Retirement spend down
Encyclopedia
At retirement
individuals relinquish a steady stream of employment earnings and enter a phase where they will rely upon the assets they have accumulated to finance the rest of their lives. Retirement spend down refers to the strategy a retiree follows to spend down, or decumulate, assets during retirement. Retirement planning
aims to prepare individuals for retirement spend down because the alternative spend down approaches available to retirees depend heavily on decisions they make during their working years. Actuaries and financial planner
s are experts on this topic.
ers will retire every day between now and 2027. This represents the majority of the more than 78 million Americans that comprise this generation – those born between 1946 and 1964. 74% of these people are expected to be alive in 2030, which highlights that most of them will live for many years beyond retirement. The following statistics emphasize the importance of a well-planned retirement spend down strategy for these people:
risk – the risk of outliving their assets. This can spell financial disaster. Avoiding this risk is therefore a baseline goal that any successful retirement spend down strategy addresses. Generally, longevity risk is greatest for low and middle income individuals.
The probabilities of a 65-year old living to various ages are:
Longevity risk is largely underestimated. Most retirees do not expect to live beyond age 85, let alone into their 90s. A study of recently retired individuals asked them to rank the following risks in order of the level of concern they present:
Longevity risk was ranked as the least concerning of these risks.
Each has unique risk, eligibility, tax, timing, form of payment, and distribution considerations that should be integrated into a retirement spend down strategy.
(often incorporating Monte Carlo simulation) or deterministic.
Standard input variables
Additional input variables that can enhance model sophistication
Output
There are three primary approaches utilized to estimate an individual’s spending needs in retirement:
Asset allocation
contributed significantly to these issues. Basic investment principles recommend that individuals reduce their equity investment exposure as they approach retirement. Studies show, however, that 43% of 401(k) participants had equity exposure in excess of 70% at the beginning of 2008.
Saving more and investing more aggressively are difficult strategies for many individuals to implement due to constraints imposed by current expenses or an aversion to increased risk. Most individuals also are averse to lowering their standard of living. The closer individuals are to retirement, the more drastic these measures must be for them to have a significant impact on the individuals’ retirement savings or spend down strategies.
Postponing retirement minimizes the probability of running out of retirement savings in several ways:
Studies show that nearly half of all workers expect to delay their retirement because they have accumulated fewer retirement assets than they had planned. Much of this is attributable to the market downturn of 2008–2009. Various unforeseen circumstances cause nearly half of all workers to retire earlier than they intend. In many cases, these individuals intend to work part-time during retirement. Again, however, statistics show that this is far less common than intentions would suggest.
model where supply and demand represent the following, which vary across different retirement ages:
Under this approach, individuals can specify a desired probability of retirement spend down success. Unlike traditional spend down approaches, retirement age is an output. It is identified by the intersection of the supply and demand curves. This framework allows individuals to quantify the impact of any adjustments to their financial circumstances on their optimal retirement age.
. Regardless of the strategy employed, they seek to ensure that individuals’ assets available for retirement are sufficient to fund their post-retirement liabilities and expenses.
Retirement
Retirement is the point where a person stops employment completely. A person may also semi-retire by reducing work hours.Many people choose to retire when they are eligible for private or public pension benefits, although some are forced to retire when physical conditions don't allow the person to...
individuals relinquish a steady stream of employment earnings and enter a phase where they will rely upon the assets they have accumulated to finance the rest of their lives. Retirement spend down refers to the strategy a retiree follows to spend down, or decumulate, assets during retirement. Retirement planning
Retirement planning
Retirement planning, in a financial context, refers to the allocation of finances for retirement. This normally means the setting aside of money or other assets to obtain a steady income at retirement...
aims to prepare individuals for retirement spend down because the alternative spend down approaches available to retirees depend heavily on decisions they make during their working years. Actuaries and financial planner
Financial planner
A financial planner or personal financial planner is a practicing professional who helps people deal with various personal financial issues through proper planning, which includes: cash flow management, education planning, retirement planning, investment planning, risk management and insurance...
s are experts on this topic.
