chart combines all four annual spending curves for comparison. The two curves in the middle result from efficient consumption. Inefficient consumption produces the two extremes.

Your personal ratio of annual spending to net worth should suggest whether your own spending is more likely to rise, fall, or remain somewhat constant throughout retirement.

To summarize this information, Banerjee tells us that two-thirds of retirees will experience declining expenditures as they age and only 16% will see increased spending. Blanchett tells us that spending will likely increase for Low Spending, High Net Worth households as they realize they are able to spend more as they age, as it will likely decrease for High Spending, Low Net Worth households as they realize they are running out of savings. Among households that consume efficiently, those with High Spending and High Net Worth are more likely to spend less later in retirement because they will have more discretionary expenses to "age out of" than will Low Spending, Low Net Worth households.

Some expenditures change for reasons that have little to do with how much annual spending a retiree targets or how wealthy they are. Some changes are the result of aging. Health care expenses tend to increase as we get older but we also become less active and other expenses decline. I recently read that international air travel declines among septuagenarians and domestic air travel declines among octogenarians. I suspect the sales of bungee-jumping and rock-climbing gear decline in those market segments, as well. I spend less on hair care expenses.

These two studies deal with typical retiree spending patterns and assume that expenditures will follow some trend, rising, constant or declining, throughout retirement. They don't, however, deal with the most likely scenario for an individual household, irregular net spending.

Both income and expenses in retirement are likely to vary significantly over time. Income will vary, for instance, as Social Security benefits ramp up for retired couples and more income needs to be withdrawn from savings early in retirement. There may also be large planned expenses later in retirement, like college for a child or grandchild. Net spending is the important consideration, the difference between annual income and annual expenses. Irregular net spending from savings might look like the red bars in the following chart:

These irregular net spending years, whether they are caused by changing income or changing expenses, must be considered when calculating a sustainable amount to spend in the current year. Like steadily rising or steadily declining expenditures, spending rules assume flat future spending and don't accommodate irregular net spending very well.

It is helpful to know that expenses typically decline in real terms throughout retirement, but yours may not. You need to plan for expected spending declines but be prepared for a worse case. Like portfolio returns, total expenditures in retirement are unpredictable.

So, most retirement income strategies assume constant spending throughout retirement and most retirement expenditure studies show that constant spending isn't the norm. What's a retiree supposed to do with that?

In my next post, Spending Rules That Fit the Patterns of Retirement, and Some That Don't, I'll explore spending strategies in light of future spending expectations.

2015 RIIA Practitioner Thought Leadership Award

The Retirement Income Industry Association® (RIIA) today announced that Financial Planner Dirk Cotton, author of The Retirement Café blog and founder of JDC Planning, LLC, is the winner of its 2015 RIIA Practitioner Thought Leadership Award. The Award recognizes his paper, “Sequence of Return Risks: A New Way of Looking at Spending or Saving Scenarios with Path Dependence,” for contributions to retirement thought leadership and RIIA’s Body of Knowledge. The paper appears in the Spring issue of RIIA’s peer reviewed industry publication, the Retirement Management Journal®.

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Spending Typically Declines as We Age

The most common assumption of retirement spending strategies is that real (inflation-adjusted) spending from savings will be flat throughout retirement, yet most studies of actual retiree household expenditures show that constant real spending is atypical. For most retirees, expenditures decline pretty consistently as we age.

Two of my favorite studies on this topic are David Blanchett's Estimating the True Cost of Retirement (2013, PDF) and Sudipto Banerjee's Expenditure Patterns of Older Americans, 2001-2009 (2012, PDF). The results of the studies are quite similar – not surprising since they used the same databases – but each provides unique information.

Blanchett christened his findings the "retirement spending smile", though be forewarned that if you Google "Blanchett smile", you will find a multitude of photos of Cate Blanchett's lovely face with poor David nowhere to be found. (It wasn't a terrible disappointment.)

