Empty Nest Phase a Crucial Catch-Up Time Before Retirement

Note: This article is part of Morningstar's 2019 Portfolio Tuneup week. A version of this article appeared on Jan. 22, 2018.

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The empty nest years can be a crucial period for retirement planning. Joining me to discuss that topic is Michael Kitces. He is a financial planning expert.

Michael, thank you so much for being here.

Michael Kitces: Thanks. Good to be here.

Benz: You had a really thought-provoking blog post on your blog looking at these empty nest years, the period after which college is paid for …

Kitces: When the kids are finally out.

Benz: Right. So, let's talk about why so many families find themselves kind of playing financial catch-up after this time.

Kitces: So, we've all seen the statistics of the overwhelming majority of baby boomers are now approaching retirements and are behind on their retirement savings and all of this angst that baby boomers weren't savings enough. And being in the phase with family myself, having seen clients going through this for years, I've always looked at this and said, well, of course, they don't necessarily have a lot saved up right now. They've been dealing with kids and college for the past 20 years. And like, we seem to have set up this environment that expects that even though raising kids is so expensive, you should somehow magically have enough dollars to raise the kids, all of the expense of the kids, and save for their college so they can go to college. Oh, and you should have a big retirement nest egg already well on track by the time the kids are graduating from college, so you can just cruise through to the end and of course, as we see kind of literally in the national statistics, there's just not enough dollars to go around to do that for most people.

Benz: Right. And one of your messages is don't beat yourself up. If you are parents at this life stage, you're looking at your retirement kitty, it doesn't look like it will be enough, don't beat yourself up that some of these headwinds of funding the child-related expenses really do limit your ability to save …

Kitces: Yeah, they really do. So, there's kind of two implications to that. So, on the one hand, I think we've gotten a little bit too concerned about--maybe about how far behind some people are in saving for retirement because it's just part of the natural course of what happens when you're raising family. The flip side though is, what that really means is that that empty nest transition moment is actually probably the seminal transition moments for people working toward retirement because suddenly a whole lot of household cash flow gets freed up. I'm not spending as much on the kids, maybe they'd boomeranged back and I've got a little bit of expenses, but less expensive than when I was bringing them up.

Benz: Right. Boomerangs.

Kitces: At least, I'm not still saving for their college. They can deal with finding a job now. So, all this cash flow becomes available and that's dollars we can save and we don't even have to take a cut in our lifestyle. Mom and dad, keep spending what you were spending on your lifestyle, take all the dollars that don't have to be saved for college or paying college tuition or paying other expenses for the kids, take that, redirect that to savings.

And what we've seen in practice is a lot of clients do this and suddenly they are saving 20% of their income or 30% of their income, big savings numbers, not because they took a giant hit to their personal lifestyle because that's tough for most of us, simply because they took all the money that starts freeing up when you get into that empty nest phase and they shifted it over to say, all right, this is going to be our savings dollars to catch up. And the reality is, when you're actually saving that much, you can catch up on retirement very quickly.

One of the national studies that came out that assumed people that transitioned into the empty nest phase which saved the bulk of the additional dollars that they now suddenly had available, when they did the study they found out most of the nation's retirement crisis vanishes if you just assume that money gets saved. Not everybody's problems go away, but a huge portion of the shortfall vanishes if we just give people credit for, A, being behind because they were just raising the family and that's the expense of raising a family, but once that money becomes available in the empty nest phase, it's OK to play catch-up and you can actually play catch-up really fast.

Benz: Well, a question though is obviously if you are really ramping up savings and say, you are in your 50s, you have a lot less time to benefit from compounding though, right?

Kitces: You do have less time to benefit from compounding. Ideally, if we think of it is as you, kind of, end up with three phases, before the kids, during the kids, after the kids. So, if we can get a little bit of money in there during the before kids phase that at least does get a really nice compounding track. So, nothing wrong putting in a little bit in there early to get started. When we get to that later empty nest phase, the time horizon is shorter, but it's not ultrashort. A lot people still can be 50--historically, it was more like 20 years, right? We would have kids in our 20s; we would be empty nest in our 40s; we go on and retire in our 60s, and you get a 20-year run. And even as I just said, at moderate growth rates like 7% a year on average your money doubles about once a decade. So, I mean, 20 years actually means the early dollars can quadruple in growth, you actually have a lot of time still to grow the money.

Now, we've shifted a little later when we're having kids, at least we're going to retire at the same date when we start kids later, the time horizon gets a little shorter. But even having time periods like 10 to 15 years there's actually still a lot of time for growth to happen. I mean, you think a lot of people--we see this a lot they're in their early 50s and they've got $300,000 saved up and that's actually a really good number for a lot of people and they are saying, oh, wow, I'm supposed to get to like $1 million in 10 or 15 years, how do I do that? And the answer is, well, actually just $300,000 growing at 7% or 8% will be at a $1 million in about 15 years, just compounding actually really is that powerful, and I find often we don't appreciate how good it is. Never mind what happens when you start saving 20% or 30% of your income because you take all the money you are spending on kids and college and the rest and you redirect that over to savings.

