Spending Trends Boost Safe Withdrawal Rate for Retirees

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. How does spending change over retirees' life cycles, and what are the implications for safe withdrawal rates? Joining me to discuss that topic is financial planning expert Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: Thanks, Christine. It's good to be here.

Benz: You and a colleague wrote a piece about retirees' spending patterns looking at how retirees spend over their own life cycles. So, I know there's a body of research in this area. Let's talk about what the data tell us and talk specifically about how when you look at the data you do tend to see spending trail off a little bit as people get older.

Kitces: Yeah. So, there has been a lot of interesting data that's starting to come forth over the past five and 10 years, some very good national data sets that look at spending behavior patterns and even now some major financial institutions that can like literally look internally--how do all their bank customers behave. And we're learning some interesting stuff. The prevailing view has always been people want to live a stable standard of living in retirement. I mean, the whole essence of a pension is built around you're going to get the same check every year for life--hopefully, it's an inflation-adjusted check, like at least an inflation-adjusted standard of living is going to remain constant throughout retirement. And now, we're digging into the data and we're finding out it's not what people actually do.

So, your colleague actually here at Morningstar, David Blanchett, did a nice slice of this data a couple of years ago and found this effect where when we look at inflation-adjusted spending what we find is, as people get older, the spending trails off. It trails off by about 1% a year through our 60s, 2% a year through our 70s, and then another 1% a year through our 80s. So, if you were to kind of draw that it goes negative, more negative and then a little less negative. So, David called it like a smile, retirement spending smile.

Benz: Healthcare expenses at the end, right?

Kitces: Right. So, early on our spending slows down a little as our lifestyle slows down. In the middle, our lifestyle slows down a lot. We get kind of the slow-go years, much less traveling, discretionary expenses fall off. And then even in our 80s the spending still trails off. So, inflation-adjusted it starts slowing down by less, but even in our 80s the data is showing that the average household spending continues to decline in our 80s even with the uptick of healthcare because the other stuff, mostly kind of our discretionary buckets, slows down even more. So, yeah, I have more healthcare spending, but we only need one car now. Those kinds of trade-offs that start shifting in the household means the spending continues to slow down even in the later years.

Benz: OK. Let's take a look at the implications then for sustainable withdrawal rates, because a lot of the research there sort of assumes that, oh, yes, I'm going to need 4% and then I'm going to inflation-adjust that dollar amount over time, and it assumes a fairly stable level of consumption when in fact the data don't necessarily support that.

Kitces: Yeah. The early safe withdrawal rate studies--I mean, I've been guilty of this as someone that published to that literature as well--we were all essentially looking at replicating pension streams of income, which were stable inflation-adjusting streams of income, and so we shot for the same thing in a lot of the research. Now we get all this data coming forth that says, well, actually people's behavior doesn't match that.

So, we actually reran some of the numbers and published a study a couple of weeks ago about what does it look like when you actually assume decreasing spending by something like maybe 1% a year through retirement or 10% a decade or like maybe we stay steady for the first decade but then we slow down in the second and third. And what we found--I mean, no great surprise--your withdrawal rate gets a little higher when you assume spending decreases.

Now, the interesting effect is, it's actually not as much of a boost as maybe you would think. If you imagine spending going down by 1% or 2% a year for 30 years, like that cuts 30% to 40% off your inflation-adjusted spending by the end. So, it's a big number. But what we found is the safe withdrawal rate only goes up a little. It goes from 4% to maybe something like 4.4% to 4.8%. So, we get maybe a 10% or 20% increase in safe withdrawal rate for what could actually be a 30% or 40% decrease in cumulative spending.

Benz: And what sort of asset allocation do you assume there?

Kitces: So, we look at over a range of asset allocations, what we generally find is balanced portfolios really do still work the best where we can rely on the interest and the dividends and the capital gains and tapping the principal when we need to. The good news of diversified portfolios is there's always something that we can tap from year to year to generate the cash flows and that still matters. Too conservative, inflation is damaging; too aggressive, market volatility is damaging. But when we get back to those balanced portfolios, generally in the 40/60 to 60/40 kind of range, we would find these effects where your initial safe withdrawal rate lifts up some, but not a huge amount, in part because even though your spending declines, it's only in the later years. So, kind of, cumulatively over retirement, your spending does decrease quite as much. And the effect that we still have to deal with good old-fashioned sequence risk.