Importance
More than 10,000 Post-World War II baby boomPost-World War II baby boom
The end of World War II brought a baby boom to many countries, especially Western ones. There is some disagreement as to the precise beginning and ending dates of the post-war baby boom, but it is most often agreed to begin in the years immediately after the war, ending more than a decade later;...
ers will retire every day between now and 2027. This represents the majority of the more than 78 million Americans that comprise this generation – those born between 1946 and 1964. 74% of these people are expected to be alive in 2030, which highlights that most of them will live for many years beyond retirement. The following statistics emphasize the importance of a well-planned retirement spend down strategy for these people:
- Percent of workers who do not feel very confident about having enough money to retire comfortably: 87%
- Percent of retirees who do not feel very confident about maintaining financial security throughout their remaining lifetime: 80%
- Percent of workers over age 55 with less than $50,000 of savings: 49%
- Percent of workers who have not saved at all for retirement: 25%
- Percent of workers who are not currently saving for retirement: 35%
- Percent of workers who have not tried to calculate their income needs in retirement: 56%
Successful retirement spend down
Individuals each have their own retirement aspirations, but all retirees face longevityLongevity
The word "longevity" is sometimes used as a synonym for "life expectancy" in demography or known as "long life", especially when it concerns someone or something lasting longer than expected ....
risk – the risk of outliving their assets. This can spell financial disaster. Avoiding this risk is therefore a baseline goal that any successful retirement spend down strategy addresses. Generally, longevity risk is greatest for low and middle income individuals.
The probabilities of a 65-year old living to various ages are:
Probability | Male | Female |
---|---|---|
75% | 78 | 81 |
50% | 85 | 88 |
25% | 91 | 93 |
Longevity risk is largely underestimated. Most retirees do not expect to live beyond age 85, let alone into their 90s. A study of recently retired individuals asked them to rank the following risks in order of the level of concern they present:
- Health careHealth careHealth care is the diagnosis, treatment, and prevention of disease, illness, injury, and other physical and mental impairments in humans. Health care is delivered by practitioners in medicine, chiropractic, dentistry, nursing, pharmacy, allied health, and other care providers...
costs - Inflation
- InvestmentInvestmentInvestment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
risk - Maintaining lifestyle
- Need for long-term care
- Outliving assets (longevity risk)
Longevity risk was ranked as the least concerning of these risks.
Sources of retirement income
Individuals may receive retirement income from a variety of sources:- Personal savings
- Retirement Savings Plans (i.e., Individual retirement account (United States)Individual Retirement AccountAn individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
, Registered Retirement Savings Plan (Canada)Registered Retirement Savings PlanA Registered Retirement Savings Plan or RRSP is a type of Canadian account for holding savings and investment assets. Introduced in 1957, the RRSP's purpose is to promote savings for retirement by employees. It must comply with a variety of restrictions stipulated in the Canadian Income Tax Act...
) - Defined contribution planDefined contribution planIn economics, a defined contribution plan is a type of retirement plan in which the amount of the employer's annual contribution is specified. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts plus any investment earnings on the money...
s (i.e., 401(k)401(k)A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
, 403(b)403(b)A 403 plan, also known as a tax-sheltered annuity, is a tax-advantaged retirement savings plan available for public education organizations, some non-profit employers , cooperative hospital service organizations, and self-employed ministers in the United States...
, SIMPLE, 457(b), etc.) - Defined benefit pension planDefined benefit pension planIn economics, a defined benefit pension plan is a major type of pension plan in which an employer promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending on investment returns...
s - Social InsuranceSocial insuranceSocial insurance is any government-sponsored program with the following four characteristics:* the benefits, eligibility requirements and other aspects of the program are defined by statute;...
