How spending changes in retirement, and the resulting need for inflation protection

 

The last two posts have both dealt with inflation. #120 showed that we’ve experienced very high inflation recently, but it’s in asset prices, not in consumer spending. #119 suggests that while retiree consumer inflation may, on average, be 25 cents a year higher than for workers, for every $100 of spending, that’s too small to worry about and there’s nothing you can do about it anyway. #119 did add, however, that there’s one aspect that is genuinely within your control. It’s the extent to which your financial planning takes the likelihood of future inflation into account. This is something you should definitely do – but it was beyond the scope of that blog post.

Naturally, that calls for a follow-up. This is it.

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You’ll recall that the extent to which inflation affects you depends on your personal pattern of spending, and that’s why no inflation measure will ever apply perfectly to you. The best that’s possible is to average spending patterns over large segments of the population. That’s how retiree inflation is measured: by comparing retiree spending against worker spending.

But retirees are too large a segment to consider as a whole, really, because there’s a general pattern of changing expenditures during retirement. The lingo refers colloquially to three stages of activity: go-go, slow-go and no-go.

We start our retirement with the go-go years. That’s when we explore the physical, mental and social goals we’ve had repressed inside us for some time, and we’re happy to be able to release all that pent-up longing and energy. This is freedom! We finally have the time and money to do it all.

But it’s not forever. Things become less exciting once they’re repeated, and we tend to lose vitality slowly. And so our lives tend to slow down: hence the slow-go stage, when our lives downsize, and sometimes we also choose to downsize our homes. We’re far from inactive, but we’re not as rushed. We still do some of the go-go things, but less so; and more of our activities become localized.

Commentators say this may start around age 70 or 75. But of course even that is variable; and what if you and your partner have a noticeable age gap – whose age 70 or 75 is relevant?

Regardless, even if we don’t notice the change, it does tend to happen to most retirees.

The no-go stage is much less common. That’s the unfortunate stage in which we may need long-term care. The best statistics I’ve seen (from US insurance companies) are that perhaps one-third of their long-term-care policyholders make claims for care that exceeds 90 days.

The cost of long-term care varies not only from one country to another but also from one location in a country to another. If it concerns you, I suggest you seek expert help.

Now, what’s the point of saying all this? It’s that there are financial implications.

If our activity isn’t constant, then neither is our spending. As our activity gradually declines, so does our spending. Much later, for some of us, it may turn up again, if we need and have to pay for long-term care. The image that I tend to remember is one that was invented by Dr David Blanchett, the head of retirement research for Morningstar’s Investment Management group: it’s that, if you draw a curve showing how retirement spending changes as we age, it may look like a smile [https://ahe.illinois.edu/2019/08/14/exploring-the-retirement-consumption-puzzle/ ]. Whatever level it starts at, it tends to go down gradually, and might turn up again near the end.

In general, therefore, even if we can’t find a way to keep up with inflation precisely, it isn’t strictly necessary to keep up fully when our spending pattern itself declines.

Given his investigations into the rate at which go-go becomes slow-go (and perhaps, for some, no-go) over time, Dr Blanchett suggests that we’re likely to be close to OK if we budget for spending growth that’s 1% a year below inflation.

That’s the best I can find, and I repeat that everyone is an individual, and potentially different from the average person.

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Finally, how can you do this?

Start by remembering that we often have inflation-indexed assets, even though we don’t tend to list them among our assets. For example, in many countries the Pillar 1 pension (a government pension, such as Social Security in the US) is indexed to inflation. (The actual measure isn’t terribly important, as we now realize.) So our resources may already be at least partly inflation-indexed.

That more than compensates for inflation, for a certain portion of our retirement spending.

We can then see how much projected spending (increasing at 1% less than projected inflation) isn’t automatically covered.

That can be covered in one or more of several ways. I’ll illustrate them via a numerical example to show the impact.

 

ILLUSTRATION OF FINANCING SPENDING IN DECUMULATION ROW Year: 1 2 3 4 5 Av incr p.a. (1) Nominal spending 100 100.00 100.00 100.00 100.00 (2) Add 2% for inflation 100 102.00 104.04 106.12 108.24 2.00% (3) Lifetime pension 25 25.00 25.00 25.00 25.00 (4) Add 3% for inflation 25 25.75 26.52 27.32 28.14 (5)=(2)-(4) Balance req’d 75 76.25 77.52 78.80 80.11 1.66% (6) Buy lifetime income plus 3% 30 30.90 31.83 32.78 33.77 (7)=(5)-(6) Balance req’d from drawdown 45 45.35 45.69 46.02 46.34 0.74% (8) Buy level lifetime income 30 30.00 30.00 30.00 30.00 (9)=(5)-(8) Balance req’d from drawdown 45 46.25 47.52 48.80 50.11 2.72%

In this table, Row (1) shows the amount you’re planning to spend each year, as you start your Life Two decumulation. For convenience I’m calling this 100 units of spending.

