The Truth About Spending in Retirement and Why It’s Good News

0:01How your spending may change in retirement and why it might mean you could withdraw more in retirement. That's the topic of discussion on this Saturday personal finance edition of the Motley Fool Hidden Gems Investing Podcast.

0:16Knowing how much income you'll need in retirement is a key variable in determining how much you need to have saved before you stop working. But retirement isn't just one financial goal, it's a series of annual goals. how much you need in the first year of retirement, then how much you need in the second year, and then the third year, and so on. Here to talk about how spending changes over the course of retirement is David Blanchett, the head of retirement research at Prudential Financial and a portfolio manager at PGM. David, welcome back to the show. Good to be here. So when it comes to retirement planning, the default assumption is that retirees need their income to go up each and every year with inflation.

0:49And we see this assumption in most retirement calculators. I think most financial planners assume that. And even most of the research into retirement, including the old 4 % rule. For over a decade, you've been doing research that has questioned this assumption, including in a recent study. So tell us about your latest thinking about how spending changes over the course of a retirement. Sure. I mean, to be fair, I still do research where I assume spending rises by inflation. So it's a very common assumption. I still use this out there a lot. But I think that one of the most important questions we've got to ask ourselves thinking about retirement is like, how do we think spending is going to change over time, right?

1:28And the most common assumption that we use in research and financial planning tools and all this is that spending is going to increase every year by inflation. So effectively, what you're going to spend in the future is the same as what you spend today in today's dollars, right? So historically, inflation has averaged about 3 % a year. So we would assume that every year you'll spend effectively 3 % more. And a piece of research I wrote that was published about a decade ago, and then an updated piece that was just released in the Financial Planning Review, I kind of revisit this topic of, well, how does spending change over time?

2:00And there's pretty convincing evidence that most people as they move through retirement won't increase their spending by the full amount of inflation. So, for example, if inflation is 3 % a year, you might only spend 1 % a year per more, and that kind of compounds over time. So is this due to choice, or is it people not having enough money and they realize, oh, no, I shouldn't have retired. I need to cut back my spending. That's one of the most common questions I get asked about this research, both currently and then historically. And I think it's a mix of both. But one thing that we can do is look at retirees who have lots and lots of money and see how their spending changes.

2:37And so even if you just focus on retirees who could spend more, so they're very well funded, they actually tend to cut back as well. So I think that a lot of this actually just is choices. It's a fun model. People talk about the go-go, the slow-go, and the no-go years. I think that for a lot of people, as they age, they slow down. Part of that is because they have health issues, but part of it is just because we just don't want to do as much the older we get sometimes. Is there anything else going on here? For example, according to the Federal Reserve, about two-thirds of the people in the age ranges of 65 to 74 have debt.

3:11Maybe they're paying off a mortgage? Or is there anything like, you know, people enter retirement married, but sadly, one spouse passes away and expenses drop? Is there anything specific about that? Or is it just a general decline in spending? It's just a general decline. I mean, I've looked at it through a lot of different lenses through a lot of different kind of cohorts and retirees. And I think that it's very messy. Now, to be clear, like year over year, some households spend a lot more, some spend a lot less. But there's actually kind of this really large body of research now looking at a variety of data sets that does really strongly suggest that as people move through retirement, they don't increase their spend every year by inflation.

3:47You mentioned you took a look at people who have very well-funded retirements, and you calculated that about 35 % of people enter retirement not well-funded. And some people can look at that and say, they use the term retirement crisis. When you look at that, as someone like you and me, who educate people about how to save retirement, do you feel like, oh no, there is a crisis. We need to do a better job of teaching people how to determine whether they're financially ready to retire. Or do you feel more like, eh, people retire when they retire, they figure it out, they drop their spending. And as you cite in this research and other research you've done, retirees on the whole are pretty satisfied with their lives.

4:28Yeah. So I think first, I do think we need to do more to help more Americans save more for retirement. But if you look at any objective or certain measure of retirement well-being, of overall financial satisfaction, when people retire, they are a lot happier. Very anecdotal, when I was at a wedding last week and talking to someone who was at a significant cut in their overall spending level, but they couldn't be happier. They have a lot more freedom. So I think that, yes, we need to help folks be better prepared for retirement. But if you look at the research and the surveys, most Americans find a way to make it work.

5:00I mean, if anything, like what this research would suggest is that, you know, a lot of the models that talk about like crisis, for example, assume that people need to increase their spending by inflation. That doesn't track with reality. So people are actually better off than a lot of these models could suggest.

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5:55All investments involve risk, including the potential loss of principal. Past performance is not indicative of future results. This is a paid advertisement. When you look at what goes down and what does go up over the course of retirement, there are a few things that do go up. One is cash contributions, which is giving to charities and maybe other people, which I love because I love that as people get older, they're maybe building up some karma as they get ready to meet their maker. That's right. And of course, is healthcare. And the thing about healthcare is it's so variable. It's such a wild card in terms of whether it's going to go up for you.

