It's smart to budget
for inflation. But if you're overly conservative, you may be setting yourself
up for a less fun retirement or years longer working than necessary, because
your retirement spending calculation may be wrong.
by: Ray E. LeVitre, Investment Adviser, CFP November
17, 2017
“How
much can I spend each year during retirement?” Retirement-planning software and
statistics clash on this point.
If
you, or your adviser, are using retirement software to determine your
recommended spend rate in retirement, it is highly possible that the
projections are inaccurate. These miscalculations could put unnecessary limits
on the amount you can spend during your early (and healthier) years of
retirement. In addition, these potential errors could suggest that your
nest-egg needs to be much larger than is needed, forcing you to stay in the
workforce longer than you have to.
If
you are a retiree, or soon-to-be retiree, understanding these potential
inaccuracies could help you better determine when you can comfortably retire,
and adjust your spend rate to make the most out of your retirement as you age.
Traditional Planning
Retirement-planning
software requires you to input an assumed retirement inflation rate. Most
software defaults to 3%, which is roughly the 100-year average in the U.S. That
means the software is going to assume that you will need 3% more money every
year to buy the same things you bought in the previous year. For example, if
you need $60,000 this year to cover your expenses, next year you’ll need
$61,800 to buy the same things, and $63,564 the next year and so on.
At
that 3% pace, you’ll need $108,367 20 years from now to buy what $60,000 buys
today. These projections should work out beautifully if we do, in fact,
experience 3% inflation. But life’s not that simple.
The Facts
Even
though inflation should always be a consideration in your retirement planning,
you shouldn’t let it scare you into unnecessarily overworking and
underspending, because research by the U.S. Bureau of Labor Statistics (BLS)
suggests that folks actually spend less as we get older, rather than more.
While our spending on things like health care increases somewhat during
retirement, it is more than offset by a decrease in things like housing, food,
clothing, transportation and entertainment.
According
to the BLS, there is a spending decrease of 17% between ages
55-65 and ages 65-75, and another decrease of 24% for those over age 75,
vs. their age 65-75 counterparts. And that’s more than enough to cover for
rising prices, when compared to inflation’s historical average.
So,
for someone who is age 55-65 and needs $60,000 to cover their annual living
expenses, the BLS numbers suggest that they will likely need 17% less, or
$49,800, between age 65-75, and then $37,848 after age 75 (assuming today’s
dollars). The BLS numbers don’t suggest that there isn’t inflation experienced
during retirement, but rather that we simply buy fewer things.
Comparison
So,
let’s look at the difference between someone planning on rising expenses or
falling expenses during retirement. Let’s assume we have two couples, both age
65, and both needing $60,000 to cover their retirement expenses (chart below).
Both couples receive $36,000 from Social Security, $20,000 from a pension
before tax, and the balance of what they need from their $500,000 IRA
portfolios. We are also assuming a life expectancy of age 95, a 5% rate of
return and an 18% nominal income tax rate.
Constant Rising Expenses (Traditional
Projections)
Jim
and Barbara are using traditional retirement projections with a 3% inflation
assumption. With this conventional wisdom they are assuming they will need 3%
more money every year to cover their living expenses. By age 75 they assume
they will need $80,635 to cover their expenses and by 85 that will rise to
$108,367. Based on these assumptions, Jim and Barbara’s portfolio will be
completely depleted at age 87. As their adviser, if I stopped at this point,
I’d have to suggest that they continue working and building their portfolio, or
decrease their spending to $50,000.
Falling Expenses
Robert
and Susan have developed a more detailed analysis and are assuming their
expenses will fall at different points during retirement. Using the BLS numbers
as their guide, they have determined they will need $60,000 for the first 10
years of retirement, $50,000 for years 11 through 20, and $40,000 thereafter
(adjusted for 3% inflation). Using these assumptions, their analysis indicates
that they will have $392,972 left at age 86 and $198,910 left at 95. If Robert
and Susan wanted to be even more aggressive in their spending, they could spend
an additional $5,000 per year for the first 10 years of retirement without
running out of money by age 95.
Being Conservative Comes at a Cost
If you take the conventional wisdom, a constant 3% increase per year throughout retirement, you are definitely being conservative. However, you may be being too conservative. The cost of your conservativeness may be an unnecessary reduced spending rate early in retirement when you are healthy and able to enjoy your money. On the flip side, being conservative in your planning will help you handle the unknowns that may arise, like the added cost of a nursing home stay, lower-than-anticipated returns, living much longer than projected, higher-than-projected inflation rates, etc.
The
key here is to understand the limitations of retirement calculators in light of
spending trends among retirees. The closer you can estimate your actual
spending, the better your analysis will be. You don’t want to look back when
you are 85 and no longer physically able to do as much as you once could, and
wish you would have taken a few more trips when you were younger and more
healthy. You also don’t want to spend too much too soon.
I’d
suggest running your projections assuming expenses are increasing over time,
and also projections assuming your expenses are reducing over time. This will
likely take the help of a financial professional who has access to cutting-edge
software. Once you’ve run and compared the numbers, you will likely conclude,
as I have, that your spending should be somewhere in between the two
approaches.
This
article was written by and presents the views of our contributing adviser, not
the Kiplinger editorial staff. You can check adviser records with the SEC or
with FINRA.
Ray E. LeVitre, Investment Adviser, CFP Founder, Managing Partner, Founder and
Managing Partner, Ray LeVitre is an
independent fee-only Certified Financial Adviser with over 20 years of
financial services experience. In addition he is the founder of Net
Worth Advisory Group and the author of "20 Retirement
Decisions You Need to Make Right Now."
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