Budget models of retirement spending

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Budget (or expense) models of retirement spending come in a variety of forms. Their common factor is that they estimate total retirement spending by working with estimates of spending in numerous, smaller budget categories. This general approach offers a lot of flexibility for modeling retirement spending patterns, but it has at a price. Specifically, it takes longer to assemble spending estimates for each budget category.

You usually start the budget modeling process by developing a single estimate of your total spending at the start of retirement. There are two typical approaches, which this article refers to as a Current Spending approach and a Bottom-up approach.

The Current Spending approach starts with your total (current) spending just before retirement. You then examine each spending category to see what adjustments, either up or down, you anticipate immediately after retirement. You then use these spending changes to arrive at a total spending just after retirement.

The Bottom-up approach develops a spending estimate for each expense category “from scratch”. Usually you would use a detailed budget worksheet to help ensure that you do not overlook any category of retirement spending. You then total these category estimates to give you the total spending estimate. This approach is more time consuming than the Current Spending approach, but can to produce a better estimate. The Bottom-up approach also gives you a better starting point for projecting how your budget might change as retirement progresses.

A Dual Budget model is a direct extension of the Bottom-up model, and incorporates two total spending estimates. The first or Essential budget represents the lowest level of retirement spending that you can accept. The second or Preferred budget represents a higher level of retirement spending that you want to achieve. The difference between these two budgets is Discretionary spending. Your spending in any year is assumed to fall within the range bounded by these two budgets.

You can model changes in real (uninflated) spending as retirement progresses using budgets. Two popular approaches are Step Change budgets and Flexible Spending budgets.

The Step Change approach considers retirement as divisible into stages (or phases) within which real spending does not change. It often uses three stages to cover a 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. You can think of it as as a Step Change budget model in which each stage could last for as little as one year. In addition, it uses 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 it may take you significant time to learn to use such a calculator.

Introduction
This article focuses on the budget (or expense) model approach for estimating retirement spending.

The most common type of budget model uses a single budget to describe all retirement expenses. However, you can use the same approach to create retirement spending models that use more than just one budget. This flexibility is valuable because Surveys of retirement spending consistently show considerable diversity of retirees' spending patterns.

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, you can get a better grasp on how to proceed.

Figure 1 shows a generalized approach to categorizing the expenses you are likely to encounter in retirement. Medical expenses (shown to the left) are separate 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 you are budgeting for medical and non-medical expenses over a 20 to 30 year retirement, you cannot ignore this difference in price inflation.

Figure 1 separates retirement expenses vertically into two categories: Ongoing and Limited Duration. Ongoing expenses in retirement are those that you can reasonably expect to persist throughout your entire retirement. Some might occur every year, such as medical insurance premiums or housing expenses. Others might occur periodically, such as new appliances or cars, but you can conceptually budget for them using an annual, pro-rated spending. In contrast, the Limited Duration retirement expenses are ones you anticipate will 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 complete before you start retirement.

Starting with these higher level budget segments, you can make further spending subdivisions. The goal is to create a sufficient number of distinct budget categories so that you can easily track and model your retirement spending. Many people find it useful to start with pre-made budget worksheets. Using worksheets is an important part of developing any budget model: they help you to consider all potential expenses.

For reference, 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 Surveys of retirement spending wiki article.

Inflation
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. Because of this, inflation is considered the retiree’s worst enemy.

The majority of retirement planning approaches treat inflation as an independent, adjustable variable. In doing so, they separate nominal retirement spending for any year into two components: real cost referenced to a base year, and an inflation adjustment. This article follows the same approach. Unless stated otherwise, the budgeting models discussed in this article deal with real expenses, not adjusted for inflation. Inflation adjustments are covered in Inflation and retirement spending.

Income taxes
Many of the budget models here do not consider taxes on income (earned or unearned) as an independent budget item, but rather an outcome of the total spending for other budget categories. However, like property taxes for homeowners, some income taxes merit separate budget items. An example of this is income tax for a Roth IRA conversion.

Any complete estimate of retirement spending must eventually include all tax payments.

Single budget models
Single budget models help someone approaching retirement 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, extrapolation might ignore real spending changes during retirement: the initial, real spending budget is assumed to be the same across the entire retirement. But often the initial spending budget is assumed to exhibit real spending changes as retirement progresses.

In practice you would typically develop the budgets using current costs (that is, 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 you need to model spending in nominal (inflated) dollars at retirement, you apply an inflation adjustment.

There are two main approaches to building a single 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 to implement this approach.

Step 1: Determine your latest, annual pre-retirement spending Step 2: Subtract expenses that will be lower 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: The result is your simple budget total spending.
 * Start with your latest, full year total 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, meals away from home)
 * Spending on your children (living and educational costs)
 * Home mortgage payments
 * Medical costs, if Medicare and 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. The GSU/Aon RETIRE Project to derive post-retirement spending from a pre-retirement gross income. uses this same four step calculation.

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. See Replacement rate models of retirement spending for more information on replacement rates and the GSU/Aon RETIRE Project.

Bottom-up approach
In this approach you develop a personalized spending budget "from scratch" by estimating your retirement spending for every conceivable budget category. Use a highly detailed budget worksheet to guide you through the process. (The budget categories in Table 1 above are not detailed enough.) Make spending estimates using current costs (that is, in this year’s dollars). When you have entered spending estimates for all categories, total them up. This becomes your estimate of real budgeted spending at retirement.

The Bottom-up approach gives you the best spending estimate when you use a comprehensive budget worksheet as a guide. Table 2 contains examples of such budget worksheets.

Dual budget models
A Dual Budget model is a direct extension of the Bottom-up budget model. Instead of estimating a single spending budget at the beginning of retirement, you develop two budgets. The first budget, variously called a Minimal / Basic living / Essential budget, represents the lowest level of real retirement spending that you can accept. The second budget, variously called a Desired or Preferred budget, represents the higher level of real retirement spending that you want. The difference between these two budgets is your Discretionary spending. Your 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 do not 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 (for example, 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 you cannot safely maintain your essential spending level, then you should delay retirement and build more financial resources. On the other hand, it is 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 the worksheet accepts two entries: an essential spending amount and a discretionary spending amount. The sum of both gives your desired or 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 supports dual budgets.

Relationship with withdrawal methods
When you use dual budget spending models for retirement planning, you should combine them with Withdrawal methods that allow your real spending to vary. A simple example of such a withdrawal method is Constant Percentage. Under this method a 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 chosen 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. The retirement planning calculation combines all these restrictions to give 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.

Pyramid budgets
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 proposed goal-segmenting retirement assets to cover four categories. Starting from the pyramid base, these categories are:
 * Base Fund – for essential retirement living expenses.
 * Contingency Fund – for hedging against significant, unpredictable 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 five 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.

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, see: Models of spending as retirement progresses.

Step change budgets
This modeling approach typically uses three to four 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. If you wish to implement a Step Change budget model, you 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 could not be merged. In such a composite budget model there would be an Essential and a Preferred spending level within each of the three (or more) step change budgets.

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 and Medigap combination at age 65.
 * A retiree wants to explore how possibly needing to pay for their mother’s long-term medical care in seven years might affect how long her own savings would last.
 * A near-retiree with mortgage payments lasting another thirteen years wants to incorporate this into their proposed retirement spending plan.

What all of these situations have in common is a significant expense which starts or stops at some arbitrary time during retirement. A Flexible Spending model can 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 three 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 one 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 publicly available, free calculators that incorporate this modeling approach.