A recent University of Michigan study breaks down spending patterns for different groups of Americans nearing retirement age. They create four groups – typical spenders, discretionary spenders, housing spenders, and health spenders, and then try to track their behavior in retirement. The study reveals enormous diversity in spending patterns and suggests the need for individually tailored retirement plans. We will go over these groups of spenders to help you determine how to better plan your retirement.
1- Typical Spenders
This group has a median income of $56,000 and average spending of $47,000 per year. They spend 25% on housing, 11% on transportation, 9% on food, 9% on out of pocket health expenses, 5% on entertainment and 11% on gifts, charitable contributions, and clothing. This group generally sees a big decline in transportation expense on retirement. This is probably due to the fact that one or more members of the household has substantial transportation expense going to and from work.
2- Discretionary Spenders
This group includes most affluent and upper middle income American households. It spends 25% on entertainment, gifts and charitable contributions. The group has significant financial assets on average and generally continues to be discretionary spenders into retirement.
3- Housing Spenders
This group includes most low income American households and actually spends 60% on housing. This is a difficult number to process and suggests that this group suffers real hardships in making ends meet. It’s the group most severely affected by the “affordable housing” problem we read so much about. It includes many single person households, people on disability, etc.
4- Healthcare Spenders
This group spends 20% on out of pocket health care costs. Oddly enough, this group experiences a drop in healthcare spending percentage when it hits age 65 but then the percentage goes up again over 75. The drop is probably due to Medicare. This group probably has very expensive health insurance or a variety of copays, and uncovered healthcare expenditures.
Discussion About The Different Type of Spenders
The study shows that there are several dynamics that come into play as each group heads into retirement. For many people, housing costs go down either because a mortgage is paid off or because of downsizing and a move to less expensive housing further away from one of our very expensive cities.
Another dynamic is the decline in transportation expense as noted above. Many people are surprised when they calculate the “all in” (parking, gasoline, vehicle repair and depreciation, insurance, etc.) cost of commuting to and from work. The decline in this expense comes as a “pleasant surprise” with retirement. If the “work from home” movement that has been accelerated by the coronavirus continues, many may reap benefits in terms of these kinds of savings long before they retire.
Healthcare costs are a frustrating and sometimes unpredictable issue for many. But, again, these costs can actually go down at least in the early years of retirement due to Medicare – and, for some people, attractive and/or former employer-subsidized Medicare Advantage or Supplement plans. Later on, healthcare needs may become so massive that the expenses are forced up.
The 4% Rule
The 4% rule has been bandied about over the years as a solid benchmark for retirement planning. There are certainly worse ways to approach the retirement planning issue, but – in reality – each retiree household has to examine its individual assets and needs in order to develop a sound approach.
Age at Retirement
One important issue is how old you are when you retire. The younger you are at retirement, the longer your assets have to last in order to finance your lifestyle. Planning is very different for someone retiring at 45 in comparison with someone retiring at 77.
Other Assets
Most people apply the 4% rule to their portfolio of publicly traded stocks, bonds and other securities. But in many cases, there are other assets. These can include rental properties, annuities, the cash surrender value of whole life insurance, a second home, a private defined benefit pension plan, private partnerships, vehicles that will not be necessary in retirement and other things. A comprehensive plan should take all of these items into account.
The Big Enchilada: Housing
Housing is an enormous factor in retirement planning for several reasons. On the asset side, many retirees who live within commuting distance of one of our very expensive cities find that they have a home which is larger and more expensive to maintain that what they really need. In many cases there has been substantial price appreciation since the house was bought. Although they may prefer to stay put (at least initially), it may make sense for them to think of the house as a “life raft” to be deployed at times of distress in order to provide – 1) a substantial net profit upon sale, and 2) lower living costs at a cheaper location going forward.
Other Factors on the Spending Side
For many retirees, spending may take a V-shape pattern – higher in the early years, then down considerably, and then up again. This may be due to the fact that younger healthier retirees want to pursue expensive travel and entertainment options early in retirement while they’re still healthy enough to do so. If you always wanted to try sky diving, it’s probably better not to wait until you are 85 years old to start.
In addition, in the early years, retirees may elect to stay in their residence in order to be in touch with friends and participate in local events. The upkeep and management of a large house may be less of a strain for a 65-year old than it is for an 80-year old.
So while housing and entertainment expenses may be high in the early years of retirement, there may come a point at which adventure travel loses its allure and the desire to downsize and simplify one’s life becomes compelling.
This may lead to the bottom of the V at which retirees can live in a small home or apartment, take limited travel focusing on opportunities to travel off season at lower rates, can eliminate one or more of their vehicles and – as a result – dramatically change their spending profile and reduce their overall expenditures. Suddenly expenditures are much lower, life is still fun, but retirees may actually be piling up yield in their portfolios.
Then the expenditures start rising back to the second peak of the V – and this may be quite abrupt. This is usually due to the need for assisted living in one form or another. At this point, retirees may need help from siblings or children in navigating the treacherous waters of nursing homes and long-term care.
As retirees pass through this V-shaped journey, the percentage that they spend on various categories jumps around dramatically and – sometimes a bit unpredictably.
One Solution – Stress Test
One solution for retirees which may allow them to sleep better at night is to use a periodic “stress test” similar to that employed by financial institutions. One way to do this is to try to calculate a “melt down” scenario and its impact. Imagine that the equity portion of your portfolio declines some 70% in value and the hybrid portion declines by 30%.
Then, take into account the fixed income portion of your portfolio, your other assets, what you could get net of commissions and taxes for your house, your pensions, etc. Try to determine an annual pre-tax income level. Then, try to determine the affordable rent level that you could handle assuming that your rent expenditure is 30% of your pre-tax income. Bearing in mind that you might find it optimal to move to a different neighborhood or even a different part of the country, try to imagine whether you would find it comfortable or tolerable to live in the kind of housing that would be affordable.
After performing this exercise, many retirees will reflexively consider selling equities and buying fixed income securities in order to get a better score on the “stress test” and to be able to afford a better apartment in the hypothetical scenario it envisions. Unfortunately, ultra-low interest rates make fixed-income investing unattractive for two important reasons. The first reason is that yields are very low. The second reason may be more important. Long-term fixed-income securities may decline enormously in price if interest rates and/or inflation increases from current, very low, levels.
The Hybrid Solution
No matter what kind of spender you are, a hybrid investment strategy composed of fixed income and equities provides – not only retirees – with a solution to the dilemma. At High Dividend Opportunities, we have been proposing such a solution based on a “model portfolio.” Although we recommend some fixed income and some equity entries, many of the entries are in fact hybrids – preferred stocks, BDCs, REITs, CEFs, etc. These hybrid securities yield quite a bit more than most fixed-income securities do. Their yield is a larger portion of expected total return than is the yield of a pure equity portfolio. For that reason, the total return is less dependent on the day-to-day price of the security. A well-constructed portfolio of this type can give a retiree a much higher yield and total return than they will get from a fixed-income portfolio with less overall risk than is present in a pure equity portfolio. Put another way, a properly designed portfolio does better in a stress test and allows retirees to get decent returns while also getting some sleep at night.