Following is a chart of the "smile" from Blanchett (2013). (A quick note: you can double-click any chart in my posts to see a larger version. Also, while burnt orange text indicates a link to another website, yellow text indicates a mouse-over. Hover your mouse over the link for more information.)

There are three things I should note about the chart. First, the term "Experience" labeling the y-axis is an "auto-incorrect" for "Expenditures." Second, the smaller smile was added because of limited sample sizes for some tests. Pay more attention to the 30-year smile. My third point is a larger issue.

I suspect that some readers interpret the spending smile as showing that spending is high in early retirement, becomes lower until age 75 and then returns to nearly the level of early retirement near age 90, but this is not a graph of total annual spending. It is a graph of the annual real change in consumption for a typical retiree. In other words, it shows a decrease (and very rarely an increase) in spending at say, age 61 compared to age 60. It shows not the change of spending, but the rate of that change.

The rate of the decrease changes throughout retirement, but because these rates are nearly always negative (below the zero percent line on the y-axis in Blanchett's chart above), spending constantly decreases, but at different speeds. Banerjee shows the data in terms of total spending instead of the rate of annual change in spending and this point is more clear in his chart:

Reconstructing annual total expenditures from Blanchett's annual rate of change data for a retiree with a $100K annual spending target, we see a chart below that is similar to Banerjee's.

Mathematically speaking, the Banerjee curve is an annual spending function and the Blanchett smile curve is the derivative of the spending function. Banerjee shows the spending curve for a typical retiree while Blanchett shows the acceleration of that curve. Both show that expenditures generally decline with age, as have earlier studies. Blanchett additionally shows that expenditures drop more rapidly each year of early retirement and drop more slowly each year of late retirement, but both show that the amount of spending almost always declines.

Medical expenses late in life can increase expenditures significantly, but both studies appear to show that even when medical expenses do increase expenditures at older ages, they are lower than early retirement spending in real dollars.

The Banerjee chart and the Blanchett annual expenditure chart are not identical. Banerjee shows a steeper decline. Part of the reason for this may be, as Blanchett suggests, that he scrubbed the data to eliminate data points that seemed unreasonable, while Banerjee appears to have used the entire dataset.

Another reason is that Blanchett shows that rates of spending decline vary for undersavers and oversavers, while Banerjee provides a single rate of decline for all households.  Regardless, both studies find that typical retiree expenditures decline as we age. They do not remain constant in real dollars as spending strategies generally assume.

Why is this important? It should be obvious that when we try to estimate an amount of our savings that we can safely spend in the current year we must make some assumption about our future spending patterns. Spending strategies assume that our expenditures in real dollars will remain flat throughout retirement. If our actual spending will increase over time, we can safely spend less in the current year than these strategies predict, and the reverse is true if our expenditures will actually decline after we retire.

A 30-year retirement with level real spending of $100,000 a year would cost about $2.4M if we discount future expenses at 2%. Assuming Blanchett's findings for a retiree with a spending target of $100,000 a year, the same retirement would cost about $2.1M. Using the Banerjee 2012 finding that expenditures tend to decline about 2% annually, that retirement would cost only about $1.8M.

The following chart shows the expected annual spending and cost of an initial $100K annual retirement using all three assumptions:

Future spending is difficult to predict with any accuracy, but a spending strategy that assumes flat real spending throughout retirement, as nearly all do, will underspend early in retirement if the retiree's expenditures decline over time as Blanchett, Banerjee and several other researchers believe they commonly do. In these examples, Blanchett predicts a 12.5% less expensive retirement and Banerjee forecasts 25% less. From another perspective, that means a worker would need to save 12.5% or 25% less to fund retirement.

To quote Blanchett, "While many retirement income models use a fixed time period (e.g., 30 years) to estimate the duration of retirement, modeling the cost over the expected lifetime of the household, along with incorporating the actual spending curve, results in a required account balance at retirement that can be 20% less than the amount required using traditional models."

