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.

Reverse Mortgages: When the Last Resort is the Best Resort

Recent research into reverse mortgages to fund retirement suggests that the conventional wisdom of spending home equity as a “last resort” after other savings are depleted should be rethought. On the contrary, I believe there are many retirement scenarios in which spending home equity as the last resort is the best resort.

The “don't wait” philosophy stems primarily from a paper written by Barry Sacks and Stephen Sacks in 2012 and the current unique circumstances for HECM reverse mortgages.

In a paper entitled, “Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income (2012), Barry Sacks and Stephen Sacks write:

“A retiree whose primary source of retirement income is a securities portfolio and who also has substantial home equity must decide early in retirement whether to live within the safemax limit set by his or her portfolio . . . This decision is a fundamental component of overall retirement planning . . . The decision process also must take into account the degree of economic discipline required to live within the safemax limit.

If the retiree does conclude that he or she would, on balance, prefer to live beyond the safemax level and wants to remain in his or her home as long as possible, a reverse mortgage, including its substantial costs, is one tool to consider.”

The term “SAFEMAX” derives from the work of William Bengen and typically refers to a “safe withdrawal rate.” Historically argued to be around 4% to 4.5%, more recent work by Wade Pfau suggests that in the current low-interest rate environment the “safe” rate may be closer to 3%.

Sacks (2012) actually makes a fairly modest claim compared to the explanations subsequently provided in the media that spending as a last resort might be unwise. They state that the strategy isn't for everyone. The authors note that “particularly in the range of initial withdrawal rates between 5 percent and 6.5 percent, we have found substantially greater cash flow survival probabilities when the reverse mortgage credit line is used in either of two active strategies rather than in the conventional, passive, strategy as a last resort.”

In other words, for retirees willing to risk spending more (about 5% to 6.5% instead of 3% to 4%) from a volatile portfolio than planners have conventionally considered safe, using home equity to leverage an investment portfolio might provide better outcomes. That's a far cry from claiming that the conventional wisdom of spending home equity as a last resort is wrong, as subsequent reviews of the paper may have suggested.

Wade Pfau concluded in his 2016 book, Reverse Mortgages, that a simple strategy of opening a HECM reverse mortgage early in retirement and not using the line of credit until late in retirement outperformed both of the currently-proposed “coordinated strategies” and the use of tenure payments.

"Of the six strategies that use home equity," Pfau reports, "the strategy supporting the smallest increase in success is the conventional wisdom of using home equity as a last resort and only initiating the reverse mortgage when it is first needed . . . Meanwhile, the "use home equity last" strategy provides the highest increase in success rates."

(Note that Pfau compares two “Last Resort”strategies. The first spends as a last resort but waits to open the reverse mortgage until it is needed. That strategy performs worst, but opening the reverse mortgage early in retirement and letting the line of credit grow before spending as a last resort after savings are depleted performs best. Pfau refers to the latter as “using equity last.” Pfau further notes that if your goal were to create the greatest legacy and not to maximize the probability of successfully funding retirement, tenure payments provided the best strategy most often.)

The current unique circumstances for the HECM are the increased loan limit of $625,500 and present historically-low interest rates. When combined, these two factors could allow a borrower to create a very large line of credit, perhaps greater than the home's fair market value over a long retirement. As Jim Veale recently explained in a comment, the maximum HECM loan amount was increased from $417,000 to $625,500 as part of the American Recovery and Reinvestment Act of 2009. Many believed the increase would be temporary but it has thus far survived.

Regardless, there are many conceivable retirement scenarios in which spending home equity as a last resort, as the conventional wisdom holds, would be advantageous, given that opening the line of credit early is a clear benefit with any strategy.

Avoiding risk to home ownership when it may never become necessary

Some retirees want to pass their home debt-free to heirs. They probably should not borrow a reverse mortgage. Some don't plan to keep the home in their estate and won't mind risking ownership. Still others would like to leave their homes to heirs but realize they might not be able to pay for retirement without using home equity. By spending home equity as a last resort instead of committing it early in retirement, the latter group might find that they never need to risk their home or that they can at least minimize the amount of equity they do need to spend.

Think of it as matching home equity to contingent late-retirement liabilities.

Not encouraging overspending

Imagine a couple that divorces late in life after spending a lot of their home equity. Neither wants to continue living in the home. Perhaps neither can afford to continue living in the home, given their new financial situations. Their best financial alternative may be to sell the home, in which case their HECM will have to be repaid. Although they had planned to age in the home, they find themselves leaving the home and without much remaining home equity to pay for new housing.

