Historically, retirement planning is rooted in rational expectations theory. Assuming complete economic rationality, planners typically frame a retirees’ goal is to maintain the standard of living throughout retirement in real economic terms. This implies that an individual should make a realistic inflation assumption and scale their spending needs year-over-year in order to properly budget every year of retirement. Looking at data from the BLS consumer survey report over the last 35 years, this evidence does not appear to support this assertion. What the data shows is that the most predictive indicator for spend in the 75 and older cohort appears to be the 10 year lag of the 65 – 74 year old cohort. This finding implies that retirees are more apt to create a nominal spending budget and stick to that same budget over the course of retirement. This is known as “nominal rigidity” in economics. The chart below demonstrates how the “rational” planning model overestimates where retirees spending should have been.
A “rational” actor trying to fix their standard of living in “real” economic terms will be required to save a significant amount more as their saving’s value erodes over time with inflation. This is caused by holding assets, like cash and fixed income bonds that inherently lose “real” economic value over time. If a planner ignores the “nominal rigidities,” she will tend to overestimate the retiree’s financial needs and recommend a sub-optimal plan for her client.
With this being said, a planner would not be helping her clients if they solely adhered to an overly strict form of nominal rigidity either. Retirees will update their budgets from time-to-time based on many economic factors that are at play, causing a complete nominal budget to underestimate a retirees needs. As all economic factors cannot be predicted, a sensible approach to balancing out these competing factors would be a mixed model where a planner would “haircut” the expected overall inflation rate, adding that factor to each successive year. Based on the BLS survey data, reducing your spending needs inflation factor to 20% of expected inflation appears to fit the spending needs of the 75 and up US cohort best. Depending on how risk-averse a planner’s client is to missing their potential spending needs, this factor should be increased for those more risk averse.
Ultimately, the traditional approach of fixing retirement planning must be re-examined by financial planners. As we can see, employing the traditional methodology is likely to cause retirees and retirement savers to appear underwater in the plans. This can cause several pernicious effects like abandoning efforts to save, mis-allocation of portfolios and selection of wrong financial products in retirement. Since the fundamental goal of a financial planner ought to be maximizing a customer’s financial outcome given their needs and assets, ensuring an accurate representation of the clients needs is a necessary first step in properly planning for a client’s future.
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