Over the last few decades, public policy concerns have motivated a substantial body of research on Americans’ preparedness for retirement. Although it remains an actively debated topic, most of the studies conclude that retirees will need between 70% and 90% of their working income to maintain their living standard in their postretirement years. This metric is known as the income replacement ratio (IRR).
In last week’s article, I explained how recommended replacement rates vary significantly depending upon the assumptions we make about taxes in retirement. Higher taxes dictate a higher IRR and vice versa. This week we examine the second key variable in estimating retirement income needs---spending. Most retirement experts assume that while spending patterns change for those transitioning from work to retirement, spending levels remain fairly stable. The expectation is that employment related expenses such as business clothing and transportation costs that disappear will be offset by increased spending for leisure related expenses such as travel and entertainment.
Most middle-income and affluent Americans have become accustomed to a high standard of living and could easily reduce discretionary spending without materially affecting their well-being. The premise that retirees will spend the same as they did when they were working, however, may not stand up to scrutiny.
Retirement means more free time and for active seniors that usually means spending more money for travel, entertainment and recreation. While these lifestyle expenses are discretionary and can be adjusted to fit a person’s budget if necessary, it is naïve to think that someone who has the money to enjoy these activities with family and friends would not do so.
Healthcare expenses are not discretionary and have become the wild card in retirement planning. While on the job, most employees pay only a portion of their medical insurance premiums with employers subsidizing the balance. Upon exiting the workforce households are largely on their own, leading sensible consumers to budget an ever increasing portion of their income for health care costs in their postretirement years. These increases will likely manifest themselves in several ways. First, as we age we require more medical care, including expensive dental procedures that in most cases will be uninsured. Second, Medicare, our nation’s largest social program faces an enormous financing shortfall that will need to be addressed in fundamental ways. Shifting more of the burden onto retirees through increased cost sharing and higher premiums especially for wealthier beneficiaries is a likely scenario. Medicare supplemental policies like Medigap or Medicare Advantage are essential to help pay for those expenses that Medicare does not cover. Premiums for these types of policies have followed the general trend of health care costs rising at nearly twice the rate of inflation over the last 15 years.