How does this impact our retirement plan? Clearly our future spending trend assumption has a significant impact on both how much we need to save and how much we can "safely" spend in the current year. Unfortunately, like assuming many other critical retirement unknowns such as future market returns and the length of our own retirement, choosing a future spending assumption is both critical and challenging.

In my next post, Retirement Spending Assumptions and Net Worth, I'll explore these two papers to see what they tell us about how we should choose.

Time to Retire the Probability of Ruin?

The following post originally appeared on Advisor Perspectives, a blog for financial planners, in April 2015.

Perhaps no other retirement finance concept has gotten more ink than the "probability of ruin", which is interesting because few other economic concepts model the real world as poorly. The gist is that a retiree who spends a constant dollar amount throughout retirement is exposed to the risk of outliving her savings. The problem with the economic model is that no one would actually do that.

A constant-dollar spending assumption served us well when William Bengen formalized the notion of path dependence, but it seems that even he didn't anticipate that planners might implement the strategy by rote. In Conserving Client Portfolios During Retirement, Bengen states, ". . . the adviser should examine the projected current withdrawal rate through the entire time horizon of the clients, not just the first year of retirement." He even put it in italics.

Probability of ruin is largely an artifact of those constant-dollar SWR studies.

(Note: You can hover over yellow terms.)

Once constant-dollar SWR escaped the lab, though, the mainstream press and popular retirement newsletters latched onto the belief that constant-dollar spending was OK. These same publications softened their stances quite a bit after retirements were destroyed in the Great Recession, but I recently received a Kiplinger retirement newsletter still espousing the constant-dollar strategy.

Nearly all retirement income strategies avoid the probability of ruin issue in theory by spreading spending thinner and thinner as savings decline – a rational rationing strategy. Annual Recalculated Virtual Annuity (ARVA download PDF), RMD,  Milevsky's formula for sustainable withdrawals without simulation, and the 3D dynamic updating strategy (download PDF) of Frank, Mitchell and Blanchett all spread spending over remaining life expectancy. Constant-percentage SWR doesn't, but won't deplete a portfolio in theory, either.

Unfortunately, these strategies reduce the probability of ruin by reducing spending, our "standard of living."

Life annuities are different because they augment their payouts with a mortality premium and both guarantee a standard of living and provide longevity protection.

I was rereading a study recently about evaluating retirement strategies and noticed the author suggested that retiree's want an income strategy that guarantees they will not outlive their savings. While this is no doubt true, what we really want is an income strategy that guarantees we won't lose our standard of living. That's a bigger ask than avoiding ruin. A strategy that ignores standard of living but guarantees the retiree won't go broke is easy to develop, though perhaps not very useful.

Probability of ruin analyses are not good models of rational human behavior. Michael Kitces has often argued that no one actually implements a constant-dollar SWR strategy. If a retiree's portfolio grows significantly after retirement, any rational person would begin to spend a bit more and surely the reverse is true. What rational person would lose a large portion of their savings and believe they wouldn't need to spend less?

Wade Pfau says it a little differently: constant-dollar SWR is a research technique, not a retirement strategy.

Following this line of reasoning to its logical end, I have calculated the true probability of ruin resulting from consistent overspending with sequence of returns risk for nearly all retirees under nearly all economic conditions.

Zero.

That's the probability I estimate that an actual retiree will just keep spending the same amount every year as she faces clear prospects of ruin. She will, instead, reduce spending and face the prospects of a diminished standard of living. This is a more rational model and the risk that we should be discussing. The probability of a reduced standard of living is more difficult to quantify than probability of ruin with constant-dollar spending, which is why we use the latter in the first place, but ease of calculation doesn't make it a useful metric. 

I have given this question a great deal of thought relative to my own retirement finances and I cannot imagine the impact of outliving my savings, nor can I assign a probability of doing so that I would consider "acceptable." I can say that my number is far closer to zero than to 5%. 