I was recently asked to explain how this couple would have been better off by not borrowing the HECM. The answer is that the HECM may have encouraged them to spend more than was safe early in retirement, leaving them with little financial reserve in a crisis.

Giving the household more time to see how retirement will unfold before committing resources

Committing to an early-spending reverse mortgage strategy (matching home equity to early-retirement liabilities) involves betting that the household will remain in the home and age in place. It is a bet against divorce and the early death of a spouse. It is a bet that you will feel the same about your home in 10 to 15 years that you do at the beginning of retirement. It is a bet that your home will accommodate future infirmities.

As Shelly Giordano's book on reverse mortgage suggests, waiting a decade or so before committing to spending your home equity provides more time to see how your retirement will unfold.

Holding a reserve for spending shocks

As I explained in Why Retirees Go Broke, the reason is usually a positive feedback loop of financial setbacks stemming from spending shocks, not from sequence of returns risk or poor investment results. Health care costs are an obvious risk, but there are many potential spending shocks that could leave a HECM borrower unable to afford their home going forward. In those instances, the HECM will need to be repaid leaving the borrower with little equity to help with housing costs.

Just in the past few weeks, I have heard the following stories of financial crises in which a HECM borrower would sorely miss home equity as a last resort after having used it to increase early-retirement consumption:

• A wealthy corporate executive was driven into bankruptcy by his wife's Alzheimer's disease.
• A woman's home is being taken by the state using eminent domain to build a highway through the property.
• An elderly HECM borrower ran out of money and asked her loan originator to “send more.”
• A couple needed to move his father into their home as his dementia progressed.

These crises might also occur after you spend your savings and begin spending home equity as a last resort, of course. In that event, you simply ran out of money and neither spending strategy was likely to save you. The danger is in finding the opportunity for additional consumption early in retirement too attractive and experiencing a more critical need for the reserves later in retirement.

Controlling balance sheet leverage

Leverage is risk and like any financial risk can be beneficial if appropriately exploited and dangerous if it is not. Any balance sheet that includes debt is leveraged and anyone who simultaneously holds a mortgage, conventional or reverse, and an investment portfolio has leveraged those investments. Understanding this leverage risk is important and maintaining a prudent amount of leverage is critical. (Michael Kitces explained it well here.)

Retirees who spend home equity as a last resort after depleting their portfolio will not simultaneously hold reverse mortgage debt and an investment portfolio – they will hold them sequentially. That doesn't mean they won't have leverage from other debts, or that the amount of leverage created by the reverse mortgage will be imprudent. That depends on the rest of the balance sheet. But, it does provide an opportunity to manage that leverage.

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When spending home equity as a last resort is the best resort.

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There are a number of advantages to spending home equity late in retirement. Retirees who don't live a long time may find that by waiting to use home equity they never need to risk their home to fund retirement. Delaying may enable the retiree to better observe how her retirement financial situation will unfold before committing to spending home equity. Some retirees will find a more critical need later in retirement than additional consumption early in retirement. Borrowing later may help control balance sheet leverage.

On the other hand, the argument that spending home equity early in retirement beats conventional wisdom isn't particularly compelling. Sacks (2012) argues only that it might provide better outcomes for retirees willing to commit home equity early and to spend more than most planners would consider safe. Pfau's analysis showed that the best outcomes were the result of simply opening a HECM line of credit early in retirement and waiting to spend it until after the savings portfolio is depleted.

If you expect to remain in your home throughout retirement, my advice is to consider opening a HECM line of credit today, while interest rates are low and the maximum HECM loan value is high, but to hold off on spending much of it until you see what life has in store. Often when spending home equity, the last resort will prove the best.

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Your retirement planner says you have a 95% chance of funding retirement successfully? Find out what that means in my next post, Trump, Monte Carlo and Insectivores.

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REFERENCES

Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income, B. Sacks and S. Sacks, Journal of Financial Planning, 2012.

Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement, Wade Pfau, 2016. Available on Amazon.

Spending Rules That Fit the Patterns of Retirement, and Some That Don't

I noted in a recent blog post that Spending Typically Declines with Age after we retire. In a follow-up post, Retirement Spending Assumptions and Net Worth, I explored two recent papers on retirement expenditures that suggest how much spending might decline for you based on how much you plan to spend annually on non-discretionary expenses and your net worth.

I also pointed out that spending rules typically assume that spending will be flat throughout retirement, contrary to what Blanchett, Banerjee and several other researchers have found in studies of data for actual reported retirement spending.

