Opinion: How much will retirement cost you?

I often find clients have a hard time quantifying how much retirement will actually cost. It’s not an easy task.

One common starting place is the use of the 4 percent rule, which assumes a withdrawal rate of 4 percent of your investable assets each year. If we look at some of the more prominent research on the subject, we will find two studies completed in the 1990s, which describe 4 percent as a safe withdrawal rate.

The original study conducted by William Bengen established what he described as a “Safemax,” or the highest sustainable withdrawal rate when considering the worst case scenario from rolling historical data. Later, three professors from Trinity University furthered studied the 4 percent rule and slightly altered the results of the original study. The Trinity study describes the success rates associated with various withdrawal rates of 3 to 10 percent.

There are three components changing the way we look at retirement spending. People live longer, health care costs are on the rise and investment return expectations are low compared to historic averages. Combine all three factors and 4 percent might be a little aggressive. These considerations are becoming even more important as more retirees rely on defined contribution plans, such as 401(k)s, and less on pension plans.

Let’s consider each of these facts separately and the impact they have on forecasting retirement spending.

• Longevity. It’s no secret people are living longer. According to research from the National Institute on Aging, life expectancy at birth in several countries is now 81, which is quite an improvement considering most babies born in 1900 didn’t see their 50th birthday.

• Investment returns. Most investment managers are forecasting slightly lower investment returns out of the stock and bond markets over the next five to 10 years. This can be impactful when considering a safe rate of withdrawal.

• Health care costs and inflation. We currently use 2.5 percent as our standard inflation rate and 6.5 percent for inflation in health care. In some cases health care costs can be greater than all other household expenses.

The above factors create a rise in concern about the cost of retirement, but do not take into consideration all the factors we see with retirees.

First, there is a misconception retirees’ consumption spending is constant over the course of their retirement. A more accurate reflection of consumption spending is the recognition of varying spending patterns at different stages of retirement. The second consideration is retirees adjust spending with market returns. We often see that clients will hold off on large expenditures when stock market returns are below expectations. Retirees also in many cases forgo an inflation adjustment with their annual living expenses. They become accustomed to a certain amount and often adjust their lifestyle to fit into that annual living expense.

The basis for financial planning generally has been to assume retiree expenses or consumption increase each year by inflation in retirement.

However, there is empirical research that states quite the opposite. This research shows retiree spending decreases approximately 1 percent per year in retirement. This of course goes against conventional wisdom and economic theory. Specifically, the life-cycle hypothesis that suggests that retirees will maintain the same lifestyle expenditures over their lifetime.

Jeremy Loftin is a vice president and relationship manager with Central Bank of the Ozarks. He can be reached at jeremy.loftin@centraltrust.net.