There are a number of ways to approach a cost estimate and I will tell you up front that none of them will be particularly accurate. Retirement planning is about predicting the future and humans are demonstrably poor at doing that even for a few years, let alone for thirty.
Retirement costs depend on many factors, including how you plan to spend your time (fly fishing is cheaper than traveling the world), how healthy you and your spouse will be, how long the two of you will live, how much financial help your children or grandchildren may need and a host of other possible expenses both within and beyond your control.
Income Should be the Upper Limit on Spending
We can place an upper bound on our retirement spending by looking at the income we estimated in previous blogs, because our spending shouldn't be more than that. If we overspend, our savings will eventually be depleted and our standard of living will almost certainly decline if we are fortunate enough to live for a long time. To state the obvious, whatever our retirement will cost, it can't be greater than our income, at least not for long.
Back in Where Will Your Retirement Income Come From? Part 2, we estimated that the combined personal savings and Social Security benefits at full retirement age for our fictitious retiring couple, John and Sara, would total $47,950 per year. Their expenses, therefore, shouldn't exceed that amount for any prolonged period. If they do, our retired couple will need to reduce their standard of living and tighten the budget.
You might be thinking, "I'm not an idiot, I know my income needs to exceed my expenses", but bear with me. It's a starting point. If John and Sara's expenses are currently $90,000 a year and they know they'll have only half that much income in retirement, then basing an estimate of retirement expenses on how much they spend now is somewhat irrelevant. They will have to spend less in retirement.
The Percentage Estimation Method is Flawed
One way we could anticipate retirement expenses is to look at how we spend before retirement and try to adjust for some of the changes that our new lives will bring. Many financial service companies suggest that we estimate future expenses as a percentage of pre-retirement expenses. For example, they suggest that we will spend 80% of our pre-retirement expenses after we retire. These recommendations are flawed for a number of reasons.
First, these financial experts sometimes recommend 70%, sometimes 80% and a few even recommend 100% or more. A range that large is useless.
Second, annual spending isn't a single amount. It varies throughout retirement. We may spend 100% of pre-retirement levels for a few years, then drop down to 80% as our desire to travel the world wanes, and increase to 120% when a child needs help with medical expenses. Our spending needs may decline again, only to increase with our own medical expenses late in life. Those unknowns make costs really difficult to predict, especially thirty years into the future.
Lastly, and perhaps most importantly, basing our retirement budget on pre-retirement spending levels assumes that we were spending the "right" amount before we retired. In reality, we may have been spending an unsustainable amount and saving too little, or saving too little and limiting our standard of living. 80% of the wrong number is just another wrong number.
The "percent of pre-retirement spending" estimate, though simple and attractive, doesn't provide a good estimate of future spending. It vastly oversimplifies the problem.
How Will Our Spending Change after We Retire?
Another method for predicting how much we will need to spend in retirement is to evaluate pre-retirement expenses and modify them to account for spending changes we can anticipate. In other words, look closely at what we're spending before retirement and think about how spending will change after we retire.
This approach suffers one of the same problems as the percentage method described above. It assumes that we are spending "the right amount" before retirement. This is a major flaw, but we'll look at fixing that in a future session. (I will show you how to determine a sustainable spending level in a later installment.)
In other ways, this approach is better. As we consider how our spending might change in retirement, we can take into account how spending levels may vary in late retirement due to increased health care costs, or decline in mid-retirement as we become less active. Instead of assuming that we will spend 20% less after we retire, we can identify precisely what those cost reductions might be. And this approach provides a useful bonus for many of us— it forces us to create a detailed analysis of how we are actually spending money today.
We need to start the estimate with a detailed accounting of current spending. If you have an accurate budget already, that's great. If not, I'll discuss ways to create one in my next blog.
The difficulty in using this approach is the dramatic differences of spending requirements among retirees. Some will retire and spend their days fishing or visiting the grandkids. Others will take long-awaited trips around the world. And others, myself included, still have kids in college.
Some general trends have been noted. Retirees tend to be more active, travel more and spend more on recreation in the first decade of retirement. You might plan on spending a little more during that time. In fact, some retirees spend more during this first ten years than they spent before they retired.
Between the ages of about 75 and 85, though, many retirees become less active because they're less capable of handling the physical demands of an active life. Some costs may drop during those years.
Lastly, between ages of 85 and 95, or thereabouts, retirees are less active but may experience a dramatic increase in medical costs. Studies have shown that many people spend the majority of their lifetime medical expenses near the end of their lives.
These are generalizations, but they do point out that retirement expenses not only vary dramatically among retirees, but also can vary significantly at different points during retirement for the same retiree. When we modify pre-retirement spending to estimate expected spending after retirement, the result is actually a list of expected expenses by year for thirty or so years of retirement. That's thirty answers, not one, and that's one of the reasons the percentage rule of thumb method many financial planners want to use doesn't work.
To recap, one way we might estimate retirement expenses is to first calculate expected income in retirement. Our expenses can't exceed that income for a prolonged period, no matter how much we spent before retiring.
A second way to estimate how much we will need to spend in retirement is to determine how much we are spending before retirement and modify that amount to account for changes we expect to make to our spending patterns after we retire.
There is yet another way to consider retirement spending forecasts that is based on the assumption that most people will want to have a standard of living after retiring that is similar to their standard of living before. This approach uses an economics technique known as consumption smoothing, which we will consider in the next blog.
The Key Points
- Predicting expenses thirty years into the future is a formidable undertaking. It is impossible to do with any accuracy.
- There is a "right amount" to spend in retirement. It is the amount of spending that we are capable of sustaining throughout retirement. Basing retirement budgets on our pre-retirement budget assumes we were spending the "right amount" before we retired, which may not be true at all.
- One thing is certain, we won't be able to spend more than the expected retirement income we calculated previously. Not for a prolonged period, anyway. That income is an upper bound on spending estimates.
- The financial services industry's "rule of thumb" that you will spend 80% of pre-retirement income after retirement is deeply flawed and should be ignored.
If You're Playing Along at Home
If you are developing a retirement plan as you read these, find a recent copy of your detailed budget of current spending. If you don't have one, follow the steps in the next blog to develop one.