Wednesday, September 12, 2018

Two Tweets and a Comment: Spending in Retirement

The inspirations for this week’s post are two tweets and a reader comment, which could be the title of a movie about retirement planning if anyone were ever desperate enough to film one.

Retirement planner and researcher, Larry Frank[1] tweeted a link from a Wall Street Journal article by Dan Ariely, a professor of psychology and behavioral economics. The article, entitled “How Much Money Will You Really Spend in Retirement? Probably a Lot More than you Think[2] suggests that the conventional wisdom that we will need to replace 70% to 80% of our pre-retirement income may be vastly optimistic and the real number could be as high as 130%. That will require workers to save twice as much as they expect, according to Ariely.

Before you throw up your hands and give up on ever saving enough, let me explain that these two numbers, 70% and 130%, don’t measure the same thing.

The leader in estimating “replacement ratios”, the income needed for the first year of retirement as a percent of the income needed to buy the same standard of living as the year before retirement, is AON Consulting.[3] AON doesn’t calculate a single replacement ratio but notes, for example, that it is higher for lower-income households than higher-income households. Over time, “conventional wisdom” settled on about 70% for a replacement ratio no matter what your circumstances, which is obviously a poor rule of thumb, however widely accepted.

Beware the Ides of March and rules of thumb.

For my two cents, from some unrelated research I'm doing using the Health and Retirement Survey data from 1992 to 2014, I find that about 550 one-person, retired households experienced a median replacement ratio of about 107% and about 850 two-person households experienced a replacement ratio of about 112%. I don't yet know how long those increases continued. As I mentioned, replacement ratios are about the first year of retirement. Furthermore, these are medians — your mileage may vary.

To be perfectly clear, I'm not a fan of replacement ratios as a planning device.

Two Tweets and a Comment: Spending in Retirement.
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Ariely’s calculations are the results of an experiment in which people were asked what they hope to do after they retire. Of course, many would hope to travel the world, eat all their meals in fancy restaurants, take the grandchildren to Disney World annually or retire to a golf resort. That will cost a bit more than simply staying home from the office, living in the same place and doing the same things as before without the commute, which is closer to the AON calculations.

The important points I learned from the Ariely column were more behavioral than economic. Here's one. I’ll bet if you ask most workers whether retirement will cost more or less than pre-retirement, most would answer, “Less, of course!” Ariely shows that really depends on what you plan to do after retirement and where you plan to do it.

The WSJ column provides a link[4] to Ariely's spreadsheet to calculate replacement costs based on your own retirement dreams. If you calculate that replacement ratio and then compare it to the AON Consulting replacement ratios specific to your financial circumstances, you may find numbers that differ significantly from 70%. Both numbers may help your planning by providing a range of estimated spending and they might also provide a warning flag that your expectations of what you can afford in retirement may be overly optimistic.

I found the behavioral aspects of the column more compelling than the economic perspective. First, replacement ratios compare costs for the first year of retirement to the year before. Hopefully, your retirement will last longer than a year and it is unlikely that if you decide to travel the world at age 65, for example, you will still be flying at 85. (Airlines statistics show that retirees tend to stop traveling internationally in their 70s.)

Even if the retirement you envision requires a 130% replacement ratio, that increase won’t last forever and probably won’t require doubling your pre-retirement savings target, though it will increase it. If an early-retirement spending increase were to actually be sustained for your entire retirement then your savings needs might double but I doubt that it will.

Ariely states that in retirement "Every day becomes just like the weekend. And on the weekend, we have all kinds of time and opportunities to spend money. We shop, travel, buy tickets for events and eat out." As a retiree of 13 years, I don't know any retirees who would agree that retirement is like that, at least not moreso than when we worked, and I will repeat my assertion that we need more researchers with retirement experience (a personal peeve).

My second inspiration was a tweet from a financial planner who didn’t understand why estimating retirement spending is difficult. He suggested basing it on the past four months of current expenses. Calculating current spending is indeed relatively simple and estimating spending for the first few years of retirement isn’t a stretch; the challenge is estimating spending 10, 20 or 30 years into the future.

Will your retirement spending go up or down after you retire? I think the best research on this question comes from David Blanchett[5] and Sudipto Banerjee[6]. Blanchett concludes that a household’s spending trajectory is a function of the ratio of retirement savings to the desired standard of living or said differently, a function of whether the retired household has saved appropriately for the desired standard of living, under-saved, or over-saved.

Blanchett found that households with appropriate savings tend to see a 1.5% to 2% annual reduction in the cost of retirement (spending), though it isn’t a smooth decline. He found that households that “over-save” tend to realize they can spend more after a few years and do. At the other extreme, households that haven’t saved enough tend to notice their savings are declining too fast and reduce spending.

Some have interpreted Blanchett’s findings to suggest that spending declines for the "first half" of retirement and increases for the second half. That’s really only true if you live to 100 or so. Most households won’t and their spending trajectory will look a lot like Banerjee’s chart, which is to say that spending will tend to decline throughout retirement and even large end-of-life costs will likely be smaller on an inflation-adjusted basis than first-year spending.

Which direction your spending will head is unknowable. It’s important to understand that these projections are made for the population of retirees and there is no way of knowing if your household's unique retirement spending will be like any of these averages. Your retirement spending will be determined not only by your wealth and income but also by how much life decides to charge you and for how long.

My final inspiration was a reader asking how much money she will need to spend annually throughout retirement. You can see my response in the comments section at The Critical Factors of Portfolio Ruin Aren't Predictable but there is one inescapable reality — no one can predict how much wealth and income an individual household will have or how much it will need with any accuracy for more than a few years.

To summarize this information about retirement spending, I would say we have some good research on population averages but they can’t predict the future of a single household. Ariely tells us that the retirement we want might be more expensive than the one we can afford and perhaps more expensive than our pre-retirement standard of living. Blanchett and Banerjee tell us that retirees who have saved enough and those who have saved too little tend to experience spending declines throughout retirement. The airlines tell us that we become less adventurous in our 70s.

No one can tell you how much your household will need to spend or be able to spend for more than a few future years. The only realistic solution is to plan for the long term but adjust often.

Retirement finance has no cruise control.


[1] You can follow Larry Frank on Twitter at @LarryFrankSr and you can follow me at @Retirement_Cafe.

[2] How Much Money Will You Really Spend in Retirement? Probably a Lot More than you Think, Wall Street Journal.

(I frequently have problems with the WSJ paywall but you should be able to read this by clicking "sign in" if you don't subscribe. If not, I found that I could read it by Googling "How Much Money Will You Really Spend in Retirement? Probably a Lot More Than You Think" and clicking the link on the Google search page.)

[3] AON Consulting Replacement Ratio study, AON Consulting.

[4] Retirement Spending spreadsheet, Dan Ariely.

[5] The True Cost of Retirement, David Blanchett.

[6] Expenditure Patterns of Older Americans, 2001-2009, Sudipto Banerjee.