Spending in Retirement
Retirement is spending! After years of setting money aside for the future, the future is now!
If you have saved enough to retire, you need to look at all your sources of income in retirement and figure out what you have to spend.
You have ‘guaranteed’ lifelong sources of income, such as social security, pensions, and income annuities. These can floor your income; that is, provide a steady source for your needs during retirement. Other sources of income, such as business and rental income may also be more or less continuous streams of income.
In addition, you have your investment assets such as stocks and bonds. These provide a variable source of income and are best suited to provide for your wants.
But before we can talk about income in retirement, we need to consider expenses.
What are the expenses during retirement? Are they constant? Are retirement expenses like a “smile” or perhaps rather more “lumpy” than that?
Let’s explore spending in retirement by evaluating the Retirement Spending Smile vs. Lumpy Retirement Expenses.
Retirement Spending Smile vs. Lumpy Retirement Expenses
The retirement spending smile loosely describes overall spending in retirement. The idea is that spending gradually decreases during retirement, especially on fun things (variable expenses). Of course, if you live long enough, there will be increased spending late in life on medical and personal care expenses.
The retirement spending smile, above in figure 1, demonstrates real spending (black line) decreases with time. The initial slope of the decrease is rapid and flattens over time.
Health expenditures, however, manifest later in life. These expenses are uncertain and variable, and increase with age.
Lumpy Expenses and Retirement Spending Shocks
Variable expenses, on the other hand, pop up during retirement as well. These are either known or unknown.
Known lumpy expenses include automobile purchases, vacations, and routine but unscheduled home issues such as new HVACs and roofs. One could assume that common uninsured health expenses, such as dental and hearing aids also fit into the known lumpy expenses.
Unknown lumpy expenses or spending shocks include unexpected health care expenses (major medical issues), family expenses (like failure-to-launch children and aging parents), divorce, and last but certainly not least, the loss of a spouse.
Smile vs. Lumpy
So, are retirement expenses like a smile and decrease with age, or lumpy like the price of a stock? They are, of course, both!
Let’s look more closely at each and model of retirement expenses so as to optimize retirement spending and thus retirement income planning. How do you want to model your expenses in retirement?
Lumpy Expenses to Watch out for in Retirement
Let’s talk about what might constitute a lumpy expense in retirement.
What are some lumpy expenses to be aware of?
Perception of Lumpy Expenses in Retirement
It is interesting to see which lumpy expenses people worry about. Compare what current retirees worry about vs what they think their parents’ concerns were.
First off, the red bars represent retirees’ own experience of lumpy expenses. The yellow bars show what retirees think their parents’ spending shocks were.
Retirees believe they have more home issues, dental issues, and market losses than their parents.
More interesting than that, look at what people think their parents’ issues were! Illness, disability, loss of capacity and Medicaid are all issues more likely to happen to my parents than to me! Interesting!
What can we learn from this? Perhaps, personally, we need to worry more about illness, disability and loss of capacity. We see these issues reflected in our parents, but are less concerned about these serious issues personally.
A List of Actual Lumpy Expenses
What are the lumpy expenses we need to consider in retirement?
Taxes not infrequently are well-to-do retirees’ largest expense. One with significant resources outside of social security should expect 85% of their social security to be taxable as part of ordinary income. The Tax-Torpedo is a lumpy tax issue faced by those with fewer resources during retirement.
Aside from social security, pension income and pre-tax accounts are fully taxable at ordinary income rates. How do you get a lumpy tax problem? By having other lumpy expenses and having to pull money out of your pre-tax accounts to pay for them.
The flip side of this is a tax-deductible lumpy expense. There are times when one gets a tax deduction and SHOULD pull extra money out of pre-tax accounts to harness the lower tax brackets exposed by the tax deduction.
Healthcare, after running out of money, is the largest concern for retirees.
The healthcare system is broken, and a major issues is the lack of price transparency. From surprise out-of-network charges, to catastrophic illness or ambulance/helicopter bills that aren’t covered, you never know when you are going to need to reach into your billfold or purse to pay medical bills.
Above a floor, healthcare costs can be deducted from your income. This is a slightly confusing topic, and it doesn’t help that the IRS changes the floor from 7.5% to 10% back to 7.5% again.
When are you subject to lumpy medical bills?
Healthcare is such a concern, I want to spend some time looking at the lumpy costs associated with it. Above are out-of-pocket medical expenses by age. Note that median spending is the highest at age 90-94 when health care spending is pretty common.
The 95th percentile out-of-pocket expenses stay pretty flat until above age 85.
Key Point About Lumpy Medical Expenses
This brings me to a key take home point. Concerns about lumpy medical expenses are common. It is important to note, however, that most folks have medical insurance in retirement. So, while medical costs are common lumpy expenses, they are often mitigated by the presence of insurance.
As represented by figure 3, see the median cost of health care really doesn’t go up a lot over time. With insurance, health care costs are more of a fixed expenses. However, there are expensive outliers, or a fat right tail on the distribution curve. Note the 95th percentile costs going up sharply late in life.
I fear long term care expenses. Chances for lumpy expenses are high.
Statistics, however, are misleading because ‘the industry’ wants you scared enough to buy Long-Term Care insurance. Statements like “70% need long term care at some point in their life” are absurd! This is the percent of folks who will need some type of services during their lifetime. A much smaller proportion of people actually get through the 90 day elimination period and begin accessing insurance benefits.
