Executive Summary
Estimating retirement expenses over the entire duration of a client's retirement years is a fundamental part of retirement planning. Yet there is surprisingly little agreement from planners about the spending behaviors of clients as they go through retirement.
Some suggest that retirement spending rises as clients age, due to the accumulating impact of health care expenses. Others suggest that retirement expenditures decrease, as clients reduce their spending in areas like travel and restaurants. Still others suggest that retirement spending is relatively level and simply keeps pace with inflation, as the increases in one category (e.g., health care) offset the decreases in others (e.g., travel and restaurants) - which, notably, is also the implicit assumption of steady inflation-adjusted spending that underlies the research regarding safe withdrawal rates and how much income is sustainable from a portfolio.
So which is it? A growing cadre of research suggests that in reality, client spending probably does decrease over time... with some notable exceptions. And if you don't use a proper assumption, you may force clients to save more than is needed, or retire later than is necessary!
The inspiration for today's blog post is a conversation I had with another planner after last week's blog post regarding whether and how retired clients experience ongoing annual inflation. In our discussion, the planner highlighted a recent situation with an elderly client couple who had not materially changed their spending withdrawals in nearly a decade, and insisted that they were not really being impacted by inflation. In delving deeper, though, it became clear that in reality, the issue was not whether the client couple was being affected by inflation, but whether the couple was altering the underlying composition of their spending in the first place as they aged. In other words, the couple was experiencing inflation, but increases in the cost of things the couple buys was being offset by the fact that the couple just wasn't buying as much stuff anymore!
In point of fact, this issue was covered several years ago in the June 2005 issue of Journal of Financial Planning, in an article by planner Ty Bernicke entitled "Reality Retirement Planning: A New Paradigm for an Old Science". In his article, Bernicke drew on data from the Consumer Expenditure Survey conducted by the Bureau of Labor Statistics to analyze retiree spending patterns. The data are striking, suggesting that those in the later half of retirement (age 75+ by the BLS data) spend an average of almost 30% less than early retirees (those aged 65-74). In fact, Bernicke shows that this gap has been remarkably persistent over time; the difference is almost the same (on a relative basis) whether you look at the data from 2004, or 1984. The BLS data - along with data from the Health and Retirement Study conducted by the National Institute on Aging that show a smaller but similar decline - have also been widely examined in analysis by the Bogleheads community.
Both the Consumer Expenditure Survey and the Health and Retirement Study support the premise that health care expenses rise with age; the results are evident in both studies. However, the clear trend of the data is that in the end, those increases are not enough to offset decreases in other categories, from food to entertainment to transportation costs (e.g., as the household not only drives less and spends less on gasoline, but transitions from having two cars down to only one). The limited impact of health care cost increases is likely due in large part to the fact that in the end, Medicare puts a significant constraint on how much health care expenses can rise; for instance, as I've written in the past on this blog, even a rather affluent retired couple with $150,000/year of income likely pays only about $10,000/year in health care expenses, and between Medicare parts A, B, and D, and a Medigap policy, there's very limited exposure to further costs from there. While $10,000/year isn't cheap, it's not catastrophic to "mass affluent" clients, and aside from health care inflation adjustments to the cost of the insurance, there's very limited risk of a precipitous increase in costs (outside of long-term care needs, which can also be insured separately).
In addition, I suspect the impact of changes to the composition of retirement spending - i.e., how much is spent across various categories - is also highly dependent upon overall income and wealth levels. And the reality is that the aforementioned surveys look at the average American, who in reality has significantly less affluence than the average financial planning client. For instance, the Health and Retirement Study shows that for married couples at the bottom of the income scale (5th to 15th percentiles), spending on health care alone is 16%, and total expenditures on housing, health care, food, and transportation comprises a whopping 81% of all household spending. On the other hand, for those at the upper end of the spending levels (the 85th to 95th percentiles), health care drops to 13%, and the total expenditures on housing, health care, food, and transportation together are only 55% of household spending. At the upper wealth levels, spending on entertainment, gifts, and other durable goods purchases rises dramatically to fill the void. Yet in turn, many of these highly discretionary expenditures like entertainment only fill the void in the early years, and are the most likely to decline later with age.
In fact, a study released several years ago by Sun Life entitled "The Expense Reality" - discussed on this blog back in 2008 - showed indeed that international travel spending declines for retirees in their 70s, domestic travel expenses decline for retirees in their 80s, and a wide array of other miscellaneous expenses, from new/second business start-up expenses, to hobby expenses, decline in the later years. On the other hand, the study also showed that certain categories have "unexpected" increases; for instance, expenditures on luxury items jumps for those in their 70s, and charitable giving rises for those in their 80s. Yet these are perhaps the ultimate in purely discretionary expenses... suggesting that the reality is not only that other spending categories decline in the later years, but that clients who can afford to sustain the spending actually increase consumption on luxury items and charitable giving to fill the spending void left by other category decreases!
