Worried that their money may not last as long as they do, many retired adults underspend their nest eggs.
It may seem crazy that some people don’t spend enough in retirement. After all, most of us worry that we won’t have enough amassed to get us through the years after we stop working. The percentage of people with pensions is declining, investment returns are expected to be reduced in coming years, and retirees may live longer in the future. So what gives?
How Much is Enough?
Most of us have calculated how much we think we’ll need to retire. We may have used the rule of thumb to save 25 times our salary at the end of our career. Others have followed the 4 percent rule, which holds that a portfolio invested in 60 percent stocks and 40 percent bonds can safely yield 4 percent (increased annually for inflation) over a 30-year retirement period.
Say you have $1 million saved up when you retire at age 65. Using the 4 percent rule, you would withdraw $40,000 the first year, adjusting that figure upward every year thereafter to cover inflation. Add to that Social Security, a pension and any other sources of income for your total annual budget in retirement.
Following the 4 percent rule has been touted as a good way to make your savings last, and there’s a lot of research to support that. Many online calculators use the approach to project how much you’ll be able to safely spend. However, today’s financial professionals may use a more conservative 3 percent estimate, due to low bond yields and projections that future stock market returns may not match historic levels. But in the same way that your budget today doesn’t reflect what it was 10, 20 or 30 years ago, your budget in retirement is unlikely to remain static.
Financial Planning Software
Like many, you may have used online calculators to figure out how your savings stack up against projected spending in retirement. There are endless variations on the theme available, from BlackRock’s new LifePath tool, which produces an estimate based strictly on your age and total savings, to Personal Capital, a robust wealth management tool that provides Monte Carlo simulations for future predictions.
These tools are great for do-it-yourselfers who want estimates at their fingertips. However, it’s wise to use a financial advisor or financial planner for these important calculations. These professionals have industry software that is not available on the internet, and can provide a detailed analysis and projections. Combined with the professional’s experience and knowledge, the result is a comprehensive plan that can be altered over time to accommodate changing circumstances.
Not every professional and their approach is a good fit for every client, however. In addition to varying personal styles, there is a wide range of industry software that financial planners can choose from. You may want to ask if a professional uses goals-based software that estimates whether or not you can save certain amounts toward retirement or a college fund, for example, or a program based on cash flow that accounts for every dollar spent. Does the professional assume straight-line spending, or use Monte Carlo simulations? Does the software include tax brackets and deductions, and can it plan around your state’s tax rules?
For a chart of the “Financial Planning Software Landscape” and a detailed discussion of the many iterations available, check out industry guru Michael Kitces’s blog on the subject. It can help you find the software you prefer, which you can use to search out a financial professional who syncs with your style and needs.
Retirement Budget Patterns
“This is my 35th year in practice, and I can tell you none of my clients has ever spent on a straight line,” says Neal Van Zutphen, a certified financial planner (CFP) with the firm Intrinsic Wealth Counsel in Tempe, Arizona. “Your spending habits and your spending needs will change over time.”
This is an important concept, because the tendency is for spending in retirement to go down as we age. CFP Michael K. Stein has termed these three stages the Go-Go years, the Slow-Go years and the No-Go years, and we teach these terms in the Society of Certified Senior Advisors' Working with Older Adults class.
Research seems to back up this pattern. In its Consumer Expenditure Survey, the Bureau of Labor Statistics found that the mean spending for households headed by 55- to 64-year-olds was $65,000 in 2017. That number fell to $55,000 for households headed by 65- to 75-year-olds, and then dropped again to $42,000 for those headed by someone aged 76 or more.
That trend has shown up in a spending patterns study by J.P. Morgan Asset Management. Reviewing customer data, the firm found that the decline was accentuated for retirees with $1 million to $3 million in assets, according to Katherine Roy, chief retirement strategist.
“It appears that the more you have, the steeper the spending decline in real terms,” Roy says. The impact on retirees is profound. Roy estimates that financial planning tools designed to cover a 30-year retirement “could overstate spending in late retirement by 30 percent or more.”
Which Profile Fits Your Spending?
