Budget models of retirement spending
Budget (or expense) models of retirement spending come in a variety of forms. They all have in common the estimation of total retirement spending by working with estimates of spending in numerous, smaller budget categories. This general approach offers a great deal of flexibility for modeling retirement spending patterns. This flexibility comes at a price: the greater amount of time needed to assemble spending estimates for each budget category.
The budget modeling process usually starts by developing a single estimate of total spending at the start of retirement. Two approaches are typically used, which are referred to in this article as a Current Spending approach and a Bottom-up approach. A Current Spending approach starts with the total (current) spending just before retirement. Each spending category is then examined to see what adjustments, either up or down, are anticipated immediately after retirement. These spending changes are then applied to arrive at a total spending just after retirement.
The Bottom-up approach develops a spending estimate for each expense category “from scratch”. Usually a detailed budget worksheet is used to help insure that no category of retirement spending is overlooked. These category estimates are then summed to yield the total spending estimate. This approach is more time consuming than the Current Spending approach, but has the potential to yield a better estimate. The Bottom-up approach also supplies a better starting point for projecting how the budget might change as retirement progresses.
A Dual Budget model is a direct extension of the Bottom-up model that incorporates two total spending estimates. The first or Essential budget represents the lowest level of retirement spending that can be accepted. The second or Preferred budget represents a higher level of retirement spending that is actually desired. The difference between these two budgets is referred to as Discretionary spending. The retiree’s spending in any year is assumed to fall within the range bounded by these two budgets.
Changes in real (inflation adjusted) spending as retirement progresses can also be modeled using budgets. Two popular approaches are referred to in this article as Step Change budgets and Flexible Spending budgets. The Step Change approach considers retirement to be divisible into stages (or phases) within which real spending doesn’t change. Often 3 stages are used to cover the retiree’s lifespan. At the boundary between each stage there is a discontinuous change in real spending, the step change. Usually only the total spending is modeled as changing in moving between stages. But some models apply independent step changes to each of a limited number of spending categories.
A Flexible Spending budget represents the ultimate in budget modeling complexity. It can be thought of as a Step Change budget model in which each stage could last for as little as one year. In addition, there are a very large number of spending categories, each of which can have its own series of independently-timed step changes. This type of budget model is very good at accurately describing spending patterns that are unique to a particular retiree. Retirement calculators based on this approach can be quite complex, and learning to use such a calculator takes significant time.
This article focuses on the budget (or expense) model approach for estimating retirement spending. Budget models come in a variety of forms. These all have in common the estimation of total retirement spending by working with estimates of spending in numerous, smaller budget categories. The most common type of budget model involves the use of a single budget to describe all retirement expenses. However the budget approach offers the flexibility to create retirement spending models that utilize more than just one budget. This flexibility is valuable because Surveys of retirement spending have consistently shown there to be a great deal of diversity in retiree spending patterns. But flexibility comes at a price: the greater amount of time needed to assemble spending estimates for each budget category.
For people who have not used a written budget to track their spending, getting started can seem daunting. But by thoughtfully breaking a Retirement Spending Plan into smaller spending units, it is possible to get a better grasp on how to proceed. Figure 1 shows a generalized approach to categorizing the expenses likely to be encountered in retirement. Medical expenses (shown to the left) are separated from non-medical expenses because the former have a significantly higher expected inflation rate. Over the last 20 years (1992-2011) medical expenses have been increasing at roughly 6.1% annually, while general living expenses (as measured by the CPI-U inflation index) have only increased by about 2.5% annually. When budgeting for medical and non-medical expenses over a 20 to 30 year retirement, this difference in price inflation can't be ignored!
Vertically in Figure 1 retirement expenses are separated into 2 categories: Ongoing and Limited Duration. Ongoing expenses in retirement are those that can reasonably be expected to persist throughout the entire retirement period. Some might occur every year, such as medical insurance premiums or housing expenses. Others might occur periodically, such as new applicances or cars, but could conceptually be budgted for by using an annual, pro-rated spending. In contrast, the Limited Duration retirement expenses are anticipated to occur only over a limited time frame. Medical examples would be end-of-life hospitalization or long term care expenses. Non-medical examples would be home mortgage payments which might not be completed before retirement begins.
