Spending Realities in Retirement

It’s usually worthwhile to question conventional wisdom. At the minimum you usually learn where that wisdom came from. Often you learn the conventional wisdom is not the best approach. This happens to apply rather well to the topic of retirement spending. Lets take a look at the conventional wisdom regarding retirement spending and see why it may not be the best approach.

All the standard retirement models tell retirees to adjust spending every year for inflation right? This how the SWR (Safe Withdrawal Rate) model works. You pick a percentage of the portfolio to withdraw in year 1 and then adjust that spending every year for inflation. Simple enough. The theory being that at the minimum we want to maintain the same ‘standard of living’, i.e. real spending, from year to year. The biggest question to ask is this model actually how retiree spending evolves over time?

Anectodally, this model has always felt a bit off to me. For one, I meet a lot of retirees and speak to them quite a bit about finances and spending. Many I’ve met have held spending constant for years while maintaining their quality of life. In my personal situation, on average spending has either stayed the same or declined every year. What gives?

Fortunately, some recent research has shed some light on this topic. Michael Kitces has a great post covering this research which I highly recommend. I’ll just highlight a few points from the post. Lets first look at how retirees actually spend. Here is the data:

The orange line in the graph above is spending adjusted for inflation, real spending. This is the line all retirees fall on according to the recommended retirement models. The reality is somewhat different. For the majority of retirees real, inflation adjusted spending declines in retirement. Even towards the end of life. The declines are on the order of 1% a year, growing to 2% a year, then back to 1% a year in the later years but still never positive. Definitely a different reality than the models portray. An important point: this is real spending. Actual spending may still actually increase. For example, inflation is 3%, spending goes up 2%, real spending is then down 1%. Now lets look at how you can use this in your retirement.

I think the best way to use this research is to take a look at your retirement in stages. Michael also talks about this in his post but basically the idea is to divide retirement into three spending stages. Like pictured here;

Each of the three stages can be modeled with a different change in retirement spending. For first stage, say 60 to 70, -1% per year in real spending could be used (or conservatively the standard model’s o% per year), for the second stage, 70 to 85, -2% per year, and for the third stage back to -1% per year. This can be tailored to be fit your specific circumstances which is also much better than the standard retirement model.

OK, so far all we’ve done is match the retirement model to a better representation of retirees’ actual experiences. Now for the punchline. Being that realistic scenario is less spending than the model means one of several things. One, the standard SWRs are too conservative. Two, retirees need less money to retire to being with. Three, worst case, the SWRs from the standard retirement model plus a more realistic spending outlook means a much higher probability of success in retirement. I’ll take a look at some of these implications in later posts.