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Planning Your Retirement Spending

This article may sound a bit “out there” at first. But stick with me. I think it has some interesting ramifications for retirement planning.

Imagine this (clearly hypothetical) scenario:

  • You’re 65 and recently retired.
  • You have an inflation-adjusted pension that, together with Social Security, will meet your most basic spending needs.
  • You also have $250,000 saved.
  • The only way you can invest this money is in a savings account with a return that precisely matches inflation each month.

In other words, we’re eliminating two of the biggest uncertainties that go into retirement planning — inflation and market returns — and leaving only one: longevity risk. You don’t know how long you’re going to live.

In light of that fact, how much would you spend each year?

Possible Retirement Spending Approaches

One obvious approach would be to look up your remaining life expectancy and plan to spread your $250,000 evenly over that period.

Or, you might plan to spread your spending evenly over a longer-than-average life span in case you’re lucky enough to live longer than average. (Though if you do that, how much longer than an average life span would you plan for?)

Probability-Weighting Your Budgeting

In the book Pensionize Your Nest Egg by Moshe Milevsky and Alexandra Macqueen, the authors argue in favor of a third strategy: Plan to spend more in the early years because there’s a higher probability that you’ll be alive to enjoy them. (That is, it’s less likely that you’ll be alive at age 100 than at age 67, so it makes sense to budget less inflation-adjusted spending for age 100.)

Fascinating idea.

I think I agree that it makes sense to give more weight to happiness in years you’re more likely to experience than to happiness in years you’re less likely to experience.

Marginal Utility of Money

On the other hand, there’s also something to be said about the decreasing marginal utility of spending. (That is, the second $10,000 spent in a given year typically provides less happiness than the first $10,000. And the third $10,000 provides even less.)

The interesting thing about marginal utility of money is that it’s different for every person.

For example, for me, the second $10,000 of discretionary spending each year may provide far less happiness than the first $10,000. In that case, when planning how to spend my $250,000, it would make sense to plan for only $10,000 of spending in each of the early years, rather than giving them a higher spending level as a result of the fact that they’re the years I’m most likely to experience.

In contrast, if the happiness that you get from the second $10,000 of discretionary spending each year is only slightly lower than from the first $10,000, it may make sense for you to budget for a higher spending level in the early years of retirement, so as to take advantage of the fact that you’re more likely to live to see them.

What Does This Have to Do with Real Life?

If you temporarily ignore market risk, inflation risk, and every risk other than longevity risk, you can see what sort of spending path you are shooting for. Then, you can create investment and spending plans that increase the likelihood that reality conforms as closely to that goal as possible.

For example, if you know that your happiness is hugely dependent on having a certain level of income every year, no matter how long you live, it probably makes sense to purchase a fixed annuity to ensure that level of income.

Alternatively, if you’re flexible with your spending and don’t mind living very frugally when you have to, you can probably afford to take more risk in your portfolio and/or use a more aggressive spending rate in your early years.

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  1. What a great article. I still have a long way to go until retirement, nevertheless I often think about it. I don’t want to be one of those retirees that cannot afford this or cannot afford that.

    My plan is to have enough sources of passive income so that I don’t have to be concerned about financial issues. I know this is hard to achieve but with persistence and time on my side (I am still 32 years old) I believe I can get there.

    I do like your comments about marginal utility of money. No matter how much money you have you want to maximise its use and what you get from it, especially during retirement where you may incur extra costs such as health costs.
    Thank you for another great article.

  2. Interesting twist on the topic. I’m one that spends less than I have coming in and don’t desire extravagance. Wealth offers security & peace of mind for our family. (Stop by and check out my eBook, you are included)

  3. Hi Barb.

    That’s about where I am too. I’m in a place right now where an extra $X of spending wouldn’t be as exciting as a $X decrease would be annoying.

    Also, I just finished reading your ebook. Well done! And thanks for including my blog. 🙂

  4. I have a CPA cousin who has always reminded me that most of his older clients tend to send significantly less money than they expected after age 72 or so, mainly because they become far less active and tend to stay closer to home. As a result, they ended up “leaving money on the table,” so to speak, that will ultimately end up in the hands of their heirs.

    Personally, I don’t plan on leaving my heirs a fortune. I’m working for me. 🙂

    For that reason I have always planned to spend more of my nest egg in the early part of my retirement.


    Len Penzo dot Com

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