How To Avoid Underestimating Your Spending Needs When Planning For Retirement

By: Michael Carbone, CFA, CFP®

This article was written for those attempting to estimate their spending needs during retirement.

From 30,000 feet, your ability to retire can be boiled down to one question: Will you (or do you) have enough in available savings/investments to pay for your future spending needs?

These “needs” will always vary from household to household. For example, it may be important to you that your children receive a sum of money upon your passing. Alternatively, you may wish to spend as much as possible without running out of money during your lifetime.

The point is that you will have spending needs – and in order to make an informed retirement decision, you must clearly understand what these are.

Consequences of Getting Your Spending Wrong

Underestimating your spending is the easiest way to blow up your retirement plan. Why? Because it takes a lot of money to produce a little income, in a sustainable way. So, for each marginal dollar of spending (that wasn't planned for), your risk of running out of money, or not meeting other goals, increases significantly. Also, overlooking your spending may also compromise your ability to handle unforeseen financial shocks.

Spending Defined

The financial services industry can’t seem to agree on what items are considered “household expenditures”. I believe that household expenditures should consist of anything that’s consumed. So, in the context of planning for retirement, I don’t believe taxes and retirement savings should be viewed as an “expenditure”, but rather as separate items.

Assessing Realistic Retirement Expenses

“Rules of thumb” can be helpful tools for thinking about your retirement spending but it’s important to not rely too heavily on them – they’re intended to be used as guidelines. Although it's often easier said than done, I believe it's incredibly important to conduct an honest appraisal of what your future living costs are likely to be.

As you begin to plan for retirement, I believe it's helpful to categorize your future living expenditures by what will be:

  • Ongoing
  • Intermittent
  • One-time, and
  • Unforeseen
By doing so, you're far less likely to miss something.

What are your ongoing expenditures?

Your ongoing spending needs will likely account for the greatest portion of your cumulative spending in retirement. Fortunately, this category of spending is sometimes predictable. Why? Because the "baseline cost" of your lifestyle is unlikely to materially change as you transition into retirement. So, leaving out certain costs that may change when you stop working (e.g., work-related transportation, level of taxes, or longer vacations, etc.), your normal spending in retirement is likely to closely mirror what it was during your pre-retirement years.

If your income is relatively stable (i.e., your income doesn't significantly fluctuate year-over-year apart from a typical pay raise):

Building from the last paragraph, your historical “ongoing spending” will likely be your greatest indicator of what your future ongoing spending may be. So, to gain an understanding of this, your first step may be to see what you’ve been spending.

One way to do this is to dig up your recent years tax returns. In the last few years, how much income have you earned before paying taxes? How much of that income went towards paying taxes? How much income went towards retirement savings or health savings accounts? What’s leftover is the amount of income you had available to spend. If your savings accounts have not risen (ignoring any investment returns), your normal spending is likely close to this number.

This should be an intuitive process – how much income was available to spend, and how much of that income was spent.

If your income often fluctuates year-over-year:

To gain an understanding of your ongoing spending needs, you might look to your bank statements. Most banks will allow you to print a report summarizing your annual cash flows across the accounts used to pay your bills. How much cash came in? How much cash went out?

On creating a budget:

Budgeting can also be a valuable exercise - particularly for using as a comparison against your other analysis. The process of creating a budget worksheet may also help you to better understand costs that may be typical vs. costs that may be intermittent.

How can you "capture" less predictable, intermittent expenses?

Intermittent costs are items that would be considered atypical but are bound to occur over time. These are most commonly associated with upkeep and maintenance on your home and the purchase of new vehicles. Many households miss these expenses entirely – resulting in artificially low retirement spending assumptions and overoptimistic retirement projections.

Although intermittent costs are not entirely random, it may be unproductive to guess each expense and it’s exact timing. So, how can you capture these expenses in your retirement planning efforts?