You might realize, hey, yeah, I'm not probably going to do as much world cruising when I'm 80, but unfortunately if you do lots when you're in your 60s and there's a bear market and you run out of money, it doesn't really matter that you're going to do less travel in your 80s because you might have no money left. And so, that need to have a little bit of conservatism in the early years to defend against sequence risk is part of way even if we assume spending goes down a bit, we don't quite get as much of an offsetting increase in the initial safe withdrawal rate, because we still have to hedge a little against that sequence risk.

Benz: And that's arguably particularly important right now given the confluence of still-low bond yields and relatively high equity valuations?

Kitces: Yeah, absolutely. I had published some research years ago showing that whole safe withdrawal rate rule that we talk about really is only necessary in a small subset of environments. Most of the time if you just merely get average returns, the safe withdrawal rate is actually about 5%; if you're in a good return environment, safe withdrawal rate is 5.5% to 6%. You use 4% because when you get into elevated valuation environments where there's at least a higher risk that some bad stuff can happen, that's when it matters and unfortunately, just when you look at long-term valuation measures like Shiller CAPE combined with low yields, we are in one of those environments where caution is merited and so we do tend to anchor on the conservative side of, let's really use those safe withdrawal rate numbers, this is at least the time when it may turn out to matter.

Benz: One other question on this topic is, how do I know in advance when I'm, say, 65 that I'm not going to be one of those outlier people, where I'm maybe at 90-plus where I still feel like going on cruises and spending that money, but I've overspent early on. Is that kind of a balancing act that retirees need to strike?

Kitces: I mean, to some extent, it's a balancing act. But again, the whole point of looking at some of the safe withdrawal rate research is to find out like, well, what happens if we want to maintain that lifestyle. I mean, literally get down to a trade-off if you want to assume decreasing spending, we get our safe withdrawal rate around 4.4%. If you want to not assume decreasing spending, you get an initial withdrawal rate around 4%. So, if you want to view it from the flip side, start at 4.4%. If you want to plan for living it up in your 90s, you got to spend 10% less now. That becomes your trade-off. If you want to do a little less now to hedge against spending more in the future, that's your prerogative. If you want to flip it around, that's your choice as well.

The caution that I do give folks--and I mean, we see this a lot with clients that say, yeah, but I might want to stay really active in our 80s and 90s. We work with a lot of folks in their 80s and 90s, life just slows down a little. I mean, I don't want to be depressing about it. But I mean, if you know folks that are in their 80s and 90s, I mean, for a lot of our, the folks that we work with, it's well--I mean, do you have your parents still with you? More and more people do have at least one parent still with them well into their 80s and 90s. Well, what's their lifestyle look like? I mean, what are you planning in early retirement? What does their lifestyle look like in later retirement? We sort of acknowledge things just slow down a little bit. And even with some of the advances we are making in medical science, we're living longer but we still slow down. I mean, the great news is, heart disease may not be killing me, but after my third hip break I just don't do a lot of world traveling anymore because I don't get around as well as I used to.

And one of the drivers that we see as to why spending seems to fall so persistently--and it's not even just a, well, maybe those people are spending down their portfolios and running out of money so they have to constrain their lifestyle--we even see from the research and David Blanchett's work in particular highlighted this, also a recent study from Chase that looked at what happens in spending patterns with affluent folks, what we find is, when you look at those that have a higher lifestyle and are very much not portfolio-constrained, their spending falls more in the later years of retirement because we tend to do more of that fun, active, discretionary spending in the early years. When life just slows down a little, as health slows us down a little, the spending falls off even further in the later years.

Benz: OK. Fascinating research, Michael. Thank you so much for being here to discuss it with us.

Kitces: My pleasure. Thanks for having me.

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