The question most of these spending rules answer is, "how much can I safely spend from savings this year assuming I will spend that same amount every remaining year of retirement?", when the question retirees actually mean to ask is "how much can I safely spend from savings this year given what I assume I will need to spend in the future?"

The difference can be substantial. Quoting Blanchett from Estimating the True Cost of Retirement (PDF), 

"When combined, these findings have important implications for retirees, especially when estimating the amount that must be saved to fund retirement. 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, result in a required account balance at retirement that can be 20% less than the amount required using traditional models."

Sustainable withdrawal rate models make this flat-spending assumption, though it isn't difficult to change the models to fit a different spending assumption. I ran my own Monte Carlo model assuming a 50% equity allocation with constant spending and estimated a 95^th-percentile safe withdrawal rate of 4.1%. Then I modified the model to spend 1.5% less in real dollars for each year of ten thousand 30-year scenarios. The second model estimated a 95^th-percentile safe withdrawal rate of 5%. That's 22% more annual spending, or $9,000 a year more "sustainable" spending than the SWR model suggests for a $1M initial portfolio balance.

Looked at from the wealth accumulation perspective, a retiree would need to save 18% less to generate the same annual spending if she expected expenditures to decrease 1.5% a year on average rather than assuming expenses would remain flat throughout retirement as most spending rules assume.

The ARVA (PDF) spending strategy model, or annually recalculated virtual annuity, is more problematic. ARVA assumes that the correct sustainable amount to spend in the current year is the amount that an inflation-protected life annuity purchased in the current year would pay out. The retiree doesn't actually need to buy the annuity, she can simply base spending on what would happen if she did. An inflation-protected annuity will pay out the same amount throughout retirement and it isn't clear to me how ARVA could be adapted to predicted declines in spending needs as we age.

This problem extends to life annuity strategies, in general. Inflation-protected life annuities will pay out a flat rate throughout your lifetime in real dollars that will not match declining expenditures. From that perspective, nominal life annuities may not be quite as bad as they seem, since inflation will eat away at the real annual payouts, but expenditures will probably decline, too. The problem is that even "normal" inflation of 2% to 3% is greater than the estimates of expenditure declines, so this is a poor way to match income and expenses. Runaway inflation could be devastating.

Moshe Milevsky's formula for calculating sustainable withdrawal rates without simulation also seems problematic, as it, too, assumes the sustainable spending that it calculates will continue to be spent throughout retirement. It isn't clear to me that regularly rising or declining spending could be incorporated into his probability models, let alone irregular net spending, but his math is well above my pay grade. Milevsky's formula doesn't accommodate the loss of a first spouse except under the assumption that spending doesn't decline. Based on his responses to similar questions in the past, I would guess he would tell us that these scenarios would have to be calculated individually with numerical analysis if we want to avoid simulation.

As I mentioned in Retirement Spending Assumptions and Net Worth, it is probably more common for a retiring household to experience irregular spending throughout retirement, and the SWR model can easily be modified to accommodate that expenditure, as well. I repeat that chart here for your convenience. The red columns show irregular spending. Your spending in retirement is much more likely to resemble this than a straight line.

Bond ladders work well with any spending pattern including irregular ones. It is simple enough to match bond purchases to different amounts of future spending.

If spending increases as we age in retirement, most spending rules will overestimate the safe amount to spend in the current year. It is more likely that your spending will decline over time, in which case these models will provide current-year safe spending amounts that are too conservative. With irregular spending, it's hard to know where to begin with most spending rules.

My last three posts have followed a theme. First, spending is more likely to decline as we age than to remain flat.

Second, by looking at our own non-discretionary spending and net worth, we may be able to determine a more accurate assumption for our own retirement expenditures.

And, third, most spending rules aren't based on a realistic financial model of actual retirement. They assume flat spending, fixed lifetimes (e.g., 30 years), constant risk aversion, and average market returns and they make other spherical cow assumptions that simplify the math but can lead to inefficient saving and spending.

I suggest modeling your expected expenses and income to consider expected market returns, life expectancy and expected expenditures. They are all "stochastic variables", which means they have a random probability distribution that can be analyzed statistically, but can't be predicted precisely.

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.

Negotiating The Fog Of Retirement Uncertainty

Households who want to pay retirement expenses from an investment portfolio turn to spending rules like the 4% Rule, fixed percentage rule, or IRS Required Minimum Distribution (RMD) rules, to estimate how much they can spend each year. Retirees hope these rules will offer both a high probability of paying their future bills and a low probability of outliving their savings.

