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How Empty-Nesters Can Play Retirement Catch-Up

By saving rather than spending their freed-up dollars and by avoiding lifestyle creep, investors at this life stage can make significant headway.

Note: This article is part of Morningstar's 2021 Portfolio Tuneup special report. The interview ran as a video on July 5, 2016.

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

Raising children is expensive. But after college has been paid for and the kids are (hopefully) on their own, parents can use this window of time before retirement to play financial catch-up. Christine Benz discussed the issue with Michael Kitces. This is an edited version of their conversation.

Christine Benz: Why do so many families find themselves playing financial catch-up after they've raised their children?

Michael Kitces: We've all seen the statistics about how the overwhelming majority of baby boomers who are now approaching retirement are behind on their retirement savings. Being in that phase with my family myself and watching clients go through this for years, I have to say, "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!" We have set up this environment that expects that even though raising kids is so expensive, parents should somehow magically have enough dollars to raise the kids, cover all of the expense associated with their kids, save money for their college educations--and have a big retirement nest egg built up by the time the kids are graduating from college. In reality, the statistics show us that there just aren't enough dollars to go around for most people.

Benz: One of the key messages in your blog post about this topic is: The headwinds of funding child-related expenses limit your ability to save. If you are parents at this life stage, you're probably looking at your retirement kitty and it doesn't look like it will be enough to cover your retirement. Don't beat yourself up.

Kitces: I think we've gotten a little bit too concerned 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 a family. As a result, the empty-nest transition moment is probably the seminal transition moment for people with kids working toward retirement, because suddenly a whole lot of household cash flow gets freed up. You're no longer saving for college. Parents aren't spending as much on the kids--in some cases, maybe the kids have boomeranged back and you have a little bit of child-related expenses. But the kids are still less expensive than when they were being brought up.

All this cash flow becomes available, and those are dollars you can save and you don't even have to take a cut in our lifestyle. Mom and Dad, keep spending what you were spending on your lifestyle, then take all of the dollars that don't have to be saved for college tuition or covering other expenses for the kids, and redirect those dollars to savings.

What we've seen in practice is that a lot of clients do this, and suddenly they are saving 20% or 30% of their incomes--big savings numbers--not because they took a giant hit to their personal lifestyles, but simply because they took all the money that gets freed up in that empty-nest phase and shifted it toward retirement savings. When you're saving that much, you can catch up on retirement very quickly.

A national study assumed that people who transitioned into the empty-nest phase and saved the bulk of the additional dollars that they now suddenly had available. The study concluded that most of the nation's retirement crisis vanishes if you assume that freed-up money gets saved. Of course, not everyone's retirement problems go away, but a huge portion of the shortfall vanishes if people use that money to play catch-up.

Benz: If you are 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. Think of it as three phases: investing for retirement before the kids, during the kids, and after the kids. If you can get a little bit of money in there during the "before kids" phase, those dollars can get a really nice compounding track. When we get to that later empty-nest phase, the time horizon is shorter, but it's not ultrashort.

Historically, people would have kids in their 20s; they would be empty-nesters in their 40s; they'd retire in their 60s. Empty-nesters would get about a 20-year run before retiring. At moderate growth rates like 7% per year on average, your money doubles about once a decade. Twenty years gives you a good amount of time still to grow the money.

Now, as we've shifted to having kids later, the empty-nest time horizon before retirement gets a little shorter. But 10 to 15 years is still a lot of time for growth to happen. We see a lot of people in their early 50s who have $300,000 saved up for retirement, they are wondering, "How are we supposed to get something like $1 million in 10 or 15 years?" And the answer is, $300,000 growing at 7% or 8% will be at $1 million in about 15 years; compounding actually really is that powerful. I find we often don't appreciate how effective compounding can be. Nevermind what happens when, on top of that, you start saving 20% or 30% of your income because you take all the money you were spending on kids and college and you redirect that money over to savings.

Benz: Let's discuss some practical tips for making this a reality for empty-nesters. One piece of advice is to avoid lifestyle creep at this stage. In other words, don't view this freed-up money as disposable cash for, say, vacations or renovations. You need to prioritize saving that money.

Kitces: You've got to be careful with lifestyle creep. People in their mid to late 50s are looking at retirement five to 10 years out. They think they've got a long way to go toward hitting their retirement goals. And we sit down and consider what can they save to bridge this gap. They may say they just don't have a lot of money left at the end of the month, because they're doing all this "stuff." That's when I ask, "When did you start spending on all this 'stuff?'" And the answer often is, we started spending about five or seven years ago when the kids flew the coop and they suddenly had all this additional income. They bought new cars, transitioned to a new house that wasn't actually smaller, etc. As empty-nesters, they used all the dollars to upgrade their lifestyles rather than bridging their retirement gap.

If you want to avoid lifestyle creep, the classic answer is to spend a little more on experiences and not necessarily on stuff. If you're excited to be in the empty-nest phase, take a lovely vacation with your partner because you don't have to bring the kids along. Don't buy a giant house and buy new cars that are going to kind of saddle down your cash flow for all the years between now and retirement. I'm not saying don't enjoy your money and pretend this transition 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 go ahead, but make sure there's money left over to ramp up your retirement savings.

Benz: Your asset allocation in your 50s should look different than it did when you were a very early accumulator. How should empty-nesters be thinking about their asset allocations?

Kitces: As an empty-nester, you're not going to go entirely to cash or fixed income and out of stocks. The reality is, you may be five to 10 years away from retirement, but you might be 30 or 40 years away from the end of your retirement. As you enter retirement, you're only going to be spending a small portion of the portfolio, say 4%. The other 96% remains invested for a very long period of time. As a result, you still need some growth in there.

We recommend that you become a little more conservative coming into retirement, in part because if you stay really aggressive right as you're coming in at retirement and you experience a sharp bear market before you retire, you can derail the timing of your retirement. I call it retirement date risk: 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 down at the wrong time.

Benz: You mentioned a 7% return earlier. Is that a reasonable rate of growth to assume for a portfolio, or is that too optimistic?

Kitces: Yields are still low in absolute terms; valuations are 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 return 8% to 9% if they were tilted a little more aggressively. When you become more conservative in your allocations and see a 6% or 7% return. But that's still a more intermediate-term problem as we would view it. Markets run in cycles. Low-return environments tend to be followed by nice-return environments. It doesn't 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.

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