(i.e., Canada Pension PlanCanada Pension PlanThe Canada Pension Plan is a contributory, earnings-related social insurance program. It forms one of the two major components of Canada's public retirement income system, the other component being Old Age Security...
, Old Age Security (Canada)Old Age SecurityThe Old Age Security pension is a taxable monthly social security payment available to most Canadians 65 years of age or older. As of July, 2011, the basic amount is C$533.70 per month. At tax time, recipients with 2010 incomes over C$67,668 must pay back a portion of their Old Age Security at a...
, National Insurance (United Kingdom)National InsuranceNational Insurance in the United Kingdom was initially a contributory system of insurance against illness and unemployment, and later also provided retirement pensions and other benefits...
, Social Security (United States)Social Security (United States)In the United States, Social Security refers to the federal Old-Age, Survivors, and Disability Insurance program.The original Social Security Act and the current version of the Act, as amended encompass several social welfare and social insurance programs...
) - Rental income
- Annuities
Each has unique risk, eligibility, tax, timing, form of payment, and distribution considerations that should be integrated into a retirement spend down strategy.
Modeling retirement spend down: Traditional approach
Traditional retirement spend down approaches generally take the form of a gap analysis. Essentially, these tools collect a variety of input variables from an individual and use them to project the likelihood that the individual will meet specified retirement goals. They model the shortfall or surplus between the individual’s retirement income and expected spending needs to identify whether the individual has adequate resources to retire at a particular age. Depending on their sophistication, they may be stochasticStochastic
Stochastic refers to systems whose behaviour is intrinsically non-deterministic. A stochastic process is one whose behavior is non-deterministic, in that a system's subsequent state is determined both by the process's predictable actions and by a random element. However, according to M. Kac and E...
(often incorporating Monte Carlo simulation) or deterministic.
Standard input variables
- Current age
- Expected retirement date or age
- Life expectancyLife expectancyLife expectancy is the expected number of years of life remaining at a given age. It is denoted by ex, which means the average number of subsequent years of life for someone now aged x, according to a particular mortality experience...
- Current savings
- Savings rate
- Current salarySalaryA salary is a form of periodic payment from an employer to an employee, which may be specified in an employment contract. It is contrasted with piece wages, where each job, hour or other unit is paid separately, rather than on a periodic basis....
- Salary increase rate
- Tax rate
- Inflation rateInflation rateIn economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...
- Rate of returnRate of returnIn finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
on investments - Expected retirement expenses
Additional input variables that can enhance model sophistication
- Marital status
- Spouse’s age
- Spouse’s assets
- Health status
- Medical expense inflation
- Estimated Social Security benefit
- Estimated benefits from employer sponsored plans
- Asset class weights comprising personal savings
- Detailed expected retirement expenses
- Value of home and mortgageMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
balance - Life insuranceLife insuranceLife insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger...
holdings - Expected post-retirement part-time income
Output
- Shortfall or surplus
There are three primary approaches utilized to estimate an individual’s spending needs in retirement:
- Income replacement ratios: financial experts generally suggest that individuals need at least 70% of their pre-retirement income to maintain their standard of living. This approach is criticized from the standpoint that expenses, such as those related to health care, are not stable over time.
- Consumption smoothingConsumption smoothingConsumption smoothing is the economic concept used to express the desire of people for having a stable path of consumption.Since Milton Friedman's permanent income theory and Modigliani and Brumberg life-cycle model, the idea that agents prefer a stable path of consumption has been widely accepted...
: under this approach individuals develop a target expenditure pattern, generally far before retirement, that is intended to remain level throughout their lives. Proponents argue that individuals often spend conservatively earlier in their lives and could increase their overall utility and living standard by smoothing their consumption. - Direct expense modeling: with the help of financial experts, individuals attempt to estimate future expenses directly, using projections of inflation, health care costs, and other variables to provide a framework for the analysis.
