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Differentiating Your Retirement Spending by the Degree of Inflexibility. What is the Solution to Address Inflexible Spending?

If you are trying to determine how much you would need to accumulate for financial independence, or whether you have reached the state of F.I.R.E, your mastery over your spending determines a large part of how much you need.

By taking your expenses divided by a certain safe withdrawal rate, you can roughly figure out how much you will need to accumulate. If you give less than accurate expenses or it doesn’t reflect close to your retirement reality, then you will get a less than useful figure to accumulate.

In part two of a Retire With Style podcast, Michael Finke returns and explains to us why he split our spending between flexible and inflexible spending. Why does he define spending between these two terms and not other names?

The hosts share deep insights on retirees’ spending patterns and the nature of inflation and spending in reality. They also share what are the more suitable financial solutions to tackle inflexible spending.

Here are the notes.

We Roughly Spend the Same Amount After Retirement as Before Retirement

Research shows that there is not much difference in retirement spending of retirees compared to their spending before retirement.

JPMorgan also did similar research and came to roughly the same conclusion.

Humans tend to be creatures of habit, so we live in the same house, pay the same property taxes, spend the same groceries, and our vacations may pick up more, but the spending in the retirement year generally is not too different from before.

JPMorgan found out that people tend to spend more early on such as buying an RV but they cut back in the future.

Rick Miller, a CFP-certified adviser, with a PhD in economics, thinks that if you are able to cover the desired lifestyle before retirement with safe investments, anything above that are good-to-haves.

Using an 80% Income Replacement Rate as Retirement Income Estimation is Less Accurate for People with Higher Income

What is the Replacement Rate: An estimate of your retirement income based on a percentage of your last drawn income before retirement.

What Michael Finke found is that higher-income people (Those in the US earning $200,000 or more) are already saving 20% of their income, and based on the amount of taxes paid, a more sensible replacement rate is 55-60% of their last drawn income.

Wade Pfau and David Blanchett: Spending Tends To Not Go Up Proportionately With Inflation

In David Blanchett’s 2012 research exploring the Retirement Consumption Puzzle, his conclusion is that although the inflation on the items a retiree spends on tends to increase at a rate higher than inflation, the actual retiree spending tends to decline in retirement in real terms.

The decrease in real spending averages 1% a year in retirement.

David analyzed the spending from real household survey data from retired households from 2001 to 2009.

Wade Pfau provides the following illustration to show a possible inflation-adjusted spending path versus an inflation-adjusted spending path if a retiree does not adjust all the line items:

Blanchett observes that the spending smile reflects the same types of outcomes we have described thus far. At the start of retirement, retirees spend more as they enjoy travelling, eating out, and other types of discretionary expenses. As they continue to age, retirees tend to slow down and spend less.

However, while discretionary expenses are declining, health costs tend to rise, and at some point later in retirement, these rising health costs offset reductions in other spending categories. Exhibit 2 provides a further illustration of this process.

Wade Pfau ran a simulation to find out the number of assets needed based on the spending smile and found out that we may need 17% fewer assets for this spending setup.

Why Do We Differentiate Our Spending Based on Flexible or Inflexible Spending Categories?

We want to identify a key characteristic in each line item in our spending that will affect the investment asset solution we design for the retiree. The investment product solution ideal for some spending does not require a risk premium or a bonus because you cannot cut back on some spending if you do not get that bonus for taking investment risks.

They found in research that 66% of our spending is in these inflexible spending categories. They analyze the US consumer expenditure survey, which is a very detailed survey conducted by the US Bureau of Labor Statistics, to determine based on their opinion which spending categories are inflexible or flexible to derive this 66%. Finke admits his process is less scientific but David Blanchett did the research his own scientific way and came up close to Finke’s figure.

Finke’s definition of what is considered inflexible may be different from yours:

  • Property taxes
  • Maintenance
  • Utilities
  • Insurance
  • Eat
  • {Other debatable ones like pet grooming}

We should not cover these expenses with a solution that is based on market returns.

Client adviser or yourself (if you DIY plan) need to have:

Which part of your expenses do you wish to lock in with some strategies to make sure that you don’t have to worry about cutting back on those expenses?

Answering this question will allow you to separate which part of your expenses is truly flexible.

