Experts frequently warn that most people are not saving enough for retirement. And for good reason. According to the Employee Benefit Research Institute (EBRI), many workers closest to retirement have far too little set aside for their later years. The EBRI’s latest annual Retirement Confidence Survey found that 45% of workers age 55 or older have less than $100,000 in savings and investments.
However, there’s a segment of retirees with a very different “problem.” They have enough of a nest egg, but they are overly reluctant to spend.
A study published in the Journal of Financial Planning found a “consumption gap” among wealthier retirees in which they “were spending nowhere near an amount that would place them in danger of running out of money.”
Similarly, United Income CEO Matt Fellowes wrote a report titled "Living Too Frugally?" (PDF) in which he cited research showing as people age they become more pessimistic about the stock market and their own financial situation, leaving wealthier retirees vulnerable to living “overly insular lives because they may feel relatively less free to travel and spend money on entertainment, or socialize with friends over meals out.”
An enviable problem?
Some may argue this isn’t a problem at all. Spending cautiously in retirement is the better part of wisdom, they would say, not an issue of concern. Besides, some retirees may want to live modestly in order to leave a large bequest.
However, living an unnecessarily frugal life can be a problem if fear or faulty assumptions leave you scrimping on healthcare, refusing to enjoy the fruits of your hard work and disciplined saving, or missing out on the joy of doing more of your “givin’ while you’re livin.’”
Here are three common reasons why some retirees find it difficult to spend, along with some suggestions.
- A General Hesitancy to Spend
After years of systematic saving, many retirees find it difficult to flip the switch and start spending from their nest egg. What to do?
First, use the most powerful personal finance tool available — a budget. Instead of relying on general rules of thumb, such as planning to spend 80% of your pre-retirement income, a personalized budget will help you accurately plan for your essential and discretionary expenses. Plus, whereas a budget helps some people avoid over-spending, it may help you avoid under-spending. Instead of instinctively believing you can’t afford to take a trip or eat out, seeing in black and white that you actually can afford it may give you a new sense of financial freedom.
Also, covering most of your essential expenses with guaranteed income, such as Social Security and perhaps an immediate fixed annuity (purchased with a portion of your nest egg), can be liberating. Knowing your essentials are covered may help you feel a bit more freedom regarding discretionary expenses.
- Fear of Catastrophic Medical Bills
There are some scary healthcare-related statistics floating around! One Fidelity study found that a 65-year-old couple retiring this year will need to spend $275,000 on healthcare over the course of their retirement (not including potential long-term care expenses). And Genworth’s latest annual “Cost of Care” study reported the average monthly cost of a private room in a skilled nursing facility is now more than $8,000.
Here are some ways to combat those potentially debilitating expenses. First, fill Medicare coverage gaps with a Medigap or Medicare Advantage policy and consider at least some long-term care insurance coverage, especially if you have a family history of dementia.
Also consider purchasing a longevity (or “deferred income”) annuity, which is a relatively affordable way of generating additional income starting at age 80 or 85, when your medical costs are likely to increase.
Last, if you’re still working and using a high-deductible health insurance plan, make the maximum contributions to a Health Savings Account with an account provider that allows you to invest your balance.
- Fear of Falling Markets
Recent retirees may keep an especially tight rein on spending over concerns about sequence of returns risk — the possibility of a downturn right at the beginning of retirement, which can cause serious damage to a nest egg’s staying power. What to do?
First, take the bucket approach in which you enter retirement with your nest egg distributed across several buckets. One, containing three-to-five years’ of living expenses, would be in savings. Another, containing the majority of your portfolio, would be invested.
When the market is doing well, you tap your investment bucket to pay living expenses. When it isn’t, you tap the savings bucket, allowing time for the market — and the invested portion of your portfolio — to recover. This can give you peace of mind about how much you’re spending because your entire nest egg is not subject to the ebb and flow of the stock market.
Next, make an informed decision about how much of your nest egg to withdraw each year. One of the most common approaches, the 4% rule, is to withdraw that percentage from your nest egg in the first year of retirement and then increase that amount by the inflation rate in each subsequent year. This approach is designed to help ensure you don’t fully deplete your retirement savings over the course of your remaining years.
However, according to an analysis done by Michael Kitces, a financial planner and author of the popular Nerd’s Eye View blog, “most retirees actually could spend far more, either initially or by increasing spending along the way.” In fact, he found that when retirees follow the 4% rule, over two-thirds of the time their nest egg ends up twice as large by the time they die as it was at the beginning of their retirement.
To allow more freedom of spending, while also addressing the common desire to err on the side of caution, Kitces recommends taking a ratchet-style approach. Begin by following the 4% rule, but allow yourself to increase withdrawals by 10% (above the annual inflation adjustment) if your portfolio balance rises more than 50% above its starting value.
Other planners have suggested pairing the 4% rule with a dynamic withdrawal strategy, where an annual review of portfolio returns and spending needs may lead to higher or lower spending in the year ahead.
However, Kitces’ ratcheting strategy is designed to avoid ever having to lower spending. “It turns out that any time the account balance ever grows 50% above its starting value (after withdrawals), the portfolio is already far enough ahead that it won’t be depleted in a 30-year time horizon and there will be extra money left over,” he wrote.
To add one more protective layer to the idea, Kitces recommends not ratcheting up spending any more frequently than once every three years.
Avoiding sequence of frugality risk
As you consider your retirement spending, keep this final point in mind. There’s a difference between voluntary frugality and frugality that may be dictated by your circumstances. The early years of retirement are when you will be healthiest and most able to travel and enjoy various recreational activities. As time goes on, declining health may mean transitioning from the go-go years to the slow-go years to the no-go years. Hopefully the ideas discussed here will free you to enjoy financially attainable experiences while those experiences are still an option.