Budget models of retirement spending

Introduction
This article focuses on the budget (or expense) approach to estimating spending in retirement. As will become clear, this approach offers a great deal of flexibility. This flexibility is valuable because surveys of retirement spending have consistently shown there to be a great deal of heterogeneity in retiree spending patterns. But flexibility comes at a price: the time needed to gather the budget spending information.

For people who have not used a budget to track their spending, getting started can seem daunting. 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.

Inflation
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.

Simple budget (or expense) models
Simple budget 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. 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 simple budget model: 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 Step 2: Subtract expenses that will be reduced at retirement. Examples include but are not limited to: Step 3: Add expenses that will increase at retirement. Examples include but are not limited to: Step 4: Result is your simple budget total 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.
 * Work-related expenses (clothing, transportation, food 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.
 * Vacation travel
 * Dining out and entertainment
 * Medical costs, especially if they were formerly employer-subsidized

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.

STRENGTHS :
 * 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.

WEAKNESSES :
 * 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.

Bottom-up approach
In this approach you develop “from scratch” a personalized spending budget. Usually a detailed budget worksheet is used to guide you through the process. (The budget categories in Table 1 above are not detailed enough!) For each budget category you must develop an accurate estimate of your anticipated spending at retirement. 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.

Since the Bottom-up approach depends on having good budget worksheets, Table 2 contains representative examples that you can use to track your budget.


 * {|border="2" cellspacing="0" cellpadding="4"


 * +Table 2. Representative Budget Worksheets
 * align = "center" |Title
 * align = "center" |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.
 * }
 * 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.
 * }
 * 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.

STRENGTHS :
 * 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.

WEAKNESSES :
 * 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 call a Desired or Preferred budget, represents the higher level of real retirement spending that would be preferred. 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.

Practical implementation
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 Rate 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 additional methods is given on the Variable Withdrawals in Retirement page at Bob’s Financial Website. Of these additional methods, the Floor and Ceiling withdrawal methods have the closest relationship to the dual budget spending model.

STRENGTHS :
 * Provides a more realistic model of retiree spending that a simple (single) budget model.
 * Better suited for combining with safe withdrawal rates detemined using variable spending methods.

WEAKNESSES :
 * More work to develop dual budgets than a simpler, single budget.