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Mark Miller: Remaking Retirement

Retirement Spending Just as Important as Retirement Income

Income replacement rules for retirement don't account for one big question: How much will you actually spend?

We've all heard the rule-of-thumb: To retire comfortably, you need to replace 70% to 80% of pre-retirement income. Add a couple of percentage points for inflation every year, and you'll have what you need to meet your expenses in retirement.

But the rule-of-thumb never was meant as a way to think about spending in retirement, says Michael Kitces, partner and director of research for Maryland-based Pinnacle Advisory Group. Instead, it's always been about income.

"The origin of the rule of thumb was that if you wanted to replace your pre-retirement income, the figure to hit was 70%," he says. "It just referred to the actual income workers take home after adjustments for payroll and income taxes, retirement account contributions, and miscellaneous work expenses, like business clothing and commuting. It wasn't about a spending ratio when it was first invented, but at some point it morphed into that."

As a crude estimate, the rule-of-thumb isn't a bad starting point--so long as you understand your own mileage will vary. "All these averages you see--no one is average," says David Loeper, CEO of Wealthcare Capital Management. "The average represents everyone lumped together, so it's exactly the wrong assumption to apply to any individual."

The rule also is problematic for anyone struggling to achieve retirement in a hard times economy, because it doesn't start with the right questions: What lifestyle will you want--and be able to afford--in retirement? What will you need to spend on non-discretionary items, like food, shelter, transportation, and utilities? What discretionary spending do you really expect?

For more affluent households, the rule flies in the face of a growing body of financial planning research showing that retirement expenses rarely move in a straight, inflation-adjusted line. A 2005 research paper by financial planner Ty Bernicke challenged the idea that retirees need a constant level of inflation-adjusted income in retirement. Using statistics from the U.S. Bureau of Labor Statistics' Consumer Expenditure Survey (CES), he showed something different: Retirees over age 75 spend less than retirees age 65-74. And the 65+ crowd spent less than people age 55-64.

Researcher Wade Pfau recently updated Bernicke's CES analysis, and found that retirees age 65-74 spend 20% less than those who are 55-64; 75+ retirees spend 40% less than those who are 55-64, and 26% less than the 65-74 crowd. The argument here is that discretionary spending on travel, dining out, and entertainment decreases with age and encroaching health problems. While health-care spending is a major cost factor in retirement, Kitces notes that it's a smaller percentage of overall outlays for most affluent households, and Medicare stabilizes spending for most seniors.

Individual health-care spending can vary tremendously, too, depending on your longevity, major health conditions, and even location. I ran some hypothetical examples to illustrate this recently using a software tool developed by Healthview Services in Boston that allows financial planners to project clients' specific health-care expenses. Healthview relies on actuarial longevity data adjusted for gender and major health conditions; it also incorporates regional differences in health-care costs, chiefly Medigap policies.

The numbers suggest that a healthy 55-year-old man's lifetime health-care expenses from age 65 can vary as much as 25%, depending on where he lives. That's before any long-term care expense--an important wild card that is best contained with insurance.

Kitces' analysis of Pinnacle's clients at age 64 and 84 pointed toward a decline in spending of more than 20%. Overall, he thinks the trend is most pronounced among affluent households. "The proportion of their spending that is discretionary is much higher than for the general population, and that's the spending that is most prone to declining in later years," he says. "My gut and the anecdotal evidence is that we tend to dramatically understate how much spending tails off."

For married couples, he adds, longevity is another key factor. "The odds are decent that one spouse will live 20 or 30 years in retirement, but not so good that both will," he says. "So, it's important to plan around that." On the income side, this will mean the end of one Social Security benefit--although the surviving spouse might step up to a higher survivor benefit. Any defined benefit pension income also would stop.

But expenses likely will fall, too. "We'd expect to see food expenses drop a bit, along with discretionary spending like restaurants and vacations," Kitces says. "We might see a consolidation from two cars down to one. Medicare Parts B and D premiums also stop. And in some cases, the house feels too big when one spouse dies, so there's a downsizing."

Overall, Kitces argues most retirement spending plans can be given a "10% haircut in your mid-70s and another 15% in your mid-80s." If that's the case, the implications for the retirement plans of more affluent households are profound. It could permit earlier retirement, smaller contributions to 401(k)s and other retirement accounts, or more liberal spending on hobbies.

Most important, it points to the need for flexibility in your plan, Loeper argues. "People have no shortage of experts telling them to save more money, but mathematically, if it's possible not to be saving enough, is it not mathematically possible to be saving too much? If no one is telling you when you are saving too much--or spending too little--how would you know? Financial planning is a terrible name, because it sounds like something you have to stick to. It makes more sense to adjust to changing conditions, but in the context of a lifelong plan. Have a map with boundaries that lets you know whether you're over- or under-funded."

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of