Many retirees and retirement planners are heavily invested in spending rules, with the 4% Rule most widely known. Spending rules attempt to protect us from outliving our savings but don't promise to pay our future bills. Retirees need both. Whether a retired household will actually outlive its savings will be determined by:

• the length of retirement,
• realized sequence risk (not market return expectations),
• portfolio spending needs (actual needs, not spending-rule estimates), and
• portfolio value.

If we could know all of these future values today, we could precisely determine how to fund retirement, so these are the factors we should include in a model to estimate how to fund it with portfolio spending.  

A household's length of retirement is the most important factor in determining sustainable portfolio spending. (A one-year retirement is easy to fund; a 30-year retirement, not so much.)

The length of retirement depends on longevity at the age of retirement. If two households have the same joint life expectancy but one retires five years sooner, the latter household should expect a 5-year longer retirement.

I simulated household finances for a sample of retired households from the Health and Retirement Survey (HRS). The average retirement age for this sample was 64 for men and 60.4 for women. Life expectancies were randomized using Society of Actuaries actuarial tables. About two-thirds of single-household retirements in this sample lasted from 14 to 23 years.

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Spending rules attempt to protect us from outliving our savings but don't promise to pay our future bills. Retirees need both.

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About two-thirds of two-person household retirements lasted from 22 to 32 years. The length of your retirement is quite uncertain and, since your household is a sample of one, could actually range from less than a year to 40 or more. Life expectancy simply provides an average for many people who are a lot like you and there is no reason to believe yours will be average.

Sequence of portfolio returns is the second largest determinant of retirement success after retirement length (for retirees who spend from a portfolio, of course) and is even less predictable than retirement length. The sequence of your future portfolio returns is unknowable and, as Karsten at EarlyRetirementNow.com[1] explains, the sequence of returns is much more important than average returns. "Precisely what I mean by SRR [sequence of returns risk] matters more than average returns: 31% of the fit is explained by the average return, an additional 64% is explained by the sequence of returns!"  

Spending needs (expenses) are the third most important factor of successfully funding retirement when we spend from a portfolio. (They're second when we don't.) Most spending rules ignore how much you will actually spend or even probably spend and instead make the dubious assumption that whatever amount of spending that will not likely deplete your savings portfolio will also be enough to pay your bills.

In a recently published paper entitled, "LDI Misapplied", David Blanchett and Thomas Idzorek explain how liability-driven investing, when used appropriately, is an improvement over asset-driven portfolio optimizations like Modern Portfolio Theory's mean-variance portfolio optimization (MVO)[4]. The primary difference is that LDI optimization also considers future spending requirements while MVO only considers portfolio assets.

Similarly, spending rules that also consider future liabilities are an improvement over spending rules based on assets alone. In both contexts, adding liabilities creates a more realistic model of future household finances.

Blanchett has published several studies on spending and the cost of retirement. Estimating the True Cost of Retirement finds that on average spending tends to decline as retirement progresses but not for all households. In fact, the study says that "households that are overfunded and not spending optimally (the “low spend, high net worth” group) actually tend to increase consumption." 

In the most recent study, Blanchett and Idzorek find that:

50% of the households experienced relatively small changes between [biannual HRS survey] waves. However, the other 50% of the 288 households experienced larger changes in spending, with the 5th and 95th percentiles indicating large changes in wave-over-wave spending. Focusing on the 5th and 95th percentiles and the five distributions in Exhibit 14, for approximately 90% of the households the wave-over-wave change was less than plus or minus 30%.

Blanchett notes that actual spending variability is probably even substantially higher than measured in this sample, as some outliers were rejected.

These two studies suggest that both the long-term trend of retirement spending and year-over-year spending can vary substantially for individual households. In other words, our household's future retirement spending is relatively unpredictable.

Even when we do include future spending in the spending rule estimate, we do so with substantial uncertainty. If we don't include it, we ignore a lot of risk. 

The value of the portfolio over time is also a key factor in determining sustainable portfolio spending. The future value of an individual household's portfolio is uncertain because the three previous factors are uncertain. Assuming sustainable spending will equal some pre-determined spending rule percentage of an unknowable future portfolio value is equally uncertain. 4% of an unknowable number is another unknowable number.

All four major determinants of sustainable portfolio spending are uncertain individually. Combining the distributions of random variables increases the uncertainty but ignoring one or more of them is worse.

It is extremely unlikely that our actual spending path throughout retirement will even remotely mirror sustainable spending predictions. The 4% Rule suggests larger percentages of spending as remaining life expectancy declines. RMD requires percentage withdrawals from tax-deferred portfolios that increase with age. Fixed percentage rules suggest a constant withdrawal percentage at all ages. All three are percentages of an unknowable future portfolio value.

