Retirement budget models

Retirement budget models attempt to answer the question “What will it cost me to live as a retiree?”. This allows investors to calculate an estimate of the portfolio size needed at retirement. Another way to estimate retirement income needs are income replacement rate approaches, but budget models are much more detailed and personalized.

Estimating your retirement spending can be broken down into two steps: 1) estimate an initial spending at the start of retirement, followed by 2) extrapolating that initial spending as retirement progresses until eventual death.

Initial spending estimation is often done with a single budget to describe all retirement expenses. Alternatively, dual budget models (having a lower Essential spending and a higher Preferred spending) provide a more flexible framework. "Pyramid" budgets add additional layers.

Models used to extrapolate retiree spending until death include (1) constant spending; (2) stages of retirement models; and (3) investment returns dependent models.

It is common practice to separate nominal retirement spending into two independent components: real spending, and an inflation adjustment. This article deals only with the real spending component.

Initial retirement spending

These models guide the pre-retiree to develop an estimate of their anticipated spending early in retirement, often targeting spending for the very first year of retirement.

Single budget models

Two approaches are typically used to obtain a single budget spending estimate: a Current Spending approach and a Bottom-up approach.

Current Spending approach

A Current Spending approach starts with the total (current) spending just before retirement. Each spending category is then examined to see what adjustments, either up or down, are anticipated upon retirement. These spending adjustments are then incorporated to arrive at a total spending just after retirement.

Consider these possible downward adjustments to your budget:

• You will not be making contributions to Canada Pension Plan (CPP), Québec Pension Plan (QPP), a company pension plan, your Registered Retirement Savings Plan, or unemployment insurance any longer
• You will not have a work-related clothes budget
• You won't need a work-related transportation budget (can you even sell one car?)
• Do you plan on downsizing your home and/or moving to the countryside? (this could lower your property taxes, heating, home insurance and maintenance costs)
• Perhaps your mortgage payments will disappear just in time for retirement, or children-related costs

But also think about these possible upwards adjustments:

• Will you travel more?
• What hobbies will you pursue? What will they cost?
• Will you be dining out more?
• Do you plan on any major purchases or renovations to your home?
• Will you be supporting other family members financially?

Bottom-up approach

The Bottom-up approach develops a personalized spending budget “from scratch” by estimating the retirement spending for every conceivable budget category. A detailed budget worksheet should be used to help ensure that no category of retirement spending is overlooked. These category estimates are then summed to yield the total spending estimate. This approach is more time consuming than the Current Spending approach, but has the potential to yield a better estimate. The Bottom-up approach also supplies a better starting point for projecting how the budget might change as retirement progresses.

However, if you have not been tracking your current expenses in the pre-retirement period in detail, it can be easy to underestimate some future expenses for your retirement budget. One trick is to look carefully at 1-2 years of bank statements and credit card records, to help you 'remember' where all the money went and be more realistic in the bottom-up budget.

Pros and cons of single budget models

Strengths	Weaknesses
Can supply more accurate spending estimates than a replacement rate model. Better for handling spending estimates for big, infrequent expenses than a replacement rate model. A Bottom-up budget model provides a particularly good starting point for incorporating real spending changes over time.	Requires more time and effort than a replacement rate model. Realistic spending estimates are difficult to determine unless you are already tracking your personal spending.

Dual budget models

Dual Budget models incorporate two total spending estimates using a bottom-up approach. The first or Essential budget represents the lowest level of retirement spending that can be accepted. The second or Preferred budget represents a higher level of retirement spending that is actually desired. The retiree’s spending in any year is assumed to fall within the range bounded by these two budgets.

The easiest way to estimate the Dual budget models is by using a worksheet designed for this purpose. Each budget category on such a worksheet accepts two entries: an essential spending amount and a discretionary spending amount. The sum of both gives the preferred budget spending estimate.

