Last month we talked about replacement ratios and whether 70% of your income is the right amount to assume as your income during retirement. What we found was that while 70% is very close to the average that people take in retirement, it’s not a great rule of thumb because the variation among retirees can be extremely high. This time we’re going to talk a little bit about how replacement ratios change over time and how spending can change as you age during retirement.
Generally, we break retirement into three stages:
- The go-go years, which include the early years of retirement when people are checking things off their bucket lists. In many cases, they might spend more money during their go-go years than they did during the years leading up to retirement. As a result, some of their replacement ratios may be closer to 80%, 100% or even 110% of their pre-retirement income.
- The slow-go years when people age in retirement, begin to travel less and spend more time at home and with family. These years become more about the routine rather than the things to check off their bucket lists.
- The no-go years or the years when retirees really aren’t in a position to travel as much and their health generally becomes a concern and or limits their activity.
A person might have very different spending requirements during each of these stages. There’s not one solution for every person and obviously some couples or individuals might skip a stage or never experience one of the stages.
Here is a graph that shows how replacement ratios change by years in retirement:
You will notice that the replacement ratio is around 73% during the first or second year of retirement. So you go through those go-go years in the first two years and then there’s a big drop off to the third and fourth year from 73% to 63%. Then it sort of trails down by the time you get to the ninth or tenth year and you are looking at roughly 54% as a replacement ratio.
This really helps illustrate that people spend less as they age. Of course this is on average and as mentioned earlier everyone’s stages will last a different period of time. However, it’s pretty common for the first couple of years to be the highest spending period of time. People tend to be very aggressive about completing the things they always wished to do while they were working and it’s interesting to see how that trends down.
One of the things many retirement planners do is that they assume that if you need $6,000 a month, that $6,000 should increase for inflation every year for the rest of your life. The replacement ratio numbers are shown in real spending so they take inflation out of the equation. It turns out retirees probably don’t need to increase their spending for inflation every year. Over the first 10 years, the average person has his or her replacement ratio go down from 73% to 54%, which is a really large drop. So really his or her spending might be in dollar terms about the same 10 years into retirement as it was in the first year. It calls into question whether or not we need to be thinking about inflating your income need every single year.
When we are creating a retirement income plan and ask you how much money you will need, the best answer might be that you need $6,000 a month for the first 5 years, $4,500 a month for the next 10 years and $4,000 a month after 10 years. Since those amounts are all in today’s dollars, you will have to inflate those dollars to what you would actually need in the future.
We discuss with our clients how much of an increase they expect over time. And in many cases, a good retirement plan actually assumes that spending increases as something less than the overall inflation rate. Let’s say you expect inflation to be 3% over a long period of time, but maybe your expenses only need to increase about 1.5% a year. There is no right answer, but it seems very clear in the data that the average person reduces his or her real spending over time.
Bottom line: You need to think about the three stages of retirement, what you want to do and how those early years may be more expensive. There are a lot of different ways to approach that spending, but you should address the three stages of retirement in your discussion.
From the desk of Kris Carroll