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.