Strengths	Weaknesses
Provides a more nuanced model of retiree spending that a single budget model. Better suited for combining with Withdrawal methods that allow variable real spending.	More work to develop dual budget models than a single budget model.

Pyramid budgets

Some retirement planners have suggested extending the Dual budget concept to incorporate even more levels of spending. Branning and Grubbs (2009) proposed goal-segmenting retirement assets to cover four categories. Starting from the pyramid base, these categories are:

• Base Fund – for essential retirement living expenses.
• Contingency Fund – for hedging against significant, unpredictable events.
• Discretionary Fund – for spending above the essential levels.
• Legacy Fund – for inheritance and charitable purposes.

Or, using the four "L"s of retirement goals:

Note that only two of the levels actually correspond to regular expenses that can be budgeted. These are the same (base and discretionary) as in dual budget models, corresponding to longevity and lifestyle goals. The advantage of the "pyramid" is the visualization of potential "one-off" expenses, that may need to be planned for, in the contingency (liquidy) and legacy layers.

Strengths	Weaknesses
Provides a more realistic model of retiree spending that a simple (single) budget model. Visualization of one-time expenses	More work to develop dual or pyramid budgets than a simpler, single budget.

Budget categories

The following table shows a simplified set of budget categories, Canadianized from the bogleheads wiki.

Table 1. Simplified Budget Spending Categories

Category	Detailed Description
Housing	Mortgage payments, home/renter insurance premiums, property tax payments, rent, utility costs (electricity, water, heat, phone, and cable and internet services), spending on house/yard supplies, and home cleaning / maintenance costs
Health Care	Medical insurance premiums, health services, drugs and medical supplies. Also includes long-term care expenses.
Food	Expenditures on groceries but not spending on dining outside of the home
Personal Appearance	Clothing of all types; personal beauty & hygiene
Transportation	Automobile finance charges, automobile insurance premiums, gasoline, and automobile maintenance
Entertainment	Dining out, vacations, tickets to events, and hobbies
Gifts	Charity and other gifts
Big, Infrequent Expenses	Purchases of automobiles, home appliances (refrigerators, washers, dryers, dishwashers); electronics (cell phones, televisions, computers); major home renovations and repairs.

Income taxes can be either considered separately (as an independent budget item), or included in other budget categories, which would then be grossed (before-tax) figures.

Spending as retirement progresses

The models previously described supply a starting point for the more important problem of modeling how real spending changes as retirement progresses.

Constant spending models

This is the simplest of all approaches used to model spending as retirement progresses. The real spending at the time of retirement is assumed to continue unchanged until death. Although this approach is widely used, including in free Internet retirement calculators, it doesn’t correspond to the typical spending patterns exhibited by retirees. It usually (but not always) leads to an overestimate of the savings needed at retirement.

A constant real spending model could be appropriate if your retirement is involuntary and your financial resources are limited. This situation would force you to immediately drop down to an essentials only spending budget. If you were living at your minimum acceptable level, you would expect your nominal spending to grow at around the rate of inflation (constant real spending) as you are forced to pay ever increasing prices for essential goods.

Strengths	Weaknesses
Easy to understand, so they are useful for illustrative (teaching) purposes. Easy to implement in a retirement calculator or spreadsheet.	Does not match the reality of how average retirees spend money as they age. Often leads to an overestimation of the total savings needed at retirement.

Stages of retirement models

Several studies show that the spending patterns of actual retirees change over time, with a general declining trend. This decline in real spending is voluntary and not a result of limited financial resources.

A typical retirement can be divided into three to four Stages or Phases. These are popularly known as:

1. Go-Go: most active phase
2. Slow-Go: stable retirement phase
3. No-Go: least active phase

Within each stage, retirees tend to exhibit similar patterns of physical activity and spending. For many retirees, the Go-Go phase can be the most expensive, for those who can afford it (think travel, sports, eating out, home renovations...). The Slow-Go phase may be less expensive (more sedentary lifestyle, fewer activities). Expenses may increase again during the last phase, depending on medical needs (e.g., long term care). Blanchett (2014), looking at US data, calls this 'U' pattern of expenses the "retirement spending smile".