Starting with these higher level budget segments, further spending subdivisions can be made. The goal is to create a sufficient number of distinct budget categories so that retirement spending can be easily tracked and modeled. Many people find it useful to start with pre-made budget worksheets. Links to sample budget worksheets are therefore provided to help in this regard. Using worksheets is an important part of developing any budget model: they guide the user to consider all potential expenses. For reference purposes, Table 1 shows a simplified set of budget categories. This table is a slightly modified version of the Health and Retirement Study category table in the wiki: Surveys of retirement spending.
|Housing||Mortgage payments, home/renter insurance premiums, property tax payments, rent, utility costs (electricity, water, heat, phone, and cable and internet services), spending on house/yard supplies, and home cleaning / maintenance costs|
|Health Care||Cost of insurance premiums, deductibles, and co-pays for health services, drugs and medical supplies. Also includes long-term care expenses.|
|Food||Expenditures on groceries but not spending on dining outside of the home|
|Personal Appearance||Clothing of all types; personal beauty & hygiene|
|Transportation||Automobile finance charges, automobile insurance premiums, gasoline, and automobile maintenance|
|Entertainment||Dining out, vacations, tickets to events, and hobbies|
|Gifts||Charity and other gifts|
|Big, Infrequent Expenses||Purchases of automobiles, home appliances (refrigerators, washers, dryers, dishwashers); electronics (cell phones, televisions, computers); major home renovations and repairs.|
The size of your retirement spending budget will typically increase each year because of price inflation. These price increases can be very irregular and in some years quite large. It is for this reason that inflation is considered the retiree’s worst enemy. 
The majority of retirement planning approaches treat inflation as a independent, adjustable variable. In doing so, they separate nominal retirement spending into two components: real spending, and inflation adjustments. This article follows the same approach. Unless stated otherwise, the budgeting models discussed in this article deal with real spending. Inflation adjustments are covered in the article Inflation and retirement spending.
Single budget models
Single budget models guide the pre-retiree to develop one estimate of their anticipated spending early in retirement, often targeting spending for the very first year of retirement. These budget estimates supply a starting point for extrapolating how spending changes as the retiree ages. In the very simplest case, such extrapolations might ignore real spending changes during retirement: the initial, real spending budget is assumed to be valid across the entire retirement! But often the initial spending budget is assumed to exhibit real spending changes as retirement progresses.
In practice the budgets are typically developed using current costs (i.e. in this year’s dollars). This makes it simpler to come up with a realistic spending estimate for the various budget items. The real budget costs at retirement are assumed equal to the current cost estimates. If spending in nominal (inflated) dollars at retirement is needed, an inflation adjustment is applied.
There are two main approaches to building a single budget model, which in this article are referred to as the Current spending approach and the Bottom-up approach.
Current spending approach
This is the simpler of the two approaches. You start with your current annual spending and make adjustments for expenses that decrease or increase at retirement.  The following step-by-step sequence describes how the current spending approach is implemented.
Step 1: Determine your latest, annual pre-retirement spending
- Start with your latest, full year total taxable income.
- Subtract payroll taxes (OASDI, Medicare) and income taxes (federal, state and local)
- Subtract savings: IRA contributions, self-employed plan contributions, bank and brokerage account additions.
Step 2: Subtract expenses that will be reduced at retirement. Examples include but are not limited to:
- Work-related expenses (clothing, transportation, meals away from home)
- Spending on your children (living and educational costs)
- Home mortgage payments
- Medical costs, if Medicare + Medigap cost less than your current insurance.
Step 3: Add expenses that will increase at retirement. Examples include but are not limited to:
- Vacation travel
- Dining out and entertainment
- Medical costs, especially if they were formerly employer-subsidized
Step 4: Result is your simple budget total spending.
There is a close relationship between this approach and a personalized (individually adjusted) replacement rate. This same four step calculation is also used by the GSU/Aon RETIRE Project to derive post-retirement spending from a pre-retirement gross income. The Current Spending budget approach stops with the retirement spending. The RETIRE project goes on to calculate replacement rates by dividing the retirement spending by a pre-retirement gross income. Refer to the article Replacement rate models of retirement spending for more information on replacement rates and the GSU/Aon RETIRE Project.
- Quicker and simpler compared to other budgeting approaches.