Benz: So, let's talk about some practical tips for making this happen. One of your pieces of advice and we've talked about this before is this idea of lifestyle creep, that don't just say, well, we've got this disposable cash because we're not paying for college anymore. Yay, we can take some vacations! You say to really prioritize that spending versus letting …

Kitces: Yeah, you got to be careful with that lifestyle creep. The biggest challenge point we see when we talk to a lot of folks in their mid to late 50s, they are looking retirement five to 10 years out. They are saying, oh, we've got a long way to go. And we started looking at, well, what can we save? Can we try to bridge this gap and saying, well, we just don't have a lot of money left at the end of the month because we're doing all this stuff. And I'm looking at a lifestyle, and I'm like, when did you start spending all this stuff? And the answer is, well, about five or seven years ago when the kids flew the coop and suddenly, they had all this additional income and they bought new cars and they transitioned to a new house that wasn't actually smaller. Even though they were empty nesters, they just got a smaller house of upgraded quality and actually spent more money on it, and they kind of gobbled up all the dollars that could have been available to save and actually bridge this retirement gap by upgrading the lifestyle. So, be careful of that.

In general, what it means, if you want to avoid lifestyle creep, the classic answer is spend a little more on experiences and not necessarily on stuff. So, if you're excited that you're in empty nest phase, take a lovely vacation because you don't have to bring the kids and you could enjoy it with the two of you. Don't do a giant house upgrade and buy new cars that are going to kind of saddle down your cash flow for all the years between now and retirement. So, I've never taken it from the perspective of don't enjoy your money at all and you could have to pretend this change never happened. But if you want to do some one-time spending on experiences and enjoy a little of the empty nest phase, by all means enjoy some dollars, but you should still find there's a whole lot of money left actually to start saving as those kids' expenses relieve as long as you don't upgrade permanent aspects of your lifestyle that just takes the savings dollars off the table altogether.

Benz: One other thing I want to touch on with you is asset allocation, because your asset allocation once you're in your 50s should look different than it would when you were a very early accumulator. So, let's talk about that and also, is a 7% return reasonable to expect if you've some sort of a balanced portfolio?

Kitces: So, as we look at it, as you approach retirement, the portfolio starts getting a little bit more conservative. You're not going to go entirely to cash or fixed income or out of stocks. The reality of time horizon we might talk about it in terms of, if I'm five to 10 years away from retirement, but you might be 30 or 40 years away from the end of retirement and even when you hit retirement, you're only going to be spending a couple of percent of the portfolio. The other 96% still stays invested for a very long period of time. So, we still need some growth in there.

We can get a little bit more conservative as we approach retirement and actually, we recommend that in part because if you stay really aggressive right as you're coming in at retirement a sharp bear market or a sharp turn in the market right before you retire can drastically derail the timing of your retirement. So, I call it retirement date risk, which is the more aggressive you are, the more risk there is that the timing of your retirement does not occur when you expected because the markets go, I was going to say sideways, or maybe go down at the wrong time.

So, we can start dialing down to be a little bit more conservative. But we still see--I mean, even in a lower-growth environment and we would characterize today's environment as lower-growth. Obviously, yields are low in just absolute terms; valuations are at least somewhat elevated when we look at long-term measures like Shiller CAPE, but that still doesn't take returns ultralow. That just means balanced portfolios in the past used to do 8 or even 9 if you tilt a little more aggressively. Now, you might do 7 or 6 as you get a little bit more conservative in the allocations and the growth numbers come down a little bit. But that's still a more intermediate-term problem as we would view it. I mean, markets do go in cycles. Low-return environments tend to be followed by nice-return environments. So, it doesn't actually concern me as much for people looking at 30 to 40 years of finished savings for retirement and then going through retirement. It means maybe there is a little bit more pressure on saving in the homestretch. But again, that's kind of the whole point of this transition that if you're preparing yourself or even if you are still in the phase where you've got kids and you kind of feel beat up that you're not saving enough for retirement, like, it's OK, but you do need to be planning that you're going to save a whole lot more when you get to that transition that you're going to earmark a lot of those dollars to save, and indirectly, this is why things like disability insurance start becoming important as well because the biggest caveat actually for people doing that homestretch of retirement saving is, what happens if it just turns out that you are physically able to work, if there is a health event or something else comes up.

Benz: OK, Michael. An important topic. Thank you so much for being here to discuss it with us.

Kitces: My pleasure. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.