"Maybe we should concentrate more on pre-retirement spending - what will reduce; what will increase; and what additional spending will occur."
We are familiar with target replacement rates which target replacement incomes that are less than income received whilst in employment. This can of course help with saving discussions. As retirement approaches, the conversation changes to, when can I afford to retire?
Incidentally over the last decade the cost of retirement income when measured by level annuity rates has increased by close to 50%, and the amount that can be withdrawn from invested solutions needs to be accessed conservatively in the current economic environment.
Often individuals are encouraged to complete a retirement budget to determine the income they will need. They are not retired and for reasons set out below I do not believe this to be the right approach leaving individuals, in my opinion, open to spending risks.
For some time I have had problems coming to terms with the view that spending will always be less in retirement. The assumptions behind this view are:
- They will have no commuting costs - fine if you are a London commuter paying £5,000 a year for an annual rail ticket, but what if you work from home or in the next street?
- They will have no mortgage to pay for - many pay off mortgages many years before retirement and there are large numbers approaching retirement age with interest-only mortgages and no means to pay off their mortgage. Retiring will have no impact on their outgoings.
- They will have no dependents to finance - the bank of mum and dad (or grandma and granddad) is being called upon with greater frequency. Similarly they may be providing or financing care for elderly relatives.
Then there are the aspects of retirement which increase costs. If the house is empty during the day while at work, it will require heating during the winter if it is being occupied. Similarly, if leisure time increases there is more opportunity to spend which will increase outgoings. Retirees are still consumers who will be encouraged to buy first and think later.
I would recommend that all who are involved with retirement income issues take a look at the Employee Benefit Research Institute Paper 420 published in November 2015. Amongst its many informative findings were the following:
- Although average spending in retirement fell, a large percentage of households experienced higher spending following retirement. In the first two years of retirement, 45.9% of households spent more than what they had spent just before retirement. This declined to 33.4% by the sixth year of retirement.
- In the first two years of retirement, 28% of households spent more than 120% of their pre-retirement spending. By the sixth year of retirement 23.4% of households still did so.
- In the first two years of retirement, only two in five households (39.3%) spent less than 80% of their pre-retirement spending. By the sixth year of retirement, a majority (53.1%) of households did so.
The paper goes onto say that there was no discernable difference in its findings between income groups. Although this is a USA study, it is difficult to imagine that a similar study in the UK would deliver different outcomes.
The findings are not so surprising when Milton Friedman’s permanent income hypothesis, published in 1957, is considered. This is often cited by the Office of National Statistics in its publications on Household Income and Spending. The hypothesis implies that a sudden change in income does not result in a change in spending patterns. If an individual suffers a sudden loss (or for that matter gain in income) they will continue with their habitual spending as if nothing had happened. It will be those who have suffered multiple shocks that will be more frugal in their spending patterns than those who have not.
The EBRI findings appear to support the hypothesis. If it takes time for individuals to adjust their spending to a reduced income scenario, then the early years of retirement will be particularly risky. An insured solution (annuity) will not provide them with sufficient income; an invested solution (drawdown) will exaggerate the investment risks, particularly the sequence of returns, if withdrawals are far in excess of what would otherwise sustainable. This is the ‘spending risk’.
Part of the retirement income advice process often involves a budgeting process to understand income needs. Maybe we should concentrate more on pre-retirement spending - what will reduce; what will increase; and what additional spending will occur. We then need ways to assess how flexible they will be adjusting to reduced income and the need to preserve wealth for future spending.
If they are going to be high risk the conversation needs to open out as to what are the contingencies available to mitigate the consequences. In the medium-term, this will be much better than dealing with clients in distress situations.