So what does all this mean from the planning perspective? It suggests that as a baseline, we probably should project client spending to decrease by at least 10%, if not 20% to 30%, in the later years (e.g., age 75+, or especially age 80+), on an inflation-adjusted basis. This is especially true if the client has otherwise put reasonable insurance in place for health care and long-term care. The greater the affluence of the client, and the larger the percentage of discretionary spending relative to total spending, the greater the projected spending decline in later years. Arguably, this means that clients may need less to retire that we often suggest, and/or could retire earlier; from the safe withdrawal rate perspective, it implies the initial withdrawal rate could potentially be much higher, if later spending cuts are built in up front.
On the other hand, it's equally notable that this would just be the baseline; if the portfolio is actually performing well, and/or spending has declined earlier for some reason (for instance, a change in health by one member of the couple that resulting in a travel spending decrease earlier than anticipated), it is highly probable that affluent clients may and will choose to replace some discretionary spending decreases (e.g., travel and entertainment) with other voluntary discretionary spending increases (e.g., luxury items or gifts to charities or family members), as the Sun Life study shows. But these later outflows would truly be voluntary and discretionary; they would only occur if the wealth was already there, which is why they would not be part of the baseline scenario. In other words, the plan might assume spending will decline in the later years, with a contingency that clients will simply choose to spend more if they can in fact afford to do so when the time comes.
So what do you think? Do your clients spend more, or less, in their later retirement years? Do you see greater spending decreases by your clients with higher levels of discretionary spending? Have you seen affluent clients "replace" their spending in some categories (e.g., travel and entertainment) with outflows in other categories (e.g., luxury items and gifting)? Do you project a spending decrease for your clients in their later years?
Michael,
Interesting analysis. Actually, you’ve scooped me a bit, as I am halfway through writing on this same topic for my next Advisor Perspectives column. I think I can make my column sufficiently different from yours, though I think we both are arriving at the same conclusions. In particular, I will also describe a bit about Somnath Basu’s Age Bander work, and William Bengen’s Prosperity model. Both speak to this issue also. I will be interested to follow your reader comments.
Best wishes, Wade
Wade,
Sorry about that – wasn’t trying to scoop you! 🙂
But yes, I think it’s a very interesting topic. I’m especially curious about how these spending behaviors function for the typical financial planning client, who generally has far more affluence, and a far more portfolio-based retirement plan, than the mere “average” American.
Even the 85th-95th income percentile in the HRS study still spends something less than $4,000/month, which would probably be on the very low end of most of our financial planning clients!
– Michael
I liked this Michael, and agree to a point.
Retirees do spend less as they age. As a matter of fact I’ve classifed ages 75-80 “the frozen budget zone,” where health problems moderate (don’t worsen) seniors are not as mobile so they remain closer to home and activities are low cost. This is anecdotal at best from 25 years experience face-to-face with clients.
I’m confident retirees are trying hard to spend less in early retirement too. Or they’re returning to the work force. The world is not the same: 2005 is an eternity away for some of these people. Conditions are not the same.
We constantly need to consider how the financial crisis has ravaged the investment nest egg, how the unprecedented pressure on conservative savers/investors due to Fed actions has caused distress. Behaviors have changed, spending habits too.
Recently, I was at a national department store in the early afternoon. There were nine registers available. All nine registers were operated by seniors. Nine grey heads ready to ring up my package of mozzarella cheese sticks. I stared. Since I’m usually chained to my desk during the work day, this observation sucked the wind out of me. I don’t recall ever seeing this. I felt like I was staring at my future.
Before the financial crisis, before the Fed decided to decimate what you can earn on safe investments, older citizens were able to enjoy at least some of the golden years. To preserve principal, to give their retirement accounts some breathing room from withdrawals, this little group decided to re-enter the work force. It wasn’t like this before, I’m sure of it. Either that or I need to get out more.
Recent studies show how without social security, a majority of retirees would be in trouble. I tend to work with cross section of clients so I’m not just working with the mass affluent so I can understand what’s real out there.
I love your contributions to our business..
This blog captures the three phases of retirement wonderfully: the “go-go” years, the “slow-go” years and the “no-go” years.
Spending patterns are not consistent throughout retirement…and I would argue that the pattern itself varies between affluent and middle class folks.
As more people engage in new hobbies, start new businesses, etc. as a part of their early retirement years, there is often even a spike in spending in the intial phase.
Eventually, folks tend to want to start downsizing their life and simplifying things as they age. And finally, they enter a phase where they can no longer physically do all the things they once did.
For many middle class (and below middle class) retirees, the impact of this is significantly reduced because there is less expense to downsize. In other words, the proportion of fixed expenses to discretionary expenses is much smaller.
