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.

Safe Withdrawal Rates
Many studies on retirement spending 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, known as the Safe Withdrawal Rate. These models treat the maximum amount of savings as an independent variable. The amount of spending is adjusted so the savings last as long as planned.

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

Inflation
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 article Inflation and retirement spending.

Retirement calculator models
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.

The usefulness of retirement planning software will be limited by its least realistic assumption. 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
 * Single budget models
 * Dual budget 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 three main approaches for developing this estimate:
 * 1. Replacement rate (or ratio) models
 * 2. Single budget (or expense) models
 * 3. Dual budget 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.

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.

STRENGTHS WEAKNESSES
 * Provides a quick and easy estimate of gross income in retirement.
 * Well suited for use by persons who are far from retirement. The uncertainties in the GSU/Aon replacement rates will likely be on the same order of magnitude as uncertainties in other aspects of the retirement plan.
 * GSU/Aon replacement rates need further adjustments for best accuracy.
 * Require a supplemental calculation to obtain after-tax spending.
 * Persons far from retirement will need to estimate their gross income just before retirement in order to use replacement rates.
 * Generally less accurate than a Budget model approach for persons who are close to retirement.

Single budget models
Budget (or expense) models 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. The most common type of budgeting approach involves the use of a single budget to describe all retirement expenses.

Two approaches are typically used to obtain a single budget spending estimate: 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 adjustments are then incorporated to arrive at a total spending just after retirement.

The Bottom-up approach develops a personalized spending budget “from scratch” by estimating the retirement spending for every conceivable budget category. A detailed budget worksheet should be 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.

The in-depth article Budget models of retirement spending provides links to detailed worksheets useful for developing a single budget spending model. Many retirement planning calculators also incorporate worksheets for developing budget spending estimates. However it is better to develop the budget using an independent, detailed worksheet. Doing so minimizes the possibility that important spending categories get overlooked. For example, spending on big, infrequent purchases are very important, but tend to be omitted by most calculators’ built-in worksheets.

STRENGTHS : WEAKNESSES :
 * Capable of supplying more accurate spending estimates than a replacement rate model.
 * Better suited to handle spending estimates for big, infrequent expenses than a replacement rate model.
 * A Bottom-up budget model provides a particularly good starting point for incorporating real spending changes over time.
 * Requires more time and effort than a replacement rate model.
 * Realistic spending estimates are difficult to determine unless personal spending is already being tracked.

Dual budget models
Dual Budget models are a direct extension of the Bottom-up budget model that incorporate 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 retiree’s spending in any year is assumed to fall within the range bounded by these two budgets.

The easiest way to estimate the Dual budget models is by using 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 preferred budget spending estimate.

Dual budget spending models are particularly suited for combination with Withdrawal Methods that allow real spending to vary. Examples of such withdrawal methods are the Constant Percentage method and the Floor and Ceiling method. The Dual budget model supplies an additional restriction on the calculation of total savings at retirement: real spending can’t rise above the preferred budget nor fall below the essential budget.

STRENGTHS : WEAKNESSES :
 * Provides a more nuanced model of retiree spending that a single budget model.
 * Better suited for combining with Withdrawal Methods that allow variable real spending.
 * More work to develop dual budget models than a single budget model.