- Can give a very reasonable result if your current lifestyle and expenses are close to those you anticipate having early in retirement.
- Unless well thought out, the expense adjustments in Steps 2 & 3 may be unrealistic.
- May underestimate the average contribution of big, infrequent expenses (e.g. automobiles or major appliance) if too few of these occurred in the year whose spending is being analyzed.
- This budget may not provide a good starting point for incorporating real spending changes over time.
In this approach you develop a personalized spending budget “from scratch” by estimating your retirement spending for every conceivable budget category.  A highly detailed budget worksheet should be used to guide you through the process. (The budget categories in Table 1 above are not detailed enough!) Spending estimates are made using current costs (i.e. in this year’s dollars). When spending estimates have been entered for all categories, they are added together. This becomes your estimate of real budgeted spending at retirement.
The Bottom-up approach yields the best spending estimate when a comprehensive budget worksheet is being used as a guide. Table 2 contains examples of such budget worksheets.
Table 2. Representative Budget Worksheets Title Description Secure Your Dreams Manual entry (printable). From Iowa State University Extension  Fidelity Retirement Income Planning Workbook Manual entry (printable). Financial Planning for Retirement Workbook Manual entry (printable). From Purdue University Extension. Worksheet 5 is particularly good for big, infrequent purchases. Vanguard Retirement Expenses worksheet Enter data online. Standard & Poors Projected Retirement Expense Calculator An online budget calculator. Retirement Living Expenses Calculator Downloadable spreadsheet. Mimics the BLS Consumer Expenditure Survey budget categories. Simple Budget Worksheets Downloadable spreadsheet. Has separate worksheets for regular/ongoing and big/infrequent purchases.
Pitfalls with the Bottom-up Approach:
- If an important spending category is overlooked, the final budget estimate could be significantly low. This can be a particular problem for big, infrequent purchases.
- If too little time is spent making a realistic assessment of the spending for each category, then the estimate for that category could be too low or too high.
- Medical expense estimates can be particularly difficult to develop
Overcoming the Pitfalls:
- Work with detailed budget worksheets designed especially for retires. Include a separate worksheet for big, infrequent purchases. 
- Devote half a year (or more) to collecting detailed records of your ongoing, regular spending. This information will help you develop better spending estimates.
- Get current prices for big, infrequent purchases. Ask for current estimates of their anticipated lifetimes.
- Learn about general health care options for retirees. Explore your own medical insurance options and their costs. Refer to Medical spending in retirement.
- Capable of supplying very accurate spending estimates.
- Particularly suited to handle spending estimates for big, infrequent expenses.
- This budget provides a good starting point for incorporating real spending changes over time.
- Forces the pre-retiree to think through their retirement lifestyle. For couples, it can promote useful discussions about their respective retirement expectations.
- Requires a significant amount of time and effort.
- Realistic spending estimates are difficult to achieve unless personal spending is already being tracked.
Dual budget models
A Dual Budget model is a direct extension of the Bottom-up budget model just discussed. Instead of estimating a single spending budget at the beginning of retirement, two budgets are developed.   The first budget, variously called a Minimal / Basic living / Essential budget, represents the lowest level of real retirement spending that can be accepted. The second budget, variously called a Desired or Preferred budget, represents the higher level of real retirement spending that would be preferred. The difference between these two budgets is referred to as Discretionary spending. The retiree’s spending in any year is assumed to fall within the range bounded by these two budgets.
Retiree spending behaviors
It is simplistic to imagine that retirees would maintain a fixed real spending each year. Rather, they would be expected to cut back on their spending during times when they don’t feel as financially secure. For retirees having savings invested in stocks or stock mutual funds, stock bear markets would be such a time of reduced spending. This is a natural response to declines in personal net worth caused by declining equity values. But the Dual budget model sets a lower limit on this reduced spending: the essential budget spending level. Conversely, when a retiree feels financially secure (e.g. during a stock bull market), they would once again increase their real spending. The Dual budget model sets an upper limit on this increased spending: the desired budget spending level.
Working with an essential budget is a smart approach to retirement planning. After all, if the essential spending level can’t be safely maintained, then retirement should be delayed and more financial resources accumulated. On the other hand, it’s also possible to say that retirees will adjust their spending to whatever income is available, regardless of how low that might be. In some cases this does happen , but it can be an extremely painful experience for the retiree.
