To me, the starting point of any retirement plan is forming an accurate picture and understanding of what it will actually cost you and a spouse to live when you retire. Several years ago I created a spreadsheet that itemizes our retirement living budget. Because we are not yet retired, our retirement budget is only a prediction. I update it regularly with more current and accurate data.
First, if you don’t make a reasonable attempt to predict your retirement living expenses, you will not be able to predict if or when you can afford to retire. Second, you can factor inflation into your hypothetical retirement budget by using one of two strategies. The first strategy is to predict an average inflation rate and apply that rate mathematically to your current predicted amounts.
The second strategy is to design your retirement portfolio so that you fund at least your basic living expenses with assets that produce income that adjusts with inflation. Examples would include Social Security income, annuity income with an inflation rider, and government-issued TIPS and I-Bonds.
I prefer the second strategy because it removes at least one significant prediction (inflation rate) from the equation.
Many so-called retirement planning experts like to use income replacement ratios instead of actually predicting retirement expenses. I believe this is a silly, arbitrary, and potentially dangerous approach to retirement planning that is not based on good science. It’s just another rule of “dumb” that permeates the financial planning industry. Some of these “experts” use the income replacement approach to frighten us into making more risky investments that just happen to pay them higher fees and commissions.
None of us can really know with certainty what we will spend when we retire no matter how diligent we are in maintaining and updating our hypothetical retirement budget. This is where knowledge of the experiences of those who retired before us can help. Fortunately for not-yet-retired baby boomers, that real world data is increasingly available. We can use this data to cross-check and quality control our own predictions.
Recently the Employee Benefit Research Institute (EBRI) published a paper entitled “Expenditure Patterns of Older Americans 2001-2009. The EBRI used data gathered by other organizations and its own survey of 5,000 retired households. The study broke down these seniors’ retirement expenses into seven categories: home-related, food, health, transportation, clothing, entertainment, and other.
Here are some of the EBRI survey and analytical results that I found to be the most compelling:
1. The median annual expenses for all retired households aged 50+ declined with age. Interestingly, the decline is almost linear. For example, median expenses at age 65 were approximately $35,000 then declined by 34% to approximately $24,000 at age 85. (The expense figures are expressed in 2010 dollars.)
2. While retired households have a median income that is 57 percent that of working households, these retired households spend 80 percent of what working households spend. For these numbers to actually work, a retired household must have retirement assets that can be used to close the gap between their income and their spending.
3. For all retired age groups, home-related expenses were the largest category, by far. Housing expenses increased as a percentage of total retirement expenses from 38% in 2001 to 47% in 2009. This is another red flag that signals the importance of killing that mortgage (or downsizing) before retiring.
4. Health care expenses increase with age. This should not be surprising. What you may not have considered – but the survey shows – is the long term care expenses and private health insurance premiums are significant components of this increase.
I encourage everyone to read and digest the EBRI report. Use what the EBRI provides – and what our predecessors have actually spent – to reconsider your own retirement plan and budget.
You can find a link to the EBRI report here.