But of course there’ll be inflation that you’re planning for. Let’s say, just for this example, that you’re projecting inflation at 3% each year.

That means, according to Dr Blanchett’s rule, that you’ll budget for your own spending to increase 1% a year less than that, so that’s a 2% increase each year. That’s shown in Row (2). You’ll budget for 100 in Year 1, 102.00 in Year 2, 104.04 in Year 3, and so on.

The columns show the years, and for convenience I’m only showing the first 5 years.

Now, what about your assets?

In this illustration let’s say you have a lifetime pension from the government that’s fully indexed to the 3% inflation, and let’s assume it starts at 25. That annual 25 is shown in Row (3); but of course who cares about that, when you’re projecting 3% annual inflation? It’s really Row (4) that shows what you’ll expect to receive.

Now look at Row (5). This shows how much you still have to generate, after receiving Row (4), in order to have Row (2) available for spending. So Row (5) is Row (2) minus Row (4).

Notice, in the right-hand column, that the numbers in Row (5) increase (from year 1 to Year 5) by 1.66% a year. That’s less than the 2% increase that you initially needed! In other words, the fact that your government pension is fully indexed at 3% is a bonus when all you’re looking for is 2%. So you only need to generate 1.66% a year from your retirement savings. Excellent!

Your first option is to draw down the numbers in Row (5), having of course invested your savings sensibly. If that’s what you do, then you’re self-insuring your longevity risk, and no doubt you’ll use the ideas in blog post #12 [https://donezra.com/12-how-long-should-you-plan-to-make-your-money-last/ ] about how long to make your money last.

Your second option is to buy a lifetime income that’s also indexed to inflation.

Let’s assume that it’s for a starting amount of 30 in Year 1. Then, if inflation is 3% a year, in subsequent years you’ll get the amounts shown in Row (6).

Subtract this from what you need in Row (5), and then Row (7) shows how much you still need from your remaining retirement savings.

Notice that this series of numbers is only increasing by 0.74% a year over this 5-year period. Why so low? Because now you have both Row (4) and Row (6) working for you at 3%, when all you need in total is 2%. So you only have to cover 0.74% a year in Row (7) to reach your 2% target.

And once again you’ll remember that Row (7) is still self-insured, as far as longevity risk is concerned.

An alternative to buying an indexed lifetime income is to buy a series of government bonds indexed to inflation. This will also generate the projected 3% inflation indexing assumed in this illustrative example. Two caveats. One is that the Row (6) series of numbers is now also subject to longevity risk. The other is that it’s tough to find government bonds that pay you precisely the amounts you need.

The final option I illustrate is for you to buy a level lifetime income. Let’s say that’s for the same starting amount of 30 that we used before. This generates the series of payments to you shown in Row (8).

Once again, subtract it from Row (5) to see how much you need to draw down from your invested savings, and you get Row (9).

Aha, but over these 5 years those numbers in Row (9) are increasing by 2.72% a year. Why? Because Row (5) needs 1.66% a year, and Row (8) contributes nothing towards that requirement. So the burden on your remaining assets is higher than 1.66% a year; it turns out to be 2.72% a year. But notice that it’s still less than the projected inflation of 3% a year. So in this illustration, thanks to Dr Blanchett’s rule of subtracting 1% from inflation, and having a government pension that’s fully indexed to inflation, the balance of your spending never increases by as much as inflation.

Row (9) of course is also subject to longevity risk.

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Get the idea?

That’s a long explanation to write down, but I hope you see what I’m driving at.

By the way, I projected to Year 10 and to Year 25 also, though I can’t find a way to print a large table here. So I’ll just tell you what I found.

In Row (5), the required average rate of increase required from the remaining drawdown is pretty much constant, falling imperceptibly from the 1.66% p.a. over the period to Year 5, to 1.65% p.a. to Year 10 and 1.61% p.a. to Year 25.

The corresponding numbers in Row (7) fall very slightly faster, from the 0.74% p.a. over the period to year 5, to 0.66% p.a. to Year 10 and 0.35% p.a. to Year 25.

And the corresponding numbers in Row (9) fall from the 2.72% p.a. over the period to Year 5, to 2.64% p.a. to Year 10 and 2.43% p.a. to year 25.

In other words, the story essentially stays the same in all three rows.

If you’ve now lost track of everything because of all the numerical detail, I’ll summarize the whole story in the takeaway.

 

Takeaway

(1) The typical pattern of activity in Life Two goes from go-go to slow-go at some stage. No-go is less likely, about one chance in three. (2) Dr Blanchett suggests building in 1% less than inflation, as you project your annual increase in spending. (3) In many countries you already have a base income automatically linked to full inflation. (4) If so, the rest of your spending requires less than full inflation protection. (5) Action steps could involve some purchase of a guaranteed lifetime income (whether or not linked to inflation), or simply self-insuring your longevity risk, in which case you might also consider the purchase of inflation-index-linked government bonds.

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