The easiest way to estimate the Dual budgets is to use a worksheet designed for this purpose. Each budget category on such a worksheet accepts two entries: an essential spending amount and a discretionary spending amount.  The sum of both gives the desired / preferred budget amount. The process of filling in cost estimates for each category is identical to that already described for the Bottom-up budgeting approach. The Excel Retirement Living Expenses spreadsheet accommodates dual budget development.
Relationship with withdrawal methods
When dual budget spending models are used in the retirement planning process, they should be combined with Withdrawal Methods that allow real spending to vary. A simple example of such a withdrawal method is the Constant Percentage method. Using this method the retiree is never allowed to withdraw more than a pre-determined percentage (often 4.5% to 6.0%) of their previous year-end total savings. As total savings rise and fall in response to stock market cycles, nominal withdrawals will likewise rise and fall. The maximum withdrawal percentage is selected to fulfill the Safe Withdrawal Rates restriction that savings will not be depleted even if a long period of poor investment returns occurs. The dual budget model then supplies an additional restriction: the allowable spending set by the withdrawal rule will also not drop below the essential budget level. All these restrictions are combined in the retirement planning calculation to yield a personal savings target at retirement.
Besides the Constant Percentage method, there are many other Withdrawal Methods that allow real spending to vary. An extensive summary of these methods is given on the Variable Withdrawals in Retirement archived page from the old Bob’s Financial Website. Of these additional methods, the Floor and Ceiling withdrawal methods  have the closest relationship to the dual budget spending model.
Some retirement planners have suggested extending the Dual budget concept to incorporate even more levels of spending. As part of their Modern Retirement TheoryTM approach to retirement planning, Jason Branning and Ray Grubbs have proposed goal-segmenting retirement assets to cover 4 categories. Starting from the pyramid base, these categories are:
- Base Fund – for essential retirement living expenses.
- Contingency Fund – for hedging against significant, unpredicatable events.
- Discretionary Fund – for spending above the essential levels.
- Legacy Fund – for inheritance and charitable purposes.
Mitch Anthony in his book The New Retirementality  proposed using a 5 level spending pyramid. Starting from the pyramid base, these levels are:
- Survival Money – to pay for the basic necessities of living.
- Safety Money – to pay for guarding against potential retirement risks.
- Freedom Money – to pay for activities and trips that bring enjoyment.
- Gift Money – to give to people and causes we cherish.
- Dream Money – to enable fulfillment of your deep desires.
Each spending level covers an increasingly discretionary need. His book contains a series of worksheets for estimating spending at each pyramid level.
- Provides a more realistic model of retiree spending that a simple (single) budget model.
- Better suited for combining with safe withdrawal rates determined using variable spending methods.
- More work to develop dual or pyramid budgets than a simpler, single budget.
Time-varying budget models
The previous budget models have focused on spending at one point in time, particularly at the time of retirement. But the budget model approach can be expanded to describe changes in real spending as the retiree ages. Often such time-varying budget models focus only on real changes in total spending. However, time-varying budget models can also be designed to accommodate independent changes in real spending for numerous expense categories. Two popular approaches are referred to in this article as Step Change budgets and Flexible Spending budgets. For a more detailed discussion of ways to model spending from retirement until death refer to the article Models of spending as retirement progresses.
Step change budgets
This modeling approach typically uses 3 to 4 separate budgets to approximate changes in real spending as the retiree ages. Some retirement planners recommend each budget last a specified number of years or to a specified age.  Others recommend flexibility in how long each budget stage lasts. Changes in real spending are discontinuous when switching from one budget to the next, hence the step change designation for such models. As a specific example, consider the following proposal by Robert Carlson: 
- Stage 1 budget: First few years of retirement. Higher spending than in pre-retirement as the retiree pursues leisure time dreams while still having relative youth and good health.
- Stage 2 budget. Until about age 75. Spending settles back down to a lower, stable value.
- Stage 3 budget. After age 75. Spending shifts down again. Cites the BLS Consumer Expenditure data to suggest a 25% drop in real spending relative to early retirement.
- Stage 4 budget. End of life. Medical / long-term care expenses might drive up spending unless insurance is available to cover these costs.