Impact of market downturn
Market volatility can have a significant impact on both a worker’s retirement preparedness and a retiree’s retirement spend down strategy. The global financial crisis of 2008–2009 provides an example. American workers lost an estimated $2 trillion in retirement savings during this time frame. 54% of workers lost confidence in their ability to retire comfortably due the direct impact of the market turmoil on their retirement savings.Asset allocation
Asset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
contributed significantly to these issues. Basic investment principles recommend that individuals reduce their equity investment exposure as they approach retirement. Studies show, however, that 43% of 401(k) participants had equity exposure in excess of 70% at the beginning of 2008.
Coping with retirement spend down challenges
Longevity risk becomes more of a concern for individuals when their retirement savings are depleted by asset losses. Following the market downturn of 2008-2009, 61% of working baby boomers are concerned about outliving their retirement assets. Traditional spend down approaches generally recommend three ways they can attempt to address this risk:- Save more (spend less)
- Invest more aggressively
- Lower their standard of living
Saving more and investing more aggressively are difficult strategies for many individuals to implement due to constraints imposed by current expenses or an aversion to increased risk. Most individuals also are averse to lowering their standard of living. The closer individuals are to retirement, the more drastic these measures must be for them to have a significant impact on the individuals’ retirement savings or spend down strategies.
Postponing retirement
Individuals tend to have significantly more control over their retirement ages than they do over their savings rates, asset returns, or expenses. As a result, postponing retirement can be an attractive option for individuals looking to enhance their retirement preparedness or recover from investment losses. The relative impact that delaying retirement can have on an individual's retirement spend down is dependent upon specific circumstances, but research has shown that delaying retirement from age 62 to age 66 can increase an average worker’s retirement income by 33%.Postponing retirement minimizes the probability of running out of retirement savings in several ways:
- Additional returns are earned on savings that otherwise would be paid out as retirement income
- Additional savings are accumulated from a longer wage-earning period
- The post-retirement period is shortened
- Other sources of retirement income increase in value (Social Security, defined contribution plans, defined benefit pension plans)
Studies show that nearly half of all workers expect to delay their retirement because they have accumulated fewer retirement assets than they had planned. Much of this is attributable to the market downturn of 2008–2009. Various unforeseen circumstances cause nearly half of all workers to retire earlier than they intend. In many cases, these individuals intend to work part-time during retirement. Again, however, statistics show that this is far less common than intentions would suggest.
Modeling retirement spend down: Alternative approach
The appeal of retirement age flexibility is the focal point of an actuarial approach to retirement spend down that has spawned in response to the surge of baby boomers approaching retirement. The approach is based on a supply and demandSupply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
model where supply and demand represent the following, which vary across different retirement ages:
- Supply = the number of post-retirement years an individual’s financial resources are expected to cover
- Demand = the number of post-retirement years an individual is expected to live
Under this approach, individuals can specify a desired probability of retirement spend down success. Unlike traditional spend down approaches, retirement age is an output. It is identified by the intersection of the supply and demand curves. This framework allows individuals to quantify the impact of any adjustments to their financial circumstances on their optimal retirement age.
Similarity to individual asset/liability modeling
Most approaches to retirement spend down can be likened to individual asset/liability modelingAsset/liability modeling
Asset/liability modeling =The ongoing financial crisis drove the 100 largest corporate pension plans to a record $300 billion loss of funded status in 2008. In the wake of these losses, many pension plan sponsors have been led to re-examine their pension plan asset allocation strategies, to...
. Regardless of the strategy employed, they seek to ensure that individuals’ assets available for retirement are sufficient to fund their post-retirement liabilities and expenses.
External links
- Post Retirement Needs and Risks, Society of Actuaries
- Financial Planning and Retirement Portal, AARP
- Retirement Portal, 360 Degrees of Financial Literacy
- Employee Benefit Research Institute
- Center for Retirement Research, Boston College
- Journal of Financial Planning