I don’t like traditional Long Term Care insurance. We may see these policies implode in the next two decades.
I don’t like hybrid insurance either. Most folks who have lumpy long term care costs can use these as tax deductions which allows tax-free withdrawals of pre-tax money. This is a difficult concept and the insurance salesmen out there certainly haven’t figured it out yet.
The money pit. Major housing expenses are common lumpy expenses. Home retrofits for medical issues are also of concern.
This is a good lumpy expense! Take the cruise around the world.
Supporting kids, grand kids or parents with gifts can be lumpy expenses. Is your daughter’s wedding considered a gift?
Pets are important for psychological health and can be expensive!
Loss of a Spouse
Spousal loss is inevitable but the timing is uncertain. Becoming a widow or widower has huge financial ramifications which are not often considered when making a retirement spending plan. The Widow Tax Penalty can be devastating under the right circumstances.
Summary: Lumpy Expenses in Retirement
There will be lumpy expenses! Consider the idea of “consumption smoothing.” This is a concept whereby retirees seek to have consistent spending both in their retirement and pre-retirement years.
Consumption smoothing is not probable. A better solution is a cash bucket in retirement. This is not a 3-6 month “emergency fund,” this is actually a cash bucket of 2-3 years set aside for spending. Yearly, you would refill this bucket from your other assets to smooth consumption over the years.
Let’s move on to the Smile!
The Retirement Spending Smile
Some find it difficult to start spending in retirement after decades saving.
Also, during downturns in the economy, it is the natural tendency for most folks to cut back even during retirement. This might be a form of self-insurance– running out of money is one of the largest concerns for those who are retired.
The trend in general, however, as we saw above, is a gradual decrease in spending over the majority of retirement until healthcare costs start to increase late in life. This is the retirement spending smile!
Let’s look at some issues with the Retirement Spending Smile which are important to consider.
Inflation and the Retirement Smile
Above, you can see the inflation adjusted spending as the constant straight dark blue line. This means you take out the same inflation adjusted amount over the 30 years represented above. It is an example of how you would plan future spending using, for example, the 4% rule.
Real spending, however, decreases for the first 15-20 years of retirement and then increases rapidly in the last 5 years prior to death. Note the spending smile does not get above the inflation adjusted amount until the last year or two of life.
Digging a little deeper, the smile depends on the resources available for retirement.
Effect of Income on the Retirement Smile
Affluent retirees have a different smile curve than those with limited resources (such as just social security). Those with plenty of reserve actually rapidly decrease the rate of spending in early retirement, while those with less resources have a different curve. This implies a bit of flexibility in the decrease of spending in retirement.
This is represented above in figure 5. The blue line represent folks with less income. The slope of decrease is slow and not as deep as those more affluent in green. The rate of increase in the curve is higher and faster in those with less reserve, and they actually have increased real spending above inflation adjusted amounts at the very end of their retirement.
What about the future of spending in retirement?
Future Pressures on the Spending Smile
There are headwinds in the future when thinking about retirement spending. Many are predicting retirement income shortfalls in the near future. Why is that?
Fewer retirees have pensions as private companies switch to defined contribution plans.
There is significant legislative risk surrounding Social Security. You may correct in assuming that there will be a small (10-20%) cut in your benefits if you have more than a few decades before you plan to take social security. But who knows?
Many have saved a significant amount in pre-tax accounts. There is a large liability in the future to pay taxes at an unknown rate, again, based upon legislative risk
Future Expected Returns
Pundits are worried about future expected returns given high stock valuations and low interest rates on fixed income.
Longer Life Span
Folks will continue to live longer. Longevity is a multiplier of all the other risks faced in retirement.
Significance of the Smile
Income need is usually projected as gradually increasing in the future due to inflation.
Since expenses actually decrease during retirement, you can plan to spend more during the beginning of retirement than many projections allow.
But you must leave yourself some wiggle room for the known and unknown lumpy expenses.
Setting some money aside for the future and then spending the rest “early” is a reasonable consideration.
Others may consider “flooring” expenses after age 80 (with “guaranteed” income) and spend the rest freely on variable expenses.
Conclusion: Retirement Spending Smile vs. Lumpy Retirement Expenses
The retirement consumption puzzle states that spending actually decreases in inflation-adjusted terms during retirement. Yet while planning for retirement, we plan constant or even increasing spending goals.
The basic 4% Safe Withdrawal Rule method simulates spending that keeps pace with inflation. This may result in having too much money left over at the end while not spending enough early in retirement on things you enjoy!
Planning to need ever increasing amounts of income in the future restricts what can be spent early in retirement!
There are, however, known and unknown lumpy expenses that must be accounted for throughout retirement.
Known lumpy expenses tend to be greater at the beginning and middle part of retirement. Late lumpy expenses tend to be medical in nature, and at least covered by insurance. Only outliers have very large late lumpy expenses. This leads to complicated planning decisions.
Long-Term Care continues to be the most inscrutable issue in Retirement Planning, as it may be either a large late lumpy expense or the cause of the gradual up slope in the smile. In a way, Long Term Care is like Schrodinger’s Cat, it is both at the same time until you actually experience it, then it is either-or.
Long-Term Care issues must be addressed separately.
Nevertheless, all of this argues for more liberal spending early in retirement. And perhaps getting a cat.
Spending in Retirement