Although others besides Carlson have suggested a Stage 1 budget with higher real spending , it is clear from Surveys of retirement spending that, on average, real spending drops slightly at retirement and continues to drop steadily as retirees age into their late 70’s. Still others have pointed out that a substantial percentage of retirees (up to 25%) leave work involuntarily and experience a real spending drop at retirement that corresponds to shifting immediately to a Stage 3 budget.  The clear message here is that retiree spending patterns show a great deal of diversity. Any budget model (or retirement calculator) that assumes stepwise changes in real retiree spending must be able to accommodate such individual differences. Otherwise it will be applicable to only a limited subset of the retiree population.
Other Variations. Those wishing to implement a Step Change budget model might find some variations on this approach to be intriguing. For example S. Basu has published a variation called Age Banding. There is nothing particularly unusual about his use of three budget stages with rather fixed age ranges (66-75, 76-85 and 86-95). But he brings an added degree of realism into the model by incorporating a separate budget for each of 4 broad expense categories: taxes, basic living, healthcare and leisure. At each of the age band boundaries the model allows a step change in real spending, either upwards, downwards or no change. For example, basic living expenses could be given step drops at each age band boundary, but healthcare given step increases at each age band boundary. Further, his model allows for a different inflation rate to be applied to each spending category within each age band.
Conceptually there is no reason why the Dual budget and the Step Change budget models couldn’t be merged. In such a composite budget model there would be an Essential and a Preferred spending level within each of the 3 (or more) step change budgets.
- Step Change budgets provide a more realistic treatment of spending changes during retirement than just assuming a constant real spending.
- There is no capability to have category spending change other than at the pre-selected stage boundaries. Stated differently, real spending must always be constant within any budget stage.
Flexible spending budgets
The most general budget models for retirement spending allow complete decoupling of spending patterns for a wide range of living expense categories. Consider the following situations where such budgeting flexibility would prove useful:
- An early retiree plans to purchase expensive, personal medical insurance until they become eligible for a less expensive Medicare + Medigap combination at age 65.
- A retiree wants to explore how possibly needing to pay for her mother’s long-term medical care in 7 years might affect how long her own savings would last.
- A near-retiree with mortgage payments lasting another 13 years wants to incorporate this into his proposed retirement spending plan.
What all of these situations have in common is a significant expense which starts and/or stops at some arbitrary time during retirement. A Flexible Spending model is able to incorporate such category-specific, step changes in real spending. At the same time other spending categories, for example basic living expenses, could be modeled as exhibiting fairly smooth, real changes.
This type of budget model can be viewed as a logical extension of the Age Banding budget model previously discussed. Instead of 3 spending categories (plus taxes), a Flexible Spending model allows for a very large number of categories. Instead of fixed-length age bands for each category, the spending can start and stop at arbitrarily selected ages. Looked at from a different perspective, age bands have been effectively reduced to 1 year lengths.
Flexible Spending budget models are more often used within commercial retirement calculators. Such calculators tend to be used by professional financial planners. But there are a few publically available, free calculators that incorporate this modeling approach.
- Provide a personalized and very realistic treatment of spending changes during retirement.
- Gathering the data to input into this budget model is very time consuming.
- Calculators with Flexible Spending models are more difficult to learn and use.
- This annualized average medical cost inflation was calculated from the National Health Expenditure Data Set, CY 1960-2011, Table 21, published by the Centers for Medicare & Medicaid Services. It is an average of the All Benefit data for Medicare and for Private Health Insurance.
- This annualized average CPI-U was calculated from data in the Bureau of Labor Statistics All Urban Consumers Price Index CPI-U History Table, 1913 to Present
- Wikipedia file: US Historical Inflation.svg
- John Howe, Inflation – A Retiree’s Worst Enemy
- Scott Pearson, Inflation: The greatest enemy of your retirement plan (Sept. 2008)
- In economics real refers to the purchasing power net of any price changes over time. Refer to the Wikipedia article Real versus nominal value (economics).
- B. Tacchino, “Determining the Amount a Client Needs for Retirement,” Chapter 5 in Financial Decisions for Retirement, (The American College Press, 2005), pp5.1-5.55.
- Dana Anspach, Estimate How Much You Will Spend Each Year in Retirement, About.com, Money Over 55.
