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Research has shown that individual and household spending declines in real-dollar terms upon and following retirement. Yet most financial advisors still use traditional retirement planning approaches that target constant real-dollar spending for the client’s planning period. This targeting of constant dollar spending in retirement has more to do with following traditional practice and software limitations rather any specific desire to meet client needs. In this article, I will:
- summarize some of the research in this area;
- point out some of the weaknesses of traditional financial planning surfaced by this research; and
- show how these weaknesses can be easily addressed by using the actuarial approach that I advocated in my Advisor Perspectives articles of November 14, 2016, The Only Withdrawal Plan You Will Ever Need, and September 7, 2015, Think Like an Actuary to Become a Better Advisor.
I will conclude the article with an example to illustrate how the actuarial approach can be used to:
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- increase your client’s spending budgets;
- decrease the assets necessary to satisfy a given spending objective;
- increase spending flexibility; or
- some combination of the above
by developing a spending strategy for your clients that better aligns with their declining spending needs in retirement.
In his 1998 book The Prosperous Retirement: Guide to the New Reality, Michael Stein talked about the “go-go, slow-go and no-go” phases of retirement and their implications for retirement planning. Stein’s first rule of retirement was that the active stage (go-go) spending budget “tends to equal the pre-retirement budget, if the retiree can afford it.” In the subsequent stages, spending is reduced as older retirees tend to grow weary of long vacations and traveling.
In his 2005 FPA Journal article, Reality Retirement Planning: A New Paradigm for an Old Science, Ty Bernicke criticized “traditional retirement planning” where “consumers tend to over save for retirement, underspend in their early years of retirement or postpone retirement.” He advocated a new retirement-planning approach based on the reality that a household’s real spending will generally decrease incrementally throughout retirement. The anticipated result, per Bernicke, was “clients can make more realistic retirement saving assumptions and will be able to retire sooner.”
In his 2005 Association for Financial Counseling and Planning Education article, Age Banding: A Model for Planning Retirement Needs, Somnath Basu discussed several weaknesses inherent in what he referred to as the traditional financial-planning approach, and he proposed a new “age banding model” approach to planning for retirement needs. A main criticism lodged by Basu against the traditional approach was the assumption made by financial planners that “all living expenses during retirement [would] increase at the overall rate of inflation.” Basu suggested that a retiree’s projected expenses be determined from a matrix consisting of four categories of expenses and three age bands. The present value of these projected expenses would then be compared with assets needed to support the retiree’s expenses. Basu’s approach was, in many ways, like the actuarial approach I advocate, but was thought to be too complicated at the time.
By Ken Steiner, read the full article here.