Retirees tend to Struggle to Spend More Money

Retirees that Michael talked to are proud of their frugality and able to source great deals to keep their spending lower.

When Michael commented that they would really like to pass on the money to their kids, they said the money they saved is not to leave a legacy.

Michael feels that people are not deliberate enough with how they compartmentalize how much is for spending and how much is for legacy.

They didn’t answer:

How do I get the lifestyle that I can, from the money that I got, recognizing that my spending pattern is going to change over time?

If they recognize that, then people would probably spend a lot more money in their late 60s, and early 70s than we might expect.

Alex commented that people are effectively creatures of habit and we spend such a large proportion of our time squirrelling our money away. That habit does not necessarily disappear during retirement.

Some were proud they spent less.

Alex thinks that behavioural coaching is more suited to existentially help people spend more money in retirement. It is not good to be in retirement apprehensive about spending.

Many retirees have been told and shown that they have enough money through maybe a 95% success in a Monte Carlo simulation, but in their head, they would still have that “extra layer of security” which cause them to spend less. E.g. advisers have one layer of security, then the client added another layer.

10-20 years later, they have much money but they do not have the capability to spend anymore.

They remained unfulfilled in their life.

A lot of those people who listen to their podcast are likely to be the Ant compared to the Grasshopper, and it can be rather hard to change that mindset.

If you are not going to spend it in the future, what is using it for.

Contractual Income vs Total Return Income

The total return income strategy if works correctly will always have assets left over because you are not sure about the markets.

In contrast, retirees have fewer problems spending the income from contractual products such as a private pension/annuity.

Buying a contractual-based product turns your lump sum into an income stream.

But retirees need to get through that psychological barrier about holding on to their nest egg because if the goal is to live a better lifestyle, then why not give yourself a license to spend that money, one way is to buy a pension that you know is never going to run out.

Research shows that when the market falls, people start cutting back on their spending.

If your retirement income plan is not set up to let you spend your income comfortably, no matter what happens to the markets, then you are failing because you are not as happy in retirement as you could be.

Wade Pfau divides your spending goals into a few categories:

  1. A Longevity Goal is inflexible spending
  2. A Lifestyle Goal is a flexible spending
  3. Reserves are for unexpected spending shocks.

A longevity type of global would be ideal to make use of a contractual-based product or solution.

People don’t dare to spend also because they do not know what spending shocks they might experience. If they do not know how much to set aside, how can they comfortably spend the rest of the money?

There was a study done on the spending of Swedish retirees versus US retirees. In Sweden, they have government-protected long-term care. The hypothesis is that Swedish retirees would spend more because they have that protection from extended long-term care shocks as they do not have to cover that through their own assets.

And they could do exactly that. With the protection, it freed them up to spend more in retirement.

One of the advantages of any sort of insurance is that you can just buy away that anxiety, and you are free to spend the remainder of these savings without constantly worrying that you need to hoard.

Wade thinks that if you can comfortably carve out the amount you need to hedge that long-term care risks, it will allow you to spend easier psychologically.

Can You Fund Your Retirement with TIPS?

Wade shared that sometimes you may not need to put your money into these contractual-income solutions.

For example, we know that one of the most conservative ways to fund inflexible recurring expenses is through TIPS.

But you would need more capital.

If you have enough capital for TIPS to fund your inflexible recurring expenses, this tells you how much to set aside as well.

It does not mean you need to put your wealth in TIPS but that is the magic number to put in a total return equity and bond portfolio.

You can also ask yourself whether you wish to take the market risk for your portfolio.

Taking more Investment Risks just increases the Range of Lifestyle Outcomes, which May not be a Bad Thing

The conventional financial planning advice:

You have a required rate of return that is needed to meet your financial goal and if you are very far away from your retirement goal, then you need to take more investment risk.

That is very befuddling to Wade and Michael because when you take more risks, you are just increasing the range of potential outcomes. Whether you are saving 5 years into retirement or future spending goals, when you take more risks, you will have greater variation in the lifestyles that you will live in the future.

It is never appropriate for those who may not have enough assets to take more risks, subject to a range of lifestyle outcomes, which may cut deeper into their inflexible expenses.

Michael thinks that people should just do away with using the required rate of return as retirement income advice.

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