A small probability of a catastrophic outcome is not something that most of us can internalize. We only know that we want to avoid it.

Probability of ruin is a useful research technique that can allow us to compare the relevant benefit of two strategies, but translating that to real-life benefit isn't straightforward. The concept can rarely be communicated with a retiree, unless that retiree has an unusually strong understanding of probabilities, and even then an acceptable probability for losing one's savings late in life is just too big an ask.

I wonder if it's time to retire the probability of ruin, or at least drive it back into the lab. It's not clear to me that we are helping retirees by focusing on it.

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Michael Kitces has posted two outstanding columns (more, actually) on Social Security benefits at his blog, Nerd's Eye View. The first, Valuing Social Security Benefits As An Asset On The Household Balance Sheet, was posted April 8, 2015. This led me to a 2014 post, How Delaying Social Security Can Be The Best Long-Term Investment Or Annuity Money Can Buy.  I highly recommend them, and Nerd's Eye View, in general.

Variable Spending Strategies: Variations on a Theme

We could easily name ten or twelve retirement income strategies but several of them are really just variations on a theme. When you're trying to choose one, it may help to visualize them that way.

In a recent post, Dominated Strategies and Dynamic Spending, I showed that fixed-dollar sustainable withdrawal rates (SWR-Fixed), fixed-percentage rate SWR (SWR-Variable), and Required Minimum Distribution strategies are all dominated by a dynamic updating strategy. Game theory tells us that dominated strategies should never be played and that guideline should narrow the field of choices.

In A Second Look at Time Segmentation, I argued that the benefits of time segmentation strategies may be largely behavioral. Holding large allocations of cash will reduce expected returns and Moshe Milevsky has shown (download Word doc) that the strategy cannot be counted on to bail us out of a bad sequence of returns, though it sometimes will. 

Nevertheless, many retirees appear to find comfort in time segmentation strategies, knowing that any spending problems are at least five years into the future. I'm always in favor of sacrificing a little economic efficiency if it helps the retiree sleep at night.

I’m now going to argue that these are actually the same strategy applied to different degrees.

A dynamic updating strategy, or dynamic spending strategy as I have sometimes referred to it, tells us to modify our spending periodically (typically annually), to reflect our ever-changing portfolio value, diminishing life expectancy, new expectations about market returns and risk, and any changes to our personal risk tolerance and risk capacity.

If we calculate a sustainable spending amount once at the beginning of retirement, we have an SWR-Fixed strategy. This strategy's attraction lies in its simplicity of implementation and maintenance, but it condemns the retiree to spend based on conditions that might have existed two or three decades earlier. In other words, it ignores any new information after retirement begins – a foolhardy approach.

Michael Kitces argues that no one really implements SWR-Fixed because retirees eventually realize they must spend less or can spend more and do so, and he has an excellent point. Wade Pfau argues that SWR-Fixed is a research technique and never was a retirement income strategy. I think he’s right, too. Yet, I don't completely buy the idea that no one tries to use the SWR-Fixed strategy by rote.

For a decade or more, Money magazine touted the SWR-Fixed strategy, relenting only after many retirements were trashed in the 2008 market crash. I recently received a sample Kiplinger newsletter suggesting the strategy. With so much ink in the popular press for so long, it’s hard for me to accept that no one believes it. I hope Pfau and Kitces are correct, but I have a nagging suspicion that they are not entirely. If you’re implementing a SWR strategy by rote, please stop.

In a post entitled, Sequence of Returns Risk and Payouts, I showed that an SWR-Variable strategy, in which a retiree spends a fixed percentage (like 4%) of remaining savings portfolio balance each year, eliminates the possibility of ruin inherent in an SWR-Fixed strategy. It provides variable annual spending but a more constant risk of failure than SWR-Fixed. SWR-Variable moves risk from longevity (running out of money) to payouts (perhaps needing to spend less), where it seems to do less harm.

