How Much Do I Really Need to Save for Retirement: Rethinking the Retirement Budget

When planning for retirement, a common assumption is that our spending will remain constant or even increase over time due to inflation and rising healthcare costs. The "standard" approach is to take your income, multiply it by 70 or 80%, and then plan on saving up enough to cover that amount for your entire retirement.

Here's the traditional approach to calculating how much you really need to save for retirement. Suppose your household income is $100,000 today. The "standard" approach would say that you need about $70,000 per year to maintain your lifestyle in retirement. So you'd take that number for say 35 years of retirement, punch it into a calculator, and get a total of about $750,000 needed for retirement.

There's a LOT of problems with this approach. I mean, the assumptions alone! And you didn't even consider...

Sorry, Red Leader. I'll focus!

But I'm going to focus in on just one problem for this post. Just one. Promise!

That problem? We DON'T spend the same amount each year in retirement!

What is the Retirement Spending Smile?

There's a fascinating concept in retirement research known as the "retirement spending smile". It suggests that you are not likely to spend the same amount of money every year. Let's explore how this idea might mean you won't need as much as you think during your golden years.

The retirement spending smile is a pattern that researchers have observed in retirees' spending habits. Instead of a steady, linear increase in expenses, retirees often experience a U-shaped curve in their spending. In the early years of retirement, spending tends to be higher as people travel, pursue hobbies, and enjoy their newfound freedom. As they settle into retirement, spending typically decreases. Finally, in the later years, expenses can rise again, primarily due to healthcare costs.

Thanks, Kitces.com, for making this lovely graph for me!

Why Does This Happen?

1. Active Years: Initially, many retirees embark on the adventures they’ve long dreamed of—whether it’s traveling the world, taking up new hobbies, or spoiling grandchildren. These activities often come with higher costs.

2. Settling Down: After a few years, the novelty of retirement can wear off, and many people find a more predictable, often quieter routine. Spending on travel and leisure usually decreases, and this phase can last for many years.

3. Healthcare Costs: As retirees age, healthcare expenses often increase. This phase is what causes the uptick in the spending curve towards the later years of retirement.

What Does This Mean for Your Retirement Planning?

Understanding the retirement spending smile can have significant implications for your retirement planning. Here’s why you might not need as much as you initially thought:

1. Overestimated Budgets: Many retirement plans assume a constant or steadily increasing spending rate. However, the middle, quieter phase of retirement often involves lower spending, which can reduce the overall amount needed.

2. Dynamic Planning: A more dynamic approach to retirement planning, which accounts for different phases of spending, can provide a more accurate picture of your financial needs. This might mean you can save less than expected and still enjoy a comfortable retirement. A dynamic spending plan also allows you to adjust for changes in expectations. Afterall, you're retired! You're free from work, why not be free from the need to spend the same amount of money every month?

It's true that a dynamic spending plan is far harder to calculate, and so knowing that you are going to spend varying amounts over the years can take away from your sense of financial security. It makes it difficult to know "for sure" that you have enough money. It makes up for that by reducing the total amount that you need to save, and by allowing you to be more flexible in how you plan to save.

We all did, Will!

The Research Behind the Smile

One academic study that highlights this concept is “Understanding the Retirement-Consumption Puzzle” by Michael Hurd and Susann Rohwedder. They found that spending indeed tends to decrease in the middle years of retirement before rising again later, primarily due to healthcare costs . This research challenges the assumption that spending steadily increases throughout retirement and underscores the importance of dynamic planning.

Practical Steps for Adjusting Your Plan

1. Review and Adjust Your Budget: Look at your retirement budget and consider the phases of the retirement spending smile. Adjust your savings goals and withdrawal strategies accordingly.

2. Plan for Healthcare: While spending may decrease in the middle years, ensure you have a solid plan for potential healthcare costs later in life. Consider long-term care insurance or dedicated healthcare savings.

3. Stay Flexible: Life in retirement can be unpredictable. Stay flexible with your spending and be prepared to adjust as needed.

Final Thoughts

Retirement is a time to enjoy the fruits of your labor, but it's also essential to approach it with a realistic and dynamic financial plan. If you're asking yourself "how much do I really need to save for retirement?", understanding and applying the concept of the retirement spending smile can help your savings last longer and provide the security and freedom you’ve worked so hard to achieve. So, as you plan for your future, remember to smile—both for the joy of retirement and for the more accurate, perhaps less daunting, financial road ahead.

References

1. Hurd, M., & Rohwedder, S. (2006). “Understanding the Retirement-Consumption Puzzle.” NBER Working Paper No. 12508. National Bureau of Economic Research.