Published On: September 28, 2020
Written by: Ben Atwater and Matt Malick
Although saving and investing are incredibly important, as you approach retirement, it is vital to take a closer look at spending. For most people, the last decade of work will require peak savings and a sharp eye on current and future (retirement) expenses.
The U.S. Bureau of Labor Statistics estimates the average household spends most of its income (65%) in four areas – housing (28%), transportation (14%), food (13%) and health care (10%). For more affluent households these percentages tend to drop as more money is spent in discretionary areas like travel, collectibles, fashion, etc.
In our experience, people tend to underestimate their spending. This phenomenon is almost universal. We believe this stems from an exclusion of “one-time” expenses, which, unfortunately, tend to occur regularly into retirement. This year, you may need to replace the roof on your home, which may hold up for the rest of your life. But next year, you will need a new car, or the basement will flood, or an adult child will need support. In our experience, “one-time” expenses come in a variety of forms and happen more frequently than we would like.
Budgeting is extremely important, but we can very easily trick ourselves into inherently believing our budgets. Therefore, we should check them with the following eye-opening exercise . . .
Take your household gross income, then subtract the taxes you pay and the savings you set aside each year. Remember, this savings must be in an account somewhere or an actual investment. Use three years of data for this exercise. Most mass affluent families will be quite surprised with the extent of their spending. Gross wages minus taxes minus savings must equal spending. This is an inescapable equation.
Of course, this does not reflect any debt you might be accumulating, but it would include debt service. If your debt is amortizing, or if you are leasing, then this equation will work. However, it is vital to have an excellent understanding of your liabilities. We can quickly become over-leveraged and vulnerable from job losses or other serious income disruptions.
After performing this exercise, it is appropriate to revisit your budget and figure out where the holes exist. Said hole is often a “one-time expense.” Budgets should include an extraordinary expense line that is equal to your average extraordinary expenses over the last three to five years. These expenses typically do not go away with retirement.
A common example that people do not count as spending and mischaracterize as an investment is the purchase of a vacation home. Purchasing a vacation property is not only a current expense but it is also an obligation to incur future annual expenses (property taxes, mortgage, upkeep, etc.). There is nothing inherently wrong with a vacation home. As a matter of fact, it is a great thing, but you need ample money to truly afford one without impacting your retirement plan. If you plan to rent the second home to cover its expenses, be careful that your analysis of revenue and expenses is realistic.
To analyze how much spending impacts retirement, let us consider a married couple who plans to retire in less than two years. This couple, we will call them the Hasselhoffs, expect to have after-tax spending of $72,000 per year plus another $9,780 in Medicare-related expenses. In today’s dollars, that is a total of $81,780 in annual after-tax spending. At full retirement age, 66 years and 2 months for the Hasselhoff’s, they will receive about $54,000 per year in pre-tax Social Security. They have about $1.3 million invested in retirement plans with a balanced growth asset allocation and are saving about $30,000 per year to these plans until they stop working.
In this scenario, the Hasselhoffs are in great shape for retirement. However, if we test their non-healthcare after-tax spending at $92,000 per year, a $20,000 increase, their probability of success, using statistical testing, falls below the confidence level in our analysis. Of course, $20,000 is a big increase in this case study, but it may represent realistic “extraordinary” expenses in a year. If the Hasselhoffs did not account for extraordinary expenses in their budgeting process, then they may face trouble in retirement. If they did truly account for extraordinary expenses in their $72,000 spending estimate, then they are well-positioned for retirement.
As a general rule of thumb for retirement spending, replacement income should be about 80% of your working income. This makes intuitive sense if you are saving 15% of your pay while you’re working and your effective tax rate will fall by roughly 5% after retirement, leaving 20% (15% + 5%) less retirement “income” to replace your working wages.
Another good rule to consider is, the lower your household income, the higher the percentage of replacement income you will likely need. Some folks may need 100% replacement income, while higher earning households might need 60%, depending on your taxes and saving rates while you are working.
An analysis by Fidelity Investments suggests average spending after age 65 drops to $46,295 from $58,708 before 65. We believe much of this is a forced reduction in spending. In other words, people are modifying their lifestyles to make retirement feasible. There is nothing wrong with this approach, but it is better if this is a long-term plan versus a forced decision. Truly understanding spending is key to retirement. Concentrating on expenses in the five years leading up to retirement is the best way to prepare for a successful retirement.
Fidelity also finds that average household spending does trend lower over time. This seems logical, as people age, they have less ability and less desire to undertake expensive activities. The obvious exception here is end-of-life healthcare costs, like long-term care.
The closer you get to retirement, the more important the spending factor becomes. At a certain point, say two years from retirement, you likely cannot substantially increase your savings, largely “it is what it is.” The variable, however, you likely have the most control over is spending.