- MetLife Retirement Income Worksheet (2009)
- This is not your Adjusted Gross Income (AGI), but the Total Income on IRS form 1040. This total is located just before the “above the line” deductions are taken into account.
- Ignore pre-tax contributions to 401(k), 403(b) and similar savings plans. Such pre-tax contributions are withheld before your employer reports your taxable income.
- 2008 GSU/Aon RETIRE Project Report
- Walter Updegrave, "Create a Retirement Plan That Works for You", chapter 5 in We’re Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World (Crown Business Publishers, 2004) 304pp.
- Robert C. Carlson, "How Much Will You Need", Chapter 3 in The New Rules of Retirement: Strategies for a Secure Future, (John Wiley & Sons, Inc., 2004) 288 pp.
- B. Wollam, D. Donald and K. Petersen, Estimating Your Retirement Expenses, Chapter 5 in Retirement - Secure Your Dreams, Iowa State University Extension, (June 2007)
- Janet C. Bechman, Financial Planning for Retirement Workbook, Purdue University Extension document CFS-685-W (Oct. 2006), 25pp.
- Paul Merriman, Live it Up Without Outliving Your Money, revised and updated edition (John Wiley & Sons, Inc., 2008), 206pp.
- Ellen Hoffman, Time to Abandon the 70% Solution, Business Week, March 11, 2005.
- Helen Modly, Helping Clients to Accurately Estimate Retirement Expenses, Morningstar Advisor (Aug. 31, 2005).
- Kevin J. Lansing, Gauging the Impact of the Great Recession, Federal Reserve Bank of San Francisco FRBSF Economic Letter, July 11, 2011.
- Lonnie K Stevans, Aggregate consumption spending, the stock market and asymmetric error correction, Quantitative Finance, Vol. 4 (2004) pp 191-198.
- For a particularly eye-opening example of how low retiree income might drop, read about the retirement experiences of Paul Nelson in the article Unretired: Retirees are Back, Looking for Work, Business Week, Dec. 15, 2008.
- William Bengen, Conserving Client Portfolios During Retirement, Part IV, Journal of Financial Planning, (May 2001)
- Colleen Jaconetti and Francis Kinniry Jr., A more dynamic approach to spending for investors in retirement Vanguard Research (Nov. 2010) 9pp.
- Jason K. Branning and M. Ray Grubbs, Modern Retirement Theory: Reaching Client Goals in Every Market, Journal of Financial Planning supplement on Retirement Distribution Planning (Dec. 2009), pp 14-17.
- Mitch Anthony, The New Retirementality, 3rd Edition (John Wiley and Sons, Inc., 2008) 281 pp.
- Michael Stein, The Prosperous Retirement: Guide to the New Reality, (Emstco, LLC, 1998), 312 pp.
- Somnath Basu, Age Banding: A Model for Planning Retirement Needs, Financial Counseling and Planning, Vol. 16, No. 1 (2005) pp29-36.
- M. Cowell, R. Helman, A. Rappaport, S. Siegel and J. Turner, The Phases of Retirement and Planning for the Unexpected, Society of Actuaries 2007 Risks and Process of Retirement Survey Report (Aug. 2008), 26pp.
- J. Fisher, D. Johnson, J. Marchand, T. Smeeding and B. Torrey, The Retirement Consumption Conundrum: Evidence from a Consumption Survey, Center for Retirement Research at Boston College Working Paper WP 2005-14, (Dec. 2005), 30 pp.
- Erik Hurst, Understanding Consumption in Retirement: Recent Developments, Chapt. 3 in Recalibrating Retirement Spending and Savings (eds. John Ameriks and Olivia Mitchell), Oxford University Press (2008) pp 29-45.
- Most budget models don’t consider taxes to be an independent budget item. Rather, they calculate taxes based on the income required to cover spending in the remaining categories.
- Commercial retirement planning calculators with a Flexible Spending budget capability include J&L Financial Planner Professional Version, VeriPlan Retirement Planning Software, and Money Tree TOTAL Planning Suite.
- Retirement planning calculators with a Flexible Spending budget capability that can be accessed for free on the Internet include the Flexible Retirement Planner and the Fidelity Retirement Income Planner (Fidelity account login required).