March 13, 2012
Table 1 details how the approach works with these four spending categories and three time segments (65-74, 75-84, 85-94). These numbers are not calibrated closely to data; they are meant to be illustrative for a typical client. The inflation rate for taxes is 3%. At age 65, the lifestyle adjustment factor for taxes is an assumed drop to 50% of their pre-retirement level, as payroll taxes are no longer paid. Those lifestyle adjustment factors are progressive; a value of 1 at age 75 means that tax amounts will not change relative to their real values at age 65, they may only grow with inflation. The same is the case for taxes at 85. Overall, taxes drop by 50% at retirement but then stay at this same inflation-adjusted level.
Next, though always adjusted for 3% annual inflation, basic living expenses are assumed to fall by 30% at retirement, and then by another 20% at age 75, and then by another 10% at age 85. Thus, by age 85, real spending on basic expenses has fallen to about 50.4% of its pre-retirement level. (0.7 x 0.8 x 0.9 = 0.504.)
As for health care and leisure, both have an inflation rate of 7% instead of 3%. And health care expenses also increase with age, adjusting upward by 15% at 65, by 20% at 75, and by another 25% at 85. By 85, real health expenses are assumed to be 3.7 times larger than their pre-retirement value, assuming a somewhat simplified overall inflation rate of 3%. Leisure increases by 50% at retirement as clients set out to enjoy life, then drops by 50% at 75 and another 75% at age 85. By 85, even with the higher inflation rate, leisure spending is only 40% of its pre-retirement level in terms of the overall price index.
By capturing both the differential inflation rates and the changing dynamics by age, age banding provides a useful tool for planning long-term client budgets. With this approach, however, it is not obvious that retirement spending will decline with age. It may, and the data suggest that spending does decline, but rapid growth in health care expenses could potentially lead to an overall increase in spending needs at the highest ages.
What does this all mean for retirement planning?
So which is the better baseline assumption to use: constant inflation-adjusted spending or decreased spending as one ages? This is a big question that is still not fully resolved. We need to track individual households over time in order to better see the variety of spending patterns and how they relate to personal characteristics of the household. What percent of households voluntarily reduce their spending? What percent are forced to increase spending because one or more family member enters a nursing home or experiences large medical bills? Are personal characteristics linked to different spending patterns in such a way as could help advisors make better assumptions for their clients? For instance, higher net worth retirees may have much larger discretionary expenses when they enter retirement, while a more typical retiree may find that most of their spending is for essential needs, which will not decline and must adjust with inflation.
Spending may decline and I would not fault anyone for using assumptions of gradual real spending declines along of the lines of 10% or even 20% over the retirement period. But pending further research developments, I would avoid moving too far in the reduced spending direction as a baseline assumption. Though the standard assumption of constant inflation-adjusted withdrawals could be improved, it builds in reasonable conservatism and may not be too far off as a baseline. Applying differential inflation rates and age-based lifestyle adjustment factors, as in Basu’s age-banding approach, may be the best approach for working with individual clients.
Wade Pfau, Ph.D., CFA, is an associate professor of economics at the National Graduate Institute for Policy Studies (GRIPS) in Tokyo, Japan, and the curriculum director for the Retirement Management AnalystSM designation program. He maintains a blog about retirement planning research at wpfau.blogspot.com
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