N = 1
Have you ever noticed the auto-fill feature in a Google search? You start typing your search and Google tries to predict what you're looking for and attempts to save you some keystrokes by filling it in. When typing "planning for", the search engine prompts me with:
... retirement
... a baby
... the future
... burial
What an odd mix! "Planning for retirement" yielded about 15mil results but there were 602mil for "the future" and 128mil for "a baby". "Burial" had less than 1mil, but that's understandable, right?
It makes sense that "planning for the future" has more search results than "planning for retirement". Planning for the future is catchy, general, and uplifting. You can plan for the future in pictures, poetry, even song. Thinking about retirement often involves pictures of faraway beaches, mountain lakes and streams, and beautiful sunsets. But planning for retirement is challenging work.
A big part of the challenge is figuring out what your cash flow and budget situation is likely to be once you're no longer working for pay. Should you plan to spend a percentage of your working-life budget? What's the percentage? Will that match up with the lifestyle you want? Will it allow flexibility for life's inevitable changes?
As with many complicated planning tasks, rules of thumb exist that purport to make things easier. But common rules of thumb, such as "Plan to spend 80% of your pre-retirement spending during retirement", make planning harder because they're too general.
In reality, everybody is an experiment of one (N = 1). The details of your plan will be unique, even as there are commonalities with the plans of others. And if your planned budget happens to match up with an 80% rule of thumb, it will just be coincidence.
But how do you start thinking about your retirement spending budget and cash flow needs? The following excerpt is from an article by Christine Benz, Morningstar's Director of Personal Finance (link to full article below), and gets to the five most important steps to consider.
Step 1: Start with Today's Expenditures
To help arrive at anticipated spending needs, begin with an assessment of household living expenses today, both fixed and discretionary. If you're saving on an ongoing basis but expect that to cease in retirement, you'll obviously want to adjust your cash-flow needs downward to account for the subtraction.
Step 2: Consider Housing Changes
Apart from likely decreases in your savings, do you envision any other substantial changes in retirement? Housing costs are one line item with the potential to change substantially in retirement. Is your plan to come into retirement without a mortgage, for example? Or perhaps you intend to relocate or downsize in some fashion? Even though the main goal of downsizing may be to add the home-sale proceeds to your retirement kitty, it can have the salutary effect of reducing property taxes and lowering outlays for insurance, utilities, and maintenance. As a senior homeowner, you may also be able to qualify for a reduction in your property taxes, depending on where you live.
Of course, not every household sees a drop in housing costs during retirement; some retirees stay put in their primary residences while also purchasing second homes that actually add to their total housing-related outlays.
Step 3: Factor in Anticipated Lifestyle Changes
How about other living expenses? In his paper, Blanchett [David Blanchett, Morningstar's Director of Research] cited previous research pointing to food costs as one of the expense items likely to decline the most in retirement; one paper showed a 5% to 10% drop in food expenditures for households following retirement, while another showed a 6% decline. Not only do retirees have more time to prepare food at home than they did while they were working, the researchers conjectured, but they also have more time to shop for grocery bargains.
As with housing costs, lifestyle-related outlays aren't guaranteed to decline in retirement, so don't assume a reduction in yours without crunching the numbers. If a heavy travel schedule or an expensive hobby are on your retirement to-do list, you might see any cost reductions on line items like food offset by increased expenditures elsewhere. Bear in mind, however, that big spending on travel often occurs in the early years of retirement but then tapers off later on, as discussed in Blanchett's research.
Step 4: Add in Higher Healthcare Costs
Thus far, we've focused on ways that retirees might expect to see their expenses drop in retirement. But there's one major area where they're likely to increase, and that's in the realm of healthcare. A recent Fidelity study showed that the average out-of-pocket healthcare outlay for a retired couple was $260,000, and that figure doesn't even include long-term care expenditures.
Of course, costs aren't a brand-new expense in retirement. Even if you had employer-provided health coverage, you likely had premiums and other out-of-pocket outlay. But Blanchett's research has demonstrated that healthcare expenditures are a bigger share of the consumption basket for elderly households in the Bureau of Labor Statistics' Consumer Price Index calculations. Blanchett also notes that increases in healthcare costs at large are a key reason that the CPI-E has tended to be about 5% higher than the general inflation rate.
Not only have healthcare costs outstripped the general inflation rate, but they also tend to trend up through retirees' own life cycles. Higher healthcare costs later in life are the key reason that Blanchett identified what he calls the "Retirement Spending Smile." That's the tendency for household expenses to be on the high side just after retirement (when spending on travel and leisure is apt to be high), dip in midretirement, then head back up toward the end of life as healthcare costs increase. If you're someone who's going without long-term care insurance, in particular, recognize that your household's total healthcare-related outlay could spike dramatically toward the end of your or your partner's lives.
Step 5: Add a Fudge Factor
Working through each of these line items may get you closer to your actual income-replacement rate rather than relying on rules of thumb such as 75% or 80% for income replacement. At the same time, it's worthwhile to approach the exercise with the knowledge that there's much about your future spending that you can't foretell. Long-term care costs are the biggest wild card for people who don't have long-term care insurance or for those who have policies that are capped at specific benefits. Many seniors have also been called upon to help their adult children or their families, unexpectedly increasing their financial outlays in retirement. Homeowners, too, can incur costly and unexpected repair bills at random times. All of these factors can send your expenditures out of line with what you thought they would be. The potential for those unanticipated expenses argues for nudging your own income-replacement rate a bit higher to allow for some wiggle room in your planning.
Some pre-retirees go so far as to model out their annual expenses in retirement using a spreadsheet. That allows them to depict how they expect their outlays for various expenses to change throughout their retirement years: Travel expenses may taper down, while healthcare outlays have the potential to jump up. Such an exercise also allows retirees to plan for lumpy, big-ticket outlays such as new cars or expected home repairs (new furnace, roof, etc.).
Have questions? Ask me. I can help.
- Created on .
