How to Manage Retirement Spending Cycles

Most retirement plans assume spending at a steady rate throughout retirement. That might have been a good idea when retirement lasted only five to 10 years, but today’s retirement is a very different case. Spending is not steady in retirement.

This is not a small point. A plan that assumes steady spending in retirement might indicate that a person needs to save more money than really is needed. The person could unnecessarily deprive himself during the working years or worry at retirement time that there isn’t enough money. Or the plan might not allow for enough spending in the early retirement years, unduly limiting the standard of living.

Steady retirement spending means that to be safe a retiree can spend only 4% to 4.5% of the portfolio the first year, and increase the withdrawal by the inflation rate each year after that. That could be too low a spending rate to support the desired lifestyles of many people. Assuming variable spending in retirement can justify a higher spending rate in the early years.

When retirement was relatively short, it made sense to assume steady spending. But recent research is showing that as retirement stretches to 20 or 30 years, people vary their spending during retirement. For example, a Department of Labor study, Consumer Expenditures in 2003, found that annual spending varies by age. Spending peaks at around age 50 and then steadily declines. Those over age 75 spend at dramatically lower rates than do younger retirees – an annual spending reduction of 25% or more.

That report makes sense. A typical retirement follows this pattern.

A new retiree is relatively young and healthy. After a lifetime of work, there usually are numerous pent-up desires such as travel or other recreation. These desires often cost money. Some refer to this is as the retirement honeymoon period. The new retiree is very active and spends at a relatively high rate.

After a few years, the retiree settles into a more normal and regular lifestyle. Spending smoothes, and the spending rate is lower than during the honeymoon period.

There are two more spending stages, but they do not apply to every retiree.

The third stage is another ratcheting down in spending and activity as the older retiree simply does less. The fourth stage might be characterized by generally lower living expenses but with some major medical expenses or long-term care expenses.

Another point about variable spending is that most people have some flexibility in their budgets. If need be, a number of expenditures can be deferred or eliminated. These expenses include travel, new car purchases, and home repairs or remodeling. A retiree also might reduce restaurant meals, entertainment, and other optional activities when needed.

A retiree should realize that spending can be adjusted in retirement. If overspending one year or portfolio fluctuations disrupt the plan, the retiree can adjust spending accordingly.

These insights can lead to some non-traditional features of a retirement plan that could enhance retirement:

Plan to spend more in the early years. A retiree might assume his retirement is likely to follow the typical pattern described above. That justifies some higher spending in the first few years and a reduction after that.

But don’t go overboard on the early years’ spending. Some new retirees go on travel and spending binges that put them on schedule to run out of money within 10 years. A few surveys show that Baby Boomers anticipate being able to spend 7% of their portfolios in the first year of retirement, and increase spending after that. You’ll need to run the numbers for your own plan, but that probably is an aggressive spending plan.

Flexible annual spending tied to portfolio changes can be a valuable retirement planning tool. Some plans provide that there is no inflation increase in spending if the portfolio return was negative for the year or the portfolio did not earn enough to make back the previous year’s withdrawal. Some plans allow spending to increase by only three quarters of the inflation rate instead of 100%.

One of my favorite spending rules is the one used by the Yale Endowment. This is described in my book, The New Rules of Retirement and in the Cash Watch section of the web site Archive.

The level of one’s medical expenses and long-term care insurance should have a great effect on spending freedom. The most likely unexpected major expense people incur is for medical care or long-term care. A retiree who has good coverage – through either a former employer or insurance – can be more comfortable that later years’ medical expenses will not deplete the retirement fund. That makes higher early years’ spending safer. This is especially important when there is a spouse also relying on the fund.

There are other ways to make a spending plan more flexible. The only limits are your creativity and circumstances. A retirement spending plan should not be viewed as something that is set in stone. It should be flexible, and you should consider it likely to be adjusted each year. As inflation, the markets, and your needs change, the plan also can change.