Spending Plan: How Much Can I Spend?
One of the most common question for any pre-retiree is how much can I spend? once I decide to retire. And, of course, this makes perfect sense. After all, you wouldn’t want to rush into retirement without having a solid understanding of what you could spend each year.
In this article, we will discuss the important variables and key planning assumptions that will have the greatest impact on your retirement spending plan and your strategy for funding it.
Let’s get started by reviewing the key components of your retirement spending plan.
Your Retirement Spending Plan
Any modern-day retirement plan involves the ongoing management of many financial complexities. However, at its most basic level, funding your retirement spending is a fairly straightforward formula.
In the chart below, we show the key components of your retirement spending plan.
Planned Spending Level
At the core of any modern-day retirement plan is a retiree’s Planned Spending Level. This will include spending on everything from basic needs such as medical insurance, groceries, and utilities to more discretionary items such as travel, hobbies, and dining out.
However, the reality of any retirement plan is that your ongoing spending will be limited to a certain sustainable range. This means that all retirees should want to focus of reducing wasteful spending whenever it is possible.
The most common examples of wasteful spending will include items such as unnecessary taxes, subscriptions or memberships you never use, or excessively priced goods or services that are available elsewhere for a better price. By trying to avoid wasteful spending and focusing instead on spending on those items that matter most to you, you can preserve your retirement savings over time.
Taxes
Unfortunately, your Annual Cash Need in retirement includes more than just those items that you need or want to spend money on. You will also need to pay federal and state taxes on a year to year basis.
With taxes often representing the single largest expense for retirees, one valuable way to reduce your Annual Cash Need is the use of personalized tax strategies to reduce the taxes you pay each year.
Simply put, the less you spend on taxes, the more savings you can preserve over time.
If interested in the tax planning framework that we use with clients, please refer to our article, Reduce your Taxes and Preserve your Wealth.
Recurring Income Sources
When we discuss recurring sources of income, we are referring to any dependable form of monthly income that is not derived from one’s savings or investment activities. The most common types of recurring income include Social Security and a pension.
In retirement, it is important to maximize any sources of recurring income as any spending need that exceed your recurring sources of income will require you to take withdrawals from your savings. Therefore, by maximizing your recurring sources of income, you can take smaller withdrawals and preserve more of your savings.
Social Security:
For many modern-day retirees, your full Social Security Benefit can easily range from $40,000 to upwards of nearly $60,000 (2024). And of course, this level of benefit can go a long way toward covering many basic spending needs such as medical insurance, car payments, property taxes, and groceries.
Another valuable aspect of Social Security income is that your annual benefit adjusts higher for inflation each year. This unique aspect of Social Security can be a major positive for those retirees worried about the risk of high inflation in the future .
When claiming Social Security, you have a range of options that includes claiming a smaller benefit as early as Age 62, your full retirement benefit between Age 66 and Age 67, or waiting to claim the largest possible benefit at Age 70. And for those who are married, widowed, or divorced, there is an opportunity to claim additional benefits on the work record of your spouse (or former spouse).
With these key details noted, it is important to understand what level of Social Security benefit you are entitled to claim as this will ensure that you maximize your total benefit over time.
Pension Income:
Every public and private pension plan is governed by its own unique terms which means that “pension income” can look very different from one retiree to the next.
For instance, some pension plans offer only one specific benefit at a specific age whereas other pension plans offer dozens of options based on different pension start dates, whether you want a lifetime annuity or a lump sum payment, or whether you want your spouse or even your children to retain rights to your pension after your death.
With such a wide range of possibilities, it is difficult to speak in generalities about any specific pension decision. Ultimately, the right pension decision for you will be driven by your unique financial needs as well as your assessment of the pension plan’s long-term financial health. With many underfunded public and private pension plans, it is important to understand whether your plan is adequately funded prior to making any pension decision.
Withdrawals from Savings
The reality for many of today’s retirees is that your Social Security and pension income may fall short of funding 100% of your Annual Cash Needs. To address the unfunded portion of your spending plan, most retirees will rely on planned or as-needed withdrawals from your savings and investments.
As a result, an important part of any modern retirement plan is the ongoing management of your savings and investments which should include the use of tax planning strategies to take all withdrawals in a timely and tax-efficient manner.
The Key Planning Assumptions
While it is helpful to understand how you might fund a specific year of retirement spending, the reality is that you will need to fund many years of retirement and do so as the cost of living continues to increase. This means that the three most critical planning assumptions in any retirement plan will be your longevity estimate, your estimate of future inflation, and your investment return assumption.
Longevity
To highlight how longevity can impact your retirement spending, let’s review a simple example of a 65-year old retiree who expects to live until Age 90 and plans to withdraw $60,000 per year from her savings. To achieve this objective, she will need $1.5M in savings to fund $60,000 of annual withdrawals across all 25 years.
Now let’s assume the retiree decides that an Age 95 life expectancy is more appropriate based on family history. To fund these additional 5 years of $60,000 in annual withdrawals, she would now need $1.8M in savings to fund all 30 years. However, if she no longer had time to save these additional funds, she could still fund a 30 year retirement with $1.5M in savings so long as she planned to withdraw no more than $50,000 per year.
As highlighted in this simple example, your longevity estimate will play an important role in determining what level of annual spending is sustainable.
Inflation
Another variable to consider is the role that inflation will play in your retirement spending plan. In the scenario above, $150,000 in current Annual Cash Needs would translate into $304,919 of Annual Cash Needs in Year 25 when accounting for the impact of 25 years of 3% annual inflation.