When actual spending exceeds the spending rule estimates, the household is exposed to greater risk of underfunding retirement than the spending rule previously suggested. When estimated spending rates exceed actual needs, the household becomes more likely to underspend.

This isn't to say that spending rules have no value but they're at best a ballpark estimate from within an enormous ballpark. On the other hand, as my friend, Peter frequently reminds me, bad breath is better than no breath at all. The errors of the estimates are reduced as we age and we experience diminishing uncertainty about the future.

Spending rules that consider all four factors provide a better model and should provide a better estimate. Most rules consider three or fewer.

The key is to recognize that a spending rule estimate is good for perhaps a year. They should be recalculated at least annually. Retirement plans based heavily on spending rules have a one-year planning horizon.

Managing with a one-year retirement planning horizon is like driving while looking only at the road immediately in front of your car. When we can't see clearly what lies ahead, on foggy days perhaps, most of us respond by becoming less confident and driving more conservatively.

The important question is how confident we should be in spending rule estimates and the answer is not very.

Why is this important? As I mentioned in Honey, What's Our Retirement Plan?, the most important decision you will make in retirement planning is how much of your resources to allocate to the upside and floor portfolios. The less confident we are in our upside portfolio's ability to deliver on its promises, the more we should allocate to the safe floor portfolio.

Many retirees and even some planners seem to be massively overconfident in upside-portfolio spending rules.

Perhaps they haven't noticed the fog.

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REFERENCES

[1] EarlyRetirementNow.com blog.



[2] LDI Misapplied, David Blanchett and Thomas Idzorek.



[3] Estimating the True Cost of Retirement, David Blanchett.



[4] Liability-Driven Investment.

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.

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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.


REFERENCES

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[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.

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.

Expense Risk in Retirement

I have recently posted about bankruptcy risk, positive feedback loops, chaos theory and Kaplan-Meier estimators and now I'll try to tie all of those posts together. They're mostly about the unpredictability of spending in retirement compared to sequence of returns risk, the probability of outliving your retirement savings due to market volatility. A retiree can enjoy a favorable sequence of market returns, limit spending to a sustainable amount, and still suffer insolvency as a result of huge medical bills, divorce or identity fraud.

Much of retirement writing focuses on the unpredictability of market returns, but unpredictable spending is a greater risk. The most you can lose of your savings is 100% of your portfolio, but you can have unexpected expenses far greater than your savings – a medical catastrophe, for example. Retirees typically plan for a 5% to 10% probability of outliving their retirement savings, but about a half-percent of Americans 65 and older file for bankruptcy, and that number appears to be growing.

First, the big picture. Your retirement finances will likely include some combination of Social Security benefits (in the U.S., or a similar program where you live), private pensions, personal retirement savings, and more and more, working longer. Sadly, private pensions, known as defined-benefit (DB) plans, are disappearing and a sizable majority of Americans don’t have a significant amount of retirement savings to invest. The GAO recently found that older households typically have retirement savings only “equivalent to an inflation-protected annuity of $310 [to] $649 per month.”

Your retirement finances will also include expenses and that spending side of the equation is significantly less predictable than market returns. Most retirement research assumes that you will only spend a "sustainable" amount of your savings portfolio ( a "spherical cow") but in reality, you will spend whatever life costs. Spending a sustainable amount of your portfolio is "retirement savings insurance", not bankruptcy insurance.

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Spending a sustainable amount of your portfolio is retirement savings insurance, not bankruptcy insurance.

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David Blanchett and Sudipto Banerjee showed that retirement spending typically declines about 2% annually for retirees spending appropriately for their wealth and that even when there are large end-of-life expenses these are usually less in real dollars than spending was at the beginning of retirement. Spending crises, however, are not typical. They develop from unpredictable and uncontrollable expenses like large medical bills, housing problems, debt problems, and fraud.

Much retirement research focuses on how to make your personal retirement savings last your entire lifetime, by spending only 3% or 4% annually, for example. This does not, however, consider what happens when life costs more than your sustainable withdrawal plus your Social Security benefits. If it costs a lot more, you could end up insolvent.

You can manage your savings portfolio's longevity risk by reducing spending, but elder bankruptcies are most often the result of spending crises. By definition, you can’t reduce spending in a spending crisis. Controlling spending is the problem, not the solution.