SWR-Variable reduces sequence of returns (SOR) risk by reducing spending when portfolio value declines. If we recalculate a sustainable spending amount annually, instead of once at the beginning of retirement like SWR-Fixed, and only update portfolio balance, we have an SWR-Variable strategy. Because it uses more new information, it dominates SWR-Fixed, but because it doesn’t update life expectancy, market return expectations and risk tolerance and capacity changes, it is dominated by dynamic updating.

So, calculate spending once at the beginning of retirement and you have SWR-Fixed. Apply it annually, updating only your savings balance, and you have SWR-Variable.

Basing spending on IRA Required Minimum Distributions (RMDs) also exposes us to less SOR risk than SWR-Fixed because spending will be reduced when portfolio values decline. RMD bases spending on an annual updating of portfolio balance and remaining life expectancy (updated annual spending is roughly current portfolio balance divided by remaining life expectancy), but ignores changes to expected market returns and changes to risk tolerance and capacity. As a result, it is also dominated by dynamic updating.

Still, studies show that the RMD strategy is a reasonable approximation of dynamic updating strategies and a lot simpler. To quote David Blanchett, et. al. from a 2012 paper entitled, Optimal Withdrawal Strategy for Retirement Income Portfolios, "As a practical matter, for retirees who can’t replicate the results presented here or don’t have access to them, the RMD method emerges as a reasonable alternative to the more common constant dollar and constant percentage of assets withdrawal strategies."

Dynamic updating strategies calculate a new sustainable spending rate each year incorporating all critical factors of the probability of ruin: current savings balance, remaining life expectancy, market return expectations and current risk tolerance and risk capacity. Spending is no longer tied to your personal financial situation as it existed at the beginning of retirement, or even the previous year.

Lastly, let's look at time segmentation strategies. Time segmentation strategies hold four or five years of expenses in cash, the next five to seven years of expected spending in intermediate bonds, and the remainder in stocks to cover long term spending.

As I argued in A Second Look at Time Segmentation, this strategy is largely an SWR strategy with perhaps too large an allocation to cash for its own good. It could be an SWR-Fixed strategy if the retiree calculates spending once, an SWR-Variable strategy if the retiree recalculates spending periodically based on a current portfolio balance alone, or a dynamic updating strategy if the retiree updates all critical variables periodically. If we look at the portfolio holdings alone, it may be impossible to distinguish an SWR strategy from a time segmentation strategy. (A larger than expected cash holding tips us off that it is probably the former.)

The more critical parameters we consider in our retirement income strategy, the better the approximation of sustainable spending.

The following table summarizes the variables considered by each strategy. Time segmentation is not included because it dictates an asset allocation but can use any of these spending strategies.

How does this help a retiree? It should help by simplifying the broad array of retirement income strategies available. A retiree will always be better off updating her spending as her financial situation changes and the more critical information she updates in the process the better. 

SWR-Fixed, SWR-Variable and RMD strategies simplify sustainable spending calculations by ignoring critical new information. Time segmentation can be added to any of these strategies, but the financial justification for it is much weaker than the behavioral justification.

What is the benefit of ignoring relevant new information? Only that it simplifies the math and reduces the management process a tiny bit – spending is recalculated just once a year in any case, except for SWR-Fixed, of course.

Retirees unwilling to do that little bit of extra work will likely be better off with a set-and-forget strategy like TIPS bond ladders and life annuities.

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The sidebar shows a link to a recent post by Wade Pfau at Advisor Perspectives entitled, The Hidden Peril of Sequence of Returns Risk. SOR risk is complicated and nuanced. In several ways, it is unlike any other form of retirement financial risk, and certainly different than investment risk. No retirement income strategy is perfect, but the risks of SWR strategies are more difficult to understand than the rest. A great read.

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