6:29So what does your research say about how likely it is that you're going to have a really big healthcare expense? And how do you account for that in a retirement plan? If you look at most retirees, most retirees don't experience significant unknown healthcare expenses, right? I mean, there's like the known stuff like Medicare, Part B premium, stuff like that, that you're going to pay pretty much no matter what. I think where things get really tricky is later in retirement, in your 80s and 90s, the implications of some kind of long-term care event. And that can be cataclysmic, that can be incredibly expensive, and that's really hard to plan for.

7:07And so in the paper, I kind of look at total out-of-pocket spending based upon age of death. And for most Americans, healthcare isn't that big of a deal, but there's going to be some minority, 5%, 10%, 20%, where it is a really, really big deal. And it's really hard to plan for. So I don't want to dismiss the implications of late life health expenses on retirement outcomes, but there is going to be some portion that it really does affect them. So taking all of this, the real life spending of retirees, how should someone factor that into their retirement plan when it comes to determining how much they need before they retire and maybe how it affects their withdrawal rates once they retire.

7:47I mean, I think the first thing is for advisors and retirees, just be aware of this effect. I think there's reasons why you might want to run a financial plan where you assume spending increases by inflation. So you're kind of building this kind of implicit slush fund to pay for long-term care expenses. Okay, like that's there. But I think that it's about having honest conversations because a lot of people get to retirement and they're really not in the best financial shape. You talked about a retirement a crisis, for example. And so I think what this does is if you have this conversation with an advisor, you understand this effect, it might make you more comfortable spending earlier in retirement when you're going to be healthier and more active and more able to enjoy that 30 or 40 years of savings.

8:27So I think that, again, everyone has a different retirement, different outcome. But when you incorporate this into a financial planning model, you might see, for example, in the research, initial safe withdrawal rates go from five-ish percent to six, six and a half percent if we don't assume the spending every year rises by inflation. You brought up safe withdrawal rates. Let's move on from this topic of whether retirees need their income to go up every year to the related topic of whether retirees could be flexible with their spending and how that affects the safe withdrawal rate. So this brings us to another recent paper of yours entitled Rethinking Safe Withdrawal Rates, which you published in May.

9:03What's the main message you're trying to convey with that research? So with that research, it's that a lot of the models that we use to quantify retirement outcomes really aren't very good. The most common outcomes metric we see in financial plans is the probability of success. And what that is, it's a metric where we do this thing called a Monte Carlo projection. We run like a thousand fake retirement. We vary market returns and we see what happens. And there's only one of two outcomes using that metric. There's either you accomplish your goal in its entirety, you get a one. If you fall a dollar short, you get a zero.

9:35And so then you average the percentage of trials or runs or fake retirements where you fully accomplish your goal. And where that's problematic is, is like, I wouldn't define like falling a dollar short of your goal in the 30th year of retirement as a failure, right? I think that you didn't accomplish all of your goal, but like using, it's what's called a binary outcomes metric. There's just ones and zeros. It doesn't provide the right context on how you're actually doing, right? So if you think about how we quantify outcomes, if we think about the fact that certain expenses we have in retirement are really important for us to pay, like health care, like our mortgage, like buying food.

10:10But others may be like where we go on vacation, what we do with our time. If I have to cut back those, it's not that big of a deal. When we kind of wrap this all together, what it suggests is that people can probably spend closer to like 5%, 5.5 % out of the game in retirement versus 4%, which you often see in, I think, more simplistic retirement income forecasts.

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12:22And I think more retirees should think in terms of, right, this is what I absolutely need to cover versus this is the stuff that's a little more discretionary. As you said, you'd cut back. And the research indicates that if you have a large part of your portfolio covering basically a flexible portfolio, you really can start at a higher withdrawal rate. On the other hand, if your portfolio is covering a lot of essential expenses, maybe you need to start at a lower rate. Yeah, I think that a really good rule of thumb in retirement is to have all of your essential expenses covered with lifetime income.

12:57What that does is it kind of, I think there is the more traditional kind of like economic benefits of allocating a lifetime income, but there's also just that behavioral component. If you know that no matter how long you survive, you've got the basics covered, that better enables you to spend from your portfolio. And the key to your point is that you can take out a higher withdrawal rate, right? If you're willing to cut back if you have to, then you can spend more initially. It's kind of a trade. And so the more flexibility you have around how much you spend in the future, the more you can take out today.

13:25Well, David, this has been another fascinating discussion. Thank you so much for joining us. Sure thing. And that, my foolish friends, is the show. Thank you so much for listening. And thanks to Bart Shannon, the engineer for this episode. As always, people on the program may have interest in the investments they talk about, and The Motley Fool may have formal recommendations for or against. So don't buy or sell investments based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only.

13:56To see our full advertising disclosure, please check out our show notes. I'm Robert Brokamp. Fool on, everybody.

14:09Thank you.