When a household’s finances crash and lead to bankruptcy, it is most often the result of a positive feedback loop of two or three problems. Not only is the household subjected to multiple problems, but these problems feed off one another and act in synergy, “the interaction of two or more agents to produce a combined effect greater than the sum of their separate effects.”

The key point of the Positive Feedback Loops: The Other Roads to Ruin post is that a financial crisis in retirement is often the result of a spending problem that causes another problem that causes a third problem, the problems become synergistic, and then the downward spiral is nearly impossible to stop. These failures can begin without warning and can bankrupt a family in a year or less.

Your retirement plan should consider all risks to your financial well-being, not just sequence of returns risk, and you should not be overconfident even if you have a low annual withdrawal rate. The four households I discussed in that post were all flying high a year before insolvency.

Positive feedback loops in retirement finance suggest the presence of chaos. In Retirement Income and Chaos Theory, I investigated that possibility and found that there are good reasons to believe that retirement finances are chaotic. If they are, then we will never have enough empirical data to understand the underlying mechanisms. Predicting your financial future using probabilities based on past data will always be suspect and can also lead to overconfidence.

The key point of that post is not that our financial future is totally unpredictable and planning is useless, or to measure how much more random market returns are than we believe. The take-away is that, while simulations and forecasts are useful when our finances are in equilibrium (which is most of the time), there will be times when our finances can behave wildly outside expectations. We need to plan for that.

We should plan for the most likely outcomes but try to create backup plans for “worst-case” scenarios. Like a floor, for instance, made up of assets that are not exposed to the equity markets and are protected from creditors.

In the post entitled, “Why Retirees Go Broke”, I combined the findings of an outstanding paper from Dr. Deborah Thorne with a paper my son and I recently co-authored analyzing the timing of portfolio ruin to show that, while sequence of returns risk might eventually deplete your savings, it is unlikely to be a major contributor to bankruptcy.

Outliving your savings and going bankrupt are two different risks. You can outlive your savings without going bankrupt. You may not spend all of your savings if you declare bankruptcy because Social Security benefits are protected from creditors and so are some retirement account assets, especially in bankruptcy. But, poor market returns aren’t the only way to deplete your savings. A spending crisis can deplete savings even faster than market losses and can lead to bankruptcy.

(ERISA-qualified retirement accounts – 401(k)s, are a typical example – are typically protected from judgments even when bankruptcy is not declared, but protection of non-ERISA-qualified retirement accounts like IRAs is complicated. You should discuss both with an estate attorney, but you can find good explanations at Nolo.com and at the Strictly Business Law Blog.)

You can become insolvent even if you invest all of your savings in Treasuries and annuities because expenses will still be uncertain – owning stocks isn’t a prerequisite for financial disaster. The culprit is unpredictable expenses.

The point of the bankruptcy post is that you should not confuse mitigating portfolio ruin with mitigating insolvency. Most elder bankruptcies result from spending crises, not poor market returns. Plan for both.

Most retirement research calculates a lifetime probability of portfolio ruin, the probability that you will deplete your retirement savings sometime during your life. Spend 3% of your portfolio annually, for example, and you have only a 5% probability of outliving your savings. In reality, that probability of portfolio survival ranges from near zero in the first decade of retirement to 5% after three decades or so. Kaplan-Meier curves, as I described in Death and Ruin, show how your probability of portfolio survival changes with age.

That post also explains that unless you live past your median life expectancy, you probably won’t outlive your savings with a reasonable withdrawal rate. The biggest risk of portfolio ruin, assuming you select a reasonable annual spending rate, is longevity, not market risk.

Retirement finance may be quite different than what you’ve read. Losing your savings due to market volatility is only one risk of retirement and it isn’t the worst outcome. You aren’t likely to go broke because you spend 4% of your savings annually instead of 3%, or even to completely deplete your savings. You’re more likely to see your savings decline, then to reduce spending to avoid going broke, and finally to suffer a decline in your standard of living as a result. About half of us won’t live long enough to be exposed to sequence of returns risk, at all.

In the unlikely event that you do spend all your savings, that doesn’t mean you’ll be bankrupt. Bankruptcy is far worse. It means you have more debt than you can repay and your debts need to be reorganized. You may lose all your assets that are not protected from creditors, but you will still receive Social Security benefits and you will keep assets in retirement accounts, although traditional and Roth IRA's are only protected to an inflation-adjusted $1,000,000 (currently about $1,200,000) and this applies to all your plans combined. You won't have credit and you will probably have trouble using banks for a long time.

