Models of spending as retirement progresses

Introduction
This article examines in detail various models being used to describe how retiree spending changes from retirement until death. The material here is an in-depth expansion of the section Spending as Retirement Progresses from the introductory article on retirement spending models. Please also refer to that article for background information concerning approaches used to model Initial Retirement spending. These initial spending models supply the starting point for spending extrapolations across the retirement lifespan.

As in other modeling articles of this series, this article treats retirement spending as the key 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.

This article considers only the real component of retirement spending. Inflation adjustments and how they are incorporated into the retirement planning process 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 article Retirement calculators and spending contains an extensive list of calculators which have been categorized in terms of the retirement spending model(s) they use. The tables in that article particularly highlight models of spending as retirement progresses. Refer to that article to find real-world examples of the spending models discussed here.

Retiree spending: key observations
The article Surveys of retirement spending reviewed and summarized data on retiree spending patterns that have been collected by two ongoing, national U.S. surveys: the Bureau of Labor Statistics' Consumer Expenditure Survey, and the Health and Retirement Study. From these surveys, as well as from the practical experiences reported by professional financial planners, certain key facts have become clear:
 * The average retiree exhibits a slight drop in real spending at retirement, followed by a steady decline in real spending as they age into their late 70’s. This decline in real spending is voluntary and not a result of limited financial resources.
 * A substantial fraction of retirees (perhaps as many as 25%) enter retirement involuntarily. They exhibit a sharp drop in real spending at retirement.  If the involuntary retirement was health related, such retirees may subsequently exhibit a medical expense induced, real increase in total spending until their death.
 * Some smaller percentage of retirees exhibit an increase in real spending at retirement.  This is often driven by a jump in travel or other leisure activities.  After a certain time period, these special activities end and real spending patterns once again match those of “average retirees.”

The ability of each spending model to represent these key retiree spending patterns will be an important topic in the discussions.

Constant (real) spending models
This is the simplest of all approaches used to model spending as retirement progresses. The real spending at the time of retirement is assumed to continue unchanged until death. Inflation is not ignored, but as explained in the Introduction, it is treated as an separate, adjustable variable in the retirement planning process. From a nominal spending perspective, this model states that spending for any year in retirement is equal to spending in the first year times an independent inflation adjustment.

The constant spending model is most often combined with a Replacement Rate or Single Budget model of Initial retirement spending. When a Dual Budget model of initial spending is used, it tends to be combined with a model that allows real spending to vary between the essential and preferred budgets as retirement progresses.

Comparison with retiree spending
Constant real spending models do not reflect the reality that the average retiree’s spending steadily drops as retirement progresses. Many retirement planners have pointed this out as a major shortcoming. They have also pointed out that such models lead to an overestimation of the total savings needed at retirement.

A constant real spending model could conceivably be appropriate in cases where retirement is involuntary and financial resources are limited. This situation would force the retiree to immediately drop down to an essentials only spending budget. To the extent that they really are living at their minimum acceptable level, their nominal spending would be expected to grow at somewhat the rate of inflation (constant real spending) as they were forced to pay ever increasing market prices for those essential goods. However, such a retiree would also be motivated to substitute, when possible, less expensive items for their essential budget spending needs. Such a Substitution Effect would cause spending to somewhat lag behind constant real spending.

Relationship to withdrawal studies
Some of the earliest research on Safe Withdrawal Rates used constant real withdrawals in their calculations. Constant real withdrawals is a close proxy for constant real spending that omits the complication arising from taxes. The constant withdrawals constraint allowed the researchers to focus on their main issue of interest: how Sequence of Returns Risk impacts retiree savings survival. But because so much subsequent research has maintained the constant withdrawals constraint, some have drawn the mistaken conclusion that this is a realistic approximation to how retirees withdrawal and spend money. But as previously emphasized, the average retiree exhibits real spending that steadily drops as they age.

Use in retirement calculators
Constant spending is the most commonly used model in free Internet retirement calculators. This is especially true for calculators that are deterministic, less so for those that utilize Monte Carlo or Historical Returns calculational approaches. It is used both for calculators that predict the target retirement savings starting from a desired retirement spending, as well as in calculators that proceed in the opposite direction.

