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.

Models used to extrapolate retiree spending until death include (1) constant spending; (2) declining spending 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.

Pros and cons of single budget models

 * {|style="border-collapse: collapse;" border="1" cellspacing="0" cellpadding="2" width="90%"

STRENGTHS WEAKNESSES
 * - valign="top"
 * width="50%" |
 * Capable of supplying more accurate spending estimates than a replacement rate model.
 * Better suited to handle 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.
 * width="50%" |
 * Requires more time and effort than a replacement rate model.
 * Realistic spending estimates are difficult to determine unless personal spending is already being tracked.
 * }

Dual budget models
Dual Budget models incorporate two total spending estimates. 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.

Dual budget spending models are particularly suited for combination with withdrawal methods that allow real spending to vary.


 * {|style="border-collapse: collapse;" border="1" cellspacing="0" cellpadding="2" width="90%"

STRENGTHS WEAKNESSES
 * - valign="top"
 * width="50%" |
 * 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.
 * width="50%" |
 * More work to develop dual budget models than a single budget model.
 * }

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

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.

Declining spending 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. Within each stage, retirees tend to exhibit similar patterns of physical activity and spending.

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

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.

A Dual Budget model can be added as a natural complement to such variable withdrawal methods. The Essential budget spending level would set a lower limit on spending as retirement progressed. The Preferred budget spending level would set a corresponding upper limit on spending. These constraints would be included with those supplied by the withdrawal model when calculating the approximate savings needed at retirement.

By itself an Investment Returns Dependent spending model is not able to adequately describe the key observations on retiree spending discussed earlier. 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.