Sequence of returns risk will rarely be a big contributor to bankruptcy and it takes decades to erode savings. Bankruptcy will strike like a bolt out of the blue as a result of spending shocks and may cost much more than just your savings. (All four of the families I wrote about in Positive Feedback Loops lost their homes, too.) The crisis will be difficult to stop once it starts.

Some shocks are impossible to avoid, but we should plan for the ones we can. We should be aware of the ones we can’t, if for no other reason than to avoid overconfidence in our retirement planning.

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Retirees should focus on a bigger picture than just spending sustainable amounts of savings and the right asset allocation.

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The expense side of the retirement finance equation is at least as important as the income side and it's probably riskier. Retirees should focus on a bigger picture than just spending sustainable amounts of their savings and getting their asset allocations right.

Retirement research should, too.

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In my next post, I'll review the major expense risks of retirement and suggest a few ways to deal with them.

Moshe Milevsky just published a piece entitled, "It’s Time to Retire Ruin (Probabilities)". Regular readers of this blog will recall a similar post, "Time to Retire the Probability of Ruin?", from last April, though Dr. Milevsky makes a much better argument.

Adding Risk to the Model, Part 2

In my last post, A Model of Retirement Planning, Part 1, I suggested that “The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses.” 

Let me break that down. "Best positioning our available resources" means placing our best bets because retirement is unpredictable and we can't know in advance which strategy will outperform the others. "Maintaining our desired standard of living throughout retirement" is typically the retiree's first goal, but it may not be the only one.

I began building a high-level view of retirement finance and the main point of that post was that the three most critical factors of retirement finance are lifespan, income, and spending and all three are largely unpredictable.

Once we lay out an estimate of the cost of the standard of living we desire in retirement (the expenses), estimate the amount of income we might be able to generate from all available wealth resources, and choose a life expectancy for planning purposes, there will be a large range of potential retirement strategies still at our disposal. Different households with virtually the same expected income, expenses, and lifetimes may plan very differently because their risk tolerances differ. We need to add risk tolerance to the model.

The primary risk of retirement is that of losing our standard of living. (Notice I didn’t say the primary risk is depleting our savings. It’s possible to deplete our savings – or even to not have savings –  and still maintain our standard of living. The latter is more important.)

Risk tolerance refers to how much risk we can tolerate emotionally and psychologically. Nearly everyone is risk-averse, meaning that, when exposed to uncertainty, we attempt to reduce that uncertainty. But, some of us are more risk-averse than others, and some are more risk-tolerant, so we tend to choose whatever strategy “lets us sleep at night.”

Given identical expectations of future expenses and income, two households might choose very different retirement strategies because one household is significantly more worried about the prospects of losing their standard of living than the other. Generally, the higher standard of living one chooses, the greater the risk of outliving savings.

Because income can be a range and not a single amount and expenses are a range and not a single amount, there is a budget range within which we can plan. Say we expect annual expenses to range from $30,000 to $35,000 and income to range from $40,000 to $42,000. We can take some risk and plan on $42,000 of income and $30,000 of expenses, be conservative and plan on $40,000 of income and $35,000 of expenses, or choose something in between.

The amount a household will spend in retirement depends somewhat on how much risk they are willing to accept that they will run short of money late in life. Consequently, risk tolerance is a key factor in the basic retirement finance model.

A household that finds that it doesn't have enough expected income to pay for the expected cost of their desired standard of living has three levers to pull in any combination. The household can reduce expenses, increase income, or take more risk of a lower standard of living late in life.

First, we can lower our expenses, reducing discretionary expenses like travel for example, or accept a lower standard of living. We might relocate to someplace where our desired standard of living is less expensive. We can also lower expenses in retirement by working longer and thereby shortening the length of our retirement.

Second, we can increase income by delaying retirement and working and saving longer (the most effective strategy). We may also be able to increase income through part-time employment. We can increase income by delaying the claiming of our Social Security benefits. We may even increase it by changing our funding strategy. A life annuity, for instance, might generate more lifetime consumption than investing in stocks and bonds.

Third, we can spend more early in retirement if we are willing to accept more risk of a lower standard of living at the end of retirement. One way to do this is to bet a lot on the stock market. If the market performs very well during our retirement, we will have more money to spend. Unfortunately, if the market performs only moderately well or poorly, we will have less to spend later in retirement. Many people seem willing to make that bet.

We can also take risk with our life expectancy. Some people bet that they won't live a long life and they increase spending accordingly. That seems like a risky bet for a healthy person, the downside being a low standard of living in old age, but people tell me frequently that they “won't live past 80.” I have no idea how they know that. Once again, this allows us to increase spending in early retirement at the risk of a lower standard of living late in retirement.