However, this may not be true for everyone. When the firm grouped its customers according to their spending patterns, the data showed a surprising result. Clients were put into 1 of 4 categories: health care spenders, globe-trotters, homebodies or foodies.
Although there is overlap for everyone, it may be important to figure out which group fits you best, according to Wade Pfau, a professor at the American College of Financial Services and director of retirement research at McLean Asset Management. The first three groups saw very little to no reduction in their spending habits over time. The biggest group, the 39 percent of retirees who fell into the food and drink category, saw their spending decline as they got older.
What About Health Care?
Hold on, you may be thinking, what about the cost of medical treatment and prescription drugs as I get older, and what if I need a nursing home or move into assisted living? Most of us are aware that those involve substantial expenses.
It’s true that increases in spending in the later years of retirement are almost always related to health care, according to the Health and Retirement Study, a project of the National Institute on Aging and the University of Michigan. However, according to David Blanchett, head of retirement research at Morningstar, those in their 70s and 80s usually spend less than their younger counterparts.
“The real change in annual spending through retirement is clearly negative,” says Dr. Blanchett. He feels that financial advisors need to communicate that information to their clients. “They can say, ‘The most common assumption is that you’re going to increase your spending by inflation, but here’s the deal: The average person doesn’t do that.’”
Dr. Blanchett offers a fix for calculations that overestimate spending as we age: Run the program with the assumption that spending goes up by one percentage point less than inflation.
“How does that change how you can spend your money?” Dr. Blanchett asks. “One thing it can do is free up money when you can most enjoy it. Take that cruise when you’re 65 or 70 because you’re probably not going to be able to take it when you’re 80.”
Barriers to Spending
There are other barriers to adequate spending besides faulty projections. Some people have enough saved for a more lavish lifestyle but find it nearly impossible to spend beyond daily needs. Financial writer Michael Kitces refers to this as a “consumption gap” in his Nerd’s Eye View blog.
"Where I have seen it be a problem is on the behavioral front," says Jeffrey Farrar, managing director of Procyon Partners in Wilton, Connecticut. He says that some clients obsess over an arbitrary net worth number and fail to enjoy their wealth.
Or, as Luis Rosa, founder and CFP at Build a Better Financial Future in Las Vegas, says, “Do you want to be the richest person in the graveyard?” He uses this question to jumpstart conversations with clients who are overly frugal.
The failure to spend may be largely psychological. After a lifetime of saving, clients may be loath to see their balance go down. They may have an irrational fear about running out of money before they die. After all, says David Nash, owner of Magister Wealth in San Antonio, “You are advocating against the good habits that gave them this enviable circumstance.”
Running calculations to show they have plenty of money may not be the answer. "You can't satisfy an emotion with a number in your bank account," says Jeffrey Stoffer, founder of Stoffer Wealth Advisors in San Rafael, California. "The emotion is fear and it doesn't just go away when you hit a magic number."
Financial professionals can use various tactics to assuage the worry these clients feel around spending their money. First, discuss the big picture using a financial plan. This can drive home the point that sacrificing their lifestyle doesn’t really buy them anything. Second, use a random Monte Carlo simulation to project balances in even the worst of circumstances. Finally, suggest an annuity for clients with anxiety around spending. Having a fallback every month that pays for essentials can help them view the rest of their portfolio as “fun money.”
The Very Wealthy
Another category of retirees who may not be spending enough are those whose estates will exceed the estate tax exemption when they die. Currently, that stands at a whopping $11.4 million. But there’s a kicker. There are no guarantees the exemption won’t be reduced, perhaps significantly, in the future. The top estate tax rate may rise, too. If you died today, Uncle Sam would take 40 percent after the exemption, but that number was 55 percent as recently as 2001, when the exemption was $675,000.
Instead of paying the government upon death, these lucky retirees should be distributing wealth to loved ones and favored charities while they are still alive. Working with a financial professional, they may choose to donate cash, appreciated securities and/or property. Vehicles such as donor-advised funds or a private foundation may be useful to administer funds.
Click below for the other articles in the August 2019 Senior Spirit
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