There are free Internet retirement calculators that allow you to choose models other than constant real spending. But these will often include a constant spending model for purposes of comparison with simpler calculators.

Retirement calculators offered for sale are much less likely to rely solely on a constant spending model. But they often include this model for comparison purposes.

Although Life Cycle spending models typically target a constant real spending in retirement, they do so from an entirely different, Economics Perspective. This approach is discussed in its own section below.

Refer to the article Retirement calculators and spending for examples of retirement calculators that incorporate a constant real spending model.


 * {|style="border-collapse: collapse;" border="1" cellspacing="0" cellpadding="2" width="90%"

STRENGTHS WEAKNESSES
 * - valign="top"
 * width="50%" |
 * Easy to understand, so it’s useful for illustrative (teaching) purposes.
 * Easy to implement in a retirement calculator or spreadsheet.
 * width="50%" |
 * Does not match the reality of how average retirees spend money as they age.
 * Often leads to an overestimation of the total savings needed at retirement.
 * }

Stages of retirement models
Many studies have recognized that a typical retirement can be divided into 3 to 4 Stages or Phases. Within each Stage retirees tend to exhibit similar patterns of physical activity and spending. As a specific example, consider the following 4 Stage proposal by Robert Carlson:


 * {|border="1" cellspacing="0" cellpadding="4" width="83%"


 * align = "center" width="21%"|Budget Stage
 * align = "center" width="79%"|Description
 * align = "center"|Stage 1
 * 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.
 * align = "center"|Stage 2
 * Until about age 75. Spending settles back down to a lower, stable value.
 * align = "center"|Stage 3
 * After age 75. Spending shifts down again. The BLS Consumer Expenditure data suggest a 25% drop in real spending relative to early retirement.
 * align = "center"|Stage 4
 * End of life. Medical / long-term care expenses might drive up spending unless insurance is available to cover these costs.
 * }
 * align = "center"|Stage 4
 * End of life. Medical / long-term care expenses might drive up spending unless insurance is available to cover these costs.
 * }
 * }

Not all retirees pass through Carlson's Stage 1 of increased real spending early in retirement. The average retiree doesn't, but some retirees do. Typically retirees pass though Stages 2, 3 and 4. (These are the only stages considered in most 3 Stage models.)   Some retirees in very poor health might experience increased real spending in Stage 4, but this depends on whether their insurance is able to cover the associated higher medical costs.

Many authors besides Carlson have chosen to use age 75 as one of their stage boundaries. There are likely several reasons for this. For retirees having reasonable health, this age is approximately when natural aging processes lead to a slower pace of living (Michael Stein's Slow-Go stage ). It is also possible that this age is chosen to match the BLS Consumer Expenditure tables, which break down their retiree data into age groupings of 65-74 and 75+.

Other authors feel that the diversity in retiree life experiences and associated spending prevent fixed ages from being assigned to the stage boundaries. An example commonly cited is involuntary retirement. For those entering retirement involuntarily with insufficient financial resources, their spending could very quickly drop down to a low, Stage 3-like level even though they could be in their early 60's. Keeping such diversity in mind, a good Stages of Retirement model should allow the boundary ages to be adjustable.

Stages having constant real spending
In the very simplest Stages of Retirement model the real spending within each Stage is assumed to be constant. All changes in spending occur at the boundaries between stages. For the average retiree spending drops at these boundaries. This is especially true at the commonly used age 75 boundary. If a budgeting approach is used to estimate the real spending within each Stage, these can be referred to as  Step Change budgets. But a changing (usually dropping) replacement rate could just as easily be used to model spending in each stage.

More realism can be brought to this type of model by further breaking down spending into budget categories within each stage. In his Age Banding model Somnath Basu incorporates a separate budget for each of 4 broad expense categories: taxes, basic living, healthcare and leisure. At each of the stage boundaries his 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 stage boundary, but healthcare given step increases at each boundary. Further, his model allows for a different inflation rate to be applied to each spending category within each stage.