Regardless, if you are willing to take more risk of a lower standard of living in late retirement, of not reaching late retirement, or of not encountering many large, unexpected expenses, you can increase your spending in early retirement. Spending won’t depend solely on your income and expenses, it will also depend on your risk tolerance.

Imagine two married households with identical financial resources on the eve of retirement, but with vastly different risk tolerances.

The risk-tolerant household can assume that they won’t live much past median life expectancy, that they won’t need long-term care or have other large unexpected living expenses and that the market will return 8% after inflation throughout their retirement, so they invest most of their savings in a stock and bond portfolio and spend 4% of it each year.

The more risk-averse household will assume the husband will live to age 90 and the wife to 100. They will work as long as they are able and delay claiming Social Security benefits. They will purchase long-term care insurance and use their savings to purchase a life annuity so they maximize consumption and avoid market risk entirely. They will relocate to an area with a lower cost of living. They will spend less early in retirement and hold some back for a possibly long retirement.

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Risk tolerance is critical to retirement planning, but can vary over time with risk capacity and risk perception.

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The risk-tolerant household will feel comfortable spending significantly more in early retirement than the more risk-averse household, which is to say that they will choose a higher standard of living with a greater risk of dying broke. If the more risk-tolerant household is too conservative, they will have a lower standard of living than they would have otherwise had. If the more risk-tolerant household loses the bet, they will have a higher standard of living in early retirement than in late retirement.

One last important point about risk tolerance should be considered. We might imagine that risk tolerance is constant for a given retiree, but that isn't always the case. Like most other key factors of retirement planning, risk tolerance can be unpredictable. It can change situationally or with age.

William Bernstein has written often about investors who feel quite risk tolerant during a bull market only to find during a market crash that they fear losses much more than they expected. He recently wrote that investors who take measure of their risk tolerance during good times should probably halve it. It is difficult to predict how you will feel in a gut-wrenching crash like 2007 until you have lived through one or two.

Research differs on the correlation between age and risk tolerance. This 1997 study (download PDF) concluded that “Risk tolerance increases with age when other variables are controlled”, while a 2010 study reports that “Risk tolerance generally decreased as people age.” In both cases risk tolerance changed significantly with age, but the direction of the change differed.

Interestingly, the study that showed older people become more risk tolerant concluded during the Tech boom and the study reporting that risk tolerance generally declines with age concluded just after the Great Recession, consistent with Bernstein's observation.

Regardless, the important point for a retirement model is that risk tolerance is critical to planning but it can vary over time as our risk capacity and perception of risk change. Like most critical factors of retirement finance, it isn’t something we can establish at the beginning of retirement and assume will remain unchanged. And, because we frequently can’t predict our future risk capacity with any certainty, nor our future perception of risk, our risk tolerance over time can be somewhat unpredictable.

To plan for retirement, we need to estimate future expenses, estimate future income, establish a life expectancy for planning purposes and understand how much risk we are willing to take with those estimates. We add the risk of losing our standard of living to the basic retirement model as follows.

“The challenge of retirement income planning is to best position our available resources to maintain our desired standard of living throughout an unpredictable length of retirement with somewhat-predictable future income but largely unpredictable future expenses. Retirees can choose to spend more or less, within the range of available resources, depending on their risk tolerance. Retirees with high risk tolerance can increase spending in early retirement and consequently increase the risk of a lower standard of living in late retirement while more risk-averse retirees can decrease spending in early retirement and consequently reduce the risk of a lower standard of living in late retirement.”

Once we have an estimate of expected retirement income and expenses, choose a “comfortable” level of the risk of losing our standard of living late in life, and choose a life expectancy parameter for planning, we have gone a long way toward bounding a set of retirement finance strategies appropriate for our household. Choices of details like asset allocations, withdrawal rates, construction of a safe floor portfolio, and annuity considerations will flow from these basic decisions.

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Retirement planning should be a top-down process, rather than choosing from a menu of strategies.

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The previous paragraph has significant implications for retirement planning. It suggests that planning should be a top-down process driven by the choices identified initially within the high-level model, rather than a process of choosing from among a menu of all possible strategies. By identifying the key factors first, we immediately eliminate many inappropriate or irrelevant strategies from consideration.

There is at least one more important top-level characteristic of retirement finances our high-level model must incorporate – retirement's “chained state” nature. Retirement planning isn't a one-time decision.  It's a series of moves in a sequential financial game.  (A sequential game against nature, in the vernacular, and a little more game theory.)

I'll get to that in A Random Walk, A Sequential Game, Part 3.