March 13, 2012
Crucially, Bernicke’s analysis also obscures the fact that inflation is higher in some spending categories than others, a fact he misses because he considers spending between different age groups in the same year. In Figure 3, I show health care spending by age groups adjusted for inflation to 2010 dollars. In a given year, the total spending for the 65-74 and the 75+ groups is close. But what matters is that real health care spending increases over time, in part because health care has a higher inflation rate than the CPI. Ten years later, when the 65-74 group joins the ranks of 75+, one should expect higher health care spending, a dynamic Bernicke’s analysis does not capture.
Somnath Basu’s age banding
That leads us to California Lutheran University professor Somnath Basu’s Age Banding: A Model for Planning Retirement Needs, which he published in the first 2005 issue of Financial Counseling and Planning. Though the article provided a comprehensive retirement planning framework, here I will focus specifically on the findings that covered post-retirement spending patterns. Basu’s framework is the most promising generalized approach I’ve seen for how to incorporate changing spending needs into retirement planning.
As an easy-to-digest example of his framework, Basu considered a 30-year retirement divided into three 10-year intervals. Rather than assuming a constant rate of inflation for expenses during retirement, he divided spending into four general categories: taxes, basic needs, health care, and leisure. Within these categories, he investigated the spending patterns by age and made allowances for differential inflation rates between these categories. For instance, he noted that retirees spend more on leisure in the early part of retirement and more on health in the later part of retirement.
Table 1 |
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|
Inflation Rate |
Lifestyle Adjustment Factor at Age 65 |
Lifestyle Adjustment Factor at Age 75 |
Lifestyle Adjustment Factor at Age 85 |
Taxes |
3% |
0.5 |
1 |
1 |
Basic Living |
3% |
0.7 |
0.8 |
0.9 |
Health Care |
7% |
1.15 |
1.2 |
1.25 |
Leisure |
7% |
1.5 |
0.5 |
0.25 |
|
|
|
|
|
Source: Adapted from the stylized example in Somnath Basu's "Age Banding: A Model for Planning Retirement Needs" |
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