Stages having variable real spending
Numerous studies have pointed out that retirees steadily reduce their spending as they age rather than exhibiting in a few sharp drops in spending. Based on this observation several retirement planners have suggested that Stages of Retirement models be made even more realistic by allowing real spending to vary gradually within one or more of the stages.

Tacchino & Saltzman. A very widely cited paper that suggested incorporating a steady spending drop into retirement planning calculations was published in 1999 by K. Tacchino and C. Satlzman. Arguing from the U.S. Consumer Expenditure survey data, they concluded:

"'...all available data and research indicate that there is a gradual reduction in spending starting shortly after retirement. Spending decreases are natural, voluntary and acceptable, and should be reflected in the client's accumulation model. The downward adjustment in spending by age 75 is approximately 20 percent of the initial spending levels during retirement that starts at age 65.'"

This 20% reduction (2.2% annually) is an average across all retiree income levels. They present data showing that real spending drops for every income range within the BLS survey data, although the percentage decrease varies in a somewhat random fashion.

Tacchino and Saltzman didn't particularly emphasize using a continual (annual) real spending reduction until age 75. They spent more time presenting ways in which stage models having constant spending could be modified to approximate the steady spending decreases. But they did state that a retirement calculation incorporating a real spending drop each year would lead to a better estimate for the total savings needed at retirement.

Bernicke's Reality Retirement Planning. Ty Bernicke published a widely cited paper Reality Retirement Planning: A New Paradigm for an Old Science in 2005. In it he emphasized using a steady, real spending reduction in each successive year of retirement until age 75. Real spending was assumed to remain constant in stages after age 75. His arguments were (again) based on data from the BLS Consumer Expenditure Surveys.

In his paper Bernicke recommends using a 50% spending drop between the 55-59 age group and age 75. A sample calculation presented used an annual real spending drop of 3.7%. This is certainly too large. Referring back to Table 1 in this paper, it can be seen that the raw Total Consumer Expenditure dollar amounts from the 2002 CE Survey were used. These dollar amounts included savings dollars (Social Security payroll taxes and personal retirement savings) which should have been subtracted out before estimating the percentage spending drop. Also, there was no correction for the different average household sizes between the age groups (i.e. 2.1 persons for age 55-59 versus 1.5 persons for age 75+). Incorporating these corrections would have reduced the predicted spending drop by age 75.

Recommended Annual Spending Drop. Bernicke's annual percentage drop of 3.7% until age 75 is too large. The equivalent annual spending drop from Tacchino and Saltzman, 2.2%, is much lower and probably closer to the truth. Fisher et.al. have analyzed the same Consumer Expenditure Survey data and recommended using a 1% annual real spending drop until the late 70's.

The BLS Consumer Expenditure Survey doesn't supply the best database for analyzing drops in real spending as retirement progresses. This is because the BLS survey doesn't follow the same households in each successive year. Changes in spending patterns with aging can only be derived by comparing shifting averages in large populations of households. It would be much better to perform retiree spending studies using the Health and Retirement Study survey database. In this biennial survey the same households are followed from age 51-56 until death. Unfortunately no such study of retiree spending patterns appears to have been performed.

William Bengen’s Prosperous Retirement. Published in 2001, Bengen’s Prosperous Retirement model is aimed at those retiree’s whose spending early in retirement is higher than average. This is in contrast to the previous two models that targeted a more "average" retiree. This model has 3 Phases: Active, Transition and Passive. In the Active Phase (until age 75), the model assumes a constant real spending. In the Transition Phase the model has a strongly declining real spending each year until age 85. (The example in the paper used 4% below inflation annually.) In the Passive Phase the model has a weakly declining real spending each year until death. (The example in the paper used 2% below inflation annually, which gave a slightly increasing nominal spending each year.)

Comparison with retiree spending
The use of 3 (or 4) Stages of Retirement, each of which can have a different real spending, allows for much better modeling of retiree spending patterns. All three of the basic patterns discussed earlier in the Key Observations section can be mimicked. And if the first one or two stages allow a gradual annual spending drop rather than just a constant real spending, then an even better match to actual retiree spending can be achieved.

