Journal of Financial Planning: April 2017
Jonathan Guyton, CFP®, is principal of Cornerstone Wealth Advisors Inc., a holistic financial planning and wealth management firm in Edina, Minnesota. He is a researcher, mentor, author, and frequent national speaker on retirement planning and asset distribution strategies.
Retirees often cover ongoing living expenses with Social Security and any pension benefits. If these sources aren’t enough, they are sometimes advised to cover the rest by using assets to purchase guaranteed sources of inflation-adjusted income, such as bond ladders or single premium immediate annuities (SPIAs).
Depending which they choose, the use of retirement savings to fund these “essential” expenses can be an irrevocable decision. The amount of capital required to fund each real dollar of such lifetime spending is about $30. Remaining financial assets can then be earmarked for “discretionary” (in theory, nice, but not necessary) expenses and invested more aggressively for growth, because assets funding essential expenses no longer enjoy that opportunity. In its most extreme form, this approach advocates investing a great majority, if not all, of these assets in equity assets.
This strategy, often called essential-versus-discretionary, seems logical, sounds simple and reasonable, and would work flawlessly if people were spreadsheets and not human beings. But retirees are indeed human. And their lifestyle costs don’t often follow a spreadsheet’s COLA on a steadily rising path. So this advice can have significant, unintended consequences.
Essential Core Spending
Most retirees’ discretionary expenses actually seem quite necessary to them. As one of our clients put it, “If we can’t keep doing these things in retirement, it’s not worth it to retire.” He has a point. For these reasons, our firm does not advocate this approach when advising clients, although I understand why other advisers do.
It’s understandable that retirees are not ambivalent about the quality of life funded by these so-called discretionary expenses. After all, people often enter retirement with wishes to fulfill, bucket lists to live out, deferred gratifications nearing their live-by dates, in addition to travel dreams, key lifetime events for children and grandchildren, etc., while aware that their health is the most precious asset of all given its unknown longevity. But here’s the planning challenge: just because a client considers a spending item to be essential doesn’t mean it will be a part of their spending (at today’s level) 10 or 20 years into what may be a 40-year retirement.
We treat expense items reasonably expected to be a part of client spending for the rest of their lives—at least 25 years at a similar annual inflation-adjusted amount—as “essential” core spending. This typically includes all housing-related items (including second homes, since they are often retained longer than people expect), food, insurances, transportation, personal care, and entertainment. (As a patron of the performing arts, I’m always inspired by the physical ailments older audience members overcome to continue attending the performances they love; it’s usually the same with other entertainment.) Everything else we consider discretionary—that is, not essential—if they are expected to occur for less than 20 years, will decline in real terms over time, or are irregular, spontaneous, or one-time expenses. These we fund via a different strategy.
We probably need different labels. Calling them “core” avoids the Spartan-esque connotation of being merely “essential.” But whatever they’re called, one of the most important things our retired clients have taught me is that far more of their expenses when retirement begins fit the “discretionary” definition than I initially realized. Research by David Blanchett (see “Exploring the Retirement Consumption Puzzle” in the May 2014 issue of the Journal) backs this up: he found that real spending declined 25 to 30 percent by age 85 for households whose lifestyle costs were over $100,000 in their early 60s.
An Example
Consider the financial planning implications of this, beginning with the amount of capital needed to fund essential or core lifestyle spending. This, of course, directly determines what’s available for items that don’t meet the definition of core spending.
Imagine a household with a pre-tax income need of $130,000 to retire as they wish. If $60,000 of this is (eventually) covered by pension and/or Social Security, it requires at least another $2 million of dedicated capital to fund the other $70,000 of core spending. If their retirement savings total $1.5 million, this isn’t a very encouraging picture; it would seem they were more than $500,000 short of being able to retire.
But what if $30,000 of this (about 25 percent) in the truly golden years didn’t meet the above definition of core lifestyle costs? Instead, this $30,000 was to fund a decade or two of ambitious travel and other bucket list items, meaning that financial assets were actually needed to fund $40,000—not $70,000—of annual, ongoing core lifestyle. That changes the retirement math dramatically.
Now, while still employing the basic tenants of an essential-versus-discretionary approach, the core lifestyle is fully funded. And remaining liquid financial assets could be as much as $300,000. Clearly, such a discretionary fund would be drawn on more heavily in the first 10 to 15 years of retirement, but that is precisely the point, especially if clients hope to have higher spending in retirement’s first five to 10 years. A situation where the essentials of this approach previously included a heavy dose of scarcity now contains an abundance of freedom, discretion, and flexibility for intentional spending.
Lifestyle Risk
But even with this adjustment to the core-discretionary spending dichotomy, there could still be unintended lifestyle costs. Investing a discretionary fund too aggressively can make its value so volatile that retirees may unwittingly hitch their ability to enjoy bucket list dreams to the stock market’s short-term fluctuations. That’s because when equities experience their inevitable big declines, these funds could fall so much that retirees feel they have no choice but to change their plans. Although they know deep down that markets will recover, it is their physical health that may not allow them to wait out a recovery—a certain recipe for regret.
To illustrate, it was 10 years ago in 2007. The Johnsons were two years from some joyous family events. In 2009 they would celebrate their 40th wedding anniversary, and their younger daughter would be married. They had promised $25,000 toward her wedding and, to celebrate their own marriage, the Johnsons planned to host their three children, spouses, and grandchildren for a week of family adventure and memory-making in Hawaii. For this, they budgeted another $25,000. They previously determined they could earmark $100,000 of assets for such events, as it wasn’t needed to fund their core spending. Although they had high hopes for further travel after this, they were comfortable using half the $100,000 in 2009 because they expected high returns from these assets, investing 80 percent of it in stocks. Sadly, markets didn’t cooperate. By early 2009 when final payments were due, these assets had fallen nearly 40 percent to $63,000. It was a horrible time to take out $50,000. So, with heavy hearts they cancelled the Hawaii trip, telling their disappointed children and grandchildren they hoped it would be possible in 2014 at their next significant anniversary, hoping that their health permitted it.
Writing in 2012, Michael Kitces suggested that such market-induced delays, cancellations, and the regrets they trigger signify the failure of one’s retirement plan itself (see “The Problem with Essential-Vs-Discretionary Retirement Strategies,” posted May 30, 2012 at kitces.com/blog). He is still right today. For unfortunate families like the Johnsons, this generated a huge increase in lifestyle risk, which has been documented.
In mid-2011, the Journal surveyed advisers who used various strategies to generate retirement income (see “Study Suggests Link between Planner Retirement Advice and Client Lifestyle Changes,” in the December 2011 Journal). The survey asked about clients who felt it necessary to make “significant changes” to their lifestyle in the years just after the Great Recession. The results were striking: 64 percent of advisers who recommend the essential-versus-discretionary approach saw more than 20 percent of clients undergo a significant lifestyle change—even though their income for essentials did not change. By contrast, just 36 percent of advisers using other approaches had that high a frequency of significant lifestyle changes. Noticeably, half of these saw just 4 percent or fewer of their clients suffer a significant change.
What did these financial planners do differently? In short, they took a more balanced, flexible approach and employed a more dynamic, policy-based withdrawal strategy. It’s yet another example of why retirement planning done well must also consider human nature and behavior in addition to analytics and spreadsheets.