Effect of Spending Habits on Retirement Planning

The traditional approach to retirement assumes that retirees will maintain their pre-retirement standard of living as they transition into retirement, and then sustain that lifestyle throughout retirement. But a growing base of research that analyzes the actual spending habits of retirees, reveals a different story.

In reality, retirees tend to experience a slow but steady decline in real spending throughout retirement. Spending decreases slowly in the early years of retirement, more rapidly in the middle years, and then slows again in the final years, in a path that looks like a “retirement spending smile.” Even the uptick of health care expenses in a retiree’s later years are generally not enough to offset all the other spending decreases that typically occur in retirement. That’s important, because it means your clients may not need as much money in retirement as they think.

Trends in Retirement Spending

Research on retiree spending patterns is finding that in practice, retirement spending often occurs in three phases.

Early in retirement, the so-called “go-go” years, your clients are likely to continue to be active. They may even travel more than they did before retirement. After 10-15 years, they transition into the “slow-go” years, when their health and energy begin to decline, and their spending starts to decline, too, especially discretionary spending. By their 80s, most retirees reach the “no-go” years, and there is an almost total shut down of discretionary activity-related spending. Only core expenses for basic food and shelter tend to remain.

While this three-phase approach may describe your client’s discretionary expenditures, it leaves open one of the key concerns in late-retirement spending: expenditures on health care. Yet, a look at the data reveals that while health care spending becomes a larger part of the pie in the later years, it’s still typically offset by the decreases in other discretionary categories.

Even clients who fear health care expenditures may rise in the later retirement years should still assume some decrease in spending throughout much of retirement. This is especially true for the subset of retirees who:

have full Medicare Part B and Part D coverage

are enrolled in a Medigap supplemental policy

have long-term care insurance

Of course, households that aren’t fully insured may need to set aside some additional funds for contingencies. And for a subset of lower-income households, the co-pays on Medicare Part B and Part D can be burdensome. For moderately affluent households, health and long-term care insurance has a remarkably stabilizing effect. In other words, despite the increases in the health and long-term care categories, when matched against other discretionary spending categories that decrease, the net result is still a decrease in overall real spending. Notably, “nominal” spending tends to rise in retirement – but not enough to keep pace with inflation, which results in a decline in real (inflation-adjusted) spending.

The bottom line is that you should be assuming some level of spending cuts for most clients in retirement, unless their net worth and spending is so modest that it’s impossible for any spending declines to occur without curtailing basic subsistence. This is especially true for married couples who generally experience additional spending declines in later years when at least one spouse is likely to have passed away. Once these adjustments are accounted for, retirees may need as much as 20 percent less to retire than what traditional models have predicted.

For more information on retirement planning, the AICPA Personal Financial Planning Division has released The CPAs Guide to Practical Retirement Planning, providing a comprehensive look at retirement planning and what CPAs need to know.

Michael Kitces, Partner and Director of Wealth Management for Pinnacle Advisory Group. Michael is co-founder of the XY Planning Network, and publisher of a continuing education blog for financial planners, Nerd’s Eye View. You can follow him on Twitter at @MichaelKitces.

Retirees courtesy of Shutterstock

Effect of Spending Habits on Retirement Planning

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