Use in retirement calculators
Calculators having a Stages of Retirement spending model are much less common than those using a constant real spending model. Referring to the Calculators and Spending article, only a few of the calculators explicitly incorporate this model. Some of these have included Ty Bernicke's Reality Retirement Planning approach.

Although the documentation for only one of calculators explains how (the Flexible Retirement Planner), it is usually possible to set up a Stages of Retirement model with any calculator having a Flexible Spending capability. Each spending Stage (start age, stop age and constant real spending amount) is modeled using one of the custom spending inputs. To make this calculate properly, it may be necessary to set the initial spending budget to $0.


 * {|style="border-collapse: collapse;" border="1" cellspacing="0" cellpadding="2" width="90%"

STRENGTHS WEAKNESSES
 * - valign="top"
 * width="50%" |
 * Allows the diversity in retiree spending patterns with aging to be incorporated into the retirement calculation.
 * Significantly improves model accuracy without excessively increasing complexity.
 * width="50%" |
 * Additional work needed to estimate budgets or replacement rates for each Stage.
 * There is some uncertainty in the most realistic annual percentage spending drop to age 75.
 * Somewhat more difficult to implement in a retirement calculator that constant real spending.
 * }

Investment returns-dependent models
It isn’t surprising that retirees would 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, bear stock 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. Conversely, when a retiree feels financially secure (e.g. during a bull stock market), they would naturally increase their real spending. These periods of increased and decreased spending can be modeled by using Withdrawal Methods that contain a dependency on either the previous year’s total savings or its investment return. An extensive summary of these methods is given on the Variable Withdrawals in Retirement page at Bob’s Financial Website.

A Dual Budget model can be added as a natural complement to such variable withdrawal methods. The Essential Budget spending level would set a lower limit on spending as retirement progressed. The Preferred Budget spending level would set a corresponding upper limit on spending. These constraints would be included with those supplied by the withdrawal model when calculating the approximate savings needed at retirement. But since the Dual budget is an initial spending model, some method of extrapolating the spending across the retiree’s lifetime must be used.

It seems reasonable to extrapolate the Essential budget component of a Dual budget model using  constant real spending. To the extent that a retiree really was living at their minimum acceptable level, their nominal spending would be expected to grow at somewhat the rate of inflation (constant real spending) as they were forced to pay ever increasing market prices for those essential goods.

Extrapolating the Preferred budget component using a constant spending model is not reasonable, for all the reasons previously discussed. Instead, the Preferred budget should be extrapolated using either a Stages of Retirement model or a  Flexible Spending model. Both allow a more realistic description of how actual retirees alter their real spending as they age.

Comparison with retiree spending
By itself an Investment Returns Dependent spending model is not able to adequately describe the key observations on retiree spending discussed in the Introduction. It has no ability to match the steady decline in real spending as retirees age. But it does supply an element of reality that other models lack: the ability to reflect how retirees alter their spending in response to changes in their net worth. A combination of these two spending tendencies would be very beneficial.

A useful analogy is to think of waves on the ocean as the tide goes out. The waves would represent the investment return-dependent spending and the tide going out would represent the steady decline in spending as the retiree ages. The presence of the waves raising and lowering the ocean surface level will not nullify the more power effect of the lowering tide. But without including both effects, the water level at any instant can’t be fully described. Similarly, retiree spending in any year is better described by combining these spending models.

Use in retirement calculators
Calculators having an Investment Returns Dependent spending model are much less common than those using a constant real spending model. However, referring to the Calculators and Spending article shows that more calculators incorporate some variation of this model than those explicitly incorporating a Retirement Stages model.


 * {|style="border-collapse: collapse;" border="1" cellspacing="0" cellpadding="2" width="90%"

STRENGTHS WEAKNESSES
 * - valign="top"
 * width="50%" |
 * Reflects the tendency of retirees to adjust spending up or down as their net worth changes.
 * Nicely complements variable withdrawal methods used to insure savings survival in retirement.
 * More realistic than a Constant Spending model.
 * width="50%" |
 * Doesn’t match the reality that average retirees spend progressively less money as they age.
 * Less able to mimic the broad range of retiree spending patterns than a Stages of Retirement or a Flexible Spending model.
 * }