Every household has its own economic system consisting of its own unique inflation rates, monetary policy, political system, employment rates (and unique threats to that rate), etc.
We must stop modeling all households, all retirement projections, all monte carlo simulations and all withdrawal strategies using the same assumptions.
This paradox also applies in reverse. The “household inflation” experienced by a young couple is immensely different than the CPI, yet we still simply tie a 3% – 4% rate to their spending. What inflation rates do not capture is lifestyle spending increases that creep into cash flow due to things like innovation.
For example, my first cell phone a mere ten years ago was $49 and cost me $50/mo for 100 anytime minutes. Today, we don’t bat an eye at a $400 phone and $160/mo plan. This is not the result of inflation.
Many people who chose to upgrade their lifestyle to these new phones and plans (or cable TV and internet packages, flat screen HD TV’s in every room of the house, tablets along with laptops, etc.) are the same folks complaining about rising gas and food prices. The inflation rates on everyday items pales in comparison.
One of the biggest assumptions we make in our projections and monte carlo simulations is that spending will be static, despite the fact that we know with absolute certainty that won’t be the case.
Ultimately, we have to do a better job understanding each household’s spending patterns and assess the likelihood of a change in either direction.
Regards,
Joe Pitzl, CFP®
Michael,
This type of analysis is always helpful, as it helps bring lifetime spending into perspective. It’s difficult to get a “lifetime snapshot” of individual clients until they have already lived their life, so it’s important to see other’s research to help gain perspective.
From my own experience with clients at different stages of life (as well as my own parents and in-laws), I think you are pretty spot-on. Obviously, the risk factors surrounding health care costs and long-term care expenses (or potential expenses) have been the two largest variable factors – by far – among my clients in their later years.
Because of this, I have made a very conscious effort over the years to bring those risks front and center with my clients. I prefer to have more “knowns” than “unkowns” as far as spending is concerned. So having adequate health insurance coverage and LTC insurance (or a plan in place if not insurable) has become critical.
Thanks for the insights.
Robert C. Henderson
President, Lansdowne Wealth Management
What a huge topic.
You’re talking about behaviors and economic factors in the same article. Maybe I can add my own focus?
I want to talk about the non-wealthy. So let’s focus on the baseline and ignore discretionary expenses, which are more forecastable and adjustable with just a bit of client & planner teamwork.
Focusing on baseline, there are 2 things that can knock our baseline expenses off course. Inflation and an expensive health care or long term care issue.
So for non-wealthy, we need to add two safety margins to our baseline.
Now we’re back to questions we can ask planners. How much safety margin do we include for inflation, and how much safety margin do we include for worst case health or LTC expense?
OK, how much safety margin?
I’ve found it a great opportunity to talk to clients about their estate. When you’re talking to middle income clients, initially, it’s often “I’d like to die with zero net worth”. But even those clients concede they don’t want to EVER be a financial burden on their children, so they’re going to need a bit of safety margin.
I’ve found those clients receptive to leaving an inheritance if it is designated as also being the safety margin for both inflation and LTC and healthcare surprises.
This simplifies planning but you have to make sure their adult children understand the purpose and priorities of the combined estate/emergency fund.
Oh no. Did I go off on a tangent or did I succeed in describing how your article relates to my approach as a financial planner?
I agree that, all things being equal, people spend less as they age.
However, I can envision two areas that may be changing. The first is that clients are having children later in life. And rather than being supported by children, are often supporting their adult children. You and I might consider these expenses discretionary, but often the clients don’t.
The second issue is the unsustainability of the health care model. I would anticipate that the costs will have to rise (particularly for affluent folks) and/or the benefits will need to be cut, and therefore some of our clients may choose to pay for services that current retirees receive for free.
Both issues are hard to predict or model.
Michael,
My 2 cents. I have both my parents alive and living in a retirement facility in Oakland. They moved 4 years ago from their owned home in Brooklyn. Monthly costs in their own home were under $3,000. Their independent living home costs about $6,000/month. I have 2 other clients one with both spouses alive over 90 and the other with both spouses alive just under 90. Both moved from their own homes and moved into an independent/assisted living optional retirement community. In both cases their expenses rose significantly when they moved. They are all middle class with assets between 500K and 750K. Many of the residents in my clients retirement community have significant assets and could be spending more or less than when they lived in their own home. Also my anecdotal observation is that couples and singles are staying in their home longer. The individual or couples living situation has a large impact on spending later in life. And what is their life expectancy once they move out of their home is another important factor when providing planning.
Interesting and amusing distillation of HS Dent research showing spending patterns over a lifetime for a range of items, starting with bathroom linens, admission fees to entertainment, airplane tickets, …
http://read.bi/wZGF9Z