Vettese (2018) reviews longitudinal studies on retirement spending in the UK, Germany and Sweden. Such studies look at the same subjects (actual retirees) over long periods of time, using a large number of households. Based on these studies and other reports, he comes up with the following post-retirement spending guidelines:

• spending is constant in real terms until age 70 (i.e. nominal spending increases along with inflation)
• real spending then declines by 1% a year throughout one's 70s (i.e. nominal spending increases, but by 1% less than the rate of inflation)
• real spending declines by 2% a year in one's 80s
• real spending is flat from age 90 onward

Although such spending guidelines are useful for general retirement income planning purposes (decumulation plans), retirees should also think about the possibility of increasing expenses in old age due to health issues, the last upward sloping part of the 'U'. These difficult to forecast expenses can potentially be funded through “buffer assets”, like cash reserves, home equity, etc.

Strengths	Weaknesses
Allows the retirement calculation to incorporate diversity in retiree spending patterns with aging. Significantly improves model accuracy without excessively increasing complexity.	Needs additional work to estimate budgets for each Stage. There is some uncertainty in the most realistic spending patters.

Investment returns dependent models

Investment Returns Dependent models allow spending in retirement to vary based on how total savings or investment returns change over time. If stock markets decline, spending must also be reduced to allow premature portfolio depletion. Conversely, when a retiree feels financially secure (e.g. during a stock bull market), they would naturally increase their real spending.

In this perspective, it is not the desired retirement spending that governs portfolio withdrawal patterns, but what the portfolio will actually allow. An example of such a flexible withdrawal strategy is Variable percentage withdrawal.

By itself an Investment Returns Dependent spending model is not able to adequately describe how retirees actually tend to spend their wealth. It has no ability to match the steady decline in real spending as retirees age. But it does supply an element of reality that other models lack: the ability to reflect how retirees alter their spending in response to changes in their net worth. A combination of these two spending tendencies would be very beneficial.

Strengths	Weaknesses
Reflects the tendency of retirees to adjust spending up or down as their net worth changes. Nicely complements variable withdrawal methods used to ensure savings survival in retirement. More realistic than a Constant Spending model.	Does not match the reality that average retirees spend progressively less money as they age. Less able to mimic the broad range of retiree spending patterns than a Stages of Retirement model.

Budget models versus withdrawal methods

Single budget, constant spending

Several decades before retirement, there are many unknowns (final salary, retirement age, family size, etc.). Using an replacement rate approach, or a single budget model, followed by constant spending during retirement (adjusted for inflation), simplifies calculations. This fits naturally with the constant real dollar withdrawal method ("4% rule"). Those assumptions can be used to provide a very rough estimate of the portfolio size needed to retire, following the conventional approach.

Dual budgets, variable spending

Perhaps up to 10 years before retirement, planning can become more detailed and realistic. A single retirement budget could still be appropriate, but with much more detail included. Or a dual budget model may become of interest, along with spending that varies over time (e.g., stages of retirement models, investment-dependent models).

In the safety-first approach of retirement planning, essential expenses are funded with protected income sources while discretionary expenses can be funded from portfolio withdrawals, typically using a withdrawal method that allows total spending to vary. So dual budget models are well suited for the safety-first approach.

In a total return decumulation framework, a single diversified portfolio is used. With a flexible withdrawal method, the yearly withdrawal amount could potentially range from a minimum to reach the essential budget (taking other income sources into account, e.g. OAS and CPP/QPP) to a maximum representing the preferred budget. These constraints would be included with those supplied directly by the withdrawal model when calculating the approximate savings needed at retirement.

External links

• Bogleheads wiki: Introduction to retirement spending models
• Bogleheads wiki: Budget models of retirement spending (US content)
• Bogleheads wiki: Models of spending as retirement progresses (US content)