On Estimating Annualized Intermittent Expenses

I believe the most productive way to plan for intermittent expenses in retirement is to estimate an aggregated annual average. By doing so, you’re effectively giving yourself a “buffer” to ensure these needs will be met when they occur. For example, instead of guessing the roof will need to be replaced in 20-years and the driveway in 10-years – you’re essentially consolidating all of these costs into one figure and giving yourself an allowance to tap funds to pay for them as they occur.

There’s no perfect way to estimate home upkeep and maintenance related costs; however, it’s commonly estimated that these annual costs tend to average ~1-3% of the home’s market value over time. Where you fall on this spectrum will depend on a number of factors. For example, if your home is due for major items and you’re not inclined to pick up a hammer, you may plan for annual costs of 3% of your home’s value. Alternatively, if your home was recently constructed and you know your way around a circular saw, you may plan for these costs to average 1% of your home’s value.

Another common expense that may occur intermittently would be the purchase of new vehicles. To capture this future cost, you can simply take the price you’d pay for a new vehicle today and divide it by the number of years you tend to own cars. So, for example, if you tend to spend ~$40k on new cars and replace them every decade, your annual cost for new vehicles would be ~$4,000 (i.e., $40,000 divided by 10-years).

Remember, this is an intuitive process. So, be careful not to double-count these expenses with your ongoing spending needs. For example, if you’ve concluded that your ongoing spending needs are $150k/year based on your historical available income vs. bank account growth, but you purchased a car for $40k during the period, be sure add back this expense.

How much cash will you need for one-time goals and how might this affect your other spending categories?

One-time expenses may be a bit easier to predict as they’re often associated with items that require due diligence. For example, you may wish to purchase a second home to use in retirement. Due to the significance of this purchase it’s likely that you have a reasonable expectation for what this need will be and can therefore plan accordingly. More importantly, be careful not to ignore the impact a one-time purchase may have on other expense categories thereafter. So, using the same example, purchasing the second home would also increase your intermittent expenses to carry the property. Ignoring this will ultimately result in an artificially low future spending assumption and overoptimistic retirement projections.

How can you plan for unforeseen spending needs?

Certain expenses in retirement may be impossible to predict. These unforeseen spending needs may be incurred due custodial care/ out-of-pocket medical expenses or for emergencies in general. So, how you can plan for these needs?

Due to the inherent challenge of predicting these unforeseen expenses, the extent which you will depend on how comfortable you are with uncertain outcomes.

With regard to the occasional emergency and out-of-pocket medical expenditures, one way to “capture” this in your spending assumption would be to inflate your overall spending – providing a buffer to insulate you from needing cash that’s incremental to your regular spending needs.

It’s also important to understand your medical insurance. For example, Medicare and supplemental policies will typically have stop-loss provisions to protect you from outlier medical costs. If you’re concerned about experiencing outlier-medical events – you might consider baking this stop-loss amount into your later-year expenses.

With regard to the potential need for custodial care, your exposure primarily lies with a healthy spouse. Should one spouse need custodial care while the other spouse is relatively healthy, the costs of custodial care risk impoverishing the healthy spouse. This is an extensive topic which you can read more about here:

In Summary…

Your ability (or inability) to retire safely is predicated on your ability to pay for your future spending needs. So, it’s incredibly important to understand these needs – particularly when you’re modeling your retirement to gauge whether your savings may be able to support your future needs. Due to the high-stakes nature of retirement, it’s crucial to get your spending right.

I believe it’s helpful to think about your future expenditures in terms of what will be ongoing, intermittent, one-time, or unforeseen. I believe that spending the time to conduct an honest appraisal of your retirement expenditures is essential to making an informed financial decision.

If you feel that you’d benefit from a second opinion of your retirement goals – answer a few questions to see if you may be a good fit for a complimentary consultation.

I wish you the best of luck and hope to hear from you soon!


Important Disclosures

Eppolito Financial Strategies, LLC. is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc

Any opinions are those of Michael Carbone - not necessarily those of Raymond James. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that is accurate or complete. Expressions of opinion are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

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