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Retirement income: Why spending patterns are important

(MoneyWatch) Whether or not you expect your future retirement spending to increase, stay the same or decrease has a dramatic impact on the amount of retirement savings you need and, consequently, when you can afford to retire. Welcome back to my third post this week on the topic of spending during your retirement years. My previous posts explored data that suggests retirees' spending decrease as they age, but I cautioned readers about relying too much on this assumption for their retirement planning.

First, let me point out that in most situations, assuming you'll actually spend less in terms of dollars as you age is dangerous when you take inflation into account. At the very least, I'd assume level spending in dollar terms; this means you think you'll buy less stuff as you get older, but inflation will make the stuff you buy more expensive. In this case, you're assuming that your reduced spending would neutralize the impact of inflation and that you could plan on sources of income that remain level over time. One possible situation where it might make sense to assume you'll actually spend fewer dollars in the future might be if it's reasonable to expect a significant drop in your living expenses, say, by paying off your mortgage.

This assumption -- whether or not you need retirement income that increases over time -- is critical. You can see this by taking a look at my recent retirement income scorecard for immediate annuities. Suppose a 65-year-old couple with $100,000 in savings buys an immediate annuity to generate their retirement income. With an annuity that's fixed in dollar amount, they'd receive an initial annual income of $5,615, compared to the initial annual income of $3,343 they'd receive with an inflation-indexed annuity where the monthly income increases each year by the Consumer Price Index (CPI) rate. The initial income is 68 percent higher with a fixed annuity.

Put another way, suppose the couple mentioned above needs an initial amount of annual retirement income of $10,000 to supplement their Social Security income and any pension they might have. If they bought an annuity with a fixed monthly income, they'd need about $178,000 in retirement savings to generate that amount. But if they bought an annuity with income that increased for inflation, they'd need about $299,000 -- an increase of more than $120,000 -- in retirement savings.

If instead you used systematic withdrawals to generate retirement income, you'd see similar differences if you assumed you'd never increase your withdrawals for inflation. In Wade Pfau's recent excellent article, "How Do Spending Needs Evolve During Retirement?" he shows one example where the annual withdrawal rate is 4.15 percent factoring in the income increases for inflation, whereas the withdrawal rate would be 5.55 percent assuming no increases for inflation. In this case, the retiree could retire with 25 percent less in savings if he or she accepted an income that remained level over time.

So what should you do when planning your retirement? When deciding how to generate retirement income from your savings, consider the entire picture regarding spending and income, and how you expect your spending to change during your retirement. Some people may feel more comfortable if they plan for most of their retirement income to increase for inflation. Others may decide they don't need to plan for full inflation increases on all of their retirement income; after all, Social Security income is already increased for inflation, and it's an important component of most people's total retirement income.

In this case, it may be reasonable for you to buy a fixed annuity upon retirement with part of your retirement savings so that together with Social Security income you've covered your basic living expenses. Then you could invest and draw down the remainder of your retirement savings and use this money as a reserve for inflation if your spending increases, or if you need additional income in your later years to pay for long-term care.

My advice: Don't plan for an average retirement by relying on average spending patterns. Instead, spend the time to plan for sources of retirement income that meet your individual spending needs. You'll feel more confident about your retirement if you do.

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