Retirement: The New Math of Personal Finance

There's one key fact of life that most retirement planning advice gets wrong: the way people actually live and spend when they retire. Put simply, most retirement calculators and planners aim for decades of level spending, but most people reduce their spending as they move through retirement. That's a disconnect that can significantly skew the results of the typical planning exercise, says a recent study from the Society of Actuaries and the Actuarial Foundation. It could lead workers to take greater investment risks, or be overly frugal during their final years of work or their first active years of retirement.

When workers retire, their budget often goes through four phases: (1) early retirement, when travel, home improvement, hobbies, and new wardrobes can raise expenses beyond workday levels; (2) mid-retirement, when people (and their spending) typically slow down; and (3) late retirement, when spending and activity slows even more; and (4) end of life, when spending for health care and personal assistance can use up what's left of a retirement kitty. But the typical retirement calculator calculates first-year spending based on a worker's last year of salary, and then simply adjusts that estimate up every year by the inflation rate. "Replacement rates may make sense as an analytical tool when peoples' income and expenses are stable over time. However, generally neither is the case," the study says.

In fact, retirement spending actually declines markedly over time, according to data from the Bureau of Labor Statistics. The average household headed by someone between the ages of 55-64 spent $54,783 in 2008, the last full year for which data has been published. That same year, households between 65-74 spent $41,433 and those over 75 spent just $31,692. Between the youngest group and the oldest group, spending fell by 42 percent, on everything from food to housing to clothing. Entertainment spending fell by almost two thirds. Federal taxes fell away, almost entirely.

That has implications for how pre-retirees save and how retirees draw down their money. It is also causing the insurance industry to start peddling new products aimed at that last, most expensive period.

"The first couple of years will be the most expensive. People should plan on that," says Diahann Lassus, a financial adviser from New Providence, N.J. "We're going to take dollars from future years and front load because we want to take these trips and do these things while we are all healthy and want to do them together. But at some point, you're going to be paying those dollars back."

How would this work, from a practical standpoint? A rule of thumb holds that your money will last all the way through retirement if you take 4 percent of your savings out the first year, and then increase the amount of your withdrawal by the inflation rate every year. But if your spending starts out high and doesn't increase with the inflation rate, you can take, say 6 percent out the first year, but not adjust your withdrawals annually by the inflation rate. By the time you start slowing down, in the midpoint of retirement, your withdrawals will have backed down, proportionately, to where they would have been had you been inflating a smaller withdrawal from the beginning.

There are, of course, caveats to that approach. Baby boomers who have the bulk of their retirement savings in tax-deferred vehicles may not see the same reduction in taxes as their parents did. A really bad year in the stock market, coupled with your first few years of outsized withdrawals, can wreck the whole retirement plan, says Tim Maurer, a Hunt Valley, Md., financial adviser. He tells clients to view their active early years of retirement as a multi-year stage, and save the expensive cruise for a good year. He also tells active retirees that they should continue to earn some money during those first active and expensive years of retirement, both to keep themselves satisfied and to bring in enough cash to pay for those extras. "Medically and financially, it makes significantly more sense to go with a pseudo retirement" that includes part time or consulting work.

Finally, there's the issue that even retirees that have seen their spending dwindle for decades can get socked with big monthly expenses as their health deteriorates. They may need long-term care or expensive personal assistance. There are a variety of ways to deal with that–if they haven't already downsized their home, they can sell that and spend the proceeds on their later years. Advisers often recommend long-term care insurance to clients well-heeled enough to afford the premiums, which typically top $200 a month.

Insurance companies are busy devising new products aimed at the latter years of retirement. Called "longevity insurance," these products really are deferred annuities that don't kick in until the owner turns 80 or so. But they tend to be too expensive for what they deliver, says Lassus. "We aren't big fans."