Friday, May 8, 2015

Retirement Expenditures and Costs of Retirement

Some great questions and comments about my previous posts on spending in retirement, beginning with Spending Typically Declines as We Age, suggest that I should add a bit more to my explanation. Or as Ricky Ricardo might have said, "I got some 'splainin to do."

Will the cost of retirement decline as you age?

The fact is I don't have any idea how much you will spend late in retirement, nor does anyone else. I can't predict what a household's finances will look like in two or three decades (which is why glide path discussions don't much interest me). My arguments about declining expenses as we age and dynamic updating are about how much you can spend now based on what you now know, not about how much you will spend later in life.

(Reminder to readers: Hover your mouse pointer over yellow text for further explanation. Double-click any chart to see a larger version. Orange text is a hyperlink. "PDF" denotes that clicking will download a PDF of the referenced document.)

The Banerjee and Blanchett studies show that retirement expenditures typically decline with age. Expenditures, however, are not the same as the generally accepted definition of “cost". Think of expenditures as consisting of non-discretionary spending (“basic costs") and discretionary expenses (“lifestyle costs”). In fact, Blanchett showed that the group of retirees with high net worth and low spending are the ones most likely to experience an increase in expenditures, not because their costs go up in many cases, but because at some point they realize they can safely spend more money on their lifestyle than they have been.

No one knows if your spending or your costs will decline as you age, but these studies (and many others) show they are very likely to. Banerjee shows that expenditures decline for two out of three retired households. That is the best initial assumption until experience with your actual retirement results indicates that you are on a different track. (You can refine that initial assumption, as I explained in Retirement Spending Assumptions and Net Worth.)

Is it dangerous to assume that costs will decline?

Not really, and for two reasons. Theoretically, using this approach, if we assume costs will decline and they don’t, we will spend money early in retirement that we might come to need late in retirement. That’s a risk.

It's important to note that the risk of overspending early in retirement isn't exclusive to a plan that assumes decreasing spending. 

But, Banerjee showed that spending declines for about 66% of retirees and increases for about 16% in real dollars. If many of the 16% of retirees who eventually spend more do so because they realize they can afford to, then the danger zone is the 18% chance that spending will remain flat.

However, assuming declining costs in order to provide the most accurate assessment of how much money a retiree can spend today isn’t a one-time calculation, at least it shouldn't be. These calculations should be made annually (see Dominated Strategies and Dynamic Spending). A retiree who initially assumes declining expenditures but ends up in the 18% or so of retirees who don’t see declines in spending should quickly notice the divergence from plan and correct spending within a few years. Annually adjusting spending and assumptions about future spending should should provide for a quick and relatively smooth correction. This is the first way we hedge the risk of assuming declining expenditures.

The second hedge is control of our discretionary spending. We can budget discretionary spending to target a planned decline in spending as we age to increase the probability that our spending does, in fact, decline as we assumed it would. In other words, we have some control over those spending declines. As Blanchett shows, the larger the portion of our budget that consists of discretionary expenses, the more our spending is likely to decline with age. If your spending is largely non-discretionary, then your expectations for spending declines should be modest from the beginning.

There are other arguments for assuming flat spending, including building in a margin of error and having the excess available to pass to heirs. Perhaps the first argument is a matter of personal choice, but I prefer to make the best prediction that I can of future expenses and allow for a margin of error separately. I like to understand both the expected costs and the risk, and not have risk tossed in as an afterthought.

Assuming flat spending as a safety margin is, after all, quite arbitrary. Why not assume a half-percent annual increase in spending, instead of flat spending? Without studies like Banerjee and Blanchett, most retirees and planners couldn’t identify the magnitude of that margin, let alone determine if that is the correct safety margin. Regardless, in my opinion, the risk of running out of savings should be addressed in the floor portfolio, not as additional margin in the risky portfolio.

I have a similar concern with planning legacies as an afterthought of spending, first because I believe that any serious concern about a legacy deserves its own plan and, second, because Scott, Sharpe and Watson (PDF) have shown that planning with “reserves” (hedging sequence of returns risk with over-saving) can be very costly.

In my next post, Retirement Expectations: A Reality Check, I'll write about what we should hold as reasonable expectations of retirement. Hope to see you there.


  1. Amen - nice summary Dirk! This puts the focus on where it should be - considering one's specific situation and likelihood of how that situation may change. Best summary of this research I've seen yet!

    1. Thanks, Larry! Sounds like we may be speaking on a panel together in New York in the fall. That should be fun.

    2. Yes. I'm glad they reached out to you. Looking forward to meeting you in person instead of electronically!

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