Everyone has a different idea of their dream retirement. Whatever you envision, it’s essential to plan ahead so that your nest egg will last.
What do you envision for your retirement? Traveling the world? Frequently entertaining friends and family at home? Delving into pastimes you had little leeway for during your working years? Whatever your pursuits, it’s essential to plan ahead for your spending needs to help ensure that you can afford your dream retirement.
My team and I at Morgan Stanley spend a lot of time examining how spending tends to evolve over the course of retirement and how lifestyle choices can affect retirement readiness. One thing we’ve consistently found: Spending rarely stays constant in this stage of life.
The reality is that spending can vary substantially over the course of one's retirement.
Some investors may assume that planning for retirement means accumulating a large enough portfolio that withdrawing about 4%1 of it each year will replace your working salary, with small increases in withdrawals over time to cover the increasing cost of living due to inflation. In reality, retirement spending typically varies substantially over three distinct phases: The active early years of retirement when spending rates are highest but gradually decline with age; the mid-retirement years when activity slows and spending rates are lowest; and the final years when medical and long-term care needs cause spending rates to rise again.
To be sure, life in retirement has many individual variations, but this “retirement spending smile” pattern can help most people build a plan that accounts for this common pattern of expenses.
Spending tends to evolve over the course of retirement.
Of course, no two retirements look alike. One person’s idea of a “dream retirement”—and the associated costs—may be very different from someone else’s. That’s why it’s essential to plan ahead, with an eye toward your unique lifestyle preferences and spending needs. To explore this idea further, my team and I created six hypothetical retiree profiles and then used financial modeling to test how each retiree’s unique habits would affect their retirement readiness. Specifically, we looked at:
spend heavily on home remodeling and may also pursue other pastimes, such as restoring antique cars or donating to community projects, resulting in above-average spending early on.
spend more of their income on food and beverages to entertain friends and family at home. Their overall spending tends to decline more rapidly early in retirement than other groups.
spend a large fraction of their budget on travel prior to retiring. Once they retire and have more free time, travel expenses increase even more, especially in the early and middle years of retirement.
- EARLY BIRDS
live by the motto “you only live once.” Early Birds tend to retire early, and have higher spending rates, especially on travel and entertainment.
- HEALTH-CARE SPENDERS
use a significant share of their disposable income on higher insurance premiums for supplemental policies, prescription-drug expenses and special treatments in excess of insurance coverage.
- AVERAGE RETIREES
set the benchmark by which the other five types can be compared. Their spending most closely resembles the “retirement spending smile.”
How did each hypothetical retiree make out in our modeling?
Assuming everyone starts retirement with a $2 million tax-exempt portfolio, 60% in stocks and 40% in bonds, could they successfully cover their costs? The good news is that all six retiree types had a very high likelihood of being able to cover their essential expenses, such as food and housing, throughout retirement.
However, some hypothetical retirees had an easier time than others affording both their essential and discretionary expenses. Due largely to their more modest spending habits, Average Retirees and Entertainers fared best, each with a 66% chance of being able to cover the total cost of their desired lifestyle throughout retirement. Home Hobbyists and Health-Care Spenders, respectively, had a 51% and 43% likelihood.
However, Globetrotters and Early Birds may have to take a hard look at their spending plans. Their probability of covering all of their retirement expenses was only 12% and 2%, respectively, due to their much higher spending in early and middle retirement, with the Early Birds facing the added challenge of a longer retirement and having to pay health insurance premiums out-of-pocket until they become eligible for Medicare at age 65.
Despite the sometimes sobering study results, there are a number of steps anyone can take to increase the odds of a successful retirement. Three that we often recommend, particularly for retirees who spend more heavily:
- Part-time work in early retirement. Taking on a home-based gig can help retirees boost their savings, while also keeping the mind engaged.
- Belt-tightening. Cutting back on nonessential expenses if investments underperform can give a portfolio the space it needs to recover and grow. This approach may be necessary for higher-spending retirees.
- Time-segmented bucketing. With this approach, investors allocate assets into three pools of spending, reflecting the three aforementioned phases of retirement. Each pool is then invested based on investor risk preferences for the time horizon of each phase. For example, investors might consider allocating funds for shorter-term early-retirement expenses in more conservative assets, while initially investing funds for later years in more aggressive growth assets.
The bottom line: If you’ve saved diligently and made smart investment decisions during your working years, a dream retirement is within reach—but it’ll likely require careful planning and, for some retirees, a willingness to make certain tradeoffs to make your dream a reality.
Speak with your Morgan Stanley Financial Advisor about what kind of retiree you want to be, so that they can help you assess the health of your retirement plan and recommend strategies best suited for you.
- Is the amount I’m saving and investing on pace to equal the money I’ll need for the retirement lifestyle I want?
- What strategies may increase my odds of being able to sustain my desired standard of living throughout retirement?