Therefore, if inflation did not exist, a retiree’s total cash needs over all 25 years of retirement would be $3.8 million. However, when we assume a 3% annual inflation rate, a retiree’s total cash needs over all 25 years increases by $1.7 million to $5.5 million. Ultimately, this observation highlights the importance of selecting an investment strategy that allows your savings and investments to keep pace with inflation over time.
With future inflation trends playing a key role in determining your total long-term funding need, it is important to model a variety of inflation rate scenarios to ensure that you understand how different levels of inflation might impact your spending plan.
Investment Returns
Identifying the right level of investment risk is a challenge for every retiree.
Of course, if we knew markets would perform well, it would be an easy decision to use higher risk investments as you would confidently earn high returns which would allow you to spend more.
Alternatively, if we knew the economy and markets were headed for a major downturn, we could invest conservatively to avoid the sizable losses that might derail our retirement finances.
Unfortunately, no one knows how the economy and markets might fare in the years ahead. This means that every retiree must decide how much risk they are willing to take with their investments based on an evaluation of what they might gain and what they might lose if they pursue a higher risk or a lower risk investment approach.
In the chart below, we detail the potential outcomes of a lower risk portfolio and a higher risk portfolio. When evaluating the lower risk portfolio, we note a lower expected level of spending as a lower risk portfolio is expected to earn lower returns. However, we also note that the lower risk portfolio offers far more consistent results should economy or markets struggle in the years ahead.
When it comes to any higher risk portfolio, the main assumption is that the higher risk level will result in higher returns and a higher spending level over time.
However, unlike the lower risk portfolio, the higher risk portfolio has the potential for sizable losses which can result in a significant future reduction in your spending level. In fact, when an investor in a higher risk portfolio sustains a large loss, he or she may be forced to spend even less than what they could have spent if they just picked the lower risk portfolio from the start.
Investment Assumptions vs. Investing Realities
Another important consideration when it comes your investment return assumption is distinguishing between what we assume we will earn and what we will actually earn.
While it is tempting to assume you will consistently earn high returns throughout your retirement years, a retiree who overestimates what he or she can earn on their investments can run into major financial problems.
The reason that major financial problems can arise is that a retiree who overestimates his or her returns believes they can spend much more each year than they should be. Should that high level of assumed return fail to materialize, the retiree will likely end up spending far too much of their savings far too quickly.
As a result, it is generally advisable to build any retirement spending plan around more conservative investment return assumptions. After all, should your investment results exceed your conservative assumptions, you can always elect to spend more in the future.
If interested in some additional thoughts on investing in retirement, please refer to our article, Investing For Success.
Identify a sustainable spending level
The next step in building your retirement spending plan is to evaluate how longevity assumptions, future inflation trends, and potential investment returns might impact the spending level you can sustain over time.
By studying how different assumptions might impact your plan, you can establish a range of spending that looks to be reasonably achievable - even though you don’t know exactly what inflation will be, what your investments will earn, or how long you might live.
For instance, as highlighted in the chart below, a favorable set of planning assumptions such as low inflation and higher returns might support upwards of $15,000 in monthly spending. Alternatively, a less favorable set of assumptions such a higher inflation and lower returns might only support $9,000 in monthly spending.
The benefit of evaluating many different planning scenarios based on different assumptions is two-fold. First, by understanding how a wide array of assumptions might impact your plan, you can make far more informed planning decisions that improve your odds of a financially successful retirement.
Second, by spending time analyzing how your plan might fare under more unfavorable future scenarios, you can build your confidence and peace of mind. After all, it is valuable to know that even if more challenging future scenarios unfold, you can still maintain an acceptable level of spending throughout your retirement years.
Protect your Plan from Risk
By the time you reach this final step in the planning process, you have worked hard to establish a sustainable spending plan that maximizes your financial resources and peace of mind.
With a solid retirement plan in hand, there is just one potential risk that still needs to be addressed - bad luck!
Thinking about how you might deal with bad luck is important in retirement because every retiree has a finite amount of financial resources. This means it is critical to protect against bad luck and the significant financial losses that can result.
How you can manage Risk
The first step in the risk management process is identifying whether the risks you face are Insurable Risks or Uninsurable Risks.
Insurable Risks
Insurable Risks are risks that can be addressed with simple and often inexpensive solutions such as buying home and auto insurance, an umbrella policy to protect against major lawsuits, and a quality health insurance plan that covers the doctors and specialists you might need in the future. Simply put, if an affordable annual premium exists to protect you against a catastrophic expense, it is usually a sound decision to acquire that insurance protection.
Uninsurable Risks
However, when it comes to Uninsurable Risks such as high inflation, large investment losses, or the loss of retirement income upon the death of a spouse, these risks are often addressed within the design of your retirement plan. For example,
You might address the risk of high inflation by maximizing the size of your Social Security benefit as Social Security income increases with inflation each year.
You might address the risk of future investment losses by electing to invest more conservatively even if that means spending a little bit less each year.
You might address the risk of lost income upon a spouse’s death by electing to take a joint life pension benefit, purchasing a small life insurance policy, or electing to spend a little bit less each year to ensure adequate savings exists later in retirement.
When it comes to the management of Uninsurable Risks, the right solution often comes down to evaluating the risks that you are willing to bear in exchange for certain benefits such as the ability to spend more. Since the consequences of bad luck and the benefits of “taking your chances” will differ greatly amongst retirees, the right choice to manage an Uninsurable Risk is often a very personal decision that should be thoughtfully analyzed.
In conclusion:
When determining what you can spend and what you should spend in retirement, there are many important variables and certain key assumptions that need to be weighed and analyzed. However, for those retirees who invest time and effort into evaluating these important variables and assumptions, you will put yourself in the very best position to maximize your retirement spending, and do so, with confidence and peace of mind!