Introduction to retirement spending models

Introduction
When most people think of retirement planning, one of their first questions is, “What will it cost me to live as a retiree?” Answering that question can seem overwhelming for many people. Frankly, coming up with an exact answer is probably impossible: there are simply too many future unknowns. But that does not mean that useful estimates of retirement spending are impossible to obtain. What is needed are some guidelines to assist in the process of estimating retirement spending. These guidelines will be referred to as models of retirement spending.

When thinking about future retirement spending, there is always a question of how much detail to put into the models / guidelines. This question is at the heart of any economic model : how much can the reality of the situation be simplified and yet still maintain usefulness. As will be seen, many models of retirement spending are possible, ranging from the extremely simple to the detailed and complex. This article will review the main modeling approaches currently being used for retirement spending, explain their key simplifying assumptions, and give a general feel for their strengths and weaknesses.

Excluded topics
This article treats retirement spending as an independent variable in the retirement planning process. The future retiree first develops an estimate of their desired spending in retirement. The planning process then starts from that desired spending, makes assumptions about longevity, inflation and investment returns, and estimates the future savings required to potentially sustain that retirement spending.

The reader needs to be aware that many studies on retirement spending reverse this process. They start with an estimate of future retirement savings and then estimate the spending that might be achievable in retirement. Such studies are often especially concerned with estimating the maximum spending that won’t lead to premature depletion of personal savings, the so-called Safe Withdrawal Rate. These types of spending models treat retirement spending as a dependent variable. Although an important component of retirement planning, such models are not covered in this article.

The effects of inflation on retirement spending are also excluded from this discussion. This is not meant to imply that inflation is an unimportant consideration. Just the opposite, inflation is probably the retiree’s worst enemy!  But 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. Inflation adjustments are covered in the wiki Inflation and retirement spending.

Relationship to retirement calculators
There is a strong connection between retirement spending models and retirement planning calculators. Most software used for retirement planning, whether explicitly or implicitly, is written assuming some model of retirement spending. The adjustable options included in the software reflect the choice of spending model. It is an unfortunate fact that some retirement calculators have great strengths in many aspects of their design, yet are needlessly weak in how they incorporate retirement expenses. A recent publication by The Society of Actuaries exhaustively examines retirement software strengths and weaknesses, including weaknesses in the area of expenses. As is true for any economic model, the usefulness of retirement planning software will be limited by its least realistic assumption. The software developer needs to keep this in mind. It makes little sense to develop retirement software having numerous investment type choices along with a detailed Monte Carlo treatment of potential future returns, if the real retirement spending is estimated using only a simple replacement rate model.

Organization
Having a classification system for retirement spending models is useful because it emphasizes similarities and differences. In this article the following classification will be used to organize retirement spending models:
 * Models of initial retirement spending
 * Replacement rate models
 * Simple budgeting models


 * Models of retirement spending changes over time
 * Constant (real) spending models
 * Age-varying spending models
 * Investment return-dependent spending models
 * Complex budgeting models
 * Life Cycle models

Models of initial retirement spending
These models guide the pre-retiree to develop an estimate of their anticipated spending early in retirement, often targeting spending for the very first year of retirement. There are two main approaches for developing this estimate: replacement rate (or ratio) models and simple budgeting (or expense) models.

Replacement rate models
Replacement rate (or ratio) models represent the simplest, most generic approach to estimating retirement spending. In their basic form, replacement rate models are also the least accurate. But the approach is flexible enough to allow it to be personalized, in which case the predictive accuracy can be greatly improved.

Rather than directly yielding an estimate of spending, replacement rate models give an estimate of pre-tax, gross income after retirement. This model is based on the following equation:


 * Gross Income (retired)  =  Gross Income (pre-retirement)  &times;  Replacement Rate

Assuming the pre-retiree has an idea of their gross income just before retirement, all that is required is a replacement rate multiplier to derive a gross income just after retirement. An actual retirement spending amount, if needed, can be calculated from the gross income by subtracting federal and state taxes.

In its simplest form, this model assigns the same replacement rate to everyone: 0.75 being a commonly suggested value, but sometimes a range of 0.70 to 0.85 is suggested. In this form the replacement rate model is extremely generic and for many retirees the least accurate.

But less generic replacement rate values are readily available. The RETIRE project at the Georgia State University’s Center for Risk Management and Insurance has studied how replacement rates change with key household characteristics. They, along with Aon Consulting, have published tables giving suggested replacement rates as a function of household composition and pre-retirement income. These replacement rate tables, as well as a more detailed discussion, are located in the wiki article Replacement rate models of retirement spending.

The replacement rate model quickly and easily yields an estimate of desired gross income in retirement. Compared to the much greater time required to use a budgeting model, this is a significant advantage.

For persons who are far from retirement, the replacement rate model can be a reasonable choice. The uncertainties in the replacement rates will likely be on the same order of magnitude as uncertainties in other aspects of the retirement plan. Gross income just prior to retirement can be extrapolated from current income. Perform this extrapolation using either historical wage growth indices or by comparing current salaries to those of persons in the same profession who are close to retirement.

But for persons who are close to retirement, the replacement rate model is probably less accurate than would be desired. This is true even when using the GSU/Aon RETIRE replacement rate tables. Significantly, RETIRE and Aon Consulting both recommend that further adjustments be made to their tabulated replacement rates before applying them to specific individuals. But the effort required to make such adjustments may not be much greater than required to use a budgeting model.

Some retirement planning calculators are built around the replacement rate model. When using such calculators, replacement rates from the GSU/Aon tables are preferred to a generic estimate. More preferably, the GSU/Aon replacement rates should be further adjusted to increase their accuracy.